Don’t Let the Tail Wag the Dog - A Lesson on Tax Planning

This article is going to sound a bit like heresy, especially in the world of tax advisory but since I tend to wear two hats in my life as an investor and as a tax advisor, I’m always keen to emphasize and strike a balance between the two. Today we’ll be discussing why tax savings isn’t really your primary focus when you’re considering an investment or transaction, but rather is a secondary consideration after you’ve determined the path to undertake.

The Scenario

Typically, my clients or prospective clients want to schedule time with me to discuss a new business venture or a real estate investment. The questions usually follow two different paths. The first path is something along the lines of “Hey I’m considering moving forward with an opportunity to make an investment and as part of my analysis, I’d like to consider what my after tax consequence would be to factor in to my analysis. Once I know this, I can compare it to other investment opportunities before I make a final decision.” This type of thinking in my opinion is the optimal way to consider tax planning. They’ve already identified a profitable opportunity, but are considering taxes in comparison to other opportunities. I can have a very good discussion about this, point out some planning considerations, and calculate the pre and post tax consequences of the investment so that they can compare it to other investments.

The second type of discussion is the one I usually dread. It goes something like this “Hey I’m thinking about starting up a business, tell me all of the tax deductions I can take! I heard I can buy a Cadillac Escalade every year and save tons on taxes through bonus depreciation!” I can tell that this line of thinking will lead to a very poor outcome because they are so focused on tax savings that they’re forgetting the economic outcome. Let’s take the Escalade example. They usually go around $85K+ at the time of this writing, so ostensibly, you’d be able to depreciate $85K (when it was 100% bonus in 2022) and realize a tax benefit of presumably 37% multiplied by $85,000, which is $31,450. If they were already planning to buy one as part of their business plan, then by all means, go ahead! But can you imagine spending $85,000 to save $31,450 on an asset that tends to lose value very quickly? In 3-4 years, the SUV may be worth $45K, thus representing an overall economic loss of $13,550 ($45,000-$31,450). So as we can see, buying an vehicle solely to save on taxes works out poorly.

Timing of Investments

Alternatively, another line of thinking tends to be prevalent around the disposition of investments. The question usually is “what is the most tax efficient way to dispose of my stock to realize the lowest tax rate?”

That’s an easy question to answer, just hold it for more than a year! But simply following that advice may not be the best outcome. Let’s take the example of the meme stocks of 2020 — if we can recall Gamestop was going bonkers from a share price of $12 to upwards of over $200 in the short span of a few months. Very few people actually believed that $200 per share represented the true value of that company at the time. If they decided to solely focus on taxes, they could have held it for a year and sold it at roughly what they paid for it at maybe between $15-20 per share at a capital gain tax rate of 20%. Or they could have sold it at $200 for a short term gain of 37%. Which would you rather choose?

Don’t Do Something Because It’s Not Tax Deductible

This concept of not doing anything not tax deductible is also a bit crazy to me. There can be very good business cases for making expenditures which confer zero deductibility in the tax code. Case in point, entertainment expenses. For tax years 2018-2025, entertainment related expenditures are 0% deductible. To be clear, it’s not illegal for businesses to pay for entertainment for their clients and vendors. The only thing is that if you’re looking for a tax deduction for that, you just won’t get it. Therefore, taking clients out to the country club or Lakers game are totally valid business decisions, it’s just that the cost of doing so is a little more expensive since you won’t receive a deduction.

Closing Thoughts

Regardless of how you approach taxes, I strongly urge you all to always put the economics of your transaction far ahead of tax planning. Before talking with your CPA, have a clear path in mind of the plan of action you’re planning to undertake and a list of alternative considerations to that path. Don’t let the endless quests for saving taxes distract you from the truth: Don’t let the tail wag the dog, economics supercedes tax savings any day of the week.