17 December 2017

Tax reform is in the news lately, and I have fielded more than a few questions about the anticipated impacts of the current proposals. I usually try to side-step the question. While I spend a lot of time analyzing tax laws I try not to spend too much time analyzing tax bills. I can’t predict what our government is going to do, and I don’t find a lot of value in trying to figure it out in advance. Hopefully you aren’t too distressed by that. If you are, look at it this way - if I could accurately predict what the government was going to do with tax laws and how that would impact each individual tax situation, you could not afford me.

I will make one observation on the flurry of activity coming out of the beltway, however; I believe we are about to see increased chaos at the state income tax level. Here’s why:
There are two bills floating around, one passed by the House and the other by the Senate. Our legislators are reportedly working to reconcile the differences between the two bills, so they can get something for the President to sign into law. Both bills contain the following provisions:

• Standard deduction nearly doubles
• Personal exemptions are eliminated

Unless the states scramble to change their own laws, both of those changes at the federal level will have significant impacts on state income tax returns. Let’s look at the impacts they would have on a Virginia income tax return. If you’re in another state, you may be able to use this discussion to determine if it will apply to your state’s income taxes as well.

Virginia is what we call a ‘conformity state’, meaning many of the tax laws in Virginia conform to federal tax law. The first line on a Virginia income tax return is “Federal AGI”, which is line 38 from your federal form 1040. That means that everything the federal government counted as income, and everything the federal government counted as an adjustment to income is embedded in the first line of your Virginia income tax return. There may be subsequent additions or subtractions to your federal adjusted gross income to calculate your Virginia adjusted gross income, but they start from the same point because Virginia conforms to federal tax law unless the Virginia code expressly stipulates otherwise.

Let’s look at the personal exemptions issue. Virginia currently allows you to take a $930 personal exemption for each person listed on your tax return - you, your spouse, and your dependents. The Virginia definition of ‘dependent’ (for tax purposes) conforms to the federal definition of dependent. If the federal personal exemptions go away, how and where are dependents going to be defined for Virginia tax purposes? If you don’t need to enter dependent information for your federal return, is Turbo Tax going to ask you for that information for your state return? Will personal exemptions on Virginia tax returns also need to be eliminated if the federal personal exemptions are eliminated?

To compensate for the loss of personal exemptions, the federal bills double the standard deduction. There is no bill pending in Virginia to double the standard deduction. If the Virginia personal exemption goes away, Virginia taxable income goes up.

Under Virginia law, if you claim the standard deduction on your federal return, you must claim the standard deduction on your Virginia return. If you itemize deductions on the federal return you must itemize deductions on your Virginia return. With the doubling of the federal standard deduction, many more taxpayers will elect to use the standard deduction on their federal return. That means they will be forced to use the standard deduction on their Virginia return.

The Virginia standard deduction is $3,000 for single filers and $6,000 for married couples filing jointly. Not much. In this situation, it might be better for someone to use the federal standard deduction on the federal return, but significantly better to itemize deductions on their Virginia tax return. This puts taxpayers in the position of needing to figure their taxes both ways (using the standard and itemized deductions) to determine which gives the best overall result. Is it best for your wallet to pay a high federal tax bill and a low Virginia tax bill, OR is it better for your wallet to pay a low federal tax bill and a high Virginia tax bill. Good luck getting Turbo Tax to help you through that. (I’m not trying to knock TT, but they would literally have to program the software to calculate this using the tax laws in the 43 states that have an income tax. That’s a tall order.)

One of the stated intentions of tax reform is to simplify filing for Americans. I don’t see that happening in the short term if you are required to file a state income tax return. State legislators will undoubtedly move to adjust their state tax laws once the federal tax law is settled. That strikes me as something that will likely take a few years to sort out. That means we are likely looking at a few years of changes before things settle down again and people know the most advantageous way to file.

If greater income tax simplicity becomes a reality down the road, then it may be worth the temporary increase in chaos, but I think temporary increase in chaos is inevitable with this iteration of tax reform. There are too many moving parts and interactions between Virginia law and federal law, and the impact to state returns does not seem to have been fully analyzed.

I am not advocating for or against the federal income tax proposals currently making headlines. I just wanted to point out that tax simplification is not a simple process. All tax software, including my rather expensive professional version, starts with the federal tax return and then uses the data from the federal return to populate the state tax return. If there is a disconnect between federal and state law I expect to see more people in my office this year who have completed and filed their federal tax return, but need help with their state return(s). Hopefully I am wrong. Time will tell.

If you need help with your taxes, please contact me.

• Tax Preparation Business
• Exemptions
• Virginia State Taxes

10 December 2017

If you worked under a job covered by Social Security, but were then injured and unable to work for a year or more you may qualify for Social Security Disability payments. These payments can sometimes be the difference between solvency and insolvency for those who need them, but they can also cause tax complications. Nothing is easy when it comes to government programs, right? Social Security Disability Benefits are sometimes taxable, but sometimes not taxable. To further complicate things, there is such a backlog of claims your first payment might cover more than one year of benefits. If you were injured and applied for benefits in 2017 you might not receive any benefits until 2018, at which time you could receive a lump sum payment for benefits going back to the date you were injured. Under the tax code you generally pay taxes on money when it is received, so you could have a tax problem in the year you receive a large lump sum. 

There is a way to fix a tax problem created by Social Security lump sum payments, but you must know the fix exists and how to use it. There is a provision known as Section 86(e) allowing you to elect to have the portion of the Social Security Benefit received for a prior year to be taxed as it would have been if it had been received in that prior year.  You don't have to go back and amend that prior year return, you just have to calculate the tax as it would have been calculated on that return. This can provide a very nice tax benefit when it's needed. Let’s look at an example situation to take a closer look at how the problem develops and how it gets resolved.

John works in a job covered by social security. His wife Jenny is a school teacher, but their financial plan is for Jenny to take a few years off work to stay at home with their infant son. She may even stay out of work longer to have more children. Then life happens...in January 2016 John is injured. His doctor says he will not be able to work for at least a year, possibly longer. John applies for Social Security Disability Benefits.

Throughout 2016 John is unable to work.  He is also unable to provide adequate care for their son on his own. Jenny stays at home to care for them both. They burn through their savings, but they make it. By early 2017 John is strong enough to look after their son, so Jenny goes back to work as a teacher, earning $48,000 for the year.

In July 2017 the Social Security Administration approves John’s application for disability benefits and pays him $15,000 to cover the period back to the time of his injury. $10,000 of this amount is for 2016, and $5,000 is for 2017. For the remainder of 2017 John receives disability benefits totaling an additional $5,000.

John receives a 1099-SSA from the Social Security Administration in January 2018 stating he received $20,000 in benefits from the SSA in 2016. While this is true, it is also a bit misleading, and poses a big tax disadvantage for John and Jenny. Social Security benefits are taxable based on the amount of other income you make. Up to 85% of the benefits can be taxed if you make more than $44,000 and file a joint return. ($34,000 if you file individually.)

In 2016 John was recovering and Jenny was taking care of her husband and son. They had very little income that year. If they had received $10,000 of the Social Security disability benefits during 2016 as they should have, they would not have to pay income taxes on any of it. But they didn’t receive it in 2016, they received it in 2017. In 2017 Jenny earned $48,000, so now 85% of the $20,000 Social Security benefit received in 2017 ($17,000) could be exposed to taxation.

Section 86(e) to the Rescue

There is a fix for this in Section 86(e) of the Internal Revenue Code, commonly called the “Lump Sum Election”. This allows the taxpayer to calculate the tax on the Social Security as it would have been calculated had it been received in a timely fashion. In our example, if John and Jenny had timely received the $10,000 of 2016 Social Security Disability benefits, that $10,000 would have been taxed at 0% (or, rather, it would not be included in taxable income). Therefore, they can claim a Lump Sum Social Security Payment Election under Section 86(e), and get the 2016 tax treatment on that amount on their 2017 tax return.

On their joint tax return John and Jenny will put the full amount ($20,000) from the 1099-SSA on line 20A. On line 20b (the taxable amount of their Social Security benefits) they will put $8,500. They arrived at $8,500 using worksheets in IRS Pub. 915. Essentially, they take the 2016 rate times the 2016 amount and add it to the 2017 rate times the 2017 amount. The 2016 rate was 0% times $10,000, plus the 2017 rate of 85% times $10,000.

The IRS has never issued guidance on how to formally make the Lump Sum Election, so taxpayers are advised to include a statement with their tax return indicating they have chosen the Lump Sum Social Security Benefit Payment Election Under Section 86(e). You may even want to show the math used to come up with the amount taxable you include on line 20b.

Be advised the election is not required. It is permissible to treat the entire lump sum as received in the current year if that is more advantageous to you. For example, if Jenny was still working in 2016, but not working in 2017, it would be more advantageous for them to pay the 2017 rate on the entire lump sum. In this situation, they would NOT elect to use Section 86(e) to apply the 2016 tax rate to part of the lump sum payment from Social Security. 

Section 86(e) is one of those strange aspects of tax law that is highly useful, but not widely known. Most people never have to use it and virtually no one ever uses it more than once. It can save you quite a bit at tax time, though, if you can apply the Lump Sum Social Security Benefit Payment Exclusion to your advantage. If you find yourself in that position and you’re stuck, give me a call. If you know someone who received a large Social Security Disability payment covering multiple years, send them a link to this article. It might be very valuable to them!

• Above the Line Deductions
• Income

03 December 2017

As I have written before, I am a fanboy of 529 plans in general and the Virginia 529 plan in particular. The Commonwealth has done an uncommonly good job at taking the federal guidelines for 529 plans and creating an efficient, effective, and user-friendly program. I like any program that gives us a tax break for education. What I particularly like about the 529 plans is that:

1. 529s are one of the few tax-advantaged higher education programs in which room & board is a qualified higher education expense. That’s good news if your child might eat or sleep at some point during their time at the university. I don’t know what planet our lawmakers are from when they don’t consider room and board necessary expenses for other college tax breaks. It was a significant chunk of what we spent on our children’s college educations, and we were glad we had the 529 plans in place to help us cover it.

2. Anyone can use the 529 plan. Most of the other tax breaks available for college have income limitations. Earn too much and you can’t take advantage of the program. Not so with the 529 plans. There is a limit to how much you can contribute, but there is no income barrier to participation.

3. Even if you don't plan far enough ahead to take advantage of the tax-deferred growth in a 529 plan, you can still get a tax break for your contribution by using the Virginia College Wealth program and running your education funds through a Virginia 529 account in the same year you make the payments. It's a nifty little loophole anyone can use.

As easy as Virginia 529 makes it to save for college, some mistakes can be made when you withdraw that will negate the great advantages you received for using a Virginia 529 plan. You can end up with a tax penalty if you aren’t careful. You can even wreck your eligibility for other (more valuable) college benefits. Here are 4 mistakes I see, and how to avoid them.

1. Using a 529 from a non-parent early in the student’s education. This is how this scenario frequently unwinds: Grandparents have a 529 for the student they started when they initially became proud grandparents. Now it's time for freshman year and Grandma and Grandpa take money out of the 529 and give it to the family to help with college expenses. That is unbelievably thoughtful and sounds wonderful, but it can have somewhat dire unintended consequences. Why? Because needs-based federal student aid is concerned with parent’s money and student’s money – and student’s money counts nearly 4 times as much as parent’s money when calculating eligibility for student aid. When Grandparents take money out of a 529 for a student, that counts as student money for federal student aid purposes. The grandparent’s helpfulness could get overshadowed by the student aid that gets lost as a result.

The solution here is to wait until the student’s junior year to tap into grandma and grandpa’s 529 money. There’s a built-in lag in income reporting to student aid. By the time the student aid folks are told about the grandparents 529 money, the student should be through their senior year.

2. Withdrawing money too early from the account. Here’s the scenario: You know the school is going to bill you on January 10th, so you withdraw money from your 529 plan on December 22nd so the money is ready and available when the bill arrives. Makes perfect sense, and you should be rewarded for being so prepared and organized. Except the IRS isn’t always concerned with what makes sense, or how this fits your personal method of organizing. Money withdrawn from a 529 in 2017 must be used to pay for college expenses in 2017. January is in 2018, so you can’t apply that 2017 withdrawn money against the 2018 college bill and keep it tax free.

The solution here is to wait until January to make the withdrawal for the January bill. You could also elect to do what we did, and withdraw from the 529 plan on a reimbursement basis. We would pay the college bills from current operating monies and then reimburse ourselves from the 529 after the fact. This had the added benefit of making our withdrawals more precise. We knew exactly how much we had spent on room and board by the time we made the withdrawal.

3. Withdrawing money to cover travel, commuting, and parking. As generous as the 529 plan is, there are still things that just aren’t covered. Travel, commuting, and parking are common expenses that are not allowable as qualified higher education expenses for the 529 program.

There is no solution for this. Plan ahead for these expenses, but not with your 529 money!

4. Assuming the 529 is only good for room and board if the student lives on campus. Every once in a while, I’ll find someone who believes you can only use the 529 money on dorm fees and pre-paid meal plans. It just isn’t so. You can use your 529 money for room and board off campus. The limitation is that you cannot claim a greater expense than what it would cost to put them in the dorms and buy the meal plan. If you want to put your son or daughter in the Ritz Carlton for a semester and let them eat caviar, knock yourself out. But...the most you can claim as a qualified higher education expense on your tax return is the same as it would cost to house and feed them on campus.

There isn’t a solution needed for this. Just be aware the student can live off campus and still use the 529 money. Also, be aware that it’s usually easier for me to take the posted on-campus rates from the university when I am calculating education expenses than it is for me to look at actual expenses.

The Virginia 529 plan is a great way tosave for college expenses. This is especially true if you know your student is going to be living on or near the campus. The important thing to remember is that you can accidentally make things worse with your 529 account if you aren't careful. When in doubt you should call me first.

• Tax Credits
• Education Tax Breaks

19 November 2017

Schedule A of the individual income tax return is where taxpayers are invited to list their itemized deductions. The top part of the form contains the itemized deductions most Americans easily recognize; medical expenses, state and local taxes, deductible interest, and charitable contributions. Then come lines 21 – 27, mystically labeled: Certain Miscellaneous Deductions, and then there's line 28: Other Miscellaneous Deductions. Let’s take a closer look at those certain and other miscellaneous deductions. (And please forgive my cartoon - it amused me!)

The first thing you’re probably wondering is what’s the difference between certain miscellaneous deductions and other miscellaneous deductions? You probably suspect there is a reason the IRS calls them different things, but you don't know why. (You're right about that, of course.) The difference is that certain miscellaneous deductions must clear a 2% of AGI (adjusted gross income) threshold before they start to make a difference on your tax return. Lines 25-27 are actually for calculating your 2% of AGI threshold and seeing if you have enough cumulative certain miscellaneous deductions in excess of the 2% of AGI threshold.

Other miscellaneous deductions do not need to clear a 2% of AGI threshold before they start having an impact on taxes. Their effect is immediate. You just need to total your other miscellaneous expenses and record them on line 28.
There are fewer other (not subject to the 2% limitation) miscellaneous itemized deductions than certain miscellaneous itemized deductions. I will list the other (no 2% limit) miscellaneous deductions here and provide a brief explanation of each. I will do the same for the certain (subject to the 2% limitation) miscellaneous deductions in a subsequent article.

Other Miscellaneous Deductions (Deductions for which there is no 2% threshold or limit)

Amortizable premium on taxable bonds. That’s a mouthful, eh? Let me try to briefly explain. You pay a premium on a bond when you pay more for it than its face value. It may be possible for you to amortize that premium over the remaining life of the bond, and deduct it from your taxes. (I wouldn’t worry too much about this. If you are paying a premium for bonds, chances are good you are not preparing your own taxes!)

Casualty and theft losses from income-producing property. You can deduct casualty and theft losses for which you do not receive insurance compensation on your tax return. (We saw this quite a bit after Hurricane Matthew. Tax payers down in Houston and Florida are going to be dealing with this a lot this coming spring.) Normally this deduction is subject to the 2% rule. However, if the lost or damaged property was income producing property, then there is no 2% rule for the deduction.

Federal estate tax on income in respect of a decedent. Income in respect of a decedent is income that would have been paid to someone else, except they died. You were their beneficiary, so you received the income and included it on your tax return. When the deceased’s estate was made final that income was also included in the estate, so estate taxes were paid on it. In order to not double-tax that money the amount paid in estate taxes is deducted from your tax return. (So, if you inherit an IRA from someone whose estate paid estate taxes, you may not be liable to pay income taxes on 100% of the inherited IRA.)

Gambling losses up to the amount of gambling winnings. Gambling winnings are taxable income. You can deduct gambling losses, only up to the amount of your gambling winnings. For example, you went to Las Vegas in April and won $5,000. You went to Atlantic City in October and lost $12,000. You must claim the $5,000 of winnings as income, but you can deduct $5,000 as gambling losses on Schedule A. Even though you lost $12,000 you can only claim $5,000 of losses, because that was the extent of your winnings. (The IRS has serious record keeping requirements to be able to support claiming the gambling losses, so if you plan to claim gambling losses, start keeping really good records!)

Impairment-related work expenses of persons with disabilities. If you have expenses for special equipment or services to enable you to work, those expenses are deductible on your tax return. The example the IRS uses is their manual is that you have a job that requires reading, but you are blind. You hire the services of a reader to assist you at work. The expenses associated with the reader are deductible on your tax return.

Loss from other activities from Schedule K-1 (Form 1065-B), box 2. Form 1065 is a partnership return. Losses from partnerships are frequently, but not always, passive losses. Passive losses are reported in box 1 of the K-1, and are subject to passive loss limitations. Box 2 is for losses from other (non-passive) activities. These are not subjected to passive loss limitations, so they are deducted on Schedule A.

Losses from Ponzi-type investment schemes. If you were the victim of a Ponzi scheme you can deduct those losses on Schedule A of your tax return.

Repayments of more than $3,000 under a claim of right. As an example – you were paid $50,000 for a job in 2015. You claimed that money on your 2015 income tax return and paid taxes on it. You were subsequently sued because the person who hired you didn’t like the quality of the work you did. The court orders you to repay this person $30,000. Since you had already paid taxes on this money back when it was received you can deduct it from your taxes when you pay it back.

Unrecovered investment in an annuity. Another one that needs an example. Dan worked for Acme Company for 40 years. He participated in the Acme pension plan by contributing $1,000 each year toward his pension. When Dan receives his pension (annuity) the portion of the pension that was his own contribution to the plan is tax free. Dan receives pension payments from Acme, but when he dies he has only collected $2,000 of the $40,000 ($1,000 per year for 40 years) he had contributed. Acme must pay out the other $38,000 to Dan’s estate. This amount is then deducted on Dan’s final Schedule A as an unrecovered investment in an annuity.

Taxes can be complex and confusing. If you run into a situation that may have bearing on your taxes, it’s probably best to get a professional involved. You can always contact me with your questions or concerns.

05 November 2017

The rigors of military life and the inherent lack of control over one’s personal schedule are well known to those of us who have lived them. You can’t always predict (or control) where you’ll be at a given time, or if you’ll have access to a computer or even your personal records and files. Fortunately, Uncle Sam has authorized the IRS to be a little lenient with military personnel when it comes to the tax filing deadlines. Some military personnel may even qualify for an extension to pay taxes owed – which is something the IRS doesn’t allow very often. Extending the tax deadlines could save you time and money - but you have to know them to take advantage of them.

In a Combat Zone

The greatest allowances are made for service members serving in a combat zone. The nature of modern warfare has filtered into the tax code such that contingency operations are also included as duty in a combat zone. Combat zones are declared by Executive Order, and the IRS is currently recognizing three named combat zones – The Afghanistan Area (which includes several countries quite far from Afghanistan, so be sure to check), the Kosovo Area, and the Arabian Peninsula.

If you are serving in a combat zone or contingency operation you are granted an extension of the deadline to file your return, pay any taxes owed, claim a refund, or take other actions (discussed later) with respect to your tax return. The extension starts the day you depart the combat zone and extends for 180 days plus any time you had left to file your return by the original due date after you were deployed. For example, if your tax return was due April 15 and you were deployed to a combat zone on March 31, your deadline extension would be 180 days plus 15 days (April 1 – April 15), or 195 days.

If you were injured in the combat zone your deadline extension starts the day you are released from the hospital. For example, Private Blazer was injured in a combat zone and evacuated to a military hospital in Germany.  He was released from the hospital on July 15. His deadline extension clock starts ticking on the day he leaves the hospital (not the day he was evacuated from the combat zone).

What are some of those other actions (mentioned above) you might want to take impacting your taxes? How about:

• Filing a claim for a credit
• Making a qualified IRA contribution
• Collection action by the IRS for taxes due
• Examinations (audits)
• Others (somewhat obscure, but valuable if you're in an atypical tax situation for a military member.)

What if You’re NOT in a Combat Zone?

If you are not serving in a combat zone you may still qualify for some deadline extensions. If you are stateside, you can use the automatic extension to file. You get this by timely filing form 4868 either on paper or electronically. If this form is received by the IRS prior to the original filing deadline you are granted a six-month extension TO FILE your tax return. This is only an extension to file the return. IT IS NOT AN EXTENSION TO PAY YOUR TAXES. Many people get that confused. Any taxes owed are to be paid when the extension is filed. If you owe and don’t pay when you request the extension, you will be subject to penalties and interest.

If you are serving outside the United States (and Puerto Rico) you can get an automatic 2-month extension to file without filing form 4868. When you file your tax return you must attach a statement showing you were serving in the military outside the United States on the date the tax return was due. If you owe taxes they should be paid by the original tax deadline. Tax payments received after the original tax deadline will be subject to interest.

If you are serving outside the United States (and Puerto Rico) and you need an extension to file greater than 2 months, you will need to file form 4868. This will give you an extension to file of 4 additional months. Form 4868 must be received by the IRS prior to the automatic 2-month extension expiring.

Virginia Residents

Not to be outdone, Virginia extensions are even more generous. If you qualify for an extension from the IRS due to service in a combat zone, the minimum extension period granted by Virginia is one year.  “Members of the Armed Forces serving in a combat zone will receive either the same individual income tax filing and payment extensions as those granted to them by the IRS, plus an additional fifteen days, OR a one-year extension, whichever date is later.”

If you are not in a combat zone, Virginia will grant you an automatic six-month extension of time to file. There are no forms or applications for this six-month extension. Like the IRS, this is an extension to file. If you’re not in a combat zone and you owe Virginia taxes they must be paid by the original due date or you will be subject to penalties and interest.

North Carolina Residents

North Carolina follows the IRS with respect to the rules on extensions for military personnel serving in a combat zone. North Carolina is a bit more generous than the IRS when it comes to military personnel serving outside the United States (but not in a combat zone). Personnel serving outside the United States (and Puerto Rico) can receive an automatic four-month extension. You simply check the box that says, “Out of the Country” when you file your return. If you don’t pay your North Carolina taxes by the original due date they will accrue interest (but not penalties) through the extension period. If you need more than 4 months, you can request an additional 2 months by specifying your request on form D-410 by August 15.

Additional information on federal extensions can be found in IRS Publication 3, Armed Forces’ Tax Guide, which also contains a treasure trove of tax tips for military personnel. If you are in the military and prepare your own tax returns you should read all 37 pages of that guide annually. If you’ve got a complex tax situation, or you just want someone else to take care of your tax preparation – give me a call! That’s what I do!

• Tax Penalties
• Virginia State Taxes
• Military Tax Issues