Diane, it’s great to have you on the show.
Thank you for having me. Tax is the thing to talk about and I’m excited to share the information.
Tax doesn’t sound like something very exciting to a lot of people. We can make it exciting by saving them lots of money. What’s even better than making lots of money is saving lots of money because then you don’t have to work for it.
I like to say that whenever you have these tax plans, it’s money that goes directly in your pocket. It’s like tax-free money because you don’t have to pay tax on tax savings. Not only that, but we can also talk about some little insights about the new study that has come out about the IRS and who they’re auditing. There are some ways to reduce your chances of IRS audit too while you’re doing that.
There’s this thing called the IRS Dirty Dozen or something like that.
Their stats have changed as well, largely because their funding has gone down over the last eleven years. Because of that, there are certain areas that they’re not concentrating on anymore. I don’t want to say there are huge loopholes like it’s something wrong. Position yourself for success so you can take advantage of positioning yourself, so you’re much less likely to be a target.You have to take advantage of positioning yourself for success so you're much less likely to be a target. Click To Tweet
I learned that if you have a Schedule C-type of LLC, then you open yourself up to getting audited significantly more than if you’re a Subchapter S election.
That’s one of the things. What’s happened is that with the budget cuts, a lot of the more experienced auditors have left. The IRS is now relying on more of the computer audits. If you’ve ever seen what they do, they’re computer generated letters and it’s based on an algorithm that maybe your expenses are a little out of alignment. The computer is doing the “audit.” They want you to fax in or mail certain data to them. You can’t email the IRS but you send that in and then it’s inputted in the computer, the algorithm decides if that’s sufficient or if they are going to move it on to the next stage. For corporations like an S Corporation that we’re talking about, an LLC can make that election to be taxed as an S Corporation. They don’t have very many auditors who are capable of auditing a corporation. That’s something that a computer can’t do. That right there is one of the tricks. Make sure that you’re in the right structure for your business.
Since we’re talking about the IRS Dirty Dozen, let’s get it out on the table. What are some of the things that are on that list that will get you a much likelier chance of getting audited?
Some of the things that they’re looking at are foreign accounts, foreign bank accounts. There’s nothing illegal about having a foreign bank account when you put that out there. There are certain disclosures that American taxpayers need to make on their tax return. This is true, even if you have a foreign bank account that you have set up, an account you’re not hiding from your taxes, there’s no tax benefit. You want to have assets outside of the country, maybe for asset protection reasons because it’s harder to sue them and get those assets. You have to make a disclosure on your tax return of that. That’s part of what the IRS has gotten data from all of these foreign companies, banks, trusts and whatnot that show who’s got bank accounts. If you don’t say or check the box saying you have that, then they’re afraid something is up. That’s one who’s likely to be audited.
For people who are involved in cryptocurrency, you may have been following this over the past year. The IRS was successful in receiving records from one of the clearing houses for crypto transactions. Anyone who had done over $20,000 in transactions, even if all you did is bought and held, which is nothing you have to report if you don’t do anything with those. Those people are now targeted and the IRS is looking and checking to see if they have filed any transactions. If not, there’s a real good chance there’s going to be an audit with that because they’re figuring people are trying to use cryptocurrency, and they’re buying and selling it and not reporting gain. They believe this is low-hanging fruit for them that they can get that.
Another one is trust in general. There’s nothing wrong with a properly set up and reported trust, but there are people who use those to illegally avoid taxes. The IRS has been looking at that. However, the study that came out in December 2018 says that they have dropped the ball on the trust audits because they’ve lost all their high-powered auditors who knew how to handle those audits. There is a concern that those are slipping through the cracks. The concern is on the IRS standpoint, I don’t care. It’s interesting to see, another thing to throw out here. By no means am I recommending anybody do this, but there is a ten-year statute if you have a Federal tax debt. If they’ve gone and they’ve done an audit or they’ve determined that you didn’t pay all your taxes, they have ten years to chase you down. If in ten years they haven’t gotten their money, the debt is gone. The statute of limitations has run. In the past, this never happened. They never let that expire. They always did something, Hail Mary pass at the very end to try to get the money. They are letting those pass in record numbers because the system has crumbled. I do believe that’s something that we’re going to see in 2019 that the IRS is going to step up their action because that’s silly to let those statute of limitations run on that. Without enough manpower, they don’t know what they’re doing and they can’t get that done.
I’ve heard that there’s a limit to the number of years that the IRS can go back and reevaluate your tax return and figure out if you’ve shorted the money. Is it seven years or is it ten years?
It’s actually three years from the filing date of the return. However, if they’ve determined there’s fraud, it can actually be unlimited. In real numbers though, what typically happens is if a client comes to me and they haven’t filed in twenty years, generally there is a specific way that we go and approach the IRS. One, what we do is we take the last six years and get those tax returns prepared and then we file those all at once. Sometimes people make the mistake if they’ve got that. I had a client once that wasn’t making a lot of money and so it didn’t matter that they weren’t filing. They should have been filing, they should have been paying a little bit but it wasn’t a lot. Suddenly they inherited a lot of money and that kicked it up. Unfortunately also kicked up the IRS and the IRS was successful in putting a lean on all of the money. They didn’t get anything and we’re talking a substantial amount until they filed the returns. In that case, what we typically do is we reach an agreement and say, “Here’s six years. We do it all at once.” Then it wipes the slate clean and we move forward.
In general, if you filed your returns on time and it’s been good and you’re concerned, “They’re going to audit me and find out maybe my meals deductions don’t have receipts for everything. I’m a little worried about it,” or something like that, they’ll go back only three years from when you filed. A comment here though, be careful with states. If you have also a State return you’re filing, the States might have different statutes. For example, Arizona can go back six years. Most states though are three years with the exception of California. Their tax flaws are horrible. You have an unlimited statute of limitations for California tax. California has decided they can go back forever but the IRS has only three years.
You mentioned receipts. What receipts do you have to keep on hand and for how long?
First of all, figure out what state and statute you have. If you’re one of those states it’s the same as the federal, I like to have at least three years. A lot of people, my clients especially use something like Dropbox or some Cloud storage for receipts that they scan or take a picture with their camera. If you go out to a meal and it’s something that you can deduct because you went out to a meal with a prospect, a vendor or you took your CPA to lunch, take a picture of that and hang onto that receipt. That’s a good receipt. Then you need to show that there’s a business purpose to it. You talked about business in some way. Under the 2018 law, you’ve got a 50% tax deduction for that.
Do you have to make a note on the receipt or somewhere that there is a business purpose or that there was a business discussed?Hang on to your receipts. If it's a good receipt, then you just need to show that there's a business purpose to it. Click To Tweet
If you have a physical copy that you actually grab a pen and write on it, the prospect of business, a new product line or whatever it is something that will trigger your memory. If you are audited, typically that’s at least two years after you give whatever it was, you might not remember what it is. Some of my clients make notes, have a journal or they use their calendar on their phone about their meetings and will talk about, “We’re having a meeting, I’m meeting with Joe and the goal here is this.” There’s the assumption that’s what was talked about because you tried to get your costs down, a new product or you’re trying to sell them on a service, something like that.
What if your spouse or significant other is part of the business as well and you go out to dinner and you do discuss business in the dinner, is that a tax write off?
Does the IRS look at that and say, “You’re going out to dinner with your significant other, we’re totally on to that?”
My husband has worked with me in the business since 1997. When you’re together working in a business, I don’t know that there are a lot of meals that you have that aren’t some type of business. We don’t write everything off but we do write a lot of them off and it is legitimate. We’re talking about we need a new system. The software that we’re using isn’t working. How we are going to work on the marketing plan for the book, whatever it might be that we’re talking about? I make notes about that. I have been audited once in all of these years and there was a no change on it, so it works.
You made it through unscathed but you must have spent a lot of time doing all the rigmarole that they make you, all the hoops they make you jump through.
The reality is sometimes I have clients that will handle it themselves and they’re so excited like, “We had an audit and I’m getting money back.” My response, unless it’s a whole lot of money back, it’s usually, “That’s too bad.” They think I’m crazy but a no change audit is not written anywhere but it pretty much gets you a get out of jail free card for a couple of years. If you’ve got a no change audit, then they know you’ve got good records, there was nothing to see here and they pass you by for a few years. It’s very rare that you’re audited again in a couple of years if you’ve had a no change audit. Whereas if you have an audit and there’s like, “We’re going to give you $500 back,” that was an expensive audit for you because they know that there’s a problem and chances are higher that they’ll audit you the next year.
I’ve heard that you’re not supposed to be able to expense alcohol. If you go take your client out for drinks, that’s not something that you can claim whereas a meal is?
We had a lot of confusion with the 2018 Trump Tax Plan but it’s technically called the Tax Cuts and Jobs Act that came out for 2018. We lost the ability to take a deduction for entertainment. We have a deduction for meals and drinks fall under the meals category as long as you’re talking about business. There was clarification later that was given on this, that’s how we know that. The confusion in the entertainment part is it used to be that, “I’m going to meet with my client and then we’re all going to go to a game. We’ll enjoy the game together and then afterwards we’re going to talk about business.” That in the past would have been a deductible expense, getting the tickets for the game or maybe getting a Skybox or something like that. You can’t take that deduction now. It used to be that as long as you had a business associated before or after the event, it was the deductible. Now, it’s not deductible at all, there would have to be a meal. Taking that Skybox example further, if you had a Skybox and you had it catered and the bill came in separate, then the meals part, that catering would be deductible but you don’t get the deduction for the Sky Box and the tickets and anything else that you might have as part of that event.
Probably quite a lot has changed in regards to taxation, what’s allowed and what’s not allowed because of the Trump Tax Law changes. Do you want to highlight some of the key ones?
People I work with primarily have businesses or are active investors. I’ll start with business owners. The two big changes are for any business is a flow-through or pass-through entity. An S Corporation, a Partnership, those are entities that you file a tax return for. There’s a Schedule K1 that’s part of that tax return and then you report that income or loss on your personal tax return. The big change that’s happened with that is that you may be able to take a 20% income deduction. Let’s say you have an S Corporation and the pass-through income on that is $200,000. That means you get a deduction of 20% of that $40,000, which is huge. That’s why everybody’s saying, “There’s this huge tax break for the rich,” which isn’t true. It’s a tax break for people who have businesses. It happens to be that the rich typically have businesses and that’s how they got those. If you’ve got a pass-through entity, there are two questions that you should think about.
Number one is, do you have what they call a service business? This is under a new definition they’ve got, Specified Service Trader Business, SSTB. Don’t assume you know the answer to that because the rules are weird. For example, if you’re a legal, lawyer, accountant, doctor, those are clearly service businesses. There’s a lot of gray area about some things though. For example, if you’re in financial planning, if you take a fee for your services, that’s considered a service business. If all you do is receive a commission for products you sell, that’s not a service. It’s an example of how it can get crazy. A bank is excluded, a real estate agent is excluded, an engineer is excluded, these are all just specific exclusions that they have on. This is crazy. That’s the part to identify.There are a lot of strategies available depending on how far outside of the box you want to look. Click To Tweet
If you have a service, then the amount of deduction you have will be limited based on how much your taxable income on your personal return is. There’s what’s called an income threshold. If you are married filing jointly and you have $315,000 or more of taxable income, then you have to meet other criteria in order to get that deduction. If you’re single, it’s $157,500. That’s the second question. Number one is do you have an SSTB? Number two, how much is your taxable income likely to be? Are you above or below that threshold? Part of planning is it’s important if you’re close to getting under that number. $1 could mean you lose a deduction of $1 more in income. Make sure that you take the write off for that new computer, the cell phone or that meal. Whatever that deduction might be, make sure you take it because you want to get under that amount there.
The second big area of law that changed was for C Corporations. A C Corporation is a type of corporation that does not pass through income to you. It files its own tax return, it pays tax itself and it pays tax based on its own past bracket. Two big changes there, one is it’s a flat rate of 21% which it used to be that it started at 15% and then went on up to 35% flat rate 21%, so that’s huge. The second is it used to be that professional service companies, again doctors, lawyers, accountants, they could not be C Corporations and get the special benefits. Now, they can. We’re seeing a big shift there because based on that first question, “Is your income over that taxable income threshold?” If so, maybe it’s time to be a C Corporation. It’s a totally different way of looking at your businesses.
On the individual side, what’s happened is your ability to take itemized deductions has been reduced. For example, if you own a home in California, chances are you’re paying a lot in real estate property taxes plus your state income tax. In the past, those were deductions that you got to take as itemized deductions. The most you can take in total is $10,000. I’ve seen people that are making all their money online that have moved out of California. They want to go to a state that’s got lower taxes because they lost a huge tax break and it was the tipping point of, “It’s time to move because I can’t take that deduction anymore.” All you can deduct are medical expenses over 7.5% of your adjusted gross income, up to $10,000 of your state and real estate taxes, the charitable donations and then mortgage interest, but that might be limited as well. Everything else has gone for itemized deductions. We’re seeing additionally people that always itemized in the past are now like, “It’s better to take the standard deduction and be done with it.” That’s created a big shift too because maybe that big home isn’t such a deduction anymore. Maybe it’s better off to have a big house you rent and then own rental properties. A lot of change in how people are approaching taxes is the reality of all these sinks in. It’s an exciting time to be working in tax because so much has changed and there are brand new strategies. There’s a lot that is rewarding people for planning ahead and for owning businesses, which I love working with business owners.
If you are in a state that has high taxes, you might want to move out of state or even out of the country to avoid some of those taxes. There are a handful of states that have zero state income tax like Nevada, Wyoming and Florida. What are some of the other ones?
South Dakota, if you happen to want to go to South Dakota. Alaska, Texas with an asterisk because if your income gets over a certain amount of your gross revenue, then they have a gross receipts tax they’ll add on. For people that are under that amount, it’s something about a million dollars. If you’ve got gross receipts about a million dollars check to make sure what it is if they’re thinking about Texas. Most of my clients that are moving to Nevada, Wyoming. Some are going to Florida, and that seems to be the draws to those states because houses tend to be cheaper and lifestyle’s good, real estate property taxes are less and there’s no state income tax.
Nevada is not as good as Wyoming though because you have that minimum fee that you guys pay there in Nevada. You’re based in Nevada, right?
I am. That’s a tough one. If you’re performing entities, it truly is better to do it in Wyoming. If you happen to live in Nevada and you can prove that you have enough of a connection to Wyoming, the term is called Nexus, you can form Wyoming companies and operate in Nevada. You’re living in Nevada, you have your company in Wyoming and the reason is that it’s $400 a year in Nevada. They’ve got that minimum amount that you have to pay. However, you can’t operate a Wyoming company to a certain extent. There are some little hoops you have to jump in to make sure that you can show that it’s legally established in Wyoming. At least so far you can avoid that $400 fee doing that.
Nevada, is it $400 or is it $700? I thought it was like $700.
I should have said that. There are a couple of ways that you can get out of the $700. It gets down to $400. You’re right, for a lot of people that is $700.
I’m surprising myself how much I know about this stuff and not that I’m going to become a competitor and go into business as a CPA or anything. I’m curious why are there so many corporations out there as a Delaware company? Why Delaware?
We saw Delaware a lot for East Coast companies, the State that was known. The biggest reason, when I see Delaware and my first thought is that either it has been there for a long time because Delaware is the old school place to get incorporated or they’re planning to go public. It is a state that lends itself to doing an IPO on it at some point. That’s probably the main reason why you see Delaware. It’s very well-accepted, it’s got great law for that. Before we leave Nevada, let me throw in another little idea. Nevada allows you to do something called a series LLC. The way the series works is you set up one LLC but it’s a special LLC. It allows you to do these subsidiaries or cells underneath that main one. This is something Nevada law has. Texas law has this as well. Wyoming does not allow that. One strategy, let’s say you’ve got a couple of three different businesses, you’ve got some real estate, you want to keep everything separate for asset protection reasons. Series can work well for that and in this particular case, you only pay the fee once in Nevada. That annual fee that we were talking about for Nevada, it’s once.
You don’t have to pay it on the four different companies you happen to have under that main one. Additionally, they fall in the cracks, these little subsidiaries because you don’t need to register those anywhere. It’s something that you do manually. You personally set up the articles that you set up a subsidiary, you apply for an EIN with the IRS and you can file a tax return with them. You can open a bank account with that but there’s no filing record anywhere. If you’re operating as ABC Sell, that isn’t the name you’d use but if it was that of the subsidiary and somebody is trying to find out who owns it because they want to sue you, they’re going to have a hard time figuring it out because there isn’t a public record of it anywhere. The series LLC in the right circumstance can be a real benefit in Nevada and a way around in getting hit by a lot of these separate taxes.The IRS, Treasury Department, Justice Department, and everybody else don't quite know what to do with cryptocurrency. Click To Tweet
Speaking of getting sued, there’s this idea of a corporate veil that you protect your personal assets from getting sued when you have a company. The company gets sued and can have its assets exposed and potentially taken but your personal assets are protected. If you have a sole proprietorship, that’s not the case.
The corporate veil is actually a protection. It protects you personally and your personal assets for something that might happen within the corporation. It is something you have to maintain though. You have to make sure that they’re certain corporate formalities that you follow. That’s always a warning I like to give my clients because sometimes they think, “I formed a corporation, I can do whatever I want.” I could tell a little story of a client that came to me who had set up a corporation. He had a strip mall, one of those malls that got little buildings, retails, opening up to a big parking lot. I would say we might call it a C-property where it wasn’t really super well-maintained. It was in little seedier parts of the retail outlets through there.
He owned the building and then he had renters and tenants. The parking lot wasn’t super well-maintained. A woman was coming out of one of the stores, fell in a hole and broke her leg. Unfortunately, the parking lot was definitely found at all that it wasn’t well-maintained. She was older and she ended up in a wheelchair. It was something that couldn’t be fixed. Her life was dramatically changed. She got a lawyer and the lawyer sued. One of the first things the lawyer wanted to see, this was before the gentlemen became my client, was all the paperwork on this corporation that owned the strip mall. Their first thing was, “There’s not a lot of value in this corporation. Can we get to this guy?” because this guy happened to have a lot more personal assets.
The problem was he had been operating that corporate checking account like a personal checking account. In fact, he was older and he got a Social Security check and he was having it direct deposited into the corporation account. From the corporation account, he was having his home mortgage paid. He wasn’t taking any tax deductions he shouldn’t have. He was just doing something we call commingling, where he was mixing up the corporate money with his personal money all in one account. In the end, the accounting sorted it out. That was enough in court to be able to pierce the corporate veil. They came after him and were successful in getting a personal judgment against him and took everything that he owned personally.
Setting it up is great. Maintaining it though, you’ve got to maintain it to keep it in place. That was a hard lesson. I tell a story as much as I can because we all need to learn from something like that when you do it. A couple of things, one is that was back in the day when we used corporations primarily. You were protected from a corporation. A better strategy these days is to actually get an LLC, a limited liability company. An LLC, I call it a tax chameleon because it gets to elect how it wants to be taxed. An LLC can say, “I want to be an S Corporation,” and that’s something you file with the IRS in the States and say, “You’re an S Corporation.” In paper, as far as all the taxing authorities are concerned, you’re just like an S Corporation. The reality is that you’re an LLC.
An LLC has the added advantage of not only protecting you for what happens inside that business, but it protects the business from what happens for you. Let’s say you have a great party at your house and somebody falls down your stairs and is able to sue you because the banister was loose. They’re able to sue you personally because there was something bad in your house. Now they’re going to come after your company. If your company was held just a straight S Corporation, they can sue and take your shares away from you of the S Corporation. If it was held in an LLC that’s elected to be taxed as an S Corporation, they cannot sue and come take the LLC away from you. LLC has what’s called charging order protection. What that means is that you can’t go get the LLC assets. An LLC S, which is what we call an S Corp, protects both ways. It protects you from the company and the company from you. We’ve moved a lot of our clients who have straight S Corporations into LLC S’s just as one more added layer of protection. Once it’s set up, it typically doesn’t cost anything different to run that. It just added protection in there.
I have one of those.
There you go. Good job. If we come to your house and fall down the stairs, then don’t sue us. Back to that sole proprietorship that we talked about though. If a sole proprietorship is just in your name and it’s just a Schedule C Sole Proprietorship, everything you own is at risk. Everything inside that sole proprietorship might be at risk. The suit can go both ways. If you set up an LLC, a limited liability company, and you do not make an election and there’s only one owner, it’s what we call a single member LLC, a single member LLC that has default taxation because you didn’t make any election is going to be taxed as that Sole Proprietorship Schedule C. It’s just like it for tax purposes, but for purposes of asset protection, you’re protected. That’s a much better thing to do.
I personally prefer the S-Corp businesses because you’ve got that asset protection or the LLC-S that the asset protection plus you’ve got a much lower chance of audit. In general, it’s something that you’re weighing as you’re going through it. The downside is for sole proprietorships, they’re much easier tax returns to prepare, the bookkeeping is easier for some people. I don’t care if I pay a little extra if I don’t have to deal with all this hassle. It’s worth it. Those get down to personal decisions. At that point, it becomes a bit of a math question, “How much does it save you and what does that work?”
I’ve interviewed Loral Langemeier on the show. She hates sole proprietorships. Anybody that’s filing their taxes with a sole proprietorship, she will just let them have it because they’re at greater risk of getting audited. They’re missing out on tax benefits. They don’t have the corporate veil or that protective veil around your assets. It’s just a disaster waiting to happen.
The LLC is a much better way to go. You’re going to have a sole proprietorship because of all these other reasons that you don’t want to deal with it. At least get an LLC so you’re protected. It doesn’t help you with the rest of it though.
I have an LLC with an S election for my operating company. I have another company that holds my IP and that company is a C Corp. That C Corp, I have set up a medical expense reimbursement plan. My wife and I are able to use that medical expense reimbursement plan for medical expenses where you’re the only employees of that C Corporation. The operating company, the LLC, doesn’t have that capability of having the MERP, the Medical Expense Reimbursement Plan because it just not allowed. It’s only with a C Corp. Another thing that we’ve done that’s really cool is we have staggered tax year-end. We have a tax year-end of the calendar year for the LLC but mid-year, June 30th for the C Corporation.There are very few tax breaks available in general. If you buy crypto and hang on to it, you're not going to pay any taxes. Click To Tweet
All of the fantastic ideas, the Medical Expense Reimbursement Plan, MERP we call it, is a wonderful benefit, especially for people as they’re losing their itemized deductions. If you’ve got medical expenses that aren’t a few thousands a year and it’s not enough to qualify as an itemized deduction, you can take it through the MERP. It works much better than nothing. Additionally, it works better than the payroll deduction because I hear that sometimes people saying, “I’ve set up payroll and have it withhold my paycheck.” The challenge with that is that has to be planning in advance. If you do one of those where you have a payroll deduction that’s setting aside for medical costs, that’s great. In some cases, if you withhold too much, it rolls over to the next year. In some cases, depending on the plan, it doesn’t. You just lose it.
If something happens and suddenly have a big expense you have not expected, too bad, you’re paying for that with nondeductible money. In the case of the MERP, it’s after the fact you get reimbursed for expenses, so you don’t have to plan ahead. I think that alone is just priceless. I’ve had plans to run into that and all of a sudden something happens that you didn’t expect and they’ve got a $10,000 expense because with medical insurance costs these days and deductibles, that’s not an uncommon amount. They don’t get a deduction for it. With the MERP, you get that $10,000. It’s a great planning device. Just to comment out here that MERP needs to make sure it’s filing an annual tax return. It’s not a complicated return. It’s just one more thing you need to remember to do or else the IRS can void the plan.
The thing you were talking about that you have to plan in advance, that’s the Health Savings Account, the HSA?
Yeah. I’m just saying that because when I talk about MERP, that will usually be the objection, “I’ve got an HSA and so everything’s fine.” They’re different in how you view those. The MERP really is a more powerful one. The other comment I want to make is that I really am happy you’re using a fiscal year-end for your C Corp. When it works, you will love that. Sometimes I run into that with my clients. In December, we’re having a meeting and we discover, “It looks like you made $100,000 you didn’t expect.” They’re like, “What am I going to do? I don’t have the money set aside for the taxes. I don’t have time to buy anything. Even though I need equipment, I’m too busy or everything’s closed, it’s too late.”
If you have a C Corp, you don’t have that conversation because it’s possible that if you have income that goes from your S Corp or your C Corp that maybe you pre-pay some items or you take on another project that you’re paying in advanced. You find a legitimate reason that you can take income out of that operating company and move it to the C Corp. In your case, you’ve got June 30th year-end. You have six months of what you’re going to do with that extra $100,000. You can now go out and do the things that you wanted to do, you just didn’t have time to do in your operating company.
There’s a little more recordkeeping that I’ve found with a C Corp that I wasn’t used to with an LLC like the annual meetings, the meeting minutes and all that sort of stuff. Do you find that if you don’t keep those up-to-date and have the annual meetings and so forth, they can pierce the corporate veil that way?
They can and they will. Unfortunately, if you did, it happened to get an audit although the good news is the C Corps are not being audited very frequently these days because the IRS doesn’t have anybody to do it. If you did get an audit, they almost always ask for minutes as one of the first things they’re asking for. What they’re going to try to do is prove that you really didn’t have an operating C Corporation. You weren’t running it like that. There’s a term for it where you’re using it like another pocket. If they can do that, then this will just blow it all as personal. Having the minutes are important. Here’s some good news as part of all of this. The annual meeting is actually a deduction and it can be held somewhere else.
You live in California, so you’re not going to probably want to take the California vacation. Let’s say you decide, “We want to go to New York City and we’re going to go to some Broadway shows and we’re going to do this and that, but we’re also going to have a board meeting.” The Broadway shows aren’t going to be a deduction unless there’s a way we can tie that into your business somehow. The trip there and part of your expenses while you’re in New York City are a deduction because you’re having your annual meeting there. Is that a reason to do the minutes? Maybe. You get to take this great write-off while you’re doing it.
We talked about some different states, but we didn’t talk about Puerto Rico. I want to bring that up because there’s the Act 20 and Act 22 and you get the 4% tax rate instead of the crazy taxes we have to pay in the mainland. Do you have clients that are moving or have moved to Puerto Rico?
I do. I also have clients and friends that are Puerto Rican that live there. That’s a really interesting part. If you don’t mind, I’m going to get my website out, USTaxAid.com. If anybody’s considering that, I have a good friend who’s an attorney who was part of the original legislative session that put the bill together, the original Act 20 and Act 22. He’s now an attorney in private practice in San Juan. He helps businesses that are relocating and individuals that are relocating. I can help you with that connection for that. This is a wonderful strategy, especially if you move there. It’s not going to pay in taxes if you set it up properly and you move there.
We’ve seen a number of the crypto millionaires going there. You might have heard the term that they’re trying to create, a society, Worktopia I think they call it. The thing is it’s really happening. They are making some major changes. They’re helping restore the island in ways that the US mainland wasn’t doing. For that, all businesses are being rewarded. There was a concern they weren’t going to with Act 20 and 22 going because they needed so much money after the hurricanes. This really has worked well for them and they are continuing it. Let me just sum it up with if you move there and you invest money there and you’re a resident, you have capital gains once you establish a residency there that you won’t pay any tax on that.
It also doesn’t mean that you have to be there and you never leave the island. You do have to be in Puerto Rico for more days than you’re off of the island. It can be your primary residence, but you can also still travel back to California or wherever you might have additional homes. Puerto Rico becomes a great way to do that. I have a number of clients and in fact some of the CPAS that work in my firm, we have a virtual CPA firm, live outside of the US. We take advantage of that. I have a home in Baja, California. I’m actually in Baja, California more than I am in the US so I’m able to qualify for the Foreign Earned Income Exclusion, which means that the first approximately $220,000 that I make is not subject to US tax or Mexican tax because you’re able to go through a little crack there.The IRS doesn’t view cryptocurrency as a true currency; they’re viewing it more as property. Click To Tweet
There are a lot of strategies depending on how far outside of the box you want to look. This is absolutely 100% legal. I received the notice, I got the copy to of it that for US citizens living outside of the mainland US, they have lessened some of the requirements on the bank accounts. There had been some problems with something called backhoe, which I had to do with foreign accounts. US citizens owning accounts outside of the US, those restrictions were lifted in November 2018. That’s helping a lot of people who are living at least part of the time outside of the US mainland.
If you’re going to spend more time than half the year, like 180 days off of the island, then you’re screwed, right?
Not entirely. If you have a legitimate business that’s operating there, then your business is going to get some exclusions as well and some tax breaks. For people who created their own crypto, started their own ICO, were doing mining or bought cheap, when it was $200 for a Bitcoin for example. They’re still making tons of money regardless of what the market is showing for Bitcoin. If they’re going to about to sell some, they can be advantageous to live in Puerto Rico. You have to be careful. They want to make sure that they’re seeing assets that were purchased after the time you got there. There are strategies for that as well. The bottom line in all of this is if you’re a resident it’s better but having a business is certainly possible. You have to be able to show that you have a business there. A client of mine does a lot of online internet marketing things. He has his online businesses, he’s moved his customer service into Puerto Rico. That was enough for it to peg that’s a Puerto Rican company. He’s taking advantage of all those tax breaks.
This is a loophole though because the US is one of the few countries in the world that taxes on worldwide income. How is it that Puerto Rico is this one haven where you don’t have to pay the 30%, whatever your tax bracket is in the US being a US citizen?
Why does it exist? The answer is I don’t know. Puerto Rico is a territory of the US, people who live there are US citizens. They do not receive a lot of federal benefits. They can’t vote in federal elections. There’s a lot of quasi-US laws regarding Puerto Rico. I would give a guess and I’m not an expert in this field at all. My guess is that there’s a tradeoff there that Puerto Rico gets to have some autonomy in exchange for giving up their right to claim federal benefits. I don’t know if that’s true, that’s my guess. This is one that I frequently hear from people though that they cannot believe how good the break is for Foreign Earned Income Tax Credit for people who live outside the country. They all think it’s a loophole that the government’s going to close and the answer is no. The reason that we have that one is that there are so many people that are working private industry on military operations. Part of the attraction is for private contractors that they can get people to go over there and work there. They don’t have to pay tax on the earnings that they have in these war-torn countries. That’s why that exists. It happens to be that other people can live in other places and take advantage of the same tax credit.
I know some people who are living in Puerto Rico because of this great benefit. They go from whatever crazy tax bracket they were in like the top one usually to nothing, 4% or whatever. John Lee Dumas, he’s been a guest on this show and he lives in Puerto Rico. He has this amazing low tax that he has to pay. We actually talked about it on the episode.
I’m curious, did you recall if he talked at all about why Puerto Rico had this special break?
I don’t think he did. What are the tax implications around cryptocurrency investing and using cryptocurrencies? You a new book out on the topic of crypto tax. Let’s talk a bit about that.
It’s like the IRS, the Treasury Department, the Justice Department and everybody, they don’t quite know what to do with cryptocurrency. The IRS has come out and said, “It’s property.” However, if it’s property, if people who do real estate or investing in real estate, they know that if you have a property that goes up in value. You can sell it and do a rollover and exchange into another property and not pay tax on it. It defers into the next one. You’re not allowed to do that on crypto. They’re trying to create this new category and there’s a lot of confusion about it.
The bottom line is that there are very few tax breaks available. In general, if you buy crypto and hang on to it, you’re not going to pay any taxes. If you use it like you’re buying goods or service on it, that’s actually a taxable event. You have to pay tax on whatever the gain is that the fair market value of that crypto happens to be. I’ll pick on Bitcoin. Let’s say that you bought in when it was $200 and it’s worth $5,000. You exchanged that $5,000 Bitcoin for goods or service worth $5,000. You have to pay that difference tax on that $4,800 capital gains that you’ve got when you use it.
When the crypto does a harder soft work and you end up with in any other investment, we call dividends, when you received those “dividends,” those are taxable as ordinary income. You don’t get any special rate on those. Sometimes the crypto will say, “We’re not going to use this anymore. Instead, we’re going to use that.” We go from A to B and so you change your A investment into a B investment. That ends up being something taxable for you because there isn’t that ability to do an exchange. We can’t do a lifetime exchange. There are a lot of things that trigger it that you might not realize. A couple of other things that we do that are nice is one, if you have a stock that’s gone down in value, you cannot sell it and then immediately buy it back. The reason you might sell it is that you want to take the loss on your tax return. You immediately buy it back, it’s called a wash sale. You don’t get to take advantage of it because crypto isn’t really a stock, you’re able to do wash sales.
One strategy can be if you’ve got a bunch of gains you want to create some loss, go ahead and sell the crypto and then buy it right back. You’ve got a loss now that you can take to offset your other ones. This is assuming that particular type has gone down. Another one is because we don’t have good rules yet on cryptocurrency and we don’t know how do you inventory it. Let’s say, I buy some every few months and I’ve been doing it for years. I now sell it, which the IRS hasn’t figured out how to allocate what the basis in that because you’ve bought it at low times and high times. One thing you can do is you have different online wallets. You can then say, “I’m going to sell from this wallet so that I’m going to take some of my stuff that maybe was at a higher cost when I bought it and so I’d have less gain. Maybe I want to create some gain so I’m going to sell this crypto over here that has lower gain.” You’re able to play with basis when you sell.
Those are a couple of the strategies that you can use to take advantage of the fact that the IRS doesn’t have great rules. The bottom line is just to be careful. Don’t assume that the rules regarding property or what you might think currency would apply here because the IRS says no. One of my favorite examples is let’s say I’ve exchanged some of my money into Mexican pesos and then the dollar changes its valuation according to the peso and I use my Mexican peso. Nothing happens on my tax return, it doesn’t matter either I did a great exchange or I did a bad exchange. Depending on what happened to the value in portion. With crypto, it does matter because the value you that you exchange becomes a taxable event either gain or loss.It's interesting how we're dealing right now with tax law and the rewards that are being given to technology. Click To Tweet
Doesn’t it handicap the cryptocurrencies in relation to regular currencies? If I do currency trading as a way to make some money as a side thing, I don’t have taxable events all the time, I’m moving money around from one currency to another but if I do it with cryptocurrency is I do.
Although we would call it cryptocurrency, the IRS does not view it as a true “currency.” They’re viewing it more as property but they don’t give it the advantage as the property have. At the same point, they view it like you might view stocks. For example, we used to be able to take a lot of things as investment expense deductions and with the Trump Tax Plan in 2018, those are all gone. The same is true for crypto, you can’t take deductions for software that might help you decide when to buy and sell or courses that you take to learn how to be a better crypto trader. The only way that you get to take those deductions is if you’ve got an ICO, you’re in the business of it somehow, the Initial Coin Offering or you are mining it. If you’re mining it, then it’s considered an active trader business. There can be something to be said for starting a little mining operation so you can pick up your deductions.
There are so many little details to think about that stuff. If you’re going to create a little part of the business that does something like mining or whatever you’re doing that is potentially R&D related, then there are Research and Development credits that you can claim. Do you want to talk about that?
That has changed with the 2018 law to a little extent. I would push people back to my website, USTaxAid.com. The American Institute of CPAs, AICPA has asked for a definition from the IRS regarding some of that R&D related to crypto. It’s so up in the air that I would say, “Let’s see how that’s responded to.” If you go to my website, USTaxAid.com, I’ll have the information right there. It’s such an interesting thing, my book was supposed to come out in December and I purposely didn’t release it. I call this the heads and tails from the cryptocurrency. The book didn’t come out right away because I was waiting for some opinion letters that we needed to hear from because they’re really going to change some of the strategies we use. The R&D credit is one of those things. It’s interesting how we’re dealing with tax law.
If you have a business that builds software, there’s some R&D component to the business. You can get a tax benefit off of that.
The whole Software as a Service and strategy has become a very powerful one. Besides the R&D tax credits, this new pass through 20% income deduction that we’ve got the possibility, they have decided to exclude Software as a Service. Using software as an idea is if you’re building out software, you might also get a 20% income deduction on that. Even though we call it software as a service, it is not considered a service under that definition of the Trump Tax Plan. There are just some huge benefit possibilities with that. It’s interesting to see the rewards that are being given to technology.
Let’s say that you want to buy some real estate. Do you want to buy that with a company or do you want to buy that personally or with a trust? What do you recommend?
In general, I like having them inside an LLC. It is possible to also include a trust as well. A trust might be owned by the LLC and that gets you great asset protection. It also gets you a state planning protection. They get a whole bundle of things when you do those two together. In general, I don’t like holding real estate inside of an S Corporation and never inside a C Corporation. We don’t like having appreciating property, it’s something that’s going to go up in value inside a C Corporation because you lose your capital gains exclusion. If you sell it that’s the only purpose for the corporation, you can face something called a liquidating dividend, which is subject to double taxation. Typically, the best structure is something that has an LLC that is not electing S or C as a component part of that.
If somebody wanted to read your books, take some of your online courses, get coaching from you or have you do their tax planning, how would they get in touch?
It’s USTaxAid.com. When you go there, you’re going to see that I post usually about three blogs a week of current strategies. There’s a way to ask tax questions and you can find out about the live coaching that we do, consultations, tax prep, all of that to find us there.
Thank you so much, Diane. Thank you to our audience. Hopefully, you’re armed with some really good tax-saving information that you can apply when you file your taxes. Also set up your entities the right way, as we discussed in this episode so that you aren’t getting overtaxed. We’ll catch you in the next episode.
- Taxmageddon 2018: How to Brace for the Trump Tax Plan
- Mike Packman – previous episode
- Diane Kennedy
- Loral Langemeier – previous episode
- John Lee Dumas – previous episode
Your Checklist of Actions to Take
☑ Choose the best business structure carefully before I apply for a business permit. For S Corporations, having an LLC can make an election be taxed as an S Corporation.
☑ Disclose tax returns of any foreign bank accounts that I may have to avoid the risk of being audited.
☑ File cryptocurrency transactions that are over $20,000 even if it’s only bought and held onto. For as long as it’s reached that amount, I must report it.
☑ Know the limit for which IRS can go back and reevaluate my tax return. Diane says it’s three years from the filing date of the return, but be cautious with states as they may have different laws.
☑ Keep a record of at least 3 years of my receipts and be prepared to show that there’s a business purpose for it. Take a picture, save it, and make notes.
☑ Pay attention to how the Trump Tax Law affects my business. If I have a pass-through entity, figure out if it’s a service business because the amount of deduction I have will be limited based on how much my taxable income on my personal return is.
☑ Be informed of the states that have zero state income tax like Nevada, Wyoming, Florida, South Dakota, Alaska.
☑ Get an LLC. Diane calls it a tax chameleon as it gets to elect how it wants to be taxed. Also, through an LLC S or S Corp, it gives you the protection from the company and the company from you.
☑ Reach out to experts, get coaching and better plan my tax strategies by visiting USTaxAid.com.
☑ Grab a copy of Diane’s book Taxmageddon 2018: How to Brace for the Trump Tax Plan and be informed of the various tax strategies that I can apply for my business.
About Diane Kennedy
Diane Kennedy is an NYT best-selling author of tax, business & investment books. She’s a CPA and is founder of a virtual CPA practice with CPAs & clients around the world. Her latest book “Taxmageddon 2018: How to Brace for the Trump Tax Plan” is a #1 Amazon best seller in 6 categories.
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