This is a question I often get from higher income earners looking to minimize their tax liabilities. It’s understandable to want to keep more of our hard-earned money from the sticky fingers of the IRS, but having business losses may not always have the impact you are hoping for.
This topic can get very deep, so we are going to stay very surface level here. Not all business income is the same - The IRS considers some income as passive, other income as active. Each has its own set of guidance, regulations, and rules on how to apply the various income streams.
I cannot deduct passive loss against active income. So, a taxpayer throwing money at a business investment in which they will have zero involvement regarding their time is impossible to offset business gains from their primary business where they do devote all of their time.
In general, the IRS has thought through most ways we could easily game the system as taxpayers. It really doesn’t make sense to be able to deduct losses for more skin than one has in the game, so there is a whole section of Internal Revenue Code devoted to policing this. Originally adopted in 1976, Sec 465 addresses the At-Risk Limitations for deducting business losses.
If you invest $50k into a business venture that fails, your losses will be limited to the $50k invested. As such, the belief that one can invest in a business with the goal of continuing to lose money in excess of their investment and experience tax benefits is false.
Losses in excess of investment are not lost forever though. They can be carried forward to a time when the business does have income to offset it. I do see this commonly early on in startups. Some of the capital they have used is borrowed and as such their losses have exceeded their initial investment from owner(s). Those losses cannot be deducted during that tax year, but yield future benefits by offsetting income once the entities became profitable.
Bottom line, the IRS’s view of businesses is that they are held for profit and not a hobby. If a business goes long enough without showing profits, there can be complications with the IRS which cause you to lose all business deductions. For more information on At-Risk Loss Limitations, the link below may be helpful.
Is this actually a myth?
Truth to tell, I haven’t had anyone who is actually retired tell me this. They know the truth, which is that this myth is patently false. I have, however, had many younger people share their belief that social security and other retirement incomes aren’t taxable, a painful lesson to learn by being wrong.
How much of retirement income is taxed?
As much as 85% of your social security income can become taxable. The math of how to determine the specific amount is complicated, but essentially if you have other income streams you will likely see some portion of your social security income taxed.
The added sting comes from these earnings beings taxed a second time. Your social security contributions throughout your life came from after-tax funds either held from paychecks or paid in the form of self-employment tax. This means I paid taxes on the money paid into social security at the time I paid in, and then get stuck paying taxes on the money a second time when I receive the benefits.
Wow! That's kind of redundant. What about 401K/IRA contributions?
Most pension income will be taxed and unless your 401K/IRA contributions were all ROTH contributions, then there will be some taxes due on your distributions.
So, tax planning is important?
Tax planning for retirees with multiple income streams can be very complicated. When each person should start drawing their social security depends on a variety of factors as well as the personal philosophies of the taxpayers. There most certainly will be income taxes paid in most situations.
We always recommend working closely with your financial and tax advisor to setup the most favorable outcomes for your finances leading up to and during your retirement years. This is best accomplished with in-person planning, but if you prefer to research for yourself the following link may be helpful:
https://www.thebalance.com/tax-planning-strategies-for-retirees-3193492
Whose fault is it if your tax advisor files your taxes incorrectly?
In most all cases, you are responsible for what is on your
tax return, whether you prepared it or not.
There are a lot of assumptions taxpayers often make about what their
accountant, advisor, or tax preparer is or isn’t doing for them.
I have met prospective clients who believe that the accountant is on the hook if the income and expense information they provided to them is found out later to be inaccurate by the IRS. This is not accurate, if information provided is inaccurate, that is on the taxpayer to remedy.
What happens if the error was the cause of an "honest mistake?"
I know people who became victims of honest mistakes on their tax returns who were greatly surprised when the IRS still expects them to pay the correct amount, even though they didn’t make the mistake. So maybe having Crazy Uncle Joe prepare your tax returns isn’t as safe as you thought?
What should business owners and individuals know about tax liability?
The bottom line here is that your tax liability is YOUR tax liability. There most certainly can be relief from IRS penalties if the mistakes resulted from relying on bad advice (such as from a tax preparer or even the IRS), but the income tax itself will still be owed.
This also doesn’t mean you have no recourse against egregious errors or gross negligence from the accounting firm who prepared the returns. In this case however, the taxpayer still owes the IRS and must separately take legal action to try and recoup from the offending party the damages they caused.
While we are not qualified to give legal advice in any way, but for more information on tax liabilities stemming from accountant errors, the following link might be helpful.
https://www.marketwatch.com/story/what-to-do-if-your-accountant-botched-your-tax-return-2018-04-05
How it works
It is possible to deduct any loss a business incurs from the income for that year, a common practice amongst most small business entrepreneurs. It is common for business ventures to fail to make a net profit for long periods after startup. A famous example of this is Facebook, which was unable to make any profit for years, even after attaining a reputation as a multi-million-dollar corporation.
High-income earners are also looking for ways they can minimize their tax liability. Not every business income is similar. Therefore, they may consider some of the income to be passive while declaring other income to be active. However, each option has its own set of guidance, regulations, and rules.
If business losses exceed the income from all the sources in that year, it is defined as a net operating loss (NOL).Even though it is not desirable to lose money, a net operating loss helps to reduce the tax liability for the relevant year and the future. However, you cannot deduct what you have as a passive loss against your active income. Therefore, it is impossible to offset all of the business gains from the first business where they do not dedicate all their time.
If a business is operated based on a partnership or corporation model, an entrepreneur's share of the business' losses can be passed through the business to the individual's return. Hence, the losses are deducted from personal income using the same technique as with a sole proprietor.
On the other hand, if one operates the business as a limited company, business losses belong to the corporation, which means they cannot be deducted from a personal return.
If someone invests $50,000 in a business venture that fails after a while, then the losses will be limited only to the $50,000 invested. However, the losses that are in excess of the investment are not lost forever. They can only be carried forward to a time when the business will have an income to offset it. This type of scenario is generally experienced in the early stages of startup ventures.
In this case, some of the financial resources that business owners have used will be borrowed. This operation is performed such that their losses are found to exceed their initial investment from the shareholders. These losses cannot be deducted during that tax year, but they can be postponed for future benefits by offsetting income once the business becomes profitable. In fact, it does not make any sense for the losses to be deducted when the business is not stable for tax returns.
You save money on taxes if you file separately from your spouse.
Background Information
In practice, particular scenarios exist where one can save money on income taxes. An example of this is marriage.
For a couple to be classified as being married by the IRS, the following conditions must be met:
- Couples must be lawfully married.
- The couple must live together within the state.
- They have yet to be officially registered as divorced due to a lack of maintenance forms or a final verdict.
The Truth
The origin of this myth can’t be pinpointed, but many believe it has probably gained prominence from a couple who were successful in reducing their tax costs through these means.
All married couples usually have the option of choosing a method for filing their tax returns—jointly or separately. The myth is that separating your tax filing returns will save you a lot, but this is not always the case. By filing separately as a married couple, you cut the deductions for IRA contributions while eliminating possible reductions, such as child tax credits and other tax breaks.
A partner may pay less to the IRS by filing individually when both spouses work and earn the same amount of money.If having compared the tax to be paid under separate and joint filing statuses, couples may discover that by combining their earnings, then they may fall in a higher tax bracket.
There are situations where the exception may be valid. One fact that remains is you will pay less in taxes filed jointly as a couple. In doing so, you lose certain credits and gain deductions, such as the child tax credit (CTC), adoption tax credit, earned income credit, student college tuition credits, or loan interest deduction.
Why couples prefer filing separately
Splitting the tax bill is also associated with tax liability between spouses. This is the most common reason why married couples prefer filing taxes individually. There are multiple valid, legal reasons why couples would want to split tax liabilities, especially when one or both spouses own businesses. There are also times when a spouse may be uncomfortable with the other’s tax principles and would prefer to safeguard themselves from potential tax complications; thus, filing separately can become an option.
If a divorce is being considered or pursued, however, filing separately will possibly minimize any complications with the IRS after the divorce has been passed.
Need for caution
While you look for strategies to reduce your income taxes, it is essential to be careful while taking tax advice from friends and family who are incompetent to do so. Even though the intentions are often good in most cases, one can still be misguided. They can cause you a lot of grief in the form of lost time, energy, and money.
Relying on advice from a cousin, for example, won’t get someone out of penalties from the IRS, since his or her advice may turn out to be inaccurate.
There is a wildly popular- and misinformed- belief that high school and college students and minors do not have an obligation and are not required to file and pay taxes. There are some truths to this particular assumption, however, it is not entirely accurate. There are certain minimum income and maximum age requirements established as to not wrongfully tax and impede on the financial situation of young individuals.
Being a full-time student is not a sufficient enough circumstance to completely exempt an individual from filing an income tax return. Any income received or finances used for tuition must be reported to determine if any federal taxes are to be paid or returned. Scholarships, grants, and fellowships are classified as tax-free resources if the amount received is used for tuition and supplies. Any portion of those resources apportioned to living expenses must be claimed. Often times college campuses will provide resources and consultations to help students file their taxes. Alternatively, online software is available as a quick solution for filing an income tax return.
There are many factors to consider when filing taxes while in college. The first step is to determine your dependency status; if you are claimed as a dependent by an adult you cannot make claims for yourself. Dependent status is typically dropped at the age of nineteen, however, parents can claim dependent children in college until they are twenty-four years old. As a dependent, there must be a clear distinction and no overlap between claims made by the parents and the individual. It is also important to know which tax forms are needed to complete an income tax return. W-2 forms can be obtained from an employer to indicate the amount of taxes withheld during the tax year. Tuition information is documented in the Form 1098-T, provided by the student’s college. Optional education credits such as American Opportunity Credit can be determined in the Form 8863. Lastly, the 1098-E form exists to show interest paid on certain student loans.
There exists a minimum income amount received by students that is necessary for the income to be subjugated to taxation. As of 2018, the standard deduction for all individuals is declared to be $12,000. This means that a received income of $12,000 or less will end up being non-taxable, and these students will be exempt from filing a tax return. The majority of students who work have some amount of federal taxes held from their checks. While they may not be required to file if make less than determined $12,000, they are not eligible to receive a refund for the amounts withheld from their paychecks. Filing is hence not mandatory but is often favored in instances where returned taxes are profitable.
Investment incomes available to minors and young adults are also subject to taxation. This income includes portioned amounts of money delegated in trusts and assets like estates, savings account, stocks, and bonds. Child income from interest and dividends of investment are also subject to taxation. If the child receives $2,100 or more in investment income they are required to file and may be subjected to the tax rates of their parents.
The taxation code in which part of a minor’s net unearned income can be taxed at the federal income tax rates is deemed the ‘Kiddie Tax’. However, this is an unfavorable tax because the trust and estate rates are unlike the rates individuals which can prove to be costly for minors without any earned income. The Kiddie Tax applies to individuals that are below the age of nineteen. Similar to the rules of student income tax return filing, college students under the age of twenty-four are classified under the Kiddie Tax and must report any of their unearned incomes.
The Kiddie Tax is calculated by adding the amount of unearned income to the amount of any earned income. The standard child deduction is then subtracted to determine the total amount of taxable income. This income is then taxed at regular rates if it exceeds the $2,100 income threshold. The Kiddie Tax is obviously inconvenient for individuals without any earned income. Consulting with tax professionals or college campus tax advisors is often beneficial in these situations to determine any available strategies available for reducing the burden of this tax.
Details of the aptly named ‘Kiddie Tax’ linked below:
https://www.marketwatch.com/story/new-tax-law-makes-dreaded-kiddie-tax-more-expensive-2018-09-24
Filing taxes is described as being a voluntary action, but its origins are uncertain, likely from a variety of resources and situations. The Form 1040 Instruction booklets use the term ‘voluntary’, but this does not mean that participating in the filing of taxes is voluntary. In light of this expression, many people have taken their opposition against this proclaimed voluntary action to the highest tax courts and have summarily found themselves facing steep fines and imprisonment. Individual taxpayers’ claims refute the necessity of voluntary action and make misinformed assertations that are eventually disproved by the Internal Revenue Service and government courts. These inappropriate contentions are subject to legal punishment and provide an example of dishonesty among some taxpayers.
The term voluntary, or voluntary compliance, refers to taxpayers’ abilities to calculate their own tax liability, rather than having the government do this for them. Of course, if what you report is disputed, then the IRS will calculate your liability for you and demand you pay the difference plus penalty and interest. Similarly, the description as voluntary refers to the voluntary compliance with the tax code that is evident by tax reporting and paying. Cooperation is described as the honest and accurate filing of annual tax returns. Any form of classified taxable income must be reported, and although this may seem involuntary, the action of filing taxes is prompted by individual free will. Further, accurate identification and information is required when completing income tax return forms.
As stated in the tax codes and laws, any taxpayer who has received more than a statutorily determined amount of gross income in a given tax year is obligated to file a return for that tax year. This means that with whatever taxable income is received and whatever kind of employment it is received through must be noted and used to file a tax return for that year. Many taxpayers participate in a form of tax fraud in order to reduce their income tax liability. This liability corresponds with the amount of taxable income that a recipient obtains during the tax year. In turn, these dishonest filers report no income and therefore no tax liability despite the existence of both. Filing a so-called zero-return while receiving a taxable income is considered an illegal action. Likewise, another method of manipulation is exhibited when taxpayers intentionally provide false information on their W-2 tax filing forms. The wrongful and inappropriate filing of taxes demonstrates dishonesty and noncompliance with the law which becomes problematic for the economy. Paid taxes are apportioned to different government institutions like police and firefighting units and to resources like the maintenance of road conditions.
A reported dispute, as mentioned above, is managed by the Internal Revenue Service, commonly called the IRS. Further, any taxpayer who fails to file a tax return will be penalized in a civil court or face criminal liability charges. In these instances, the IRS will prepare the tax returns on behalf of the individual. Another common contention against the IRS is the false belief that an administrative summons can be ignored and avoided. However, the IRS is authorizes to summon a taxpayer to appear in court to testify and provide documentation of taxable income. Many individuals also assert that any financial compensation received by an individual for a personal provided service is not taxable. However, taxable income includes any wages, salaries, bonuses, commissions, and tips received in exchange for any provided service, whether personal or professional.
Whether you agree with the taxation system or not, this is the current implemented law and the IRS is a collection agency that has an extraordinary power evident in the established tax codes and laws. The law compels individuals to voluntary file income taxes and provide verifiable personal information by threatening government penalization. Tax evasion and nonpayment can result in fines and often times imprisonment. Despite the establishment of these existing codes and laws, many senseless taxpayers search for loopholes in the system. They often suggest that taxation is not a mandatory responsibility since it is described as being voluntary. However, this is obviously a misinformed assumption. Taking a senseless tax argument to the courts is hence not recommended; history has demonstrated that the IRS has little tolerance for facetious oppositional tactics and prevails as the authoritative contender. Further, actively resisting and disregarding the law identifies an individual as a criminal whose taxes will continue to require monitoring and verifying in the future. Below is a link to the IRS guidance on and evidence against past frivolous tax arguments.
Your children can actually earn up to $12,200 each as of 2019 without being subject to Federal income taxes. This provides a wonderful way to effectively take assets from the business into the family with an added tax benefit.
The business gets to deduct the payment of wages, but the recipient child may not have to pay any income on this income, keeping 100% of it within the family unit.
Be mindful, the $12,200 limit before income is taxable doesn’t apply only to the wages paid, but also if the child has other wages or even some investment income that counts toward that limit of $12,200. If they have more combined income than this, they will be subject to some income tax.
The reason for this is simple – All taxpayers get a standard deduction from their income of $12,200. If you make $12,200 or less, then your taxable income is $0.
Creating the income for your children shouldn’t be a sham or fake job, there really needs to be an employee-employer relationship. Remember, there are plenty of opportunities here to teach your children about the virtues of employment, getting something for nothing really isn’t one of them.
Using the money paid to fund a ROTH IRA can be another value-added strategy, while also teaching the virtues of saving for the future. The taxpaying child could let that money grow for 45-50 years until their own retirement age, and $1,000 invested at age 15 could be worth $20,000 - $80,000 at age 60, depending on the interest rate earned. ROTH IRA’s grow tax-free and come out tax-free, so you can create a powerful tool with exponential capabilities for your children.
If you would like to explore utilizing this family wealth creation strategy for your family, reach out to us for a free consultation. We can explain all of the ins and outs, and even recommend some financial advisors if you need help opening the ROTH IRA’s.
Should I file my tax return even if I don’t have the money to pay?
One of the most common tax problems I encounter is having unfiled tax returns. There are a lot of reasons why this happens, but many of them come from misconceptions held by the taxpayer. Without a doubt, the most common reason I have been given for the unfiled returns was the taxpayer not believing they have the funds to pay the amount due. Out of fear and hoping the problem could be dealt with later, the situation often snowballs and can end with you owing a lot more than you would have.
In almost every case, you should be filing your tax returns on time, whether you can pay what you will owe or not. There are many penalties you can be charged by the IRS, the highest of which is for not filing your return.
Up to 25% of taxes owed as Penalty for Failure-to-File your return
Failure to file your tax return on time, even one day late, will have a minimum penalty of 5% of the amount of taxes you owe. This means if you are one day late filing your return and owed $10,000, now you owe $10,500.
The penalty increases at 5% per month late until hitting a maximum of 25%. This means if you file your tax return late by more than five months and owed $10,000, now you will owe $12,500.
This is quite a steep and easily avoidable penalty. Can you imagine how easily this can pile up with multiple years of unfiled returns?
Up to 25% Penalty for not paying your taxes on time
Not paying your taxes on time carries its own set of penalties. While the penalty for not paying the tax can also be 25% of the amount of unpaid taxes, it accrues much slower, at 0.5% per month.
If you pay your taxes 6 months late, you are looking at a 3% penalty, and this is substantially less than the 25% penalty you would get on top of this if you also filed the return 6 months late.
How do Extensions affect the Failure-to-file and Failure-to-Pay Penalties?
Most people are away, and they extend their tax filing deadline by 6 months. By filing a simple form, you get an extra 6 months before your return is due.
What many people fail to understand is that the date your taxes were due to be paid does not get extended. Many taxpayers are surprised when filing – after their extensions – and paying their taxes due to receive letters from the IRS, demanding penalties and interest.
Are there any exceptions for these penalties if you file and pay late?
Yes, there are two main ways a taxpayer can get relief from these penalties.
1) The IRS will waive these penalties if there is a reasonable cause for not filing and/or paying on time.
There is a set of circumstances and situations provided by the IRS, where it will consider waiving these penalties. Below is a link to their website, where they discuss in detail the subject.
https://www.irs.gov/businesses/small-businesses-self-employed/penalty-relief-due-to-reasonable-cause
2) Penalty abatement - Even if there is not a reasonable cause for the delay in filing and paying your taxes, you may be able to get the IRS to abate (remove) some or all of the penalty.
If you have filed and paid on time the preceding 3 years, have currently filed all required tax returns and paid or made arrangements to pay all taxes due, then you can get a one-time abatement of penalty. More information on penalty abatement in the link below.
Bottom line – it is much more expensive not to file your tax returns on time than it is not to pay them on time. Deal with getting them filed first; there are many ways to address paying the amounts owed over time. Don’t let a bad situation get worse.
If you have unfiled tax returns or are concerned about getting your taxes filed in time for the upcoming deadline, reach out to us today for a free consultation.
Auto deductions can essentially take 2 separate paths – actual expenses or the standard mileage rate.
Standard Mileage Rate
The simplest method for calculating your vehicle-related deductions is to use the standard mileage deduction. This method is pretty simple to use and, from my experience, is the right choice for 80-90% of the people I have visited with.
You are eligible to count any miles you drive for business-related purposes. In 2018, the standard mileage rate was 54.5 cents per mile. With gas south of $2.00 here in Oklahoma City, that’s a nice-sized deduction. If you get 25 miles per gallon, then you get a $13.00 deduction for each gallon of fuel used.
In order to claim this deduction, you do need to keep a mileage log. Your mileage log should include the date, start time and end time, the activity involved, and the beginning and ending of odometer readings. If the IRS examines you, you can expect them to want to see validation of your mileage. There are plenty of apps and easy ways to do this now.
When using the mileage method, you don’t get to deduct any other automobile expenses. If you drive 10,000 business miles, then 10,000 x $0.545 = $5450 is your deduction. Once this method is chosen, you are not allowed to deduct any other expesenses. If you’d prefer to deduct other items, you need to use the Actual Expenses method.
Actual Expenses
This method can be more complicated. Instead of taking a mileage deduction, you would deduct the various actual expenses from the automobile usage, including:
• Gas and Oil
• Maintenance and repairs
• Auto insurance
• Auto loan interest
• Registration
• Depreciation
Depreciation is where this method can become a little tricky. Depreciation is how you recapture the expense of purchasing a vehicle. A vehicle purchased for $30,000 can be depreciated up to $30,000 over time. Purchasing an automobile for $30,000 doesn’t mean you get to deduct the whole $30,000 in one year, though in some cases you can. The type of automobile and even the amount you purchase the car are factors in what options you have in depreciating the vehicle.
ProRation of actual expenses – If the automobile used is not 100% business use, then you don’t get to use 100% of the actual expenses. For example, 50% business use means you get to use 50% of the actual expenses as the deduction. Business use % is often determined by miles.
Which is Better?
The Standard Mileage Rate method is better in the majority of instances, though certainly not in all. If you drive a vehicle 20,000 business miles and it was 100% business use, you would be looking at a mileage deduction of $10,900.
By using the actual expenses method, if you bought that same vehicle in the tax year for $40,000, you could depreciate that vehicle as well as the fuel, maintenance, and insurance expenses.
Can I switch methods?
In short, no. Once you pick a method, you are stuck with it. If you are a business with more than 5 vehicles, then you have to use actual expenses for those vehicles.
This article is intended to provide you with general information; it does not constitute any type of tax advice. The views expressed in this article are those of the author alone. For recommendations related to your overall financial and tax status, get in contact with our CEO, Josh Morphew – josh@insightful.tax.