People who are not self-employed receive at the end of the year an income receipt slip from their employers. They complete their Form 1040 (United States Individual tax return) then submit it to the IRS. They either pay additional tax or enjoy a moderate refund. It is through this income reporting that lenders verify the amount of income you receive throughout the year as being true. The theory being that when the government has accepted what you reported, it must be true or you would be audited.
Understanding that financial institutions place such a high value on your tax return means you should take time to understand the tax system the best you can. Purchase a book, or speak with a tax consultant (or read web sites like CLF) to review your options. Learn to maximize every benefit available in the annual tax process you qualify for. Find a balance in the amount of income you report each year and your related expenses / allowable deductions.
Operating a Business Purely for Tax Reasons
You may have heard people operate a small business for tax reasons, but what does that really mean? The answer can be as complicated as you like, but in an effect to keep things simple, I will try to outline the general concept here of a sole ownership / proprietorship. Owning a business costs you money to operate. You need to purchase supplies, pay utilities for the space you occupy (even if it’s only a room in your home), additional labor expenses, as well as vehicle costs. If you own a small business you are also generating an income (the IRS assumes, as you should, you are operating this business to make a profit). It is conceivable you are likely to lose money from time to time depending on the market conditions and the effort you put into your business. Some sole proprietors show losses related to one-time expense items (a large purchase or repair) that is not expected to be repeated again.
If your income from business is in a negative balance after deductions, you will find that you are able to reduce the amount of tax you pay from your regular salaried employment. (see a tax planner, chartered accountant, or bookkeeper for more in-depth overview than presented here if you are not familiar with this practice).
The trick is to have expenses that lenders are willing to add back into your income. As reviewed earlier, these include depreciation/amortization, capital cost allowance, interest and one-time expenses (most of which don’t actually use up cash). If done correctly, the value of these items can be added back to your available income to service debt.
Banks consider debt to be repaid only through cash availability. The more available, the more debt can be serviced – obviously. The stronger your borrowing power, the more preferred a client you become. A common error usually seen with sole proprietors is they don’t properly research what expense items a bank will add back to their income. In doing so, they fail to weigh expenses against reserving some income to service debt. When it comes time to apply for credit they discover they have merely created expense items for tax purposes and are unable to include these items back to service debt as first thought.
Though they have reduced the amount of tax payable to the IRS, they have not reserved enough income to service their debt, which negatively impacts their TDS and GDS ratios. They have in effect, reduced their borrowing power relative to reducing their income for tax purposes.
How You Interpret Tax Rules 😉 Wink Wink
People interpret tax rules differently. Bending the rules to interpretation is very different from breaking them, and not all rules can be bent to serve your purpose. At the end of the day, if you are unable to convince the IRS to your perception of their rule in an audit situation, you will be required to pay the tax owed to them along with any interest penalties. After the IRS’s decision demanding you to repay tax, the amount could appear on your credit agency reports as a collection item. The IRS can also garnishee your salary until they receive all that is due to them.
Having said that, tax department employees are very willing, in most circumstances, to negotiate scheduled repayment terms with you as long as you meet the commitments you make them. If you find yourself in a poor situation such as this, be upfront and forthcoming with the IRS staff and they will be more willing to work with you. Ignorance is no excuse with the IRS. It is wiser to seek professional tax advice in the beginning than to have to repay the government back taxes with interest penalties and possibly receive a bad mark on your credit report.
Most people, when asked, will say their biggest expense in their lives is their mortgage. That’s not always entirely true, and the government is happy that most of us have this perception. Our biggest expense is actually the amount of tax we pay, once you include all of the sales taxes, insurance taxes, and general taxes from every single angle. We are taxed when we earn money working hard to build the economy and we are taxed when we spend supporting our economy through shopping. Understanding this may encourage you to think about the amount of tax you pay, and how to reduce it.
Remain focused on strengthening your borrowing power while tax planning. Use expense items banks will add back to your total income.
Another reason financial institutions rely heavily on your tax return to prove income is the IRS Notice of Assessment created by the federal government, and is sent to you, also shows when you owe back taxes. If you owe the IRS from prior years, pay them before going for a loan or mortgage and be ready to prove you have done it. Banks rarely lend to those in the tax arrears position. If you can’t pay the government, it’s likely that you can’t pay a bank loan either; not to mention the federal government has access to your personal assets before all others. The IRS gets paid first before bank – before anybody. It would serve you well to remember that.
It may be a good idea in your situation to request of your employer to deduct more withholding tax from each paycheck for submission to the IRS. This can be done through your HR office, and has some benefits to it – you are in control of the amount of tax being paid on your income throughout the year, versus waiting to hear at the end of the year if you owe additional taxes or not, which may place you further into debt.
Basically, you are using the government as a way to force yourself to save, predicting you will have contributed too much tax and will receive a refund at the end of the year. Though this does not accumulate interest, it does force you to save. Be sure to put the refund in your 401(k), or pay off a loan to receive the full benefit. Don’t piss the refund away as it can provide you with a debt-free future when you handle your affairs properly.
Commissioned Sales People
When you are a commissioned salesperson, your income will be reviewed more intensely by the lenders. You will be required to show at least three years of income verification (tax returns with notice of assessment’s). Your yearly commission income will be considered by using an overall average of those three consecutive years. If you had a big income year and want to buy a new car, remember the commissions of the two previous years will be added to the one great year you just had, and it is the average of the three years that will be used calculate the cash you have available to service the new loan you are applying for.
Cash is the only thing that services debt payments. Not a cosigner, or a strong guarantee from someone you know. It’s so important to understand the way to properly present how much cash you have each month, and the type of debt you service each month. Financial institutions don’t care that you may be a great person, and just need a break. Their job is to focus on minimizing the risk of you not being able to repay your loan on time. Like you didn’t know that – right?
Continued in the Carol’s Borrowing Series Category of Clf.
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