CINCINNATI BUSINESS COURIER
April 21 – 27, 1986
INVESTMENTS
Charles D. Vaughan
LIARS and TAXES
LIARS According to Will Rogers, “The income tax has made more liars out of people than golf has. Even when you make out (a tax form) on the level, you don’t know when it’s through if you are a crook or a martyr.”
Whether income tax filing makes liars of us all is questionable, but it certainly makes us philosophers. English economist John Maynard Keynes said, “The avoidance of taxes is the only intellectual pursuit that still carries any reward.” Probably an overstatement, but definitely a pointer in the right direction.
The intelligent investor directs his efforts not only to acquiring profit, but also to keeping it. That implies two significant phases. The first is that of avoiding the return of the profit to the market from whence it came a topic we discussed last week. The second, and equally important, is that of keeping it from the tax man.
I am not in any way implying that illegal or questionable means be used to save taxes. There are two terms often confused by taxpayers that need clarification. The first is “evasion.” This is a legal term for the use of illicit methods to reduce taxes. It includes the fraudulent concealment of income or the gross overstatement of deductions and expenses. The second term is “avoidance.” This is the application of any legal method of reducing one’s tax burden.
The concept of avoidance takes its cue from a decision rendered decades ago by legal scholar and Court of Appeals Judge Learned Hand. He stated, “Anyone 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.”
There are basically four legal methods of reducing one’s tax bill that may be applied by the investor:
DEFER: This approach involves making investments that produce income or profit that is not taxed currently but will be at some future date. The best known example of this is the Individual Retirement Account (IRA). Taxes are not due on money placed in these accounts until withdrawn, but must eventually be paid. It permits current tax savings, and more importantly, tax deferred compounding of investment earnings.
DEDUCT: In addition to legitimate expenses incurred in the pursuit of profits, this category includes actual reduction of taxable income through select investments. The most effective of these are known as “tax shelters.” Real estate investments as an example generate deductions through pass through of interest expense and depreciation.
CONVERT: Some investments permit taking income in a special tax category that has a lower rate structure. Long term capital gains rates are very beneficial to most investors. A profit made by holding a capital asset for more than six months is currently taxed at a rate equivalent to 40 percent of his marginal tax rate, to a maximum of 20 percent. Several investments qualify for such treatment and some, such as real estate, actually change the tax effect of an income stream.
TAX FREE INVESTMENT: Under current tax law, investments in securities issued by states and certain agencies of states pay interest that is not subject to federal taxation. In some cases it is also exempt for state income taxes. The investments, known as municipal bonds or “tax free” bonds generally pay less interest than taxable securities, but have been effective for many investors for years. Social security recipients can be affected by interest earned through these bonds.
All of the techniques listed above require advance planning to be effective. A new tax year’s resolution might be in order to follow Judge Hand’s counsel and so arrange your affairs that your taxes shall be as low as possible this time next year.
With many changes pending in tax legislation, it might well be worth the cost of getting some professional tax advice. We can’t be sure what form the new law will take, but we can be assured that it will be shaped by many lobbies.
To quote the famous Sen. Russell B. Long, tax reform means, ‘Don’t tax you, don’t tax me, tax that fellow behind the tree.’ “