Tax Planning
As the end of 2020 approaches, it is important to look at your tax situation for the year and project what your tax liability will be and how to potentially reduce it. Most people take a reactive approach to tax planning by trying to save taxes on April 14th of the following year. It is almost always impossible to do anything at that time other than possibly doing a retirement account contribution. Pro-active tax planning is the key to permanent and substantial tax reduction. While year-end tax planning is very important, it is not as important as daily tax planning. Every financial decision, dollar you spend, and dollar you earn has a big impact on your tax situation.
Here are three key areas I like to take a look at when doing tax planning:
1. Deductions
The average taxpayer does not have many deductions. They may get a deduction for mortgage interest, some property taxes, or donations. In order to maximize your deductions, you have to be in business. Employees do not get the same deductions as business owners (see my first newsletter "Start a Side Business"). Additionally, having solid bookkeeping is the foundation for ensuring you are maximizing your deductions and have good documentation. In order for an expense to be deductible, it must meet three tests:
1. It must have a business purpose
2. It must be ordinary or typical in your industry.
3. It must be necessary - in other words, the expense should be expected to help you increase revenues, profit, or market share.
2. Income Shifting
Income-shifting involves looking at other people's tax brackets that are lower than yours and shifting income to their lower bracket. Some examples include paying your children, parents, or grandparents, shifting ownership of your business, and using lower tax rates of a C-Corporation.
3. Deferral
Although this is not my favorite area as it typically only leads to temporary tax savings, it can be very helpful and in many cases can lead to permanent tax savings. Examples of deferral include retirement plan contributions, accelerating business expenses, and 1031 exchanges.
A comprehensive tax plan looks at the above three areas among others to create an action plan that must be implemented by the taxpayer to ensure the savings are eventually achieved and are legal with sufficient documentation.
