“You must pay taxes. But there’s no law that says you gotta leave a tip.”
~ Morgan Stanley advertisement
We have covered many a topic since we embarked on our journey as to how to succeed in any business.
We went over penny pinching, budgeting, and so on. We obviously know that as a business owner, there are many variables that will ultimately spell your success story – there is marketing, being great at what you do and letting it show, simply being polite to your patrons.
Success is not any one thing or action you need to do, it is a combination of sorts that will get you where you want to be.
We do know for sure that if you do want to succeed in any business, not so obvious is the maneuvering of complicated tax laws. We do not expect for you to be well versed in the tax code, leave that to the professionals; however, we do need for you to be informed, to ask questions of your tax team, and to try to leave no stone unturned.
It is the well informed that get ahead.
That being said, let’s discuss tax planning strategies, and how they can help you as an individual or as a business owner.
Using Differences in Tax Rates to Your Advantage
Since tax planning is a vast and very specific discussion, let’s cover the three basic concepts of tax planning:
- Recognize taxable income when you are in a low tax bracket
- Accelerate your tax deductions when your income tax bracket is high, and
- Postpone income taxation whenever possible
Know when you are in the Alternative Minimum Tax (AMT) category
So you think you can deduct as much as possible, and you have accelerated all those deductions this year, only to later find out that they did you absolutely no good whatsoever? That is correct, the AMT is designed to ensure that you pay at least a minimum tax, as the name implies, so be careful when planning to not overlook this common trap for the unwary.
Also note that there is a credit for the AMT in the year following the year you were exposed to this tax; hence, the AMT can be considered a planning opportunity, don’t overlook this credit.
Gross Income is considered income from whatever source derived, unless specifically excluded by the tax code. Be sure to check if your income is specifically excluded, partially excluded, or excluded on different levels of taxation.
A common trap for many is the Social Security benefits, as they can be taxed at 0%, 50%, or 85% of the face value distribute to you in any given year – and the amount that will be ultimately taxable really depends on your other income.
You should make sure that you plan for any changes in your income levels, or you may find yourself with an unexpected tax bill one year.
States generally exclude retirement income from taxation of residents that have moved to a new state of residency. Be careful when moving to a new state as each state has different rules and regulations on how they tax retirement income. Retirement income is very broad and can include different retirement vehicles that would be treated quite differently when comparing state to state and circumstance to circumstance. For example, one state can tax Social Security benefits, while another would not, another state can exclude $20,000 of specific retirement income regardless of your gross income and another may exclude specific retirement income until your gross income is below $100,000.
Shifting Income – Moving Money From One Pocket To The Next
Shift income from one year to another, or move the income to a family member in a lower tax bracket. This is not always as straight forward as it sounds as there are many ways this can go wrong, please make sure this is something you consult with your tax advisor on.
Decelerating Income – The Basics
This would involve advanced strategies such as delaying collections on your receivables, or perhaps negotiating for a deferred compensation package with your employer. Year-end bonuses can be paid in the following year for the past year, this would help those attempting to delay their income, and for the employer, this would delay additional expenses related to employee compensation. It could be a win win, depending on your particular circumstances.
Other planning strategies to postpone income:
- Incentive Stock Options – qualified incentive stock options (ISO) are not taxed for regular tax purposes until disposition (note, however, that the AMT tax may be imposed under certain circumstances)
- Tax-Free Interest Income – transfer funds from an interest-bearing account to Treasury Bills or a bank certificate, where interest will only be recognized at maturity, thus pushing it into the following year
- Annuities – transfer funds from an interest-bearing account to an annuity, this way the income won’t be recognized until you begin to draw on it, and then you will only be taxed on the earnings portion, not return of your investment
- Maximize retirement plan contributions – whether through your job, your business, or independently, best practices dictate to contribute as much as possible to a retirement plan
- Like-kind exchanges of property to defer recognition of gain from the potential sale of the property – this only applies to property held for business or investment
- Installment sales (other than stock or securities) of business property will allow for slower recognition of income, however, ensure that your installment is secured, and that the purchaser also pays an interest on the unpaid portion of the sale. Since depreciation recapture would go into effect in the year of the installment sale, try to negotiate a sale with a payment large enough to cover you for any additional tax exposure
Recognizing Income Sooner Rather Than Later – What You Need To Know
You might ask yourself, why would anyone wish to accelerate income?
It is a good idea to accelerate income if you are in a lower tax bracket this year, and you anticipate you will be in a higher tax bracket the following year.
- Changes in marriage or divorce can affect your future combined income levels
- Changes in employment
- Sales of assets can bump you into the next bracket as well
Tips on how to accelerate income:
- Collecting receivables – if you are self-employed, you can increase your income for any year by billing your clients before the year end
- Year-end bonus – this would be the opposite of above, negotiate for the bonus to come in before the close of the year whenever the opportunity presents itself
- Restricted stock options – if your employer has granted you compensation in the form of stock and/or property which is subject to restrictions, you generally are not taxed until the restrictions are lifted. Typical restrictions would include forfeiture of granted property in case of employment termination. One way to accelerate income from such circumstances would be to elect taxation with the IRS as if the restrictions have vested, and the property was fully granted to you. This can be accomplished by filing a statement with the IRS within 30 days after receiving the stock. The risk is such, that once you incur the additional income tax, the damage is irreversible if you later decide you wish to give up your rights in the property. Before making any elections, one must consider the current value of property and how likely it is that you will have the opportunity to have the property vested so that you can reap the benefits of stock
- Retirement plan distributions – have you already reached the age of 59 ½? If you have, you can now distribute your retirement benefits without incurring any additional tax penalties for making early distributions. You should always check with your plan administrators for other restrictions that do not deal with taxation
- Lawsuits, insurance claims, etc. – if you are in litigation and are awaiting on a settlement, for example a claim of income from employment, property damages, taxation will occur once you receive the money. You can speed up the recognition of income by settling early and taking less. You may lose by receiving a smaller judgement, but you may save in paying less taxes if you are in a smaller bracket that year
- EE bonds – if you decided to purchase EE bonds to postpone income taxation on the bond interest, you can simply liquidate these bonds and recognize earned but yet unpaid interest income in the year of the sale
- Capital gains – only you have the control of when to sell your assets, and that is the greatest advantage you have when deciding when to accelerate income. Remember that the new long-term capital gains rates are now as high as 20% if you are in the 39.60% marginal federal tax bracket, 15% if you are in 25%, 28%, 33%, or 35% marginal federal tax brackets, and 0% if you are in the 10%, or 15% marginal federal tax brackets. Use this to your advantage.
- Dividends – if you have control over the company, you can ensure the dividends are paid before close of the year.