Tax savvy business owners meet with their tax professional at least once per year and more often if necessary to discuss the tax implications of any major upcoming transactions. These business owners have discovered that to minimize taxes, they must review operations periodically and anticipate and structure major transactions to maximize tax savings.
Unfortunately, very few small business owners meet with their CPA at all prior to the end of the tax year, not to mention before they enter into any major transactions during the year. Those business owners generally miss out on opportunities to save thousands in taxes. These business owners are unaware of the extra taxes they are paying, because they want to save CPA fees. They are tripping over dollars to get to the dimes.
Even if you meet with your CPA regularly to discuss tax planning, you may not have discussed the following tax strategies. Not all of them can be used by every business, but you should explore them with your tax advisor to find out if they will work for your business.
The following tax strategies are perfectly legal (under current tax law, see my disclaimer below) and essentially allow you to deduct expenses from income that you would otherwise be taxed upon, or to accelerate write-offs of investments made in the current year, to minimize your current taxable income.
- 1. How would you like to deduct expenses such as kids’ clothing, toys, school supplies, etc. from your taxes? Employ your children!
Wages of minor children are tax exempt up to $6,300 for 2016. Additionally, these earnings may be exempt from social security and medicare taxes. Many small businesses can employ their children to do minor tasks, such as filing. As long as the rate of pay is reasonable for the task, the IRS will allow it.
Have you ever watched a local commercial on TV that includes the kids of the business owner? Have you ever received a brochure that includes pictures of smiling kids? Most likely, these business owners are employing their children as models, which is earned income for the kids and deductions for the business.
The tax savings strategy here is that by employing your children, you will reduce the taxable income of the business and shift the income to your children who may be tax exempt, as noted above, and otherwise should be in a lower tax bracket than you.
Deposit these funds in your child’s checking account (with you as a signatory) and use these funds to pay for the children’s expenses, such as school supplies, clothes, or entertainment that would otherwise come out of your pocket. Thus, you will have converted some of your non-deductible living expenses to fully deductible business expenses.
Certainly, you can find some task that your children can do for your business.
- 2. How would you like to get a tax deduction for taking money from one pocket and putting it in the other pocket? You can by renting your house to your company for business events less than 15 days per year!
Do you sponsor sales events for clients or training events for employees, such as seminars? Do you rent space for these events at local hotels or other meeting facilities? If you do, then this tax reduction strategy may work for you.
Here’s how it works. Let’s say that you hold one of these events each month. It costs your company $1,000 to rent a meeting room for the day. So, your company spends $12,000 per year on renting space for these meetings. Now, instead of renting meeting rooms at the local hotel, your company rents your house for these events, at $1,000 for the day, one day each month, totaling $12,000 for the year. This is a fully deductible expense for your company. Since you rented your home for less than 15 days, this $12,000 in rental income is non-taxable income to you [IRC Sec 280A(g)(2)].
In essence, this tax reduction strategy allows you to move money from one pocket to another and take a tax deduction for doing it!
As you can imagine, this strategy takes some thoughtful planning. Here are some assumptions I made in the example above:
- You do not take a home office deduction for the use of space in your home;
- Your business is a separate legal entity (although this may work with a sole proprietorship);
- Your home is rented for an event with a definite business purpose and it is “reasonable and customary” for your business to rent space for such an event;
- Your home has suitable space for such an event.
Also, you’ll want to document how you arrived at the rental fee for the event. Some contemporaneous quotes from local meeting venues should be sufficient.
Certainly, your business can develop a series of seminars for your clients and prospects in an effort to boost sales?
- 3.How would you like to get a tax deduction for taking a vacation?
You can deduct travel expenses for travel with a business purpose. Therefore, if you’re planning a vacation or other trip, then you should also consider how to include some business with that trip. As long as you can justify that an expense was reasonable and customary for the conduct of your business, you can deduct the expense.
So, how do you include some business with your trip? Well, that depends upon your business. Many businesses send their personnel to training seminars or trade shows, so if there is such an event that you could attend in the area and you attend it, then you have conducted business during that trip. If you have clients in the area, then you could call on them. If you are in the real estate business, then you can investigate potential investment properties and make offers on them. How about conducting your annual shareholder or member meeting at your destination? Make sure you document the meeting with minutes for your corporate files.
There are any number of ways to include business with any trip you take. So, before you take any trips with the family, do a little brain-storming to come up a business purpose for the trip and include some business on the trip. Then, while on the trip, document the business purpose. Most, if not all, of your travel expenses may be deductible.
Certainly, you can find a business purpose for all of your travel?
- 4.How would you like to lower your taxes by reclassifying your income?
Does your primary business own equipment or real estate? If so, then you may be paying too much tax, including self-employment taxes. How is this possible? Generally, you will pay higher taxes on “active” income than you will on “passive” income, since passive income is excluded from self-employment tax.
Here’s how that works. Let’s say that your business owns the building it occupies and it pays a monthly note. If it didn’t own the building, it would be paying $10,000 per month in rent, or $120,000 per year. The interest on the note during the year is $75,000. The depreciation on the building during the year is $25,000. By having your business own your building, instead of renting it, you will save $20,000 a year in expense, which results in $20,000 of income for the business. If this increased business income is subject to self-employment tax, then you will also pay an additional $3,060 in SE taxes on this income.
Now, let’s say that your building is owned by an LLC, which you own, and your LLC leases the building to your business. Your LLC will rent the building at fair market rates, which is $10,000 per month or $120,000 per year. Your LLC also has to pay the mortgage and gets to depreciate the building, which we stated above results in $75,000 of interest expense and $25,000 in depreciation expense, or $100,000 in costs per year. Your business picks up all the other costs, as before, in a triple net lease. Therefore, your LLC generates $20,000 in rental income and your business incurs $20,000 in additional expense due to the difference in rents.
You should notice that your income is unchanged. You have transferred $20,000 in profits from your primary business to your LLC via rents. But the rental income of your LLC is not subject to self-employment taxes! Thus, by shifting this income from your primary “active” business to your “passive” rental LLC, you have saved the $3,060 in self employment taxes that you would have paid in the previous scenario. That’s $3,060 per year! And, rents normally increase each year . . .
Certainly, you can make sure that your active business rents its facilities from your LLC?
- 5.How would you like to lower your taxes by depreciating over a shorter period any real estate purchased for business use or rental activity?
The IRS allows business to deduct a portion of the cost of fixed assets over a set period of time, based upon the nature of the asset. This deduction is called “depreciation”. Under IRC section 179, businesses can fully deduct most equipment purchased during the year up to a certain limit, which can change annually at the whim of Congress. For real estate, the depreciation life is 39.5 years, or 27.5 years for residential rental property. The value allocated to the land cannot be depreciated at all.
So, you can see that when you purchase real estate, you only get to expense a small portion of that purchase during any given year. Unless you break down the real estate purchased into its various components . . .
Real estate consists of land, buildings, improvements and “attached” equipment. Most people, including most CPAs, only separate the purchase cost of real estate into the land and the building. Furthermore, if the CPA doesn’t have some documentation that states the value of the land, then that CPA may allocate 20% of the purchase price to the land. So, right off the top, 20% of the purchase price cannot be depreciated.
A better method of allocating the purchase cost for depreciation purposes is to begin with allocating value to the “attached” equipment, first; any improvements to the land, second; the structure of the building, third; and finally the remaining amount, if any, to the land. The goal being to justify allocating as much of the purchase price as possible to the depreciable assets and minimize the value allocated to the land. This method is called “cost segregation” and will allow you to depreciate some of the purchase cost more rapidly than viewed as a whole.
Many CPAs believe that you must have a cost segregation study completed by a trained consultant in order to use this method. These studies are expensive. However, the secret is to simply itemize the equipment attached to the building and the improvements made to the land and then document your estimate of their value. Equipment that can be itemized are items that can be removed without destroying the structure of the building. Improvements are any additions to the property outside of the building, such as landscaping, parking lots, fences, etc.
If you purchased real estate within the past two years and paid any income taxes, you should consider amending your tax returns to correct the allocation of the real estate into its components and reduce your taxable income for those years and get refunds. The IRS limits the amount of rental losses that you can use to offset other active income. So, you should discuss with your CPA how these limitations apply to you before incurring the cost of amending your returns.
Certainly, you will never look at real estate the same way in the future?
© 2016 Bob Norton Consulting APC. Bob Norton is a licensed CPA and real estate broker in Louisiana. The opinions and ideas expressed in this article are informational only and are not meant as tax advice. Consult with your tax advisor to determine how these ideas apply to your situation.