The
Basics of Tax Planning
Tax planning is a process of
looking at various tax options in order to determine when, whether,
and how to conduct business and personal transactions so that
taxes are eliminated or reduced. As an individual taxpayer, and as a
business owner, you will often have the option of completing a taxable
transaction by more than one method. The courts strongly back your right
to choose the course of action that will result in the lowest legal
tax liability. In other words, tax avoidance is entirely proper.
Although tax avoidance planning is legal, tax evasion — the reduction of tax through deceit, subterfuge, or concealment — is not. Frequently, what sets tax evasion apart from tax avoidance is the IRS's finding that there was some fraudulent intent on the part of the taxpayer. The following are four of the areas most commonly focused on by IRS examiners as pointing to possible fraud:
- A failure to report substantial amounts of income, such as a shareholder's failure to report dividends, or a store owner's skimming from the cash register without including it in the daily business receipts.
- A claim for fictitious or improper deductions on a return, such as a sales representative's substantial overstatement of travel expenses, or a taxpayer's claim of a large deduction for charitable contributions when no verification exists.
- Accounting irregularities, such as a business's failure to keep adequate records, or a discrepancy between amounts reported on a corporation's return and amounts reported on its financial statements.
- Improper allocation of income to a related taxpayer who is in a lower tax bracket, such as where a corporation makes distributions to the controlling shareholder's children.
How a tax plan works. There are countless tax planning strategies available, particularly if you own a small business. Some are aimed at your individual tax situation, some at the business itself. But regardless of how simple or how complex a tax strategy is, it will be based on structuring the transaction to accomplish one or more of these often overlapping goals
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Reducing the amount of taxable income
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Reducing your tax rate
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Controlling the time when the tax must be paid
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Claiming any available tax credits
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Controlling the effects of the Alternative Minimum Tax
- Avoiding the most common tax planning mistakes
In order to plan
effectively, you'll need to estimate your personal and business income
for the next few years. This is necessary because many tax planning
strategies will save tax dollars at one income level, but will create a
larger tax bill at other income levels. You will want to avoid having
the "right" tax plan made "wrong" by erroneous income projections. Once
you know what your approximate income will be, you can take the next
step: estimating your tax bracket.
The effort to come up
with crystal-ball estimates may be difficult and by its nature will be
inexact. On the other hand, the better your estimates, the better the
odds that your tax planning efforts will succeed.
The thought of spending time reading about income taxes probably rates right up there with having a root canal without painkillers.
So why should you
spend your time reading about income taxes? Even if you use software or
delegate the preparation of tax returns to your accountant or
professional preparer, the ultimate responsibility for a missed payment
or filing deadline, an improperly claimed deduction, some overlooked
income, or incomplete records is yours alone.
Whether or not you
plan to do your own taxes, you need to create (or at least oversee the
creation of) the basic personal and business records that will be used
to complete the forms. You also need to know what kind of documentation
to save throughout the year, not only to prepare your return, but also
in case you're audited and you need to substantiate your responses to
the questions on the forms. You can safely assume that a tax auditor
won't look kindly on you if your only defense is "I didn't know I had to
do that." The old legal saying that "ignorance of the law is no excuse"
is perhaps most often applied in tax settings.
While the current
U.S. tax code is almost unbelievably complicated - the law, regulations,
and explanations run to over 42,000 pages and it provides numerous
opportunities for tax savings, if you know where to look.
Our goal in this
material is to lay out the rules for you as clearly as possible. We know
that your immediate concern is to get your taxes filed correctly and on
time, so that you get any refund that's due and so you don't get socked
with penalties and interest if you're selected for an audit.
We also want to tell
you about the many ways you can save taxes by structuring your affairs
to take the greatest possible advantage of the existing laws and
regulations. While our main focus is on tax issues that impact you and
your family, we'll also discuss tax rules for small businesses operated
as sole proprietorships.
Keeping Good Records
Everyone who pays taxes is required to keep accurate, permanent books and records so they can determine the various types of income, expenses, gains, losses, and other items that affect their income tax liability for the year, and should be retained for a least five years.
- You should retain basic records showing the source of all income you receive, including W-2 forms, 1099 and 1098 forms, and year-end comprehensive statements from financial institutions.
- For any deductible item, you should retain documents proving the expense itself (a receipt, bill, or invoice) and proving that you paid it (a canceled check, credit card slip, or bank statement itemizing your checks).
- If you are claiming employee business expenses, the recordkeeping rules for each type of expense are the same as those that apply to business owners, as discussed in more detail below.
- If you receive or pay alimony, you should keep a copy of the separation agreement or divorce decree.
- If you are claiming the child care credit, you must keep records of the name, address, and Social Security number or employer identification number of all caregivers.
- If you are claiming deductions for charitable contributions, you may need to get a receipt from the organization to which you made the donation, or an appraisal of the item.
- If you have gambling winnings, you should be keeping a diary of your winnings and losses that includes the date, type of activity, and location of the establishment, the names of other people who were present, and the amount you won or lost.
Reducing Taxable Income
The primary way to
reduce the part of your income that is subject to tax is to take full
advantage of all available tax deductions, both business and personal.
In order to do this, you must become aware of what is deductible and
what isn't, and the special rules that apply to certain types of
deductions such as meals and entertainment, automobile expenses, and
business travel.
In many cases a business owner can deduct benefits
that would otherwise be classified as nondeductible personal expenses.
Don't overlook the possibility of purchasing health insurance, investing
for your retirement, or providing perks like a company car through your
business.
But do remember that claiming some kinds of deductions
may have a tax impact in later years. An example of this is the
recapture of certain depreciation deductions upon the sale of business
property.
Reducing Your Tax Rate
Although you can't literally lower your tax
rate, there are certain actions you can take that will have a similar
result. These include:
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Shifting income from a high-tax-bracket taxpayer (such as yourself) to a lower-bracket taxpayer (such as your child). One fairly simple way to do this is to shift investment assets to your children. If you have a small business, you can hire your children. Another possibility is to make one or more children part-owners of your small business, so that net profits of the business are shared among a larger group. The tax laws limit the usefulness of this strategy for shifting unearned income to children under age 14, but some tax-saving opportunities still exist.
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Choosing the optimal form of organization for your business (such as sole proprietorship, partnership, or corporation). If your business income is under $75,000 and your business is not a personal service business like medicine, law, architecture, engineering, accounting, the arts, or consulting, you may be able to save tax dollars by incorporating. Otherwise, the sole proprietorship or pass-through entities (partnerships, LLCs, S corporations) usually offer more tax benefits.
When we say "tax
bracket," we're referring to the highest federal tax rate that you pay
on any of your taxable income. This is the rate that will apply to each
additional dollar that you earn, until you earn so much that you
graduate to the next bracket. You need to know your current tax bracket
in order to make wise tax planning decisions, since many decisions will
make sense for those in certain brackets, but not for those in others.
Controlling the Due Date for Taxes
The idea that we're
trying to convey is that it's usually worthwhile to delay the due date
for your tax liability, if you can do so legally. This is true even if
you figure that you'll be in the same tax bracket in all relevant years.
What you gain is the use of your money for a longer period of time. The
advantage may be as little as passbook earnings on the money, or as much
as the growth resulting from a needed investment of money or equipment
into your business.
Now, you generally
don't have the option of actually delaying payment of the income tax you
owe. While most taxpayers can get an automatic four-month extension of
the time to file their return (e.g., until August 15), you still have to
pay the taxes you owe by April 15 or face penalties and interest
payments. It's possible to obtain an extension to pay tax if you can
demonstrate to the IRS's satisfaction that you could not pay on time
without undue hardship. However, this is not something that you'll want
to do unless absolutely necessary, since even if you can get the
extension you will owe interest on the unpaid taxes, beginning on the
original due date.
What we're really
talking about is the fact that it's often possible to delay your taxes
indirectly, by taking actions that delay the time when particular income
items must be reported on your return. Your primary strategy will
usually be to postpone receipt of income until the next year, and
accelerate payment of expenses into your current tax year. (This will be
much easier to do if you use the cash method of accounting.) In this way
you can delay your tax liability to the next quarter, or even the next
tax year.
As a general rule of thumb, you should always
try to minimize your taxes in the present year, even if doing so means
you may have to pay slightly more tax in the future.
After all, no one
knows what the future holds. The tax laws are constantly changing, and
there's a good chance that whatever you think you may owe in the future
will be different by the time you get there. Furthermore, economic
conditions or personal plans can change, and your business may look
entirely different even one year down the road. In the worst-case
scenario, you could die unexpectedly, and in some cases you can avoid
tax altogether if you die before paying it.
In broad terms, you
can minimize taxes in the current year by postponing the receipt of
income so that more of it will be taxed next year, and by accelerating
deductions into the current year.
Restrictions on Tax Planning
The fact that you
chose to use one form of transaction rather than another in order to
minimize tax will not invalidate a transaction for income tax purposes.
However, even if the form of a transaction is
valid, the IRS will look at the substance or true nature of the
transaction in order to determine what the tax consequences should be.
Although the IRS says that the substance of a
transaction, not its form, determines its tax consequences, a taxpayer
who casts a taxable transaction in a particular form may have a
difficult time changing his or her mind later, and then trying to
convince the IRS that the substance of the transaction differs from its
form for tax purposes. So, the general rule is that the IRS may
look behind the form of a transaction in order to determine its
substance for tax purposes, but taxpayers are generally locked
into the form of the transaction. The thinking here is that since a
taxpayer can freely choose how to set up a transaction, it's only fair
to require him or her to live with its tax consequences.
Step transaction
doctrine. The IRS sometimes
uses what is known as the "step transaction" doctrine to argue that the
substance of a particular transaction is different from its form. When
it relies on this doctrine, the IRS is generally saying that it will not
break up a single transaction into two or more steps for income tax
purposes. So, the intermediate steps in an integrated transaction will
not be assigned separate tax consequences.
Related taxpayers.
The IRS pays close attention to transactions that involve taxpayers who
have close business or family relationships. In some cases, the tax laws
have given the IRS special powers to deal with specific areas where
related taxpayers have historically used their relationships to unfairly
cut their taxes.
Examples of this
include the denial of interest-paid deductions to businesses that borrow
money to purchase life insurance contracts benefiting their officers and
employees, and the special accounting rules that apply to interest and
expense payments between related parties.
You can expect that
IRS agents will closely scrutinize business dealings that you have with
family members or other related parties. Often, the IRS will combine its
audit of returns for a closely held corporation with an audit of returns
of the corporation's owners or principal officers, in order to discover
any attempts to shift personal expenses to the corporation.
I hope this
guide has helped you gain a better understanding of tax planning and how
it can help you. If you have any questions or need assistance do not hesitate
to contact us.
