“The avoidance of taxes is the only intellectual pursuit that still carries any reward.”

- John Maynard Keynes

Congratulations! You’ve just taken a giant step towards beating the IRS. This plan gives you a personalized road map for the maximum tax savings allowed by law. But before we start with specific recommendations, let’s review how this plan is organized and how you can use it to squeeze the biggest savings out of your return. You’ll find five main sections:

1. How the Tax System Works: This section outlines how the tax system works to lay a foundation for understanding specific strategies to come.
2. Family, Home, & Job: This section covers day-to-day strategies for your family, your home, and your job. This section outlines tax strategies for financing college and elder care, buying and owning your home, and making the most of popular employee benefits.
3. Your Business: Owning your own business—a bona fide business with a legitimate profit intent—is the best tax shelter left in America. This section outlines strategies for organizing your business, deducting day-to-day expenses, buying and owning real estate and equipment, and choosing retirement and employee benefit plans.
4. Your Investments: Making money is hard. Keeping it is easier. That’s because you have more control over tax-efficiency than any other aspect of your portfolio. This section outlines how to use IRAs and retirement accounts, how to buy and sell stocks, bonds, and mutual funds, and how to manage real estate for maximum after-tax return.
5. Cashing Out: This final section outlines strategies to defer or eliminate taxes when you sell personal, business, and investment assets. Just one of these ideas can avoid six- and seven-figure tax bills and help assure your financial legacy for generations.

Supreme Court Justice Oliver Wendell Holmes called taxes “the price we pay for civilization.” But he didn’t say we had to pay retail. This plan is your guide to tax discounts throughout your return. Enjoy your savings. And don’t spend it all in one place!

Adjusted gross income minus deductions and exemptions equals taxable income. Once you determine your taxable income, you can determine your actual tax. The tax system is designed to gather the most tax from those of us most able to pay. So the percentage of income you pay increases with your income. Tax brackets govern the amount of tax you pay on each dollar of income. Your “tax bracket” or “marginal rate” is the percentage you pay on your last dollar of income. The table at the bottom of the page lists tax bracket thresholds for various filers.

The Declaration of Independence says that all men are created equal. But not all income is created equal. Pay attention to these important exceptions to the general rates:

• Self-employment income from proprietorships, partnerships, and limited liability companies is taxed at 15.3% up to the Social Security wage base ($97,500 for 2007) and 2.9% on income above that base. This is on top of regular income tax and replaces Social Security for self-employed taxpayers.
• Long-term capital gains from the sale of property held more than 12 months are generally taxed at no more than 15%.
• “Qualified corporate dividends” are taxed at no more than 15%, regardless of your tax bracket.
• “Kiddie tax” is a special tax at your marginal rate on unearned income over $850 paid to children under age 18.
• Alternative minimum tax is a parallel tax intended to stop “the rich” from escaping tax entirely.
• Don’t forget state and local taxes!

Choosing which entity to operate your business involves two fundamental choices: 1) will you remain personally liable for business debts; 2) how will you and your business pay tax? There’s no “pat” answer, and in many cases you’ll want more than one entity. Consider these options as starting points:

• Proprietorship: This is a business you operate yourself, in your own name or trade name, with no partners or formal entity. You remain personally liable for business debts. You report income and expenses on your personal return and pay income and self-employment tax on your profits. These are best for startups and small businesses with no employees in industries with little legal liability.
• Partnership: This is an association of two or more partners. General partners (“GPs”) run the business and remain liable for partnership debts. Limited partners (“LPs”) invest capital, but don’t actively manage the business and aren’t liable for debts. The partnership files an informational return and passes income and expenses to partners. GP distributions are taxed as ordinary income and subject to self-employment tax; LP distributions are taxed as passive income.
• “C” Corporation: This is a separate legal person organized under state law. Your liability for business debts is generally limited to your investment in the corporation. The corporation files its own return, pays tax on profits, and chooses whether or not to pay dividends. Your salary is subject to income and employment tax; dividends are taxed at preferential rates. These are best for owners who need limited liability and want the broadest range of benefits.
• “S” Corporation: This is a corporation that elects not to pay tax itself. Instead, it files an informational return and passes income and losses through to shareholders according to their ownership. Your salary is subject to income and employment tax; pass-through profits are subject to ordinary income but not employment tax. These are best for businesses whose owners are active in the business and don’t need to accumulate capital for day-to-day operations.
• Limited Liability Company (“LLC”): This is an association of one or more “members” organized under state law. Your liability for business debts is limited to your investment in the company, and LLCs offer the strongest asset protection of any entity. Single-member LLCs are taxed as proprietors; multi-member LLCs choose to be taxed as partnerships or corporations. This flexibility and asset-protection strength makes LLCs the entity of choice for many new businesses.

Limited liability companies (“LLCs”) are associations of one or more members operating the business themselves or through appointed managers. Your liability for business obligations is limited to your investment in the business. LLCs offer the limited liability of a corporation and flexibility to allocate income and losses of a partnership, without the ownership limits of an S corporation or double taxation of a C corporation. This versatility is making the LLC the entity of choice for most new businesses.

• Single-member LLCs are disregarded for federal and most state taxes.1 You’ll file Schedule C or Schedule E:

• Income and loss from trade or business activities is treated as self-employment income and subject to self-employment tax.2
• Income and loss from rental real estate is passive income and loss. Income is subject to ordinary income but not self-employment tax. Losses can offset passive income and may be available to offset ordinary income if you qualify for the rental real estate loss allowance or as a “real estate professional.”

• If you’re actively involved in managing the LLC’s trade or business, you’re treated as a “general” partner:

• The IRS has issued proposed regulations treating income from trade or business activities as ordinary income, subject to income and self-employment tax.3
• Income and losses from rental real estate activities is “passive” income and loss. Income is subject to ordinary income tax, but not self-employment tax. Losses can offset passive income and may be available to offset ordinary income if you qualify for the rental real estate loss allowance or as a “real estate professional.” Losses you can’t currently use are “suspended” until you have passive income to offset or you dispose of the activity.

• If you work less than 500 hours per year, you’re not personally liable for any LLC debt, and you play no role in managing the business, you’re treated as a “limited” partner. Your income from both trade or business and real estate activities is passive income, subject to ordinary income but not self-employment tax. Losses can offset passive income, but not ordinary income. Losses you can’t currently use are “suspended” until you have passive income to offset or you dispose of the passive activity.

“S” corporations are corporations that elect not to pay tax themselves, but to pass income and expenses directly through to shareholders. S corporations can have up to 100 shareholders, all of whom must be individuals (no nonresident aliens), estates, or certain trusts. S corporations can have just one class of shares; however, they can own taxable or “qualified subchapter S” subsidiaries.1 S corporations offer these advantages:

• Avoid Self-Employment Tax. Shareholder-employees draw salaries, reported on Form W-2 and subject to FICA tax. Corporate profits are passed through to their personal returns on Form K1, taxed as ordinary income, but not subject to FICA or self-employment tax.2 (For 2007, this is 15.3% of W-2 compensation or net self-employment income up to $97,500 plus 2.9% above that.3) You still have to pay yourself a reasonable salary.4 Otherwise, the IRS can recharacterize your dividend as wages and impose employment tax.5 “Reasonable compensation” varies from industry to industry, so be sure you can justify the salary you choose.
• Shift Income. You can use an S corporation to shift income to lower-bracket shareholders. You can give shares in the corporation to children or other lower-bracket beneficiaries so that their share of profits is taxed at their lower rate.
• Avoid Audits. S corporations can cut audit risk substantially. For FY 2005, the IRS audited 3.68% of Schedule Cs reporting incomes up to $25,000, 2.21% of Schedule Cs reporting incomes from $25,000 to $99,999, and 3.65% of Schedule Cs reporting income of $100,000 or more — but just 0.30% of all S corporations.7

“C” corporations pay tax on their income at corporate rates.1 They can retain after-tax profits or pay them to shareholders as dividends. Dividends are taxed again as personal income at preferential rates up to 15%. This “double taxation” is more bark than bite if you “zero out” profits by paying them as salary or bonus. This avoids corporate tax as long as your salary is “reasonable compensation” for the services you provide.2

C corporations have none of the ownership limitations that apply to S corporations. And C corporations offer you the widest range of deductible benefits. In fact, many businesses include C corporations in their entity structure specifically to pay benefits.

• If your personal tax rate is 28% or more, you can keep up to $50,000 in profit to be taxed at 15%, then distribute the remaining after-tax net as a “qualified corporate dividend” to be taxed at 15%. This yields an effective tax of just 27.75%.
• If your corporation pays for your life insurance (other than group term coverage up to $50,000), the corporation pays tax on the premium and you pay tax on the value of the coverage (valued at the “PS 58” rates used to value group term life or the insurer’s annual renewable term rate, whichever is less). Those combined taxes may be less than you’d pay for insurance personally with after-tax dollars.
• Your corporation can deduct employee disability insurance premiums; however, benefits are then taxable. If you pay premiums yourself (and forego the deduction) benefits are tax-free. This sounds like a hard choice—but the IRS has ruled that you can deduct premiums until the year in which you become disabled, then forego that year’s deduction and take benefits tax-free.3
• You can borrow up to $10,000 tax-free from the corporation4 so long as you show a business purpose other than avoiding tax.5 If you borrow more than $10,000, you need to pay interest at least equal to the applicable federal rate (“AFR”) or pay tax on the difference between your rate and the AFR.6
• If you own up to 50% of a partnership, LLC, or corporation, you’d like to deduct benefits for yourself, but you can’t afford to include rank-and-file employees, consider establishing a C corporation to deduct benefits for yourself without including parent entity employees. (If you own more than 50% of the parent, your corporation is part of a “controlled group” and you’ll have to offer equal benefits for both businesses.) (Your spouse can establish or use a separate business to offer deductible benefits, so long as they don’t own an interest in your parent entity or serve as director, fiduciary, or employee of that entity.7)

If your business involves real estate or capital equipment, consider establishing a separate entity or entities to own the property, then lease it to the business. This offers several tax and asset protection advantages. The biggest may be shifting income from the business to the leasing entity. This lets you draw income in the form of tax-advantaged rent (sheltered by depreciation), rather than compensation or profits taxable as ordinary income. Here’s how it works:

1. You pay $400,000 for an office condominium, individually or in an LLC, to house your business. You put $40,000 down and finance the remaining $360,000 for 30 years at 7%. Your monthly payment is $2,395.09 per month.
2. Your business leases the property for $3,250 per month under a “triple-net” lease with the business assuming all operating expenses, including utilities, insurance, and property taxes.
3. At the end of the year, your real estate activities show income of $39,000. $28,426.49 is deductible as interest, leaving just $10,573.51 of net income. Depreciation offsets most or all of this, leaving you with little or no taxable income.

Leasing business assets offers these additional advantages:

• You can sell or gift interests in the property without diluting your ownership or control of the business. For example, you can transfer the real estate into a family limited partnership and make gifts of partnership interests to reduce your taxable estate without giving interests in the actual business.
• You may qualify to title the entity in your spouse’s name to establish employee benefit programs such as retirement plans or medical expense reimbursement plans you might not wish to establish for your primary business. (This may not work if your spouse is active in your primary business.)
• You can refinance business assets to tap equity and draw income in the form of nontaxable loans.
• You protect business assets by segregating them in different entities, making it harder for creditors of one to reach assets held in another.

Code Section 132 lets you deduct “certain fringe benefits” you provide your employees—including yourself or your spouse if you qualify:

• You can pay employees a “length of service” award of up to $400 in property (not cash) as often as every five years.1
• You can deduct the cost of a gym or athletic facility located on your premises, operated by you, and substantially all the use of which is by your employees, their spouses, and their dependents. Facilities include your swimming pool, tennis court, and fitness equipment.2 Depreciate personal property and land improvements such as pools, and deduct operating expenses such as chemicals and cleaning.
• If you offer a retirement plan (including a SIMPLE IRA or SEP) you can deduct “qualified retirement planning services” you provide employees and their spouses. Services aren’t limited solely to your employer plan, but don’t include related services like tax prep, accounting, or legal services.3

You can also deduct a range of “de miminis” fringe benefits. These are property and services (not cash) that the IRS doesn’t tax because their value is “so small as to make accounting for it unreasonable or administratively impractical.” The generally accepted threshold for these items is $25.4

• Occasional meals or “supper money” and transportation (car service, etc.) to let employees work late.
• Occasional cocktail parties, group meals, or picnics for employees and guests.
• Traditional birthday or holiday gifts of property (not cash) with a low fair market value ($25 or less).
• Occasional theatre or sporting event tickets.
• Coffee, juice, and doughnuts you provide for employees at the office.
• Flowers, fruits, books, or similar property you provide to employees under special occasions, such as illness, outstanding performance, or family crisis.

These may be mere rounding errors for the Microsofts of the world. But they can really add up! Most months have at least one holiday. And, while you can’t write off season tickets as a block, those trips to the ballet or local amusement park can add up.

“Allowance” and other financial aid you extend to your children, grandchildren, or even parents is a deductible business expense if you pay them to perform bona fide work for your business and pay them reasonable compensation for that work.1 Of course, at that point, it isn’t allowance. It’s wages. If you’re hiring your kids, they might even learn not to treat you like “The First National Bank of Mom and Dad”:

• Your child can earn up to the standard deduction for single taxpayers ($5,350 for 2007) before they owe tax on their income. The next $7,825 is taxed at just 10%. Earned income isn't subject to the “kiddie tax” for children under 18.2 Other family employees pay tax at their regular rate.
• The Tax Court approves wages for children as young as 7.3
• Your family employee’s work should be directly related to your business.4
• Pay your employee a reasonable wage for their age and the service they perform. Their wages should be similar to amounts paid for similar services by similar businesses under similar circumstances—with adjustments made for their age and experience.
• To verify your deduction and audit-proof your return, keep a timesheet showing the dates, hours, and services performed.5 Pay your child by check, and deposit the check in an account in the child's name. This can be a Roth IRA, Section 529 college savings plan, or custodial account. You can’t use custodial assets for your obligations of parental support; however, parental support doesn’t include “extras” like private or parochial school tuition, summer camps, and similar expenses.
• If your business is taxed as a proprietorship or partnership, you don’t owe Social Security or Medicare taxes on your child’s wages until they reach age 18.6 You don’t owe unemployment tax until they reach age 21.7
• Hiring family members to help work in your business also lets you establish employee benefit programs such as a medical expense reimbursement plan, education assistance plan, and retirement plans.

Medical expense reimbursement plans (“MERPs”) let you reimburse your employees, their spouses, and their dependents for uninsured medical costs.1 Plan benefits are deductible by the business, and nontaxable to the employee. Here’s how they work:

• You have to establish the plan for employees. If you run your business as a proprietorship, partnership, LLC, or “S” corporation, you're considered “self-employed,” and not eligible.2 If you’re single, you can establish a C corporation and pay benefits to yourself as an employee. If you’re married, you can hire your spouse and pay the benefits through him or her.3 If you operate as an S corporation, you and your spouse are both considered self-employed. (In that case, segregate part of your income through a proprietorship or C corporation and pay benefits through that entity.)
• You can’t discriminate in favor of highly compensated employees.4 However, you can use a classification test (such as “all participants in Employer’s group health plan”) to qualify participants.5 You can also exclude those under age 25; those who regularly work less than 35 hours per week; those who work less than nine months out of the year; and those who have worked for you for less than three years.6
• You can’t reimburse employees for costs they incur before the plan effective date.7

Paying medical expenses through a MERP offers several advantages:

• You can deduct 100% of your employees’ health insurance. Deductible health insurance costs include major medical and supplemental premiums, Medicare premiums, qualified long-term care premiums, and Medicare supplemental ("Medigap") policies.
• Out-of-pocket medical costs include routine expenses such as co-pays, deductibles, and prescriptions; occasional expenses such as eyeglasses and dentistry; big-ticket items like orthodontics, fertility treatments, and schools for learning-disabled children.8 It also includes nonprescription medicines and health-care supplies.9 You can reimburse employees or pay health-care providers directly.10
• The plan lets you deduct 100% of your out-of-pocket costs, bypassing the usual 7.5% floor for itemized deductions. You’ll also avoid any self-employment tax you would otherwise pay on amounts you deduct as plan benefits.

Education assistance plans let you reimburse employees for undergraduate and graduate level education expenses, whether they are directly related to the employee’s job or not. Here’s how they work:

• The plan must be a separate written plan for the exclusive benefit of employees.1
• You can reimburse up to $5,250 in expenses per employee per year. Reimbursements are deductible by the business and nontaxable to the student.2
• Education assistance plans can’t pay more than 5% of their total benefits in a year to the employer’s owners, spouses, or dependent children.3 But, if your child is age 21 or older and you no longer claim them as a dependent, your ownership of the business is no longer attributed to them.4 This means that you can hire your college-age child (under the same rules as for hiring any child) and pay them an extra $5,250, tax-free, for college. (To verify your deduction and audit-proof your return, keep a timesheet showing the dates, hours, and services performed. No payroll or paychecks are required if you pay your child in the form of education assistance plan benefits only.)
• Education assistance plans aren’t subject to the Employee Retirement Income Security Act (ERISA). You don’t need to establish a trust or pre-fund benefits.5 You don’t need to file Form 5500 or any other prescribed reporting. And you can pay plan benefits out of general assets or day-to-day cash flow. 

Social Security benefits are generally nontaxable income. However, there’s a special retirement earnings test that may cut your benefits if you keep working while you receive Social Security. And benefits are taxable if your “provisional income” exceeds certain limits.

Earnings Test

If you’re between age 62 and 65 and you work while you collect Social Security, you'll lose $1 of Social Security for every $2 of earned income above $12,960 (2007). In the year you reach full retirement age, you’ll lose $1 for every $3 of earned income above $34,440 until the month you reach full retirement age (2007). (The penalty ends at “normal retirement age.”) This applies to earned income from wages, salaries, commissions, and self-employment. If your earned income tops these thresholds, consider waiting to collect benefits.

If you own your own business, you can use several strategies to hold down earned income between ages 62 and full retirement age. You can pay yourself with loans, rents, or S corporation dividends, rather than earned income. You can create a special class of stock or LLC interest, or sell shares back to the business.

Taxable Benefits

Social Security is intended as backup retirement income along with pension plans and personal savings. Benefits are nontaxable unless your “provisional income” exceeds certain limits. (Provisional income includes regular taxable income, tax-exempt interest income, and 50% of Social Security benefits.) You owe tax on 50% of your benefits if your provisional income exceeds $25,000 ($32,000 for joint filers). You owe tax on 85% of your benefits if your provisional income exceeds $34,000 ($44,000 for joint filers).

This rule can be a real blow to your income and artificially spike your tax bracket. One dollar of Social Security can add $1.85 to your taxable income. Consider investments that don’t increase provisional income:

• Permanent life insurance lets you draw tax-free income from loans and withdrawals.
• Immediate annuities to offer partially tax-free income equal to your “exclusion ratio.”
• Fixed and variable annuities accumulate income without generating taxable interest, dividends, or capital gains.

Rental real estate is ordinarily a “passive” activity. You can’t use passive income as a basis for employee benefits like medical expense reimbursement or qualified retirement plans. But you can establish a “C” corporation to manage your properties, hire yourself to work for the corporation, then establish a wide range of benefits through your corporation.

You can pay your corporation the same property management fees you might pay an outside manager. If this isn’t enough, consider paying your corporation general contractor fees for maintenance, repairs, and improvements, or fees in lieu of commissions for properties you sell.

You’ll need to observe the same corporate formalities as with any corporation in your state. If you pay yourself a salary, you’ll need to manage a payroll just as with any other employee. Once you qualified as an “employee,” you’ll qualify for the complete range of tax-advantaged employee benefits:

• Medical expense reimbursement plans
• SIMPLE IRA, 401(k), or other retirement plans
• Education assistance plans for children and grandchildren
• “Certain fringe benefits” under Code Section 132

Kerry M. Kerstetter, CPA (referred to as The Tax Guru by other CPAs around the country) helps capitalists, investors & small business owners win the tax game.

All of the information in this report is of a general nature and should not be implemented without the assistance of an experienced professional tax advisor.