Secrets of the Rich
In the past two issues, we have covered the Seven Proven Steps that the rich use to make and grow their money. In the first edition, we covered the overview of the system and debuted the seven steps:
- Create a Business.
- Discover Your Hidden Business Deductions.
- Pay Your Taxes.
- What's Left Goes Into Real Estate.
- Real Estate Income Comes Out Tax-Free.
- Buy a House the Right Way.
- Make Your House Give You Money.
Last month we discussed how simple it is to have a business in the IRS's eyes. This is a critical first step. Don't skip it! You must have a legitimate business in order to take advantage of the steps shown in this edition.
Discover Your Hidden Business Deductions
My firm, DKA, encourages our clients to look for "hidden business deductions" from their personal expenses. Don't go buy something just for the tax deduction! I've heard people say, "I'm going to buy this new equipment because I'll get a tax deduction." But, when asked, they admit they really don't want or need the equipment. They are just looking for the tax break. That's an example of looking for cents but forgetting common sense. You don't want to spend a dollar when you'll just get 40 cents back (assuming 40% federal and state blended tax rate). That means you're losing money. If you don't want what it is you're buying, don't buy it just for the tax deduction! Our philosophy is to instead look for what you are already spending money on. What can you turn into a legitimate business expense?
What Qualifies as a Business Deduction?
First, let's review what the IRS considers to be a business expense: Internal Revenue Code Section 162(a). This Code section says, in just 27 words, what you can deduct for your business:
"There shall be allowed as a deduction, all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business."
We know what a business is from Step One in last month's edition, but what does it mean to be an "ordinary" or "necessary" expense? These two words are further defined by the IRS as:
Ordinary Expenses: Expenses that are normal, common, and accepted under the circumstances by the business community.
Necessary Expenses: Expenses that are appropriate and helpful.
That pretty much leaves the door wide open! Anything can be a deduction, in the right circumstances. Keep good track of your deductions and then make sure you review the information with your tax preparer. The following three most missed business deductions are excerpted from Loopholes of the Rich – How the Rich Legally Make More Money and Pay Less Tax. Note that this is just a small amount of what could be legitimately deducted from your business income. In fact, I list over 300 possible business deductions in Loopholes of the Rich!
Commonly Overlooked Business Deductions
Following are the business deductions common to almost all business. Take the time to review the list and make a note of ones that might be applicable to your business.
- Auto Expense
There are many ways to deduct the cost of an auto. And, that can be confusing.
- You can buy the car in your business. The business can deduct the cost of maintaining the car (gas, oil, repairs, tires, car washes, etc.). Plus, the business can deduct the interest portion of any payments and then depreciate the car, using the limits established by the government.
- Your business can lease the car. A "luxury automobile," (defined as anything worth more than $15,500), will have a small amount that will not be able to be deducted. For example, a vehicle worth $31,500 will have to have $260 of the lease added back in the first year.
- You can buy or lease the car yourself, and be reimbursed for mileage at the current rate. In 2003, the amount is $0.36 per mile. The payment is deducted from the business income, but is not considered income for you.
- If you buy a vehicle that is over 6000 GVW (Gross Vehicle Weight), the "luxury" automobile limitation does not apply. In this case, your business can depreciate the vehicle just like it was any other piece of capital equipment. That includes being able to make a Section 179 deduction of $100,000 (!) right up front.
- Bad Debt
Bad debt is a commonly misunderstood deduction. It is most overlooked at the personal level, though, and not at a business level. An individual can write off loans made to someone that have no hope of collection. An individual can also take a deduction for debt or expenses paid on behalf of others that will not be repaid. The burden of proof will be on whether the item is actually a gift. To prove a bad debt, you must attempt to collect just as you would with any other debt. I recommend that my clients first have a note drawn up for all loans and then show proof of collection attempt by sending a certified letter demanding payment.
Where most people will overlook the bad debt expense at an individual level, they will mistakenly try to take a bad debt expense deduction for a business when it is not allowed. The only way that a business can take a bad debt expense is if the income was first reported and tax was paid on it. In other words, if your business is "accrual" based, which means that accounts receivable are counted as income even if they have not been collected, then when that receivable is not collected, there is a bad debt expense. Most small businesses, however, are "cash" based, which means that income is only counted when it is received. There cannot be a bad debt expense offsetting income, because the accounts receivable income was never recognized.
- Business Start Up
There are many expenses BEFORE you begin your business. And, unfortunately, since one of the steps is setting up your accounting system, and the expenses occur first, you might forget them. Here is a checklist of some common start up expenses that you can deduct (or capitalize and deduct over 60 months). It is not complete. Use it as a memory jog for items you can deduct in your business.
- Legal expenses (will need to be amortized over 60 months). These are costs that you pay to an attorney or document preparation service to prepare the initial paperwork for your business. After the business is going, most legal fees are deductible immediately.
- Business structure set-up (cost of incorporation, etc. – amortized over 60 months). This includes the costs you pay to have special business structures set up – such as the cost of forming a corporation.
- Filing fees. These are the costs paid to the state and local agencies for the privilege of doing business and include business licenses, state filing fees, fees for lists of directors and others. The exact fees will depend on the type and location of your business.
- Accounting Fees. Hopefully, you will consult with an accountant and bookkeeper to get your books set up as soon as possible. Those costs are deductible.
- Office Equipment. There is a lot of office equipment needed for a basic office in this electronic age. Computer, printer, fax machine, phone – these are just a few of the items needed. Many people already have some of these items before starting a business. Your business can pay you the fair market value for these items from its proceeds, but you need to track the expenses first.
- Office Furniture. Office furniture can include your desk, tables, chairs, and filing cabinets, as well as art you hang on the walls.
- Cost of Investigating Business (seminars, books, travel, advisors' fees). A prudent business owner takes time to investigate and learn all they can about their business first. This can include going to seminars, buying books, subscribing to magazines, dues to professional organizations, travel to look at other businesses, and talk to advisors.
- Office set-up costs (stationery, business cards, logo design). The cost of designing a logo, setting up a web site, preparing stationery, etc., are all part of the office set-up costs.
These are just three of the over 300 business deductions that we've discovered for our clients. For a complete list, see Loopholes of the Rich.
In the next edition, we'll discuss "pay your taxes" and strategies you can use to control how and when you pay your taxes.
Diane Kennedy is a CPA/Tax Strategist and the author of the best-selling book Loopholes of the Rich: How the Rich Legally Make More Money and Pay Less Tax and co-author of the best-selling book
Real Estate Loopholes: Secrets of Successful Real Estate Investing. For more information on how to legally use the tax loopholes and make the IRS your partner, contact Diane's CPA firm, DKA, at 888-592-4769 or www.dkacpa.com. Tax law is constantly changing! Keep up to date for free by signing up for a free e-newsletter at www.taxloopholes.com