We Live in a "Taxing" Environment
My Mom's favorite show to watch on television was "Wheel of Fortune." I'm sure you've seen it. Thousands of dollars in prizes are given away in every episode, and the ecstatic contestants squeal with delight as they are presented with such things as trips to Fiji and new automobiles. Who wouldn't love such a good deal?
But wait a minute....you have a "partner" in this transaction - Uncle Sam. Suddenly your great windfall becomes a burden, especially if you are awarded merchandise instead of cash. For example, let's say you just won a new car worth $29,000. The game show will issue you a Form 1099 that shows you have just earned $29,000 in income. Not only might that bump you into a higher tax bracket, but state taxes may also apply. You could find yourself having to come up with an extra $7-9000 just to pay the taxes on your winnings. You might even have to sell the vehicle to do that.
Your government wants it's money (you didn't think it was yours, did you?) and it will get it. Ask any retiree about Required Minimum Distributions and they'll give you a very good answer on how our tax code affects us all.
Some Tax Concepts You Should Know
There are 3 concepts that are essential in understanding how our tax code functions. Each of them are represented in various ways by the IRS tax code, judicial decisions, and other elements of tax law. Knowing these concepts is fundamental in understanding what will be taxed, and what won't.
The Doctrine of Constructive receipt
In a nutshell, this doctrine means that an individual will report income in the year that it's received, or available to be received. For example, suppose a mechanic renders services to a customer in December, but then sends a bill, and is paid for those services in January of next year. The money he receives would not be counted for tax purposes until the next year, the year he actually got the money. Basically, if the money is available for you to take, even if you don't take it, it's considered taxable. For example, your employer offers you a certain amount of deferred compensation, and you can take it anytime you want to, then the IRS considers it taxable even though you may not have accessed it at all.
Economic Benefit Theory
What, exactly, does the IRS consider to be income? The economic benefit theory says that any economic benefit conferred on a taxpayer, no matter what form it takes, such as cash, stocks, game-show prize winnings, or a goat in exchange for mowing someone's yard, is considered to be taxable.
The Assignment of Income Principle
This principle is not so much about "what" is taxable, but about "who." This principle states that "the taxpayer whose personal efforts generate income, or who is the owner of property that generates income, must declare that income on their tax return. For example, a father arranges for income from his portfolio of corporate securities to be paid directly to his son. Even though the son is the one who receives the income, the father will be the one paying the taxes because he's the owner of the stock. This rule is designed to prevent someone in a higher tax bracket from shifting the tax burden onto someone in a lower bracket.
There's Nothing New Under the Sun
I've been somewhat amused by our recent election, in which candidates on both sides accused the other of not paying taxes. There's nothing morally wrong with not paying taxes, as long as it's done legally. The tax code is filled with exclusions and loopholes designed for just that purpose: to allow a tax-savvy citizen to take advantage of these laws to lower, and many times even eliminate, their tax bill. That's why people use financial planners, like me.
Like some help with your tax situation? Give me a shout. The money you can save over a lifetime of smart tax-planning can be substantial (see Case Study: Estate Tax Reduction.
Until next time,
Are you a serious investor? Like to keep up with what's happening on Wall Street. Take a look at our commentary on what's happening in the market. Delivered weekly to your in-box!