Tax planning evaluates various tax options in order to determine when, whether, and how to conduct business and personal transactions so your taxes are eliminated or reduced. As an individual taxpayer, and as a business owner, you will often have the option of completing a taxable transaction by more than one method. The courts strongly back your right to choose the course of action that will result in the lowest legal tax liability. In other words, tax avoidance is entirely proper.
Although tax avoidance planning is legal, tax evasion - the reduction of tax through deceit, subterfuge, or concealment - is not. Frequently, what sets tax evasion apart from tax avoidance is the IRS's finding that there was some fraudulent intent on the part of the business owner. The following are areas that IRS examiners most commonly focus on when looking for possible fraud:
- Failing to report substantial amounts of income, such as a shareholder's failure to report dividends, or a store owner's failure to report a portion of the daily business receipts.
- Claiming fictitious or improper deductions on a return, such as a sales representative's substantial overstatement of travel expenses, or a taxpayer's claim of a large deduction for charitable contributions when no verification exists.
- Engaging in accounting irregularities, such as a business's failure to keep adequate records, or a discrepancy between amounts reported on a corporation's return and amounts reported on its financial statements.
- Improperly allocating income to a related taxpayer who is in a lower tax bracket, such as where a corporation makes distributions to the controlling shareholder's children.
- Engaging in a "sham transaction," such as paying your children for work they did not perform.
A business owner may not reduce his or her income taxes by labeling a transaction as something it is not. So, if payments by a corporation to its stockholders are in fact dividends, calling them "interest" or otherwise attempting to disguise the payments as interest will not entitle the corporation to an interest deduction. It is the substance, not the form, of the transaction that determines its taxability.
How a tax plan works. There are countless tax planning strategies available to a small business owner. Some are aimed at the owner's individual tax situation, some at the business itself. But regardless of how simple or how complex a tax strategy is, it will be based on structuring the transaction to accomplish one or more of these often overlapping goals:
- reducing the amount of taxable income
- reducing your tax rate
- controlling the time when the tax must be paid
- claiming any available tax credits
- controlling the effects of the Alternative Minimum Tax
- avoiding the most common tax planning mistakes
In order to plan effectively, you'll need to estimate your personal and business income for the next few years. This is necessary because many tax planning strategies will save tax dollars at one income level, but will create a larger tax bill at other income levels. You will want to avoid having the "right" tax plan made "wrong" by erroneous income projections. Once you know what your approximate income will be, you can take the next step: estimating your tax bracket.
The effort to come up with crystal-ball estimates may be difficult and by its nature will be inexact. On the other hand, you should already be projecting your sales revenues, income, and cash flow for general business planning purposes. The better your estimates, the better the odds that your tax planning efforts will succeed.