When we look at the savings we achieve using smaller tax-saving strategies, we often discount them, believing that a few thousand dollars in deductions will not make much of a difference in the overall amount we will eventually have to pay. We forget that collectively those same strategies can add up to tens of thousands of dollars in deductions.
Have you implemented all the strategies – especially the small strategies – that will help you maximize your savings in 2022?
Make sure during this live discussion led by Kami Elhert, Tom Gibson, CPA, and Brian Shey will discuss some of the small tax saving strategies that can add up to big savings, including:
Transcript (edited for clarity)
Kami Elhert: Hello, and good morning. Thank you for joining the webinar today, Small Strategies, Big Savings. I’m Kami Elhert, Senior Client Relationship Manager. And today, I’m joined by Tom Gibson, CPA and Senior Tax Strategist. Good morning, Tom.
Tom Gibson: Good morning, Kami. Good morning to all the folks on the webinar.
Elhert: We’re also joined today by Brian Shey, TSP Family Office Strategist. Good morning, Brian.
Brian Shey: Hello to everyone. Kami, Tom, good to be with you guys. And welcome to everybody on today’s webinar. Good morning.
Elhert: Some of us look at the savings we achieve using smaller tax strategies, often discounting them by believing a few thousand dollars of deductions will not make much of a difference in the overall amount that we pay. We forget that, collectively, those same strategies can add up to tens of thousands of dollars in deductions. Some of those strategies are items like hiring the kids, grandchildren, nieces, nephews, tax-free rent, travel, and home office.
Tom, I know that the scorecard is one of the strategies that we go over a lot with our clients. And a lot of times, they look more towards some of the big-ticket items that provide bigger deductions.
Gibson: Absolutely. We do so much for our clients with strategies like cost segregation study, captive insurance companies, and of course, the real estate investment that has the potential to go into conservation. And those are knocking out, in some cases, up to 50% of taxable income. And it can be tough to then drop back to something that’s going to knock $2,000 to $4,000 off your tax bill and get super excited about that. But Kami did mention that term collectively. And really, that applies in two different ways.
First, I can’t think of a single plot where we’re only utilizing one scorecard deduction. We’ll find six to eight of these that are a good fit. So there’s a snowball effect in the current year. But beyond that, there’s the fact that you can utilize these deductions year after year after year. And so the scorecard definitely is worth the trouble if you pay attention to what Kami and the other client relationship managers tell you, which is what, Kami?
Elhert: Set it and forget it, right? Get a good system in place. We love a good system, and we love to know that those deductions are coming through and you really don’t have to think about them.
I will have been with the firm 11 years in August. I can’t tell you how many conversations I’ve had over the last 11 years in January with someone who said, “Well, I’m just going to wait and pay the kids at the end of the year, and I’m going to write my tax-free rent check at the end of the year. I’m going to reimburse myself from my home office expenses at the end of the year.” And then we get into the holidays, and it slips their mind because it just slips their mind. I don’t have a client who’s not busy. And then they call me in January, “Well, what can we do?” And the answer is not a lot. Sometimes, we can go back with tax-free rent and maybe shoehorn that in for the prior year. But the IRS wants to see transactions, not journal entries. And plus, the fact with things like hiring the children, there’s payroll taxes. There’s kind of a domino effect. Kami hit the nail on the head.
We want to get a system in place, get things set up, and then we don’t have to remember it. We don’t run the risk of forgetting to remember something at the end of the year. It’s happening every month like clockwork. And at the end of the year, the deductions are there.
Elhert: We talk about hiring the kids with our business owners. But it just doesn’t stop there. I know, Brian, you have some nephews living with you at this point. And that’s one of the things we always like our clients to consider as well. It doesn’t just apply to the kids. If you have family, grandkids, nieces, nephews – if they’re willing to work and do their jobs, they’re able to be hired as well.
Shey: I do have an extended family living with us. And for the better part of 20-plus years, I was a sole practitioner. I have some LLCs, and I own some real estate. So I’m able to take advantage of the strategies that I’ve gleaned over the past number of years just working with Tom and Kami and the rest of the team.
Tom mentioned have a plan and get it in place. And for the clients out there that are not using a payroll company, setting it and forgetting it, I highly recommend doing that. Don’t take it on yourself. I’m married. I have three sons. All of them are on the payroll, and they all have the bank accounts. And yes, it took a little bit of setting up. But I use QuickBooks. Let me rephrase. My wife uses QuickBooks. I can’t open up the program, but she pays all of us. And we use our children’s bank accounts for all the expenses that we can that refer to them. It’s a small strategy, but it adds up. And I don’t think we mentioned that it’s not just one year. It’s every year and every year and every year. And it’s a small strategy that, over time, really compounds.
Gibson: Absolutely. And just a plug for what Brian said about payroll companies. Some of you have payroll already and we’re just adding the kids onto an existing payroll, that’s easy. It’s not really any different than bringing on any new hire in terms of mechanics of what you need to do with your payroll company.
Other folks, though, maybe have a Schedule C business, and they haven’t really had payroll up to this point. I’ll preface what I’m about to say by telling you, you could not pay me enough to get me to do payroll for somebody because payroll is a thankless job. And the problem is, if you make a mistake, there’s always a ripple effect because you’re not just filing payroll tax returns with the federal government. Most states have state unemployment, other things that come into play. There are workman’s comp issues. There are all kinds of things. So the $100 per month that you’re paying a payroll company to take care of all the payroll tax filings for you, do the W-2s at the end of the year, it’s worth every penny. Plus, that $100 is obviously a deductible business expense. So if you’re in the 37% tax bracket – we’ll just stick to the federal – your actual out-of-pocket is about $63 a month. And I will say this, in 11 years, I’ve never had a client who tried to do payroll themselves where it turned out well. There’s always some little mistake that happens. And fixing the mistake takes four times as much time as just hiring somebody who specializes in that and letting them do it, to begin with.
Elhert: We really do say that about the payroll services. We recommend Gusto for some of our smaller business owners who work really closely with the employees they have. So the cost could even be a little less than that. But getting them on board and involved is huge.
Gibson: Absolutely. And the crux of these scorecard deductions is that you’re going to spend this money one way or the other. It’s not a question of whether or not. You’re going to go on vacation. You’re spending money on your kids. You’re talking about business at home. You’re utilizing part of your home to work on things related to your business. That’s all going to happen. The only question that we’re trying to help answer is, is there a way to structure this so that we’re at least getting some tax benefit from these dollars that you’re going to spend one way or the other? Hiring the kids is the poster child of that. I have four children. They’re grown. They’re out on their own. They’re doing well, and I’m eternally grateful for that. But I have not forgotten how expensive it is to raise kids. And to whatever extent we can convert part of that expense of getting ready for college, helping pay for all of the things that they’re into while they’re younger, anything we can do to convert even part of that is definitely going to be a step in the right direction.
So to just kind of refresh things – and we’ll talk about children first and then some other potential scenarios – but whether it’s your children, your grandchildren, nieces, nephews, there’s kind of a bright line in federal labor law at age 14.
Below the age of 14, we’re pretty limited in terms of job descriptions. Those of you who have younger children, as you know, corporate modeling is a job that is completely non-controversial for a young child, and it tends to pay well. Once they get to age 14 and above, we can add on additional job duties. As a result, we can increase their pay. The other thing to keep in mind, of course, is reasonableness: first that the job needs to fit the child, and secondly that what we’re paying them needs to be commensurate with what we would pay a third-party arms-length who’s not related to us to do the same job. And modeling is a perfect example of that. My clients in Newport Beach, California and in Manhattan get a very different modeling rate than my clients in Oklahoma City for doing exactly the same job. That’s a function of cost of living. It’s a function of California having a little bit more robust modeling industry than Oklahoma does. And so there are lots of things that factor into that. But the client relationship managers do a lot of that background work to make sure that we’re hitting both of the meanings of reasonable.
Now, there can be others you think about bringing on the payroll. We do definitely like to get the spouse on the payroll. It just makes it easier to implement some of the scorecard strategies, particularly tax-free rent. Plus, at the level apart from the payroll taxes that might result from that, at the level of your joint return, personally, it’s an absolute wash in terms of the income taxes. We’re getting a deduction in the business. We’re picking up some additional W-2 income on line one, and it just cancels itself out.
Parents can be a little bit trickier. We have a lot of folks who are helping their parents financially. If mom and dad are local and they have some things that they can do for you in your business, obviously, it’s more advantageous for you to help them in such a way that you’re going to have a tax deduction from it, as opposed to just giving money out of the goodness of your heart. Again, you’re going to do it one way or the other. What we’re trying to do is help you find the most tax-efficient way to do it. The only little wrinkle with mom and dad sometimes is Social Security benefits. There’s a point at which, if you earn over a certain amount, your Social Security benefits or part of your Social Security benefits have to be counted in your taxable income. We can give you some guidance on where those numbers lie. But if we can get a tax benefit for you without causing financial hardship for your parents – or it can even be a friend, whomever you’re helping – that’s what we want to do.
Elhert: The other advantage to hiring the children, too, is it creates a lot of different opportunities: taking care of private school and all the sports and afterschool activities, extracurricular, but really building that foundation for a future. And I know that, Tom and Brian, we’ve talked a lot about this in the past with our clients as far as what they can actually do with that money for their children, in addition to paying for the piano lessons.
Shey: Let me jump in quick, Tom, and then I know that you’ll pick up the baton from what I’m about to add.
Before I jump in, I want to take one step backwards and talk about using a payroll company. For the people out there that aren’t doing it, I just had a recent client meeting where the client was talking about moving payroll or whatever over to an accounting or a payroll company or whatever it may be. It was something like $200 a month or something like that for limited transactions. And I went, “Well, that sounds a little bit high.” But then, the client came back and mentioned that the payroll company would also handle the tax returns. That was a game-changer. I said, “They’re going to do your personal tax return and the corporate tax return and then handle the P&L, the balance sheet, all of the transactions that are going through the company? That, to me, is a no-brainer.”
I just want to reemphasize that because there’s not a lot of our clients that will handle that themselves. But there’s a handful out there that, for some reason, maybe make a seven-figure income and are concerned about the $100 on a monthly basis that’s a tax deduction to the company for payroll. Outsource it, and go have a nice sweet tea and whatever.
The other side of that is, and to Kami’s point, anyone that’s had their meeting this year or end of last year knows that I’m a big proponent of the book, The Power of Zero. David McKnight, the financial advisor who wrote the book back in 2014, talks a lot about Roth conversions, talks a lot about getting money out of a taxable environment, moving it over to a tax-free environment. And obviously, Tom and I talk a lot about Roth conversions and repositioning assets, and then also the utilization of permanent life insurance. And I’ll back it up with before everybody disconnects off the webinar because God forbid we’d ever talk about life insurance. Who wants to hear about that?
Again, one of the better tax strategies still left in the code. And when we’re hiring kids, as Tom mentioned, the younger kids, maybe it’s a $6,000 salary that you put them on. For the kids over 14, $12,550? We’ll talk about putting some of that money into a Roth for the children, and then maybe using the other half of it for life insurance for the children. There are different reasons for doing both of those.
Gibson: Yeah. Absolutely. So this is just a little example. The requirement to fund a Roth IRA is pretty simple. You need to have an earned income, and you need to be below certain threshold levels that we are nowhere near with the way that we use hiring the kids. If we take that $6,000 and we put that into a Roth account. The child, because he or she is below the threshold of the standard deduction, no paid tax is paid on the $6,000. Let’s say we do this for 10 years. We get a late start.
At a certain point, hopefully, the child is going to do well enough financially that he or she is probably not going to be able to directly contribute to a Roth. That being said, there was actually – and you’re not going to hear me say this much – there was a good piece of tax legislation that passed the House a couple of weeks ago that is really going to liberalize the ability to have a Roth arrangement in 403(b) plans, 457 plans, and 401(k) plans. It’s actually a very good piece of legislation. But at some point, if we depended on the Roth IRA, their income is going to be too high and they’re not going to be able to contribute.
Back to our example. Say we do this for 10 years. And of course, we’re assuming that the investment is going to grow some. We’re just using 8.5%. So we put money into this for 10 years, and then we’ll just stop. And then we let it sit for 40 years and just grow. 50 years into this and the child’s going to have about $2.7 million inside an account that is never going to be taxed. That is a huge leg-up on the future for that child. And it’s something that is so, so, so simple to do.
Now, however, with the Roth – and to just kind of set the stage for what Brian’s going to talk about a little bit with life insurance, with any type of pension arrangement, doesn’t matter, Roth, 401(k), even a defined benefit plan – we’re always bumping up against statutory caps on how much we can put into those types of arrangements. It’s not that there aren’t limits with life insurance. There are. You’ve probably heard Brian talk about the MEC line, where it becomes a modified endowment contract. We don’t want that to happen. There are unpleasant consequences from that. But the simple fact is that you can put much more money into a life insurance policy than really any type of pension arrangement. So it’s not either/or. Most of the time, the smart tag is both/and. You’re doing both. So Brian, what are some other reasons that life insurance makes a lot of sense for younger folks?
Shey: First of all, for anyone out there that has heard me say this, you know that the life insurance industry has been around for about 300 years. I tell people all the time that the industry has managed to mess itself up for about 300 years. That normally gets a chuckle. And everybody’s eyebrows raise up as they say, “Yeah, they certainly have.”
This has to do with the fact that, if you’re willing to get out of your own way and actually look at an insurance policy contract and if it’s properly designed, properly crafted, properly funded, it’s one of the better tax strategies still left out there for people to use. The problem is that we’re all in denial of our own mortality. People ask, “Why would I ever buy a life insurance policy on my children?” It’s certainly not to collect the death claim. But when my kids were zero, they all got life insurance. And it’s due to the fact that I understand how they work. As Tom mentioned, the life insurance industry was not invented by the government. And life insurance was not invented by the government. Therefore, within reason, we don’t have to play by their rules.
Again, there’s really no limit, if you will, on how to fund these policies. You can overfund them early on. And as most people understand, life insurance and a Roth IRA are identical from a tax standpoint. You put after-tax money in, it grows tax deferred. You’re taking it back out all tax-free. The difference is that with the life insurance policy, because the government didn’t invent it, there are eight or nine other positive benefits to using this, not only for yourself but for your children also, that a Roth IRA just does not provide.
I want to share that one of the other points there is, here at TSP Family Office, not only do we talk about growth – as Tom mentioned, he just showed you what the growth pattern would be over a 40-, 50-year period if you just invest a little bit of money into a Roth for your children – but it’s not just one generation. By using half of that money that you’re paying your kids, maybe through life insurance, that starts to compound to not $2 million or $5 million or $10 million, but $15, $20, $30 million dollars over multiple generations because, again, life insurance transfers across generational lines tax-free. You need to think generationally. We certainly want to take care of our clients in this lifetime. But your kids and your grandkids and your great-grandkids do not need to be giving money to the government of the United States.
Elhert: Especially with how high I’m sure the rates will be at that point, too, right? The reality is planning ahead and making sure that all of that is in place is really important.
Gibson: Let me throw something in here because about half of being an adult is the ability to think about things that you don’t want to think about. And a huge issue in favor of getting children insured sooner rather than later is the issue of insurability.
You don’t know what the future holds. You don’t know what might happen that could mean that child potentially couldn’t be insured later on down the road, so getting a leg-up on it early on. And by the way, it’s coming out of money that you’re paying them. Doing it in a tax-advantaged way makes all the sense in the world.
Elhert: Absolutely. We were talking about the importance of having a good system in place so that you can set it and forget it and take advantage of some of these smaller strategies. One of the other ones that we talk a lot about here at TSP Family Office is tax-free rent via the Augusta Rule.
Gibson: Absolutely. If you’re a business owner, you’ve heard about this a couple of times at this point. It’s that little provision that allows you to rent out your personal residence for up to 14 days per year. The income that you derive from that rental transaction is not includable in your taxable income. And if we’re renting your home back to the business for the purpose of holding these meetings in your home, you’re getting a deduction for the rent expense. So we’re getting to double dip just a little bit with this. Now, the one thing over the last few years that we’ve had to get a little bit more clarity on is the Airbnb issue. If you’re Airbnb’ing a property out and you’re going over the 14 days, well, this isn’t going to be available to you.
Elhert: And that’s your personal residence. Correct?
Gibson: That’s your personal residence. Yes, that’s right. Or it can be a property that is located on the same plat as your personal residence. We had a client at one point who had a pool house. They were Airbnb’ing the pool house. The problem was it was all on one lot. And so it was considered a part of their personal residence, and it kind of killed that.
But as you all know, the client relationship managers do all of the background work to make sure that we’re using a fair and reasonable rate in your area for what it would cost us to rent kind of plain manila conference room space at a local hotel. They’re preparing invoices that you can give to your bookkeeper so that they can have a document that explains what this check is for. Obviously, we want it to be for rent because of where this little exception exists in the code. And they will even provide you with meeting agendas as well. Now, those aren’t written in stone. In fact, we encourage you very strongly, when you’re having your meetings, make notes on those agendas. Cross out things you didn’t talk about. Write in things that maybe aren’t on the agenda. Make notes. If there are some additional people who were a part of the meeting in the attendee section, maybe who aren’t included in the original agenda. All that just strengthens the documentation for you. So Kami, how does set it and forget it come into play?
Elhert: One of the things that we always try to encourage our clients to do is setting that automatic draft, informing the bookkeeper to know that this is a payment that will be coming out every month. Although, I will say there’s one little caveat. We can set it and forget it for 12 months through automatic banking and through different services. We really want to take advantage of this. I believe that all of our business owners are talking about business more than 14 times per year, I’m sure. Brian, you and your wife only 14 times?
Shey: Good segue there, Kami. I really love this strategy. But my wife loves it even more and even probably more than Amazon. And my CPA had no idea about this. He’s only 73 years of age. He’s been doing taxes, well, probably a long, long time. But the Augusta Rule is great. In my area, which is Gainesville, Florida, my wife enjoys getting an $800 deposit on a monthly basis. I’ve already mentioned she handles the payroll, so she never misses that, ever. She really enjoys June and December because she gets it twice. It’s a double-dip. As Tom mentioned, I get to expense it through my LLC. My wife picks it up, and we enjoy a small, little $10,000 on an annual basis that’s non-reportable to the government. But again, small strategy, but it’s every year, ongoing and ongoing. And I definitely joke that Amazon normally gets just about all of it. But it is what it is. Small strategy, but it adds up.
Elhert: Often when we’re talking to our clients and telling them just set it and forget it, we want them to put those reminders into their phone. Putting those business meetings in your phone always helps to solidify that those meetings are happening. But also, setting a little extra reminder in June and December to make sure that we’re getting the benefit of the 14 days that you’re entitled to. So, making sure that it says in June that you’re having that extra meeting on X and X day. Be sure to draft or manually write that check because, obviously, if you’re setting it and forgetting it, you’re only going to get those 12 meetings.
Writing those manual checks in June and December is very important. Best way to, like I said, set it and forget it is reminders on our cell phones. Put it on your calendars, having that information just pop up for you and take five minutes, write the check, and then you can move on.
One of the other things that we talk to our clients about as well are holding meetings in their parents’ home. So again, we talked about hiring them, Tom. This is just one of those other strategies that can work in addition. But hiring them, this actually doesn’t get picked up as income.
Gibson: That’s right because the 14-day rule applies at the level of an individual’s personal tax return. So you could have 14 meetings in your home. But again, if you’re helping your parents financially in some fashion and they live in the area and you could hold meetings in their home, well, you can definitely do that, too. And they can take advantage of that same 14-day rule. The difference being, because it is not part of their taxable income, it’s not necessarily going to impact some of the other things that we mentioned earlier.
All these things are kind of tangled up together. Kids are away at college. Your children who are your employees are away at school. You’re going to fly them home for the holidays. Do you deduct those plane tickets? Yes, you do, because you’re going to do their employee review. While they’re in for the holidays, you’re going to take pictures that are going to end up on social media for your company. And so that trip is a business trip. Same thing goes. You’re going up to homecoming. You’re going to see them again. We make it into a business trip, so all these things really kind of work together.
Elhert: And again, you can even, if you’re renting a condo or you own a condo for one of your college-age children and you’re going and visiting them, talking about some of the social media campaigns or your web page. If you’re having those meetings at that home, you can also take advantage of renting it out.
Gibson: We have to watch that just a little bit, though, Kami, because if mom and daddy own the condo, we can still do 14 meetings. We can give divvy it up any way we want to. But the child needs to be the one who is paying the lease.
But I’ll give you a great example of this. I had a client. Their daughter lived in the village in New York City. She was getting married. Mom and dad flew up a couple of weeks early because mom and the daughter were basically planning the equivalent of the Normandy invasion. And so they were working on wedding stuff, and dad was working while he was there because you know how it is when you’re the dad at the wedding. You don’t really have a lot to do except write checks. And so he was working. Do you have any idea what the day rate is for office space there?
Elhert: Offhand in Manhattan? It’s $2,500 for a conference space.
Gibson: Here’s what they did. The daughter paid for her own wedding, but she paid for her own wedding with money that her dad paid her for the use of that space in her flat in New York. So there are lots of different ways to use this. If you have something coming up, if you have questions about this, call us because it can save you a lot of money. If there’s a way to do it, we’re going for figuring out how to do it that’s going to be safe and legal and, hopefully, get you a tax deduction at the same time.
Elhert: Absolutely. And along with that, Brian, you have your kids on the payroll, and Reyna’s on the payroll as well. That really helps with travel. Brian, you travel a lot. I’m sure, sometimes, having those family vacations are important. But I’m sure you are always working, even if you are traveling. And travel is one of those things that a lot of people don’t consider.
Shey: I’m certainly not going to even allude that my mind is like Tom’s. I can’t think of all of them. Normally, I definitely ask for forgiveness with my CPA most of the time. I try to figure out a way to write everything off. But the traveling is definitely an easy one. Some of our clients know of my occupation of refereeing college basketball. And there’s a number of years when my CPA didn’t like a new pair of tennis shoes or my gym membership or my treadmill or my Peloton or anything dealing with exercising and whatever. Somehow, I write all of that off because of my refereeing career, if you will. But from the travel standpoint, we always like to advise everyone to get the traveling started on a Thursday. And Tom’s probably more eloquent in delivering this, so I’ll hand it to him and let him talk a little bit about that and why we do that.
Gibson: Absolutely. I mean, what we do is called tax planning for a reason because, if you want to do it the easy way and if you want to have everything that you need at the end of the year to give to your CPA and to take the deduction, that’s going to require 10 to 15 minutes of your time before the trip with Kami or one of her counterparts and someone like myself.
Brian hit it off. If you want to do it the easy way, you start your trip on Thursdays. You work four hours on Friday. That’s 50% of the business day. You arrange the trip so that you’re staying over the weekend. So we have business for four hours on Friday. We have Saturday and Sunday, which we get to count as business days, the layover days. But we don’t really have to do anything on the weekends. Monday and Tuesday of the following week, we get in four hours each day. Wednesday, we head back home. Again, that’s going to be a travel day. And normally, if you plan things right, you can take a seven-day trip, work 12 hours, document what you did during those 12 hours, and write off the bulk of the cost of the trip. If we hit that 50% business activity limit, you’ll get 100% deduction for your travel expenses: plane tickets, rental cars, things like that. You’ll get 100% deduction for your lodging. And up through the end of this year, you will get 100% deduction for your business meals, as long as you’re getting those from restaurants in the area where you’re staying. You can’t run to the Publix or the Kroger and pick up food and deduct that. That’s not what we’re talking about. But if you’re getting meals from restaurants, 100% deductible through the end of this year. Then we’ll drop back to the 50% deductible that we had prior to COVID.
Elhert: We can’t stress enough planning ahead, keeping your client relationship manager informed on any trips coming up or any travel that the kids may have coming home for holidays or their annual reviews. Let us know that so we can put together those agendas. We’re more than happy to help you with that.
In my opinion, one of the most uncommonly used or looked-down-upon deductions that we stress to our clients to utilize is the home office. Tom, I think there was a saying back when I first started here that was, “I don’t want to trigger an audit using the home office.”
Gibson: Here’s the benefit of pushing 60. I was working in a CPA firm when the home office deduction came into the code. We were sitting at our desks lit by candles with our quill pens trying to figure out this new law. The reason that the home office deduction got a bad reputation early on was, like so many provisions in the code, it’s not that there was anything wrong with the law. It’s that people were trying to take the deduction incorrectly.
Just a little background on this. The red flag myth about the home office comes from the way that some multi-level marketing companies were telling their people to take the deduction. I’ll pick on Amway and Mary Kay for a minute. And they may not have actually been telling folks this because people tend to hear what they want to hear. But they were telling folks, “If you are displaying product in any room of your house, you can count that as part of your home office footprint.” And so what people practically understood that to mean was, “If I have a jar of cold cream on my side table in the living room, that’s part of my home office.” If you’re filing a home office deduction as a sole proprietorship, which, of course, is the way most MLM people file their taxes, you file an additional form if you’re taking the home office deduction. And the IRS started getting all these forms in with people claiming 100% business use of their home. I can only think of a couple of businesses that might apply to and selling cold cream and makeup isn’t one of them. In any event, they were taking the deduction wrong. And then the IRS started realizing there are a lot of people with Amway and Mary Kay and Avon that are taking this deduction incorrectly. That’s where the fun started because then anybody who got a 1099 from one of these types of companies also got a letter from the IRS about their home office deduction. And again, there’s nothing wrong with the provision. It’s been in the code forever, but they were just taking it incorrectly.
As you’ve heard me say, there’s a right way to take a deduction, and there are a few hundred wrong ways to do it. What’s the right way to take the home office deduction? Depending on your circumstances and depending on how your business is reporting its taxable income, there are a couple of different ways to do this. If you are in a sole proprietorship or a Schedule C business, you would file that additional form.
There are two types of expenses that are part of the home office deduction. The first are indirect expenses associated with the home office. I have a 2,000-square-foot house. My home office is 200 square feet. So I’m using 10% of my home for business. The indirect expenses allocation is based on your home office percentage. That’s things like your utilities, your homeowners’ insurance, garbage collection, cable, property taxes, mortgage interest. Those would all be examples of indirect expenses. You fill out the additional form, and you get to write off 10% of them. So that’s one category.
The second category is what are called direct expenses. And direct expenses are dollars that you’re spending that only benefit the home office. We have a client who didn’t have a home office. He’s building a new house and wants to have a home office. He’s putting in built-in bookshelves, 100% deductible. He’s putting in flooring, 100% deductible. He’s putting in drapery. He’s buying office furniture. He’s buying a computer. All of that, 100% deductible. You don’t have to pro-rate direct expenses based on square footage. You get to deduct all of those.
For most of our clients who are doing business, what we see more than anything else are S corporations. That is far and away the most common entity type that our clients use, and it’s a little different process. In your tax-saving portfolio, there is what is called an accountable reimbursement plan. That covers a lot of things, and one of those things is the home office. For a Schedule C business, you own the home and so it’s not that you’re able to take depreciation on your home; you are required to take depreciation on your home if you’re in a sole proprietorship.
But let’s say you’re doing business in an S corporation. Well, the corporation doesn’t own your home. Therefore, it’s not entitled to take depreciation on the house. But you can do what’s called an accountable reimbursement plan. You use exactly the same computation for the indirect expenses. And once a quarter, you turn your worksheet in to your bookkeeper, and they get your check cut to reimburse you for the expenses associated with the work that you were doing on behalf of the business in your home office. That’s really the only difference in the two methods.
And again, we’re back to, are you going to pay your electric bill this month? Are you going to pay your water bill this month? Well, sure you are. So if we can deduct 5%, 10% of it as a business expense with a pretty low effort – I don’t know about everyone on this call, but I pay every bill I’ve got at this point online. Unless we’ve got somebody coming over to the house to do something for us, I don’t write checks. I pay it all online. Because of that, I can hop on my Florida Power and Light account, and I know exactly what I paid for electricity the previous three months. I can look at my mortgage statements, and I know exactly how much has gone out for homeowners’ insurance or property taxes or whatever. We ask you to provide the measurements so that Kami and the other coordinators can pre-code a spreadsheet that you can then use, first of all, to record the expenses and, secondly, it doubles as an invoice for your bookkeeper.
Elhert: Tom and Brian, we were talking about hiring the kids. Well, when they get a little older and they can have increased job duties, what a great time to get them involved in paying bills, seeing how money is going out, coming in. It’s a great exercise for them to get familiar with filling out the spreadsheet and understanding the baseline of the utilities and the percentage.
Shey: Without a doubt. It’s a good task that I’ve asked my 16-year-old, he’s my middle guy, to start doing. So he’s looking at – well, he doesn’t work with me on it because I don’t pay the bills – but he does work with Reyna on it, and she’s training him how to take over the QuickBooks. It’s always eye-opening to allow your kids to see how the money comes in and goes out – they still think it grows out in the backyard. It’s interesting when they start seeing it. And the earlier you can do it, the more appreciation that they have, so there’s no doubt it’s a really good point, Kami.
Gibson: That’s one of the big things. Florida is, at the moment, toying with having a requirement for a financial literacy class to be able to pass high school, get out of high school. And I think there are lots of things that have to happen before that class happens. But nevertheless, I think it’s a great idea because so many folks don’t really know. If you’re not a business owner and you’re taking your taxes to H&R Block or whatever the kiosk is at Walmart this year to get your returns done, then the parents can’t teach their kids how to do a tax return because they don’t have a clue how to do a tax return.
And Brian hit the nail on the head. The money just doesn’t appear out of thin air. There’s work that goes into it, and there’s a smart way to do things. And then there’s a maybe not quite smart way to do things. The quicker your kids can make that connection between– which is another great benefit of hiring the kids – them figuring out that money comes from working is a huge step in the right direction.
Elhert: Exactly. Thank you, gentlemen. This has been very informative. I know that we’ve gone over a lot, but as you can see, year after year, these small strategies really do turn into big savings and can amount to millions at a certain point if you’re really taking advantage of them and utilizing them in the right way.
We do have a question: “Is there a difference between the job description for someone under 14 and someone over 14?”
Gibson: Yes, there is. As I mentioned a little bit before, as we were talking about this, it has to do with federal labor laws and particularly child labor laws.
Children can only work a certain number of hours. You have to take school into account. There are lots of caveats under the age of 14. Modeling is a perfect fit for that situation. It is not terribly time intensive. A lot of the modeling that our clients’ children do is ending up on their social media. It’s when they’re at the dance recital. It’s when they’re at the Little League game. They’re snapping pictures, and it’s going up on social media. Once they hit age 14, we’ve got more latitude. Now, there are still rules, but we have a lot more latitude on what they can do. We have to keep them away from inherently dangerous situations, so no forklifts, no bandsaws.
Elhert: No mercantiles. I was doing research for a client, and I told him, “Well, I’m not sure if you want your 11-year-old working in the mercantile business, but that’s excluded.”
Gibson: Exactly. But 14 is kind of the bright line. Now, I’ll just be honest with you. I don’t ever want them to stop being corporate model, so. It pays well. If we can get as much bang for the buck from them doing modeling as we can for some of these other administrative duties, then we want to do as much modeling as we can because it does tend to pay better.
Elhert: And family pictures are something that we’re always sharing, right? So social media, our websites for saying Merry Christmas or happy new year from Doctor X, and you put your family up there. A lot of people don’t realize that is corporate modeling. It’s one of those things that, even as they do grow up and get older, we keep in their roles and responsibilities because it does help with substantiating that business need and the business relationship.
Gentlemen, I want to thank you both for joining me today on our webinar, Small Strategies, Big Savings. And to our audience, if you do have any follow-up questions, reach out to us at (772) 257-7888.