Income Tax Planning
A Conceptual Approach
George S. Jackson
- Darlene, a CPA and IT specialist, was approached by her friend
and coworker, Harold, who wondered whether his $250 annual subscription
for the Wall Street Journal was deductible on his tax return.
“Of course it’s deductible,” replied Darlene.
“You take it as a job expense on Schedule A.” Right
answer, perhaps, but not right enough. If Harold follows her advice
without probing further, he risks losing all or some of the tax
savings that arise from an expenditure related to one’s livelihood.
not mention that he is in the process of buying a piece of rental
real estate, nor that he often moonlights as an IT advisor for
new businesses. Darlene failed to ask about his sources of income.
She might have been busy, or perhaps she did not want to invest
time in handing out free tax advice. There is another possibility,
however; her answer suggests that she approaches tax issues using
approach, the issues are merely whether income items are included
or excluded, and whether tax expenditures are deductible or nondeductible.
Darlene would have provided better advice if she employed a methodology
that first focused on the big picture, wrapping around specific
tax issues. Thereafter, she could have better addressed individual
items of income or expenditure.
many CPAs focus on areas other than taxation. Nonetheless, CPAs
can expect to occasionally encounter tax issues, some posed by
clients or others who assume all CPAs are tax experts, and some
arising from work on primarily nontax matters. In such circumstances,
rather than attempting to master the entire tax code, or altogether
ignore it, a more realistic alternative would be to acquire and
maintain a conceptual grasp of the structure of the federal income
tax along with an approach to tax planning.
Internal Revenue Code (IRC)’s complexity, breadth, and continual
revision make staying current a daunting task, even for tax specialists.
For example, Congress changed the “kiddie tax” rules
in 2006 and then again in 2007. Changes to the tax laws are sometimes
so sudden that the IRS cannot keep up. The 2006 Form 1040 did
not include lines for deducting expenses incurred by teachers,
tuition payments, and state or local sales taxes, because Congress
was still addressing tax matters in December, after the forms
went to press.
Basic Concepts for Tax Advisors
is a logical tax planning approach that embraces four fundamental
tax concepts, each of which gives rise to subsidiary tax planning
principles. (See Exhibit
1.) Neither the principles nor the concepts address the treatment
of individual income or expenditure items. Instead, they deal
with underlying tenets derived from a theory of income taxation.
Because the principles often suggest how individual items are
treated, a conceptual approach to tax planning is a valuable tool
for making preliminary assumptions about the tax consequences
of a particular transaction.
1: There is a uniform formula for determining individual federal
income tax liability. The more complex an accounting
issue, the more beneficial it is to analyze the problem using
the basic accounting equation. The same approach applies to tax
planning. The best way to begin analyzing a tax issue is to draw
a mental picture of the income tax formula that every individual
= Adjusted Gross Income
– Standard or Itemized Deductions
= Taxable Income
x Rate (Ordinary, Capital, AMT)
= Gross Tax
– Tax Credits
= Net Tax
logic focuses on the specific item under examination rather than
one’s overall tax circumstances. But many expenditures can
be deducted in more than one location on Form 1040. Had Darlene
first pondered the tax formula in the example, she might well
have answered, “Of course it’s deductible. The issue
is where do you deduct it?”
treats the subscription expenditure as a job expense, it will
reduce his tax bill only if he itemizes deductions, and then only
to the extent he has similar expenditures exceeding 2% of his
adjusted gross income (AGI). Recent IRS statistics indicate that
fewer than 10% of all taxpayers actually benefit from the miscellaneous
job-related expenses deduction.
by itemizing the deduction on Schedule A, he forgoes the chance
to reduce his AGI, which affects many other deductions and credits.
For example, the $1,000 child tax credit begins to phase out once
AGI reaches $110,000 for taxpayers filing jointly ($75,000 for
taxpayers filing singly). Education tax credits are reduced once
AGI reaches $94,000 for taxpayers filing jointly ($47,000 for
taxpayers filing singly), and altogether disappear if AGI exceeds
$114,000 for taxpayers filing jointly ($57,000 for taxpayers filing
singly). Where and how an expenditure is classified on Form 1040
significantly affects how much benefit it provides the taxpayer.
with the federal income tax formula reveals four subsidiary principles
of tax planning:
1-1: Dollar for dollar, tax credits are better than tax deductions.
A $1 tax credit reduces one’s tax bill by $1. The decrease
in tax that results from a $1 tax deduction is always less than
$1; the exact amount depends on the taxpayer’s applicable
1-2: Above-the-line deductions are better than below-the-line
deductions. Taxpayers who can deduct an item above the line do
not risk losing it merely because their itemized deductions do
not exceed the standard deduction. Approximately two-thirds of
all tax returns use the standard deduction. Accordingly, many
so-called “deductible” items (charitable contributions,
for example) do not actually affect the tax liability of most
taxpayers. Above-the-line deductions also provide a trickle-down
benefit: They decrease AGI, which, in turn, often increases the
amount of many other deductions and credits.
1-3: Within the below-the-line category, exemptions (such
as the personal or dependency exemptions) are better than itemized
deductions. As noted above, itemized deductions often do not generate
tax savings because the taxpayer elects to take the standard deduction.
You get one or the other, but not both. In contrast, exemptions
are not sacrificed when one takes the standard deduction.
1-4: Tax rates count. Always focus on the marginal tax rate,
because the value of any deduction depends upon the taxpayer’s
marginal tax bracket. IRS statistics indicate that the highest
federal income tax bracket for nearly three-fourths of all taxpayers
is 15%. (See Exhibit
2 for a breakdown.)
2: Different types of income receive different tax treatment.
Not all income is taxed. To understand how and when
income is taxed, one must be familiar with the terms “realized
income” and “recognized income.” For income
to be realized, there must be some measurable transaction. Under
the widely acknowledged all-inclusive rule, once income is realized,
it is recognized on Form 1040, unless it is specifically excluded
from taxation by action of Congress or the courts. However, knowing
that income is taxable does not address the issue of how it will
2-1: Income must be recognized before it is subject to taxation,
but not all realized income is recognized on Form 1040. Interest
earned on local government bonds, for instance, is clearly realized,
but generally it is excluded from taxation. The recognition of
other types of realized income, such as the gain realized on the
exchange of like-kind properties, is sometimes deferred to a later
2-2: Most recognized income is taxed at ordinary income tax
rates. Currently, the brackets begin at 10% and go as high as
35%. The rates are progressive, so as one’s taxable income
increases, the income tax rate also increases. While the applicable
rates change periodically, the principle of progressive tax rates
is firmly entrenched in the tax code.
2-3: More favorable rates apply to certain types of income.
Traditionally, gains resulting from the sale of capital assets
held more than one year (long-term capital gains) have enjoyed
favorable treatment. At present, most long-term capital gains
are taxed at either 5% or 15%. In 2003, Congress added many types
of corporate dividends to the long-term capital gain category.
2-4: Less favorable rates also apply to certain taxpayers.
Many individuals with high incomes are subjected to a parallel
income tax, the alternative minimum tax (AMT). Younger taxpayers
with significant amounts of unearned income may be subject to
higher than normal tax rates because they must substitute their
parents’ marginal tax rates. (See Exhibit
3 for an illustration of these examples.)
3: Different types of taxpayer expenditures receive different
tax treatment. As evidenced by the tax formula,
many taxpayer expenditures reduce taxable income. In contrast
to the “all-inclusive” rule for recognizing income,
tax deductions for amounts spent by taxpayers are considered excluded
from income absent specific legislative action. This is sometimes
known as the “legislative grace doctrine.”
When a taxpayer
makes an expenditure, too often the analysis focuses merely on
whether it is deductible. Not all deductions are created equal,
however. Viewing the deductibility of an item as a continuum (see
4) helps determine the likelihood that a particular expenditure
will be deductible, and, if so, whether it will be above the line,
or below the line.
3-1: Trade and business deductions are preferable to production-of-income
deductions. A trade or business is a regular and recurring activity
entered into with intent to earn a profit. These expenditures
are always deducted above the line, and, when unusable in the
current year, they can be spread to other years via the net operating
loss (NOL) deduction.
3-2: Production-of-income expenditures are preferable to
employment-related expenditures. These expenditures, arising from
an irregular activity entered into with intent to earn a profit,
are sometimes deducted above the line (e.g., expenses related
to rental real estate) and sometimes deducted below the line (e.g.,
tax and investment advice). Unlike the rule for a trade or business,
if production-of-income expenditures exceed revenues, the resulting
losses do not qualify for the NOL deduction and, in many instances,
cannot be used to offset other current-year taxable income.
3-3: Employment-related expenditures are preferable to nonbusiness
expenditures. Usually they are deducted below the line on Schedule
A. As a result, they are deductible only when the taxpayer chooses
to itemize and then only to the extent they exceed 2% of AGI.
When possible, it is preferable to categorize an expenditure as
a trade or business or production-of–income expenditure,
rather than a nonbusiness expenditure.
3-4: With several notable exceptions, nonbusiness expenditures
are not deductible, and losses on nonbusiness assets generally
cannot be deducted. When nonbusiness expenditures are deductible—with
notable exceptions—they are generally deducted below the
line as itemized deductions. Consequently, the deduction may not
be used if the taxpayer instead elects to take the standard deduction.
It bears repeating that approximately two-thirds of all individual
income tax returns use the standard deduction.
4: Tax planning generally involves reducing taxable income or
reducing the effective tax rate. Reducing what a
taxpayer owes can be accomplished by reducing taxable income through
the exclusion or deferment of income or inclusion or acceleration
of deductions; or by reducing the effective tax rate through splitting
income into other years, converting it to more favorably treated
forms of income, or generating tax credits (see Exhibit
4-1: Excluding income means that it never enters into the
taxable income calculation. The effective tax rate on the excluded
income is 0%. A similar result occurs when one is able to “include”
a deduction. In both instances, the tax savings equals the amount
of the excluded income (or deduction) multiplied by the marginal
tax rate of the taxpayer. This is also comparable to “including”
a tax credit, but the percentage saved is 100% of the tax credit
4-2: Many opportunities exist for deferring gain. Investing
in annuities is one way. Postponing the recognition of income
reduces current taxable income. The same result occurs when one
is able to accelerate a deduction. In both instances, there is
less income taxed in the current year. In later years taxable
income will increase; however, the taxpayer benefits from the
time-value of money. The longer the deferral, the greater the
benefit to the taxpayer.
4-3: Splitting can lower the tax bill on a gain by causing
all or part of it to be taxed at a lower rate. Splitting can occur
between different taxpayers (e.g., parent and child) or different
years (the split as deferment). On the opposite side of the tax
equation, it is sometimes advisable to bunch deductions, particularly
when expenditures have to exceed some minimum amount before they
yield a tax benefit. Some taxpayers, for example, alternate between
itemized deductions in one year and the standard deduction in
4-4: Converting ordinary income into a long-term capital
gain, with the accompanying favorable tax treatment, usually lowers
one’s overall tax bill. A common conversion strategy is
to hold capital assets for more than one year. A less obvious
approach involves pulling excess inventory (e.g., real estate)
from a trade or business, and recategorizing it as a nonbusiness
tax planning does not take place in a vacuum. For example, all
things being equal over time, accelerating deductions is generally
advantageous. But economic conditions and marginal rates commonly
change, so the time value of today’s tax savings must be
weighed against the taxpayer’s expected future tax rates.
In some cases, it can be advantageous to postpone deductions.
In other cases, a particular tax issue might change because of
Congressional action, or because the taxpayer’s expectations
did not come to fruition. The planning process needs to be continually
assessed, with transactions analyzed before they are executed.
taxes, with maximum rates sometimes approaching 20%, can complicate
matters. Many states, for example, do not follow the federal approach
of taxing capital gains at rates lower than ordinary income, and
a few states actually tax long-term capital gains at higher rates.
with a broad range of conceptual strategies, it is important to
bear in mind that what works best for one taxpayer might have
negative consequences for another. This is why it is so important
to examine the details of each taxpayer. Consider real estate
investors, for example. An individual contemplating the sale of
real estate might want the activity categorized as the production
of income, rather than a trade or business, in order to reduce
the effective tax rate. Investment property (production of income)
qualifies for long-term capital gains treatment, but business
inventory does not.
estate investor, one who is still improving property for eventual
sale, might fare better when categorized as a real estate dealer
(trade or business), allowing a quicker write-off of tax credits.
In addition, dealers are often able to immediately deduct, rather
than depreciate over time, cash outlays for vehicles, office equipment,
and other personal production-of-income property.
of a Conceptual Approach
complexity, the federal tax structure is more than just a maze
of rules to be feared by all and understood by few. CPAs should
be familiar with its structure and the basic techniques for minimizing
the tax consequences of a transaction. More often than not, the
treatment of individual items of income and expense is determined
by an underlying logic. Understanding a few fundamental concepts
provides a tax advisor with an approach to analyzing most simple
While a conceptual
understanding of the tax formula and the fundamentals of tax planning
frequently will not provide the right answer to a specific tax
inquiry, it is a good starting point, and it helps one better
phrase the question. Once the issue is put into proper context,
investigating the specifics should be considerably more fruitful.
to the conversation between Harold and Darlene, the lesson for
Harold is that over time it is in his best interest to seek more
than piecemeal assistance with tax issues. Not only would he be
better assured of securing the maximum available tax savings on
recurring expenditures such as the cost of his periodical subscriptions,
but more important, tax considerations will become a more integral
part of planning for his varied income-generating activities.
For Darlene, and CPAs whose practices do not focus on taxes, the
moral is twofold: 1) anticipate that others expect CPAs to have
a base knowledge of tax matters; and 2) it pays to acquire an
understanding, at least conceptually, of the structure of the
income tax formula and the basic principles of tax planning.
S. Jackson, LLM, CPA, is a professor of accounting at the
Walter R. Davis School of Business & Economics at Elizabeth
City State University, Elizabeth City, N.C.