Back to Basics Part XVII – Form 4562 – Depreciation and Amortization

Originally published in the Cedar Street Times

June 26, 2015

If you want to take a relatively simple concept and complicate it to the nth degree, then you will fall in love with depreciation expense!  I am sure there have been numerous doctoral candidates in the accounting field that have written their dissertations on the topic of depreciation.  There are so many angles – matching the expense of an asset with the revenues it generates, shifting economic policies, grandfathering of legacy rules, and of course politics and lobbyists.  Today we will be talking about Form 4562 – Depreciation and Amortization.  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 .

At its core, the concept of depreciation expense is rooted in what accountants call the “matching principle.”  You are trying to spread out the cost of purchasing an asset for your business or investment activity over the years that it is useful to you – thus allocating the expense to the periods of revenue that result from the asset.  Take a pencil for example.  You purchase the pencil at the beginning of the year.  You use it to write notes, draft reports, and fill out forms, which lead to revenue throughout the year.  By the end of the year you are left with a short stub, riddled with bite marks and a half-used blue pencil top eraser with a split down the side…so you throw it away. On your tax returns you have a $50,000 of revenue, offset by a $0.25 deduction for the pencil that helped generate the revenue.  Clearly, the revenue and the expense were matched in the same period.

But what about the stapler that you also bought at the same time as the pencil?  You bought a quality, metal stapler for $25.  It could be sitting on your desk until you retire, and then get passed on to your successor!  Let us assume it helps you earn revenue for 25 years before becoming the victim of a careless office prank.  The matching principle would say you take the $25 and spread it out over the 25 years of its useful life, taking a $1 of expense each year against the revenue it helped you earn all those years.  You would of course have to track the stapler on a schedule and each year update it for the depreciation expense taken.  It would be helpful to have a column for the accumulated total of depreciation you had taken over the years so you know what is left to deduct as well.

That is depreciation expense in its simplest form.  Unfortunately, the tax code is anything but simple – sometimes for good reasons, and sometimes for not so good reasons.  A full explanation of depreciation rules would require thousands of pages of text.  Here are some of the key concepts to help you swim with depreciation.  It is important to note that depreciation is not a choice.  There are choices within the depreciation laws, but you cannot just say – I do not want to participate.

Depreciation vs. Amortization – essentially a matter of semantics. Depreciation is the word used in association with tangible assets purchased; amortization is the word used in association with intangible assets purchased, such as goodwill, patents, and copyrights.

Depreciation Policy – it would be impractical to track every asset you buy that has a useful life of more than a year (like the stapler!), so depreciation policies are developed in accordance with limits established by law.  For instance, everything over $500 will be depreciated, and everything below that will just be expensed in the year it is purchased.

Asset Classes – the IRS has pre-determined the periods and methodology for depreciating the vast majority of assets.  The Modified Accelerated Cost Recovery System (MACRS) is the system used for depreciation today.  Inside that there is the general depreciation system and the alternative depreciation system (ADS) (ADS is mainly used for assets held outside the U.S.).  Inside the more common general depreciation system there are 3-year, 5-year, 7-year, 10-year, 15-year, etc. on up to 50-year asset classes.  For instance, off-the-shelf computer software is 3-year property; machinery, equipment, and computers in a business are 5-year property; and land improvements are 15-year property.

So you do not just pick the expected useful life in your opinion – you use what the IRS says, instead.  Of course there are always strange nuances – such as furniture in a business is 7-year property but furniture in a residential rental is 5-year property.  Or the fact that the residential rental house you own is 27.5-year property, but an entire “motorsports entertainment complex” is only 7-year property (think NASCAR lobbyists).  These classes are generally “accelerated” as well, meaning you do not simply divide the cost by the number of years and depreciate it ratably.  That would be “straight-line depreciation.”  Instead there are methods such as 200% Declining Balance and 150% Declining Balance that front-load the depreciation expense in the early years, resulting in less in the later year.

There are also “conventions” depending on the asset class and date it is placed in service during the year when you first acquire it.  These include “half-year,” mid-quarter,” and “mid-month,” and determine how you calculate the depreciation in the first year.  To make matters more complicated, the tax laws have changed over the years, but the system that was in place when you placed the asset in service governs it for life.  MACRS was established in 1986.  Prior to that, there were several other systems with their own sets of rules: the Accelerated Cost Recovery System (ACRS) was used from 1981-1985, and prior to that, the Asset Depreciation Range (ADR) system was used.  It is still possible to have assets under ADR, ACRS, and MACRS!  To say that software is necessary is an understatement.  It certainly works wonders with the calculations, but you still have to understand the laws and options to make the right selections and decisions.

Section 179 Deduction – from year-to-year the political and economic environments dictate an incredibly powerful deduction under IRS Code Section 179.  This code section is kind of like an override that allows you to elect to expense assets in their entirety in the year purchased rather than spreading the deduction out over a period of years.  The code section was created in 1958 when it had a $2,000 cap.  The amounts were slowly raised up to $25,000 by 2003.  Since then, each year Congress has made huge overrides to the codified $25,000 amount jumping it to $100,000, $125,000, $250,000, and even $500,000 where it has been for the last five years, but it generally defaults back to the $25,000 figure where it currently sits for 2015, unless Congress “saves the day” again.  Many business owners have come to rely on this for large purchases, but it is good to remember, it may not be there.  Certain assets do not get 179 treatment or there are modified rules.  Vehicles for instance are not eligible unless it is a vehicle with a gross weight rating of over 6,000 pounds.  Even then, the depreciation amount has been capped at $25,000 in recent years on those particular vehicles.  For assets you want to elect to claim the 179 treatment, you still must go through the formal process of setting them up on a depreciation schedule and reporting them on the Form 4562.

Bonus Depreciation/Special Depreciation – these are additional concepts that Congress has created over the years allowing more depreciation in certain circumstances.  One of the concepts with special depreciation has been that the assets must be brand new (not purchased in used condition).  This was certainly a policy implemented to try to stir the economy.

Other Rules – there are a host of other rules, such as how to handle assets that you exchange for other ones (like trading in a vehicle), what do you do if you convert the asset to personal use, or use assets for both business and personal use, what do you do when you sell assets, etc.  And there are lots of very pointed rules that clearly address certain industry desires such as “qualified second generation biofuel plant property,” which apparently was important enough to the masses to warrant half a column among the sea of information that could have been presented in the condensed 22 pages of instructions to the Form 4562!

The Form 4562 itself is two pages long.  The first section deals with reporting any assets for which you are electing to take a Section 179 deduction.  The next section deals with Special Depreciation.  The third section deals with reporting assets under the regular MACRS depreciation asset classes, but you only have to list the assets on the form during the first-year they are placed in service – not every year.  Your separately maintained depreciation schedules will track them for all years.  Depreciation schedules need not be submitted to the IRS with your returns, but should be maintained for reference and in the event of an audit.  The fourth section is a summary.  The majority of the second page deals with automobiles and listed property, which are required to be reported each year, since they have special limiting rules.  Listed property includes certain types of property that often have mixed personal and business use, so the IRS wants to monitor these more closely. The final section is for amortizable assets.  As with depreciable assets, you only have to list amortizable assets in the first year they are placed in service.

Keep in mind that besides the regular depreciation schedules, you also typically have to maintain separate state depreciation schedules, which can have their own rules.  California, for instance, does not conform to Section 179 deductions among many other things.  In addition, you should track Alternative Minimum Tax (AMT) versions of the federal and state schedules as they can differ as well, should you be impacted by AMT.

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 XVI – Form 3903 – Moving Expenses

Originally published in the Cedar Street Times

June 12, 2015

The U.S. Census Bureau estimates that average Americans will move 11.7 times in their lifetimes, with 6.4 of those moves between the ages of 18 and 45.  Most of those moves between 18 and 45 will likely be work related moves that will qualify people for tax breaks on the expenses incurred during the moves.  Today we will be talking about Form 3903 – Moving Expenses.  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 .

A lot of people may not realize they can deduct expenses related to a move.  It is true, that in order to receive preferable tax treatment, a move must have a change of work location component, but it does not actually mean you have to find a job before you move, or even be the reason you move in the first place.  You could move to the Monterey Peninsula, or anywhere for that matter, simply because it is beautiful, and you could still deduct moving expenses as long as you meet two primary tests – time and distance.

The time related test says that you must have a full-time job for 39 weeks out of the first 52 weeks in your new location.  You do not have to know in advance.  The weeks do not have to be contiguous, nor do they even have to be with the same company, or even start when you arrive, but they do need to be full-time.  There are some exceptions to this 39 week requirement, such as getting laid off, getting transferred by your employer, or retiring to the U.S. from another country.  Another out for you is to keel over and die, at which point your executor can still claim the moving expenses on your final return…people rarely go for this tax planning strategy.

If you are self-employed, you have to work full-time for 78 weeks out of the first 104 weeks after moving.  You might wonder how you are supposed to take a deduction for something that takes longer than a year to really know if you qualify.  The answer is that you claim the deduction in the tax year or tax years the moving expenses are incurred if you have reason to believe you will meet the requirements.  If you are wrong, and you claimed expenses you should not have, you are supposed to either amend the prior return(s) or add it as additional income to your next tax return.  If you did not claim expenses and later realized you qualified, then you have to amend.

The other test is the minimum 50-mile distance test.  People often think the distance test is based on the distance from their old home to their new home, but it is actually based on the difference between the distance from your old work place to your old home and your old work place to your new home.  So if your old commute was 10 miles one-way to work, then the distance from your new home to your old work place needs to be at least 60 miles.  This could create some interesting situations.  Let’s assume you work a block from your house.  Then you receive a high-paying job offer in another town 51 miles away.  Your family is rooted in your existing community so you really do not want to leave the area.  With the increased pay you decide to buy the house for sale which is next door to your old house.  In this case you would meet the distance test, even though you will have only moved next door, and you can deduct any qualified expenses.

So what expenses qualify?  In a thimble, the answer would be packing costs, transit of household goods and family members, as well as lodging costs.  In other words, all the packing boxes, tape, markers, bubble wrap, movers, truck rentals and related fuel, airline costs, parking and tolls, pet transportation costs, hotel bills, etc.  If you drive your cars to transport them, or if you use them for trips back and forth to haul goods, you can deduct 23.5 cents per mile or deduct gas and oil receipts.  You can also deduct the cost of storing your goods between houses for up to 30 days.  In addition, you can deduct the cost of disconnecting or reconnecting your utilities.  If you are moving overseas, you can deduct the costs of storage of your household items in the U.S. each year until you return.  After the year of move, these expenses would not go on a 3903, but directly on your 1040 or 1040NR.

There are number of costs you are specifically NOT allowed to deduct as well.  Some of these include meals during the move, extra driving or lodging due to sightseeing during the move, pre-move house hunting expenses, fees paid for breaking leases, or security deposits given up on your old home, among others.

If you are in the military, and you receive PCS (Permanent Change of Station) orders, you are automatically qualified, and neither the time nor distance tests apply.  You can also deduct the costs of your move within one year of ending your active duty.  There are other special rules for military moves as well.

Regardless of who you are, if you get reimbursed by your employer and the reimbursements are not treated as taxable income to you (included in box 1 of your W-2 as income), then you can only deduct the expenses in excess of the reimbursement.  Normally, employers report moving expense reimbursements in box 12 with a code ‘P,’ and they are not treated as income in box 1.

Once you figure out your deductible expenses and reimbursements, the Form 3903 is a short five-line form.  It feeds into the adjustments to income section on the face of your 1040.  This is positive since it is available to all taxpayers, and not just those who itemize deductions.

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 XV – Form 2848 Power of Attorney

Originally published in the Cedar Street Times

May 29, 2015

Question: My mother is older and it is sometimes difficult for her to sign her tax returns.  I have a general power of attorney over her affairs that her estate planning attorney put together for us, so am I authorized to sign her tax returns?  Also, we need to file a tax return for my son, who is away at college.  Can I sign for him now that he is over 18?  Can I call the IRS and talk to them about my mother’s taxes or my son’s taxes if needed?

Answer: In all of these cases, the IRS would first want you to file a Form 2848 – Power of Attorney.  This is a limited power of attorney that just governs tax issues. (California also has an equivalent Form 3520, although they will generally accept a copy of the IRS Form 2848 as well.)

The Form 2848 is the standard document the IRS uses to process any individual that is acting as a representative for another person.  As a CPA, I use this document as well when a client needs me to get access to their past tax information, balances owed, current status of notices, etc.  It is also used if they need me to represent them during a tax audit.  As with a general power of attorney, it is only good as long as the person is living.  Once someone dies, a Form 56 – Notice Concerning Fiduciary Relationship is filed instead.  An authorized executor or trustee, for instance, would file a Form 56, as a fiduciary, and they literally step into the shoes of the deceased individual with all the rights and authority that person had.  After filing the Form 56, the fiduciary could then file a 2848 to authorize someone else, such as a CPA to represent them.

It is important to note that you cannot give just anyone full representation rights by filing a Power of Attorney.  CPAs, attorneys, EAs, and immediate family members, are the only ones you can appoint for individual representation and provide them with full authority and practice rights before the IRS.  (There are certain other classes that have limited practice rights, however.)

The Form 2848 also allows you to designate what authorities and for what tax periods you want to designate to your representative (such as “Income taxes and Gift taxes, Forms 1040 and 709, 2011-2015″).  You can also indicate if you want your representative to receive copies of all IRS communication with you, if you want them to be able to add additional representatives without your consent, sign your returns, etc.  If you want them to be able to sign your returns, there is additional language required as specified in the instructions to the 2848.

Generally, anytime you file a new Form 2848 it will replace any prior power of attorneys on file with the IRS unless you indicate otherwise and provide copies of the prior power of attorneys you wish to remain in effect.  Both, the taxpayer and the representative must sign the power of attorney.  Also note that this IRS Form 2848 – Power of Attorney does not replace or affect a general power of attorney in any way for other purposes.  It is only used with the taxing authorities.

If the taxpayer is competent, but unable to sign the Form 2848, the IRS will allow an “X” to be made with the signature of two witnesses as well, and an explanation.  In the case of someone who is incompetent, hopefully they had a general power of attorney.  In these cases, as with the situation of the mother in the question at the beginning of the article, the power of attorney can be filled out with the exception of the taxpayer signing, and then the general power of attorney can be attached to the Form 2848.  In the case of incompetent individuals without a general power of attorney in place it can become a sticky situation.  A conservatorship is the proper legal vehicle to give one adult authority over another adult’s affairs when that person is incompetent and no other planning is in place, but this can be quite costly and impractical at times.  I’ll let you wrestle with the IRS on that one!

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 .

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.

As an addendum to the print version of this article, I am adding this additional information regarding authorizing someone else to sign your tax returns for you.  Generally, you can only authorize someone to sign your returns if: 1) disease or injury prevents you from signing, 2) you are out of the country for at least 60 days prior to the tax return due date, or 3) you request and the IRS grants you permission.  In the question of the college student who needs a parent to sign his returns or the mother who has difficulty signing, both would have to meet one of these three requirements as well.

What Does a Tax Accountant Do After the Last Return is Filed on April 15th?

Originally published in the Cedar Street Times

April 17, 2015

 

As I am writing this article, it is the evening of April 15.  Phew!  I decided to take a break from the Back to Basics series to pen a sigh of relief.  Every tax season has its own unique flavor, its own sense of flow and timing, and its own trials and tribulations, but one thing they all have in common is an end date!  “End date,” is a rather soft term as there are lots of extended returns to complete during the rest of the year, but the most intense time is over.  Sometimes people assume we all have our airline tickets in hand and head off on vacation the very next day.  Only once have I tried this…we left for a vacation on April 18th – but it was just too rushed!  The reality is that there will still be a flurry of activity over the next few weeks finishing up returns that were close to completion.   But the majority of extended returns will be completed later when missing information rolls in.

Sometimes early filers think that only lazy people extend their returns (!), but that is far from the truth.  There are many people who are waiting on required information that is beyond their control, and that information may not show up until the summer or even the fall.  And occasionally, you will have legitimate situations where required information does not come until after the extended due date in October!  For some people, filing an extension allows them to work on their tax details when their business or personal life is slower.  And yes, there are the procrastinators as well!  But whatever the reason, it is necessary to have extenders, as there is no way tax preparers could prepare every tax return in America by April 15th – especially when Congress is still changing the rules well into January in some years, and then not requiring reporting to taxpayers until late February or March in some situations.  Even with extensions, I would love to see America move to a system that spreads return due dates throughout the year, perhaps based on birth dates, or something of that nature.  It would be better for taxpayers, for the taxing authorities, and for tax preparers.  Maybe I need to run for Congress.

All of this said, I always take April 16th off as a personal day.  It just helps to decompress.  So what am I doing?  I am taking my three-year-old son, Elijah, in the morning to his first gymnastics class.  We will then rendezvous with Mommy and nine-month-old Claire at an increasingly familiar dining establishment Elijah calls “Old McDonald’s,” and learn about Mommy and Claire’s time at Parents’ Place in Pacific Grove.   In the afternoon, the kids will go to daycare for a few hours while Mommy works.  (I half-cringe, every time I use the word “kids” in reference to my children as I had a Political Science teacher in college that wouldn’t tolerate that reference and would always let us know that kids are baby goats.  But as one of my English professors in college also said, once you know and understand grammatical rules, then are you free to break them!  I like the word “kids,” and I’m sticking to it…besides, a nine-month-old eats anything it can put in its mouth anyway – very goat-like.)

This leaves Daddy all by himself for an afternoon!  If it is a nice day, I may take the motorcycle out and cruise down the coast, or maybe play a round of golf.  Of course, I will bring my wife some flowers, but I won’t be doing taxes!

We will take a vacation, but not until May, when we head down with some friends and take our “baby goats” to graze in Disneyland for the first time!  That should be fun!  We will also fit in a third birthday party for my son who turned three on April 3rd.  For some reason, Daddy was not able to fit a party into his schedule in early April…sorry, but you are going to have to get used to it kid – besides you were the one that decided to be born two-and-a-half weeks early even though I clearly explained all of this to you while you were in the womb!  Elijah loves fire trucks, so we want to extend a special thank you to the people at the Pacific Grove fire station who have agreed to host a bunch of three-year-olds!

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.

Back to Basics Part XIII – Form 4868 Application for Automatic Extension

Originally published in the Cedar Street Times

April 3, 2015

Two weeks ago we discussed underpayment of estimated tax – a penalty that is assessed prior to the April 15 due date if you did not pay enough tax in ratably throughout the prior year.  Essentially these penalties are the equivalent of the taxing authorities wanting to be paid in installments rather than a lump sum check at the end of the year.  (You would be equally upset if your employer only paid you once a year as well!)  So they effectively charge you interest (currently a three percent rate) if you do not have enough tax paid in quarterly throughout the year.  This week we are going to talk about filing an extension and the penalties and interest that you will incur beginning after April 15 if you do not file and/or pay on time.  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 .

The most important piece of advice is to file your return on time!  When I say on time, I mean by April 15, or if you file a valid extension, then by October 15.  In years where those dates fall on a weekend or holiday, the return due date is pushed to the next business day.  There can be hefty penalties for filing a late return, which we will discuss later.   Form 4868 is the federal form used to apply for an extension, and you have to postmark it by April 15 for it to be valid.  If you are concerned of a postal mishap, U.S. certified mail is the correct way to document it was mailed on time.  California gives you an automatic six month extension if you need it, and nothing is required to be filed to receive the extension.  (Note there are exceptions regarding extensions for individuals out of the country on April 15, as well as for military people overseas, which we are not discussing in this article.)

Regardless of whether or not you file an extension, the tax is still due on April 15.  So you want to be sure you have enough tax paid in to cover the liability when you finally do file the return.  This means, you have to do a rough calculation at least, and then send in a check for the estimated tax with the 4868.  It would be prudent to estimate on the high side if there is any doubt.  If you end up not owing as much as you paid in, you can get a refund when you file the returns, or you can have it applied to the next year’s tax returns, and it will be credited to you as of the original April 15 due date when the first estimated tax payment was also due for the current year taxes (for those that pay quarterly estimates, this is very helpful).

When putting people on extension that pay quarterly estimated taxes, I will typically have them pay the remaining projected balance due from the prior year, plus the first quarter estimate for the current year and have all of this applied as a payment towards the prior year return.  This gives them a cushion in case the estimates are wrong.  Then, after the returns are filed, any leftover amount is then applied to the current year return and gets credit as of April 15 and everything is fine.  If you project you will owe to California, then you will have to fill out a California Form 3519 Payment for Automatic Extension for Individuals and remit a check with that form.

The mechanics of filing the federal Form 4868 are quite simple.  On the left side of the form you fill out your name, address, and social security number.  On the right side you list your estimate of your total tax liability, the amount you have paid in so far, and then subtract the two to get the estimated amount you are short or over.  If you are short, then you write in how much you are planning to pay with the extension.   Hopefully you have enough to pay the balance, but if you do not, just pay what you can, and keep making payments when possible.  Write your name, social security number, the year for which the tax is due and “Form 4868″ on the check as well.

The California Form 3519 Payment for Automatic Extension is quite simple also.  You do not even have to list estimates, but just the amount you are paying in addition to your name, address, etc.  You would provide similar information on your check to California as well.  Federal checks are made out to the “United States Treasury.”  California checks are made out to the “Franchise Tax Board.”  The mailing addresses are on the forms and related instructions, which can be downloaded online for free. If you are sending in a check for a married filing joint tax return, it is best to put both taxpayer names and social security numbers on the forms AND on the checks.

Now let’s talk about what penalties and interest you will incur if you do not file on time and/or pay on time.

Late Return Penalty

As I mentioned earlier, the most important piece of advice is to file your return on time!  A late tax return with the IRS carries a hefty penalty of five percent of the unpaid tax PER MONTH or portion of a month until you file your tax returns.  For those of you who aren’t doing the math in your head, that is the equivalent of an annualized interest rate of 60 percent per year (and you thought credit cards were bad!).  Fortunately they cap that penalty after five months of delinquency thus maxing it out at 25 percent.  Not to be left out, California conforms to this and charges the same for late returns based on the amount of California tax owed.

Late Payment Penalty

Regardless of whether or not you file an extension, if you do not pay the tax by April 15, the IRS will assess you 0.5 percent PER MONTH on the unpaid tax, capping out after 50 months at 25 percent.  If the return is also delinquent (no extension filed), the five percent per month late return penalty includes the 0.5 percent per month late payment penalty for the first five months.  After the first five months, then you only pay the additional 0.5 percent late payment penalty.  So the maximum federal late return and late payment penalty could be 25 percent late return penalty (4.5 percent plus 0.5 percent for five months) plus another 22.5 percent (0.5 percent per month for the next 45 months for the continuing late payment penalty) equals a total of 47.5 percent.  California has a slightly different approach on this and immediately charges five percent of the balance if you are even one day late.  In addition they assess 0.5 percent PER MONTH or part of a month for the first 40 months, also capping you at 25 percent.  So one day late in California will actually cost you 5.5 percent in late payment penalties.

Interest

In addition to the above penalties, interest is also charged starting on April 16 until the taxing authorities get paid in full.  Since you had the use of the money and they did not, they want to be paid for their lost use of the funds.  The interest rate varies and is adjusted each quarter for the IRS and twice a year for California.  The current interest rate is three percent for both the IRS and California.  If you had the money sitting in a bank account, you clearly lost out, however, if you had it invested in the markets, you would have probably come out ahead in the past few years.  Whereas, you can sometimes get the taxing authorities to waive penalties if you had reasonable cause, interest is virtually impossible to waive.  Without the before mentioned penalties, there are many people that would love a three percent loan!

If you have noticed a common thread for the above interest and penalties, it is that they are all based on the amount of tax you were short starting on April 15.  If you had paid in more than enough on April 15, there would be no penalties and interest, even if you did not file an extension.  Theoretically, you could file several years late and incur no penalties as long as you eventually give them a return showing all the tax had been paid in on time.  I do not recommend this practice, however!  Eventually you would receive notices and they would even estimate a tax return for you and assess tax, penalties, and interest.  Those are usually not in your favor!  Also, you never start the statute of limitations running, so you keep yourself open for audit longer.

Most importantly, like me, have fun when you are preparing these forms.  If you find all of this interesting, perhaps you should have become an accountant!

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 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.

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