Out-of-Pocket...I mean out of YOUR pocket

Anyone whose sits across my desk knows the drill.  We chat about our families, you hand me your forms, I start keying data into the return and then I grill you for the things that don't show up on the forms.

"Did you purchase anything that would qualify for the Energy Credits?  A new furnace, insulation, doors, windows, hot water heater...?"

"How much was your excise tax last year?"

"Did you take any college classes?"

"Any unusually high medical expenses you had to pay out-of-pocket?"

Let's pause for a second.  Out-of-pocket.  Merriam-Webster defines it as requiring an outlay of cash.

I thought it was self-explanatory; not tax jargon like amortization, double-declining balance, accelerated cost recovery, passive activity or unrecaptured section 1250 gain.  Imagine my surprise when a client called me about an audit.

"Dave, the IRS is asking for all of my medical expenses from 2010.  They want receipts, canceled checks, credit card statements...the works".  I pull up the 2010 return and there was $13,000+ of medical deductions.  I then pull up the document the client gave me listing all of their expenses.  In my notes I wrote:

"TP (taxpayer) had surgery in 2010 and was put on many Rx drugs after.  TP list shows OOP (out-of-pocket) expenses of $13,219."

I told the client to pull his records together and call back to schedule an appointment to write an appropriate cover letter to the auditor.  The audit was being conducted by mail (as opposed to a desk audit where you actually show up at the IRS with your records) so I wanted to make sure the documents were easy for the auditor to follow.

The client shows up with the proverbial shoebox of receipts.  I put a new roll of adding machine tape in the calculator and start plowing through.  A half hour later I have a 18 foot tape but there's a problem...I only have about $4,000 of expenses accounted for.  I bring it to the client's attention and he hands me a file folder stuffed with paperwork.  I breath a sigh of relief but then I see what's inside.  It's all EOBs (Explanation of Benefits) from his insurance company.  Apparently the client included all of the charges that Blue Cross paid directly to the hospital...about $10,000.

I took a deep breath and explained that he can only deduct what he paid.  Not what his insurance paid.  He said he thought out-of-pocket included what came out of Blue Cross' pocket too.  I shook my head and explained that he's going to have to pay back the taxes taken on the medical deduction.  About $2,500 plus interest.  I was able to talk the IRS out of penalizing the client 20% of the tax for accuracy but he was still on the hook for the tax and the interest.

So when we talk about out-of-pocket, I want to be clear that this has to be what you paid with your own funds or charged to a credit card. 

The same goes for when I ask for unreimbursed expenses related to your job.  If you get an allowance for tools, uniforms, travel, etc. you can't deduct it on your return. If you spend more than the allowance, then you get to deduct what you paid out-of-pocket.

I want every client to pay the lowest possible tax every year.  But as this unfortunate client discovered, when the your number is pulled in the audit lottery you better have the records to back it up.  Oh, and it helps to know the definition of out-of-pocket.

IRS E-file...WTH? (What's The Holdup)

So IRS e-file went live today.  Usually, this is when I celebrate getting all of the returns I've been holding over the wires so everyone gets their refunds.  So after transmitting over 40 returns why am I still holding several back?  For all my clients that are asking "what's the holdup?", here is why.

There is plenty of blame to go around.  Congress changed the tax code on January 2nd of this year retroactive to 2012 for several items.  This includes the Alternative Minimum Tax, the way certain things are depreciated and they reinstated the Residential Energy Credit.  This requires the IRS to reprogram their computers and create/modify the tax forms.  Certainly understandable that the IRS needs additional time to do this. 

Then there is the IRS who decided just days before the filing season opened that they wanted to tweak how Form 8863 is e-filed for those taking the education credits (including the Lifetime Learning Credit and the American Opportunity Tax Credit). 

So certain clients are going to experience delays in getting their returns e-filed with the IRS.  Here's the holdups:

Form 8863 for the education credits is being delayed until mid-February per the IRS.

The IRS is also advising us that the following tax forms are going to be delayed until "late-February to early-March":

• Form 4562 (Depreciation and Amortization)
• Form 3800 (General Business Credits)
• Form 4136 (Fuel Tax Credit)
• Form 8582 (Passive Activity Losses)
• Other forms that my clients rarely file

Clients who will be affected include:

• Virtually all clients who file Schedule C (Profit and Loss from Business), as it usually requires From 4562.
• Virtually all clients who file Schedule E (Supplemental Income and Loss) to report rental income since it usually requires Form 4562 and if claiming a loss, Form 8582.
• Clients who receive "pass-though" income and losses from partnerships and S-Corporations because there is often a Form 4562 and/or 8582 in the return.

Note that this only delays the filing of your return electronically.  If you've already scheduled your tax appointment, don't cancel it. There are only so many slots open between now and April 15th.  I should be able to prepare the return, let you know what your refund or balance due is and get a printed copy to you as soon as possible.  But until the IRS gives us the "thumbs up" for e-filing these forms, we'll be in a holding pattern.

As the IRS gives us more definitive dates, I'll update the blog and note it on Facebook and Twitter.

The Tax Court Gave This Schedule C An "F"!

I was taking a break yesterday and ran to my mailbox to stuff it with 1099s I needed to get out for a client. The mailman had just delivered my TaxPro Monthly (aka Porn for Tax Guys) and I stumbled upon an article by Casey Ashman, CPA about an interesting tax court case.

The Moores were operating 3 businesses.  A mortgage brokerage company, a real estate brokerage company and a used car dealership.  Mr. Moore worked full-time for the City of Houston and supposedly ran the real estate and used car dealership.  Mrs. Moore ran the mortgage business.  According to the Moore's they often traveled 100 to 200 miles per day for their businesses.  Mr. Moore's mileage log had the same abbreviations on virtually every day of the year with "generalized" descriptions of the business purposes of the trips.

The Moores filed their 2003 return well after the due date on 12/31/07.  They claimed their 3 businesses lost over $84K which more than wiped out any taxes owed on Mr. Moore's wages of $51K.  I'm sure you already guessed that the IRS thought this was odd.

The IRS issued a Notice of Deficiency in May of 2009 after redetermining the Moore's tax to be over $18K.  On top of the tax, the IRS was looking for $3600 in late filing penalties and $3700 in accuracy-related penalties.

The Moore's made several mistakes with their Schedule Cs (the IRS form used to report self-employed business income and expenses) including:

• Deducting charitable contributions - while they are allowed on Schedule A as a personal itemized deduction, donations to charity do not belong on Schedule C as a business expense unless there is a business purpose to the donation.  For example: donating to your local youth athletic association in exchange for advertising on their baseball fields.
• Trying to deduct start-up expenses of a new business before it opened - Mr. Moore claimed over $35K in expenses for his used car dealership before it was even open for business.  The Schedule C for this business showed zero income, just expenses.  None of those expenses could have been deducted until Mr. Moore opened his doors and even then they are recovered over a 15 year period through amortization (though there is an election to immediately deduct the first $5K in start-up costs in certain circumstances).
• Failure to keep adequate business records - the Moore's were unable (or unwilling) at the time they were audited to provide copies of invoices, statements, canceled checks, etc. to the IRS for their business expenses.  When they went to Tax Court, they did have some documentation which the IRS did accept, but the IRS would not concede all of the deductions the Moore's reported.
• Failure to keep adequate mileage logs - the Tax Court noted that despite the taxpayers having logs, "those mileage logs, however, contained far too many errors, irregularities, and questionable entries to be considered reliable".  The judge disallowed over $34K in auto mileage deductions.

The court case can be found here.  In almost every case that is related to whether or not a taxpayer is entitled to a deduction the court will state, "Deductions are a matter of legislative grace, and the taxpayer bears the burden of proof to establish entitlement to any claimed deduction."

What I want my self-employed clients to take away from this post is that I can't stress enough the importance of documentation of income and expenses. 

• Get used to saying "can I get a receipt for that?"  Your canceled checks and/or credit card statements are not enough if you are audited.  You need proof of payment and proof of what you paid for. 
• Fill out those mileage books I give you every year and be sure you are noting the business purpose of your travel!  Want an app for that?  I use MileBug for iPhone.
• Keep track of all of your income (checks, credit cards and cash received). 
• Use separate bank accounts for your business and dedicate a credit card for just business expenses.  It just makes things easier for everyone.
• Travel, meals and entertainment always have stricter documentation requirements than other business expenses.
• Ask questions of your Enrolled Agent if you are unsure if something is deductible.  Hint: the expense needs to be both ordinary and necessary for your business.  While a DJ would be allowed to deduct his iTunes downloads, that same expense wouldn't fly on my tax return.

Remember, you can never have enough paperwork.  I tell my clients all the time that I've never lost an audit because the IRS said I gave them too much documentation.  Oh, and those penalties the IRS assessed the Moores...the Tax Court upheld them.

 

Talking Taxes With Teenagers

So this year I finally incorporated my business.  On Saturday my wife and I had the corporation's first Board of Director's meeting on an island.  Please don't be jealous, it was the island in our kitchen folks.  The meeting kind of went like this:

Me:  Sign here, here, here and here.
Angela:  What am I signing?
Me:  You just approved my salary.
Angela: Is that it?
Me:  Oh, and you were voted Secretary
Angela:  Don't expect me to get you coffee.

Then we spent the rest of Saturday morning running around opening bank accounts.  Let me tell you, thanks to the Patriot Act opening a bank account is about as much fun as watching paint dry.  "Sign here"..."Can I see your license again?"...What's your Social again?".

Getting back to the real meat of this post...Talking Taxes with Your Teen.  I'm posting this because of a conversation I had last night with my daughter.  She's 16 and has been working in the office since she was 10 on nights and weekends.  She dusts, vacuums, takes messages, greets clients and is great with small talk.  This year she'll also be scheduling appointments.  But tonight we had to have "the talk".

Me:  OK, so you're committing to 5-8PM during the week and all day on Saturday.
Teenager:  Fine
Me:  Remember, this is a job.  But you also need to be sure you get your homework done before you work.
Teenager:  Fine
Me:  I'm counting on you especially on Saturdays.  You can't leave me hanging.
Teenager:  Fine
Me:  You need to dress appropriately.  No flip flops!
Teenager:  {Huge eye roll}
Me:  No texting and no Facebook when clients are in the office
Teenager:  {Eye roll with a huge sigh}
Me:  The work week is Monday to Sunday.  You get paid the following Friday.
Teenager:  What?...Nevermind, fine.
Me:  Oh, and because I changed businesses I'll need to take out some taxes?
Teenager:  #$&@!

And so the talk started.  She was full of questions (and statements).  Here are some of my favorites:
"Who is FICA?"
"So when do I get my refund?"
"If I can't get a refund then there must be a form for me to fill out so you won't take them!"
"Don't people pay you to get their taxes back?"
"Why are you doing this to me?"

The war took to Facebook and a string of posts shortly followed.  I'm sure by the time you read this she will have started a "My Dad and FICA Stole My Paycheck" page.  What my lovely daughter doesn't realize is that this is completely out of my hands.  When I was a sole proprietor I could use a special rule that allowed me to pay my children and not withhold FICA or Medicare taxes until they turned 18.  As a corporation, those exemptions simply don't exist.

It did open a dialog about how we all pay into FICA and the government uses tax revenues to pay for Social Security benefits that her grandparents are now collecting.  Hopefully her grandchildren will be underwriting her Social Security check someday.  Meanwhile, I now have a teenager whose life goal is to retire at 17 so she can "finally get her FICA back".

The biggest misconception about teens and taxes is that they don't pay them.  This couldn't be further from the truth.  While it is often true that teens earning less than a few thousand dollars a year won't pay income tax; 99.9% of them will pay into FICA (aka Social Security or OASDI) and Medicare when they get a paycheck. 

It's also a good time to remind them that every time they go to Dunks for an iced latte or a burger at Mickey Ds they are paying meals tax.  When they buy lipstick or download the latest Justin Bieber single from iTunes they are paying sales tax.  When you take them to Disney or the Cape you have to pay a lodging tax.  Oh, and their cell phone bill is loaded with all sorts of taxes. 

Medicare tax is never refunded by the IRS.  FICA is only refunded when you have more than one employer and the combined FICA taxes are more than the annual limit (for 2012 the wage limit is $110,100).

As far as income tax goes, if you are claiming your child as a dependent and their only taxable income comes from wages then they can earn $5,950 in 2013 and not pay a dime in federal income tax.  For Massachusetts, income up to $8,000 is also tax-free.

If your child's wages fall below these amounts they are not required to file a tax return.  However, if they had federal or Massachusetts withholding tax taken from their pay (which will appear on their W-2 Form), they can file a return to get the income tax refunded to them.  If you know for certain that they are going to be earning less than $6,000 then you can tell them to not have income tax taken out of their check by writing the words "EXEMPT" on line 7 of Form W-4 and give it to their employer.  That will save you the cost and hassle of having to file a return for them. 

If your teen is going to make more than $6,000, you should have them check the box for "Single" and enter the number 1 or 0 on line 5 on Form W-4.

There is a special "kiddie tax" that can kick in if your child has $1000 or more in investment income (interest, dividends or capital gains).  This is a topic worthy of it's own post and to be honest, I didn't dare broach the subject with my daughter after the whole FICA thing.

One last tip...if your child does need to file a return please have your return prepared and filed first if at all possible.  Every year I have at least a dozen parents whose return is rejected by the IRS e-file system because their teen accidentally claimed their own exemption.  Since the exemption generally belongs to the parents if the child is not providing more than half of their own support, the parents are forced to file their return on paper (which means 8-12 weeks to get a refund) and the child needs to amend their return.

Oh, and please don't mention FICA to my daughter if she is booking your tax appointment.  She will chew your ear off for at least 20 minutes. Kids!

Your tax accountant's top 10 "no" responses for 2012

I have the best clients.  They're honest, hard-working Americans who faithfully file their taxes every year.  I've weeded out the list over the years for the rare clients that asked me to compromise my ethical responsibilities as an Enrolled Agent.  But by and large my client base is made up of people that sometimes feel more like family than customers.

Even in the off-season it's not uncommon in a day to reply to 20 or more client e-mails and voice-mails with creative ways they've come up with to slice their tax bill.  Being your tax pro often mimics my job as a parent...the most common response to a question is "no".

Here are some of the most common "no" responses I have to give:

Q1.  My child is 20 and dropped out of college.  He lived with me all year, made only about $5,000 and stayed on my health insurance.  I fed him, gave him money for clothes, didn't ask for room and board and even paid his car insurance.  I figure I spent well over $10,000 this year.  Can I claim him as a dependent?

A.  NO.  Unless your child is a full-time student, once they turn 19 and have gross income of more than the federal personal exemption amount ($3,800 for 2012), they can no longer be claimed on your tax return UNLESS they are permanently and totally disabled.

Q2.  My child is 30 and decided to return to school full-time.  She earned $10,000 from a part-time job, but I paid $20,000 for tuition plus books and a laptop she needed.  She lived with me all year and did not pay room or board.  Can I claim an education credit for what I spent?

A.  NO.  In order to claim an education credit the tuition paid must be yours, your spouse's (if filing a joint tax return) or your dependent's.  You can claim a dependency exemption for your child until age 23 if they are a full-time student regardless of the student's income (provided the student did not provide more than half of their own support).  However, since your child's income is more than $3,800, you cannot claim her as a dependent and therefore cannot claim an education credit based on her tuition that you paid.

Q3.  My son is 17 and is working part-time during the school year and full-time during 8 weeks over the summer.  He's a student so he doesn't need to pay taxes, right?

A.  NO.  If you are claiming your child as a dependent they can earn only a certain amount before federal taxes kick in.  For 2012 they are allowed the standard deduction of $5,950.  I have seen many times that an ambitious teenager can pass that amount in one year and therefore end up with a federal tax liability.  A child who earns $10,000 and is claimed on their parent's return will pay $405 in income tax.  If the child claimed exempt on their W-4 for the entire year, they would owe that to the IRS the following year.  This is not the way I like to introduce teenagers to our US tax system.

Q4.  I just got married.  Human Resources sent me a new W-4 to fill out.  Should I check "Married"?

A.  NO.  Assuming your spouse is also working, you need to discuss this with your tax professional or continue as "Single" for the remainder of the year.  Note that unless you take the time to fully complete the "Two Earners/Multiple Jobs" worksheet on the back of the W-4, you could find yourself under withheld when you have your return prepared.  Remember, unless you complete the worksheet, "Married" tricks the payroll company's computer into thinking that you are the only one working.  If you file a joint return, your incomes and deductions get combined.  I have too many sad stories of newlyweds whose first interaction with the IRS as a married couple is to go on an installment plan because they screwed up their W-4 form. 

Q5.  I don't have a house so there is no way I can itemize my deductions.

A.  NO.  Everyone's facts and circumstances differ.  I loathe hearing from new clients that their prior tax "pro" told them that.  Yes, most people start itemizing because they own a home due to the high mortgage interest and real estate tax deductions.  However, I have many renters that legitimately itemize their deductions.  Some clients have very high employee business expenses (I have several ironworkers that pay well over $4,000/yr in union dues).  Some are very generous to charity.  Some are earning $80K or more and have high state income tax payments.  Others have very high unreimbursed medical expenses. 

It's really easy to get lazy in the business and just look at the forms the client gives you, transcribe some numbers into the computer and produce a return.  That's not a tax professional...that's a typist.  A good tax pro will ask you many questions to see if there is anything going on in your financial life that may legally lower your tax bill.  That comes from experience and a deep-rooted desire to ensure every client pays the lowest tax they are required to pay under the Internal Revenue Code.

Q6.  My mom is 90.  So she doesn't need to file, right?

A.  NO.  Whether or not to file depends on your gross income.  There is no age cut-off (despite rumors to the contrary).  For a single person 65 or older, a return is not required if their income (excluding Social Security) is less than $11,200.  For a married couple who are both 65 or older, the income limit is $21,800 for 2012.  Note that even if their income is below these amounts, their tax forms (particularly Form 1099-R and 1099-SSA) should be checked for federal tax withheld.  If taxes were withheld they can file simply to get this refunded to them even if they are not legally required to file a tax return.

Q7.  I used to work 5 miles from my home.  My employer moved the office and now my commute is 50 miles each way.  I can deduct mileage for my longer commute, right?

A.  NO.  Commuting is considered a personal expense regardless of the distance.  As an employee you are allowed to deduct unreimbursed use of your automobile for business purposes other than commuting.  So if you go to work and then need to meet various clients throughout the day you are allowed to deduct mileage for leaving your office and going to visit your clients and returning back to the office.  But your 100 mile daily commute is not deductible.  Note that an exception does exist for mileage traveled between two jobs worked in the same day.

Q8.  I need to wear a suit and tie to work.  If I don't I'll be fired.  Can I deduct the cost of buying business clothes and having them dry cleaned?

A.  NO.  Clothing is a personal and therefore non-deductible expense.  The are generally 2 exceptions.  If the clothing is not suitable for outside wear, it can be deductible.  This would include things like nursing scrubs, police uniform or an article of clothing with a company logo on it (think of the old Century 21 jackets the real estate agents used to wear).  The other exception is protective clothing such as steel-toed boots, work gloves or a hardhat.  I often have men and women in skilled trades (construction, painting, plumbing) noting that they go through scores of jeans for work because they get ripped, stained, etc.  Jeans are suitable for outside wear and are therefore non-deductible.

Q9.  I'm often paid in cash.  My coworker said I only need to declare what was paid to my by check.  Is he right?

A.  Hell No.  All income from employment is taxable.  This includes payments by cash, check, credit card and even bartering one thing for another.  Believe me, the IRS knows certain trades are cash-intensive.  These trades are more likely to be audited and their cash transactions scrutinized. 

Q10. I know I will owe. There is NO WAY I can pay the IRS what I owe them, but I should be able to pay them in full in a year. My best bet is to just file next year when I have the money.

A. NO! NO! NO! I can't stress enough the importance of filing a return on time. Even if you owe thousands of dollars. The penalty for not paying the tax by the due date is 1/2% per month (0.50%). The penalty for not filing the return is 5% per month. The cost of not filing the return is literally 10 times higher than the cost of not paying the tax. So get the return filed by April 15th (or October 15th if you are "on extension") and work (or have me work) with the IRS to setup a payment plan.

Bunching deductions for a bigger refund

After last week's tragedy at the Sandy Hook Elementary School, I'm ready to close the book on 2012 fast in hopes that 2013 will be a year of peace here in our country.  But before we do, here are some last-minute tax strategies to consider by December 31st:

Bunch your deductions...especially if you expect your income to decrease next year
Several clients are calling and emailing that bonuses are back or their incentive pay is up significantly.  Others are noting that they needed to raid their IRA or 401K accounts.  When your total income for the year is more than usual it sometimes pushes you into a higher tax bracket.

One way to combat this is to "bunch" your deductions in a tax year - especially ones that are going to be paid in January next year regardless.

If you are normally in the 15% tax bracket and you plan to pay deductible expenses in early 2013, consider paying them on or before 12/31.  Examples include:

• Mortgage payments that are due on 01/01/13
• Real estate taxes due on 02/01/13
• Planned charitable contributions for early 2013

Example

• Your mortgage payment of $2,000 includes $1,500 of interest
• Your real estate taxes due next quarter are $1,200
• You pledged $2,400 to your church for 2013 and
• You normally are in the 15% tax bracket but due to an unexpected bonus you are being pushed into the 25% tax bracket for 2012 - you expect your income to be significantly less for 2013 (back to the 15% tax bracket)

If you make the mortgage payment, pay the real estate taxes and donate $600 (the first 3 month's of your annual pledge for next year) to your church by the end of the year you have an additional $3,300 in deductions for 2012.  Multiplied by your 25% tax rate your overall tax is reduced by $825 and you get that added to your refund when you file in 2013.  If you were to deduct these in 2013 at the 15% tax rate, the overall tax is only reduced by $495 (and you won't received the refund until 2014).

Other "bunchable" deductions

• Medical expenses (if you are deducting already)
• State estimated income tax payments normally due on 01/15/13
• Business expenses if you use the cash method of accounting
• Rental property expenses

Caveats

1. No one knows for certain where tax rates will be for 2013.  If things remain unchanged and Congress lets us go over the Fiscal Cliff then the rates will go up for everyone.  Already there is talk of increased taxes on "the rich" but we don't know exactly who will fall into that category.  Are you rich at $200K?  What about $400K?  Or is it $1 million? 
2. Deducting extra state, local, sales or property tax will not help anyone caught in the Alternative Minimum Tax trap.  This is not only a 2013 issue, as Congress has not patched the exemption for 2012 either.  If it isn't patched, millions of taxpayers will be paying additional taxes due to the AMT being triggered.
3. Self-employed business owners may want to actually defer taking additional deductions in 2012 and postpone them until 2013 due to the expiration of the 2% reduction in self-employment tax.
4. Remember that this is a "Rob Peter to pay Paul" technique.  Therefore, if you should expect your 2013 refund to be lower if you use this method.

That first 2013 paycheck

With no real end in sight, the fiscal cliff looks like it will become a reality when we get our first paychecks in January.  There are two forces working against us:

The end of the temporary payroll tax cut
With the exception of certain governmental and church workers, most of us pay into the Social Security system.  The tax may show up on your pay stub as "SS Tax", "OASDI", "FICA" or some other name.  For as many years as I can remember, it's been 6.2%.  Two years ago Congress passed (and the President signed off on) a temporary reduction of 2%.  The reduction was reinstated for 2012, again on a temporary basis.  If a third extension of the reduction isn't passed the tax will revert from 4.2% back to 6.2% next year.

Expiration of the Bush tax brackets
When the Bush tax cuts were put into play back in 2003, lower rates and more brackets were created.  Prior to this, the first bracket was 15%, the second bracket was 25% and they climbed all the way to 39.6%.  For 2012 we have a 10%, 15%, 25% and continue to a max of 35%.  If the Bush tax cuts aren't extended, our bosses need to start withholding under the old laws.

Example
A single person earning $70,000 who claims Single and zero allowances on their W-4 form at work.  On a bi-weekly paycheck in 2012 they would have the following deductions:

$113  FICA
$500  Fed Tax
$613

Now take a look at the change to their first paycheck in January:

$167  FICA
$573  Fed Tax
$740

Between the return of the pre-Bush-era cuts and the return of the FICA tax to it's previous levels, this employee will have $127 less in their paycheck.  If you earn more, the impact will be even worse.  Let's not forget that many employers also change their health insurance premiums in January too (and usually not to the employee's benefit).

Unless the IRS takes the bold step to freeze the withholding tables at the 2012 levels, we need to brace ourselves for less money when we open that first paycheck next year.