What is the difference between tax evasion and tax avoidance?
Let’s start with tax evasion, as that’s the most straightforward the two to understand.
The Merriam-Webster dictionary defines tax evasion as the willful attempt to evade the imposition or payment of a tax.
The Legal Information Institute at Cornell Law School further explains that tax evasion is using illegal means to avoid paying taxes. Typically, tax evasion schemes involve an individual or corporation misrepresenting their income to the Internal Revenue Service. Misrepresentation may take the form either of underreporting income, inflating deductions, or hiding money and its interest altogether in offshore accounts.
In short, tax evasion is what you and I would normally refer to as tax fraud.
In the United States, tax evasion constitutes a crime that may give rise to substantial monetary penalties, imprisonment, or both.
What is tax avoidance?
The IRS defines tax avoidance as the use of tax rules to lessen one’s tax liability and maximize one’s after-tax income. Tax avoidance is perfectly legal. IRS regulations allow eligible taxpayers to claim certain deductions, credits, and adjustments to income, and the IRS expects taxpayers to use them.
If tax avoidance is legal, why does it have such a bad rap?
The issue is an issue of perception, not of legality.
There is a general perception that certain tax rules are written in a way that benefit certain privileged taxpayers at the expense of others less privileged ones.
Other times, tax rules are written hastily, allowing professional tax consultants to find legal ways to circumvent those rules in a manner that provides a benefit to their client, perhaps contrary to the spirit of the rule.
Depending on what side of the fence you are sitting with regards to those rules or provisions, you may view them one way or the other. It the tax rules benefit you, you are more likely to view them as tax relief. If they benefit someone else, especially if it’s someone you don’t like, you are very likely to view them as an unfair loophole!
There is a spectrum of tax planning, tax avoidance and tax evasion, from the non-controversial and 100% legal plain-vanilla tax planning on the left, to controversial and 100% illegal tax sheltering on the extreme right.
On the non-controversial side, there are obvious tax planning tactics everyone is expected to use to legally reduce their taxes. These include basic tax planning actions like taking the standard deduction, making contributions to a retirement account to reduce taxable wages, or making deductible charitable contributions. Not taking such measures to reduce one’s taxes can be viewed as irresponsible. The expectation is that you will.
At the center, there are tax avoidance techniques that may be a little more obscure because they are not available to everyone, like the carried interest rule, or over which there is disagreement about their legality and appropriateness, like some of the positions apparently taken by the President in his tax returns. We will explore some of those shortly.
Finally, on the extreme right end of the spectrum, there is downright tax evasion: the willful misrepresentation of income and deductions in ways not permitted by tax law.
The New York Times report does not mention any obvious instances of tax evasion in the President’s tax returns, but it does mention some deductions and credits that appear a little questionable, or as they put it, “aggressive”.
Which are some of those aggressive tax positions purportedly taken by the President? Here are four examples:
- Assignment of income: The assignment of income doctrine holds that a taxpayer who earns income from services that the taxpayer performs or property that the taxpayer owns generally cannot avoid liability for tax on that income by assigning it to another person or entity. The President is said to have claimed $26 million of “consulting fee” deductions, some of which were paid to unknown consultants, and others to ineligible recipients like his daughter Ivanka, who was already receiving wages as an employee of the Trump organization and who is also a related party to the President.
- Deducting personal expenses as business expenses: $70,000 in hair styling expenses, over $95,000 to Ivanka’s stylist or $2.2 million in property taxes on a potential personal home. The Tax Court has repeatedly rejected personal grooming expenses as deductible business expenses for TV personalities, but the Trumps have deducted hundreds of thousands of dollars of them. Deductible personal property taxes are limited to $10,000 because of tax reform. The President apparently reports a home that does not appear to be rented or used to generate income, as an investment property instead of a personal use home, to avoid the $10,000 property tax limitation and the mortgage interest deduction and deduct over $2,190,000 in additional expenses as a result.
- Abusive conservation easements: conservation easements are voluntary agreements by which a landowner limits the future use of part of their land in exchange for a charitable contribution deduction. Many conservation easements are legitimate, but some have been ruled abusive by the IRS, especially when there is suspicion that the value of the land placed in conservation has been overstated to overstate the charitable contribution deduction and disproportionally reduce taxable income. President Trump used conservation easements to limit his taxes in at least four occasions according to the NYTimes report.
- Inappropriate legal fee deductions: the President apparently deducted as business expenses legal fees paid to attorneys to defend family members from charges related to their participation in political campaigns. Legal expenses can only be deducted when the fees are directly related to running the business
I am not sure that anything will come from this NYTimes report, other than perhaps some embarrassment for the President about the state of his businesses, which for the most part are far from profitable.
Some Democrats have expressed concerns about $400+ millions in loans he holds, some of them apparently foreign, that the President will be required to repay or renegotiate during his second term in office, if he is re-elected. These loans re-negotiations can make him vulnerable to foreign influence or interfere with his capacity to govern.
Other than that, I don’t think anyone is surprised that the President pays very little to no taxes, that he takes very aggressive tax positions on his tax returns and that so far this appears to work extremely well for him.
At least I’m not.
For the rest of us, such aggressive tax positions are unlikely to be a good idea. What is available to us are the myriad of legal ways to reduce one’s taxes without getting into dangerous waters.
And here is our Key Insight of the Week: #10
“Tax evasion is illegal, tax avoidance is legal and good tax planning can avoid taxes without causing tax trouble”
See you again next week.