Each chapter of this text has a section on tax planning opportunities related to the chapter’s material. Tax planning is the process by which taxpayers arrange their financial affairs to minimize tax. There is nothing wrong with tax planning using legal methods. In fact, Judge Learned Hand stated, in 1947:

When illegal methods are used to reduce tax liability, the process becomes tax evasion. Tax evasiontax evasionIllegal methods of not paying tax. can subject the taxpayer and tax practitioner to fines, penalties, or incarceration. Illegal acts are outside the realm of tax planning services offered by a professional tax practitioner.

As the tax planning opportunities are presented in later chapters, note that there are two basic categories of transactions: the “open” transaction and the “closed” transaction. In an open transaction all the events have not yet been completed; therefore, the taxpayer has some degree of control over the tax consequences. In a closed transaction all material parts of the transaction have been completed. As a result, tax planning involving a closed transaction is limited to presentation of the facts to the IRS in the most favorable, legally acceptable manner possible.

Tax planning cannot be considered in a void. Any tax planning advice must consider the business and personal goals of the taxpayer. Tax planning for a transaction should not override sound business judgment and common sense.

Important to any tax planning situation is an evaluation of the tax savings arising from increasing deductions or the tax cost of generating additional income. The tax consequences are dependent on the taxpayer’s tax rate. The taxpayer’s tax rate may be defined in several ways. For tax planning purposes, the taxpayer needs to understand the difference between the “average” tax rate and the “marginal” tax rate. The average tax rateaverage tax rateTax rate paid on all taxable income; stated as a percentage. merely represents the average rate of tax applicable to the taxpayer’s income and is calculated as the total tax paid divided by the total income of the taxpayer. The marginal tax ratemarginal tax rateTax rate paid on the last or next taxable dollar; stated as a percentage. represents the rate at which tax is imposed on the “next” dollar of income.

When making tax planning decisions the taxpayer’s marginal tax rate is the most important tax rate. For example, Jurgen has a 30% marginal tax rate and a 20% average tax rate and is considering making a tax-deductible investment of $2,000. His after-tax cost of the investment is calculated using his marginal tax rate, not his average tax rate. Jurgen’s after-tax cost of the investment would be $1,400, calculated as follows: [$2,000 − ($2,000 × 30%)]. On the other hand, if Jurgen is to receive any additional income, he knows that he will pay tax at a rate of 30% on the next dollar of income.

One of the more common mistakes made by taxpayers can be heard when they say “I just want a deduction to save on my taxes.” The statement would not be made if they understood tax concepts. An expenditure of a $1 on something that would not have been spent will yield a tax savings of only a portion of the $1 spent. If the taxpayer would not normally have made the expenditure, most of the $1 is wasted.

Tax rates can also be used in comparing tax-free investments to investments on which tax must be paid.