Tax avoidance is reducing the tax that would otherwise be owed, by means the law permits. It covers claiming a deduction or a credit the statute allows, making an election the Code offers, choosing a permitted method of accounting, timing when income and expense fall, funding a retirement account, and choosing one entity form over another.
None of that is a loophole. The Supreme Court has said that a taxpayer’s legal right to decrease what would otherwise be his taxes, or to avoid them altogether, by means which the law permits cannot be doubted (Gregory v. Helvering, 293 U.S. 465, 469, US Reports).
What Counts as Tax Avoidance
Deductions are the plainest case, because the Code allows them by listing them. In computing taxable income under section 63, there shall be allowed as deductions the items specified in that part, subject to the exceptions in part IX for items not deductible (26 U.S.C. 161, allowance of deductions). Taking one the statute grants is the statute working as written. Credits reduce tax rather than taxable income, and that difference is set out in tax credit.
Retirement saving arrives by the same route. There shall be allowed as a deduction an amount equal to an individual’s qualified retirement contributions for the taxable year, subject to the dollar cap in subsection (b) and, where the individual or spouse is an active participant in an employer plan, the phase-out in subsection (g) (26 U.S.C. 219, retirement savings).
The method of accounting is a choice too, and not one choice for the whole enterprise. A taxpayer engaged in more than one trade or business may, in computing taxable income, use a different method of accounting for each (26 U.S.C. 446(d), taxpayer engaged in more than one business). Which methods are permitted, and what it takes to move off one, are in accrual accounting.
An election is avoidance as well, made by choosing a treatment the Code offers. The S corporation election runs on a clock, which is what makes it planning rather than hindsight. An election to be an S corporation may be made at any time during the preceding taxable year, or during the taxable year itself on or before the 15th day of its 3d month (26 U.S.C. 1362(b), election, revocation, termination). Who may elect and what changes once it takes effect are in S corporation and C corp vs S corp.
How Avoidance Shows Up in a Firm’s Work
Nobody in a firm argues about avoidance in the abstract. It arrives as a position on a return, and a position either carries enough authority to stand on its own or it gets disclosed. What those standards demand of the preparer who signs is in the position your firm signs.
Disclosure has a form of its own. Form 8275 is used by taxpayers and tax return preparers to disclose items or positions, except those taken contrary to a regulation, that are not otherwise adequately disclosed on a tax return, and it is filed to avoid the portions of the accuracy-related penalty due to disregard of rules or to a substantial understatement of income tax for non-tax shelter items if the return position has a reasonable basis (IRS, Instructions for Form 8275, revised 10/2024). A position taken contrary to a regulation goes on Form 8275-R.
Some transactions get reported whatever the strength of the position on them. Form 8886 discloses information for each reportable transaction a taxpayer participated in, one category of which is the listed transaction, meaning one that is the same as or substantially similar to a type the IRS has determined to be a tax avoidance transaction and has identified as a listed transaction by notice, regulation, or other form of published guidance (IRS, Instructions for Form 8886, revised 10/2022). Filing it concedes nothing, because the same instructions say the fact that a transaction must be reported does not mean the tax benefits from it will be disallowed.
What Tax Avoidance Is Not
It is not tax evasion, which is the willful attempt to evade or defeat a tax that is owed and is a federal felony. The elements and the penalties are in tax evasion, and where the line falls on a live position is in tax avoidance vs evasion.
Common Questions
Yes. The word describes lawful reduction, so the question on any position is whether the law permits it, not whether the saving looks large. Opting out of paying altogether is a different question, and the offenses that answer it are in tax evasion.
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