Are you satisfied with the amount of taxes you pay? Are you confident that you’re taking advantage of every available tax break? But most of all, is your tax preparer giving you proactive advice to save on your taxes?
The bad news is that you probably do pay too much tax and you’re probably not taking advantage of every tax break. And most preparers do a poor job of actually saving their clients money.
The good news is that you don’t have to feel that way. You just need a better plan. This article reveals some of the biggest tax mistakes that business owners make. Then, it gives brief solutions to actually solve these problems. Please note that this article is designed to be an informational tool only. Before you implement any of these strategies, you should consult a tax professional for more specific guidelines and requirements.
#1: FAILING TO PLAN
The first mistake is the biggest mistake of all. It is failing to plan. It doesn’t matter how good your tax preparer is with your stack of receipts on April 15. If you didn’t know that you could write off your kid’s braces as a business expense, it’s too late to do anything when your taxes are prepared the following year.
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 real estate agent, you have two ways to put more cash in your pocket. Financial offense is increasing your income. Financial defense is reducing your expenses. For most agents, taxes are their biggest expense. So it makes sense to focus your financial defense where you spend the most.
And second, tax coaching guarantees results. You can spend all sorts of time, effort and money promoting your business. But that can’t guarantee results. Or you can set up a medical expense reimbursement plan, deduct your daughter’s braces, and guarantee tax savings.
#2: MISUNDERSTANDING AUDIT ODDS
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 2008 – the overall audit rate was just one in every 99 returns. Roughly half of those audits targeted the Earned Income Tax Credit for low-income working families. The IRS primarily targets small businesses, especially sole proprietorships, and cash industries like pizza parlors and coin-operated laundromats with opportunities to hide income and skim profits.
#3: TOO MUCH SELF-EMPLOYMENT TAX
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 $106,800 of “net self-employment income” and 2.9% of anything above that in 2010.
Let’s say your profit at the end of the year is $60,000. You’ll pay income tax at your regular tax rate, depending on your total taxable income. But you’ll also pay about $9,200 in self-employment tax. This tax replaces the Social Security and Medicare tax that your employer would pay and withhold if you weren’t self-employed.
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 owner’s income into two parts, wages and pass-through distributions.
“S” corporations are so attractive because even though you pay the same 15.3% on your wages as you would on your self-employment income, there is 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 $4,600 in Social Security taxes. But you’ll totally avoid $4,600 in self-employment tax on the $30,000 pass-through distribution.
The “S” corporation takes a little more paperwork to operate than the proprietorship. 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. But the IRS is on the lookout for agents who take all their income as pass-through. The reasonable wage for agents varies, depending on the amount of time spent on real estate activities and your location.
#4: WRONG RETIREMENT PLAN
If you want to save more than the current $5,000 limit (additional $1,000 for taxpayers 50 or older) for IRA’s, you have three main choices: Simplified Employee Pensions (SEPs), SIMPLE IRAs, or 401ks. Generally, if you have a business retirement plan, it must be offered to all your employees and the calculations for contributions must be applied in the same manner as for yourself or any family employees.
The SEP and SIMPLE IRAs are the easiest plans to set up and administer. There’s no annual administration or paperwork required. Contributions are made directly into employee retirement accounts. For SEP plans, self-employed individuals can contribute up to 25% of your “net self-employment income,” to a maximum of $49,000 for 2010. For SIMPLE IRAs, the maximum contribution for 2010 is $11,500 (50 or older can contribute an extra $2,500 catch-up.) SIMPLE IRAs may be best for part-time or sideline businesses earning less than $40,000. You can also hire your spouse and children, and they can make SEP or SIMPLE contributions.
For even larger retirement contributions not limited to 25% of your self-employment income, consider a 401(k) retirement plan. 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. And the 401(k) lets you contribute far more money, far more flexibly, than either the SEP or the SIMPLE. For 2009, you and your employees can “defer” 100% of your income up to $16,500. If you’re 50 or older, you can make an extra $5,500 “catch-up” contribution. You can also 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 $16,500 or $22,000 deferral, for a total maximum contribution of $49,000 per person in 2010. 401(k)’s are generally more difficult to administer. There are anti-discrimination rules to keep you from stuffing your own account while you stiff your employees. Like SEPs and SIMPLE IRAs, you can still 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 401(k)’s, consider a traditional defined benefit pension plan where you can contribute an amount to guarantee up to $195,000 in annual income. Defined benefit plans have required annual contributions. But you can combine a defined benefit plan with a 401(k) or SEP to give yourself a little more flexibility.
#5: 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.
- The IRS has upheld deductions for children as young as 7.
- Their first $5,700 of earned income in 2010 is taxed at zero to the child. That’s because of the standard deduction for a single taxpayer – even if you claim them as your dependent. Their next $8,375 is taxed at just 10%. So, you can shift quite a bit of income downstream.
- You have to pay them a “reasonable” wage for the service they perform. This is what you would 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 daughter helps keep your books, pay her a bit less than a bookkeeping service might charge.
- 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 the account can be a ROTH IRA, Section 529 college savings plan, or custodial account that you control until they turn 21.
- If your business is unincorporated, 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.
#6: MISSING MEDICAL EXPENSES
Surveys used to show that taxes were small business owners’ main concern. But now it is skyrocketing health care costs. If you’re self-employed and pay for your own health insurance, you can deduct is 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.
But there is a way to write off all your medical bills as business expenses. It’s called a Medical Expense Reimbursement Plan (MERP), 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 and don’t qualify. But if you’re married, you can 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 this 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 say that you are a self-employed real estate agent and you’ve hired your husband. The MERP plan lets you reimburse your employee for all medical and dental expenses he incurs for his entire family -including you as his spouse. All of these expenses qualify for reimbursement: major medical insurance, long-term care coverage, Medicare and Medigap insurance, co-payments, deductibles, prescriptions, dental care, eye care, chiropractic care, orthodontists, fertility treatments, special schools for learning-disabled children, vitamins and herbal supplements, medical supplies and even over-the-counter medicines.
You can reimburse your employee or pay health care providers directly. You will need a written plan document and a method to track your expenses. There’s no special reporting required. You’ll save income tax and self-employment tax.
If you have non-family employees, you have to include them too, but you can exclude employees who are: under age 25, work less than 35 hours per week, work less than nine months per year, or have worked for you less than three years. Non-family employees may make it too expensive to reimburse everyone as generously as you would 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.
For example, a married self-employed agent with two children pays 25% in federal income tax and 15.3% in self-employment tax. A traditional insurance plan was replaced with a high-deductible plan – $5,000 for the family which 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 in taxes by switching from his traditional healthcare plan to the Section 105 Medical Expense Reimbursement Plan.
If you can’t use a Medical Expense Reimbursement Plan, 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 $1,200 for singles or $2,400 for employees and an out-of-pocket limit of $5,950 for singles or $11,900 for families in 2010. 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 health savings account. You can contribute 100% of your deductible up to $3,050 for singles or $6,150 for families. You can use it for most kinds of health insurance, including COBRA continuation and long-term care plans. 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 health-care costs.
#7: MISSING A HOME OFFICE
If your home office qualifies as your principal place of business, you can deduct a portion of your rent, mortgage interest, property taxes, insurance, home maintenance and repairs and utilities. You will also depreciate your home’s basis over 39 years as nonresidential property.
To qualify as your principal place of business, you must (1) use it “exclusively” and “regularly” for administrative or management activities, and (2) have no other fixed location where you conduct substantial administrative or management activities of your trade or business. “Regularly” generally means 10-12 hours per week. The space doesn’t have to be an entire room.
Your business use percentage is calculated by either dividing the number of rooms used by the total rooms in the home if they are roughly equal, or by dividing the square feet used by the total square footage in the home. Special rules apply when you sell your sell your home, but the home office deduction is still a very valuable deduction for most agents.
#8: MISSING CAR/TRUCK EXPENSES
If you take the standard mileage deduction for your business, you may be seriously shortchanging yourself. Every year there are various vehicle operating surveys that are published. Costs vary according to how much you drive – but if you’re taking the standard deduction for a car that costs more than 50 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 also can’t switch from actual expenses to the standard deduction if you’ve taken accelerated depreciation on the vehicle.
#9: MISSING MEALS & ENTERTAINMENT
The basic rule is that you can deduct the cost of meals with a bona fide business purpose. This means clients, prospects, referral sources, and business colleagues. And how often do you eat with someone who’s not one of those people? For real estate agents and other professionals that market themselves, this might be “never.” Generally, you can deduct 50% of your meals and entertainment as long as it isn’t “lavish or extraordinary.”
You don’t need receipts for business expenses under $75 (except lodging), but you need to record the following information: (1) How much?, (2) When?, (3) Where?, (4) Business Purpose?, and (5) Business Relationship.
You can also 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.
#10: FAILING TO PLAN
Now that you see how real estate agents like you miss out on any so many tax breaks, you should realize what the biggest mistake of all is – failing to plan. Have you ever heard the saying “if you fail to plan, you plan to fail?” It’s a cliché because it’s true.