Tax Planning Follies - Part Two

Lady Gaga is touring the country promoting awareness of bullying. I think she is a good argument for more bullying. If she had been bullied the proper amount, she wouldn't be so strange. If she didn't have a great singing voice, she would be toiling at a tattoo parlor in some God forsaken place. She is a fine example for kids everywhere. How many more tattoo artists does the world need? If you're “born this way,” you might want to consider changing.

Late breaking news – I read in yesterday's Washington Post that Maryland's Governor, Martin O'Malley, wants to team up with Lady GagMe for an anti-bullying initiative. This is political correctness for a political purpose. He would rather deal with bullying than face the perennial Maryland budget mess to which he contributes annually. Soon he'll announce that motherhood is sacred, and that we should all eat our veggies.

If you believe your child has been bullied on Facebook, please learn some parenting skills. Bullying, by definition, cannot happen on a web site. Really. If little Susie can't survive a little drama on Facebook, don't be surprised when she is thirty years old and still living with you. At this point, I intended to write, “I get so mad about this subject, I could smack a dwarf.” But my wife made me delete it. I wish I had a great segue into tax planning from this, but I don't.

There are two primary tax planning techniques that can be used to reduce your income taxes. Actually, there are three. The first is doing no planning at all. I covered that adequately in my first installment on tax planning.

The first real method of income tax planning is creating less taxable income or creating more non-taxable income. For example, you can accomplish this by investing in tax free municipal bonds instead of regular taxable bonds. You can also create less taxable income by something as simple as accurately tracking all of your business expenses. In other words, take full advantage of the tax breaks available.

Contributing to a Roth IRA is another great way to create non-taxable income. While you don't get a tax deduction for the Roth contribution, the income in your Roth account grows tax free, and most importantly, can be withdrawn tax free at retirement.

Similarly contributing to a section 529 college savings plan creates non-taxable income. The contributions get only a limited state tax deduction, but the earnings can be withdrawn tax free for qualified college expenses.

Another cool way of creating taxable income that isn't as taxable as it might be is to put your children on your payroll. Kids are typically in lower tax brackets than their parents. In many cases, the tax rate on a child is zero. Shifting income from parents to children saves taxes. There are rules governing how you have to do this. Your kids actually have to work – unlike many of your other employees. There are other restrictions as well, but this is a fine technique we suggest regularly. Consult with your CPA for details – yada, yada, yada - insert disclaimer here.

The second method of tax planning is deferring income or accelerating deductions. One popular way to defer income is to delay your December billing so that you don't get paid until the next year. The key point about tax deferral is that you aren't really reducing your taxes. You are electing to pay them later. The problem is that later comes eventually.

A really popular real estate tax strategy is the section 1031 exchange. In a 1031 exchange, you defer taxes on the profit from selling a property by buying another piece of real estate. The profit from the first property doesn't escape tax. The profit reduces your tax basis in the new property. When you sell the second property, you pay the taxes then unless you do another 1031 exchange. This tactic seems like a no brainer. You get to delay paying taxes. Isn't that always good?

No, in fact it is not always good. I know a few people, who have done 1031 exchanges in the last couple of years, who have really screwed themselves. In the year they sold the first property, the federal capital gains tax rate was fifteen percent. Given the federal deficit, how long do you think the low fifteen percent capital gains rate will continue? I am betting in another year or two, that these people will find out they deferred income from a fifteen percent year into at least a twenty-eight percent year. Yes, I raised this issue with them. This pay no taxes now attitude is just a variant of the pay no taxes ever attitude I discussed in part I. The saying in the tax business is “Pigs get fat. Hogs get slaughtered.” Oink oink, Miss Piggy. Two years from now, these people will incur an ugly tax bill.

There are lots of other ways to defer income taxes. Accelerating depreciation deductions is another effective tactic. As I write this, you can fully depreciate up to $500K of equipment purchased during 2011. For 2012, the amount goes down to $125K. This is called a section 179 deduction. There are a number of limits that would take more space than I have and more indulgence than you would give me. But I should mention that a section 179 deduction cannot reduce your taxable business income below zero. It cannot be used to create a loss.

There is another type of accelerated depreciation still in effect for 2011 called bonus depreciation. Bonus depreciation only applies to the purchase of new equipment, furniture, and fixtures. Purchasing used items doesn't qualify. In 2011, you can deduct the entire purchase price paid for most equipment, furniture, and fixtures. Again, there are some limits, but nonetheless, it is a really good deal in a lot of circumstances.

Notice I didn't say accelerated methods of depreciation are good in all situations. When you deduct accelerated depreciation now, you are really just borrowing deductions from future years. For instance, if you deduct the cost of a $25K machine you purchased in 2011, you will get no further depreciation deductions on this machine in the future. This isn't always the correct decision. If you expect to be in a lower tax rate in 2011 than in the future, you shouldn't take accelerated depreciation. Save the deductions for the higher tax rate years. Many tax preparers automatically use accelerated depreciation without considering the effect of future income and tax rates. If you are using one of them, it sucks to be you.

From mid-October through December 31^st, I work practically full time preparing income tax projections for clients. I believe strongly in the value of tax planning. Of course, it pays pretty well too. All I am really doing over and over is using the two basic methods of tax planning discussed above: creating non-taxable income and deferring , or accelerating in some cases, taxable income.

Thanks for reading. Merry Christmas! For more information on S&K tax planning services, please visit the main S&K web site www.skcpas.com. End of commercial message.