December 15, 2021 – “Anyone may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”
Gregory v. Helvering, 293 U.S, 465 (1935) was a landmark decision by the United States Supreme Court concerned with Income Tax law. The case ruling became the basis for two essential doctrines that guide our interpretation of the Tax Code:
- The business purpose doctrine essentially states that if a transaction has no substantial business purpose other than the avoidance or reduction of Federal tax, the tax law will disregard the transaction.
- The substance over form doctrine states that a taxpayer is bound by the substance of a transaction even if it varies from its legal form.
Despite these rigid standards, the case did acknowledge that the tax law allows various deductions, credits, and allowances that would result in a lower tax if appropriately used by a taxpayer. This form of “tax avoidance” is legal and supportive of the Congressional intent to incentivize or encourage a particular economic behavior by the taxpayer. However, these “incentives” are difficult to find within the U.S. Tax Code, which is not your cozy, fireside reading material. The Code comprises two books, and is 2,652 pages long, which translates into an estimated one million words – about the same as the whole series of Harry Potter books and one-third longer than the King James Bible.
The difficulty of interpreting and applying the U.S. Tax Code drives many taxpayers to seek assistance preparing and filing their tax returns. Those more tech-savvy can utilize tax preparation software, while others seeking a personal touch or having more complexity will look toward a professional tax preparer.
Finding a quality tax preparer can be confusing. If you are lucky enough to find a quality preparer, be prepared to pay dearly for exercising your “civic duty.” The best tax preparers will ask you to complete a questionnaire and then utilize that “shoebox” of tax forms, statements, receipts and miscellaneous documents to enter data into their more sophisticated tax software. After a rigorous review process, computer and human, the final tax return is ready for signature and filing. Mission accomplished, and although you are one of the 99.9% of U.S. taxpayers who believe they pay too much in tax, you are ready to move on.
But maybe you are right, and you did pay too much tax. It could be because your preparer made a “mistake.” It could be because you forgot to tell them something pertinent to your tax situation. It could be because your employer or custodian issued an incorrect W-2 or 1099.
While all of these scenarios are possible, the real reason you might have paid too much tax is that you did not plan to pay less! When the ball drops on New Year’s Eve, it’s “pencils down” on tax planning and, in about 30 days, begins what I call the “tax puzzle.” It’s a challenging endeavor because, unlike most puzzles, there is no “picture on the box” that signifies the perfect final product. So, one must take all the puzzle pieces, lay them into the appropriate tax return line, check the remaining details, and arrive at the best result within the deadline given.
Our firm provides Tax Management services to our clients. For us, our pencils are never down because when the “ball drops,” we are already starting to plan for the New Year. Being proactive with clients in the current year allows us to draw the picture on the puzzle box and understand how and where the pieces fit in the puzzle. Why? Because we planned it that way. Without question, the most significant value received by our Tax Management clients is a result of our tax planning. Much like tax preparation, the cost of tax planning might cause sticker shock for some. However, wealthy taxpayers understand the significant cost/benefit of participating in tax planning.
The following six factors contribute to a successful tax planning process:
- Understand the U.S. Tax Code – Duh! This goes without saying. It is critical to know what is allowed, what is not allowed, and what is subject to interpretation – the famous “grey area.” While highly complex transactions get a lot of attention, many tax events are basic and can be appropriately handled by knowing the rules. Tax preparers often steer clients away from a tax-saving strategy because of a potential “Red Flag,” supposedly drawing IRS attention. Tax planning eliminates “Red Flags” by establishing a position allowed by the tax code or advising the client to take specific actions to make the strategy allowable.
- Continuing Tax Education – Unfortunately, the tax code, unlike the Harry Potter series, is subject to change. And change it does, often dramatically. Given its role as the primary revenue source to run our country and a significant political trigger in our election process, you can understand why proposed changes are always on the table. It is crucial to be aware of proposed tax changes, their effects, and any steps to reduce your tax burden or take advantage of the change.
- Avoid Expensive Mistakes – Some tax mistakes are worse than others. There are two types of errors that proper tax planning can help avoid. The first mistake most people think about is “getting something wrong.” These types of errors happen rather often. The trick is to be very careful with the kind of mistakes you make. The IRS not only will request that you pay the additional tax and charge you interest on the shortfall, but will also assess monetary penalties, which in the case of incorrect distributions from retirement and other tax-advantaged accounts can be pretty onerous. If the first mistake is “doing something wrong,” the second and more impactful mistake is “not doing something right.” An adage says, “there is nothing more expensive in life than a missed opportunity.” The primary purpose of tax planning is to be thoughtful in seizing all tax avoidance opportunities.
- Tailor Individual Strategy – Tax planning is most effective when done in conjunction with achieving your goals. While making charitable deductions can reduce your taxes, it is not an excellent strategy for those not charitably inclined. Be wary of advice that asks you first to adopt a tax strategy and then craft the situation to justify it. The tax code is a “wonderland” of incentives to accomplish many of our population’s fundamental goals, including going to college, getting married, starting a family, buying a home, owning your own business, investing money, saving for retirement, and many more. Rather than first thinking of a tax angle, think of a life angle and then find the tax strategy to make it work. In our line of work, we advise clients, “do not let the tax tail wag the dog!”
- Helping Others – Of course, it is desirable to have Uncle Sam fund some of your goals and dreams, but there are also powerful tax incentives for those of us who attain great joy in helping others. Tax law is very favorable to those willing to donate to charitable causes, and countless strategies are available to gain significant tax advantages. Likewise, less publicized techniques help family members in a tax-advantaged way, such as providing low-interest rate loans, hiring family members, tax-free gifting, and caregiver stipends, among others.
- No Surprises – When appropriately done, tax planning will provide the roadmap for actions needed to avoid taxes. Remember, it’s legal to do so! The steps need to be executed in the current tax year to impact the return you file on April 15th. Proper tax planning will avoid the anxiety of not knowing how much tax you might owe come April and the possibility of having a tax due without the funds to pay.
Our business model integrates Tax Management services with Investment Management and provides a Financial Life Plan. Being able to see the whole picture, solve for competing priorities, make informed short-term and long-term decisions, and have clients engaged in the process is a game-changer.