CASE STUDY: Using The Tax Law To Make You Wealthy -- A Master Tax Reduction Plan For A Self-Employed Entrepreneur
By: Albert Aiello
Why can the tax law make you wealthy? Because any taxes you save can be immediately invested in other profitable opportunities which in turn can create more cash flow and wealth. You can reinvest the taxes as follows:
In Real estate for exceptional yields and more tax shelter To market and expand your existing business for more income In another business for more income and tax shelter In a tax-deductible Keogh, SEP, or IRA for tax-free yields To enjoy life, take a vacation, whatever! (Better in your pocket and not the IRS!!)
IT’S NOT JUST THE TAXES YOU SAVE BUT THE INVESTMENT OPPORTUNITIES THAT YOU CAN ATTAIN WITH THE TAXES YOU SAVE!
With the Master Tax Reduction Plan, one of my students, Tina, decided to reduce her tax burden by taking the initiative to implement a plan of tax reduction. That is, instead of just hoping, she decided to make it happen!
Before starting this plan, Tina’s Schedule C’s income as a self-employed individual was typically a gross income of $110,000, expenses of $29,000 and a resultant net business income of $81,000. On this net income, Tina was paying federal income taxes, Social Security taxes and local taxes of $36,000+, in a total (rounded) bracket of 45%. $36,000 is a lot of money! So Tina does the following: STEP 1: SHE GETS ORGANIZED and sets up a system of superior recordkeeping. Besides being a superior weapon in an IRS audit, this recordkeeping system will generate additional tax deductions from auto,
office, entertainment, travel another business related expenses. These additional deductions will be shown as we proceed. To implement this recordkeeping system, Tina does the following: a. Hires her 16-year old son, Eric, to assist her with recordkeeping, operate the computer and other duties. She already has been paying him a nondeductible allowance. Now she will pay him a deductible salary of $4,000 a year. Because it’s under $4,400, Eric does not pay any income taxes (yet he still can set up a Roth IRA). Because he is under 18 working for a parent, Eric (and Tina) do not pay any social security taxes. In some states he may be exempt from state taxes. Also, keep in mind that having an assistant frees up Tina’s time to do what she does best so she can make more money and have more relaxing leisure time. This in turn will also make her even more productive. b. Tina Invests $5,000 in money making assets (computers, etc.) to streamline her business and for better recordkeeping. She will fully deduct this cost of $5,000 as Section 179 First Year Expensing on IRS Form 4562 (Part A), then on her Schedule C. Tina also ELIMINATES IRS FEAR - By using IRS audit proofing techniques per Section 19 of the Bible. Superior recordkeeping will also eliminate IRS fear. By eliminating IRS fear, Tina can feel much more comfortable in being creative & aggressive in her tax reduction strategies. Being creative & aggressive can create huge tax savings, every year! STEP 2: TINA INVESTS IN TWO RENTAL PROPERTIES - These are in a good location. While they show a positive cash flow, they also show deductible “paper” losses of $20,000 because of component depreciation, repair segmentation and other creative property deductions. These real estate investor losses are fully deductible by Tina as an active real estate professional. (For a further discussion of these Goldmine strategies, refer to Albert Aiello’s Real Estate Investor’s Goldmine Of Brilliant Tax Strategies) STEP 3: TINA CLAIMS A HOME OFFICE DEDUCTION - She will use her office for administrative functions and therefore can claim the deduction per the tax law change in 1999. The deduction will be $1,500. She also was missing some deductions in the amount of $500 within the home office as discussed in Section 10 of the Bible (office accessories, cleaning, etc.). Total deductions here are $2,000. [TIP: TWO OTHER BENEFITS OF A HOME OFFICE: (1) Your homeoffice will be a business location which means you can now convert nondeductible commuting into deductible auto travel from home to work locations (See Section 7 of the Bible) and (2) There is no need to keep track
of the business use of a computer used in a home office. It is assumed to be business property and not “listed property”.] STEP 4: TINA INCREASES HER CAR EXPENSE DEDUCTIONS - By establishing a home office as a business location per the above, Tina will increase her business mileage which will increase her auto deductions. Here, Tina uses a recordkeeping shortcut known as “3-Month Sampling" for her business auto travel. With this method, the IRS allows you to use a 3-month “sample” period to compute your business mileage for the year. . Thus, you only have to keep auto mileage records for only 3 months of the year and you can pick any 3 months you want. Tina will select the 3 months where she is the busiest so she can get a high representative business-use of her auto. This, and being able to deduct commuting, will further increase her auto deductions by $1,000. Tina has found a number of overlooked auto deductions. For example she was not deducting the following car expenses: Car washes & waxing - $500 per year; Fluids, cleaning products, lubricants, supplies, etc. - $200 per year; Auto club dues - $50 per year; Tolls & parking - $450 per year. Plus a $1,000 above. Total deductions here are $2,200. STEP 5: TINA INCREASES HER ENTERTAINMENT EXPENSES Besides the lost marketing power, many professionals overlook or minimize this valuable deduction because they think it is limited. When you are selfemployed many non-deductible expenditures become tax deductible gems. The numerous "fun" activities of entertainment, amusement or recreation are prime examples. Tina was not deducting all possible entertainment. "Entertainment" goes well beyond dinner at some restaurant. It includes entertaining guests at meals, cocktail lounges, bars, night clubs, theaters, opera, sporting events, yachts, country clubs, hunting lodges, open houses, conventions and even at your home. All of the above qualify provided there is a documented business purpose. For example Tina was not deducting the following business entertainment expenses: House parties - $1000 per year; dinner with clients before concerts and the opera - $300 per year. Breakfast meetings with a referral networking group - $300 per year. The total here is $1,600 from which you must subtract 50%, equals $800. Tina documents these in her Daytimer and generates another $800 in deductible entertainment expenses.
[TIP: A lot of smaller deductions = one BIG deduction and BIG tax savings]
STEP 6: TINA INCREASES HER (OUT-OF-TOWN) TRAVEL EXPENSES - "Travel" is not only airfare, but also -- meals & entertainment, telephone, telegraph, stenography fees, expenses for sample rooms, side business trips, registration & seminar fees, taxi cabs, car rentals, other local transportation while at the destination, display materials and any other business expenses while at the travel destination. Even included here is cleaning and laundry expense for your personal clothing.* [*TIP: WEAR DIRTY CLOTHES! What I mean is to have your clothes cleaned right before your trip, while at the travel site and even again when you return home. Here the total cleaning (dry cleaning, laundry, shoe shine, etc.) is deductible as a business expense under “travel”. The IRS says so in their own Publication 463. TIP: Use your business credit card so you do not forget to take this overlooked deduction] Now that Tina’s son is her employee, she can deduct his travel too, provided he serves a bonafide business purpose, which Tina will document as per Section 12 of the Bible. Tina’s spouse, David, will also become her part time employee in order to set up a Medical Reimbursement Plan (discussed next). Moreover, she can now deduct her husband’s travel in the same manner as she can deduct her son. Consequently, travel deductions (including cruise conventions) will increase by $3,000. STEP 7: TINA DEDUCTS 100% OF HER MEDICAL COSTS AS A BUSINESS EXPENSE ON SCHEDULE C VIA A SECTION 105(b) MEDICAL REIMBURSEMENT PLAN. Tina will do this by hiring her spouse, David, as her assistant. The family medical insurance and other out-of-pocket medical costs are $5,000 a year. Because these expenses are now part of her husband’s compensation, via the medical reimbursement plan, they are now a fully deductible Schedule C business expense as opposed to a limited Schedule A deduction. This deduction will amount to $5,000.
Let’s summarize Tina’s total increased annual business deductions so far:
$ 4,000 Her Son’s salary 5,000 Section 179 First Year purchase of money making assets (computers, etc.). 2,000 home-office deductions 2,200 car expenses 800 entertainment deductions 3,000 travel deductions
5,000 Medical Reimbursement Plan deduction $22,000 Total increase in business expense deductions.
The above increased deductions of $22,000 reduces Tina’s present net business income of $81,000 down to $59,000. In a total tax bracket of 45%, the tax savings thus far are $9,900 ($22,000 x 45%). NOTE: Tina was paying just about all of the above expenses anyway, but not deducting them. Now, thanks to our master tax plan, she is deducting them. This means that the government, via tax savings, is paying for part of them. This is how you build wealth, using other people’s money (“OPM”)!
STEP 8: TINA SETS UP A DEDUCTIBLE RETIREMENT (QUALIFIED KEOGH) PLAN - Tina now realizes that retirement plans are a great deal. What you are really doing is taking money from one of your pockets, putting it in another one of your pockets, and deducting it! It’s still your money, plus the earnings in the plan grow exponentially because of the power of tax-free compounding! It may even pay you to borrow to make the tax-deductible contributions. Plus, there are several ways one can take out money of retirement plans and not pay any penalties. These ways are the following: 1. Periodic withdrawals based on life expectancy 2. For medical costs for yourself, spouse, or dependents 3. For college expenses 4. For first-time homebuying expenses.
By setting up a “self-directed plan” you can also lend money to unrelated parties (including homebuyers) out of your IRA, SEP or Keogh plans.
Tina’s net business self-employment income is now $59,000. Tina can contribute about 20% of this amount or about $12,000 in more deductions to a defined contribution Keogh plan. She sets up by the plan by the required time of December 31* of the current tax year. [*TAX TIP: By setting up the Keogh plan by December 31 of the current year and by properly filing extensions, Tina has until October 15th of the following year (over 9 months) to make deductible contributions for the previous tax year. To timely and properly file extensions.]
The above $12,000 Keogh deduction along with the $20,000 rental property loss deductions (per Step 2) total $32,000 which can reduce her taxable income even further. This additional deduction will not reduce her net business income for social security taxes, but will reduce it for income tax purposes. Assuming a 30% rounded income tax bracket, these additional deductions of $32,000 would result in additional tax savings of $9,600.
Let’s add up the total tax savings for Tina - From the increase in deductions of $21,000, her tax savings are $9900 and from the Keogh plan and rental property deductions of $32,000, her tax savings are $9600. When you add the $9900 and the $9600,
TINA’S TOTAL TAX SAVINGS ARE $19,500 PER YEAR! Her potential increase in wealth is as follows: If Tina were to invest the tax savings of $19,500 every year at 10% for 5 years it would grow to almost $120,000 and in 10 years to over $310,000! This is what you lose when you do not take the initiative to save taxes!!
REMINDER: IT’S NOT JUST THE TAXES YOU SAVE BUT THE INVESTMENT OPPORTUNITIES THAT YOU CAN ATTAIN WITH THE TAXES YOU SAVE!