Were you unable to complete your tax returns by April 17th? 

It's important to note that when you file for an extension, you are asking for more time to finish paperwork, not more time to pay any money that is due. If you owe taxes as of April 15th, expect to pay interest, and possibly a penalty, on the amount due. Whether you're subject to a penalty depends on the amount of taxes owed after April 15^th.  Let's look at the basics:

• Interest:  If you have a balance due to the IRS after April 15th, expect to  be charged interest by the IRS.  The current interest rate is 7%, which is a lot less than the rate charged by most credit card companies.
• Failure to Pay Penalty:  If you file for an extension, and you owe more than 10% of your final tax liability, expect to get hit with a "failure to pay" penalty that runs at 0.5% per month.  That’s in addition to any interest you’ll owe on the balance due.
• Failure to File Penalty:  If you don't file an extension request by April 15th, the "failure to file" penalty runs at 5% per month, up to a maximum of 25% of the taxes owed.

For example, let's say you earn $100,000 this year and have a total federal tax liability of $20,000.  To avoid the 0.5% per month failure to pay penalty, you can't owe more than $2,000 when you file a tax return later this year.  By having 90% of your  total tax liability paid by April 15th, filing an extension provides for an extra six months to come up with the remaining tax dollars owed at a relatively low interest rate. 

What if you didn't bother to file for an extension?  Unless you can show the IRS "reasonable cause", expect to be assessed the failure to file penalty of $100 per month on a $2,000 balance due.

Extensions Can Make Sense For Self-Employed Individuals

If you're self-employed, you might benefit by filing for an extension even if you can complete your tax returns by April 15th.  That's because you have until the due date of your tax return, including extensions, to fund your retirement accounts for the year.  Even if you don't have a retirement plan set up yet, a SEP IRA can be established as late as the extended due date of your return, or October 15, 2006.

By filing a Form 4868 with the IRS, you get an additional six months to fund your retirement plan and deduct the contribution made on your prior year's return.  One strategy common to self-employed individuals is to pay the full amount of taxes due with an extension, and then to fund their retirement plans prior to October 15th.

Keep in mind that an extension does not give you any more time to fund your Roth IRAs, traditional IRAs, and Coverdell Education Savings Accounts (ESAs) for 2005.  The due date for these tax-advantaged retirement plans and college savings accounts is April 17^th.

Does An Extension Increase The Chances of An Audit?

I have clients who are convinced that filing for an extension is a red flag with the IRS.  And I have others who always file for an extension because they've heard that they're less likely to be audited by doing so.  Personally, I've never seen any connection.

Can’t Pay Your Taxes By April 15th?

What if you need more time to pay your taxes?  If you owe so much taxes that you won’t be able to pay them off by October 15th, one option is to file the paperwork to enter into an installment arrangement with the IRS. This is done by completing and filing a Form 9465, and attaching the completed Form 9465 to the front of your federal income tax return. On this installment request form, you tell the IRS how much you can afford to pay each month and the day of the month that the payment will be made. 

The IRS charges a fee of $43 to any taxpayer who enters into an installment arrangement. In addition, the IRS will charge interest at the prevailing federal rate (currently 7% per year), and a "failure to pay" penalty of 0.25% per month on the outstanding balance. Plus, failure to make a scheduled payment will cause the remaining outstanding balance to become immediately due.  And you generally aren't allowed to enter into an installment agreement if you have an open installment agreement for a previous year that hasn't been paid off yet.

Always Submit Your Paperwork On Time

The moral of this story is simple.  Since the failure to pay penalty is so much smaller that the failure to file penalty, always try to file all your tax returns and extension requests on a timely basis, even if you're unable to pay the full amount of the taxes due at that time.

Renting out your vacation home might seem like the best way to help you cover expenses, but take care. Whether your home is classified as a second residence or rental property will affect the home’s treatment at tax time. It’s a good idea to learn the rules before you decide to rent out your property.

Two simple steps can help you determine your home’s classification each year.

1. Add up the number of days you and your family used the home for personal purposes ____.
2. Choose the larger of (a) or (b) below ____
   (a) 10% of the days your property was rented, or
   (b) 14 days.

f your answer in step one is more than your answer in step two, the IRS considers your home a second residence. If not, it’s rental property.

When It’s a Second Residence

You generally must report the rent you collect as income on your tax return. (An exception is discussed later in this article.) However, you’re allowed tax deductions for various expenses, including mortgage interest and property taxes, maintenance, utilities, and depreciation. But limits apply.

When It’s Rental Property

You must report the rental income you receive. While there’s no deduction allowed for mortgage interest allocated to personal use, all rental expenses are potentially deductible. Losses are restricted by “passive loss” rules.

A Compromise

If you rent out your home for fewer than 15 days during the year, you won’t have to report the rental income. Property taxes and qualifying mortgage interest are deductible if you itemize deductions. None of the other expenses of renting out the home are deductible.

These rules are complex, so be sure to consult your tax advisor.

Often, when entrepreneurs decide to create their own businesses, they focus solely on the enjoyment they’ll receive from doing something they’re good at and being financially rewarded for it. Typically, new business owners don’t think about the administrative side of the business and merely back their way into a tax strategy. In effect, these entrepreneurs allow the IRS to tell them what to do, when actually they need to understand the impact their approach to setting up and running their business will have on both their business growth and their personal taxes. If you own a business, you can save thousands of dollars each year on income taxes by being proactive about seeking advice from us and by understanding your own financial objectives.

Before starting a business, you need to determine why you are doing it. Are you grooming the company to sell it for a profit? Or are you using it to fund personal life goals, such as a college education or a mortgage? The strategies you pursue for these objectives are completely different. Furthermore, every business owner should plan how he or she eventually will get out of the business. Will the kids take it over? Will it be sold to employees? Or will you simply let it wither and die? Again, each of these goals requires different financial strategies.

The first step in creating a business is to decide what type of business entity it should be: a sole proprietorship, a partnership, a limited liability company (LLC), a C Corporation or an S Corporation. The choice of entities depends in part on your personal financial situation and goals. Are you married? Do you have a business partner? You’ll want to select the entity type that best matches your particular circumstances. We can help create the entity in a way that changes the manner in which the IRS looks at your income to determine how much is salary and how much is derived from investments. Each of these streams of income is taxed at much different rates, and you should do all you legitimately can to get the lowest tax rate on the greatest proportion of your income.

For example, an LLC usually is a good choice of entity for a small business run by a husband and wife or a family unit. In a member-managed LLC, we may establish the wife as the operator of the business and the husband simply as a passive partner in the partnership. We set up the business so the wife owns 20 percent, yet is the managing member, and the husband owns 80 percent while having no control of the daily operation of the business. When the IRS considers the company’s income, only the wife’s 20 percent will be subject to self-employment tax or employer-side FICA and Social Security taxes. Furthermore, the husband’s 80 percent is considered investment or passive income and is taxed at a much lower rate than a salary or even pass-through net income would be, especially if the couple is in a high income bracket. Structuring a business in a way similar to this example can cut self-employment taxes by thousands of dollars a year.

Another way to reduce taxes and still access your money for personal goals is to choose the right deferred-income option, such as a traditional IRA, simple IRA, SEP IRA, 401(k), Roth 401(k), 401(k) profit sharing with safe harbor option (which automatically satisfies certain nondiscrimination testing requirements), or even a deferred benefit plan. Higher-income-earning individuals can place as much as $44,000 a year into a deferred-income option if they are a principal of the business, versus just $15,000 allowed for an individual with a conventional 401(k). This type of 401(k) plan entails higher administrative costs, but those are far outweighed by the tax benefits of the program. Your choice of a deferred-income program depends on how much you’re willing to spend for its administration. SEP IRAs are simple and inexpensive, while defined benefit plans are more costly but provide a wider range of potential benefits, such as a “golden parachute” that provides large benefits if the company is acquired and the current owner is fired.

You can save money tax-free for your children’s education by paying them royalties from advertising and other promotional work. Put your children in your television spot or your print ad and pay them a royalty for every time the promotion appears, rather than a W2-based salary. The first $4,000 of income can go tax-free into a child’s SEP IRA or 401(k) and never be taxed. When the child is ready to enter college, you can pull the funds out with no penalty and no taxes applied, because higher education is one of the exceptions allowed by law that permits early withdrawals. The result is a tax-free way to transfer money to your children. You can do the same thing with regular earnings, as well, but they will be subject to Federal Insurance Contributions Act (FICA), Social Security, Medicare and unemployment-insurance taxes, unlike earnings from royalties.

The building you own for business also can become a source of income for you that is subject to lower taxes if you handle the acquisition of the building correctly. You should consider owning assets personally and leasing them to the business. In this example, buy the building with personal funds and lease it to the company you own. All the lease payments are tax-deductible to the business, whereas only the interest payments would be tax deductible if the business had bought the building directly. Even after lease payments have compensated completely for the original cost of buying the building, you can continue to collect rent from the company and deduct the cost of repairs and maintenance that you make. You are making your building 100 percent deductible to the business and lowering the amount of income that is passed through to you personally from the corporation. You are lowering your taxable income without changing any of your cash flow. The same technique can be applied to equipment, real estate and other high-ticket items.

One of the keys to setting up your business, then, is not to react to your situation but to be proactive with your team of advisors and plan around your particular circumstances. Tax savings are out there waiting for you to take advantage of them; successful people manage their tax situation, not react to it. Above all, find an advisor you trust to be shoulder deep in your personal and business financials, and then listen to him or her. You’ll live a wealthier life and run a more successful business.

1398 Wilmington Pike ∙ West Chester, PA 19382 ∙ Fax (610)399-4978

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