You should have read this last year
If Rick Taylor had his way, you wouldn’t be reading this article right now.
You would have read it before you incorporated or before the end of last year.
To Taylor, giving tax tips now is akin to closing the barn door after the horses run out – it’s all about timing.
"When people sit down at tax time and they say, ‘How can I save money on taxes?’ or even when they sit there now and say, ‘What deductions am I missing?’ the truth is, there aren’t a lot of deductions that they’re missing," Taylor, a partner with accounting firm Clifton Gunderson, says. "There isn’t a lot you can do after the fact. It’s not one of these things where you can buy a book and find some missing deductions or mine your personal records for tax gold. That doesn’t exist.
"How you save money is proactively structuring your business going forward and setting things up right in the first place," he says.
Taylor knows tax law and the machinations behind it. Before joining Clifton Gunderson – the 13th largest accounting firm in the nation – in 1997, he was a partner in the Washington, D.C., national tax office of KPMG Peat Marwick. He currently directs Clifton Gunderson’s tax and financial planning services nationally, and is recognized as an authority on closely held businesses, having authored three books on the subject as well as being quoted in such national publications as The Wall Street Journal, BusinessWeek, Newsweek and Money Magazine.
Taylor’s first tip for small business owners: Don’t incorporate.
"For some reason, when people go to start a small business, the first thing that they think they should do is incorporate," Taylor says. "It’s almost as if by incorporating it’s a declaration of ‘I’m in this for real, and I really mean this.’ But that’s probably the single worst thing that a small business does."
For one thing, by electing C-corporation status, the business owners set themselves up for double taxation. The corporation pays income taxes, and then, should it pay a dividend to its shareholders, the shareholders are taxed on the dividends. Perhaps the biggest risk, says Taylor, is the corporation’s susceptibility to IRS audits.
"If you’ve got personal expenses in a corporation, think about the motivation of the IRS," Taylor says. "The IRS is going to come in and say, ‘Oh, it’s a C-corp. We’re going to look more closely at these (expenses) because, one, we’re going to knock them out [disallow the deductions], we’re going to increase the corporate tax, and then two, we’re going to ding the shareholder for it and hit them with a dividend.’"
It’s not as bad if personal expenses were found during the course of an audit of a limited liability corporation (LLC), partnership or an S-corporation because those are pass-through entities where all of the profits and losses are reported on the individual shareholders’ returns. In this scenario, the shareholders would simply report (and pay taxes on) the disallowed deductions.
Taylor favors the LLC over the C- and S-corporation formats for a number of reasons. In an LLC, the shareholder gets basis for the debt of the entity, which enables a shareholder to include more losses from the business on his or her individual tax return than the other types of entities.
For example, a shareholder contributes $20,000 to start a business and the business takes out a $200,000 loan to get the operations off the ground. In the first two years of operations, the business generates $220,000 of losses. In a C-corporation, the shareholder can’t take any loss; in an S-corporation, the shareholder can only claim $20,000 in losses because that’s the amount of his or her equity invested in the business; but in an LLC, the shareholder can take $220,000 in losses because of the $20,000 in contributed equity and the $200,000 in the business’s debt.
"That’s a huge difference and I don’t think business people focus on that, and I don’t think planners focus on that," Taylor says. "And I think some of it’s because some accountants are looking for off-season work, and you can’t have off-season work with pass-through entities without the required payment [to extend the individual’s personal return]. So if the client comes in and says, ‘I’m a C-corp and I have a June 30 year end,’ they (accountants) just keep their mouths shut because they think, ‘I’d rather be doing the audit in September and October than doing it in January and February when 90% of my work hits.’
"The problem with that is that doesn’t benefit the client," he says.
Tip No.2:
Shifting income
Taylor has some practical advice for taxpayers with children. He called shifting assets, like stocks and interest-bearing instruments, to children "the best planning strategy." Each child can receive up to $750 in income without being taxed and the next $750 is taxed at 10%, so a family can shelter $1,500 at a cost of $75. That could save about $375 in a dual-earner family, according to Taylor.
And if parents are nervous about giving their children the underlying assets, Taylor suggests setting up a limited partnership where the children are limited partners and the parents are the general partners. The assets are controlled by the general partners (parents) and the children receive the pass-through income, but they can’t get to the underlying assets of the partnership because they’re limited partners.
Rebate, what rebate?
Taylor also warns tax preparers – professional and amateur alike – about the rate reduction credit. Instead of adjusting the tax withholding tables immediately in May when the tax bill passed last year, Congress wanted most taxpayers to get cash in hand ("They wanted some sort of gimmick so people would associate Cash = Congress = President = Good," Taylor jokes) and issued $300 or $600 rebate checks. The rebate checks reflected the reduction in tax rates of the first $6,000 of income from 15% to 10%.
But when taxpayers fill out their tax returns, they’ll discover the tax table still reflects the old 15% rate. "Then it says you get a rate reduction credit, which is used to reduce the tax table on the first $6,000 down to 10%, but you don’t get that credit if you received a rebate check last fall," Taylor said. "… It’s a huge problem for the IRS."
Capital loss limitation
Another unfortunate development with the economic recession and concurrent stock market slump is people cutting their losses in the market and running, thus realizing capital losses. The problem that Taylor sees is that because people feel cash-poor due to their stock losses and figure that those losses can be used to offset other income, like salaries, they have stopped making quarterly estimated tax payments. What they don’t realize is that capital losses, after offsetting any capital gains, are limited to $3,000 each year, so people that stopped or significantly reduced tax payments may find themselves in penalty situations when they file their income tax returns.
He also sees massive confusion when it comes time to filling out the capital gains and losses (Form 1040 Schedule D) form beginning this year. The confusion involves Congress’s attempt to decrease capital gains rates for higher-income taxpayers from 20% to 18% and from 10% to 8% for lower-income taxpayers. Suffice it to say that Taylor predicts that 50% of the CPAs preparing returns won’t know how to handle the changes correctly so don’t feel bad if you feel confused.
He pulls no punches when it comes to the people responsible for making the law as convoluted as it is.
"You want to talk about a joke," he says, referring to last year’s estate tax repeal. "It’s fraudulent that they call this thing an estate tax repeal. (Congress) didn’t repeal the estate tax, (Congress) actually caused more trouble because now, how do people plan? They’ve got all these wills that are basically designed for the system that’s eventually going to fade out [through 2009], go away for a year [2010] and then come right back [2011]."
Because the economic stimulus packages have stalled in the political quagmire between the two houses, Taylor worries that if a deal finally passes, it could cause the economy to get too hot, causing inflation. Of all the proposals being pushed he believes the two most likely to get through will be the bonus depreciation, where, over the next three years, companies would be entitled to accelerated depreciation equal to 30% of the purchase price of capital assets, and the 13 weeks of unemployment insurance aid to workers who have lost their jobs.
He shakes his head at the names that both political parties give various tax bills and economic stimulus packages. The current Democratic stimulus package was shortened to ‘The Hope for Children Act.’
"It causes you to completely lose confidence," Taylor says. "These are the people that are running your country. If this act was going to give children hope, we’re in real trouble."
March 15, 2002 Small Business Times, Milwaukee
