4: Reducing the Personal Tax Burden

Chapter 4

Reducing the Personal Tax Burden

The only thing that hurts more than paying an income tax is not having to pay an income tax.

Lord Thomas R. Duwar


Objectives
At the completion of this chapter, the student will be able to:
1. Describe the organization of federal Form 1040.
2. Define the purpose of the various supporting federal forms and schedules.
    Schedule A: Itemized Deductions
        Form 8283: Noncash Charitable Contributions
        Form 2106: Employee Related Business Expenses
    Schedule B: Interest and Dividend Income
    Schedule C: Profit or Loss from Business
        Form 4562: Depreciation and Amortization
    Schedule D: Capital Gains and Losses
3. Differentiate between deductible and nondeductible personal expenses.
4. Apply the principles of basic tax planning to the personal tax return.


Key Terms
adjusted gross income (AGI)
adjustments to income
audit triggers
business deductions
corporate practice
earned income
estimated tax declaration
federal income tax
filing status
net tax liability
occupational taxes
partnership practice
personal deductions
    standard deduction
    itemized deductions
personal exemptions
    marginal tax rate
     progressive
    regressive
personal income tax
postponing taxes
proprietorship
sECA self-employment tax
shifting income
sinking fund taxes
state income taxes
tax
tax audits
tax credits
tax elimination or reduction
tax evasion
tax forms
    Form 1040
    Form 1065: Partnership Return Schedule K-1
    Form 1120: Corporate Tax Return
    Form 2106: Employee Related Business Expenses
    Form 4562: Depreciation and Amortization
    Form 8283: Noncash Charitable Contributions
    miscellaneous deductions
schedules
    Schedule A: Itemized Deductions
    Schedule B: Interest and Dividend Income
    Schedule C: Profit or Loss from Business
    Schedule D: Capital Gains or Losses
    Scheduled SE: ­Self-Employment Tax
tax-free income
tax rate
taxable income
    alternative minimum tax (AMT)
    tax liability
    tax rate
taxpayer compliance audit
total (gross) income
unearned income


Goal
This chapter is a general discussion of personal income taxes. The discussion focuses both on dentists who are practice owners (proprietors or partners) and those who are employees. Personal tax planning strategies will also be highlighted.

Taxes are a fact of life in the United States. As government provides more services for the population, they require more money to do those services. Government services may be thought off as primarily entitlements (such as welfare and Social Security), probably because those items are often in the news. However, governments at all levels provide many other services used by all, including military protection, the road system, basic education, the university system, air traffic safety, and restaurant safety inspections. Because of these varied services, taxes to pay for them are also varied and substantial. Table 4.1 shows how much a person might pay in total taxes (both actual and hidden). Given this huge tax liability, it is ­crucial that a dentist manages his or her tax liability effectively.

The single largest item of tax expense for most Americans is personal income tax. This chapter ­discusses personal income taxes, how the taxes are calculated, and what can be done to reduce this tax burden. The federal government levies the largest portion of income tax. Many states also have separate income taxes. Many local governments (city or county) have taxes on income beyond the federal and state taxes. Worrying about income taxes is, in a sense, a nice problem to have. It means that a person is making money.

Table 4.1 Example of Total Tax Payment*

Type Percentage
Federal income tax 28%
Social Security tax 7%
State income tax 7%
City income tax 2%
Sales tax 5%
Property tax 3%
TOTAL 52%

* Both actual and hidden taxes. Additional (hidden) taxes include real estate transfer taxes, licenses, excise tax, gasoline tax, personal property tax, recording fees, inheritance tax, airport departure fees, corporate income tax, entertainment tax, hotel room tax, and transportation tax

Federal Income Taxes

Federal income taxes are due on any money that a person makes during the year. This income can be earned income or from investments (unearned income). Dentists who are in business for themselves determine their profit or loss from operating their business on a separate form (Schedule C) and then bring that profit or loss to the personal tax form (Form 1040). These are all due on April 15 of the following year.

If a dentist is the proprietor owner of a practice, he or she must file a long Form 1040. (There is an abbreviated version [1040-EZ] for people who do not have complex returns.) If a person owns a corporate or partnership practice, he or she will need to file returns for those entities also. If a person is a nonowner employee of a practice, he or she will have a simpler time computing personal taxes because he or she does not have to report the practice information.

Most dentists have their accountants do their taxes for them. If a person understands the basics of tax law, then he or she can give an accountant complete infor­mation and can make more informed decisions regarding his or her own individual tax status.

Income

The IRS develops and implements tax laws for the ­federal government. The IRS has a simple rule concerning whether money made is income or not for tax purposes. They consider any money made to be taxable income unless there is a specific waiver for that type of income in the tax codes. A few specifically designated types of income are either exempt from income taxation or taxed at a lower rate. Municipal bond income, scholarships or grants, and gifts or inheritances are exempt from income taxes. Ordinary income is the same as earned income. A person makes this money through working. Investment income (either capital gains or dividends) is unearned income. The IRS taxes it at a lower rate. Also, because a person did not earn it, he or she does not owe Social Security and Medicare (or self-employment) tax on this type of income (Table 4.2).

The form of the income is immaterial. (It does not have to be cash money.) If a person barters a crown for a house painting job, he or she has received income according to the IRS. That person should record as income the value of the house painting job. The painter should similarly include the value of the gold crown in his or her income.

Table 4.2 Tax Rates Paid for Earned and Unearned Income

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Taxes are paid when the income is realized. This means that a person pays tax when value changes hands. For example, a person buys 100 shares of XYZ stock at $10.00 per share. If the price goes to $25.00 in the first year and $35.00 per share the second year, he or she pays no tax until the stock is sold. If the stock is sold in the fourth year for $55.00 per share, he or she pays tax on the appreciated value (55.00 – 10.00 = $45.00 per share) in the fourth year. By the same reasoning, a person pays no income taxes on accounts receivable because they are not income until the money is received.

Personal Deductions

Deductions are expenses that may be subtract from income before the tax owed is calculated. Some ­deductions are personal. Some are for business. (In this chapter only personal deductions are discussed.) The IRS has a rule similar to the “Income Rule” when looking at deductions. It considers no expense to be deductible unless they have specifically granted deductibility in the tax codes. (Just because a person believes that an expense should be deductible does not make it so.) A dentist may need to prove the amount and necessity of this expense to the IRS, so keeping ­excellent records that include a description of the deduction, a receipt, and a canceled check for the item is always a good idea. A canceled check, by itself, is not enough documentation.

Basic Personal Tax Formula

Box 4.1 provides a basic tax formula. Dentists need to understand the components of this formula to ­understand how to reduce tax liability. This is for personal (not business) tax, which will be covered later. Net income from the practice becomes personal gross income for tax purposes.

1. Total (Gross) Income Gross income is all the money that is made for the year. It includes income and wages, tips, profits from a business, such as a dental practice, tax refunds, rental income, or any other form of income. Earned income is income that is earned from working. Unearned income is money that is made from investments. Both are considered income for tax purposes, although the IRS treats them differently in specifics of tax code.
2. Adjustments to Income The tax code allows a person to adjust (or subtract) amounts that he or she paid for some specific items. Those include IRA and other retirement contributions (for self), moving expenses if he or she moved to take a new job, half of ­self-­employment tax (if he or she is self-employed), and any alimony (but not child support) that he or she paid. Adjustments are important because they lower income, and therefore, how much tax that will be paid later.
3. Adjusted Gross Income (AGI) AGI is simply gross income less any adjustments. AGI is important because it is used later for setting minimums for Schedule A deductions, phase outs for exemptions, and other tax matters.
4. Standard or Itemized Deduction (whichever is greater) A person then may deduct valid tax ­deduction items from the AGI. Two methods can determine this ­adjustment. A person can use either one. There is a choice, but a person should use the larger one because it reduces his or her apparent income more. This results in a lower tax liability. The two methods are:

  • Standard Deduction A person may take a standard amount. This amount changes depending on filing status. There are four possible filing statuses. As a rule, if married, a person should file jointly. The exception is if one spouse has high itemized ­deductions that could not be used if using a joint filing status because of AGI limitations. The ­standard deduction is an amount that the IRS ­estimates typical filers would show. If a person owns a home or has significant medical or employee expenses, he or she is generally better off to itemize deductions.
  • Itemized Deduction The second method that a person may use to calculate deductions is to itemize personal deductions. Box 4.2 lists the types of valid personal deductions. (These are personal ­deductions. Business deductions are itemized on a different form [Schedule C].) If/>
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Jan 4, 2015 | Posted by in General Dentistry | Comments Off on 4: Reducing the Personal Tax Burden
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