So you think the government is out to rob you of all your
hard-earned money? Every time you hear the word "tax,"
you recoil in fear? Cheer up! It's not that bad--especially if
you're a business owner.
Tax expert Sandy Botkin, author of Lower Your Taxes Big Time! and a former
IRS attorney, says there is hope for all us saps who just hand over
our paychecks to Uncle Sam. Read on for Botkin's tips on taking
advantage of tons of business tax deductions--all within the letter
of the law.
You say that homebased business is one of the few legal tax
shelters left. What does that mean?
Sandy Botkin: First of all, understand something: We have
two tax systems in this country. [Many] times people think
there's one for rich and one for poor. That is a huge myth.
What the systems are is one for employees--people who don't
know the rules, which are designed to take your wealth--and one for
self-employed people, [the rules of] which are designed to create
economic growth. The reason for that is, small business generates
over 70 percent of the jobs in this country. So Congress passes
good tax laws. And there are good tax laws--let me emphasize
this--for small business.
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Let's say your business generates a loss. If that loss
exceeds the income from that business, you can use that loss
against any form of income you have: interest, dividends, rents,
wages, pensions, anything. Say you make $50,000 in salary and you
have a small business that creates a $10,000 loss. You only pay tax
on $40,000. Let's say the loss exceeds your whole income. You
can carry back all business losses in 2002 five years and actually
get a refund from the last five years' federal and state income
tax you paid. In 2003, by the way, that number is going down to two
years. Or you can carry forward all business losses 20 years and
offset the next 20 years of earning. So you never lose a properly
documented business deduction.
What if your homebased business is profitable? How can you
still save on your taxes?
Botkin: By having a profitable homebased business, you can
set up a host of fringe benefits, many of which I include in my
book. You can set up a self-insured medical reimbursement plan and
write off all your deductibles, eyeglasses, co-insurance,
pre-existing conditions. Usually that stuff has to exceed a certain
threshold [7.5 percent of your adjusted gross income] to deduct
anything. With a self-insured medical reimbursement plan, you get a
deduction regardless. It's dollar for dollar.
What other deductions do people not typically know
about?
Botkin: As an employee, you have to pay [taxes on
everything]. As a self-employed person, you don't pay tax until
all your deductions are over. So [if you're an employee making]
$60,000 a year, you've got to pay Social Security on 15.3
percent of $60,000. You've got to pay income tax on $60,000,
regardless of your employee business expenses. [But] if you're
self-employed--let's say you have $40,000 of expenses on that
$60,000, you only pay tax on $20,000. You pay tax on your net. See
the difference?
So what are some things you can do? If you have a child and you
want to send them to college, that isn't deductible. And if you
pay for their wedding, is that deductible? The answer is no. But if
you were to hire your children in your business and pay them [the
same] wage you'd pay an assistant, that's deductible. And
if they use that money to pay for their own college or their own
wedding or their own car, aren't you in essence getting a
deduction for those things?
And by the way, children under 18--if you hire them in a sole
proprietorship business--are exempt from Social Security and
federal unemployment taxes, and the first $4,700 they made in 2002
is exempt from income tax. Result? You get a deduction, and they
get that money tax-free.
So to protect yourself, you need to do the same paperwork as
you would a normal employee?
Botkin: Good point. You want to have things like time sheets
or a tax diary showing what your kid did. So for example, you might
say Matthew, my son, sorted files and made 3-by-5 cards for four
hours on February 3. That shows what he did, when he did it and how
long he worked.
You also want to pay by check--none of this under-the-table
nonsense, because [checks] establish a payment from you to your
child to your child's bank account. You want to have the
appropriate paperwork done. There are W-2s you have to file once a
year and 940s and 941s for unemployment and Social Security. But I
recommend using a payroll service, because people don't want to
do all this paperwork. They will do all the payroll, all the forms,
all the filings. You also want to have a contract for services
showing you hired your kids and what you're paying them, a
normal contract like any other employee.
Does all this apply when you hire your spouse as
well?
Botkin: Yes, it's all the same. Now for hiring your
spouse, you can set up a self-insured medical reimbursement plan. I
can deduct all my medical expenses, dollar for dollar--not because
I'm paying medical, but because I'm providing a medical
reimbursement plan for my employee, who I happen to be married to.
And the IRS has approved this, by the way. It's not some
loophole I thought up.
What are some other techniques for taking
deductions?
Botkin: A lot of people don't know that when you're
in business, you can deduct your fun. IRS says in their regulations
that you can deduct 50 percent of your fun and 50 percent of your
[business associate's] fun if you talk business within the same
24-hour day as the fun. Say you invite a prospect over to go to a
football game. You talk business over the phone and then pick them
up two hours later. Is that talking business within the same
24-hour day? The answer is yes. Say we go to a restaurant and I
talk to you in the car about our business or try to get referrals
and then we go to a nice theater. Is that talking business within
the same 24-hour day? The answer is yes.
You also don't need receipts for entertainment if it's
under $75 per expense. Now when you do entertain, the IRS requires
certain documentation. So with entertainment, you have to write
down what I call the four Ws and an H:
- Who: name and occupation
- Where: We went to Greasy Lloyd's restaurant.
- Why: Why did you take that person out?
And here's one of the biggest mistakes self-employed people
make. You must be specific in the documentation. The word
"prospect" isn't specific enough. "Good
will" isn't specific enough. Specific would be "try
to get a referral" or "talked with a reporter about my
book." Don't be general.
- What: What was the date, and was it for breakfast, lunch or
dinner?
- And finally, how much.
If you write down all five things, you'll never have to
worry about an IRS audit again. If you leave out any one of the
five, your deductions will be disallowed and the IRS will hit you
with a 75 percent penalty, plus interest.
Why is it so important to make yourself aware of these
things?
Botkin: What amazes me is, say you look at your credit card
statement and there's a $200 charge you never saw before.
Aren't you going to call the credit card company and find out
what's going on? And you might spend an hour on the phone doing
that. Yet taxes are the number-one expense in this country. They
exceed what most people pay for food, clothing, lodging and
transportation combined. [But] 99 [percent of people] give it a
10-minute thought. And the reason is, there's a huge myth in
this country. "My accountant takes care of my taxes."
What are some audit red flags that people need to
avoid?
Botkin: The number-one red flag is failing to report all
your income. The IRS matches all those 1099s you get from your bank
accounts, your stock brokerage companies, whatever. If there's
a mismatch--suppose you made $30,000, but you only report
$28,000--then you're calling attention to your tax return.
The second thing you want to do is do not use cents in figuring
out your tax return. Always round. Mathematical errors cause some
of the biggest scrutiny of your tax return because things don't
match up. If you use cents, you're just increasing your chance
of making an error.
If you do your own tax return, for the most part, you increase
your chance of being selected for an audit. The IRS figures if you
do your own return, you don't know what you're doing,
unlike accountants who might do hundreds of returns. People tend to
make more mathematical mistakes when they do their own returns than
accountants make.
Third major tip to reducing your chance of audit: Always, always
send in your tax return with a return receipt. And if there's a
check, send it registered mail or FedEx. There [have even been]
cases where if you do send it FedEx [and it is lost], the IRS will
waive penalties.
I'll give you another nice tip. Many times people call the
IRS for information, especially during this time of year. The
problem is, the IRS isn't bound to anything they tell you.
However, there is one situation where you can call IRS and if you
get a bad answer, they'll waive penalties. But you've got
to get six things when you call them: The person's name, their
badge number, the date of the call, the time of the call, the
nature of the question and the answer. If you write down all six
things and you get a bad answer that IRS relied on, they'll
waive penalties.