Ten Tax Mistakes to Avoid
Tax Planning Gives You Control of Your Outcome
By Teresa Bilsky
Most all investors, business owners, and even individual taxpayers have experienced that sinking feeling of receiving a letter from the Internal Revenue Service or reviewing their tax return with different results than they expected. Your rental property lost money, so why aren’t you seeing the savings in taxes? Or perhaps you received a penalty letter citing some obscure tax code that you were expected to know!
Though there is a wealth of information available (some accurate, some that could land you in jail, some that used to be accurate but is no longer so, and some that is comprised of lots of half-truths), the bottom line is that you are expected to know and understand the laws. Penalties sting, but the real issue that taxpayers are wasting millions of dollars on are missed opportunities. So, where do you begin? Begin with the basics.
1. Missing Filing Deadlines
Filing deadlines are absolute. Missing them creates penalties that may not be deductible as an expense. For example, 1099-NECs are required to be filed by Jan. 31 regardless of submission method. Penalties range from $50 to $290 per form. Though there is not a deadline for obtaining the W-9 tax information needed to complete the 1099-NEC in a timely manner, we recommend that businesses obtain a completed W-9 prior to any contractor payments.
2. Federal Tax Extensions
Extensions are available to allow for the accurate reporting of tax transactions as well as required disclosures. However, money is due when money is due. Extensions do not apply to the payment of tax. Avoid costly penalties and interest by knowing how much you owe by the due date. The failure to file/failure to pay penalty is the federal short-term rate plus 3%, compounded daily.
3. Estimated Tax Payments
These payments are due in April, June, September, and January and should equal 25% of the required minimum amount. You often hear these payments referred to as quarterly tax payments though there is humor in that Congress apparently cannot count in threes.
The time between Jan. 16 and April 15 is used to complete the calculation of the actual tax due. Payments are due with the return or extension filing by April 15. Business owners receiving a W-2 from their entity may meet this requirement with withholding regardless of the when, or how many times a payroll is received during the year.
The law treats W-2s as having been paid equally throughout the year. Missing those due dates by even one day subjects that portion of the tax to the failure to file/failure to pay penalty. This is such a common penalty and common waste of money that there is a box for it on the personal tax return, form 1040.
4. Tax Liability
The IRS announced that beginning in October 2023, the interest rate for underpayment or late payment of tax will increase to 8% in addition to the 5%-10% late payment penalty. Generally, the required minimum tax is either 100% of your tax liability from your prior year return or 90% of the current year liability.
For an Adjusted Gross Income over $150,000, you need to pay 110% of the prior year or 100% of the current year to reach Safe Harbor. The Safe Harbor date is Jan. 15. Safe Harbor means meeting this required prepayment which grants you the January to April time frame to complete your total tax estimate. Many states follow the same time frame and concept.
5. Holding Period
Oh, what a difference a day can make. Closing on a sale held 365 days or less is taxed as ordinary income. The 2023 highest rate is 37%. For long term capital gain treatment, the holding period is a year and a day. Capital gains are taxed between 0%-20%. The additional 17% in tax for that one day is a lot of your money.
6. Real Estate Professional Rules
The “Good” and the “Bad.”
The Good — Real Estate Professionals are not subject to passive activity loss limitations (PAL) on their rental activities. Nor are they subject to the 3.8% Net Investment Income Tax.
The Bad— they are subject to the 15.3% Self-Employment Tax on rental activity profits. You must understand the annual election rules.
To qualify, 750 hours must be dedicated to real estate activities AND more than 50% of service income must derive from those activities. Paying off the mortgage on a rental property may cost you more than you think you are saving.
7. Tracking Business Activities
Accounting for income and expenses is essential to saving on taxes and for avoiding or repeating costly mistakes. Many business owners use personal money which is never visible and rarely remembered when recapping activates, once a year.
With the top tax rate at 37% and the Self-Employment Tax at 15.3% for a total of 52.3%, EVERY dollar matters. Tracking expenses goes beyond saving taxes, it also provides feedback on areas where you may be bleeding money in small amounts that add up but are not easily felt during your day-to-day activity.
Properly accounting for your expenses includes recording non-cash transactions such as depreciation, recording deductible portions of mortgage payments and so on. Some transactions should be tracked even though the tax benefit is limited or disallowed in order to have a complete understanding of how your business is performing.
8. Use Entities
There are over one-million words in the US Tax Code. Use them all
Entity structures are designed to help with various issues including taxes. Understand the differences and optimize the opportunities to report the very same activities and very same numbers on different pieces of paper for very different outcomes. Also understand when the entity is completely ignored by the IRS. Most importantly, using an entity goes beyond forming it.
A business entity must have its own ID and its own bank account. Track and report its own specific transactions. Treat them as a separate person. This is your new best friend. Plan together, be in business together and call-in favors.
A business entity is the best one-sided relationship of your life.
9. Spending Money to Save on Taxes
One of the most common mistakes in tax planning and one of the most popular advertising techniques by retailers, is Section 179 and Bonus Depreciation. Buy a new car, buy more equipment, buy, buy, buy to save on taxes.
Accountants giving this advice should be ashamed of themselves and business owners need to be aware of when it is a good decision and when it is hype. When a business has a need for a new piece of equipment, then considering the tax implications may be crucial. However, when the entire purpose of the purchase is to “save on taxes” … remember before you sign on the dotted line… that seven-year note on that new shiny $75,000 truck is a reduction of taxable income not a tax credit. You do not save $75,000 in taxes; you save the amount of your effective tax rate. If your effective tax rate is 18% (18 cents of every dollar earned is paid back in taxes) then you save $13,500. You pay the entire note regardless of the tax savings. Bonus depreciation is 80% in 2023, down from 100% in prior years and Section 179 has limitations.
Buy assets when they make sense for your business not for a fractional tax savings.
10. Tax Compliance vs. Tax Planning
Tax Compliance Season is Jan. 15 through April 15. This is the time of year when tax professionals convert your business decisions from the prior year into the language of tax also known as a tax return. Tax Planning Season is Jan. 1 through Dec. 31. Planning is done during the year of the activity or in many cases the years prior to the activity.
Tax planning is more than just saving on taxes; it includes planning for long term financial goals, estate transfers, retirement, business exit strategies and so on. The advantages equate to saving money, taking advantage of financial opportunities that are only acquired through tax planning, and a peace of mind that comes from having a plan with measurable results.
Understand that tax preparation and tax planning are two different skillsets. Tax planning gives you control of your outcome.
In a nutshell, spend money only to build your business, track your success, optimize the laws for your benefit and know the outcome before the Compliance Season rolls around. If this sounds like a lot, that is because it is.
Tax laws change often through Congress, regulations and court rulings. For the tax year of 2020, the laws changed the last week of March 2021, after millions of tax returns had already been filed.
Keeping up with changes, phaseouts, court rulings and so on is much more than preparing a tax return. It is a constant game of financial Tetris. The pieces keep falling and changing shape with the same goal of making them disappear. Tax Planners align your game pieces to make the tax disappear, thus allowing you to keep more of your money to grow.
