What is Tax Planning?
Tax Planning is minimizing your tax liability by making the best use of all available deductions, allowances, rebates, thresholds, etc as permitted by income tax laws, rules stipulated by the government of a country. It helps in effective cash flow and liquidity management for taxpayers and better retirement plans and investment opportunities.
Types of Tax Planning
Now let’s discuss the 3 different types in detail.
- Periodic Planning – Tax planning can either be of short or longer period of time, if done for less than 12 months, is known as shorter period planning, whereas planning done for more than 12 months is known as longer period planning. For example, there are short term and long-term capital gains taxes depending upon the holding period of assets/investments.
- Liberal Planning – Here, the planning conforms to law provisions of tax and distinguishes the same with tax evasionTax EvasionTax Evasion is an illegal act in which the taxpayers deliberately misreport their financial affairs to reduce or evade the actual tax liability. This includes using multiple financial ledgers, hiding or representing lesser income, gains, or profits than actually earned, overstating deductions, & failing to file returns. or tax avoidance.
- Intended Planning – This method is based on loopholes in the tax laws and unexplored areas.
Examples of Tax Planning
Let’s take some examples to understand this concept.
For married couples or civil partners where one partner is a basic rate taxpayer, and the other is a higher rate taxpayer, it is logical that the person who has the lowest income to receive the taxable rental income. This is generally cost-efficient, where there is a loan on the property as interest relief will be restricted in future periods.
John is starting a new business and expects to make annual profits of £37,500 before tax and national insurance.
Consider the financial effect of his choosing to trade as a sole trader or, alternatively, through a company, paying him a salary of £12,500 and then the largest possible dividendDividendDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company., not giving rise to a loss of capital. Assume that accounting profitsAccounting ProfitsAccounting profit is the net income available after deducting all explicit costs and expenses from total revenue, and it is calculated in accordance with generally accepted accounting principles (GAAP). Operating expenses, labour, transportation, and sales expenses are common examples of these costs. equal taxable trade profits and that alan will be the sole employee and a director of the company. Use 2017/18 tax rates.
They can have some great benefits for any business regardless of nature and size; few of them are listed below:
- The main core is to reduce the amount of tax you pay by taking full benefit of all available deductions.
- It helps in saving some extra bucks out of your monthly earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments., which you can use to invest in other lucrative investment opportunities and generate a handsome amount of returns over that surplus money.
- Eliminate unnecessary stress and uncertainty by knowing just what your tax liability will be and make informed decisions, ultimately obtaining peace of mind.
- The earlier in your professional/business journey you start to tax planning, the more strategies you can explore to maximize the effects.
- They help in learning about the tips and tricks of tax laws, different tax minimization techniques, which ultimately helps in tax compliance and effective adherence to tax laws as stipulated by the government.
- Tax planning, when clearly distinguished with tax avoidanceTax AvoidanceTax avoidance is the process of reducing the income tax liability of an individual or firm by adopting the lawful methods. The taxpayers can claim exemptions and deductions as allowed under the nation's tax provisions. Such as investments in municipal bonds and deductions for business loss./tax evasion, leads to lesser interaction with tax authorities and unnecessary litigations as well.
The only minor disadvantage is that it could lead to blockage of your money into buying of tax saver products such as ULIPS, Mutual fundsMutual FundsA mutual fund is an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks., Life insurance, bonds, etc. which could impact your short-term liquidity and buying these products just for the sake of tax savings and ignoring other aspects such as annual returns.
Some of the limitations are as follows:
- There is a sort of distrust between the tax authorities on one side and business or professional community on the other. The income tax department thinks that the taxpayers sometimes are unable to distinguish between tax planning and tax evasion/avoidance and misinterpret tax laws as intended by the government, whereas the taxpayers think that their money is not being spent appropriately on infrastructure development and sanitation.
- For the salaried class of taxpayersTaxpayersA taxpayer is a person or a corporation who has to pay tax to the government based on their income, and in the technical sense, they are liable for, or subject to or obligated to pay tax to the government based on the country’s tax laws., the responsibility of correct deduction of tax at source is thrown on employers. While in the case of a business or profession, they are responsible for declaring correct income. So, an employee may hide his other income and not declare to his employer in order to avoid taxes, and business owners also claim excess expense claims and deductions to reduce their tax burden. So in these cases, it takes backstage, and tax evasion/avoidance takes center stage.
Changes in Tax Planning
- The consequences of tax changes should be anticipated and considered as you evaluate choices for financial strategies. You can usually be aware of any tax law changes well in advance to incorporate them into your planning.
- Tax deductions, allowances, and slab rates tend to frequently change every year as per the economic scenario and taking into government fiscal targets. These changes must be kept in mind while doing tax planning as a ready reckoner.
- Changes in tax laws are brought in sometimes to boost the economic scenario, infrastructure growth, and industrial development. For example, recently, the scope of capital gains tax in the UK for Non-UK residents was extended to include all disposals of UK property. These are just the first in the line of reforms coming down the track in the next few years that will have a significant impact on landlords.
Tax planning has numerous advantages and lesser disadvantages. They should be done within the applicable limits of tax laws and clearly distinguished with tax evasion or tax avoidance, both of which are not allowable under the applicable limits of tax laws. Also, any changes in tax laws should be kept into consideration.
They can only be done up to a certain amount limit as per the thresholds fixed by the government tax laws. There are many tax-saving financial products available in the financial markets. Those products need to be evaluated with pros and cons before buying the same and whether it can actually lead to tax savings or not.
This article has been a guide to what is tax planning and its meaning. Here we discuss types and examples of tax planning along with importance & limitations. You can learn more about accounting from the following articles –