October 16, 2015 - Phil Hodgen

The four ways to save taxes

Hey it’s Phil. Welcome to the Friday Edition, written today from the executive lounge of the Conrad Hotel in Bangkok.

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What I’m doing in Bangkok

My wife is with me, and at the moment she is out there somewhere, looking at fabric and places to get some women’s clothing manufactured. Yesterday we had lunch atKuppa with a friend who lives here, and his wife. My friend and I walked back, through the Tobacco Monopoly properties, to a place for me to get a haircut at a back street hair salon. Mary went off with my friend’s wife on a fabric and shopping expedition. In the evening they took us to their favorite restaurant for dinner.

Thanks Pat and Aey. We are so happy with our stay in Bangkok.

I’m in Bangkok to give a talk on Saturday at the DCBKK. You will be shocked, I’m sure, to hear that I am talking about tax stuff. My thanks to Dan and Ian, who run theDynamite Circle for the invitation.

This week’s Friday Edition

This week I am going to give you an excerpt from the talk I will be giving. These ideas apply to all tax work — domestic or international.

These are some basic principles that help you understand tax law.

I am talking about this in my presentation, in order to show my audience where two different topics fit into the portfolio of tax planning strategies.

Four (and only four) ways to save tax

Tax is a bit of a mystery to most people. It is a mystery because of its vast metastasizing complexity. When a tax boffin throws some ideas at you (“You should do X! You should do Y!”), it is easy to get confused.

But there are underlying concepts. Once you know them, it is easy to categorize those Brilliant Tax Strategies(tm) and thereby begin to demystify them.

The general principle of income tax law is that all additions to your wealth will be treated as income unless otherwise specified. IRC ยง61. Income is taxed, so your constant question will be “How can I pay less tax while keeping income the same?”

There are four — and only four, as near as I can tell — things that you can do in order to make your income tax number smaller:

  • Earn income now, pay tax never
  • Earn income now, pay less tax
  • Earn income now, pay tax later
  • Earn less income (aka better living through bookkeeping)

Earn income now, pay tax never

The first principle is everyone’s favorite. Receive income, but never pay tax on it.

This can be done, but only if you find a specific reason in the Internal Revenue Code. “All income is taxable unless we say otherwise” is the law’s philosophy.

For my DCBKK audience, the primary tool is the foreign earned income exclusion. IRC ยง911(a). See Form 2555 to make it happen. The title to Section 911(a) tells you the whole story: “Exclusion from gross income”.

This law says, to any American living abroad, “Earn up to $100,800 from your labors. The U.S. will not make you pay income tax on that.”

There are other examples. Municipal bond interest is one of them. You own a bond, and you receive interest payments. For various political reasons, that interest income you receive is not taxed.

  • Exploit this by finding income exclusions in the Internal Revenue Code.

Earn income, pay less tax

The second way to pay less tax is to earn a dollar of income but have it taxed at a lower tax rate.

The long-term capital gains tax rate is a classic example. In theory there should be no difference to a dollar you receive from salary vs a dollar you receive from selling stock. Yet the tax law encourages capital investment by giving you a lower tax rate if you hold the investment for more than a year. (Or look at it another way — Congress punishes people who earn money from their labor. As Charlie Munger says, “Invert. Always invert.”)

Carried interests for hedge fund operators are the classic example.

  • Exploit this by using character-transformer strategies — methods that make ordinary income look like capital gain, for instance.

Earn income, pay tax later

The third way to save tax is to receive your income now but pay tax later.

Usually, tax laws require you to pay the income tax you owe in the year that you receive the income. But there are ways to legally postpone the day of reckoning. You can earn the income now but pay the tax later.

Here, you are finding methods in tax law to legally wait to pay tax until a future year. Then you are harnessing the time value of money concept.

  • If you owe $10,000 in tax this year, you can either pay it to Uncle Sam or you can put it in the bank and pay Uncle Sam later.
  • If you put the $10,000 in the bank and earn a princely 1% interest, at the end of the year you have your original $10,000 (that you owe Uncle Sam) and you have the $100 of interest.
  • You pull the money out of the bank, and pay the tax (a year late). You have $100 left over — the interest income.
  • Of course, now you owe income tax on the interest income you received. Let’s say your tax rate is 40%. You pay $40 of tax, and keep $60 for yourself.

Merely by postponing the payment of your tax bill by one year, you have made yourself $60 richer.

The tax law doesn’t like this, and discourages you from using this strategy by using late payment penalties and charging you interest if you do not pay your tax bill on time.

But there are many strategies where you can use time to make yourself richer. Youhave the money to work with, not the U.S. government. Eventually the U.S. government will get the money, but in the meantime, those little dollar bills are working for you, not Uncle Sam.

You can see this in action (even if you do not know the technical details) if you look at Apple, Google, or any multinational corporation. They have untold billions of dollars of cash parked outside the United States. Why? Because they don’t have to pay U.S. income tax on that money (earned through foreign business operations) until they bring the money back to the United States.

  • Exploit this by any strategy that has delayed gratification ๐Ÿ™‚ built into it.

Earn less income (aka “better living through bookkeeping”)

There’s a fourth strategy. To me, in my “Hey kids, get off my lawn” ๐Ÿ™‚ mode, it’s my favorite.

You are allowed to reduce your income with business expenses — deductions — to compute your taxable income.

For tax nerds, gross income minus allowable deductions = taxable income.

The easiest place to look for this played at a master’s level scale is Amazon. Every year Amazon reports next-to-no profit. Yet it has been growing for decades.

  • Exploit this by having great bookkeeping.

Here is an example for the digital nomad, or any self-employed person, really.

You need some little odds-and-ends. A couple of USB sticks, a cable or two, maybe an external hard drive — all so you can get on the road to meet customers. You spend $200 on this, but you don’t capture the data on this purchase.

At the end of the year, you don’t take a tax deduction for the $200 that you spent on what is unquestionably a business expense.

Here are the economics:

  • You are out of pocket $200 for the stuff you bought;
  • You did not take a tax deduction for $200, and that means your taxable income is higher than necessary; so
  • You will be out of pocket for some additional tax.

How much additional tax?

The answer is $200 x your income tax rate. At the maximum Federal tax rate (approximately 40%) that is an $80 tax that is entirely optional, depending on your willingness to capture, track, and deduct expenses.

Or put it another way . . . your $200 of electronic miscellany actually cost you $280.

Where is your focus?

Finally, this isn’t about tax at all but . . .

If you run a business, your focus and attention is the most valuable thing you have. Take those hours and devote them to reducing your tax bill. What’s the best you can do? Answer: zero tax. Let’s say you pay $50,000 of tax per year. The return on investment for all of those hours is $50,000, if you’re lucky.

Or you can take those same hours and, following the advice of Saint Peter (Drucker), go create a customer or two.

See you in two weeks.

Friday Edition Tax and Trusts