4 Tax Mistakes Business Owners Make And How To Avoid Them

FROM FORBES.COM

“I’m proud to pay taxes in the United States,” ukulele-wielding entertainer Arthur Godfrey once said. “The only thing is, I could be just as proud for half the money.”

Some business owners take the sentiment too far. They fall for a misguided tax scheme, get in trouble with the IRS and pay twice the money rather than half. There aren’t enough ukulele gigs in the world to make up for that.

It’s not always easy to distinguish between smart tax planning, aggressive tax strategies and downright tax evasion. With the help of a trusted advisor a business owner can review a tax strategy and decide whether to proceed.

When tax strategy goes wrong, it can be entertaining as much as it is informative. Don’t do what these taxpayers did.

Lesson 1: Don’t try to deduct personal costs as business expenses

Indictment: Doctor falsely reported wedding expenses to IRS.

That was the Associated Press headline just a few weeks ago when a pain management physician was alleged to have falsely reported at least $56,000 of wedding-related expenses as business costs. Ouch.

She is accused of filing corporate income tax returns with many entries identified as business expenses that were actually personal expenses to pay for her wedding.

An advantage of having a business is that the Internal Revenue Code (IRC) allows a deduction for “ordinary and necessary expenses.” But these expenses must be related to the business. Over the years, the IRS has developed sophisticated tracking systems for assessing personal versus business expenses.

Ethics aside, it simply is not worth it to try to sneak personal expenses through a business account. It will likely be found, and the penalties are potentially huge. Who needs pain management now?

Lesson 2: Avoid too-good-to-be-true tax opportunities

Federal tax law is awash with tax breaks. Beware of promoters who try to take these tax breaks and make them do the impossible.

Life insurance is a good example. This product has long enjoyed favorable tax features, including the tax-deferred build-up of cash values, first-in-first-out taxation of surrenders and tax-free treatment of death benefits. Some promoters, however, feel the need to take a good thing and leverage it beyond its intended benefits.

For businesses, these promoters typically try to add the element of deductibility of life insurance premiums. The pattern has been to leverage other provisions in the Internal Revenue Code (specifically sections 79, 412 and 419) to create a business deduction for all or part of the premium without generating a matching tax inclusion to the recipient – usually a business owner or key employee.

In a case decided this summer, an attempt to justify a life insurance transaction under IRC 419(e) ended up with the employer losing the deduction and the employees being taxed. To make matters worse, the court imposed the 30 percent accuracy-related penalty applicable to tax shelters. The total bill? Approximately $2.5 million of taxes additional taxes were assessed, as well as over $500,000 in accuracy-related penalties

The old adage still applies. If it looks too good to be true, it probably is.

Lesson 3: Be prepared for the consequences of aggressive tax planning

This is a lesson from the late owner of the Detroit Pistons.

William Davidson, at his death in 2009, was listed by Forbes as the 68th wealthiest American. His estate plan included what planners typically would call a “SCIN in GRAT” transaction. That would be a self-cancelling installment note in a grantor retained annuity trust.

In past posts, I’ve discussed both SCINs and GRATs, and they can both be effective estate planning tools in their own right. In this case, the aggressive, combined use of the concepts did not work out as intended. The bill to Davidson’s estate was in excess of $500 million.

In a new twist, a complaint has now been filed in New York on behalf of the Davidson’s estate against Deloitte Tax, LLP, for over $500 million in damages. It’s alleged that Deloitte harmed the estate in devising the unsuccessful plan. A key contention is the alleged failure by Deloitte to warn of the arrangement’s risks.

Consider yourself warned.

Lesson 4: Bad tax strategies can lead to other bad decisions

Just over a decade ago, a popular but abusive tax shelter that came to be known as “Son of BOSS” was shut down by the IRS. Its predecessor was called the Bond Options Sales Strategy (BOSS) – hence the son of BOSS – had been busted earlier, but this was a slightly different take.

For Son of BOSS, the idea was to create an artificial tax loss to balance taxable gains. Bad idea. Eventually, the IRS collected $3.2 billion from the tax dodge. The promoter of the scheme, KPMG, paid $456 million to the IRS and admitted criminal wrongdoing.

Scott and Robin Baker are just one family shattered by the greedy use of this tax shelter. Hardly victims, the unsuccessful use of Son of BOSS in 2001 initiated a decade-long series of bogus business transactions that only made the family’s financial mess worse.

Eventually, the couple, in deep financial distress, divorced. Even with the split, their troubles continued. This year, Scott was found liable for fraudulent transfers made as part of the divorce.

While the court did not declare the divorce itself invalid, it held that the property transferred from Scott to Robin in the separation was a fraudulent transfer. Dishonest tax planning led to even worse legal problems. For this family, bad has gone to horrible.