The Downside of Controversial Tax Strategies
As a CPA firm, we often get suggestions from clients on tax deductions they feel eligible for based on articles read or seminars attended. There exists a cottage industry of consultants who promise to lower your taxes if you engage them, but, oddly, these consultants will typically avoid actually preparing returns. Why? Signing a tax return as a preparer puts the CPA at risk too. If an audit were to be done, the preparer must provide the support documents and rationale for all deductions applied. If deductions were wrongly applied, yes, the taxpayer will owe taxes, penalties, etc but the preparer will suffer too. Penalties, and even loss of licensure, can reign down. This is why we find it ironic that the consultants will call your CPA “timid,” but then will sit on the sideline when it comes to tax preparation.
Below are some of the most common "strategies" from consultants along with our take on the applicability and legality:
STRATEGY: Create a Management Company to Leverage C-Corporation Tax Rates
Their Recommendation: If you have a small business, you can create an additional management company and register it as a C-Corp. Your small business will pay the management company $50,000 for "managing" or "marketing" of your legitimate small business.
One of the advantages to the C-Corporation structure is that the first $50,000 of income is taxed at 15%, which is usually lower than a business owner’s individual tax rate. There are also certain deductions that a C-Corporation can take that are not eligible to the flow through entities that many businesses use.
On the surface this sounds like a great strategy. The problem we see is that the IRS taxes C-Corps that are Personal Service Corporations at a flat 35%, not the flat 15% as advertised by consultants. They IRS defines a personal service company as “any activity performed in the fields of accounting, actuarial science, architecture, consulting, engineering, health, law and the performing arts.” So, the question is, how comfortable do you feel that the IRS would not consider management services to fall under the broad definition of consulting services? I’m not sure I’d bet on it. Furthermore, the IRS has an important “substance over form” doctrine, which means you can technically follow the law, but if the substance is to avoid taxes, then they can override your position. So, how comfortable do you feel that they would allow the deduction if you were magically performing management services only for companies that you own and the result was this was saving you taxes?
STRATEGY: Rent out Your Home to Your Business
Their Recommendation: Have your small business rent your personal home out for 14 days a year at $1,000 a day for "officer's meetings" or "company retreats."
The IRS has a “vacation home” rule that states so long as you rent a property for 14 days or less that you do not have to pay any income tax on those earnings. The purpose of this law is to let people occasionally rent a property without having to go through all the compliance hoops of documenting the income and expenses.
Many of these tax consultants will say you should rent your home to your business for 14 days and reduce your income by $14,000 or so. While we do feel, this can be a legitimate deduction the key thing here is to have great documentation to justify why your home was being used. What was the purpose of the rental? How did you determine your rental rate? Why was the home needed versus your existing place of business? Simply going, “mark me down for $14,000” doesn’t cut it.
STRATEGY: Deduct of Home Fitness Facility Including Your Pool
Their Recommendation: Build out that home gym, put in a pool and have your business pay for it. It counts as a exercise and wellness equipment for use of the business or practice.
Yes, businesses can deduct the cost of exercise and wellness equipment they place in the business. The question becomes, “does this count if I put it in my home?” Some of these advisors seem to think so stating that you “just need to make it available to your employees” and this will suffice as business use. If you legitimately open up your home to all of your employees and have them use the equipment, then yes, this would apply. But think about that for a second. Do you want your employees stopping by your home to use the gym? Do you have liability insurance that would cover any injuries that they might incur? Understandably, you could see the IRS denying this deduction.
STRATEGY: Kids on the Payroll
Their Recommendation: By paying your children (increasing employee wage expense), you can reduce the net income of your small business (reducing taxes) but still receive the benefit of the income in your family.
We have no issues with children on the payroll and think it’s not a bad idea to get them some exposure in the business. Where we take issue is paying your newborn baby $6,000 to be a model on your website. We get that your child is cute, but you can probably get a model for a fraction of the cost. We have had clients take this deduction and they have received letters from the Social Security Administration asking for detailed descriptions of these infant’s jobs. You think the IRS is getting wise to this? We do.
STRATEGY: Home Office
Their Recommendation: Claim a home office and therefore write-off a portion of your home expenses (mortgage, utilities, etc) against the business revenues.
This is a great deduction for self-employed people who have no principle place of business and it should be used. However, what if you already have a principle place of business outside your home? While the IRS will allow a deduction, there is this caveat:
"You use it exclusively and regularly for administrative or management activities of your trade or business. You have no other fixed location where you conduct substantial administrative or management activities of your trade or business."
We think this makes it tough to take that deduction, unless you essentially replicate what you are doing at your principal place of business at home.
In closing, we certainly don’t want clients overpaying on taxes, but we also want to give them realistic advice and prepare taxes in a manner that will sustain an audit. Some suggestions by consultants hinge on you never being audited. Sure, anything is deductible so long as your crazy enough to try it, but you better have the money reserved to pay the taxes, penalties, and interest down the road. This is not our recommended approach to taxes or life. When we sign off on our clients tax returns, we are putting our names, livelihoods, and reputation on the line and ensuring that we stand with you.