Taxes: Go for the Gray

There are two time-honored ways to play the year-end tax game—smart and reckless. If you're smart, you'll go for the gray; if you're reckless, you may go to the slammer.

See if this description fits: You're an honorable, self-supporting, productive individual. When the year's toil is done, you're given a W-2 (or 1099, or some other wretched chit), showing how much the feds have ripped you off, and you're sick of the whole rotten system. So you reach for REASON and eagerly turn to this column, hoping to discover some secret bit of free-enterprise lore that will make it all work out okay—a little magic, like a foreign bank account, or a mail-order preacher's license, or an overlooked but miraculously potent clause of the Constitution, or some special way to fill out your tax return so you'll be free to enjoy the fruits of your labors. Well, you're the reckless type, and you won't like what I'm going to tell you: Forget it!

The secret phrase to utter in Tax Court that will paralyze the judge and make the IRS lawyers run from the room in panic is nothing but a pipe dream. All you can really do is agonize over the fine print in the tax forms as you decide whether you can deduct your kids' acne medication. Tough, but that's the way it is.

The best thing you can do for the year now ending is to avoid the spectacularly stupid mistakes described below. Then, resolve that for the rest of your life you'll go for the gray.

Go for the gray? I'll get to it, but first let's discuss some examples of year-end tax stupidity. Their number is infinite, but here are a few of the more obvious ones:

• "aggressive" (that is, crazy) tax- saving schemes, which always fail in court;

• "abusive" (too-good-to-be-true) tax shelters (a topic worth a future column or two);

• fraud, which we'll discuss in later columns; and

• tax-protester activities, absolutely none of which saves taxes (but also worth some discussion in future columns).

You're groaning. Is there any hope? Sure. You can come away from any bookstand with a long list of items that are deductible on your income-tax return. But that's not where you can save the big bucks. All serious tax dollars are saved in the "gray areas."

Tax forms may look frightfully precise, but the law has lots of nooks and crannies. They're the gray areas, the hidden loopholes where the answers aren't clear, and they're the reason for the existence of tax lawyers. Knowing about and taking advantage of the gray areas is what professional advisors are for.

For example, in a surprisingly large number of cases, it's a professional judgment call whether some asset you sold was a capital asset, the sale of which generates—you guessed it—capital gain. If it isn't a capital asset, its sale generates ordinary income (or loss, of course).

Consider an everyday transaction—a piece of land someone buys and sells. For that person it might be a capital asset, but maybe not for the outfit the land was bought from. Suppose the original seller subdivided a tract and sold a hundred identical lots. For him it was inventory; therefore selling it generated ordinary income. For the next owner it was an investment; thus its sale generated capital gain. But it's still the same piece of property! Now suppose you own a few of those lots and sell one or two. Where does that put you? In the gray area.

If you've got the right facts going for you, and if your lawyer can weave them into a plausible scenario supported by judicial precedents, and if he's willing to put it all in writing and sign his name to it, then you've got a shot at transmuting ordinary income into capital gain.

But at year's end it's already too late, and next April 14 is way too late. You need good tax advice at the very beginning of a transaction. You need to deliberately build the gray areas into your deals.

Okay, that's wonderful, but what can you do about the year that's ending now? It's probably too late to do much of anything except get with your advisors to do the traditional nickel-and-dime stuff. These things aren't very exciting, but they can add up to serious money, they're legal, and your accountant already knows what to do, so you don't need to run up any big legal bills. Here are some of them:

• Start an individual retirement account (IRA) if you haven't got one already.

• Consider a Keogh plan.

• Think about taking those painful stock market losses now, while they're still short-term.

• If you're getting married or divorced, do the tax computation both ways. (You may be better off by hastening your status change before the end of the year—or delaying it until next year.)

• If you're keeping your tax books on the cash basis (as opposed to the accrual method) try to shift income into next year. You know what to do—ease up on collecting revenue, speed up on paying expenses. But there are limits to this. For instance, it's December, and you decide to prepay your office rent. But how much can you get away with? One month? Why not. Two? More? That depends. At some point, your advance-rent deduction will be disallowed (if you're audited). A year's prepaid rent should probably be shown as an asset on your books, not an expense. In between is the gray area.

Whatever happens to this year's tax law, gray areas will always be there. And so will the opportunities to save money. So as the year fades away, take my advice and do two things: avoid recklessness, and go for the gray.

Happy new year!

Warren Salomon is an attorney in Miami.