Tax Avoidance vs. Tax Evasion: Key Differences Explained

Introduction

The main objective of a tax advisor is to help clients reduce their tax burden as much as possible within the confines of the law, so as to avoid crossing the line into tax evasion. In this role, the tax advisor guides clients based on the legal distinctions between tax avoidance and tax evasion. This paper compares these two concepts using Gregory v. Helvering as a central reference point, along with several other cases that cite that decision. The discussion examines how these cases illuminate the practical boundaries between lawful tax reduction and illegal tax evasion, and how an individual can minimize taxes without violating the law. The paper also addresses whether tax liability minimization falls under tax avoidance or tax evasion.

Comparison of Tax Avoidance and Tax Evasion

The American income tax system is based on the principle of voluntary compliance, under which taxpayers bear the responsibility of reporting all their income. Nevertheless, taxation remains a highly controversial and divisive issue. As a result, some people attempt to avoid or evade taxes — including by failing to report certain money-making activities — which is considered illegal and a violation of the law. The tendency among some individuals to evade taxes is itself partly attributable to the principle of voluntary compliance: because the government expects citizens to report their income freely and calculate their tax liability correctly, filing timely and accurate returns depends heavily on individual honesty. In practice, however, this ideal is frequently undermined by the adoption of tax avoidance and tax evasion strategies (Murray, 2017).

Throughout the years, tax avoidance and tax evasion have been used interchangeably, though they are fundamentally different concepts. The major distinction is that tax avoidance is legal while tax evasion is illegal (Murray, 2017). Individuals or businesses get into trouble with the Internal Revenue Service (IRS) when they deliberately engage in tax evasion. By contrast, individuals or businesses can work with a tax advisor to implement strategies that legally reduce their tax obligations without running afoul of the IRS.

Tax avoidance can be described as actions undertaken by a taxpayer — whether an individual or a business — to reduce tax liability and maximize after-tax income. Under IRS regulations, eligible taxpayers are permitted to claim income adjustments, credits, and deductions in order to lessen their total tax liability. For instance, businesses can avoid taxes by establishing employee retirement plans or using other legal mechanisms to reduce their tax burden. An illustrative case citing Gregory v. Helvering is The Sherwin-Williams Company v. Commissioner of Revenue. In that case, Sherwin-Williams challenged the 1991 tax assessment and the disallowance of nearly $47 million that the company had deducted from its taxable income for royalty payments made to two passive investment firms (Leagle, 2002). The court found that Sherwin-Williams was not motivated by improper tax avoidance in making those payments, and that the transactions carried genuine economic substance rather than being driven solely by tax benefit considerations.

Tax evasion, by contrast, is an illegal activity involving the use of various techniques to avoid paying taxes that are legally owed. While individuals or businesses engaging in evasion may be carrying out otherwise lawful activities, they become liable for tax evasion when their underlying motivation is to avoid paying what they owe. According to Murray (2017), the most commonly employed evasion techniques include failing to report income, failing to pay taxes owed, and claiming expenses that are not legally permitted. Individual taxpayers also evade taxes by failing to report income from activities in the underground economy, while businesses may engage in evasion through manipulation of state sales taxes and employment taxes or through illegal practices related to excise taxes and other federal, state, and local obligations (Murray, 2017).

A landmark illustration of the evasion boundary is Gregory v. Helvering itself, in which Evelyn Gregory treated the transfer of Monitor Securities Corporation's stock — through United Mortgage Corporation, a company she wholly owned — as capital gain on her federal tax return. Gregory orchestrated the reorganization of United Mortgage Corporation in technical compliance with all statutory requirements for corporate reorganization, thereby attempting to claim the tax benefits available to shareholders during such restructurings (Leagle, 1935). However, the Supreme Court ruled in favor of the federal tax commissioner, finding a deficiency in Gregory's taxes. Although Gregory met every technical statutory requirement and correctly characterized the transaction as capital gains, her actions were motivated by tax evasion rather than any genuine business purpose. She was therefore found guilty of tax evasion because her conduct was driven by illegal intent to avoid paying taxes rather than by a legitimate corporate objective.

Examples of Tax Avoidance

One of the most commonly used tax avoidance strategies is forming a limited liability company (LLC) in order to reduce personal tax liability. An LLC functions as a pass-through tax entity, which makes it a legal mechanism for tax avoidance. Unlike a corporation, an LLC can provide an individual or business with significant tax savings. The primary advantage is flexibility in taxation: the owner can choose to be treated as a disregarded entity or to obtain corporate treatment, depending on desired personal income levels and the amounts to be reinvested in the business. Both approaches can yield substantial tax savings.

Another way an LLC can limit personal tax liability is through leasing assets to a corporation. Leasing personal assets to a corporation allows an individual to create a deductible business expense for the LLC while simultaneously increasing personal income. A relevant example is Niuklee, LLC v. Commissioner (2015), in which the co-founder of Hometown Quotes, LLC, formed Niuklee LLC to purchase and lease an aircraft (Leagle, 2015). He formed Niuklee after carefully considering both his own personal liability and the tax consequences of using the LLC to buy and lease the aircraft. The court found that his decision to create Niuklee for this purpose was a legitimate business decision rather than an improper tax avoidance scheme. The court also determined that Niuklee was exempt from sales and use tax on the purchase of the aircraft — a Cessna C-400. Through this approach, the taxpayer effectively and legally reduced his tax exposure by forming a limited liability company.

A second example of tax avoidance is the use of inter-firm royalty payments, which enables businesses to reduce their tax burden in a manner approved by federal, state, and local law. Governments generally allow deductions for royalty payments, and since such payments are a deductible expense under the U.S. tax system, they reduce the business's overall tax liability. The legitimacy of this strategy is demonstrated by The Sherwin-Williams Company v. Commissioner of Revenue (2002). In that case, Sherwin-Williams challenged the 1991 tax assessment and the disallowance of nearly $47 million it had deducted for royalty payments made to two passive investment companies: Dupli-Color Investment Management Company (DIMC) and Sherwin-Williams Investment Management Company (SWIMC) (Leagle, 2002). Both SWIMC and DIMC were incorporated in Delaware in 1991 and were eligible for exemption from that state's corporate income tax. After transferring legal title of its trademarks to the two companies, Sherwin-Williams licensed them back and paid royalties accordingly.

The court determined that the transfer of legal title and the license-back arrangement constituted legitimate business transactions not motivated by improper tax avoidance. The court further found that the transactions had real economic substance, as demonstrated by the income earned and the investment activities and obligations of SWIMC and DIMC. The royalty payments were therefore recognized as a lawful tax avoidance strategy, particularly given their genuine economic effect.

Conclusion

Individual taxpayers and businesses need to engage in careful tax and financial planning, ideally with the assistance of qualified tax advisors. During the planning process, taxpayers must ensure that their strategies comply with the law in order to avoid conflict with the IRS. This is especially important given the frequent confusion between tax avoidance and tax evasion — two concepts that are commonly used interchangeably but refer to fundamentally different practices. Tax avoidance is a legitimate means of reducing taxes and increasing after-tax income through IRS-approved methods, while tax evasion is the illegal practice of failing to pay taxes through means such as falsifying income or expenses or deliberately underpaying. As the cases discussed in this paper illustrate, tax avoidance is a lawful practice, whereas tax evasion is illegal and can result in significant penalties and legal liability. Furthermore, tax liability minimization falls squarely within the category of tax avoidance, as it relies on IRS-sanctioned methods to reduce taxes while maximizing after-tax income.

References

Leagle. (2013). Bank of N.Y. Mellon Corp. v. Commissioner. Retrieved June 29, 2017, from http://www.leagle.com/decision/In%20TCO%2020130211A00/BANK%20OF%20NEW%20YORK%20MELLON%20CORPORATION%20v.%20COMMISSIONER%20OF%20INTERNAL%20REVENUE

Leagle. (1935). Gregory v. Helvering. Retrieved June 29, 2017, from http://www.leagle.com/decision/1935758293US465_1704/GREGORY%20v.%20HELVERING

Leagle. (1935). Maguire v. Commissioner of Internal Revenue. Retrieved June 29, 2017, from http://www.leagle.com/decision/In%20TCO%2020120606E18/MAGUIRE%20v.%20COMMISSIONER%20OF%20INTERNAL%20REVENUE

Leagle. (2015). Niuklee, LLC v. Commissioner. Retrieved June 29, 2017, from http://www.leagle.com/decision/In%20TNCO%2020151116579/NIUKLEE,%20LLC%20v.%20COMMISSIONER

Leagle. (2015). Our Country Home Enterprises, Inc. v. Commissioner. Retrieved June 29, 2017, from http://www.leagle.com/decision/In%20TCO%2020150713A66/OUR%20COUNTRY%20HOME%20ENTERPRISES,%20INC.%20v.%20COMMISSIONER%20OF%20INTERNAL%20REVENUE

Leagle. (2002). The Sherwin-Williams Company v. Commissioner of Revenue. Retrieved June 29, 2017, from http://www.leagle.com/decision/2002509438Mass71_1504/THE%20SHERWIN-WILLIAMS%20COMPANY%20v.%20COMMISSIONER%20OF%20REVENUE

Mgammal, M. H., & Ismail, K. N. I. K. (2015, December). Corporate tax planning activities: Overview of concepts, theories, restrictions, motivations and approaches. Mediterranean Journal of Social Sciences, 6(6), 350–358.

Murray, J. (2017, February 28). What is the difference between tax avoidance and tax evasion? Retrieved June 29, 2017, from https://www.thebalance.com/tax-avoidance-vs.-evasion-397671