Tax Strategies that Don’t Work

‘Tis the season for talking about taxes. I thought I’d repeat some tax strategies that don’t avoid taxes, they evade them (the first is legal, a great American pastime, and one of the things I love about what I do; the second can lead to penalties, interest, and if you try hard enough, jail).

Before we get started, I’d like to address a common misconception – money doesn’t always equal income. Some sources of money (the principal part of loan payments, for example) aren’t income. Some sources of income (debt forgiveness, for example) don’t show up as money coming in. One of the more common ways that this misconception plays out is with my clients who insist that their dividends aren’t taxable because they were reinvested rather than paid out.

As a rule of thumb, any transaction that increases your assets (net of liabilities) is probably income. Principal repaid on loans isn’t income because the money coming in is offset by the decrease in the amount owed to you (an asset). Cancellation of debt is income because it decreases a liability (increasing your assets net of liabilities). Dividends are income because (barring our recent stock market insanity) they increase the stock that you own (another asset)*.

Also, not all income is taxable. Certain types of income (gifts, for example) are exempted from taxation. The IRS’s take is that if it’s income, and it doesn’t meet any criteria to be excluded from income, it’s taxable.

Cash:
Some businesses will offer hefty discounts if they are paid in cash instead of checks or credit cards. Some of these discounts may reflect lower processing cost for cash versions payments like credit cards. But I suspect that at least some of these businesses are offering discounts because they don’t intend to report or pay income tax on payments received in cash. Because cash that isn’t deposited doesn’t show up on their bank statements, they assume that they won’t get caught. The IRS can and does do life-style audits – comparing what they calculate you must spend to maintain your lifestyle to all sources of income (including nontaxable) that you report.

Bartering:
I’ve heard bartering suggested as a way to avoid taxes. Unless otherwise excepted, the fair market value of goods and services you receive in exchange for your services (or goods) is taxable income. While bartering won’t increase your bank account or cash assets, it does increase other assets (the ones that you receive) or provide you with services that you would otherwise have to pay for, which would decrease your bank account or cash.

Tax Free Internet:
It’s generally true that if you buy from an out of state company, they won’t collect sales tax (unless they are also operating in your state). What is not true is that purchases over the internet are exempt from tax. California, like many states, has a requirement to report and pay use tax (equal to the sales tax) on purchases that would be subject to sales tax if made from a California vendor. Since I’ve received mailings for the past two years from the state reminding me to ask my clients about use tax, use tax made it to the first page of this January Franchise Tax Board’s Tax News, and California recently concluded a use tax amnesty program, I expect this to be an audit focus in coming years.

Nevada Corporations:
Many Californian’s like the idea of forming a corporation across the border in Nevada to take advantage of the fact that Nevada has no state income tax. No doubt, one of the reasons that Nevada doesn’t have a state income tax is to encourage businesses to operate in Nevada. However, even if you’re incorporated in Nevada, California can still tax you on the income that you make in California (and the California Franchise Tax Board has an entire department dedicated to making that happen).

You may have heard that Nevada (like some offshore jurisdictions) allow “bearer” shares (stock certificates) – where the owner of the stock on the certificate is listed as “bearer” (basically, it’s owned by whomever holds the certificates), and the owner is not recorded on the company books. This is sometimes promoted as a way to hide assets, hide from lawsuits, or hide from controlled group taxation. Hiding is nothing more than a way of trying not to get caught. Bearer shares have been around for a long time, and the IRS is halfway decent at catching folks who don’t want to be caught.

Another downside is the nonneglible possibility of ownership being lost by misplacing a piece of paper (and passing the piece of paper, because it’s worth part of a company, can quickly trigger some hefty gift tax implications). BTW, on June 18, 2007 the Nevada passed a law requiring that companies maintain a “record of a beneficial ownership[that must be] available on request by the Secretary of State during the course of a legitimate criminal investigation).

This is the first few bogus strategies that came to mind, and I make no claim that this is a comprehensive (or even prioritized) list. There are lots more (check out the IRS’ Dirty Dozen for some leading contenders). The truth is, in taxes, like investments, mortgages, and plastic surgery, if it sounds too good to be true, it probably is.

* Most taxpayers cannot recognize their losses in the stock market until they sell the stocks, and selling the stock and they buying it back within 30 days will subject you to wash sale rules, where the losses are suspended (you generally can’t take them until you sell the replacement stock). Taxpayers who qualify (not many do, but some bonafide daytraders may) to and make the mark to market election can generally recognize losses based on the fair market value of equities at year, and are exempt from the wash sale rules.