SECTION 2 LEARN WHAT THE RICH KNOW

pillar 3

The Fundamentals of
2

TAXES

In this world nothing can be said to be certain, except death and taxes.
Benjamin Franklin

obody likes taxes. Ever since the Boston Tea Party in 1773, when colonists dumped British tea into Boston Harbor rather than paying the tax on it, Americans have been seeking ways to avoid giving their hardearned money to the government. Their efforts have been in vain. Today the Internal Revenue Service is a fact of life, and we all have to pay taxes. But theres no reason you have to hand over more than your fair share. If you take the time to learn some of the basics of tax law, youll reduce your burden and keep more of your money. By becoming financially literate, youll learn what the rich already know: While you cant beat the IRS, you can turn it to your advantage.

Pillar 3: The Fundamentals of Taxes

income tax: a Pocket history Personal income tax is a relatively new phenomenon in American life. It wasnt until 1863 that the federal government even began collecting income tax to fund the war effort, and nine years later the tax was repealed. For the next forty-one years the government funded most of its activities by levying duties on imported goods such as wool and shoes. The system of duties, however, prevented the United States from gaining a competitive edge in world trade. Thus in 1913 Congress reduced duties on imported goods and, to make up for the loss in revenue, ratified the 16th Amendment to the Constitution legalizing personal income tax.
During World War II, paycheck withholding was introduced. Under this system, taxes were taken out of a persons paycheck each payday instead of annually, giving the government enough ready cash to cover the cost of the war. To reduce government borrowing, the tax rate was also raised, in some cases to a whopping 94 percent of personal income. Since then rates have settled back down, but notas the tax wars of the last few decades suggestto everyones satisfaction.

That the institution of the income tax will tend to silence all boasting about wealth may ... be regarded as one blessing associated with it; we know at present of no others.
The New York Times in 1913, the year income tax was introduced

2-41

LEARN
What the Rich knoW

BecoMing tax liteRate

The U.S. tax system is progressive, meaning people earning more money pay tax at a higher rate than people earning less. If only it were that simple ... The present Byzantine tax code may have your money passing through more than one tax bracket before your final tax bill is calculated. The rate you pay depends on many factors, not just your income but whether youre married or single, how many children you have, and so forth. So complicated is the tax system that some lawmakers in Washington have repeatedly called for a straightforward proportional tax, that is, a tax that takes the same percentage of each persons income. It is often called the flat tax. Instead of overhauling the tax code, Congress is forever tinkering with it, changing this and adding that. The result resembles a house built without blueprints. Doors give way to walls, and staircases lead nowhere. Many laws are written to favor investors, others are not. Its important to know the laws, and it can be very expensive if you dont. For instance, in 1986 Congress passed the Tax Reform Act which eliminated the tax break for real estate investors whose expenses on rental properties exceeded the rents they collected. When the law changed and the government stopped subsidizing people for losing money, some people went bankrupt and the stock market took a steep dive. Its never a good idea to invest in something just to avoid paying taxes or in something thats losing money. The idea is to make money, not lose it. The 1997 Taxpayer Relief Act introduced a whole new set of rules, and it contained some good news for some. For example, now if youre married and you sell your house, you can avoid paying capital gains tax on profits up to $500,000. The law is always changing, and the best way to reduce your tax burden is to keep abreast of developments. How? By watching the financial news on television, reading the financial section of your newspaper, or consulting your tax attorney or accountant.

This is too difficult for a mathematician. It takes a philosopher.

Albert Einstein, on preparing his income tax return

2-42

tyPes of Business entities

Most people earn money, pay taxes through withholding, and spend what little is left over. The rich do it differently. They earn money, spend it, and then pay taxes. The government gets less that way, and its legal.
eMPloyees of coRPoRations:

Pillar 3: The Fundamentals of Taxes

Earn

pay taxes

spend

the Rich Who have coRPoRations:

Earn

spend

pay taxes
R ic h D a D s tiP

What is the secret of the rich? They take advantage of the tax loopholes that allow individuals to choose different entities for their businesses. Loopholes, though they may have a negative connotation for some, are intended to help businesses grow and prosper. The tax law allows a corporation, for example, to earn, spend everything it can on legitimate business expenses, and then be taxed only on what remains. How can you get in on this secret? First by learning what business entities are available to you and what the advantages and disadvantages are of each. These entities include the sole proprietorship, the partnership, the corporation, and the limited-liability company, which is a hybrid partnership/corporation. In the Rich Dad program, it is important that you be aware of the various entity choices and their primary attributes. Consult your legal and tax advisors about what entity may be most appropriate for you and your intended business, whether it is real estate, a purchased business, or a start-up.

You cant beat the IRS. Concentrate instead on earning as much as you can, knowing that you can reduce, but not eliminate, your tax burden.

2-43

LEARN
What the Rich knoW

FEAR:

My hard-earned profits will disappear in the black hole of the IRS.

FACT:

There are business entities available that may help counteract your tax burden. By consulting with your tax and legal advisors, you can structure your business in such a way as to maximize your tax deductions.

FREEDOM:

If you structure your business properly, you can protect more of your profits.

Its a game. We (tax lawyers) teach the rich how to play it so they can stay richand the IRS keeps changing the rules so we can keep getting rich teaching them.
John Grisham

sole PRoPRietoRshiP
This is the oldest and simplest form of business. The owner and the business are one and the same, enjoying all the benefits but assuming all the debts and tax responsibilities. Only one person is required to form a sole proprietorship, and since there is legally no difference between the owner and the business, all income generated by the business is regarded as personal income. The owner reports all business income and losses on a personal tax return (Schedule C) and is allowed to deduct business expenses. The owner is also personally liable for the business and can be sued by an unhappy customer or unpaid creditor. If business assets cannot satisfy such a claim, the owners house, car, and other personal assets are vulnerable.

sole Proprietorship
Pros Owner in complete control Flexible decision making Business expenses deductible Owner earns all profits Easy and inexpensive to set up cons Owner completely liable for debts and suits Business terminates with owners death Tax rate may be higher than other entities

2-44

PaRtneRshiP
A partnership is two or more people co-owning a business for profit. The partners agree to establish and run the business, sharing in profits, assuming responsibility for all losses and liabilities, and paying all taxes, which are paid at the individual rate. There are two types of partnerships: general and limited. In a general partnership, the partners have full rights to control all the day-to-day affairs of the business. They also share all the liability for the partnerships debts or obligations. If the partnerships assets are insufficient to meet its obligations to creditors, or if a third party is damaged or injured, then each partners personal assets can be taken to satisfy the debt.

Pillar 3: The Fundamentals of Taxes

Partnership
Pros Combined assets and expertise Flexible decision making Partners, not partnership, taxed at the individual level Business expenses deductible Ease of formation cons Partnership terminates on death or withdrawal of any partner Partners totally liable Each partner can enter into other business agreements, so control is difficult Each partner is individually liable for agreements made by any partner

A limited partnership has both general partners, who run the daily business and make all the decisions, and limited or silent partners, who generally put up the money in hopes of profit. Limited partners have limited financial liability, meaning that if a creditor or an injured party sues, limited partners cant be held responsible for any more than the amount they originally invested. When it comes to taxes, general partners and limited partners are treated the same way. Any profits from the business go directly to them, that is, they are passed through to all the partners, who report their share of the partnership net income on their individual tax returns.

2-45

LEARN
What the Rich knoW

limited Partnership
Pros Limited partners are not personally liable for the partnerships debts and obligations Partnership does not dissolve with death of limited partner Number of partners/owners unlimited cons Transfer of interest usually requires general partner approval Complete and separate paperwork filings Limited partners have little, if any, control over daily operations

R ic h D a D s tiP

coRPoRation
Most people think of a corporation as a business in a big building with lots of employees. A corporation is really nothing more than a way of doing business. It is a legal entity regarded as separate from the owner, one that offers distinct tax advantages as well as liability protection from creditors and others who might sue. The owner controls the corporation and is a shareholder, possibly the only shareholder. As owner and shareholder, the owner is the boss. The owner controls what happens in the corporation, but because the corporation is a separate entity, the owner doesnt own any of the corporations assets and therefore doesnt have to assume any of the corporations debts. The corporation owns its own assets and pays its own debts. This is one of the secrets of the rich: Own nothing, but control everything. This was Rich Dads favorite form of entity in which to build businesses. There are two types of corporations: C and S. The C corporation, named for Subchapter C of the federal tax code, is also known as a regular corporation. It offers all the legal protection just mentioned but is taxed as a separate entity. In general, income tax rates for a corporation are lower than rates for individuals. After the C corporation deducts business expenses from its income, tax is paid on the corporations profits. The owner/shareholder in turn pays tax on any money received from the corporation, usually in the form of a salary or bonus, and the corporation can deduct these payments as expenses on its tax return. However, when a corporation pays a dividend to its shareholders, the dividends are taxable to the shareholders but not deductible by the corporation. This is often

Utilizing the corporation is one of the secrets of the rich: Own nothing, but control everything.

2-46

called double taxation, that is, tax is paid on the income by the corporation when it earns the money, and tax is paid again by the shareholder when the corporation pays a dividend with that same money. But theres a way around double taxation, and the rich use it all the time. When the C corporation deducts legitimate business expenses and pays out profits in the form of compensation to its shareholders, there may be no taxable income left. In that case, the corporation doesnt have enough income left to pay dividends. Shareholders must report any compensation (deducted on the corporations return) on their individual tax returns, but they have no dividend income to report. Taxation occurs once, not twice. Note: The shareholders must be performing duties for the compensation they are receiving, and compensation should be reasonable, not excessive. Another advantage of the C corporation is in the area of fringe benefits. The C corporation usually gets a deduction for fringe benefits, and the employee does not recognize taxable income. Many of the fringe benefits available to the C corporation are not available to, or are restricted in, an S corporation, partnership, or LLC. For example, a C corporation can make contributions towards life, accident, health, or other insurance deductibles and offer taxfree benefits under a medical-expense reimbursement plan. c corporation cons Pros Double taxation occurs when dividends are paid to Liability limited in case of lawsuit shareholders Shareholders risk only their Corporations must comply with investment recordkeeping and other Corporation can survive the government regulations death of owner, officer, or State laws can limit operating shareholder flexibility Easy to sell small portions of stock to raise capital Tax rate may be lower Corporation can elect different year-ends than shareholders helpful for tax planning Corporation can provide certain benefits not available to other entities

Pillar 3: The Fundamentals of Taxes

2-47

LEARN
What the Rich knoW

Also named from a chapter in the tax code, S corporations offer the same legal protection as C corporations but dont pay corporate taxes. Instead, shareholders report the companys income and losses on their individual tax returns. The tax may be higher at the individual level than it would have been at the C corporate level, but because the S corporation itself pays no taxes, the income is only taxed once, not twice as it can be with the C corporation. Lets say your business isnt yet profitable and youre earning money from another source, such as a part-time job. The money from this other source is taxable, but if you have an S corporation, you can reduce the amount of your total tax by deducting your S corporation operating loss from income being earned from other sources. Reducing the amount of taxable income in this way may add up to significant tax savings.

s corporation
Pros No double taxation Changing from C to S and from S to C is possible cons Company must be registered as a domestic corporation Corporation can issue only one class of stock Limited number of shareholders can own stock Limitations on who qualifies for shareholder status

liMiteD-liaBility coMPany (llc)

This relatively new type of business is a cross between a C corporation and a partnership. An LLC gives its shareholders, or members, all the legal protection that a corporation offers, but an LLC may elect how it is to be taxed, whether as a corporation or as a partnership. This is called the check the box election. If the LLC elects to be taxed as a partnership, it means that profits earned by the LLC are passed through to the members, who report them on their individual tax returns. If the legal protection and the tax setup are the same for both an LLC and an S corporation, how is an LLC different? In an S corporation, there are certain laws restricting the number of

2-48

shareholders and also the type of stock that can be issued. With an LLC, none of that applies. Thus an LLC has more flexibility than an S corporation. But theres a downside. Because LLCs are relatively new, there is no solid history of legal test cases, and laws governing LLCs vary from state to state. Some states have bulletproof laws, meaning that if you establish an LLC and follow all the rules, youll automatically be given favorable tax status. In other states you may follow all the rules but not gain favorable tax status. Its best to check with a legal expert before forming an LLC.

Pillar 3: The Fundamentals of Taxes

limited-liability company
Pros Owners or members have management authority Allows an unlimited number of shareholders Can elect to have income or loss pass through to members returns Liability protection of a corporation with no responsibility for debts cons More expensive to open than a partnership Rules may vary by state Must have consent of members to transfer interest to another person

the secRet of the Rich

Now that you know something about corporations, you have more insight into the secret of the rich. This secret has been around ever since the days of sailing ships, when the rich created the corporation as a vehicle to limit their risk. The rich would put their money into a corporation to finance a voyage. If the ship was lost the crew lost their lives, but the loss to the rich would be limited to the money they invested for that particular voyage. Corporations can protect assets and serve as vehicles for the creation of new assets. If you understand that basic secret, then youre ready to master the art of building the B-I triangle.

2-49