Five Ways to Avoid—Not Evade—Taxes

Five Ways to Avoid—Not Evade—Taxes

March 05, 2020
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KEY TAKEAWAYS:

  • Tax avoidance is supported by the U.S. government.
  • High-quality tax professionals can help you identify legal strategies that make sense for your situation.
  • Trusts, insurance and qualified plans are three ways to potentially reduce taxes.

When it comes to lowering your tax bill—something seemingly all entrepreneurs want to do—it’s crucial to make sure you’re avoiding taxes and not evading them.* The difference:

  • Taxavoidance is the use of governmentally sanctioned methods—legal methods—to minimize your tax When you’re engaged in tax avoidance, you’re not breaking the law.
  • Taxevasion is when you use illegal means to not pay your Evasion can include not reporting income or investment profits as well as claiming fake business expenses on your (fraudulent) tax return. But it can also be very complex—using trusts, partnerships and other structures (as well as sham transactions) to illegally not pay taxes.

Here’s another way to look at it:

Question: What’s the difference between tax avoidance and tax evasion?

Answer: About four inches.

Why four inches? That’s the width of a typical prison wall! Why would you even want to take the chance?

Why tax avoidance is good

Here’s something most of us don’t fully appreciate: The government supports tax avoidance. They know it’s good for you and good for the country. The government has social goals and uses the tax code to foster them. That’s why the government intentionally creates ways for you to legally lower your tax bill!

Take, for example, the social goal of people having 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.

Another example: charitable contributions. The government wants to promote philanthropy. It’s a social good. So when you make contributions to recognized charitable causes, you get a tax deduction. With the intent of fostering charitable giving, the government has created various tax benefits depending on the way you donate. For example, using a charitable trust to sell some of the equity in your business can enable you to get a tax deduction—as well as avoid capital gains taxes on that equity.

Most recently, the Tax Cuts and Jobs Act of 2017 created economic opportunity zones. The incentive for investors is tax benefits. The social goal is to increase investment in distressed communities and foster economic development and job creation in these areas.

Two purposes of tax avoidance

When you’re using the types of tax avoidance strategies described here, you have two purposes. Arguably, the most important purpose is the social and personal goal. The second purpose is tax mitigation.

Take retirement plans. Having money later in life can be highly advantageous. So too can taking current tax deductions. The money in a qualified retirement plan grows tax free—and there’s the possibility that you’ll be in a lower tax bracket when you eventually withdraw the money from the plan.

There are different types of qualified retirement plans. While most entrepreneurs are familiar with defined contribution plans such as a 401(k), fewer are as aware of defined benefit plans. Business owners could potentially benefit significantly from understanding the pros and cons of the different types of qualified plans.

Five ways to avoid taxes

There are many ways to lower your income tax bill. Some strategies that entrepreneurs tend to consider and benefit most from include:

 1.   Use qualified retirement plans

Money put into a qualified retirement plan is tax deductible and grows tax deferred. For various reasons, not all business owners set up qualified retirement plans. However, among those who do establish such plans, 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—might do a much better job for business owners. One big reason: DB plans can allow business owners to put in a lot more money.

2.   Use captive insurance companies

A captive insurance company (aka a “captive”) is a closely held insurance company set up to insure the risks of the parent company. The owner of the parent company wholly owns the captive insurance company. That means the business owner controls the captive insurance company’s 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, entrepreneurs can use captives to reduce income taxes. Under the right conditions, the premiums paid into a captive insurance company can be tax deductible. A company is then able to get a current-year write-off, even though losses may never occur.

Pro tip: The services of a high-quality accountant can help you get the most from your possible deductions.

There’s also the issue of avoiding capital gains taxes. This is often a big goal when entrepreneurs sell their businesses. Too often, however, entrepreneurs wait until just before the sale to think about capital gains avoidance—at which point it’s generally too late. Instead, consider tax mitigation strategies well before the sale of a business or any appreciated asset.

3.   Use charitable trusts

If you gift some or all of the appreciated equity in your business to a charitable trust and the trust sells it, the capital gains taxes on the equity will be eliminated. A percentage of the money in the trust can also be used to provide you (or someone you designate) with an income stream. Also—and perhaps most important—a nonprofit of your choosing will end up getting funding.

The upshot: Charitable trusts are very powerful tools for entrepreneurs because they’re one of the few ways to eliminate capital gains when selling appreciated assets such as a business. They’re also a way for entrepreneurs to provide money to loved ones and charitable causes they care about.

4.   Use tracking partnerships

Within the business world, disharmony among family members or unrelated business partners can also mean a higher tax bill if the owners are forced to divide assets among its members. Through the use of sophisticated partnership structures, entrepreneurs can structure a division of their companies, eliminating capital gains taxes at that time.

As a general rule, any asset can be contributed to a partnership and 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, there’s estate taxes. If you’re really successful, you might create enough personal wealth that you’ll owe estate taxes when you die. But with careful and thoughtful wealth planning, you may be able to significantly reduce—and maybe even eliminate—future estate taxes.

5.   Freeze the value of a business

You can lock in the current value of your business for estate tax purposes. This means if your company increases in value between now and when you sell it, for instance, the appreciation over that time is not included in your estate—and therefore not subject to estate taxes.

Working with a high-quality tax professional

All of these types of tax avoidance approaches are called “bright line transactions.” That means there’s no question about their legality, as they’re clearly specified in the tax code. Moreover, every knowledgeable and capable tax professional—lawyers, accountants, wealth managers and the like—should know about these and other ways to help you potentially legally avoid or reduce taxes.

The catch, however, is working with a knowledgeable and capable tax professional.

The tax professionals you want to work with will not only be very technically adept, but will also seek to truly understand you—your personal and professional objectives and dreams, concerns, and anxieties. Armed with an in-depth understanding of your world, a high-quality tax professional can work with you to design and implement solutions that are best suited to serve your particular situation in terms of tax mitigation.

Important: High-quality tax professionals all have access to the same legal tax mitigation strategies. Because of the formal government-created tax code, no strategies are secrets known only to a few. Indeed, if someone claims to have a proprietary tax strategy, it’s a potential red flag that he or she could be veering into tax evasion territory. At a minimum, you should probably get a second opinion on that strategy’s legitimacy.

Best advice: Avoid taxes as best you can, using the advice of smart tax pros—but stay on the right side of that wall by steering clear of all tax evasion strategies and the people who peddle them.

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Disclosure: Tax laws are subject to change, which may affect how any given strategy may perform. Always consult with a tax advisor.

Securities offered through LPL Financial, Member FINRA/ SIPC. Financial Planning offered through M Financial Planning Services, a registered investment advisor and separate entity from LPL Financial. VFO Inner Circle and AES Nation, LLC are not affiliated with LPL Financial.

ACKNOWLEDGMENT: This article was published by 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. Past performance is no guarantee of future results. An investment in any security involves significant risks and any investment may lose value. Refer to all risk disclosures related to each security product carefully before investing.