Are you interested in discovering how to legally pay less taxes and keep more of your income? In this episode, we’ll help you understand how.
Senior Financial Advisor, Patrick Lonergan explains Level 1 tax strategies and the importance of proper documentation. He offers practical write-off examples and discusses five straightforward strategies that anyone can implement immediately.
• Write off examples for tax savings
• Real estate deductions
• How to include your kids on the payroll
Sponsored by Vital Wealth
Music by Cephas
Produced by BrightBell Creative
Research and copywriting by Victoria O’Brien
Episode 002 | Level 1 Tax Planning: Opportunities Every Entrepreneur Should Consider
Welcome to the Vital Strategies podcast, where entrepreneurs learn how to pay less tax, build wealth, and live a great life. In today’s episode, we are going to outline our level 1 tax strategies. You won’t want to miss how we uncover over $350,000 of tax savings in the example we discussed.
To start off, here’s the definition of a level 1 tax strategy. The IRS gives us guidance and it doesn’t take any investment. These are the best tax deductions because they don’t require you to tie up your money to get the deduction. We look at them as good administration and bookkeeping. These are the easiest tax deductions and unfortunately many CPAs don’t take advantage of these strategies.
We don’t think that it is right that you are unnecessarily sending too much money to the IRS. So, we are going to equip you with the right information. First, let’s define a tax deduction. There are two tests we need to pass before an expense is a legitimate deduction.
First, let’s look at code section 162a. It says the expense must be ordinary and necessary. So ordinary means it has to be fair market value. If there’s related parties involved, there needs to be a qualified appraisal.
Necessary means, is it helpful for you to pay that amount? Now this is a very low bar, but it’s a standard in an audit. There are limits to section 162, such as requirement to capitalize expenses for tangible property.
So, if we look at this office building that I’m in now, it’s a fancy way of saying, I can’t write the whole thing off in year one, I’ve got to depreciate it out over time, or spread that deduction out over time. The second test is the economic substance doctrine. 77010, there’s a business purpose test that says you have to have a business purpose to have a tax deduction.
Here’s an example of how we tie these two together. I can take a trip with my wife. The expense can be ordinary and necessary, meaning I paid the market value for the plane tickets in the hotel, which were necessary for me to get there and stay at that location. But I can’t write that off because there’s not a business expense if we’re just going on vacation.
But if I attend a conference or we have an annual meeting while we’re there. That now becomes a tax deductible business expense. If the deduction fails this test, we won’t advise you to do it and you shouldn’t take the deduction. Complete and thorough documentation are critical. If you don’t have it, it doesn’t happen in the eyes of the IRS.
Having good books and records makes your tax planning easier. It helps defend against an audit if one were to ever show up. Thinking of a tax deduction, here’s some things that should typically either be owned by the business or taken as a tax deduction. If you’re a new business owner, make sure you’re getting these deductions.
Have a separate bank account for business income to flow into, and a separate credit card or debit card tied to that business bank account to help you keep track of your business expenses. You don’t want it all jammed together in your personal account. It makes it very easy for the IRS to come in and come and disqualify expenses you’re taking.
Here’s things if you own a business you should have deducted, cell phone, computers that work is being completed on, business travel, business meals, software subscriptions.
All right, we’ve got some of the basics out of the way. Let’s get into our example here. We’re going to show you an example and what tax savings would be available for each of these different scenarios, these different strategies that we’re going to outline.
So, here’s the example couple that we’re going to use. They’re married, they live in California. They own a digital marketing agency. Their net taxable income is $1 million. They have two teenage kids, age 11 and 14. They own two rental properties worth 2. 2 million. One spouse runs the business. The other manages the real estate.
Currently that would put them in the 37% federal tax bracket and 11.3% California state income tax bracket. That’s a total of 48. 3 percent tax rate for every dollar they earn over $815,000. It’s not right that we pay almost 50 cents on the dollar that we earn to the government. We’d rather keep those dollars in your hands.
So, let’s walk through some potential deductions that this couple could take. Now you won’t be able to use all of these together, because some require you to skip a smaller deduction so you can get a larger deduction elsewhere.
We’re going to start off with five strategies that we think anybody can do. You can do these on your own. Then we’re going to work on two strategies that help to get professionals involved to make sure you don’t make any mistakes. And then we’re going to finish up with real estate deductions that again, are great deductions that don’t cause you to invest any money outside of buying the real estate.
So let’s start off with these five that are just low hanging fruit, you can do on your own. 280 AG is also known as the Augusta rule. You can rent your house out for 14 days and not have to claim it as income on your personal income tax return. If your business needs to rent a venue for business meetings, employee meetings, meeting with contractors, potential clients, it counts as a tax deduction. There’s a business purpose.
This means you can rent your house out to your business for fair market value and book the deduction on the business side and not have to claim it as income on the personal side. Let’s assume you can rent your house out for $1,000. This would be $14,000 deduction in this example.
The way we verify that is we can go get an appraisal that will justify it, or we can look and get some comparables from Airbnb, Peerspace. We put together a legitimate lease, outlining the terms of using the property for the business, and we get to book that deduction. Again, documentation matters. You transfer the money from the business to yourself personally.
In that example, the $14,000 deduction saves us $6,762 that we don’t have to send to the IRS. Again, this is one of the easiest deductions you can take.
Next, we’re going to look at itemizing our home office deduction. Your home office qualifies as your principal place of business if, one, you use it exclusively and regularly for administrative and management activities of your trade or business, And two, you have no other fixed location where you conduct substantial administrative or management activities of your business.
Now, just because I go to the office every day, doesn’t mean I’m doing the administration at the office. I can be doing that at home. So, keep that in mind, and you also need to have that space utilized strictly for business in your house. It can’t be a spare bedroom that guests stay in, or your kids sleep in, and you do your work in. It needs to be solely for home office.
So, in that example, we can take everything from our property tax, mortgage interest, maintenance, housekeeping, lawn care, utilities, add all that up. If our home office is 10% of our square footage of our house, we can take 10% of those expenses and write it off our taxes, deduct it.
So in this example, we’re going to use $4,500 as that expense. That gives us $2,173.50 that we get to not send into the IRS. Again, with these two strategies alone, we’ve saved over $8,000, almost $9,000 in income tax, just by simply doing some good bookkeeping. Next, let’s put our kids on the payroll. Children, grandchildren, and even parents can be put on the payroll.
And we currently get a $13,850 deduction for the standard deduction, so we can earn that amount and not have to pay tax on that. If your kids are anything like mine, we’re spending at least $1,000 a month on their activities. Could be private school, clothes, equipment, vehicles, any of those things. You can have that money paid for by your children.
So it moves it from the 48% tax bracket in this example down to effectively the 0 tax bracket. It’s a wonderful strategy. So if we do that for both kids, that’s $27,700 that we get to deduct by running the kids through payroll. That saves us $13,379 in income tax. Again, an incredible strategy.
The next strategy we like to talk about is 132J4. It’s a pool slash athletic facility expense. You can deduct the cost of a gym or athletic facility located on your premise, operated by you, and substantially all of the use of which is by your employees, spouses, or dependents. We’ve already established that you’ve got a home office deduction.
Now if we have a pool, and we’re maintaining that pool, we pay somebody to do that. Let’s say we spend $3,000 a year, we can write that expense off. There’s $1,449. Again, we don’t have to send to the IRS. Next, let’s take a look at the pass through entity tax. The state of California says if you pay your state income tax, you don’t have to pay the federal tax on that. That’s a fantastic rule.
In this example, before any of the deductions, these clients would have paid $104,750 that would need to go to state income tax. That would save them $38,757. On the federal tax side. So again, by paying your state income tax, you get a deduction on the federal side, which is a tremendous savings. So, so far, we’ve taken the Augusta rule, home office deduction, put family on payroll, and deducted the athletic facility expense or the pool expense, along with getting the pass through entity tax.
Just looking at these strategies alone, we’ve saved almost $60,000 in income tax. Tremendous savings just by doing good bookkeeping.
Next, we’re going to move on to a couple more advanced strategies. The first one is 199A, the Qualified Business Income Deduction. This is fairly complex. We do these calculations for our clients because a lot of times they can be made in error. You have to factor in all of the other deductions you’re taking, then do the QBI deduction. It’s a critical part of the strategy.
Here we’re going to assume no other deductions are being taken. They have a $100,000 salary, $900,000 distribution coming out of the business. Now, the QBI deduction can simply be explained as you get the lesser of two numbers.
You get the lesser of 50% of the wages you pay, or 20% of the net income. So 50% of the wages is a $50,000 deduction. Okay? Because we have a $100,000 salary. 20% of the wages is $180,000 deduction. It’s frustrating to me that we miss out on $180,000 deduction. And unfortunately, we can’t take all $180,000.
But there is a sweet spot when we raise wages to get to the point where the wages and the net income number are exactly the same. In this example, it’s around $285,000 in wages. $285,000 at 50% is $142,500. That leaves us with $715,000 net income out of the business. 20% of that is also $142,500.
So those numbers match. It’s a great strategy. So instead of being limited to a $50,000 deduction, I now get a $142,000 deduction. Again, an incredible strategy that leaves us with an additional $92,857 in deduction, which saves us $44,849 that I don’t have to send to the IRS. Again, almost $45,000 just by doing good bookkeeping.
The next example is taking an S election. In this example, the client is paying all of their money on schedule C. When you’re a high income or in breaking. Probably over a half million dollars a year. We see Schedule C as: C stands for catastrophe, if all of your income is flowing through there. And here’s the reason why.
In this example, all of the money you pay self-employment tax when it comes through on Schedule C, that means $27,533 are exposed to self-employment tax. If you pay a $100,000 wage, You only pay $7,065 in self-employment tax. So we saved $20,000 just by making the S selection. It can be done in 15 minutes by sending in a form to the IRS.
It’s very simple, but we’ve had clients making over $2 million that have come into our office that we’ve met with, and all of their money is going through Schedule C. It’s an absolute waste of money, and the CPA should be held liable for that situation.
Now, we can see how the S election and the Qualified Business Income Deduction can work against each other. The S election, it makes a lot of sense to have a really low wage, so we pay a low self-employment tax. But the self-employment tax is a cheaper tax than the income tax. So, we’re happy to pay a little bit more in our QBI deduction discussion. Wages up to $285,000. Because it allows us to not have to pay all of that income tax by getting the huge deduction.
So there’s an opportunity where we have to choose which one makes the most economic sense. We work them both in conjunction together, but it still works out better to have $285,000 of wages and $715,000 flowing through on Schedule E versus all of it showing up on Schedule C. S election makes a big difference.
Now we’re going to move on to real estate opportunities. There’s four opportunities we’re going to discuss on the real estate side.
The first is a cost segregation study, which allows us to bring a bunch of the depreciation forward. With the Tax Cuts and Jobs Act, we can now take 80% of our 5, 7, and 15 year depreciation all in the first year. It’s a tremendous benefit.
In this example, we have $2 million of real estate that we can depreciate. That’ll allow us about $500,000 of deduction. Now at the state level, we have to keep it on the schedule, but on the federal side, we can take that 80 percent deduction. So our total tax savings on that $500,000 deduction is $191,000.
Again, our total tax savings on the $500,000 deduction is $191,000. It’s a tremendous benefit. We have to be a real estate professional to capture that, that benefit. If not, we’re limited to $25,000 of passive losses, which limits us to $12,000 in tax savings. There’s a huge benefit to being the real estate professional.
Next, we’re going to look at partial asset disposition study, better known as a PAD study. This also works with the cost segregation study. And if we have to make any improvements to a property. We get to write some of those off. Oftentimes we have to capitalize them, but if we do the PAD study, we can take that deduction in year one.
So, let’s assume we put a new roof on the building. It was $50,000 to replace the roof. That saves us $24,150 in money we don’t have to send to the IRS or the state. Again, a tremendous strategy. We have a client that saved over a million and a half dollars in income tax. Not as a deduction, but tax savings by using the PAD study.
He’s a real estate developer and had no idea this existed until he contacted us. Next is the 45L tax credits. These are energy efficient tax credits. If I do things like install new HVAC that’s energy efficient, windows, doors, insulation, I can take a tax credit per unit. Tax credits are better than deductions because it’s money I don’t have to send into the IRS.
In this example, they made some of those improvements and they got $8,000 in tax credits. Now, if you were able to apply all of these deductions, you would have over $350,000 of tax savings. Now, that is impossible because some of these deductions reduce or eliminate other deductions. But what if you were able to capture just 10% of these savings?
That puts an additional $35,000 in your pocket that you don’t have to pay to state and federal tax. What would that mean to your family, your business, your peace of mind?
So here’s your action steps for this episode Go to vitalstrategies.com/episode 2 and download our free summary of all of these deductions Mark, which deductions you think apply to you and talk to your CPA about how to apply these deductions And finally save tens if not hundreds of thousand dollars in tax I working through these level 1 tax strategies, don’t let another year go by and pay too much money to the IRS.
If you want help paying less tax, check out our five minutetaxmakeover.com or schedule an introductory phone call at vitalwealth.com.