That's not perfectly true, but it's close enough. We tax professionals are able to legitimately help taxpayers reduce their exposure to income taxes, but we cannot eliminate income taxes (unless the taxpayer decides to quit making money). However, the tax code is so complex and enforcement is so lax a lot of tax myths are able to flourish. For example, a few years ago my brother-in-law asked if he could "hire" his wife and kids and funnel most of their wages into a 401(k) plan. (This would allow whatever he paid them to escape current income taxation while giving his business a tax deduction.) I said, "Sure. What are they going to do to earn their wages?" He was shocked that there might be some requirement his wife and kids had to actually do something to earn the money that would be salted away into a 401(k) account. He was even more shocked to learn the money, once in the 401(k) plan, could not be used by him for his own business and investment purposes. Why was he shocked by these rather obvious (to a tax professional at least) requirements? He has friends who claim they were hiring family in their businesses and doing precisely what he'd described to me. So far, his friends have gotten away with it (not surprising given the low audit rate). Eventually, those friends will be audited and the IRS hammer will fall -- hard! In the mean time, a tax myth has been created that this kind of thing is appropriate tax planning.
The same thing was true, only on a much larger scale, with the tax shelters of the late 1990s and early 2000s. Lots of individuals and businesses participated in the shelters because they'd heard that everyone else was and the IRS had blessed the transactions. It was an easy thing to believe. If you'd heard of dozens of people selling their business who'd avoided tax on several million dollars of gains and none of those people had gotten in trouble with the IRS, why shouldn't you believe that you, too, could avoid the tax on your large transaction? In this case, silence from the IRS was not the same as permission. It just took the government a decade to catch up with what was going on. Much grief and anguish followed.
« Flu | Main | War and Crimes » More on Sheltering Business Income16 Nov 2009 01:44 pm
From commenter Dave Walser, a tax professional:
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The shock that this commenter's client showed reminds me a lot of the shock I have encountered repeatedly from clients who were absolutely sure that incorporating their business would be a complete shield from personal liability in lawsuits. The legal tricks just don't work that way.
Related is the claim that you can create a corporation to borrow a bunch of money, pay yourself a bunch of it calling it salary/bonuses/whatever, then let the company go bankrupt and you'll avoid having to pay it. An intoductory business law class tells you this isn't true, but it pops up every once in a while still.
Not to mention that banks are not wholly stupid (recent evidence to the contrary) and usually require the sole owner/officer to guarantee all the loans.
One thing you can do, as far as I know, once your kid starts earning some actual money from dogwatching or babysitting or what have you is:
(1) Have the kid put her entire income into an IRA, ideally one that will require minimal minding over the next 45 years (like a Vanguard age-adjusted index fund combo). (I think you can do a Roth, but I would want to check).
(2) Gift your kid an amount equal to the IRA contributions.
(3) Have your kid declare the whole arrangement, then pay her $0 in taxes.
Presto! Assuming the arrangement doesn't bite your kid in the @ss when it comes time to calculate college tuition, you've effectively started your kid her retirement planning.
It seems to me that this is a question of degree. Thus, if you pay your 3 year old $50,000 for his services to the business and your homemaker wife $250,000 for her services, you’ll have big problems. But if you pay your 10 year old, $2500 for filing, shredding and copying, your 12 year old, $2500 for light janitorial work, and your wife $25,000 for some bookkeeping and other office work, I’d be very surprised if the IRS would challenge those expenses.
I agree that if you spend the money, it is easier to pay the tax.
I will say there are ways you can structure your life that are better than others. Being self employed does save a lot because you can deduct traveling to your client's site as opposed to non-deductable commuting. I probably paid the same total tax on 40% more revenue when I was self-employed, but the problem is you can't really get promoted that way.
JJW, paying your wife $25k may be legal, but you wouldn't really save money that way after FICA, unemployment tax, franchise fees, and the marriage pentalty.
Basically, it just comes down to understanding the law, understanding the business reality, and making the best decision. But if there were an easy way to save money everyone would be doing it.
The whole premise of Megan's post is that paying your wife can be a way to evade taxes. If "FICA, unemployment taxes, franchise fees[?], and the marriage penalty" negate that advantage, then I don't see any point to this post.
FICA and unemployment taxes are a problem, but if the wage paid to the wife is dumped into a 401k, there is a possibility for overall tax savings. Pay the wife $20,000 and she puts away $15,000 in a 401K with her and her husband in the 35% bracket, there is a tax savings.
You have also sheltered the earnings on the growth of the $15,000 until a future date, one in which you may be in a lower tax bracket.
It certainly doesn't work for everyone, but I see people do it successfully.