Tax optimization consists of lowering the amount of tax liability by complying with the tax obligations in force in a given state/country by using the regulations to the taxpayer’s advantage. The taxpayer will thus use and take advantage of the tax mechanisms put in place by the State in order to reduce their share of taxation. Tax optimization can be used by both individuals or companies to reduce their tax liabilities and charges.
The term optimization means to improve an established method or mechanism for the purpose of improvement and increased profitability. Tax optimization hence means using the law to reduce the tax burden and is a legal mechanism, in comparison with tax fraud, which is prohibited. Tax optimization also needs to be distinguished from tax evasion, which consists in using illegal means to avoid paying taxes and involves misrepresentation of the actual income to the Internal Revenue Service.
An illustration of tax optimization can be found in the practice of yacht-owners registering their boats in countries where the registration of such boats is cheap and where foreign income is tax-exempt. Such mechanisms are legal and are used by individuals to reduce their tax liability. Another illustration is income deferral: as the IRS does not tax the money saved in pension plans, retirement savings plans and universal life insurance, some individuals keep their money in those plans and only withdraw the money and use it when they are in a lower tax bracket.
[Last updated in April of 2022 by the Wex Definitions Team]