Disclaimer: Information contained below was accurate as of the date of publication. Due to frequent tax law changes, information may no longer be accurate. For the latest tax information, please contact a member CPA.

WHY GOOD TAX PLANNING BACKFIRES

by Andrew D. Schwartz, CPA

Don't pay any taxes before you absolutely have to.  That was the generic tax advice offered by CPAs when I first started working fifteen years ago.  And for good reason.  Prior to 1987, tax rates were high, tax shelters were abundant, and deductions such as sales tax paid and credit card interest were still allowable. 

Everything changed in 1997, however, with the advent of Roth IRAs.  While Roths grow tax-free, amounts contributed into a Roth aren't deductible.  All of a sudden, financial advisors and CPAs found themselves in uncharted waters, and began instructing their clients to forego a tax deduction today in anticipation of tax-free growth in the future.

The 1997 Tax Act pushed the tax planning community into even more treacherous and uncharted waters.  That's because you could also elect to pre-pay your taxes on your retirement money by converting your traditional IRAs and certain 401(k) plans to a Roth IRA.  The amount converted would be taxed at your tax rate - so if you rolled over $10,000 from your traditional IRA into your Roth IRA, and were in the 28% tax bracket, you'd pay $2,800 in federal income taxes.  Depending on your age, you'd pay those taxes decades earlier than would otherwise be necessary.

I'm not disputing that Roth IRAs are a great investment opportunity that make sense for lots of people.  But is it worth foregoing a tax deduction today, or pre-paying taxes years earlier than necessary, just to maximize the amount of money in your Roth IRA?  Only time will tell.  If Congress ever replaces the current tax code with an alternative tax, or needs money so badly that they decide to make Roth IRA distributions taxable, then the strategy of paying higher taxes in exchange for maximizing the money invested within your Roth would surely backfire.

"The government wouldn't do such a thing", you say to yourself.  Or would they?  Just look back a few years, and you'll see that the government increased the percentage of social security benefits that is taxable from 50% to 85%.  Considering that the social security taxes you pay aren't deductible, this change in the law means you'll essentially be taxed twice on any social security benefits you ultimately receive.  If the government tinkered with the taxability of social security benefits, why wouldn't they look at Roth IRA distributions as a way to raise tax revenues down the road?

For more proof, take a look at what the 2003 Tax Act did to a provision of a previous tax law change.  Under the pre-2003 rules, a new 18% capital gains tax rate was slated to take effect.  The reduced rate would have only applied to investments purchased subsequent to January 1, 2001 that were held for more than five years before being sold. 

To be fair (and to raise tax revenues), the government allowed you to pre-pay taxes on your investments purchased prior to 2001 that had appreciated in value, even though those investments weren't actually sold.  By pretending to sell some or all of your investment portfolio on January 1, 2001, and then paying taxes on the appreciation, those investments would qualify for the 18% tax rate as long as they were held for at least five more years.

Sounds like a great deal, right?  It might have been, until President Bush signed the 2003 Tax Act into law.  As part of this tax bill, Congress reduced the capital gains tax rate on investments held for more than one year to 15% through 2008.  Anyone who elected to pre-pay taxes in 2001 on their investments did so at a rate of 20%, which is a whopping 33% premium over the new rate of 15%.  Plus, they paid their taxes at least 2 years earlier than necessary.  

Here's the moral of this story.  No matter how great a tax planning opportunity might look on paper, pre-paying taxes and foregoing tax deductions is risky business, since you're relying on the government not to change the rules of the game.  And based on the frequency of the tax law changes that I've seen during my 15 years in practice, I don't like the odds of that happening in the long run.  For that reason, the safest strategy is one we've all heard before - Don't pay any taxes before you absolutely have to.

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ARE YOU AN EMPLOYEE OR AN INDEPENDENT CONTRACTOR?

by Andrew D. Schwartz, CPA

It's a debate that's been going on for years.  Are you an employee or an independent contractor?

The IRS prefers that people be compensated as employees, since they're more likely to get their tax dollars.  Remember, employees have social security, Medicare, and usually federal income taxes withheld from their pay.

Many people prefer to be compensated as independent contractors, however.  That's because they can deduct expenses directly against their income, and can usually set aside a lot more money into pre-tax retirement accounts.  Plus, self-employed individuals can be more aggressive with their deductions, and can even deduct some personal type expenses such as automobile expenses or home-office expenses.

When trying to determine whether you're an employee or an independent contractor, there are very specific guidelines to follow.  Head on over to www.irs.gov, and download IRS Publication 15-A.  Starting on page 5, there is an explanation of who qualifies as an employee and who qualifies as an independent contractor.

Basically, the IRS looks at the three factors to determine the degree of control maintained by your employer and the degree of independence maintained by you.  The more control your employer has over you, the more likely you should be classified an employee for tax purposes.

The first factor is behavioral control.  You're most likely an employee if your employer tells you:

• When and where to do the work
• What tools or equipment to use
• Where to purchase supplies and services
• What work must be performed by specific individuals
• What order or sequence to follow

The second factor is financial control.  If you have a significant investment in equipment, get paid by the job instead of being on a set salary or hourly wage, and can realize a profit or loss, then you're most likely an independent contractor.

The third and final factor is type of relationship.  If you receive benefits from your employer, or have been hired for an ongoing and indefinite period, you're most likely an employee.

In addition to analyzing these three factors, you need to take a look at how similar workers in your industry are generally classified.  In many instances, the standard practice in your industry carries a lot of weight in determining whether you should be classified as an employee or an independent contractor.

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