Ted and Ellen first needed to set their goals and then needed to look at
where they spent their money to determine potential tax loopholes. After
they completed the First Step Financial Profile we fully understood
what their goals were and where their money went.I was happy to hear that they had included starting a business in
their plans. Government incentives to promote public policy are written
for business owners and investors. Any other so-called loopholes phase
out as income increases or are completely negated by the Alternative
Minimum Tax.

Step 1—Creating Income

Step 1 reviews the tax loopholes involved in how Ted makes money in his
business and how Ellen plans to make money in her new business venture.As a computer consultant, Ted makes a monthly income in excess of
all of the deductions that we anticipate taking. Currently, he is taxed as
sole proprietorship. If you haven’t selected a business structure, the IRS
selects one for you—the sole proprietorship. If you have a partner, the
default business structure is that of a general partnership. In both cases,
the taxable income will be reported on your personal tax return and you
will have to pay self-employment tax in the amount of 15.3 percent.
In Ted’s case, his business structure (or actually lack of a business
structure) meant he paid an extra $3,000 per year in self-employment
tax. That was our first order of business: get the right business structure
to reduce taxes. In Ted’s case, we set up an S corporation so that the income
would flow through directly to him. He took part of the income
out in the form of salary, on which he then paid payroll taxes, and the
rest in the form of a distribution. The distribution would not be subject
to payroll taxes, only income tax.

The nine criteria that the IRS
uses for determining a real business are:
1. Do you carry on the activity in a businesslike manner?
2. Do the time and effort you put into the activity indicate you intend
to make it profitable?
3. Do you depend on income from the activity for your livelihood?
4. Are your losses due to circumstances beyond your control (or are
they normal in the start-up phase of your type of business)?


5. Do you change your methods of operation in an attempt to improve
profitability?
6. Do you, or your advisors, have the knowledge needed to carry on
the activity as a successful business?
7. Were you successful in making a profit in similar activities in
the past?
8. Does the activity make a profit in some years? (How much profit
it makes is also considered.)
9. Can you expect to make a future profit from the appreciation of
the assets used in the activity?
Ellen was able to prove that she was serious about her business, and although
there was a business loss in the beginning, she was confident that
she would soon turn it around to create a profit.
We decided to set up an S corporation for Ellen’s new venture. This
allowed her losses to flow through to their personal tax return where
they were able to offset some of Ted’s income.

Step 2—Hidden Business Deduction

We next determined the hidden business deductions for both Ted’s and
Ellen’s businesses. To do this, we reviewed the “How Do You Spend Your
Personal Income?” portion of their First Step Financial Profile. A copy of
this form is more fully discussed at Chapter 9 as part of the Jump Start!
Your Wealth method.
We reviewed the general business deductions to make sure Ted and
Ellen took advantage of standard deductions such as inventory items sold,
computer, software, advertising, and contractors. We also looked at the
items that they currently paid for with after-tax money. In other words, as
employees, they made their money, paid their taxes, and then paid all
their expenses with what was left. But, as business owners, they would
make the money, pay the business expenses, and then pay tax on what is
left. The difference is that the business owner will pay much less tax.
In the case of Ted and Ellen, we discovered another $10,000 in expenses
in the form of business use of an automobile; meals out; educational
expenses such as books, tapes, and subscriptions; employing a
child in the business; and travel. Their current tax rate is approximately

Step 3—Pay Your Taxes!

We now looked at some smart strategies for paying Ted and Ellen’s taxes.
One strategy for paying your taxes is to use a business structure that has a
different year-end than you personally do. In other words, you would use
a C corporation with a year-end date of anything other than December
31. In the case of Ted and Ellen, this won’t work because they both will
form S corporations. The S corporations generally must have a December
31 year-end.
However, we were able to project a total annual tax savings of
$4,500 immediately from Steps 1 and 2. As they grow their businesses,
we’ll be able to take advantage of even more loopholes. Meanwhile, they
know that they will be able to have an additional $4,500. They could
wait until they file their tax return and get the refund from the IRS. But
that’s the equivalent of giving the government an interest-free loan.
That’s not good business! So, instead, we had Ted and Ellen change their
withholding certificates at work so that they had $4,500 less withheld
from their checks. If they had been currently paying estimated tax payments,
we would have reduced those amounts instead. Generally, I don’t
recommend that you use estimated tax payments as a way to pay additional
taxes if you can instead have the additional amounts withheld directly
from paychecks. If you use the estimated tax payment method,
your quarterly payments will be tracked and if you underpay one quarter,
you face interest penalties per quarter. On the other hand, if you use payroll
withholding, there is no underpayment penalty as long as you meet
the minimum requirements. In most cases, the minimum tax payment
requirements are 90 percent of the current year’s tax or 100 percent of
the prior year’s tax.

Step 4—Invest in Real Estate

Ted and Ellen needed some of the income they earned from their businesses,
so they weren’t fully able to take advantage of this strategy. For
now, they made the decision to begin looking for a single-family property
that they could rent out. This would start them on the road to creating
passive income from real estate rentals.
We discussed the different ways you could make money from real estate.
Some examples of that are: commercial rental properties, multifamily
residential rental properties, fix-up properties (later put up for sale),
development, raw land held for appreciation, and the like. They wanted
property that required a lower down payment to begin and offered good
tax benefits and depreciation. The single-family residence was the best
fit for their plan.
One of the traps for new investors is the excitement they feel when
they see all the real estate possibilities. The problem isn’t lack of opportunities.
The risk is actually choking on opportunities.
Step 5—Tax-Free Money from Real Estate

Ted and Ellen weren’t ready for this step yet. Once they had purchased
their first property we would then be looking for all the techniques to
ways that real estate creates value.
Immediate cash would come from received cash flow (excess of
rental income over expenses) from the property. The cash flow would
then be offset by the phantom depreciation deduction. We love depreciation!
It’s a tax benefit that the government gives you that you don’t
have to pay tax for. Even better, there are loopholes available that allow
you maximize this loophole so you won’t have to pay tax even if you
have huge cash flow. More on that in the Jump Start! section (Part II).


Step 6—Buy a Home

Ted and Ellen already owned a home. They had purchased their home,
though, thinking that was the way to wealth. Actually, buying a home
isn’t a real loophole. In fact, a home, when you buy it wrong, becomes a
big liability. It will take money out of your pocket every month for an
uncertain theoretical return.
Since Ted and Ellen already owned a home and weren’t willing to
move, we looked for ways they could protect what they already had.
Ted and Ellen lived in California. The equity (fair market value less
current debt) on their house was currently $150,000. If they were ever
sued and lost the lawsuit, all of that equity would be gone. There are
three methods for protecting the equity in your home: (1) homestead exemption,
(2) limited liability company (LLC), and (3) debt.
The homestead exemption protects a fixed amount of equity for the
homeowner. The amount of the homestead exemption varies by state.
For example, Florida has unlimited homestead exemption. So does
Texas. Unfortunately, California protects only $75,000 of the homeowner’s
equity. That meant that Ted and Ellen had a lot at risk.

Step 7—Home Loopholes

Ted currently ran his computer consulting business out of a spare bedroom
in their house. He had heard that it was an IRS red flag to take a
home office deduction, so he hadn’t been taking advantage of this very
legal home loophole.
We reviewed the current rules for the home office and discovered
that there was no problem at all taking advantage of the home office for
Ted. In order to have a legitimate home office, you must prove two things:
1. You have a space in your home that is used exclusively for business.
2. You regularly perform some kind of business activity in that space.
“Exclusively” means just that. You can’t use a corner of the dining
room table or the kitchen counter. It needs to be a spot that is used
only for business.
Once you have established a legitimate home office expense, you
can then take a deduction for a pro rata portion of the home-related expenses
such as mortgage interest, property tax, insurance, utilities, maintenance,
and the like. The proration is determined by dividing the
square footage of the business use by the total square footage. You can
also depreciate a pro rata portion of the home.
The second tax myth that Ted and Ellen had heard was that youshouldn’t take the home office deduction because it would put the future
tax-free gain in jeopardy when you sold your house.
The home office deduction will not reduce the $500,000 (for married
filing jointly) capital gains exclusion. The IRS tells us that if the
home office is part of the same “dwelling unit” as the home, then there is
no need to attribute part of the gain to the business for the sale of the
principal residence. If you have taken a depreciation deduction for that
part of the home, then you will need to recapture the depreciation upon
sale. But that’s it! You do not need to pay capital gains tax on the sale.
Ted used a room that was 200 square feet. The total area of the house
was 2,000 square feet, so he was using 10 percent of the home for business.
That meant that 10 percent of their home-related costs were now a
deduction against Ted’s income. The home office deduction can’t create
a loss, but it can be used to offset income. Because Ellen’s business wasn’t
yet making a profit, it didn’t make sense to attribute any of the office
space to Ellen’s business.