If tax deductions are your destination, then the tax code is your road map. As you follow this map, tax strategy dictates the kind of car you will drive, the road you will take, your departure and arrival times, and how fast you will drive. To arrive as quickly as possible at your destination, you must choose the correct route, select the right kind of car, leave on time, and avoid getting caught speeding. In tax language, this means knowing the tax law, adhering to IRS rules, keeping good records, meeting required deadlines, and engaging in ongoing pro-active planning. Effective tax planning combines knowledge of the tax code with tax strategy to help you achieve your goals. And if you’ve ever taken a trip, you know that planning is half the fun.
With effective tax planning you can:
- Use the tax law to your advantage
- Convert temporary deductions to permanent deductions
- Convert non-deductible personal expenses into deductible business expenses
- Lower your audit risk
- Move more quickly towards your wealth goals
Using the Tax Law to your Advantage
The government specifically incentivizes those who help it achieve its primary objectives of increasing jobs, housing and the economy. These people are generally business owners and investors. Proper tax planning moves you into one of these categories and allows you to take advantage of the intended benefits of the tax code.
As business owners, self-employed dentists are helping the government achieve its objectives. In addition to the typical deductions for business expenses, dentists who manufacture items in-house such as crowns and dentures can take advantage of the Domestic Production Activities Deduction and save several thousand dollars in taxes each year. Tax strategy dictates good record keeping to separate income and expenses related to the manufacturing activity from other income and expenses generated in the business.
Temporary vs. Permanent Deductions
Many of the most popular deductions, such as contributing to a 401(k) plan are temporary; they just defer the taxes until later. The best deductions are permanent, meaning they reduce your taxes forever. Employing a solid tax strategy helps you take advantage of the permanent deductions and helps you turn some temporary deductions into permanent deductions. Permanent deductions generally move you more rapidly towards your wealth goals.
Depreciation is a temporary deduction that can be made permanent. Let’s use rental real estate as an example. The depreciation deduction is temporary because when you eventually sell the property, gain on the sale will be increased by any depreciation taken over the life of the asset and “recaptured” as income. A tax strategy of keeping a piece of real estate for the long-term and passing it to your heirs when you die makes the depreciation deduction permanent because it removes all the depreciation recapture and allows your heirs to sell it essentially tax free, or to keep it and depreciate it all over again.
Lowering Audit Risk
Converting your business entity from a sole-proprietorship to an s-corporation is a good example of a permanent tax deduction that also lowers audit risk. For a dentist, the typical annual tax savings from this strategy can be about $5,000 per year. That’s $5,000 per year, every year, for as long as you operate the business. To make this deduction work there are rules that must be followed. You must follow corporate formalities, pay yourself “reasonable compensation” for the service you provide to the business, report your shareholder medical insurance on your W-2, and so on.
Making non-deductible expenses deductible
Employing your minor children is another effective way to permanently reduce your taxes that requires very good record keeping and documentation to protect from audit risk. If properly done, it can allow you to shift up to $6,400 per child per year to a zero percent tax bracket. You can also use it to convert previously non-deductible personal expenses into deductible business expenses. One way to do this is to require your children to use a portion of the money they have earned to pay for personal expenses such as soccer league registration, clothing, or private school tuition. Also, your business may provide cell phones and other benefits to its employees. Within reason, meals with employees during which you discuss business are generally deductible, as is business related travel. If your children are integral parts of your business, it is easy to think of business expenses that benefit them, and you.
Owning rental real estate in locations you like to visit is another great way to make formerly non-deductible personal expenses into deductible business expenses. I encourage you to buy rental properties where your kids go to college, where you like to travel, near where your relatives live, and so on. With appropriate record keeping and strategy, business travel can be entirely deductible.
Reaching your wealth goals more quickly
Taxes are the single largest annual expense for many people and businesses. Permanently reducing your taxes as much as possible, and reinvesting the savings is the quickest way to reach your wealth goals. Effective tax planning combines knowledge of the tax law with tax strategy and speeds you down the road towards achieving your dreams.