Banking

A friendly reminder: Learn the legalities of tax deductions

Even the smartest business owners misunderstand taxes and the IRS. John McCormick offers a refresher course on tax deductions and playing by the government's rules.


My recent column, Corporate perks: What do they mean for a small firm? elicited a response from Lloyd, who got my attention because his note demonstrates just how badly some people misunderstand taxes and the IRS.

In the column, I encouraged readers to incorporate their businesses in order to take advantage of tax deductions. Lloyd wrote back, saying, "You can have it any way you like as long as you are prepared to evade tax. Corporations eventually have to pay you… You can try every trick in the book, but if you start bragging to your neighbor, or the guy still working at the corporation, their envy might incite them to pick up the phone and complain to the IRS. Everything you've mentioned is creating tax shams… Don't throw a dollar in the street just to watch the IRS throw in 25 cents.”

Here's my answer to Lloyd and other readers who may be confusing a strict interpretation of the tax laws with somehow being a tax "cheat."

Learn the rules
I mean no offense to Lloyd, but his is a common problem even among highly educated people. My cousin, a hot criminal lawyer, thinks that following IRS deduction rules is using something she calls "loopholes," as if there were something wrong with following the rules set up by the government.

I even know a corporate vice president of a fairly large company who invests in municipal bonds. That makes perfect sense because she is in a high tax bracket. What doesn't make sense is that she puts tax-free bonds in a tax-sheltered IRA.

Those are just two examples of highly-educated professionals who haven't the slightest understanding of the tax code, and it costs both of them a lot of money.

If we have to follow IRS rules when it is to our disadvantage, then we must follow them when they are to our advantage. That's how the tax code is set up—otherwise it isn't fair.

How is taking a legitimate corporate deduction any different from individuals deducting home mortgage interest? The answer is, it isn't.

Operate in a "business-like fashion"
If you ever get audited and the IRS sees that you are ignoring common practices involving legitimate deductions, they just might disallow your business as a hobby. The test for whether you have a "business" isn't whether you make money, but whether you carry on your operations in a "business-like fashion." If you ignore common legitimate tax deductions, then you aren't working in a business-like fashion.

Second, if several people have a financial interest in the corporation and you don't take legitimate deductions, you’re setting yourself up for a civil suit based on your failure to exercise proper fiduciary care.

Nothing I have described is cheating, a trick, or "evasion" in any way, shape, or form.

Lloyd pointed out that ”corporations eventually have to pay you.” Obviously, you have to get paid if you're a statuary employee, just as you pay other corporate employees. In fact, corporate officers in public administration must get paid a salary far above minimum wage, but the point is that a corporation deducts expenses first, reducing the amount paid out in salaries.

Lloyd also seems to misunderstand how corporations operate. Sure, you get paid, but the corporation doesn't have to pay all its net out in salaries. It can also pay dividends and bonuses. It can even keep some money from year to year.

If you have a successful business, you may decide to retain a significant amount of cash in the corporation to pay income taxes at a lower rate than many individuals in higher tax brackets. Read the IRS regulations and you’ll find that this isn't cheating—it's the law.

Take advantage of the law
"You can try every trick in the book," Lloyd also wrote. I agree, except these aren't "tricks." Leasing vehicles, holding board of director meetings, and so forth are standard business practices, not tricks. Some are even required by law.

Is IBM perpetrating a sham when it holds board meetings and serves coffee and snacks? No, whether they hold the meeting in Paris, France, or Paris, ME. How about Wang Labs when I worked for them and they provided free coffee for clients and employees? Was that a sham? No, it was good business.

My corporation also provides free coffee for everyone who comes in the door whether it's an employee or the FedEx driver. The cost is such a tiny fraction of the corporate gross that it's no problem and ensures great service.

These attitudes about deductions being the same as "cheating" stem from a basic misunderstanding of just what a corporation is, as well as the tax code. A corporation is not just a way of doing business—it’s also a separate entity under the law. You form a corporation, you die, the corporation continues.

In an attempt to retain high-tech employees, many high-tech firms now offer day care, paid vacations, incentives, bonuses, 401(k)s, health spas, stock options, and lots of other perks. These are reasonable expenses whether a corporation has one employee or 10,000, as long as all employees of a certain class—such as full-time—are treated the same way. If it's legal for Oracle, then a smaller corporation can and should do the same things when they make sense.

Play by the rules
Lloyd did make one important point with which I agree wholeheartedly: "Don't throw a dollar in the street just to watch the IRS throw in 25 cents." That's a restatement of a very common piece of financial advice usually phrased as, "Don't do anything only for tax purposes."

You don't throw money away just for a deduction, but if you need to do something for good, sound business reasons, you can certainly do it in a way that makes it legal to deduct the expense. Do you need a vehicle in your business? Then why use your own car when the corporation can buy a truck and expense the entire cost?

This isn't cheating on your taxes. Cheating is buying that truck from your brother and lying about it. Cheating is saying a vehicle is used solely for company business, then letting your spouse use it to go to the market and the kids’ soccer practice. Those are examples of cheating on your taxes, and in extreme cases, you can go to jail for them.

All my corporate perks are common, fully approved by the IRS, and closely scrutinized by my CPA. Different circumstances will make different deductions customary and reasonable for your business.

I urge you to play by the rules and check the IRS regulations, as I did. Anyone who tries to operate a business without a grasp of the IRS rules is going to be in big trouble down the road.
If you have a question or suggestion for John McCormick, e-mail him at siliconsamurai@usa.com. If you have a general comment, e-mail TechRepublic.

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