Can One Choose Not to Declare Some Deductions to Increase Net Income?

[GoldenBear17]

Let's say you have a sole proprietorship. For a given year, let's say you have $50,000 in Schedule C income and $10,000 in deductible expenses related to that business. Your net income for the year then is $40,000 which has implications for various things, including how much you qualify to contribute to retirement accounts.

Is it allowed to choose not to declare some of the deductions in order to have a higher net income and therefore qualify, among other things, for higher retirement contributions? For example, could you simply choose not to declare $2000 of the $10,000 in deductible expenses so your net income would then be $42,000 instead of $40,000 for the year? You would obviously pay tax on the greater net income, but you would also then be allowed to contribute more to certain retirement accounts and the tax advantages on the growth of that new money in the retirement account, over time, could outweigh the extra taxes you would pay in the present day.

To be clear, I'm not advocating doing anything you're not allowed to do. I'm simply trying to understand what is and is not allowed. Is this allowed? And if so, do you think it would ever make sense to do this?

[the_wiki]

The IRS is happy when you pay more tax than you need to. So I would not worry about that.

I’m suspect that you could come out ahead. You’d be paying extra taxes up front on that money, and then paying again at withdrawal, assuming 401k. So double tax.

[secondcor521]

No, it is not legal nor is it proper, even in situations where it might be advantageous. Although it is certainly done by some taxpayers, most commonly to increase the Earned Income Credit.

From the IRS website:

"I know self-employed individuals have to report all income. My question is about deducting expenses. Are taxpayers required by law to claim all expenses pertaining to their business?

Yes. A self-employed individual is required to report all income and deduct all expenses. Revenue Ruling 56-407, 1956-2 C.B. 564, deals with the issue of taxpayers not taking all allowable deductions in computing net earnings from self-employment for self-employment tax purposes. Rev. Rul. 56-407 held that under §1402(a), every taxpayer (with the exception of certain farm operators) must claim all allowable deductions in computing net earnings from self-employment for self-employment tax purposes.

Net earnings from self-employment are included in earned income for EITC purposes. It is defined by cross-reference to the definition of net-earnings from self-employment under I.R.C. §1402(a). This ruling applies equally to the EITC. CCA 200022051 also provides insight regarding deduction of Schedule C expenses."

-- https://www.eitc.irs.gov/tax-preparer-t ... d-business

[GoldenBear17]

No, it is not legal nor is it proper, even in situations where it might be advantageous. Although it is certainly done by some taxpayers, most commonly to increase the Earned Income Credit.

From the IRS website:

"I know self-employed individuals have to report all income. My question is about deducting expenses. Are taxpayers required by law to claim all expenses pertaining to their business?

Yes. A self-employed individual is required to report all income and deduct all expenses. Revenue Ruling 56-407, 1956-2 C.B. 564, deals with the issue of taxpayers not taking all allowable deductions in computing net earnings from self-employment for self-employment tax purposes. Rev. Rul. 56-407 held that under §1402(a), every taxpayer (with the exception of certain farm operators) must claim all allowable deductions in computing net earnings from self-employment for self-employment tax purposes.

Net earnings from self-employment are included in earned income for EITC purposes. It is defined by cross-reference to the definition of net-earnings from self-employment under I.R.C. §1402(a). This ruling applies equally to the EITC. CCA 200022051 also provides insight regarding deduction of Schedule C expenses."

-- https://www.eitc.irs.gov/tax-preparer-t ... d-business

Thank you! I had no idea there was such a clear definitive answer to this right on the IRS website!

[GoldenBear17]

The IRS is happy when you pay more tax than you need to. So I would not worry about that.

I’m suspect that you could come out ahead. You’d be paying extra taxes up front on that money, and then paying again at withdrawal, assuming 401k. So double tax.

If you paid the extra tax now on $2000 and then put it in a Roth account where it earned tax-free for decades, I think you could come out way ahead. If you put it in a pre-tax account, you'd get a bigger deduction at present that would balance into the equation. This is probably exactly why the IRS says what they say in the post just above linking to their answer. So it seems to me this could be advantageous, and hence why it's not allowed.

[ncdcpa]

Increasing earned income and taxable income can also result in being able to claim or increase certain credits, including some refundable credits. So not reporting expenses to increase reported income could result in claiming benefits beyond those allowed by law, more than offsetting any increase in taxes. This is likely a factor in why the IRS would want to prohibit and detect to this. (And sadly, it seems to be that for some gig-economy work, the expenses swamp the revenue.)

[JBTX]

Technically you are supposed to pay your correct tax liability so you should declare legit expenses. However I’m not sure how this would ever be raised as an issue or how it could be flagged.

Generally paying more taxes to get a higher (but much less) retirement account deduction is likely a losing proposition.

[PatrickA5]

Saw this a lot while preparing taxes, almost always from someone collecting EITC. I'd ask about their expenses and they'd say "yeah, I have some but don't want to include them". By some miracle, they also ended up with the exact amount of income to qualify for the highest credit. Amazing. I usually told them to find someone else to do their taxes if I couldn't convince them to report actual expenses.

[GoldenBear17]

Technically you are supposed to pay your correct tax liability so you should declare legit expenses. However I’m not sure how this would ever be raised as an issue or how it could be flagged.

Generally paying more taxes to get a higher (but much less) retirement account deduction is likely a losing proposition.

It wouldn't be to get a higher deduction. It would be to benefit from no taxes on all the gains from that contribution over many years. That could be even more beneficial in a Roth.

[JBTX]

Technically you are supposed to pay your correct tax liability so you should declare legit expenses. However I’m not sure how this would ever be raised as an issue or how it could be flagged.

Generally paying more taxes to get a higher (but much less) retirement account deduction is likely a losing proposition.

It wouldn't be to get a higher deduction. It would be to benefit from no taxes on all the gains from that contribution over many years. That could be even more beneficial in a Roth.

Let’s say you have $10,000 of expenses you decide not to declare. Assume your marginal rate is 24%. You are paying $2,400 more in taxes, and possibly another 1,200 or so in payroll taxes. If you had taken the deductions - you could invest $3600 in tax savings in a taxable account and let it grow.

If you have solo 401k, not taking $10k of expenses increases income $10k, and that may give about $2,000 to invest in solo 401k, and an about a $500 initial tax savings.

I doubt the cumulative tax savings from the $500 in the 401k will ever catch up to the tax savings of $3,600 invested in taxable. Perhaps you could construct some hypothetical scenario where it might.

[ncdcpa]

I'm no expert on this, but, apparently according to at least one CPA,
"Tax fraud is said to be evident if the taxpayer is found to have: ... Misrepresented the actual state of their affairs so as to falsely claim tax deductions or tax credits"
https://www.investopedia.com/terms/t/tax-fraud.asp
I don't know of an authoritative source on this topic, preferring to stay as far away from it as possible.

I don't think everything discussed here fits into this description, but I don't know where the boundaries are.

[Raycpact]

Let's say you have a sole proprietorship. For a given year, let's say you have $50,000 in Schedule C income and $10,000 in deductible expenses related to that business. Your net income for the year then is $40,000 which has implications for various things, including how much you qualify to contribute to retirement accounts.

Is it allowed to choose not to declare some of the deductions in order to have a higher net income and therefore qualify, among other things, for higher retirement contributions? For example, could you simply choose not to declare $2000 of the $10,000 in deductible expenses so your net income would then be $42,000 instead of $40,000 for the year? You would obviously pay tax on the greater net income, but you would also then be allowed to contribute more to certain retirement accounts and the tax advantages on the growth of that new money in the retirement account, over time, could outweigh the extra taxes you would pay in the present day.
To be clear, I'm not advocating doing anything you're not allowed to do. I'm simply trying to understand what is and is not allowed. Is this allowed? And if so, do you think it would ever make sense to do this?

I imagine the circumstances where increasing income in order to increase retirement contributions makes financial sense is rare, however, there may be ways to increase your income.

First, if you adopt the accrual method some earnings might be accelerated into current year if receivables run higher than payables. Also, if you purchased items that have a longer useful life you could depreciate them over time. In hind sight if you were on the cash basis, you could pay some of your expenses late and accelerate billing and collection. If some office expenses, home office, auto, etc. are also used personally, you could adjust them down.

When lowering your income by not deducting expenses increases a tax credit or other benefit then the IRS would have an issue. Increasing your earnings can cause the earned income credit to increase. Also, its seems counterintuitive but the self employment tax is actually viewed as a benefit because the higher the income being taxed the higher the benefit. In a similar way, I could see the IRS disallowing the retirement deduction on similar grounds and causing an excess deduction and resulting penalties.

[GoldenBear17]

It wouldn't be to get a higher deduction. It would be to benefit from no taxes on all the gains from that contribution over many years. That could be even more beneficial in a Roth.

Let’s say you have $10,000 of expenses you decide not to declare. Assume your marginal rate is 24%. You are paying $2,400 more in taxes, and possibly another 1,200 or so in payroll taxes. If you had taken the deductions - you could invest $3600 in tax savings in a taxable account and let it grow.

If you have solo 401k, not taking $10k of expenses increases income $10k, and that may give about $2,000 to invest in solo 401k, and an about a $500 initial tax savings.

I doubt the cumulative tax savings from the $500 in the 401k will ever catch up to the tax savings of $3,600 invested in taxable. Perhaps you could construct some hypothetical scenario where it might.

Perhaps it would make more sense for those in a lower tax bracket?

If you don't declare $10,000 in expenses, it might only be $1200 more in taxes and some more in self-employment taxes. So let's just say you have $2000 you could invest in taxable to grow.

With a Solo 401k, if you're not maxing out, the $10,000 in expenses not declared, which increases income $10,000, could give closer to $8000 or $9000 more to invest in a Solo 401k, couldn't it? Basically you can contribute that entire $10,000 minus half the additional self-employment tax?

Wouldn't that change the calculation? Just for curiosity's sake though. It's clear from this thread that not declaring deductions in order to do this is something the IRS is not ok with so not recommended anyway.

[Makefile]

A place that was a gray area is the Home Office Deduction.

Before 2013, there was no simplified method. And I know that people would avoid taking it, because if they sold their house later, they would have to recapture all the depreciation they took for the home office.

Now that the simplified method exists, there is no such trade-off and it is moot, but must you take the home office deduction if you have no other office for your business?

[Nohbdy]

I’m definitely not a tax expert but my understanding is that there is some optionality to how you depreciate assets that you buy for your business.

It has been a few years - hopefully someone can explain this better or correct me but I believe that one can choose different accounting methods to depreciate a business asset, which could impact how much of the deduction lands in each year.

[JBTX]

Let’s say you have $10,000 of expenses you decide not to declare. Assume your marginal rate is 24%. You are paying $2,400 more in taxes, and possibly another 1,200 or so in payroll taxes. If you had taken the deductions - you could invest $3600 in tax savings in a taxable account and let it grow.

If you have solo 401k, not taking $10k of expenses increases income $10k, and that may give about $2,000 to invest in solo 401k, and an about a $500 initial tax savings.

I doubt the cumulative tax savings from the $500 in the 401k will ever catch up to the tax savings of $3,600 invested in taxable. Perhaps you could construct some hypothetical scenario where it might.

Perhaps it would make more sense for those in a lower tax bracket?

If you don't declare $10,000 in expenses, it might only be $1200 more in taxes and some more in self-employment taxes. So let's just say you have $2000 you could invest in taxable to grow.

With a Solo 401k, if you're not maxing out, the $10,000 in expenses not declared, which increases income $10,000, could give closer to $8000 or $9000 more to invest in a Solo 401k, couldn't it? Basically you can contribute that entire $10,000 minus half the additional self-employment tax?

Wouldn't that change the calculation? Just for curiosity's sake though. It's clear from this thread that not declaring deductions in order to do this is something the IRS is not ok with so not recommended anyway.

I suppose if you are in a very low tax bracket but expect to be in a much higher tax rate in the future you may be able come up with a scenario. While unlikely if you were in zero tax bracket then the deduction would not do you any good anyway.

Many business expenses for a solo business require some degree of judgment anyway. Personally I wouldn’t hesitate not to take expenses like vehicle mileage or certain shared home expenses if it were beneficial not to. Stuff like payroll where you also have payroll taxes you have to file I would always declare regardless.

[GoldenBear17]

Perhaps it would make more sense for those in a lower tax bracket?

If you don't declare $10,000 in expenses, it might only be $1200 more in taxes and some more in self-employment taxes. So let's just say you have $2000 you could invest in taxable to grow.

With a Solo 401k, if you're not maxing out, the $10,000 in expenses not declared, which increases income $10,000, could give closer to $8000 or $9000 more to invest in a Solo 401k, couldn't it? Basically you can contribute that entire $10,000 minus half the additional self-employment tax?

Wouldn't that change the calculation? Just for curiosity's sake though. It's clear from this thread that not declaring deductions in order to do this is something the IRS is not ok with so not recommended anyway.

I suppose if you are in a very low tax bracket but expect to be in a much higher tax rate in the future you may be able come up with a scenario. While unlikely if you were in zero tax bracket then the deduction would not do you any good anyway.

Many business expenses for a solo business require some degree of judgment anyway. Personally I wouldn’t hesitate not to take expenses like vehicle mileage or certain shared home expenses if it were beneficial not to. Stuff like payroll where you also have payroll taxes you have to file I would always declare regardless.

Again the main benefit is not the deduction in the present. In fact, it may be more beneficial to use the increased net income to put more in a Roth. The benefit is the tax free growth over decades to come on the increased money you qualified to contribute to a retirement account. But seeing the IRS language earlier in the thread, I wouldn't do this.

[bsteiner]

No, it is not legal nor is it proper, even in situations where it might be advantageous. Although it is certainly done by some taxpayers, most commonly to increase the Earned Income Credit.

From the IRS website:

"I know self-employed individuals have to report all income. My question is about deducting expenses. Are taxpayers required by law to claim all expenses pertaining to their business?

Yes. A self-employed individual is required to report all income and deduct all expenses. Revenue Ruling 56-407, 1956-2 C.B. 564, deals with the issue of taxpayers not taking all allowable deductions in computing net earnings from self-employment for self-employment tax purposes. Rev. Rul. 56-407 held that under §1402(a), every taxpayer (with the exception of certain farm operators) must claim all allowable deductions in computing net earnings from self-employment for self-employment tax purposes.

Net earnings from self-employment are included in earned income for EITC purposes. It is defined by cross-reference to the definition of net-earnings from self-employment under I.R.C. §1402(a). This ruling applies equally to the EITC. CCA 200022051 also provides insight regarding deduction of Schedule C expenses."

-- https://www.eitc.irs.gov/tax-preparer-t ... d-business

That was to prevent people from inflating their income to get enough quarters of coverage to qualify for Social Security.

[LadyGeek]

The question has been answered (per IRS website). This thread has run its course and is locked. See: Locked Topics

Moderators or site admins may lock a topic (set it so no more replies may be added) when a violation of posting policy has occurred. Occasionally, even if there are no overt violations of posting policy, a topic (or thread) will reach a point where the information content of the discussion has been essentially exhausted and further replies are much more likely to cause distress to the community than add anything of value.