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.

ARBITRAGE IN THE TAX CODE EQUATES TO FREE MONEY FOR YOUR FAMILY

by Andrew D. Schwartz, CPA

Free money.  Reward without risk.  Both of these phrases describe the term Arbitrage.

Many financial firms spend big money on talented personnel and sophisticated software to try to locate and exploit opportunities for arbitrage.  One common technique is to purchase shares of a company's stock on a domestic stock exchange, while simultaneously selling the same number of shares of that company's stock on a foreign exchange. 

By capitalizing on minute fluctuations in the foreign exchange rate between the U.S. dollar and that country's currency, this set of transactions can generate substantial profits.  And since the firm simultaneously buys and sells the same number of shares in the same company, they never take on any of the risks generally associated with owning stock of a publicly traded company. 

Financial gain without risk - that's what arbitrage is all about.   Would you believe that the IRS provides self-employed individuals with an opportunity for arbitrage?  All you need to do is employ your child under the age of 18.

The Basics

According to the IRS' Circular E, Employer's Tax Guide, "payments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to social security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child."

Plus, your child will not owe any federal income taxes as well, provided he or she earns no more than $5,350 in wages (during 2007), and has no other investment income.

On the other side of the equation, you as a business owner get to deduct on your Schedule C all the expenses paid during the year in connection with your trade or business.  Keep in mind that salaries and wages paid to your staff, including reasonable wages paid to your child, count as allowable expenses. 

Arbitrage In The Tax Code

Let's look at an example where:

• You're in the top tax bracket

• Your wages and net self-employment income do not exceed the social security max of $97,500 (in 2007)

• You pay your child $5,000 in 2007

With a top marginal tax rate of 35%, and a top self-employment tax rate of 15.3%, the $5,000 of wages you'll deduct on your Schedule C saves you just about $2,400 in federal income taxes and self-employment taxes.  Meanwhile, on the $5,000 of wages received, your child won't pay a dime in taxes.

So by paying your child $5,000 in wages, the IRS rewards you with a $2,400 tax break.  A risk-free transfer of money from your business checking account into your child's savings account earns you a substantial financial gain of 48 cents on the dollar.  Sounds like arbitrage to me.

Caveat Employer

The IRS is well aware of this strategy, and there are certain guidelines you should follow for this deduction to survive an audit.

• Set Yourself Up As An Employer.  You're required to obtain an Employer Identification Number (EIN) and file certain payroll tax forms, including a From 941 each quarter or a Form 944 annually.  You will also need to issue your child a W-2 each January.  Most CPA firms can help you out with this paperwork.

• Pay Your Child a Reasonable Wage. The IRS wants to see you pay your child only for the hours worked at a rate commensurate with that you would pay a non-family member to do a similar job.  It's a good idea to document your child's wages with timesheets or work logs.

• Compensate Your Child Throughout the Year.  Writing your child a check for $5,000 on December 31st won't cut it in the eyes of the IRS.  Instead, if you have other employees, pay your child as often as you pay your other staff.  Otherwise, you should probably prepare your child's paycheck no less than monthly.

Additional Benefit

Putting your child on payroll also provides you with the opportunity to contribute to a Roth IRA on behalf of your child.  Each year, your child can contribute the lesser of his or her gross wages, or $4,000 (increasing to $5,000 in 2008), into a Roth IRA. 

Assuming the Roth rules don't change during your child's lifetime, your child will benefit from decades of compounded growth within these tax-free investment accounts.  While contributing to a Roth IRA doesn't qualify as arbitrage, it's still a great tax-planning strategy worth pursuing.

TOP

SPRING CLEANING

by Andrew D. Schwartz, CPA

Spring is traditionally a time to clean up your yard upon the completion of another winter.  While you're in the cleaning mood, why not take a few steps to clean up your personal credit as well.

Review and Revise

May is a great month to take a step back and review your outstanding credit card debt.  That's because the summer spending season is still more than one month away, and you have more than a half a year before you will even commence your shopping for the 2007 holidays (unless you're really a Type A holiday shopper).

Start by taking an inventory of what you currently owe on each of your credit cards.  Then, take a few minutes to reset how much you plan to pay towards your credit card debt each month for the remainder of the year. 

Need help crunching these numbers?  Downloading our (Microsoft Excel) debt/savings calculator should save you a lot of time with this step.

Order Your Free Credit Report

Currently, three companies, Equifax, Experian, and TransUnion, track everyone's credit histories.  Don't forget that banks, lenders, retailers, landlords, and other "credit grantors" use credit reports generated by these companies to determine your creditworthiness.

Your credit report reflects quite a bit of information about you and your financial affairs. 

• The bulk of your credit report focuses on your various loans and credit card accounts. Included is the name of each of your creditors, as well as the type of account, the minimum monthly payment, the account's limit or high balance, and the current outstanding balance.

• Your credit report also reflects the most recent twenty-four month payment history for each creditor, showing whether each month's payments were current, delinquent, or in default.

• Another section on your credit report details inquiries that were made by potential creditors.  In this section, the name of the creditor and the date of inquiry are listed for each request that has been made.

• Your credit report also includes "public records" such as tax liens, bankruptcies, and judgments made against you.  Most public records remain part of your credit history for seven to ten years.  If you have any tax liens, they won't be removed from your credit report until they are paid off.

The best way to find out how your credit report looks is to order one.  You're now allowed to order three free credit reports per year - one from each credit bureau - through annualcreditreport.com. 

How's Your FICO?

Your FICO score is a number that quantifies your creditworthiness.  The higher your FICO, the more attractive you'll be in the eyes of lenders, retailers, landlords, and other credit grantors. 

According to our friends at www.myFICO.com, the FICO score for most people is calculated as the weighted average of these five attributes: payment history (35%), amounts owed (30%), length of credit history (15%), new credit (10%), and types of credit used (10%).

To find out your FICO score, as well as suggestions on ways to improve your FICO score, visit myFICO.com

TOP

TAX AND FINANCIAL PLANNING CALENDAR FOR MAY, 2007

 TOP

2006 & 2007 TAX FACTS

• For 2006, the standard deduction for a single individual is $5,150 and for a married couple is $10,300. A person will benefit by itemizing once allowable deductions exceed the applicable standard deduction. Itemized deductions include state and local income taxes (or sales taxes), real estate taxes, mortgage interest, charitable contributions, and unreimbursed employee business expenses.
• For 2006, the personal exemption is $3,300. Individuals will claim a personal deduction for themselves, their spouse, and their dependents. 
  
• The maximum earnings subject to social security taxes is $97,500 for 2007, up from  $94,200 in 2006.
  
• The standard mileage rate is $.485 per business mile for 2007, up from $.445 per mile in 2006.
  
• The maximum annual contribution into a 401(k) plan or a 403(b) plan is $15,500 in 2007.  And if you'll be 50 or older by December 31, 2007, you can contribute an extra $5,000 into your 401(k) or 403(b) account this year.
• The maximum annual contribution to your IRA is $4,000 for 2007.  And if you turn 50 by December 31st, you can contribute an extra $1,000 that year.  You have until April 15, 2008 to make your 2007 IRA contributions. 

TOP

copyright - 2007 - CPANiche, LLC