Law Office of David S. Howard
David S. Howard, CPA

Separating Tax Myths From Reality

While there is a long list of tax myths, these three common myths are harder to kill than Freddy Krueger.

Myth #1: Form a corporation and save a ton of income taxes by deducting personal expenses as business expenses.

Contrary to popular belief, forming a corporation does not magically transform personal expenses into business expenses. If you have a legitimate business, then legitimate business expenses are deductible. You do not have to form an expensive corporation to get those deductions. You do have to form a legitimate business organized for the purpose of making a profit. To be deductible, the expenses must be ordinary and necessary for the type of business being conducted.

A regular C corporation can be quite expensive to maintain. Corporate books and records must be maintained, minimum annual state taxes must be paid, and an annual tax return must be prepared and filed, even if there is a loss.

If the corporation has income, it will owe taxes. To pull those taxed profits out, there may be a separate personal tax. Assets owned by a corporation which increase in value cannot be withdrawn from the corporation without paying tax on the appreciation. This applies even if you are the sole owner of the company and you are pulling the asset out to give to yourself.

It is expensive to kill a corporation, and you must agree to be personally liable for any income taxes the corporation may owe and has not paid. Even if there is a tax audit years later, you will have to pay the tax bill personally and get no tax deduction.

If you use a portion of your home exclusively for your business, then you may be able to deduct that business use. You need to allocate between the business use and personal use of your equipment, furnishings, and other items. Accordingly, many expenses you previously treated solely as personal expenses become business expenses.

This transformation does not take place, however, because you incorporate – it occurs because you start a business. You do not necessarily need to form an expensive and high maintenance corporation to run a business. An option is to be a sole proprietor and use a Schedule C on your Form1040. If you want the protection of limited liability, but do not want to deal with the hassles of having to file business tax returns, you might form a single member LLC. Get expert advice when determining your business’s form of entity.

Myth #2: If an expense is tax deductible it doesn't cost you anything.

I have often hear people say: "Let me pay the bill. It is tax deductible for me so let the IRS pay for it."

I just don't know how this works. If the person is in the 50% tax bracket and the dinner is $100 here is what happens. Meals and entertainment expenses properly documented with a receipt, recorded on a log, giving the names of all those in attendance, stating their business relationship, and stating a valid business purpose for the event are deductible up to 50% of the amount of the expense. So that means the $100 meal creates a $50 deduction. If the person picking up the tab pays 50% taxes including federal and state, then he might have a $25 tax savings. Hardly anyone pays at the 50% rate so the savings is usually less than $25.

The same goes for buying an expensive car and using it in your business. There are big limitations on the amount that can be deducted for cars that cost over a certain amount and this is not a big number. The best you can do is have your business lease the expensive car and attempt to deduct as much of the lease expense as possible. However, if the car is not used in your business and the lease expense is not deductible. Then it almost always costs a lot less money to purchase your car rather than lease.

Myth #3: An IRS audit is more daunting and painful than a root canal.

Many individuals and business owners dread the thought of an IRS audit. If they receive a notice they are being audited they fear they will be raked over the coals, lose their savings or even their business. In most cases these are needless worries.

Audits will be nearly painless if you will remember and apply these simple principles. First of all, you don’t need to deal with the IRS agent at all if you will give a power of attorney to an Enrolled Agent, CPA or lawyer. If you do choose to meet with the agent yourself then realize that he or she has no personal grudge against you. There was something on your tax return that triggered the audit and they are meeting with you to get the answers. They get just as much credit for doing a good job if they give you a refund as they get from collecting more taxes. Auditors are not collection agents. If an IRS collection agent is after you there is a whole different set of principles that apply.

Time is your friend when it comes to an audit. Do not rush the process. You may be better off granting an extension to the statute of limitations to give the auditor to finish his job without rushing. Space out your meetings to give yourself the time you need to gather the information that was requested. If you do not have all the requested information bring what you have to the meeting and then schedule a follow-up meeting to provide the balance.

Before you start digging out all your records, cancelled checks, travel logs, etc. it is better to meet with the agent and find out what triggered the audit and what specific answers he or she is seeking. Then gather the information needed to address those specific issues.

Auditors are human beings with different levels of experience, ability and personality. Many feel they are disliked and worry that you will be abusive to them. They is why your polite cooperation goes over very well. Also, your reassurance that you are an honest person who wants to be treated fairly as well as wanting to treat the agent fairly goes a long way.

At the end of the audit the auditor will write up a report that shows his or her suggested changes. You will have the opportunity to either agree or disagree. If you disagree you have the opportunity to meet with an appeals officer before you have to pay any taxes. The appeals process is very successful. The appeals officers are very experienced, technically competent, and conciliatory. They want to settle with you so you do not take your case on to Tax Court. They know when the auditor is wrong. This is a much better place to deal with the unreasonable auditor. Don’t waste your time arguing with the auditor or the supervisor. Let them write up the report and then go to appeals. The appeals officer gets his or her rewards for reaching an agreed settlement with you.

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