Common Tax Myths to Avoid
- Published: 12/03/2010
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Helping clients manage their tax situations is sometimes similar to being an auto mechanic working with an overly eager do-it-yourself-er. Imagine you’re a mechanic. Dave, a long-time customer, walks into your garage holding a carburetor. The carburetor is apparently used - covered in grease and grime. Dave hands you the carburetor and says, “My brother-in-law said this carburetor will cut my fuel cost in half.” You look thoughtfully at the device for a moment. “Well, Dave, it depends,” you calmly explain. “It certainly could double your mileage under the right circumstances.” Dave’s tone stiffens, “My brother-in-law said it worked perfectly on his car.” You shuffle your feet, then throw a glance towards Dave’s vehicle. “Is that the truck you want this carburetor on?” “Yea”, he says, “What’s wrong?” his voice twists a tether of fear and exasperation. You sigh, before you start to explain. “Dave, this carburetor is for a Mazda four cylinder. It’s just not going to fit that big block Chevy.”
The only difference between this situation and scenarios commonly encountered by tax professionals is this: if the mis-matched carburetor had been installed on the Chevy, the truck would have failed to start. The mistake would have been known immediately. Unfortunately, those who follow over-the-counter tax advice are seldom as lucky. They “install” the advice and turn the key. The advice actually works, on paper – taxes decrease, refunds increase. What they can’t see, however, is the extremely costly repair that awaits them, often years down the road, when they learn the tax advice was a bad fit for their situation.
The majority of costly, ill-fitting advice we correct at HBS involves individuals and their businesses. Today, I’ll briefly discuss four common and costly tax-myths that exist in the business community. If you find yourself receiving advice similar to these “myths,” please seek professional assistance immediately, or at least before you act on it.
Myth One: Getting Paid in Cash Saves Taxes. There are different versions of this myth. The most common is that cash payments to a business for products or services do not need to be reported as income (or at least the IRS cannot find the income during an audit). This is a complete falsehood. All income must be reported, regardless of the manner of payment. What’s more, hiding cash income is far easier to uncover than subscribers realize. Acting on this myth is a very dangerous way to gamble with one’s future. Over time, unpaid taxes mount, as so do the penalties, which can reach the level of criminal prosecution.
Myth Two: Paying Unlicensed Individuals as Contractors Saves Taxes. This myth is common in construction-related businesses. The myth states, in part, that it is OK to pay individuals who provide services on a daily or regular basis as though they are business owners and not employees, even when they are not legitimately licensed businesses. There are several common-law tests and checklists used to determine whether individuals are contractors or employees. “Subs” that fail the tests can be reclassified as employees. The employing business may now be responsible for paying years of employment related taxes, plus penalties, plus interest. If you find yourself in this situation and want to confirm that your “subs” are self employed, please contact our office.
Myth Three: Your business can lose money year after year. The IRS estimates that this myth costs the US Treasury thirty billion dollars annually. For a business to exist, it must be operated with the intent of making a profit. Without this “profit motive” it is not a business. It is a Hobby. Losses that result from hobbies are not deductible. The IRS generally presumes that a profit motive exists if the activity generates a profit for three out of five years. If not, it is up to the owner to prove that the activity is, in fact, a business and not a hobby.
Myth Four: A certain business structure is automatically better than others. There is seldom a week that goes by that we do not encounter a business whose owners do not realize the tax consequences of their decision to form a LLC, Partnership, Corporation, or S Corporation for a particular enterprise. Before making such a business-leap, please define exactly what your business will do, create a list of tax-related questions, and seek professional advice.
Today, I discussed four common myths that pervade “over-the-counter” tax advice. If you should find yourself needing advice or assistance regarding these tax issues, please do not hesitate to contact our office to consult with a tax professional.