More Basic Building Blocks of Tax Planning

In my previous tax planning blog post, I explained the three methods (deduction, exclusion, and credit) that are derived from the tax code.  This post will briefly explain four methods that focus on planning.

Method 1: Extraction

What is it?  Extraction occurs when the taxpayer removes (or “extracts”) an item of income from the tax base.  This most commonly involves moving an item from the US economy and placing it into a tax haven and then structuring the transaction to somehow escape inclusion in the US taxpayer’s US tax base.

Method 2: Deferral

What is it? Here, the planner simply moves the realization event (which triggers inclusion into the taxpayer’s gross income for a specific year) to a future date.  The farther into the future the planner can place the event, the better.

Method 3: Compression

What is it? Here the planner makes a total amount of assets appear smaller, reducing the tax burden.  The most common example is a family limited partnership where the planner will make the children limited partners and then mechanically encumber each limited partnership interest to lower its fair market value.    

Method 4: Conversion

What is it? The most common example is changing an item that would be taxed at higher ordinary rates and converting it to a lower-level capital gains tax rate.  The most common way to accomplish this is with a qualified retirement plan like a 401(k) or IRA.

And there you have it: all the basic tools that a tax planner can use to change or alter your taxes due.