Lower overall taxes can be obtained by splitting income among members of a group. The next question is, “Who can make up that group?” Such a group can be composed of:
(1) Family members or relatives,
(3) Entities (e.g., trusts, partnerships, corporations), or
(4) Any combination of the above three.
(1) Unincorporated business – sole proprietorship or partnership,
(2) “C” (or regular) corporation,
(3) “S” corporation,
(4) Family partnership under §704(e),
(5) Custodianship under UGMA and UTMA, and
(6) In certain limited instances, an interest-free loan.
Because of tax reform, one of the best tax shelters is your own business. Consider the following tax advantages:
For the self-employed, business expenses are deductible in full directly from gross income. On the other hand, employees may only deduct their business expenses when they itemize, and most of these deductions were reduced by 2% of AGI. Now, from 2018 through 2025, all miscellaneous itemized deductions that were subject to the 2% floor are suspended.
If you operate a business out of your home, a portion of the expenses of your residence may be allocated to the business. However, you must prove that such portion of the home is used exclusively and regularly for business purposes.
1. There must be a specific room or area that is set aside for and used exclusively on a regular basis as:
a. The principal place of any business, or
b. A place where the taxpayer meets with patients, clients or customers in the normal course of your trade or business, or
c. A separate structure that is used in your trade or business and is not attached to your house or residence.
2. An employee can take a home office deduction if he or she meets the regular and exclusive use test and the use is for the convenience of the employer.
3. No deduction is allowed unless there is a trade or business involved.
Two special exceptions are made where part of a home is regularly, but not exclusively, used for business purposes:
Inventory: A wholesaler or retailer who uses part of a home to store inventory that is held for sale. However, this exception applies only if the dwelling unit is the taxpayer’s sole fixed location of the trade or business.
The TRA ‘97 enhanced the ability of taxpayers who work at home to claim deductions for home office expenses by expanding the definition of “principal place of business” to include a home office that is used by the taxpayer to conduct administrative or management activities of the business, provided that there is no other fixed location where the taxpayer conducts substantial administrative or management activities of the business.
Doctor Dan consults with patients at local hospitals and uses a portion of his home exclusively and regularly to conduct administrative or management activities. Dan does not conduct any other significant administrative or management function at another fixed location. Dan qualifies for the home office deduction.
This expansion restores the office deduction to the vast majority of millions of business people who work out of their home, such as:
(1) Home-based employees who telecommute to the main office,
(2) Doctors who perform their duties in hospitals but need to do their billings from their home office,
(3) Salespeople who call at the customer’s place of business,
(4) Professional speakers who prepare at home but deliver the presentation at hotels and convention centers, and
(5) Plumbers and other tradespeople who perform their duties at job sites away from the shop.
Many taxpayers who have a second business conducted out of their home will be able to deduct their traveling to and from their “home office” to their main office (previously considered nondeductible commuting mileage) under this expanded definition.
Effective for tax years beginning on or after January 1, 2013, R. P. 2013-13 provides an optional safe harbor method for individuals to determine the amount of their deductible home office expenses (see also IR-2013-5). Under this safe harbor, the maximum deduction is $1,500 (which is not indexed for inflation) and the allowable square footage is 300 square feet.
Business owners may make annual deductible contributions of up to 20% of business income or $57,000 (in 2020), whichever is less, to a defined-contribution Keogh and may stash away even more in a defined-benefit Keogh.
Having your child work for the family-owned business can be a tax benefit. Earned income is taxed at the child’s tax rate. In addition, the company gets a deduction for the child’s salary. However, children must perform actual services for reasonable compensation.
When a spouse is an employee, they may participate in any retirement plans that you have for employees (pension, §401(k), etc.). In some cases, they may qualify for deductible IRA contributions.
Travel deductions are easier for business owners. IRS auditors often ask employees why their company didn’t reimburse them if their travel costs were truly “ordinary and necessary.”
Business casualty losses can be deducted in full against business income. Formerly, personal casualty losses were deductible only for itemizers and were reduced by 10% of AGI plus a $100 deductible (§165). However, from 2018 through 2025, the deduction for personal casualty losses is suspended.
Business bad debts are fully deductible in the year they become uncollectible because they are incurred in connection with a trade or business (§166(a)). However, personal bad debts are treated like capital losses – you may deduct only up to $3,000 a year.
If a taxpayer is a sole proprietor, the taxpayer will have to pay self-employment tax (§1401). The self-employment tax is the non-employee portion of the Social Security tax-raising system. The self-employment tax rate is normally equal to 15.3% of income (12.4% for social security [OASDI] and 2.9% for Medicare [HI]) from self-employment.
Note: For 2011 and 2012, TRUIRJCA temporarily reduced the OASDI tax rate (but not the HI tax rate) under the SECA tax by two percentage points which resulted in a combined rate of 13.3% (10.4% for OASDI and 2.9% for HI).
Note: Deductible items like home mortgage interest, real estate taxes, state income tax, Keogh plan or IRA deductions, etc. do not reduce self employment tax. However, since 1990, business deductions, plus an amount equal to the self-employment tax on half of self-employment income, are allowable in reducing the self-employment income figure.
Before 1990, taxpayers could usually save money on this tax by incorporating. As a corporation, any salary paid (up to $48,000 in 1989) was subject to both individual and corporate FICA tax of 7.51%, or a total tax rate of 15.02%, versus a 13.02% rate for self-employment tax. However, the employer half of the FICA tax was all deductible for corporate income tax purposes, which
could considerably reduce the net after-tax cost of the FICA.