Tax Planning
Tax Planning discusses the basis for and value of tax planning for individuals as well as corporate entities. Many taxpayers greatly undervalue the process of tax planning. Much like a trip to the dentist, tax planning never seems like something to actively anticipate. In this episode Janathan Allen discusses the reasons for and economic benefit of an effective tax plan.
Jan
This episode is about tax planning.
Neil
Jan, as we discuss the concept of tax planning, let’s start with the overarching goal. What is the goal for tax planning for either an individual or a corporation?
Jan
Well, the whole idea behind tax planning is to affect the amount of tax that either an individual or a business makes. So the ultimate goal of tax planning is to reduce the tax liability pursuant to the code and regulations
Neil
And the goals of our client
Jan
Which is always reduction of taxes.
Neil
So let’s begin with the individual. What are the individual steps in planning for tax strategies for an individual?
Jan
In our practice, there are a few individuals that are very proactive in terms of tax planning, but I want to step back and talk about most individuals and where it is and when it is, they begin to even think about tax planning, and that’s generally about mid-year October 15th, extension deadlines are coming. And that’s really when most people begin thinking about tax planning. And I guess the admonition that I would make is at that point, it’s almost too late. While there are certain things that can be done, the time to go back and do tax planning is at the beginning of the year, not the middle or the end of the year. So for individuals that are contemplating tax planning and really affecting the tax liability that they pay, that time to think about it is at the beginning of the year, not the middle or towards the end.
Neil
And what’s the first step in tax planning for an individual?
Jan
Well, there are a couple of steps. We go back and we review the financial information from the previous year. We note any changes that may have occurred in the income streams or the liabilities or the businesses that an individual may have. But then we go back and we talk about the goals of the individual and what it is that they’re hoping to achieve, not only from a financial perspective and how to achieve that financial perspective, but also how to mitigate the taxes in achieving those financial goals.
Neil
And part of that is a balance between their federal situation and the fact that California taxes everything.
Jan
That’s the common thing that I hear. I think a more appropriate way to describe it is that California doesn’t follow necessarily the federal code, and there are several deviations from that that can go back and impact the tax liability. So for example, if you have capital gains, if you’ve sold a capital asset and you’re subject to capital gains at the federal level, California doesn’t follow suit in that it does not have a specific different capital gains tax rate as the federal government does. So everything in California is generally taxed at the one tax rate, whatever the marginal tax rate for the amount of income that’s earned is.
Neil
Do you think that more people focus on their federal situation and the California they just think will follow?
Jan
I think there’s probably confusion about how it is. California does things, for example, in the 2017 tax Act when Congress went back and limited the amount of state taxes that could be taken on the federal return that wasn’t limited under the California returns. So there are differences that can be of benefit to the client or can harm the client depending on the type of transaction that we’re actually looking at from a tax basis.
Neil
So Jan, I think there’s a lot of myths about California taxation that most taxpayers don’t understand. For example, if I leave California and move away, I’m not going to be responsible for California taxes anymore. Can you talk a little bit about that?
Jan
Yes. There are a lot of instances that California will reach back and tax income even though an individual may have left the state and moved and established residency in another state. And a couple of those items could be, for example, if you worked in the state of California and you earned a pension here in the state of California, when you leave the state to move to another state and you start receiving those pension benefits, California will reach out and tax those benefits because effectively they were earned within the state of California and not in the new state of residence. Another example that I can go back and point to is, for example, if you are working for a corporation and you are earning stock options, and I had one client that was actually headquartered in Texas, had moved to California briefly, was earning stock options all the time that they were involved with this company, although they made a move personally into California and then moved back to Texas when the company went private, those stock options were liquidated and California reached back to that taxpayer and wanted to tax them on the portion of those options that were earned while they lived in the state of California.
Neil
Wow. So California is very aggressive about how and when income is earned in the state and how aggressive the state will be in carrying out measures to go back and obtain the appropriate state tax to be paid. So after the review of the situation that the individual has incurred in a tax point of view, then the next step is to establish what their goals are so that we can begin to structure their life accordingly?
Jan
Yes, because when you’re looking at income, income to most individuals is just income, but the code really divides income into various types. So for example, if you working and you have W2 income, that’s called active income. If you happen to have rental real estate that’s known as passive income. If you have investments, say you are invested in a mutual fund, then that’s deemed to be investment income. And the ways and the types of tax that are paid on those differing types of income can go back and greatly change depending on the tax tools that are used to minimize the tax in those areas.
Neil
And so that leads us to goal setting. What’s a typical conversation when it comes to goal setting for the coming year?
Jan
So for most of our clients, we try to go back and create a balanced, what we call a balanced portfolio. Some people are really big into cryptocurrency, or at least they were. There are a lot of people that think real estate is the only way to go, and yet there are others that only will go back and invest in the stock market. Our goal is to go back and get clients so that they’re far more balanced in terms of what they hold so that in the event that there is a downturn in one sector, another sector may not be subjected to the same downturn but instead may actually appreciate. And you can really see that particularly in terms of real estate in the last couple of years while the stock market was holding steady, not really moving, the real estate market just took off. And so there was great appreciation that was gained in the areas where people were holding real estate, whether it was multifamily or residential or whatever type of real estate it was. And now we’re beginning to see a reverse. So it depends on what sectors the individuals hold assets in, how it is that they hold them, and then of course what’s impacting those particular sectors based on the economy at any given point.
Neil
So we’re not only talking about helping them to look at where they are and setting some goals on how to restructure what they’re doing, but to develop a plan that gives them the actual steps they can take to achieve those goals.
Jan
Yeah, that’s right.
Neil
And the overarching goal is to minimize tax associated with accomplishing those goals.
Jan
Yes.
Neil
And before we leave the individual situation, Jan, a lot of US taxpayers now have offshore interests and investments from crypto to offshore investment vehicles. Do you believe most US taxpayers are now aware of the restrictions and the reporting requirements and the tax implication of offshore holdings?
Jan
Generally not. I think a lot of taxpayers, particularly those that are involved in crypto, don’t recognize that some of the platforms that they may be investing in may not even be domestic US platforms. And to the extent that you go into the crypto world and you start trading on platforms, it’s really critically important that you understand where those platforms are located because to the extent that they are not located in the US then you have foreign holdings. And the reporting requirements for foreign holdings is far different than it is for just the normal US tax return that most individuals execute at the end of the year. So between crypto, some individuals will go and they will hold interests or directorships in companies, for example in Europe and not recognize that the ownership portion that is associated with directorships in Europe, unlike here in the States, is actually an additional filing requirement and can have some fairly complex tax implications if it’s not reported correctly.
Neil
So Jan, I think especially when you consider the position of US Expats, they think if I’m below the number, I may not know I even have to file a return, but they may not understand the tax implications of a simple thing like the retirement plans they have at work or investments that they may be making, let alone the accounts they’re holding. How would you approach tax planning for an expat or someone with offshore investments?
Jan
Expats are probably some of the most complicated returns that we do, primarily because expats really don’t understand the implication of some of the income sources that they hold while living overseas. And the best example I can give of that are investments such as mutual funds. Here in the United States, we have stock brokerage houses throughout the US and people have no second thought about investing in a mutual fund. But for an expat, going back and investing into a mutual fund outside of the US can create some fairly traumatic tax liabilities. And the reason for that is in Europe and the rest of the world, the way that investments are taxed are different than they are here in the us. So for example, if you have a mutual fund in the US and you have, for example, you’re investing in a major bank pick Chase or Wells Fargo and you’ve invested in their mutual funds at the end of the year, you get this very large 10 99, and it will give you an assessment of what’s happened in that count during the year, and you pay tax on the interest that’s reported, the dividends, the capital gains, even though you may not have received any income or actual cash from those particular transactions.
In Europe, when you invest in a mutual fund, the taxes are not paid on the dividends, the interest, and any capital gains until the transaction is actually finalized and there is a cash transaction. So effectively in the US what we’re doing is we are paying taxes on appreciation, and in Europe, you are only paying taxes on what is realized. So there’s a distinction between recognized and realized for the taxpayers, and that becomes a source of consternation for a lot of expats who don’t recognize that the calculations for something as simple as a mutual fund becomes incredibly complex when it’s a foreign mutual fund. And that transaction really is subjected to what’s known as a PFIC computation. And a PFIC computation is simply going through and creating effectively the 10 99 that would have been received had those investments been incurred in the US for the taxpayer to hold them in Europe, which means a lot of work for accountants and taxpayers as well as their tax preparers. So it’s complicated, it’s costly, it catches expats off guard. And so my chief advice to most expats that are intending to retain their US citizenship is to avoid mutual funds, at least European mutual funds, and instead in invest in mutual funds in the states
Neil
Because the tax rate on PFICs is literally double or more than any other form of income tax. Is that accurate?
Jan
Well, it’s generally higher, and it’s generally higher because of the computation that is created and the marked to market rules and the underlying computation which can increase the taxes. Yes, that’s true. But more than that, it’s really the preparation time and the increased cost in actually preparing a tax return due to the complexity of that particular type of transaction.
Neil
Very good. Let’s shift the conversation to planning for a business. So how do you approach tax planning from a business perspective?
Jan
Businesses are generally a tad bit easier because most businesses have plans either two, three, or perhaps five year plans, and they have a fairly clear direction in terms of what it is that they want to do. So we start with the previous year’s financial statements and we take a look at what it is that’s been trending over time. We look at the market and the market segments that the company may be in, and we take a look at whether or not the projections are really necessarily accurate and foreseeable, and taking those figures, taking those performance, going back and calculating the tax, and then determining how best based on the goals of the company and how it is, is that they choose to grow, what types of investments, what types of expenditures will help best reduce their tax liability.
Neil
And that conversation really begins with a review of budgets and performers and the financial statements
Jan
It does. And in recent years, particularly during the pandemic, was the recognition that there are market forces that control a lot of things that are happening around us that we really have no way to interpret or to be able to assimilate within a plan, but you have to be ready to be able to make some fairly quick moves in the event that something in the economy changes.
Neil
So Jan, what are some of the best tax planning strategies that corporations or businesses can use as they approach the coming years?
Jan
Some of the best tax tools are really coming from the code itself. And if you look back to the 2017 tax Act, there was a lot of changes in terms of things like depreciation, things that had been depreciated over a period of time. The depreciation that’s allowed now in the first year under various different regulations has been greatly increased. So investment in equipment, investment in things that are driving the business in terms of operation can be useful tax tools depending on what the overall goal of the company is. Another one of the tax tools that we utilize as well, other than depreciation, is taking a look at what types of investments a company can make. For example, there was one publicly traded company that had investment in cryptocurrency, and one of the things that had occurred was that all of the investment dollars in this particular company went to cryptocurrency. And of course, when crypto fell last year, what happened was the balance sheet of that company was upside down. It was really sort of a disaster. So what we looked for and what we’re looking to do is to assist management in making decisions that are effective in terms of growth and their growth goals, but by the same token, again, are more balanced in terms of what it is that’s happening economically around them as opposed to just diving into one particular philosophy and hanging onto it until the market this.
Neil
And I think most business people we’ve often discussed, Jan, don’t really understand or appreciate the value of accounting is part of the tax planning, to look at the accounting systems in place and how we’re tracking things so that we can leverage and maximize our tax position.
Jan
And this will be a mantra that will probably be reverberated through most of these podcasts. The idea of virtually everything in a business drops down to the simple fundamental task of accounting. And in terms of going back and assuming that someone knows how to do accounting, and I’m thinking of my smaller business clients who of course want to obtain a bookkeeper as opposed to a controller or perhaps a CFO because it costs them less money. The issue is, is that the individual that completes the books on behalf of a company really needs to understand what they’re doing. They need to be up to date on the tax rules and the investments that can be made. They need to understand how a transaction will be booked. That comes down to contractual relationships, contracts by and among and between suppliers, how it is that you can accelerate income in a contract, how it is you can decelerate it. There are so many tax planning tools that are dependent that go back to the underlying accounting of a business that make it probably the most critical component of tax planning.
Neil
So Jan, in the end, tax planning is like planning a trip to the dentist. It’s not something most people really aggressively want to do. And then there’s the, well, how am I going to offset the cost of all this planning? And does it really make a difference in my bottom line and the amount of money I get to keep and a reduction in tax? How do you answer that kind of question?
Jan
I had a client the other day that was heavily into crypto, and we were looking at a previous year’s return. And when I looked at the return that had been prepared by another firm, I realized that what was being projected on that return was not accurate. So when I went back and posed the question to the client, when you’re dealing in an area such as crypto, which is really going to be heavily audited, the accuracy of the underlying data that is then transferred to the tax return becomes absolutely critical. And the only way to go back and ensure that the accuracy of the data is there is to go back and tax plan. So this particular individual came into our office was here in July. We had September tax deadlines looming, and we had 12 months worth of work to go back and recalculate. By the time the whole exercise was over and the tax returns were filed, the tax liability was pretty high and the taxpayer was not happy.
And as I explained to the taxpayer, I said, the issue that we have is we had no time. We’re working in reverse. All of this had been completed. So yes, you paid an awful lot in taxes that could have been avoided had you sat down and planned. But of course, the old adage is, Well, I don’t want a tax plan because it costs me money. In most instances, when you tax plan, you can save not only the cost of the tax planning, but incrementally the amount of tax that you pay over time can be far less than what it would be if you don’t tax plan. So the moral of the story is for a taxpayer who wants to keep as much of their money as they can, tax planning really needs to be an integral part of what it is that they do, whether it’s in their personal lives or their business lives, and not one thought at a particular point of the year. Tax planning is an integrative process and should be looked at in everything that a taxpayer does as an individual or for a business throughout the year.
Neil
Thank you, Jan.
Jan
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