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.

Rent vs. Buy

Over the years I’ve had lots of clients tell me that they’re buying a house, and they’re expecting to save so much money in income taxes. I’ve also had clients who asked me ahead of time to run some numbers, to tell them how much they can really expect to save in income taxes. Similar to the questions I’ve gotten about leasing a car vs. buying, and tax savings for dependents, one of the first replies I give people is “you can’t live your life for tax consequences”. I know, I’m a CPA, taxes are my job, and I’m supposed to help people save taxes, and I do that. But sometimes there are other factors involved that can outweigh income tax savings, and that’s what I want to toss out in this article.

A few months ago I brought up an imaginary couple, Bristol and Levi. I’d like to revisit them, as they’re considering making a major financial decision that could have income tax and other consequences. Between the two of them, they make $100K in wage income, and their investment income (interest and dividends) is negligible, so for tax purposes, their adjusted gross income is $100K. They’re currently renting a 1 bedroom/1 bathroom apartment in Ballston for $2K/month. Since that rent isn’t deductible, their joint federal tax return shows a standard deduction plus two exemptions, their taxable income is about $81K, and the federal tax is about $13K.

Bristol and Levi just found out that they’re going to be parents, and realize that the apartment will be too small for three occupants, so they decide it’s time to buy a house in the burbs. With all the income tax they’re going to save, it’ll be easy to buy all those Pampers, right? Not so fast, folks! They soon discover that things aren’t that cheap in the burbs, plus they realize that they can’t move too far from DC, because the commute will be a killer. They decide to focus on Fairfax, and find a nice place that has four bedrooms and two bathrooms, which sells for $420K. As they move forward with the process, they find out that the real estate taxes are $4K/year, and a 30 year fixed rate mortgage has a 4.5% interest rate. Armed with that information, they soon find out some surprising results.

As homeowners, they’re entitled to itemized deductions for mortgage interest and real estate taxes. Taking a mortgage for 80% of the value ($336K), the total interest they’ll pay in year one will be about $15K, which will be their itemized deduction, along with the $4K of real estate tax. Assuming no other itemized deductions (medical, charity, etc), their projected taxable income will be about $74K, and federal tax will be about $11K, or about $2K less than if they rent. Woohoo, that’s a lot of Pampers…isn’t it?!

O.K., so they save a couple of thousand dollars by renting, but is that really enough financial incentive to buy a house? Let’s look at cash flow, since it’s not just taxes we’re talking about here. Renting is costing them $2K/mo, or $24K/yr. The monthly mortgage payment is about $1700/mo, or just over $20K/yr. The real estate taxes are $4K/yr, so when all’s said and done, the savings in cash flow is pretty much just the $2K saved in federal tax. There are all sorts of other “intangible tangible” things to think of too, including

-they’ll need to accumulate the 20% down payment of $84K, or else the interest rate will probably be higher, or they may not even qualify for a mortgage
-they’ll have to pay homeowner’s insurance
-their monthly utility bills will probably be a lot higher (electric, gas, oil, water)
-they’ll have to pay for lawn care, snow removal, etc
-they’ll have to pay for repairs and maintenance (roof, a/c, etc)
-if the house needs upgrades, they’ll have to pay for those, or take a home equity loan, if they can get it

I’m sure there are other things that I’ve left out of this computation, which are beyond the scope of this discussion (such as time value of money/opportunity costs), but the bottom line here is to remember that tax consequences can’t be the sole basis of a financial decision, in spite of what any CPA might say.

Please leave a comment, and let me know if you have questions, or if I can help you with running some numbers.

I Thought I Was Getting A Refund!

I had a real life experience recently, which I’d like to share with you, as it’s a perfect example of why you should file your income tax returns timely, and NOT ignore notices from the IRS.

A new client was referred to me last year, who hadn’t filed any tax returns since 2003, so she needed my help with 2004 through 2009. It’s been almost a year since I wrapped up all those returns, but the problems that were lurking a year ago have not gone away, and in fact, have gotten worse.

As I was in the process of getting the information from the client that I needed to prepare all those returns, I found out that the client had received numerous notices from IRS for the 2004 through 2006 tax years, in particular. The notices requested tax returns for each of the years, but my client didn’t reply to the notices. IRS then sent notices saying that since she didn’t reply to the original notices or submit returns, they were computing the returns themselves, based on information received from payors (i.e. W-2s, 1099s etc), and gave her a deadline to reply and/or submit returns. She didn’t do either. IRS then assessed and billed her for the balances on the ‘returns’ that they computed, and she didn’t pay them. The next step was liens that showed up on her credit report, and then collections. The problem now (and why this has gotten more complicated) is that as far as IRS is concerned, 2004-2006 are closed cases/years, meaning, they computed the returns, the client’s lack of reply was taken to mean that she agreed with their computations, and they just want their money. As of today, IRS is saying that the client owes them about $142,000!

I spent about three hours on the phone with four different IRS representatives, trying to get a handle on what was going on, and what needs to be done, to straighten this all out. What we have to do now is re-submit 2004-2006 and ask IRS to re-open those cases/years and reconsider the returns, which show a total balance due of only about $4,000 for the three years, not $142,000! I was told it could take months to hear back about the reconsideration of these returns, and there’s no guarantee that IRS will agree, and adjust the balances down to what they’re supposed to be.

After the call with IRS, I called my client, and in the course of the conversation, I asked her why she never filed all those returns, and her answer was that she was expecting refunds for those years, and had never previously owed tax to IRS. I told her that if she was expecting a refund, then that’s even more incentive to file on time, so she could get her money back, and not give an interest free loan to IRS (see my Apr 25 article).

It’s taken hours of my time to date, and will take a lot more time to get to the end of this. All of it could’ve been avoided if the client had just filed her tax returns on time. So the moral of the story is, even if you’re expecting a refund, get your taxes done timely, so you can get your refund back. You might even get an unpleasant surprise, and find out that you have a balance due, when you thought you were getting a refund. Either way, it’s way better to find out before IRS gets involved!

Surviving as a Surviving Spouse

In recent past, my wife and I have seen two people we know lose their husbands. I can’t even begin to think about what my life would be like, if Karen (my wife/girlfriend/dive buddy/cooking partner/etc) was gone, as suddenly as the two husbands I mentioned above. After writing last week’s article, my editorial advisor (guess who…Karen) suggested that I write an article about some things that a surviving spouse needs to think about, aside from immediate things, like arranging a funeral. Since there are many details to address, this article isn’t meant to cover every conceivable one, but lays out a few things to ponder, and take care of.

1-Don’t rush

After the death of a spouse, there are all sorts of things running through the surviving spouse’s mind; grief and potentially anger are a couple that come right to mind. Regardless of the range of emotions being felt, thought processes will most probably be more than a bit cloudy and confused, so it’s important to remember that this is not the time to be making any major financial decisions that you’ll be bound to (and will be costly to undo), or will be regretted later on. Additionally, whatever decisions need to be made, a few weeks or even months of extra thought may not make a big difference, compared to the consequences of an incorrect knee-jerk decision. So hold off on big things, like buying or selling a house, or making big changes to your investment portfolio.

2-Get your @#$% together

I couldn’t resist that one (I’m a New Yorker!). The point is, important documents will need to be dug out of filing cabinets or storage, to be used for various purposes, such as transfers and re-titling of assets. Some of these documents are
-will and trust documents
-insurance policies
-death certificates (get at least ten certified copies)
-social security numbers
-marriage license
-military discharge papers
-statements for retirement plans and brokerage accounts

This list isn’t all inclusive, so be ready to dig for other documents, as requested.

3-Get the estate plan into motion

Since you’ve all diligently followed my recommendation from last week, you’ve engaged an estate attorney, and had a will drawn up, and an estate plan put into place. This is something that should be started as soon as practicable. Obviously it’s not meant to be the first call made, after a spouse passes away, but if the wheels are put into motion sooner rather than later, you’ll feel a lot more settled personally, once the estate is settled. Remember that in cases where an estate return needs to be filed, this must be done within nine months of the date of death.

4-Do you have enough money to live?

I know, in #1 above I instructed everyone to not rush into things, but when it comes to having enough money to live on until the estate/finances are settled, it is necessary to figure out whether there are enough liquid assets available to cover at least six to twelve months of living expenses. In this case, if there’s any life insurance, the claims process needs to be put into motion. The deceased spouse may have some unpaid vacation pay or other cash payments due, so check with the employer. Some investments may need to be sold, in order to provide cash, but remember, you don’t need to liquidate the entire portfolio.

There are lots of other details to think about, at what will probably be a time when one least wants to have to think about it. I welcome any thoughts and comments you have, and would be happy to discuss additional details with you. And please forward this article to people you know, who can use the information.

Estate Planning…It’s Not Just For the Dead

Mention estate planning to people and you get all sorts of reactions. A couple of my favorites are “why should I care, I’ll be dead”, and “estate planning is just for rich people”. Given that a majority of the people living in the U.S. are, in fact, alive, and not necessarily “rich” (use your own definition of this), does that mean that we should discount estate planning for just a select few, in the upper echelons of income and net worth? Absolutely not!

Discussing one’s own mortality is a difficult subject for most people, but the truth is, “estate” planning has evolved into something that not only deals with dispositions of assets (and other matters) after death, it also includes matters that arise during lifetime, such as disability and incapacity.

Consider these scenarios:

1-A couple owns a home jointly, with a right of survivorship upon the death of the first spouse. What happens if one spouse becomes disabled or incapacitated (physically or mentally); how can the house be sold (or the mortgage refinanced) if both spouses signatures are needed on various documents? Similarly, what if a single person owns a home, and then becomes disabled or incapacitated; what happens to the house?

2-What happens when a person is clinging to life after a stroke, and life or death medical decisions need to be made immediately? Who gets to decide whether to ’pull the plug’ or not?

3-Mom and dad die simultaneously in a tragic car accident. Who will care for their two children, and decide about their upbringing and education?

What people don’t realize is that if matters are left to the laws of the state where one resides, the results may not be what was expected, or hoped for, and could ultimately cost a lot more money than what the cost would be to put together a comprehensive estate plan. I’m a CPA and not an attorney, but from all the years that I’ve been working on cases with estate attorneys, I’ve seen what happens when decisions are left to the state of residence, and you don’t want that to happen.

You’ve probably heard terms such as “durable power of attorney”, “living trust”, “healthcare proxy”, and “nominating a guardian”. These are some of the tools that are used in putting together an estate plan, to deal with the scenarios mentioned above. A competent estate planning attorney will be able to discuss these things (and more) as part of putting together a plan. It’s one of the best investments you can make, and something that one should not keep putting off. Make sure your wishes are carried out the way that you planned. Whoever you work with, check their credentials and qualifications, since estate planning is a very technical and tax driven area. Be very wary about somebody who has only been practicing estate planning for a couple of years, or who “specializes” in many different areas of law. If your gut tells you that the attorney doesn’t have enough experience, he/she probably doesn’t. I’ve seen the consequences of inexperience. If you don’t know any estate planning attorneys, I can make a referral (at least for the Northern Virginia metro area and New York City).

Is That Charitable Contribution Deductible?

Like many Americans, you make contributions to charitable organizations out of the goodness of your hearts…and the tax deduction. But is that contribution actually deductible?

This article is an alert to individual taxpayers, but is also a wakeup call to responsible parties of tax exempt organizations. Continuation of your tax exempt status is no longer a given, if you have not fulfilled your reporting requirements.

A few days ago, IRS announced that approximately 275,000 organizations had automatically lost their tax exempt status, because they did not file legally required annual reports for three consecutive years. At the same time, the Service also announced special steps to help organizations apply for reinstatement of their tax exempt status.

In 2007, a filing requirement was imposed on small organizations, where there had been no requirement previously. At the same time, the law allowed IRS to automatically revoke the tax exempt status of any organization that didn’t file the required returns for three consecutive years. Since that time, IRS has made many efforts to inform exempt organizations of these changes, and also gave smaller organizations additional time to file required returns.

All exempt organizations are required to file one type of Form 990 or another. There is the ‘long form’ 990 (Return of Organization Exempt from Income Tax), the ‘short form’ 990-EZ, and the 990-N ‘e-postcard’. For organizations with annual gross receipts of $50,000 or less for 2010, the filing requirement is satisfied by submitting the e-postcard. Not filing at least one of these three returns for the last three years subjects an exempt organization to the automatic revocation of its exempt status. For organizations that have had their exempt status revoked, IRS has procedures for reinstatement that include reduced application fees.

Now back to you, the one making the charitable contribution. Before you take that deduction, check the IRS website, as they have lists of organizations that qualify as public charities, as well as lists of organizations that have had their exempt status revoked. You may only take a deduction for contributions made to qualifying charitable organizations.

If you have any questions about this, please contact me, and please post a comment. And if you have any friends who are involved in small exempt organizations, have them read this article.

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.

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.

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