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28 May 2017
Flip Wilson was one of my favorite comedians of the 1970s. From 1970 - 1974 he hosted his own prime time comedy TV show. I used to beg my mother to let me stay up late enough to watch it. Each episode of the show consisted of several sketches featuring characters Wilson created and portrayed. One of his most popular characters was a sassy woman named Geraldine Jones, whose never seen boyfriend "Killer" was invariably in jail or at the pool hall. It was always the Devil's fault for whatever predicament Geraldine found herself in - and she was always in some predicament. Geraldine saying "The Devil made me do it" became such a popular character and catch phrase that Flip Wilson released a comedy album as Geraldine Jones titled "The Devil Made Me Buy That Dress".
I sometimes think about Geraldine Jones when I am reviewing the self-prepared tax returns of a new client. I will see something unusual - something I think may be wrong, so I will ask the new client why they claimed a deduction or credit for which they don't seem to qualify. Most common answer: Turbo Tax let me claim it.
I envision this person sitting in front of their computer screen, reading a question from the Turbo Tax interview, not really sure of the meaning. They read the question 3 or 4 times hoping the lightning bolt of clarity will magically strike. Getting bored and frustrated with both the question and the tax preparation process in general they decide on a meaning and plug in an answer. If Turbo Tax takes it they must be OK - right?
Many taxpayers mistakenly believe if the tax software (Turbo Tax being the most commonly used) allows you to claim a deduction, then it is OK to claim it. This belief is categorically NOT TRUE. Some even believe if the tax software allows it, then the tax software company is liable for any mistakes on the tax return. Again - NOT TRUE. The taxpayer is solely responsible for the contents of the tax return they file. (You may be able to purchase additional insurance from your tax software company, but that doesn't mean you aren't responsible for you tax return. It just means you can get compensated by the tax software company if you're being held responsible.)
The Tax Court has ruled on this issue many times, the most commonly cited case being Bunney vs Commissioner from April, 2000. Mr. Bunney had taken early distributions from his IRAs, but had not reported them on his tax return. He also claimed deductions to which he was not entitled. He was assessed the tax, the 10% early withdrawal penalty tax, plus an additional 20% negligence accuracy-related error penalty. Mr. Bunney petitioned the court for relief from the 20% negligence accuracy-related penalty because he had a "complicated return" for which he used tax software. The court ruled against Mr. Bunney stating, "Tax preparation software is only as good as the information one inputs into it."
A more recent attempt (Bulatikes vs Commissioner, May 2017) ended with the same result. Mr. Bulatikes claimed deductions to which he was not entitled. To avoid the accuracy-related penalties he blamed Turbo Tax. He received the same result as Mr. Bunney - the court upheld the finding of the IRS that the use of tax software does not provide a reasonable basis for claiming deductions to which a taxpayer is not entitled.
I think the most common software-induced error I see locally is the deduction of vehicle registration fees on the federal tax return. The IRS allows you to deduct any taxes you paid on personal property that are based on the value of the property. In some states the cost of annual vehicle registration is based on the value of the vehicle being registered - making the cost of registration deductible on your federal tax return. Virginia IS NOT one of those states. In Virginia the cost of registration is determined by vehicle class, NOT vehicle value. Therefore, the vehicle registration fee paid to Virginia is not deductible on the federal return.
Several times this past season I was confronted by taxpayers who were certain their Virginia vehicle registration fees were deductible items on their federal tax return. In each of these cases I heard the argument "Turbo Tax has let me do it for years." The implication being if Turbo Tax allows it, then it has to be correct. Not true.
Turbo Tax allows it because in some states the vehicle registration can be deducted. Virginia just isn't one of those states. It is the responsibility of the taxpayer to know whether or not the vehicle registration for their state meets the criteria for a federal deduction. A trained and experienced tax professional (such as an enrolled agent) can add significant value when you don't know all the answers yourself.
If you still want to tackle your taxes on your own, just remember - Turbo Tax made me do it will not get you off the hook with the IRS!
16 May 2017
I didn’t really “fire” the last CPA I used to prepare my taxes, but it was clear from our final conversation that he was not going to be rehired the next year. I had already determined I should be getting more for my $700 than access to someone I had to teach how to prepare my tax return.
He was a poor communicator, which made him a horrible fit for someone providing me a service. I tend to have a lot of questions about my money, and since my taxes are my money, I had a lot of questions. He didn’t want to talk to me at all. I don’t think it was just me. I don’t think he liked to see any of his clients. He had me upload my documents to a web portal early in the tax season. When I went to pick up my completed return (the first time) it was waiting for me with his receptionist. A big fat envelope with my tax return in it and the signature sheets (and my bill) stapled to the outside. The receptionist showed me where to sign and asked how I’d be paying. I wasn’t offered the opportunity to review the return. I wasn’t even offered a chair. Sign here. Pay up. Get out.
Not my style.
I opened the envelope and my eyes went straight for the bottom line. Right away I knew something was wrong. My income was similar to the previous year, but my tax bill was considerably higher. It took me about 2 minutes to find the error. I showed the receptionist, who was, of course, clueless. The CPA was too busy to see me then, so I left a note about the error and left everything with the receptionist.
He emailed me later that day to tell me the tax return was correct – that the error I found was not an error. I emailed him back a link to the IRS pub explaining the IRS rules on the matter. He waited a day and then agreed the return needed to be corrected.
A few weeks later I went back to sign the corrected return. Once again it was waiting for me with the receptionist. I checked to be sure the error was corrected. It was, and the bottom line on my tax return looked like a reasonable number. I signed the e-file authorization forms and then looked at the bill. He had added $125 for fixing the error on my tax return.
I told the receptionist there was no way in H377 I was going to pay an additional fee for finding a mistake and having it corrected. She was again clueless. The CPA was again too busy to see me. I again left a note. I took the e-file forms with me and left everything else. He e-mailed me later to say he had subtracted the extra $125 from my bill. A few days later I went back and finished the signing-and-paying procedure. The CPA’s door was open this time, so I stuck my head in to make sure he knew exactly where our client-practitioner relationship stood.
That was many years ago, but that story came back to mind recently as I was reviewing a tax return with a client. A very nice seasoned citizen, she had had her taxes prepared by a CPA firm for many years. She was looking for a change, and her financial planner recommended me. I was showing her how her adjusted gross income was calculated when she interrupted me:
Client: What you’re doing is remarkable.
Me: What’s that?
Client: Explaining my taxes to me. No one has ever done that before.
It was her use of the word remarkable that stuck in my head later. Remarkable? That indicates I was doing something out of the ordinary. A tax preparer explaining someone’s tax return to them before asking them to sign it ought to be altogether ordinary. The tax payer is responsible for the contents of the return no matter who prepared it. They need to at least be a little familiar with its contents.
I also like to review a tax return with a client because we make a formidable team when we go over a tax return together. I am an expert on taxes. You are an expert on you. Those two things merge on your tax return. Going back to my CPA story, I was able to see something was amiss with my tax return almost immediately the first time I reviewed it because I knew it was very different from my prior year return. That was knowledge the CPA lacked (although he had a copy of my prior year return).
Reviewing the return with the client also gives us the opportunity to discuss tax planning strategies for the coming year. Sometimes it even segues into a general financial planning discussion, allowing me the opportunity to recommend some additional services to the client.
Also – and I hate to admit this – clients make good proofreaders. I type thousands of social security numbers and birth dates each tax season. I have a process to catch my typos, but even so a few sneak by. I much prefer having them caught by the client when we review than to have a return bounced by the IRS because the data was entered incorrectly.
It got me wondering why a tax preparer would prefer not to review a tax return with the client. My only explanation is it’s a money issue. I read tax professional practice management articles, blogs, and forums online. Some tax pros are reporting staggeringly high numbers of tax returns completed in a season. They must forgo reviewing the return with the client in order to attain such a high volume of tax returns. That’s not how I want to operate, but if their clients are satisfied I suppose there is no harm being done.
On the other hand, the client might just find it remarkable to have their tax return explained to them.
28 April 2017
Tax Season 2017 (during which we mostly prepare tax returns for 2016) is finished. I have a few clients on extension (or as Wandering Tax Pro Robert D. Flach calls them "GDEs". - the "E" stands for extension, you can figure out the "GD" for yourself.) I also have a few clients who need to amend previous tax years, but the pace has definitely slowed.
And what a pace it was for me! Virginia Beach continues to turn out and turn up at PIM Tax Services. My client base grew dramatically from the prior year. I was grinding pretty hard for 2 months straight, and I love it! I hit quite a few of my business development milestones this year and it was very gratifying. Thank You Virginia Beach!
Last year I made a post about the most common tax errors I saw during tax prep season. I think I'll make that an annual tradition. Not because I want to make any of my clients feel ashamed for making mistakes, but I know a lot of DIYers search for help/knowledge on the internet and I don't mind letting them know what to watch out for. Just because you don't have me prepare your taxes doesn't mean I want you to overpay the government!
So without further ado - here are the top mistakes I saw during Tax Season 2017:
1. Not Treating a Rental Property as a Business. Virginia Beach is densely populated with military personnel. It’s fairly common for military members and couples to purchase a home and then receive PCS orders out of the area. For a variety of reasons many military members (and even some non-military members) decide to turn their home into a rental property. I call these “accidental” or “unintentional” landlords. They didn’t buy the house with the intention of making it a rental property, but it ended up being a rental property anyway.
The tax code is blind to your intention in this regard. The IRS does not care WHY you bought your house. The minute it becomes a rental property it is a business property, and it gets the same treatment as every other residential rental property. If the IRS is treating your property like a business, you should, too. There are significant tax advantages to doing so, and significant disadvantages for not doing so. If you don’t know what they are, then you ought to get a tax professional involved from the onset. So many people wait a few years, realize they’ve made a mess, and then come looking for help to sort it out. It’s so much easier (and cost effective) to get it right the first time.
I have written this many times, and it is still true - I have found costly mistakes on 100% of the self-prepared Schedule Es I have reviewed.
2. Not Responding Immediately to an IRS (or State) Tax Notice. The IRS scares people. There are good reasons to have a healthy respect for their authority, but some people get really rattled when they see a letter from the IRS. Sometimes they set it aside for a while, afraid to open it. Sometimes they open it, read it, and set it aside to respond to later. DON’T DO THAT! IRS notices age like bread, not wine. The longer they sit the worse they get. Not to mention independent research has shown that two-thirds of IRS notices are INCORRECT.
The IRS has a system called the Automated Under Reporting (AUR) program. The AUR system spits out IRS notices to taxpayers based on an algorithmic review of a tax return, and they are not reviewed by any person at the IRS before they are sent. Most of them are wrong, but they all have a deadline by which you must respond or further IRS action will be taken. Don’t sit on them, take action immediately.
3. Sloppy Record Keeping. I’ve written about this a few times, but it bears repeating: Tax records are for YOUR benefit. Here’s why – the courts interpret the internal revenue code to mean that ALL your income is taxable. Any adjustments, deductions, or tax credits you might receive are bestowed upon you through legislative grace. It is the taxpayer’s responsibility to prove they are entitled to any adjustment, deduction, or credit.
May people seem to believe it is the other way around – that they are entitled to claim adjustments, deductions, and credits and the IRS must prove they are not entitled to claim them. It absolutely does not work that way. If you are audited and you cannot document your qualification for a deduction or credit the IRS will disallow it and charge you additional taxes, interest, and possibly penalties. Keep good records!
4. Planning Too Late. Every year I am contacted in April and asked what can be done about reducing someone’s tax burden for the prior year. While there may be a couple of options available, the best opportunities have come and gone. You plan by looking out the windshield at where you are going, not looking in the rear view mirror at where you’ve been. If you want to do some tax planning – and I think everyone should – then call me in April about THIS year, not last year!
5. Those Damn Charity Receipts. Pardon my French, but you’ve seen them. They are everywhere. Goodwill, CHKD, DAV, Eggleston, Vietnam Veterans, etc. they all offer the same deal. You drop off items you no longer want, they hand you a blank receipt for it. Then 8 months later you hand that blank receipt to me to prove you made a charitable donation because you (rightfully) want the deduction from your taxes. The problem is I wasn’t there when you made the donation. I don’t know if you gave them one old sock or an oak bedroom suite.
YOU have to fill out the rest of that receipt. The charity you gave the items to isn’t allowed to fill it out – YOU have to do it. You have to write down what you gave them, what its value was, and how you determined that value. (hint: it’s usually “Thrift Store Value”.)
Like I wrote above – it’s up to you to prove your right to every adjustment, deduction, and credit. That extends to the charitable deduction as well. A blank receipt is not proof that you donated anything. Fill them out!
Overall I had a great tax season. PIM Tax Services continues to grow and I find it very exciting. I made a lot of new friends/clients this season and – even more fantastic – nearly all of my 2016 clients returned in 2017. I’m always looking for ways to improve and become more efficient. Helping people head off their tax issues before they come to see me is one way I hope to accomplish the delivery of affordable tax planning and preparation services to as many people as possible.
If you have any questions, please contact me.
24 January 2017
I bought a new gizmo the other day and I was hoping to find a manual in the box. I'm old school. I like a book when I can get it. The kind with pages and such. Unfortunately, those are quite rare these days and my new gizmo was no exception. There was a Quickstart Guide - that 1 or 2 page graphically intensive sheet with basic instructions on how to not break your new gizmo before you get online to find the actual documentation you need to learn how to work it.
It occurred to me taxes have become the same thing. We used to go down to the library or post office to pick up tax forms and instructions. No longer. Now all of the instruction manuals are online. The only thing missing is the Quickstart Guide. There isn't a Quickstart Guide for taxes. I started to contemplate what one might look like. Then I decide, what the heck - I'll make one. And just for fun I'll throw in my analogy about taxes being membership dues owed to Club America.
Behold, my friends - the completely unofficial federal tax Quickstart Guide. I hope you find it useful.
07 January 2017
Money is tied to most of the decisions we make in life. Where we work, if we work, which schools our children attend, the car we buy, the house we live in, how and when to retire, where we eat, what clothes we wear - money is a factor in all these decisions and many many others. Anything so intricately entwined in our lives will influence our emotions. It cannot be escaped. I don't look at this as a good or bad situation. It simply is.
On paper taxes are all about numbers. There are columns of numbers to be added and subtracted until you get to the final answer. There shouldn't be anything emotional about it. In the real world, however, there can be a tremendous amount of emotion surrounding the preparation of a tax return. These emotions are natural, but I have witnessed them influence people's behavior in a variety of ways that cost them money. I believe that's OK as long as they understand that is what they are doing. I could save money by changing the oil in my car myself, but I don't want to. That's my choice, and I know why I am making it.
Below are some of the emotions I frequently see and the results they can have that cost people money.
1. Reluctance to See a Professional Tax Preparer. Hiring a professional to prepare your taxes is going to save you time and if your tax situation is even a little complex it will likely save you money. Yet, many people are reluctant to hire a professional to prepare their taxes. I see several emotions behind this:
A. Fear of Looking Ignorant and/or Disorganized. In our society money is one way we keep score. If you have more money, you are winning the rat race. Even more valued than having lots of money is the perception of being shrewd and efficient with your money. Mr. Money Mustache has made a career out of demonstrating his ability to live well on very little money. Many people don't want to use a professional tax preparer because they fear looking ignorant and inefficient with their money. They avoid that feeling by avoiding professional tax preparers. It is probably costing them money.
B. Overconfidence. Some people find this difficult to believe, but we humans are naturally more confident than we should be. Evolution bred lack of confidence out of us long ago. Picture a nomadic tribe during a drought thousands of years ago. They have been walking for weeks looking for water. They get to the top of a hill and they see nothing but another hill on the horizon. The confident ones set out for that next hill, certain they will find water if they keep looking. The ones lacking confidence sit down and perish. We have evolved to be confident. That's why I yell instructions at the Browns' quarterback on my TV on Sundays in the fall. In my fervor I somehow believe I know more about football than someone who made it to the NFL. At tax time a lot of people think they know a lot about taxes. They are determined to prepare their own tax returns, and it is probably costing them money.
C. We're All a Bunch of Crooks. Some people had a bad experience with a tax professional in the past. Or someone they know did. Or they read about it in the paper or saw it on the news. It's a legitimate fear. There are scoundrels in every profession and tax preparation is no different. There aren't as many as you think, though, and there are easy ways to tell the good ones from the bad ones. Don't let your bias against tax professionals cost you money.
2. Immediate Gratification. Some people are just not very patient when it comes to pleasure. Getting money can be a pleasurable experience, and some people can't seem to wait a week or two to experience it. They want their refund and they want it right now! That's why refund anticipation loans (RALs) and refund anticipation checks (RACs) are so popular. They provide instant gratification to the taxpayer - you can walk out of your tax preparer's office with a check or a direct deposit to your bank account already on the way. But make no mistake, those RALs and RACs are expensive. There might be a good reason why you can't wait a week or two for your tax refund, but most of the time people are just feeling an urgency to have the pleasure of getting their refund, and it is costing them money.
3. Fear of Owing the Government at Tax Time. Behavioral economists call it loss aversion. It is the concept that losses feel about twice as bad as gains feel good. In other words, losing $100 has about the same amount of psychological impact as finding $200 - just in the opposite direction. With respect to taxes people react to loss aversion by allowing the government to withhold excessive taxes from their paychecks throughout the year so they can get a refund when they file their tax returns. There is no logical reason to do this. It is your money. A tax refund check is not a bonus from the government. They are simply returning the money they took out of your paychecks all year to cover your tax bill. If you get a refund it is because they took more than was necessary to pay your taxes and they are returning it to you. I don't think anyone would voluntarily overpay their Cox Cable or Dominion Power bills every month just so they could get some of it returned at the end of the year. Yet millions of Americans overpay their tax bill every paycheck so they can get a refund when they file their taxes, and it's because writing a check to the government feels twice as bad as getting a refund feels good. That is an emotional decision, not a logical one. If you are providing the government with an interest free loan it is costing you money.
I am not trying to convince you that we should all make the same decisions about money. Money impacts emotions and different people react differently to money situations. We all have our own comfort level. Some of us lay awake at night because we didn't do the most logical thing with our money, and some of us lay awake at night because we did. Each of us has to make decisions that leave us relaxed enough to sleep. The point of this article was to raise awareness that many people (maybe you) are making decisions regarding their taxes based on emotion, and that they might not be aware that they are. Most people would prefer to pay the absolute minimum amount of tax they are required to pay, but many people are not paying the lowest possible tax because they are unknowingly making emotional rather than logical decisions.
Like everyone, I get emotional about my money. I try to limit it, but it is unavoidable. However, if we are talking about your money I will be the calm, rational person in the discussion. If you would like a calm, rational perspective on your tax situation you should give me a call.
02 January 2017
I am not an accountant, but I will tell you without hesitation that accounting is important. If you are self-employed or starting a small business it is more than important – it is essential. You might get away with having your personal financial records in disarray, but if you are self-employed or starting a small business and you aren’t keeping your books properly you are begging for trouble.
Accounting is the language of business. It allows anyone to look at your books and understand where your business stands financially. Who might want to do this?
The bank if you need a loan.
The tax man (federal or state)
Someone thinking about buying (or buying into) your business
Anyone – like you – who is making decisions for the business
Roughly 40% of small business owners say that accounting is the worst part about running a business. You can put me in that category. I just wanted to help people with their taxes and financial planning. Keeping track of receipts for office supplies and internet service wasn’t supposed to be so darn time consuming! But I do it because it is important for PIM to succeed. More than half of small business startups in the United States fail. How many wouldn’t have if they had kept better track of their accounting?
Now that I have stressed the importance of accounting, let me take a step back and suggest something my accountant friends might find radical. (Possibly even alarming.)
Not everyone needs full strength accounting.
If you’re just starting up and/or self-employed you might not be considering a bank loan for your business. You might not be thinking about selling your business or bringing in a partner. You might just be doing your thing on the side and enjoying the extra cash flow when it happens. If this is the case, you might not need monthly/quarterly cash flow and income statements. You might not need to be able to produce a balance sheet on short notice. You might not need full strength accounting.
But you do need some accounting. You can’t escape the tax man. He will have his due. However, you may be able to satisfy him with some simple tax basis record keeping – and keep the tax man (and your tax preparer) satisfied when it is time to file (and pay) your taxes.
Tax basis record keeping is performed with the end result in mind. The end result is your tax return. You must have sufficient records to file a correct tax return. So, what does the tax man want to know?
The tax man wants to know how much you made, because that’s what you pay taxes on. Therefore, you have to have some records showing how much money you earned – how much revenue you generated. You need to keep track of the cash that is coming into your business.
Does the tax man also want to know your business expenses? Not really. Your business expenses are deducted from your revenue, and that reduces the amount the tax man can tax. The tax man is perfectly content for you to pay taxes on all of your revenue. He doesn’t care whether you have any business expenses or not – but YOU do. You need those business expenses to reduce the amount of taxes you pay.
What the tax man cares about is whether or not you can properly document your business expenses. You are allowed to take the legitimate business expenses that you can prove. Therefore, proper record keeping of expenses is in your best interests.
For many self-employed people or small startup businesses, tracking your income and expenses is all the accounting you need. You can get a fancy program or hire an accountant for that, but I’m not sure why you would. A simple spreadsheet will do, and you can get simple spreadsheets for free with a Gmail account. (Google Sheets)
It will be helpful if you group your expenses in roughly the same manner the IRS does on schedule C (lines 8-27). You’ll be glad you did when it comes time file your tax return. Don’t lose a lot of sleep trying to figure out the difference between “supplies” (line 22) and “office expenses” (line 18) (or any of the several other poorly-defined categories on schedule C). Just pick one and do your best to be consistent. You’re not going to lose an audit for calling a commission (line 10) a professional service (line 17). They all get totaled on line 28, so no matter which category you chose it’s going to end up on line 28 sooner or later. Do your best and if you have questions, call me.
Slimmed down tax basis accounting can be a time (and money) saver if you don’t need full strength accounting. Just make sure you don’t need full strength accounting before you decide to cut some corners you actually shouldn’t be cutting. If you have a capital intensive business, need to borrow to expand, have employees and payroll, or thinking about selling your business one day you are going to need a balance sheet and cash flow statements. You will need full strength accounting.
But...if you’re driving for Uber, being a weekend photographer, walking dogs in the afternoon, or baking cupcakes in your home – you can probably just use a spreadsheet to keep track of your income and business expenses with a little tax basis accounting and be fine.
08 December 2016
With the election of Donald Trump as President and the return of a Republican Congress to Washington the press is jumping with speculation about changes to U.S. tax laws. I suspect some tax law changes are coming in 2017, but I won’t try to speculate about what the final outcome is going to be. I don’t have a working crystal ball, and if I did I wouldn’t be giving away its secrets for free on the internet. As I’ve said elsewhere, if I could predict the future you probably couldn't afford me.
Instead, let’s focus on what we actually know for sure. There are some known tax changes on the way. Some are already here and some are coming. Knowing them can help you prepare your taxes this year and plan for the future. That is valuable information. Far more valuable than me guessing about what President-elect Trump is going to do.
Issues Impacting 2016 Taxes.
1. The standard deduction increased for Head of Household filers in 2016. (Everyone else stayed the same.) The 2016 standard deduction amounts are in the table below.
|Filing Status||2016 Standard Deduction (2015 value)|
|Married Filing Jointly||$12,600|
|Head of Household||$9,300 ($9,250)|
|Married Filing Separately||$6,300|
2. The personal exemption for each person claimed on your 2016 tax return increases to $4,050 (from $4,000 in 2015). This amount gets adjusted for inflation every year, and is always rounded to the nearest $50.
3. Due Diligence forms for the AOC and CTC tax credits. This is new and annoying. The American Opportunity Tax Credit (AOC) and the Child Tax Credit (CTC) are partially refundable. That means you can have a zero ($0) tax liability to the IRS and still collect a ‘refund’. Free money from the government attracts fraud, and the IRS solution is to turn tax preparers into Tax Cops. They do this by forcing tax preparers to interview tax clients and record their responses on a special form that gets submitted with your tax return. If you are eligible to receive either of these credits I will be asking you several seemingly silly questions designed to prove that your children are your children and they are really going to college as you claim. I apologize in advance – it wasn’t my idea.
4. ACA Penalty Increases. The shared responsibility payment (a.k.a Obamacare Penalty) for not having health insurance is now $695 per uninsured adult and $347.50 per uninsured child OR 2.5% of your AGI – whichever is GREATER. (I have seen predictions the ACA will be repealed, but as of this writing it remains the law of the land.)
5. HSA contribution limit increased if you have family coverage. In 2016 you can contribute up to $6,750 if you have family health insurance coverage on a high deductible health care plan (up from $6,650 in 2015). If you have individual coverage you can contribute up to $3,350 (same as 2015). HSA contribution limits include money your employer contributes as well as your own contributed money. You can contribute to your HSA up until the tax filing deadline (April 18, 2017) and still take the deduction on your 2016 tax return.
6. IRS Launches More Online Tools. The IRS is attempting to move more customer service features online to allow taxpayers to resolve tax issues without involving an actual agent. These new tools allow a taxpayer to see if they owe a balance to the IRS and integrate with existing payment options to allow taxpayers to “take care of their tax obligations in a fast and secure manner”. Given the significant difficulties the IRS has had with existing online tools, I suspect there may be some growing pains. I’ll be standing by to see if/how this works.
For Planning Purposes Going Forward.
47 provisions of the tax code will automatically expire at the end of 2016. Most of them you’ve never heard of, and will have no impact on you (unless you were looking for accelerated depreciation of your race horse, or a tax credit for mine rescue training…). There are a few, however, worth discussing.
Taxes are complicated, that’s why some tax firms charge ridiculous fees for their service. While we can’t do too much with speculation on where the tax code is going to be next year, there is a lot we can do with the hard information we have about changes that have already happened or are about to happen. As always, if you have any questions, please contact me.
22 November 2016
You borrowed $25,000, quit paying on the loan, and then the lender decides to cancel your debt. Sounds good, right? You don’t have to pay it back. Your credit score probably took a beating, but at least that creditor will quit blowing up your phone and making you dread the trip to the mailbox. This seems like a very good thing. You might even do a little happy dance.
Then in February you receive a form 1099-C in the mail. It says “Cancellation of Debt” in big letters on it. This looks suspiciously like a tax form. What does this mean? Tax forms are almost never welcome news. Did you do your happy dance too soon?
You may have. You received that form because the tax code considers cancelled debt to be income, and income is taxable. It may need to be included as income on your tax return. You might have succeeded in getting one creditor off your back, but if you can’t pay your taxes on the cancelled debt you may have only traded one creditor for another one. The most relentless and capable creditor on the planet – the IRS.
Debts for which you are personally liable (responsible) are known as recourse debts. If a recourse debt is forgiven or discharged for less than the full amount owed, the unpaid amount is considered to be income to you. That amount will be on the form 1099-C issued to you by the lender. A copy of that 1099-C also goes to the IRS, and they will be looking for you to include that amount as income when you file your next tax return.
That is...unless you qualify for one of the exceptions or exclusions.
There are certain situations in which that cancelled debt does NOT have to be included as income. If you have cancelled debt you will want to investigate these to see if you qualify for one of the exceptions or exclusions. If you do, maybe you can get your happy dance back.
Exceptions exempt you from paying taxes on the cancelled debt due to the nature of the cancelled debt. There are several exceptions, but I am only going to cover the two most common ones.
Gifts and Inheritances. You borrowed money from your parents to purchase your first home and you’ve been paying them back on terms you have agreed to. Then, at Christmas they decide to forgive the remainder of the debt as a gift to you. You do not have to include this cancelled debt as income. (It would be pretty weird if your parents issued you a 1099-C in this situation, but hopefully you get the point of the example.)
Likewise, if someone forgives your debt in their will, you don’t have to include that debt forgiveness as income.
Student Loans. Student loans issued by government and/or non-profit organizations can be forgiven if the person receiving the loan works in a specified – usually some type of public service - profession. (There are too many professions and nuances for me to list here, but Student Loan Hero does a good job of tracking them.)
If your loan and your work qualify for student loan forgiveness, you do not have to count that cancelled debt as income.
Exclusions exempt you from paying taxes on the debt because of your particular circumstances when the debt was cancelled. There are several exclusions, but I am only going to cover the top three.
Bankruptcy. If your debts were cancelled as part of a chapter 11 bankruptcy judgement, you do not have to include them as income. Your bankruptcy judgement must be final before you can claim this exclusion. The IRS does not consider matters pending before a court to be evidence of qualifying for the exclusion.
Insolvency (this is The Big One). Most people don’t just get up one morning and decide to stop paying on their debts. In most cases, they stop paying on their debts because they don’t have enough money to make the payments. In this situation, you may be what is known as insolvent. If you can prove you were insolvent immediately before the debt was cancelled, you do not have to include that debt (to the extent of your insolvency) as income on your taxes.
Of course, the IRS makes you prove you were insolvent (and the extent to which you were insolvent). You do this by filing form 982 with your tax return. On form 982 you list the assets and liabilities you had right before the debt was cancelled. You do not have to list any assets that are beyond the reach of your creditors (such as a retirement savings account) on form 982. If your liabilities exceed your assets, you are insolvent. The amount your liabilities are greater than your assets is the extent of your insolvency. Let’s look at some examples.
1. You had $10,000 of debt cancelled by the lender. Immediately prior to the cancellation of debt you had $80,000 of assets and $100,000 of liabilities. The extent of your insolvency is $20,000. The extent of your insolvency is greater than the amount of your cancelled debt, so you do not have to include any of the cancelled debt as income.
2. You had $10,000 of debt cancelled by the lender. Immediately prior to the cancellation of debt you had $80,000 of assets and $84,000 of liabilities. The extent of your insolvency is $4,000. In this case, only $4,000 of the cancelled debt can be excluded. $6,000 of the cancelled debt must be included as income.
Qualified Principle Residence. If the cancelled debt was used to purchase your main home, then it is excluded from income. The IRS defines your main home as the one in which you live the most. You can only have one main home. If you refinanced your home only the amount of the loan that covered the principal of the original loan is qualified principle residence debt. Let’s look at an example.
Your original mortgage in 2005 was $200,000. In 2008 the principal on that loan was $180,000 and you refinanced for $280,000. You used the extra $100,000 to fund your son’s college education. Only the amount of the original mortgage principal ($180,000) secured by the refinancing loan is excludable as qualified principle residence debt.
There are some additional rules on qualified principle residence debt regarding money spent to make improvements and additions to the home that I don’t want to try to explain here. I just mention them so you are aware they exist if you have mortgage debt cancelled. If that is your situation, contact me and we can dig into the details.
Having a debt cancelled can be a good first step in getting your finances reorganized. Just be aware that the lender will issue you (and the IRS) a 1099-C reporting this as income to you. If that happens, contact me and we will see if there is a way for you to legally exempt your cancelled debt from your income.
10 November 2016
I stumbled across this interesting quote while reading a recent blog post about taxes. It comes from the Tax Court Judge's opinion on a case he had decided:
Deductions and credits are a matter of legislative grace, and taxpayers must prove entitlement to the deductions and credits claimed.
I'm not altogether happy with the term legislative grace to describe tax deductions and credits. Congress writes deductions and credits into the code to encourage behaviors they have deemed beneficial. Congress wants us to buy houses, so they create a deduction for mortgage interest. Congress wants us to be educated, so they create tax credits for higher education. I'm not sure grace accurately describes that situation. But I digress...
The real point the judge is making is that taxpayers aren't entitled to claim a deduction or credit just because they exist. You have to qualify for them; and, if asked, you have to provide evidence that you qualified for the ones you have claimed. If you can't provide such eveidence, then your right to the deduction or credit does not exist.
A paper trail is almost always the best. Receipts, invoices, financial statements, proper bookkeeping, and journal (or log) entries make very compelling arguments in favor of your right to claim the deduction or credit. It may seem bothersome to keep track of and keep up with these things, but not nearly so bothersome as getting your tax deduction revoked by the IRS and getting a bigger tax bill (with penalties and interest).
How you retain and organize your document trail is up to you. The IRS does not dictate any specific record keeping system. (They have been known to accept notes written on a paper plate!) However, good record keeping can save you (and me) a lot of headaches at tax time. Accordion files are inexpensive and you can even get them with tabs to help you sort your documents. Get one and start saving your tax documents in it. If you're not sure whether or not to save a document, save it. It is much easier to throw away documents that aren't needed than it is to locate a copy of something you've thrown away.
If you're handy with technology you might consider going paperless. You can scan in your receipts and other documents and save them digitally. Just be sure to use a logical file naming method. DSC2016-0798.jpg isn't a very helpful file name to describe a hotel receipt. It would take quite a while to find that hotel receipt mixed in with a bunch of other files named DSC2016-XXXX.jpg. You should also maintain different file folders to sort your receipts by the tax category they fall under, and then keep those tax category folders within another folder for each tax year.
There are also computer programs and apps for smart phones that can help you store, organize and keep track of your tax documents. It doesn't really matter how you do it - it just matters that you do it.
So, keep good records. If you still don't know what that means, or how to do it, come see me. I will get you squared away.
Nerdy Tax History Stuff
It is sometimes possible to claim deductions without a paper trail. It's known as the Cohan Rule, named after the composer, playwright, and Broadway producer George M. Cohan. (That's a picture of his statue in Times Square.) Mr. Cohan had a lot of business-related expenses. As a Broadway big shot he traveled frequently and had to wine and dine lots of folks for business purposes. He claimed these as legitimate business expenses on his income tax return. He wasn't very good at keeping records, though. When the IRS asked to see proof of his business expenses he could not produce any. The IRS agreed that such expenses were legitimate in Mr. Cohan's business, but since he couldn't prove when or how much he had spent on travel and entertainment for clients the IRS revoked ALL of his unsubstantiated business deductions.
Mr. Cohan disagreed with the disallowance of all his business expenses for which he could not prove an exact amount, and took the IRS to court. The U.S. Circuit Court of Appeals agreed with Mr. Cohan. Judge Learned Hand (possibly the best-named judge in US History) wrote in his opinion:
...there was basis for some allowance, and it was wrong to refuse any, even though it were the travelling expenses of a single trip. It is not fatal that the result will inevitably be speculative; many important decisions must be such...
Today the Cohan Rule can be applied as justification for deducting some business expenses for which there is no paper trail so long as the expenses are reasonable and credible. But if you find yourself trying to use the Cohan Rule to defend some of your deductions, you probably need a lawyer, not an Enrolled Agent. Keeping good records is so much cheaper!
Paul D. Allen is a proud member of the National Association of Enrolled Agents, the National Association of Tax Professionals the Financial Planning Association of Hampton Roads, the National Association of Personal Financial Advisors (NAPFA), and The Tidewater Real Estate Investors Group. You can read more about Paul's background here.
Bought some software and then started having second thoughts? Stuck on a particular issue? Give me a call and ask about a consultation. I might be able to get you back on the path to finishing your own return.