By Albert B. Crenshaw
Sunday, April 23, 2006
The week after Tax Filing Day is frequently a time when taxpayers are inspired to "do something" about the amount of tax they have to pay.
This is a good thing when it leads to better planning, better understanding of the tax laws and ways to get a better return from the dollars extracted from us by local, state and federal governments.
It's not such a good thing when it makes us susceptible to the blandishments of promoters of tax shelters that don't work. And despite the efforts of the Internal Revenue Service and the adverse publicity showered on these promoters -- who in recent years have included accounting firms, lawyers and investment banks that one might have thought of as reputable -- they are still out there.
Indeed, IRS Commissioner Mark W. Everson recently expressed concern that while it appears that the big, well-known firms that got exposed by the Senate permanent subcommittee on investigations a couple of years ago have pulled back, smaller players marketing to less-sophisticated taxpayers are still in the business.
Small businesses and sole proprietors seem especially vulnerable to these marketers. Typically, these taxpayers work hard and many, frankly, resent the taxes they pay. They also hear a lot about "loopholes for the rich" -- a term often thrown about loosely in the media -- so when they get a pitch that throws around terms such as "charitable trust" and "managing director" and "international business company," plus a lot of legal-sounding mumbo-jumbo, they can persuade themselves that there really is a way to exempt themselves from the tax laws.
But buying into these schemes often means buying into trouble.
This month, the U.S. Tax Court whacked two insurance agents, one in California, the other in Ohio, who had tried setting up trusts and doing business through them. One argued that while his income might be taxable to somebody -- perhaps the trust -- it wasn't to him. The other set up a series of trusts, which the court concluded were designed to hide income, and indeed marketed the setup to others.
Both ended up liable for thousands of dollars in back taxes, penalties and interest.
So what can an ordinary taxpayer do that's both legal and helpful?
The first step is to understand the law, or at least its broad outlines.
Today, certain kinds of income -- capital gains and many corporate dividends -- are taxed at lower rates than wages, interest and other "ordinary income." At the same time, the Alternative Minimum tax (AMT), which is hitting more and more individuals and families, means that many of the old rules of thumb don't work as well as they used to.
So here are three steps to take to ease your pain next April 15:
1. Reduce your taxable income.
The step most readily available to the average taxpayer is retirement saving. A large number of employers now offer 401(k) retirement-savings plans, which are typically funded in part by you and in part by your employer. Money you put into one of these plans comes off the top of your pay so that it is not included when your taxes are computed. Neither is any matching contribution your employer may make.
If you are self-employed or run a business, even if it's a sideline to your regular job, there are numerous tax-saving retirement plans you can employ. Some of these are complicated, such as Keogh plans or individual 401(k) plans, and require expert help to set up. But they permit deferral of taxes on big chunks of your income, so they are worth the trouble.
If you invest outside of tax-favored accounts such as the foregoing, consider tax-exempt bonds or bond funds. Many of these pay interest that is exempt from both federal and state income taxes -- though watch out for the AMT. More on that below.
Rates on these are lower than on taxable bonds, but you may be better off after taxes are figured in.
If you know your tax bracket -- this is the tax rate on your last few dollars, not how much you pay overall -- you can do a quick check to figure out which taxable rate a tax-exempt rate is equivalent to.
To figure this, you divide the rate on the tax-exempt bond by 1 minus your tax bracket. In other words, if you're in the 28 percent bracket and are looking at a tax-exempt bond that pays 5 percent, the taxable equivalent rate is: 0.05/(1-0.28) = 6.94 percent.
In this case, the tax-exempt bond would pay you the same after tax as a taxable bond paying 6.94 percent.
Finally, if you are concerned for the safety of your savings, consider U.S. Treasury securities. Their interest is exempt from state and local taxes.
2. Control your investment income.
One of the enduring complaints of mutual fund investors is the unexpected capital gains distributions that sometimes show up late in the year. The mutual fund industry is urging Congress to allow investors to defer taxes on these distributions if they are reinvested in the fund, but such a rule hasn't passed.
But there are things you can do.
Many mutual fund families now offer "tax-managed" funds in which the managers try to do things such as match up sales of winners with sales of losers to minimize any taxable gain.
Index funds are also useful. They trade little -- typically only when a company's stock is added to or deleted from the index -- so you have a big capital gain only when you sell, allowing you more flexibility in recognizing capital gains and paying tax on them.
A similar benefit applies to a buy-and-hold approach to stock investing. It's not easy to time the market, of course, but you can time your taxes somewhat, such as by selling winners and losers together so gains offset losses.
3. Take the AMT into account .
This tax is capable of inflicting a nasty April surprise, and in many cases, there's not much you can do. But by structuring your finances with the AMT in mind, you may be able to ease the bite.
In simple terms, the AMT is sort of a flat tax (only two brackets, 26 and 28 percent), with a lot fewer deductions than the regular tax and a big de facto standard deduction (called the exclusion amount). You compute your taxes both ways and pay whichever is higher.
But there are a few twists. Nominally, capital gains are taxed at a maximum of 15 percent, AMT or not, but under certain circumstances, a big capital gain can result in seeing more of your other income exposed to the AMT. So if you are contemplating selling a large asset, such as a house, talk to your tax adviser first. This may be one situation where an installment sale -- letting the buyer pay over time -- may be advantageous. Or you may wish to postpone closing into a later year.
There are also special rules for tax-exempt bonds. "General obligation" bonds are exempt from both regular tax and the AMT, but "private activity" bonds, such as industrial revenue bonds, are subject to the AMT. So if you're being hit by the AMT, be careful what you buy.
Mortgage interest on a refinancing that is not used to buy, build or improve your home is also subject to the AMT. Under the regular tax, you can pull up to $100,000 out of your home in a re-fi and the interest is deductible.
Personal exemptions are disallowed under the AMT, so getting the chicks out of the nest can help. Also, if they are independent, they may be able to qualify for other benefits, such as the various tuition tax credits.
Finally, if you're thinking of moving, check the tax rates in the destinations you're contemplating. State and local taxes aren't deductible under the AMT, which reduces or wipes out the subsidy that the regular federal tax provides to high-tax jurisdictions such as the District.
Texas, anyone?
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The number of millionaire households -- defined as those with net worth of $1 million or more -- jumped 800,000 last year to 8.3 million, according to a survey by the Spectrem Group, a Chicago consulting firm. "Ultra High Net Worth" households, those with a net worth of $5 million or more, surged 26 percent in 2005, to 930,000, the survey found. "It's been a great couple of years for America's millionaires," said Spectrem Managing Director Catherine S. McBreen. The figures are for assets minus liabilities and exclude the value of the primary residence.
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Desperate taxpayers? On April 17, the tax-filing deadline in most of the country, there were 3,385,936 visits to the IRS's Web site, http://www.irs.gov , topping the record of 3,337,300 visits set April 15, 2005.
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