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posted on: 6/9/2006
revised: 3/8/2010
The IRS reports (Headliner Volume 168,
May 23, 2006) that numerous recent examinations of self-employed
taxpayers have resulted in increased taxes and penalties due to
improper deductions taken. At first we would suspect that the
overly complicated tax laws that govern retirement plans are to
blame for this trend. The surprise is that the problems are
much more basic and could easily be avoided.
IRS says the two primary problems are:
1) taking a deduction that is larger
than the amount of self-employment income. This seems to
be a common problem for statutory employees. In any case, the
amount of deduction taken in a self-employed retirement plan cannot
exceed the amount reported on schedule SE as "self-employment
income". This is worth repeating in different words: you
cannot take a tax deduction that is more than the income you report
as earned.
2) taking a deduction but then
failing to actually make a deposit into a retirement account. I
suspect that in many cases the taxpayers ask the tax preparer to
report a retirement plan deduction that they hope to take, but have
not yet funded as of the date that the return was filed. In most
cases a taxpayer has until April 15 to make a retirement plan
contribution although the tax return is prepared prior to that date.
Ideally, the same professional financial adviser who prepares the
tax return would also be responsible for handling the retirement
plan transactions but in many cases taxpayers use one adviser for
investments, another for taxes. In this case neither adviser
may be aware of the problem.
IRS says that the majority of the errant
tax returns are prepared by professionals. The tax preparers
probably know the basic rules of retirement plans and probably know
the high probability of this error being caught though IRS's
automatic electronic error detection. Most accountants and tax
preparers are at least vaguely aware that IRS has a matching program
that compares retirement plan deductions taken with the deposits
reported by IRA and retirement plan custodians. These two
errors have an almost 100% chance of being caught. It seems
unlikely that many tax preparers would deliberately recommend taking
these positions.
Another possible explanation is the
financial planning habits of those considered "statutory employees".
Statutory employees include life insurance agents, real estate
agents and route salespeople. Apparently statutory employees
make up a large part of the IRS' audited group. These people
have their social security taxes paid by their employer (the same as
if they were regular employees) but have to calculate their federal
income tax as if they were self-employed. This creates an
incentive to report a lower net self-employment income (by
maximizing business deductions) and in most cases this is a
legitimate tax strategy. But in many cases the statutory
employee has not budgeted for federal income tax bill and becomes
hard-pressed for strategies to reduce that bill at tax filing time.
One strategy is to take a large deduction and hope to come up with
the money to fund a retirement plan through the next "big sale"
before the tax due date. The solution seems simple: better
financial planning during the year will avoid bad news at tax filing
time. In real life, it may not be that simple.
Salespeople are, by nature, more likely to focus their efforts on
the next task at hand than to take time to reflect backwards on the
financial transactions of the year to date. Also, sales people
are more likely to fall into the "earn and spend" personality type
than the "save and conserve" group.
keywords: Tax, IRA, Keogh,
self-employed, statutory employee, IRS, audit
related topics:
Copyright 2010 by Tony Novak. Originally produced and published for the "AskTony" column syndication prior to 2007. Edited and independently republished by the author in March 2010. All rights reserved. |
