Whether we like it or not, heavy incentives are built into the U.S. tax code. In fact, many a tax law is built around the idea that people will react differently in the presence or absence of a tax. In some cases, large tax increases help to spur major swings in how we make business and investment decisions.
For instance, capital gains is broken into both short (assets held for less than one year) and long term (assets held for greater than one year) to help incentivize investors to keep their money tied up in projects that will produce long into the future. Some would argue, the built-in long-term incentive still isn’t strong enough to spur the growth we seek. However, there is still a big difference (which politicians have been dickering over for some time now) in taxes on income and taxes on capital gains. If you’re married, like myself, here are some rates to pay attention to for 2013:
- 25% on taxable income over $72,500 to $146,400
- 28% on taxable income over $146,400 to $223,050
- 33% on taxable income over $223,050 to $398,350
- 3.8% Obamacare tax on income above $250,000
[To find your tax bracket, click here]
Investments aside, tax is the price the professionals must pay for a little taste of financial success. The self-employed are often hit especially hard with self-employment tax. However, if you own a business, there are a few pointers to consider when weighing the potential tax hits. Understanding the nuances becomes increasingly important as you begin to creep from one bracket to the next.
Rising tax rates have incentivized many to sell businesses and other income-producing assets like real estate and stock. There is a downside to this, however. In most instances, the sale of a business will boost the taxable bracket for the year in which it occurs, creating an even greater immediate tax liability.
If you can stomach not having cash on hand and need to sell assets, then try to do so in times when your income may be a bit more lean. It can be a big tax-savings tool. Additionally, holding assets is a wise strategy in general, especially when you’re not strapped for cash. Income-producing assets are especially worthwhile to hold as they tend to appreciate, provide cash flow and can provide further opportunities for “writing-off” expenses [you can read more about passive income here].
Some would argue against a hold strategy under the simple assumption that tax rates are expected to continue north for some time. I would also argue that truly valuable assets will also appreciate as time marches on, further diminishing or negating any potential future—albeit larger—tax liability. Holding assets for the long-haul is wise when you don’t need the cash and you have a large current tax liability thanks to your income level.
The tax code significantly incentivizes the exchange of assets through things like the 338 election and 1031 exchange. Instead of taking the tax-hit now by receiving a boatload of immediate cash up front, you can simply delay the liquidity event, but transferring assets from one business to another, one stock to another or one real estate property to another. For those looking to truly maximize the sale of their assets, it may be wise to do asset transfers as often as possible so as to avoid taxable gains triggered by the sell-off.
Buy Assets or Invest in Your Business
There are a couple of clear instances where buying assets, equipment or other business investments for your business is clearly a wise move. Doing so can significantly reduce your overall tax burden in the given year and can also provide a boost for your business, making it more productive in the years and months to come.
Buying advertising, real estate space or equipment during really good times can help to alleviate the burden of tax in the year in question. For those with owner-operated LLCs, investing in projects you had intended on investing in at some point in the future, but for which you’ve not yet made the plunge is a wise move in a year when you’ve had some great wins. It will give you the assets you may need or desire, but then reduce your taxable gain for the year. You’ll be giving more assets to yourself and not boosting the coffers over at the IRS.
Give to Charity
For the truly kind-of-heart, the tax code still encourages the giving to your favorite charity with the promise that you can take a taxable write-off for your charitable contribution. This may be opposed to the more selfish reasons outlined above, but is certainly much more altruistic.
The takeaway is not that we should be incentivized to not be successful, but once we become so, to be as smart with our resources as we prudently can. It’s not that the government doesn’t need our tax dollars to operate, it’s simply that I’m of the firm belief that we can stretch many of those dollars much further than Uncle Sam ever could.