As a society, we’re not really taught much, if anything, about taxes in high school or college. My first personal experience of preparing my tax returns while working through college was one of sheer terror. All I had was a W-2 to report earnings and withholdings, but the task was overwhelming and the stakes were high. At least I saw it that way at the time. Would the IRS come knock on my door if I had reported something wrong? Would I go to tax jail?
Given the ubiquitous and often insidious nature of taxes, it’s surreal that there’s not some basic level of education of how taxes work and their impact on us. We pay sales tax on the goods we buy, payroll taxes on the wages we earn, property taxes on the real estate we own, income taxes on our business profits, capital gains taxes on selling appreciated assets, etc. In an economy driven by earnings and consumption, most adults in the United States are paying some type of income or consumption tax nearly every day, often without even realizing it.
The Internal Revenue Service, the department tasked with enforcing federal tax laws in the US, isn’t much help either. If you contact the IRS for help applying tax law to your specific situation, you’re either doing it on your own and the struggle will be real, or you have paid a professional to help and the struggle will be real and expensive. Day-to-day tax management for many individuals and most businesses require professional help. Quite a bit of it, in fact, since as of January 2020, a little over 800,000 individuals were registered with the IRS as paid tax return preparers.1
During my years of working in taxes, I’ve repeatedly seen the same misunderstandings, mistakes, and fears, so I’ll address some of them here. I doubt you’ll walk away from this article more interested in paying taxes, but I do expect you’ll be more enlightened and more confident about the mysterious working of our tax system.
Here we go:
- Most people have at least a passing interest in reducing their taxes. That’s what I’m in the business of doing, so I love to hear that! If you’re in this boat, there are things you should know:
- If you want to put tax-savings strategies in place, you almost always need to have three things: A) a somewhat complicated tax situation which is usually the result of multiple sources of income, B) cash flow available to generate some kind of deduction, and C) enough of an attention span to make something happen.
- When it comes to tax strategies, for the most part either everyone knows it and does it, or it’s tax evasion. Are there little known and underutilized areas of the tax code that could benefit your particular situation? It’s entirely possible, and I certainly see that among my clients. By and large, though, it’s the standard strategies – maximizing deductible retirement plan contributions, properly reporting all business expenses, and so on – that help the most people.
- If it feels good, it’s probably taxable. But you already knew that.
- Every situation is different. Just like one additional symptom can mean a different diagnosis, one extra bit of information can lead to an entirely different optimal answer. Make sure your tax advisor has insight into your entire financial and legal situation.
- The IRS is old school. In an age of machines in our pockets that can determine our position nearly anywhere on the planet, the IRS is still faxing and mailing confidential tax information to the address you lived at 3 moves ago. While you may be accustomed to filing your tax return electronically, many tax returns still must be filed via snail mail. You can deal with nearly any major company online, yet the IRS still requires phone calls and in-person visits for many critical interactions. It’s no wonder the IRS still hasn’t figured out how to tackle cybersecurity issues such as fraudulent tax return filings.
- There is a big difference between tax avoidance and tax evasion. Tax avoidance is legally structuring your taxable activities to minimize tax exposure. Tax evasion involves illegally underreporting your taxable activities, failing to pay taxes owed, and similar shenanigans. By the same token, there is a big difference between a tax shelter such as a 401k retirement account and an abusive tax shelter such as ones for which the IRS requires special disclosures on tax return filings. I encourage everyone to minimize taxes through legal methods and to not engage in tax evasion.
- There are many reasons you might request the IRS issue you a taxpayer identification number. You may be starting a business or a non-profit. You may be a foreign individual with a US tax filing requirement. You may be an estate executor. Whatever the reason, KEEP THAT NUMBER FOREVER! Do NOT throw away the form that shows this number. You will need it again, I promise. Trying to obtain that number again from the IRS is impractical, if not impossible.
- The United States is one of only two countries to tax its citizens on their worldwide income regardless of where that citizen lives.2 Most countries that have an income tax have either a residence-based or a territorial taxing regime which means that an individual’s country of residence, not their citizenship, is the primary factor in determining which country or countries are entitled to tax from that individual’s activities. This makes for super confusing situations for US citizens living abroad and for non-citizens who stay in the US long enough to become resident aliens who generally fall under the same tax reporting requirements as US citizens. To add to this, penalties for failing to properly report worldwide activity are costly and potentially criminal. If you have any multi-country activity, and one of those countries is the US, you need to be working with a US tax advisor.
- While tax laws may often make sense to those drafting and approving of them, the outcome is that they are often arbitrary for those impacted by them. If you never noticed before now, 2020 made this perfectly clear. Taxes are funds that allow governments to provide services and, well, whatever else governments decide they want to do. Tax laws are influenced by the government’s agenda, the current and expected economic climate, special interest groups, a taxing jurisdiction’s population, and so many other factors. For tax professionals, a historical perspective of how a particular law came to be can be useful when we’re in the weeds of helping a client. For everyone else, either accept a tax law or challenge it, but there’s probably little to be gained in understanding the intent of any particular piece of tax legislation unless your tax advisor encourages you to.
- All sorts of penalties are associated with tax payments and tax filings. There are penalties for paying taxes late, filing tax returns late, substantially understating your income, ad nauseam. And not all penalties are monetary. For serious matters, penalties include having your US passport revoked and going to jail. Whoa! How do you best avoid all of this?
- Pay taxes owed by the appropriate due date. So simple, so true.
- File your tax returns on time. Even if you owe and can’t pay, file your tax returns.
- Be honest and reasonable with your tax filings.
- If you have other people’s tax money in your possession, do NOT use it for your own purposes. An example of this would be a business withholding payroll taxes from employees and using that money to keep operations afloat rather than remitting the funds to the government. Bad, bad things are in store for anyone involved in such schemes.
- Do not fail to disclose non-US assets or non-US income to the IRS.
- One of the biggest tax benefits that impacts the most taxpayers at some point is the Internal Revenue Code Section 121 gain exclusion. Generally, when you sell real estate that has appreciated in value, you have taxable gain on the difference between what you sold it for less what you paid for it + substantial improvements + closing costs. There is an important exception to this rule. Section 121 allows for up to $250,000 of this gain to be excluded from federal taxation, presuming a few criteria are met. This exclusion doubles to $500,000 for married couples. Most folks take it for granted that they won’t be taxed on the sale of their home, but there are pitfalls and ignoring them can be expensive:
- Not keeping adequate records on purchase and substantial improvements to prove your cost basis.
- Failing to do upfront planning to ensure meeting the criteria to exclude most/all of the gain.
- Transferring ownership of the home in such a way as to partially or entirely eliminate the gain exclusion.
- Not considering this exclusion anytime there may be a transaction related to your primary residence such as purchasing, selling, gifting, using for rental or business purposes, etc.
- Looking at a tax return and seeing a refund of any amount is not, by itself, a very meaningful observation. The US operates under a pay-as-you-go tax system. This means that if you are an employee, your employer is generally required to withhold and remit income taxes from your paychecks. If you are self-employed or retired, you may be expected to make estimated tax payments during the year. When you file your personal tax returns the following year, part of that filing includes a “true up” of your tax liability (how much you actually owe) compared to the payments you made. All of this means that the amount of taxes your completed tax return reflects as owed or overpaid is only meaningful from a cash flow perspective. This number by itself doesn’t tell you how much your tax liability was for the year, how much you benefited from tax strategies you put into place, or how much you overpaid the government by not putting tax strategies into place. Again, looking at a tax return and seeing a refund of any amount is not, by itself, a very meaningful observation.
- If you take away nothing else from this article, understand this: sometimes taxes work like algebra and sometimes taxes work like chemistry. In algebra, 1+2=3 and so 3-2=1. Sometimes taxes work this way. Very often, though, taxes work like chemistry. Consider H2 Two atoms of the element hydrogen and one atom of the element oxygen combine to create water – a necessary component for life as we know it. By adding an additional atom of oxygen, we get H2O2– hydrogen peroxide. Adding more oxygen doesn’t give you, say, heavier water, but instead results in an altogether different substance with different characteristics, applications, and so on. This is how taxes very often function. This is why adding one more dollar of income can cause you to completely lose a valuable tax credit or why married couples merging their tax situations get a wildly different result than you’d expect from looking at each spouse’s set of facts on its own. This is why, so very often, the answer to a tax-related question is “it depends.”
The great physicist Albert Einstein is attributed as saying, “the hardest thing in the world to understand is the income tax.” And tax law has only become more convoluted since Einstein filed his tax return. I hope you found something here to make taxes less, well, taxing.