Education and Taxes

What’s the first word that comes to mind when you think about education…taxes, right? Well, even if it’s not the first thing that you think about, the expenses of higher education for a taxpayer or dependent can save money on taxes, via a deduction or a credit. A deduction will save you taxes based on your top marginal tax rate, so for example, if you’re in the 25% tax bracket, a dollar spent on qualifying education costs will save you twenty five cents in tax. A credit is much more powerful, since it directly reduces your tax, so if you have a tax credit of a dollar, it will save you a dollar in tax. This discussion will tell you about a few ways that Uncle Sam can help you pay for higher education costs.

American Opportunity Credit-this credit can be claimed for four years of post-secondary education per student, with a maximum annual credit of $2,500 per student. The full credit is available to single taxpayers with modified adjusted gross income (MAGI) of $80,000 or less, and married couples filing jointly, with MAGI of $160,000 or less. The credit phases out for MAGIs above those thresholds.

Lifetime Learning Credit-this credit can be claimed for all students enrolled in eligible educational institutions, and is up to $2,000, period, regardless of how many students are claimed on a tax return. Unlike the American Opportunity Credit, there’s no limit on the number of years a student may claim this credit, though only one credit or the other may be claimed in one year, not both. This credit is handy for graduate students (who have already received the maximum of four years of American Opportunity Credit), students who are taking only one course, or people who aren’t pursuing a degree.

Tuition and Fees Deduction-as I mentioned above, credits are more valuable than deductions, but if taking this deduction nets more tax savings than, say, the Lifetime Learning Credit, then you claim the one that saves the most. Similar to the Lifetime Learning Credit, the maximum deduction is $4,000, regardless of how many students are claimed. This deduction phases out with the same thresholds as the American Opportunity Credit.

Student Loan Interest-generally, personal interest paid (other than home mortgage interest) is not deductible. If MAGI is under $75,000 single/$150,000 married filing jointly, interest on student loans to pay for higher education is deductible, up to $2,500 per year.

There are other ways that education expenses can save you tax dollars, and, as with anything having to do with IRS and tax laws, there are numerous requirements, thresholds, and fine print, so make sure you speak to your favorite CPA (hint hint) if you have any questions. Have you saved taxes with higher education expenses? Please leave a comment about how you did it. As always, forward this article to somebody you know who could benefit from it, and let me know other topics you’d like to see me write about.

Tax Simplification? I Think Not!

I participated in a tax update webinar the other day, and I wanted to pass along a couple of changes that probably affect most taxpayers in this country. The common thread between the two changes is that they point out how tax preparation is becoming more complicated (and not to be attempted by amateurs), and just how much ‘big brother’ is watching.

Credit Card Sales By Businesses-Beginning with tax year 2011, credit card companies will be sending Form 1099-K to all credit card accepting merchants/businesses. Form 1099-K is titled “Merchant Card and Third Party Network Payments”. Guess what…every penny that customers charge to pay for a business’s goods and services is going to be reported to IRS, and wait, it gets better. The form breaks down the annual total by month, which will make it easier for IRS to trade information with all of the states, who, in turn, will match the information up with sales tax returns being filed every month (or quarter). Additionally, on business returns, line 1 reporting has gotten more complicated. Starting with 2011 tax returns for businesses (Forms 1065, 1120, 1120S, even Schedule C for sole proprietors), line 1 gross receipts reporting will now be split out to one line for credit card income and one line for all other income. If a business accepts credit cards but doesn’t report that income on the credit card line (i.e. includes it with all the other income), I’m almost willing to bet that they’ll receive an inquiry from IRS. If the gross sales on sales tax returns doesn’t amount to at least the amounts reported on the 1099-K, I’d bet an inquiry from the state will be coming, too. This is all pretty scary stuff!

Securities Sales Reporting, and Reporting of Basis-If you have any type of securities account (through a broker or through a mutual fund, etc), you may have already received a piece of mail talking about how the broker/fund is going to be required to report to IRS the basis of securities sold. The letter also describes what method the broker/fund will use to compute the basis (such as ‘first-in first-out’, average cost, etc). There’s a possibility that you ignored this letter, and may have even thrown it out. I recommend that you read this letter, and understand it, as the ‘default’ the broker/fund will use may not be the best for you tax-wise. In addition to this change in reporting by the brokers/funds, the way you report securities sales on your tax return is going to get WAY more complicated. Describing all the changes can be an article in itself, but let me say that you’re not only going to have to file Schedule D (as in the past), but Form 8949 will also need to be completed…as many as six times! In short, separate Forms 8949 need to be filed for short and long-term gains or losses, as well as for gains or losses where the broker reported the basis, gains or losses where the broker didn’t report the basis, and gains or losses where a Form 1099-B wasn’t received from the broker.

As with air travel these days, when this tax season rolls around, you’re going to have to pack a little patience, and be prepared for more questions from your tax professional, as we’re going to have a lot more work to do for preparing business and personal returns on behalf of our clients.

Please pass this article along to anybody who may benefit from the information. As I said at the outset, these two changes alone will affect a large percentage of business and personal taxpayers, so chances are you personally know more than a couple of people who will be affected. Please leave a comment about your thoughts on these two new tax developments.

Spring Cleaning…Fall Tax Planning

For those of you who don’t me personally, one of my favorite extra-curricular activities is performing in community theatre. I was just in a show in which I played (of all things) an accountant! In one scene, one of the other characters asks me if it was a slow time for accountants, to which I reply “I’m doing a lot of tax planning for clients these days”. The play takes place in November, so I’m a couple of weeks ahead of that, but now’s the time to start thinking about tax planning, since there’s still plenty of time before year end to consider various things.

Defer income and accelerate deductions-this is a “standard” CPA tax planning mantra. For wage earners, deferring income isn’t something that usually happens (“thanks boss, but you don’t have to pay me this month…wait ‘til January”), but for small business owners with the ability to hold off billing clients, this can effectively push off income (and tax) from this year to next. Prepaying the January mortgage payment in December can increase the amount of mortgage interest deductible this year. If you think that you won’t wind up with an Alternative Minimum Tax (AMT), prepaying your January state tax estimate by Dec 31 could help save some federal tax.

Capital gains and losses-now is a good time to take a look at last year’s tax return, and see if you have a capital loss carryforward to this year. On the outside chance that you have some stocks that are actually up right now, it may be a good time to lock in those gains, if you have loss carryforwards to offset the gains. On the flip side, if you have a bunch of gains from earlier this year, you might want to think of selling some losers off now, to offset the losses against the gains.

Retirement plans-my character in the play talked about “retirement plans, IRAs, 401Ks, pensions” as part of the tax planning for clients, and you should follow my character’s lead! If you can afford to take money out of current cash flow, and put it toward your retirement, do it, and do as much as possible. If you’re in a 28% marginal federal tax bracket, and earn a dollar in taxable interest income, you’ll net seventy two cents in your pocket. If that same dollar is in a retirement plan (any type) you’ll net one hundred cents!

Charitable giving-if you are charitably inclined, and have securities that have appreciated in value, but you don’t want to pay tax on the gain (if you sell), you can give appreciated stock to a recognized charity, and get a deduction for the fair market value of the stock. So not only do you not pay tax on the gain, you get a deduction for the appreciated value!

These are just few things to consider, to help you save a few bucks in taxes by the end of this year. I hope you found this article helpful, and please pass it along to somebody you know who could benefit from the information. As always, if you have any thoughts or personal experiences on this topic, please leave a comment, and let me know if there’s a topic you’d like to see me write about.

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.

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!

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.

Tax Refunds

Everybody who wants an interest free loan, raise your hand. While that hand is raised, those of you who got a big tax refund, use that hand to smack yourself over the head! Why, you ask? It’s because you just gave the government an interest free loan. Let me ask you this; would you give a complete stranger a loan, and not expect to get at least some sort of market rate interest on that money? I didn’t think so, but why are you so quick to give the government your money for free? Even having that money in a savings account earning .25% (you know how low rates are these days) is better than earning zero.

For years I’ve heard clients tell me that they look forward to that big check at tax time, and how they have too much tax withheld on purpose, and it’s ‘forced savings’, blah blah blah. My reply has always been “if you want to force yourself into saving money, why not just cut a check (or set up an automatic debit) every month to invest in a mutual fund, or fund an IRA”? It’s such a no brainer that can only help people, which is why it’s confounded me for years. Obviously my job is to advise my clients, and of course they’ll do whatever the heck they want anyway (much the same way as I ignore advice!).

With proper tax planning/projecting, it’s possible to get to the end of the tax year at close to a breakeven (i.e. either very small refund or very small balance due), without incurring penalties, and having more money saved (and no interest free loans to Uncle Sam or Uncle Governor-of-your-state). By changing your withholding exemptions, you’ll have more money in your pocket each paycheck, and won’t have to wait until tax time to get your loan money back from the government.

I have a challenge; allow me to bug you on a monthly basis, to send me a check, payable to the mutual fund/investment of your choice, and I’ll make sure that check gets deposited to your account, so you can earn something on your money…more than the zero percent the government’s giving you. Better yet, you can loan me the money interest free, I’ll invest it, keep the income, and then pay back your loan at the end of the year! Just kidding, but you understand my point.

With that raised hand, give yourself one more smack over head. O.K., you can put your hand down now! Now that your hand is down, please leave a comment. I’m interested in hearing your thoughts on this.

Love and Taxes

It’s spring, and love is in the air. You may be planning for the big June wedding right now. All the details; what caterer to choose, what color are the bridesmaid’s dresses, who sits next to whom, filing joint or separate tax returns, where to honeymoon, where to live. Whoa, back up…did I just say ‘filing joint or separate tax returns’? I sure did, and I bet you haven’t given that as much thought as you have about who gets stuck sitting next to Aunt Sophie! Well, as they say (whoever they are), there’s no time better than the present. So while you’re stressing out about which band to pick, add this to the list, and get the valium ready!

I thought this would be an interesting topic to write about, because over the years I’ve had to explain to countless newlyweds why they now owe taxes, when, in their single days, they always got refunds.

First thing to understand; when you’re married, you cannot file your tax return with the ‘single’ filing status. To quote IRS “If you are considered married for the whole year, you and your spouse can file a joint return, or you can file separate returns. There are a few examples that IRS gives for what’s considered ‘married for the whole year’, all of which pertain to the last day of the year. To simplify it, if you were married on December 31, you’re considered married for the whole year. This article isn’t meant to be political, so I would like to recognize all the same-sex partners reading this, and please don’t shoot the messenger; IRS makes the tax laws, not me.

Being a numbers guy, I threw together a very simple Excel worksheet, to compare the tax bite between single, married filing jointly (MFJ), and married filing separately (MFS). Even though you can only file jointly or separately if you’re married, I imagine there are people out there who might put off getting married if it’ll save them taxes, which is why I’m including single in this comparison.

Our love struck couple (let’s call them Bristol and Levi) each earn $100K/year in wages, each receives $3K/yr in interest and dividend income, and each have a rental property that generates $5K/yr net rental income. On single returns, they both have adjusted gross income (AGI) of $108K. On a MFJ return, their AGI will be $216K, since all of their respective income items will be on one return. On the MFS returns, they’ll each have AGI of $108K, same as single. Both claim a standard deduction, which will be $5,700 apiece, for either single or MFS. For MFJ, the standard deduction will be double, $11,400. They will each get one exemption of $3,650 on the single and MFS returns, and the MFJ return will have two exemptions (one for each) for a total of $7,300. When standard deductions and exemptions are subtracted, on the single and MFS returns, our lovebirds will each have taxable income of $98,650. On the MFJ return, the taxable income will be $197,300. Now comes the fun part!

Going to the tax charts/tables, the tax on taxable income of $98,650 will be $21,338 for single taxpayers. For MFJ, the tax on taxable income of $197,300 will be $43,488. Let’s summarize; two single returns will generate a total tax of $42,676, compared to a joint tax return which will generate a tax of $43,488. So being married and filing a joint return costs $812 more in federal tax! But wait, it gets worse. When filing separately, each return will generate a tax of $21,751, for a total of $43,502 for the two returns, or $14 more than filing jointly. Now if that isn’t a kick in the pants!

For all my unsuspecting newlywed clients, I’ve had to explain the “phenomenon” of the marriage penalty. Regardless of any attempts or claims by congress to mitigate this, it’s still there. The reason for this is that tax brackets for MFJ aren’t exactly double the brackets for single. What winds up happening is that on a joint return, more dollars wind up being taxed at a higher bracket than on a single return. And MFS is even more, which is why it comes out with the highest tax.

The moral of this story is, Bristol and Levi got scared off by the taxes, and decided to not get married! For all the “real” people out there; obviously there are a lot of other factors to consider when getting married, but when tax time comes, at least you’ll understand better why you just got smacked with taxes. Now go and enjoy that wedding. I’ll be here to talk taxes when you return.

%d bloggers like this: