Late Filings of Tax Returns - Common Answers
Taxpayers should file all tax returns that are due, regardless of whether or not full payment can be made with the return. This is because there is a penalty for not filing a return (if there is a payment of tax due). So even if you cannot pay, it's important to at least file the return! Depending on an individual's circumstances, a tax payer filing late may qualify for a payment plan. All payment plans require continued compliance with all filing and payment responsibilities after the plan is approved.
Here are some facts about filing tax returns:
1) Failure to file a return or filing late can be costly. If taxes are owed, late filings can result in penalty and interest charges and can SIGNIFICANTLY increase your tax bill.
2) There is NO PENALTY for not filing a tax return if a refund is due. However, in order to receive a refund, the return must be filed within three years of the due date. If you do not file within this timeframe, you forfeit your right to receive your refund.
3) If you file a return and later realize you made an error, the deadline for claiming any refund due is three years after the return was filed or two years after the tax was paid, whichever expires later.
4) Taxpayers who are entitled to the Earned Income Tax Credit must file a return to claim the credit even if they are not otherwise required to file. The return must be filed within three years of the due date in order to receive the credit.
5) Self-employed individuals must file returns reporting self-employment income within three years of the due date in order to receive Social Security credits towards retirement.
Paying the IRS - For those taxpayers who cannot pay their income tax due along with their return, the IRS suggests the following payment options:
1) Pay what you can - Since your unpaid balance is subject to interest (compounded daily) and monthly late payment penalties, it's important to pay what you can immediately, even if it's not the full amount of taxes due. This way, interest and penalties will be calculated only on the remaining balance due.
2) Obtain Financing - Consider financing the full payment of your tax liability through loans such as a home equity loan from a financial institution, etc. The interest charged by the lender is often less than interest and penalties that continue to accrue from the IRS. Using the loan proceeds to pay off the IRS will stop future interest and penalties from accruing.
3) Installment Agreements - If you cannot pay the tax liability in a lump sum, the IRS offers a payment by installment option. This agreement must be approved by the IRS.
4) Offer in Compromise - In some cases, (generally after all other options are exhausted); the IRS may accept payment that is less than the full amount owed. This is a fairly complicated process but is an option when all other methods of payment are exhausted. Like the installment play, an Offer in Compromise must be approved by the IRS.
Finally, it's important to respond to any IRS notice you receive. So many times taxpayers ignore such notices, hoping that the problem goes away. Quite simply, it won't go away if issues are not addressed. Like any other collection problem, the taxpayer will be viewed more favorably if he/she responds to such notices and shows a sincere attempt to resolve problems.
Year-End Tax Strategies Back to top
In addition to all the hustle and bustle of the Holiday season, let's not forget it's also that time of year to take care of some year-end financial related “stuff” like taxes! There are some things you can do to help you plan for next year's tax liability, hopefully making it a bit less. Most of these things require action BEFORE December 31st rolls around.
When all is said and done, we all want to avoid paying more taxes than we have to!
The most basic form of year-end tax planning involves deferring income into the next year and accelerating deductions into the current year. Paying deductible expenses by a credit card for example, is an acceptable way of accelerating deductions. You would be able to take these deductions as long as the charges appear on the current year statement even though you may not actually be paying until next year.
It's very important to note however, that deferring income and/or accelerating expenses is not always the right thing to do. If for example, you know that you're going to be making more money next year, then it may not be wise to use this strategy. You don't want to be in a higher income tax bracket next year just because you wanted to save a little money on your current year taxes. Also, your adjusted gross income effects such things as the taxable portion of social security, deductibility of IRAs, phase out of itemized deductions and personal exemptions.
The Alternative Minimum Tax is another very important thing to consider. More and more upper middle income people are being caught in this “trap” that was originally intended for the wealthy.
Regarding your investment portfolio, you might consider matching up your gains and losses. You may want to dump holdings that you don't feel are not going anywhere to help offset gains that you've realized during the year. If your losses exceed your gains, you can only deduct $3,000 of this excess. The rest would be carried into future tax years.
It's also important to remember that assets held longer than one year qualify as long-term and may receive the more favorable capital gains tax rate of 15%.
Taking advantage of your retirement plan or traditional IRA can also help. Self-employed individuals (especially owner-only type operations) can deduct a SIGNIFICANT amount under the right circumstances. There is much more flexibility here due to the Economic Growth and Tax Relief Reconciliation Act of 2001. Business retirement plans of course must be established before year-end. (IRA contributions on the other hand, CAN be made in 2006 for the tax year 2005 right up until the tax filing deadline).
For those of you who make estimated tax payments, check to make sure that you are paying in enough to cover your tax liability so that you don't get penalized. The opposite is also true; there's no sense in paying in too much if this year was not as profitable as you had previously estimated.
Space does not permit me to write about many tax issues. The bottom line is this: if your situation changes significantly this year, it's best to check with your tax preparer. Doing this before year-end is critical so you have time to make any needed changes.
Volunteer Firefighters' and Ambulance Workers' Credit Back to top
For the 2007 tax year, there is a new credit for NY State volunteer firefighter and ambulance workers.
The volunteer firefighters' and ambulance workers' credit is available to full-year NY State residents who are active volunteer firefighters or volunteer ambulance workers for the entire tax year for which the credit is claimed.
The credit is for $200 per person. So if for example, if both spouses are active volunteers both would receive the credit against NY State taxes!
You must be an active volunteer firefighter or ambulance worker. An active volunteer firefighter means a person who has been approved by the authorities in control of a duly organized NY State volunteer fire department. Furthermore to be active you must be considered to be faithfully and actually performing service in the protection of life and property from fire or other emergency, accident or calamity in connection with which the services of the fire department are required.
An active volunteer ambulance worker means an active volunteer member of a NY State ambulance company as specified on a list regularly maintained by the company for purposes of the volunteer ambulance workers' benefit law.
How to file the credit - It's easy to file the credit. Just fill out form IT-245 with your NY State tax return. The form is as easy as putting in your name, social security number, and answering 3 easy questions. If you qualify, you have to put the name of the qualifying volunteer fire company/department or ambulance company and their address.
The credit is “refundable”. This means that the credit amount goes up to and beyond your NY State tax liability.
One final note, it's important to realize that beginning in tax year 2008, a volunteer firefighter or ambulance worker will NOT be allowed to take this credit if they receive a real property tax exemption relating to their volunteer service. My understanding is that at this time, you can take one or the other but not both.
House Passes the “AMT Patch” Back to top
Many of you have probably heard of the controversy regarding the “AMT Patch” and whether or not it would be passed again this year. On Wednesday, December 19th, after months of bickering, the patch was finally passed.
What this means is that an estimated 21 million taxpayers will avoid paying additional tax known as the AMT (Alternative Minimum Tax). The tax is essentially a parallel tax system that was designed nearly 40 years ago. Its main purpose was to stop wealthier individuals from paying little or no tax. The problem is, the AMT numbers were NEVER adjusted for inflation the way the normal tax code has been. For example, each year standard deductions and personal exemptions are increased to help “make up” for inflation. This has never been done under the AMT.
The AMT basically takes your income and reworks it by disallowing certain deductions. This has the effect of making your taxable income under AMT higher than it would otherwise be. The next step is to take this higher income and reduce it by an allowable AMT exemption. This is where the AMT patch comes in.
Without the “patch”, the exemption would have reverted to the “pre-patch” levels of only $45,000 for joint filers and $33,750 for single filers. The temporary fix for 2007 allows an increase in the exemption amount to $66,250 (married filing jointly) and $44,350 (single). These numbers are an increase over last year's numbers of $62,550 (married filing jointly) and $42,250 (single).
The controversy over the AMT has been mainly two issues:
1) Can the Government afford to get rid of the AMT all together?
2) If the AMT is modified or eliminated, how to deal with the shortfall in revenue.
The AMT patch for 2007 will cost the government an estimated $53 billion in lost revenues. The big controversy was that some wanted to make up for this loss of revenue through other sources (i.e. additional taxes) while others wanted to ignore the loss in revenue the patch will bring. This is the approach that finally won.
Ultimately, the AMT (along with so many other issues) has to be dealt with fundamentally and not with “patches” or ignoring reality for “just one more year”. The choices are really quite simple, you either have to raise taxes (to accommodate huge spending) OR cut spending (to accommodate less tax revenue).
What the Government continues to do is to increase spending without a correlating increase in tax revenue. This has the effect of adding onto our National Debt which is fast-approaching 10 Trillion Dollars!
The good news is that Congress has provided some tax relief for an estimated 21 million individuals. The bad news is that fundamental, long-term solutions continue to be ignored.
The NY State Property Tax Credit Back to top
This week I'll discuss the NY State Real Property Tax Credit for Homeowners and Renters.
This credit is available to NY State residents who have household gross income of $18,000 or less and pay either real property taxes OR rent for their residence. If all qualified members of the household are under 65, the credit can be as much as $75. If at least one qualified member is age 65 or older, the credit can be as high as $375. The Property Tax Credit is a “refundable credit”. This means you will be refunded (i.e. cash paid out to you), any excess of the credit over your NYS tax liability. Otherwise, the credit will be used to simply reduce your NYS tax liability.
Here are the criteria for a homeowner to qualify for the credit:
1) Household gross income of you and the members of your household was $18,000 or less.
2) You occupied the same NY State residence for six months or more in the calendar year.
3) You (or your spouse) paid real property taxes on your residence.
4) You were a NY State resident for the entire calendar year.
5) You cannot be claimed as a dependent on someone else's federal income tax return.
6) Your residence was not completely exempt from real property tax.
7) The current market value of your residence is $85,000 or less.
A renter must meet the same requirements as above except that instead of paying real property taxes, the average monthly rent paid needs to be $450 or less (NOT counting charges for heat, gas, electricity, furnishings, or board).
I should note that household income is generally income from most sources, even if they are not taxable. This includes such items as worker's compensation, public assistance, social security benefits, etc.
Because the criteria to qualify for this credit is pretty narrow, only people with very low household incomes receive the benefit of this credit.
To claim the Real Property Tax Credit, you must use form IT-214 and attach this along with all your other NY State tax forms. For more detailed information, see NY State Publication 22
Social Security Taxation - Some Benefits can be Taxable Back to top
For most people on social security, benefits are not taxable. For people who have other income (earned or unearned), some of Social Security benefits might be subject to taxation.
Like many other things in the tax rules, it's a little difficult to determine whether your benefits might be taxable. A quick way to help you determine this is to do the following:
Add one-half of total Social Security benefits you received to all your other income including tax exempt interest and other exclusions from income.
If the total is above $25,000 (Single) or $32,000 (Married Filing Jointly) then some of your Social Security Benefits are taxable.
If part of your benefits are taxable, how much of it is taxable depends on the total amount of your benefits and other income. If you have a higher income then more of your Social Security benefits will be taxable and vice versa.
The general rule of thumb is that 50% of your benefits will be taxable. This percentage however can be 85% if either of the following situations applies to you:
The total of one-half of your benefits and all your other income is more than $34,000 (Single) or $44,000 (Married Filing Jointly)
You are married filing separately and lived with your spouse at any time during the tax year.
There are several worksheets to figure your taxable benefits and these worksheets are in the instructions to the Form 1040.
Disability Income - Please note that these same rules also apply to Social Security disability and survivor benefits. Many people are under the mistaken impression that these benefits are not subject to the rules regarding social security taxation.
Lump-Sum Social Security Benefits - Much in the same way as regular Social Security, lump sum benefits must be applied to a similar test to determine if some of these benefits are taxable. There are two ways to report this income. One way is to report the total lump sum in the year you receive it OR (if it will reduce your overall tax liability) you can apply portions against prior year's income to which the Social Security benefits relate.
IRS Publication 915 discusses the area of Social Security and equivalent Railroad Retirement Benefits.
NY Empire State Child Credit & Non-custodial Parent EIC Back to top
This week, I'd like to go over a couple of NY State tax credits for people who have children. One of the credits is the New York Empire State Child Credit.
This credit is available to full-year New York State residents who have a federal child tax credit or a federal additional child tax credit and a qualifying child OR meet certain income thresholds and have a qualifying child.
To qualify for the NYS credit, the child must have qualified for as a qualifying child for Federal income tax purposes AND be at least four years of age. Essentially the children must be between the ages of four and under 17 at the end of the tax year to qualify.
The credit is a “Refundable” tax credit. This means that the amount of credit will count towards payment of your tax liability, just as if you paid cash. Even if have a refund before application of this credit, your refund would now be larger by the amount of this tax credit! This is unlike many tax credits that are non-refundable. Non-refundable credits reduce any amounts you might owe. Any remaining credit amount beyond what you owe would be lost.
To file this credit, use IT-213 along with your regular NY State income tax forms. It's a relatively simple form. The bottom line is that the amount of the Empire Tax Credit is about 33% of your federal child tax credits (regular and additional).
The other NY State tax credit I'd like to go over this week is the Noncustodial Parent NY State Earned Income Credit (EIC). This credit is available for a full year resident who is 18 or older, is a parent of a minor child or children who does not reside with the individual, has an order requiring the individual to make child support payments payable through a support collection unit, and has paid child support during the tax year for every order that requires the individual to make support payments.
This credit can be claimed on form IT-209. The credit is equal to the greater of:
20% of the federal EIC that would have been allowed if the noncustodial child met the definition of a qualifying child. OR
2.5 times the Federal EIC that would have been allowed if you had satisfied the eligibility requirements, computed as if you had no qualifying children.
This credit, like the Empire State Child Credit, is a refundable credit.
For additional information, see forms and instructions for IT-213 (Empire State Child Credit) and IT-209 (Claim for Noncustodial Parents NYS Earned Income Credit).
Earned Income Credit Back to top
For the past couple of weeks I've written on some common tax credits for which some taxpayers qualify. This week I will continue with the popular Earned Income Credit (EIC). There are many rules regarding this credit and the calculations are sometimes complicated. I'll go over some basic information about the earned income credit including what it, how much it is, and what the criteria is to qualify.
The EIC can be a great benefit for low-income workers. This credit returns a portion of the taxes you might have paid and even produces a refund for eligible filers who had no tax liability (or a tax liability below the EIC amount). This means that the EIC is “Refundable” as opposed to non-refundable like most other tax credits.
Many people think that the EIC is only for people with children. This is NOT the case. It is true that the EIC is much greater for low-wage earners with children, however single individuals can qualify for an EIC.
For 2007, the maximum credit can be as much as $4,716 for workers supporting two or more kids. A worker with one child can receive up to $2,853 with the credit. A maximum amount of $428 is available for a childless worker. These amounts are adjusted slightly for inflation each year.
A single filer's adjusted gross income (AGI) must be less than $12,500 if he has no children; $33,001 with one child; and $37,001 with two or more kids. Married couples filing jointly are allowed to earn $2,000 more in each category and still claim the credit. I should also note that anyone who has investment income of $2,901 or more CANNOT receive the earned income credit regardless of their earned income or adjusted gross income (AGI).
If you (and your spouse if married) do not have a qualifying child, the basic criteria to qualify for the EIC is as follows:
At least 25 years old but under 65 at year-end.
Cannot be claimed as a dependent on someone else's return.
Home must be in the United States for at least 6 months of the year
Here is the criteria for being a qualified child for purposes of the EIC:
Can be your child, grandchild, stepchild, adopted child, etc. as long as you can claim him/her as a dependent on your return.
Your Brother, Sister, Stepbrother/sister or a descendent of any of them who you cared for as your own child.
Age limit of 19 or less at end of year (age 24 if student). Child can be any age if permanently disabled.
Child must have lived with you for greater than one-half of the year.
Custody Complications - Claiming the earned income credit can be especially confusing for people sorting through child custody issues. When custody is split, only the parent who physically housed the child for more than six months can claim the credit. Sometimes, however, a child might be claimed by either parent. When such complications arise, there are rules the IRS goes by called “tie-breaking” rules, to see who gets the credit.
Because the earned income credit is a “refundable” credit designed to help low wage earners at tax time, you should definitely look into it if you think you might qualify.
Common Tax Return Errors
Now that the tax season is nearly upon us, I'd thought it'd be a good idea to highlight the most common errors that people make when filing their individual tax returns. This information can be found on the IRS website www.irs.gov (tax topic 303 - Checklist of Common Errors When Preparing Your Tax). The most common errors are:
1. Incorrect or missing social security numbers.
2. Incorrect tax entered from the tables.
3. Computation errors in figuring the child and dependent care credit or the earned income credit. Also, missing or incorrect identification numbers for child care providers.
4. Withholding and estimated tax payments entered on the wrong line, and
5. Math Errors. Both addition and subtraction.
It is important that you review your entire return, especially since many of the most common errors are administrative or clerical. Errors usually will delay the processing of your return and therefore any refund that may be due.
Before filing your return, review it to make sure it is correct and complete. The following checklist may help you avoid errors:
Did you use the peel-off label and enter any corrections? If you used the label, did you enter your social security number in the space provided?
If you do not have a label, or there are too many corrections, did you clearly print your name, social security number, and address, including zip code directly on your return?
Did you enter the names and social security numbers for yourself, your spouse, your dependents, and qualifying children for earned income credit or child tax credit, exactly as they appear on the social security cards? If there have been any name changes be sure to go to www.ssa.gov or call at 1-800-772-1213.
Did you check only one filing status?
Did you check the appropriate exemption boxes and enter the names and social security numbers exactly as they appear on the Social Security Card, for all of the dependents claimed? Is the total number of exemptions entered?
Did you enter income, deductions, and credits on the correct lines and are the totals correct?
If you show a negative amount on your return, did you put brackets around it?
If you are taking the standard deduction and checked any box indicating either you or your spouse were age 65 or older or blind, did you find the correct standard deduction using the worksheet in the Form 1040 Instructions or the Form 1040A Instructions?
Did you figure the tax correctly? If you used the tax tables, did you use the correct column for your filing status?
Did you sign and date the return? If it is a joint return, did your spouse also sign and date the return?
Do you have a Form W-2 (PDF) from all of your employers and did you attach Copy B of each to your return? File only one return, even if you have more than one job. Combine the wages and withholding from all Form W-2's, on one return.
Did you attach any Form 1099-R (PDF) that shows tax withheld?
Did you attach all other necessary schedules and forms in sequence number order given in the upper right-hand corner?
If you owe tax, did you enclose a check or money order with the return and write your social security number, tax form, and tax year on the payment? Refer to Topic 158 for more information, and
Did you make a copy of the signed return and all schedules for your records?
E-filing your return can avoid many clerical or administrative type of mistakes. If however you file manually, it's especially important to double-check your figures, or better yet, have someone else take a look at the return.
Federal Child Tax Credit/Additional Child Tax Credit Back to top
This week, I'm going to discuss the child tax credit for Federal income tax purposes. This is basically a credit that can be claimed if you have a qualifying child and your income falls in the appropriate category to take the credit. Remember that a credit (as opposed to just a deduction) is a dollar for dollar reduction of your tax liability!
To claim the credit, you must first have a qualifying child who:
Is a United States citizen, U.S. resident, or a national of the United States AND
Is under the age of 17 at the end of the tax year AND
Is your son, daughter, stepson, stepdaughter, legally adopted child, or a child placed with you by an authorized placement agency or by court order, or a descendant of any such person, AND who
Shares with you the same principal place of abode for more than one-half of the tax year, or is treated as qualifying child under the special rule for parents who are divorced, separated, or living apart.
The credit is limited based on income levels and filing status. The maximum credit is $1,000 per child. A phase-out of the child tax credit begins once your modified adjusted gross income is above $110,000 (Married filing jointly) or $75,000 (Single or Head of Household).
For the most part, the child tax credit is considered a “non-refundable” credit. This means that any credit in excess of your total tax liability will not be “refunded” to you in cash. For example, if you owed $500 in income taxes and your child tax credit was calculated at $600, your credit would be limited to your $500 tax liability.
There are two very important exceptions to this rule however and they are the basis for the “Additional Child Tax Credit”
If the amount of your child tax credit is greater than your income taxes you may be able to claim the additional child tax credit if your EARNED income is below the base amount for the year. To do this, you must fill out a rather lengthy worksheet to see if you qualify.
If you have three or more qualifying children, you may be able to claim an additional child tax credit up to the amount of Social Security taxes you paid during the year, less any earned income credit you receive.
If you qualify under both of the above rules, then your additional child tax credit will be for whichever calculation is larger.
Finally, I should mention that individuals who receive the Child Tax Credit may also be able to receive other credits such as the Earned Income Credit (EIC) and the Child and Dependent Care Credit.
Hiring Your Kids Can Save Business Owners' on Income Taxes Back to top
This week, I'd like to discuss some of the advantages of hiring your children for your small business.
Many of you might not know that wages paid to your children between the ages of 7 and 17 are a valid payroll expense as long as the kids do bona fide work and are compensated at a reasonable level.
Your children can earn up to $5,700 before having to pay income tax. ($5,700 is the standard deduction amount for 2010). This way, you receive a bona fide business deduction, one that you will not have to pay taxes on!
Another BIG advantage is you do NOT have to pay Social Security and Medicare taxes on them! This represents a total savings alone of 15.3% of the amount you pay them in additional taxes you'd otherwise pay. In regards to unemployment taxes, you do not have to pay them as long as they are under 21.
If you don't mind paying your children more than the standard deduction amount (and of course they are doing bona-fide work), you will still come out ahead if you are in a higher tax bracket. This is because you will effectively be able to shift income from your higher tax bracket to the child's tax bracket.
To take this a step further, you might even want to shelter income paid beyond the standard deduction amount, into an IRA. This will allow even more tax advantaged savings.
In regards to record keeping, you must treat them like any other employee. Their time should be well-documented, along with their duties and what work was performed. You would also need to file the appropriate payroll forms, even though there will be no tax due.
Perhaps the most important advantage of hiring your children is one completely non-financial, one that is for the children themselves. Working and earning money should give children an advantage in managing money over children without such experience. As the saying goes, a little work never hurt anyone. The sooner they begin learning useful skills, the better prepared they will be in the real world later on.
DO I NEED TO MAKE ESTIMATED TAX PAYMENTS? Back to top
We often get questions from clients regarding the need to make estimated tax payments. Wage earners typically have income tax withheld from their salary and never have to consider estimated taxes. However, if you are self employed, have significant earnings from interest, dividends, or capital gains, you may need to pay into the system. Other taxpayers who are retired and don't have tax withheld from their pensions or are taking IRA distributions, divorced taxpayers receiving alimony payments, the unemployed, or if you work at multiple jobs you may need to make estimated payments.
The federal income tax system is considered a “pay as you go” tax. As you earn income during the year the IRS requires you pay the tax due. Generally, if you wait until the filing date of your tax return to pay the tax and owe more than $1000 the IRS will assess an estimated tax penalty. The penalty is based on the prevailing IRS interest rates for the year and usually ranges between six to eight percent. There is usually a one year “grace period” allowed if you did not need to pay taxes with the previous year's return. For example, if you had a refund or owed less than $1000 with your 2005 return and you owe more than $1000 with your 2006 return you wouldn't be assessed a penalty with the 2006 return. However if you ended up owing more than $1000 again on your 2007 return (because you did not pay enough estimated tax payments) then you would be assessed a penalty for underpayment of taxes. This is one of the many reasons we usually like to see a copy of the previous year return with new clients.
Also, during the year if you paid in at least as much estimated tax as you owed in the previous year you may be able to avoid the penalty. If your income is above $150,000 for most filers ($75,000 for married filing separate) you will need to pay 110 percent of the previous year's liability. The other way to avoid the penalty is to file your taxes and pay the final estimated tax payment by January 31 for most taxpayers. Farmers or fishermen are allowed to file their tax return and pay all of the income tax due by March 1 without penalty. The due dates for the estimated tax payments are usually April 15, June 15, September 15, and January 15. The IRS prefers that tax payments are withheld from your income sources over the estimated payment method. The IRS calculates your tax liability for each calendar quarter during the year and generally, withheld taxes are credited against each quarter's liability. As long as you have adequate taxes withheld to meet the IRS guidelines you would not be subject to penalties. If you make estimated tax payments under some scenarios you could be subject to estimated tax penalties even if you covered your tax liability for the year. Most commonly this would occur if your income is not consistent during the year and your estimated payments did not match your income. This might occur if your income is seasonal, you had a substantial distribution from an IRA, had a large capital gain, or held a mortgage with a large annual payment and you made four equal estimated income tax payments. If the IRS was able to determine your quarterly tax payments did not match your quarterly liability during the year they could assess a penalty.
I had mentioned taxpayers working multiple jobs as someone who might incur penalties. Most payroll software makes the assumption that the taxpayer is only working at one job and calculates income tax withholding accordingly. The tax code allows most wage earners to make a certain amount of income before they are subject to the income tax, depending on their standard or itemized deductions and number of exemptions. However once this income level is exceeded each dollar of income is taxed at the marginal tax rate. If you work at three or four different jobs and each tax withholding calculation allows for your deductions and exemptions your total income tax withholding is going to be too low. I usually know immediately a client is not going to be happy when I see him or her bring in three or four W-2s all with low withholdings.
These are the general federal guidelines for individuals. Different rules apply for corporations, estates and trusts, not for profits, etc so consult with your tax professional for these guidelines. Also New York State follows similar guidelines but the threshold for penalties usually starts when you owe $300 or more.
Tax Refunds - Are they such a great thing? Back to top
This week, I'd like to discuss the subject of tax refunds. When taxpayers receive a tax refund, it essentially means that they paid in more to the government (withheld) than they had to during the previous tax year. Some people use their withholdings as a “forced” savings account and look forward to seeing a big “windfall” of cash at tax time.
I see it as giving the government a short-term loan on your hard earned money and getting it back in the next year without receiving interest!
For people who work for someone else, withholdings are calculated on IRS form W-4 (Employees Withholding Allowance Certificate). This form must be filled out for all employees and determines the amount your employer will deduct from your paycheck. The higher the number, the less your employer will withhold from your paycheck each week. Some people artificially make this number lower and therefore have more withheld than necessary.
There's also a place at the bottom of the W-4 to make yourself exempt from having any Federal taxes withheld. This should only be done if you had NO federal tax liability in the prior tax year and you expect the same for the current tax year.
Employees should update their W-4s to reflect any major changes in their life such as a marriage, having a child, purchasing a new house, etc. All of these changes will affect their tax situation. Still, there are many people who do not change their W-4 to reflect these changes.
Although the W-4 is a two page form, there is other guidance in IRS publication 919 (How Do I Adjust My Tax Withholding?). This is a 19 pager along with 7 worksheets. There is also a web calculator available on the IRS website. Both the publication and the web calculator are not nearly as intimidating as they appear to be. You can also get help from your tax preparer and usually your employer!
The main thing is to update your W-4 to reflect your financial/tax reality and avoid paying in too much and also avoid not paying in enough.
Having a more accurate amount deducted from your paycheck will give you more take home pay. I would suggest taking this extra “pay raise” and using it properly (i.e. paying off bills, credit cards, or debt OR investing it for later on).
On the flip side, you need to make sure that you are paying in enough to Uncle Sam. The general rule is that if your tax shortfall is $1,000 or less, you will not be assessed any interest or penalties. Amounts owed greater than $1,000 will cause additional penalties and interest.
Sale of a Primary Residence Back to top
This week I would like to discuss the tax treatment of the sale of a primary residence. Even though the rules for sales of primary residences were changed dramatically in 1997, there is still confusion in this area and many people are unaware of these changes.
One rule included the requirement of reinvesting sales proceeds into another home. This rule has been completely repealed. You do not need to reinvest sales proceeds to receive a tax benefit on your gain of selling your primary residence. The other rule, known as the “Once in a Lifetime” Exclusion” (for sellers 55 and up) is also gone.
In their place was instituted a new law allowing up to $250,000 of profit from the sale of a primary residence per person ($500,000 per couple) to be excluded from taxation. The full amount is available if the seller(s) used the home as their primary residence for at least two years out of the five years prior to the sale. This does NOT mean that the property had to be owned for a full five years, as some might believe.
Vacant Land - The home sale exclusion can include gain from the sale of vacant land that has been used as part of the principal residence, if the land sale occurs within two years before or after the sale of the dwelling unit. The land must be adjacent to land containing the dwelling unit, and all other requirements of Section 121 (Sale of a primary residence) must be satisfied. The sale of the land and the sale of the dwelling unit are treated as one sale for purposes of the $250,000/$500,000 exclusion limitation amounts.
Any profit above the excluded amounts is taxable regardless of what is done with the money. If the property was owned less than 12 months, it will be subject to ordinary income tax rates. If it was owned for more than 12 months, it will qualify for the lower long-term capital gains tax rates (currently 15%).
As has always been the case, no deduction is allowed for losses on the sales of personal residences.
Finally, I should also note that this exclusion applies only to sales of primary personal residences. It does NOT apply to sales of second personal residences or rental properties. Avoiding capital gains on these sales would require the use of another strategy called the 1031 tax deferred exchange which I have written about in a previously article.
Vehicle Related Tax Benefits for 2009 Back to top
Car Sales Tax Deduction: The recently passed American Recovery and Reinvestment Act of 2009 provides for a deduction for State and local sales and excise taxes paid on the purchase of qualified new vehicles purchased between 02/16/09 and 12/13/09. “Qualified motor vehicles” are defined as a passenger automobile or light truck having a gross vehicle weight rating of 8,500 pounds or less. Motorcycles also qualify for this deduction! Keep in mind that this is a DEDUCTION, not a tax credit; taxable income is reduced by the deduction amount. A credit on the other hand reduces your tax liability dollar for dollar.
There is a limit however as to how much sales tax you can deduct. Generally, sales tax paid up to $49,500 of the purchase price qualifies for the deduction. Unfortunately the deduction is NOT available for those who purchase a used car. Also please note that this deduction is only for those 2009 purchases AFTER 02/15/09.
There is also an income limit for those taxpayers otherwise eligible to take the deduction. Those taxpayers whose modified adjusted gross income (MAGI) is less than $125,000 ($250,000 for married filing jointly) will receive the full deduction. It is completely unavailable for those taxpayers with MAGIs of $135,000 (single), $260,000(married filing jointly). If a taxpayer's MAGI falls in between these two amounts, the deduction will be reduced.
It is NOT required that you itemize your deductions on your tax return to be able to use this deduction. There will be a special line item (per the IRS) on the 2009 tax return to accommodate this credit. It's also worth mentioning that unlike the First time homebuyer's credit, you may not amend your 2008 return to take this deduction. The sales tax deduction must be taken on your 2009 return. If you happen to purchase more than one qualified vehicle, you can also take the sales tax deductions on those.
CARS (Cash allowance rebate system) Better known as the Cash for Clunkers Program - This program is actually run by the National Highway Traffic Safety Administration. This benefit is NOT a tax benefit per se but rather is a discount of up to $4,500 when you purchase or lease a new, more environmentally friendly vehicle from a qualified dealer AND you trade in a clunker. Originally the government provided a total of 1 billion for this program. As of today's writing, this amount has been exhausted, BUT the Obama Administration vowed to continue more funding for this benefit. However continuation of this program may be modified from its current form. (For purposes of this article, I am summarizing the program in its current form).
The timeframe for this program is for purchases between July 1, 2009 and November 1, 2009 (or when authorized funds are no longer available). There are numerous qualifications for your trade in to qualify as a clunker (i.e. less than 25 years old, must get 18 MPG or less, registered and insured continuously for the full-year preceding the trade it, etc.). The dealer gives you the credit off your new purchase and receives the credit amount from the government (supposedly within 10 days). There are several “hoops” that dealers must go through in order to receive their money. The most important of which is to scrap the vehicle that you traded in.
If you are planning on purchasing a new vehicle and think you might have a qualified clunker to trade in, you should contact your dealer for additional details!
Child & Dependent Care Credit Back to top
Last week, I discussed the Child Tax Credit; a credit that is available to most taxpayers with children. This week, I'll go over the Child & Dependent Care Credit.
If you paid someone to care for a qualifying individual so you (and your spouse if married) could work or look for work, you may be able to claim the credit for child and dependent care expenses. If you are married, both you and your spouse must have earned income, unless one spouse was either a full-time student or was physically or mentally incapable of self-care. The expenses you paid must have been for the care of one or more of the following qualifying individuals:
1) Your Dependent under the age of 13 when the care was provided.
2) Your Spouse who was mentally or physically not able to care for him/herself and who lived with you for at least half of the year
3) Your Dependent (who even though he/she is over the age of 13), cannot care for him/herself due to a physical or mental limitation.
In addition to the conditions described above, to take the credit, you must meet ALL the following conditions:
1) You must provide the social security number of the qualifying person
2) Your filing status must be a status other than married filing separate.
3) The payments for care cannot be paid to someone you can claim as your dependent, or to your child who is under age 19 even if he/she is not your dependent.
4) You must report the name, address, and taxpayer identification number of the care provider on your return. (You can use Form W-10 to request this information from your care provider).
Most people would use Form 2441 to calculate the amount of the tax credit. If you receive dependent care benefits from your employer, these amounts would have to be deducted from eligible child and dependent care expenses for purposes of calculating any applicable credit.
Credit Amount - The amount of the credit is a percentage (based on your adjusted gross income) of the amount of work-related child and dependent care expenses you paid to a care provider. Qualified expenses are the lesser of actual expenses or $3,000 (for one child) or $6,000 for two or more children). The maximum percentage of qualified expenses is 35% and is based on an adjusted gross income (AGI) of $15,000 or less. This equates to a credit in the amount of $1,050 (for one child) or $2,100 (for 2 or more children). The percentage decreases as AGI increases. However, in no case, will the percentage go below 20%, even if your AGI is high. This means that nearly everyone will qualify for at least 20% of eligible child and dependent care expenses regardless of income level.
Finally, the child & dependent care credit is a non-refundable credit, meaning that you can only use the credit to reduce your tax liability. If your tax liability is less than the credit, then you would only be able to take the credit up to the amount of your tax liability.
Next week, I'll go over another popular credit; the earned income credit.
Is it a Business or a Hobby? Back to top
One of the common items of dispute that comes up in an IRS audit is whether an activity is considered a hobby (in which case no deductions are allowed) or a business. Business deductions are allowed. The problem arises when a taxpayer claims that a particular activity is a business and the IRS disagrees!
The IRS uses certain criteria to determine whether a particular activity is considered a hobby or a business. Among them are the following:
1) How much time is devoted to the activity? The more time one devotes, the stronger the case that the activity be classified as a business. If you're a lawyer for example, who has a hobby farm where you work for 10 hours on the weekend; it might be difficult to consider this a business.
2) Maintaining Separate Books - Maintaining separate books and segregating cash accounts for your activity helps build your case for a legitimate business deduction.
3) Profit Motive - There is a misconception that a business must make a profit (in 3 of the past 5 years for example) to be considered a business. This is simply not true. It is helpful though for the business to have profits to build its case that the activity is not a hobby. Farmers for example, can go years without posting a profit due to large depreciation deductions, bad economic conditions, bad weather conditions, etc. This however does not mean that the full-time farmer is doing all his hard work as a “hobby”.
4) Keeping up with the latest industry trends/technology - There are several ways to do this. Subscribing to trade publications, consulting with experts, etc. are all ways you can help prove that you are treating your activity as a business. In addition, if you implement important upgrades to your activity that keeps up with the latest technology, it strongly proves that you are running your activity as a business and not a hobby. A printer who does some printing jobs on the side might be viewed as a hobbyist if he has an old-fashioned press from the mid 1900s. This is in part because his revenue would be limited due to the archaic nature of his old-fashioned press. The IRS might be able to use this against the printer and say his activity is therefore a hobby.
5) Use of Advertising - This would show intent to make a profit.
6) Written Documentation - Outside of keeping separate books and maintaining separate cash accounts, having other documents such as a business plan or budget will substantiate your intent to run your activity as a business.
7) Financial Status of Taxpayer - Lack of substantial income outside of your activity will definitely help you stay away from hobby status. Large income from other sources might weigh against you, especially if it's construed that you get receive elements of personal pleasure from your activity.
By looking at the items above, you can probably start to get a feel for what the IRS looks for in determining whether your activity might be construed as a hobby. The bottom line is that anything you can use to help prove your activity is a business vs. a hobby will be helpful should this issue ever come up in an audit.
Like the criteria I discussed for independent contractors in last week's article, the IRS takes a look at your activity as a whole to make a determination. Therefore it's important to be aware of the potential pitfalls that could jeopardize your activity's business status.
Sales Tax Deduction Back to top
New for 2004 - Sales Tax Deduction - The American Jobs Creation Act of 2004 authorized a “Sales Tax Deduction” as an option for those who itemize deductions. You now have a choice of deducting NY State income taxes paid OR deducting sales taxes you paid during the year.
Taxpayers should compare the two amounts to see which one will entitle them to a larger deduction.
There are two ways of calculating the sales tax you paid for the year. One is using actual expenses. The other, more practical solution is using the Optional State Sales Tax Tables provided by the IRS. Under this method, you look up the amount of sales tax deduction you're entitled to based upon your State of residence, income, filing status, and exemptions claimed.
Certain other large purchases can be added to the Optional State Sales Tax Table amount to come up with your total eligible deduction. Examples include sales tax paid on a motor vehicle (car, truck, motorcycle, ATV, etc.) and home building materials. Be sure to tell your tax preparer if you made such purchases during the year as you are more likely to benefit from the sales tax deduction.
The sales tax tables are not included in the tax instruction booklets because this did not get enacted until later in the year. The tables are however posted on the IRS website. You can also stop by my office if you would like a copy.
Realistically, this deduction will mainly benefit taxpayers with a State or local sales tax but no income tax. As you all know, NY has an income tax. Nonetheless, if you made some large purchases in 2004 and paid some hefty sales tax, you very well may benefit from this new deduction. You will also want to take this new deduction into consideration for 2005 expenses. The way it stands now, the sales tax deduction is allowable for tax years 2004 and 2005. As local sales tax increases occur, this deduction may be extended into future tax years and many more people may benefit from it.
AMT (Alternative Minimum Tax) Back to top
This week, I'm going to discuss a little talked about part of the IRS code called the Alternative Minimum Tax (AMT). This tax is a parallel tax system. Taxes are calculated separately from the regular way in which we calculate our taxes. Basically, if the amount of taxes is calculated at a higher rate under the AMT, then this would be the tax liability you would have to pay.
This system was designed in 1969 to help ensure that very wealthy individuals paid their fair share in taxes. In a nutshell, the AMT disallows or reduces certain deductions that are allowable under the regular tax code. Until recently, the AMT affected less than 1% of all taxpayers. Since 2000, the number of people subject to this tax has increased significantly. Many estimate that by the year 2010, some 30 million Americans will be subject to this tax. This would be approximately 20% of all U.S. taxpayers.
The increase of individuals subject to AMT is happening due mainly to the following two reasons:
AMT deductions have NOT been indexed for inflation. The best way to explain this would be to look at the 2009 standard deduction under the regular tax system. For a filing status of married filing jointly, the standard deduction is $11,400. This amount was $10,900 for the 2008 tax year. Although an extra deduction of $500 in one year doesn't seem like much, just think of how little this deduction would help us if it wasn't increased for over 30 years! This is exactly what has happened under the AMT.
Recent tax cuts - The other reason why more people are exposed to the AMT result from tax cuts enacted in 2001 and 2003. Because AMT amounts have not been adjusted for inflation, cutting regular income tax liabilities have actually put many more people into “AMT land” than would have otherwise been the case.
Unfortunately, the AMT now primarily affects middle to upper-middle income taxpayers. To put this into context, let's take an example of a couple with four children with a yearly income between the husband and wife of $150,000 per year. $150,000 is a nice yearly income but I think as most of you would agree, it is not nearly as much money as it was in 1969 when the AMT was enacted. Back then a yearly income of this size would have been quite high for most Americans. Now, however, you could argue that this is fairly modest, especially when you have children, college education expenses to help pay for, etc.
Again, the AMT was designed to affect only the wealthiest of Americans back when it was enacted. This is now simply NOT the case.
Another very unfortunate disadvantage of the Alternative Minimum Tax is its complexity. AMT calculations can be very complex….as if the regular tax code isn't bad enough! Taxes are calculated under the regular way and under the AMT. If the AMT calculation is higher then this is the tax liability you would pay. Planning for the AMT is also challenging because it usually goes completely against any type of planning you might have done in the past. With AMT planning, you're not looking to avoid paying taxes, you're looking to avoid paying taxes under the AMT system (which would result in a higher tax liability)!
Space does not allow me to go into more detail this week but in future articles I will discuss the AMT in more detail including common deductions that may subject people to the AMT.
Alternative Minimum Tax (AMT) - Part II Back to top
In last week's article, I discussed some basic information on the Alternative Minimum Tax (AMT) including what it is, its history, and the fact that more people are running into this separate tax code. I also touched on how lawmakers have NOT adjusted the AMT amounts to account for inflation and how this is causing (and will continue to cause) more and more taxpayers AMT headaches. This week, I'd like to go over some of the common items that can send taxpayers into this tax.
To briefly recap, the AMT is a tax code that is parallel to the regular income tax code. Under the AMT, certain deductions allowed under the regular tax code are either disallowed all together or reduced significantly.
Here are some common items that can “raise a red flag” regarding AMT:
Accelerated Depreciation - This is where business owners take more depreciation for tax purposes than normal. This is not an uncommon thing for business owners to do and is perfectly legitimate. In 2003 and 2004, we even had “special depreciation” allowances signed into law to provide a stimulus for the economy. Significant accelerated depreciation however could raise a red flag for AMT and you could be paying AMT tax for having too much depreciation.
Tax-exempt interest - Significant tax-exempt interest can certainly raise the AMT flag.
High Income - “High” is relative, especially when compared to the original intent of the AMT. (It was enacted in 1969 following testimony by the Secretary of the Treasury that 155 people with adjusted gross income above $200,000 had paid zero federal income tax on their 1967 tax return).
The AMT consists of two brackets: 26% for incomes below $175,000 and 28% for incomes above. It allows a standard exemption that exempts most low-income taxpayers ($45,000 for married filing jointly and $33,750 for most other taxpayers). AMT disallows many of the deductions and tax preferences allowed by the regular income tax including depreciation for state and local income taxes, unreimbursed business expenses, and certain medical expenses. This is why the AMT now affects mainly middle to upper-middle income taxpayers. (people with fairly modest incomes who itemize deductions). Low income taxpayers are obviously unaffected by the AMT but so are the wealthy. This is because the effective tax rate on the wealthiest taxpayers under the regular income tax system is higher than the AMT rate of 28%.
The end result is an extremely complex, outdated tax code aimed at middle to upper-middle income Americans. This trend will continue if the AMT code is not changed and more and more Americans will face higher taxes under this burdensome tax code.
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Bob Tackabury is owner of Robert L. Tackabury, CPA 2556 Rt. 12B, Hamilton, NY 315-825-0255 and is an Investment Registered Representative. Securities offered through IBN Financial Services, Inc., 404 Old Liverpool Rd.Liverpool, NY 13088. 315-652-4426.
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