Every business owner cheats on taxes
Except for you, of course. But THEY sure cheat the IRS, we know it for a fact. How do we know? Well, they brag non-stop about paying zero taxes. How is this possible, unless they cheat?
Maybe they do, and maybe they don’t. Interestingly, there is a third option: maybe, they do not mean to cheat – but end up cheating anyway. Such “innocent cheating” is exactly what this article is about.
Before we address unintentional cheating, let’s get on the same page in regards to intentional cheating: if you know that you’re cheating – then it is clearly against the law, and it could even be criminal. Your potential punishment is anything from a monetary penalty to some leisure time in federal prison. Not worth it, if you ask me.
If it’s so dangerous, then how come that all these people who make up fake deductions, double- and triple-dip, and hide their income – how come they get away with all of that, year after year, and some of them even hold public offices? Same reason why people get away with constant speeding: not enough cops (thankfully) to catch everyone. Still illegal, and still painful when you are caught.
Continuing with my speeding analogy, have you noticed that the cars they pull are not necessarily the worst offenders? Same with the IRS: even if your friends and coworkers cheat far worse than you do, their blatant lies can go unnoticed, while your “mild exaggeration” can get you in deep trouble. Once again, even if we ignore the moral and ethical issues, outright cheating is simply not worth the risk.
Innocent cheating – does it exist?
Seriously, how can you possibly cheat and still expect presents from Santa Claus? That, of course, depends on the definition of cheating. I define tax cheating as paying less taxes than you’re legally supposed to. It happens if you report too little income or too many deductions, or use the wrong calculation. In short, it happens all the time.
- You charged your tenant $25 late fee and forgot to include it in your income at the end of the year. Cheater!
- You deducted a book of stamps that you bought for business mailing, but you used a few of those stamps for personal holiday cards. Cheater!
- You received a $50 mail-in rebate for your new computer but deducted the full cost from original store receipt. Cheater!
- And did I mention the infamous mileage log that, of course, you keep in your glove compartment and update after each trip?
As you noticed, my definition of cheating refers to fuzzy concepts like supposed to, too much and too little. Anything but that elusive “right amount” would be cheating. And who can tell us exactly how much is the right amount? Exactly the problem!
Bottom line: when it comes to business taxes, there is no such thing as the “correct” amounts. Why? Right off the bat, I can name three reasons.
First excuse: I did not know this was the rule!
Amen, there are two many darn rules, and they change too darn often. So many and so often that even professional tax accountants like myself cannot possibly keep up with all of them. Let me illustrate.
Your tenant is on the phone: that old refrigerator finally died on him. Not willing to spend a lot of cash, you find a used unit in pretty good shape, for $300. It would be only reasonable to deduct this $300 as maintenance expense, agree? Not so fast.
- A refrigerator is considered a business asset that must be depreciated – meaning deducted partially over several years instead of immediate full write-off. How many years? According to the traditional rule, 7 years.
- However, a few years ago, that rule was amended by the IRS to allow 5-year depreciation for rental appliances. To most reasonable people, this would mean that we take $300 cost, divide it by 5 years, and arrive to $60 per year deduction.
- Wrong again! Five-year depreciation is calculated by a ridiculously complicated formula that is best left for computers. I confess that being an experienced tax accountant myself, I will not attempt depreciation calculations by hand, relying on special software instead.
- Your software tells you to deduct $60 in the 1st year, but $96 in the 2nd year, and some strange numbers thereafter. Besides, the whole five-year process takes six years.
- Whatever, are we done now? Not really. If you bought the fridge at the end of the year, and bought no other assets – your $60 deduction shrinks down to $15. Don’t ask why.
- If you studied tax rules, you may have heard of Section 179 instant depreciation that should let you deduct the entire $300. Not the case though: there is an exception to the general rule that specifically prohibits Section 179 deduction for landlords.
- However, the landlords are eligible for another little-known (and temporary) opportunity called bonus depreciation. It should allow you to deduct $150 out of $300 right away, plus some additional “normal” depreciation on top of it.
- During later part of 2010, bonus depreciation became 100%, giving you complete $300 write-off if the refrigerator was purchased after the new law took effect.
- Unless you read the small print, that is. For bonus depreciation, the asset must be new, and your fridge is a used unit. Ouch.
If you foolishly assumed that we covered all applicable rules, fear not. There’s more. For example, the IRS allows several alternative formulas for calculating depreciation that you can choose from. Each of them will give you a number different from the standard $60. Also, if your old refrigerator was destroyed by a natural disaster (your tenant does not qualify as such), you may be able to deduct the entire $300. And trust me, I can fill a few more pages with endless exceptions to exceptions from the exceptions to the rules.
In case you wonder, the IRS agents usually know much less than we accountants do. What can you expect if you take business owners who know little or no tax rules, have their tax returns prepared by accountants who know most but still not all rules, and then have those tax returns inspected by IRS agents who know half the rules, at best? Ain’t pretty. Thank you, Congress!
Second excuse: But it says I can deduct it!
A lot of the tax rules are as clear as Buffalo Bayou after a typical Houston flood. Let’s take one classic example from real estate taxation: repairs vs. improvements.
- Per IRS rule, if you do something that increases value of the property or extends its useful life – it is an “improvement” (bad for taxes). Accordingly, installing new floors throughout the house is an improvement.
- The next IRS rule says that if you do something that merely restores the property to its prior operational condition – it is a “repair” (good for taxes). Patching damaged carpet certainly fits the definition of repairs.
Let’s see. Replacing one tile is a repair; while retiling the whole house is an improvement. Can you tell me – how many tiles does it take before such repair turns into an improvement?
If you know the answer, you should not be reading tax articles, you should be writing them. Personally, I do not have an answer other than it depends. Not only it depends on your specific case, it also depends on who interprets the rule – you, I, or the IRS agent. Which one of us has the “right” answer?
Third excuse: You must be kidding, right?
So, the first two problems were too many rules and too much uncertainty in them. The third and final problem is compliance with the rules. Even if you’re familiar with the rules and the wording of the rules is reasonably clear, it is often impossible to comply with, from practical point of view.
Want an example? You’re entitled to deduct business portion of your computer usage. Well, how exactly do you figure out business portion if you also use this computer for personal needs? Was it 25%? 50%? 79.3%? Should we keep time log? And what if we watch the online news while typing a business letter?
I once asked a particularly detail-oriented IRS auditor how she expected my client to calculate business use percentage for a cell phone. She thoughtfully suggested that we print out monthly call logs, highlight all business calls (after verifying the phone numbers, of course), add up all highlighted business minutes and divide the result by the total monthly minutes. She was not kidding. I’m sure you will find her advice very practical and adopt it immediately. You’re welcome.
Need another example? Sure. After devastating Hurricane Ike, many of us in Houston were eligible to deduct casualty losses. The calculation was based on two numbers: initial cost and loss of market value. Guess what – the records of the initial cost were frequently destroyed by the very hurricane we’re talking about. As for loss of market value, it is supposed to be the difference between two professional appraisals: before and after Ike. And since nobody had those appraisals, the only alternative was to hire a fortune teller or a meteorologist. They are experts in random guesses – which is exactly what loss of market value is.
What’s the IRS solution for a calculation based on such non-existing numbers? They suggest we use reasonable estimation. Great! If only we all could agree on the meaning of reasonable, I would not have had that many clients going thru divorce, and my own kids would not have had to deal with their unreasonable parents.
Who are you cheating, anyway?
Well… Thousands of pages of tax rules that make no sense and are impossible to comply with anyway – and you still want to calculate the “correct tax”? Do you see my point now?
Yes, I do insist that there is no such thing as accurate calculation of income tax due on business operation. You can do your best by learning the rules, interpreting them and following them – and you still will have to partially rely on estimates, judgment calls, and pure old-fashioned guesses. If the IRS decides to audit your tax return, they may very well challenge your decisions and demand that you pay more taxes. They may even accuse you of cheating.
What is the right thing to do, then? My answer is: it is strictly a matter of your personal choice. As an example, I will use a painfully familiar issue: business mileage.
Let’s admit it: most of us do not keep a daily mileage log, as required by the IRS. You know that you put 20,000 miles on your Chevy truck last year, and a lot of that were business miles – but there is no actual log to figure out the exact number. Your gut feeling is that it was somewhere between 10,000 and 15,000 miles. Fine, it is a 5,000 miles uncertainty. Unfortunately, it translates into approximately $1,000 uncertainty on your taxes. In other words, if your tax return says 10,000 business miles – you will pay $1,000 more in taxes than if it says 15,000 business miles. This is one thousand dollars. Got your attention?
I can understand if your solution is ready: let’s use 15,000 miles and save a cool grand! I also understand if you’re tempted to push it even further. Sure, you can “save” another $1,000 if you add 5,000 more miles to your figure. When do you stop pushing? I guess, when you receive a love letter from the IRS.
The little inconvenience that comes with the territory is that the IRS may ask you to prove your numbers. And, as you remember, there’s no mileage log. Houston, we have a problem.
If you claim 15,000 miles while the real number was 10,000 – you’re cheating the IRS. If you claim 10,000 miles while the real number was 15,000 – you’re still cheating! Only this time, you’re cheating yourself out of a legitimate tax deduction and out of $1,000 cash that is legally yours. Who would you rather cheat?
I know what you thinking. Let’s use the middle number of 12,500 miles and keep everybody happy. Sorry to burst your bubble: you’re not solving the problem. You’re only reducing your cheating in half, from $1,000 to $500. Would you prefer to cheat the government out of $500 and risk a possible future confrontation with the IRS? Or would you prefer to cheat yourself out of $500 and risk a guaranteed immediate confrontation with your spouse?
So, what should I do?
Ultimately, like I said, it is a personal decision. Who are you more afraid of? How much in extra taxes are you willing to pay for some extra peace of mind? It is always a choice between saving money and pleasing the IRS.
As long as you’re not cheating intentionally.