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Tax Credits

New IRS Tax Credits Help Small Business Owners With Payroll Costs

Please return April 12, 2020 for this complete article.

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Tax Planning

Understanding tax breaks for higher education

If you’ve been effected by the economic downturn and decided to return to school to further your own education, or you support a dependent that is a college student, there are three education tax breaks that you should be aware of.

Each of the three is unique, and only one of them can be claimed for any particular student in a given tax year. But, you can claim one type of education credit for a child, for example, and another type of credit for yourself.

The three most common tax breaks for higher education are:

  1. American Opportunity Credit (AOC)
  2. Lifetime Learning Credit (LLC)
  3. Tuition and fees deduction

All three of these tax benefits can be claimed regardless of whether you itemize or claim the standard deduction. The AOC and LLC are claimed using Form 8863, and while the IRS didn’t start processing tax returns filed with this form until late in the current tax return filing season, they are now doing so. The tuition and fees deduction is claimed using form 8917.

A few legislative notes:

  1. The “fiscal cliff” bill passed Jan 2, 2013 by Congress extended the AOC through tax year 2017.
  2. The same law also retroactively extended the tuition and fees deduction through tax year 2013, since it actually had expired at the end of 2011.
  3. The LLC is a permanent part of the tax code (at least for now – that could change tomorrow, of course).

It should be noted that none of these tax benefits can be claimed by a non-resident alien, nor a person filing as Married Filing Seperately.

The AOC is aimed at full time college students completing their first four years of undergraduate education. Students must be at least a half-time student for at least 5 months out of the year to claim this credit, and they must also not have any felony drug convictions. The Lifetime Learning Credit, as the name implies, is applicable to all students, including part-time and graduate students. The tuition and fees deduction generally provides the least direct tax benefit, but can usually be claimed by people that can’t claim one of the other two for some reason.

The most common reason for not being eligible for one of the other two tax credits is due to income limitations. For 2012, the AOC starts to phase out for single taxpayers with adjusted gross incomes over $80,000 (double that for married couples), and the LLC starts to phase out for single taxpayers with AGI’s over $52,000 (also doubled for married couples).

The AOC can be as much as $2,500, and up to $1,000 of that is refundable. These amounts are per student. Refundable credits increase your refund even when your annual tax liability is zero. The AOC is also the only education tax break for which expenses other than tuition and fees can be claimed. The most common example is textbooks, which are AOC-eligible expenses, but are not for the other two tax breaks.

The LLC can be a maximum of $2,000 for an entire tax return, and is not a refundable credit. This means that the LLC can be used to reduce your tax liability to zero, but you don’t get a refund of the excess.

The tuition and fees deduction is just that — a deduction against taxable income. The maximum deduction for 2012 is $4,000, and the full amount can be claimed by joint filers with modified AGI of up to $130,000 (half that for single filers). The tuition and fees deduction requires only one course to be taken, and it does not need to be part of an actual degree program, but it does still need to be taken at an eligible post-secondary institution.

One of the most common questions I get regarding education tax breaks has to do with what’s reported on the student’s 1098-T. The tuition and fees reported on the 1098-T may actually differ from what you can actually claim as expenses for the tax credits, so be sure to speak with a tax professional or refer to the form instructions for clarification on what to actually claim.

It should also be noted that tuition and fees paid with loan proceeds are still eligible to be claimed, but not so for tuition paid with scholarships, grants, and tuition assistance. You must subtract scholarship and grant money from tuition and fees paid, and only claim the remainder for purposes of these education tax breaks. Also note that scholarship money in excess of tuition could be taxable income, and if it’s used to pay for living expenses, it’s definitely taxable income.

If you or a dependent are in school, I would encourage you to take advantage of these tax breaks. Remember the motto: Pay what you are legally required to in taxes, but not a single penny more!

Categories
Tax Returns

Firefighter and ambulance meal deduction facts

There is a pervasive myth within the emergency services professions regarding a tax deduction for meals during their on-shift days.

This myth is most common with the firefighter ranks, but is also seen within ambulance, police, and other emergency services professions.

Where this myth comes from, I’m not certain. But it definitely maintains it’s urban legend status due to being passed from one person to another. It can only be assumed that tens of thousands of emergency services personnel illegally take this deduction every year.

So let’s set the record straight: There is no on-shift meal deduction permitted for emergency services personnel.

It doesn’t matter if you work a 24-hour shift, and it doesn’t matter what you do for a living (this isn’t limited to emergency personnel, it’s EVERYBODY): If you’re at your job, in your home area, regardless of shift length, there is no meal deduction. Period.

Meal deductions, including per diem (Meals and Incidental Expenses – M&IE), are only permitted when you travel away from home for business or work, and are not reimbursed. If you actually get paid per diem, you can’t also deduct it (no double dipping, in other words).

Here is what firefighters and other workers can do, however. Some fire stations, police stations, and other work places where it is common to work long shifts have what is called a common meal fund. Basically, everybody pitches in a certain amount of money per day, and it pays for food for the entire crew for that day.

If everybody does it, and it’s required by the employer, then it’s deductible. In other words, your fire department or other agency must have made it a mandatory participation practice. In this case, the money you put into the food bucket every day is deductible on Form 2106 under Miscellaneous Deductions, which are subject to a “floor” of 2% of your Adjusted Gross Income.

Hopefully this will clarify this practice. If you work in emergency services, do your co-workers a favor, and refer them to this blog post — it may help them avoid an “undesired IRS interaction.”

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Tax Planning

Cheapest Tax States To Reside In

Choosing to reside in a state with low tax rates can be an effective way to reduce your cost of living, often by a double digit percentage. State taxes come in a variety of forms, including income, sales, real estate, and personal property taxes. All states charge at least one of these taxes, and most charge all four to varying degrees. Your lifestyle will often dictate which type of tax is most critical for consideration when evaluating where to live. In this article, I’m going to present four states that offer different tax benefits for residents.

Alaska
Alaska has the lowest overall tax burden per resident of any state in the Union. Alaska is one of only two states that has neither a state income tax nor a state sales tax. Local municipalities in Alaska are allowed to levy their own local sales taxes, which can be as high as 7.5 percent, although many towns do not levy a sales tax. Alaskan property taxes are on par with the national average. Because of oil revenues to the state, Alaska is the only state that actually pays residents for living there. Alaska Permanent Fund Dividends vary each year, and were $878 per eligible resident in 2012.

New Hampshire
New Hampshire is the other state with no state sales tax and no state tax on ordinary income. The state does levy a tax on dividends and capital gains, so individuals who earn a large portion of their income from these sources should take this into consideration. Local municipalities in New Hampshire do not have sales tax, but New Hampshire’s state and local property taxes are the highest in the United States. Therefore, New Hampshire can be a zero tax state if you are a wage earner and do not own property.

South Dakota
While South Dakota does levy a 4 percent state sales tax, and local municipalities may also levy sales taxes, South Dakota has the second lowest overall tax burden for residents of any state. This is primarily because of the lack of a state income tax, and some of the lowest personal property taxes in the country. However, while real property tax rates exceed New York state’s, low property values statewide keep the actual property tax bills low. South Dakota is one of the most popular residency states for full time RVers that don’t own real estate, and is growing in popularity as a “tax home” for Americans living abroad for extended periods of time.

Nevada
Like most low-tax states, Nevada lacks a personal income tax. The state’s 6.85 percent state sales tax, with up to an additional 1.25 percent tacked on in some municipal areas, makes Nevada less attractive in comparison to other low-tax states. Nevada is unique among all states in that it charges property taxes on only 35 percent of the assessed value of property. Of particular interest to retirees, Nevada will rebate up to 90 percent of property taxes paid by those over age 62 who meet certain income criteria, making Nevada particularly attractive to retirees who engage in limited shopping.

Conclusion
While there is no one perfect state in regards to taxation, some states are definitely more attractive than others. Factors such as whether you will own a home or not, and how you earn your income, are important factors in determining whether one state or another is better for your situation.

Categories
Taxpayer Representation

Bankruptcy vs IRS Offer in Compromise

If you have a large amount of other debt besides just tax debt, bankruptcy may be an option you end up considering. Is this the right thing to do when you have tax liabilities?

For some people, bankruptcy can be the right way to go. While bankruptcy will not erase most tax debt, the bankruptcy court determines what you pay each creditor, and may remove some of the penalties and interest, depending on the case.

The interest rate that the IRS charges, to be honest, isn’t that bad. The rate is adjusted several times per year, and it currently sits at 4%. What kills people are actually the penalties. It is not uncommon for tax debtors to max out all their penalties, which tacks on a whopping 45.5% to their principal, and THEN interest accrues on the whole thing.

To determine whether bankruptcy is the best route for you, you should consult with a bankruptcy attorney. If all you have is IRS debt, and don’t have significant other creditors and/or don’t want the bad credit associated with bankruptcy, but you cannot otherwise go on a monthly payment plan, then consider an Offer in Compromise with the IRS. It’s a good non-bankruptcy alternative for folks that might otherwise have no other choice but to file Chapter 7, but would only be filing chapter 7 because of their IRS debt.

If you do choose to file for bankruptcy, it’s important to have a contingency plan for those taxes that cannot be discharged. For example, Trust Fund Recovery Penalty assessments, property taxes, and sales taxes will not generally be flushed in a Chapter 7. So, if your tax liability consists of those tax types, you need to be looking at other options.

Personal income taxes (1040 taxes) can be discharged in bankruptcy if they meet certain criteria. In general, income taxes must be at least three years old to be discharged in bankruptcy, and the tax return on those tax debts must have been filed at least two years ago. So, if you haven’t filed the actual tax returns that will incur the tax debt you want to discharge in bankruptcy, you’re going to have to file the returns and then wait two years.

Filing bankruptcy is obviously not a decision to be taken lightly, and you must consider the tax debt implications of doing so. However, bankruptcy isn’t nearly as bad of a thing to go through as many people think it is (and I’m talking from experience, by the way). Consult with both your tax professional and your bankruptcy attorney regarding this important decision.

Categories
Tax Planning

The Tax Shelter Over Your Head Is Still a Good Idea For 2013

Home prices, which had been on a tear, have leveled out and even fallen in places. The housing “bubble” definitely appears to be over. So, the question becomes: Is real estate still a good place for your money?

Despite uncertain real estate prices, buying a house is still a smart choice for most families. Buying, rather than renting, replaces nondeductible rent with deductible mortgage interest. You can borrow tax-free against your home’s growing equity. And you can still sell your home for up to $500,000 profit, tax-free. This particular capital gains tax break isn’t likely to disappear in 2013, despite all the rhetoric about classic tax breaks disappearing.

Mortgage Interest

Tax-deductible mortgage interest is a cornerstone of tax planning for many families. You can deduct interest on up to $1 million of “acquisition indebtedness” you use to buy or substantially improve your primary residence and one additional home. You can deduct interest on up to $1 million of construction loans for 24 months from the start of construction. (Interest before and after this period is nondeductible.) Plus, points you pay to buy or improve your primary residence are generally deductible the year you buy the home if paying points is an established practice in your area. This deduction, while discussed as one that could get the axe by Congress, is too politically sensitive to actually be taken away from American voters in 2013.

Home Equity Interest

You can deduct interest you pay on up to $100,000 of home equity loans or lines of credit secured by your primary residence and one additional residence. Using home equity debt to pay off cars, colleges, and similar debts lets you convert nondeductible personal interest into deductible home equity interest.

Make sure you compare after-tax rates before you refinance consumer debt with home equity debt. If you can buy a car with a special interest rate, your nondeductible personal interest may still cost less than deductible home equity interest. If you can transfer a credit card balance to a new card with a low introductory rate, you could save money and avoid the paperwork needed to refinance your home.

If you pay points to refinance your home, you can’t deduct those points immediately. However, you can amortize them over the life of the loan. If you pay off the loan before fully deducting your points (including refinancing with a new lender), deduct the remaining balance the year you retire the loan.

You can still deduct the interest you pay on home equity balances over $100,000 if you use the proceeds for a deductible purpose. If you use home equity debt to buy stocks, for example, you can deduct it as investment interest; if you use it to finance your business, you can deduct it as a business expense.

Property Tax

You can also deduct property taxes you pay on your primary residence and vacation homes. Microsoft founder Bill Gates can deduct over $1,000,000 he pays on his Seattle-area compound. But be aware that property tax deductions may be limited by the AMT.

Tax-Free Income From Selling Your Home

The Taxpayer Relief Act of 1997 made important changes when you sell your primary residence. The old law, effective for sales before May 5, 1997, let you roll unlimited gains into a new home and offered a one-time $125,000 exclusion if you sold your home after age 55. The new law lets you exclude up to $250,000 of gain ($500,000 for joint filers) every two years, with no need to roll your gains into a new home.

You can exclude $250,000 if:

  1. You owned the home for two of the last five years,
  2. You occupied it as your primary residence for two of the last five years, and
  3. You haven’t used the exclusion within the last two years.

You and your spouse can exclude up to $500,000 if:

  1. Either of you owned it for two of the last five years
  2. Both of you used it as your primary residence for two of the last five years, and
  3. Neither of you has used the exclusion within the last two years.

You can exclude part of your gain (calculated by dividing the number of months you qualify by 24) without meeting that two-year minimum, if your move is due to:

  • Change in employment (you, your spouse, a co-owner of the house, or any other person whose principal abode is in the home accepts a job whose location is at least 50 miles farther from the home than their previous place of employment);
  • Health (a qualifying person or their relative moves to treat a disease, illness, or injury or to obtain or provide medical care for a qualified individual); or
  • “Unforeseen circumstances” (including, but not limited to, involuntary conversion, natural or man-made disaster, or a qualifying individual’s death, unemployment, change in employment or self-employment status, divorce, or multiple births from the same pregnancy).

Taking advantage of the tax shelter over your head won’t guarantee gains. You have to consider how long you will own your home, the cost of maintaining and repairing it, and the eventual cost of selling it. But the tax shelter over your head is still likely to prove a long-term winner.

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Taxpayer Representation

8 Questions To Ask When Choosing An Accountant

The vast majority of small businesses could use the services of an accountant. The number of ways in which it is possible to introduce errors into your business through accounting practices is staggering. Your accounting includes issues related to payroll, monitoring profitability, inventory control, avoiding penalties and interest on taxes, and much, much more. It is wise to select a competent professional in this field to help you navigate the minefield of accounting pitfalls. Selecting such a professional can be difficult, especially since not all accountants are created equal.

Here are some questions to ask to help ensure that you are selecting the best accountant you can for your business.

1. Do they have any complaints with the Better Business Bureau?

When many individuals decide to take action and make a complaint against a firm, they often think first of the BBB. Check with your local division, or look them up online, and make sure that the company you are considering hiring has a good record with the BBB. If they have a Gold Star award from the BBB, then you’re on the right track to working with a company that is reputable and stands by their word. The BBB’s new letter grading system can also help you in selecting a good firm.

2. Have they ever been investigated by your state Attorney General’s office or state board of accountancy?

This is another place to do your own due diligence. Complaints with the state AG or Board of Accountancy is an automatic red flag and should be highly considered before selecting a firm.

3. What services do they provide, and what services do you need?

Think about exactly what you’re looking for in a service provider. Do you need full service accounting, outsourcing all functions to another person or firm? Or do you just need year-end tax preparation? Knowing the answer to what services you need will help you pick the best person to do what you need, and will affect your budget for getting it done. For example, if you just need tax preparation, then you might be better off with an experienced tax preparer instead of a CPA firm that mostly does auditing and general accounting. If you only need payroll services, then you might want to hire a payroll company rather than a bookkeeper that does payroll on the side. If you need the books updated weekly or monthly, most communities have competent, independent full charge bookkeepers that you can hire.

If you’re looking for somebody to come set up your books and show you how to use your accounting software, you may want to consider a general CPA or a competent bookkeeper. If you do all your own books using Peachtree, Quickbooks, MS Money, or another popular commercial software package, it can be very helpful to have somebody to call should something go wrong. The large commercial accounting software publishers all provide some sort of certified expert rating system for individuals that are experts on using their software. You may want to look for and consult with such a certified expert on your particular accounting software. For example, Intuit offers its Quickbooks Certified ProAdvisor program to consultants. Finding one of these certified individuals can really help you a lot if you’re doing the books yourself.

If your only interest is in tax compliance, look for a CPA that specializes in taxation, or an Enrolled Agent (EA). An EA is an individual licensed directly by the U.S. Treasury to handle tax matters, and this individual can represent you before the IRS just like a CPA or an attorney. By nature of the credential, EAs are dedicated tax professionals and are generally more competent in areas of tax issues than a general CPA, unlicensed tax preparer, or bookkeeper.

Selecting the type of professional you need is a serious consideration in this process, and depends largely on what you plan on doing yourself, and what you expect to need help with.

4. Are they licensed in some way?

Credentials are not always the most important thing to consider, but they do reflect at least a minimum level of professional competency, in theory. If they are a CPA, they’ve passed a rigorous four part examination and have at least a bachelor’s degree in accounting and two years of professional experience, at a minimum. If they are an Enrolled Agent, they have passed a very rigorous three part exam covering individuals, businesses, and practices and ethics that is administered directly by the Internal Revenue Service.

The individual preparing your tax returns, doing your books, or processing your payroll doesn’t necessarily need credentials in order to do the tax and do it right, so experience is a critical piece of the puzzle you’ll want to inquire about.

Do keep in mind that if you’re audited by the IRS, only CPAs, EAs, or attorneys can represent you, unless you wish to represent yourself, which is not recommended.

5. How much experience do they have?

How many years have they been doing what they do? What type of companies do they generally work with, such as which industries and what size companies? Inquire as to how many of each of your type of entity they work with each year. If they’re experienced working with your type of legal entity, within your industry, or your size of company, they might be a good fit.

6. How do they charge, and how much?

Don’t be afraid to ask about the money. Some firms will charge by the hour, or on a piece rate for the type of work being done. Bookkeepers will usually charge an hourly rate, while tax preparers often charge a flat rate per form and schedule. If your tax return is pretty complex, expect to pay more, which could be a base rate plus an hourly rate for doing accounting work to generate the numbers needed for various line items on the return. If you’ll be seeking software assistance, find out what they will charge for this, usually at an hourly rate. It can’t hurt to know whether you’ll be over your head in terms of what you can reasonably afford for the services you are seeking.

A word of caution: Price should not be the ultimate determining factor when decided who to use and what services to do yourself. If you’re genuinely over your head when it comes to certain tasks, don’t be afraid to spend the money. There’s an old saying that goes like this, “Do what you do best, hire out the rest.” Accounting can be one of the most frustrating aspects of owning a business, and trying to do it all yourself can take time away from what you should be doing, which is running your business to the best of your ability to generate a profit.

7. Are you comfortable with the individual?

Even if you hire a large firm to do your accounting, there is still going to be an individual person that will be doing the work and with whom you will work with almost exclusively. You need to sit down with this person and make sure that you are comfortable working with them. If anything makes you uncomfortable in any way, you need to find somebody else. Think about it: This person is going to have access to an incredible amount of private financial information, so it has to be somebody you feel comfortable trusting.

8. Don’t be afraid to make a change.

Even after selecting somebody to work with, don’t be afraid to find somebody else if things aren’t working out. Your accounting is too important to the success of your business to leave it in the hands of an incompetent person or somebody you don’t completely trust. Problems with your current accountant could range from having just plain bad interpersonal chemistry to gross incompetence on their part, or perhaps you have the wrong specialist to meet your needs. Regardless, don’t hesitate to take your business elsewhere, since your accounting, bookkeeping, and taxes are simply that important to the life of your business.

Using the eight steps outlined in this article will give you a great start towards finding the accountant that is right for you. Identify the type of professional that can best provide the services you need, find a few local tax firms in our directory, then check them out and interview them personally. This process will ensure that you get the best accountant for your business needs.

Categories
Tax Planning

2013 Tax Numbers Announced, Plus 2013 Tax Planning Advice

A variety of numbers that are important for 2013 tax planning were recently released by the Internal Revenue Service and Social Security Administration.

First, let’s talk retirement accounts. In 2013, maximum 401(k) contributions from your own paycheck will be capped at $17,500 for the year, an increase of $500 over 2012. For folks 50 and older, the “catch-up” limit remains the same, at $5,500. Personal IRA contributions will be limited to $5,500 for those under 50, and $6,500 for those age 50 and older. For SIMPLE accounts, the maximum contribution increases to $12,000, with a $2,500 catch-up limit for those 50 and over.

While elimination of the Social Security taxable wage limit is one of the proposals on the table in Washington, D.C., the inflation adjusted cap for 2013 is currently slated to be $113,700, up from $110,100 for 2012. This is the maximum salary level per year per person on which Social Security taxes are charged. Your wages above that amount are not subject to that particular tax. Expect this to be a hotly debated item during the next Congressional session.

Also on the Social Security front, retirees that have not yet reached full retirement age for their birthdate can earn up to $15,120 in 2013 from employment without losing any Social Security benefits.

If you provide cash gifts to others, you’re in luck in 2013: The annual gift tax exclusion has increased to $14,000 for 2013. Do note, however, that this is als a hotly contested item, and may be on the retroactive chopping block for 2013.

Lastly, Health Savings Account (HSA) contribution limits will increase to $3,250 for individuals and $6,450 for families next year.

Categories
Taxpayer Representation

Penalty Abatement Statements – A Humorous Example

Taxpayers have the right to request relief from penalties assessed by the Internal Revenue Service. The IRS sets very specific criteria for the granting of penalty abatements. It can be very difficult to demonstrate that a taxpayer’s circumstances meet the criteria for penalty relief. Most of the time, we will request a written statement from the taxpayer explaining the circumstances that lead to the accrual of their tax liability, and then use that to create our own penalty abatement request that fits to one of the IRS criterion, cites case law, etc.

Most of the time, taxpayer’s have some reason for not paying their taxes that ties back to not having the money to do so. Lack of funds does not meet IRS reasonable cause criteria, but the circumstances behind the lack of funds sometimes can be reasonable cause.

Occasionally, the taxpayer’s explanation for failing to pay their taxes doesn’t leave us with a lot to work with. On rare occasions, we receive an explanation that is quite humorous.

This example is from a taxpayer that elected to continue NOT paying his taxes because it was financially convenient. With a struggling business, a divorce, and alimony and child support to pay, the taxpayer was experiencing financial hardship. He wrote:

I financed [business] shortfalls with credit card advances and soon I had unsupportable credit card debts and many other expenses…

As things started to turn around for the taxpayer, he continues:

In early 2001 I noticed that I somehow had enough money to pay my bills. Later, I discovered that I had inadvertently neglected to call in the 941 payment [for fourth quarter], even though the check had been generated by the accounting program. I was consternated but simply didn’t have the money to make good.

This is a common reason as to why people miss a Federal Tax Deposit, often several in a row. They then try to make it up when they can. However, in this case:

I expected a notice from the IRS daily, but nothing happened and when it was time for the next 941 payment I thought, “This is the kind of tax relief I need right now.” As an expedience, I didn’t pay the 941’s for the next several months and used the respite to get back on my feet financially.

Doing this enabled the taxpayer to get current with his vendors, credit cards, etc. He skipped his payroll tax payments for 7 months, then started making them again. By this time, he was on a debt management plan for the rest of his debt, and the business was doing better. However, the taxpayer recognized that this course of action had consequences attached.

Again, the initial non-payment was an unintentional oversight. However, it was so useful in preventing bankruptcy, staying in business, and becoming solvent that I didn’t make another payment for 7 months. By that time I was in good shape and haven’t had serious problems since. I’m grateful to Uncle Sam for the loan, though it is a little like borrowing from the Mafia. However, I’m ready and able to make restitution.

Needless to say, this was an exceptionally difficult penalty abatement for us to craft, and we obviously did not submit this in the form submitted to us by the client. This is actually still an active case, and we are awaiting IRS review of our actual abatement request.

This example, while humorous, illustrates how taxpayers can get in further trouble with the IRS after an initially unintentional oversight. It also illustrates the choices that business owners are having to make in order to stay in business.

Categories
Tax Planning

5 Simple Steps To Achieving Mitt Romney’s Tax Rate

Republican presidential candidate Mitt Romney has been getting blasted for months about the fact this effective tax rate is so incredibly low. As an Enrolled Agent, I find the discussion surrounding Romney’s tax situation to be particularly interesting, because there isn’t a single taxpayer on the face of the Earth that personally wants to pay more taxes than they have to. If such a strange person does exist, there is no government that won’t happily cash your check (in fact, the U.S. government happily accepts credit cards for donations).

I’d really like to get on the phone with all these reporters and news anchors blasting Romney for his tax reduction strategies. I’d bet $100 that you can’t find one that would, themselves, personally agree to pay more taxes than they need to. Yet, they will happily ridicule somebody else for doing so.

Actually, I need to back up, because there is actually one person I know of that voluntarily pays more taxes than he’s required to. Guess who that is? Mitt Romney.

That’s right. In order to keep a campaign promise earlier this year stating that he has paid at least 13% in taxes each of the past 10 years, Mitt Romney voluntarily failed to claim $1.75 million in charitable contributions on his 2011 Form 1040. In other words, he only deducted $2.25 million of the total $4 million he actually donated to non-profits. If he had claimed the full deduction, his 2011 effective tax rate would only have been 12%.

Mitt Romney’s strategy for only paying an effective tax rate in the low teens is perfectly legal.

The Internal Revenue Code requires every American citizen, at home or abroad, to pay taxes on all income, from whatever source derived, whether that money is made in America, or overseas. The law requires everybody to pay their mandatory tax amount, and not a single penny more. The tax laws are the tax laws, and the law is the same for every citizen. Just because you are rich does not magically change the tax laws (just ask Wesley Snipes, serving three years for tax fraud).

Some people complain that the tax code favors the wealthy. This simply isn’t true. The tax code provides equal opportunity for all. Equal opportunity to minimize, but also equal opportunity to get screwed.

What does this mean, and and how can you take advantage of it?

First of all, realize that Congress typically makes thousands of changes to the Federal tax code each and every year. Just about every bill passed has some minor tweak to the tax code associated with it.

Second, understand that the tax code is used by the government as a tool for social engineering and economic stimulus. This isn’t a secret — it’s a well documented fact. Certain elements of the tax code exist for the sole purpose of wealth redistribution, such as the Child Tax Credit and Earned Income Credit, both of which are social welfare programs that the government simply chose to implement via the income tax system. Other elements of the tax code exist in order to encourage small business investment, such as tax credits for research and development and domestic production activities. Other pieces of the tax code are intended to attempt to create jobs, such as payroll tax credits for hiring veterans or displaced workers.

The secret behind Mitt Romney paying such a low effective tax rate has to do with his income sources. As I write this, I’m looking at Romney’s 2011 Form 1040, page 1. This return lists the following major income sources and amounts:

  • $4.1 million in taxable interest
  • $3.2 million in taxable dividends
  • $10.8 million in capital gains
  • $2.8 million partnership and trust income

Romney’s tax on all this income isn’t figured using the regular tax tables, and not just because the numbers don’t go that high. Currently, his interest and partnership/trust income is taxed at normal income tax rates, but the $14 million in dividends and capital gains are taxed at much lower rates, currently only 15%.

That 15% tax rate is scheduled to expire at the end of 2012, as part of the expiring Bush tax cuts. However, the U.S. has a long history of creating special reduced tax rates for dividends, capital gains, and other forms of investment income, and there is a perfectly valid reason for doing so: Investment income derives from putting your money to work within the company, which generally creates jobs.

Economic investment has long been the primary source of jobs within modern economies. Without investment, most economies would grind to a screeching halt (been to Greece lately?). In order to encourage people with money to put that money to work within the economy, rather than just saving it under a mattress, governments offer incentives for investment. One such incentive is a reduced tax rate on the investment earnings. Those investments stimulate the economy, create jobs, and keep the economic engine churning for the rest of us. It’s a very critical component of keeping a modern economy operating.

When I flip to page 2 of Romney’s 1040, I see $5.7 million in itemized deductions. Looking at his Schedule A, I can see $4 million in charitable donations alone, of which he only claimed $2.25 million. He paid $2.6 million in tithing to his church. He also deducted $1.5 million in state and local taxes he paid.

Romney could have claimed the entire $4 million in charitable donations. I also see that he claimed absolutely zero business expenses on his Schedule C, and thus paid income tax and self-employment taxes both on every dime of speaking fees he collected.

I’m not going to review every line of this 104 page tax return. What becomes readily apparent, however, is that a tax minimization strategy is possible for everybody, no matter how much or how little your income. I’ll recap the “Mitt Tax Reduction Strategy” in a short list of steps, in case you didn’t pick them up through the course of this article:

Step 1: Own and operate your own small business.
Step 2: Invest in dividend-generating securities.
Step 3: Invest in activities that will produce capital gains.
Step 4: Invest in tax-free investments, such as municipal bonds.
Step 5: Donate a large percentage of your income to non-profit organizations.

Not only does this strategy work for rich people, it works for working class stiffs like us, also. If you’re self-employed, you get to write off an amazing array of things that people that work for other companies can’t, including deductions for business use of your home and your vehicle. Everybody can invest in securities that provide tax-free interest income, generate dividends, and produce capital gains. And everybody can donate to their favorite worthy causes.

Even people earning $30,000 per year can make this sort of thing happen: I’ve not only seen it with clients, I’ve done in myself.

No matter how much or how little money you make, the tax code can either work for you, or against you – the choice is really up to you. Prudent investment management, careful personal financial management, and proactive tax planning can all work together together to drastically reduce your effective tax rate, also.

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