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Thursday
Apr092015

WAIT: Don't File Those Taxes Just Yet! 

WAIT: Don't File Those Taxes Just Yet!

By

Those of you in the US know that it’s the least wonderful time of the year: tax time.

Hopefully you haven’t filed your tax return just yet. Maybe you rushed it in because you feel ever so grateful to your government for letting you keep some of your hard-earned cash. Or maybe—like most of us—you wait 'til the very last day out of principle.

Either way, chances are you’re leaving money on the table. We want to show you how to get most of it back.

From time to time, On the Radar will feature something special that we think deserves the spotlight—research or writing that we believe is of exceptional quality and is especially valuable.

This first time around, it’s from our own Terry Coxon. And unless you enjoy writing big checks to the IRS, you’ll want to put Terry's newly updated bible on wealth protection, Keep What You Earn, on your must-read list.

It includes powerful strategies for shrinking your tax bill that very few investors have ever thought about. You’ll find a freshness in these methods, because they come in part from a fresh approach: Terry starts by looking at the tax collector’s side of the transaction.

Below is an excerpt from Keep What You Earn, addressing a notion you may find entirely agreeable: the tax collector has problems of his own. In those problems lie rich opportunities for lawful tax reduction.

If you like what you read, click here to purchase Keep What You Earn.

 

CHAPTER 2: THE TAX COLLECTOR’S PUZZLE

By Terry Coxon

Year after year, despite decades of tinkering, refinement and reform, the government continues to wrestle with an insoluble puzzle. The puzzle will keep troubling the government for as long as there is an income tax. No new plan of tax reform will make it go away.

Understanding the puzzle is central to your job of tax planning. Every tax-saving strategy under present law—or under any conceivable law— stems from this one, unanswerable question: how can the government accurately measure the income it wants to tax?

The revenue authorities take the puzzle seriously. If the government is careless in defining the “income” it taxes, it will produce results unwanted by the very politicians whose purposes are served by an income tax.

Poorly conceived tax rules allow some industries to understate their income and force others to pay taxes on income that is an accounting fiction. The industries that are hurt tend to shrink; their products become comparatively scarce and expensive. And, with their shrunken incomes, those industries may generate less tax revenue than if the government had treated them more evenhandedly.

And tax rules that mismeasure income feed public resentment, since some people pay more tax than others whose true incomes are greater. Every sign that the tax laws are flawed—that they don’t measure income accurately—increases public resistance to high rates of taxation. If resistance grows too great, people in government whose careers and conceits are fed by public spending might eventually wind up with fewer billions at their disposal.

The government doesn’t want that to happen. So it keeps trying, year after year, to reform the tax system, to devise rules that measure income accurately. Yet it never seems to succeed. It never will.

WHAT IS INCOME?

True income is the flow of economic value—anything that adds to the total value of what you own. But economic value isn’t always susceptible to accurate, objective measurement, in the way a rock can be weighed on a scale or a roasting turkey’s temperature can be taken with a thermometer. Economic value is subjective. It depends critically on what people want and feel and believe, and no instrument can measure such things unless it can read minds and hearts.

Diamonds are more plentiful than rubies; yet diamonds, carat for carat, are worth more. Why are the white stones more valuable than the red? Nothing about their objective, physical nature will give you the answer, because the answer is hidden in the tastes and preferences of the people who buy diamonds and rubies. Even if those people were eager to explain themselves, they couldn’t tell you just how much they prefer diamonds. And even if their answers were precise when given, they wouldn’t be reliable for long, since human preferences are constantly changing.

Human wants are limitless, but there are clear limits to what, at any moment, people are able to do and have. Economic values arise from the compromises people make between their vast, shifting desires and their limited opportunities to satisfy them. Because those values refuse to stand up, stand still and let themselves be measured, the tax collector will always lose the game of hide-and-go-seek that income plays with him.

A Simple Case

It might seem easy to measure the income of someone who simply earns a salary. If he doesn’t invest for deductions or have money held in trust, if he doesn’t even have a home mortgage or an Individual Retirement Account, then it might seem that his true economic income is his salary —no more and no less.

But look a little closer and you find that an individual incurs costs and expenses in earning a salary. He has to pay for transportation to and from work. He may spend money on clothes he wouldn’t otherwise buy and on lunches that would cost less at home. And he may have spent thousands of dollars acquiring the skills and knowledge he uses in his work.

Ideal, precise rules for measuring his income would, somehow, take all these and other costs into account. The rules would deduct the cost of commuting (unless he enjoys traveling about town early in the morning and late in the afternoon). They would deduct the cost of the clothes he wouldn’t otherwise buy (to the extent it exceeds the cost of the clothes he would buy anyway). They would deduct the difference between the cost of eating lunch at work and the cost of eating lunch at home (unless he would eat out in any event). And each year these ideal rules would deduct a portion of the cost of his education (unless he didn’t learn anything useful in school or had enough fun to offset the cost).

The Internal Revenue Service employs over 96,000 people. If they were expert at mental telepathy, they might be able to measure incomes accurately. But because IRS agents can’t read minds, the government gives them arbitrary rules to follow: no deductions are allowed for commuting expenses, for clothing that is suitable for wearing outside of work, for lunches that aren’t part of “business entertainment” or for the cost of acquiring the skills a job requires (although you can deduct the cost of improving your skills).

But these arbitrary rules raise questions of their own. How do you distinguish between (nondeductible) commuting and (deductible) business travel if, for example, the taxpayer makes a business-related stop on his way to work? How do you determine what clothing is suitable for wearing outside of work? How businesslike does a lunch have to be to qualify as “business entertainment?” Can a business lunch be so entertaining that it’s not deductible? And how do you distinguish acquiring a job skill from improving a job skill?

These unanswerables do not by themselves provide any special tax-saving opportunities, but they illustrate the one idea underlying all income tax planning: even in the simplest cases, income is impossible to measure precisely.

A BIGGER PROBLEM

The government’s job is even more difficult when it tries to measure the income of a business.

A large part of the Internal Revenue Code amounts to a formula for calculating a business’s net taxable income. This is where the discrepancies between the government’s rules and economic reality are greatest.

Just watching the cash register won’t tell you whether a business is making a profit. To compute its income precisely, you must know the value of everything the business owned and owed on the first day of the year and compare those amounts with everything it owned and owed on the last day of the year. The difference between the two, plus anything paid out to the owners, would be the business’s true net income. But no one, least of all the government, can collect all that information.

To begin with, what is the market value, on any day, of the equipment the business owns? You can look at the books the business keeps, but they’re only a formality—numbers calculated according to the government’s rules. They say nothing about the actual wear and tear, nothing about the machinery’s actual resale value or replacement cost and nothing about its present or future usefulness.

Nor do the government’s rules consider the business’s goodwill and reputation—assets not even the owner can evaluate with much precision. Any change in their worth during the year is part of profit or loss, but it goes undetected by the tax rules.

The government is no more successful at measuring business liabilities. The rules simply ignore the effect of inflation and interest rate changes on the value of outstanding debts. But any decrease in the value of debt adds to true economic profit—and is invisible to the IRS.

No Help from Taxpayers

And, of course, the IRS doesn’t have the taxpayers’ willing cooperation in measuring income. Most taxpayers do what the rules demand, but few do anything to make the IRS’s job easier.

The government is aware of the public’s reluctance to cooperate, and constant skirmishing ensues. Taxpayers or their advisors find a way to reduce taxes. The government responds by changing the rules. But since the rules can never be perfect, taxpayers inevitably find opportunities in the new rules—to which the government responds by writing still more rules.

As the game proceeds, year after year, the rules become more complicated. When I began writing the first edition of this book, the Internal Revenue Code was 1,648 pages long. By the time I finished writing the current edition, it had grown to 3,387 pages. The related Treasury Regulations are now a 13,458-page thicket.

Tug of War

Adding to the tax collector’s predicament is the nature of government itself.

The government isn’t a single person with a single mind. It is thousands of people, each with his own likes, dislikes, objectives, superstitions and cache of knowledge. It’s no surprise that the rules those thousands of people produce add up to a patchwork of inconsistent opinions, compromised purposes and contradictory effects. For government, multiple personality disorder is normal and incurable.

So in many cases the distortions in the tax rules are deliberate. Their purpose is to subsidize politically favored industries by understating the income of taxpayers who invest in them.

GIFT AND ESTATE TAX

The government has trouble enough taxing income. Its problems are even greater in taxing gifts and estates.

In trying to measure your income, the government has a reliable point of reference: it knows that you and everyone else ordinarily pursues his own financial interest. When you sell something (your services, an investment or anything else), you seek the highest price, while the potential buyers are shopping for the lowest price. And when you buy something, you want to buy cheaply, while all the potential sellers are trying to get as much as possible. Transactions occur when the buyer and seller find a price both are willing to accept. Their agreement hands the tax collector a useful estimate of the value they place on what is being traded.

But gifts are another matter. By their nature, gifts transcend simple financial self-interest. You don’t bargain when you make a gift; you bestow— without having to reveal to anyone the gift’s true value. This leaves the gift tax collector to decide for himself whether the value you report is correct.

The tax collector has no problem if you give money or publicly traded stocks or bonds, since the gift’s value is apparent. He knows that a dollar is worth a dollar, and he can easily find the current value of a publicly traded stock or bond.

But some things are harder to appraise. The value of a building or of a rare coin, for example, allows a range of reasonable estimates—appraisals the tax collector can’t easily dispute. This gives you latitude to declare a value that produces the tax result you want. If you give to a charitable organization, you can select a figure that’s high but reasonable, for the sake of a large income tax deduction. If the gift is to a friend or family member, you can select a value that’s low but still reasonable, to minimize gift tax.

Other gifts—such as a gift of raw land, a closely held business or privately issued securities—are even harder to appraise. The range of reasonable estimates and the opportunities for tax planning may be quite large. And some gifts, such as a business opportunity you provide to a friend or relative, are impossible to appraise—and may be effectively invisible.

The tax collector faces the same problems in appraising the estates of deceased individuals. Thus a well-planned estate may include some hard-to-value assets, so that the estate’s executor may reasonably assign a low value to them. But a wise executor won’t overplay his hand, since reporting a value that is conspicuously low invites an argument. The estate tax return of the late Michael Jackson valued the artist’s image and likeness at $2,105. The IRS determined the value to be $434 million. Litigation ensued.

OPPORTUNITY ZONE

Between economic reality and the description of economic reality incorporated in the tax rules, between true income and the government’s definition of taxable income, between the true value of a gift and its reasonably stated value, is a gap—wide in places—where all tax planning takes place.

In most cases the government’s description of an economic event is defective in one or more of three areas: valuation, recipient and timing.

Valuation. An asset’s fair market value may be obvious and indisputable, or it may be uncertain. Such uncertainty can work in the taxpayer’s favor. And in some cases an asset can be repackaged in a way that increases or decreases its fair market value.

Recipient. Who received income? In the real world, only breathing, flesh-and-blood individuals receive income. The stylized world of the tax rules, on the other hand, is populated by corporations, trusts, associations and other imaginary persons. The tax rules pretend those imaginary people receive income—and in some cases permit the real people behind them to pay little or no tax, as we’ll see.

Timing. When is income received? Value you earn in one year may not appear on your tax return until many years later. In the meantime you can invest all of it for additional income and profit. The simplest strategies delay the reporting of investment earnings for only a year or two. But by tacking delay upon delay, you can use for many years a large fund of money that otherwise would have gone immediately to the tax collector. And with some strategies, you can turn temporary delay into permanent avoidance.

No Tricks

The art of tax avoidance is commonly thought of as a bag of tricks. It isn’t.

A trick relies on deception and carries the risk of being discovered. You have no way to evaluate most of the tax tricks you hear about, no way to judge which of them would go undetected—and you have good reason to fear the consequences of being caught. So tax avoidance may seem a dangerous game, one you would be foolish to play.

In truth, there are no tricks to tax planning. There is the imaginary world implied by the government’s rules, and there is the world as it really is. Tax planning plays on the differences between the two, following the government’s rules at every step.

Don’t Look Now

In Part III, we’ll begin looking at specific ways for you to exploit those differences. But I hope you don’t skip ahead to “the good stuff.” The techniques explained in this book will be far more useful if you first take the time to examine the principles that underlie them.

You’ve just read an excerpt from Terry Coxon’s Keep What you Earn. Click here to buy the book.

 

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