Welcome to the Tax Blog

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!

• Business Deductions
• Schedule A Deductions
• Tax Penalties

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.

There is.

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.

Bottom Line Up Front

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.

The Long Version

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.

Images courtesy of WAVY.com

• Schedule A Deductions

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.

• Tax Preparation Business
• Tax Penalties

18 August 2015

Inheritances are generally not taxable to the recipient. When due, estate taxes should be paid by the estate before the beneficiary receives the assets. An exception to this rule is with traditional Individual Retirement Arrangements (IRAs) when inherited by someone other than the spouse of the deceased. When a traditional IRA is inherited by a non-spouse the recipient must pay income taxes on it for the year they take a distribution of the money from the IRA.

Roth IRAs are different. If the inherited IRA is a Roth IRA then the money should be tax free for the beneficiary to withdraw at any time. (The exception would be if the Roth IRA was less than 5 years old when the original owner died.)

Given that spouses can inherit IRAs tax free, and Roth IRAs can also be inherited tax free, the rest of this post is about non-spouses inheriting traditional IRAs.

When a non-spouse inherits a traditional IRA there are some choices to be made - and those choices may have significant tax consequences. The beneficiary chooses whether to liquidate the IRA right away, or turn it into a "stretch IRA" by taking Required Minimum Distributions (RMDs) each year. The amount of the RMD each year is calculated using IRS actuarial tables for life expectancy on this handy worksheet.

If the decedent was over 70 1/2 when they died the beneficiary has a choice between taking the RMD based on their own age, or taking the RMD based on the decedent's age. The younger the person taking the RMD is, the lower the RMD they must take each year. Lower RMDs mean a longer stretch of the IRA. The chart below summarizes the options for the beneficiary. (I stipulated individuals because the rules are different if the beneficiary of the IRA is an estate or trust.)

The most tax efficient option is to stretch the distribution of the inherited IRA for as long as possible. Distributions from an inherited IRA are counted as income. Liquidating the IRA within 5 years triggers income taxes on the distributions in the year(s) they are received. If the IRA is sizable you may find yourself paying taxes in a higher tax bracket than you ordinarily pay. If your normal AGI is $50K and you take $100K out of an inherited IRA, your AGI will jump to $150K that year, resulting in a much higher tax bill. Additionally, you lose the tax-deferred growth opportunity of leaving the bulk of the money in the IRA. Liquidating an inherited IRA should only be done if you have an urgent need for the money.

If the Deceased was over 70 1/2 when they died and you elect to stretch the IRA by taking RMDs, you can choose to take RMDs based on your age or the age of the Deceased. The most tax efficient choice is to take RMDs based on the age of the younger person. If you were older than the Deceased when they died, then you would use the Deceased's age to calculate RMDs. Otherwise, use your own age.

If you intend to stretch the IRA and take RMDs, you are on the clock. If you fail to take an RMD before 31 December of the year following the year the person died, then you are forced to liquidate within 5 years.

I have prepared the taxes for a few people who had liquidated an inherited IRA and were shocked to discover they had given themselves a substantial tax bill as a result. The states with income taxes will also tax IRA distributions. Even military service members need to beware. Your home of record might not tax your military pay, but they may very well want a piece of that inherited IRA.

If you have questions the time to ask is before you select how you want to handle the inherited IRA. Once you have received the distribution it is generally too late.

• Income
• Trusts and Estates
• Military Tax Issues

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.

Qualified Higher Education Expenses

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.

• Tax Credits
• Common Tax Mistakes
• Virginia State Taxes
• Education Tax Breaks