Legal tax avoidance is possible. It’s just that sometimes it’s not all that obvious.
- Sometimes avoiding taxes is more subtle. It may be due to the interaction of differing tax regimes.
- Sometimes the IRS objects to the tax avoidance technique being used, but can’t do anything about it until Congress changes the rules.
- And, sometimes certain financial products have been granted tax-favored status.
Below are examples of each of the above tax avoidance opportunities, using three different tax regimes. In all three cases, it is crucial to obtain knowledgeable tax advice in order to make the concepts work.
Employment Tax: It is not uncommon for companies to offer nonqualified deferred compensation arrangements, in which a highly compensated employee defers receiving (and paying tax on) earned compensation. Much like deferring money into a 401(k), the income is currently taxable for FICA employment tax purposes. So, even though an executive defers receiving some salary, he or she pays FICA on that deferred income. Because of the way FICA works, however, this is an opportunity to avoid paying some employment tax. There is a cap ($117,000 currently) on the amount of wages that are subject to the employee FICA tax of 6.2%. Since deferred compensation plans are typically limited to highly compensated employees, these employees have often already reached the FICA income cap through their regular wages. Consequently, it is to the executive’s advantage to have deferred wages treated (currently) as income for FICA. It counts as FICA wages without actually having to pay FICA taxes.
Estate and Gift Tax: Successful family business owners sometimes sell their businesses to a trust for the benefit of the family. By selling the business for an installment note at a low, fixed interest rate the seller has converted an appreciating asset (the business) into a fixed, frozen asset (the installment note). Selling the business to the family trust for a note essentially freezes the value of the business in the seller’s estate. This can save a wealthy family a significant amount of gift and estate tax. The IRS has objected to this concept as a tax avoidance technique, which it can be, but they have been largely unsuccessful in challenging its use. The simple fact is that even though laws have been proposed to limit the tax effectiveness of this technique, they have never been passed by Congress. With proper design and execution, this estate tax freeze concept can save, or totally avoid, gift and estate taxes.
Income Tax: Over the decades, financial products have been created which offer sufficiently positive social outcomes that Congress deems them worthy of tax-favored status. Municipal bonds, for example, can potentially avoid federal income tax on the interest paid. Deferred annuities, used to build retirement capital, are allowed to defer income tax on growth until they are either annuitized or surrendered in later years. And, while the owner’s cash values grow tax-deferred in a life insurance policy, the death benefit can be paid out income tax-free to the beneficiary. A specific tax provision declares death benefits income tax-free. All these are examples of ways to avoid taxes because Congress wants to encourage certain consumer behaviors.
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