If you’re like many taxpayers, you’re probably just starting to prepare your 2001 income taxes. Unfortunately, many people create unnecessary headaches for themselves by waiting until the last minute to do their taxes. While year-end tax planning can help you significantly reduce your tax liabilities, the secret to tax-saving success is year-round planning. The sweeping tax law changes passed under the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) illustrate why you need to stay on top of your tax planning.
Since fitness professionals often work part-time, at different locations, as independent contractors, from home or as the owners of their own business, their tax situation can be unique. Therefore, fitness professionals should know which tax-saving strategies to explore in more detail. This tax-planning article will introduce you to the different tax-saving strategies available to you, your family and your business. Because these issues are complex, you should discuss them with a qualified tax professional. This article does not connote tax advice for any specific individual or situation.
No matter what your situation, EGTRRA offers you exciting new ways to reduce your tax bill. Consider the following top 10 tax-saving opportunities.
Have a qualified tax preparer provide ongoing tax advice during the year and prepare your tax returns. Don’t think that by doing your own return you are dollars ahead. A good tax professional will pay for his or her fee many times over in tax savings.
Any technique that allows a legal deferment of income tax liability will almost always be beneficial. Employer retirement plans head the list of legal tax deferrals. These plans offer employers an upfront tax deduction, while employees do not need to report income from such plans. As the invested funds generate income, continued tax deferral allows for further tax advantages.
Interestingly, many small-business owners have not started offering an employer-sponsored retirement plan because they are simply intimidated by the complexity of this type of plan. Further, many owners are not certain as to the amount of tax deferral that can be attained under today’s complex rules. The retirement plan options for fitness professionals and owners are as follows:
- the Individual Retirement Arrangement (IRA)
- company qualified plans, and the Keogh (or self-employed) plan
- the Simplified Employee Pension (SEP) plan
- the 401(k), or deferred salary plan
- the SIMPLE plan
One key question fitness professionals should consider is which plan will allow the most tax write-offs without costing a lot of money to administer.
The IRA is the simplest and least expensive retirement plan to set up and operate, and many small-business owners and individuals choose it for these reasons. However, you are limited to a yearly maximum contribution of $2,000 of your earnings (you must have wage, salary or self-employment income).
A 1997 tax law provision allows a taxpayer’s nonworking or low-earning spouse an additional $2,000 contribution, for a combined contribution of as much as $4,000, as long as the couple’s combined compensation is that much. If you or your spouse is an active participant in an employer-sponsored retirement plan, that deduction is reduced.
In addition, you must consider the risks of having your funds tied up until you are 591/2 years old, the current minimum age at which you can withdraw funds.
The Roth IRA. The Roth IRA is popular with individuals and business owners because of its tax-saving benefits.
Although contributions to a Roth IRA are nondeductible, unlike those made to a traditional IRA, the real value of the former is that a participant can put away money each year and watch it grow tax free until it is distributed. The key benefit is that the distributions can be taken out tax free after five years as long as the participant has reached age 591/2.
You can contribute up to $2,000 annually to a Roth IRA, provided you have earned that much in compensation. In general, however, there are limitations for higher earners. These limitations will apply if you are single and your adjusted gross income (AGI) is expected to exceed $95,000. If you are married, the threshold is $150,000.
COMPANY QUALIFIED PLANS AND THE KEOGH (SELF-EMPLOYED) PLAN
If you have an ownership interest in a small business, corporation or sole proprietorship and you are interested in saving taxes, chances are you need to look closely at a company qualified retirement plan. Company qualified retirement plans often provide substantial tax write-offs. In addition, there are long-range benefits as your investment dollars compound and grow tax free. Before you participate in a program of this type, have an experienced pension consultant explain all the related costs and obligations.
Qualified Defined-Contribution Plan. This kind of plan can be a qualified (IRS- approved) profit-sharing plan, qualified money-purchase pension plan or both. In a profit-sharing plan, the contribution amount is left to the employer’s discretion. In a money-purchase pension plan, the contribution amount is fixed.
For 2001, the maximum contribution is the lesser of $35,000 or 25 percent of your earned income. But to contribute the $35,000 maximum, you will need both a profit-sharing plan and a money-purchase plan because you can contribute only 15 percent of earned income up to $170,000 in a profit-sharing plan. Remember, a money-purchase pension plan requires annual contributions in accordance with the plan’s formula, up to a maximum of 10 percent of earned income. Your tax accountant can explain this to you in further detail.
THE SIMPLIFIED EMPLOYEE PENSION PLAN (SEP)
Under a SEP, the employer makes contributions to employee IRAs. The main advantage of a SEP is that you can establish it after December 31, 2001, and deduct contributions on your 2001 tax return even if you make them in 2002, as long as you do so by the due date of the 2001 tax return (including extensions). In addition, a SEP does not require the same documentation as a Keogh plan, nor is Form 5500 required annually. Again, consult with your accountant.
If you are self-employed, consider a SEP if either you did not establish a Keogh plan by December 31, 2001, or you don’t expect to take advantage of the maximum annual Keogh contributions anyway. The disadvantage of a SEP is the lower contribution limits. For 2001 you can make a deductible SEP contribution of $25,500, compared to $35,000 for a Keogh plan with a money-purchase plan component.
THE 401(K) PLAN
A 401(k) is a salary deferral plan that allows an employee to elect to have a portion of his or her compensation paid to an employer-sponsored qualified retirement plan. The maximum employee elective contribution for 2001 is $10,500 ($11,000 in 2002). This annual limit applies even if the employee has more than one salary deferral plan. Matching contributions made by the employer are not treated as elective contributions and are therefore not subject to any limit.
(In an effort to assist small fitness facilities, IDEA recently introduced the IDEA P.R.O.F.I.T. System. In addition to marketing services and operational support, the system allows smaller fitness facilities to offer a 401(k) program to eligible staff at no cost to the facility or employees. For more information, please see the January 2002 issue of IDEA Health & Fitness Source.)
THE SIMPLE PLAN
An employer with 100 or fewer employees (who received at least $5,000 of compensation in the preceding year) can establish a SIMPLE plan as long as the company generally doesn’t maintain any other employer-sponsored retirement plan. A SIMPLE can take the form of an IRA or a 401(k) plan. In both cases employer matching is required. An employee may contribute up to $6,500 ($7,000 in 2002), with the employer matching that amount, up to a maximum of 3 percent of the employee’s compensation, subject to limitation. A 1 percent match is permitted in two years out of every five.
The benefit of a SIMPLE is that it is not subject to nondiscrimination and other qualification rules generally applicable to qualified plans, nor to the top-heavy rules that apply to 401(k) plans. The downsides are that you cannot contribute to any other employer-sponsored retirement plan and the elective contribution limit is lower than for other types of plans. For the employee, mandatory employer matching can be attractive, though amounts are limited based on compensation. For the employer, this requirement can be a disadvantage because contributions are not discretionary.
Taxpayers with AGIs below certain limits may contribute funds to education IRAs on behalf of children under 18 years of age. These funds, which are to be used for education expenses, are not tax deductible, but they accumulate tax free. The maximum per-student contribution for 2001 is $500. Expansion of Education IRAs. Beginning in 2002, the following rules will apply:
- Taxpayers will be able to use these IRA funds for elementary- and secondary-school expenses, as well as higher education.
- The maximum annual per-student contribution will rise from $500 to $2000.
- The phaseout range for joint filers will rise.
- The various beneficiary age limits will no longer apply to special-needs beneficiaries.
- Taxpayers will be able to claim the Hope or Lifetime Learning credit and exclude education IRA distributions from gross income as long as the IRA funds are not used to pay the same expenses for which the taxpayer is claiming the credit.
- The deadline for contributions will be the same as it is for other IRAs: the income tax return’s due date for the year the contributions are made—April 15.
Rules for prepaid tuition plans will change in the following ways, effective in 2002:
- The definition of qualified tuition program will expand to include certain prepaid tuition programs established and maintained by eligible private education institutions.
- The definition of qualified education expenses will expand to include those incurred to enable a special-needs beneficiary to attend an eligible educational institution.
- Distributions used to pay qualified higher-education expenses will be excluded from gross income.
Travel and entertainment expenses that are directly related to your business and income-producing activities are usually deductible, whether you are an independent contractor or an employee.
Travel expenses include transportation fares, automobile expenses, meal and lodging costs, baggage charges and miscellaneous business expenses (e.g., telephone charges) incurred away from home. The cost of transportation (including automobile expenses) between your home and your regular place of business is not deductible, but the cost of local transportation between business locations during the day is generally deductible. You cannot deduct travel expenses when the sole purpose of the travel is educational. There are limits on the deductibility of certain expenditures for travel, business meals, entertainment activities and entertainment facilities.
The 50 Percent Deduction Limitation. Your allowable deduction for business-related meals, entertainment and entertainment facilities is limited to 50 percent of the amount spent, including taxes and tips.
Conventions and Investment Seminars. You can deduct travel expenses for attending conventions, seminars, sales meetings or similar meetings in connection with the active conduct of a trade or business.
Unreimbursed Employee Travel and Transportation Expenses. These expenses are deductible only as a miscellaneous itemized deduction (with an exception for certain performing artists). Total miscellaneous itemized deductions are deductible only to the extent they exceed 2 percent of your adjusted gross income.
Travel and Transportation—Domestic Travel. Expenses incurred when traveling away from home overnight on business are generally deductible. Travel expenses include fares, meals and lodging. However, expenses incurred for meals and entertainment are subject to the 50 percent deduction limitation. To be deductible, domestic travel must be primarily related to business, and certain record-keeping requirements must be satisfied. (See section 8, “Substantiation,” for more details.) If you fail to properly substantiate your expenses, they may be disallowed.
Automobile Expenses. The deduction for automobile expenses can be calculated in one of two ways:
1. Actual expenses. Automobile depreciation is added to the actual expenses related to use of the automobile. The amount that can be deducted each year varies, and these amounts are indexed annually for inflation.
2. Standard rate. The deduction is computed using the standard mileage rate of 34.5 cents per mile for all miles of business use.
Planning Tip: Interest paid on a car loan is considered personal interest and is not deductible—even if you use the car for business. However, if you finance your car by taking out a home equity loan, the interest will be fully deductible as home mortgage interest. The after-tax cost of home equity payments will often be lower than the best car loan available. If you don’t own a home or have enough equity available, consider leasing. If you lease a car and use it in your business or work, you can deduct part of each lease payment. Normal operating costs and maintenance may also be deducted.
Travel Between Two Different Work Locations. If your job, as an employee, takes you to two or more places during the course of a single day, you can deduct the cost of traveling from one job to another. Keep in mind, your initial journey and final return are considered commuting and are not allowed.
Entertainment Activities. With some notable exceptions, you are not allowed a deduction for any expense item relating to an entertainment activity unless
1. the expenditure is directly related to the active conduct of your trade or business or
2. the expenditure directly precedes or follows a substantial and bona fide business discussion and is associated with the active conduct of your trade or business
In addition, for the expenditure to be deductible, the purpose of the entertainment has to be to obtain income or some other specific business benefit (goodwill is not enough). All entertainment expenditures are subject to the 50 percent deduction limitation.
Planning Tip: Travel expenses for conventions, seminars and business trips are carefully scrutinized by the IRS to determine if they are merely disguised vacations. If the business or professional activity is only a small fraction of the sojourn, the major part of the deduction, including the travel costs, will be disallowed.
You may be able to claim an accelerated-depreciation deduction and a Section 179 first-year expensing deduction for your home computer provided you use it for business more than 50 percent of the time. For you to claim these deductions, your employer does not have to explicitly require you to buy the computer. You are eligible if, by purchasing the computer, you spare your employer the cost of providing you suitable equipment with which to perform your job responsibilities.
Telephone bills are generally deductible when you can substantiate business use. However, you cannot claim a deduction for the basic local service charge for the first telephone line in your home, even if you use the phone partly (or solely) for business. You may claim the depreciation deduction for a cellular phone as long as you use the phone for business more than 50 percent of the time. Remember, a contemporaneous record detailing the business purpose of telephone calls will almost always allow you to deduct them as a business expense.
The home expense deduction is one of the most misinterpreted and misunderstood areas of the tax law affecting small-business owners today. Few know the long-range implications of claiming a deduction for your home office. Thanks to recent tax reform, however, this often controversial deduction will prove beneficial to some taxpayers.
Planning Tip: If you use a portion of your residence for business, remove all non-business-related items from this area. Although not essential, you might consider physically separating these office quarters, possibly with partitions. The key is to demonstrate that you use the space exclusively, and on a regular basis, for business.
Tax Law Update. The IRS has recently adopted new rules. One important change is that if your work arrangements cause you to spend a considerable amount of time inside your home office, you may still qualify for the deduction even though the focal point—the primary function of your business operation—is at an outside location. Important Note: As of December 31, 1998, a home office can satisfy the principal-place-of-business test if that office is used to carry on management or administrative activities and the taxpayer can show that no other fixed location is available to carry on such activities.
The general rule is that you may deduct any business expense incurred by you personally that is related to your trade or business, connected with producing income or paid to determine your tax. Consult with your tax advisor for more specific information on the items below.
- Medical savings accounts. For four years, beginning in 1997, self-employed individuals and individuals employed by “small employers” who are covered under a high-deductible health plan may deduct contributions to a medical savings account (MSA). Income earned in an MSA is tax free, as are distributions to pay for medical expenses.
- Student loan interest. You can claim a deduction for interest expenses on qualified education loans for you, your spouse or your dependents. You can claim this deduction whether or not you itemize deductions.
- Employee business expenses. If you are an employee (this includes an outside salesperson), you may deduct as an adjustment to gross income only the amount your employer reimburses you for work-related business expenses. Any expenses that your employer does not reimburse are deductible only as a miscellaneous deduction (subject to the 2 percent limit).
- Educational expenses. In general, educational expenditures, such as tuition, books, supplies, lab fees and certain travel and transportation costs, are deductible (whether or not the education leads to a degree) if the education (1) maintains or improves skills required in your employment or business or (2) meets the express requirements of your employer, or an applicable law, imposed as a condition of employment. However, educational expenditures that are made to meet minimum educational requirements or that qualify you for a new trade or business are not deductible.
- Tax preparation fees.
- Safety deposit box rental.
- Legal expenses. Legal fees that you pay to produce taxable income are usually deductible subject to the 2 percent limit. Generally, legal expenses of a personal nature are not deductible.
- Investment advisory fee.
- Certification and continuing education costs.
- Music tapes.
- Liability insurance.
- Equipment that is used exclusively with members, with clients or for educational purposes.
- Business-related meals.
Accurate documentation is necessary to claim certain deductions. You must keep thorough records in case the IRS audits you. Items that require careful tracking include (1) general travel and entertainment costs and (2) automobile mileage.
GENERAL TRAVEL AND ENTERTAINMENT RECORD-KEEPING REQUIREMENTS
Travel and entertainment expenses are an ordinary and necessary part of doing business, but you may not deduct them unless you meet particular substantiation requirements. Specifically, the law allows deductions for travel and entertainment expenditures if you substantiate these expenses through (1) “adequate records” or (2) “sufficient evidence corroborating the taxpayer’s own statement.” To claim a deduction under either method, you must substantiate the following:
- the amount of the expense item
- the time and place of travel, entertainment, amusement or recreation, or the date and description of the gift
- the business purpose of the expense item
- the business relationship to the taxpayer of the person or persons entertained or receiving the gift
Adequate Records. You should maintain an account book or a diary, log, statement of expense or similar record of the necessary information. Keep canceled checks, credit card receipts, hotel bills and other documents to substantiate any expenditures for lodging and any other expenditures of $75 or more. Record each entry in your records “at or near the time of the expenditure or use.” A log maintained on a weekly basis should normally be adequate.
Claiming a credit or deduction without adequate records (or sufficient corroborating evidence) may result in a negligence or fraud penalty in certain cases.
Additional Substantiation Requirements. If a business discussion takes place before or after a meal or entertainment, you must provide the following information in addition to the general record-keeping requirements:
- the date and duration of the business discussion
- the nature of the discussion, plus the business reason for the entertainment or the nature of the business benefit derived or expected to be derived
- the identities of the persons entertained
The Burden of Proof Could Very Well Be on You. Business owners can expect the IRS to challenge their deductions at one time or another. If your business deductions are challenged, you should be prepared to verify the following:
- You are the person entitled to take the deduction in question.
- The year for which the deduction is claimed is the current year.
- The amount claimed is deductible under the law.
Planning Tip: If you incur occasional out-of-pocket cash expenses in your business, keep a detailed daily log, even if the expenses are for minor items like telephone calls, tips or tolls. Keep a written record detailing the amount, date and purpose of each expense.
AUTOMOBILE MILEAGE RECORDS
Probably one of the most common record-keeping problems of business taxpayers is substantiation of business mileage. To save you the chore of documenting all automobile expenses, you are entitled to claim a fixed mileage allowance—for 2001, that is 34.5 cents per mile. Whether you use this allowance or detail all your auto expenses, substantiation must include tracking the actual miles traveled for business.
Tax Organizer. Adequate records include an account book, an expense statement or a written log, diary, trip sheet or similar record of each expenditure or use. However, in some cases, you may substantiate the business use of automobiles by keeping records on a sample basis—for example, maintaining an adequate record of business use during the first week of each month. If this sampling method is used, you must be prepared to demonstrate that the periods for which an adequate record is maintained are representative of your use for the year.
Record Keeping. You must meet the same record-keeping requirements for automobiles as for other travel and entertainment expenses. Also, keep a mileage log to document personal and business use of your vehicle. Remember, this deduction could mean a substantial tax savings, so keep a good auto, travel and business log in your vehicle if possible.
Planning Tip: To eliminate risk later on, keep a log to identify the location and purpose of all your business trips. If records are unavailable for the current year, begin to reconstruct your business mileage with the best evidence you can find.
If your withholding is not enough to cover at least 90 percent of your actual tax liability, you must pay adequate estimated taxes on a quarterly basis or you will be assessed a nondeductible interest charge, referred to as a “penalty.” There are several ways you can avoid this penalty and also minimize your quarterly payment instead of overpaying the IRS.
Avoiding the Penalty. To avoid the penalty, you need to pay your taxes in equal quarterly installments. To satisfy your tax liability, you will need to pay
- 90 percent of your actual tax for 2001 or
- 110 percent of the tax on your 2000 return or
- 100 percent of the tax on your 2000 return if your AGI on that return was $150,000 or less ($75,000 if married filing separately)
Not reporting all of your income could come back to haunt you when you apply for a loan (i.e., a home loan). Remember, the law requires you to report all your income, regardless of whether you receive a Form 1099 from the income source. Successful business and professional taxpayers report all their income, but they know the law well enough to take advantage of tax deductions.
While these tax-saving strategies may seem complicated, you should now have enough information to ask your tax accountant how these strategies can apply to your situation and what types of year-round tax-planning tips you should focus on. A qualified tax accountant should be able to assess your situation and determine the best tax-saving strategies for you.