When it comes to lowering your tax bill, it is crucial to make sure you are avoiding taxes and not evading them. Here’s the difference:
- Tax avoidance is the use of governmentally-sanctioned legal methods to minimize, defer or eliminate your tax liability.
- Tax evasion is when illegal means are used to not pay your taxes. Evasion can include not reporting income or investment profits and/or claiming fake business expenses. It can also be complex through the use of trusts and partnerships to create sham transactions.
Why Tax Avoidance is Good
The government supports tax avoidance because it has social goals and uses the tax code to foster them.
The social goal is for people to have money to take care of themselves when they’re no longer working. The government wants its citizens to be financially secure, so it forgoes money presently. Thus, when you put money into a qualified retirement plan, you take a tax deduction.
Charity: The social goal is to assist others. When you make contributions to recognized charitable causes, you get a tax deduction.
Community Development: The social goal is to increase investment in distressed communities to foster economic development and job creation. Most recently, the Tax Cuts and Jobs Act of 2017 created economic opportunity zones with tax deferment, elimination and reduction options.
Five Ways to Avoid Taxes
1. Use of qualified retirement plans
Money put into a qualified retirement plan is tax deductible and grows tax deferred. The tendency is to go with a defined contribution plan— such as the well-known and highly familiar 401(k) plan. That could be shortsighted, however. Defined benefit plans—or DB plans allow business owners to put in a lot more money.
2. Use captive insurance companies
A captive insurance company is a closely-held insurance company set up to insure the risks of the parent company. The owners of the parent company wholly own the captive insurance company. That means the owners control the operations—including underwriting, claims decisions and the investment strategy. The underlying reason to use a captive insurance company is risk management. There are different types of captive insurance companies that are appropriate for different business scenarios. In all cases, however, business owners can use them to reduce income taxes.
3. Use charitable trusts and pooled income funds
Gift appreciated equity in your business to a charitable trust or pooled income fund and when it sells it, the capital gains taxes on the equity will be eliminated. A percentage of the money can provide you (or someone you designate) with an income stream for the rest of their lives. And finally, a nonprofit of your choosing will end up benefiting. The upshot: These are very powerful tools to eliminate capital gains taxes when selling a business or a stock.
4. Use partnerships
Disharmony among family members or unrelated business partners can also mean a higher tax bill. Through the use of partnership structures, business owners can structure a division of their companies. As a general rule, any asset that is contributed to a partnership can be distributed from a partnership to a partner, tax free. There is no need for disgruntled partners to continue to work together—and they pay taxes only on the businesses they control. Finally, if you’re really successful, you might owe estate taxes when you die. With thoughtful planning, you may be able to significantly reduce— and even eliminate—estate taxes.
5. Freeze the value of a business
You can lock in the current value of your business for estate-tax purposes. If your company increases in value between now and when you sell it, the appreciation over that time is not included in your estate—and therefore not subject to estate taxes.
Why Tax Avoidance is Good
All of these types of tax avoidance approaches are called “bright-line transactions.” That means there are no questions about their legality, as they are clearly specified in the tax code. Moreover, every capable tax professional—lawyers, accountants, Personal CFO’s and the like—would know about these and other ways to help you legally avoid taxes. The catch, however, is working with a capable tax professional who keeps current on ever-changing tax laws. If your accountant, attorney and Personal CFO are all capable tax professionals, your ability to take advantage of even more ways to avoid taxes will open up.
Important: High-quality tax professionals all have access to the same legal tax strategies. No strategies are secrets known only to a few. If someone claims to have a proprietary tax strategy, it’s a red flag that he or she could be veering into tax evasion territory. At a minimum, you should get a second opinion on that strategy’s legitimacy.
ACKNOWLEDGMENT: This article was published in partnership with the VFO Inner Circle, a global financial concierge group working with affluent individuals and families and is distributed with its permission. Copyright 2020 by AES Nation, LLC.
This report is intended to be used for educational purposes only and does not constitute a solicitation to purchase any security or advisory services. Securities and advisory services offered through Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. Kevin Best and Best Times Financial Planning are not affiliated with AES Nation, LLC. Commonwealth Financial Network® nor Best Times Financial do not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation.