Tax Vobiscum

Nobody owes any public duty to pay more than the law demands; taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant." Thus spake Judge Learned Hand in one of his learned decisions, and Playboy heartily endorses his words. Feeling partial to the salaried male, we offer here some pointed pointers on how he may go along with the dictum of the good Judge Hand, legitimately but meaningfully cutting down on his yearly yield to the feds.

For the unattached salaried male, Transportation and Entertainment (T & E) constitute the most fertile field for tax trimming – but this is also the area wherein the revenue agents seek, and find, the most flagrant cheating. Until 1958, expense accounters were required to report all T & E reimbursements as income. They were then to deduct their expenses against such income. Not so any more. Under the new rules, if your expenses and reimbursements are equal – and if you account to your employer for these expenses – you don't have to report them at all on your tax return. This is a highly desirable procedure since it enables you to file a clean return, that is, one with no unusual deductions to arouse suspicion and invite the eagle eyes of the auditors. Sadly, this is seldom the case: most salaried employees seem to incur expenses in excess of the reimbursements received from their employers. It's the nature of the beast. If this is your situation, you will have to report your total reimbursement as income – as you did in days of yore – and list all of your expenses on your return. And you must be able to submit evidence of such deductions if your return is examined, to prove these expenses were a required part of your job.

But there is a legal way around this. Let's assume that your employment requires you to incur expenses for which you are not reimbursed. (It is practically impossible to list every phone call, taxi trip, luncheon, cocktail, hat-check tip, etc., paid out during the course of business – yet these are legitimate expenses, and deductible.) Your employer can aid you with your expense reporting by adjusting your salary downward and supplementing it with an expense allowance equal to the salary adjustment. You then account to him for these additional expenses, but he probably won't insist on an extremely accurate accounting, since your total take has not increased and the money is in a sense coming from your own salary anyway. With this happy arrangement, you can avoid the sometimes sticky job of supporting your deductions, since neither reimbursements nor offsetting expenses need be reported on your tax return. You'll also increase your weekly take-home pay immediately by this arrangement, since no payroll taxes will be withheld from your expense allowance. It works like so: say you draw a salary of $15,000 a year and incur $3000 worth of business expenses for which your boss reimburses you and $3000 worth of business expenses for which he doesn't reimburse you. Ask him to lower your salary to $12,000 a year, with an allowance of $6000 for business expenses. (He loses nothing, since his total outlay is still $18,000.) Then you furnish him with chits for your $6000 in expenses and report a taxable salary of only $12,000, your $6000 expenses having been offset by $6000 in reimbursements so that neither item – according to the new law – need be reported.

But if for some reason your employer refuses to go along with this, and you still have to deduct business expenses that have not been reimbursed, there are still ways to reduce Uncle's tax bite.

As long as you can show business justification, practically every conceivable type of entertainment is deductible. The usual entertainment deductions include tickets to the theatre, sporting events, cost of meals, drinks and club dues. You can deduct your costs of entertainment at home as well as at a club or similar place. But if you entertain at home be sure to keep detailed records on what you spend and on whom you spend it, and above all be prepared to prove you entertained for business, not for pleasure.

In the past you could deduct all your entertainment expenses – including the amount you spent on yourself. Now you'll find that revenue agents will try to disallow the cost of your own entertainment on the grounds that it's a personal expense, since you would have spent the money anyway. For example, if you took two customers to lunch and picked up an $18 tab, the agent might disallow one third of that expense, or $6, as the amount covering your luncheon cost. However, you can counter this line of attack by claiming you spent more than you customarily would on yourself because you were out with clients. In this case, you could deduct the amount in excess of what you would normally spend.

Tax agents may also try to disallow the cost of your own tickets when you entertain for business purposes at theatres, sporting events and the like. In such cases you may retain the deduction for your own ticket costs by showing that you don't usually go in for such entertainment.

Travel expense isn't as vulnerable to Treasury attack as entertainment. But true to form, the Treasury frowns on mixing business with pleasure (e.g., attending conventions or trade meetings that happen to be held in resort areas at the height of the season). You are allowed the travel expense deduction only if you can show the trip was primarily for business, not pleasure. So if you plan to attend a business convention in Hawaii lasting one week, don't spend another three weeks vacationing there – unless you have probe-proof evidence that the first week was strictly biz – or you'll find that the entire trip may be considered a pleasure jaunt. Your business-travel deductions can cover expenses for transportation, telephone, telegraph, tips, samples and display material, hotel rooms and, of course, stenographic services. You can also deduct your meal costs if you are away from home overnight. And you can take your secretary along and deduct her expenses, provided you pay for them and she performs essential services – businesswise.

Uncle Sam will absorb a portion of your auto expense, too, if your job requires the use of a car. You can deduct the depreciation of the car, insurance, gas, repairs, parking, car washes and all other required outlays. Depreciation will generally be your greatest auto expense deduction. You're ordinarily allowed to write off the purchase price of the car – less its salvage value – over a four-year period. For example, if you paid $4400 for the car, your annual depreciation, on a straight-line method, would be $1000, assuming a salvage value of $400. But you can speed up your depreciation deduction when you buy a new car and take advantage of an accelerated method of calculating depreciation: such as the 200% declining balance. Under this fast write-off, using a four-year life for the car, you can deduct 50% of the cost, or $2200, in the first year. In the second year you can deduct 50% of the remaining balance ($2200), or $1100. In effect, under the fast write-off method, your depreciation rate is double that of the straight-line method. Thus, by taking a higher depreciation deduction in the first year of car ownership, you get an assist from Uncle Sam in financing your car through tax savings. Because this write-off rate is applied to the undepreciated cost of the car each year (instead of the original cost), if you regularly buy a new car every three years, you may legitimately use a three-year life in calculating depreciation on your car. Under the fast write-off method this would result in a depreciation rate of 66-2/3 %. Based on an auto cost of $4400, the first year's depreciation deduction would be about $2900 as compared to $2200 on the basis of a four-year life. The salvage value would also be higher, and this would cut your saving a little.

It is a known and sad fact that homo sapiens non domesticus (bachelors) cannot qualify for many tax reducers open to their married brethren – no joint return, no deductions for dependent wives, no trust funds for kiddies, etc. But there are several methods by which the bachelor can garner some of the benefits available to married folk, and a little bit more. If the single fellow purchases a cooperative apartment, for instance, he can claim the real-estate tax and mortgage interest deductions available to homeowners. If he pays more than half the cost of maintaining a household for his parents, he can figure his tax from a special rate schedule which gives him many of the advantages that a married couple gets from a joint return. (Incidentally, if he contributes toward his parents' support – even though his father still works – he should apply his contribution to his mother, so that he can claim her as a dependent.) Even if he has an illegitimate child somewhere, he still has a legitimate tax deduction if he contributes to more than half of the child's support.

There is even a way that the bachelor can write off the costs of dating, by employing a so-called "short-term" trust. Say you figure you've been spending roughly $4000 a year squiring a certain young lady around town. If you wish, you can transfer some real-estate holdings – which give you an annual income equal to your dating outlay – into a short-term trust, in the name of the lady. (She receives only the income from this trust, not the assets, which revert to you on the termination of the trust.) Under this arrangement, the $4000 income is no longer taxed to you, and this means an annual saving of $2000, if you are in the 50% tax bracket (single people reach the 50% bracket when taxable income tops $16,000). This type of trust can also be used to transfer income to parents you may be supporting.

Estate planning is another legitimate means of reducing taxes. This usually involves arrangements whereby an individual gives away part of his estate during his lifetime to reduce his estate and hence estate taxes payable at his death. But younger guys can take advantage of a form of estate planning that works on the reverse principle. Here an individual gives away assets to an older person who he believes will predecease him, but who will bequeath these assets back to him.

To understand how these tax savings operate, it's important to know that the "tax basis" for assets owned at one's death is their fair market at the time of death – not at the time of purchase. A tax basis is the figure subtracted from the selling price of an asset that determines whether a taxable profit has been made. For instance, if someone buys stock for $10,000 and it goes up to $30,000 before his death, he pays no taxes on the paper profits. He only pays taxes if he sells it. If he sells it, his tax basis is $10,000 – the price he paid for it – and he must pay capital gains taxes on his $20,000 profit. But if he dies and you inherit this stock and sell it for $30,000, you pay no taxes because in an inheritance the tax basis is the fair market value at the time of death, or $30,000. Subtracting the $30,000 tax basis from the $30,000 selling price gives a taxable profit of zero.

Planning with this principle in mind, let's suppose you own stock which originally cost $10,000 but which has increased in value to $30,000. You've paid no taxes on your paper profit, but will have to pay taxes if you sell the stock. Instead, you decide to give the stock to an elderly aunt with the tacit understanding that she'll will it to you on her death. (This agreement must not be in written or contractual form, or the government may get you for tax fraud. If you merely have a tacit understanding, you should be able to get by with no trouble from the government.) You pay no gift tax on the stock, since you are entitled to give $30,000 of tax-free gifts in a lifetime. And, meanwhile, your aunt will be reaping the stock dividends. She wills the stock to you. If her estate is below $60,000, there is no inheritance tax to be paid. Since you've inherited the stock, the tax basis is now $30,000. You've saved yourself several thousand dollars in taxes, since – if you hadn't made such an agreement – the stock would still have a tax basis of $10,000 (your purchase price), and when you sold it for $30,000 you would have had to pay a capital gains tax on your $20,000 profit. Depending on your income bracket, such a tax could run up to $5000.

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Long-term capital gain provides the most desirable form of taxable income in terms of enabling you to reduce your taxes. If your regular income is subject to a tax of 50% or under, then only half (continued on page 62) Tax Vobiscum (continued from page 60) your long-term capital gain will have to be reported to the government. Should your regular income hit a tax bracket greater than 50%, then the tax payable on your long-term capital gain would be only 25%.

There are a number of conditions that must be satisfied before you can take advantage of the tax law on long-term capital gains. Capital gain income is only claimable in situations involving the sale of capital assets. Examples of such capital assets are securities and real estate. You must hold the capital asset for at least six months in order for the profit on the sale to qualify as long-term capital gain. If the asset is held under six months, any profit on the sale must be treated as a short-term capital gain, taxable at the same rate as your salary.

The sale must also be one that is not in your professional line of work. Auto salesmen may not claim the profit they make on auto sales as long-term capital gain. But the private individual who sells his car can. Stamp-shop owners can't call their profits capital gains, but philatelists who decide to part with their collections can put such earnings down as capital gains.

If you don't require investment income for current needs, you can save taxes by investing in stocks that yield stock dividends (e.g., International Business Machines) which are not usually taxable, instead of cash dividends that are taxable in the same way as regular income. Any profit on the sale of such stock dividends, if sold over six months from the time the stock was purchased, would be taxed as a long-term capital gain. By investing in stock-dividend-paying stocks, your investment income is taxed as capital gains instead of ordinary income, which can result in large tax savings.

Certain kinds of real estate offer another route to high-depreciation deductions – and hence tax savings. An investment in real estate, if sound, will generally yield a spendable return of 10% or over on cash investment. (Spendable return is the excess of rental income over mortgage payments, real-estate taxes, and all other costs of operating the property.) While receiving a satisfactory profit on your investment you may legitimately report a substantial loss. Generally, an investment in new furnished apartments permits use of fast write-off depreciation methods that produce maximum depreciation deductions, and hence lower taxes. The government figures four years as the life of furniture in a furnished apartment. The property can be sold several years after purchase, after the heaviest depreciation write-offs have been taken. The profit on the sale is reported as long-term capital gain. If you don't have enough of your own funds, you might form a real-estate investment club to make such investments on a partnership basis, or you may join a club already operating.

For those who might be interested in the tax savings of furnished apartments, but not in the problems of management, there are firms that have undertaken to build ideal tax-saving properties for investors. They will lease the entire property from the investor at a fixed rental which will cover the mortgage, real-estate taxes and other required payments. This arrangement will also produce the tax loss through depreciation, which you may then apply against your reportable income. In addition, they will contract to buy this property from you after four years at a price that will give you a good return on your investment. Some of them even guarantee their commitments by an insurance bond or equivalent collateral, making this a safe and saving way to receive a guaranteed return on your investment on a low-tax capital gain basis, and at the same time reduce your current taxable income.

You can deduct up to 20% of your adjusted gross income for donations to any type of charitable organization. And you can deduct up to an additional 10% of adjusted gross income for gifts to either religious associations, tax-exempt educational organizations, or tax-exempt hospitals. (Your adjusted gross income is the total income shown at the bottom of the first page of your income tax return.)

Everyone knows that a $1000 cash gift to an institution is deductible, but not everyone knows that you can satisfy an urge for philanthropy and still make a profit at the same time. Here's how one chap did it. As a grateful alumnus, he gave $1000 annually to his alma mater. At first these contributions were made in cash. Later, however, he donated stock worth about $1000 each year, and often the tax saved on the contribution deduction was greater than what he would have kept after taxes had he sold the stock and retained the proceeds. You can't expect to make a profit on all your contributions of this sort, but you can reduce the after-tax cost of your contribution by making it in stock or other property that has increased in value since purchase – instead of in cash.

If you're able to purchase something – usually an antique, painting or other objet d'art – at below its appraised cost, you can donate it to a charitable institution and claim its appraised value as the amount of your donation.

On a $15,000 Ming vase purchased for $5000 and donated to a museum, you can figure the full $15,000 as your deduction. (The appraised value of the gift is all that legally matters to the Treasury agent. Your purchase price need not even be mentioned.) Similarly, if you purchase a painting for $5000 and it increases in value over the years to $20,000, you'll have to pay a capital gains tax if you sell it, but you can claim the full $20,000 if you donate it.

Even life insurance may offer an avenue of tax saving. There is a form of insurance called "special whole life policy" coverage. The insurance companies offering this type of coverage work out a payment schedule which in effect reflects loans against the policy's cash surrender value so as to provide maximum coverage at minimum cost. The premiums are less than one fourth of those on regular life policies. The payments do increase slightly each year, but under this form of insurance, a major portion of your payments actually represents interest expense and can be deducted as such. On the other hand, no deduction can be taken for premium payments on an ordinary form of life insurance. Incidentally, if you now carry a life insurance policy on which you receive dividends, don't report these dividends as income. Such dividends are merely considered to be a reduction of your premium payments.

If you expect your income to be exceptionally higher this year and to place you in a higher tax bracket, you might consider prepaying interest on any loans you have in order to build up your deductions this year to offset the higher income. The Treasury recently ruled that five years' interest paid in advance may be deducted in the year it is paid.

Bunching deductions in one year by prepayment can also apply to your taxes. For example, state income tax (if you're stuck in a state that has one) is normally payable early the following year, but may be paid by December 31 of the year for which the return is filed. The same practice may be applied to your property taxes. If you later hit an inordinately low income year, you can let your prepayed taxes and interest catch up, since the deductions allowed for these in a low bracket year won't amount to much. Then, when another high-income year comes along, you can double up and prepay a year of local taxes and several years of interest.

Other basic deductible taxes are sales and gasoline taxes and your motor vehicle license – although these can't be prepaid. Nor can the prepayment method be used for medical expenses. You must have already incurred the medical expense for the payment to be deductible. But in figuring your medical expense, you can also include the travel costs in going to and from a doctor's (continued on page 83) Tax Vobiscum (continued from page 62) office or a hospital. You can also deduct travel expenses for a trip that has been prescribed by a doctor for your health. If you go to the Caribbean for sun on his advice, your travel expenses are deductible. If a doctor prescribes exercise, rubdowns and the like for your health, fees paid to a town club where these are obtained can be treated as medical expenses.

These savings may seem piddling, but they can add up to enough to put your net taxable income in a lower bracket. Casualty- and theft-loss deductions are often overlooked, since these deductions don't always involve specific outlays. Basically, a casualty loss is one that arises from the action of natural physical forces or from some sudden, unexpected cause, such as fire, storm or accident. One of the most common accident losses involves automobiles. If you're covered by insurance, the portion of loss not reimbursed is deductible. For instance, if you suffered an automobile collision and damage amounted to $125 for which your insurance reimbursement was $75 (due to a $50 deductible provision in the policy), you may deduct the out-of-pocket loss of $50. If you were wearing an expensive watch at the time of the accident which was rendered useless, the value of the watch immediately before the accident can also be deducted. You must deduct the loss in the year in which the accident occurs, but there's no need to repair the damage in order to take the loss.

Membership fees in professional, trade and business associations related to your employment can also be deducted. Union members can deduct their union dues and assessments. And since the Treasury realizes that we live in a constantly changing world and that it's important to keep pace with changes, it will let you deduct the cost of any university or professional course taken to maintain or improve the skills required by your job. But you won't be allowed a deduction for any course you take to obtain a new or better position. In addition to tuition costs, you may deduct travel to and from a school away from home and also living expenses (food and lodging) while attending the school. Business literature, supplies, books and all other items required by your job are deductible.

Alimony payments are fully deductible, the tax being borne by the recipient of your postmarital munificence. But to be lawfully deductible, you must be divorced or legally separated under a court order or decree, your obligation to pay alimony must arise under a court order or written agreement with your former wife, and the payments must be either periodic, say, monthly, until such time as she remarries or dies, or made in installments provided the payments are for a period in excess of ten years from the date of the court decree or agreement. You cannot deduct as alimony any part of the money designated as child support in your divorce agreement. But you are entitled to a dependency deduction ($600) if the amount you pay for child support is more than half the amount spent on the child. If the annual amount intended for child support in your divorce agreement is over $600, it would be advantageous for you to have it included with the alimony, and not specified as child support, so that your full payment can be deducted, rather than just a $600 dependency deduction.

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Some sixty million returns are filed each year. Of these, some forty-five million are simple low-income returns, taking the standard 10% deduction, and without much in the way of business expense and reimbursements, dividends, charitable donations, etc. The other fifteen million returns – and yours would most likely be in that group – are kept aside, and some three million of them are eventually examined each year. How the three million are selected from the fifteen million is a well-guarded secret that seems to vary from year to year. To play it statistically safe, expect to have your return individually audited at least once every five years.

All sixty million returns are checked for arithmetical accuracy. If you've made a simple error in math, you'll either receive a refund or a bill for additional tax. (The government, incidentally, is presently sitting on several million dollars in unclaimed refund checks. Such checks are never forwarded if you've moved, but are mailed to the address on your tax return and, if you've changed residence, returned to Washington and held until you write and inquire.)

Since there's a statute of limitations on income tax assessments, you can consider yourself safe if you haven't received Greetings from Internal Revenue within three years after having filed. If you've deliberately committed fraud, the period of time is six years for criminal prosecution, but unlimited for tax assessment and the accompanying fine. If Internal Revenue does write you, they'll generally pinpoint the items they question, and you can sometimes settle the matter by mail, by supplying supporting documents (canceled checks and chits) to the local IRS office. Should several items be suspect, you may be asked to appear in person at the IRS office.

If you can convince the agent to accept your return as filed, you're clear. If he doesn't buy your explanation and suggests a tax reassessment, you can either agree to this or request a conference with his Group Chief. If the result of this conference is still unsatisfactory to you, you can arrange another conference, this time with the Appellate Division of IRS. And if this still doesn't satisfy you and persuade Internal Revenue to accept your return as filed, you can either (1) file a petition in the Tax Court or (2) pay the additional tax, file a refund claim (which will be rejected) and sue for a refund in the Federal District Court or the Court of Claims – these latter often being more favorable to the taxpayer than the Tax Court.

If you're late in filing your return, you'll face a monthly fine of 5% of the tax – up to a penalty of 25%. The fine can be avoided if you can show reasonable cause for the late filing. Or if you know you won't be able to meet the filing date, you can ask your local IRS office for a ninety-day extension, stating the reason for the request. These extensions are generally granted when the request is reasonable, and can be followed by a second ninety-day extension if needed. When you finally do file, you pay 6% annual interest on the tax due.

Unless you're a short-form, salary-only citizen, best you get professional help – accountant or tax attorney – in making out your return. Incidentally, the cost of tax advice – even the cost of purchasing this magazine, if you did so to read this tax article – is deductible.