Income and Tax Planning – Part Two

Cash in Pocket

We have all asked this question before: how does a millionaire, making half million a year, end up in a lower tax bracket and paying less tax than a person making much less?  One of the reasons for their success is that they understand the rules, follow the guidelines, and plan ahead. This article plans to introduce some basic tax planning concepts that may help you analyze your personal situation to better understand your tax situation.

 

  1. Types of Income

In general, income is categorized into 3 major categories: ordinary, capital, and passive.  Each type of income is taxed differently and has different treatments and impacts on tax planning. For instance, the long-term capital gains tax rate is capped at 15%, while the ordinary income tax rate can be as high as 33%.

  • Ordinary incomes are mainly income generated from trade or business, such as a working wage (W-2) or a self-employed wage. For business owners, net income from materially participated businesses (businesses where you actively participate in daily operations) is also categorized as ordinary income.
  • On the other hand, passive income, just like it sounds, is income that is generated passively, and is neither from materially participated business nor from trade or business. Most of the income generated from rental real estates and rental properties are considered passive income.
  • The last major type of income is capital income, which describes income generated from selling a capital asset. Capital assets are mostly assets owned and used for personal or investment purpose such as homes, household furnishings, and stocks & bonds held for investments.  

 

  1. Types of Expenses

The tax code has allowed certain expenses to be used to lower our taxable income, known as “deductions.” However, not everything is tax deductible. Some of the non-tax deductible events, on a personal level, may include home insurance, a smog-check fee, life insurance, professional apparel, etc. On the other hand, items like mortgage interest, property taxes, traditional IRAs are tax deductible.

On a business level, an expense becomes deductible when it is directly related to an income-generating activity. Expenses are generally required to be ordinary, necessary, and income-generating. Ordinary means other businesses within same industry are having the same type or the same proportional amount of such expense. Necessary is a comparison of the degree and level of an ordinary expense. For example, is it necessary for a company to purchase a $150,000 luxurious automobile instead of a $30,000 ordinary automobile as a company-owned vehicle.

Deductions are one of the most complicated aspects of the tax code, but through tax planning, you can definitely use deductions as a method to reduce your tax burden.


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Daniel Lu

Daniel Lu - Certified Public Accountant

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