Tax Savvy for Small Business
Frederick W. Daily, J.D. and Jeffrey A. Quinn,
November 2013, 17th Edition
The business owner's complete tax strategy guide
Named "Best Tax Book" by Entrepreneur magazin
Getting your tax matters on track will free up your time to do what really counts: run a profitable business. Tax Savvy for Small Business can help you create a business tax strategy that can save you time, energy and money.
It shows you how to:
• deduct operating expenses
• deduct travel, vehicle and entertainment expenses
• take advantage of tax credits
• write off long-term assets
• compare business structures
• keep solid business records
• handle an IRS audit
The completely updated 17th edition of Tax Savvy for Small Business explains the latest tax breaks and IRS rules and forms.
“This plain-English guide will show you how to make the most of your tax deductions.”-BusinessWeek
“This book is one of the best plain-language books on small-business taxes.”-The Washington Post
“Even if you use an accountant, pick up a copy of this book for further understanding and tax management.”-Small Business Opportunities
- IRS Publications List
- Forms Checklist and Due Dates
- Quick and Easy Access to IRS Tax Help and Tax Products (Publication 2053-A)
Frederick W. Daily
Frederick W. Daily spent over 35 years of experience as a tax attorney, helping individuals and small business owners make smart tax decisions and stay out of trouble with the IRS. He has been featured as a tax expert on Good Morning America and NPR, and in publications across the country including Money Magazine, U.S. News & World Report, Newsweek, the New York Times, and the Chicago Tribune. He is the author of Stand Up to the IRS, Tax Savvy for Small Business and Surviving an IRS Tax Audit.
Jeffrey A. QuinnJeffrey Quinn is a Certified Public Accountant in California and Nevada and has a Masters of Science in Taxation from Golden Gate University. He worked at Price Waterhouse & Co. in San Francisco and then relocated to Incline Village, Nevada, where he has practiced ever since. He has authored weekly tax columns in the North Lake Tahoe Bonanza for nearly 35 years.
Your Tax-Saving Companion
1. Tax Basics
- How Tax Law Is Made and Administered: The Short Course
- Where to Find Tax Rules
- Marginal Tax Rate and Tax Brackets
- What Is - And Isn't - Income
- A Word About Tax Shelters
- The Alternative Minimum Tax (AMT)
2. Deductible Business Expenses
- What Is a Deductible Business Expense?
- Is It a Current or Future Year Expense?
- Top Deductions for Businesses
- The General Business Credit
- Vehicle Expenses
- How and Where to Claim Expense Deductions
3. Writing Off Long-Term Business Assets
- Tax Treatment of Business Costs
- Section 179: Expensing Business Assets
- Depreciating Business Assets
- How to Report Depreciation and Section 179 Deductions
- Tax Basis of Business Assets
- Leasing Instead of Buying
- When You Dispose of Business Assets: Depreciation Recapture
- Tax Errors in Depreciation
4. Bookkeeping and Accounting
- Why You Need a Bookkeeping System
- Should You Hire a Bookkeeper?
- Bookkeeping Basics
- What Kinds of Records to Keep
- How Long Records Should Be Kept
- Bookkeeping Methods of Tracking Income and Expenses
- Timing Methods of Accounting: Cash and Accrual
- Accounting Periods: Calendar Year or Fiscal Year
5. Business Losses and Failures
- Unincorporated Business Losses
- Incorporated Business Losses
6. Tax Concerns of Employers
- Employer Identification Numbers
- What Are Payroll Taxes?
- Reporting and Depositing Payroll Taxes
- Classifying Workers: Employee or Independent Contractor?
- Misclassifying Employees as Independent Contractors
- IRS Filing and Payment Requirements for Employers
- Record Keeping for Your Workers
7. Sole Proprietorships—Solos, Freelancers, and Independent Contractors
- What It Means to Be a Solo—From a Tax Perspective
- To Be or Not to Be—A Solo
- Solo Income and Expenses
- Solos’ Tax Forms: Schedule C Is Your Friend
- What If My Solo Biz Loses Money?
- How Solos Are Taxed
- Record Keeping for Solos
- When a Solo Closes Up Shop
- Death of a Solo
- Outgrowing the Solo
8. C Corporations
- Types of Corporations
- How C Corporations Are Taxed
- Tax Benefits of C Corporations
- Incorporating Your Business
- The Importance of Issuing Section 1244 Stock
- Taking Money Out of a C Corporation
- Tax Pitfalls of C Corporations
- Dissolving a C Corporation
9. S Corporations
- An Overview of S Corporations
- Should You Choose S Corporation Status?
- Tax Reporting for S Corporations
- How S Corporation Shareholders Are Taxed
- Social Security and Medicare Taxes
- Electing S Corporation Status
- Revoking S Corporation Status
- Dissolving an S Corporation
- Partnership Tax Status
- Tax Reporting
- Tax Obligations of Partners
- Partnership Losses
- Partnership Contributions
- Getting Money Out of a Partnership
- Partnership Expenses
- Selling or Transferring a Partnership Interest
- Ending a Partnership
11. Limited Liability Companies
- Comparing LLCs With Other Entities
- Operating Your LLC
- Terminating a LLC
12. Qualified Personal Service Corporations
- Qualified Personal Service Corporations
- QPSCs and Taxes
- Fringe Benefits
- Transferring Shares
- Dissolving a QPSC
13. Family Businesses
- The Legal Structure of a Family Business
- Income Splitting Lowers Taxes
- A Spouse in the Business
- Preserving a Family Business After Death
14. Home-Based Businesses
- Business Expenses Incurred at Home
- The Home Office Deduction
- Calculating Your Home Office Deduction
- New Safe Harbor Rule for the Home Office Deduction
- Tax When Selling the Home Office
- A Home Business as a Tax Shelter
15. Fringe Benefits
- How Fringe Benefits Save Taxes
- Retirement Benefits
- Motor Vehicles
- Travel and Lodging
- Clubs and Athletic Facilities
- Health Benefits
- Dependent Care Benefits
- Long-Term Care
- Group Term Life Insurance
- Education Benefits
- Dues and Subscriptions
- Driver and Bodyguard Services
- Moving Expenses
- Retirement Planning Services
- Gifts, Awards, Discounts, and Free Services
- Commuter Transportation and Parking
- Working Condition Fringes
- De Minimis Benefits
- Adoption Assistance
- Job Placement Assistance
- Cafeteria Plans
- Special Benefits for C Corporation Employees Only
16. Retirement Plans
- Advantages of Retirement Plans
- Overview of Retirement Plan Types
- Details About Each Type of Retirement Plan
- Where to Go for a Retirement Plan
- Potential Tax Problems With Retirement Plans
- Withdrawing Money From Retirement Plans
- Closing Your Business or Leaving Your Employer
17. Buying a Business
- Buying the Assets of a Business
- Buying Shares of Stock
- Assigning a Price to Business Assets
- State and Local Transfer Taxes
18. Selling or Closing a Sole Proprietorship
- Reporting the Sale of a Sole Proprietorship
- The Importance of an Arms-Length Deal
- How to Protect Yourself From IRS Challenges
19. When You Can’t Pay Your Taxes
- If You Owe Less Than $50,000
- Getting More Time to Pay
- Paying in Installments
- What to Expect When the IRS Gets Serious
- Dealing With a Monster Tax Bill
- When the IRS Can Take Your Assets
- Who Gets Audited?
- How Long Do You Have to Worry About an Audit?
- How the IRS Audits Small Businesses
- The Auditor’s Powers
- Should You Get Audit Help?
- Preparing for Your Audit
- What to Bring to an Audit
- Don’t Rush a Field Audit
- What Auditors Look for When Examining a Business
- How to Behave at an Audit
- How to Negotiate With an Auditor
- Your Options After Getting an Audit Report
- When Your Audit Is Final
21. Appealing IRS Audits
- IRS Appeals
- Contesting an Audit in Court
22. Penalties and Interest
- Common Reasons for Penalties
- Interest on Tax Bills
- Understanding Penalty and Interest Notices
- How to Get Penalties Reduced or Eliminated
- How to Get Interest Charges Removed
- Designating Payments on Delinquent Tax Bills
23. Help Beyond the Book
- Finding Answers to Tax Questions
- Finding and Using a Tax Pro
24. Answers to Frequently Asked Tax Questions
How Tax Law Is Made and Administered: The Short Course............... 4
Where to Find Tax Rules............................................................................. 5
Marginal Tax Rate and Tax Brackets......................................................... 5
What Is—And Isn’t—Income...................................................................... 7
A Word About Tax Shelters.......................................................................... 9
The Alternative Minimum Tax (AMT)......................................................... 10
Take it from one small business owner to another: Operating a business without tax savvy is like skydiving without a parachute—certain to end in calamity. Many business failures stem from ignoring the record keeping and taxes. Like it or not, the government is always your business partner.
Tax knowledge has powerful money-saving potential. It can give you a fatter bottom line than your competitors who don’t bother to learn. For instance, there are several ways to write off car expenses. The right choice can mean a few thousand more after-tax dollars in your pocket each year.
Four Different Federal Taxes Affect Small Business Owners
Income taxes (owed by everyone who makes a profit)
Self-employment taxes (Social Security and Medicare taxes)
Payroll taxes (if your business has employees)
Excise taxes (owed by only a few small businesses)
Thousands of federal tax laws, regulations, and court decisions deal with these four categories. We will look only at the relatively few rules most likely to affect you.
Small business or independent contractor? Self-employed people often ask whether they are “businesses.” The IRS says “yes.” Whether you run a flower shop or work at home as a website designer, you’re a small business. This includes all kinds of self-employed people, from independent contractors, consultants, and freelancers, to the guy who owns the pizza parlor down the street.
The IRS does not require or issue business licenses. Whether you need any kind of license depends on your state and local authorities. For small business start-up issues, see The Small Business Start-Up Kit, by Peri Pakroo (Nolo).
How Tax Law Is Made and Administered: The Short Course
Think of this section as a high school government lesson, only try to stay awake this time—it could mean money in your pocket.
The federal government. Visualize a three-branched tree. Congress, the legislative branch of the federal government, makes the tax law. The executive branch, which includes the Treasury Department, administers the tax law through the IRS. The judicial branch comprises all the federal courts, which interpret the tax laws and overrule the IRS when it goes beyond the law.
The power to tax incomes was granted by the 16th Amendment to the U.S. Constitution; the first Income Tax Act was passed in 1913. Contrary to what fringe groups and con artists contend, income tax law and the IRS are legal and are not going away.
The code. Tax law begins with the Internal Revenue Code (referred to throughout this book as the tax code or IRC). Congress enacts and revises the tax code. The president signs it (usually), and it becomes law. One major reworking of the IRC was officially called the Tax Reform Act, but was known to tax pros as the Accountants’ and Tax Attorneys’ Relief Act. The tax code is now over 12,000 pages of exceedingly fine print.
The IRS. The Internal Revenue Service (IRS) is a division of the Treasury Department. It is headed up by the commissioner of Internal Revenue, a presidential appointee. The IRS is charged with enforcing the tax code.
The IRS is headquartered in Washington, but it is doubtful you will ever deal directly with anyone there. The real work is done at IRS satellite offices.
The courts. The United States Tax Court interprets the tax laws and decides disputes between the IRS and taxpayers and interprets the tax code. It is pretty easy to go to tax court in most cases, even without an attorney. Tax disputes are also decided in U.S. District Courts and the Federal Court of Claims, but these require payment of the disputed tax first, unlike in the tax court. All decisions in those courts, for or against you, may be reviewed by higher courts, meaning the various U.S. Courts of Appeal and the U.S. Supreme Court. The exception is small case tax court decisions; see Chapter 21 for details.
See, that wasn’t all that bad, was it? Now, venture forth into the rest of the book and may the small business gods be with you.
Tax laws are ever changing. Some changes are made retroactive, others become law on the date they are signed by the president, and some won’t be effective until the next year or further into the future. Also, federal court decisions, which interpret the tax code, are released throughout the year and may change what is written here. Your best strategy is to make sure you have the most current edition of this book and then check Nolo’s website for any updates (see the Introduction to this book for the link). You can also check with your tax adviser to see if anything has changed in your tax world.
Where to Find Tax Rules
How to research tax law questions is covered later in this book. Here’s a brief description of the main sources of federal tax law.
Federal statutes. Congress enacts tax laws, called codes, which make up the Internal Revenue Code. Each tax provision (called a code section) has its own number and title. For example, IRC § 183 refers to tax code Section 183, titled “Activities Not Engaged in for Profit.”
IRS publications. When Congress makes tax laws, it paints with a fairly broad brush. It’s then up to the Treasury Department (the IRS is a part of it) to determine how the tax code is to be applied. The details are filled in by IRS publications, such as Treasury Regulations. These “regs” are numbered in the same order as their related tax code sections, but preceded by the numeral “1.” For example, the regulation explaining IRC § 183 is Reg. 1.183. (Not all IRC sections have corresponding regulations.)
Both the IRC and IRS publications are available at most public libraries, larger bookstores, and, of course, IRS offices. The IRC is online at the IRS website (www.irs.gov) and www.law.cornell.edu (search for U.S. Code, Title 26, Internal Revenue Code). IRS regulations are available on the IRS’s website.
Court cases. When the IRS and taxpayers go to court, a federal judge can reject the IRS interpretation of the tax law. The judges’ published opinions offer guidance on the correct interpretation of the tax code. Look up tax court opinions (from January 1, 1999, to the present) on the tax court’s website at www.ustaxcourt.gov or at a law library, courthouse, or law school.
Marginal Tax Rate and Tax Brackets
In our income tax system, the more money you make, the higher your tax rate. Often referred to as your marginal tax rate, it is the percentage at which the last dollar of income you earn will be taxed. You can find your tax rate in the annual federal income tax bracket tables published each year by the IRS. See www.irs.gov for current rates.
Example: Janice is single, lives in New York, and reports $100,000 in income in 2013. Her marginal tax rate, or tax bracket, is 28% after her personal exemptions and deductions. Janice’s income tax is figured like this: The first $87,850 of income will be taxed in increments at the 10%, 15%, and 25% tax rates, and the remaining $12,150 will be taxed at 28%. Every additional dollar Janice earns will be taxed at 28% until it reaches more than $183,250 in income, at which point her marginal tax rate, or tax bracket, will jump up to 33%, and maybe as high as 39.6%.
If Janice factors in New York state and local income taxes and Social Security and Medicare tax, her true marginal tax rate may exceed 50%. Some types of income are taxed at different, lower rates, called capital gains.
What’s your marginal tax rate? Determine the effect of additional business income or deductions by applying your marginal tax rate. For instance, if your marginal tax rate is 28%, 28¢ of every new dollar you earn goes to Uncle Sam. Conversely, you save 28¢ in federal income taxes on every additional dollar that qualifies as a deductible expense. Knowing your marginal tax rate can tell you how much you will be saving by increasing your tax deductions in any given year.
Don’t Forget About State and Local Taxes
While this book covers federal taxes, you and your business may also be taxed by your state and local agencies. Unfortunately, it can be even more time-consuming to comply with state tax laws than with federal tax laws, especially if your enterprise is a multistate affair.
State tax enforcement agencies are often more frustrating to deal with than the IRS. (For advice on dealing with state tax agencies see Stand Up to the IRS, by Frederick W. Daily (Nolo).) And many states have out-of-state enforcement offices or use private collection agencies to track you down anywhere in the United States. So, just because you live in Maryland, don’t think the tax hawks from California can’t get you.
Here are some state tax issues to watch out for:
Income taxes. Most states (41) have personal income taxes. Florida, Nevada, and Texas are the most notable exceptions.
Sales taxes. Most states have a sales tax on things sold within their borders. But each state has different rules for collection and exemptions.
Use taxes. Most states tax things purchased out of state that were shipped into your state without paying sales tax.
Business transfer taxes. Whenever a business changes hands, your state, county, or city may impose a tax on the buyer, the seller, or both. (See “State and Local Transfer Taxes” in Chapter 17.)
Inventory and other property taxes. Some states and local governments impose annual taxes on personal property used in business, such as vehicles or equipment. And, most counties tax real estate, whether it is used for business or personal purposes.
Internet taxes. There is a federal moratorium on states’ imposing taxes on Internet transactions unless the seller has a physical presence in the state. However, some states impose a “use” tax for out-of- state purchases (see above), and Internet sales are taxed if the goods are delivered within your home state.
Payroll taxes. All states with income taxes have payroll tax, withholding, and collection systems similar to the federal system.
Telecommuter taxes. New York is one of a growing number of states that tax you if you work from home in another state (for instance, Connecticut), if the main business location is in New York.
License fees. There are myriad state and local licenses that businesses must secure. Check with your local government agencies, chamber of commerce, or attorney.
Out-of-state taxes. As an employer, you can be responsible for withholding state income taxes on your out-of-state employees’ income for their home states.
Estate taxes. Most states impose an estate tax on the value of all of your assets, including your business, when the estate is large enough. (See “Preserving a Family Business After Death” in Chapter 13.) This tax is in addition to the federal estate tax discussed later in the book.
State and local agencies. To find your state tax and licensing agencies, go to www.statelocalgov.net or www.taxadmin.org for a listing of all the government agencies in your state, or look them up in your local phone book. Also, most states and many cities and counties have their own websites.
What Is—And Isn’t—Income
“Except as otherwise provided … income means all income from whatever source derived.” That’s how the tax code defines income. (IRC § 61.) Not too helpful, is it? Paraphrased, it means, “You make it, we’ll tax it.” It can’t get much broader than that.
Things That Count as Taxable Income
For the most part, Uncle Sam doesn’t care whether your income is from self-employment, wages, investments, or organized crime. If it’s income, it is taxable.
First, anything of value received by you or your business is income unless it falls within the exclusions created by Congress. Here are some common noncash sources of taxable income.
Barter or trade. Goods and services received in a business deal are income unless they are consigned to you. When you barter (trade your goods or services), the fair market value of the item or service received is income.
Example: Marvin designs a brochure for Beeline Mortgage Brokers, for which he would normally charge $500. In return, Beeline gets Marvin a new home mortgage without charging its customary $500 fee. No money changed hands, but both Marvin and Beeline should report $500 income.
A lot of bartering goes on with small businesses and self-employed people, and the IRS is none the wiser. But getting away with something doesn’t make it legal, does it?
Side jobs. You can have business income even if you aren’t involved in a money-making activity on a regular or full time basis. If you performed a service and got paid for it only once during the year, it’s still income and reportable to the IRS.
Constructive income. Constructive income is a legal doctrine that taxes things that you don’t actually have in your hands, but that you have a right to. Whether you grab it or not, it’s income the moment it’s available.
Example: On December 1, 2013, Raylene gets a $5,000 check from BigCo for her Web design services performed in November. Raylene looks at her books and sees she has already made so much in 2013 that this $5,000 will be taxed at the highest individual tax rate (39.6%). Raylene is planning on taking a lot of time off traveling the following year, and her income will be drastically reduced. She would like to hold off cashing the check until after January 1, 2014 so that she can be taxed at a lower tax rate. Can she do it? No. The $5,000 was constructively received in 2013, and so is income in that year, regardless of when she cashes the check.
Illegal and off-the-books income. The tax law is morally neutral, not distinguishing between the fruits of your labor or ill-gotten gains, so even dirty money is taxable. As the IRS is fond of telling us, the legendary Al Capone wasn’t sent to jail for murder, bootlegging, or racketeering. He went to Alcatraz for not reporting income from all those activities.
Example: Rico is a hit man for the Soprano family. The cash, Cadillac, suits, and Cuban cigars he receives for his “work” are all taxable, and reportable, income.
Also in this category are kickbacks and bribes.
You don’t have to list the source of your illegal income for the IRS—you can claim your constitutional right against self-incrimination. If this sounds like something you might try, see a tax attorney first.
Foreign income. Income you earn from wages or self-employment or any source from anywhere in the world is taxable for American citizens and most residents, with two exceptions noted below.
Example: While traveling in Hong Kong, Juliana, an antique dealer from California, spotted a rare Ming vase. She paid $200 for it and sold it to another dealer in Hong Kong for $4,800. Result: Julia must report $4,600 of taxable income to the IRS. Silver lining: If the primary purpose of the trip was for business transactions like this one, Juliana should be able to deduct at least some of her travel expenses.
Exception One: An American residing out of the United States. for most of the year can exclude $97,600 (2013) from his or her income taxes. To get this foreign tax exclusion, you must file a tax return in the United States every year claiming the exclusion.
Two additional key points:
You must still pay Social Security tax on all your foreign earnings.
You must pay income tax on any investment income you make while living outside the country.
Example: Charlene works as an English teacher in Spain for two years and earns $45,000 per year. She moves to Spain, not returning to her home in Vermont until three years later. Charlene pays Social Security tax but doesn’t owe any income tax in the United States as long as she files a return each year and claims the exclusion. (This doesn’t mean that Charlene doesn’t pay taxes in Spain, though.)
Exception Two: If you pay taxes in another country on income not covered by the $97,600 (2013) exclusion, you may get a tax credit in the United States for the taxes you paid abroad.
Example: Stanley, an independent contractor, goes to Norway for three months to extinguish an oil fire on an offshore rig in the North Sea. He is paid $100,000 for the job with $40,000 withheld and paid to the Norwegian government in income tax. Tax result: The $100,000 is taxable income that must be reported to the IRS, but Stanley gets a tax credit for the $40,000 he paid to Norway. He must file a U.S. tax return to get the credit.
For more information on these two exceptions, see IRS Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad.
Finally, even if you renounce your U.S. citizenship and move abroad, you are still subject to U.S. tax law on income and gains for ten years. So much for offshore tax havens.
Exclusions: Things That Aren’t Income
Some income isn’t taxable because it falls into the “except as otherwise provided” section of the tax law. (IRC § 61.) Here are the main legal exclusions—things that don’t have to be reported to the IRS.
Gifts and inheritances. Income tax never has to be paid by the recipient of gifts or inheritances, no matter how much is received.
Example: Aunt Sophie leaves Ralphie, her favorite nephew, her mansion on Maui, her Kentucky Derby-winning horse, and
$70 million. Tax result: Ralphie owes nothing to the IRS—but Aunt Sophie’s estate most likely paid a hefty estate tax.
Prizes and lottery winnings aren’t considered gifts, and are taxable.
Example: The Publisher’s Clearing House Prize Patrol drops off a $10 million check at Mallory’s business. This windfall is not a gift, since Mallory had to do something for it: fill in the form, place about a hundred different stickers on it, and mail it in. Uncle Sam is due his share of the $10 million.
Fringe benefits. Many fringe benefits provided by businesses to owners and employees are not taxable income, but a few are. (See Chapter 15.) Bonuses, vacation pay, and the like are always taxable.
Return of capital. Getting back what you put into a business doesn’t have any tax consequences.
Example: Elaine decides to move to New Zealand and sells her partnership interest in the Doggy Donut business to Marina for $15,000. She had owned a share of the business for only a few months and had $12,500 invested in it. Tax result: Elaine must report $2,500 of income (the gain on her investment in the partnership) on her tax return.
Loans. If the business has to pay it back, it’s not income.
Example: Roxanne pays $40,000 for the small warehouse building she uses to store and ship costume jewelry. She refinances the building and takes out a mortgage of $30,000. This is a tax-free way for Roxanne to take money out of her business.
Consignments. Goods held by your business that belong to others are neither income nor inventory.
For more details on exclusions from income, see IRS Publication 525, Taxable and Nontaxable Income.
A Word About Tax Shelters
A so-called tax shelter can be a perfectly legal way for a small business owner to reduce his or her income tax bill. One of the more common forms of tax shelters is to own rental property where the cash and noncash tax deductions, interest, depreciation, and insurance exceed the rental income. The owner/taxpayer may be able to use the loss from the rental property to offset income from other sources (such as a small business) on his or her tax return. Any appreciation in the property is not taxable until the property is sold.
2013 Federal Personal Income Tax Brackets*
Income If Single
Income If Married Filing Jointly**
$0 to $8,925
$0 to $17,850
$8,925 to $36,250
$17,850 to $72,500
$36,250 to $87,850
$72,500 to $146,400
$87,850 to $183,250
$146,400 to $223,050
$183,250 to $398,350
$223,050 to $398,350
$398,350 to $400,000
$398,350 to $450,000
$400,000 and up
$450,000 and up
* These dollar amounts are subject to annual IRS adjustments for inflation.
** Tax brackets for heads of households and married people filing separately are somewhat different.
This table does not take into account itemized or standard deductions that all taxpayers get for themselves and their dependents. For 2013, the standard deduction is $6,100 (single) and $12,200 (married filing jointly). The personal exemption is $3,900.
This should not be confused, however, with the type of abusive tax shelters that the IRS is on the watch for. These deals, often marketed by self-styled financial experts or even some big named accounting firms, involve transactions with tax reduction motives but minimal or no economic substance. They usually promise large tax deferrals, deductions, or write-offs beyond your investment cost—the tax equivalent of a free lunch. If you are audited, the IRS will demand that the proposal could stand on its own as a moneymaker, without the tax benefits.
The moral is, don’t buy into a tax savings scheme, whatever it is called, unless it has a reasonably good chance of making a profit—with tax savings as an added bonus. Many of these plans are so complicated that no one wants to admit they don’t understand them. If the promoter harps on the tax savings first, watch out. Don’t plunge in without checking with a trusted tax pro. If you get involved in a scheme that the IRS rules is abusive, you’ve got to give back any tax breaks, and pay penalties, interest, and any legal fees.
The Alternative Minimum Tax (AMT)
As if the tax code isn’t diabolical enough, there is something called the alternative minimum tax (AMT). The AMT is not a business tax but is really a second (alternative) set of tax rates that potentially can affect anyone with income of more than $40,400 (single) or $80,800 (married filing jointly) (2013). The theory of the AMT is that people who take a lot of tax deductions or tax credits should still have to pay a minimum amount of income taxes.
All taxpayers must figure their income tax under both the regular (marginal) tax rates, and the AMT rates—and pay whichever is the greater number. Ouch! Fortunately, all income tax preparation software automatically figures the tax both ways. The AMT is reported on Form 6251, and filed with your individual tax return.
The AMT effectively denies some tax deductions and credits otherwise allowed on a tax return. AMT is figured by adding back to taxpayers’ income many of the exemptions, deductions, and credits that lowered their taxable income in the regular system. The AMT is triggered by such things as:
net operating loss deductions in a business
interest deductions on home equity loans
large itemized deductions for state and local taxes
foreign tax credit
passive income or loss
certain installment sale income
unreimbursed employee expenses
exemptions for dependents
child and education tax credits for Hope scholarships and Lifetime Learning
interest income on certain tax-exempt bonds, and
the exercise of incentive stock options.
The AMT is yet another reason to take every tax break possible and use the help of a tax pro and software programs like TurboTax (Intuit) or Quicken.
Don’t understand tax terms? Check out the glossary at the back of this book for a plain-English explanation of the taxes discussed in this book.
Do You Need a Tax Professional?
This is not a tax preparation manual. Our goal is to explain the rules in plain English so you will know how they apply to your business and how to benefit from the tax laws.
As good as we hope this book is, nothing takes the place of a personal tax adviser, particularly if you’re in business. Everyone’s tax situation is unique, and tax laws change annually. But the more you know, the better you can work with your tax adviser (referred to as a “tax pro” throughout this book), and the less you will have to pay for the service. (See Chapter 23 for tips on finding and using a tax pro.)