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10 Most Expensive Tax Mistakes That Cost Long Island Business Owners Thousands
The good news is, you don’t have to feel that way. You just need a better plan.
Planning is the key to beating the IRS, legally.
The first mistake is the biggest mistake of all. It’s failing to plan.
I don’t care how good you and your tax preparer are with a stack of receipts on
If you didn’t know about the perfectly, legal techniques you could use to write off your kid’s braces as a business expense, there’s nothing we can do.
Tax coaching is about giving you a plan for minimizing your taxes. What should you do? When should you do it? How should you do it? And tax coaching offers two more powerful advantages.
First, it’s the key to your financial defenses. As a business owner, you have two ways to put cash in your pocket. Financial offense is making more. Financial defense is spending less. For most of us, taxes are our single, biggest expense.
So, doesn’t it just makes good sense to focus your financial defense where you spend the most. Sure, you can save 15% on car insurance by switching to GEICO. But how much will that really save in the long run.
Second, tax coaching guarantees results. You can spend all sorts of time, effort, and money promoting your business. But that does not guarantee results. Or, you can set up a medical expense reimbursement plan, deduct your daughter’s braces, and guarantee savings.
Let’s start by taking a quick look at how the tax system works. This will “lay a foundation” for understanding the specific strategies that I’ll be revealing shortly.
The process starts with income. And this includes most of what you’d think the
IRS is interested in:
• Earned income from wages, salaries, bonuses, and commissions.
• Profits and losses from your own business.
• Interest and dividends from bank accounts, stocks, bonds, and mutual funds.
• Capital gains from property sales.
• Pensions, IRAs, and annuity income.
• Alimony and gambling winning.
• Even illegal income is taxable.
The IRS doesn’t care how you make it; they just want their cut! (The good news is, if you’re operating an illegal business, you can deduct the same expenses as if you were running a legitimate business. If you’re a bookie, you can deduct the cost of a cell phone you use to take bets.
Once you’ve added up your total income, it’s time to start subtracting “adjustments to income.” These are a group of special deductions, listed on the first page of
Form 1040, that you can take whether you itemize deductions or not. Total
income minus adjustments to income equals “adjusted gross income” or “AGI.”
Adjustments to income are also called “above the line” deductions, because
you take them “above” AGI.
Adjustments include IRA contributions, moving expenses, half of your self employment tax, self-employed Health Insurance, Keogh and SEP contributions, alimony you pay, and student loan interest.
Once you’ve determined adjusted gross income, you can take a standard deduction or itemized deductions, whichever is greater. The standard deduction for 2009 is $5,700 for single taxpayers, $8,350 for heads of households, $11,400 for joint filers, and $5,700 each for married couples filing separately.
Tax deductions reduce your taxable income. If you’re in the 15% bracket, an extra dollar of deductions cuts your tax by 15 cents. If you’re in the 35% bracket, that same extra dollar of deductions cuts your tax by 35 cents. You can also deduct a personal exemption of $3,650 for yourself, your spouse and any dependents.
Once you’ve subtracted deductions and personal exemptions, you’ll have taxable income. At that point, the table of tax brackets tells you how much to pay.
You may also owe self-employment tax, which replaces Social Security and Medicare for sole proprietors, partnerships, and LLCs. You’ll also owe state and local income and earnings taxes.
Finally, you’ll subtract any tax credits. These are dollar-for-dollar tax reductions, regardless of your tax bracket. So if you’re in the 15% bracket, a dollar’s worth of tax credit cuts your tax by a full dollar. If you’re in the 35% bracket, an extra dollar’s worth of tax credit cuts your tax by the same dollar. There’s no secret to tax credits, other than knowing what’s out there.
Ultimately, there are two kinds of dollars in this world: pre-tax dollars, and after-tax dollars. Pre-tax dollars are great. And after-tax dollars aren’t bad. But they’re not as good as pre-tax dollars.
So here’s the bottom line:
You lose . . . every time you spend after-tax dollars . . . That could have been pre-tax dollars.
Let me repeat that. You lose . . . every time you spend after-tax dollars . . . That could have been pre-tax dollars.
I’m going to spend the rest of this report talking about how to turn after-tax dollars into pre-tax dollars.
We’re going to use three primary strategies.
First, earn as much nontaxable income as possible. Second, make the most of adjustments to income, deductions, and credits. There’s really no magic to it, other than knowing what’s available. Finally, shift income to later tax years and lower-bracket taxpayers. This includes making the most of tax-deferred retirement plans and shifting income to lower-bracket children, grandchildren and other family members.
The second big mistake is nearly as important as the first, and that’s fearing, rather than respecting the IRS.
What does the kind of tax planning we’re talking about do to your odds of being audited? The truth is, most experts say it pays to be aggressive. That’s because overall audit odds are so low, that most legitimate deductions aren’t likely to wave “red flags.”
Audit rates are actually as low as they’ve ever been for 2004, the overall audit rate was just one in every 137 returns. Over half of those audits targeted the Earned Income Tax Credit for low-income working families. The IRS primarily targets small businesses, especially sole proprietorship’s, and cash industries like pizza parlors and coin-operated laundromats with opportunities to hide income and skim profits. In fact, they publish a series of audit guides that you can download from their web site that tell you exactly what they’re looking for when they audit you!
Take a look at the bottom of the chart. You’ll see that the IRS audits just about one-third of one percent of s corporations and partnerships. If you’re really worried about being audited, you might consider reorganizing your business to help fly “under the radar.”
If you’re like most business owners, you pay as much in self-employment tax as you do in income tax. If that’s the case, you might consider setting up an “S” corporation or limited liability company to reduce that tax.
If you run your business as a sole proprietor, you’ll report your net income on Schedule C. You’ll pay tax at whatever your personal rate is. But you’ll also pay self-employment tax, of 15.3% on your first $94,200 of “net self employment income” and 2.9% of anything above that.
Let’s say your profit at the end of the year is $60,000. You’ll pay regular tax at
your regular rate, whatever that is. You’ll also pay about $9,000 in self employment tax.
The self-employment tax replaces the Social Security and Medicare tax that your employer would pay and withhold if you weren’t self-employed. How many of you plan to retire on Social Security?
An “S” corporation is a special corporation that’s taxed like a partnership. The
corporation pays the owners a reasonable wage for the work they do. If there’s
any profit left over, it passes through to the shareholders, and the shareholders pay the tax on their own returns. So the S corporation splits the owners income into two parts, wages and pass-through distributions.
Here’s why the S corporation is so attractive. You’ll pay the same 15.3% tax on your wages as you would on your self employment income.
BUT – there’s no Social Security or self-employment tax due on the dividend pass-through. Let’s say your S corporation earns the same $60,000 as your proprietorship. If you pay yourself $30,000 in wages, you’ll pay about $4,500 in Social Security. But you’ll avoid $4,500 in self-employment tax on the pass-through distribution.
You can also use an S corporation to shift income to a lower-bracket family member. Let’s say your son is attending college out of state. You can earn money in your business, pay tax on it, and use after-tax dollars to pay his tuition. Or you can give him part of the corporation, pass that income through to him directly, let him pay tax at his lower rate, and pay less tax on those tuition dollars.
The S corporation takes a little more paperwork to operate than the proprietorship. You’ll have to file articles of incorporation with the (Secretary of State/Department of Corporations, etc.), get an employer ID number from the IRS, observe the usual corporate formalities, and manage a payroll for yourself.
And you have to pay yourself a reasonable wage for your service. That means
something like you’d pay for an outside employee to do the same work. The IRS is on the lookout for business owners who take all their income as passthrough. They’re not likely to believe you’ll find a brain surgeon willing to work a year for $12,000. That reasonable wage varies from industry to industry. But the S corporation can still be an effective tool for cutting your overall tax.
Now let’s talk about the fourth mistake:
Choosing the wrong retirement plan.
If you’re looking to save more than the $5,000 limit for IRAs, you have three main choices: Simplified Employee Pensions, or “SEPs,” SIMPLE IRAs, or 401ks.
I’m not here to make you an expert on retirement plans. But I can help you decide pretty quickly if the plan you have is right for you – or if you should be looking for something more suited for your specific needs.
The next step up the retirement plan ladder is the SIMPLE IRA. This is another “turbocharged IRA that lets you contribute more than the usual $5,000 limit:
You and your employees can contribute up to $11,500. If you’re 50 or older you can make an extra $2,000 “catch up” contribution. If your income is under $42,000, that may be more than you could sock away with a SEP.
But – you have to match everyone’s deferral or make profit-sharing contributions. You can match everyone’s contribution dollar-for-dollar up to 3% of their pay, or contribute 2% of everyone’s pay whether they defer or not. If you choose the match, you can reduce it as low as 1% for two years out of five.
The money goes straight into employee IRAs. You can designate a single financial institution to hold the money, or let your employees choose. Like the SEP, there’s no set-up charge or annual administration fee.
The SIMPLE IRA may be best for part-time or sideline businesses earning less than $40,000. You can also hire your spouse or children, and they can make SIMPLE contributions. We’ll be talking more about those strategies in a few minutes.
The final step up the ladder is the 401k. Most people think of 401ks as retirement plans for bigger businesses. But you can set up what’s called a “solo” or “individual” 401k just for yourself.
The 401k is a true “qualified” plan. This means you’ll set up a trust, adopt a written plan agreement, and choose a trustee. But the 401k lets you contribute far more money, far more flexibly, than either the SEP or the SIMPLE.
You and your employees can “defer” 100% of your income up to $15,000. If you’re 50 or older, you can make an extra $5,000 “catch up” contribution. You can choose to match your employees contributions, or make profit sharing contributions up to 25% of their pay. That’s the same percentage you can save in your SEP – on top of the $15,000 or $20,000 deferral.
The maximum annual contribution is $49,000 per person, plus any “catch up” contributions.
You can offer yourself and your employees loans, hardship withdrawals, and all the bells and whistles “the big boys” offer their employees. 401ks are generally more difficult to administer. There are anti discrimination
rules to keep you from stuffing your own account while you stiff your employees. If you operate your business by yourself, you can establish an “individual” 401k with less red tape. And again, you can hire your spouse and contribute to their account.
If you’re older, and you want to contribute more than the $49,000 limit for SEPs or 401ks, consider a traditional defined benefit pension plan:
Defined benefit plans let you guarantee up to $175,000 in annual income.
You can contribute – and deduct – as much as you need to finance that benefit. You’ll calculate those contributions according to your age, your desired retirement age, your current income, and various actuarial factors.
A 412(i) plan, which is funded entirely with life insurance or annuities, lets you
contribute even more. Defined benefit plans have required annual contributions. But you can combine a defined benefit plan with a 401k or SEP to give yourself a little more flexibility.
Now let’s talk about the fifth mistake: Missing family employment.
Hiring your children and grandchildren can be a great way to cut taxes on your income by shifting it to someone who pays less.
Yes, there’s a minimum age. They have to be at least seven years old. Their first $5,700 of earned income is taxed at zero. That’s because it’s the standard deduction for a single taxpayer – even if you claim them as your dependent. Their next $7,825 is taxed at just 10%. So you can shift a lot of income downstream.
You have to pay them a “reasonable” wage for the service they perform. The Tax Court says a “reasonable wage” is what you’d pay a commercial vendor for the same service, with an adjustment made for the child’s age and experience. So, if your 12-year-old son cuts grass for your rental properties, pay him what a landscaping service might charge. If your 15-year-old helps keep your books, pay him a bit less than a bookkeeping service might charge. Does anyone have a teenager who helps with your web site? What would you pay a commercial designer for that service?
To audit-proof your return, write out a job description and keep a time sheet. Pay by check, so you can document the payment.
You have to deposit the check into an account in the child’s name. But it doesn’t have to be his pizza-and-Nintendo fund. It can be a Roth IRA for decades of tax-free growth. It can be a Section 529 college savings plan. Or it can be a custodial account that you control until they turn 21. Now, you can’t use money in a custodial account for your obligations of parental support. But private and parochial school aren’t obligations of parental support. Sleep away summer camp isn’t an obligation of parental support.
Let’s say your teenage daughter wants to spend two weeks at horse camp.
You can earn the fee yourself, pay tax on it, and pay for camp with after-tax dollars. Or you can pay her to work in your business, deposit the check in her custodial account, and then, as custodian write the check to the camp. Hiring your daughter effectively lets you deduct her camp as a business expense.
If you hire your child to work in an unincorporated business, you don’t have to withhold for Social Security until they turn 18. So this really is tax-free money. You’ll have to issue them a W-2 at the end of the year. But this is painless compared to the tax you’ll waste if you don’t take advantage of this strategy.
Now let’s talk about health-care costs. Surveys used to show that taxes used to be small business owners’ biggest concern. Now it’s rising health care costs.
If you pay for your own Health Insurance, you can deduct it as an adjustment to income on Page 1 of Form 1040. If you itemize deductions, you can deduct unreimbursed medical and dental expenses on Schedule A, if they total more than 7.5% of your adjusted gross income. But most of us don’t spend that much.
What if there were a way to write off medical bills as business expenses?
There is, and it’s called a Medical Expense Reimbursement Plan, or Section 105 Plan.
This is an employee benefit plan, which means it requires an employee. If you operate your business as a sole proprietorship, partnership, LLC, or S corporation, you’re considered self-employed. So, if you’re married, hire your spouse. If you’re not married, you can do this with a C corporation. But you don’t have to be incorporated. You can do it as a sole proprietor or LLC by hiring your spouse.
The one exception is the S corporation. If you own more than 2% of the stock, you and your spouse are both considered self-employed for purposes of this rule. You’ll need to use another source of income, not taxed as an S corporation, as the basis for this plan.
Let’s assume you’re a sole proprietor and you’ve hired your husband. The plan lets you reimburse your employee for all medical and dental expenses he incurs for himself – his spouse (which covers you) – and his dependents.
This includes all the expenses you see listed here. Major Medical Insurance, long-term care coverage, Medicare, and Medigap insurance. Co-pays, deductibles, and prescriptions. Dental, vision, and chiropractic care. Braces for your kids’ teeth, fertility treatments, and special schools for learning-disabled children. It even covers nonprescription medications, vitamins and herbal supplements, and medical supplies. The best part is, this is money you’d spend anyway, whether you get a deduction or not. You’re just moving it from a nondeductible place on your return, to a deductible place.
There’s no pre-funding required. You don’t have to open a special account, like with Medical Savings Accounts of flex-spending plans. You don’t have to decide how much to contribute, and there’s no “use it or lose it” rule. It’s just an accounting device that lets you characterize your family medical bills as business expenses.
You can reimburse your employee or pay health-care providers directly. Let’s say your husband needs to pick up a prescription. He can use his own money, and you can reimburse him. Or he can use a business credit card and charge it to the business directly.
You’ll need a written plan document, which we can provide you. You’ll need to track your expenses under the plan, which we can also help with. But there’s no special reporting required. You’ll report reimbursements as “employee benefits” on Schedule C, Form 1065, or Form 1120. You’ll save income tax and self-employment tax.
If you have non-family employees, you have to include them too. You can exclude employees under age 25, who work less than 35 hours per week, less than nine months per year, or who have worked for you less than three years.
Non-family employees may make it too expensive to reimburse everyone as generously as you’d cover your own family. But, if you’re offering health insurance, you can still use a Section 105 plan to cut your employee benefit cost. You can do it by switching to a high-deductible Health Plan, and using a Section 105 plan to replace those lost benefits.
If a medical expense reimbursement plan isn’t appropriate, consider the new Health Savings Accounts. These arrangements combine a high-deductible Health Plan with a tax-free savings account to cover unreimbursed costs.
To qualify, you’ll need a “high deductible health plan” with a deductible of at least $1,000 for singles or $2,000 for employees and an out-of-pocket limit of $5,100 for singles or $10,200 for families. Neither you nor your spouse can be covered by a “non-high deductible health plan” or Medicare. The plan can’t provide any benefit, other than certain preventive care benefits, until the deductible for that year is satisfied. You’re not eligible if you’re covered by a separate plan or rider offering prescription drug benefits before the minimum annual deductible is satisfied.
Once you’ve established your eligibility, you can open a deductible savings account. You can contribute 100% of your deductible up to $3,000 for singles or $5,950 for families. You can use it for most kinds of health insurance, including COBRA continuation and long-term care premiums. You can also use it for the same sort of expenses as a Section 105 plan.
The Health Savings Account isn’t as valuable as the Section 105 Plan. You’ve got specific dollar contribution limits, and there’s no self-employment tax advantage. But Health Savings Accounts can still cut your overall healthcare costs.
Let’s look at a specific example to see just how much the Section 105 Plan saves. Our “guinea pig” here is a self-employed consultant, married, with two children. He pays 25% in federal income tax and 15.3% in self-employment tax.
We replaced a traditional “first dollar” insurance policy with a high-deductible plan from the same company. In this case, it meant a $5,000 deductible before benefits kick in. But it cut his premium by $7,620. So even if he hits that $5,000 deductible, he saves $2,620 in premiums. And now, since he deducts his medical costs from his business income, his self-employment tax savings add another $1,156 to his bottom line. He’ll save at least $3,121 – and possibly much more.
The home office deduction is probably the most misunderstood deduction in the entire tax code. For years, taxpayers feared it raised an automatic audit flag. But Congress has relaxed the rules, so now it’s far less likely to attract attention.
Your home office qualifies as your principal place of business if: 1) you use it “exclusively and regularly for administrative or management activities of your trade or business”; and 2) “you have no other fixed location where you conduct substantial administrative or management activities of your trade or business.” This is true even if you have another office, so long as you don’t use it more than occasionally for administrative or management activities.
You have to use your office regularly and exclusively for business. “Regularly” generally means 10-12 hours per week. To prove your deduction, keep a log and take photos to record your business use.
You can claim a workshop, studio, or “separately identifiable” space you use to store products or samples. The space doesn’t have to be an entire room. If you use it for more than one business, both have to qualify to take the deduction.
Once you’ve qualified, you can start deducting expenses. If you’re taxed as a proprietor, you’ll use Form 8829. If you’re taxed as a partnership or corporation, there’s no separate form, which helps you “fly under the radar.”.
First, you’ll need to determine business use percentage of your home. You can divide by the number of rooms if they’re roughly equal, or calculate the exact percentage of square footage. You can exclude common areas like halls and stairs to boost that business use percentage
Next, you’ll deduct your business use percentage of rent, mortgage interest, and property taxes.
You’ll depreciate the business use percentage of your home’s basis (excluding land) over 39 years as nonresidential property.
Finally, you’ll deduct your business use percentage of utilities, repairs, insurance, garbage pickup, and security. If business use percentage for specific expenses differs from business use percentage for the overall home – such as high electric bills for home office equipment – you can claim the difference as “direct” expenses.”
Claiming a home office can also boost your car and truck deductions. That’s because it eliminates nondeductible commuting miles for that business.
You can use home office expenses to shelter profits, but not below zero. If your home office expenses exceed your net business income, you can carry forward those excess losses to future years.
When you sell your home, you’ll have to recapture any depreciation you claimed or could have claimed after May 6, 1997. You can still claim the $500,000 tax-free exclusion for home office space unless it’s a “separate dwelling unit.”
Now let’s talk about car and truck expenses. I don’t want to take too much time here, but I do want to point out the most common mistake clients make with these expenses.
Are you detecting a pattern here? That deduction is the same for everyone, no matter what we drive. Do you think we all spend the same to operate our cars?It might surprise you to see how much it really costs to operate your car. And it’s probably more than 55 cents per mile!
Every year, AAA publishes a vehicle operating cost survey. Costs vary according to how much you drive – but if you’re taking the standard deduction for a car that costs more than 55 cents/mile, you’re losing money every time you turn the key.
If you’re taking the standard deduction now, you can switch to the “actual expense” method if you own your car, but not if you lease. You can’t switch from actual expenses to the mileage allowance if you’ve taken accelerated depreciation.
Let’s finish up with some fun deductions for meals and entertainment. The basic rule is that you can deduct cost for meals with a bona fide business purpose. This means clients, prospects, referral sources, and business colleagues. And let me ask you – when do you ever eat with someone who’s not a client, prospect, referral source, or business colleague? If you’re in a business like real estate, insurance, or investments, where you’re marketing yourself, the answer might be “never.” Be as aggressive as you can with what you define as bona fide business discussion!
The general rule is, you can deduct 50% of your meals and entertainment, so long as it isn’t “lavish or extraordinary.” The IRS knows you have to eat, so you can’t deduct it all. But they’ll meet you halfway.
You don’t need receipts for expenses under $75. But you do need to record the five pieces of information listed on the right side of the slide in your business diary or records. And you should do it as close to daily as possible.
The IRS wants to know how the cost of the meal, the date of the meal, the place where it takes place, the business purpose of your discussion, and your business relationship with your guest.
How many of you entertain at home? Do you ever discuss business? Are you deducting those meals, too? There’s no requirement that you eat out. Don’t forget to deduct home entertainment expenses too! You can deduct entertainment expenses if they take place directly before or after substantial, bona fide discussion directly related to the active conduct of your business. You can deduct the face value of tickets to sporting and theatrical events, food and beverages, parking, taxes, and tips.
Now that you see how business owners miss out on tax breaks, let’s talk about the biggest mistake of all. What mistake is that?
The biggest mistake of all is failing to plan.
Have you all heard the saying “if you fail to plan, you plan to fail”? It’s a cliché because it’s true. Fortunately, our tax coaching service avoids the problem.
We offer true tax planning. We’ll tell you what to do, when to do it, and how to do it. We start with a three-page “check the box” questionnaire that takes 5 minutes to fill out.
Then we prepare a written tax plan that addresses you family, home, and job, your business, and your investments. We’ll even review your last three years’ tax returns to see if we can find savings that were overlooked.
About the Author
For more information on proactive tax planning contact:
Thomas L. LaMarco CPA
Tel: 631 689-1414 x 18
Fax: 631 980-3559
Abbe & LaMarco CPAs LLP
1352 Stony Brook Road
Stony Brook NY 11780
AAA Health/Dental Insurance