9

Tax Planning

The items discussed in this chapter are more prone to change than most other parts of the tax code. Be sure to consult with a tax advisor before implementing any of the tax-planning strategies mentioned here or elsewhere.

Unlike Canada, the US has numerous tax-planning opportunities. You may have heard Warren Buffet, one of the richest men in the world, say that his tax rate is lower than his secretary’s. Because Mr. Buffet is able to structure his income in such a way as to receive mostly long-term capital gains (taxed at a flat 15 percent tax rate), qualified dividends (taxed at a flat 15 percent), and municipal bond interest (tax free), his effective tax rate was approximately 15 percent, while he claimed his secretary, whose only source of income was wages, was in the 25 percent tax bracket. Without getting into the social, economic, or moral discussion on whether this treatment is right or wrong, we want to discuss various tax opportunities available in the US.

While it is common for Canadians to use Canadian-Controlled Private Corporations to defer taxes, it is rare for Americans to use regular corporations (we call them C Corporations). There are a number of reasons for this, but the tax reasons are the following:

• C Corporations are subject to double tax. Whereas in Canada, the individual receives a dividend credit to offset the tax previously paid by the corporation, the US has no such credit and therefore both the corporation and the individual pay tax on the same income, creating double tax.

• Capital gains within a corporation do not receive the lower tax rate; the income is taxed at the marginal tax rate.

While these concerns are less of a problem for service businesses where there are few assets, little or no chance for a capital gain, and bonuses can be paid out to assure there will be no corporate tax, the non-tax benefits of other forms of ownership such as a Limited Liability Company (LLC), make the LLC the entity of choice for most business owners.

Also, unlike Canada, US tax law allows for a number of tax-deferred, tax-free, and tax-favored opportunities, in addition to retirement savings plans. The rest of this chapter will discuss various tax-planning opportunities available to US taxpayers.

Before we start, let’s clarify a point of confusion. There are a number of stories claiming that Canada is a more tax-friendly place to live than the US, (Friendlier, we will give you that — tax friendlier, no way!) Those making this claim, make two true statements:

1. The US and Canada have very similar income tax rates, and in some cases, lower tax rates than the US.

2. Canadian corporate tax rates are lower than the US corporate tax rates, then jump to the conclusion that Canada must be a more tax-friendly place to live.

We prepare US and Canadian tax returns day after day, year after year, and we can see that in nearly every case the Canadian tax is higher than the US tax.

The corporate tax rate is the easiest point to discuss, so we will discuss it first. Yes, Canadian corporate tax rates are lower; in fact, the US is among the world’s highest corporate tax rates. However, as we explained above, almost no one uses corporations in the US, and the ones that do, generally pay little or no corporate tax. There is one big exception to this and that is public companies like the ones listed on a stock exchange. However, the people that run those companies are small in number and are not the readers of this book. So for those of you reading this book, the corporate tax rate could be 100 percent and it would not make any difference because you will not be using a US corporation anyway.

The personal income tax rates are also easy to explain. The reason the tax rates are similar, yet Americans pay lower overall personal taxes is, in large part, due to the fact that there are so many tax-planning opportunities. In Canada, there is relatively little difference between your gross income and your taxable income. Whereas in the US, there can not only be substantial differences between gross income and taxable income, the income that is reported may be subject to special, lower, tax rates. In addition, some of the income can be deferred to later years or be completely tax-free; you can even choose to live in a state that has no state income tax. Add to those facts, that while the marginal tax rates are similar, the income at which you reach those tax rates are substantially different. For example, in 2011, you were not in the highest US federal tax bracket of 35 percent until you had taxable income of more than $379,150. Compare that to Canada where you are paying the maximum tax rate starting at $128,800 of income. Based on our experience, you can expect to pay about one-third less as a US taxpayer. Of course, this could be more or less depending on where in Canada you live, where in the US you choose to live, and the type of income you are earning.

Note: We believe that the US is Canada’s best tax haven. For more information of why we believe this is so, you can read the book by Robert Keats, titled, A Canadian’s Best Tax Haven: The US. Here is the link if you wish to order the book: www.self-counsel.com/default/personal-finance.html. (The book is also available in electronic format.)

1. Tax Planning in General

When thinking about tax planning, it is good to start with the big picture before getting into the details. Tax planning falls into the following eight general categories:

• Convert taxable income into tax-free income (municipal bond interest)

• Convert taxable income into tax-preferred income (long-term capital gains and qualified dividends)

• Defer income into future years (retirement plans, installment sales, tax-free exchanges, annuities, US savings bonds)

• Take advantage of special tax breaks (education)

• Take advantage of special tax credits (energy, child care, adoption)

• Income splitting (with spouse or children)

• Convert normally nondeductible expense into deductible expenses (business and rental expenses)

• Timing (accelerating or deferring income or expenses to maximize your tax brackets)

Many of these items are discussed in detail in Chapter 7, but we want to pull the idea of tax planning into a coherent concept in this chapter rather than leaving it to you to gather the bits and pieces throughout the book.

Note: When thinking about tax planning, you must consider the outcome over at least two years. The easiest example to show this is, if you choose to defer income and accelerate expenses in 2012 that means that 2013 will have to include the income you deferred and will not have the expenses you took in 2012. Some cases where this might make sense are if you had an exceptionally good year in your business and you do not expect that level of income again next year. Alternatively, you could be retiring in 2013 and expect your income to drop significantly.

2. Specific Tax-Planning Opportunities

The following sections discuss specific tax-planning opportunities such as using your principal residence, other real estate investments, securities, and EE and I bonds.

2.1 Your principal residence

One tax break that is better in Canada than in the US is the exclusion of capital gains on your principal residence. As you know, Canada allows an unlimited exclusion, with certain limitations based on the size of the lot. The US allows an exemption of $250,000 per person. This exclusion applies if the residence was your principal residence for at least two of the last five years. A home, condo, mobile home, boat, RV, etc. can qualify as a principal residence as long as it has sleeping, eating, and toileting accommodations. If you have multiple homes, the rules for determining your principal residence are similar to those in Canada; basically it means where you spend most of your time.

If you rented your home, you will have to pro-rate the exclusion, even if you meet the two- out of five-year rule. This most frequently happens when you do not sell your home in Canada prior to moving to the US. Rather than leave the home vacant, you decide to rent your Canadian home until you sell it. Even if you sell the home within three years so that you meet the two- out of five-year test, you will not be able to exclude the entire $250,000 per person.

2.2 Other real estate investments

US tax law provides many incentives for real estate investment. While many of the tax incentives are similar to Canada, some are not. Some incentives that are similar are the ability to accelerate expenses through depreciation (capital cost allowance) and preferable tax treatment on the sale. One big difference that the US provides is the ability to rollover your profits into a new property in what is called a tax-free exchange.

Note: There are “passive activity” and “passive loss” rules that make real estate investing complicated, from a tax perspective.

2.3 Securities

One of the legitimate knocks on the US tax law is that it is too complex. Securities and real estate law are examples of this. Just as in the real estate sections above, we will only talk in generalities.

Common stocks allow you to defer gain and generally pay a flat 15 percent capital gains tax if the stock was held for more than one year. Gains held a year or less are subject to ordinary income tax rates. Dividends also are taxed at a preferred rate of 15 percent. Both of these laws are expected to change in 2013.

Municipal bonds are state and local government obligations. The interest paid on these obligations is free from federal tax and free from state income tax of the state they were issued. Of course, it is not quite that simple. When considering the purchase, you have to consider whether the bond is for public purpose, qualified private activity, or non-qualifying private activity. Non-qualifying private activity bonds are taxable at the federal level and tax free at the state level. Qualified private activity bonds are tax free, but have alternative minimum tax implications.

2.4 Series EE bonds and I bonds

These bonds are issued by the US government and have a fixed rate of interest and are guaranteed by the full faith and credit of the US I bonds, or inflation adjusted bonds provide a return that rises and falls with inflation. The bond has a minimum guaranteed rate and that rate can be supplemented if inflation increases. Both bonds can be bought for as little as $25, with a limit of $10,000 per year. Bonds must be held at least 12 months before they can be redeemed. If redeemed before five years, three months of interest is lost. Interest on these bonds is deferred until redeemed, or 30 years, whichever comes first.

3. Tax Breaks for Senior Citizens

If you are receiving benefits from US Social Security, Canada Pension Plan (CPP), Quebec Pension Plan (QPP), or Old Age Security (OAS), these receive special tax benefits. At a minimum, 15 percent of your benefit is tax free; if you are a low-income earner, your benefits may be completely free from US tax. Additionally, most states exempt Social Security benefits from tax; some states will also exclude CPP or QPP and OAS benefits.

If you are 65 or older on January 1, you will receive a higher standard deduction, if you do not itemize. For 2012, the standard deduction for a single person 65 or older is $7,400. If you are married filing jointly, the standard deduction is $13,050 if one of you is 65 or older and $14,200 if you are both 65 and older.

4. State Income taxes

In general, you will have to pay state income tax in addition to federal income tax. Forty-one states impose a broad-based income tax on its residents, while seven states (Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming) have no income tax, and two states (Tennessee and New Hampshire) impose a tax on interest and dividends only.

Caution: You need to consider your total taxes paid such as property (real estate) taxes and sales taxes, not just income taxes. The states with the lowest overall tax burden are Alaska, Nevada, Wyoming, Florida, and Arizona. Notice that Texas, Washington, and Tennessee did not make the list, but Arizona did. The states with the highest overall tax burden are New Jersey, New York, Connecticut, Maryland, Hawaii, and California. (The Resources section at the end of the book has links to all of the states’ taxing authorities.)

You may remember that state income tax and property taxes are expenses that are deductible on your federal tax return, if you itemize. However, if you live in a state that chooses to collect tax revenue primarily through sales taxes, you may be out of luck. For tax years through 2011 sales taxes were deductible, but for 2012 and beyond, the law is set to expire unless Congress acts. If you live in a no-income tax state, you could be disadvantaged simply because of how your state chooses to tax its residents.

One thing to consider is that because income taxes are deductible on your federal return and sales taxes are not, you may be better off, financially speaking, living in a low-income tax state such as Tennessee or Arizona than in a state like Florida, because you can deduct the tax you pay. In a very simplistic example, let’s say that you pay $100 in sales tax to Florida and you pay $120 in income tax to Arizona. You will be able to deduct the $120 on Schedule A of your federal tax return. If you are in the 25 percent marginal tax bracket, you will lower your federal tax burden by $30 (120 x 25 percent), meaning the Arizona tax cost you $90, net. In this example, you would have been better off by $10, living and paying taxes in Arizona than in Florida.

Planning idea: You have to take your particular circumstances into consideration when determining which state is best for you. Determine the amounts and sources of your income (income tax), your estimated spending (sales tax), and size of home (property tax). From these things, you should be able to get an estimate of the total tax you would pay in each state you are considering; don’t forget the after-tax cost of the taxes. Of course you should weigh any tax savings against the lifestyle you want such as proximity to an ocean, airport hub, family, health care, and arts and entertainment.

Another important tax to consider is whether the state has its own estate or inheritance tax. This topic is covered in more detail in Chapter 10, but keep in mind that 16 states and the District of Columbia have their own estate tax, 6 states have their own inheritance tax, and some states have both. The good news for some of you is that all of the states that impose an estate and/or inheritance tax are in the north, except for Hawaii.

5. Community Property

Community property is a method of holding title (owning) and assets. The reason we bring up community property here is that it can have significant tax-planning implications verses other types of ownership. Not all states allow all possible ways to own a property. In general, there are two types of laws in which to own property, they are called “community property” and “common law.”

The states that allow for community property ownership are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. There are two different ways you can purchase an asset using community property laws; “community property” and “community property with rights of survivorship.” In community property states only, married couples can take ownership as community property. In this case, they will each own a half interest in the property. Unlike joint tenants, the owners can pass their interest (half interest) by will or trust upon their death and they will not avoid probate.

Certain community property states allow married couples to own property as community property with rights of survivorship. Similar to community property, the couple will each own a half interest in the property; however, when one of them dies the survivor automatically owns the entire property and avoids the costs and time of probate.

When possible, owning property as community property with rights of survivorship is typically preferable. The reason has to do with income the tax benefits after death. When a couple owns property as joints tenants and one spouse dies, the deceased person’s cost basis in his or her half of the property gets adjusted to fair market value (FMV) at the date of death. However, couples owning property as community property with rights of survivorship will have cost basis of the entire (100 percent versus 50 percent) property adjusted to FMV. This means that if there was appreciation in the property at the time of death, the appreciation is completely wiped out when the cost basis is adjusted to FMV at death.

Community property with rights of survivorship is typically preferable to community property without the rights of survivorship because the expenses of probate are avoided. If you recall, the difference between the two forms of community property is that with rights of survivorship, the survivor automatically owns the entire property and avoids probate. Probate is the cost of settling your estate (legal mostly). Any assets that have to be passed to your heirs via your will are subject to probate.

Here is an example of the potential tax benefit:

• John and Carol Smith bought a house for $200,000; meaning that essentially they bought the house for $100,000 each. Five years later John dies when the house is worth $300,000. On the date of death they owned a property worth $150,000 for each of them and each of them had a cost basis of $100,000, giving them each a hypothetical gain of $50,000.

If the house was bought as joint tenants, only John’s half would have its basis adjusted to FMV. This means that the half Carol receives from John has its cost basis adjusted from $100,000 to $150,000. Carol continues to retain her cost basis of $100,000. She now owns the entire property worth $300,000, with a cost basis of $250,000 (Carol’s $100,000, plus John’s $150,000).

If the house was bought as community property or as community property with rights of survivorship, both halves would be adjusted at the first death. This means that Carol would inherit the property with a $300,000 cost basis (FMV = $300,000 and basis is adjusted to the FMV). This wipes out all capital gains as of John’s death. Carol could sell the property at that time and incur no capital gains.

Caution: If the property declines in value, the cost basis also declines. In this example, if the property declined to $150,000 at John’s death, Carol would inherit the property with a basis of $150,000 — a loss of basis of $50,000. Whereas if they owned the property as joint tenants, the basis would be $175,000 (John’s basis is adjusted to half of the FMV and Carol retains her $100,000 basis), leaving a $25,000 capital loss that could be taken if Carol sold the property at that time.

Note: You cannot take a loss on your personal residence.