Tax Insight

I often remember a conversation I had with an acquaintance. He was telling me about the “smart” things he had done to reduce his taxes. His business had been successful that year, so in December he purchased several pieces of equipment that he didn’t really need in order to offset his income. With a mischievous grin, he said, “It’s a deduction, right?”

Now that you are familiar with the tax formula, it is important that you understand how each of the key components works, and how each will affect your tax. This chapter will give you a deeper understanding of the following components:

In 2011 and 2012 there was much discussion in the political arena about the fact that Warren Buffett (one of the wealthiest people in the world) pays taxes at a lower marginal rate than his secretary. “How can a man who is worth billions and earns millions every year have a lower tax rate than his middle-class secretary?” they would say. “What tricks do his accountants and attorneys use to get his taxes so low? What secrets do they know?”

A chess board and a checkers board are identical. Both are made up of 64 tessellated squares that alternate between two colors. You can use the same board for either game. Other than the similarity of the game board, however, the two games are very different. They are governed by different rules that control how the pieces move and where they can go. While the rules of the game are usually unseen during play, their existence is continuously felt and the entire outcome of the game is based on them.

For centuries, economists and social scientists have recognized that people’s actions, no matter how well thought through, have unintended and un-anticipated consequences. At times the unintended consequence is minimal, such as the temperature in a freezer getting temporarily warmer when you place a new item inside of it. At other times the unintended consequence is so significant that instead of bringing a solution to a problem, it actually makes it worse.

Employment income, known as earned income in the tax code, is taxed at a higher overall rate than any other income, except for sources of income that have penalties attached to them. It is unfortunate (though by design) that this is the case, since employment income (salaries, wages, and tips) is by far the most common type of income that exists. Individuals and families struggling to make ends meet and trying to get ahead are the ones hit the hardest by this part of the tax code.

People find numerous ways to pay for their expenses in retirement. Some live off of savings. Some have pensions. Many depend on Social Security, and others work “’till they drop,” so to speak. For most people, the strategy is to use a combination of these.

In addition to employment income and retirement income, there are almost innumerable other sources of “ordinary” income. The purpose of this chapter is to address some of the more common sources of ordinary income that can catch a taxpayer unaware because of the special rules or misperceptions attached to them. The ordinary income sources covered in this chapter are:

There are several sources of income that don’t fit nicely into a particular category, such as employment income, investment income, or business income. These sources don’t really even fit into the “other ordinary income” category, in large part because these sources of income are often tax-free and don’t come as a result of normal income-generating activities. Thus I group all of these sources into one chapter and called them “

un

ordinary” income. Included in this newly named category are:

Very few sources of income are

not

taxed. In fact, I can’t think of one that is

never

taxed. However, some sources of income can be tax-free, as long as you follow all of the rules. Depending on your marginal tax bracket, this tax-free treatment of certain income sources can equate to a significant increase in the true value of that income, in comparison to income from other sources.

There are many ways in which investments are taxed. It is important to understand how a particular investment will be taxed before jumping in because that taxation will have a real effect on the true earnings that you receive. This chapter focuses on the following areas of investment taxation:

As the saying goes, “It takes money to make money.” With investments it is no different. The good news is that there are several opportunities available to reduce your income by deducting your investment expenses, and there are even a couple tax credits available as well. In this chapter I focus on five categories of opportunities for tax deductions and credits that come from investments:

There are a number of tax-benefited ways to fund a college education, each with its own set of rules. In addition, many non-investment tax strategies help with the cost of higher education. These other strategies are discussed in Chapter 20 and Chapter 30. This chapter focuses on the methods for reducing the taxes on investments set aside for education expenses, including the following:

Contributing to a tax-deductible retirement account is a well-known way to reduce taxes. There are a multitude of deductible retirement account types, such as Traditional IRAs and 401(k), 457, and 403(b) accounts. Each of these account types has its own little twists in the rules that govern it, but the basic concepts behind each type of retirement account are the same. Each account type offers a deferral of taxes on any growth and a tax benefit for contributions. The government created these “tax qualified” savings vehicles to encourage people to save for their own retirement by giving them tax incentives for doing so. In this chapter you will learn how each of these retirement accounts works, what thorns you may encounter when using them, and when their use could actually turn to your detriment instead of your gain. You will also learn about how the new health care laws affect your retirement accounts, as well as a little known credit for retirement contributions that can bring amazing benefits to those who qualify for it.

In addition to the traditional tax-sheltered retirement accounts discussed in Chapter 14, there are many alternative options available for individuals to invest for the future in ways that bring tax benefits. Excellent means of doing this are through Roth IRAs, Roth IRA conversions, and Non-Deductible IRAs as discussed in Chapter 10. Another way is through life insurance products, such as annuities and cash-value life insurance policies.

Who says you can’t mix business and pleasure? Owning a business provides one of the greatest opportunities to reduce your taxable income by transforming non-deductible personal expenses into deductible business expenses. There are a multitude of opportunities to do so with personal expenses such as meals, transportation, travel, health care, education, your home, and so on. The key to doing this is in understanding what constitutes a legitimate business expense and the appropriate way of accounting for it.

Wouldn’t it be nice to write off some of your personal expenses, such as utilities, home repairs, or even lawn care? It would be even better if you could write off these expenses against both income

and

self-employment taxes. Under normal circumstances the tax code explicitly categorizes these types of personal expenses as

non-

deductible. However, if you work at home, or even store things at home for your business, you may be able to claim a tax deduction for some of your otherwise “non-deductible” expenses.

Business travel expenses can add up to a significant amount of money. They can prove to be a great deduction when used correctly. In fact, there are even opportunities to deduct a larger amount than you actually spend. These deductions are very popular among businesses, and are often abused. The IRS is aware of this abuse and has put very strict rules and guidelines in place that govern which expenses are deductible, to what extent, and what records need to be kept. They are also very inclined to audit travel expenses that have an appearance of abuse. Even so, certain businesses will gain a lot from understanding how these deductions work and taking advantage of them on their returns.

There are many times when a meal, a gift, or entertainment is a very legitimate business expense—just as legitimate as advertising or other promotional expenses. However, there are also many times in which these “business” expenses are really just an excuse to have some fun and get a write-off in the process. Because it is not easy for the IRS to discern between legitimate expenses in these categories, and those that are not, there are strict rules imposed on the record-keeping requirements for these expenses. There are also significant limitations placed on the dollar value that you can deduct for these expenses. In many cases, 50% of the cost is taken right off the top of what you are allowed to deduct. I suppose this is Congress’s way of dealing with—and limiting—the abuse of this deduction. Even so, there are some great opportunities available to save on your tax bill by properly deducting meals, entertainment, and gift expenses.

Employee benefits are an additional expense that employers incur in order to attract and retain talented employees. Many of these benefits are tax-deductible to the employer, which can help reduce the true out-of-pocket cost to the employer. In some cases an owner is also eligible to take advantage of these “employee” benefits, which results in an even greater benefit to the employer by enabling him or her to transfer personal expenses to the business side of the equation. In this chapter we’ll discuss three types of employee benefits:

One of the greatest tax benefits of owning your own business is finding ways to transform personal, non-deductible expenses into deductible business expenses. A great non-tax benefit of owning your own business is that you are the boss and get to decide how you run that business— including whom you hire as an employee. In this chapter these two benefits meet and combine to form a powerful tax-saving strategy. Hiring family members as legitimate employees of your business can bring significant savings on your tax return. The tax available to you will depend mostly on what member of your family you employ, and as such, the strategies in this chapter are broken up into three main categories:

The rules governing depreciation are very complex, complicated, and convoluted. To give you an idea of how complex they really are, one of the premier guides on depreciation written for tax professionals, the

U.S. Master Depreciation Guide,

by CCH, is more than 1,000 pages long! Because of the vast number of details and nuances regarding depreciation, I am not going to attempt to give you 1,000 pages worth of information summed up into a 10-page chapter. Instead, this chapter will help you understand the general concept of depreciation and then focus on three key things that you will need to understand as you pursue your tax strategy. The subjects covered in this chapter will be:

Real estate has long been the traditional safe haven for taxes. It provides an opportunity for tax-free (deferred) cash flow. It also offers tax-deferred appreciation, or growth in the value of the investment. It even offers the opportunity to sell assets and purchase others without incurring any tax on the realized gains. Combining these tax benefits with the ability to use high amounts of leverage in the purchase of real estate makes for an ideal way to produce tax-favored income for the short- and long-term future. In fact, real estate is the most commonly used investment for those seeking tax incentives. Illustrating the point, after some modifications to the real estate tax laws in 1986, a committee member—Fortney H. (Pete) Stark, (D-CA)—on the House Ways and Means Committee famously stated: “It’d take a genius to invest in real estate and pay taxes.”

In many ways, the taxation of real estate is just like the taxation of any other business. In fact, if you are involved in the real estate business, Chapters 18, 19, 21, and 22 in Part 4 of this book are required reading. The same rules that apply to a business regarding travel expenses, meals, depreciation, and so on apply also to the real estate business.

Chapters 23 and 24 focused on all of the rules related to rental real estate that is solely dedicated to that purpose. In many cases, however, individuals own real estate that they rent during part of the year and use for personal benefit during another part of the year. In these cases there are a few additional rules that come into play that determine the expenses that you are allowed to claim as deductions on your tax return. At times these rules can make a significant difference in the tax you will owe, so it is important to understand how they work. It is possible that something as simple as staying one extra day in your rental in a given year could really cost you a lot of money. The following items will be discussed in this chapter:

I have found that most itemized deductions remain about the same from year to year for most of my clients. Their mortgage interest and property taxes usually don’t fluctuate very much. They donate about the same amount to charities each year. However, one deduction that changes significantly from year to year is medical expenses. Expenses for doctors, dentists, hospitals, health insurance, and other related items can be deducted from your taxable income as an itemized deduction and sometimes can add up to a significant break on your tax bill.

As a general principle, the tax code allows you to take a deduction for expenses that you incur in an effort to create income. The allowance of these deductions encourages people to invest in things that increase their income—increasing taxes as a result. That is why most expenses related to a business are allowed as deductions, when those same items are not deductible when used for personal reasons.

People seem a little shocked when they learn that I have eight children. Sometimes I joke that I have a lot of kids because they are such a great tax write-off. Although there is no truth in the joke in regard to why I have eight children, it is true that kids provide some great tax benefits.

Congress wants to encourage charitable giving because it benefits the country in so many ways. To that end, the tax code allows contributions to qualified charities to be deducted from your tax return as an itemized deduction. In fact, the tax code is so encouraging of charitable giving that it provides a rare “double-dip” opportunity in which you can get two tax reductions for the price of one.

You may ask why the government gives tax deductions and credits for higher-education expenses. One reason may be that a well-educated society is generally more prosperous, competitive, and successful. A more cynical rationalization might be that higher education generally leads to higher income, which leads to higher tax revenue—so the deductions and credits are a down payment on higher tax revenue for that person’s lifetime. Whatever the reason may be, the result is that there are some great tax benefits available for those who pay for higher education.

Every year more people are becoming aware of the existence of the Alternative Minimum Tax (AMT). Some of this awareness is the result of the media’s focus on it. Unfortunately, though, many people become aware of this tax only because it has shown up on their tax return unexpectedly. Every year more middle-income Americans find themselves caught by the AMT, and it is painful when it catches you.

Ignore them long enough and they will go away, right? Not if you’re talking about talking about the IRS or the penalties and interest that they can levy. The longer you ignore them, the worse it gets and the worse they get. I have had several new clients come to me who are at the point of receiving serious threats from the IRS because they have not filed tax returns for a few years. Once we compile all of their missing returns it is often the case that they owe more money from penalties and interest than they owed in taxes!

As you have read through this book, you have followed me into the brambles of your taxberry bush as I’ve held up the branches and showed you some of the available fruit. There are surely more berries available in your unique situation, but you are now, I hope, much more familiar with some of the better clusters and how to pick them without getting caught by the thorns.

Many people are wondering how new taxes created in the Affordable Care Act (a.k.a. ObamaCare) will affect them. In one way or another, this new bill will touch everyone. For some, the impact will be significant. Although some pieces of this chapter are scattered throughout this book in areas that the new law affects (while other parts are found only in this chapter), it is important to put the whole picture together in one chapter because of the broad impact the ACA and its provisions will have on so many people.