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If you have a question or comment, please drop me a line. Paul @ PIM Tax.
01 April 2016
Tax Preparation is an oxymoron. In the English language the word prepare means to make yourself ready for something you will be doing in the future; to get ready for upcoming events. Tax return preparation is about what happened last year. When we generate the return we are looking backward, not forward. Even though I think it should, tax preparation usually has nothing to do with getting ready for upcoming events.
A better description for generating a tax return would be tax reconciliation. You are comparing what you paid in taxes for the previous year to what your final tax bill actually was, and then you reconcile the difference. If you paid too much you get a refund. If you did not pay enough, you owe.
I don’t want to make too big a deal of this. Fussing about the language is like howling at the moon. I am known as a tax preparer, and most people understand that to mean I assist with the reconciliation of last year’s taxes, generate the tax returns, and get them filed with the appropriate federal, state, and local authorities. All of that is true, and I see no reason to go on a crusade to try to change what it is called. My inner Sheldon finds it curious, though, and I would stress that one of the primary advantages of hiring a professional tax preparer over do-it-yourself tax preparation software is that a professional tax preparer can, in fact, help you prepare for the future.
I would like to dispel a different tax myth, however, and that is the myth that all tax preparers are also accountants. Some are, but many are not. I, for example, am not an accountant.
The opposite is also true – not all accountants are tax preparers. Many accountants are, but not all. I have a client who is an accountant. He works in the accounting department of a large corporation. He seems sharp and I suspect he is good at his job, but he doesn’t know individual income tax law, so he hires me because I do.
It’s rarely a problem being confused with an accountant, but from time to time I will get a call from a potential client who does not understand there is a difference between accounting and tax preparation. They assume that since I do one, I must do the other. I think the easiest way to explain the difference is this:
An accountant tracks and assesses your financial situation. They keep track of income and expenses, assets, debts, and equity. They can tell you your financial status at any time, to include the end of the tax year. (Accountants do much more than this, but I think my brief description will suffice for this article. My apologies to any accountants who disagree!)
A tax preparer applies your financial situation (your annual income, expenses, etc.) to the tax law to reconcile your taxes in the manner that is both legal and most advantageous to you. A true tax professional, such as an Enrolled Agent, can also provide you with tax advice so you can actually prepare for taxes in future years.
In short, accounting gets you ready for the preparation of your tax return.
The vast majority of my clients are essentially their own accountant. They keep track of their finances and bring me the results from the previous year so that I can apply them to the tax laws and generate their tax return.
A few, usually with a rental property or a home business, will bring me a box (or an accordion file) of receipts that need to be sorted and totaled before I can begin generating the tax return. This is an accounting function, not tax preparation.If they bring me a lot of receipts this can be quite time-consuming, so I charge a bookkeeping fee to compensate me for the time. (I call it a bookkeeping fee to distinguish the fact that I am not an accountant.) My bookkeeping fees (currently $120/hour) are quite reasonable when compared to the fees most actual accountants charge for a similar service, but can add quite a bit to the cost of tax preparation for a client.
An easy way to avoid paying me (or another tax preparer) bookkeeping fees is to sort and total your receipts prior to engaging me as your tax preparer. I encourage all part-time landlords and small/home business owners to do this.* I have some helpful guides available for download if you need assistance with understanding the categories of business and/or rental expenses the IRS wants you to track. Or you can always call or visit my office and ask. There’s no charge for helping you get prepared for your tax appointment.
Don’t sweat the small stuff. I don’t look for excuses to charge for bookkeeping. You don’t have to build a master spreadsheet to total a handful of charity receipts or two semesters of college books. It only takes me a few minutes to add those up and put them on a tax return. I consider that just part of the tax prep fee. I like to think I apply common sense to when and where I charge for bookkeeping. I also never surprise people with bookkeeping fees. If I don’t mention it when I give you a price quote, there won’t be a charge for it.
Most people want to keep their tax preparation fees as low as possible, and I completely understand that. I’ve said for a long time I think most tax preparation fees are ridiculous. I don’t charge for bookkeeping to drive up my fees. I charge for bookkeeping because the time I spend doing it cuts into the time I have available to assist others with reconciling last year’s taxes or preparing for next year’s taxes – my primary service area.
If you have any questions about tax preparation or bookkeeping, please contact me.
*If your business is an S corporation or a C corporation, you should probably consider using an actual accountant. The complexity of those entities typically makes hiring a professional accountant a bargain.
26 March 2016
As big a fan as I am of the Virginia 529 plans, I think I am an even bigger fan of TSP. TSP is the Thrift Savings Plan, the federal government’s version of a 401(K) style retirement plan. It is open to all federal civilian employees as well as military personnel.
Here is my simple piece of advice regarding TSP – use it!
I was born a skeptic, and then I worked for the government for almost 3 decades. That time was full of disappointment about the systemic waste and mismanagement I witnessed on a daily basis. When I first heard the government had implemented a 401(K) style retirement program my first thought was I wonder how screwed up that’s gonna be.
To my extreme delight I discovered it was not screwed up at all. It’s very very good. In fact, for accumulation purposes it is quite likely the best employer-sponsored defined contribution retirement plan in America. If you are eligible to participate in TSP, but not participating, you are making a mistake.
Super Low Costs. Retirement plans traditionally invest in funds, and the funds charge a management fee. The management fees in the TSP plan are the lowest I have ever found; 0.029% as of this writing. The cheapest management fee in a fund my wife, Tade, can buy through her employer-sponsored retirement plan is 0.50%. These may seem like small numbers, but they are not. Over time they really add up. But even just at face value Tade is paying more than 17 times the management fees for her fund than a TSP participant pays – and that’s for the cheapest fund available to her!
Simple Selections. Studies have shown that the more fund choices an employer puts in the retirement plan offered to employees, the lower the plan participation rates. Employees experience choice overload, and some respond by not participating in the plan. Others respond by making selections of the easiest and safest sounding funds – which may not be the best choice for them based on their individual situation. TSP keeps it simple – there are 5 funds from which to choose. If you still can’t decide what to do, TSP will set up a life-cycle fund for you. All you do is select your retirement year and they choose the funds for you and change them over time as your retirement date gets closer. Very, very simple.
The G Fund. Would you like a guarantee that you’ll never lose money on your investment? If so, then the G-Fund might be for you. The G Fund invests in US Government Bonds, but with a twist. While government bonds can decrease in value, the G Fund comes with a guarantee that it will never be worth less than you put in it. In the current low interest rate environment government bonds aren’t paying very much, but that guarantee to never lose money makes the G Fund worth a second look if you need stability in your retirement portfolio.
TSP comes in two flavors – Traditional and Roth. Just like IRAs of the same flavors, the difference between the two is the timing of the taxes you pay to participate. With Traditional TSP you get a current year deduction, but you pay the taxes later when you withdraw the money in retirement. With Roth TSP you pay the taxes now, but future retirement withdrawals are tax free.
If you are under age 59 ½ and considering a TSP withdrawal for anything other than your retirement, please contact me first. There are a lot of rules about early withdrawals, the circumstances surrounding them, and the tax penalties that might result. Talk to me first before you make an early withdrawal. I prepare taxes for several clients each year who wish they had!
Combat Pay and TSP
If you are in the military and deployed to a tax-free combat zone for part of the year, there are some special rules you should be aware of.
If there's one area in which I think TSP could get better it's in the area of distributions. TSP isn't as flexible as some other plans. You can set up periodic withdrawals, or you can take a lump sum, but you can't do both. For most people these options will probably work out just fine, but if you want maximum flexibility to do something spontaneous like travel whenever you want you can't just make a withdrawal from your TSP account to do it. If you need that kind of flexibility you might want to roll your TSP account assets out to an IRA when you retire.
TSP is a fantastic retirement plan for many reasons. There are also many tax breaks, tips, and tricks associated with TSP that can help you out in different situations. If you want to know more about your TSP and taxes, contact me.
16 March 2016
I am big fan of the Virginia 529 program. It offers a lot of flexibility and a variety of opportunities to get tax breaks to save for higher education. Unfortunately, it also offers a lot of opportunities to screw up when you are taking the money out to spend on college. If not done properly you could find yourself paying both taxes and tax penalties on money that should have been (and was planned to be) tax free.
The biggest penalties may not come from the IRS, either. If you took a Virginia state tax deduction for your past contributions, you have to pay Virginia back the amount of tax you originally saved plus interest. You might have made that contribution 15 or more years in the past. That could add up to a lot of interest. The normal six-year statute of limitations on Virginia back taxes does not apply, either. It doesn't matter when the contributions were made, if you don't use that money for higher education (or have a qualifying exemption) you have to pay Richmond back. That could be very very painful.
This article is going to walk you through some of the things that can go wrong and what you can do to fix them if they happen. It's a little embarrassing to admit, being a knowledgeable tax professional and all, but I have been guilty of several of the examples below. So when I say it's easy to screw up the spending part of the Virginia 529 plan, I speak from experience. (What was even worse was that when I called the Virginia 529 help line they told me to speak with my tax professional. D'Oh!)
Problem - You took money out of your Virginia 529 in December for tuition you paid in January. Seems harmless enough, but that’s two different tax years. Money withdrawn in 2015 needs to get matched against qualifying expenses paid in 2015. If you can’t match up your tax qualified money against qualifying expenses on your tax return you may be in line for some taxes and penalties.
Solution – Put it into a different 529 account. If you put the money back into another 529 account within 60 days of withdrawing it then it counts as a rollover and you are not taxed. You can put it back in an account with the same beneficiary only once per year. You could also put it in another beneficiary’s account (i.e. a sibling) as long as the new beneficiary is a family member. You could even open an account for yourself and stick it in there. In a future year you can always withdraw it again and put it back in the original account. Just remember that you cannot take another tax deduction for the money if you are rolling it over. The Virginia state tax deduction only counts toward original contributions.
Problem – You paid tuition with money you withdrew from your Virginia 529 account and now you don’t have enough qualifying expenses left to claim the American Opportunity Credit. This mistake is easy to make because you might be paying the tuition in January and you won’t be filing for the American Opportunity Credit on your tax return until March or April of the next year. You’re probably not thinking about your taxes 15 months out when you’re paying the tuition. While there are several different higher education tax benefits, the IRS generally allows us to take only one tax benefit on each dollar spent on higher education.
Solution 1 – Dig for additional college-related expenses. It would be pretty rare for the tax-free character of the Virginia 529 withdrawal to be more valuable than the very generous American Opportunity Credit (AOC), so you will want to be able to claim the AOC. The list of qualifying expenses for AOC is much more limited than it is for the 529 money, so apply up to $4,000 (the max) of expenses that qualify for AOC against the AOC, and then look for additional expenses to match up to the 529 money. Room and board, parking passes, and computers are some of the expenses that qualify under Virginia 529 plan.
Solution 2 – Pay the tax on the Virginia 529 money. If you can’t come up with enough qualifying expenses to justify your Virginia 529 withdrawal, then you either have to not claim AOC or pay the tax on the Virginia 529 money. Given that situation your best choice is likely to pay the Virginia 529 tax. Fortunately, the IRS waives the penalty (not the tax, though) if your 529 money is disqualified because you took a different tax credit. Always run the numbers to be sure, but the AOC is so valuable you will nearly always come out ahead by claiming it and disqualifying all or part of your Virginia 529 withdrawal.
Problem – You didn’t take out enough money. Your child has graduated and everything is paid for, but there is still some money in the Virginia 529 account. I put this in the category of good problems to have, but it is still a problem. If you take that money out for anything other than qualified higher education expenses you are going to have to pay taxes and penalties.
Solution 1 – Leave it within the 529 system. There are multiple scenarios under this option.
a) If the original beneficiary has a sibling the money can be rolled over to the sibling’s account.
b) If you want to start saving for your grandchild(ren)’s college you can use this account even if the grandchild is not yet born. Simply leave the account with the originally named beneficiary until the grandchild is born and then change the beneficiary to the newborn. (Keep in mind that if there is substantial money involved you might run into transfer taxes – currently 40%. Come see me first if that is the case!)
c) You can open an account in another person’s name and move the money there.
Solution 2 – Withdraw the money as efficiently as possible. If you want to get the money out of the Virginia 529 program, but don’t have qualifying higher education expenses, at least try to be as tax efficient as possible with your withdrawals. Don’t withdraw so much in one year that it moves you to a higher tax bracket. You might also consider whether you or the beneficiary would pay more taxes on the distribution. Either of you can make the withdrawal and the tax is owed by the recipient. It might be more beneficial for your child to take the distribution and pay the taxes than it would be for you to do it.
The Virginia 529 plan is a fantastic program. It offers some great tax savings for parents in the accumulation phase of college planning for their children, with no income-based restrictions. But the rules are complex, and unsuspecting parents/taxpayers will sometimes unwittingly fall into a trap during the distribution phase of the college plan.
If you have questions about using your Virginia 529 plan as efficiently as possible, please contact me.
11 March 2016
I have recently found myself giving long explanations to some of my clients who have fallen into an area of the tax code I call “the crease”. It always seems to be a married couple filing jointly, and on the rise. They are at a point in their lives when the hard work is starting to pay off. They are getting the job, the promotion, or the pay raise they want. There’s a little bit of money left over at the end of the month. They are starting to think about retirement planning, college funding, a house with more room, a car that doesn’t sputter, maybe even a family vacation.
And then they do their taxes and discover that instead of the $1,500 refund they got last year they are going to have to pay $1,500 this year. A $3,000 turnaround in one year! How could this happen?
They have fallen into the crease.
For married couples filing jointly the crease is that area of income from roughly $100,000 to $130,000. That’s where some commonly used deductions and credits go away, exposing more and more of the couples’ income to taxation. Below $100,000 a married couple filing jointly typically qualifies for most (or all) of the commonly used tax deductions and credits.
• The IRA Deduction
• Tuition and Fees Deduction
• American Opportunity Credit
• Lifetime Learning Credit
• Student Loan Interest Deduction
• Child Tax Credit
• Deduction for Mortgage Insurance
• Special Allowance for Passive Activity (i.e. Rental) Losses
By the time a married couple reaches $130,000 many of these tax benefits are partially phased out or gone completely, causing a dramatic increase in the couple’s tax liability. As their pay increases, they are having taxes withheld at the same rate as the previous year, but it's not enough to cover the taxes they owe. Their rate of tax burden growth is faster than their rate of pay increases. They are still in the same top marginal tax rate bracket, but more and more of their income is being exposed to taxes, and they are getting fewer and fewer tax credits on the back end. Without realizing it, in the course of a year they have gone from a tax refund to stroking a check to settle up with the IRS.
If you ever want to deal with angry, bewildered, irritated people – become a tax preparer and tell someone who thought they were getting a $1,500 refund (just like they did last year) that they need to write a check to the IRS for $1,500 instead. That’s not fun for either of us.
I understand that frustration. Tade and I went through it some years ago. Money we thought was going toward a trip to Disney World went to the IRS. I was seeing red for days. I wanted to club somebody. (Somebody at the IRS!)
In retrospect, taking a broader view of the situation would have been helpful. The fact of the matter is that when you fall into that crease you are punching through to a new chapter in your lives. One where you are enjoying more of the American Dream. Despite the higher taxes you are earning more and prospering. No longer living paycheck to paycheck. Able to plan for the vacation or the retirement fund. The initial shock of your tax bill is rough, but it wears off. Try to see the bigger picture.
Being in the crease is also a great time to take advantage of a tax planner. Not a seasonal worker at a tax mill, and not a software program, but an actual tax professional. A tax lawyer, a CPA, or an Enrolled Agent. Someone who can look over your entire financial situation and provide you with some strategies to reduce your tax liability while helping you make progress toward your financial goals. That new and shocking tax bill could serve as a wake up call to get serious about your financial plan.
Earlier this tax season I saw some of my clients had fallen into the crease. I was able to provide them with a simple strategy that erased nearly $2,000 from their tax bill. It didn’t cost them a dime out of pocket to implement, either. They just didn’t know about this particular strategy until I explained it. The value of using a trained tax professional isn’t just making sure this year’s tax forms are filled out correctly. It’s also about devising a way forward that makes the most efficient use of YOUR money.
I certainly can't promise those results to everybody. Each taxpayer's situation is unique, so what worked for a previous client may not fit your particular situation. But you never know unless you ask.
If you would like professional assistance with your tax preparation and tax strategy, please contact me.
2 March 2016
Children under the age of 17 can be very valuable on a tax return. I miss the days when my children were younger and I could claim them all on my return. I think I was always extra nice to them around tax season after seeing how much they had saved me on my taxes. They might have noticed, though I doubt they enjoyed being called “my little exemptions” for a week or two.
Any dependent for tax purposes will provide some benefits, but this article is focused on the federal tax benefits for children under the age of 17. When I use the term “children” in this article I am referring to children under the age of 17.
The five big benefits children can bring to a tax return are:
• The child’s personal exemption, reducing the amount of your money exposed to taxation
• The ability to claim Head of Household filing status (for single taxpayers)
• Child Tax Credit/Additional Child Tax Credit
• Child and Dependent Care Credit (for children under 13)
• Earned Income Tax Credit
With all of those potential benefits, the ability to claim children on your tax return can make a huge difference in your tax liability to the federal government. Not surprisingly, the value of children on a tax return has led to some disputes between taxpayers as to who can claim a child for tax purposes. Often this is between parents who have split up, with both parents providing support to the child(ren).
The IRS has rules governing who may claim a child for tax purposes. These rules do not always match a “divorce decree” or other ruling from a state court. In such cases the IRS rules take precedence for federal tax purposes. Many people find this shocking. They spent a lot of time and legal fees to get a divorce agreement in place, and they find it difficult to believe the IRS doesn’t have to adhere to it. Well, believe it, because they don’t. Marriage, divorce, and parental support of children are governed by state laws. The IRS is not.
If you want to claim all of the tax benefits for a child then you need to have custody as defined by the IRS. Your divorce arrangement may say you have “joint custody”, but if you have not met the IRS definition of custody, then you don’t have custody for federal income tax purposes.
The IRS standard is based on the number of nights the child spent with one parent or the other. Whichever parent the child spent the most nights with is the custodial parent in the eyes of the IRS. That standard resolves the majority of custody disputes for tax issues. There are additional “tie-breaker rules” for the unlikely situations in which the child(ren) spends an equal number of nights with both parents. (If you have questions about those tie-breaker rules, call me.)
Meeting the IRS custody standard enables a taxpayer to:
a. File as Head of Household
b. Claim the child for Earned Income Tax Credit
c. Claim the Child and Dependent Care Credit
These benefits are non-transferable. If you do not have custody of the child(ren) according to the terms laid out by the IRS, you cannot claim any of the above-listed benefits – even if the other parent isn’t claiming those benefits or says they don’t mind if you do. In other words, if your child(ren) lived with their other parent more than they lived with you, you are not Head of Household, you can’t use your child(ren) to claim the Earned Income Tax Credit, and you can’t claim the Child and Dependent Care Credit. The IRS rules are very clear on this.
The parent with custody will also normally have the right to claim
a. The child’s personal exemption
b. Child Tax Credit/Additional Child Tax Credit
HOWEVER, those last two tax benefits can be claimed by the non-custodial parent if the custodial parent agrees. The custodial parent can transfer these tax benefits to the non-custodial parent by filing Form 8332, Release of Claim to Exemption for Child by Custodial Parent. Form 8332 can be submitted for a single year or for multiple years. The same form can also be used to revoke a previously made release of claim.
It is not uncommon for divorced parents to legally share the tax benefits of their child(ren) either during a tax year or over multiple tax years. Parents with two or more children may agree that some of the children lived the majority of the year with one parent and some of the children lived a majority of the year with the other parent. This enables each parent to claim the non-transferable tax benefits of the children who lived with them for most of the year.
Parents of a single child can share the tax benefits over time if the child lives the majority of the year with one parent in some years and lives the majority of the year with the other parent for the other years. This would likely cause large variations in federal taxes between the years of claiming the child and the years of not claiming the child. If both parents are agreeable, however, it should be manageable with some appropriate planning.
Remember that we are dealing with federal tax law. I don’t recommend trying to be clever and claim something that isn’t true. If your return is audited the IRS may ask for evidence that your child lived with you for the majority of the year claimed. School records, day care records, medical bills, etc. is typically what they are looking for. You might have a difficult time convincing them your child lived with you here in Virginia Beach if they attended school in Santa Monica that year.
The IRS rules on this are rigid, but there is always a little wiggle room. The laws have to apply to every taxpayer, and sometimes people’s situations are not a perfect fit to the situations envisioned by the lawmakers when they were crafting the laws. If you have questions about your ability to claim a child on your tax return, please contact me.
23 February 2016
Readers should be 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.
This article is going to explain the difference between the standard deduction and itemized deductions because this is a conversation I have frequently this time of the year:
I am about to tell you what that means.
In addition to raising revenue the federal government also uses the tax code to influence our behavior. For example, home ownership is good for the economy. When people buy homes it creates jobs for home builders, landscapers, real estate agents, bankers, etc. The government wants to encourage Americans to buy homes, so they allow money spent on things like mortgage interest and real estate taxes to be deducted from a taxpayer's income before the tax is calculated. Buying a home provides a way to pay taxes on a lower amount of income. This provides a financial incentive for people to buy houses.
But what about the people who can't afford to buy a house? Can't they get a decuction? Are they stuck paying taxes on all of their income? The government has determined that would not be fair, so they created the standard deduction. The standard deduction is an amount anyone can remove from their income before they calculate the tax owed. The amount of a taxpayer's standard deduction is based on their filing status: married filing jointly, single, head of household, married filing separately, or qualified widow(er). For 2015 the standard deduction amounts are as follows:
Any taxpayer can use the standard deduction, or they can calculate the amount of each individual deduction for which they qualify, total them, and use the total of the individual deduction items instead. As always, we are interested in the result that is LAMA (legal and most advantageous) to the taxpayer. This will almost always be whichever provides the larger deduction. To know if you itemize or take the standard deduction you need to have a sense for the things that qualify for deductions.
Other taxes you pay. The state and local income taxes you pay can be deducted from your federal tax return. That's nice as it prevents you from getting taxed twice on the same money. If you are a resident of a state with no income taxes you can deduct your sales taxes instead. Local taxes refer to the income taxes some cities place on their residents. (See my article on Alternative Minimum Tax for a big exception to Uncle Sam's generosity regarding not getting double-taxed.)
You can also deduct the real estate taxes you pay. For most taxpayers this is their residence. If you pay real estate taxes on a property you rent to someone else you don't itemize those on Schedule A. You deduct those when you figure out your rental property's operating expense on Schedule E.
Personal property taxes paid can also be deducted. In Virginia Beach that's the lovely little blue sheet that comes from the city every year telling you how much you owe because of your vehicle (or boat or trailer). People sometimes get real estate taxes and personal property taxes confused. For federal tax purposes, real estate is land and buildings. Personal property is everything else you own.
After taxes the largest deduction for which many people get a good benefit is loan interest. Specifically because mortgage interest is usually a big number and it's deductible.
Points paid on a mortgage are deductible, but you usually can't take them all in the year they are paid. Points paid must be amortized (spread out) over the life of the loan. If you paid $3,000 in points for a 30-year loan, then you can essentially take $100/year in your deduction for points.
Mortgage insurance premiums are deductible to taxpayers with an AGI below $110,000.
Donations to charity are generally deductible if you itemize your taxes. There are a lot of rules about this, but the one most taxpayers should remember is SAVE YOUR RECEIPTS. There is a common misperception that the IRS doesn't require receipts below a certain level. Not true. If you are audited you have to account for every dollar.
Side Note: It's common for people to hand me a receipt from GoodWill or Habitat for Humanity that lists a few items and the date of the donation. Then I ask the person what was the value of the items donated and they have trouble recollecting. When you get the receipt write down the value of the items donated while it is still fresh in your mind. (Not the value of the items when they were new - the amount they can reasonably be expected to sell for as used items.)
Unreimbursed Job Expenses
I frequently disappoint people trying to claim this deduction. The government standard for claiming it is higher than most people realize.There is also a minimum threshold before your expenses count. It gets complicated, so if you think you can deduct something do some research or ask your tax professional.
People bring me medical receipts all the time because for many years medical expenses were a good deduction. But, I think in the last 2 years I have only had one client whose medical expenses reached the deductible threshold. As part of the Affordable Care Act (a.k.a. Obamacare) the threshold for claiming medical expenses was raised to 10% of adjusted gross income (AGI). That means if your AGI is $50,000 your medical bills are not deductible until they total over $5,000 (10% of $50,000). (The threshold is 7.5% of AGI for taxpayers age 65 and older.)
When trying to determine if a taxpayer is going to take the standard deduction or itemize their deductions I will typcally ask the taxpayer if they own their home or rent. The vast majority of homeowners use the itemized deduction because owning a home usually qualifies for mortgage interest and real estate tax deductions. Often just those two deductions will come to more than the standard deduction. If you don't own a house (and a mortgage) you will have to give a lot of money to charity to make itemizing more beneficial than just the standard deduction.
Deductions are a great thing to have if you are trying to minimize your tax bill. Getting the largest deduction possible might be something I can help you with. If you have any questions, please contact me.
18 February 2016
Let me start by stating that I enjoy some forms of gambling - I'm a numbers guy, I like the numbers - but I really hate the federal tax treatment of gambling. I think the laws are ridiculous and grossly unfair. Ridiculous because they are nearly impossible for an average taxpayer to comply with. Grossly unfair because...well, that's a long explanation that I'll get to later. Regardless of my personal feelings, however, the laws are the laws and we will always attempt to adhere to them.
Gambling winnings of any amount are considered taxable income. If you won $50 in the office Super Bowl squares game you're supposed to pay taxes on it. Gambling winnings of that simplicity are on the honor system, though. There is no paper trail for the IRS to follow, so compliance is very low. Only a fanatically compliant taxpayer would actually consider including that $50 on his or her tax return, but legally they're supposed to.
To encourage compliance at higher forms of gambling the government requires casinos, horse tracks, and dog tracks to generate the form W-2G for certain winners. Those winners would be
Not only is the casino required to issue you a W-2G, they are also required to deliver a copy to the IRS and withhold either 25% or 28% of your winnings and send that to the IRS as well. The rules on whether to withhold 25% or 28% are somewhat convoluted, but the casino is never wrong if they withhold 28%, so many default to that amount to be safe.
Your gambling winnings go on line 21 of form 1040. If you filed a 1040EZ or a 1040A in the past, congratulations, you have graduated to the form 1040. It is the only form that can accommodate gambling winnings.
If you itemize your tax deductions you can deduct gambling losses on schedule A up to the amount of gambling winnings. In other words, if you have $1,000 of gambling winnings and $3,000 of gambling losses you can deduct $1,000 of your gambling losses. You still eat $2,000 of gambling losses without getting any tax benefit, but at least it zeroes out your gambling winnings for tax purposes. Well.... kinda... Let me show you how that isn't 100% true.
This is where I explain why I think the tax laws on gambling are grossly unfair. Let's look at an example. This example is exaggerated to make my point, but after reading it you should be able to understand the inherent unfairness of how the law works.
John is a school teacher earning $50,000 per year. He drives a Corolla, has a child, contributes $300 per month to his IRA, is working toward his master's degree, and pays his taxes on time every year. John also visits a local casino every night and bets $1,000 on a single hand of blackjack. That's it, one bet, $1,000, every night, 365 days a year.
In 2015 John won 182 times and lost 183 times for a net loss of $1,000 for the year.
Model citizen John includes $182,000 (his 182 wins) as income on line 21 of his form 1040 and deducts $182,000 on schedule A (the maximum he can deduct up to his winnings). John's adjusted gross income (AGI) for the year is now $232,000 (his gambling winnings plus his teacher's salary). At that AGI his contributions to his IRA are no longer tax deductible, increasing his tax bill by $900 given his 25% top marginal rate. He no longer qualifies for the child tax credit, costing him another $1,000. He no longer qualifies for the lifetime learning credit for his college expenses, costing him up to $2,000. He may even owe Alternative Minimum Tax.
John's $182,000 deduction for gambling losses peaks the interest of the friendly neighborhood IRS agent, who decides to audit John. Does John have records and/or receipts for his gambling losses? Probably not. Most people who gamble recreationally don't bother. Why would you? You're just having a bit of fun, not running a business. But John better hope he can prove he lost $182,000 at the casino, or his gambling deduction could be disallowed and then he is in for a ton of taxes due.
John's net gambling losses for the year were $1,000, and the tax code beats the hell out of him for it. That is why I believe the tax laws on gambling are grossly unfair. You can't net your wins and losses for the year on your tax return. You have to claim all your wins as income and then deduct the losses later on the form. That approach can wreck someone's tax situation.
When it comes to gambling, it's like Uncle Sam is your silent mafia partner. If you win you pay him his cut. If you lose he can get it out of you in other ways.
If you do a fair amount of recreational gambling it is prudent to keep a good record of your wins and losses. If you ever hit a big payout you will want to be able to substantiate the deduction for losses you'll take on schedule A to offset your winnings. If you have questions about taxes and gambling please contact me.
14 February 2016
Tom left his wife Wilma in May 2015 and moved in with his pregnant girlfriend Greta. Tom and Wilma have a 3-year-old daughter who remains with Wilma in the house where they previously all lived together. Tom is not providing any support to Wilma or their daughter. Greta gives birth to a boy in November. Legal proceedings for Tom and Wilma's divorce have not yet started.
What is Tom's filing status for his 2015 tax return?
What about Wilma and Greta? How should they file? These are tricky situations.
No one complains more than I do about the complexity of the tax code, but in some ways it has to be complex. It must cover every US Taxpayer - and there will be some unusual situations in the mix. Situations that don't fit the typical pattern or original intent of the law. Yet, the law must be interpreted to cover every one of those situations, even Tom and his children and their mothers and their living arrangements.
In this situation there are several legal ways for Tom to file, so we want to use the one that would be most advantageous. You will often hear me say Legal and Most Advantageous, which I also abbreviate as LAMA.
Based on our knowledge of the situation thus far his options may include Married Filing Jointly (MFJ), Married Filing Separately (MFS), Single, and Head of Household (HoH). There might be some additional circumstances that prevent Tom from using one or more of those filing statuses, so we need to explore them a bit further.
Tom and Wilma could file Married Filing Jointly, and this may well be their most advantageous filing status. While filing this way might be advantageous with respect to minimizing their tax burden, filing jointly would require a degree of cooperation between Tom and Wilma that may not exist. Tom can't file jointly if Wilma refuses. Likewise, Wilma can't file jointly if Tom refuses. They would need to agree to do it, and share information to get their tax return completed. They might cooperate if they are shown that it saves them money, but in situations like these it is not uncommon for people to forgo their most advantageous filing status to avoid cooperating with a soon-to-be ex. Emotion has been known to trump logic in such matters.
Tom's filing status could be Married Filing Separately. This may seem like the most logical way for Tom to file, since he is married and he is separated from his spouse. However, it is probably also the least advantageous way for him to file (but we don't yet know for sure). Remarkably, it could still require a small degree of cooperation between Tom and Wilma. When a married couple elects to file separately they must both claim their tax deductions in the same manner - meaning they must both itemize on schedule A OR they must both claim the standard deduction for married filing separately. In order to know how your spouse claimed deductions you have to ask them.
Tom may qualify to file as Head of Household. Although married, the IRS makes provision for a taxpayer to be considered unmarried and file as Head of Household if they meet ALL of the following tests:
The child in question for the above IRS tests isn't Tom's daughter with Wilma, but his son with Greta. Although the child was born in November he is considered to have lived with Tom all year. As long as Tom paid for more than half of the upkeep on the home he lives in with Greta, he can qualify. He would need to cooperate with Greta for this filing status, as she may also be able to claim the child on her return, and they cannot both claim the child. (Their contributions to home upkeep would need to be relatively close for it to be questionable who can claim the child.)
Tom could also file as single. He can be considered unmarried as he did not live with his spouse for the last 6 months of the year. State marriage laws may come into play here. If the state has a process for being legally separated it must be used. (Virginia does not have such a provision.) Filing singly is less advantageous than filing as HoH, so Tom would only use this filing status if Greta is claiming their son on her taxes.
To find the most advantageous filing status solution Tom should calculate his taxes all of the different ways and compare the results. In the above scenario I would expect the most advantageous filing status would be for Tom and Wilma to file jointly and Greta to file as Head of Household (assuming all other criteria are met), but I wouldn't know for sure until I had run the numbers through my software every possible way. That can be tedious and time consuming, but might be worth the effort.
If you have questions about your filing status, please feel free to contact me.
03 February 2016
I am writing this post because I have seen several clients who have formed a business partnership without knowing there were tax filing implications for doing so. I am not trying to dissuade anyone from forming a partnership, but I think it would be helpful for people to know how that is going to impact their tax return preparation.
OK, let me get this disclaimer out of the way: I am not a lawyer. I don't give legal advice, and this blog post is not meant to be legal advice. This post isn't even tax advice. This post is meant to educate taxpayers on the tax ramifications of forming a partnership.
A partnership can be formed in several ways, but the one that seems to surprise the most people in my experience is when they form a Limited Liability Company (LLC) together. Limited Liability Companies have become very popular for the protection against personal liability they extend to small business owners. LLCs are organized under state laws, and many states - including Virginia - have made them relatively easy and affordable to form.
When an LLC is formed the state wants to know who the members of the LLC are. The members are the owners. If you list more than one member when you form your LLC then under federal tax law you have just created a partnership. (Unless you decide to incorporate, which I cover in more detail later.)
A simple scenario might be one in which Jim and John are friends and generally handy do-it-yourselfers. John has a truck, they both have some tools, and they decide to try to make a little money on the side by doing simple repair work at people's residences. They form an LLC to limit their liability, listing both Jim and John as members of the LLC.
In the eyes of the IRS they have just formed a partnership.
Why do Jim and John care that they have just formed a partnership? Because partnerships are required to file a separate federal income tax return - the Form 1065, US Return of Partnership Income. Like most states, Virginia also requires partnerships to file a separate tax return - Form 502, Pass Through Entity Return of Income.
Don't misunderstand - Jim and John's partnership does not have to pay any tax. A partnership is a pass through entity - all of the profits and losses are passed through to the partners. Jim and John will pay the taxes for the partnership through their individual income tax returns. BUT, the partnership must file the 1065 return so the IRS has a record of the profits and losses that were passed through to each partner.
The process works as indicated in the diagram below. The partnership files form 1065. At the time the 1065 is created Schedule K-1s are created for each of the partners. The K-1 contains the information about each individual partner's income and expenses from the partnership. Each partner would use the Schedule K-1 issued by the partnership when preparing his or her individual income tax return. The information from the K-1 generally gets placed on Schedule E of form 1040 of the individual return.
(There are other uses for Schedule K-1, by the way. It's not only used for partnerships, so if you hear someone talking about a schedule K-1 it doesn't always mean there was a partnership involved.)
Partnership tax returns are generally more complex than individual income tax returns. While Jim and John have a very simple partnership, the same tax form also has to be able to handle a partnership between Berkshire Hathaway (an American corporation) and Fiat (a foreign corporation). That partnership does not exist, but those two corporations could form a partnership, and if they did the partnership would have to file a form 1065.
To further complicate things, income on an individual tax return (form 1040) falls into different categories for tax purposes. For example, long term capital gains are taxed differently than wages. Those two types of income have different character. Because the income from the partnership is passing through to the individual partners, it is important for the character of income to be preserved. Long term capital gains from a partnership must pass to the partners as long term capital gains. Rents as rents, etc. In order for this to happen some of the income items on a form 1065 must be separately stated. This can make the Form 1065 a real pain in the neck to figure out.
In addition to the complexity of the return, the software to create the 1065 isn't cheap, either. There are some significant hassles for do-it-yourselfers. I'm not saying a small business owner couldn't figure out how to prepare and file his or her own Form 1065, but Jim and John would probably benefit from some professional assistance.
Is there a way to get out of filing a partnership return? Well, there's this: You file a form 8832 and have your partnership declared a corporation. You might have some very good reasons for doing this, but simplifying your tax situation is not one of them. Corporations file their own separate tax return and some of them also have to pay their own taxes. You wouldn't reclassify your partnership as a corporation as a method of streamlining your tax paperwork, because you will very likely have more paperwork with a corporation than with a partnership.
Partnerships and LLCs are some great tools for small business owners. Just be sure your eyes are open about the tax consequences if you form one. You are going to have to file some additional tax forms. If you have questions please contact me.
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.