There’s a Smarter Way to Save Tax Dollars (And It Doesn’t Involve Hiding Off-The-Books Cash)
Editor’s Note: This blog is one in a series of tax-related blogs on tax mitigation. The blogs are based on an Addicus whitepaper, “You Think You Have a Tax Plan.” If you’d like to read the first blog in our series, go to “What If We Flipped the Proposed Tax Hike on Its Head?”
All too often, the taxpayer will hide a little off-the-books income here and there. Yet, that same taxpayer will shy away from taking competitive positions on a tax return for fear of being audited.
Outside of the fact that one approach is illegal, while one is not, there’s another key factor: A taxpayer who takes competitive positions on his tax return can often save far more tax dollars than those who hide cash income.
There’s undoubtedly a level of perception and psychology at play here. It’s not uncommon for situations to arise when what seems to be true on its face, is in fact not true at all. It’s like the “healthy person” who is too disciplined and pretentious to have a slice of beef bologna (despite loving bologna!), but will readily dive into a whole-grain sandwich stacked with extra lean Black Forest ham.
Sounds reasonable, except it doesn’t make a lot of sense when you dig into it. Both deli meats have an unsavory list of indiscernible ingredients. And while Black Forest ham has an edge on beef bologna when it comes to calories and fat, the bologna actually has far less sodium. Plus, of the two, bologna’s the sandwich meat that’s not coated in caramel coloring.
What’s Seemingly Inconsequential Is Technically Tax Evasion
Likewise, when we look into a taxpayer’s obligations and really understand the details, what’s true rises to the top.
While the U.S. tax system is daunting and complex, it has its simplicities. By definition, it’s a voluntary compliance system enforced by the IRS to ensure the requisite amount of taxes needed to fund the federal government are paid to the Treasury. It’s a basic requirement of all citizens to contribute to the operation of the country, and one of the first things we require at Addicus is for our clients to make sure they report all income.
The Internal Revenue Code Section 61 is very clear when it says, “all income from whatever source derived,” must be reported.
Still, there are situations that can lull a taxpayer into feeling comfortable keeping cash off-the-books. The opportunity is right there for the taking, directly in front of the taxpayer, while Internal Revenue Code Section 61 is hidden somewhere in small print, like the caramel color your deli ham is doused in.
Our firm once worked with a client who owned a home in a college town. His son lived in the home with roommates. The home wasn’t necessarily a rental house because his son lived in it, but it wasn’t a primary residence either because multiple bedrooms were rented to his son’s roommates. The roommates paid rent to the son each month, and the client allowed his son to keep the excess rent in lieu of paying his son an allowance.
Before becoming an Addicus client, this taxpayer didn’t report the income because it was off the books and transferred directly from the roommates to his son. While this decision was simple and seemingly inconsequential, it’s technically tax evasion.
Taking off-the-books cash and checks seems so easy. Why would a person want to report something that isn’t in the system if it only means potentially paying more taxes? While seemingly innocent, if a client fails to report this off-the-books income, he’s at fault. This is more than a small oversight; it is a crime. “All income from whatever source derived” doesn’t leave any wiggle room.
Tax Evasion Vs. Tax Mitigation
There is a massive difference in tax mitigation and planning versus tax fraud and evasion. The first two are legal, the later two are not.
Once a very wealthy professional and Addicus client, who earned more than $100,000 each year in cash, winked and said, “how will the IRS ever know?” This greedy attitude carries with it too much risk. Yet, often a taxpayer will take on this level of risk and comfortably hide cash from the IRS, while that same individual will worry until he’s filed a crystal-clean tax return without taking any positions.
There are two types of IRS agents: The ones who carry a calculator and a pen, and the ones who carry a badge, a gun and the legal authority to make arrests. Tax savings are not achieved by underreporting and bending the truth on Tax Day. At Addicus, we believe planning throughout the year, organizing assets according to strategy and establishing good, documented facts and circumstances to support bold positions can significantly reduce the tax burden.
In light of the tax savings made possible through strategy, structure and air-tight documentation, the choice to hide cash can be seen for what it is: stupid and foolish.
Judge Learned Hand said it best: “Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which will best pay the Treasury; there is not even a patriotic duty to increase one’s taxes.”
And that’s the path we choose to take.
Taking Bold, Competitive Positions
The IRS can always disagree with a position taken on a tax return or with a planning mechanism on a substance-over-form, economic substance or business-purpose.
And you know what? Sometimes the IRS is correct in its challenges. Still other times, it challenges a position and later backs off or even sometimes loses. At those times, it becomes critically important and pays exponentially to have an established, contemporaneously documented and vetted plan.
Addicus believes in arranging, establishing and documenting the proper facts and circumstances throughout the year, as each detail will minimize tax liability. The taxpayer, in turn, can go into Tax Day with great confidence because these plans have already been scrutinized and implemented by professionals, and every detail is accompanied by proper documentation.
Taking positions means the taxpayer generally pays minimal taxes. This is true even when the IRS pushes back on a position or two. The goal is to save as much as possible, while preparing a tax return that will receive the least amount of scrutiny and will be easy to defend if the need arises.
If you’d like to dig into the principals and best practices of Addicus’ approach to tax mitigation or learn more about how we develop strategic tax plans, you can download the Addicus whitepaper, “You Think You Have a Tax Plan.”