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The following is reprinted from a report I’ve written called “The 9 Biggest Tax Mistakes Business Owners Make & How to Correct Them.” While it was primarily written for business owners, there is much to be gained here for any taxpayer, and I encourage you to have a peek.
“The collection of taxes which are not absolutely required, which do not beyond reasonable doubt contribute to the public welfare, is only a species of legalized larceny.”
“Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes. Over and over again the Courts have said that there is nothing sinister in so arranging affairs as to keep taxes as low as possible. Everyone does it, rich and poor alike and all do right, for nobody owes any public duty to pay more than the law demands.”
Judge Learned Hand
Having the Wrong Buy/Sell Plan
In some cases, “stock redemption” style buy/sell plans (as opposed to “cross purchase” types) can result in needless taxation when one partner dies and the survivor(s) buy them out. Here’s why: with a cross purchase, the tax-free life insurance proceeds are paid to a partner, who then takes them and buys the dead partner’s stock; this purchase increases the surviving partner’s tax basis, so when eventually sells his share, capital gains are smaller and more of the sale proceeds are a tax-free return of basis. With the stock redemption style, the insurance money goes directly to the company, wasting the tax-free benefit of the insurance and keeping the survivor’s tax basis the same. If you have a buy/sell, getting a second opinion and update review could save you a bundle. This would also be a good time for a cost/benefit analysis on the life insurance, to see if you could get more benefit for less money.
Letting the Buyer Set the Terms When You Sell a Business
When you negotiate to sell a business, you and the buyer are at cross-purposes when it comes to tax treatment. You want as much value allocated to goodwill, personal goodwill, and going concern value since this shifts more taxable value to lower-rate capital gains treatment, and less to highest rate ordinary income/earned income treatment. This is especially important to avoid since the business sale itself will probably push you into the highest bracket, if you are not already there. Under current law, this is something like 40-46%, and very likely going up, vs. 20% for capital gains (also probably going up). That’s a difference of 400 grand on a $2M sale, not exactly chicken feed no matter who you are. The buyer is going to want to shunt value to “earn-out” things like a personal consulting contract for you, fast depreciation period assets, and so on, to accelerate write-offs and manage their own tax position.
The important thing to remember is that you need good tax counsel as part of the negotiation process, since, like the buyer, you want to protect your own tax position; once a deal is cut it is much harder to finesse the tax angles. The less tax they pay, the less you actually receive. Higher taxes mean a much lower net on the business sale, and you want to pay your cards from an after-tax in-your-pocket perspective, instead of getting infatuated with deal heat, only to lament at leisure later.
Did I mention we do buy/sell transaction structure and business brokerage consulting?
Not Using a Medical Reimbursement Plan If You Can
Medical reimbursement plans are really one of the great unsung heroes of the tax control saga. As most of us painfully remember, medical expenses are barely deductible, and ONLY IF we itemize instead of taking the standard deduction, and ONLY IF such personal deductions are not phased out because of our income or chiseled down by the AMT rules, and ONLY IF they survive all that and still amount to more than 7.5% of our adjusted gross (not bottom-line taxable) income. This smoke-and-mirrors calculation really epitomizes the fetid feint-and-bloat of the early 21st century U.S. tax system, but I wax political, and don’t want to be misconstrued, especially since I reverently believe in Health Care, especially my own. For a family with $200K in AGI, this means the 1st fifteen grand of medical expenses will never be deductible, even if one manages to leap through the previous hoops. And fifteen grand is a pretty high bar, so unless someone’s really sick, it does not even pay to add up the receipts, which is probably why you stopped doing this long ago, if you ever did.
Still, if you are like most of us, you spend substantial sums on this industry, between insurance premiums, deductibles, vitamins and Band-Aids, and other health-maintenance items, which one could argue even include gym dues, crystal-gazing, massage, and aroma therapy. (Hair and nail care might prove a tad aggressive.)
Medical Reimbursement Plans (or MRPs, authorized under section 105 of the Internal Revenue Code, a colossus pushing 10,000 sections, and growing) give us the opportunity, in the right setting, to run all this stuff on a fully-tax-deductible basis (meaning a $1.00 Band-Aid only costs $0.60 after taxes and $18,000 in insurance premiums “only” $10.800
In the worst cases, these savings can be worthwhile, and in the best, they are phenomenal. If you have one, make sure it’s tuned up; if you don’t, better check on your options before losing another hand to Uncle Sam. (Yes, you can call us, we know all about them.)
Not Income Splitting with Your Kids
This is a great boon to families, a way to give meaningful “gifts” to your kids on a tax deductible basis. Find a way to employ your children (they really need to do something you can document, but rocket science is not required, making copies and carrying out the [business] trash will suffice). The benefits? You get to shunt your high-bracket income to your kids’ low/no bracket rates, which can save the family thousands or tens of thousands given the current “progressive” tax structure which makes tax-free lower levels of income and even subsidizes it with de facto-welfare tax “refunds,” even when no tax has been paid. Your kids have the right to file their own returns, and their earned income (as opposed to the radioactive “Kiddie Tax” investment income) is taxed at very low rates and can generate valuable deductions as well. This is tax planning 101, and if you have not been encouraged to do it by your tax advisor, you might want to consider why. If you need help, we can give you some very good ideas on this, as you probably surmised.
Missing Real Estate Write-Offs
Super-Accelerated Depreciation—Old Section 179
We shouldn’t have to mention this, but we see this slam-dunk missed often enough in our tax practice that we feel duty bound to remind you of it. Instead of having to stretch the write off of asset purchases over several to many years, which, essentially, is what depreciation does, most businesses can now write off up to $250K per year of qualifying purchases and save the tax now. In a 40% bracket, that’s a cool $100K of tax savings in your pocket. Again, this is such a basic technique that I am almost ashamed bringing it up, but the oversight pops up often enough that you should be sure you are taking advantage of it. (We can tell by taking a quick look at your return.)
Missing Deductions for Legitimate Business Expenses
This is really one of my pet peeves. Far too many business people (largely on the advice of their too-conservative, too-uninformed, or too-work-adverse tax advisors) simply do not write off perfectly legitimate expenses and wind up essentially doubling their costs for these overlooked business items. I am firmly convinced that many tax preparers would rather see clients pay excess tax than face the bother of possibly having to explain their methodology (or lack thereof) of tax accounting! Commonly missed areas are business use of personal autos, travel and entertainment where at least some business/work is conducted, fuel, business items purchased on personal checks or credit cards (set up dedicated business account and cards and use them religiously!), and so on. An important point is that it be arguably deductible because of reasonable business purpose. Don’t be afraid (or let your tax adviser convince you to be afraid) to take legitimate deductions. You would be amazed at some of the extremely aggressive positions that I have seen pass muster on audit. A good way to start this is to go through your personal check registers and credit card statements (all of them) and categorize expenses that reasonably should be including on the business books. (Guess who can help!)
Here’s a bonus “mistake,” but really too important not to include now that I have nearly finished this report. If you keep sloppy books (or don’t keep books at all), invariably errors will creep in, expenses will be missed, and needless tax will wallop you. We have seen instances where non-taxable loan proceeds (a couple hundred grand in one case) were carelessly added to the income statement instead of the balance sheet, overstating taxable profit by a huge amount. If we had not been called in to clean up the books and tax position on this case—because the owner got finally fed up at the poor service he suspected he was receiving—he would have paid something like $100K in extra tax, and no one (neither he or his previous high-dollar advisor) might ever have known. It does not matter who does the books, you, your staff, or a paid outside accountant; unless they really know what they are doing, you can be really getting soaked even if your frustration never rises to the “fed up” level. What really matters is you are sure you have someone that really knows the craft and truly cares about getting you an accurate and tax-controlled result. Also, remember that tax accounting and “regular” financial accounting can have very different rules, and it can be better to run a set of tax books along with the regular books you use to steer the business the whole year rather than trying to “pull them together” months after the fact, when your tax preparer is swamped and can’t give it the time it needs, even if he wanted to. Doing it right the first time usually costs less time, money, and tax than letting things pile up to the fermentation point. Did I mention we do books?
Wrapping It All up into Tax Savings
Congratulations on actually finishing this pretty dry material (my wife feels, and I agree, that the only thing exciting about tax savings is spending them!). The best way to apply this information is to review your situation, point by point, against the concepts applied here. You can do this yourself, but you probably won’t like it, or do a very good job unless your business is already taxes and financial planning. You can ask your existing advisor to do it, but they will probably charge you, and you have to wonder that if they did not bring this stuff up to you already, how good a job will they do going forward? Or, you can take advantage of the remarkable offer I am about to make you.
I call it our “total business review,” an extremely valuable service that we offer on a completely FREE basis. Before I get into all the details of what you’ll get from this service, I need to tell you why we offer it without charge so you take the offer seriously.
The simple reason is that it represents extremely effective marketing for us. While of course not everyone hires us, enough folks are impressed with the skill and diligence we demonstrate when we meet that we get enough new business out of it that we can afford to give away the service to all who call and still make money. Even if you don’t choose to become a client, you might refer us to someone that can use us or remember us down the road when things change. However things break, we know this will be a win-win (we get more business, and you will get a first class analysis to use in any way you see fit) with us, by yourself, or with your existing advisor (perish the thought!). This I can pretty well guarantee.