Year End Tax Planning
It’s the end of 2017 and you have likely heard about all the tax reform changes being discussed on every website and news outlet. My name is Chris de Lorimier and I am an Enrolled Agent licensed by the IRS Department of Treasury, and I also have an MBA in Financial Planning. Most people aren’t familiar with the Enrolled Agent designation, but we are like CPAs. Some (not all) CPAs do taxes, but all Enrolled Agents are experts in tax. CPAs are licensed by their state’s Board of Accountancy, and Enrolled Agents are federally licensed by the IRS’ Department of Treasury.
To say that this has been a busy end to 2017 would be an understatement. I have spent the last month or so reviewing the proposed and now the new tax reform laws and how it will affect not only my clients’ and their families but also my own family since my wife is a hairstylist.
Lots of changes will be taking place in 2018, but there is no need to worry with proper tax planning and preparation.
This piece is meant to be an introduction and/or refresher for those interested in getting a better hold on their taxes and finances.
When you do report the income you receive on your taxes? When do you deduct for expenses?
If you are like most self-employed hairstylists and manicurists, you are a cash basis taxpayer which means you report income and deductions in the year that they are actually paid or received. This means that if a client pays you with a check dated December 21, 2017 and you don’t make it to the bank to deposit it until January 3, 2018, the income should still be reported on your 2017 tax return. Even though the money wasn’t in your checking account yet, the fact that you received the check makes it reportable in the year you receive it.
This goes for business expenses too! One of the most important tax planning strategies for any self-employed person is reducing your taxable income through purchases for your business.
For a business expense to be deductible, it must be both “ordinary” and “necessary” in your trade or business. This means that while it may be quicker for you to get to the salon by helicopter, a helicopter may not fit the “ordinary” and “necessary” rules to allow it to be deductible. Similarly, I had a stylist tell me that she wanted to use her baby shower as a business expense because she had invited some of her clients. That is going to be tough to defend when the IRS questions it, so we left it off her return and did not deduct it.
Now think about your business and all the “necessary” and “ordinary” expenses that you have to pay every day, week, and year. I know all of them because I see them in my wife’s business checkbook. Color, hair straightening solutions, sheers, smocks, salon rent, hair shows, credit card machines, your website design and hosting fee, your assistance’s fee, etc. The list goes on and on. You pay a lot of money out to run your business.
If the purchases are made in 2017, you can likely deduct the expenses on your 2017 tax return (reducing your 2017 income) even though you won’t be using most of the items until 2018.
If it would help you to better organize your records track your expenses, and make sure you are deducting every dollar that was “necessary” and “ordinary”, my firm has an excellent deduction worksheet specifically for hairstylists and manicurists. Feel free to email me for a copy.
What do you mean I have to pay two different taxes because I’m self-employed?
One of the biggest surprises that any new self-employed stylist learns is that they are both their employer and their employee. When you work for a company and receive a paycheck, the company pays half of your Social Security and Medicare tax (7.65%) and you, the employee, pay the other half (7.65%). You never notice this because it automatically comes out of your check.
Being self-employed, you are responsible for paying both halves of the Social Security & Medicare tax. This is called Self-Employment tax and it equals 15.3% of your net profit (gross income minus your business expenses).
This is in addition to your federal and state income tax so if you are paying 25% to the IRS, another 6% to California, and now you have to pay 15.3% of your net profit for self-employment tax, almost half of your money if going to taxes.
How do you pay these taxes? Through estimated tax payments. Approximately every 3 months (it’s not because the government has to keep it confusing), you would pay your estimated portion of taxes to the IRS and to your state tax agency (if you have to pay state income tax). An added benefit of having a tax professional such as myself is that I can assist you with determining how much you should to pay to help you avoid the big surprise that people get when they haven’t paid all year and have to come up with a lump sum when they file their taxes.
Quick side note…
An important question that I ask all self-employed clients is “Are you charging enough?”. Running a business, particularly in California, is costly. Look at all the money we are talking about going out in supplies, rent and taxes. I implore you to make sure you are charging enough to support yourself and ensure you are paid properly.
What about business miles?
Business mileage tends to be one of the areas that taxpayers get confused about, but it’s not that difficult and I’ll give you a quick summary for a self-employed person. First, what is allowed as business mileage? Commuting to the salon is NOT. Simply driving to the salon because you have a client there is not deductible. What about if you were working at the salon and one of your client’s asked you to come to his/her home to do their hair. In this case, the mileage between the salon and their home would be deductible. Same goes for that hair show you want to attend. If you drive there, you can deduct the miles as business miles and if you fly there, you can deduct 100% of the travel and even the hotel for the days of the show on your Schedule C.
The IRS is requesting more and more taxpayers to substantiate their mileage deduction by providing the IRS with a copy of their mileage log. Yes, you should have a mileage log and feel free to email me for one if you don’t!
There are apps that will currently track it, but I recommend clients keep a simple notebook in their car or spreadsheet on their computer. For a mileage log to be considered comprehensive enough to deduct the miles,
the IRS requires you to list the date you were driving, where you were going, for what business purpose and how many miles you drove.
The IRS currently allows two ways of deducting business mileage. The simple way is adding up all your business miles, multiplying it by the mileage rate (53.5 cents per mile for 2017 and 54.5 cents per mile for 2018), and deducting this amount on your Schedule C.
The more complicated way involves keeping track of all your gas receipts, car payments, oil change bills, etc. and also keeping track of those expenses on your mileage log. For most people, the simple way results in a larger deduction and allows you to keep track of less information.
Again, while you likely won’t get an IRS Revenue Agent showing up at the salon, it is required that you keep a log of your miles in case you ever get a letter from a tax agency asking to substantiate the deduction.
Retirement Planning – All my money is going to taxes! What do you mean I should save for retirement?
If you’ve ever worked for a company, you’ve likely participated or been eligible for a 401k. A 401k is simply a retirement savings account where you can put away money before taxes. If you make $50,000 a year and you put $5,000 in your 401k that year, you only $45,000 is reported as wages ($50,000-$5,000).
As a self-employed person, you have a variety of options for your retirement accounts and they all have pros and cons. One of the most popular types that I recommend to clients is a SEP IRA. A SEP IRA is similar to a 401k in that the money you contribute to the account is not taxed so you can reduce your taxable income and save for retirement. The greatest benefit of a SEP IRA is that you can contribute up to 20% of your net profit as a self-employed person and deduct that from your tax return. For example, if your net profit is $80,000, you could contribute up to $16,000 to your SEP IRA. This means you would reduce your income by $16,000 and would only have to report income of $64,000. There are some contribution requirements if you have employees but it’s something to consider.
A second option is called a Roth IRA and it is unique in that, while you do not receive an immediate tax benefit, when you ultimately retire and decide to pull the money out of your Roth IRA account, all of the earnings that have compounded and accumulated over the years are tax free to you! This type of account is particularly popular if you are younger and just starting out because you have a much longer time to save for retirement. There are some income limitations once you start making a lot of money, but tax-free growth is an excellent benefit especially over 20, 30 or even 40 years.
What about that insurance agent that keeps calling me?
The most aggravating thing that I experience as an Enrolled Agent and Adviser is the insurance agents that prey on the fear of others. If you have a spouse, children, and/or mortgage, I highly recommend purchasing a term life insurance policy. They are inexpensive, last for the period of time that you need, and they accomplish the goal of covering your family if something were to happen to you. Whole Life policies are typically sold by insurance agents because they have larger commissions and allow a portion of your premium to be set aside in a savings account should you need it. Why not just buy the cheaper term policy and keep control of your own money in a savings accounts without paying a huge commission?
As a self-employed person, liability insurance is essential to protect yourself in case a client slips or is injured while you are assisting them.
These policies are typically not very expensive and they are deductible on your tax returns.
What about disability insurance? In most circumstances, and this is my personal opinion, I believe disability policies are sold based on a fear. While the risk of being injured at work is always apparent, I would prefer seeing my clients setting aside their own emergency funds rather than paying money to an insurance company who pays its agent a large commission. You hope that if something were to happen that the insurance company would uphold it’s end of the bargain, but I am doubtful and would rather see clients controlling their own money. Again, for some individuals, disability insurance may be beneficial, but for most people I have met with, it is expensive and not worth the cost.
Emergency Savings – 3-6 months of your expenses just in case
This isn’t anything new, but I stress everyone that I meet with to start small and begin accumulating 3-6 months of your monthly expenses in a liquid savings account. By expenses, I mean the necessities (rent, food, utilities, clothing, kid’s tuition, etc.). Figure out what you pay each month and you’ll want 3-6 times that amount in a savings account. If your monthly expenses are $3,500, you’ll want to set aside between $10,500 and $21,000 in a liquid savings account to give you relief just in case an emergency happens.
This doesn’t haven’t to be done overnight. Start at $20 a week and increase it as you can. You won’t know the true benefit of an emergency savings account until an emergency happens and you have the funds available to pay for it. Talk about sleeping soundly at night!
While most people will put money in their savings account at the bank, I prefer online savings accounts over the brick and mortar bank because they pay 100 – 125 times more in interest and the money can be easily transferred to your checking account when you need it.
How long do you have to keep your old tax records before you can throw them out?
If you are like most people, you probably have an attic or basement full of stuff that you would be happy to discard. But inevitably, among that sea of musty papers and cardboard boxes are your tax records.
When can you get rid of these? In most cases, the statute of limitations for assessing additional taxes is three years from the return due date, or the date the return was actually filed, whichever is later (like a return filed late or on extension). But if you have substantially understated your tax, the three-year rule changes to the six-year rule. And in cases of fraud there is no statute of limitations.
Nonetheless, before your trip to the mall this Saturday includes the purchase of a document shredder, carefully consider this: There are circumstances when you might want to keep your records longer than what the three-year rule recommends, and there are other records that you might want to consider as permanent.
When a document or record substantiates your tax basis in an asset. This can include items such as your home, or rental property. And how about all those years of improvements on your real property? It may also include your stock options, savings bonds, or other securities. In addition to those securities, remember that dividends or similar transactions may increase your tax basis in such property.
When a document or record substantiates a liability, like the purchase price of your sole proprietorship, or the original balance of your mortgage.
When your returns themselves signify a carryforward of expenses, losses, or credits to a future year or set of years.
When your returns can substantiate important financial data for a current situation in your life, like a divorce or purchase of a major asset, or business.
Your past returns signify milestones in your life. Hence, they are historical documents. Ultimately, any deduction that you take on a return must be substantiated if the IRS or state tax agency requests it, but if you are beyond the statute of limitations listed above, you can likely discard it.
If you’ve made it this far…THANK YOU!
This post is simply meant as an introduction to assist those just starting off as stylist as well as those that want to improve upon their business’ tax planning. I have covered a lot and still it is just the beginning to increasing your financial and tax knowledge as business owners. No one should have to pay more taxes than they are legally required to pay. As an Enrolled Agent, I file tax returns and assist clients with tax planning, but I also help those on the more unfortunate side that are dealing with tax audits and collections issues. I work closely with the IRS and state tax agencies to make sure the taxpayer’s rights are being upheld and that they are being treated fairly.
Please feel free to visit my firm’s website, www.crowncitytax.com or contact me if you have any further questions or need any assistance. If it’s not something my office handles, I have developed a strong network of colleagues all across the country that are also Enrolled Agents and willing to assist taxpayers.
Additionally, I also work as a fee-based investment adviser and assist families and small business owners with their financial and retirement planning. We don’t charge commissions and 95% of our new clients come from referrals. We offer everyone a one-hour consultation at no cost to review your current situation and provide a written report. If you decide to implement the plan yourself, you are more than welcome to and owe nothing to us, but we find that the majority of people decide to work of us due to our transparency and availability.
Feel free to visit our other firm’s website, www.oconnorwealthmgt.com, and contact me if you have any questions or would like to schedule a call or meeting.
Our offices are in Monrovia and Pasadena, CA, but we work with clients across the country.
Please let me know if there is any way for me to assist you in achieving your financial goals.
I wish you and your family a safe and happy 2018.
Chris de Lorimier, EA MBA