A Supreme Court Justice was once asked by a news reporter what the difference was between tax avoidance and tax evasion. The Justice told a story that went something like this: "Between my office and home, there are two separate roads that I can take. Crossing the river on the shortest road is a toll bridge, the other road, which is a bit longer and passes through some
beautiful areas, has a free bridge. If I take the shorter route and try to pass through the toll bridge without paying my fare, that is tax evasion and is punishable by law. If, however, I pass over the free bridge on the longer route, I not only avoid paying a tax, but I should be commended for taking that route (it helps free up the shorter route). That is tax avoidance."
     Thinking in the terms given by this Justice, we see that Congress changes tax law continuously to create, shorten, enlarge, destroy or other wise modify free "bridges." Some people refer to these bridges as "tax loop-holes" or "tax shelters." The joke is that it is my tax shelter, but your tax-loop hole! The important idea here is that "social engineering" is going on and that the
Congress is trying to get the population to act in certain ways in an attempt to avoid taxation.
     One such attempt was on "All Savers Certificates" a few years ago. It was noted that our savings rate became extremely low (and, therefore, dangerous for the economy) and there was little money for the housing industry, so Congress created these certificates as tax-exempt (for 2 years) to get people to save more and specifically to save with institutions that made housing loans. The plan failed due to an unanticipated happening: people did not add to their savings, they simply moved current taxable savings to the new tax-exempt certificates. That bridge was abandoned.
    When you look at tax provisions, as found in Pub 17, you may or may not agree with the bridges that Congress has created and/or the interpretation that the IRS has given to those bridges, but adherence to those bridges is a major way for you to properly save tax dollars. You'll annually need Pub 17 and other sources to keep up with the changes that are made.

    One such major change under the Reagan Administration concerns "Regressive vs Progressive" taxation. Some types of tax do not differentiate between who pays the tax: these are "regressive."  Take an example: One person has $8 million in assets and earns well over $150,000 each year. When he goes to the grocery store, he pays the same tax rate on his food bill that you  do. Even if he eats more expensive food and buys three times more food than you do, as a percentage of his total income, this tax is small compared to the percentage of your income that goes to tax when you pay for your groceries. So regressive or flat rate taxes are equal taxes, but do not place equal burden on the populace--they are not "equitable."

    Progressive taxes are adjusted for the person's income (like "means testing"). This type of tax was the most common type of income tax in the past as they are considered "equitable" taxes. The original idea came from Europe, that those "well born" had a duty to those less fortunate.

    At our country's Centennial the tax battle cry, however, was "equality" as the bulk of the middle  class was convinced that the rich were avoiding their fair share of taxes through loop-holes (this was NOT TRUE--the Congressional Budget Office clearly shows that the actual tax dollars paid now by the rich are DRAMATICALLY reduced from the levels that they used to be and the middle class is paying a much HIGHER amount in actual tax dollars than ever before).
    Some assert that the wealthy should not have to pay for their greater earnings since that would discourage them from the tasks required to do so or that they can not invest in American jobs when tax dollars are assessed. Again the Congressional Budget Office shows that the rich invested OUTSIDE of America with their tax-savings and that, during the short 8 years of the
Reagan Administration, we DOUBLED the number of American millionaires! The Congressional Budget Office concluded that the "trickle down theory" did NOT work, but, instead, what actually happened is money "trickled UP" from the lower classes to the rich.

    Prior to Reagan the progressive income tax  went as high as 70% and as low as 11%. That meant that the LAST DOLLAR you earned was taxed at this "marginal bracket"---NOT EVERY DOLLAR!!! The average family in Utah seemed to be at about the 35% Federal Tax Bracket (paying 35 cents of the LAST dollar earned in the year) prior to Reagan and, therefore, actually paid about 15 cents AVERAGE on EVERY TAX dollar. There were more "tax forgiveness" then (dollars that escaped taxation up-front) so the average tax on EVERY dollar earned was somewhere around 11 cents.  Now the minimum tax rate is 15% with fewer forgiven dollars leaving most Utahns an AVERAGE 15 cents tax on nearly EVERY dollar earned (an actual tax increase).
    Currently the top tax bracket is 39.6% (see the tax appendix). The AVERAGE tax dollar on EVERY dollar earned, therefore, is much LOWER than the average tax dollar collected when the top tax bracket was 70% (and prior when the top bracket was 90%)! If a person makes more that an estimated $150,000 per year, the changes SAVED them actual tax dollars.

    Consider it this way: you are probably AT LEAST in the 15% bracket now (you get into the 28% bracket earlier than many people think)! The rich pay about twice the tax dollar (AVERAGE) than you do (you 15 cents average on every earned dollar, them a maximum of around 37 cents of every earned dollar), yet they earn much more than twice your salary. The progressive
income system of American has become much closer to a regressive system.    

   As of this writing (1995) there are proposals in congress to change income tax to a completely regressive tax ("Flat Tax") and other proposals to remove all taxation from investment earnings (Bush, 2003).

 

Taxation
  Taxes:  A complex and misunderstood area of the retiree's life.  Indeed, an area often causing anxiety and fear. Many older persons have given a good deal to their country through depressions and war times, and are very patriotic. Imagine the shock of receiving a computer-generated letter from the IRS which questions the  personal honesty and integrity of an older tax payer.
That scene is played out in many places, not due to intentional disregard for the law, but to misunderstanding or misinterpreting the tax provisions.

 

"Guilty Until Proven Innocent"
    One reason for these misunderstandings is who has the "burden of proof." In other areas of our society, a person is presumed innocent until the prosecution proves, with evidence strong enough to convince a judge or jury, that the person is guilty.  Not so in taxation.
    Taxation necessarily has to require the individual to provide the evidence against himself, and then the IRS checks that input against other sources for accuracy. This double checking is now very efficient owing to the use of powerful computers.  In fact, some of the most important changes made during the Reagan administration had to do with upgrading "compliance." Many
people have, in the past, been actually breaking the IRS rules without knowing it, and now are getting caught by the cross-checks of the IRS.

      One example is in real estate. For many years it has been required by the IRS that a sale of real estate be filed with them. Most people have not done that, either out of ignorance of the law or forgetfulness of the provision. But since January of 1987, the entity "closing" the deal in a real estate transaction (usually the title company) must report the transaction, the parties involved, the social security numbers, etc., directly to the IRS.
    Since May 1997, anyone (no age limitation) may sell their home, excluding up to $500,000 gain (filing joint; $250,000 single). You must have lived in it 2 of the last 5 years as your "principle residence." There is no limit to the amount of times you may do this in your life time, as long as the rules are followed.

     Another example is accounts that grandparents may create for a grandchild's education.  Since the child is a minor, the grandparent's or parent's name has also been placed on the account and often the child's social security number is listed.  Thinking everything is alright, the interest earned has not been declared on the grandparent's or parent's tax form - again something that is against the provisions (unless ALL control to the account had been given up by the use of "Uniform Gift to Minors Act").

     Older persons may also be confused by two or more different provisions.  This is often noted in the "I'm past 70, and don't have to pay taxes anymore" statement.  After age 70 a person may work and earn any amount without giving back Social Security benefits under the "excess earnings" rule.  But the earnings are still fully taxable, even Social Security income is taxed.

     Widows, who may not have handled the tax filing before, may erroneously think they do not have to file.  While it may be true that they did not file while joint returns were available, she may have to file as a single tax payer - especially if insurance proceeds are creating fully taxable interest.

    With the 1986 tax revisions, persons who thought that they would be in a lower tax bracket in retirement are finding that this is not necessarily the case.  Social Security benefits may be subject  to income tax since the 1983 tax change.  The Medicare Catastrophic coverage Act of 1988, which was repealed, would have started a "Medicare Tax" in 1989 which was to be
"indexed" to other taxes.  The maximum additional tax for a couple would have been $1,600 in 1989 rising to $2,100 by 1993.

When You Must File Federal Income Tax Forms
    If you are a U.S. Citizen or resident and had gross income of at least the amount shown on the table below, you must file a federal income tax return EVEN IF YOU OWE NO TAX: (1997)
Single person under age 65: $6,800;  age 65 and over:  $7,800
Married, joint filing both under 65: $12,200;
 both over 65: $13,800; only one over 65: 13,000
Married filing separately $2,650 at any age
Head of household under age 65; $8,700; over 65: $9,700
Qualifying widows(er) with dependent child under 65:  $9,550:

over 65 $10,350

Note:  New rules also apply if you are listed as a dependent by someone else.

 

Tax - Exempt/Tax Deferred Income
 TAX EXEMPT
   Certain investment vehicles produce tax-exempt interest income.  The term "tax-exempt" means that the interest earned from these investments is not included in your federal gross income.  Many types of municipal bonds produce tax-exempt interest.  These municipal bonds are issued by various state and local governments in order to produce funds for education and services or to finance other specific activities. 

    For federal income tax purposes, interest earned  on state, city, and municipal bonds is usually exempt from tax, as long as 90% of the benefit goes  directly to the issuer.  Interest on state, city, and municipal bonds may be exempt from state and local income taxes.  This is the case in Utah.

   A dividend is a return of the shareholder's investment in the company (or, in this case, in the municipality).  Since tax free dividends are considered return of capital, they are not usually taxed.

 

TAX DEFERRED
  Tax-deferred holdings also minimize the current federal income tax problem.  One example is the deferred annuity. A deferred annuity is an investment in which the earnings are tax-deferred until the payments are received.  Under life  insurance rules, these earnings are taxed upon distribution to you.  However, if the annuity is inherited by your beneficiary--you having not used any of it--your beneficiary will receive the value income tax free.

 

Income Tax Planning Hints
    One way to minimize your income liability is to take full advantage of your itemized deductions.  This can be done by properly timing the payment of deductible expenses over which you have control.  Here is a brief listing of when you can deduct certain expenses:

 MEDICAL...These expenses are generally deductible only in the year you pay them.  Payments for future medical services are not normally deductible in the current tax year unless an advanced payment is a requirement for services to be rendered. Payment to the medical vendor via use of credit (eg: bank credit card) are considered deductible in the year of the payment, even though you pay the debt at a later time.

 Medical deductions that have been used include:
 - treatment at drug and alcohol rehabilitation centers
 - expenses for handicapped care
 - home alteration to accommodate a disabled person

 TAXES...Most taxes are deductible in the year paid.  In fact, this rule also applies to certain prepaid taxes, such as property taxes. Remember, some taxes are no longer deductible (including sales taxes).

 INTEREST...(limited mostly to interest on the cost basis of your home mortgage) Such expenses are deductible in the year payment is made except in the case of prepaid interest. Prepaid interest must be deducted over the term of the loan on a pro rata basis. With the '86 tax law, most types of interest are not deductible.

 CHARITABLE CONTRIBUTIONS...These gifts are deductible in the year you make them, subject to certain limits. Also, several sophisticated techniques (such as a remainder trust) allow an individual to take a current deduction for a contribution which the charity will not receive until the subsequent year.

 CASUALTY LOSSES...These losses are generally deductible in the year the loss occurs.  This may or may not be the year the property is repaired or restored.  If the casualty loss is associated with a declared disaster area, you can elect to apply the loss against income of the prior taxable year.

 THEFT LOSSES...Theft losses are deductible the year the theft is discovered. When the property was actually stolen makes no difference for deductibility purposes.

 MISC...Subject to the 2% AGI (Adjusted Gross Income) "Floor",and NOT when producing tax-exempt interest, the following are some of the allowable deductions for the expenses connected with buying and selling securities:
 - Costs of books and subscriptions used in decision making.
 - Safe deposit box rental and bank fees for storage of securities.
 - Secretarial services and costs of telephone calls, postage, stationary.
 - Bookkeeping fees and fees for tax guidance and tax return preparation.
 - Fees to investment advisors and legal fees for the management or protection of investment.
 - State and local transfer taxes.
 - Premium paid to borrow stock and amounts for cash dividends in connection with "short sales".
 - Premiums for bonds to replace lost securities and margin accounts (not exceeding investment income)

 

    In most cases, you will want to accelerate your deductions so that your current income taxes can be lowered.  However, there are exceptions to this rule. For instance, you might expect your income to increase substantially the following year.  In this situation, your deductions would probably be more valuable the following year when they can be applied against income in a
much higher tax bracket.  Thus, the better strategy here would be to defer deductions past the current tax year. An anticipated increase in tax rates would be another good argument for deferring deductions.  On the other hand, decreasing tax rates such as those we've been experiencing the past few years would favor the acceleration of the deductible expenses.

 

"Passive" Activities
   Under the Tax Reform Act of 1986, up to $25,000 of the passive losses from the rental real estate activities in which the taxpayer actively participates may be used to offset non-passive income.  The $25,000 limit is phased out if the taxpayer's adjusted gross income, excluding passive losses, IRA contributions, and taxable social security benefits exceeds $100,000. 
For every $2 of AGI above $100,000, the $25,000 limit is reduced by $1.  Thus, there is no rental real estate passive loss allowed where AGI exceeds $150,000.

 

Kiddie Tax
   Under the Tax reform Act of 1986, there is a limitation to gifting assets to children under the age of 14 when used as an income shifting technique.  For a child under age 14, unearned income will be tax-free up to $500.  Unearned income over $500 is taxed  to the child at the parents' top marginal rate.  It does not matter if a grandparent or a parent gifts the income producing asset, earned income will be at the child's tax rate.

 

Tax Credit
Started in 1998, a tax credit of $400 ($500 starting in 1999) is available for qualifying dependents who are under 17 years of age.
 -Proper Use of Tax Credits- These credits may reduce your tax liability.  If the non refundable credits are greater than your tax, the excess is not refunded.  Refundable credits are treated like tax payments, (e.g. withholding or estimated tax payments).  If the total of these amounts is more than your total tax, the excess is refundable.
     The most common non-refundable credits are the foreign tax credit and dependent care credit.  The most common refundable credits are the earned income credit and credit for excess Social Security or railroad retirement tax withheld.

Income Tax Basis for Estate Assets
    Generally, your estate or beneficiaries receive a stepped-up basis in estate assets so that their income tax basis is the fair market value for the property included in the gross estate.  The fair market value for estate tax purposes is determined as of the date of death, or six months later on the alternate valuation if the executor so elects.
    If you purchased a parcel of land for $50,000 in 1960 and died in 1981 when the parcel was worth $200,000, your estate or your heir who receives the land will have a basis of $200,000 for Federal income tax purposes.  Therefore, the land could be sold shortly after receiving it, and the seller (the estate or the heir) would not be liable for any income tax on the $150,00
gain. If you have been a successful investor, and bequeath some common stock which has appreciated substantially, your estate or heir will not have to pay any Federal income tax liability on the appreciation.  The estate or heir will pay tax only on the appreciation which occurs beyond the valuation for estate tax purposes.
   The "stepped-up basis" is lost, however, on appreciated assets not inherited but gifted prior to death.  In the above example, had the title to the land been in your and your heir's name (you having purchased it alone and added the heir's name later as a gift), the heir would inherit also your purchase cost.  That means inheriting the $50,000 "cost basis" instead of the $200,000
"stepped-up" basis.  Upon sale, in the example above, the heir would pay income tax on the $150,00- gain instead of being "forgiven" of it.
    There are some exceptions to the " stepped-up basis" general rule. The most common exception is for items which are termed "income in respect of a decedent."  Included in this category are payments received to satisfy an obligation which would have been paid to the decedent except for his death, and which would have been taxable as income to the decedent.  For example, if the decedent owned Series E bonds, on which he or she had not declared the annual interest as income, the estate or beneficiary would be liable for the income tax upon redemption of the bonds.

 

Tax Shelters after the Tax Reform Act of 1986
 Rehabilitation Tax Credits
     To encourage the preservation of historic and older buildings, taxpayers became eligible for a 20% credit of rehabilitation expenditures for "certified historic structures" and a 10% credit of such expenditures for "non-historic" structures built prior to 1936. In general, $25,000 of "passive losses" in excess of "passive income" can be used to off-set "non-passive income." Any unused passive losses and credits can be "carried forward" indefinitely. There is a phase-out of this benefit for adjusted annual incomes from $200-250,000.

      Low Income Housing (was not continued after 1988) Tax credits of up to 70% were available in investing in low income housing under the TRA '86. The credit was available each year for up to a 10 year period. Limitations on deductions of losses and credits were similar to those in rehabilitation above.

 CHAPTER 12 IN RETROSPECT:
 1.  Should you file an income tax form (even if you owe no tax) this year?
 2.  Have you considered tax exempt income or tax deferred growth to help save taxes?
 3.  What is the real "net" left over for your current savings dollars after taxes and inflation?
 4.  What planning "hints" are available to you, and what professional will you check with before proceeding?
 5.  Have you been careful in co-ordinating estate planning (Chapter 11) with income tax planning (Chapter 12)?