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Sandifer Tax Services Inc.
It's your money! Don't give it away if you have the right to keep it.
The only legal way to reduce your taxes is to reduce your taxable income. Most Americans believe that the way to reduce taxable income safely is to exaggerate deductions. This is wrong! Increased deductions can act as triggers that increase a taxpayer's risk of audit.
"..There is nothing sinister in so arranging one's affairs as to keep taxes as low as possible. Everybody does so, rich or poor, and all do right. Nobody owes any public duty to pay more than the law demands." Judge Learned Hand
“Every taxpayer has a right to adjust his affairs so that he minimizes his tax liability. We recognize such steps as perfectly legitimate…" Russell Harrington, former Commissioner of the IRS.
Every person working in the United States today usually receives a report of his, or her, income for the past year. This report comes in the form of a W-2 (withholding statement), 1099 (non-employee income statement), 1099MISC (interest payment statement), etc. The Internal Revenue Service also receives a copy of these statements and uses them to match income reported on the individual's 1040 tax return. This explains why months after filing an income tax return, the taxpayer might receive a letter from the IRS informing him that his return has been adjusted and that he owes money.
One of the most often asked questions for a tax professional is "how can I audit proof my return"? It is important to understand the primary methods used by the IRS to select returns for audit. The Internal Revenue Manual states that returns are selected which will yield "the highest possible revenue..from the examination hours expended". In other words, if your return is selected for audit the IRS expects you to bring your checkbook with you.
The oldest method of selection for audit is called the "Discriminant Function System". When your return is first processed the system assigns a value to every item on your return. If the total of all those values equals or exceeds a minimum set by the IRS, the computer singles out your return for a possible audit. The computer doesn't say what items should be audited. Therefore, Revenue Agents review the flagged returns.
Another way a return can be selected for audit is the Document-Matching Program. The IRS generally matches over 95% of all W-2's, 1099's, and 1098's it receives. Every year the IRS sends out over 10 million correction notices. However, according to the General Accounting Office, about half of those notices (5 million!) are "incorrect, unresponsive, unclear or incomplete".
The Market Segment Specialization Program trains its agents to specialize in a particular field and then go out and audit as many businesses in that filed as possible. Some of those fields are attorneys, grocery stores, restaurants and bars. Notice, these deal heavily in cash.
There are several steps you can take to minimize the chance of an audit: 1. Make sure your return is neat and mathematically correct. 2. Report all income from W-2's and 1099's. 3. Do not round up numbers. 4. Avoid filing Schedule C, Income from self-employment, if possible. Audit rates for Schedule C's are about five to ten times higher than similar businesses reporting differently. 5. Keep adequate records for the appropriate period of time. Questions usually arise, not to prove if something can be done, but, rather, whether you can document what you did. 6. Avoid these areas if possible:
The most important two steps a person can take in making himself virtually audit-proof, and legally increasing his, or her deductions, is to convert personal expenses to business expenses and legally remove as much information as possible from his 1040 to another place where the chances of audit are greatly reduced.
First, let's look at the advantage of converting non-deductible personal expenses into legitimate, deductible business expenses. We do not advocate the use of the term loophole because it conveys the feeling that what we are discussing is somehow devious or illegal. We do advocate arranging the affairs of our clients in such a way as to greatly reduce their legal tax liabilities. However, simply stating that a person is "in business" does not make it so. A true business purpose must exist, not simply an arrangement for tax purposes.
As most people know, individuals are entitled to standard deductions for such things as mortgage interest, their children, contributions to charity, IRS's, etc. The problem is that the larger expenses that people incur during the year (rent, mortgage, utilities, travel, meals, medical benefits, insurance, gasoline, supplies) are not deductible at all. You spend more of your income to live but are unable to benefit from any tax deduction in doing so.
Therefore, the first step in legally increasing your allowable deductions for existing is to set yourself up in business. This is as simple as declaring that you are in business. However, you must understand, to qualify as a legitimate business, you must have the intention of making a profit (more money never hurts) and you need to conduct yourself in a business-like manner.
An example of how "being in business" can reduce your taxes can be shown below:
Middle Income and Married with 2 Children
With No Business With a Home Business Wages $60,000 $60,000 Home business Income 1,000 Taxable Income $60,000 $61,000 Standard Deductions 6,900 6,900 Exemptions (last year's figures) 10,600 10,600 Home Business Deductions 33,560
Taxable Income $42,500 $8,940 Federal Tax 6,550 1,339 State Tax (where applicable) 2,300 675
Total Tax Paid $8,850 $2,014
The difference kept for this married couple is over $6,000.00 or, a monthly savings of $500.00
It is evident that, with proper planning, the average wage earner, and his or her family, can benefit immensely when non-deductible expenses are converted to deductible, business expenses. Such expenses include, but are not limited to: Mileage deducted at $0.31 per mile Business use percentage of your home ( mortgage or rent) Business use percentage of utilities, telephone, insurance, meals Travel, entertainment In fact, over 400 deductions are available to businesses in the United States today.
The most common form of business today is the sole proprietorship. You are the business and you report your business income and expenses on Schedule C of your 1040 tax return. The problem is that people who are self-employed are generally open to greater audit risk simply because of the manner in which they are required to report that business income and those expenses.
A Schedule C requires you to define the type of business you are in and allows for the deduction of expenses necessary in the production of income. As a filer of a Schedule C you have the opportunity to underreport your income or attempt to convert personal expenses to business expenses. For these reasons the IRS takes a very hard look at Schedule C filers. In particular, the IRS looks at the type of business you are reporting to see if it falls into one of the IRS target areas: service providers, professionals, or cash-heavy businesses.
If you work out of an office in your home, you must additionally file a form with your Schedule C to list the expenses you are claiming for that home office. Form 8829 is required by sole proprietors and, although the IRS denies it, this form can single out your tax return for deeper scrutiny.
We mentioned earlier that two steps were required to make yourself more audit-proof and legally convert many personal expenses to business expenses. How, then, do we get around the fact that by April15th each year you are required to file a 1040 with an attached Schedule C for self-employment (along with that 8829 for home office deduction)? And, don't forget, income from self-employment is subject to self-employment tax, in addition to the regular tax on that income. Does this mean that there is no legal way to convert those expenses that won't come back as even more involved taxes?
The answer is simple. The taxpayer must choose a business entity that would allow different reporting requirements than the Schedule C. Today, the S corporation offers the advantage of converting those non-deductible expenses to legitimate, deductible expenses. In addition, you are a great candidate to be an S corporation if you do not need to put huge sums of money into a business, are a service business, expect to incur losses in the first year or so of business, or invest in real estate or other rapidly appreciating assets.
What can you gain by incorporation?
An S corporation's net income or loss passes through to each shareholder's 1040 on one line. Therefore, no income or expense detail shows up on the 1040. You avoid the triggers and targets that the IRS has in place for taxpayers who file a Schedule C.
There is no separate disclosure of home-office expenses. S corporations are subject to the same rules for home office expenses. However, there is no special IRS form for an S corporation to list home-office deductions.
As mentioned earlier, the IRS matches income reported on W-2's and 1099's each year and does a good job of it. However, if a payment is made for goods purchased or services performed by a corporation, the person or entity making the payment is not required to file a 1099-MISC form reporting that payment. The major exception to this is for legal services. Therefore, when the IRS uses 1099's in an audit of independent contractors, you can avoid all of this as an S corporation.
Expenses that might trigger an audit receive less attention with an S corporation. (travel, entertainment, and automobile expenses, to name a few)
RED FLAGS NO FLAGS Sole Proprietorship "S" Corporation 1099's No 1099's (except legal cos.) Schedule C Income passes through on 1 line of the 1040 Form 8829 (business use of home) No form for business use of home.
To repeat: You are a prime candidate for "S" corporation status if: 1. You do not have to put large sums of capital into your business. 2. A service business with modest requirements for investments in equipment. 3. Invest in real estate or other rapidly appreciating assets. 4. Expect to incur losses in the first year or two of business.
Requirements for an "S" corporation:
1. To have no more than 75 shareholders. 2. To have one class of stock. 3. To be a domestic corporation created and organized pursuant to federal and state laws. 4. Shareholders must be qualified individuals, estates, trusts, qualified pension and profit-sharing plans, resident aliens, or another "S" corporation. (No partnerships, corporations or non-resident aliens.
An "S" corporation may own 80 percent or more of a C corporation as well as become an owner of other kinds of business entities, including wholly owned S corporation subsidiaries.
Strategies in the early stages of an S corporation
1. Depreciation of assets is allowed even if the corporation is only a few weeks in the current year. 2. Shifting losses- your basis in the S corporation can be adjusted up or down. If you need losses in a certain year, lend the corporation sufficient money to cover your share of the losses. 3. Income from an S corporation is not subject to self-employment taxes.
There is no reason you cannot take advantage of these strategies: 1. Develop a source of income, possibly something you have always wanted to do. Or, organize your self-employment (such as an independent contractor) into a personal business. 2. Set up the business so you can work when you want to and all payments are made to the business. 3. As the business grows, incorporate (preferably as an S corporation). 4. Make your home your full time place of business, following the rules, which allow you to convert non-deductible expenses into legally deductible business expenses. 5. Make out-of-pocket expenses, previously considered personal items, as fully deductible against your business income. 6. When traveling to your customers, take business deductions for the use of your automobile. 7. Invest in a retirement plan (many allow contributions of up to $30,000.00 or 25% of your income, whichever is less. 8. Keep receipts for everything. (Note the people involved, business reason for the expense, place, time, amount, and date)
Many taxpayers are fooled by schemes that purport to take advantage of "loopholes" in the law. These same taxpayers are not aware that the Internal Revenue Service has the right to declare these actions "shams" if the IRS believes that the taxpayer's actions were not legitimately motivated. If the IRS determines the sole reason for the action is tax avoidance, the transaction could be set aside by the IRS.
There is a fine line between tax avoidance and tax evasion. The main difference is defined in the motives and knowledge of the taxpayers. We are committed to helping you achieve greater financial wealth, legally lowering your taxes, providing tax-free income to you from your business, and all within the letter of the law.
Salary strategy for S corporations
If you control the amount of salary you take out of your S corporation you reduce FICA taxes and eliminate self-employment taxes. If an S corporation has a net income before salary deduction of $50,000 and the owner takes the $50,000 reportable on a W-2, the combined FICA taxes for the employee and corporation will be approximately $7,600. If, however, the owner takes a reasonable salary of $30,000 the FICA taxes are only $4,500, a tax saving of over $3,000. The remaining $20,000 is passed through to the owner on a Form K-1 and there is no self-employment tax.
Especially for independent contractors
You are considered an independent contractor if: 1. You work for many people and choose when to perform services. 2. You perform services off premises. 3. You invest in your own facilities, such as a home office, tools, or supplies. 4. You make your services available to the public. 5. You stand to realize a profit or suffer a loss as the result of your services.
Of great importance, please understand that an independent contractor doing business as a corporation stands the lowest risk of being audited by the IRS. A corporation, by definition cannot be an employee. Since corporations do not receive 1099's, it is never recorded next to the individual's name and keeps you from being swept into a random sampling of independent contractors for audit.
We are committed to helping you save more of what you earn. Remember, it's your money! Don't give it away if you have the right to keep it.
For more information on a service that can form a corporation for you in any state..contact:
Sandifer Tax Services Inc. 251 Doolin Drive Williamstown, West Virginia 26187 Phone: 304-375-2605 Fax: 304-375-2606
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