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 business owner. 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 failure to report a portion of 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.
A business owner may not reduce his or her income taxes by labeling a transaction as something it is not. So, 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. It is the substance, not the form, of the transaction that determines its taxability.
How a tax plan works. There are countless tax planning strategies available to a small business owner. Some are aimed at the owner’s 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:
Reducing the amount of taxable income
Reducing your tax rate
Controlling the time when the tax must be paid
Claiming any available tax credits
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, you should already be projecting your sales revenues, income, and cash flow for general business planning purposes. The better your estimates, the better the odds that your tax planning efforts will succeed.
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.