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Top Twenty Tax Myths and Why They’re Wrong—Part 2

Feb. 17, 2021, 9:46 AM

Bad tax takes aren’t limited to questionable TikTok videos: You can find them almost anywhere. And the more those takes are shared, the more legitimate they may appear to taxpayers.

Countering lousy advice, especially during tax season, is crucial. Here’s a look at some tax myths—and why they’re wrong. This is part two of an effort to bust common tax myths. If you don’t see your favorite lousy tax take here, check out Part 1.

  • If you create an LLC, you can write off your lifestyle. This myth has really gained traction during the pandemic as a result of some TikTok videos suggesting that anything is deductible if it’s inside of a business. Spoiler alert: You can’t deduct personal expenses on your tax return, ever. You can deduct legitimate expenses incurred in your trade or business—even if you don’t have an entity—so long as they are “ordinary and necessary.” Under tax code Section 162, an ordinary expense is one that is common and accepted in your trade or business, while a necessary expense is “one that is helpful and appropriate for your trade or business.” It doesn’t matter if those expenses are incurred inside of an LLC or a corporation since creating an entity doesn’t change their character.
  • If you start an S corporation, you don’t have to pay payroll taxes. S corporations gained popularity because they allow owners to claim different tax treatment for salary and distributions. You pay income tax and payroll taxes—typically, Social Security and Medicare taxes, which are referred to as FICA taxes—on salary, but distributions are only subject to income taxes. Some business owners see this as a boon: Why not just convert to an S corporation and pay yourself $0 in salary? Abracadabra: Your FICA taxes are gone! As you can imagine, the IRS is on to this strategy and requires that S corporation owners be paid “reasonable compensation” for services to the business. That compensation is subject to payroll tax.
  • You can save money by making your employees independent contractors—they just need to sign off. Running a business can be expensive, so it’s not unusual for employers to think of ways to cut costs, including the temptation to characterize employees as independent contractors. In 1987, the IRS released Revenue Ruling 87-41 which outlined tests to determine if a worker is an independent contractor. Since then, the IRS has simplified things by issuing “common law rules” or three categories to consider when determining the degree of control and independence. The categories are: behavioral control, financial control, and type of relationship. No matter what a written contract might say—even if the worker agrees—the facts as applied to these tests ultimately determine the classification for IRS purposes.
  • You don’t have to pay tax on money that you received illegally. Tax code Section 61(a) defines gross income as income from whatever source derived, including but not limited to, “compensation for services, including fees, commissions, fringe benefits, and similar items.” There’s no exception for illegally gotten gains. Don’t believe me? Look at Al Capone.
  • If you don’t receive a tax form, like a Form 1099, you don’t have to report the income. This myth is likely tied to the holy grail of tax and accounting: The paper trail. We like having official forms to match up on your tax returns but you don’t need Form 1099 to file your taxes in all cases. If you are an independent contractor, you should keep records of your income—and expenses—and report those on your tax return even if you don’t receive a form.
  • If you reinvest the proceeds from the sale of your house, you don’t have to pay any tax. This is another example of where a tax myth has some basis in fact: Before 1997, homeowners were subject to capital gains tax when they sold their primary home but could get a break if they bought a replacement home worth the same or more. There was also a provision which allowed homeowners age 55 or older to claim a one-time capital gains exclusion. Some taxpayers remember that rule and appear to have mashed it up with a like-kind exchange: Under Section 1031, you can avoid capital gains taxes when you sell an investment property if you reinvest the proceeds in a like property or properties worth the same or more. Neither the old 1997 rule nor Section 1031 applies to the sale of your home: Now, homeowners can exclude capital gains of $250,000—$500,000 for married taxpayers—when they sell their homes, no matter their age or whether they buy a replacement property.
  • Taxes work the same for federal and state. It’s easy to talk in generalities. I’m guilty of doing this, too. But it’s important to note that there are significant differences in how tax breaks and tax items are treated on the federal and state level. Not all states follow the fed’s lead on tax legislative: Fewer than half of the states have rolling conformity, and even those states often make exceptions. The home office deduction for employees? Not deductible for federal purposes, but might be in states like California. PPP forgiveness? It can’t be included in income for federal purposes, but some states like Maine aim to tax it. Don’t assume that the IRS rules apply to your state—or vice versa.
  • You don’t make enough money to be audited. High-income taxpayers, those with incomes of $10 million and above, are audited at a higher rate than taxpayers in every other income category. Those numbers may make you think that you won’t be audited if you make much less, but that isn’t true. In 2015, the last year that the IRS released comprehensive data, more than half a million taxpayers making up to $50,000 had their returns audited. That’s a relatively small percentage of all of the returns submitted, but it’s still not zero. You can be subject to examination at all income levels.
  • Getting a tax refund means that the IRS has accepted your tax return. When your tax refund lands in your bank account, you may be tempted to issue a sigh of relief and assume that all is well—and it may be. But significant chunks of tax return processing, like forms matching and issuing refund checks, are automated. A refund check doesn’t mean that the IRS has approved your return: Your return may still be pulled for review. The IRS generally has three years to review your return—more in cases of substantial understatement of income or fraud.
  • Your tax preparer is responsible for any mistakes. Mistakes can happen, even when you’re dealing with a reputable tax preparer. But when you sign your tax return, you are confirming that “I have examined this return and accompanying schedules and statements, and to the best of my knowledge and belief, they are true, correct, and complete.” In other words, you are ultimately responsible for what gets reported on your tax return. If your tax return does have an error, don’t ignore it. Instead, talk with your preparer about the best fix.

To contact the reporter on this story: Kelly Phillips Erb in Washington at kerb@bloombergindustry.com

To contact the editors responsible for this story: Rachael Daigle at rdaigle@bloombergindustry.com; Colleen Murphy at cmurphy@bloombergtax.com

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