Want to Pay More Tax? Then Forget About Reinvested Dividends!

Here’s a question I’ve asked clients countless times over the years, when they’ve sold a mutual fund; “when did you buy the fund, and how much did you pay for it”? The title of this article refers to reinvested dividends, which comes up most often with mutual funds, but for those who own stocks in dividend reinvestment plans, this discussion also applies.

I decided to write this article for two reasons. The first reason is that I’ve had plenty of clients who had no idea that reinvested dividends increase the cost basis of their investment. The second reason is that when I tell these clients about this, they either don’t want to go back and gather the information on the reinvested dividends, or are unable to get that information. That’s a shame, because they wind up paying more tax than they need to, due to reporting a higher gain or smaller loss than they should.

The best way to explain the effect reinvested dividends has on a sale is by example. Suppose I invested $10,000 in the JayCPA Aggressive Growth Fund on November 4, 2009. Based on the share price of $100 that day, the $10,000 bought 100 shares of the fund. On December 22, 2009, the fund paid a dividend of $10 per share. For the 100 shares I own, the dividend received was $1,000, and because I chose to have my dividends reinvested (rather than paid out in cash), the $1,000 bought an additional 10 shares. I now have 110 shares that cost me $11,000. On April 16th (my first day of post-tax-season freedom), I go out and buy a new motorcycle, and need some cash to help pay for it, so I sell my 110 shares of the JayCPA Aggressive Growth Fund. The share price that day is $200, so I net out 110 X $200, or $22,000 (do I know how to invest, or what?!).

It’s nice that I made such a good profit on the sale of that fund, but, of course, I need to think about taxes. If I disregard the reinvested dividends, and just pick up my original purchase price, I’m going to reflect a gain of $12,000 ($22,000 sales proceeds less $10,000). This is incorrect because I sold 110 shares but I’m only picking up the cost of 100 shares. Reflecting it correctly, my gain would $11,000, not $12,000 ($22,000 sales proceeds less $11,000 cost basis). So by not reflecting the value of the reinvested dividends, I’ve overstated my gain by $1,000, and since I held that fund less than a year, I have to treat that gain as ordinary income, subject to my top marginal tax rate. If I’m in the top (35%) federal tax bracket, I’ve just overpaid my tax by $350 ($1,000 x 35%). That’s a costly “penalty” for sloppy record keeping.

The best way to avoid overpaying tax on sales of mutual funds or stocks in dividend reinvestment plans is to keep track of your reinvestments. Why pay more tax when you can pay less?! Contact me if you have any questions, and please feel free to leave a comment.

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The 2011 Dirty Dozen Tax Scams (Abridged)

It’s a sad fact that there are people out there who look to take advantage of innocent taxpayers, in ways you may not have thought of. Unfortunately, they’re not the only ones who are scamming the ‘tax system’. IRS recently published its annual list of “dirty dozen” tax scams, and this article briefly discusses a handful of them.

Hiding Income Offshore-Taxpayers have tried to avoid or evade income tax by hiding income in offshore bank or brokerage accounts, among other ways. IRS currently has a voluntary disclosure initiative, which is designed to bring offshore money back into the U.S. tax system.

Identity Theft and Phishing-With an individual’s personal information, a criminal can file a fraudulent tax return and collect a refund. IRS reminds people that they never contact taxpayers by email, and that IRS impersonation schemes are out there. Never give out personal information to anybody claiming to be from IRS.

Return Preparer Fraud-Most tax return preparers (including yours truly) are professionals who provide honest and excellent service to their clients. As with other businesses/professions, there are rotten apples. Dishonest return preparers can skim or divert a portion of a client’s refund, charge inflated fees, or attract clients by making false promises.

Filing False or Misleading Forms-IRS is seeing instances in which scammers file false or misleading returns to obtain improper tax refunds. One way is by claiming incorrect amounts of tax withholding, based on fabricated information returns (1099s, for example).

Frivolous Arguments-You’ve probably heard this one before; filing a tax return is voluntary, or the income tax system is unconstitutional, or it’s against somebody’s religion. Don’t believe any of these.

Abuse of Charitable Organizations and Deductions-This isn’t a matter of deducting the $5 you put in the Salvation Army kettle last Christmas, but can be overvaluing the broken down car that was donated to charity. Penalties have increased for inaccurate appraisals, and IRS has cracked down on deductions for donated cars.

The title of this article includes the word “Abridged”, and you don’t need a calculator to see that I’ve only included a half dozen out of the Dirty Dozen Tax Scams. Drop me a line if you’re interested in hearing about the other six, and please, feel free to leave a comment.

The Risk of Fraud in Small Businesses

As small business owners, we wear many hats. For example, a restaurant owner can also be the procurer of supplies, chef, maitre d’, waiter, and bottle washer. One hat many small business owners tend to not wear is the bookkeeper’s, and therein lies the risk of fraud. To many, the lack of bookkeeping knowledge, hatred or fear of numbers, the need to focus on growing the business, or lack of time, drives the need for employing a bookkeeper.

In the accounting world, there’s a term called “segregation of duties”. In a nutshell, this refers to having different people do different accounting functions. For example, the person receiving customer payments isn’t also the person writing (or signing) checks. The problem in many small businesses is that they can’t afford to have an entire accounting department (such as accounts receivable, accounts payable, payroll), so all the functions are performed by the one bookkeeper. The danger here is that you’re entrusting someone with your money (i.e. your checkbook), and if that person isn’t honest, embezzlement can be the result. It’s beyond the scope of this article to get into the numerous ways a bookkeeper can “rob you blind”, but the point is that regardless of how busy the small business owner is, she/he needs to pay very close attention to what the bookkeeper is doing with deposits and payments, as it’s possible for both money coming in and money going out to be diverted. Bank statements should be reviewed for irregularities when received, blank checks should never be pre-signed, internal financial statements (such as a balance sheet and profit & loss printed from QuickBooks) should be reviewed, and payroll needs to be monitored, both for false employees and for pay rates. There are too many ways of misdirecting company funds, and the small business owner needs to be mindful of the possibilities.

I hope you’ve found this article helpful, and that it’s got you thinking. Please contact me if you have any questions, and if you know of any real life “horror stories” involving employee fraud, please leave a comment.

How Long Do I Have To Keep This Stuff?!

Now that the April 18th tax filing deadline has passed (and your returns are filed…hopefully), you may have a pile of W-2s, 1099s, and all sorts of other papers sitting in a stack, and you’re wondering whether you need to keep it all. The short answer is yes! You’re probably also thinking about the papers sitting in your filing cabinet/boxes/closet/attic/storage, gathering dust over the last five or twenty years. Is it really necessary to schlep this stuff around every time you move? Unfortunately, there’s no short answer to this question.

IRS recently issued Tax Tip 2011-71 “Tips for Managing Your Tax Records”. Unlike me, they don’t use the word ‘schlep’ in a sentence, but, like me, they do give some good advice. The first tip is one that you may have heard before, that is, tax records should be kept for three years. The reason for this is that IRS generally has a three year statute of limitations to audit a tax return. This is three years from the due date of the return, or when you file the return, whichever is later. It would follow, then, that if there’s a chance that your 2010 return could be audited within the next three years, keep your supporting papers for the next three years.

Now before you go tossing all your 2010 stuff out three years from now (or tossing out all of your 2007 papers now), check out IRS’s second tip, which is “some documents-such as records relating to a home purchase or sale, stock transactions, IRA and business or rental property-should be kept longer”. This article would be way too long if I gave you examples for every one of these things, but the idea here is that you need to keep any documents that will help you compute a gain/loss claimed on a tax return (such as a capital loss on a sale of stock, or gain on the sale of a home). So while you’re in the heat of spring cleaning, before you toss out those boxes of papers, make sure they don’t contain something you’ll need in the future.

As far as the types of records you need to keep, IRS’s tip says “…bills, credit card and other receipts, invoices, mileage logs, canceled/imaged/substitute checks, proof of payment, and any other records to support deductions or credits you claim on your return”. For this, personally, I like to work backwards. If I have an accordion file full of papers, I’ll toss out anything that had absolutely nothing to do with either my business or personal taxes. And when I say ‘toss out’ I mean shred… you can’t be too careful these days. Whatever’s left I’ll keep for at least three years.

There are other tips that IRS has, but we’ve run out of time. I’d be happy to tell you about them; just contact me for more information. And please, leave a comment, to let others know how you deal with your records.