Tax Planning

I. Introduction

A. Understanding Federal Tax Law

Taxes in the United States is a unique system compared to other countries. For one, the tax system is a progressive tax system. So what does that mean? It means, taxpayers pay at lower levels of tax first, then higher levels as taxable income increases. Each level of tax is called a tax bracket.

Don't get it twisted.

So don't get it twisted. When someone says that they are in the 25% tax bracket, it does not mean that if they earn $100,000 that year in taxable income, they pay $25,000 in federal taxes. It just means that any additional taxable income they make until they reach the next bracket will be taxed at 25%.

Federal Budget Receipts in 2011
Individual Income Taxes 44%
Corporation Income Taxes 12%
Social Insurance Taxes and Contributions 36%
Excise Taxes 4%
Other 4%

Adam Smith's Canons of Taxation

  • Equality
  • Convenience
  • Certainty
  • Economy

B. Tax Law

C. Tax Computation

The key components to the U.S. tax system are the standard deduction, personal and dependency exemptions, and tax determination.

Components of the Tax Formula

  • Income
  • Exclusions
  • Gross Income
  • Deductions for Adjusted Gross Income

Deductions for adjusted gross income are sometimes known as above-the-line deductions because on the tax return they are taken before the "line" designating AGI.

  • Adjusted Gross Income (AGI)
  • Personal and Dependency Exemptions
  • Itemized Deductions
  • Nondeductible Expenditures

The Standard Deduction

Filing Status for 2015 Deduction Amount
Single $6,200
Married, filling jointly 12,400
Surviving Spouse 12,400
Head of Household 9,100
Married, filing separately 6,200

To determine whether it is best to itemize, the taxpayer compares the total standard deduction (the sum of the basic standard deduction and any additional standard deductions) with total itemized deductions.

Individuals Not Eligible for the Standard Deduction

  • Married individual filing a separate return where either spouse itemizes deductions
  • A nonresident alien
  • An individual filing a return for a period of less than 12 months because of a change in the annual accounting period

If a dependent, the basic standard deduction for 2011 is limited to the greater of $950 or the sum of the individual's earned income for the year plus $300. This amount changes if the dependent is 65 or over, where $1,450 is added to the standard deduction for a dependent.

The deduction is capped at $5,800 which is the standard deduction for a single taxpayer.

Personal Exemptions

Exemptions that are allowed for the taxpayer and spouse.

Dependency Exemptions

A taxpayer is permitted to claim an exemption of $3,700 for 2011 for each person who qualifies as a dependent.

A qualifying child must meet the relationship, abode, age, and support tests. (IRC 152(c))

  • Relationship Test - A taxpayer's child, adopted child, stepchild, eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of these parties.
  • Abode Test - Qualifying child must live with the taxpayer for more than half of the year.
  • Age Test -Qualifying child must be under the age of 19 or 24 (if in the case of a student).
  • Support Test - Provides more than one-half of his or her own support

A qualifying relative must meet the relationship, gross income, and support tests.

Filing the Return

The amount of tax varies considerably depending on which filing status the taxpayer uses.

Unmarried individuals who maintain a household for one or more dependents may qualify to use the head-of-household rates.

Abandoned Spouse Rules
These rules allow a married taxpayer to file as not married, and thus either as single or head of household, if it meets the following characteristics:

  • The taxpayer does not file jointly
  • The taxpayer paid more than one-half the cost of maintaining his or her home for the year
  • The taxpayer's spouse did not live in the home during the last six months of the year
  • The home was the principal residence of the taxpayer's child dependent.

Filing Requirements

General Rules

The general rule is that a tax return is required for every individual who has gross income that equals or exceeds the sum of the exemption amount plus the applicable standard deduction. In 2011, this amount would be $3,700 + $5,800 = $9,500

Tax Determination — Computation Procedures

Tax Rates for 2015 (Single Person)
The Federal income tax rate structure is progressive, with current rates ranging from 10% to 39.6%.

Over Under Tax Rate Of Amount Over
$2,300 $11,525 10% $2,300
11,525 39,750 $922.50 + 15% 11,525
39,750 93,050 $5,156.25 + 25% 39,750
93,050 191,600 18,481.25 + 28% 93,050
191,600 413,800 46,075.25+ 33% 191,600
413,800 415,500 119,401.25 + 35% 413,800
415,500 119,996.25 + 39.6% 415,500

The kiddie tax was designed to reduce the tax savings that result from shifting income from parents to children. The net unearned income of certain children is taxed as if it were the parents' income.

How to determine child's tax liability:

  1. Determine child's net unearned income
  2. Determine allocable parental tax
  3. Determine child's nonparental tax
  4. Determine child's total tax liability

Gains and Losses from Property Transactions—Capital Gains and Losses

Capital gains are taxable, and capital losses are netted against them, resulting in a net capital gain or loss.

Taxation of Net Capital Gain

Classification Maximum Rate
Short-term gains (held for one year or less) 35%
Long-term gains (held for more than one year) 28%
Collectibles, certain property used in biz 25%
All other long-term capital gains 15% or 0%

Sometimes the special tax rate applicable to long-term capital gains is called the alternative tax computation.

Tax Planning

Maximizing the Use of the Standard Deduction

Families in the initial stages of home ownership will invariably make the itemization choice due to the substantial mortgage interest and property tax payments involved. Certain cases have the difference between the standard deduction and itemizing to be not so significant.

Dependency Exemptions

A married person can be claimed as a dependent only if that individual does not file a joint return with his or her spouse.

The support of a qualifying child becomes relevant only if the child is self-supporting. This is because the gross income test of $3,700 for 2011 does not apply to qualifying children, only relatives.

State law (common law vs community property) can affect the dependency exemption.

Generally, medical expenses are deductible only if they are paid on behalf of the taxpayer, his or her spouse, and their dependents.
In planning a multiple support agreement, take into account which of the parties is most likely to exceed the 7.5% limitation on medical expense deductions. One exception permits the deduction of medical expenses paid on behalf of someone who is not a spouse or a dependent.

If a taxpayer who is in the 15% bracket this year and expects to be in the 28% bracket next year should, if possible, defer payment of deductible expenses until next year, to maximize the tax benefit of the deduction.

A taxpayer's effective rate is the taxpayer's tax liability divided by the total amount of income.

A few ways of lowering the effective rate are to:

  • Invest in municipal bonds if the income is higher than the after-tax income of taxable corporate bonds
  • Make sure that the taxpayer's expenses and losses are deductible

For the unearned income of certain children, taxpayers can put money in to growth stocks with little dividend yields for their children. So when these children get older, they might receive a higher return from the growth of the stock and be able to sell the share at their child's own tax rates.
Series EE bonds also might be another alternative to defer taxable income until the child is free of the kiddie tax.
Also taxpayers who can employ their own children in their business can pay their children a wage for their work, and be able to shelter that income by the standard deduction, and the parents can deduct the wages in their business. The income could be sheltered further if it is contributed in to a retirement plan.

II. Gross Income

Concept of Gross Income

What is it?

Section 61(a) of the IRC defines gross income as:

Except as otherwise provided in this subtitle, gross income means all income from whatever source derived.

The concept of gross income is derived from the 16th Amendment to the US Constitution.

The accounting versus economic concepts of income. Economic is a change in net worth, while the accounting is based on the realization of income. When comparing the accounting and tax concepts of income. The differences lie with when the income is realized. The primary goal of financial accounting is to provide useful information to the management, shareholders, and other interests. Possible errors in financial accounting should be misdirected in the understated direction rather than overstated direction for net income and net assets. (Thor Power Tool Co. vs. Comm., 79-1 USTC 9139, 43 AFTR 2d 79-362, 99 S.Ct. 773 USSC, 1979) Whereas the tax law should give no fraction to uncertainty in its determination.

III. Deductions and Credits

IV. Property Transactions

V. Special Tax Computations & Accounting Methods and Periods

VI. Corporations

VII. Sole Proprietorships, Partnerships, LLCs, and Other Entities

VIII. Advanced Tax Considerations

IX. Family Tax Planning Strategies

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