In a speech last May, President Obama said, "Nobody likes paying taxes . . . . And yet, even as most American citizens and businesses meet these responsibilities, there are others who are shirking theirs." He was referring to offshore tax havens and other loopholes that wealthy Americans often exploit to reduce their tax burden. But it doesn't take moving money to Switzerland to avoid paying taxes. If history is any guide, 2010 will be a year in which many Americans use a few simple methods to reduce their tax liability, which could potentially cost the government billions of dollars.
This year is the last before the expiration of tax cuts originally put in place by the Bush administration. If Congress allows these tax cuts to expire, as the president supports, in 2011 the top marginal tax rates will increase from 28, 33, and 35 percent to 31, 36, and 39.6 percent.
Although it is not certain that tax rates will go up, many wealthy Americans are looking at 2010 as the end of the party. "Everybody thinks taxes are going up and tax breaks are being eliminated. Everybody's thinking this, and they're planning for it," says Lance Wallach, a New York author, lecturer, and financial consultant who advises high net-worth clients, including entertainers and athletes. His phone is ringing off the hook with questions from clients about how they can take advantage of this year's rates relative to 2011's.
One of the most popular strategies is moving income from 2011 to this year. Usually, accountants encourage clients to postpone income so there is less income taxed in one year. But in 2010, the incentives have flipped. "This is the exact opposite. Accelerating your income makes 100 percent sense," says Wallach.
Creative maneuvering. This would not be the first year taxpayers have pursued this strategy. In 1992, Bill Clinton was elected president with promises to raise taxes on wealthy Americans, which Congress did in 1993, boosting the top marginal rate from 31 to 39.6 percent. In late 1992, many taxpayers, expecting rates to be higher the next year because of Clinton's victory, moved more income onto 1992's tax return to avoid paying more with the higher rate. Robert Carroll, an economist at a Washington research organization called the Tax Foundation, estimates that about $20 billion was shifted and paid at the 31 percent rate rather than the 39.6 percent—meaning there was about $1.5 billion that the federal government did not collect in revenue.
Something similar could happen this year. "Anyone who has flexibility with income is going to try to shift their income," says Carroll. An example of flexibility would be a business owner who gives himself or herself a bonus in December 2010 rather than January 2011.
There's also an incentive to delay tax deductions. For example, state property and income taxes can be deducted from federal income tax returns. Wallach says he is recommending that clients hold off on paying those taxes until next year, so that the deductions can be cashed in at the higher rate.
Some may choose to delay charitable gifts for the same reason—charitable giving is tax deductible, so some taxpayers may decide to hold off on a gift they would make in 2010 and instead give a larger amount in 2011. "What we know from history, if the taxes go up, people will delay their giving," says Nancy Raybin, chair of the Giving Institute, an association of nonprofit consultants. But Raybin says such delays usually are not significantly damaging to charities because people will often just push a gift forward a few months—from December to January, for example. "If there's a 12-month delay, it could be a problem. But if a donor is just delaying one month, it's not a big problem," she says.
These tax-avoidance strategies will probably be a one-time deal for those who pursue them. A study by economist Austan Goolsbee, currently a member of the Council of Economic Advisers, found that the 1993 drop-off in reported income was temporary. Income bounced back in following years. If tax rates appear to be steady after 2011, accelerating one's income or delaying deductions is no longer advantageous. But taxpayers will continue to look for ways to reduce their liability—they just need the time and money to find the loopholes. Wallach says most of his clients will adjust to higher tax rates with his help. "For the very sophisticated people, there will always be loopholes," he says, such as deducting travel and entertainment expenses. "None of my clients pay more in taxes than a schoolteacher."