Episode 22 - Domestic Tax Planning
Episode 22 – Domestic Tax Planning lays out a general outline of domestic tax planning: “The first is what I would call the marshaling of the assets and the marshaling of the assets is really learning about what it is an individual or their individual and a spouse actually hold, earn, and have. So it could be investments in real estate, it could be investments in stocks, it could be investments in fine art or maybe old cars. But it’s really sitting down with the client and understanding what it is that they have. Secondarily is what it is and how it is that those assets are held. Because I can’t tell you how many times when I ask a client how it is that they hold an asset that that can be an issue in terms of tax planning itself. And then third is the types or the entities that may be utilized or are not being utilized that could go back and effectively save individuals taxes.”
Jan
Welcome to AB Cast, integrating Legal Tax Accounting and Business Solutions. I’m Janathan Allen. This podcast is about domestic tax planning.
Neil
So Jan, today we start our conversation about domestic tax planning. Perhaps we should start with just an overview of what you consider to be the essence of domestic tax planning and who should consider this process?
Jan
Well, effectively what tax planning is and does is probably applicable to virtually anybody that pays taxes. Some people will tell you that they don’t have to plan for taxes because they’re say a W2 wage earner, but the fact of the matter is, regardless of who you are, how much money you make or what it is that you own, tax planning can achieve savings for virtually everybody.
Neil
So Jan, what are the basic elements of domestic tax planning?
Jan
Well, it’s very similar to putting together an estate plan. The first is what I would call the marshaling of the assets and the marshaling of the assets is really learning about what it is an individual or their individual and a spouse actually hold, earn, and have. So it could be investments in real estate, it could be investments in stocks, it could be investments in fine art or maybe old cars. But it’s really sitting down with the client and understanding what it is that they have.
Secondarily is what it is and how it is that those assets are held. Because I can’t tell you how many times when I ask a client how it is that they hold an asset that that can be an issue in terms of tax planning itself. And then third is the types or the entities that may be utilized or are not being utilized that could go back and effectively save individuals taxes.
Neil
How does the timing of when income is realized affect tax planning?
Jan
Well, the timing of when income is recognized for most taxpayers on a W2 that are earning W2s, that tax date or the tax aggregator is what’s called a calendar year end. That calendar year end is effectively whatever it is that you earn within that calendar year is reportable on your tax return, which is due the following April. But when you begin to utilize differing vehicles or entities to hold assets, those entities can have differing year ends.
In other words, they don’t have to be calendar year ends, they can be fiscal year ends. So the way or the methodology that income may be earned or reported in a fiscal year entity is different than it would be for an individual with a calendar year end. And that differential is what really gives rise to some unique tax planning opportunities in either the acceleration of income or the acceleration of expenses or the acceleration of income and expenses depending on which tax rate in what tax year will be more beneficial for the client.
Neil
And we’re talking about even for W2s, when do I take my bonus? How are stock options given or exercised? All these things have a timing to them that can really impact tax.
Jan
They absolutely do. And for individuals that are W2s, oftentimes they don’t have any say if they don’t understand the ramifications of stock options and how they work. And I think it’s really important that they understand what it is that they’re able to do and what they should ask to be able to do.
Neil
And for international tax clients, those that have holdings offshore. There’s also a question of “where,”
Jan
Well, I think the interesting thing about asset holdings offshore becomes far more complex, and we’re seeing it virtually every day in clients that have chosen to invest. For example, in crypto, when I ask a crypto investor where it is, they’re invested, they sort of look at me with strange looks and want to know why it is. I need to know that. And the fact is, if you don’t understand the exchange that you’re on, it could be domestic, it could be international it. The differentiation between those two investments is huge, not only in terms of tax reporting, tax timing, and the IRS interest in those particular assets.
Neil
So while many of our clients have both domestic and international assets, we’ve had several podcasts and we invite you to listen to them about international tax planning and strategies. We’re going to focus today on the domestic side of the house, Jen. So what are some of the important areas to consider as you start to establish a domestic tax plan?
Jan
Well, domestic tax plans are really, again, predicated based on the assets that the client holds. And when I talk about tax transactional planning, the planning that we do not only integrates the more common tax tools that are utilized most commonly, for example, a 401k or maybe a SEP IRA, but there are other vehicles that can be utilized as well. And the whole goal within this tax planning, whether it’s domestic or international, is to take the buckets of assets and the types of income that are being earned and arrange them in such a fashion and with entities so that it is the most tax minimized structure that we can create on behalf of our clients.
So that often means going back and creating entities on behalf of a client in order to get differing types of income that are generated from say, an LLC or an S Corp as opposed to the straight operating or earned income at the individual tax level. So the domestic tax planning is very, very much akin to the international tax planning. It’s just done domestically.
Neil
And for those that are W2, which is the majority I think of Americans, there are things that they can do within even W2 income that can affect their tax exposures like FSAs and HSAs.
Jan
Absolutely. There are a number of tax solutions, tax minimizing solutions that are available to individuals with just W2s. And you just mentioned two of them. And that’s effectively prepaying medical expenses with pre-tax income that allows you to not have to pay taxes on the income in order to make payments on medical bills.
So HSAs, FSAs, there are things like SEP IRAs if you don’t have a 4 0 1 K in your workplace that you could go back and set up for yourself and contribute to. And then again, there’s the idea of what is it that you can invest in and the types of entities that you could create in order to, once you’ve created the investment and you’ve invested your hard earned post-tax dollars, how is it that you can mitigate taxes on those investments in the long term?
Neil
There’s a difference between deductions and tax credits. And one example of that, Jan might be a simple divorce that how you structure childcare, how you custody and visitation might have a direct impact on the tax credit that you’re going to be able to take. And that’s part of as you’re approaching your divorce, you might want to take that into consideration.
Jan
Yeah, when you talk about divorce tax planning, that gets incredibly complex because of course what ends up happening is one of the best plans may not be approved by the court or the opposing counsel may not, and their client may not want to pursue a tax minimized policy because it is not in their best interest and may limit their income. That becomes a whole, that’s a podcast in and of itself,
Neil
And it will be.
Jan
And so as we take a look at the more generalized area of domestic tax planning, we concentrate again on the assets, the types of vehicles we can utilize those assets differing tax years and changing the characterization of income in order to minimize tax.
Neil
So Jan, you’re talking about income or capital gains and losses or capital losses. Let’s start with the income side of the equation. From the IRS’s point of view, what types of income could a US taxpayer have?
Jan
There are generalized free buckets that we typically deal with, and that’s what we call ordinary income, which is income that’s earned from whatever a person does for a living. And that can be in the form of a guaranteed payment coming out of an LLC. It could be in the form of W two wages because you work for an employer.
The second bucket is what we call passive income. And passive income really has two typical types of investments. One is real estate because with the 1986 tax Act, which really ushered in the idea and the era of passive income coming from real estate and then investments, which has always been considered passive. And then of course there’s capital gains and losses and ordinary gains and losses. And those losses are really predicated based on the type of asset that you’re selling and for how long you held that asset, which will determine whether it’s a capital or ordinary gain or loss.
Neil
And what is the difference, Jan, between a short-term capital gain and a long-term capital gain
Jan
In terms of tax planning? Quite a bit. If you have a long-term capital gain, then there are effective tax rates that are much lower than the ordinary income tax rate of 35, 30 6% at the individual level. Capital gains rates run between 15 to 18 to 20% depending on what tax brackets you’re in, but it’s substantially lower than the ordinary income tax rates.
But in order to achieve that long-term gain, you have to have an asset that’s deemed a capital asset and have held it for more than a year. If you haven’t held that asset. Or if you have an asset and you’re thinking about selling it, it’s really, really important to think about, what if I held the asset a bit longer? Would that make a difference in terms of the taxation and the amount of tax that I would have to pay on a gain if I were to sell the asset now?
Neil
And if you’re close to that end-of-year mark, the difference, especially the larger the asset, the more tax you’re going to save. This could be a substantial equation.
Jan
Absolutely. It can be.
Neil
And then from a short-term capital gain, you’re talking about assets that were held for less than a year. One of the things that immediately comes to mind Jan is crypto, and many crypto investors don’t understand that every time, even if they move it from a wallet to another wallet, that’s a taxable event and it’s a short-term capital gain.
Jan
That’s exactly right. Interestingly, bring up crypto. The IRS just released some preliminary regulations yesterday. We’re still trying to get through what it is. We think that how it is it’s going to impact this office’s tax planning for crypto because of course, every time the IRS issues a proposed regulation that can potentially change how it is that we view and what it is that we do in terms of tax planning, especially in the world of crypto.
Neil
So Jan, how does Allen Barron and how do you personally help to structure the transactions of our clients in order to reduce tax impact?
Jan
So, the structuring of a transaction can be dependent on many things, and it could be dependent on the type of transaction, whether you’re dealing with wage income, whether or not you’re dealing with rental income, whether or not you’re dealing with long or short-term capital gains or losses. But essentially, again, it comes down to the transactional planning aspect of what it is that we do. And that’s the utilization of differing entities in order to hold assets to change the income and the income characterization of those assets.
So for example, if you were to be an individual and you’ve started your own company and you’re reporting your income on a Schedule C, the issues that we have with Schedule CSS is that there is the additional 15.2% of social security, Medicare, et cetera, taxes that are paid at the individual level but are not deductible, at least the employer’s portion is not deductible on the individual return.
So effectively, when someone reports their income from a business on a Schedule C, they’re effectively paying 7.25% more in tax social security tax than they would if we were to take that same income, put it into an S corporation and run it through payroll. Because the entity, the S-Corp entity has the ability to utilize that additional 7.25 deduction because it’s the employer’s portion of the taxes that you’re not allowed under the code at the individual level. So there are many, many different ways to go back and structure how it is that an individual holds or earns income. And that’s just one example of how it is that you can save 7.25% simply by moving from a Schedule C to an entity.
Neil
You mentioned transactional planning and you’ve talked about the impact of real estate. One of the terms that comes to mind, Janice, PIGs and PALS is one of my favorite aspects of this discussion. Can you tell us what a pig and a PAL is and how we use that to reduce taxes?
Jan
We’ve done seminars effectively on PIGs and PALS for a number of real estate offices here in the area because I don’t think even real estate agents understand the differentiation between pigs and pals, but pigs and pals are an acronyms that we utilize in real estate transactions. And PIGs are Passive Income Generators because again, in the characterization of the three buckets of income under the code, the real estate is deemed to be a passive asset.
So Passive Income Generator, which is a PIG, comes from owning real estate PALs are Passive Activity Losses. And again, these PIGs and PALs can be short-term or they can be long-term depending on the length of time that you’ve held the assets. So when we create a transaction or create a transactional analysis for income or assets that are held in particularly real estate, we utilize differing types of entities with which to hold those assets because it’s the utilization of those entities that determines the type of income and when it’s taxed and whether it’s long-term or short-term.
Neil
So Jan, another advantage of working with Allen Barron on domestic tax planning is the difference between the myths and the wives’ tales, if you will, of what works and what doesn’t and what’s taxable and how to hide income versus what’s reality. And one example of that would be, okay, I’m going to create an offshore entity and I’m going to earn all my money (offshore), I’m going to transform all my income to that offshore entity to reduce my tax liability. Can you talk a little bit about just the issue of sorting through what’s fact and what’s myth?
Jan
Well, the answer to that question is really easy, and I can’t tell you how many clients have walked in the door and announce that they have already moved their assets offshore.
I had a client come in at one point and tell me that she’d taken her entire retirement account and moved it to a small island off of England, which of course was a tax haven because she was afraid of God knows what. When you listen to people, particularly those that may be in tune with conspiracy theories, there’s a lot of misinformation coming through the internet that if you go back and take your assets and you put them offshore, that somehow they’re safe from any sort of litigation or tax or any sort of confiscation. And I think confiscation is the main driver of a lot of these moves.
But the fact of the matter is when an individual takes income in the US and moves it offshore, all that does is greatly complicate their lives. I’ve read where people have put money into trusts because trusts are non-taxable, or I’ve had individuals, and again, say they’ve moved their assets offshore, but what that does is greatly complicate their lives and generally, no, I’ll take that back. Always increases their taxes.
It’s, I’ve never seen a structure that did what it would purport to do if you believed everything you read on the internet.
Neil
What records should us taxpayers keep throughout the year and after the tax season is completed?
Jan
Well, for us, because the record keeping requirement is really, really critical, and that’s becoming a more difficult question for me to answer and I’ll explain why.
Normally the statute of limitation, at least at the federal level, is three years. So if for example, you’ve prepared your tax return and you’ve maintained all of your source documents for three years, then it’s generally okay to go back and eliminate or destroy those documents. And I say that hesitatingly because there are times that that’s not okay.
And for example, if the IRS were to suspect an individual of committing fraud, then there is no statute of limitations and you don’t know when it is that the IRS is going to make an allegation of fraud.
So I’ll give you an example of a client that we have that left the United States. A typical when an individual leaves the United States and they feel, well, I’m not working in the United States, I’m not earning money in the United States, and hence I’ve gone to another country, I don’t have to file tax returns until all of a sudden one day the IRS comes up and knocks on your door and says, well, we didn’t get this tax return.
This is what you earned in the previous year, and we don’t have any records. So we’re going to base our income tax liability predicated on a previous year. And people come up to me and say, can the IRS do that? And the answer to that is yes, and there is no statute on that.
And the client that we are currently working with, this goes all the way back to 2012. And the issue that you have is most banks don’t maintain their records that long. The Internal Revenue Service doesn’t maintain the records that long, but if they go back and they say, this is what happened, we don’t have any record of a tax return, we’re going to assume what it is that you made from the previous year and carry that into another year, assess you a tax liability, now it’s your job as a taxpayer to disprove it.
And so if you have no record, if you’ve thrown away the records, you’ve given them up and it’s a long period of time, say 2012 to 2023, how do you disprove what the IRS now says you owe them? So the answer to this question about how long do you hang onto your records for me, the conservative person that I am, I hang onto to them all and I will hang onto them all until I retire.
Neil
So we’ve had a pretty broad ranging conversation. Jan, if you’re going to take us through the summary of tax planning, can you just walk us through the basic elements that we’ve discussed today?
Jan
Well, sure. In domestic tax planning, you always want to take advantage of the normalized tax tools that we all have, and that’s 401Ks if you have them, SEP IRAs, IRAs utilizing medical accounts, prepaying your medical deductions, charitable deductions, things of that nature that go back and impact your adjusted gross income.
The other ones would be when it is that income’s realized, and to the extent that an individual has the opportunity to say, I don’t want my bonus, for example, year end until the following year, that can greatly impact the tax liability for one year. Of course, it shoves it into the following year, but there may be reasons that that would be more advantageous than taking it in the year in which the company would like to pay it.
Transactional planning is always one of the things that we suggest for our clients, and that’s again, aggregating the assets that a client has identification, aggregating, and then segregating and putting them in an order that minimizes the taxes, utilizing the appropriate tax entities and vehicles.
And finally going back and particularly for individuals that are in real estate because real estate has become such a pronounced investment, particularly in light of covid, that understanding how passive income that’s earned from passive investments and the passive losses can be aggregated in which to increase the losses that an individual could utilize on their tax returns if they’re properly structured. So those are probably the four best elements. There are others, but they’re beyond the scope of this podcast.
Neil
And you’re talking about PIGs and PALs. One final thought, for those of us that just simply own a home, but here in San Diego, that’s a substantial asset and if we put it into an entity and we have to do repairs, we have losses associated with that. Can that come back to help us on the tax point of view?
Jan
Well, what ends up happening is houses are a bit of a different animal. And I say that because they’re not deemed a passive asset. And the reason is is because they aren’t classified that particular way. They’re real estate and they’re passive, but the loss isn’t passive when, for example, if you have a home and you sell it, that’s not deemed to be a passive loss. That loss can carry through assuming there’s a loss and can carry through and offset ordinary income. But it’s one of the few assets that does that.
I would say about the houses, whatever it is that you’ve done to it, improvements, please maintain the records because for those of us that have been in our homes for a couple of years, every time you put an improvement into it or it adds to the basis, which of course then when you go to sell, it will decrease the potential appreciated gain if you maintain those records. But again, if you don’t have the records, it’s incredibly difficult to prove that increase in basis from the purchase price.
So it goes back to how long should you keep your records. It depends on the types of deductions and the types of information you’re going to have to report in the future.
Neil
And then while we’re on the topic of homeowners, let’s crosstalk a little bit. If it’s not an entity, it should absolutely be a trust.
Jan
There are trusts that we always advise that the heart of a transactional plan is a living trust. And the reason that that is, is because there is the issue of probate in the event that particularly if you’re a couple of one of the spouse’s passes and the movement of the title of those assets into the name of the remaining spouse, it saves dollars, it saves time, and it saves anguish, but yet a living trust, which is essentially a flow through entity at least until the death of the first spouse is always at the top of our list.
Neil
And then after the passing of the second spouse passing it to the next generation, what’s the tax advantage end of going through a trust versus the cost of going through probate?
Jan
The idea of going through a trust is that you avoid the cost of the probate because probate is only, it really is merely a way to transfer the title of assets into another name, and there’s a cost associated with that. And if you don’t have to do that then, and you can create a trust and transfer assets to the next generation.
And there are differing types of trust that you get out of the living trust, there could be a family trust, there are a number of that you can utilize in which to go back and transfer assets that you currently have in order to minimize tax estate tax. Which brings me to one last point. In 2025, there’s going to be a number of laws that are going to sunset the 1 99 a deduction for small taxpayers, which gives us a 20% cut off the top.
If you’re an S Corp or an LLC, we’ll be gone unless Congress gets its act together and goes back and extends that sun setting provision. The same thing is with the estate tax. Currently it’s running, I think about 12.5 million, but it’s due to be reduced to seven and a half million.
So now all of a sudden you’re in the realm where there’s going to be more taxpayers that are going to be in the estate tax issues than they were prior to the reduction of that unified credit. So there’s lots of things that we need to plan for. 2025 is coming up fairly quickly and now’s the time to start.
Neil
Thank you, Jan. This has been a very robust discussion and informative as well. Thank you.
Jan
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