The terms "avoidance" and "evasion" are words of art under federal tax law. Avoidance involves the legitimate and legally permissible choice of methods of arranging a taxpayer's affairs, all methods being bona fide and legal, but some of which will eliminate or reduce certain tax liabilities. Evasion involves the use of colorable, fictitious or concealed transactions to reduce taxes and implies fraud, deceit and sham.
As the renowned Judge Learned Hand famously stated: "Over and over again, courts have said that there is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich and poor; and all do right, for nobody owes any public duty to pay more than the law demands; taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant" [Comm'r. v. Newman, 159 F.2d 848 (2nd Cir. 1947) (dissenting opinion at 850)].
A later opinion of the United States Court of Appeals, Sixth Circuit (citing three Supreme Court decisions), stated: "The general principle is well settled that a taxpayer has the legal right to decrease the amount of what otherwise would be his taxes, or altogether avoid them, by means which the law permits... and that the taxpayer's motive to avoid taxation will not establish liability if the transaction does not do so without it" [Chamberlin v. Comm'r, 207 F.2d 462, 468 (6th Cir. 1953), citing, e.g., Gregory v. Helvering, 293 U.S. 465 (1935)].
Substance vs. form
Taxpayers may properly structure any legitimate transaction in order to save taxes, provided that any transaction is, in fact, what it appears to be in form. As stated by the United States Supreme Court: "The incidence of taxation depends upon the substance of a transaction... To permit the true nature of a transaction to be disguised by mere formalities, which exist solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress" [Comm'r v. Court Holding Co., 324 U.S. 331 (1945)]. This doctrine of "substance-over-form" must always be borne in mind by financial advisors when tempted to structure transactions in a form solely for tax purposes, which does not accord with the true economic substance of the matter at hand. Literal compliance with tax statutes may not insulate transactions against challenge. The IRS is able to re-characterize the form of a transaction to reflect its true economic substance.
Be wary of any scent of tax abuse
Don't be sold on a tax avoidance arrangement that is specifically designed to exploit a loophole. Tax loopholes are not like they used to be -- when technical gaps in the Code or clever manipulation of provisions to operate in an unintended manner could be exploited until Congress acted to amend the Code. Now the IRS has expanded loophole fighting authority and vigilance, and is quick to act administratively to thwart abuses. From situations as widespread as the abusive leveraged COLI arrangement (the so-called "janitor insurance" bought into by hundreds of the largest corporations), down to small business schemes -- the lure may be enticing, but the ultimate consequences can be very costly.
Life insurance delivers reliable tax benefits
One of the powerful and reliable tax benefits of a life insurance contract is the accumulation of cash value for the benefit of the policy owner, year by year, without any current taxation of these annual increases. This is often referred to as tax-deferred "inside build-up" of cash value. In this respect, a life insurance contract is an important tax avoidance tool: earnings can accumulate and compound tax-free as long as they remain within the shelter of the insurance contract.
For a comparative analysis and comprehensive discussion see the article: "Life Insurance Offers Tax Advantaged Asset Accumulation" in AUS
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