No One Understands AMT

Have you ever been asked to explain any of these things?

•  The Holy Trinity
•  The Tooth Fairy
•  Why you only ever see one shoe on the side of the road, and never two?
•  How your Aunt Dottie is always drunk, no matter what time of day it is, and you never see her drink anything?

If you've ever been asked to explain the Alternative Minimum Tax (AMT) to someone, you see what I’m getting at. I would have an easier time explaining the benefits of waxing to a bear.

When a client is all of a sudden subject to the AMT for the first time, their eyebrows go up and their mouth begins to form the words “What the hell…”. I can see it coming…that incredulous tone bordering on defensive that signals I have some explaining to do and quick. As though I handed them a tax return prepared in Latin and have asked them to recite it an audience.  And I don’t blame them. AMT is difficult to understand, and difficult to explain.

So, what is the AMT?

The present AMT was enacted in 1982 (thanks, President Reagan).  Like all magical alternate universes, it wasn’t necessarily created for evil.  But, in order to understand AMT, you must visit the alternate universe much like an alien.  This universe requires you to suspend what you know about regular income taxes and calculate a different tax, an alternative tax, one where some deductions are allowed and some aren't; where you make money and pay taxes, but like the portkey in Harry Potter, a seeming ordinary and innocuous event transports you to a magical and alternate universe, where you could owe more tax. In the regular universe, there are deductions that one can take.  In the AMT universe, where Voldemort and IRS live, some of those deductions vanish.  POOF!

The two common disallowed deductions that impact our clients when assessing taxes in the land of AMT are:

•  state income taxes paid

•  miscellaneous itemized deductions.  

For regular universe income taxes, these are great deductions. In the land of AMT, they don’t exist. So, when you add those deductions back to your taxable income, along with other required calculations (remember that portkey), turn your head to the left and spit in the air, then assess the flat tax rate of 26% or 28%, if your tax under AMT is higher you must pay it. If not, then you pay your regular income tax. 

But, how did I get to the land of AMT?
Most people are under the assumption that if they make a lot of money, they will be subject to AMT. Not true. It’s funny that AMT was created to level the playing field between the higher income earners and average income earners, but it only succeeded (in my opinion) in subjecting more average income earners to a higher level of tax. As with every road that Congress paves, hell was involved, as were good intentions. So, income is only a small part of how you end up in the land of AMT. 
You don't find AMT. You don't plan a vacation to AMT. You end up there, like that bar you end up visiting at 1am. A series of situations occurred that lead to AMT. 

The AMT form instructions are 14 pages long. FOURTEEN PAGES OF IRS-SPEAK. Harry Potter is 7 books, and it is far easier to explain. This blog post wasn't intended to tell you how to avoid AMT. It's tricky, it is everywhere and nowhere at the same time. It wasn't even a good attempt at explaining AMT.
This blog post was written to increase your awareness of AMT, and also let you know that we can meet to discuss if and how AMT impacts you.

So, bring your abacus, your Latin-to-English dictionary, and a shot glass and we’ll discuss it further. Try to avoid portkeys on your way.

Is Tax Avoidance Really a Strategy?

I know…I know. Some of you are already raising your eyebrows. Let me be clear about something. I didn’t reference “tax evasion.” I referenced tax avoidance. There is a difference, and it’s not 10-25 years.

Every business owner wants to avoid taxes, but maximize profit at the same time. Sounds easy enough, right? Sure. And we will meet on my private yacht to discuss how to do this.

I recently worked with a client who was interested in selling an expensive business vehicle to a family member who was NOT involved in the business. When we met to discuss the decision, I casually mentioned that the sale was going to result in income to him. 

“But why should I have any income on the sale?  I am planning to pretty much give this truck to him.” (Client, annoyed)

“I think that’s honorable, but you can’t do that.  You can’t just sell this truck that would appraise for $25k to your family member for $10 and avoid the gain.  You’ll record the sale at FMV.  And remember when we fully depreciated the truck a few years ago to avoid taxes?  Yeah, all of that depreciation comes back and guess what?  It’s not capital gain.  It’s ordinary income.”

“But I still owe $20k on the loan.  I won’t have any money after I pay those taxes and the loan balance.” (Client, more annoyed)

“That is absolutely correct.” (Me, hesitant)

“I want my money back.”

He didn’t actually say that last line, but I know he was thinking it.  

The fact is that most clients looked at the accelerated depreciation rules we had in place over the last 13 years as license to buy assets, finance them to the hilt, avoid taxes, and disregard the tax implications of selling them. It’s a pretty good gig, until you realize the idea only works until you sell the assets.

It’s hard to advise a client to pay some tax to avoid more pain later, but I think we are not doing our job if we don’t at least raise the issue. The fact is that while you can certainly avoid taxes in a perfectly legal manner by rapidly depreciating qualifying asset purchases, that decision comes home to roost when you consider selling them. We take for granted that clients can see the future as well as we can, and while we work for some of the smartest clients around, it’s our job to analyze the transaction as it stands now and as it may stand later. As an IRS agent told me the other day, these difficult conversations are why we get paid the big bucks.

Raise your hands if you think your tax rates will be less in 5 years than they are right now. Exactly as I thought…there’s only one of you.  So, those generous depreciation rules we had in place from 2000-2014 were just that. They were generous, for a time. Yes, we used the rules to reduce taxes in the short-term, only to potentially expose the client to a gain they didn't expect on the back-end. Legal tax-avoidance at its best, but swallowing the tax on the gain when those assets are sold is a difficult task.

Don’t let depreciation cause you heartburn. The most powerful antacid can’t cut that pain.

Who Doesn’t Like a Refund?

Imagine that you’re walking down the street, and you see a hat on the ground.  You are curious and you pick up the hat, to find a stack of cash underneath it.  There’s no penalty for keeping it, it’s just free money.  You keep it, and you’re happy.

Imagine instead that you went to that hat every day for a year and placed a dollar underneath it.  No one but you knew the location of the hat, so there was no danger of someone stealing the money.  But every day, you stopped and placed $1 underneath the hat as opposed to taking the money home with you, or buying groceries.  On April 15, you stop at the hat each year and take your $365. 

Are you still happy? Or do you feel as though the money was yours all along, but you just let the hat guard it for a year at 0% interest and 100% opportunity cost?

Yeah, that’s how tax refunds work for most people.

I know that there are circumstances that create refunds for taxpayers, and those little added bonuses are nice and unexpected. Your child is in college, and you are due a refund because of the American Opportunity Tax Credit, for instance.  Or you make about $75k as a family and you receive the tax credit for participating in a pension plan at your work.  You didn’t expect them, but they happened.  Those are refunds granted to you by the IRS not because you paid those taxes up front, but because you made other decisions.

If you’re the kind of person who gets those “hat refunds” and you want to begin holding onto your own money, this is your invitation to do something different.  Our clients who work with us throughout the year often ask us to help them forecast their tax liabilities so they can make changes to their exemptions and take more of their paycheck home each pay period.  I love doing that.  I worked with a client last year who always received about $18k each year in refunds.  This year, he owed about $1k in taxes, but guess what?  He was able to utilize the $18k throughout the year rather than waiting for a large chunk in April.  I was proud of him.

If this appeals to you, what are you waiting for?  Get in here.

The Mustard Bomb

My dad and mom owned a family business of one type or another for most of my at-home life.  My dad painted houses with my uncle and with my grandfather, and then he and my mom owned a hardware store together. The biggest success they had, however, was with the general store they ran together for 22 years. I began working in that store when I was 11, and I worked there with varying levels of frequency until I graduated Clemson in 1994.

My dad is what I like to call a quiet teacher. In other words, he won’t speak his lessons….he lives them, so you learn by watching. I love that about him. The man has little to no temper to speak of.  My mom, on the other hand, has a fiery temper. I inherited a pleasant mix of both, and when I was younger, I let my temper get the best of me with a customer in their store.

We sold the best hot dogs in town. It was my dad’s chili recipe that sold them, and people ordered them all day, every day.  The first order usually went out at about 6am and we didn’t stop until the machine was broken down and cleaned at 8pm each night. This particular day, a lady came in and ordered a hot dog from me. I didn’t want to be there….I was probably 13 or 14 at the time. I was half-listening, and so I didn’t make it the way she said she requested it.  She wasn’t very tactful in the way she voiced her displeasure and it embarrassed me in front of my mom. So, what did I do? I took the hot dog from her, and threw it into the wastebasket by the register, splashing chili and whatever else was on there into the air, and made a scene. Under my breath, I called her a not-repeatable name, and went back to make her another hot dog.

She explicitly asked for “no mustard.” Being the jerk that I was that day, I decided to give her "no mustard". I found a hot dog bun with an air pocket in it. Then I filled that pocket with mustard. I nicely wrapped up the hot dog and sent her on her way. I smiled at the thought of her biting into it and how suprised she would be to find a big ole' mustard bomb.

I know for sure that somewhere down the line, my dad heard about this incident. He never mentioned it to me, but I just know he knew about it. But, what did my dad do? He kept showing me how to provide good customer service. By the way he talked to his customers, who sometimes yelled at him or acted foolishly. By the way he smiled and wished every single person a nice day even if they hadn’t ever spoken a kind word to him. By the way he extended credit to people knowing he’d never get paid. He wasn’t a push-over. He just couldn’t call himself a good man if he didn’t allow them to purchase diapers for a newborn baby. I guess those uncollected receivables made up his pro-bono portfolio in the end. But his customers were loyal, and they trusted him to do right by them.  And he did, every single time.

Family businesses have this dynasty-feel to them. We feel like we are building something to leave to our children, or maybe even to our grandchildren. But a dynasty is more than a building or a sizable inheritance. I learned how to reason with an angry customer who knows beyond the shadow of a doubt that he's right; I watched my dad agonize over pricing his inventory when he knew that the local farmers' crops didn't come in as they'd hoped; I saw my dad sweep up the dirt around the gasoline pumps so that the asphalt was as clean as possible; all of those experiences taught me that owning a business is often difficult, trying and not very glamorous.  My dad’s store eventually closed when he and my mom sold it, but he had left me a dynasty. He had shown me everything he did to run a successful business. He empowered me to do exactly the same thing.

The family business is a powerful example.

"Tax Season Sucks." There... I Said It.

• Renewing your driver's license
• Leaving that little tag on your mattress
• Clicking on the "Agree" button to the Terms of Agreement of Your Bilateral Contract and Trade Agreement with iTunes each time you purchase something online
• Re-writing your health insurance information on every single field trip request that your school sends out

All of these are things that you have to do in order to be allowed to take advantage of certain opportunities in your life on a day-to-day basis. Most of the time these are things you have to do in order to do something else. (Well, maybe not that mattress thing.)   But, what do the other three have in common?

There was a law written in a galaxy far, far away that requires you to comply in order to participate in the activity in question.  In order to drive without harassment, you must have a valid driver's license.  In order to purchase Candy Crush, you have to agree with Apple's terms (which no one, including Apple, has ever read).  In order to send your child to the Peace Center to see dinosaurs dance, you must let the school know that you have insurance and that your child isn't allergic to various carpet fibers in auditoriums.  There's no way around it.  You have to do it.  If you don't there is no driving, no Candy Crush and no dancing dinosaurs.

Do these compliance requirements enrich your life?  Nope.

I'm about to blow your mind.  The same goes for tax returns.

Say what?

Tax returns do nothing to enrich your life, or mine.  That is a pretty bold statement coming from the guy who pays for dancing dinosaurs and Candy Crush with fees paid (in part) from preparing tax returns.

Tax Returns simply keep you from being harassed by the IRS or your state's department of revenue.  They have to be completed, filed a certain way, signed in a certain place, mailed to a certain destination, and then acknowledged by the agency in question. Then, if you do anything wrong, go buy some paper and lots of toner....you'll be writing letters for quite a while. 
This, my friends, sucks the life out of more entrepreneurs than you will ever know. 

We, as entrepreneurs, like to think of ourselves as a brave bunch.  After all we did start a business.  That's a risky proposition and we should be commended for doing so.  But how many times do you, as a business owner, find yourself doing something you don't enjoy....just because it has to get done?  

Why are you doing that?

 Because you've always done it.  Because businesses "like ours" do this kind of work.  Because we don't like change and neither do our clients.  

It's time to stand up and say, "I'm done."

You started your business to not only make money and fill the needs of your clients, but didn't you also want to enjoy it?  I bet if you looked at your To-Do List right now, you'd find things on there that have been sitting for weeks.... because you hate doing them. But, they remain on that to-do list because they have to get done.  When will they get done? At the last possible minute, because you hate them.
And that is going to throw a wrench into the OTHER things that are more profitable and more enjoyable....that your clients REALLY value.  

So what's stopping you from saying "NO" to the drudge work and focusing on the more profitable, satisfying, "I could do this all day" type of work?  Could it be....

• Fear of losing business
• Fear of losing revenue
• Fear of paying out more
• "It is just faster if I do it myself, because I am the only one who knows how to do it."
• "I don't know how I would teach this to someone else."
• "I don't trust someone else enough to hand this over."
• A desire to please everyone
• A desire to be "full-service"

It's a little bit of all those things, isn't it?  Would you give that same advice to your child, if they wanted to start a lemonade stand?  Would you say "Now, son, you can start this business, but you won't have any control over the work you do. I know you like lemonade, but some people prefer tea or mango smoothies. You will have to bend and cow tow to the whims of your market.  You will have to file all your incorporation documents on your own.  And don't forget you sales tax.    You'll just have to bite the bullet and do it.  That's how it is, its not going to be about the lemonade."  

Who in their right mind would start a business if that was the case?

Now, let's take this argument one step further.  What if you could outsource your very own business processes to someone else and focus on the engagements that are more profitable and more enjoyable....those engagements that your clients love so much that they say "It's a joy to write this check to your company each month"....how would you feel?

This arena, my loyal readers, is where Godwin & Associates, CPA exists to consult and advise these days.  We have taken entrepreneurs who were stuck, and helped them move past a point of frustration into one of profitability and ultimate enjoyment with their businesses again.  It's the most gratifying work we have ever done.  If you want to take your business to the next level, have a conversation with us and find out if you can move beyond the heavy sighs and lengthy To-Do Lists.  Rip that mattress tag off and say "Enough.  I deserve more than this."

Create a Personal Cash Flow Statement

As the focus on the previous tax year ends, this can be an excellent time to review your financial circumstances. You can look back at 2014 and see how much money came in and where it went during the year without adjusting for seasonal variations. The knowledge you’ll obtain by creating a personal cash flow statement can help you make realistic financial plans for 2015. (If you’re married or cohabiting, you can use this technique to create a household financial statement.)

Tabulating income

Begin the process by adding up all the spendable cash that came in during 2014. Typically, that information can be found in the monthly statements from your checking account or accounts. If you haven’t kept all the monthly statements, or if you don’t feel like juggling all the papers, you probably can retrieve all of last year’s statements online from your bank’s website.

            
If you are an employee, you probably have your paychecks (after various deductions) deposited directly into such an account; if you are retired, your Social Security checks (after Medicare deductions) go there, along with any pension you’re receiving. Self-employment income and investment income paid by checks also will show up as deposits, as well as transfers from investment or savings accounts.

           
 Generally, only cash income (payments in currency) won’t show up in a statement from a bank or investment account. If you do receive meaningful amounts of cash regularly, you should have some idea of the total. In fact, you’ll need records in case the IRS questions how much cash you've received from working during the year.

            
Once you've calculated all the income you've received, make any necessary adjustments. Subtract inflows not likely to occur again in 2015, such as exceptional gifts, bequests, asset sales, and so on. Altogether, you’ll have an idea of how much cash flow you can expect in 2015, raising or lowering the number to keep up with current circumstances, such as a higher salary this year.

Tracking your outlays

Your checking account statements also will show how much you've spent during the year: checks you wrote, bills you paid automatically, personal checks that you cashed for spending money. Be sure to include your debit card or ATM withdrawals in the money you spent during 2014, even if they are linked to an account other than your regular checking account.

            
To complete the picture of what you spent during the year, request annual statements from your credit card companies. If your credit card bills are not on auto-pay and you've paid less than the total balance, you may have increased your outstanding debt during the year. Credit cards usually charge double digit interest rates, and the interest you pay is not tax deductible, so paying down any balances (or converting to deductible home equity debt) probably should be a top financial priority for the year.

Focus on the future

Once you have calculated your cash flow from last year and the amount you spent, you can make certain plans for 2015.

            
Example 1: 
Steve and Sue Smith had $150,000 of cash flow last year and $130,000 of expenses. The Smiths contributed a total of $2,000 a month to their 401(k) plans in 2014, or $24,000 in all. Going over their cash flow, the Smiths see they’ll be able to increase their retirement savings by $20,000 in 2015 without crimping their lifestyle. They plan to boost their 401(k) salary deferrals this year.

            
On the other hand, this procedure can be valuable to show you that a cutback is necessary, and where to trim.

           
Example 2: 
Jim and Joan Jackson also had $150,000 of cash flow but they spent $170,000 last year, in addition to adding to their credit card balances. Going over their cancelled checks and their annual credit card summaries, the Jacksons were surprised to learn how much they spent on dining out and online merchandise purchases. They decide to rein in all their outlays, especially in those areas, and pay down their credit card balances.

            
Creating a personal or household cash flow statement can give you a greater grasp of your finances. In addition, this exercise is an excellent way to begin gathering the data you need to prepare for your 2015 tax return. :)

Self-Employment Tax….Merely FICA in Disguise?

I remember an episode of a popular sitcom from years ago, where someone looking at a paystub asked the question “Who is FICA, and why is he getting all my money?”  That line still makes me laugh.  For profitable, self-employed entrepreneurs, it’s not FICA who gets all the money, but IRS, in the form of self-employment tax.  It’s yet another tax imposition that many businessmen and women don’t completely understand.

 

Let’s do some math:

• When you work for an employer, your gross wages are subjected to a few different taxes.  There’s federal tax, state tax, and then there is Social Security tax and Medicare tax.  
• Social Security and Medicare tax form a duo, known as FICA tax, and they take 7.65% of your gross pay each time you receive a paycheck.
• Your employer, generous person that she is, has to then match your FICA tax with an expenditure of her own, resulting in a second 7.65% paid to the government.
• If you add those two percentages together, they come to 15.3%.  Guess what percentage self-employment tax you pay on the profit from your business venture?  You got it…15.3%.  IRS decided years ago that if you chose to leave your job and start a new business venture, and you operated as a sole proprietorship (and in some cases, a partnership), you would be responsible for both parts of the FICA duo and the employer match.  That was nice of them, huh? 
• And did I mention that this is completely separate from the income tax you have to pay on the profit?  Your profit is assessed tax on three different levels…federal, self-employment and state.

Now, it’s not all gloom and doom.  You are allowed to take an income adjustment for ½ of the self-employment tax that you are assessed on your tax return.  But still, 15.3% is quite a chunk.  That’s why I tell my clients that tax deductions for the self-employed are like gold.  You need to make sure you don’t overlook any of those allowable deductions, because the tax imposed on the profit is steep. 

Case in point:

Assume you’re in the 25% tax bracket for federal purposes and 6% tax bracket for state.  If your effective tax rate on the federal return is around 18%, you will pay 39.3% tax on the profit from your business (15.3% self-employment tax, 18% federal tax, and 6% state tax).  WHOA!  That’s crazy!

In my experience, new clients who have attempted to prepare their own taxes through a period of self-employment do not deduct too much.  They tend to be conservative and not deduct enough.  IRS is pretty generous with small business tax deductions, so make sure you take advantage of them.  You’ll never get a letter from IRS, telling you that you missed one.