Monday, March 24, 2014

Stupid tax trick

In college I worked part-time for H&R Block, doing people's tax returns, and some of my economics courses covered tax law.  We're doing our income tax these days, and trying to answer the questions that the online 1040 program asks, 99% of which don't apply to us, and I was explaining to Vicki about state tax refunds being taxable income this year if (and only if) you itemized and deducted them the previous year.  And it occurred to me that the scheme the government uses in trying to recapture that revenue could easily be exploited to create a very effective and possibly legal tax shelter, or at least tax deferral instrument, modeled on the cattle feeding shelters of the 1950's.

Back then, when the ordinary income tax rates went up to 91%, but there was a lower rate for capital gains of more than 6 months, rich people could buy cattle in July and feed them until January, deducting all the expenses of the operation on the first year's return (against 91% income) and then in the following year report a capital gain when they sold the fattened cattle, and be taxed at the lower rate.  The whole operation might even lose money, but the tax savings could be much larger than the operational losses.  Since those days, the code has evolved so that such schemes are no longer viable, or else are outright prohibited.  Transforming ordinary income into capital gains is one of the things they scrutinize very closely.

But, suppose in one year you have a higher than normal income, perhaps a "stay bonus" from a failing company (cough-cough DHL), and then in December you're laid off and don't work for a few months.  Or maybe you retire, or you plan to retire next year, and next year's income will be much less.  You change your W-4 to withhold extra state tax, or file an estimated tax payment to the state (if you live in a state without an income tax, you might even do it as a non-resident of a neighboring state that does have one) in December, in the amount of, say, your bonus.  Suppose it's $50,000 and your Federal tax rate is 25%, and you were going to itemize anyway.  In January you file your Federal taxes and deduct the $50,000, and get your refund of $12,500.  And you file your state taxes, on which you get the whole $50,000 back, because you didn't really owe it in the first place.

Then the next year, that $50,000 refund is additional taxable income, but you're no longer in the 25% bracket, maybe it's 15%.  So you pay only $7,500 tax on it (instead of $12,500) and you pay it a year later.

Even if you'll still be in the same tax bracket a year later, you'll have the use of the money for a year, which is worth something.  At 0% interest, it's not much, but it's something, perhaps only the peace of mind of having it in your savings account, just in case.  Or you could use the $12,500 to pay down a loan that carries a higher rate, maybe your mortgage or your child's student loan.

I can't think how this would be prohibited, or even detected, at least on a small scale.  Using a neighboring state might give away the secret, if the computer were looking for it.  But with the documentation of the W-2 all the computer matching they could do will look completely legitimate.

Too bad I didn't think of this 5 years ago.

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