From the course: Accounting Foundations

Strategy 3: Change the character of the income

From the course: Accounting Foundations

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Strategy 3: Change the character of the income

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- The third basic tax planning strategy is to change the character of the income, which can then change the rate at which the income is taxed. Taxpayers wish income to be classified as long-term capital gain income, which is usually taxed at a lower rate than is ordinary income. Remember, ordinary income comes from working for an employer, owning and operating your own business, earning interest on a bank account, and so forth. It's ordinary. Capital gains income is income earned from buying an asset low and selling it high. Simple examples are stock investments or real estate investments that increase in value. The capital gains income is the amount of the value increase. And with ordinary income in the United States, the tax rates dependent on the level of income ranged from 10% to 37% in 2024. However, again, in the United States, long-term capital gains income tax rates vary depending on your overall level of income from zero to 15% or sometimes as high as 20%. The key point is that long-term capital gains tax rates are lower. Okay, so how do I convert ordinary income into long-term capital gains? Well, the most common technique is to make sure that you hold appreciated assets, such as stock investments or real estate investments, for more than one year. If you buy shares for a thousand dollars and sell them for $1,400, that $400 capital gain is taxed as ordinary income if you sell the shares within one year. If you wait for more than a year to sell the shares, the $400 capital gain is taxed at the lower, capital gains rate. Okay, so how about more complex techniques to convert ordinary income into long-term capital gains? Well, the short answer is that you and I are almost certainly never going to be involved with these complex strategies. The longer answer is that this is where subtle tax shelter arrangements arise. Here are a couple of examples. Carried interest is a compensation arrangement in which an investment fund manager is paid in the form of additional shares in the fund rather than with a straight salary. If and when those shares go up in value, this income is taxed as capital gains, not as ordinary income. Another example of a strategy to change the character of income is called ISOs or incentive stock options. The idea is similar to the carried interest idea, employees are paid with incentive stock options rather than with a straight salary. Employees who hold the ISOs, the options, when they eventually exercise the options and then sell the shares purchased in the option exercise, the excess of the share selling price over the option exercise price is taxed as a long-term capital gain at the lower capital gains rates. Okay, let's review the three basic tax planning strategies. First, shift income from one time period to another. The taxpayer uses this strategy, such as an IRA or a 401k plan, to delay the taxation of income. Second, shift income from one pocket to another. Taxpayer shift income from a high tax state or country to a low tax state or country. We talked about this in the context of a multinational corporation, such as Microsoft, moving operations to low tax jurisdictions. But individuals also use this strategy when deciding whether to take a job in Texas, Florida, California, or New York. Taxpayers certainly consider the fact that neither Texas nor Florida has a state income tax, whereas both New York and California have relatively high state income tax rates. Third, change the character of the income. Typically, from ordinary income to long-term capital gains income. This strategy can reduce the rate at which the income is taxed. Now, except for making sure that we hold investments for more than a year before we sell them, this tax planning strategy is probably not for regular people like you and me.

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