Back to Basics Part XII – Form 2210 – Underpayment of Estimated Tax

Originally published in the Cedar Street Times

March 20, 2015

Believe it or not, time is actually starting to run out if you plan on filing your taxes by April 15.  Many firms require complete information to be in the office by late March or the beginning of April in order to assure the returns are completed by the April 15 rush.  Most people understand that personal tax returns and any tax owed are due on that day.  Even if you file a 6-month extension for the return, the tax is still due on April 15.  This requires you to consider the possibility of a short-fall and then send in an estimate by April 15 if deemed necessary, otherwise you will incur interest and penalties if you underestimate.

There are a number of charges the taxing authorities stack up to collect a little extra flow for the general treasury if you are delinquent, and they are all based on unpaid tax.  There is a late return penalty, a late payment penalty, an underpayment of estimated tax penalty, plus interest!  If you have ever seen the play Les Miserables, it can seem a bit like the opportunist innkeeper, Thenardier who sings, “Charge ‘em for the lice, extra for the mice, two percent for looking in the mirror twice!  Here a little slice, there a little cut, three percent for sleeping with the window shut.”

In two weeks we will discuss filing extensions and cover the penalties that can start accruing after April 15 – those include late return penalties, late payment penalties, and interest.  This week we will focus on the penalty that can accrue throughout the past year up until April 15 – underpayment of estimated tax.  If you would like to catch up on our Back to Basics series on personal tax returns, prior articles are republished on my website at www.tlongcpa.com/blog .

Underpayment Penalties and Form 2210

While underpayment of estimated tax sounds like a concept that would just apply to people that make quarterly estimated taxes, the reality is that it applies to all of us.  It even applies to those that file their returns on time and pay all of their taxes by April 15th.  So why would you owe penalties for being such a model citizen?!

Think of it like this: if your employer decided that paying you every two weeks for the wages you had earned was too much of a hassle, and decided instead they were just going to cut you a check once a year in December (or heck, how about April 15 of the following year – why rush it!), you may have a difficult time paying your bills throughout the year, and would then have to borrow money and pay interest on it to carry you until you got your next annual paycheck.

Even if you were a superb money manager and budgeted your annual paycheck carefully so you wouldn’t have to borrow money, you would still conclude that this is an unfair deal and demand that they pay you some interest since you do not particularly fancy giving your employer a free loan for a year!  The taxing authorities are the same way.  Their “paycheck” is the taxes you owe them and they want to get paid throughout the year, or at least get compensated for your continued use of their paycheck.  California and the federal government do not exactly have stellar records of managing money (what government does?).  As such, they have to issue bonds to borrow money to cover their expenses and then are stuck paying interest on the bonds!  So they want their paycheck!

Employees have taxes taken out of each paycheck and remitted regularly by their employers.  Self employed people do not, and generally must pay quarterly estimates.  But in either case, if you come up short at the end of the year, the taxing authorities will assess “underpayment penalties” if you do not meet certain thresholds.

So when are underpayment penalties assessed? In the simplest calculation, the federal taxing authorities take your total tax liability at the end of the year, divide it by four and assume they should have received 25 percent by April 15, 25 percent by June 15, 25 percent by September 15, and 25 percent by January 15 of the following year.  They look at the dates and amounts sent in by you and then figure out how much your were short and for how many days.  They then assess the three percent rate on those figures and amounts of time.  California has a special schedule which requires 3o percent paid in April, 40 percent paid in June, 0 percent in October, and 30 percent in January.  This unequal schedule requiring 70 percent of your tax to be paid in during the first five months of the year was California’s little trick to help balance the budget a few years back.

You also may be wondering why it is June 15 and September 15 instead of July 15 and October 15, as June is only two months after the first quarterly payment was due (but you owe it on income for three months!).  The answer is that I have no idea.  I heard once that it had to do with a projected budget short fall by Congress many decades ago, and they were trying to balance their budget.  That would make sense, but I can’t say for sure.

If you have taxes withheld by your employer or another source, for calculation purposes, they are evenly spread out to the four quarters, no matter when the taxes were actually paid.  For instance – if you got a large bonus at year-end, the taxes would be allocated evenly to all quarters.  This makes sense since in the default calculation, the income is also spread out evenly to all quarters.

Self employed people can have problems with this, however, since the actual dates of the estimated tax payments are used in their cases, but the income is still spread out evenly by the default calculation.  This could create unjust penalties if they earned a big chunk of their revenue near year end, and then sent in a check at year-end.  The revenue would be spread out to all quarters, but the taxes would look delinquent since they were paid at year-end.  The Form 2210 allows you to correct this by using an annualized income installment method whereby you enter in your year-to-date cumulative net income (as well as other income and deductions) at the end of each quarter to change the calculation method, and avoid these penalties.

Fortunately, there are some general rules that may allow us to be “penalty proof” so we do not have to worry about this every year,  1) If you have paid in at least 90 percent of the current year tax liability you are penalty proof, or  2) If you paid in at least as much tax as your tax liability in the prior year, then you are penalty proof unless your income is over $150,000  (75,000 if Married Filing Separate), then simply paying in at least as much tax in the prior year will not qualify you – you will have to pay in 110 percent of the prior year amounts, or 3) If the net tax you owe is less than $1,000 after subtracting out payments you made by April 15, then you are penalty proof.  California conforms to all of these federal rules.  It also has an additional rule for taxpayer’s that make over $1,000,000 ($500,000 Married Filing Separate) – those taxpayers are required to pay in 90 percent of the current year tax or they will face penalties.

Contrary to its unfortunate label as a “penalty,” it is essentially just interest.  And it is currently at that same rate of three percent per annum.  I often have clients that say they hate paying penalties and want to do whatever they can to avoid underpayment penalties.  When I ask them if they would like a loan at a three percent rate of interest instead, they want to know where they can get more of it!  If you are going to owe a substantial sum and would need to take the money out of investments that are almost certainly earning more than three percent in todays markets, it would be a wise decision to pay the penalties and pocket the spread.  If your money is just sitting in a bank account, however, it would be a different story.

In addition to the calculation sections, the Form 2210 also has boxes to request relief from late payment penalties.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part X – Schedule F

Originally published in the Cedar Street Times

February 20, 2015

When the Long family emigrated from Switzerland in 1737, they settled in the colony of South Carolina.  At the time, the headright system was in place, and every person received 50 acres of land for making the journey across the Atlantic.  The Longs stayed in South Carolina, and the land remained in our family until my dad and his sister-in-law sold the last remaining four hundred acres about ten years ago.  (Somewhere in our files we still have that original grant paperwork.)  Four hundred acres may sound like a lot to native Californians, but the phrase “dirt cheap” actually means something in other parts of the country!

Anyway, my dad grew up on that farm raising animals, picking cotton, and then in high school, packing peaches for another farmer in the area.  As time rolled on, farming became tougher for small farms, and the government eventually started paying my grandfather to NOT farm, and plant trees instead!  What a deal!  That was fine for my grandfather as he also had an architectural practice already dividing his time.  I am sure the subsidies he received were part of some government plan aimed at decreasing supply and driving up prices for other farmers, and I am sure he had to report those on a Schedule F – Profit or Loss from Farming.

Schedule F is our topic today.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

The header section of Schedule F is an information gathering area about the type of farming you do, your participation level in the business, and various other questions.  Similar questions can be found on Schedule C for businesses or Schedule E for rental or other supplemental income activities.

Schedule F is a two page form, and nearly half of that real estate is devoted to gathering income.  By comparison most other schedules in the tax return have a tiny section devoted to income gathering.  This is due to the wide variety of sources of farming income.

Section I covers income for cash basis farmers.  Cash basis simply means you declare income when you receive the money, and you deduct expenses when you pay out the money.  Section III on page two covers income gathering for accrual basis taxpayers.  This means income is declared when it is earned (not necessarily received), and expenses are deducted when incurred (not necessarily paid).

Farming has been at the root of American lives since the country was founded, and it is not always an easy or a consistent business to run.  As a result there are many special programs available to farmers (or non-farmers as in the case of my grandfather) as well as certain tax advantages.  Farmers may see income from all kinds of sources, many tied to government programs or insurance, such as direct payments, patronage dividends, counter-cyclical payments, price loss coverage payments, agriculture risk coverage payments, price support payments, market gain from the repayment of a secured Commodity Credit Corporation (CCC) loan gains, diversion payments, cost-share payments (sight drafts), crop insurance proceeds, federal disaster payments, etc.

Due to the unpredictability of nature, there are even special provisions available to farmers that allow them to average their income over a three-year period. This is done by completing Schedule J.

You can imagine being a little upset if instead of having your income spread evenly over two years and being in a top bracket of 15 percent in both years, that you make zero in one year due to a drought and double in year two due to wonderful rain and sunshine, and then wind up in a 25 percent top bracket!  Not only did you suffer the hardship of having no income one year, but then you ended up with a bigger overall tax bill on the same amount of income.

Another example of a favorable provision says that if you have to sell livestock due to weather-related conditions, such as a drought, you have the option of reporting the income in the year following the sale.  So you get to defer the income.  Your farm must be located in an area qualified for federal aid due to the weather-related condition.

Part II of Schedule F deals with gathering expenses.  Due to the length of time it takes to get many crops or animals into a productive state, there are a lot of very specific rules regarding deducting versus capitalizing farm expenditures.

For example, if a crop takes more than two years growing time before it comes to fruition, you generally must capitalize the costs during the period. In most cases you can make an election to expense the costs, however.  The instructions to Schedule F tell us, “you cannot make this election for the costs of planting or growing citrus or almond groves incurred before the end of the fourth tax year beginning with the tax year you planted them in their permanent grove.”  As you can tell, the rules can get very specific depending on what you are growing, and where!

Similar to a Schedule C business, if an unincorporated farm is owned and operated by a husband and wife in a community property state, such as California, they should split the income and expenses according to the work performed and file two Schedule Fs.  This assists with filing two Schedule SEs for self-employment income for each.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part IX – Schedule E

Originally published in the Cedar Street Times

February 6, 2015

So you decided to put your home up for rent for two weeks surrounding the AT&T Pebble Beach National Pro-Am.  Fortunately for you, it was rumored that Arnold Palmer once spent the afternoon on your front lawn.  As a result, there are so many prospective renters that you are having to beat them away with golf clubs.

Finally you settle on a renter and a nice fat $40,000 check for two weeks!  Score!  But then you remember this pesky thing you do each year called taxes, and you start wondering how you are going to report this on your tax returns.  The surprising answer is that it won’t get reported at all.  There is a rule which states if you rent your home for 14 days or less during the year, you do not have to report the income.  All $40,000 is tax free!  But what if your renters need an extension of one day?  Don’t do it!  If you do, the entire amount is now taxable on Schedule E.

In this issue, we are discussing Schedule E – Supplemental Income and Loss.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

Schedule E is a two-page form used to report income from rental real estate, royalties, and income from partnerships, s-corporations, trusts, and estates.  Part I handles the reporting of income and expenses of rental real estate and royalties.  There is a section regarding rental real estate that asks for the number of days rented at fair market value and the number of days of personal use.  This information is necessary in order to apply limitations regarding the rental of personal residences and vacation homes.  Any personal use will affect the allowable deductions to some extent.  (See my articles “Renting Your Vacation Home” on my website originally published August 10 and 24 of 2012 for more details.)

All expenses related to caring for your rental real estate can be deducted.  Besides costs such as property taxes, interest, repairs, etc., you can also use the standard mileage rate (56 cents per mile for 2014) to deduct any rental related mileage you drive.  If your property requires you to travel away from home overnight, you can deduct lodging and 50 percent of your meals as well.

If rental property generates a loss, there are several tests that must be applied near the bottom of Schedule E page one to determine if the losses will be allowed, or suspended for use in future years.  You can only take losses to the extent that you have an investment at-risk.  Form 61K-198 is used to determine this.  There are also rules limiting the amount of losses you can use against other income if the losses come from passive activities.  Rental real estate is generally considered a passive activity, and Form 8582 is used to determine if your losses will be limited.

Part II of Schedule E begins on page two and summarizes income and losses from flow through activities of partnerships and s-corporations.  Your share of these activities is reported to you on a Form K-1.   Again, at-risk and passive activity loss limits are applied.  Your basis in the underlying partnership or s-corporation activity as well as your level of participation and type of ownership interest are considered in these calculations.

Part III covers your share of estate and trust activities reported to you on a K-1 in a similar fashion as in part II.  The main difference being that there are generally no at-risk limitations to worry about.

Part IV covers income or losses from Real Estate Mortgage Investment Conduits.  These are essentially mortgage-backed securities: a solid product which earned a bad reputation during the financial crisis from 2007-2010 when sub-prime mortgages were bundled and sold together.

Part V summarizes the income and losses from the first four parts of Schedule E and pulls in farm land rentals as well which are calculated on a separate Form 4835.

Getting back to your $40,000 two-week rental.  It turns out that the Arnold Palmer that spent an afternoon on your front lawn was simply a glass of watered-down iced tea and lemonade, and your renters backed out.  Better luck next time…

In two weeks we will discuss Schedule F – Profit or Loss from Farming.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics – Part VIII – Schedule D

Originally published in the Cedar Street Times

January 23, 2015

Imagine yourself on Antiques Roadshow and they tell you that an old porcelain mug you found in your attic last summer is worth $8,000-$10,000 dollars!  You are of course elated, and decide to sell the mug.  Fast forward to February, and your accountant starts asking you questions about this sale, such as your adjusted cost basis and your holding period.  You really have no idea how you even got it.  You know it was in the family for a long time, and you think that maybe it was in a box of things your mom left for you when she moved to Palm Springs where she now resides.  What do you do?  I don’t know exactly, but I know this much – it will go on your Schedule D in some form.

In this issue, we are discussing Schedule D – Capital Gains and Losses.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

Schedule D is used to report gains or losses from the sale or exchange of capital assets.  Capital assets consist of a variety of things.  The personal use items you own – such as your home, your vehicles, household items etc. are capital assets.  Gains from the sale of personal items are taxed.  Losses, however, are generally disallowed. Your personal investments such as stocks, bonds, or real property held as an investment are also capital assets.  Gains and losses are allowed on personal investments.

The same types of items used in your trade or business, however, would be reported on a Form 4797 and would be taxed differently as well.

Assets that have a mix of personal use and business use can have elements reported on both forms.

To determine your gain or loss on a capital asset, you must know your cost basis in it.  If it is something you bought, your cost basis is generally the amount you paid for it; if it is something you inherited, your cost basis is often the fair market value at the date of death; or if it was something given to you, your cost basis is generally the same as that of the prior owner.

There can also be adjustments to this basis, such as when you make improvements to your home – the money you spend would be an adjustment upwards.  Once you know your adjusted cost basis, you simply subtract it from the sales price to determine your gain or loss.  If you scrapped it, your sales price is zero.  Sometimes it can be quite challenging to determine the cost basis, especially if records no longer exist.  Technically, if you cannot prove your basis, the IRS can take the position that your basis is zero.  This could be very unfavorable, especially if you just sold a $10,000 mug with unknown origins!

It is also important to know the length of your “holding period.”  The date you purchase the property is generally the beginning of your holding period and the date you dispose of the property is the end of your holding period.  For property received as a gift, you include the holding period of the person who gave it to you.

If your holding period is over a year, it is subject to favorable long-term capital gains rates – basically a 15 percent federal rate for most people.  (Although it could be as low as zero percent or as high as 20 percent depending on your tax bracket and the amount of capital gains you have.  Also, collectible items you sell such as old coins or antique vehicles are taxed at a 28 percent rate.)  If your holding period for the asset is a year or less, it is considered a short-term holding and is taxed like ordinary income (a higher rate for most people).  Inherited property is always considered to have a long-term holding period.  California does not have a special rate for long-term holdings and treats all capital gains as ordinary income on its tax return.

As mentioned before, there is no deduction for losses on your personal use items.  You can, however, take a loss on your personal investments.  They would reduce any other capital gains, first, and then if there are still losses remaining, you can use $3,000 to offset any other type of income you have on your tax returns.  The rest would get carried over to future years.

The Schedule D itself is essentially a summary of capital gain and loss activity that are mostly determined by other forms that feed into the Schedule D.  Part I summarizes short-term gains and losses, and Part II summarizes long-term gains and losses.  Form 8949 is the main supporting form used in both of these sections.  It was added a few years ago after changes to broker cost basis reporting requirements occurred.  The Form 8949 sorts out long-term and short-term transactions for which cost basis is reported to the IRS and not reported to the IRS, and handles the actual transactional reporting.

Parts I and II also have areas were short-term and long-term gains can be reported from other forms such as installment agreements, business casualty and theft losses, like-kind exchanges, as well as pass through entities such as partnerships, S-corporations, estates, and trusts.  Long-term capital gains distributions from mutual funds on a 1099-DIV are reported in Part II.  (Short-term capital gains distributions from mutual funds are actually included as ordinary dividends on the 1099-DIV, and are reported on Schedule B instead.)  In addition, short-term and long-term loss carryovers from prior years are added into their respective parts on Schedule D.

Part III nets the short-term gains or losses against the long-term gains or losses.  It then helps you determine the gain or loss to enter on the 1040.  It also walks you through several worksheets to determine the amount of tax and tax rates you will pay on any gains.

So what would you do about the mug?  Hopefully mom would have some recollection of the history.  Maybe there was a somewhat recent time when it was passed by inheritance and would have received a step-up in basis.  Of course, you should have figured that out before you sold it, and then had an appraisal done to support it!  Otherwise, if it had just been gifted from one person to the next, the mug probably had very little if any cost basis, and you might be stuck with a big taxable gain.

In two weeks we will discuss Schedule E – Supplemental Income and Loss.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back To Basics Part VII – Schedule C

Originally published in the Cedar Street Times

January 9, 2015

In this issue, we are discussing Schedule C -Profit or Loss from Business.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

Schedule C is generally used to report income and expenses for your self-employment activities for which no partnership exists or no entity has been established (such as a C or S-Corporation or LLC) – in other words, it is used for a sole proprietorship.  Of course there are exceptions and wrinkles to the rules.  Here are a few common ones.  In most states, a husband and wife which own and operate a business together would file a partnership return instead of a Schedule C.  However, since California is a community property state, a husband and wife should generally file two Schedule Cs and split the income and deductions based on their distributive shares, even if filing a joint return.

One important reason for doing this is that two Schedule SEs would also be filed reporting the Social Security and Medicare taxes separately for each spouse.  They would each be subject to the full taxable wage base for Social Security, but they would also each receive credit for their earnings which would figure into their Social Security checks in retirement.

An LLC with only one member that is operating a business would also report the business activity on a Schedule C instead of a 1065 Partnership return.  Since you can’t have a partnership between you and yourself, the formal entity structure is disregarded for federal tax purposes and reported like a sole proprietorship.  In community property states such as California, a husband and wife that both own and operate the business are actually considered one member for LLC purposes.  If they were the only two owners, the entity would be disregarded, but they would then report on two Schedule Cs as discussed above.

Now that we have discussed who uses the form, let’s move to the form itself.  The initial section of Schedule C asks for identifying information – the name of the business, the type of business, address, etc.  If you have an employer identification number you can enter that as well.  This would be required if you have employees on payroll.  You can also obtain one if you simply do not want to hand out your Social Security number whenever a formal taxpayer identification number is needed – such as for filing 1099-Misc forms for independent contractors.

There are also some other direct questions regarding your basis of accounting, level of participation, and filing compliance.  Most small businesses under $10 million in annual revenues operate by the cash method of accounting as it has many advantages.  Material participation is a tightly defined standard  by the IRS which can affect your ability to take losses in a down year.  The questions on 1099 filings are loaded questions designed to help the IRS easily identify businesses that are not filing required 1099s for payments to independent contractors, for interest received, etc.

In Part I Income, you list your gross receipts, subtract sales returns and allowances, subtract cost of goods sold (which are detailed in Part III) and then add other income such as interest income or certain credits.  Part III Cost of Goods Sold is mainly geared towards retailers, wholesalers, and manufacturers.  It provides a place to detail beginning and ending inventory and any associated labor and material costs associated with production of the goods.  Even taxpayers on a cash basis are generally required to track inventory.  Cash basis typically means you get the deduction when you spend the cash, and you record the income when you get the cash.  But with inventory, you do not get the deduction until the inventory is sold or disposed.

In Part II you detail all your expenses.  The instructions to Schedule C do a pretty good job of explaining what types of expenses they want on each line.  Some of the lines are supported by additional forms such Form 4562 Depreciation and Amortization feeding into Schedule C line 13 for Depreciation.  Line 24b for Meals and Entertainment is unique as most qualified meals and entertainment are allowed only a 50 percent deduction.  Another unique aspect is that preset per diem rate deductions are allowed for self-employed individuals (and employees) for meals, entertainment, and incidental expenses in lieu of tracking actual receipts.  Some of these per diems are quite generous depending on the location of travel, and taxpayers can sometimes get a much larger deduction than the amount they actually spend.

Line 30 for expenses for business use of your home is another example where an entirely separate form (Form 8829) is used to calculate the deduction.  There is also an alternative simplified method introduced with the 2013 returns that gives you $5 square foot for business space (up to $1,500) without having to track actual expenses on Form 8829.

Line 32 contains a few questions about whether your investment in the business is “at-risk” or not.  Basically they are asking if you are financially liable if things go south, and could you lose the money you have injected into the business in the past.  This affects your ability to take losses in down years.

Part IV details your vehicle deduction for standard mileage rate users.  For 2014, this amount is 56 cents a mile.  If you track actual expenses instead, you would not fill out this part.

Part V is for any additional expenses not discussed in Part II.

In two weeks we will continue our Back to Basics series with Schedule D – Capital Gains and Losses

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back To Basics Part VI – Schedule B

Originally published in the Cedar Street Times

December 26, 2014

In this issue, we are discussing Schedule B – Interest and Ordinary Dividends.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

Interest you earn from the use of your money by others is reported in detail  in Part I of Schedule B and then summarized on Line 8a of Form 1040.  Interest is taxed as ordinary income depending on your tax bracket.  The most common form is interest earned from your banks or investment companies.  You will generally receive a Form 1099-INT telling you the amount you paid if the amount is over $10.  If it is under $10, there is no requirement for the payor to go through the hassle to report it to you and the IRS; technically that does not alleviate your responsibility to report it on your tax returns, however.  This holds true for all IRS reportings.  Some people think if no tax document is received, they are somehow relieved from the responsibility to report.  This is an incorrect notion.

Other forms of interest to report on Schedule B could be interest earned from personal loans made to friends or family, or loans made to a business.  In practice, you often will not receive a 1099-INT from individuals you loan money to, but they actually have the same requirements as a bank to file a 1099-INT for interest they pay to you, and they could be penalized for not doing so.

Another form of interest you need to report on Schedule B is interest earned from a seller-financed mortgage.  If you sold your home and carried back a note on the house from the buyer, the interest they pay you is reportable interest on Schedule B.  You are required to track the interest and report it properly.  You and the buyer are both required to provide your names, Social Security numbers, and addresses to each other for proper tax reporting and matching.  You list the buyer’s information in Part I of Schedule B next to the amount they paid you.  A buyer will do the same for reporting the mortgage interest on Schedule A.  A Form W-9 is the best document to request and provide Social Security Numbers.  Buyers and sellers could each be penalized if they fail to provide their Social Security numbers for this purpose or if they simply get it verbally, and it is incorrect.  A W-9 signed by the other party is a protection to you.

Be careful to not include any tax-exempt interest such as from U.S. Treasury Bonds or tax-free municipal bonds on Schedule B.  These would be reported on Line 8b of Form 1040 and are generally not taxable unless there are other adjustments such as those made for Alternative Minimum Tax on Form 6251.  Another source of interest to avoid reporting on your Schedule B is interest earned from investments in your retirement plan (I have see people make this mistake!).

There are other forms of interest or adjustments such as original issue discounts, private activity bond interest, amortizable bond premiums, and nominee distributions which are beyond the scope of this article.

Dividends are reported in detail in Part II of Schedule B and summarized on Line 9a of Form 1040.  Dividends are essentially a return of part of the profits of the business to the owners.  When you own shares of stock in a company, for instance, they may pay out a certain amount per share if the company is doing well.  You can reinvest the dividends and buy more shares or take the cash.  Either way, the dividends get reported on Schedule B.

Dividends are taxed at your ordinary income tax bracket rate unless they qualify for special capital gains rate treatment.  Then they are called qualified dividends.  To qualify for special treatment the dividends must be from U.S. corporations, corporations set up in U.S. Possessions, or in foreign countries with certain tax treaty benefits, or if readily tradable on U.S. stock exchanges.  If you have held the stock for less than a year, there are also some specific holding period requirements that could still allow the stock to qualify.

The portion of ordinary dividends that are considered qualified are reported on Line 9b of Form 1040, and don’t actually show up on the Schedule B.  This is a large advantage as people in the 10 percent or 15 percent income tax bracket pay no tax on capital gains and qualified dividends!  People in the top 39.6 percent bracket pay a 20 percent rate on qualified dividends and everyone in between pays 15 percent.

Part III of Schedule B consists of questions about any foreign accounts or trusts you own or have signature authority over.  These questions are EXTREMELY important to answer correctly.  If you have a foreign account you will also need to file FinCen Form 114 with the Treasury Department.  There are potentially massive penalties for failure to properly report on FinCen Form 114, even if unintentional, and possible jail time if you willfully do not report.  You may also need to file a Form 8938, a 3520 or other forms related to foreign assets.  If you have foreign assets, you should seek professional support that has experience in this area.  Getting caught is much worse than coming forward.

In two weeks we will continue our Back to Basics series with Schedule C – Profit or Loss from Business

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part V – Schedule A Wrap-Up

Originally published in the Cedar Street Times

December 12, 2014

In this issue, we are finishing our discussion on Schedule A – Itemized Deductions.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

The fifth section of Schedule A is for personal casualty and theft losses.  This is designed to help people with major losses.  The deduction on schedule A is calculated by taking the amount of the loss, subtracting $100, then subtracting 10 percent of your adjusted gross income.  Any amount left over will be an itemized deduction (if any).  There are several ways to calculate the amount of the loss but it is generally limited to the lesser of your adjusted cost basis or the decrease in the fair market value.  Sometimes appraisals are necessary to establish the decrease, but in all cases, the amount of any insurance proceeds received would reduce the loss.  Another salient point is that the loss generally has to be sudden, unexpected, and permanent in nature; it is not the result of degrading over time.  For instance, a car accident or theft would qualify; termite damage would not qualify.  Losing something does not qualify either.  Business casualty losses are not reported on Schedule A.

The next section deals with miscellaneous itemized deductions subject to two percent.  This means you take all the deductions in this section, subtract two percent of your adjusted gross income, and the left over amount is your itemized deduction for this section (if any).  Some of the deductions here include unreimbursed employee business expenses, union dues, investment expenses, income tax consultations and preparation, legal expenses related to your job or to the extent they deal with tax issues or the protection of future taxable income, job search or education expenses (if they relate to your current field), etc.

Unreimbursed employee business expenses are those which are ordinary and necessary and the employer expects the employee to pay for the expenses.  If the employer has a reimbursement plan, but the employee simply fails to request reimbursement, the expense will not qualify.  It is best if the employer has a written policy, or as part of the employment agreement, spells out what things the employee is expected to cover.  Sales people can often have high deductions in this area through business miles on their vehicles and meals and entertainment for clients.  If a company provides no office space for an employee and the person has an office in his or her home, deductions can be taken for that as well.

Investment expenses paid to financial advisors or even IRA fees can be deductible.  Financial advisor fees must be prorated if you have taxable investment income and tax free investment income such as municipal bond interest.  Only the portion allocated to taxable income is deductible.  For IRA fees to be deductible, they must be paid with funds outside the retirement plan.  This is preferred anyway so as not to deplete your retirement account by using IRA funds to pay the fees.

The last section of deductions on Schedule A is called “Other Miscellaneous Deductions.”  These are NOT subject to the two percent of adjusted gross income floor, and the full amount become itemized deductions.  These are less frequently encountered and include things like Federal estate tax on income in respect of decedent, gambling losses up to the amount of winnings, losses from Ponzi schemes, casualty and theft losses on income-producing assets, amortizable bond premiums, unrecovered investments in annuities and other items.

The final part of Schedule A is one more “gotcha.”  If your income is over $305,050 for Married Filing Joint or $254,200 Single, part of your deductions begin to phase out.  Medical expenses, investment interest, casualty, theft, and gambling losses are not subject to the phase out.  The rest of the deductions can be reduced by as much as 80 percent!  The amount is determined by taking your adjusted gross income, subtracting the above figure based on your filing status, and multiplying the result by three percent.  That is your adjustment capped at the 80 percent maximum.

In two weeks we will continue our Back to Basics series with Schedule B – Interest and Ordinary Dividends.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part IV – Even More Sch. A

Originally published in the Cedar Street Times

November  28, 2014

In this issue, we are continuing our discussion on Schedule A – Itemized Deductions.  Prior articles are republished on my website at www.tlongcpa.com/blog if you would like to catch up on our Back to Basics series on personal tax returns.

The third section on Schedule A covers deductible interest you have paid.  For most people the big item here is the mortgage interest on their principal residence.  You can also deduct mortgage interest on one other personal residence as well.  A lot of people assume that if the interest shows up on a Form 1098 that it is deductible.  Contrary to popular belief, that does not determine deductibility.  People with rental and personal properties, for instance, that refinance and pull money out of one property and put it into another are especially at risk of having made a major mistake.

The home mortgage interest deduction requires the debt to be secured by a qualified home and have been used to acquire, construct, or improve the home up to $1,000,000 of debt and up to $100,000 of additional debt for any purpose.  Assume someone refinances a rental property and pulls $200,000 out of it to buy a personal residence.  The interest on the $200,000 is not a rental property deduction on Schedule E because the funds did not go into the rental property activity.  It is also not deductible on Schedule A as home mortgage interest because the debt is not secured by a qualified personal residence – it is secured by the rental property!  Oops – nondeductible personal interest!  There are some work-arounds to this, but they are not always easily accomplished, and the problem is more likely to be found in an audit when it is too late.

Another common problem crops up for people on personal residences who take out a second loan, open a line of credit, or do a cash-out refinance and do not use the cash to improve the home.  This portion is called home equity debt.  You can only deduct the interest on up to $100,000 of total home equity debt.  Anything beyond that becomes non-deductible personal interest, and would need to be tracked properly.  If you later refinance your primary loan and the home equity loan into one loan, the character of the debt remains the same.  This means you have to keep track of the portion of the debt that is home equity debt versus acquisition debt that comprises the one loan.

Other deductible interest would include points paid during a purchase or refinance.  Often these are not included on the 1098 and you must look to the escrow closing statement to pick them up.  New purchases allow 100% deduction of the points in the year purchased.  Refinances, require amortizing and taking a portion of the deduction each year over the life of the loan term.  Private Mortgage Insurance (PMI) used to be deductible as interest, subject to limitations, but is not currently slated for a deduction in 2014.  Investment interest is another item that falls into this section of Schedule A.  A simple example would be borrowing money to invest in the stock market – like a margin loan.  However, investment interest expense is only deductible to the extent that you have investment income (Form 4952).  So, if you paid $1,000 of interest, you better have made a $1,000 of investment income, otherwise the excess gets suspended and carried forward for the future.

The fourth section on Schedule A deals with gifts to charity.  Volumes have been written on this topic!  Gifts to charity must be made to qualifying organizations for U.S. tax purposes.  There is a 50 percent of your adjusted gross income limit each year regarding regular donations to charities.  There are also 30 percent and 20 percent limitations for donations to certain types of organizations and types of property donated.  So if you gave a very large gift, it could get suspended and carried over to the future.  There is generally a five-year carryover limit, at which point any remaining deductions would be lost.

All donations must have substantiation, no matter how small.  Cash donations under $250 must be substantiated with a properly worded letter from the organization, a cancelled check, a bank statement, or a credit card statement.  Cash donations over $250 require a letter from the organization.  Noncash donations have a lot of rules.  Every noncash donation requires a receipt from the organization.  Noncash donations over $500 require the filing of an 8283.  Noncash donations over $5,000 require a qualified appraisal as well.  It would be in your best interest to ensure you have properly planned when making (or anticipating to make) a donation over $5,000.  The $5,000 threshold is cumulative throughout the year for similar items.  This means that many trips throughout the year of donating to the local charitable thrift store of household goods would retroactively require an appraisal to claim over $5,000.  And it is hard to appraise items you no longer have!  As you can see there can be much to consider.

You can deduct out-of-pocket charitable volunteer expenses such as uniforms or gear necessary for the volunteer work.  If you travel on your own dime overnight, and you have substantial duties and very little personal activities, you may be able to deduct airline tickets, meals, lodging, etc.  Volunteer excursions that are not away from home overnight do not qualify for meal deductions.  If you use your vehicle for charitable purposes you can deduct the mileage at 14 cents per mile, or track gas and oil expenses.

A few things that are definitely not deductible but are commonly misunderstood by individuals as well as by small charitable organizations: 1) gifts to needy or worthy individuals –  even if you give to a qualified organization be sure you do not earmark your donation for a particular person or family, or your deduction is not legitimate ,  2) gifts of your time or services – like the artist trying to deduct a self-created painting at “fair market value” – you can only deduct hard costs such as the canvas and paint costs.  Since you never included in income and paid tax on your services, you cannot take a deduction for them,  3) charity raffles, bingo, lotteries  4) charitable auctions or other donations to the extent of the value you received in return – such as paying $75 in a charity silent auction, but you get a $100 gift certificate – no deduction allowed.  Or the local public radio station sends you a set of CDs they value at $100 in return for your $125 donation – you only get to deduct $25.

In two weeks we will continue our discussion regarding Schedule A.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Back to Basics Part III – More Sch. A

Originally published in the Cedar Street Times

November  14, 2014

Two weeks ago we discussed the purpose of schedules and forms in a tax return and then began a discussion on Schedule A – Itemized Deductions.  We discussed that itemizing deductions is an option if you have more than what the IRS allots as a standard deduction to everyone for things like medical expenses, taxes, charitable donations, and other miscellaneous deductions.  This week we are going to look more closely at the different types of deductions that you can itemize on Schedule A and how these deductions can get a shave and a haircut and look like less than when you started.

The first section on Schedule A covers out-of-pocket medical expenses (not reimbursed by insurance).  Things like doctors, dentists, chiropractors, Christian Science practitioners, hospital bills, prescription drugs (not over the counter), eyeglasses, contacts, copays, etc. all fit into this category.  Health insurance is also deductible here unless it is for self-employed people, in which case it can get potentially better treatment as an adjustment to income on page one of the 1040 instead.  Health insurance would include your Medicare payments which most people see deducted from their Social Security checks.

Sometimes people are surprised to learn that substantial expenditures on your home can be deductible if done to improve accessibility – such as widening doors and bathrooms, installing ramps, hand rails, etc. (there are a number of rules to be aware of, however).  You can also deduct medical related miles at 23.5 cents per mile and even deduct overnight travel expenses if you must drive to a hospital that is not local, for instance. The problem with medical expense deductions is that for the vast majority of people, none of the expenses even make it towards counting as an itemized deduction. 

You have to have in excess of 10 percent of your adjusted gross income (the bottom number on page one of your 1040) in medical expenses before a single dollar counts.  So, if your adjusted gross income is $100,000, and you have $10,500 of out-of-pocket medical expenses, only $500 counts towards your itemized deductions.  If you or your spouse are over 65 you have a 7.5 percent threshold through 2016, and then you will jump to ten percent as well.  A really nice planning opportunity around this dilemma is having a health savings account in connection with a high deductible plan.  It has the ability to effectively convert some or all of your nondeductible medical expenses to deductible expenses.  Ask your tax preparer or insurance agent about this.

The second section on Schedule A covers deductible taxes you have paid. This includes state income taxes you paid during the year, SDI withholdings from your CA paycheck, real estate taxes on your personal residence(s), personal property taxes assessed on value such as annual vehicle taxes (license fee on your CA DMV renewal), boat, aircraft, etc.  Remember, as a cash basis taxpayer, these (as with generally all income and expenses on your tax returns) count in the year you actually pay them (or charge them in the case of a credit card), so it doesn’t matter what year they are supposed to cover – just look at when they were paid.  There has been an option in past years to deduct sales taxes you paid during the year if they were greater than the state income taxes you paid, but that is currently not an option for 2014, unless Congress takes action.

In two weeks we will continue our discussion regarding Schedule A.

Prior articles are republished on my website at www.tlongcpa.com/blog.

Travis H. Long, CPA is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. He can be reached at 831-333-1041.

Follow

Get every new post delivered to your Inbox.

Join 109 other followers