Oh No…IRS Calling!

You come home from a nice relaxing vacation (or a hard day at work), flip through the pile of mail you grabbed from the mailbox, and it hits you right between the eyes…the envelope with the return address that starts with three big bold letters…IRS. The blood drains from your face, your palms get clammy, you get a knot in your stomach, and you think “am I going to jail?”

Hopefully this hasn’t happened to you, but I’m here to tell you that if you do get an envelope from the IRS, you most probably aren’t going to jail (but if you do, I’ll come visit!). The IRS sends millions of letters and notices to taxpayers each year, for various reasons, and recently came out with Summertime Tax Tip 2011-22, which is titled “Eight Tips for Taxpayers Who Receive an IRS Notice”. For tax professionals like me, who have seen our share of notices, it doesn’t even raise the blood pressure to have to address a notice on behalf of our clients. For people who have never received a notice before, it can be an extremely stressful thing, even if it ultimately turns out that IRS was wrong. Just seeing that envelope can make ones heart skip a beat or two.

IRS gives eight tips, but I’d like to add a ninth, by adding one of my own, which is, open the envelope, and reply if requested. I can’t tell you how many times over the years I’ve had a client hand me an envelope (or two or three or more) from IRS that’s unopened and/or unanswered. Read my post from 7/11/11 (“I Thought I Was Getting A Refund!) and you’ll see a scary example of what kind of a mess will result from ignoring notices from IRS. And now, on to some of IRS’s tips!

-“Don’t panic”-this sounds pretty basic and straightforward, and it is. As IRS points out “many of these letters can be dealt with simply and painlessly”, and as I said earlier, a letter from IRS is not a jail sentence, so stay calm.

-“Each letter and notice offers specific instructions on what you need to do to satisfy the inquiry”-in other words, read! Unfortunately, too often I’ve found this to be a problem in general…people don’t read things, and that creates or intensifies problems needlessly (not to mention creating more stress). Take the time to read the letter/notice from start to finish. If you don’t want to do that, have your friendly neighborhood CPA read it for you, and help you.

-“If you receive a correction notice, you should review the correspondence and compare it with the information on your return”-IRS isn’t correct 100% of the time, but the only way to know if they are or not is to compare what they sent against what’s on the return.

These are just a few of IRS’s tips for what to do when a notice is received. What experiences have you had with correspondence from IRS? Please leave a comment, and let me know if there are any topics you’d like me to write about in the future. And please feel free to forward this article to a friend in need.

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Roth IRA “Gift”

I read an interesting article about Roth IRA conversions recently, and wanted to share some highlights with you, about an almost unbelievable estate planning possibility.

In the not too distant past, a couple of tax law changes created some major estate planning opportunities. The first change was the lifting of the $100,000 income restriction on who could make a conversion from an IRA or 401(K) to a Roth IRA. In the past, if a taxpayer’s adjusted gross income (AGI) exceeded $100K, a conversion to a Roth IRA was not allowed. Since the $100K AGI limit was the same for either single or married taxpayers, many people were precluded from making a conversion. By eliminating that income restriction, IRS has opened the door for people to make Roth conversions, regardless of the amount of income showing on a tax return. Keep in mind that income tax will need to be paid on the amount of the conversion, but the tax paid could potentially be far outweighed by the future tax saved. Read on…

The second change that has enabled a greater transfer of wealth was the increase in the generation skipping tax (GST) exemption, to $5,000,000. GST is owed when amounts in excess of the exemption are passed from an individual to a grandchild (inherited), effectively skipping a generation. Before the most current increase, the exemption was $3.5M, and had been scheduled to drop to $1M, before the last tax law change. What this means is that more assets can be transferred without estate tax or GST.

The “gift” I was alluding to in the title refers to what happens when the effects of the two law changes are combined. With no income limitations, it’s possible for an individual to make a Roth conversion of any size from an IRA or 401(K) account, and then $5M can be passed by inheritance to a grandchild, without having to pay estate tax or GST. If that grandchild is young, the value of that account can grow astronomically during that person’s lifetime. Even with required annual distributions for Roth heirs, those distributions would be income tax free, which could greatly offset the tax paid on the original rollover. That’s an incredible “gift” from the IRS!

This is a great planning opportunity for many people, not just the super wealthy. Speak with your favorite CPA about more details. As always, I’d be happy to field comments and suggestions on topics for future articles.

Divorce and Taxes-Part 2

When last we met, I left you hanging with a couple of divorce related tax thoughts to keep in mind. Let’s wrap up this discussion with a few more things to think about while planning (or waiting for) the next spiteful spousal action(!)

Transfers of property-“Generally”, property transferred from one spouse to another can be made without tax consequences to either party, as long as the transfers are made “incident to the divorce”. As with anything that IRS uses the word “generally” for, there are exceptions and rules to follow to make sure that the transfers don’t create taxable income for one of the spouses.

Marital home-Similar to the discussion above, if the transfer of one spouse’s interest in the marital home is incident to the divorce, there’s no gain recognized on the transfer. Additional things to consider are who gets the deduction for mortgage interest and real estate tax, and whether there’s excludable gain on the sale of the ‘principal residence’ (and who gets it).

Filing status-I covered this subject briefly last week, but I wanted to add one other ‘curveball’ to this discussion. Under certain circumstances, an individual may be able to file a return as “head of household”, which will result in a lower tax bill than “married filing separately”. There are a number of requirements that must be met, in order to do this.

Alimony and child support-Alimony is deductible to the payer and taxable income to the recipient, while child support is nondeductible and nontaxable.

Attorney fees-As with many other issues, attorney fees generally are not deductible. Fees paid for the actual divorce/separation/custody/etc issues aren’t deductible, but fees paid for tax planning and tax advice are. If that’s the case, be sure the invoice splits out the portion of the fees paid for tax related services.

As you can probably tell, since it’s taken two articles to barely scratch the surface of the topic “divorce and taxes”, this is a very complex and treacherous area to deal with. To repeat what I said at the beginning of part 1, I strongly recommend that you engage the services of an attorney and a CPA to help you through both the legal and tax aspects of the divorce.

I hope this two-part article has been of help to you, or people you know who are going through one of the most stressful of life events. Please feel free to pass a link to this article to someone who may benefit from it, and leave any comments you may have. If you have any subjects that you’d like to see addressed in future articles, please let me know.

Divorce and Taxes-Part 1

Did the title of this article grab your attention? Divorce and taxes are two subjects that can be pretty painful and gut wrenching on their own, but put the two together, and one may well want to run away and bury their head in the sand. To quote John Lennon, “living is easy with eyes closed”, but that won’t help get either a divorce or taxes behind you. Two words come to my mind in this situation; attorney and CPA.

I’m not an attorney, but being married to an attorney who spent a number of years practicing matrimonial law, I can tell you that you don’t want to go through the divorce process alone, and you need representation to make sure you’re not signing your rights away. Enough said on that; let’s talk about taxes.

When a couple is divorcing, there are all sorts of tax implications to think about, and this is why it’s imperative to engage a CPA for help. This is for your benefit, not for my job security! Similar to the paragraph above, you don’t want to make any tax mistakes, or give anything away, because you weren’t properly advised. Let’s look briefly at some tax things to think about, when going through the divorce process.

Filing Status-I’ve told clients for years that 99.9% of the time, ‘married filing jointly’ will produce a lower tax than the combined tax from two ‘married filing separately’ returns. A divorcing couple may not want to file jointly, since they’re probably already at the point of separating their finances, and don’t want the other to see what’s on a tax return. If one spouse is opposed to filing jointly, the other may have no choice but file separately. Another twist on this is the fact that a joint return means that both spouses are jointly and severally liable for any tax. What this means is that if a couple files jointly, divorces, and then a year later it’s determined that there’s more tax due, IRS can look to either spouse for payment of that tax. This is a major reason why many divorcing couples choose to file separately, i.e. to not be potentially responsible for the other’s tax.

Dependents/exemptions-How many people know divorced couples who have kids (I have two hands raised). Besides legal arguments over custody and child support, there’s the question of which spouse gets to claim the kids as dependents on their tax return. This is a question/issue not just for the year of divorce, but also for subsequent years. There are all sorts of rules and tests to determine who claims the dependents. This article would be way too long if I got into a detailed explanation, but let’s just say that generally the custodial parent would be entitled to claim the dependent/exemption, but there’s a lot behind the word “generally”.

Next week I’ll wrap up this discussion with a few other tax issues to keep in mind when going through a divorce. If you know somebody who’s going through a divorce (one of the most stressful life events), please pass this article along, and if you’ve heard of any divorce/tax “war stories”, please share them.

Online Sales, Nexus, and Sales Tax

For those of you who are thinking I missed a typo, no, I didn’t mean to write “Lexus”. I meant nexus, and get used to hearing that word, as it’s something you’re going to hear more about in the near future.

In the last week I read two separate articles about online sales and sales tax. As one article says, budget shortfalls for the states total about $103 billion nationwide. As you can imagine, the states are looking for any way that they can increase their revenue, and one source is sales tax. It’s projected that online sales for 2011 will be about $46 billion, and for fiscal 2012, web sales will cost the states about $11.3 billion in sales tax. That’s a lot of lost revenue!

Needless to say, the traditional ‘brick and mortar’ stores can’t compete against online sales in the sales tax arena, because of one word, nexus. A real basic definition of nexus is a retailer having a physical presence in the state where a buyer lives. If you drive to your local Wal-Mart, you’ll be charged sales tax on your purchases, because Wal-Mart has nexus, a physical presence in your state. If you go online and buy a Kindle from Amazon, you won’t be charged sales tax on your purchase, unless Amazon has nexus in your state (a physical warehouse/distribution center, for example).

Congress and various states have recently gotten into the online sales tax battle with Amazon and other online sellers. Last week, one senator introduced legislation that would require internet-only retailers to add sales tax to their invoices, just as brick and mortar stores do now. One House Representative plans to introduce a similar measure. At issue is a 1992 U.S. Supreme Court ruling which said that online retailers only had to charge sales tax if nexus was present. States are claiming that with all the affiliate programs that Amazon runs, nexus is being created for Amazon in every state where one of their affiliates is located.

Obviously this is an issue with far reaching consequences for businesses both big and small, whether online or brick and mortar, and could mean billions of dollars to the states. Keep your eyes on the news to see how it eventually plays out. If you’re a business making retail sales online, be very careful about who you need to charge sales tax to. And for the consumer, did you know that if you make purchases online and don’t pay sales tax, you’re supposed to claim the tax and pay it on your state income tax return? I can’t speak about all fifty states, but in Virginia, you should be reporting the sales tax on line 21 of Schedule ADJ.

Do you think that sales tax should be charged on internet sales? Leave a comment, and also, let’s hear how many people have reported and paid sales tax on their income tax return.