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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!
25 October 2016
I was contacted by a couple of clients yesterday who had suffered losses at the hands of Hurricane Matthew. One was particularly impacted. Her home was flooded and she and her children are currently displaced. Her insurance is not covering all her expenses. She is thankful no one was hurt when they evacuated their flooded home, but she is dealing with the added expense of a hotel room (that accepts pets), the expense and stress of arranging repairs to her home, replacing her damaged furniture and appliances, and working full time through all this to stay financially afloat. She was exhausted and I could hear her frayed nerves in her voice. She wanted to know if there is something that might help her financially. Something, perhaps, in the tax code.
Casualty losses due to flooding (and other natural disasters) can be deducted from your taxable income, lowering your tax bill, and/or increasing your refund. This is accomplished when you file your return, which I explain in greater detail later.
I wrote two versions of this article. One for the folks like my client who are dealing with a lot of [poop] right now, and don’t have time to digest a long tax article. For them I present the “Bottom Line Up Front”. Two paragraphs on what to do right now so that you have the documentation available at tax time to claim your casualty loss deduction.
For those with more time and interest I wrote “The Long Version”. I hope you find one or the other (or both) helpful.
If Matthew tore up your home and you’re displaced to a hotel or a friend’s house, here’s what you should do:
1. Keep all your paperwork. Every estimate, every insurance notice, every invoice, every receipt. Keep it all. Put it in a folder and bring it with you when we prepare your taxes in the spring. Don’t worry about whether you should save something or how to sort it. You have too many other urgent things going on right now, so just put it in a folder and bring it to me. I’ll go through it. I know what I’m looking for.
2. Take pictures. Most of us have a camera on our phone. Use it. Take pictures of all the damage and keep them. Download them to a folder on your computer. I’ll explain how to get them to me later when we prepare your taxes. They will become part of your tax record for 2016. We want to do this for two reasons: 1) my objective eyes might see something in them that you don’t, and 2) if the IRS wants proof you suffered casualty losses, pictures are a great tool to satisfy them.
Just do those two things for now, then focus on the other more urgent things. We’ll sort you out at tax time.
Hurricane Matthew came and went a few weekends ago, but many of us are still cleaning up and restoring our lives. Tade and I suffered little. Our daughter spent Saturday night in her old room because she lost power at her apartment. We woke up Sunday to find the electricity had been off briefly during the night (the flashing digital clocks always let us know) and the cable was out. There were a few branches down and the neighbor’s shutter was on our lawn, but that was about it. We missed a little football, but were otherwise no worse for the wear.
I have several friends and clients who suffered property damage. Something few of them knew before talking to me is that you can deduct casualty losses (for which you are not compensated by insurance) on your tax return. It doesn’t make up for all your losses, but it can help take some of the sting out of your tax bill, or increase your refund.
The biggest bummer about this tax deduction is that it must exceed 10% of your adjusted gross income before it starts to count. That’s a big hurdle to get over, but don’t let it dissuade you from claiming it. I have clients who suffered significant property damage in 2015. Deducting it from their taxes increased their 2015 tax refund by about $14,000. Not everyone can expect such dramatic results, but I mention it to highlight this is not a tax benefit you should ignore.
How it works
Casualty (and theft) losses are itemized deductions on Schedule A of the Form 1040 – meaning you have to itemize your tax deductions in order to claim it. If you take the standard deduction you can’t claim the casualty losses. It is legal to claim your deductions any way you want to, so (as always) we want to file your tax return in the manner that is LAMA (legal and most advantageous) to you.
You also need to claim this in the year that it happened. Matthew came through in 2016, so you need to claim any casualty losses from Matthew on your 2016 tax return. There are some provisions in the law to enable taxpayers to claim the damages on a prior year return, but Matthew happened late in 2016, so claiming casualty losses associated with Matthew are best handled on the 2016 tax return. There is no provision in the law to delay claiming the losses until you file your 2017 taxes.
There is a heavy paperwork lift to claiming this deduction correctly. The IRS wants to know:
a. How much you paid for your damaged property
b. Insurance reimbursements received for the damages
c. The Fair Market Value of the property before it was damaged
d. The Fair Market Value of the property after it was damaged (Salvage value)
I bet if you’re reading this because you had casualty losses that list just pushed your frustration level up a couple of notches. Again, don’t let it dissuade you. It’s not as hard as it looks. Take a couple of deep breaths and keep reading.
Of course you don’t remember how much you paid for each item in your home. Nobody does. That line is really there for any personal property you have that might have appreciated (increased) in value since it was purchased. For most people this would only be their house – and you probably remember what you paid for your house. (If you don’t you can easily find out). Nearly all other personal property (furniture, cars, clothes, etc.) depreciates (decreases) in value from the time it is purchased. For those items, a reasonable estimate of the purchase price will suffice.
If you were reimbursed by insurance there should be a statement from the insurance breaking down the reimbursable items. Typically, however, there are only two categories: the house and the contents. Nearly all of us have the contents of our houses listed as “unscheduled property” with our insurance companies. That means we haven’t listed each individual item with the insurance company, but instead we accept a flat rate (usually 10% of the house’s replacement value) as the insured value of all the contents of the house. It’s easier than updating your insurance policy every time you buy a chair, but the downside is that you can easily have losses exceeding the insured value of your home’s contents.
Knowing the Fair Market Value of your property is also something that few people can easily do. Unfortunately, this is where we are going to need to spend some time to get it right because this is the amount you can deduct from your taxes (after adjusting for salvage value, see below). Fair Market Value is NOT replacement cost. The Fair Market Value is the price you could have sold the property for the day before it was damaged.
The IRS uses the following example in their guide:
You bought a new chair 4 years ago for $300. In April, a fire destroyed the chair. You estimate that it would cost $500 to replace it. If you had sold the chair before the fire, you estimate that you could have received only $100 for it because it was 4 years old. The chair wasn't insured. Your loss is $100, the FMV of the chair before the fire.
Fair Market Value after the property was damaged is also known as “salvage value”. If your property was ruined after Matthew and you have it hauled off to the landfill, then its salvage value is $0. However, if it was damaged, but still usable, then it has some salvage value. You have to estimate this if you keep the item, or keep track of what you sold the item for if you sell it. If you donate the item to a charity, the salvage value is the same as the amount you claim as a deduction for the charitable donation.
We use all of the above numbers to figure out your actual losses. Then, strangely, we subtract $100 from it. It’s like the IRS has a $100 deductible. Then we subtract 10% of your adjusted gross income, and you can deduct the remainder from your taxes. If you had large casualty losses relative to your income for the year it can make a big difference to your tax bill.
Losses from a casualty can be devastating both emotionally and financially. Some things have more sentimental value than cash value, and might be irreplaceable. I hope this didn’t happen to you, but if it did, I hope you at least found a few answers in this article that help put your mind at ease.
I covered a lot of information in this post. There is a lot more to claiming casualty losses that I left uncovered. If you have questions, please contact me.
21 October 2016
Criticizing the IRS is an American pastime. Most of us do it at least a little. Some of us do it a lot. How awesome would it be to get paid to criticize the IRS? To actually look at how the IRS does business and tell them how they are getting it wrong. There is someone who has this great gig, and her name is Nina Olson. She is the National Taxpayer Advocate. Not only does she get paid to provide feedback to the IRS on how they can improve service to taxpayers, but she has an army of 2,000 tax professionals to help her do it!
The Office of the Taxpayer Advocate, more commonly known as the Taxpayer Advocate Service (TAS), was created in 1996. It is an independent office within the Internal Revenue Service with two Congressionally mandated functions. 1) Provide help to individual taxpayers in dealing with the IRS, and 2) Provide systemic help to the IRS to improve service to taxpayers.
If you are having significant issues in dealing with the IRS to resolve a tax problem, you may be able to get help from the Taxpayer Advocate Service. They have offices in all 50 states, DC, and Puerto Rico. If the TAS takes your case, you are assigned a specific representative who will personally work with you until a solution to your issue is found.
Just keep in mind the Taxpayer Advocate Service isn’t there to answer every tax question you might have. They are there to assist taxpayers who are experiencing abnormal difficulties. Cases the TAS will accept fall into four general categories:
1. Where a taxpayer is experiencing some financial difficulty, emergency, or hardship, and the IRS needs to move much faster than it usually does (or even can) under its normal procedures. In those cases, time is of the essence. If the IRS doesn't act quickly (for example, to remove a levy or release a lien), the taxpayer will experience even more financial harm.
2. Where many different IRS units and steps are involved, and the case needs a "coordinator" or "traffic cop" to make sure everyone does their part. TAS plays that role.
3. Where the taxpayer has tried to resolve a problem through normal IRS channels but those channels have broken down.
4. Where the taxpayer is presenting unique facts or issues (including legal issues), and the IRS is applying a "one size fits all" approach, isn’t listening to the taxpayer, or doesn’t recognize that it needs new guidance for those circumstances.
In their role of providing direct support to taxpayers the TAS is in a unique position to gather data on the most common issues causing taxpayer distress. These are the issues that may indicate a systemic problem in the IRS and the National Taxpayer Advocate is required to address these issues in an annual report to Congress.
In the 2015 Annual Report to Congress the National Taxpayer Advocate highlighted 24 serious problems at the IRS. Below are some of the comments Ms. Olson made about the IRS to Congress:
• TAXPAYER SERVICE: the IRS has developed a comprehensive “Future State” plan that aims to transform the way it interacts with taxpayers, but its plan may leave critical taxpayer needs and preferences unmet.
• IRS USER FEES: the IRS may adopt user fees to fill funding gaps without fully considering taxpayer burden and the impact on voluntary compliance.
• REVENUE PROTECTION: hundreds of thousands of taxpayers file legitimate tax returns that are incorrectly flagged and experience substantial delays in receiving their refunds because of an increasing rate of “false positives” within the IRS’s pre-refund wage verification program.
• PREPARER ACCESS TO ONLINE ACCOUNTS: granting un-credentialed preparers access to an online taxpayer account system could create security risks and harm taxpayers [Paul’s Note: Seems like a great reason to make sure you’re hiring an Enrolled Agent to prepare your taxes!]
• AFFORDABLE CARE ACT (ACA): the IRS is compromising taxpayer rights as it continues to administer the premium tax credit and individual shared responsibility payment provisions.
• IDENTITY THEFT (IDT): the IRS’s procedures for assisting victims of IDT, while improved, still impose excessive burden and delay refunds for too long.
Of course, not all systemic failures are the IRS’s fault. They don’t write the tax laws; they just implement them. Assisting thousands of taxpayers each year will sometimes uncover problems, discrepancies, or inconsistencies in the underlying tax law. So, in addition to telling the IRS how to get better, the National Taxpayer Advocate gets to tell Congress how they screwed up the tax law. The 2015 Annual Report to Congress contains 15 recommendations to Congress on how to fix the tax laws to protect taxpayer rights, reduce taxpayer burdens, minimize IRS waste, and improve the Whistleblower program to enhance compliance.
I think I would thoroughly enjoy a job where I got paid to tell Congress and the IRS how they are messing up. Especially when I am learning how they are messing up by helping individual taxpayers get their tax issues resolved - which is something I already enjoy doing.
If you think you might qualify for assistance from the Taxpayer Advocate Service, get in touch with them. It is your right as a taxpayer. Just remember that you need to exhaust all ordinary means of resolving your situation first (unless you are about to suffer grievous financial damage at the hands of the IRS – then you get head-of-the-line privileges).
If you are having an issue with the IRS (or a state taxing authority) you can give me a call and I will help you get it resolved. Don’t delay. The IRS starts a timer as soon as they send you that letter, so the sooner we get to work your problem, the better. In fact, being ahead of the IRS timelines can help to put us in an advantageous position with respect to getting a favorable outcome to your issue.
08 October 2016
Readers shouldbe aware the tax law signed by the President on 22 December 2017 dramatically changed the applicability of this article. Most of these rules have changed or are obsolete. I have decided to leave it here for consistency and posterity.
One remarkable side effect from being a tax preparer is that it has enhanced my opinion of my fellow citizens. I used to feel like I was one of the few people left in America who wasn't lying on his tax return. Preparing taxes for other people has shown me that my previous suspicions about the rest of you weren't true. In my experience the great majority of taxpayers are honest. They are not trying to cheat on their taxes. They want to take all of the deductions to which they are entitled, and they don’t want to try to get away with claiming deductions for things they are not qualified to claim.
That observation leads me to believe the rules for deducting work-related clothing are misunderstood. Or, perhaps, do-it-yourself software doesn’t do a very good job of helping people through the process of claiming that particular deduction. Perhaps it is a combination of those two things. Either way, I review several tax returns every year that get this deduction wrong. The taxpayer didn’t claim the clothing deduction when they were qualified to do so. Or, the taxpayer deducted clothing expenses that don’t meet the IRS standard for being work-related. I will try to clarify.
The tax code allows self-employed taxpayers to deduct expenses related to their business. Similarly, taxpayers who are employees can deduct the business-related expenses of being an employee. Therefore, work-related clothing can be deducted by taxpayers regardless of whether they are self-employed or employees.
The IRS has a standard definition for work-related clothing. In order for an article of clothing to be work-related it must meet two tests:
1. It must be required by your employer.
2. It must not be suitable for use outside your place of work.
BOTH of these must be true in order for the clothing to be deductible. Let's look at each in greater detail.
This is an easy test to meet if you are self-employed. You are your employer and you wear what you require. If you are an employee it can be a little less straight forward, but is usually easy to determine. Perhaps you work in a restaurant and your manager requires khaki pants and a blue polo shirt. Perhaps you work as a mechanic and the manager requires you to wear a blue shirt with your name patch sewn on it. Perhaps you are in the military and you have uniforms to wear. These are all situations in which your employer required you to purchase and wear particular clothes for work.
I think this is the part that is misunderstood. If the clothing is suitable for use outside of work it is NOT work-related clothing - even if your employer required you to have it. Khaki pants and a blue polo shirt are suitable for wear outside of work. It doesn’t matter if you don’t wear them outside of work. It doesn’t matter if you would not be caught dead out in public in khaki pants and a blue polo shirt. They are considered suitable for use outside of work, and therefore NOT deductible as work-related clothing.
Many military uniforms are also considered suitable for use outside of work. If you can wear it off base it is not deductible as work-related clothing.
Of my previous examples, that leaves the mechanic with the blue shirt and name patch. This clothing is not suitable for use outside the place of work. People don’t typically walk around in public sporting their name and the company logo on their clothing. If the mechanic paid for these items himself, the shirt, the name patch, and the tailoring to attach the name patch to the shirt would all be deductible as work-related expenses by this employee.
I will often see people take a large deduction for clothing when they start a business or a new job. “I needed a new wardrobe,” they will tell me, “I am in sales. I see clients, it is essential to my job that I look professional.” "I only bought these clothes because of the new job."
I believe them, and I understand. I see clients. I try to look presentable. I spend money on suits, shirts, sport coats, and ties that I only wear at work. This does not make them deductible. It is clothing that is suitable to be worn outside of my work, and is therefore not deductible as work-related clothing on my tax return. Your new clothes, even though you bought them because of your job, are not work-related if they can be worn outside work.
When I was a young sailor we had uniforms that could not be worn off base.* There seem to be fewer of those today, but they still exist. Those uniforms would be deductible as work-related employee expenses, but only to the extent that you paid for them out of pocket IN EXCESS OF your annual uniform allowance.
Additionally, there are certain ceremonial items required by some military personnel that are not regular uniform items. Things like an officer’s sword or a flag-aide’s epaulets. These items are also deductible if they exceed your annual uniform allowance.
If you have qualifying work-related clothing you should be deducting it from your taxes. Just make sure that it meets the IRS definition of work-related. If it doesn’t your deduction will not hold up in an audit, and you’ll owe penalties and interest on top of the additional taxes. If you have questions or concerns about work-related deductions, please contact me.
*A short sea story: When I was a junior sailor we still wore the dungaree working uniform. It was not to be worn off base. The rule was you could drive to and from work wearing your dungarees as long as you did not get out of your car between home and work. I observed this rule stridently... except once. I lived about 40 miles from the base and stopped at a gas station near my home. I was low on gas and figured I could just pump the gas quickly, jump back in my car, and not have to go back out later. Standing there pumping the gas a car pulled up on the other side of the pumps. I could see that two-starred fouled anchor on his combination cover from a mile away. The Master Chief stepped out, gave me the stank eye, and asked which command I worked for. I told him, of course, then got in my car and drove off. I never heard anything else about it, but I also never stopped anywhere in that uniform ever again!
15 September 2016
My daughter, a senior in college, recently asked me a reasonable question about whether or not printer cartridges were eligible expenses under the 529 program. This led to a broader discussion of the process I use to keep track of her qualified higher education expenses and their corresponding tax breaks. It occurred to me that might be good information for other taxpayers to have as well. I’ll use our specific situation to illustrate my method, but with generic numbers.
The big picture is that I have to keep track of three things with respect to my daughter’s college:
1. Tax Break 1 - Daughter qualifies for the American Opportunity Tax Credit (AOC).
2. Tax Break 2 - We have money in a Virginia 529 account that remains tax free as long as it is used for her education.
3. Expenses - Tracking qualified higher education expenses (QHEE) and matching them with the correct tax break of the two listed above.
There are a lot of different expenses when it comes to college. It should come as no surprise the IRS has rules regarding the expenses you can use to get tax breaks for education. They refer to them as qualified higher education expenses (QHEE), meaning they qualify for the tax break. What might come as a surprise is the rules are not the same for the two tax breaks that concern me most (AOC and 529). The list of qualified higher education expenses for the AOC is more restrictive than the list of QHEE for the 529 plan. (You can’t really blame the IRS for that. Congress legislates this stuff.)
The chart below lists the most common higher education expenses and whether or not they are qualified for the AOC and/or the 529 plan. (Costs to commute to and from campus and parking permits are not qualified under either tax break, but I included them because I often get asked about the eligibility of those two expenses.)
Like most taxpayers, the AOC is more valuable to us than the 529 tax break. Therefore, I am careful to make sure the AOC is accounted for first. In our situation this is not a problem because my daughter is a full-time student at a four-year university. Tuition each year is over $9,000. Tuition is also a QHEE for the AOC.
The maximum amount of QHEE needed to get maximum benefit from the AOC is $4,000. (At $4,000 the AOC is 'maxed out'.) Therefore, I count the first $4,000 of tuition against the AOC and that valuable tax credit is taken care of.
Remember: Double-dipping is not allowed. I can’t claim all $9,000 of the tuition against the 529 money and then also claim $4,000 of it for the AOC. That would be claiming the same expense against two different tax breaks, and it is not allowed. That $4,000 of tuition money that gives us the maximum AOC benefit must come from some place other than the 529 account.
This is where it gets a little tricky. We have non-qualified money in a savings account that is used to fund the college expenses, which is then reimbursed from the 529 plan money. Tuition gets paid right before the start of each semester. Other QHEE for books, room & board, etc. get paid throughout the semester. At the end of the semester I pull money out of the 529 account to reimburse the savings account for all of the expenses EXCEPT for the first $4,000 of tuition, which is reserved to qualify for the AOC. I made a graphic to help explain my method.
The graphic is essentially 3 stacked timelines showing the order of the money flow over the course of a calendar (tax) year from the 529 account to the savings account to the expenses associated with college. Reading from left to right, tuition and other expenses get paid from the savings account and then at the end of the semester the savings account gets reimbursed from the 529 plan.
While the tuition gets paid in a lump sum just before the start of each semester the “Other QHEE” is a number of payments throughout the semester. My daughter has elected to live off campus, so she pays rent and utilities and buys groceries. She can claim all of these as QHEE (against 529 money) as long as the total does not exceed what the university would have charged for on-campus room and board. She has a roommate, so this has never been an issue. If she were living a lavish lifestyle in a penthouse condo and her actual expenses exceeded what the university charges for room and board, her QHEE (for room and board) would be limited to the amount the university charges.
There are other ways to manage this process, but this works for me. I can be sure I will not take too much from the 529 account because I already know what the expenses were for the previous semester. I protect the AOC in the spring by withdrawing $4,000 less from the 529 than the actual qualified expenses were for the spring. That ensures I used non-qualified money for $4,000 of the tuition, which means I can apply that toward the AOC when I am filing tax returns the next year.
We are fortunate to be able to pay out-of-pocket each semester and reimburse ourselves from the 529 plan. (Fortunate because we made a plan and nothing derailed that plan.) We started saving for our children’s education when they were very young. Daughter did her first two years of school at the local community college and then transferred to the university, significantly reducing the overall bill for a bachelor’s degree. She has also worked full time during her schooling and contributes financially to her own education. I’ll be there when she graduates from the Strome College of Business at Old Dominion University next spring. I’ll be the one beaming.
This is a complex issue, which is probably why I write so often about 529 plans. If you have questions about the American Opportunity Tax Credit, qualified higher education expenses, your 529 plan, or any other tax breaks for college, please contact me.
30 August 2016
I do free reviews of individual income tax returns. Two couples took me up on this last week, and my perfect record remains intact. When it comes to rental properties I have found amendable errors on 100% of the tax returns I have reviewed. (It's baseball season, so I guess we should say I am batting 1,000 at finding mistakes on Schedule E.)
These couples didn't know each other (still don't), but there were some unusual similarities in their tax returns. Both involved residential rental properties. Both of their tax returns had the same, somewhat uncommon error, that I don’t see too often. And, this error was costing both of these hard working, tax paying couples some money.
Their mistake? Both of them were deducting the mortgage interest for the rental property on schedule A (as an itemized deduction) instead of schedule E (as a deductible expense of the rental business).
Can’t You Just Deduct Rental Property Mortgage Interest on Schedule A?
The short answer to this question is “no”. In order to deduct mortgage interest on Schedule A the mortgaged property must be a qualifying main home or second home. The IRS defines these terms on page 4 of Pub 936.
Main home. You can have only one main home at any one time. This is the home where you ordinarily live most of the time.
Second home. A second home is a home that you choose to treat as your second home.
Second home not rented out. If you have a second home that you do not hold out for rent or resale to others at any time during the year, you can treat it as a qualified home. You do not have to use the home during the year.
Second home rented out. If you have a second home and rent it out part of the year, you also must use it as a home during the year for it to be a qualified home. You must use this home more than 14 days or more than 10% of the number of days during the year that the home is rented at a fair rental, whichever is longer. If you do not use the home long enough, it is considered rental property and not a second home. [emphasis mine]
Essentially, unless you are also using the rented home for personal use, it is not a qualified home, and you cannot deduct the mortgage interest for it on schedule A. But, that’s OK, because it may be more advantageous to you to deduct it on schedule E anyway.
Why is it Usually More Advantageous to Deduct the Mortgage Interest on Schedule E?
The short answer is because deducting the mortgage interest on schedule E lowers your adjusted gross income (AGI). For tax purposes it is usually better to have a lower AGI than it is to have higher itemized deductions on Schedule A.
Married couples filing jointly start to lose significant tax benefits when their (modified) adjusted gross income gets over $100,000. (Taxpayers with different filing statuses lose these tax benefits at different thresholds.) Of note, the Child Tax Credit and Lifetime Learning Credit start to phase out at $110,000, the Student Loan Interest Deduction starts to phase out at $130,000, and the American Opportunity credit starts to phase out at $160,000.
If your income falls into that range, then you want to lower your adjusted gross income to qualify for as many (and as much) of these tax benefits as possible. If you claim the mortgage interest deduction for your rental property on Schedule A it comes off your taxes well after your AGI has been calculated. If you deduct it as an expense on schedule E, then it lowers your AGI, and can increase the value of the tax benefits listed above.
That is exactly the case for the two clients I saw last week. One client was able to get a larger Child Tax Credit once we moved the mortgage interest deduction from Schedule A to Schedule E, netting over $300 of additional tax refund. The other client was able to get maximum value for the American Opportunity Credit, which netted them about $425 in additional tax refunds.
What If Your Rental Property IS a Qualified Home?
If you used your rental property during the year and it is a qualified home, it might be more advantageous to deduct the mortgage interest on Schedule A. This would only be if all of the following are true:
a. You don’t qualify for any of the previously mentioned tax credits
b. The rental property is losing money (after depreciation)
c. You make too much to deduct passive (i.e. rental) losses (AGI of about $150,000 for MFJ couples)
That’s a narrowly defined set of criteria, but there are taxpayers in that situation. If that is your situation, then you may want to deduct the mortgage interest for the rental property on Schedule A so you can get some tax benefit for it in the current year.
Taxes are complex, and I have just hit the high points on this topic. There are quite a few variables, and each situation is unique. It might be worth your while to have a tax professional give you a hand. I review tax returns for free, so if you’d like me to take a look at yours, just give me a call to set up a time.
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.