How To Reduce IRS Taxes: Part 2
12 Simple Steps To Legally Lower Your Tax Burden Part 2 of a 2-Part Investment U White Paper Report
By Alex Green, Investment Director, Investment U, The Oxford Club
Contributors: David Melnik, QC, JD; Michele Cagan, CPA
(continued from How To Reduce IRS Taxes, Part 1)
Boost Your Charitable Donations (and Cut Your Tax Bill)
Donating Property Can Save You Big Money
Giving to charity is an American tradition. In fact, according to Giving USA 2002, U.S. charitable donations stood at a whopping $212 billion for 2001! Over 75% of those contributions came from individuals, proving again that Americans are very generous givers.
Charity for its own sake is a noble pursuit, but there are also very real tax advantages that flow from modern day philanthropy, thanks to our current tax laws. Not only will donations give you a current income tax deduction when you itemize using Schedule A of your 1040, they also reduce the size of your estate, thus reducing any future estate taxes you might have to pay. On top of that, if you donate capital property that has appreciated in value, you completely avoid any capital gains tax (which would have been levied if you had sold the asset) and you get a deduction for the fair market value of the asset.
Let’s say you want to make a large contribution to your favorite charity. You own a piece of art that has gained considerable value since you bought it ten years ago, and you decide to sell it and donate the proceeds. This transaction will trigger the capital gains tax, thus substantially reducing the amount left to give. Instead, you should donate the artwork to the charity. Then you get to deduct the current fair market value of the gift, and you pay no taxes on the appreciation in value.
Donations of property aren’t limited to capital assets. You can clean out your basement and attic, box up all the things you aren’t using (but can’t bear to throw away) and donate them to charity. That’s right-these worthy groups want your old clothes, books, games and furniture. While these items may be worthless to you, they’re worth a lot more as a tax deduction than as attic clutter. Now you’ll have plenty of room for new things and a tax write-off at the fair market value of your junk.
Your old junk adds up to big deductible bucks faster than you’d think. For example, clothing rates a fair market value at 30% of the original cost. So an old pair of designer jeans that originally cost $60 rates a $20 deduction. And some items pull in even more. Wedding gowns can be donated with a fair market value of what they would sell for: a gown you paid $2,000 for a year ago can give you a deduction of close to $1,500.
Make sure to get a receipt-if your donation is worth more than $250, you’ll need it. If your donated item exceeds the $5,000 mark and the fair market value isn’t abundantly clear, you’ll have to have it appraised before you can take the deduction. When your total non-cash deductions add up to at least $500 in any given year, you also have to fill out a special tax form (Form 8283) and attach it to your personal income tax return; if you don’t, the IRS will likely disallow your deduction.
Some property donations may be subject to limitations in the year that you make the contribution. Have no fear, though-any amount not deductible this year can be carried forward to future years’ returns.
Volunteer Work Can Lead to Deductible Expenses
If you do volunteer work for a qualified organization, you can deduct all of your unreimbursed expenses. That includes mileage driving to and from the charity at 14¢ per mile. You can also deduct parking and tolls. If your volunteer activities require an overnight stay (such as a convention) when you are acting as an official delegate of the group, you can deduct the cost of your meals and lodging.
Other qualified unreimbursed expenses that you can deduct include:
- The cost of uniforms you need to serve the organization.
- Telephone calls.
- Stamps and stationery.
- All expenses involved in hosting a fundraiser, from invitations to food and drinks.
Another way to get a deduction in the current tax year is to charge your donation on a major credit card in December. You don’t have to pay the bill until the following year, but the deduction counts for that tax year. The contribution is considered made as soon as you put it on the card.
Some credit cards even donate a portion of your charged purchases (minus a small administrative fee) to charities you’ve selected. At the end of the year, your credit card company will send you an annual statement of the contributions. The IRS has actually ruled that the credit card holders can deduct the charitable donations in the year they are actually paid by the credit card company. So just by making normal purchases throughout the year, using a card that provides this service, can earn you another deduction come tax time.
If you have a vacation home that you only use for part of the year, you can donate home ownership to a charity for the remainder of the year-and get a hefty deduction. For example, you may have a beach house that you only use from May through August, and the house remains vacant for the other eight months. If you donate the eight months of use to a qualified organization, you can deduct 66% of your home’s value that same year since the charity gets the right to use it that portion of the year. Then you get to use the house for the summer and greatly reduce your taxable income. A word of caution, though: this situation is a bit tricky, so make sure your tax advisor is familiar with the IRS ruling that deals with this unique situation (Revenue Ruling 75-420).
The Often Overlooked Miscellaneous Expense Deductions
Many taxpayers are totally unaware of how broad the deductible miscellaneous expense category can be. That’s mainly because the IRS tends to downplay this section of the Schedule A. Its forms and instructions generally de-emphasize this tax-saving portion of your tax return, and with good results-most people completely skip over this section because they have no idea what goes into it.
Deductible miscellaneous expenses include an extensive range of items, such as investment expenses, legal fees, the cost of getting your taxes done (including tax preparation software that you buy to do it yourself), professional seminars and educational expenses. It’s a good idea to bunch your expenses into one year as much as possible (as discussed in the medical expense deduction section) because the total of all the expenses must be greater than 2% of your adjusted gross income to be deductible.
Little-Known Employee Expenses You Can Deduct
Generally, you have to file an additional form (either Form 2106 or 2106-EZ) to claim job-related expenses that weren’t reimbursed by your employer. In some cases (where you receive no money back from your boss for expenses and you’re not claiming any travel, transportation, meal or entertainment costs), you can just put the total of your employee expenses directly on Schedule A without using Form 2106. These expenses are also subject to the 2% limitation.
Professional Dues and Subscriptions Increase Your Deduction
If you’re a doctor, lawyer, accountant or other similar professional, you can deduct the membership dues for any professional society you belong to. If you’re a securities dealer, your fee for sitting on the stock exchange is deductible. You can also deduct dues for trade organizations, unions, your local Chamber of Commerce and community “booster” clubs (that are set up to attract tourists to your area of business). You can also deduct subscriptions to professional journals and trade magazines.
Some Lucky Taxpayers Can Deduct Commuting Costs
If you hold two jobs, you have deductible commuting mileage. While you can’t deduct the cost of traveling between both jobs and your home, the mileage between the two jobs is deductible. If you only have one job, but your employer has two offices that you must travel between, that mileage is deductible as well.
Commuting mileage can also be deducted if you’re on a temporary work assignment away from home (temporary includes only assignments lasting less than one year). When you’re out of town on the temporary assignment, all of your mileage is deductible-including the mileage from your place of lodging to your place of business. Your miles commuting will even be deductible if you have an out-of-town temporary job assignment but choose to drive back and forth from your home every day.
The rate in effect for the 2002 mileage allowance is 36.5¢ per mile
|
Taking Some Classes to Keep Up with Your Current Job? Deduct Them!
Any courses you take to sharpen your skills for your current position, especially those you have to take to keep your job, are deductible (to the extent your employer doesn’t reimburse you). On top of the tuition payments, you can also deduct books, lab fees and equipment required for the course. You can even deduct the travel expenses to and from school. And if the school is away from home, you can deduct not only the travel expenses but also your lodging and 50% of your meals while you’re at school. One caution, however, the travel expenses can’t be deducted if the course lasts for more than one year.
To take the deduction, your continuing education must pass some IRS requirements. 1. You can’t deduct the cost of courses that you take to meet the minimum requirements of your job. The fact that you have your job doesn’t by itself prove that you already meet the minimum standards for the position. If the minimum standards change during the course of your employment, though, you can deduct expenses to meet the new requirements.
2. If the course leads to qualification for a new profession, you can’t take the deduction. You also can’t deduct the cost of college courses that will earn you a bachelor’s degree. However, if the classes prepare you for a specialty within your current profession, then the classes are deductible.
3. The classes you take must be to maintain or improve your current job skills. If the course just happens to lead to a promotion or change of position in the same occupation doing basically the same type of work, you can still deduct expenses.
4. You can deduct all the education-related expenses when you’re required by your employer, or by law, to obtain further education.
Between Jobs? You Still Have Deductible Expenses
The expenses associated with your job hunt, as long as you’re not changing fields, are deductible. These expenses include everything from getting resumes printed to visiting out-of-town firms for interviews. You can deduct these expenses even if you don’t end up taking a new job, as long as you were seriously considering taking a new job. (Expenses you incur looking for your first job are not deductible.)
If you’re between jobs and you continue to entertain your former clients or customers, your expenses may still be deductible. In a landmark Tax Court case that overturned an IRS ruling, a jewelry salesman maintained his former contacts by entertaining buyers and their representatives. The IRS disallowed his deduction, but the courts disagreed. All of his entertainment costs were deductible business expenses.
Special Tax Breaks for Entrepreneurs
There are a lot of benefits to being your own boss-and special tax breaks are one of them. Self-employed individuals are entitled to several above-the-line deductions that no one else can take. On top of that, many expenses that wouldn’t be deductible if you were an employee can now be subtracted from your income.
The sole proprietorship is the most popular form of small business in the U.S. today. This is due in large part to the ease of both setting up and dissolving the sole proprietorships. All you really have to do to be a sole proprietor is to start working. The business income is reported right on your 1040, Schedule C. Owning the business allows you to take advantage of some tax savings not normally available to employees.
“S” corporations seem to be second in the popularity race. These corporations offer more protection from liability than sole proprietorships, and some tax advantages. The S corporation is considered a “pass-through” entity-meaning the business itself pays no income taxes; the business owners report all the income on their personal returns. Unlike the sole proprietorship, though, the income earned by an S corporation is not subject to self-employment taxes-a 15.3% tax savings right there. This form of business offers more tax planning and potential savings than the sole proprietorship, but is also more complicated and expensive to start up.
Gaining ground are both single- and multi-member LLCs. This partnership-corporation hybrid is fast overtaking S corporations as a favorite among small business owners. Like the S corporation, the LLC offers both favorable pass-through taxation and liability protection. But it goes one step further-operating as an LLC allows entrepreneurs to avoid all the red tape associated with running a corporation.
Sole Proprietor Advantages
If you own an unincorporated business, you have to include all your business income on your personal return. One major drawback to this form of business-your net income is subject not only to income tax, but also to self-employment tax. Self-employment tax is really just both halves of Social Security and Medicare taxes (normally 1/2 of this is paid by your employer), but it comes to a whopping 15.3% of your earnings. To give small businesses a little bit of a break, half of this tax is subtracted to get to your AGI.
Schedule C filers are also allowed to take 70% of any health insurance premiums they pay for themselves and their families as an above-the-line deduction. (The percentage will rise to 100% in 2003.) The remainder of your insurance premium costs can go on Schedule A as part of your itemized deductions. For tax-year 2002, there is a little-known way to get a 100% deduction for your health insurance premiums. If you have employees (you don’t count as one), you can hire your spouse and have her covered by the business regular health insurance policy just like a regular employee. Since most policies allow for family coverage, you can be taken care of under your spouse’s coverage. The rules: your spouse must actually work for the company (meaning receive a paycheck with withholding taxes taken out) and your business must have a health insurance policy that covers all eligible employees. Once those conditions are met, you can deduct 100% of the premiums as a legitimate business expense on your Schedule C.
The Remarkable Keogh Plan
Anyone who earns self-employment income can establish one of the best tax shelters available to small business owners-the Keogh Plan. These retirement plans are somewhat complicated, so you should consult with a professional when you set it up-but its benefits are well worth the cost. Not only do you get a tax-deferred retirement plan; you can also get an above-the-line deduction of up to $40,000 for 2002.
To be able to make contributions and take the associated deduction, you have to formally set up your Keogh, in writing, before the end of the tax year. If you haven’t already set one up for the tax year you still can. The most important point to remember when you set it up: you must include all full-time employees over age 21 who have worked for you for at least one year in the plan. (If you have no employees, you can still set up the plan for just yourself.)
There are two kinds of Keogh plans: defined contribution and defined benefit. In general, a defined contribution plan is easier to deal with because it doesn’t require any actuarial calculations. Also, a defined benefit plan requires you to make contributions even if you have no profits! With a profit-sharing defined contribution Keogh plan, you can make sure the contributions are linked to your profits.
Because these plans allow you to sock away more retirement cash than any other type of plan and get a huge personal income tax deduction at the same time, the IRS makes you jump through hoops to have a Keogh. The plan has to file its own annual return with the IRS. Figuring out your maximum deductible contribution can be confusing-there are a lot of rules involved. Your plan needs IRS approval (generally, advance approval is your best bet). As we said before, it’s best to have a professional advisor set up and administer your Keogh, especially if you have employees. The expenses are worth it (and deductible to the business) for the incredible benefits you’ll receive. No other retirement plan will give you a maximum $40,000 deductible contribution.
You Can Take a Home Office Deduction without Fear-Just Follow These Guidelines
In the past, the rules for whether your home office qualified for deductibility were so stringent that many business owners who legitimately worked out of their homes were denied the deduction. Home office expense got a reputation as an audit flag-some people still think of it that way.
If you really do use part of your home as your office, fear not-take the deduction. The use tests are much more reasonable now. To take the deduction, you need to use your home office exclusively and on a regular basis either as:
1. A place of business to meet or deal with clients or customers in the normal course of business, or
2. Your principal place of business, meaning you spend most of your time working there and most of your business income can be traced to your activities there.
To make the rules even more flexible, you can deduct the home office if you regularly and exclusively use it to carry out only the administrative portion of your business-even if you spend most of your time working at outside locations. The administrative portion includes billing, bookkeeping, setting up appointments and other such tasks.
To take the deduction, simply fill out Form 8829 along with your Schedule C. The first part of the form just calculates what portion of your home your using for the office. These are your overall home expenses then multiply this amount by the business use percentage. The second part lists all the deductible expenses, such as:
- Property taxes.
- Utilities.
- Mortgage interest.
- Security system.
- Homeowner’s insurance.
- Repairs and maintenance expenses that “benefit” the office space (such as a new roof).
- Cleaning service.
- Depreciation (calculated on Part III of the form) Depreciation for your home office can’t bring you to a net loss, but any disallowed depreciation deduction can be carried over to the next year.
Planning a Family Vacation? Make It Deductible!
If you combine a family vacation with a business trip, some of your expenses may be deductible. As long as the primary purpose of the trip is business, your transportation costs can be deducted. And if your spouse or any other family members legitimately work for your business (meaning they get paychecks and benefits like all other employees), their transportation costs are business expenses as well. In addition to travel expenses, your lodging and 50% of your meals are deductible.
To ensure your deduction doesn’t get disallowed, you should keep a log of your business activities while on the trip. It’s best (for tax purposes) to spend more than 50% of the trip on business, but your transportation costs will still be deductible if you can show you would have gone even if no vacation were possible. Even if your travel expenses do get disallowed, you can still always deduct expenses that you can prove are directly related to the business (such as client lunches or seminar fees). One word of caution-the IRS tends to scrutinize trips abroad more than those within the United States, so try to keep your business/vacation trips domestic.
Convention and Seminar Expenses Can Be Deducted
You can deduct the expenses for conferences, conventions, seminars or any industry event/meeting that is related to your business. For example, if a conference, convention or seminar is held within the United States, all you have to show to qualify for the deduction is to be sure that attendance is ordinary and necessary to your job. The IRS does keep an eye on this, because conferences and conventions frequently combine business and pleasure (they especially like to scrutinize the deduction if you brought your spouse or other family members along). You don’t have to prove, however, that the specific business event/meeting you attended dealt specifically with your particular job. It’s enough that your attendance could advance or benefit your position.
Once you’ve established that your attendance at such a business event/meeting is primarily for business, you can deduct travel costs to and from the event, meals and hotel rooms. If you entertain business clients, you can deduct those expenses, too. (Only 50% of meal and entertainment expenses are deductible).
The most important thing to remember is to keep records of everything. Keep track of your payments for strictly business items-including the cost of attending the event itself. This holds especially true for expenses you incurred while entertaining clients. But as long as you keep decent records, and can show that the business event/meeting was related to your job, you can claim all the expenses associated with your participation. Once again, these expenses are subject to the 2% limitation.
Tax Tip: Get the proof you need to show that the principal purpose of the trip is business. For example, retain your copy of the convention program, check off the sessions you attended, and take notes. If each session has a sign-in book, sign in. If the convention secretary keeps this book after the sessions are concluded, you can obtain certified extracts, copies or even the books themselves.
Investment Seminars
The Internal Revenue Code denies the deduction for conventions, seminars or similar meetings for investment purposes unrelated to carrying on a trade or business.
Example.
International Investors holds a convention at which stock market investors pay to discuss strategies with representatives of brokerage firms. They also listen to presentations from executives about their companies. Result: The Code Sec. 212 restriction bars deductions by the investors for their expenses, but doesn’t affect the deductibility under Code Sec. 162 of expenses by stock brokers and others at the convention for business reasons. Among the expenses disallowed are travel to the convention site, attendance fees, meals, lodging and local travel while attending.
Conventions on Cruise Ships
In certain circumstances, you can deduct expenses up to $2,000 per person per year for attending conventions, seminars or similar meetings held on cruise ships. The ship must be a U.S. flagship, the meeting must relate directly to the active conduct of your business, and all ports of call must be located in the United States, its possessions or Puerto Rico. You must attach separate statements signed by the convention’s sponsor on your returns. You must give the cruise’s length, business activities scheduled, hours spent on scheduled business activities and other information required by IRS regulations.
Expense Deductions for Attending Foreign Conventions and Seminars
Foreign convention expenses are subject to special disallowance rules. Generally, no deduction is allowed for attending a convention, seminar or similar meeting held outside North America unless you establish that the meeting is directly related to the active conduct of your trade or business. You must also prove that, after taking certain factors into account, it is reasonable for the meeting to be held outside North America. If the trip is primarily personal, no business expense deduction is allowed, except those subsistence expenses that are properly allocable to your trade or business.
The factors to be taken into account are:
- The purpose of the meeting and the activities taking place at the meeting.
- The purposes and activities of the sponsoring organizations or groups.
- The residences of the active members of the sponsoring organization and the places that other meetings of the sponsoring organizations or groups have been or will be held.
- Such other relevant factors as the taxpayer may present.
How To Reduce Taxes While Keeping the IRS at Bay It’s our duty to ourselves to try to pay as little in taxes as we possibly can. The goal of the IRS, however, is to collect as much tax money as possible. This obvious conflict of purposes leaves some Americans shaking in their shoes come tax time. But we can show you how to keep your return as audit-proof as possible. And if by unlucky chance you do get called in for an audit, we give you some advice on how to handle it. Especially this advice: Always bring your tax preparer or advisor along with you on an audit; never face the IRS alone.
What Are the Odds That You’ll be Audited?
In general, the odds are fairly low that your return will be singled out for audit. Because of limited time and staff, the IRS has a system that screens returns for audit potential-those that are most likely to end up coughing up more cash.
A lot of factors determine how likely it is that you’ll be audited:
- Where you live.
- Your income level.
- Your profession.
- Which schedules you include with your return.
- The kinds of deductions you claim.
You’re also likely to be audited if you’ve been audited before and had to pay more money. Another factor that can increase your chances of being called in before the IRS-a whistle blower; if an informer tells the IRS you’re leaving income off your return, you’re almost guaranteed an audit.
Avoid These “Red Flag” Audit Triggers on Your Tax Return
The first thing the IRS looks for is understatement of income, and the first place they look is on third-party documents (such as W2s or 1099s). If the information you report on your tax return doesn’t match your tax documents, you’ve set off the first alarm. If you neglect an entire category of income-such as tips-that the IRS expects you to report, you’ve just set off alarm number two.
Itemized deductions can set off a warning-whether they’re too high or too low. If you think some of your deductions look too high and don’t claim them to avoid scrutiny, you’re probably drawing attention to your return. If your itemized deductions exceed IRS “targets,” your chances of being audited increase greatly. While the IRS isn’t so kind as to publish its criteria for determining excessive deductions, they do release statistics showing the average deductions claimed based on AGI. The chart below is an excerpt from the IRS figures based on deductions claimed on 1999 personal income tax returns:
|
Average Itemized Deductions |
||||
| AGI | Medical | Taxes | Interest | Donations |
| $75,000-100,000 | $6,945 | $5,916 | $8,298 | $2,527 |
| $100,000-200,000 | $11,835 | $9,229 | $10,941 | $3,684 |
| Over $200,000 | $31,727 | $38,253 | $24,846 | $21,403 |
| Source: IRS Individual Income Tax Returns, 1999, Table 3. | ||||
Another sign the IRS watches out for: fictitious or improper deductions. If you invent a non-existent dependent, you can settle in for a long, painful audit. If your business expenses are particularly large compared to your income, you’ve just set off another alarm. Allocating income to related taxpayers is another sign the IRS looks for. Never make allocations to fictitious taxpayers, and be careful of “sham” transactions when you make an income allocation. The IRS regularly scrutinizes this type of arrangement.
Once You’ve Been Selected, Make Sure You’re Prepared
Try to schedule your audit far enough in the future that you can be prepared. The IRS will try to give you short notice, sometimes even appearing at your home or office and trying to begin the audit immediately. Don’t let them rush you; you have the right to reschedule at a time that is convenient for you and your tax advisor. They will also try to see you alone, but don’t agree to that. Make sure your tax advisor is there with you the whole way through. They have a lot more experience with the IRS and won’t be intimidated into answering inappropriate questions.
The first thing the IRS will ask for is documentation. When you show up, bring only copies of those records they have asked for. Never volunteer anything they haven’t asked for, and never give them original documents. They are particularly interested in taxpayers who don’t keep books or records, and those who routinely postdate documents. If you refuse to provide information, or claim that all your records were lost or destroyed, the IRS will consider you hostile and your audit will intensify.
One Form You Should Never Sign
The IRS has three years after the date you filed your return to assess additional taxes. If that time is running short, they may ask you to (or try to pressure you into) signing Form 872-a blanket extension of the statute of limitations. In its original state, this form can extend your audit indefinitely on your entire return. You absolutely do not have to sign this form.
Sometimes, however, it’s in your best interest to sign a modified version of Form 872. If you just refuse to extend the time limit, the auditor will find against you for every dispute and you’ll have to take the matter to the Appeals Office. What you can do instead is negotiate a limit on the extension and keep it confined to only those issues currently in dispute. Try to keep the new deadline close-it will keep the auditor focused on your case and hasten a wrap-up. (Plus, if need be, you can always re-extend the deadline.)
Final Note: Be sure that your tax planner follows IRS deduction and exemption rules to the smallest technical details. Additionally, make sure that you are aware of all the IRS rules and regulations pertaining to your deductions/exemptions. Following IRS rules to the letter will save you time and potential messy audits. For example, if you wanted to transfer assets from IRA #1 to IRA #2 and fail to file the appropriate paperwork within 60 days, you will have to pay the full tax amount on the transferred money as well as a 10% excess tax.
Good investing,
Alex Green
Return to Part 1 of How To Reduce IRS Taxes: 12 Simple Steps To Legally Lower Your Tax Burden I also encourage you to sign up for the free, three-times weekly Investment U E-Letter, headed up by renowned economist and best-selling author Dr. Mark Skousen. It’s full of actionable investing wisdom you can put to use right away to become a better investor.
Tax-Related Articles from the Investment U Archives:
- Investment Tax Advice: 5 Moves To Make Now
- 7 Tax Scams to Steer Clear of and 1 Real Way to Earn Free Money
Investment U RSS Feed