A taxpayer has the right to use all legal means to avoid or postpone a tax. Th rough proper tax planning, the taxpayer may reduce the tax bite. As a basic goal, taxpayers should try to reduce current and future taxes. Usually, it is a good idea to defer taxes to future years, if possible.
Overview of the Tax Structure 1–31
¶. Acquire Working Knowledge of Tax Laws
Th e tax laws contain an overwhelming number of rules covering a multitude of personal, business, and investment situations. Th e average taxpayer should not expect to develop even a general famil- iarity with all aspects of these laws. However, the “game of life” necessarily involves taxation, and it is diffi cult to play the game without a working knowledge of the basic rules. Taxpayers should focus on those laws that impact their particular personal and business environments. Developing a working knowledge of these rules is most benefi cial in reducing current and future taxes. It will improve tax problem recognition skills. It will also lead to improved record keeping and reduced time for tax return preparation. For taxpayers who use computer tax software, knowledge of the tax laws will provide some assurance that the software produces proper results.
Although taxpayers may hire tax advisers to prepare their returns, knowledge of the tax laws should help minimize the adviser’s fee. Most advisers base their fees on a return’s com- plexity and the preparation time. For a knowledgeable taxpayer, the adviser will not have to charge for explaining simple transactions. Although advisers can prepare tax plans, they charge fees for their time. If the taxpayer wastes the adviser’s time with general conversation, the taxpayer should expect a bill for this time. To the tax adviser, time is money.
¶. Advanced Planning to Reduce Taxes
Th e way the law taxes a completed event or transaction is fairly clear. Consequently, it is im- portant for taxpayers to plan their transactions in advance. Once an action is taken, the tax consequences are usually locked in. Proper planning of the action, however, can produce desir- able tax results.
Taxpayers need to be aware of those available deductions and tax credits that will benefi t their particular situations. To facilitate planning, taxpayers should become familiar with methods that will:
1. Accelerate or postpone the recognition of revenue. 2. Accelerate or postpone the recognition of expenses.
Taxpayers whose total itemized deductions are about the same as their standard deduction amount can use the bunching process, which results in a slowdown or a speedup of itemized deduction payments. By using the bunching process, the taxpayer infl uences the year in which an itemized deduction falls. Taxpayers who use this process itemize their deductions in one year and take the standard deduction in the next. Most taxpayers who use bunching fi nd charitable contributions, medical expenses, property taxes, and state income taxes easiest to control.
Couples might arrange their wedding date (December versus January) to reduce the tax bite. Usually, taxpayers do not bunch their personal and dependency exemptions. However, taxpayers with dependents under the multiple support rules can use the bunching process. By controlling the amount they pay to support other persons, they can control the numbers of dependency exemptions they can claim. Finally, to some degree, taxpayers can control their tax credits. Usually, they should claim their credits as early as possible to generate cash (tax) savings sooner rather than later.
Example Bob Bruno fi les as a single taxpayer. Bruno’s total itemized deductions are usually around
$5,000, which includes $1,500 of charitable contributions he annually makes to his church each December. For 2009, the greater of Bruno’s standard deduction or itemized deductions would be the $5,700 standard deduction for single taxpayers. If Bruno were to delay making the $1,500 charitable contribution for 2009 until early 2010, then he would still deduct $5,700 in 2009. However, his 2010 itemized deductions of $6,500 ($5,000 + $1,500) would exceed his 2010 standard deduction. By using this bunching strategy, Bruno would get a greater deduction from AGI in 2010.
Although tax planning is advantageous for everyone, the law restricts the advantages for the average employed person. Because the great majority of such people use the standard deduction, tax planning has its limits. Most tax benefi ts, unfortunately, favor business owners. People who have their own businesses stand to gain the most through tax planning. Current trends show an increasing number of people starting their own businesses. Th us, a greater number of taxpayers will benefi t from comprehensive tax planning.
For business owners, greater deduction possibilities exist. Th ey can convert many item- ized deductions and nondeductible items into deductions from gross income. Knowledge of these situations is highly benefi cial.
Timing the recognition of revenues and expenses is more easily done in a business set- ting. For example, taxpayers in service businesses who use the cash method of accounting can control end-of-year income. Th ey might increase income by accelerating service billings or postpone it by delaying them. Other taxpayers who use the cash method of accounting (most persons) can control end-of-year gains and losses by advancing or delaying the closing dates in property transactions. Taxpayers who control transaction timing can adjust their income and deductions to take full advantage of the tax laws.
As indicated previously, taxpayers can reduce their taxes by careful planning. Some tax plans cover a short-term period, while others cover a long-term period. A short-term plan tries to reduce taxes over the next few years; a long-term plan tries to reduce them over a longer time span. Long-term plans usually involve complex techniques beyond the scope of this book. Th ey include selecting retirement plans and developing estate, gift, and trust strategies. A taxpayer with stable income, deductions, exemptions, and credits usually uses a one-to-three-year tax plan. When uncertainty exists, the taxpayer should consider liberal, conservative, and middle- of-the-road assumptions. In all cases, the plan should be updated annually.
¶. Maximize Unrealized Income
Some taxpayers want more after-tax dollars so they can spend it on consumable items. Oth- ers prefer to accumulate wealth. For those who want to accumulate wealth, the principle of maximizing unrealized income is important. Taxpayers can generally accumulate more wealth by investing in assets that produce income that is not currently taxable. Such income can then compound without being taxed each year.
Th e tax laws operate under the realization principle, where gains from property are not taxed until realized (the property is disposed of ). Th us, taxpayers that invest in property that appreciates in value (e.g. stocks or real estate) can defer (delay) the tax on the unrealized gain (i.e., the appreciation).
Overview of the Tax Structure 1–33
¶. Keep Good Records
To do a good job of tax planning, taxpayers need a good record-keeping system, which allows easy access to the nature, purposes, and amounts of old transactions. Th e underlying fi les should contain invoices, canceled notes or checks, payment receipts, property titles, and copies of old tax returns. An orderly indexing system helps taxpayers fi nd stored documents. Finally, a good record-keeping system helps prevent taxpayers from overlooking deductions at tax time.
Watch for Tax Opportunities
As taxpayers learn more about the tax laws, they can spot planning opportunities more quickly. Remember the basic goal: reduce current and future taxes. As you study each chapter, keep this goal in mind and watch for tax-reducing suggestions.