If you're in business for yourself, don't sell yourself short. Reap all the tax-saving benefits you deserve with this clear, concise, step-by-step guide that shows you exactly how to take advantage of every tax deduction allowable by law. Inside, you'll find all the facts the IRS doesn't want you to know, and glean all the advice you need to:
* Convert everyday living expenses into business deductions
* Audit-proof your tax return how to keep records that will satisfy the IRS
* Choose the form of entity that's best for you
* Utilize insider's tips on numerous deductions: your home office, business equipment, car, credit card interest, clothing, meals, entertainment, trips and vacations, and medical expenses
* Use hiring techniques that save you money
* Income shifting techniques make your family part of your tax shelter
Plus, you'll get invaluable insights into retirement plans for the self-employed, including IRAs, Keoghs, SEP and 401(k) plans, and much, much more. Packed with informative charts, worksheets, questionnaires, and self-tests, Keep Your Hard-Earned Money provides solid advice you can take to the bank.
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About the Author
Henry Aiy'm Fellman is a lawyer, accountant, and small-business tax expert with more than twenty years of experience helping people lower their taxes. He is a well-known consultant, author, and speaker. His workshop series, Keep What You Earn!™, is available through continuing education facilities throughout the western United States, and via organizations whose members are self-employed.
Read an Excerpt
KEEPING MORE OF YOUR HARD-EARNED MONEY
Do you know your Tax Bracket?
When I ask this question at my Keep What You Earn! workshops, invariably I'm met with many blank stares. Then I explain, "Your tax bracket is the percent of your next dollar of income that will go to the government. In other words, if the profit from your business is $50,000 for the year, how much of the last dollar you earned for the year do you get to keep?" I get responses ranging from "I don't know" to 70%. Whatever the answer, everyone agrees IT'S TOO MUCH! We all want to keep more of our hard-earned money.
* THE #1 TAX SHELTER
Procedures that help us keep more of what we earn are generally called tax shelters. Many people think of tax shelters as a means of reducing taxes. However, if that's all they did my job would be easy. I'd just tell you, "Stop working!" Your taxes would be reduced to zero, but you'd have no money. In addition to reducing your taxes, the other essential characteristic of a tax shelter is that it increases your cash flow or wealth.
Contrary to what many people believe, tax shelters are not just for the rich. In fact, if you're your own boss, you're already set up to benefit from the best tax shelter YOUR BUSINESS.
If you own your own business, you will save thousands of dollars every year by implementing the tax-saving strategies presented throughout this book. You will learn what every business owner should know: how to convert everyday living expenses into business deductions; how to shift income from your tax bracket to your children, parents, or friends in lower tax brackets; the best type of retirement plan; and the form of taxable entity that's best for your business (partnership, sole proprietorship, etc.).
Depending on where you live, there can be as many as five taxes that need to be considered in computing your tax bracket. They are:
* Federal income tax
* State income tax
* Local income tax
* Social Security tax
* Medicare tax
An income tax is a tax that is based on income you received throughout the year. The source of income can be derived from active pursuits, such as compensation received as an employee or profits from your business. It can also be from passive sources, such as investments from which you derive interest, dividends, or profits from their sale.
The federal income tax is a graduated tax that increases incrementally. That is, as your income gets higher, the tax rate increases. However, when you go into a higher tax bracket, you don't pay the higher rate on all your income just on the amount over the lower tax bracket.
For example, if in 1996 you filed as "married filing jointly," and your taxable income was $60,000, your total tax would have been $11,587. This tax is computed as follows: the first $40,100 is taxed at 15%, resulting in a tax of $6,015; and the next $19,900 is taxed at the 28% rate, resulting in a tax of $5,572. Although the composite federal income-tax rate is 19.3% ($11,587 divided by $60,000), the federal income-tax bracket is 28%. That's because 28% of your last dollar earned for the year went to the IRS for the federal income tax. Refer to the tax-rate schedule in Appendix A, which shows the federal tax brackets for each different filing status.
State and local income taxes vary from area to area. Some states, like Washington, Texas, and Florida do not have an income tax. Others have a graduated tax, and some have a flat tax. Only a few local governments, like New York City, have an income tax.
State income taxes are either a graduated incremental tax, such as the federal income tax, or a flat tax. As described above, a graduated incremental income tax imposes different rates of taxation on different levels of income. On the other hand, a flat tax imposes the same rate on all taxable income. If the tax rate is 5%, then every dollar of taxable income you have will be subject to a 5% tax. If your taxable income is $1,000, the tax will be $50. If your taxable income is $1,000,000, the tax will be $50,000.
Social Security and Medicare taxes. Earned income, whether in the form of wages or profits from sole proprietorships or partnerships, is subject to Social Security and Medicare taxes. When applied to wages, these taxes are referred to as FICA (Federal Insurance Contribution Act). When applied to profits from a sole proprietorship or partnership they are called the self-employment tax. The Social Security tax is 12.4% of earned income. However, this tax is limited to the first $65,400 (for 1997) earned during the year. The Medicare tax is 2.9% of earned income; however, there is no upper limit.
For employees, half of the total FICA tax is paid by the employer and half comes out of their paycheck. The self-employment tax is borne totally by the business owners. However, these business owners are entitled to take a deduction that reduces their taxable income to one-half of the self-employment tax liability. After taking into account the tax savings produced by this deduction, the effective self-employment tax is approximately 13% of the first $65,400 (for 1997) of earned income, and 2.5 percent of each dollar of profit in excess of $65,400.
* CALCULATING YOUR TAX BRACKET
Special thanks to Uncle Sammy and Aunt Iris for allowing me to use their real-life situation to illustrate the strategies presented throughout this book.
Here's how Uncle Sammy calculated his tax bracket. Uncle Sammy and Aunt Iris live in Boulder, Colorado. Their sole income is derived from Uncle Sammy's tax-preparation business. They file a joint tax return with taxable income of $60,000. By looking at the Tax Rate Schedule in Appendix A, Sammy determined that his federal income tax rate is 28%. Colorado has a 5% flat tax, and there are no local taxes in Boulder. Adding his income-tax rates with the self-employment tax of 13%, Sammy determines his tax bracket to be 46%. What's your tax bracket? (To find out the tax rates in your state or locale, contact your state's Department of Revenue or a local professional tax preparer.)
* CONVERTING EVERYDAY LIVING EXPENSES INTO BUSINESS DEDUCTIONS
When you buy something, when does it cost less than what you pay? (This is not a Zen koan.)
The primary reason owning your own business is a great way to shelter your income from taxes is that you're able to convert everyday living expenses into business deductions. The resulting saving in taxes is like receiving a discount or rebate on everything you buy. This tax savings, discount, or rebate depending how you look at it is calculated by multiplying your tax bracket by the purchase price. For example, let's say your tax bracket is 46%. If you purchase $100 of computer supplies to be used for non-business purposes, you pay $100 and it costs you $100. However, if the supplies were for your business, then although you paid $100, your actual cost is only $54.
Your goal is to convert as many of your everyday living expenses into business deductions as possible. And as you'll learn in Part Four, when you own your own business, just about everything you do, everywhere you go, and everyone you meet is related to your business. And all expenses related to those activities are deductible.
Before Uncle Sammy went into business for himself, he worked for Blockhead Tax Services. His gross annual wages were $60,000. Aunt Iris, having her hands full taking care of the children and the household, did not have any earned income. Of Uncle Sammy's $60,000 of wages, $13,605 went to taxes (see chart below for breakdown of how much money went to each tax). An additional $48,000 was used to pay for the family's costs of living for the year, such as house-related expenses, food, clothing, medical care, dental care, telephone bills, and entertainment. After paying for these taxes and expenses, Sammy was in the red by $1,605 by year's end.
In order to help make ends meet, Uncle Sammy considered quitting his job and starting a tax-preparation business operating out of his home. He figured his business would bring in as much money ($60,000) as he was earning as an employee. That is, gross revenues of $70,000, minus $10,000 in additional expenses incurred for the business. He also calculated that his family's cost of living, $48,000, would remain the same. However, the difference between working as an employee and being in business for himself is that by being self-employed, Sammy is able to write off half of his $48,000 living expenses as a business deduction. From the chart below, you can see why he decided to go into business for himself. On top of gaining more freedom and control over his life, reducing the time wasted commuting to and from work, and having more time with his loved ones, he has an extra $5,204 for his family by the end of the year.
* INCOME-SHIFTING TECHNIQUES
Another great way to reduce your tax bite is by employing the income-shifting techniques discussed in Part Five. With these techniques, you will be able to shift income that would be taxed at your higher tax bracket to someone else who's in a lower tax bracket and so will pay less of it in taxes. Most typically that someone else is your child, though it could be a parent, friend, or other relative.
Here's how it works: Uncle Sammy paid his son Fred $4,000 for office work during 1996. These wages are a business deduction for Sammy, reducing his business' profit by $4,000. Since Sammy's tax bracket is 46%, he received a tax savings of $1,840 ($4,000 x 46%). On the other hand, the $4,000 is income to Fred. However, as you will learn in Part Five, since Fred is under 18 years old, working for one of his parents, and his income is not greater than $4,000, his salary will not be subject to any tax at all! That means their family ends up with an extra $1,840.
Hiring others is just one of the ways to shift income so it's taxed at a lower rate. In Part Five other techniques such as gift/leaseback, sale/leaseback, and gifting stock are also presented.
* OTHER TAX-SAVING TECHNIQUES
Converting everyday living expenses and income shifting are the two devices that make owning your own business the great tax shelter it is. However, there are also other ways self-employed business owners can use the tax law to reduce their taxes. Parts Six and Seven explore what to consider in choosing a retirement plan and form of entity.
* REDUCE INCOME TAXES WITH A SIDELINE BUSINESS
Many people are not in the position to quit their job and go into business for themselves. You don't need to. You can still reap the tax-savings benefits afforded self-employed business owners even if your business is part-time or just a sideline. In fact, why not turn something you enjoy, like a hobby, into a business?
Let's say Uncle Sammy decided to continue working for Blockhead and, in addition, started a small tax-preparation business on the side to earn extra money. The chart below reflects the effect that each of four different situations has on Uncle Sammy's cash flow for the year. Notice that in all four situations, Uncle Sammy's wages and the FICA taxes withheld from his Blockhead wages remain the same: $60,000 and $4,590, respectively. Also, in all four situations the total living expenses remain the same, $48,000. However, once Sammy begins his business, he's able to convert $14,000 of the everyday living expenses into business deductions.
Situation #1 reflects the situation Sammy's in if he stays in his job without doing anything else. He's in the red $1,605!
In Situation #2, Sammy doesn't generate any extra income from the business itself. The business takes in $10,000 but incurs additional expenses of $10,000. However, by being in business, he is able to convert $14,000 of otherwise non-deductible everyday living expenses into business deductions. This produces a tax savings of $3,193.
Situation #3 shows the business able to generate gross revenues of $15,000, offset by additional expenses of $12,000, thus increasing Sammy's cash flow by $3,000. However, after taking into account the tax savings resulting from converting the everyday living expenses into business deductions, Sammy comes out $5,593 better than he would have, had his sole source of income been Blockhead.
In Situation #4, Sammy's sideline business does really well. Before taking into account the expenses converted from non-deductible to deductible, he realizes a gain of $15,000 from the business alone. Now, Sammy and his family are $12,952 in the black. Compare Situation #1 with Situation #4. The total taxes related to income in Situation #1 are $13,605, compared with Situation #4's of $14,048. That means the extra $15,000 generated by the business is, instead of being taxed at 46%, being taxed at only 3%.
I've heard many people in need of extra money complain that it doesn't pay for them to get a second job or for their unemployed spouse to even bother looking for a job. "What's the point?" they lament, "Most of it will go to the government anyhow." That's true, if you work for someone else. Had Sammy taken a second job instead of starting his own business, their partner, the government, would get 40.65% of every extra dollar earned. However, when he works for himself, the government's take is reduced to 3%.
Turn Your Hobby into a Business
Look what happens if Uncle Sammy, instead of starting a tax-preparation business, turned his expensive hobby, photography, into a business. It seems every year Sammy's buying some kind of new equipment and he's taking more and more film, which needs to be processed. All this adds up. In fact, of the $48,000 living expenses, $5,000 is spent on his photography hobby. Normally this would not be a deductible expense. However, if he turns this hobby into a business, he'll be able to convert those expenses into business deductions. In Sammy's case, since his tax bracket is 46%, the resulting tax savings, discount, or rebate (depending on how you look at it) will be as much as $2,300 of the $5,000.
As you can see, there are great benefits to being your own boss. But you must be careful. To take advantage of the benefits afforded the self-employed you have to make sure your business is really a business in the eyes of the IRS.
Copyright © 1996 by Henry Aiy'm Fellman
Table of Contents
I KEEPING MORE OF YOUR HARD-EARNED MONEY
The #1 Tax Shelter
Calculating Your Tax Bracket
Converting Everyday Living Expenses into Business Deductions
Other Tax-Saving Techniques
Reduce Income Taxes with a Sideline Business
II MAKING SURE YOUR BUSINESS IS A BUSINESS
Convert Your Hobby Expenses into a Business Deduction
Making Sure You're a Business Owner and Not an Employee
III TAKE EVERY DEDUCTION YOU'RE ENTITLED TO
Audit Myths and Other Tales of Horror
Choosing the Right Tax Professional to Get the Most Out of This Book
Guilty Until Proven Innocent
Audit-Proofing Your Tax Return
IV CONVERTING EVERYDAY LIVING EXPENSES INTO BUSINESS DEDUCTIONS
Tax Savings from Deductions
Section A: If You're Entitled to the Home-Office Deduction, Take It!
Section B: Deduct ALL Equipment Used in Your Business
Section C: Getting the Most "TSPM" Out of Your Car
Section D: Meals, Entertainment, and Gifts
Section E: Deducting Business Trips and Vacations
Section F: Converting Medical and Dental Expenses into Business Deductions
Section G: Clothing, Interest, Credit Cards, Raising Children, and Everything Else
V INCOME-SHIFTING TECHNIQUES
Income-Shifting Technique #1: Hiring
Income-Shifting Technique #2: Gift Ownership
Income-Shifting Technique #3: Lease Property from Family or Friends
Income-Shifting Technique #4: Gift Property Instead of Selling
VI RETIREMENT PLANS FOR THE SELF-EMPLOYED
Individual Retirement Accounts (IRAs)
Simplified Employee Pension (SEP) Plans
The SIMPLE Plan
Medical Savings Account (MSA)
Keogh and Company Qualified Plans
401(k) Plans Deferred Compensation Plans
VII CHOOSING THE FORM OF ENTITY THAT'S BEST FOR YOU
The Different Entities
Choose Your Goal, Choose Your Form
The Choosing Process
A. Tax Rate Schedule for 1997
B. Sample Independent Contractor Agreement
C. 1997 Per Diem Rates (by State)
D. Sample Employment Contract
E. Resource Guide
ABOUT THE AUTHOR