May 24, 2022
The difference between avoidance and evasion
In his 2003 book “Perfectly Legal” writer and investigative reporter David Cay Johnston delves into the U.S tax laws. His mission was to show how the very rich escape– in a perfectly legal fashion–the paying of taxes.
The book raised both eyebrows and concerns. Is the U.S. tax system rigged to benefit the very rich and hoist the tax burden on the working class?
The loophole that no one–except one guy–noticed
Section 501(c)(3) of the tax code authorizes deductions made to charities. Subsection 15 authorized tax-exempt insurance companies. These “mutual” or premium-payer owned, companies served rural farmers and were basically non-profit. The mission was to keep premiums low and spread the risk (of a burned-down barn or crop) to all owner-members.
In 1986 the law changed. The insurance companies no longer had to be mutual, they could be owned by investors. Limitless capitol could be invested into the market through these companies, far more than would ever be paid out in claims. It was a perfectly legal way to make money. Ethical considerations aside, this was a tax avoidance strategy.
What tax planning does (avoidance)
There are many ethical and legal ways to manage your money. One part of money management is tax planning. Tax planning is looking at your assets and then figuring out the best way to keep most of your money. You know you have to pay some taxes, but you want to pay the least you have to. By being smart with the way you invest and spend money you can preserve and potentially grow your investments.
When you use tax avoidance strategies you work to minimize your taxable income and maximize your deductions and credits. Good tax planning also takes into account the timing of transactions.
A micro example of tax avoidance and evasion
Tax avoidance could be thought of like this: You want a $1,000 gold ring. It is available at two stores, one in a fictional suburb, Goldlandia, 10 miles from your house, and one in the fictional city center Ouchiewawa, nine miles from your house.
- If you buy the ring in Goldlandia you pay 6.25% tax, the basic state tax.
- If you buy the ring in Ouchiwawa you pay the state tax (6.25%) plus the 1% county tax, plus the 1% city tax plus a special 2% tax, and a 1% transportation tax. Plus, you will pay $15 to park.
So, the same ring costs you $1,062.50 in the suburb 10 miles away with free parking, but $1,127.50 if you drive one mile less but buy it in the city. You save $65 by driving one extra mile. Tax avoidance is choosing to buy the ring in the suburbs. (This is assuming gas prices do not go up to $100 a gallon). If you wait until Goldlandia’s anniversary sale and save an additional 15% you are really taking advantage of tax planning.
Tax evasion is asking the clerk to sell you the ring and not charge any tax at all. Maybe you convince the clerk that you have a tax ID number and you are a jeweler who will use the simple gold band as a base for one of your creations. Let’s say you are not a jeweler, performer, actor, or artist, and just want to wear the ring yourself. This is one form of tax evasion. If you also attempt to write off the ring as a business expense, this would be another form of tax evasion.
You, and most of us, want to pay our taxes intelligently and by the rules. We can do this when we take advantage of allowable deductions (reducing your taxable income), and credits (dollar-for-dollar reduction on your tax bill) and are mindful of timing.