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What is Tax Planning and How Does It Work?

What is Tax Planning and How Does It Work?

April 21, 2023

While the nature of tax planning is obvious, there seems to be some confusion over the difference between tax evasion and tax avoidance. As such, you should be fully aware of the tax practices being used.

As a full-service wealth management firm, we see a lot of different situations and circumstances which each require individual custom strategies to make the most out of your personal situation.

Utilizing top-tier technology and resources to provide maximum value to our clients, our firm has incorporated annual tax planning as part of our comprehensive financial planning process. While often overlooked, robust tax planning is one of the most valuable pieces of a complete financial plan, and we are excited to offer it to you.

In this article, we are going to cover the three main topics of Tax evasion, Tax avoidance, and Tax planning to discuss the benefits of having these strategies implemented as well as some of the misconceptions.

1. Tax planning for long-term benefits

Tax planning, like tax avoidance, is totally legal. Generally, tax planning is the process of maximizing your tax benefits under eligible provisions of the tax framework. It reduces your tax liability through a variety of means, namely deductions, credits, rebates, contributions to tax-advantaged accounts, and exemptions provided under the Income Tax Act or the corresponding tax laws.

To give an example, you can look for incentives from tax planning by contributing to your 401k. You can also make investments in specific investments such as tax-advantaged mutual funds, ETFs, or other similar accounts for the reduction of tax liability of the income generated from interest/dividends rather than claiming it as earned income which may affect your taxability of Social Security or cost of Medicare.

A key feature of tax planning is its relation to the future, whether short-term or long-term. To bring the best possible outcome for tax planning, you should take some essential factors into consideration:

  • Choice of business entity
  • Timing of income
  • Taxability of income/capital gains distributed.
  • Flexibility in case of emergency capital required.
  • The owner’s residency status
  • Capital Structure of your business

Among the three methods, tax planning is the most upright approach because it complies with the provisions of the tax laws. There are many strategies for good tax planning, but like most things being proactive and intentional with when/how/ and which form of compensation you receive may make all the difference.

WHY IS TAX PLANNING IMPORTANT?

Taxes touch every part of your financial life. Your tax return is a financial fingerprint: it's completely unique to you, complete with valuable clues and information, all of which is buried in dozens of pages and hundreds of numbers. Understanding your return equips us to have more valuable and actionable conversations with you. Additionally, we can demystify the world of income taxes and help you understand this important piece of your financial picture.

 2. Tax avoidance is 100% legal

You can get into a muddle over the meaning of tax evasion and tax avoidance. Those two terms may seem similar, but in fact, they are infinitely different. A highlight to note down is that tax avoidance is legal, whilst tax evasion is not.

Tax avoidance is the act of minimizing tax liability within the limits of the law or without breaking the law. In other words, you can use legitimate methods to reduce the amount of tax payable in association with your financial activities. The methods to avoid paying taxes to the government may include the following:

  • Using tax deductions for decreasing business expenses and business tax bill
  • Delaying the payment of tax until a later date with an appropriate tax deferral plan (SEP IRA/Traditional IRA/Cash Balance 401k)
  • Taking advantage of tax credits for legal purposes like business purchases, benefiting the company’s employees for sick leave and family leave
  • Sheltering revenue from tax liability through the establishment of employee retirement plans.
  • Utilizing strategies in today’s (after-tax) dollars to grow your money tax-free to reduce your tax liability in your distribution years (such as Roth IRA/Cash-Accruing Life Insurance)

 

It is also important to know that seeking reductions of tax obligations by tax avoidance is 100% legal, but it must be within four corners of the tax law framework. In some cases, it may lead you to step beyond the line to tax evasion, hence a violation of the jurisdiction regulations.

Thus, you should gain a good hold of relevant knowledge before using any tax strategies for minimizing taxes, and in most cases, these strategies are done in advance before you are hit with a tax liability rather than after tax season.

In addition, you should engage financial experts for legal advice on how tax avoidance can be utilized most efficiently.

3. Tax evasion is the same as tax fraud

Tax evasion is an illegal method or unlawful attempt to reduce the tax liability of taxpayers. It refers to techniques or illicit practices of showing fewer profits to minimize the individual or company’s tax burden.

Examples of tax evasion usually are the following:

 

  • Making false statements and information
  • Inflating deductions without legal proof
  • Hiding related documents to prove the earned business profits like records of transactions or reports of cash income.
  • Concealing or transferring assets illegally
  • Magnifying tax credit
  • Claiming excessive expenditure

 

Tax evasion is a form of tax fraud that indicates illegitimate and deliberate actions for not paying taxes. Since employing such unfair means is fraudulent, any taxpayer regardless of individual or business committing tax evasion behaviors would be prosecuted for offense and must be subject to stringent punishments of a heavy fine or imprisonment.

Businesses and high-income earners in search of saving tax often think of these five categories to properly understand the best practice of implementing tax planning strategies to confidently do it in a legal and ethical way.

When it comes to these categories, in the chart below you will see the key differences between tax evasion, tax avoidance, and tax planning to help you get a better understanding.

When it comes to implementing these strategies it is important to ask yourself;

  • What is the purpose?
  • Is it legal?
  • What is the nature of how we are finding savings?
  • When or How are we implementing this strategy?
  • What are the implications or impact if done incorrectly?

Purpose: All serve for tax saving, but tax avoidance aims at minimizing tax, while tax evasion means not paying tax. Tax planning, on the other hand, helps businesses to ensure tax efficiency.

Legality: Both tax planning and tax avoidance are legal. Considered fraud, tax evasion is an illegal method to reduce tax.

Nature: Tax avoidance is performed by using loopholes in the law, but by complying with law provisions and legal precedent. By contrast, tax evasion means employing illegitimate means for nonpayment of tax. Tax planning uses existing law provisions to relieve the burden of tax liability.

When: Tax avoidance is characterized as tax planning, but it is done before tax liability takes place. This method emerges with short-term benefits. Like tax avoidance, tax planning also should be done before tax liability arises, but it is associated with the future and often serves for either long-term or short-term benefits of every individual or entity. On the other hand, tax evasion is typically done after the tax liability has arisen. A reactive measure rather than an initiative-taking measure.


Consequences: Tax avoidance is subject to penalty or imprisonment if it violates the tax regulations. Tax planning is legal, meanwhile, tax evasion must be subject to penalties and other kinds of punishment.

  1. Choosing the right tax reduction strategy

 

In this regard, two essential tips that you need to consider are as below:

  • Acquire knowledge of tax laws and methods for the reduction of tax liability in the most efficient way. Keep in mind, differentiating such methods based on their purpose, legality, and features is very crucial as this would help you stay out of trouble and reduce your chances of penalty.

 

  • Seek advice from a professional tax expert or service firm. Each professional will be able to apply his/her own area of expertise and will always know how to apply the tax law to decrease your tax burden and maximize your benefits. Furthermore, tax regulations are constantly changing, and, whether your tax-saving instrument is correct or not should be put under specific advice upon circumstances by tax experts as well.

 

In conclusion, there are three instruments that taxpayers usually opt for to minimize their tax liability; Tax planning, Tax avoidance, and Tax evasion. Each method provides a different manner for tax reduction. Note, however, when it comes to reducing tax liability the right way, being proactive and aware is the only way to reduce your tax liability in a safe and compliant way.

Thank you for checking out this material Tax Minimizing Strategies. Hopefully, this gives you a better understanding of the differences between Tax Planning, Tax Avoidance, and Tax Evasion.

If you would like to set up a free consultation to see how a custom tax planning strategy could lower your tax liability, contact us today!