Chapter 7 CREATING INCOME WITH LESS TAX Create a Business A s a CPA, I see numerous financial statements and tax returns of other people. One advantage I have is I get to see what is real and what isn’t. Some people say they have a lot of money and they really do. Some people say they have a lot of money and you see them suddenly booted out of the house they never really owned and having their cars repossessed. And I also get to see the financial statements of people worth millions, even billions, of dollars who never tell anyone how much money they have. I get to see the truth. Business owners have the best ability to create cash and wealth out of an idea. And they have many tax loopholes available for them. Em- ployees, no matter how much money they make, have very limited tax- planning opportunities. And taxes are the number one expense for most Americans. In fact, as employees’ income increases, they lose the ability to write off deductions such as mortgage interest, property tax, charitable donations, and the like. And if they make enough money, they also lose the exemptions for their donations and for themselves. Even more, business owners can actually control when they pay their taxes and how much they pay in taxes. When you have a business, it is also possible to take deductions for items that were previously personal expenses. We call those the hidden business deductions. 81 ccc-kennedy_ch07_81-95.qxd 10/22/04 12:20 PM Page 81 The Problem Is Your Paycheck! Have you ever heard people complain that if they just made a little bit more money, everything would be okay? When I hear that complaint from someone, I always reply, “The problem is your paycheck, but not in the way you think it is.” The answer isn’t to change the amount of money you make. Change the way you make your money first and then you can change the amount of money you keep. It’s not how much money you make that counts, it’s how much money you keep. Earn-Tax-Spend Syndrome How did we ever get into this tax mess, anyway? Most people don’t real- ize how new the current concept of taxation by the federal government actually is. In fact, it wasn’t until 1943 that the government began re- quiring employers to withhold taxes from employees. In less than 60 years, the middle class has become conditioned to having the govern- ment get their cut first. Ask a group of people how much they make, and most will automat- ically reply with the net amount of their check. The net amount is the amount that is left after the government takes out its share. That is the amount of the paycheck that you bring home. From your share, you then have to pay all of your expenses. So, even though you make a good salary, the real answer is how much you keep after the government is finished and you pay your expenses. If you’re like most Americans, you might end up keeping a little, if anything. But a business, when set up the correct way, can reverse this process. By identifying and documenting your business deductions you can con- trol the amount of money you spend on taxes. Remember, that’s one of the largest expenses the average American has. If you’re an employee, you follow the Earn-Tax-Spend Syndrome of the average taxpayer. However, if you follow the Business Owner’s Sys- tem to Wealth you have the Earn-Spend-Tax loophole strategy. (See Figure 7.1.) 82 LOOPHOLES OF THE RICH ccc-kennedy_ch07_81-95.qxd 10/22/04 12:20 PM Page 82 CREATING INCOME WITH LESS TAX 83 FIGURE 7.1 Earn-Tax-Spend versus Earn-Spend-Tax ccc-kennedy_ch07_81-95.qxd 10/22/04 12:20 PM Page 83 What Is a Business? There are many opportunities in today’s world for starting a business part-time while you keep a day job. In fact, it’s best that you continue with your current day job until your business can support you. In Ted’s case, he clearly had created a position for himself as a self- employed person. This was a good starting point for him to begin tax plan- ning as a business owner. You might want to consider what skills you have that can be turned into a business. As more and more businesses downsize, there are a great many start-up businesses formed by downsized employees doing consulting to the very companies that had laid them off as employees. Other possibilities include network marketing and purchasing a fran- chise. The benefit of starting this way is that the systems are already in place for your business. The key ingredient that you add in either case is that you follow a program. Generally that means you can just start off selling. Everything else that goes into a business (administration, fulfill- ment, customer service, accounting, and the like) is outlined in the pro- gram provided by the network marketing company or the franchiser. You just follow their system. Still others become involved in real estate investing or stock trading. Lately, the growing phenomenon of eBay selling has created a brand- new way to start a business. You might start a business just by cleaning out your garage and posting the items for sale on eBay the way Ellen did. Hobby versus Business You undoubtedly have heard that you should “do what you love and the money will follow.” That is true as long as that thing you love is run like a business. Otherwise, you run the risk of being considered a sham busi- ness under the IRS’s hobby loss rules. If the IRS considers your business a hobby, you can deduct expenses only up to the amount of income for that venture. That means that you cannot take advantage of many of the special business deductions for start-ups. This ruling is especially detrimental in the beginning stages of a business, when most have expenses that exceed their incomes. In this case, the business loss is not deductible. 84 LOOPHOLES OF THE RICH ccc-kennedy_ch07_81-95.qxd 10/22/04 12:20 PM Page 84 Rules for Having a Business There is a general rule of thumb that you might have heard that states that a business is not a hobby if there is income in three out of five years (three out of seven in the case of certain agricultural activities). Clearly, if you have net income (after all expenses are deducted) that income is taxable, so the question of whether the business is a hobby is not valid. The three years out of five rule (or three years out of seven) is not hard- and-fast, though. In some cases, businesses have been disallowed during the loss years even when there was profit in other years. Additionally, in some cases, businesses have been allowed as losses even when there is a loss year after year. The key deciding factors actually have to do with whether the busi- ness is run like a business. No one factor alone is controlling; all factors are taken into account. You will find the Nine Steps to Business form in Figure 7.2. Com- plete this form to make sure your business meets the necessary criteria. When Is a Business not a Business? Why does the IRS go to so much trouble to make sure you have a busi- ness? The reason is because some people have taken advantage of the sys- tem that allows you to take business losses against other earned income. And so, in an effort to correct this situation, the pendulum has swung the other way. Instead of only having to prove you have expenses, you also have to prove that you really have a business when you have losses. There are some industries that are particularly vulnerable to ques- tions by the IRS. These businesses fall into two general categories: (1) businesses that could have a hobby aspect, such as animal breeding or craft-type industries, and (2) businesses that have the potential for per- sonal use write-offs with no real business purpose. This second category, “sham businesses,” is particularly vulnerable to unfavorable court rulings. In fact, home-based sham businesses are on the IRS’s dirty dozen list of potential scams that it is auditing. Avoid the risk of having your business declared a hobby or, worse yet, a sham, by making sure your business re- ally is a business. CREATING INCOME WITH LESS TAX 85 ccc-kennedy_ch07_81-95.qxd 10/22/04 12:20 PM Page 85 86 LOOPHOLES OF THE RICH Nine Steps to Business Instructions Fill in the name of your company. Fill in the type of business. You can use the IRS business type listing in Appendix C as a reference. Your accountant will use this listing to determine the business type when filing your tax return. Answer the questions with yes or no. Every “no” answer weakens your position as a business. Review this form with your tax advisor. Name of Company __________________________________________________________ Type of Business __________________________________________________________ Businesslike Manner 1. Do you have a separate bank account for your business? YES / NO 2. Do you (or your CPA) keep accounting records for your business? YES / NO 3. Do you keep copies of receipts in a filing system? YES / NO 4. Do you make an effort to collect accounts receivable? YES / NO 5. Do you review profit and loss statements regularly? YES / NO Time and Effort 6. Do you keep track of time spent in your business activity? YES / NO 7. Do you keep track of business appointments in a scheduler or diary? YES / NO 8. Do you have notes of conversations you have had with consultants or experts to enhance your business? YES / NO 9. Do you keep evidence from business seminars you have attended? YES / NO Depend on Income 10. Will you need the income from your business to sustain your lifestyle? YES / NO 11. Do you intend to replace your current job with this business? YES / NO Reasonable Losses If you have losses, do you have documentation that: 12. They are normal for the type of business you are in at the beginning? YES / NO 13. That others have experienced the same kind of downturn? YES / NO Effort to Make Money If you have losses, do you have evidence that: 14. You have made changes to try to improve the business? YES / NO 15. You have investigated ways to make your business profitable? YES / NO 16. You have consulted with experienced business owners or other advisors regarding your business? YES / NO FIGURE 7.2 Nine Steps to Business ccc-kennedy_ch07_81-95.qxd 10/22/04 12:20 PM Page 86 CREATING INCOME WITH LESS TAX 87 Experienced Advisors 17. Have you identified the advisors you need for your business? YES / NO 18. Do your advisors have the business experience needed to give you good advice? YES / NO Your Experience 19. Have you been successful in this kind of business before? YES / NO 20. Have you been successful in a similar business? YES / NO Past Profit 21. Has the business been profitable in previous years? YES / NO 22. If so, has the profit been enough to make it sensible to continue? YES / NO Asset Appreciation 23. Is the business building assets that will have future appreciation? YES / NO Scoring the Test For each of the nine sectors, rate how strong your case is as to business purpose on a scale of 1 to 5, with 5 being strongest. For the weakest elements, what can you do to strengthen your point? Businesslike Manner 12345 Time and Effort 12345 Depend on Income 12345 Reasonable Losses 12345 Effort to Make Money 12345 Experienced Advisors 12345 Your Experience 12345 Past Profit 12345 Asset Appreciation 12345 What can you do to improve your position? FIGURE 7.2 (Continued) ccc-kennedy_ch07_81-95.qxd 10/22/04 12:20 PM Page 87 Employee or Independent Contractor? More and more people are leaving their middle management jobs and becoming independent contractors in the same field. But what does it re- ally mean to be an independent contractor? Who gets to decide if you are a legitimate independent contractor or really are just an employee in disguise? And which is better? If you’re an employee, you will pay more tax. And your employer will pay more tax. The better way for the smart employee and employer is to legiti- mately set up independent contractor status. If you’re the business owner paying the independent contractor, you no longer will be responsible for withholding taxes and making Medicare or Social Security contributions. Your work space requirements may go down, along with your equipment costs. Work hours lost due to sickness or accidents can be reduced. If you’re the new independent contractor, you can now take advantage of tax loopholes and home loopholes that you never could take before. Twenty IRS Factors for Independent Contractor Freedom First, here is what the IRS says about the independent contractor issue: It does not matter that a written agreement may take a position with regard to any factors or state that certain factors do not apply, if the facts indicate otherwise. If an employer treats an employee as an in- dependent contractor and the relief provisions discussed earlier do not apply, the person responsible for the collection and payment of withholding taxes may be held personally liable for an amount equal to the taxes that should have been withheld. So, making sure that you properly structure your business work require- ments is the first step. Fortunately, the IRS has provided with some guidelines on how to do just that. The IRS looks at 20 key factors to determine whether a person is an 88 LOOPHOLES OF THE RICH ccc-kennedy_ch07_81-95.qxd 10/22/04 12:20 PM Page 88 independent contractor or an employee. Each guideline has been num- bered and is followed by the TaxLoopholes response in italics directed to the employer of an independent contractor. If you’re the employee, help your employer prove the independent contractor status. 1. Instructions. An employee must comply with instructions about when, where, and how to work. Even if no instructions are given, the control factor is present if the employer has the right to control how the work results are achieved. TaxLoopholes response: You can control the work product standard, but not the way in which the work is performed. Give your independent contractors a goal and a time frame to complete that goal, and that’s it. Don’t tell your inde- pendent contractor when, where, or how to work. 2. Training. An employee may be trained to perform services in a particular manner. Independent contractors ordinarily use their own methods and receive no training from the purchasers of their services. TaxLoopholes response: Don’t hire novices whom you will have to train. You can make this a condition of your independent contractor service agree- ment so that if someone claims to be qualified to perform a task and is not, you can void the contract. Remember, a good independent contractor shouldn’t need much, if any, training. 3. Integration. An employee’s services are usually integrated into the business operations because the services are important to the success or continuation of the business. This shows that the employee is subject to direction and control. TaxLoopholes response: Don’t integrate your independent contractors’ posi- tions or services. Don’t include the description of contracted services in your company’s personnel manual and don’t give your independent contractors any responsibility for supervising or overseeing in any way your regular employees. 4. Services rendered personally. An employee renders services personally. This shows that the employer is interested in the methods as well as the results. TaxLoopholes response: This one is a bit tougher. Usually your independent contractor will be performing the services personally. Try to mitigate this point by CREATING INCOME WITH LESS TAX 89 ccc-kennedy_ch07_81-95.qxd 10/22/04 12:20 PM Page 89 making sure your independent contractor operates through a properly formed le- gal entity. Bear in mind also that this may not be, on its own, enough to satisfy the IRS. So, make sure that you meet as many of the other factors as possible. 5. Hiring assistants. An employee works for an employer who hires, supervises, and pays workers. An independent contractor can hire, supervise, and pay assistants under a contract that requires him or her to provide materials and labor and to be responsible only for the result. TaxLoopholes response: This factor goes hand in hand with Factor 4. Be- sides making sure that you contract only with independent contractors who work through properly formed legal entities, make sure that you contract for the entity to provide the service, and not for a particular person connected to that entity. This works especially well when your independent contractor com- pany has more than one individual providing services through it. 6. Continuing relationship. An employee generally has a continu- ing relationship with an employer. A continuing relationship may exist even if work is performed at recurring although irregular intervals. TaxLoopholes response: Make sure that you enter into separate contracts with your independent contractors for specific tasks. A long-term “anything re- quired” contract is a surefire way to draw IRS attention. If your independent contractor is performing a repetitive task, keep your contract lengths short (i.e., require a new contract to be signed every three months). 7. Set hours of work. An employee may be required to work or be available full-time. An independent contractor generally can set his or her work hours. TaxLoopholes response: Review Factor 1, and make sure that you allow your independent contractors the ability to perform the work as and when that person sees fit. Provide only a project to be done and a deadline for completion. 8. Full-time required. An employee may be required to work or be available full-time. This indicates control by the employer. An indepen- dent contractor can work when and for whom he or she chooses. TaxLoopholes response: Again, it comes back to Factor 1, and the element of control you have over how an independent contractor spends his or her time. 90 LOOPHOLES OF THE RICH ccc-kennedy_ch07_81-95.qxd 10/22/04 12:20 PM Page 90 [...]... 92 LOOPHOLES OF THE RICH 13 Expenses An employer generally pays an employee’s business and travel expenses This shows that the employee is subject to regulation and control TaxLoopholes response: Do not pay for anything other than the contracted-for amount whenever possible If you must agree to reimburse expenses, then make sure they are paid by the independent contractor first, documented, and then... case, it depends on the nature of the business services If the business works for the money, the income is earned If the business’s money earns the money, CREATING INCOME WITH LESS TAX 95 such as interest, dividends, and capital gains, the income is portfolio And if the business owns an investment that creates cash flow, the income is considered passive One loophole strategy is to change the type of income... 3 4 4 4 4 4 4 4 4 5 5 5 5 5 5 5 5 No – 2 No – 2 No – 2 (Continued) 110 LOOPHOLES OF THE RICH FIGURE 8.3 (Continued) Asset Protection 13 Your likely exposure to risk from personal acts: Publicly visible _ High risk _ 14 Your risk tolerance: Your level of risk tolerance (see Figure 8.5) 1 2 3 4 5 15 Exposure to risk from the business: How high is the. .. or wrong answers The best answer is simply what is the most comfortable for the 112 LOOPHOLES OF THE RICH owner Additionally, there are some types of professions, and types of people, that are viewed as more wealthy by the public Some people are more visible and in the public eye You might have noticed that fact yourself if you peruse the Forbes list of the richest people Some of the names you will... independent contractor status Otherwise, you’ll run the risk of the IRS questioning why the change of status was made Three Types of Income for a Business We earlier discussed the three types of income: earned, portfolio, and passive Of these, earned income has the highest tax rate And the employee with earned income not only pays the highest tax rate but also has the lowest number of loopholes available A... that the individual partners can have taxable income if the partnership makes money, even if there is no distribution of cash to the partners This is called “phantom income,” which means that if you are a limited partner, with no control, you may be required to pay tax on income that flows through to you on paper from the partnership even when there is no cash to accompany it In other words, the partnership... you can adopt the S corporation status The S corporation provides liability protection to the shareholders against acts of the business In other words, if something happens within USING BUSINESS STRUCTURES TO CREATE LEGAL TAX LOOPHOLES 99 the business, the shareholders’ other assets are safe It does not protect the business against liability Income from the S corporation flows through to the shareholders... Economic Dog There must be a business purpose to your business structure Once you understand how business structures can actually utilize tax loopholes, it’s tempting to create a whole series of business structures to change earned income into passive income and maximize the use of the C corporation graduated tax structures But the tax courts are onto that trick! They have used the expression tax tail... structures to help you make your choice These first steps may seem time-consuming, but the extra time planning the right strategy will reward you in reaching your goals faster and with more ease There are three primary areas to consider: 1 Tax planning 2 Funding sources and exit strategies 3 Asset protection Tax Planning The focus of tax planning should start with you How will the income from your business... are stuck with QPS designation, you’ll pay extra taxes if you operate as a C corporation So, the S corporation status makes sense for the QPS designated owners C Corporation The C corporation is a good business structure It is also very unique It is the only structure that is taxed on its own tax rate schedule In other words, you can take advantage of the graduated tax rate tables that are available to . case, it de- pends on the nature of the business services. If the business works for the money, the income is earned. If the business’s money earns the money, 94 LOOPHOLES OF THE RICH ccc-kennedy_ch07_81-95.qxd. amount of money you make. Change the way you make your money first and then you can change the amount of money you keep. It’s not how much money you make that counts, it’s how much money you. 12 345 Time and Effort 12 345 Depend on Income 12 345 Reasonable Losses 12 345 Effort to Make Money 12 345 Experienced Advisors 12 345 Your Experience 12 345 Past Profit 12 345 Asset Appreciation 12 345 What