Now that the year is almost over, one thing on your to-do list should be year-end tax planning. There are nuances of tax law that many people don’t think about but can have a huge effect of their tax bill. As a tax controversy attorney, I have represented clients in tax audits and settled tax debts. From this perspective, I have seen the harsh consequences of bad tax planning (or not planning at all) and risk taking. Here are some things to keep in mind as you do your tax planning.
Why Do I Owe so Much?
A lot of people get sticker shock when they find out their tax bill is much more than they initially thought. There are a number of reasons for this. First, many people forget about the the self-employment tax, which is a whopping 15% of net profit for the first $118,500 you earn.
Also, you pay more cents on the dollar in tax as your income increases, and you move to a higher tax bracket. What I see from many solo practitioners and small firm lawyers is that their income does not increase gradually from year to year. Instead, their income jumps dramatically, passing several tax brackets at once.
Solosmall lawyers also lose deductions when their income increases. For example, the student loan interest deduction (the maximum being a paltry $2,500 per year) is phased out when a person’s adjusted gross income reaches $75,000.
Also, you may be subject to the Alternative Minimum Tax (AMT), a tax originally designed for the top 1% in the 1970s. While the exact mechanism of the AMT is complicated, for our purposes, it is triggered when a person claims a large amount of itemized deductions on their Schedule A. When calculating the AMT, many of these itemized deductions are added back to taxable income. The taxpayer pays the higher tax of either the AMT or the regular income tax.
For example, a colleague is a self-employed lawyer who in his first year made a $30,000 profit. His tax preparer calculated his federal and state income tax that year to be around $6,500. Last year, his net profit tripled to $90,000. So, he set aside $19,500, thinking that his income tax bill would be triple the tax he paid last year.
Unfortunately, his tax bill came out to around $33,000. This not only meant that he had to find an extra $13,500 somewhere, but he also had to plan to save $33,000 for next year’s taxes, assuming his practice stays at the new income level.
As your income increases, your tax bill can be higher—in some cases, dramatically higher. As soon as people recover from the shock, they usually ask the next question:
Why Did Someone Pay Less Tax Even Though They Made the Same Amount of Money I Did?”
We all know someone who claims they made the same amount of money but paid less in taxes. How is this possible?
First, understand that everyone has a unique financial situation. They may have a side business or investments that incurred losses, which will offset some of their income. Or they may have a higher itemized deductions due to a medical emergency or a casualty loss they suffered during the year.
Second, people prepare their tax returns differently. Most people prepare their tax returns honestly. But some will push the envelope and take questionable deductions. Some will even lie. They will take the chance with the audit roulette considering that the IRS audits less than 5% of individual tax returns with Schedule Cs and less than 1% of S-Corporation returns.
Third, some people hire tax preparers solely on the promise of the lowest tax bill or the highest refund. These preparers input false numbers on tax returns, usually without the client knowing it. And when the client asks questions, the preparer tells them not to worry because the IRS will not question it. These people rely on the preparer’s advice and usually pay a steep premium for the “expertise”.
I have seen what happens when those people get caught. The IRS will audit up to the last six years of tax returns if they see a pattern of dishonesty. Once the examination is completed, you can be hit with back taxes, multiple penalties, and interest which can add up to five- or even six-figure balances.
As your income increases, consult with a tax professional to see whether you should save more for taxes or take advantage of special tax provisions available to you based on your circumstances.