I reviewed a return for a prospective client this past week (as part of our FREE! CPA Tax Review program).  First of all, his cover letter was touching.  He’d had a very hard year, like many of you have.  He’d lost his house in a short sell, but barely managed to hang on to his business.  Then this past month (October), he discovered that he owed over $10,000 in federal taxes.  He kept asking his tax preparer how this could be when he was completely broke and the preparer never gave him a good answer.

So he sent in his tax return for 2007, plus his returns for two years prior.  That’s when I got puzzled.  In the prior year, he filed a Form 1120(S) (S Corporation Income Tax Return) for his business.  But in 2007, the business was filed as a Sole Proprietorship.  In fact, his itemized deductions wiped out the profit from the business so there was no income tax.  The over $10,000 was due to self-employment tax from his Sole Proprietorship.

Now here’s the part that puzzles me.  He didn’t have a Sole Proprietorship!  He had an S Corporation.  He said he kept asking his preparer if he was sure he really owed the money, but he didn’t know exactly what was wrong so he finally went along with it.

The preparer was the same as the prior year.  My guess is that he got busy, or tired, or sloppy and my prospective client paid the price - a very big one to the tune of over $10,000.

Occasionally a new client will ask me if they can continue to use their old tax preparer for their personal return (while my firm does all the business returns).  I’m never a fan of the idea, but until this past week I didn’t realize how much of a problem it could be.  

In this particular case, the K-1 had some more sophisticated issues.  There was a loss in the company, but because the client had signed on the debt, it was considered recourse.  You can not take a loss on your personal tax return unless you have enough basis.  So, without understanding the K-1 my client had provided, and without asking any questions, the old tax preparer had disallowed the loss.  

I knew my client wasn’t happy with his tax strategy from last year, but I didn’t realize what was going on because he had two different tax preparers involved.   This past week I got a copy of his personal return and saw what had happened.  

Now my client is faced with the same issue he had last year - how to tell someone he likes that he’s outgrown his services.  The only difference is that now he also has to figure out what he wants to do with the past year’s return.  Amend, and risk an audit.  Or, let it go and chalk it up to experience.

The Success Story part is that we can save him a lot of tax money, once we get control of the entire process - strategy, implementation AND compliance (preparing the tax returns).

There is a 5 cycle lifecycle with businesses.  Some businesses may skip one step, or pass through it very quickly, and some businesses, just like people, never really grow up and remain happily small and hands on.

As the business progresses through each of these stages, the business structures must change too.  Many CPAs are so busy with tax compliance that they never get the opportunity to actually step back and look at where their clients are right now and what the short term and long term future look like for their client.  

That’s what had happened to Bud and Sarah.  Their business had a great strategy for a beginning business, but did not recognize the additional asset protection requirements and higher income they now had in their business.  Additionally, they had IP sitting on the shelf and were missing a huge opportunity to convert some active income into passive income.  

Within one month, we had reduced their taxes by over $30,000 by making a few simple changes.  The total cost to Bud and Sarah was less than $7,000 and they were able to recognize a full $30,000 in savings for 2008.  In today’s world of uncertainty and stock and real estate losses, they were happy to see that type of ROI!

I once did a piece called “The Case Against 401(k) Plans” that went viral.  I wrote it 6 years ago and my main issues (at the time) were that (1) 401(k) plans locked you into only a few investment options (2) a 401(k) plan converted capital gains income into ordinary income and (3) a 401(k) plan assumed you would have less money in the future.

I now recommend the right kind of 401(k) plan, a Solo 401(k) and/or a Solo Roth 401(k) plan to many business owners.  I like this plan because (1) you can completely self-direct it (2) you can invest in real estate and passive business activities and especially make use of some great strategies that do NOT convert the character of the income and (3) you can put up to $51,000 per year per person away in the plan.  

Ironically, though, I often run into someone who read the article back when it was viral and everywhere, who then uses my points to quote, not realizing I was the author.  It is strange to argue against yourself, albeit in a time warp.

The Smiths (not their real name) own businesses in multiple locations and own the buildings that the businesses are in as well.  That’s a smart wealth-building strategy.  In fact, in today’s tax world that’s about the only way you’re going to get good deductions for your real estate. 

Their previous CPA had them set up 4 LLCs (limited liability companies).  That’s also smart because they are able to separate out their assets.  But that’s when the plan went strange.  They somehow ended up with default taxation (partnership taxation) for the two entities that owned the business and a default taxation (partnership) and S Corporation election for the real estate.

That meant that the business income was subject to self-employment tax.  They had a loss to partially offset their normally high income and so the extra cost was only $12,000 in 2007.  Luckily we caught it in 2008.  We’ll make a late election for the LLC and save them over $50,000 in 2008.

Don’t wait until year end!  What can we do to help you now?