Part 8: The 10 Most Expensive Tax Mistakes, Are You Satisfied with The Taxes You Pay?

Now let’s talk about the most common mistake that business owners and professionals make with vehicle expenses – specifically, calculating them the wrong way.

You know that you can calculate your “actual expenses” for operating your vehicle. Or you can use a much easier standard allowance. For 2016, the allowance is 54 cents per mile. Sounds pretty good, right? Well, it might surprise you to see how much it really costs to operate your car. And it’s almost never 54 cents per mile!

Every year, AAA researches vehicle operating costs. As the chart shows, if you’re taking the standard deduction for a car that costs more than 54 cents/mile, you’re losing money every time you turn the key.

Your first step involves calculating your “business use percentage” (BUP) for your vehicle. The IRS divides your trips into three categories: 1) business; 2) commuting; and 3) personal. Ordinary commuting and personal trips are nondeductible. Trips from home to your first business stop and trips from your last business stop to home are personal. (Daily trips to the bank, post office, and similar stops where you perform no service don’t qualify as “business.”)

Oh, and because you’ll ask – yes, you can deduct the cost of plastering your name and logo on your vehicle. But the IRS specifically says it won’t convert personal or commuting miles into deductible business miles. Sorry!

Now that we know what qualifies as “business” miles, the IRS gives you four ways to track them. All four require you to keep “adequate records or other sufficient evidence” to support your business use. This means logging mileage at least weekly and keeping receipts for all expenses over $75.

  1. “Brute Force” method: Record every business mile you drive for the year. Divide your business mileage by your total mileage for the year to calculate BUP. (If you use more than one car for business, this is the method you have to use. I know, what a hassle.)
  2. “90 days” method: Record your business miles for a “typical” 90-day period. Divide that amount by your total mileage for that period to calculate BUP, then use that percentage for the entire year.
  3. “First Week” method: Record your business miles for the first week of each month. Divide that amount by your total miles for that period and use it for the entire month.
  4. “Simplified” method: Record your starting and ending mileage for a 90-day period. Record your personal and commuting miles for that period, and assume all the rest of your miles are for business. Calculate your BUP and use it for the entire year. (This is the easiest method if most of your miles are for business.)

Travel between temporary business stops is deductible. So, for example, if you leave home, make six business stops, meet a prospect for dinner, then drive home, your mileage between your first stop and the restaurant is deductible. However, if you have a regular business stop (one that you make at least 8 to 10 times in a six-month period) that you expect to last less than a year, you can count those as business miles, too. If home is your principal place of business, then all business trips are deductible.

Once you’ve calculated your BUP, you have two ways to calculate your deduction.

  1. The mileage allowance – which was 54 cents/mile for 2016, plus parking, tolls, and your BUP of interest on your car loan and state and local personal property tax on the vehicle. (While we’re at it, the allowance for charitable use of the vehicle is capped at just 14 cents/mile, and for medical and moving use, 23.5 cents/mile.)
  2. The “actual expense” method, where you deduct your full BUP of all expenses. These include:
  • Depreciation and interest (if you’ve bought)
  • Lease payments (if you’ve leased)
  • Insurance
  • Gasoline, oil, and car washes
  • Tires, maintenance, repairs
  • License and registration fees
  • Personal property tax
  • Parking and tolls

Which one saves the most? Easy – try them both and see. Generally, the more you drive, the more the allowance saves. That’s because the allowance assumes 14 cents/mile for depreciation – and as your miles climb, that “assumed” amount can be far more than your actual depreciation. If you’re a real road warrior, logging 30,000 or more business miles per year, you’ll almost certainly come out ahead with the allowance, no matter what you drive.

Okay. What if you’ve been taking the mileage allowance (because it’s easier, or because your tax preparer told you it was all the same), and you discover you ought to be taking actual expenses. What now? Well, if you’re taking the allowance now, you can switch to the “actual expense” method if you own your car – but not if you lease.

Unfortunately, the reverse isn’t true. You can’t switch from actual expenses to the mileage allowance. You also can’t use the allowance if you use five or more vehicles in your business, or you use your vehicle for hire (taxi, Lyft, Uber, etc.).

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 katie.clawson@providentcpas.com.

Part 7: The 10 Most Expensive Tax Mistakes, Are You Satisfied with The Taxes You Pay?

Home office expenses are probably the most misunderstood deduction in the entire tax code. For years, taxpayers feared it guaranteed them an audit. Plenty of tax professionals were happy to go along with that myth. (Maybe they thought it made their jobs easier!) But the U.S. Supreme Court made it easier to qualify for the deduction back in 1994, and Congress made it even easier in 2007. So now your deduction is far less likely to attract attention.

Your home office is deductible if:

  • It’s your “principal place of business,”
  • You use it to meet clients, patients, or prospects in the normal course of your trade or business, or
  • It’s a separate structure not attached to your dwelling unit.

Most deductible home offices qualify under Rule #1. IRS Publication 587 says 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.

Example: You’re a real estate agent and you have a desk at your broker’s office. Your home office qualifies as your principal place of business so long as you use it to manage your business and keep your books, and you don’t regularly do that at your desk at the broker.

Your home office doesn’t have to be an entire room. You can use part of a room as long as it meets the requirements. You can also claim a workshop, a studio, or any other “separately identifiable” space you use to store products or samples. If you use it for more than one business, both have to qualify to take the deduction.

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.

Once you’ve qualified, you can start deducting expenses. If your business is taxed as a proprietorship, 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.”

  • Start by calculating the “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 the home’s square footage the office occupies. If you use the second method, you can exclude common areas like halls and stairs to boost the overall business use percentage.
  • Next, you’ll deduct your business use percentage of your rent or your mortgage interest and property taxes. (Deducting those expenses on your business return can save you more than on your personal return. For example, if you’re subject to AMT, you lose your property tax deduction. If your AGI is high enough, the Pease limits cut your itemized deductions. Claiming a home office lets you rescue that lost deduction, at least for the part of the home you use for business.)
  • 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.

Are there any expenses you can allocate directly to your home office? Maybe you spent extra to renovate the room itself. Maybe you have especially high electric bills for home office equipment? You can claim those as “direct” expenses.

You can also deduct the cost of furnishing, carpeting, and decorating your home office.  But be reasonable! If you buy a Picasso at auction, you don’t get to deduct it just because it’s in your office!

You can use home office expenses to reduce taxable income and self-employment income from your business, but not below zero. If your home office expenses in a particular year are more than your net income from your business, you can carry forward the difference 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 usual $250,000 or $500,000 tax-free exclusion for space you use for your office unless it’s a “separate dwelling unit.”

If this all seems like too much work, there’s a new “safe harbor” method that lets you claim a flat $5 per square foot (regardless of your actual expenses) for up to 300 square feet of qualifying home office space (regardless of what percentage it occupies in your home). If you use the safe harbor, you’ll continue to deduct your mortgage interest and property tax on Schedule A. However, you’ll forego any depreciation deduction. And if the safe harbor deduction reduces your business income below zero, there’s no carrying forward the loss.

The safe harbor is certainly easier than the traditional method. However, using it might not let you claim nearly as much as the traditional method. The only way to know is to run the numbers and calculate the deduction both ways.

Claiming a home office can also boost your car and truck deductions. That’s because it can minimize or even eliminate nondeductible commuting miles for that business.

Example: You’re a real estate agent with a desk at your broker’s office. If you don’t have a home office, your trip from home to the office is a nondeductible commute. However, if you have a home office, and you start your workday in that office, your “commute” is the trip to the home office, and your trip from home to your desk at the broker is a deductible trip from one business location to another.

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 katie.clawson@providentcpas.com.

Part 6: The 10 Most Expensive Tax Mistakes, Are You Satisfied with The Taxes You Pay?

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 10% of your adjusted gross income. But most of us just don’t spend that much on our healthcare. So we wind up losing thousands in otherwise legitimate deductions.

What if there was 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.

The first thing you need to know about a MERP is that it’s an employee benefit plan. That means (spoiler alert) it requires an employee:

  • If your business is taxed as a sole proprietorship, you’re considered self-employed. You can’t establish the plan for yourself. However, if you’re married, you can hire your spouse.
  • If your business is taxed as a partnership, you’re also considered self-employed. Again, you can’t establish the plan for yourself. However, you can still hire your spouse so long as he or she owns less than 5% of the business.
  • If your business is taxed as an S corporation, both you and your spouse are considered self-employed. This means you’ll need another source of income, not taxed as an S corporation, to establish the plan. (Alternatively, you can establish a health savings account, which we’ll discuss in a few pages, to give yourself most of the same benefit as the 105 plan.)
  • If your business is taxed as a “C” corporation, you qualify as your own employee, so you can simply hire yourself.

If you’re married, and you choose to hire your spouse, you don’t even have to pay him or her a salary. You can compensate them in the form of benefits only, which avoids the hassle of filing payroll returns. The main requirement here is that the benefits you pay have to be “reasonable compensation” for the service they perform. If your spouse works an hour a month filing invoices for you, you’ll probably have a hard time convincing an auditor that that’s “reasonable” for $4,000 worth of LASIK surgery!

Once the plan is in place, you can reimburse your employee for any medical expense they incur for themselves, their spouse, and their dependents.

  • This includes any kind of health insurance, including major medical, long-term care (up to specific IRS limits), Medicare premiums, and even Medigap coverage.
  • It includes all your copays, deductibles, “co-insurance,’ and other amounts insurance doesn’t pay.
  • It includes all your prescription drugs.
  • It includes expenses for things like dental care, vision care, and chiropractic care that traditional insurance might not cover.
  • It includes some really “big-ticket” items like braces for your kids’ teeth, fertility treatments, and special schools for learning-disabled children. Let’s say your physician diagnoses your 8-year-old son with ADHD, and prescribes tai kwon do lessons. Guess what – those lessons are now tax-deductible!
  • It even includes over-the-counter medications and supplies, so long as they’re actually prescribed by a physician.

One big advantage of the MERP is that it works with any insurance policy. You don’t have to buy special coverage. You can use a MERP with insurance you buy on your own or insurance you buy through an exchange. If your spouse gets coverage from their employer, you can even set up a MERP in your business to cover whatever out-of-pocket expenses your spouse’s insurance doesn’t cover.

Let’s assume you’re a sole proprietor with two kids and you’ve hired your husband to work for your business. The plan lets you reimburse your husband/employee for all medical and dental expenses he incurs for himself – his spouse (which brings you into the plan) – and his dependents, the kids.

This includes all the expenses listed above.

The best part is, this is money you’d spend anyway, whether you got a deduction or not. You’ll spend your money on glasses or your kids’ braces whether it’s deductible or not. The MERP just lets you move it from someplace on your return where you certainly can’t deduct all of it (and probably can’t deduct any of it), to a place where you can.

Okay, how do you make it work? Well, for starters, you’ll need a written plan document. (We can help with that.)

If you’ve hired your spouse, you’ll need to be able to verify that they qualify as a bona fide “employee.” That means you need to direct the work they perform for the business, the same as you would direct the work that any other employee performs.

Here’s one important requirement that the IRS will pay attention to in the unlikely event you get audited. You do have to run the payments through the actual business. You can’t just pay medical bills out of the family personal account, total them up at the end of the year, and throw them on the business return.

This means you have two choices. You can pay health-care providers directly out of the business account. Or you can reimburse your employees for expenses they pay out of

their personal funds. 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.

There’s generally no need for an outside third-party administrator, or “TPA,” if you’ve simply hired your spouse to write off your own family’s medical expenses. However, you will need a TPA if you’re reimbursing nonfamily employees in order to avoid violating medical privacy rules.

There’s no pre-funding required. You don’t have to open a special bank or investment account, like with Health Savings Accounts or flex-spending plans. You don’t have to decide up front how much you want to contribute to the plan, like you do with flexible spending accounts, and there’s no “use it or lose it” rule. The MERP is really just an accounting device that lets you re-characterize your family medical bills as a business expense.

The MERP doesn’t just help you save income tax. It also helps you save self-employment tax. Remember, when you work for yourself, you pay a special self-employment tax, which replaces the Social Security and Medicare taxes that you and your employer would share on your salary. That self-employment tax is based on your “net self-employment earnings” – but when you set up a MERP, the deduction reduces that self-employment income.

Now, here’s the bad news. If you have non-family employees, you have to include them too. Now, 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. You can also exclude employees covered by a collective bargaining agreement that includes health benefits. But still, having non-family employees may make it too expensive to reimburse everyone as generously as you’d cover your own family.

Obamacare also imposes a pesky new excise tax requirement on MERPs called the “Patient Centered Outcomes Research Trust Fund Fee,” or PCORI fee. For plans operating in 2016, that amount is projected to be $2.25 per person, reported on IRS Form 720, and due by July 31, 2017.

Yes, you heard that right. $2.25. You can’t even buy a decent cup of coffee for that much. But the statutory penalty for failing to file that report can be as high as $10,000. And while it’s not likely the IRS will ever actually impose that fine, you probably want to make sure you dot your “i’s” and cross your “t’s.”

Health Savings Accounts

If a Medical Expense Reimbursement Plan isn’t appropriate – either because you don’t have a spouse to hire, or you have non-family employees you would have to cover – consider establishing a Health Savings Account. These arrangements combine a high-deductible health plan with a tax-free savings account to cover unreimbursed costs.

To qualify, you’ll need to be covered by a “high deductible health plan.” This means the deductible is at least $1,300 for single coverage or $2,600 for family coverage. Neither you nor your spouse can be covered by a “non-high deductible health plan” or by Medicare. The plan can’t cover any expense, other than certain preventive care benefits, until you satisfy the annual deductible. 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 “health savings account” to cover out-of-pocket expenses not covered by your insurance. For 2017, you can contribute up to $3,400 if you have individual coverage or $6,750 if you have family coverage. (If you’re 55 or older, you can save an extra $1,000 per year.)

HSAs are easy to open. Most banks, brokerage firms, and insurance companies offer them. Many times you can even get a debit card to charge expenses directly to the account.

Once you’re up and running, you can use your account for most kinds of health insurance, including COBRA continuation and long-term care (but not “Medigap” coverage). You can also use it for the same sort of expenses as a MERP – copays, deductibles, prescriptions, and other out-of-pocket costs.

Withdrawals are tax-free so long as you use them for “qualified medical costs.” Withdrawals not used for qualified medical costs are subject to regular income tax plus a 20% penalty.

After your death, your account passes to your specified beneficiary. If your beneficiary is your spouse, they can treat it as their own HSA. If not, your beneficiary will pay ordinary tax on the account proceeds (but not the 20% penalty).

The Health Savings Account isn’t quite as powerful or flexible as the MERP. You’ve got specific dollar limits on what you can contribute to the account, which might not match your out-of-pocket costs. And there’s no self-employment tax advantage as there is with a MERP. But Health Savings Accounts can still help cut your overall health-care costs by giving you bigger tax deductions.

Flexible Spending Accounts

Flexible spending accounts (“FSAs”) let you set aside pre-tax dollars for a variety of nontaxable fringe benefits, including health and disability insurance and medical expense reimbursement. Plan contributions avoid federal income and FICA tax.

The new Obamacare rules let you contribute up to $2,550 per year to your account. Before Obamacare, there were no contribution limits at all. Many observers have called the new $2,550 limit a tax in disguise, especially for older workers with expensive prescriptions who tend to contribute more to their accounts.

Once the money is in the account, you can use it for most medical expenses. However, nonprescription drugs and supplies, long-term care coverage, and associated expenses are not eligible FSA expenses.

Your employer deducts plan contributions from your paycheck and deposits them into your account until you claim your reimbursements.

When you enroll, you have to choose how much to contribute each pay period. You generally can’t change your contribution amount in the middle of the plan year unless there’s a change in your “family status.” Eligible changes include marriage or divorce; birth, adoption, or death of a child; spousal employment; change in a dependent’s student status; and the like.

You can claim your full year’s reimbursement as soon as you incur qualifying expenses, whether you’ve fully funded your account for that amount or not.

Historically, FSA rules have required you to use your account balance by the end of the year or forfeit it. However, many employers’ plans have taken advantage of a subsequent ruling that lets them amend their plans to provide a 2½ month grace period immediately following the end of the year.

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 katie.clawson@providentcpas.com.

Part 5: The 10 Most Expensive Tax Mistakes, Are You Satisfied with The Taxes You Pay?

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 $6,350 of earned income is taxed at zero. That’s because $6,330 is the standard deduction for a single taxpayer – even if you claim them as your dependent. Their next $9,325 of taxable income is taxed at just 10%. That may be more income than you would have expected you would be able to shift 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 timesheet.
  • 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. Sleepaway 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, stroke 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 still have to jump through some paperwork hoops, like issuing a W-2 at the end of the year and reporting their income on their own return if the income is enough to require them to file themselves. But this is painless compared to the tax you’ll waste if you don’t take advantage of this strategy.

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 katie.clawson@providentcpas.com.

Part 4: The 10 Most Expensive Tax Mistakes, Are you Satisfied with the Taxes You Pay?

Now let’s talk about the fourth mistake: choosing the wrong retirement plan.

The amount you can contribute at any income level varies widely according to which type of plan you have. If you make $90,000, for example, you can contribute $22,500 to a simplified employee pension (SEP), $14,700 to a SIMPLE IRA, and $40,000 to a 401(k). (And that’s before any catch-up contributions you can start making at age 50.) But contribution limits aren’t all you need to know. Which plan gives you the best combination of contribution, flexibility, and liquidity?

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.

We’ll assume for the purposes of this discussion that you’ve already decided you want to save more than the $5,500 you can save in an IRA. We’ll also assume that you want a “traditional” arrangement, where you deduct the contributions you make now and pay tax on withdrawals. (We’ll address alternatives, including Roth arrangements and life insurance, towards the end of the chapter.)

The Simplified Employee Pension, or “SEP,” is the easiest plan to set up because it’s just a turbocharged IRA:

  • If you’re self-employed, you can contribute and deduct up to 25% of your “net self-employment income.”
  • If your business is incorporated and you’re salaried, you can contribute 25% of your “covered compensation,” which essentially means your salary.
  • The maximum contribution for any single employee 2017 is $54,000.
  • If you’ve got employees, you’ll have to contribute for them, too. You generally have to contribute the same percentage for your employees as you do for yourself. However, if your income is significantly higher than that of your employees, you can use what’s called an “integrated” formula to make extra contributions for higher incomes.
  • The money goes straight into regular IRA accounts you set up for yourself and your employees. There’s no annual administration or paperwork required.
  • SEP assets accumulate tax-deferred over time. You’ll pay tax at ordinary income rates when you withdraw them in retirement. There are penalties for early withdrawals before age 59½, and for failing to take required minimum distributions beginning at age 70½.

The SEP is easy to adopt, easy to maintain, and flexible. If there’s no money to contribute, you just don’t contribute. But remember, the contribution is limited to a percentage of your covered compensation. So, for example, if you set up an S corporation to limit your self-employment tax, you’ll also limit your SEP contribution because it’s based on that lower salary amount.

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 $5,500 limit:

  • You and your employees can “defer” and deduct 100% of your income up to $12,500. If your income is under $50,000, that may be more than you could sock away with a SEP.
  • If you’re 50 or older you can make an extra $3,000 “catch up” contribution.
  • But – you have to match everyone’s deferral or make profit-sharing contributions. You can match employee contributions dollar-for-dollar up to 3% of their pay, or contribute 2% of everyone’s pay whether they choose to 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 where to hold their accounts.
  • There’s no set-up charge or annual administration fee.
  • SIMPLE assets accumulate tax-deferred over time. You’ll pay tax at ordinary income rates when you withdraw them in retirement. There are penalties for early withdrawals before age 59½, and failing to take required minimum distributions beginning at age 70½.

The SIMPLE IRA may be best for part-time or sideline businesses earning less than $50,000, because the flat $12,500 contribution is higher than the 25% SEP contribution for incomes up to $50,000.

The next step up the retirement plan ladder is the 401(k). Most people think of 401(k)s as retirement plans for bigger businesses. But you can set up a 401(k) for any size business. In fact, you can even set up what’s called a “solo” or “individual” 401(k) just for yourself.

The 401(k) is a true “qualified” plan. This means you’ll set up a trust, adopt a written plan agreement, and choose a trustee. But the 401(k) lets you contribute far more money, far more flexibly, than either the SEP or the SIMPLE.

  • You and your employees can “defer” and deduct 100% of your income up to $18,000. If you’re 50 or older, you can make an extra $6,000 “catch up” contribution.
  • You can choose to match contributions, or make “profit-sharing” contributions up to 25% of everyone’s pay. (If you operate as an S corporation, you can contribute up to 25% of your salary, but not any pass-through distributions.) That’s the same percentage you can save in your SEP – on top of the $18,000 deferral.
  • The maximum contribution for 2017 is $54,000 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.
  • You can use “cross-testing” to skew profit-sharing contributions to favored employees. “Age weighted” plans allocate more to older employees (on the theory that they have less time to save for retirement); “integrated” and “super-integrated” plans allocate more to higher-paid employees (on the theory that they get no benefit from Social Security for their income above the Social Security wage base); and “rate group” plans divide employees into groups (such as managers, administrators, and salespeople) and make different contributions for each group.
  • 401(k) assets accumulate tax-deferred over time. You’ll pay tax at ordinary income rates when you withdraw them in retirement. There are penalties for early withdrawals before age 59½, and failing to take required minimum distributions beginning at age 70½.

The downside? 401(k)s are true “qualified” plans, which makes them harder to administer than SEPs or SIMPLEs.

You have to establish a qualified-plan trust to hold plan assets. The trust will have to file Form 5500, an informational return reporting contributions and assets, every year. And there are complicated anti-discrimination and “top-heavy” rules to keep you from stuffing your own account while you stiff your employees.

However, if the 401(k) really does make sense, there are three alternatives that might make administration easier:

  • A “SIMPLE” 401(k) avoids nondiscrimination and top-heavy rules in exchange for guaranteed employer contributions. You and your employees can defer 25% of covered compensation up to the SIMPLE plan contribution limits. Your business has to contribute 2% of covered comp or match contributions up to 3% of covered comp. This works if you want a true 401(k), but you’re afraid your employees won’t contribute enough to let you make meaningful deferrals. You can also convert an existing 401(k) to a SIMPLE 401(k).
  • A “Safe Harbor” 401(k) avoids nondiscrimination (but not top-heavy) rules in exchange for bigger employee contributions. You and your employees can defer up to the regular 401(k) limit. You can either: 1) contribute 3% of covered comp; or 2) match contributions dollar-for-dollar up to 3% of covered comp and fifty-cents-on-the-dollar for contributions between 3% and 5% of covered comp. You can even make extra profit sharing contributions on top of the required contributions.
  • If you operate your business all by yourself, with no employees other than your spouse, you can establish an “individual” 401(k) with less red tape.

Finally, if you want to contribute more than the $53,000 limit for SEPs or 401(k)s, you might consider a defined benefit plan. This is your father’s retirement plan – the traditional “pension plan” that so many employers have stopped offering because they can’t afford it anymore. However, it can still be a great choice for older, highly compensated business owners with few employees.

  • Defined benefit plans let you guarantee up to $210,000 in annual income (2106 limit).
  • 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 (sometimes called a 412(e) plan), which is funded entirely with life insurance or annuities, lets you contribute even more.

The biggest problem with the defined benefit plan is the required annual contributions. If your business doesn’t have the money, you still have to pay. However, you can combine a defined benefit plan with a 401(k) or SEP to give yourself a little more flexibility. Let’s say you could contribute up to $100,000 to a defined benefit plan, but you’re not confident you can commit to that much every year. You might set up a defined benefit plan with a $50,000 contribution, then pair it with 401(k) for another $50,000. If business is poor in a particular year, you can choose to skip the 401(k) that year.

So, now that we’ve covered the menu of traditional employer-sponsored retirement plans, let’s throw another wrench into the mix. Do you even want or need a traditional plan? Or would you be better off with an alternative? Perhaps even giving up the current tax break?

All of the plans we’ve discussed so far assume that you’re better off taking a tax deduction for plan contributions now, as they go in the plan, then letting plan assets accumulate tax-free over time, and then paying tax on withdrawals, at ordinary income rates, when you need them for retirement.

That’s a great strategy if your tax rate is higher now than it will be in retirement. You benefit now by avoiding tax on contributions, which puts more to work for you today. And you benefit later by paying less tax on withdrawals.

But that traditional pattern doesn’t always hold true. Maybe you’re young, just starting your career, and your income is low. Maybe you’re transitioning from one career or business to another, and your income is temporarily low. Maybe you think that tax rates in general will rise. (Today’s top marginal rate may seem high at 39.6%, but that’s actually quite low by historical standards.) Sometimes, contributing to a traditional retirement plan creates a ticking tax time bomb and actually costs you money over the long run.

Here are two alternatives you might consider if standard qualified plans don’t fit the bill:

  • “Roth” accounts take the traditional defer-now, pay-later arrangement and turn it on its head. The basic Roth IRA doesn’t give you any deduction for contributions you make today. But your withdrawals are generally tax-free so long as they’ve “aged” at least five years. Tax-free income sounds great, right? However, contributions are limited to $5,500 per year ($6,500 if you’re 50 or older), and you can’t contribute at all if your income is over $133,000 (single filers) or $196,000 (joint filers). (If your income is above those limits, you can still fund a Roth by contributing the maximum to a nondeductible traditional IRA, then immediately convert it to a Roth.)

If you sponsor a 401(k), you can choose to designate your salary deferrals up to $18,000 as “Roth” deferrals. You won’t get any deduction today, but your withdrawals down the road will be tax-free. (Any employer contributions will continue to be treated as deductible now and taxable later.)

If you have a SEP, you can create a backdoor “Roth SEP” by making a regular deductible SEP contribution, then immediately converting it to a Roth. Roth conversions in general are a subject for another book – I just want you to be aware that the possibility exists.

  • Permanent life insurance policies that include a cash value can offer several significant tax breaks for supplemental retirement savings. There’s no deduction for premiums you pay into the contract. But policy cash values grow tax-deferred. And you can take cash from your policy, tax-free, by withdrawing your original premiums and then borrowing against remaining cash values. You’ll pay (nondeductible) interest on your loan, but earn it back on your cash value. Many insurers offer “wash loan” provisions that let you borrow against your policy with little or no out-of-pocket costs.

These advantages aren’t completely unlimited. If you stuff too much cash into the policy in the first seven years, it’s considered a “modified endowment contract” and all withdrawals are taxed as ordinary income until you exhaust your inside buildup.

Insurers offer three main types of cash-value policies with three different investment profiles to suit different investors. The key is finding a policy that matches your investment temperament:

  • “Whole life” resembles a bank CD in a tax-advantaged wrapper, with required annual premiums and strong guarantees. Remember when we said the defined benefit pension was your father’s pension plan? Well, this is your father’s life insurance.
  • “Universal life” generally resembles a bond fund in a tax-advantaged wrapper, with flexible premiums but less strong guarantees. Some insurers also offer “indexed universal life,” which lets you profit from equity markets but give you a guaranteed return even when those markets are down.
  • “Variable life” lets you invest cash values in a series of “subaccounts” resembling mutual funds in a tax-deferred wrapper. You can choose “variable whole life” with required premiums and stronger guarantees, or “variable universal life” contracts with flexible premiums and less strong guarantees.

Once again, I’m not here to make you an expert in retirement plans or alternatives. My goal is simply to open your eyes to the wide variety of plans and options so that you can evaluate if the plan you have now is really the right plan for you.

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 katie.clawson@providentcpas.com.

Part 3: The 10 Most Expensive Tax Mistakes, Are you Satisfied with the Taxes You Pay?

The next most expensive mistake is choosing the wrong business entity.

Most business owners start as sole proprietors, then, as they grow, establish a limited liability company or corporation to help protect them from business liability. But choosing the right business entity involves all sorts of tax considerations as well. And many business owners are operating with entities that may have been appropriate when they were established – but just don’t work as effectively now.

There are four ways you can organize your business:

  • A proprietorship is a business you operate yourself, in your own name or trade name, with no partners or formal entity. You report income and expenses on your personal return and pay income and self-employment tax on your profits. These are generally best for startups and small businesses with no employees in industries with little legal liability.
  • A partnership is an association of two or more partners. General partners run the business and remain liable for partnership debts. Limited partners invest capital, but don’t actively manage the business and aren’t liable for debts. The partnership files an informational return and passes income and expenses through to partners. General partner distributions are taxed as ordinary income and subject to self-employment tax; limited partnerships distributions are taxed as “passive” income.
  • A C corporation is a separate legal “person” organized under state law. Your liability for business debts is generally limited to your investment in the corporation. The corporation files its own return, pays tax on profits, and chooses whether or not to pay dividends. Your salary is subject to income and employment tax; dividends are taxed at preferential rates. These are generally best for owners who need limited liability and want the broadest range of benefits. However, the administrative costs and complexities are also the highest.
  • An S corporation is a corporation that elects not to pay tax itself. Instead, it files an informational return and passes income and losses through to shareholders according to their ownership. Your salary is subject to income tax and employment tax (Social Security and Medicare); pass-through profits are subject to ordinary income but not employment tax. These are generally best for businesses whose owners are active in the business and don’t need to accumulate capital for day-to-day operations.
  • Finally, a limited liability company (LLC) or limited liability partnership (LLP) is an association of one or more “members” organized under state law. Your liability for business debts is limited to your investment in the company, and LLCs may offer the strongest asset protection of any entity. However, a limited liability company is not a distinct entity for tax purposes. Single-member LLCs are taxed as proprietors, unless you elect to be taxed as a corporation. Multi-member LLCs choose to be taxed as partnerships or corporations. This flexibility makes LLCs the entity of choice for many startup businesses.

I can’t make you an expert in business entities, not in a post like this. But I do want to walk through one popular choice to illustrate how important this question can be.

If you operate your business as a sole proprietorship, or a single-member LLC taxed as a sole proprietorship, you may 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 to reduce that tax.

If you’re taxed 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 $127,200 of “net self-employment income” and 2.9% of anything above that. You’re also subject to a 0.9% Medicare surtax on anything above $200,000 if you’re single, $250,000 if you’re married filing jointly, or $125,000 if you’re married filing separately.

Let’s say your profit at the end of the year is $80,000.

You’ll pay regular tax at your regular rate, whatever that is.

You’ll also pay about $11,000 in self-employment tax.

That self-employment tax replaces the Social Security and Medicare tax that your employer would pay and withhold if you weren’t self-employed. If you’re like most readers, you’re not planning to retire on that Social Security. You’ll be delighted if it’s all still there, but you’re not actually counting on it in any meaningful way.

What if there was a way you could take part of that Social Security contribution and invest it yourself? Do you think you could earn more on your money yourself than you can with the Social Security Administration? Well, there is, and it’s called an S corporation.

An S corporation is a special corporation that’s taxed somewhat like a partnership. The corporation pays you a salary for the work you do. Then, if there’s any profit left over, it passes the profit through to your personal return, and you pay the tax on that income on your own return. So the S corporation splits your 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% employment tax on your wages as you would on your self-employment income. (You’ll also pay the extra 0.9% Medicare tax on self-employment income exceeding $200,000 or $250,000, depending on whether you file alone or jointly.)

BUT – there’s no Social Security or self-employment tax due on the dividend pass-through. And that makes a world of difference.

Let’s say your S corporation earns the same $80,000 as your proprietorship. If you pay yourself $40,000 in wages, you’ll pay about $6,120 in Social Security. 

But you’ll avoid employment tax on the income distribution.

And that saves you $5,184 in employment tax you would have paid without the S-corporation.

The best part here is that you just pay less tax. It’s not like buying equipment at the end of the year to get big depreciation deductions. That may be a great strategy, but it also means spending something on the equipment to get that depreciation. It’s not like contributing money to a retirement plan to get deductions. That may be another great strategy, but it also means you have to take money out of your budget to contribute to the plan.

Now, you still have to pay yourself a “reasonable compensation” for the service you provide as an employee – in other words, the salary you would have to pay to hire an employee to do the work for you. If you pay yourself nothing, or merely a token amount, the IRS can recharacterize up to all of your income as wage and hit you with some very hefty taxes, interest, and penalties. So don’t get greedy! But according to IRS data, the average S corporation pays out about 40% of its income in the form of salary and 60% in the form of distributions. So you can see that there’s at least a possibility for real savings.

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 katie.clawson@providentcpas.com.

Part 2: The 10 Most Expensive Tax Mistakes, Are you Satisfied with the Taxes You Pay?

The second biggest mistake is nearly as important as the first, and that’s fearing, rather than respecting, the IRS.

Many business owners are simply afraid to take deductions they’re entitled to, for fear of raising the proverbial “red flag.”But what does the kind of tax planning we’re talking about really 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 simply aren’t likely to wave “red flags.”

Audit rates peaked in 1972 at one in every 44 returns. But lately they’ve dropped to historic lows. For 2014, the overall audit rate was just one in every 100 returns.

Roughly half of those centered on a single issue, the Earned Income Tax Credit for low-income working families. The rest focused mainly on small businesses, especially sole proprietorships – and industries like pizza parlors and coin-op laundromats, where there are significant opportunities to hide income and skim profits. In fact, the IRS publishes a whole series of audit guides you can download from their web site that tell you exactly what they’re looking for when they audit you!

So, if you do get audited, what then? Well, if you’ve properly documented your legitimate deductions, there’s little to fear. In fact, about 15% of audits actually result in refunds. (Another 20% result in no change either way.)

And if you lose? You’ll get what the IRS calls a “deficiency notice,’ which is simply a bill for more tax. If you still think you’re right, you can appeal it to the IRS. If you don’t like the result you get there, you can appeal to the U.S. Tax Court. There’s even a “small claims” division for disputes under $50,000.

Just how aggressive can you get before risking actual penalties (as opposed to merely paying more tax)? You can avoid accuracy-related penalties if you have a “reasonable” basis for taking a position on your return.  Generally, this means your position has more than one chance in three of being accepted by the IRS. You can file Form 8275 or 8275-R to disclose positions you believe to be contrary to law or regulations. But some advisors recommend not filing them. Why volunteer information that can attract unwanted attention? (Think of this as the tax equivalent of calling in an airstrike on your own position.)

Are you worried about getting in real trouble, as in criminal prosecution? Don’t. Seriously. For fiscal year 2012, the Service initiated just 5,125 criminal investigations (up from 4,720 in 2011). That’s an almost unimaginably tiny fraction of the 240 million returns they collect in a year. Out of those 5,125 investigations, they recommended 3,710 prosecutions (IRS investigators don’t actually prosecute offenders themselves; they turn that job over to the Department of Justice.) There were 3,390 indictments and 2,634 convictions — the Feds don’t take you to court if they’re not already pretty sure they can win. In the end, just 2,466 lucky winners drew all-expense-paid trips to “Club Fed.”

In the end, the average American really has nothing to fear from the IRS Criminal Investigations unit. As far as most of us are concerned, the IRS is just the federal government’s collection agency, nothing scarier. You’ve got to do something really outrageous to draw one of those 5,000 investigations.

Sometimes, just changing how you report an item can dramatically change your odds of getting audited. Take a look at the chart at the beginning of this chapter. You’ll see that for 2014, the IRS audited 2.16% of Schedule C businesses reporting gross income over $100,000. Yet for that same year, they audited under one half of one percent of partnerships and S corporations, regardless of how much they made. That suggests you can cut your odds of being audited by over 86% just by reorganizing your business.

Here’s the bottom line. You should never be afraid to take a legitimate deduction. And if your tax professional does recommend you shy away from taking advantage of a strategy you think you deserve, ask them to explain exactly why they say so. And don’t be satisfied with a vague reply that it will “raise a red flag.” Remember, it’s your money on the table, not theirs.

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 katie.clawson@providentcpas.com.