Tax Planning
Changing the Character
of Income/Expense
By Steven Y.C. Kang, CPA
The US and state governments encourage certain economic activities by offering preferential tax rates and tax credits.
These tax benefits originally were lobbied by interest groups, for their own benefits. There are professional lobbyists in
Washington DC and state capitols, catering to such interest groups.
In the US, laws cannot be written to only benefit a single group, as it would never get passed in the Congress or state
legislature. However they can be written in such way to limit applicability to only those, meeting certain requirements.
For example, if a tax law is to be written to benefit Tyson Foods, the tax law would be written in broad term to benefit
all livestock growers, with minimum amount of annual production, with certain other features to ensure that such tax
benefits would go to Tyson, but limit other livestock growers from benefiting the law.
If you were a livestock grower and you become aware of this law, you could also get the benefits of this tax law, if you
meet the stated requirements. If your facts do not completely meet the stated requirements, then you could change your
facts to meet the stated requirements. To do this, you need to analyze your facts and then plan to meet the stated or law’s
requirements, if it makes economic sense.
In many cases, the law’s requirements, created by lobbyists, are based on successful business practices, as such, meeting
the law requirements may actually help with your business practices. I have listed only a few such business practices here.
You should consult with your tax professional to determine how characterizing your income and expenses would benefit
you.
a. Ordinary versus capital gain.
Long term capital gain is about half of ordinary income tax rate, and depending on income level it could be zero. The
definition of long term capital gain is gain from sale of capital asset, held for more than one year. As such, if a sale if
contemplated, then meeting this one year mark would be beneficial. The definition of capital asset, although sounding
simple, is actually a very complicated area of tax law. Numerous tax court cases have dealt with the definition of capital
asset.
It has been a long time standing practice of U.S. government to encourage investment in long term assets. It is a natural
instinct for people to shy away from long term commitment, due to uncertain involved about the future. We all want
quick and visible results. It takes a leap of faith to invest in the future.
The tax policy of encouraging long term investment comes through the application of long term capital gain tax. However,
due to numerous people, trying to game the tax system, more and more tax rules and regulations have been added to stop
the abuse, resulting in a very complicated area of tax law.
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b. Meals and entertainment versus employee benefit.
Business owners love to treat their employees with meals. In most cases, tax deduction of meals and entertainment is
limited to 50% of the amount spent. However, if you are treating the employees with meals, as it is for the convenience
of the employer, then you could deduct 100% of the amount spent. So what do you have to do to characterize such
expense as for the benefit of the employees. This requires documentation, containing info as to what purpose they
pertain to. Building a team spirit among the employees is a valid business expense, to build a company, and not meals
and entertainment. As long you distinguish meals and entertainment and employee benefit related expenses, through
documentation, you should be able to get the benefit of this tax law.
c. Compensation for services performed
In a business venture, there is sweat equity and cash investment. If you are getting a part of a business or investment by
contributing your know-how and your time. That is a compensation for services performed. The other option is gifting
of ownership of the business or investment by the person who put in the money, which is not normally done among
unrelated individuals.
If you are an employee and your company gives you stock option or grant, then you have to pick up the receipt of the
stock option or grant as income, when you exercise the option or when you have complete ownership under the grant.
This income is ordinary income. However, you could characterize later appreciation of the stock into capital gain by
making Sec. 83(b) election.
d. Interest versus dividend
When you are starting a business, you need to inject money to operate the business, until it becomes profitable. This
injection of money can be either capital contribution or loan to the business. The distinction between the two can be
significant for tax purposes. If the injection of money is capital contribution and you are operating a C corporation, the
profit, which will come out later, would be a dividend. If the injection of money is a loan, then the money coming out
could be classified as repayment of loan, which is not taxable, and interest, which would be deductible by the corporation.
In a C corporation, the classification of interest would eliminate double taxation by ensuring tax deduction for the interest
portion at the C corporation level. Even if you are not operating a C corporation for your business, classifying cash
injection as loan would benefit the investor putting up the money, as the loan arrangement would reward them with
additional return (interest) for their money.
e. Auto used for business
In Southern California, no one walks. The love affair with cars in Southern California is tremendous. As such, this tax
benefit is near and dear to many Southern Californians. The deduction of auto expense, whether the car is owned by the
company or yourself, excludes commuting miles (miles driven between home and your primary place of work). As such,
shortening the distance between home and primary place of work becomes an important tax planning strategy. Another
requirement to get auto expense is the requirement to document the business miles. Such documentation requires you to
keep a log of miles driven, with explanation as to business nature of the travel. Without such documentation, your auto
expense deduction would be disallowed under the audit.
These are just few of the available tax planning strategies to characterize your income and expenses. It takes time and
effort to get benefit of these tax benefits. However, without proper planning and documentation, you would most likely
not enjoy these tax benefits. You should consult with your tax professional to make sure that you are not leaving any
money on the table.
About the Author
Steven Y.C. Kang, CPA KAGW, LLP
Independent Member of BDO Alliance USA. Member of AICPA Private Company Practice Section
Kang specializes in accounting and tax consulting for closely held businesses with international
operations.
Tel: 562-865-2727 x16 Fax: 562-865-2760
Email: steve@kagwllp.com
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