Santa vs Tax Planning

End of the year tax reducing ideas

Getting in the Christmas spirit and year-end tax planning mixes like oil and water. Who wants to think about taxes, you ask, when it’s time for Santa Claus and candy canes.
It may surprise you to know that because of his investment in a fir tree farm in Montana some years back, Santa is a non-resident alien (for U. S. tax purposes) and does some tax planning in December himself. Seriously, for a lot of people, a little time spent at the end of the year concerning taxes can save a load of money in taxes not owed.

1. Start an IRA (from earned income); the maximum this year is $5,000 (and another $5,000 for your spouse). If you are age 50 or older the max is $6,000 (and $6,000 for your spouse). Even if you can’t afford to tie up the money for a long period of time, you can “cash out” the IRA after you file (which creates a taxable event for 2009, of course) and with possible tax planning in 2009, cover the cash-out with deductions or the possibility of lower income in 2009. In the meantime, you have created a $5,000 deduction in 2008 ($10,000 with a spouse). This strategy is particularly effective if it puts you in a lower tax bracket this year, but not in 2009. There is an old rule in tax planning: Always delay paying taxes as long as legally possible.

2. Turn that new hobby you started this year into a business, especially if there is a first-year loss, as there is in most new businesses. Be aware that the IRS states that if a business isn’t profitable in three years out of five that it can deem it a hobby. Also be aware that the IRS lost its case in federal court when it tried to enforce that rule. The court did not agree with that concept, stating that we all have the right to attempt to succeed at business as long as we like; that notwithstanding, I once worked with a couple who each had a separate business. It just happened to turn out, purely by circumstance, that while he had over $20,000 in losses each of the first two years, she made a slight profit both of those years ($10 the first year and $28 the second year). Then her business took a bad turn and lost over $55,000 over the next two years while his turned around a bit and showed a $19 and $36 profit. The fifth year, he made a profit of $16 while she made a profit of $119. The end result was the IRS rule was satisfied (even though legally, it did not have to be) and the couple racked up net deductions in excess of $95,000 over the five years. Most of the losses were items they might have purchased anyway (but would not have been deductible without a business) or involved travel costs that they deemed were business related and therefore deductible. Everything was covered with the proper receipts and bookkeeping (which I highly recommend). All was accomplished with proper tax planning.

3. For those couples where one is a U.S. citizen and the other is a non-resident alien (for U.S. tax purposes), there is the decision to be made as to whether to choose to treat the non-resident spouse as a U.S. resident. If you make this choice, you and your spouse are treated for income tax purposes as residents of the U.S. for your entire tax year. Whether to make this choice or not would depend on your individual circumstances (refer to IRS Publication 519, U.S. Tax Guide for Aliens). As one example, if the non-resident spouse were subject to the 30% tax on fixed or determinable income, it might be wise to make the election described above.

4. Converting an IRA (or a part of an IRA) to a Roth IRA (this subject was discussed in the September issue of Revue). This decision must be made by December 31. However, if later on you feel you made the wrong decision (more income than you expected showed up in the forms you receive in January and February), you can change it back to an IRA with no tax consequences. That is called a recharacterization and can be done on or before April 15 of the year following the year of conversion (October 15 if you file for an extension).

Once again, I will end my writing with a quote, this time from the late Louis D. Brandeis, U.S. Supreme Court Justice: “Where I live in Alexandria, Virginia, near the Supreme Court building, there is a toll bridge across the Potomac River. When in a rush I pay the toll and get home early. However, I usually drive outside the downtown section of the city and cross the Potomac on a free bridge. If I went over the toll bridge and through the toll without paying, I would be guilty of tax evasion. However, if I go the extra mile and drive outside the city of Washington to the free bridge, I am using a legitimate, logical and suitable method of tax avoidance. And, I am providing a useful social service as well.” (The italics are mine.)