How Can I Pay The Least Tax?

Here are three suggestions you can do to help yourself pay the absolute minimum tax. They may seem tedious at times but saving tax dollars is a great way to embolden your finances (and improve your attitude). In the IRS tax classes I teach I always recommend that everyone:

  • Get familiar with all their potential tax deductions
  • Keep every deductible receipt and
  • Log every deductible mile (see Mileage below).

For example, if you are self-employed and you drive to pick up office supplies, you can deduct:

  • your office supplies expense AND
  • your round trip mileage (as much as 58½¢ in 2008).

The more you learn about what you can deduct, the better records you will keep and the less tax you will pay. People who do not develop these habits usually pay more tax than they need to. For other ways to pay less tax see Tax Planning.

Sell My Home (Home Owner Gain Exclusion — IRC §121):

If married taxpayers filing jointly have owned and occupied their home as their principle residence for any two of the last five years, they can exclude up to $500,000 of Long Term Capital Gain. Single individual owners and Unmarried Joint owners can each exclude up to $250,000 with the same qualifications. Taxpayers cannot claim this exclusion more often than every two years or claim a loss on a personal residence. If they haven't owned and occupied for the full two years there are some special circumstances (health, employment, etc.) that may allow a reduced exclusion. For more see pages 9-17 of IRS Pub 523 — Selling Your Home.

Sell A Real Estate Rental (IRC §1250):

Generally speaking, the tax on a rental property sale would be the sum of these calculations:

  • 15% of Long Term Capital Gain (Sales Price minus (Original Basis + Improvements)).
  • 25% of IRC §1250 Unrecaptured Gain ((Original Basis + Improvements) minus Adjusted Basis).
  • If rented before 1987 — Ordinary Income Tax on Accelerated Depreciation.

Example: Taxpayers Al and Bob are both in the 33% tax bracket and both sold apartment buildings for $1.2M (line 1) after purchasing for $600,000 (line 2) and immediately adding $100,000 in improvements (line 3). Al started renting his units after 1986, took $400,000 in straight-line depreciation (line 5) using the current MACRS depreciation system and had a $300,000 adjusted basis (line 7) . Bob started renting his units before 1987, took $400,000 in straight-line depreciation (line 5) plus $100,000 in accelerated depreciation (line 6) using the previous ACRS depreciation system and had a $200,000 adjusted basis (line 7) (Note: ACRS was eliminated in 1987). So the only difference is that Bob took the extra $100,000 in accelerated depreciation and therefore paid less tax during his depreciation period. Here is a table and the tax calculation (line 8) that summarizes these transactions:

Al's Unit:
Rented
After 1986		 Bob's Unit:
Rented Before 1987		 Tax Calculations
1. Sales Price $1,200,000 $1,200,000 Long Term Capital Gain Tax:
$75,000 ($500,000 x 15%)
2. Purchase Price $600,000 $600,000
3. Improvements $100,000 $100,000
4. Basis (2+3) $700,000 $700,000
5. Straight Line Depreciation $400,000 $400,000 Unrecaptured Depreciation Tax:
$100,000 ($400,000 x 25%)
6. Accelerated Depreciation N/A $100,000 Ordinary Income Tax:
$33,000 ($100,000 x 33%)
7. Adjusted Basis (4-5-6) $300,000 $200,000
8. Total Tax On Sale (1+5+6) $175,000 $208,000 $75,000 + $100,000 (+ $33,000 for Bob)

Reducing W-4 Payroll Withholding Allowances:

Of course there is no single answer to this question. People who are purchasing their first home have different tax situations just like everyone else. But overall there are four advantages to purchasing and owning real estate and all of them revolve around additional income from reduced taxes:

1-More take-home pay because owning a home will reduce the taxes owed (everything else being equal). Specifically, the tax return allows deductions for Property Taxes and Mortgage Interest paid (on loan amounts up to $1M).

Example: Generally, if the taxpayers are in the 25% tax bracket and paid $2,000 in Property Tax and $10,000 in Mortgage Interest during the year, they will pay $3,000 less tax at the end of the year than they would have paid otherwise (25% x $12,000 = $3,000). This means they can bring home $250 more per month ($3000 / 12) by increasing their withholding allowances.

2- If the taxpayers finance with a fixed mortgage rate their payments will seem high in the beginning. But after a few years they will realize they could not rent their home (from someone else) for the loan payments they are still paying. So they are paying less for a better place than what their monthly housing cost could provide if they were renting.

3- In conjunction with the previous; as they make their mortgage payments they build equity in their home as they pay off their loan. They owe more on their loan now than they will later and if they stay, they will pay off their loan and make no payments at all.

4- Most important for some: when the markets are favorable their home will appreciate in value.

Tax On ISOs (IRC §421):

There are several strategies that can lower the tax on ISOs and they all have to do with long-term investing i.e., longer than one year. And all long-term investing has to do with timing. Everything the taxpayers do will depend upon whether they firmly believe their stock will increase in value after the exercise date. If so, and certain conditions are met and they hold the stock longer than a year they will pay less tax (overall) by paying more Long Term Capital Gains (LTCG) tax (at 15%) and less Ordinary Income tax (at their ordinary income tax rate). This is the goal; to pay the absolute least amount of tax.

One strategy is to exercise the ISOs as soon as possible after the grant date. This strategy can reduce taxes on the long-term investor in two ways: it will decrease the potential Alternative Minimum Tax (AMT) in the year of purchase. And it will shift more of the taxable gain into the LTCG bracket and away from Ordinary Income.

Another ISO strategy (that can be used in conjunction with the previous) is to exercise the ISOs in January or February of Year-1 and sell in say, March of Year-2. This strategy also provides two advantages for the long-term investor: it will facilitate payment of the AMT due in Year-1 from the proceeds of the March Year-2 sale. (Recall that the Form 1040 for Year-1 is due April 15 of Year-2.) And the gain will still qualify for LTCG treatment thus will be taxed at the LTCG rate of 15%. For more see pages 9-12 of IRS Pub 525 — Taxable and Nontaxable Income.

Employee or Independent Contractor:

This is a very important question for employees and employers and the answer can be complicated. In addition, the IRS and FTB apply different sets of criteria and sometimes (but not too often) do not always agree with each other. Here is a slideshow presentation from an Employee or Independent Contractor workshop that I give as a volunteer instructor for the IRS and FTB which contains much of the relevant information. For more see pages 3-9 of IRS Pub 15A — Employer's Supplemental Tax Guide.

Home Office Deduction (IRC §280):

The Home Office Deduction (HOD) (IRS Form 8829) is one of the tax areas that is most closely scrutinized by the IRS because it is harder to qualify for than people understand. In addition there is another consideration that people should know before choosing the HOD that I mention towards the bottom of this subject.

First, if you are an employee your home office will qualify only if it is used for your employer's convenience (not yours).

Generally you can deduct business expenses that apply only to the part of your home that is used regularly and exclusively:

  • as your principle place of business
  • as a place of business normally and frequently used by your patients, clients, customers, etc. as your normal place of business or
  • in connection with your trade or business if it is a separate structure that is not attached to your home.

There are a two exceptions to the Exclusive Use rule: 1- Day Care facilities and 2- places where inventory or product samples are stored.

If you qualify for the HOD you can deduct a percentage of your Property Taxes and Mortgage Interest (or Rent), Repairs, Utilities Services, Casualty Losses and Security System.

To calculate the percentage, divide the square footage of your Home Office by the total square footage in your home. If you are run a Daycare Provider business in your home you will need to further multiply that percentage by number of hours you provide services divided by 8760 (the number of hours in a year).

Here is the other issue I see that most people do not consider before taking the HOD:

  • The HOD rules require that you depreciate the business portion of your home’s adjusted basis (the same percentage as the square footage calculation). In the near term the depreciation gives an additional tax write-off. But long term (when the house is sold) the owners will pay a 25% recapture tax on the depreciation that was taken (IRC §121 (d)(6) and Reg. §1.121-1(d)(1)). For example, if you have taken $10,000 in HOD depreciation you will pay $2,500 in additional tax when you sell (25% x $10,000). You can postpone this tax by claiming a new HOD in the newly purchased home but then more depreciation will be taken on the new home and more tax will be due eventually.

The good news is you do not have to give up any part of your IRC §121 Home Owner Gain Exclusion ($500,000 for Married, $250,000 for Single filers) when you sell your home as long as your Home Office was a part of (not separate from) your home. But in this example you can see that there would be $2,500 in additional tax to pay when the home is sold just because the HOD was claimed. I think this explanation should help people see that the HOD can be less of a tax advantage than what is commonly perceived. For more see the IRS Pub 587 — Business Use Of Home.

Mileage:

There are four types of deductible mileage fees (parking and tolls included) and you should keep logs for each type of mileage deduction you claim. See the table below for the current deductible mileage rates. If your mileage is reimbursed but for less than the IRS allowance you can deduct the remainder in accordance with the rules.

Employment (IRC §162): If you use your car for your work you can only deduct your mileage fees during work (not commute mileage). But on days you work more than one job you can also deduct the mileage fees between jobs. Remember that mileage fees deducted on Schedule-A will be subject to the 2% Miscellaneous Itemized Deductions floor (exclusion). Most but not all vehicles are eligible for the standard mileage deductions; one exception is taxi cabs.

Medical (IRC §213, §217): Here is a deduction being missed by many tax preparers. And for some taxpayers the additional taxes paid are noticeable. You can deduct ALL medical related travel in addition to your medical expenses. This would include round trip mileage, parking and tolls for the Doctor, Dentist, Optometrist, Hospital and Infirmary, the Test Labs, the Pharmacies, Physical and Mental Therapy and Rehabilitation, etc., etc. The list for deductible medical travel is extensive. But remember that all medical deductions are subject to the Schedule-A 7.5% Medical Deductions floor (exclusion).

Moving (IRC §213, §217): If you move to a new job or new job location (see Moving Expenses) you can deduct the mileage, parking and tolls between your old home and new home on Line 2 of IRS Form 3903.

Charitable (IRC §170): If you drive mileage for charitable organizations you can also deduct all mileage fees including the to and from distances.

Deductible Mileage Rates
Employment Medical Moving Charitable
Jul-Dec 2008 58½¢ 27¢ 27¢ 14¢
Jan-Jun 2008 50½¢ 19¢ 19¢ 14¢
2007
 48½¢ 20¢ 20¢ 14¢
2006
 44½¢ 18¢ 18¢ 14¢
Sep-Dec 2005 48½¢ 22¢ 22¢ 14¢
Jan-Aug 2005 40½¢ 15¢ 15¢ 14¢

Moving Expenses:

Non-reimbursed Moving Expenses are deductible on IRS Form 3903 if certain conditions related to your new job or job-transfer are met. Deductible expenses include mileage, parking and tolls and the cost of moving and storing your household goods for up to 30 days. Meals are not deductible.

Your new job location must be 50 or more miles farther away from your old home than your old job location. In other words if you had not moved, would your new job commute be 50 or more miles longer than your old commute?

If you earn wages you must also work in your new job area for at least 39 weeks during the next year after you move. If you are self-employed you must work in the area for 78 weeks during the next two years. There are several exceptions to this time-requirement including being laid-off and disabled. For more see the IRS Pub 521 — Moving Expenses.

College Scholarship:

Many taxpayers assume that all scholarships and grants are tax-free. In order for these funds to be tax-free the federal financial aid formula considers the student's income as well as the parents tax returns and income not assets is the largest factor when considering financial aid qualifications.

Another assumption is that colleges and the IRS look at scholarships in the same way. But things are more complicated and these assumptions are not always true. For colleges, scholarships and grants are defined as funds used for the benefit of the student based on need.

The IRS defines sholarship and grants by whether the funds are spent on qualified or non-qualified expenses. Qualified expenses include Tuition and Fees and required books, supplies and equipment (if they qualify). If you buy your class books from a friend the books do not qualify for deduction. If you buy them from the college bookstore they still may not qualify unless the college has a written policy requiring all class books be purchased from the college.

College Savings Plans, i.e., IRC §529 Plans have a broader definition of qualified expenses and therefore also allow room and board. Withdrawals from these plans are tax-free as long as them money is spent as required.

But we need to remember that tax-free money scholarships, Grants and §529 Plans cannot be combined with the available Education Tax credits that are applicable only to money spent from some kind taxable income. Here is an article from the National Association of Enrolled Agent's EAJournal Magazine with more information. And if you would like to do further research please see IRS Pub 970.

What is the best way to Organize My Receipts?

1-First I recommend using this process every month because it will simplify your year-end close. Also, it does not matter what your business entity is (C-Corp, S-Corp, etc.,) the expense categories are pretty much the same for all businesses.

2- Organize (divide) your individual receipts into separate piles, by category as shown in part two of the 1040 Schedule C. Let's use the January Office Supplies expense receipts as an example.

3- Separate the January Office Supplies expense receipts into their own stack sorting them by date from January 1 to December 31. Then add them up using a 10-key adding machine to find the total amount spent.

4- Keeping in the SAME order as shown on the 10-key tape paperclip and include the 10-key tape on the top of the pile. Write "January Office Supplies" on the 10-key tape. Place the pile including the tape into a envelope marked "Office Supplies".

5- Then go to the next pile (category) and repeat the process until all receipts have been categorized, added up, labeled and put into their respective envelopes.

NOTES: If you have a category that does not appear on the 1040 Schedule C (such as "Website Expenses") create a pile for those expenses and add them up the same as previously explained and put them in their own envelope. For receipts that occur only once or twice during the year you can create a "Miscellaneous" category and add them up as described.

How long should I keep my records?

There are all kinds of lists and opinions out there that tell you how many years you should keep each type of record and document. Some say keep this record for four years and that record for seven years, etc. But I believe that all of these lists are based upon keeping paper records which take up a lot of space and are not “reader-selective”.

But we are in the age of technology and my recommendation is to SCAN all your documents and copy to a password-protected CD. The space-saving advantage is huge and each document can be scanned and labeled individually which enables easy retrieval. And most people can copy all of their records on to a single CD.

In addition, to really make it really easy on yourself, ask your Tax Professional to provide you with this CD when s/he finishes preparing your tax return. I provide this service to all of my clients who have gone paperless and at very little additional cost. It's easy for me since my office is already paperless and I am seeing and scanning their records for my archives anyway as I prepare their return.

Audits:

Most Taxpayers do not like to go through an audit (although I have met exceptions). And I think it is safe to say, most Tax Preparers do not like audits either at least when they prepared the return that is being audited.

How does a return get selected for an audit?

  • Someone may report that the taxpayer is filing a false return. This information may come from a disgruntled employee or ex-spouse.
  • When returns are processed, they receive what is called a Discriminate Inventory Function (DIF) score, like an index number based upon the tax calculations contained within your return. The higher the DIF score, the more likely your return will be audited and assessed more tax.

During an audit the IRS is usually looking for unreported income and/or overstated expenses and they use different techniques for different tax situations as a means of discovery. A simple example would be an SSN match of your reported wages, interest and dividends on your tax return with those same amounts reported to the IRS by your employer, bank and broker. This match is simple and straightforward and if you report less income than your employer reports for your SSN you will usually not get audited but will receive an IRS CP-2000 letter saying you owe more tax.

What happens during an Audit? The IRS will usually check your bank deposits against your reported income. They may also perform a lifestyle audit on those who have shown little or no income but seem to have no trouble accumulating the most expensive material possessions.

Regarding the Small Businesses and Self-Employed (SBSE) that report their income on a Sch-C, the IRS may also:

  • Compare your income and expenses to other businesses similar to yours.
  • Look at your personal expenses to see if any were included with your other business expenses.

Also, if you do not show a profit for many years the IRS will want to verify that you really are a for-profit business i.e., intending to make a profit rather than just enjoying a hobby which would limit losses to income received. The IRS criteria for establishing a profit motive include:

  1. Whether you carry on the activity in a businesslike manner.
  2. Whether the time and effort you put into the activity indicate you intend to make it profitable.
  3. Whether you depend on income from the activity for your livelihood.
  4. Whether your losses are due to circumstances beyond your control (or are normal in the startup phase of your type of business).
  5. Whether you change your methods of operation in an attempt to improve profitability.
  6. Whether you, or your advisors, have the knowledge needed to carry on the activity as a successful business.
  7. Whether you were successful in making a profit in similar activities in the past.
  8. Whether the activity makes a profit in some years, and how much profit it makes.
  9. Whether you can expect to make a future profit from the appreciation of the assets used in the activity.

What is the best way to prepare for and win an audit? My first suggestions would be to submit accurate returns; know where all of your deposits come from and keep receipts for all of your deducted expenses. Some people submit returns that seem very aggressive at first pass but in many cases there are special circumstances that are understandable and therefore allowable.

And of course I would also suggest you do not represent yourself at an audit. People representing themselves tend to be nervous when talking with auditors and often volunteer too much information which can extend the audit and lead to additional taxes and assessments on top of the original audit amount. Here is another article from the NAEA EAJournal Magazine that provides more information for the Tax Payer as well as the Tax Professional.

Tax Representation:

Tax Representation may be needed during or after an Audit. What usually happens is that the IRS finds something in the tax return (too little income, too many expenses, etc.) that they do not believe is true and they send the taxpayer an audit letter. Many taxpayers feel comfortable representing themselves in an audit. This is fine if the dollar amount is small but please remember that the IRS (who listens) is very similar to sports announcers (who talk) in that they seem to get paid by the word. The point here is that if the you get nervous when talking to the IRS you may say more than you should. And usually the more you say, the more tax you pay.

Also, as a taxpayer you have a Bill of Rights (to fair representation, timely proceedings, etc.) that is usually respected by the IRS. But anyone can make a mistake. Can you be sure all of your rights have been considered and preserved when you represent yourself? Can you be sure the tax calculations are correct?

With a very few minor (and temporary) exceptions, only Enrolled Agents (federally licensed by the US Treasury) or Attorneys and CPAs (state-licensed only) can represent clients before the IRS. If significant tax principles or dollars are at stake you may be better off seeking the advice of a Tax Professional.

Installment Agreements:

The IRS Installment Agreement (IA) is sometimes needed after an audit or bad tax year when the taxpayer cannot pay the amount he owes in one lump-sum payment. It is pretty straight-forward and the amount of the monthly payment is easily calculated. To calculate the payment you simply divide the total amount owed by the number 60 (the number of months you will be making payments). You can pick the day of the month when each of your payments will be due and interest is charged during the pay-off period. There is also a $154.00 IA fee that is credited in the first payment received. If you miss a payment you should immediately contact the IRS and let them know and pay a reinstallment fee to renew your IA. If you don't renew the whole IA process starts over again. IAs can sometimes be used in conjunction with an Offer In Compromise to enable the taxpayer to pay off whatever lesser amount has been negotiated between the taxpayer and the IRS.

Offers In Compromise:

If you have ever researched Offers in Compromise you have probably heard some pretty wild claims for how little the IRS will accept when you owe so much. There are “Tax Professionals” out there who advertise you can “Settle with the IRS for only pennies on the dollar” or “...40% of what you owe”. Most of the time these companies make these claims so they can charge you thousands of dollars up-front as they insist that your chances of paying less are excellent (but of course no written guarantees). They will also tell you they are extremely aggressive and that when they “get tough with the IRS” the client always ends up paying less. These advertisements sound wonderful but are they really true? Does this even make sense?

First of all no one (not even the IRS personnel) likes dealing with aggressive people so in most cases the aggressor just ends up alienating him or herself AND the client from the IRS which usually results in less cooperation from the IRS rather than a negotiated smaller settlement amount.

Second the IRS works with these settlement issues all the time. They are used to processing settlement requests and do so using the Internal Revenue Code which contains the required legal guidelines and parameters. Does it make sense that aggression at the IRS will make them bow down and break the rules? I would suggest you deal with the IRS in an honest and professional way rather than alienate a person who really does have the power to ruin your day.

So what’s the answer? Does the IRS ever settle for pennies on the dollar? The IRS will readily admit that these types of settlements have occurred. One example they give is about a very old, terminally ill person with no money who wanted to settle with the IRS. This person owed many thousands of dollars but the IRS did in fact settle for just over one-hundred dollars. Can you see why?

The truth is Yes, the IRS will settle for less under the right circumstances. They look at each case individually and if you have the right circumstances, then you may be able to settle for less, too.

When you are ready to settle with the IRS (or any other taxing authority) the IRS will ask two questions:

  • Can you pay now? They will figure this out by looking at your current financial situation.
  • Do you have the potential to pay later? Potential is based upon your age, health, disabilities and past earnings history. Young people who owe, who have jobs, are healthy and not disabled have a tough time convincing the IRS they have no potential to earn the amount due.

So if the answer to either of these questions is Yes, then it will be more difficult to get the IRS to settle for less than the full amount due and your next step may be to consider in Installment Agreement.

Alternative Minimum Tax (IRC §55):

In 1966 there were 155 wealthy taxpayers (with over $200,000 in Adjusted Gross Income) who played the Tax Game by using certain tax exemptions, deductions, credits and losses to end up paying zero tax dollars. This news got into the papers and there was such a public outcry that Congress enacted the Alternative Minimum Tax (AMT) in 1969. As it turns out, there is some ironic humor in the name Alternative Minimum Tax because none of the taxpayers who pay AMT see it as an alternative or as a minimum tax.

But the name denotes an alternative method of calculating a minimum amount of tax due. The result of every taxpayers AMT calculation is compared to their “regular” tax calculation and the result showing the higher tax is the amount to be paid.

The AMT calculation adds back the exemptions, standard deduction (or many of the itemized deductions) and other (regular) Tax Preference Items to find the Alternative Minimum Taxable Income and then subtracts a standard AMT Exemption Amount which is assigned by Filing Status. If the resulting sum is less than or equal to $175,000, it is multiplied by 26%. If it is more than $175,000 it is multiplied by 28%. Finally, if the multiplication result is more than your regular tax calculation, you owe the AMT amount.

The biggest problem with AMT is that Congress never indexed it for inflation so each year there are more and more, lower and lower income families learning (the hard way) that they have to pay AMT. For more please see Alternative Minimum Tax 101.If you are worried that you may have to pay AMT you can find out in 5-10 minutes using the (latest available) IRS AMT Assistant.

Married Filing Separately (IRC §6013):

Generally, there are more tax advantages for married couples using the Married Filing Jointly (MFJ) than Married Filing Separately (MFS) status. But there are situations where filing as MFS may be preferable. One MFS advantage is it avoids joint liability for the taxes due on the returns. When using the MFS status each spouse is liable only for the tax showing on their separate return.

Another example might be if a spouse owes back taxes or child support the taxing authorities may confiscate the entire tax refund on the return and apply it to the back taxes owed.

There are certain situations when using MFS will reap larger refunds, e,g., if one spouses has large medical deductions or deductible expenses subject to the 2% limit on Schedule-A.

In community property states (like CA), one-half of the community income must be reported on each spouse's MFS return, meaning the spouse with less income could pay more tax than their proportional share. In ID, LA, TX and WI even separate property income of one spouse is considered community income to divide on MFS returns.

For more MFS information see IRS Pub 504 — Divorced or Separated Individuals.

ITINs — Individual Taxpayer Identification Numbers:

Yes, I can help. But my first questions to clients about ITINs are actually about Social Security Numbers. Have you talked with the Social Security Administration (SSA)? Can you get a Social Security Number (SSN)?. Quoting from the Form W-7 ITIN Application Instructions, you should “Complete Form W-7 only if the Social Security Administration (SSA) notifies you that an SSN cannot be issued.” So first talk to the SSA and apply for a Social Security Number. If the SSA cannot issue you a SSN, then apply for an ITIN.

I Can Do My Own Taxes:

I agree. Many people can do their own taxes. And to be honest most tax professionals are not particularly interested in doing simple returns. The fact is, if we aren't saving the client time, money and effort (and headaches) we won't be in business. And I am sure that some self-filers pay too much because they miss (or under-claim) legitimate deductions that would lower their tax. And if you pay too much in most cases the taxing authorities will not send you that refund. But they will certainly let you know if you pay too little.

“My return must be correct because the IRS accepted it, right?” I would ask whether the tax return is correct or if the taxpayer may have paid too much tax.

We review previously filed returns free of charge. We'll ask you some questions, find any deductions that were missed and see if it's worth amending the return. Overall, it is not unusual for us to find $1,000 or more in additional, legitimate refunds. In fact, reviewing returns is one of the two ways we obtain most of our clients. The other is by referral.