Let us first illustrate the difference when it comes to tax planning. Reactive tax planning is when we talk about tax planning at the end of the year when the tax return is due. Many accounting firms advertise that they will find you all the deductions you can use. That is after the fact planning. It can save taxes but it has limitations. The key limit is that you may not be eligible for a deduction because you did not do something upfront to ensure eligibility. Also, there are limits on the actual savings possible when you are only working with deductions. There are many more savings opportunities that are not deductions.

Proactive planning is when you plan the year before to be eligible for a deduction. But it goes further. You can also plan to be taxed at different rates. Ideas that illustrate proactive planning are identifying that certain types of sales result in different types of profits and that many governments reward hot topic business sectors with tax incentives. For example, many countries offer a lower tax rate for intellectual property businesses. Thus, we can plan ahead by splitting our profits between intellectual property income and other income to enjoy low tax rates on intellectual property and live with normal tax rates on the other income. Using this plan we can stream income to the lower tax rate. Another example of planning opportunities is splitting income between owners to utilize lower tax rates of some owners.

Lastly, we can take advantage of international businesses by allocating profits between different jurisdictions and enjoy low tax rates in some jurisdictions. The real advantage of the proactive tax planning approach is that you still can use all the reactive tax planning tools but you can do more on top of existing tax savings and multiply the benefits.