Topics covered in tax bulletin articles:

1 Deductions

We have been conditioned to think that the major purpose of tax planning is to generate more deductions of any type, that any deduction is a good thing and that the more deductions you have, the more successful you are at tax planning.  In contrast to this is structural or entity tax planning where you use different entities to achieve your goals with an overall lower tax cost.  The latter is the primarily concern of my practice.

  But those of you who never saw a deduction you did not like, you need to learn that some deductions are better than others. These are the points I think you need to keep in mind so you will not be unpleasantly surprised by me or another accountant:  

1. Schedule "C" (self-employed business person/independent contractor) deductions are good, employee deductions are not so good (indeed may be virtually useless). Schedule "C" deductions are better for several reasons:  

     a. Schedule "C" income is subject to 15.3% FICA and Medicare tax in addition to your income tax. Thus a deduction against your self-employment income will typically reduce your taxes by 30-50%, whereas a employee deduction at its best would only have a 15-35% effect.  

     b. You can only deduct employee deductions to the extent that they exceed 2% of your adjusted gross income.  Thus if your employee business deductions are $1,200, and if your adjusted gross income is $40,000, and you have no other miscellaneous itemized deductions, then your actual tax deduction will be $400 (that is $1,200 less the $800 which is 2% of $40,000).  

     c.  If you are an employee in a sales position and have more than several thousand dollars of entertainment and travel expenses, and make close to or more than $100,000, then you will likely see the effects of alternative minimum tax. This means that you will lose employee business deductions that are excess of roughly 17-20% of your gross income.  Thus if your adjusted gross income is $120,000, then you could deduct at most $21,000 of legitimate business deductions (the exact amount of the limit depends on the amounts of your other itemized deductions). Other amounts in excess of that, although legitimate, would not produce a tax benefit.     

     Most itemized deductions (e.g., medical expenses, taxes) are not deductible for alternative minimum tax, and thus will not produce a tax benefit if the amounts are large in comparison to your gross income; the exceptions are (1) qualified mortgage interest and (2) charitable contributions of cash or non-appreciated property. However, be aware of the increased substantiation requirements for charitable deductions. For tax years beginning in 1995 for charitable contributions of more than $250, in addition to your proof of payment, you need a separate letter, postcard or such from the qualified charity to confirm that the amount that was paid was solely a contribution.           

2. To have an office-in-home deduction, you need to have net income from your business in order to take the deduction.  If you have $4,000 in office-in-home deductions (e.g., prorated rent), but only $2,000 net income before the office-in-home deduction, then your net taxable income will be zero.  You cannot use the office-in-home deduction to create a loss to offset against other income.  P.S. This is in the law.  The IRS did not make this one up.  

3.  If you want to have a profit-sharing plan deduction, you need to have net income from your business.  If you want to use the IRC sec 179 write-off for purchased office equipment, etc, then you also need net business income, although for this purpose, your or your spouses wages will also count.  

     Based on the above, I hope it is clear that in many cases, chasing additional employee expense deductions becomes a waste of time.   

     Given the obvious greater utility of Schedule "C" business deductions as compared to employee business deductions for many taxpayers, the U.S. Treasury/IRS fears that some taxpayers have created and will create Schedule "C"'s on their individual income tax returns in order to be able to be in a more favorable tax situation.  For this reason, Schedule "C" projects have been started by local IRS Districts.  There are many facets to these projects, but the bottom line is that the IRS will attempt to limit the use of Schedule C to "legitimate business".