Welcome to Chris Bird’s Tax Tips! Be sure to check back regularly to be sure you take advantage of the latest tax strategies.

1. HIRING YOUR CHILDREN TO PERFORM WORK IN YOUR BUSINESS
2. IF ELIGIBLE, CONSIDER ENROLLING IN AN IRC 105 MEDICAL INSURANCE/REIMBURSEMENT PLAN
3. UTILIZATION OF THE HEAVY VEHICLE WRITEOFF
4. MAKE SURE YOUR ACCOUNTANT IS AWARE OF THE "REAL ESTATE PROFESSIONAL RULES" IF YOU OWN RENTAL REAL ESTATE
5. CONSIDER INCORPORATING AS AN S CORPORATION TO SAVE SOCIAL SECURITY TAXES
6. A SNAPSHOT OF THE TAX BILL FOR 2003 (PDF)

Tax Tip number one

HIRING YOUR CHILDREN TO PERFORM WORK IN YOUR BUSINESS

Why you ask? Because they are going to get to your pocketbook anyway! And it is an excellent opportunity to teach them the value of a dollar, while keeping the IRS at bay through the legitimate use of family in a family business.

Some pointers that have survived IRS scrutiny:

1. The children actually have to work!
2. Pay them consistently, and don’t wait till Christmas to do it!
3. Pay them according to what you would pay someone else to do it.
4. Documentation is the key to success, so keep detailed records.
5. Issue a W-2 at year-end and file a return for the child, even if no tax.
6. Don’t listen to your accountant that it is too much work.

In 2002, the standard deduction is $4700 and in 2003 it will be $4750. This is the amount that can be earned tax-free by every single person in the country, including each of your minor children. This does not mean that you can’t pay each of them more than that amount; moreover the number merely serves as a threshold of the non-taxable amount. Wages are earned income, so the “kiddie tax rules” do not apply, and the wages paid to the children are therefore taxed at their own rate, presumably the new 10% tax rate that came into being in 2001.

Example:

Wages paid to 13 year old child $6200
Less: Standard deduction for 2003 (4750)
Taxable income $1450
Tax (10% x $1450) $ 145

While for the parents:
Wages paid to the child $6200
Tax Savings (40% x $6200) $2480

For a net saving to the family of $2335

There literally is no downside to this technique, other than the slight additional paperwork involved. The minor child is exempt from workers compensation issues in most states, as well as federal and state unemployment taxes. Parents with a little financial planning in mind should consider investing up to $3,000 of the wages in a ROTH IRA for the child for future use.

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Tax Tip number two

IF ELIGIBLE, CONSIDER ENROLLING IN AN IRC 105 MEDICAL INSURANCE/REIMBURSEMENT PLAN

For those of you lucky enough to be covered under a spouse’s employer provided group medical insurance plan, consider yourself lucky and this topic is not that relevant to you. However, for those of us in the room that are paying dearly for medical insurance, the question and tax issue of getting the best deduction for these costs is of pivotal importance. On top of that, for the roughly 14% of you in this room today that have no medical insurance, obtaining the insurance coverage is of first importance, and having the IRS partially subsidize the cost through tax deductions is the second issue.

The IRC 105 medical plan.

This is not a government insurance plan, in fact I wish it were. It is merely an IRS approved method of getting the biggest tax savings that you can, if you are eligible and you are willing to “jump through the hoops” in terms of paperwork.
The three basic requirements for using this technique are:

1. You must be married. Sorry singles, but I did not write this law.
2. You must be paying your own health insurance.
3. You can be self-employed under any business form, except S corporation. This means that you can be a C corporation, a sole proprietor, a partnership, or a Limited Liability Company (LLC).

In order to qualify, the self-employed individual must hire their spouse as an employee and pay wages commensurate with the work performed. By doing so, the employer spouse can be covered under the health insurance of the employee spouse and the entire amount of health insurance premiums plus out of pocket unreimbursed medical expenses are deductible as business expenses on the business tax return. The key to this issue is that the expenses are deductible on the business tax form, which means that the deduction will save both income taxes as well as social security taxes, and possibly state income taxes. The alternative to this is claiming the deduction on the front page of the 1040, which in 2002 is a deduction of 70% of the medical insurance premiums and in 2003 this goes to 100% of the medical insurance premiums.
If your accountant is unaware of this type of plan/technique, have them contact Agri/Biz Plan a 1-800-626-2846. The average tax savings from using this technique is:

$1800-$3000.

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Tax Tip number three

UTILIZATION OF THE HEAVY VEHICLE WRITEOFF

The vehicle must have a gross vehicle weight rating (GVWR) in excess of 6000 pounds. This number can be found on the driver’s side door production plate sticker. The typical vehicles that qualify are Suburbans, Expeditions, Navigators, Durangos, many of the luxury SUV’s, most full sized pickup trucks etc. In no way in this list meant to be inclusive of all vehicles that meet this weight requirement nor is this list meant to guarantee that a listed vehicle will qualify. A prospective purchaser must inspect the production plate sticker on the driver side door to guarantee the qualification. Remember, only vehicles with a GVWR in excess of 6000 pounds qualify. And also remember that no car as you understand a car qualifies for this deduction. Only SUV’s and trucks basically qualify.

Advantages

1. Save $10000-$15000 in federal taxes in the year of purchase. (You must own the vehicle to claim the deduction, not lease, but you can be making payments on an auto loan and still qualify.
2. If you hit another car with one of these, you will be in better condition than they.
3. This deduction is basically the same regardless of when in the year you acquire the vehicle. (Except for midquarter depreciation-no big deal)

Disadvantages

1. These vehicles have the most incredible stereo systems so you can’t hear that terrible sucking sound of the fuel being consumed. Bad fuel economy.
2. Looks like a truck, and drives like a truck---my own opinion!
3. Costs a lot of money.
4. If you sell this vehicle, in a couple of years, you will pay back a lot of the tax savings, called “recapture”.

EXAMPLE
For tax year 2002: Assume the vehicle is NEW USED
Cost of Vehicle $45,000 $45,000
Assumed business % 90% 90%
Business Basis $40,500 $40,500
IRC 179 Deduction 24,000 24,000
Remaining Business Basis $16,500 $16,500
30% First Year Deduction, if New 4,950 --------
Remaining Business Basis $11,550 $16,500
Regular MACRS Depreciation (20%) $ 2,310 $ 3,300
Note: 20% assumes half year conv. Applies
Taking into account all of the above calculations, the total first year deduction would be:

NEW USED
$24,000 $24,000
4,950 ---------
2,310 3,300
Total $31,260 $27,300

Plus, in these examples, assuming a 90% business use %, 90% of all operating expenses, including gas, oil, license, washes, waxes, insurance, repairs and maintenance, interest on the loan are deductible as business expenses. The total first year deduction can easily exceed $36,000 in the case of the new vehicle and $32,000 in the case of the used vehicle.

Note: The standard mileage rate, which was 36.5 cpm in 2002, and is 36 cpm in 2003, cannot be used on this vehicle ever. And, to get the big deduction above, the vehicle must be used more than 50% for business.

The first years tax savings from this deduction can easily approach

$12,000-$16,000

Note: For regular cars, not qualifying for the above deduction, the 2002 tax law increased the first year depreciation (MACRS) deduction from $3,060 to $7,660.
However, you must claim the actual expense method on the vehicle and not use the standard mileage rate.

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Tax Tip number four

MAKE SURE YOUR ACCOUNTANT IS AWARE OF THE “REAL ESTATE PROFESSIONAL RULES” IF YOU OWN RENTAL REAL ESTATE.

In so many of the real estate seminars that I teach, participants always complain that their accountant is not letting them deduct all of their expenses, and resulting losses, from the ownership of rental real estate properties. This “nondeduction” of legitimate losses for those that qualify constitutes, in my opinion, malpractice on the part of the accountant. One of the key benefits of owning operating real estate properties is the deduction of legitimate losses in order to offset income from other sources. These losses constitute legitimate “tax shelters” for persons in the real estate profession. The governing IRS authority is IRC 469(c)(7), and is titled “Special Rules for Taxpayers in Real Property Business”.

This law has been nicknamed the “Real Estate Professional Rule” and has been in effect since January 1, 1994. So EVERY accountant should have learned this by now. In order to qualify as a real estate professional, first, the law is silent as to a requirement of a real estate license. But the law specifically does provide two tests that have to be met in order to qualify:

1. The taxpayer must materially participate more than 50% of their total personal service time in all trades or businesses during the year in a real estate trade or business.
2. The taxpayer must spend more than 750 hours of service in the real estate trade or business during the year.

Note: Real estate trades or businesses are defined by statute as:

Any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business.

In simple terms, the result of qualifying as a “real estate professional” is that all deductions, for example, interest expense, operating expenses, and depreciation are 100% deductible against the rental income generated by the property, even if the income/expenses result in a loss. For real estate investors that do not meet the definition of “real estate professional”, these rental properties are considered PASSIVE ACTIVITIES, and the deductions and resulting losses are subject to much more restrictive rules. In short, most of these latter investors are not allowed to deduct their passive losses from rental real estate unless they have passive income from other sources. These issues of Passive and Real Estate Professional are issues covered extensively in CRS Course 204.

Note: An interesting point covered by the statutes is that the activities of one spouse (as a Real Estate Professional) automatically qualifies the other spouse, so jointly owned property losses can be claimed in full.

EXAMPLE

Tom is a real estate professional, and his wife is an attorney. In 2002, Tom netted $138,000 from his real estate sales and his wife earned $125,000 as a partner in her law firm. Jointly they own 8 rental properties, which in total reflect the following amounts for 2002:

Rents $140,000
Interest Expense ($ 82,000)
Operating Expenses ($ 57,000)
Depreciation ($ 45,000)

Net Loss ($44,000)

Without the Real Estate Professional Rule of IRC 469(c)(7), this loss of $44,000 would not be deductible in the current year, and would have to be carried over to future years indefinitely until either the rental properties started showing a profit or the properties were sold. At either occurrence, the carried losses would be partly or fully deductible at that time.

Resulting tax savings in this example: ($44,000) x 35% tax rate

$15,400

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Tax Tip number five

CONSIDER INCORPORATING AS AN S CORPORATION TO SAVE SOCIAL SECURITY TAXES

This technique or strategy is not for everyone, and should be looked at only with the guidance of a competent accountant who can analyze not only the tax savings from using this strategy, but also the potential pitfalls in terms of future social security benefits and lower retirement plan contribution limits. For example, for a person who is age 30 and is aggressively acquiring real estate properties, the likelihood of receiving social security benefits (in my opinion), is small, so this strategy may be extremely attractive. On the other hand, for a person in their early 50’s who has not contributed adequately (low earnings history) to the social security system, and who is counting on benefits at age 62/65/66 etc., then this strategy is not the one to follow. This comparison simply illustrates the need for competent counsel on this matter before deciding whether to consider incorporation under Subchapter S of the Internal Revenue Code.

Two real issues arise is the decision whether to incorporate or not. The first is the issue of legal liability and the second is the issue of tax savings. Personally, I believe that a Realtors personal liability, meaning that their personal assets can be attached through a court proceeding, is great, regardless of whether the Realtor has incorporated or not. I say this for two reasons, first, that a Realtor performs personal services, meaning that their own acts will most likely be the ones that result in a lawsuit, not the acts of others, and second that most, if not all Realtors that are incorporated do not really act like a corporation. Too many time do I see commingling of funds, contracts not signed correctly etc.

From the standpoint of tax savings, the S corporation offers the opportunity to save possibly $4,000-$5,000 annually through a reduction in social security taxes. This is due to the fact that S Corporation net profits are exempt from the social security system, assuming that adequate compensation is paid to the owners/employees. The entire question, and one for which there is no clear answer, is “what is adequate compensation”. The following example compares a Realtor using a sole proprietorship to a Realtor making the same money that is an S Corporation:

Sole Proprietor S Corporation

Net Profit $100,000 $100,000
Self Employment Tax $12,800+ -0-

Salary vs. Distribution issue of S Corporations

Net Profit $100,000
Less: Salary (Determined by Realtor) (40,000)
Net Profit after Salary $ 60,000

Social Security Tax on Salary $ 6,120

Compare the $12,800+ to the $6,120 using the S Corporation, and you can see the difference. However, when all has been considered, the real annual tax savings approximates
$5.000-$5,500

Caution!!!! This technique/strategy is not without it critics. First and foremost, the IRS, in an audit, may attack the issue on the basis that insufficient compensation was claimed by the Realtor, and that $100,000 should have been claimed as salary. It is the speaker’s personal experience that this argument can be overcome through negotiation with the IRS. More important however, is the fact that few, if any, IRS audits are taking place on S Corporations. A second argument may come from your financial planner, who will complain that by taking less salary, the Realtor restricts their ability to fully fund a retirement plan. This latter argument is not without merit, so it really goes back to the objectives of the Realtor. This just emphasizes the need for a competent accountant to help in the decision making process.

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