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Back to Basics Part I – Overview of 1040
Filed under: Back to Basics | Tags: 1040, above the line, adjusted gross income, adjustments to income, Alternative Minimum Tax, AMT, basics, below the line, charitable contributions, childcare credit, credits, direct deposit, educator expenses, energy efficient upgrades, exemptions, filing status, first-time home buyer credit, health savings account contributions, Household employees, interest, itemized deductions, medical expenses, miscellaneous itemized deductions, moving expenses, other taxes, paid preparer, real estate taxes, retirement plan contributions, self-employment taxes, student loan interest, tax return, taxes, tuition and fees, understanding
Leave a comment Originally published in the Cedar Street Times
October 17, 2014
On Wednesday October 15, the 2013 personal tax filing season came to a close. Or at least it did for most timely filers. People who requested the six-month extension finally had to lay down their cards, or face increased penalties, and being branded delinquent by the taxing authorities. But I am sure you had your returns done long ago!
It is hard to believe that 2014 is rapidly drawing to a close, and soon we will start filing taxes all over again. This coming year, I would like to challenge you to spend some time looking at your tax returns and learning something new. I am a firm believer that everyone should have at least a basic understanding of the flow of a tax return. This document is a linchpin in your financial life. Let’s spend a few minutes talking about the big picture. You may wish to do this with a copy of a 1040 close at hand.
Tax returns can be hundreds of pages long with many supporting forms and schedules, but it all boils down to a two page summary whether you are John Doe or Warren Buffett…this is your Form 1040. Essentially, the first page lists your income, adjusted by a few preferential items leaving you with your all important “adjusted gross income.” “Below the line,” as it is known, is the second page, and lists your deductions and credits, calculates your tax, and determines what you owe or will get refunded.
Looking at page one in more detail, the top section captures your name, mailing address, and Social Security number. There is also a somewhat passe little box to designate three dollars of the tax you are already paying to the Presidential Election Campaign fund. If you want to learn more about this, I wrote an entire article on its history on April 18th. You can find it at www.tlongcpa.com/blog.
The first real section is where you designate your tax return “filing status” – single, married, head of household, etc. This is very important because it determines how much your standard deduction is and how quickly you will climb the tax brackets as your income increases. Your status is determined by rules, not choice. That said, married people do have the choice of the generally unfavorable Married Filing Separate status.
The next section deals with “exemptions.” This is where you list the dependents in your household – generally your children up through college (even if away at college). A parent or someone not even related can qualify, but they have to meet strict limiting rules. You get an exemption from your taxable income of $3,950 (2014 amount) for each of your dependents. Children under 17 may also qualify you for child tax credits which would go on page two.
The income section falls next. Wages from your job, interest, dividends, business income, rental income, sales of stock, money received from retirement accounts or plans, pensions, social security, etc.
After getting your total income figure, you then are allowed certain favorable “above the line” deductions for things like educator expenses, moving expenses, retirement plan contributions, health savings account contributions, student loan interest, tuition and fees, etc. After subtracting these adjustments, you arrive at your AGI (adjusted gross income). AGI is a key figure and is used in a lot of calculations which could affect your taxes in many areas. Above the line deductions are therefore preferable for that reason, but also because they will have a direct impact on taxable income. Below the line deductions such as itemized deductions are less certain and do not impact your AGI.
The taxes and credits section is at the top of the second page. This is where you get to subtract all your itemized deductions listed on Schedule A- things like medical expenses, taxes paid, interest, charitable contributions, and miscellaneous other deductions (like tax preparation fees!). If you don’t have many itemized deductions you get the standard deduction instead (for example – $12,200 for married status) as determined by your filing status from the first page.
Next, the number of exemptions you claimed on the first page is multiplied by $3,950 (2014) and that is subtracted out to leave you with your taxable income. Your tax is then calculated using tax tables and other rules.
With income generally in the $100,000 to $200,000 range ore more, you may also hit alternative minimum tax (AMT). In simple terms, AMT is a parallel tax system that has a different set of rules and allows less deductions. You calculate the AMT system on every return. If the AMT tax calculation yields a larger tax bill than the regular system, you pay the incremental difference as alternative minimum tax. Real estate taxes and miscellaneous itemized deductions subject to two-percent such as unreimbursed employee business expenses are common items that get kicked out in the AMT system.
Next you get to subtract any tax credits you may have. Tax credits are a dollar-for-dollar reduction of tax owed and are therefore more valuable than deductions, which only save you a fraction on the dollar. Depending on your circumstances there are credits for education, childcare, children in general, energy efficient upgrades, etc.
The next section is “Other Taxes.” There are a handful of other taxes people might incur , such as tax on taking money out of retirement plans too early, household employee taxes, repaying a first-time home buyer credit, etc. The most common, however, is self employment taxes. Business owners must pay the employer and employee side of their Social Security and Medicare taxes. After you add these taxes and determine your total tax liability, you then look at the payments section to see was has been paid in or credited to your account, and whether you will end up owing, or getting a refund.
At the bottom of the second page, you can choose things like direct deposit, or applying the payment to the following year. You can also designate a third party such as the tax preparer to be able to discuss the return with the IRS, if the IRS wants to discuss it. At the bottom, a paid preparer also has places to sign and fill out.
In two weeks we will start examining Schedule A – Itemized Deductions.
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.
Do I Need to Set up an LLC or Incorporate?
Filed under: Business Entity | Tags: C-corporations, California, double-entry accounting, entity, Franchise Tax, inherent risk, insurance, liability, liability protection, LLC, risk, S-Corporation, tax returns
Comments (2) Originally published in the Cedar Street Times
October 3, 2014
Two weeks ago I discussed some of the pitfalls of using an online service to help you set up an entity such as an LLC, C-Corporation, or S-Corporation for your business. In a nutshell, you really need tailored advice from an accountant and an attorney to address your circumstances and you should use an attorney to properly set everything up. I have found that people that utilize these services generally do not have a good understanding of what they did and why, and they don’t know much about their ongoing responsibilities, the importance of carrying them out, or the consequences of failing to do so.
Now I am going to turn the tables and ask you why you think you need a formal entity at all? When I say this I am thinking about small businesses getting started. If your accounting and legal advice is from family or friends, hopefully they actually are accountants and business attorneys and reviewing your WHOLE situation. Or maybe you read something online – maybe even an article like this! Be careful what you read!
My personal feeling is that there are a lot of small businesses out there that have set up entities prematurely, and have entangled themselves in a lot of extra cost, record keeping, and administrative hassle for very little benefit.
The vast majority of people setting up entities for small businesses do it because of perceived liability protection for their personal assets. Some do it for certain circumstances that can lead to tax benefits, and others do it in rare circumstances where a major customer requires it.
It is important to understand there is no bullet proof solution when it comes to shielding yourself from liability. There is almost always a way to spoil a good plan. Legions of lawyers make their living at this. Layers of protection are often implemented to mitigate the risk of chinks in your armor. For instance have an entity and also having insurance would be a good example.
It is also important to understand that entities do not protect you from all forms of claims. For instance, professionals cannot be shielded by an entity for acts of malpractice. Malpractice insurance, however, could cover you.
If you do not respect the entity by following all the rules of corporations, s-corporations, or LLCs promulgated by various government authorities, then if there is a lawsuit, the courts could say, “You didn’t respect the entity, so why should we?” They could look right through your entity and allow a creditor to go after your personal assets.
Small businesses are at a much higher risk for this since they generally don’t have a legal department trying to keep up with all the details! I have seen small businesses that have gone through the hassle and expense of setting up corporations, filing tax returns and paying the California Franchise Tax each year and yet they have never held a corporate meeting or elected officers, never recorded any corporate minutes (and even if it is just you wearing all hats, you can’t ignore these things!), and treated the bank accounts of the company like an extension of their personal checking account. And all the while they were thinking they had solid liability protection because they were a corporation…uhh no. The devil is in the details as it is said!
Besides the initial cost of setting up an entity properly which could run two or three thousand dollars or more, you then have to file separate business tax returns, file an informational filing with the Secretary of State, possibly have an attorney draft a document or two each year, have better accounting for the tax returns (true double-entry accounting which includes an accurate balance sheet in addition to the profit and loss statement), and then you get the privilege of paying California at least $800 a year whether you make a dime or not. So you have at least another couple thousand dollars each year of ongoing costs (more if you need to hire a bookkeeper when you find out that QuickBooks actually requires a fairly good amount of accounting knowledge to operate it properly.)
If the inherent risk of the business is relatively small or moderate, and especially if you are starting very small and do not even know if the business is going to be successful, then I think you need to carefully way the benefits and costs. Could you just carry really good insurance and mitigate your risk to an acceptable level? Do you need the additional layer of protection? You can always incorporate or set up an LLC later. Do you have employees, and what amount of risk do they expose you to? Are they driving vehicles a lot for your business? Or do you have rental property with lots of tenants? Maybe you are a free-lance graphic artist designing business cards remotely from your home – not much risk there! What are you trying to protect anyway – maybe the bulk of your personal assets you have would be considered exempt assets from creditors already? Although attorneys are generally risk-averse because they see all the things that can go wrong, and therefore would prefer to set up an entity, I think these types of discussions can be had with them and really question if it is right to set up an entity for your business for liability reasons.
Taxwise, there can be benefits to setting up an entity, depending on your circumstances, but it is rarely a driving force in and of itself for most small businesses. The most common one people ask about deals with reducing self-employment taxes for the owner of an S-corporation. There are ways this can be successful, but it is an issue that is in jeopardy of being eliminated. It also has the drawback of possibly reducing your future Social Security benefits – although our government will probably beat you to the punch on that one anyway.
If you read this article and think, gee, I am not sure I really need the entity I have – do not just ignore the entity and pretend it doesn’t exist anymore! Besides getting the proper tailored advice for you, you generally must properly dissolve it, or you will be plagued with continuing mandates for tax returns as well as Franchise Tax fees to California. (There are limited circumstances where you can just walk away.)
In summary, get competent advice from an accountant and an attorney in light of YOUR facts and circumstances before jumping into an entity. And question its necessity if you are small or if your business has low or moderate inherent risk and you have access to insurance that could protect you sufficiently.
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.
Travis H. Long, CPA, Inc. Blog 