Individual Income Tax Planning
A Conceptual Approach

By George S. Jackson

Harold did 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 “yes/no” logic.

Under this 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.

Like Darlene, 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.

Indeed, the 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.

Four Basic Concepts for Tax Advisors

What follows 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.

Concept 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 taxpayer uses:

Gross Income

– Above-the-Line Deductions
= Adjusted Gross Income
– Standard or Itemized Deductions
– Exemptions
= Taxable Income
x Rate (Ordinary, Capital, AMT)
= Gross Tax
– Tax Credits
– Prepayments
= Net Tax

Yes/no 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?”

If Harold 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.

Similarly, 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.

Familiarity with the federal income tax formula reveals four subsidiary principles of tax planning:

Principle 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 tax rate.

Principle 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.

Principle 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.

Principle 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.)

Concept 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 be taxed.

Principle 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 year.

Principle 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.

Principle 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.

Principle 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.)

Concept 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 Exhibit 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.

Principle 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.

Principle 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.

Principle 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.

Principle 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.

Concept 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 5).

Principle 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 amount.

Principle 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.

Principle 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 the next.

Principle 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 capital asset.

Other Considerations

Effective 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.

State income 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.

When working 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.

Another real 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.

Advantages of a Conceptual Approach

Despite its 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 issues.

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.

Returning 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.

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