“There is nothing wrong with a strategy to avoid the payment of taxes. The Internal Revenue Code doesn’t prevent that.” – William H. Rehnquist
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 April 15. If you didn’t know you could write off your kid’s braces as a business expense, there’s nothing we can do.
Remember the last time you drove a car? If you’re like most people, you probably sat down in the driver’s seat, strapped on your seat belt, turned the ignition, put the car in reverse, then backed your way to your destination, steering by what you could see out the rear view mirror.
Wait a minute… you mean that’s not how you do it?
Well, that’s how most tax preparers work. They spend lots of time looking back at what you did last year. But they don’t spend much time looking forward. They can tell you all about what you did yesterday. But they don’t tell you what you should do today, or when you should do it or how you should do it.
Tax planning, on the other hand, gives business owners like you two powerful benefits you can’t get anywhere.
First, it’s the key to your financial defense. As a business owner, you have two ways to put cash in your pocket. There’s financial offense, which means making more. And there’s financial defense, which means spending less. For most of you reading this book, spending less is easier than making more.
And for most of you reading this book, taxes are your biggest expense. So it makes 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 planning guarantees results. You can spend all sorts of time, effort, and money promoting your business – and that still won’t guarantee results. Or you can set up a medical expense reimbursement plan, deduct the cost of your teenage daughter’s braces, and guarantee savings.
But those guaranteed results start with planning. You can’t ever deduct money you spend on a medical expense reimbursement plan if you don’t set it up in the first place.
Now that we understand why planning is so important, let’s take a quick look at how the tax system works. This will “lay a foundation” for understanding the specific strategies we’ll be talking about soon.
The process starts with income. And this includes pretty much everything 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 sales of property
- Income from pensions, IRAs, and annuities
- Alimony received
- Gambling winnings
Even illegal income is taxable. The IRS doesn’t care how you make it; they just want their share! The good news, if you’re operating most illegal businesses, is that you can deduct the same expenses as if you were running a legitimate business. For example, if you’re a bookie, you can deduct the cost of a cell phone you use to take bets. The only exceptions include expenses “contrary to public policy” and most businesses involving illegal drugs.
Once you’ve added up 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:
- IRA contributions
- Moving expenses
- ½ of self-employment tax
- Self-employed health insurance
- IRA and self-employed retirement plan contributions
- Alimony payments
- Student loan interest up to $2,500
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” the line that separates total income from AGI.
Once you’ve determined your adjusted gross income, you can take a standard deduction that varies according to your filing status. Or you can itemize deductions. Obviously, it will pay to take whichever choice gives you greater deductions.
Specific itemized deductions include:
- Medical expenses, to the extent they top 10% of your AGI (7.5% if you’re above age 65)
- State and local taxes paid
- Foreign taxes paid
- Mortgage and investment interest
- Casualty and theft losses, to the extent they exceed 10% of your AGI
- Charitable gifts
- Miscellaneous itemized deductions, to the extent they exceed 2% of your AGI
If your total itemized deductions don’t add up to more than the standard deduction, just take the standard. For 2017, standard deductions are $6,350 for single taxpayers, $9,350 for heads of households, $12,700 for joint filers, and $6,350 each for married couples filing separately. Those amounts are high enough that only about a third of taxpayers itemize.
For most of us, itemizing doesn’t pay until we buy a home and start substituting deductible mortgage interest and property taxes for nondeductible rent. Here are the 2011 average itemized deductions for the five most common categories, along with the percentage of taxpayers in each group who actually take those deductions.
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 $4,050 for yourself, your spouse, and any dependents.
BUT – your deductions and personal exemptions start phasing out once your income hits certain levels. For 2016, those levels are $261,500 for singles and $313,800 for joint filers. The “Pease” limit, named for Ohio Congressman Bob Pease, costs you three cents of itemized deduction for every dollar of income above those amounts. (Bob can’t be too happy with that legacy.) And the Personal Exemption Phaseout, or “PEP limit,” costs you $50 of personal exemption for every $2,500 of income above those amounts.
Once you’ve subtracted deductions and personal exemptions, you’ll have your “taxable income.” At that point, you’ll consult the table of tax brackets to see how much to pay.
If you’re self-employed, and your business is taxed as a proprietorship or partnership, you’ll also owe self-employment tax on your business income. Self-employment tax replaces the Social Security and Medicare you and your employer would pay if you were a regular employee. (We’ll talk more about these business entities in Chapter Three.)
Some types of income aren’t taxed at the regular rate. For example, tax on “qualified corporate dividends” and most long-term capital gains is capped at 20%. Tax on “unrecaptured Section 1250 gain” (mainly from sales of real estate used in your business) is capped at 25%. And tax on “collectibles” (art, jewelry, etc.) is capped at 28%.
There’s also a new 3.8% “unearned income Medicare contribution” on investment income for single taxpayers earning more than $200,000 and joint filers earning more than $250,000. (Doesn’t “unearned income Medicare contribution” sound better than “tax”?) For purposes of this new rule, “investment income” includes interest, dividends, capital gains, rental income, royalties, and annuity distributions. You might be in the 35% bracket for regular income, but pay 23.8% on capital gains – even though there’s no such thing as a “23.8% bracket” per se.
The bottom line is that “tax brackets” and “tax rates” aren’t as simple as they might appear. Your actual tax rate on any particular dollar of income can be quite a bit higher or lower than your supposed “tax bracket.” Having fun yet?
Now, here’s where it gets really complicated. That’s because, after you go through all those steps to calculate your “regular” tax, you get to start all over again and see if you owe alternative minimum tax.
Alternative minimum tax (“AMT”) is a parallel tax system designed to prevent “the rich” from using regular deductions to avoid tax entirely. In 2009, it hit 4.5 million taxpayers nationwide, primarily in states with high income and property taxes. (This included former IRS Commissioner Mark Everson, who announced in 2004 that he had been hit for the first time.) But the tax wasn’t permanently indexed for inflation until the 2013 “fiscal cliff” legislation, and it’s become a de facto “flat tax” for upper-middle income taxpayers.
The AMT system starts with regular taxable income, then adds back specific “preference items.” These include:
- Medical expenses between 7.5% and 10% of AGI (for those over 65 who would use the lower threshold)
- State and local taxes deductible on Schedule A
- Home equity interest not used to buy, build, or improve your primary residence
- Miscellaneous itemized deductions (entirely)
- Investment interest (figured according to special rules)
- Part of post-1986 accelerated depreciation
- Gains from incentive stock options
- Interest from most “private activity” municipal bonds
Once you’ve determined your AMT income, you’ll subtract an exemption of $54,300 for single filers or $84,500 for joint filers. These exemptions phase out by 25 cents for every dollar of AMTI above $120,700 for single filers or $160,900 for joint filers. Finally, the tax itself is 26% of AMTI up to $93,900 for single filers or $187,800 for joint filers, plus 28% of AMTI above those amounts (2017).
Okay now, which is higher? Your regular tax, or your AMT? Pay that one, thankyouverymuch.
Finally, you’ll subtract any available 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.
Here are some of the more popular tax credits:
- Child Tax Credit (families with children under 17)
- Earned-Income Tax Credit (low-income working families)
- American Opportunity Tax Credit
- Lifetime Learning Tax Credits
- Foreign Tax Credit (That’s right, if you pay foreign taxes – or, more likely, if a mutual fund you own pays foreign taxes – you can take a deduction or a credit, whichever saves more. Generally, it’s the credit.)
- Business tax credits (from pass-through entities including partnerships and S corporations)
Done! That wasn’t so hard, was it?
Ultimately, there are two kinds of dollars in this world: pre-tax dollars, and after-tax dollars.
Pre-tax dollars are great, because you don’t pay any tax on them. Earn a dollar, spend a whole dollar!
And after-tax dollars aren’t bad. If you go to the grocery store to buy dinner for your family, the check-out clerk won’t turn up her nose and say “sorry, we can’t accept these after-tax dollars.” But they’re not as good as pre-tax dollars, simply because you don’t get to spend the tax you pay on them.
So, here’s the bottom line. You lose every time you spend after-tax dollars that could have been pre-tax dollars. We’re going to spend the rest of this book talking about how proactive planning can turn as many of your after-tax dollars as possible into pre-tax dollars.
ABOUT PROVIDENT CPA & BUSINESS ADVISORS
Winning the game of chess and being successful in business share something in common: Both require strategic thinking and diligent execution. Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life and win the chess game of business. If you want more information, follow us on social media.
To learn more call 1-85-LOWERTAX, or email firstname.lastname@example.org.