Individuals and business owners often have more than one way to complete a taxable transaction. Tax planning evaluates various tax options to determine how to conduct business and personal transactions in order to reduce or eliminate your tax liability.
Although they sound similar "tax avoidance" and "tax evasion" are radically different. Tax avoidance lowers your tax bill by structuring your transactions so that you reap the largest tax benefits. Tax avoidance is completely legal—and extremely wise.
Tax evasion, on the other hand, is an attempt to reduce your tax liability by deceit, subterfuge, or concealment. Tax evasion is a crime.
How do you know when shrewd planning—tax avoidance—goes too far and crosses the line to become illegal tax evasion? Often the distinction turns upon whether actions were taken with fraudulent intent.
Business owners often find themselves subject to more scrutiny than wage-earners with a similar level of income. Why? Because a business owner has more options to avoid tax, both legally and illegals. Here are some of the most common criminal activities in violations of the tax law:
- Deliberately under-reporting or omitting income. This is self-explanatory: concealing income is fraudulent. Examples include a business owner's failure to report a portion of the day's receipts or a landlord failing to report rent payments.
- Keeping two sets of books and making false entries in books and records. Engaging in 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, generally demonstrates fraudulent intent.
- Claiming false or overstated deductions on a return. These range from claiming unsubstantiated charitable deductions to overstating travel expenses. It can also include paying your children or spouse for work that they did not perform. The IRS is always vigilant when it comes to inflated deductions from pass-through entities.
- Claiming personal expenses as business expenses. This is an easy trap to fall into because often assets, such as a car or a computer, will have both business and personal use. Proper record-keeping will go a long way in preventing a finding of tax fraud.
- Hiding or transferring assets or income. This type of fraud can take a variety of forms, from simple concealment of funds in a bank account to improper allocations between taxpayers. For example, improperly allocating 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, is likely to be considered tax fraud.
- Engaging in a "sham transaction." You can't reduce or avoid income tax liability simply by labeling a transaction as something it is not. For example, if payments by a corporation to its stockholders are in fact dividends, calling them "interest" or otherwise attempting to disguise the payments as interest will not entitle the corporation to an interest deduction. As discussed below, it is the substance, not the form, of the transaction that determines its taxability.
The IRS Criminal Investigation Division is not to be trifled with, as any number of high-profile individuals, from Al Capone to Wesley Snipes, know only too well. But, in addition to the rich and famous who make the news, there are hundreds of convictions of businessmen and businesswomen who attempted to evade payment of taxes.
Example. An Ohio business man was sentenced to six months in prison, six months of home detention, and two years supervised release for attempting to evade nearly $170,000 in income taxes. He received income in the form of wages, non-salary payments, and corporate payments for his personal expenses. The personal expenses included: property tax and utility payments for his personal residence, as well as payments for a new furnace, air conditioner, air cleaner and humidifier; a down payment and loan payments for his daughter’s car; payments of his wife’s automobile insurance and car repair bills, college tuition payments for his nephew, as well as other personal expense payments.
Example. The sole proprietor of a plumbing shop was sentenced to 13 months in prison, three years of supervised release for tax evasion and ordered to pay approximately $130,000 in restitution to the IRS. The business owner willfully attempted to evade paying his federal income taxes by skimming gross receipts of his plumbing business and paying personal expenses from his business accounts and claiming them as business expenses.
As part of his tax evasion scheme, he instructed several of his employees to solicit checks from clients payable in his name, rather than in the name of the business. He then cashed these checks and did not deposit the monies into his business’ bank account. Since this money was not recorded on the books of the business, nor deposited into the business’ account, he did not include these gross receipts on his income tax return. He also deducted personal expenses as business expenses and similarly lowered the figures on his Schedule C profit, thereby substantially reducing his tax for tax years 2003 through 2006.
Keep in mind that tax evasion isn't limited to federal income tax. Tax evasion can include federal and state employment taxes, state income taxes and state sales taxes as well. The following example illustrates this.
The owner of several Illinois tobacco stores was sentenced to 76 months in prison and was ordered to pay $4.8 million in restitution to the State of Illinois and $650,452 to the United States after he pled guilty to deliberately hiding and failing to report cash receipts from business. He had deposited less than one percent of $60 million in cash receipts into his corporate bank accounts and declared little, if any, of those cash receipts on his corporate tax returns.
In addition he either filed false federal income tax returns or failed to file federal income tax returns for the years at issue. He also filed false Illinois sales tax returns. He used the unreported income to fund a lavish lifestyle in Lebanon, where he spent considerable time and built a luxurious home, purchased a farm worth hundreds of thousands of dollars, and became a successful owner of a soccer club.
Minimizing taxes requires skillful tax planning
Tax avoidance requires advance planning. Nearly all tax strategies use one (or more) of these strategies to structure transactions to obtain the lowest possible marginal tax rate:
- minimizing taxable income;
- maximizing tax deductions and tax credits
- controlling the timing of income and deductions
Forecasting income and expenses is critically important. Effective tax planning requires solid estimates your personal and business income for the next few years. Several years of income/expense projections are necessary because many tax planning strategies that lower taxes at one income level can result in an increase if income raises in the coming years.
You will want to avoid having the "right" tax plan made "wrong" by erroneous income projections. You should already be projecting your sales revenues, income, and cash flow for general business planning purposes, so you should have much of this information available for tax planning While estimates by their nature are inexact, the more accurate you can be, the better your planning will be.
Deductions and Credits Reduce Your Taxes
Your tax planning goal is to pay the least amount of tax that is legally possible. You can reduce your ultimate tax bill by attacking on two fronts.
- First, take full advantage of every available deduction—both business and personal—to reduce your taxable income.
- Then, once determine the tentative tax due, claim every tax credit that is available to you.
When you want to reduce the amount of tax that you owe, you will find that tax credits are nearly always better than tax deductions.
A credit reduces your tax bill dollar-for-dollar, whereas the value of a deduction is affected by your marginal tax rate. This is an important principle to remember when evaluating whether it is better to claim a credit or a deduction when both are available for a given expense.
Claiming Deductions Minimizes Taxable Income
To reduce your taxable income, you must be aware of what is deductible and what isn't. You also need to know the special rules that apply to certain types of deductions, such as
In many cases, a business owner can deduct benefits that would be considered nondeductible personal expenses for an employee.
Examples would be business use of a computer or business use of the family car. Don't overlook the possibility of purchasing health insurance, investing for your retirement, or providing perks like a company car through your business.
Know the rules regarding which expenses are deductible and make sure to document them properly. Over-exuberant payment of personal expenses from business funds is a red flag for audits and may be considered proof of tax fraud.
Consider the big picture when claiming deductions. Claiming certain types of deductions can have a tax impact in later years.
One example is electing to expense (deduct) the entire cost of a business asset in the year of purchase. While this will lower your tax liability for the current year, you will not be able to claim depreciation deductions in the future. If you anticipate your business income increasing in the future, you may want to scale back the current deduction so that you can claim depreciation deductions in future years.
Tax Credits Shave Dollars Off Your Tax Bill
Once you have claimed every tax deduction that you can, turn your attention to uncovering every possible tax credit that you can claim.
As noted earlier, tax credits are generally better for you than deductions because credits are subtracted directly from your tax bill. Deductions, in contrast, are subtracted from the income on which your tax bill is based.
A dollar's worth of tax credit reduces your tax bill by a dollar. However, a dollar's worth of deduction lowers your income by the percentage amount of your marginal tax bracket. So, a dollar's worth of deduction is worth only 35 cents if you're in the 35 percent bracket; it's value drops to 25 cents if you're in the 25 percent bracket.
In fact, the more you reduce your taxable income, the lower your bracket and the less valuable each additional deduction becomes. This means that you should definitely be aware of potential credits and what is required to claim them. And, in cases where you have a choice between claiming a credit or a deduction for a particular expense, you're generally better off claiming the credit.
As wonderful as tax credits can be, with tax law there's almost always a catch. In this case, the catch is that many tax credits are available only in certain, very limited situations.
Most federal income tax credits currently available to business owners are very narrowly targeted to encourage you to take certain actions that lawmakers have deemed desirable. Examples include credits designed to motivate you to make your company more accessible to disabled individuals or to provide health insurance to your workers.
Other credits apply only to certain industries, such as restaurants and bars, or energy producers. There are also a few credits designed to prevent double taxation, and a few designed to encourage certain types of investments that are considered socially beneficial.
In addition, the forms and procedures used to calculate and claim business tax credits often are quite complicated. While we do provide an outline of the basic rules, so you can decide whether to pursue a credit, we recommend that you leave the technical details to your tax professional. because the reduction in taxes may well compensate you for the aggravation in claiming them. That said, you still should aggressively explore and exploit any tax credits that apply to you.
Aim for Lowest Possible Marginal Tax Rate
The federal income tax is a progressive system. Now, in tax talk, that doesn't mean forward-looking or innovative. It means that different levels of income are taxes at "progressively" higher rates. One goal of tax planning to lower your taxable income, so you are taxed in a lower tax bracket with lower tax rates.
The federal income tax is designed to tax higher levels of income at higher tax rates. A "tax bracket" refers to the highest marginal tax rate that you pay on any part 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.
If you operate your business as a sole proprietorship, an LLC that has not elected to be taxed as a corporation, a general partnership, or an S corporation, your business income "passes through" to your personal income tax form and is taxed at the individual tax rates. If you operate your business as a regular corporation, the corporation pays its own taxes at the corporate tax rates (which may be lower than your individual rate) and you are taxed only on income received from the corporation.
The dollar amounts for each bracket depends upon your filing status (e.g., single, head of household, married filing jointly, or married filing separately). The bracket amounts are based on taxable income, not gross income. Taxable income is the amount left after you've subtracted every deduction and personal exemption to which you're entitled.
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. You can find the current tax brackets on the IRS website or in your personal income tax form instructions.
Although you can't literally lower your tax rate (the rates are established by Congress), there are certain actions you can take that will have a similar result.
- Choosing the optimal form of organization for your business (such as sole proprietorship, partnership, or corporation).
- Structuring a transaction so that payments that you receive are classified as capital gains, rather than ordinary income. Long-term capital gains earned by noncorporate taxpayers are subject to lower tax rates than other income.
- 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 by hiring your children. Another possibility is to make one or more children part-owners of your 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 18, but some tax-saving opportunities still exist.
Control the Tax Year for Income and Deductions
Although "do it now" is excellent advice in nearly every situation, when it comes to taxes there can be a benefit to carefully considering the timing of various transactions.
By choosing an appropriate method of tax accounting and by thinking ahead to accelerate (or delay) when you receive income or incur expenses, you can exert some degree of control over your taxable income in any given year.
Careful planning can delay the timing of an event or transaction that gives rise to tax liability. Delaying recognition of income can be valuable. Even you'll be in the same tax bracket in all relevant years, you will have the use of your money for a longer period of time. While this might only net you a few dollars in extra interest, it might also provide you with the liquidity to make additional investment in your business.
Delaying when your liability for tax occurs is not the same as delaying payment of tax! You very seldom have the option of actually delaying payment of the income tax you owe. 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.
Control Tax Liability by Postponing Income, Accelerating Deductions
By taking actions that delay the time when particular income items must be reported on your return, you can shift liability on that income to a different tax year. In general, you will be better off if your can postpone the receipt of income until the next year and accelerate payment of expenses into the current tax year. In this way you can delay your tax liability on the deferred income to the next tax year
Controlling the timing of income recognition and deductions is generally possible only if you use the cash method of accounting. There are rules in place to prevent accrual basis taxpayers from distorting their income/deductions by the timing.
Although delaying the receipt of income does mean that have to wait longer to receive payment, you will have the amount you save on taxes available for your use for over a year.
When is It bad to defer income and accelerate deductions?
You should not use this strategy when you will be in a higher tax bracket in the coming year—either because your income will increase or because the tax rates will increase. You want to realize income in the year in which you will be in the lower tax bracket.
You should not accelerate deductions when doing so may mean that you would lose some of the value of the deduction. For example, if you are in the 33 percent bracket this year, but anticipate being in the 39.6 percent bracket next year, you would want to structure the transactions so you can claim the deductions next year when they would be worth more.
Similarly, if you foresee that your business profits will rise substantially over the next few years, you need to balance claiming a large deduction in one year versus spreading that deduction over several years. This applies most clearly in the case of electing to claim a large depreciation deduction in the first year the property is in service, but can apply to losses from sales of capital assets as well.
Consider These Simple Ideas to Delay Income and Accelerate Deductions
If you've determined that it makes sense to defer your income and/or accelerate your deductions, then these simple ideas can help you implement that strategy. Remember, only a few of these suggestions will work if you use the accrual method of accounting. Of course, you should check with a tax professional before taking action in order to ensure that you haven't overlooked critical factors.
- Delay collections. Delay year-end billings so that payments won't come in until the following year. In general, this technique won't work for accrual basis taxpayers because the obligation to recognize the income occurs when economic performance occurs.
- Delay dividends. If your business is a C corporation, defer payment of dividends until the following year. Make sure to follow the corporate formalities when declaring the dividends and establishing the time of payment.
- Delay capital gains. If you plan to sell assets that have appreciated in value, delaying the sale to next year means that you will not have to report that income on this year's tax return. In general, this can even work for an accrual basis taxpayer, but you will have to pay careful attention to the terms of the sale.
- Accelerate payments. Cash basis taxpayers may be able to prepay deductible business expenses, including rent, interest, taxes, insurance, etc.
- Accelerate large purchases. If you close the purchase of depreciable property within the current year you may be able to claim significant deductions via the expensing election.
- Accelerate operating expenses. - If may be possible for you to accelerate the purchase of equipment, supplies, or the making of repairs, thereby obtaining a deduction in the current tax year.
Know when to be a contrarian
If you are going to be in a higher tax bracket next year—or if you know that tax rates will go up, even if your income doesn't—you do not want to follow the conventional wisdom: delay income/accelerate deductions.
Instead you want to do the opposite: accelerate income/delay deductions.
How do you accelerate income and defer deductions?
In most cases, you accelerate income or defer deductions by simply doing the opposite of the suggestions outlined earlier in this article.
For example, instead of delaying your billings, send out all of your bills early, and do everything that you can to collect them before year's end. If you plan to sell a capital asset, make sure to sell that asset in the current tax year. Delay the purchase of supplies until next year, if possible.
Again, any strategies aimed at changing the tax year of income and deductions are much easier to implement if you use the cash method of accounting.
What if you use the accrual method?
Although strategies aimed at changing the year in which income and deductions are reflected on your tax return are usually more difficult to accomplish using the accrual method, this does not mean that they cannot be done.
You'll need to learn how to navigate through the accrual method accounting rules in order to reach the tax result that you want:
- If you want to delay taxation on a certain amount of income, make sure that all events fixing the liability for payment of that income are not met by year's end. For instance, if you're selling goods, delay shipment until next year.
- If you want to accelerate a deductible expense into the current year, make sure that all events fixing the liability and amount of payment as well as the economic performance have been completed by year's end.
If you are purchasing goods, services, or the use of a property, make sure that you have a valid contract covering all necessary terms, and that the goods, services, or properties are delivered, performed, or used by year's end. If you do this, you are "one up" on a business that uses the cash method of accounting: you have received the benefit and deduction for the expense item before you have actually had to pay for it.
Be alert! Avoid common tax planning traps
Although you want to explore all avenues to reduce your taxes, you need to be aware that certain tax strategies are likely to fail. What's more, they will raise red flags to IRS examination staff.
Taking advantage of the complexity of the tax laws to reduce your legal tax debt makes good sense. Getting tripped up in the complexity and having the IRS disregard your planning strategies does not. And, deliberately disregarding the tax law to shield income is foolhardy.
In addition to the obvious: "don't hide your income or exaggerate your deductions," there are there are three over-arching rules that you should heed to make sure your planning stands up to an IRS challenge.
- Don't try to camouflage the substance of a transaction by the form the transaction takes.
- Don't try to disguise the tax impact of a single transaction by breaking it into multiple steps.
- Don't expect the IRS to treat your relatives as if they were strangers.
IRS focuses on substance, not form
Choosing to use one form of transaction, rather than another, to minimize your tax liability will not (in-and-of-itself) invalidate a transaction for income tax purposes. For example, you can elect to give your child a gift of $10,000 or put the child on the payroll where she can earn $10,000. Doing the tax calculations and picking the method that results in the lowest overall tax liability for the family is a wise course of action.
However, you can not avoid tax liability simply by the label that you give a transaction. The IRS is going to look at the real purpose—the substance—of the transaction and tax it according. For example, you can give your son a car, or you can sell your son your car. However, you can't sell your car and claim it was a gift.
Business owners often run afoul of the "substance over form" rule when they attempt to disguise compensation as "dividends" or "return of capital." The IRS will not be amused; nor will you be when you receive an increased tax bill, plus interest and (most likely) penalties.
Mike Appleton, the manager and principal stockholder of a Plasti-Cast, Inc , a regular corporation, lands a lucrative contract to supply components to a multi-national corporation. This contract means that corporate income will skyrocket from $50,000 in this year to $500,000 next year.
Mike concludes that closing this deal indicates that he is worth far more to the company than his $30,000/year salary. Therefore, he increases his salary to $450,000 in for the coming year. His corporation takes a compensation-paid deduction for $450,000.
The IRS sees things differently. After an audit, the IRS concludes, although he was worth more the $30,000, Mike's reasonable compensation was only $100,000. This $100,000 qualifies for the compensation deduction, but the $350,000 is a disguised dividend which does not qualify for the deduction.
Sauce for the goose, isn't necessarily sauce for the gander. While the IRS can step in and reclassify a transaction based upon its substance, rather than its form, taxpayers often find that they have to live with the consequences of their initial choices. This means that if you choose a particular form for a transaction, you may have a difficult time trying to convince the IRS that the substance of the transaction differs from the form you chose.
You would be wise to consider it a general rule that the IRS may look behind the form of a transaction, but you will be locked into the form of the transaction. The reasoning is that you freely chose how to set up the transaction, so it's only fair to require you to live with its tax consequences.
Step transaction doctrine can determine legality
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 will treat a multi-stage transaction as a single, unified transaction. 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.
A transfer of property from Able to Baker, followed by Baker's transfer of the same property to Charlie, may, if the transfers are interdependent, be treated for tax purposes as a transfer from Able to Charlie.
This is not to say that there aren't valid transactions that take place in a series of steps. Many sales and exchanges of property have multiple steps and, if the rules are followed, these are perfectly valid. It is to say that you can't impose an artificial step to change the impact of the transaction.
Related taxpayers face closer scrutiny
The IRS pays close attention to transactions that involve taxpayers who have close business or family relationships. In fact, the tax laws have given the IRS special powers to deal with specific areas where related taxpayers have historically used their relationships to unfairly reduce 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.
Among the items that IRS agents are likely to scrutinize carefully are vacation trips disguised as business trips, purchases of household furnishings or payments for household expenses (such as repairs and mortgage payments) charged off as corporate expenses, and excessive salaries paid to stockholders and relatives.