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Lower and middle-class Americans owe a larger portion of their income and wealth in taxes than the rich and affluent Americans. Why is it so? Because the rich know and use some tax loopholes that most people don’t.
Tax loopholes are some provisions in the taxation system that one can use to his advantage to reduce his/her tax liability. These provisions were not intended to be used as loopholes, but they are mostly used that way.
Now, since taxation is one of the most boring subjects to study, most Americans don’t bother and prefer to pay as much taxes as the government wants. But we’re invest divas and divos, and we like to earn and save as much as we can.
So in this blog, we’ll be discussing some of these tax loopholes that the rich uses, and you can too, to save big in taxes.
As always, Preston from Anderson.tax will be helping us with his tax wisdom nuggets. He is a Certified Public Accountant (CPA) who helps individuals and businesses cut their tax bills and grow fast. In case you’re interested in a free tax assessment, you can book one with Preston on his website.
Are tax loopholes legal?
One of the misconceptions people have when they hear about tax loopholes is that it is some shady, illegal thing that will get them in trouble.
But that can’t be further from the truth because tax loopholes are 100% legal, and people use them to cut their tax bills every year. In fact, big business houses such as Amazon use them in a manner that they can completely avoid taxation.
Here, you need to understand the difference between tax avoidance and tax evasion. The latter means hiding income or information from the IRS to not pay taxes, which is illegal. The former means using some tax provisions to your advantage to avoid paying higher taxes legally.
Tax loopholes are a way of tax avoidance, so they are completely legal and will not get you in any form of trouble unless you employ some illegal means.
5 Tax Loopholes You Should Know
5 tax loopholes you can use to save taxes like the rich, regardless of who the president is or what the political situation is in the country. Let’s begin.
1. Be Organised
This isn’t particularly a tax loophole per se, but it’ll help you take advantage of a lot of loopholes. Being organized is one of the first things Preston recommends to his clients because it is infinitely important for anyone.
If you’re a business owner, the very first thing you should do is get as organized as possible. Create a brick wall between you and your business, and always treat your business as a separate legal entity.
That way, whenever you have something that’s kind of on the borderline between personal and business expenses, the more you have that brick wall between you and your business, you can push it towards business and write it off.
Another thing is organization, meaning your business structure. How you’re taxed is one of the biggest things that’s going to determine how much you’re going to pay in taxes, as well as what tax loopholes will you be able to utilize.
Choosing the correct one between a C-corp, S-corp, sole proprietorship, and partnership is so essential not only during the time you’re running your business but when you’ll sell your business as well.
For example, if you’re a C-corp and you sell your business that you had for 5 years, 100% of that sale can be tax free if you qualify. This can only be done if you’re a properly set up C-corp, and you can do this for upto a $50 million sale.
So, being organized and organization are like the very first building blocks as to how to save taxes with the help of tax loopholes.
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2. Hire Your Kids
Another fun thing Preston teaches his clients is how to hire your kids in your business and pay them 100% tax free.
By doing this, you’re able to push money out of your income onto your kids, and your kid’s tax rates are literally zero. So if your tax rate is 37% and your kid’s tax rate is zero, and you pay your kid $10000, that’s $3700 that you just saved from your tax bill.
Now, there are certain age limitations that you need to keep in mind. If your kids are doing some kind of physical labor for your business, like cleaning your office or managing your documents, then the minimum age you can recruit and pay them is seven.
However, there are different ways to do it for younger kids as well. For example, If your kids are in advertisements or basically a model for your business, then there are no age limits for them because there are even baby models who get paid.
This is an easy way to get money out of your business tax-free and in your family’s hands. You can pay your kids upto $12000 per year per kid and take advantage of this loophole.
3. Health Savings Account
A health savings account or an HSA is where you can contribute pre-tax dollars into a savings account to pay for qualified healthcare expenses.
It is just like a 401k or IRA in terms of contributions, but even better when it comes to saving taxes because an HSA provides you with three layers of tax protection, meaning your contributions are tax-free, your account growth is tax-free, and unlike a 401k or an IRA, your withdrawals from an HSA are also tax-free.
Another great thing about an HSA is you don’t have to wait till you’re retired to spend it. You can use it to pay for all health-related expenses right now.
Now, HSAs are typically only allowed for people who have a high deductible health plan (HDHP), meaning a health insurance plan with low monthly premiums but higher out-of-pocket expenses.
So it is not a replacement for your health insurance but having an HSA makes a lot of sense for you if you’re a generally healthy person who just needs a tax-saving way to cover your medical expenses.
4. Medical Expense Reimbursement Plan
A medical expense reimbursement plan is something that is set-up by an employer for their employees to reimburse out-of-pocket medical expenses incurred by the employee and their dependents.
Medical Expense Reimbursement Plans (MERP) are tax-free, and all the expenses incurred on them can be written-off your tax filing.
As a business owner of a sole proprietorship or a C-corp, what you can do is set-up a medical expense reimbursement plan for yourself that will cover your and all your dependent’s medical expenses.
This way, whenever you’ll incur a medical expense the next time, you can just push it towards business expense and write it off from there.
This also shows you the importance of having a brick wall between you and your business, as discussed above.
Depreciation is the estimate for the loss of value of an asset over time. Everything, including real estate, cars, computers, etc losses its value over time. None of them lasts forever.
The IRS says that you can take the value that you paid for one of these assets or any money that you put back into it for capital improvements and spread it out over 27.5 years for residential property and 39 years for commercial property, and then take that amount off your income each year to compensate you for that supposedly lost value.
So for example, if you paid $300000 for a property, you can deduct upto $10000 on it every year from your taxable income for the next 27.5 or 39 years, depending on the type of property it is.
Now, an important point when it comes to depreciation is that you can’t depreciate land. Depreciation is applied only on assets that lose their value with time, like building, plant, and machinery. Land does not lose its value over time but gains it in many cases, so land can’t be depreciated.
Other than that, you can apply depreciation on all your properties and take advantage of this tax loophole.