In 2009, a friend of mine named Mike Gandolfi contacted the IRS for an unusual reason: He wasn't getting in touch to pay his business taxes; he was giving the IRS notice that he was owed $102,000.
You can imagine the excessive nerve it took to do such a thing. And Gandolfi was understandably on edge.
But then his nerves jumped to red alert. The reason: An audit. Unsurprisingly, the IRS had responded to his request for $102,000 with an audit. And now Gandolfi was worried.
See, recently we had helped him find and hire a new tax team to develop a smarter tax strategy for his business, and the immediate result was an audit. Because Gandolfi wasn’t a tax expert; he had put his trust in the tax team. And now he was wondering: Had the tax team gone too far? Had he done something illegal?
Fortunately, I can assure you this story has a happy ending. But, first, let’s look at why Gandolfi asked the IRS for $102,000 back in the first place, and examine how you, as a business owner, may be able to do the same thing.
Changing a company's business structure may save taxes
Before we set Gandolfi up with a new tax team, he was in a bad spot. As he told me, "We were paying a very high-priced accountant because I wanted the best, but they were giving us very poor advice.”
And he certainly was getting poor advice. Although his business was the perfect candidate to be classified as an S corporation, which comes with major tax benefits, his accountant had wrongly advised against it. An S-corp classification allows you to avoid payroll taxes, otherwise known as the self-employment tax for business owners, on a major portion of your income.
You have to pay yourself a reasonable salary, which is subject to payroll taxes. But after that, you can receive regular distributions from your company for any amount -- an amount not subject to the approximately 15 percent payroll tax. For Gandolfi, switching to S-corp status resulted in a savings of about $20,000 per year.
Understanding the magic of depreciation and cost segregation
When a business asset goes down in value, it’s called depreciation. And depreciation can be counted as a business expense, which lowers your taxable income.
Here’s a rough example: If a $10,000 business asset depreciates to $8,000, then you can write down the $2,000 depreciation as a business expense, which lowers your taxable income by $2,000.
There are all sorts of IRS rules governing depreciation, so it’s best to talk to your accountant. But in Gandolfi's case, his business owned a building that the IRS said could be completely depreciated over 39 years. And if Gondolfi's tax team hadn't known to hire an engineer, that would have been the end of it.
But because of something called “cost segregation,” his tax experts could hire that engineer to identify parts of the building the IRS would allow to be depreciated at a faster rate.
For example, carpet, which doesn’t typically last 39 years, may be depreciated much faster than other parts of the building. Usually, the IRS specifies five years' depreciation for this particular item. Five years means you can deduct one-fifth of the cost of the carpet each year, significantly reducing your taxable income.
"Having the ability to depreciate things like that at a different speed helped significantly,” Gandolfi said.
Amending the last three years of tax returns
Gandolfi's tax team looked at his returns from the previous three years and realized he had missed out on some major tax savings. Fortunately, the IRS allows you to amend tax returns up to three years later and reclaim savings that were missed. That’s how Gandolfi came to ask the IRS for $102,000 back.
Much of that savings came from missed cost segregation opportunities, but other savings came from tax writeoffs like mileage for the use of a car for business. And actually, that’s what triggered the audit. The IRS had questions about how he was using his car for business.
The result of the audit
So, what happened? What was the result of the audit?
“We think of audits as probably one of the last things that you ever want to have to experience,” Gandolfi says now about the experience, “But it wasn't painful at all. There were a few phone calls and a few documents we had to submit, and that was it. Everything else was handled and it came back that we didn't have to pay anything more."
The IRS decided that Gandolfi was actually correct to write off his mileage. In fact, his only mistake had been in not writing off enough. In fact, the IRS decided to let him write off more mileage than he even asked for.
There are a few morals to the story here. One, make sure you have an accountant that specializes in business and can help you pick the appropriate corporate structure. Two, get a second opinion on your last three years of tax returns. Another set of eyes may be able to find you savings you wouldn’t have received otherwise, like cost segregation and business mileage on your car.
And, three, realize that audits are scary only if you’re cheating the tax law. If you’re working with an accountant who knows the tax law and can use it in your favor, you have nothing to fear. You can feel confident taking every tax savings legally allowed.