Archive for the ‘interest’ Tag

Back to Basics – Part XXXVI – Form 9465 Installment Agreement

Originally published in the Cedar Street Times

April 1, 2016

After more than a year, our Back to Basics series has come to an end.  We covered the 1040, all the major Schedules (A, B, C, D, E, and F) and 27 of the most common forms.  To access any articles from the past you can read them on my website atwww.tlongcpa.com/blog .

For our last article, we have some wonderful news!  The IRS recently announced that starting next year, on a three-year trial basis, they are moving to a voluntary income tax system.  You will be asked to pay what you feel is fair and what you can afford, but there will be no requirement to actually pay income tax.

If you haven’t picked up on the date of this publication yet, it is April Fool’s Day;  this utopian ideal will have to sit on the shelf a little longer!  But, if you do find yourself in a situation where you owe more than you can manage to part with by the due date of April 18th, there are some options for you.  Remember that even if you file an extension, the tax is still due by April 18th this year.

The IRS says that if you can pay your balance due in full within four months of the April 18 due date you can simply call them at 800-829-1040 and advise them of this.  You will still have to pay interest (currently 3 percent per annum) and penalties (0.5 percent of the unpaid balance per month – effectively another 6 percent per annum) until paid in full, but you will not have to setup an installment agreement…which is your next option.

If you think you will need more than four months to pay off the balance, then you need to set up an installment agreement to avoid letters threatening actions such as liens, asset seizure, and taking your first-born child.  Well, maybe the first-born child part is a little overdramatic.  Even the concept of seizing assets, although splashed across notices relatively early in the collection phase, is hardly ever a reality, and you would likely have to have a $100K or more tax bill before they would consider taking and selling off your assets.  Wage garnishments and liens do happen more often, however.

An advantage to an installment agreement, is that it cuts the late payment penalty in half – from 0.5 percent per month to 0.25 percent per month.  There is a $120 charge from the IRS to setup and installment agreement, but I recommend you have direct debit setup to take the payment directly out of your bank account each month.  This reduces the fee from $120 down to $52.  It also prevents you from accidentally missing a payment.  If you fail to make a payment, you can be kicked out of the program, and have to reapply, and pay a new fee.  Also, if you have a balance from an old year, and you need to add to it, you generally have to setup a new installment agreement as well.

You can file for an installment agreement using IRS Form 9465.  This can be e-filed with your tax returns, or mailed by paper.  Or, you can set it up online at http://www.irs.gov.  If you owe less than $25,000, you will generally be approved without any hassle, as long as you have a good filing history.  You can take the balance owed and divide by up to 72 months.  I generally recommend that you keep the monthly commitment low so you know you will not fail to be able pay some month and then get kicked out – but go ahead and make extra payments whenever you can to pay it down faster.  Even if you owe up to $50,000, you can still get automatic approval, but you will need to fill out page two of the 9465 that asks a few more financial questions.

If you owe over $50,000, then you also have to send in a 433-F Collection Information Statement.  This has a lot more specific questions about your finances, and is pretty much like providing personal financial statements.

California has a similar installment agreement process, but the amounts and rules differ a bit.  California generally only allows an automatic installment agreement if you have up to $10,000 of unpaid tax liability.  You can go up to $25,000, but you have to show that you have a financial hardship (not by your definition, however!).

The late payment penalties are five percent of the total unpaid tax liability during the first month, and then 0.5 percent each month thereafter until paid in full (capping at 25 percent like the federal does.)  The interest rate is currently the same as the federal three percent rate.  The fee to apply is $34, and you must pay off the balance in less than three years.  I typically recommend just paying the FTB off, if possible, and then only dealing with the IRS on one installment agreement.

The California installment agreement request is made on Form 3567.  You can also fill it out online at ftb.ca.gov by choosing “Installment Agreement” under the “Pay” section.  Your other option is to call the FTB at 800-689-4776.

Finally, there are also options for an offer in compromise, if you clearly will not be able to pay off your tax debts in the future based on your income and certain expenses.  The process is fairly mechanical, and you generally will either qualify or you will not.  It is not like you sit around and negotiate the amount.

Be wary of ads you see on TV or on the radio that talk about getting rid of your tax debts.  A retired collection officer at the IRS of 30 years once told me that many of these groups charge you fees go through all the work to fill out the forms and gather the information whether or not you even have a remote chance of qualifying.  Then you simply get rejected, and you are in a worse position than when you started.  Instead, they could do some preliminary analysis, and not generate a lot of busy work for themselves.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. is located at 706-B Forest Avenue, PG, 93950 and focuses on trust, estate, individual, and business taxation. Travis can be reached at 831-333-1041. This article is for educational purposes.  Although believed to be accurate in most situations, it does not constitute professional advice or establish a client relationship.

Back to Basics Part XXIII – Form 6252 – Installment Sale Income

Originally published in the Cedar Street Times

September 18, 2015

Let us assume you are ready to sell a personal residence or a rental property that you have held for many years and it has increased substantially in value from the time you purchased it.  If a buyer comes in with all cash or obtains a loan from a bank to buy the property from you, you will recognize the full gain in the year of sale since you get paid in full in the year of sale.

This will skyrocket your income in the year of sale and reek havoc on your taxes.  Even though the gain from sale will be considered a long term capital gain, having too much in one year could subject part of the capital gain to a 20 percent rate instead of the normal 15 percent rate.  It will also make your adjusted gross income much higher.  This will in turn effectively increase your tax on other income since many deductions and credits phase out based on your adjusted gross income.  You could also hit an additional 3.8 percent tax on investment income which you may not have been subject to without the sale.  There could be a lot of negative effects.

Spreading out income over a period of years is generally a more tax efficient strategy than having one banner year.  So how can you avoid this?  An installment sale, given the right circumstances, is your answer.

With an installment sale, you are basically telling the seller to pay you over a period of years instead of all at once.  Of course, you are generally going to want some interest from the buyer as well if it is going to take a period of years for them to pay you off.  With real estate this often takes the form of a seller financed mortgage.  You are basically the bank.

In this scenario, you get to spread the taxable gain out over a period of years, thus not creating a bunch of extra tax due to a banner year, and you also create a nice stream of interest income for a period of years.  The flip side is that you bear the risk of having to foreclose or repossess if they do not make good on their payments.  Also, should you suddenly need the money from your loan to the buyer, you may have to sell the note at a discount to someone else to get your cash out.

If you choose an installment sale, generally a portion of each payment to you will be interest income, a portion will be capital gain, and a portion will be nontaxable return of basis.

Assume you bought a second home years ago for $400,000 and you find a buyer willing to pay $1 million.  If they pay all cash or get a loan from a bank to pay you on the closing date, you have $600,000 of taxable capital gain that year and $400,000 nontaxable return of basis – that is a 60 percent gross profit.

Let us assume instead they give you a $250,000 down payment at the time of sale and you loan them the remaining $750,000 with a 15-year amortized note. The payment will be about $6,000 a month with roughly half of each payment consisting of principal and half of interest in the early years.  The interest will be taxed as ordinary income as received.  The down payment and the principal portion of all future loan payments will be 60 percent taxable capital gain and 40 percent nontaxable return of basis until the loan is paid off.

This is a wonderful way to defer taxation of the capital gains and spread it out over a period of years.

The mechanics of reporting an installment sale play out on Form 6252.  The above example is the most basic version of an installment sale, but  after reviewing the Form 6252 you will see some complicating issues which could come into play depending on the circumstances – such as sales to related parties, sales of depreciable assets subject to depreciation recapture, and buyers assuming debt(s) of the sellers.

If you dig into the instructions as well as Publication 537, dedicated to this topic, you will quickly realize that installment sales can become extremely complicated, and there are a lot of special rules to follow depending on the circumstances since the deferral of tax is enticing and could otherwise be abused.  Installment sales that involve like-kind exchanges, contingent sales, sales of businesses, securities, or other things through the installment method, unstated interest rates in the loan term, dispositions of an installment sale, etc. all add additional complications.

Since installment sales require a higher risk tolerance for the seller, you often see them between related parties where trust is greater.  There are can be some unfriendly rules for such transactions.  You should consult with a tax professional prior to entering an installment sale with a related party.

The form itself is a one page form.  The beginning asks general questions about the property including several on related party issues.

Part I of the form deals with calculating the gross profit percentage and the “contract price.”  Note that the contract price is not necessarily the sale price you agreed to, but can be affected if the buyer assumes or otherwise pays off any debt of the seller.  This section is only completed in the year of sale.

Part II deals with sorting out the capital gains versus ordinary income, versus recapture income and applying the gross profit percentage to the payments received each year.  It is prepared each year.

Part III deals with specifically with related party transactions and necessary recalculations in certain of those circumstances.

If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Travis H. Long, CPA, Inc. 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 XX – Form 4952 – Investment Interest Expense

Originally published in the Cedar Street Times

August 7, 2015

Today is my brother, Justin’s, birthday, and I know just what to get him.  We were both avid baseball card collectors from the time we were seven and eight years old on up through our middle school years.  Once, we even put on a “Kids Baseball Card Show” to buy, sell, and trade cards.  We went around advertising the show with flyers on telephone polls all over the local neighborhoods, and secured the neighborhood pool clubhouse facility to host our show.  It was a great success!

At the conclusion of my baseball card collecting career I had amassed over 10,000 cards with albums full of rookie cards and great players at the time.  One of my most prized cards was a 1954 Topps Willie Mays.  I remember wondering, how much money have I invested in all these cards over the years?  Would I be able to retire after selling the cards years later?  The Beckett Baseball Card Monthly price guide certainly made me think so based on the prices they listed and the rapid rates of increase.  Old cards from the 1940s – 1960s were worth hundreds or even thousands of dollars each.

A few years after my interest in card collecting waned, a mass of new brands flooded the markets.  That combined with other problems in baseball at the time sent the card market into an unrecoverable nose dive.  Over 20 years later, most cards are still worth a tiny fraction of their peak.

Although my desire was primarily the personal fun of collecting, there were many adult investors that had serious money in cards.  As with any investment bubble, I am sure there were collectors mortgaging their homes, running up credit card debt and borrowing from family in order to get a piece of the action.

As I reflect on that now, I see there would have been an opportunity for these people to take advantage of today’s topic – Form 4952 – Investment Interest Expense Deduction.   If you have questions about other schedules or forms in your tax returns, prior articles in our Back to Basics series on personal tax returns are republished on my website at www.tlongcpa.com/blog .

Investment interest expense is reported on Schedule A as an itemized deduction and is essentially interest paid on debt used to buy property that produces or hopefully will produce income at some point.  It doesn’t include interest expense incurred in your trade or business, or for passive activities like most rental properties.  These types of interest get reported elsewhere.  So, borrowing money to buy investments such as stocks, bonds, or annuities would qualify.  Many financial companies offer margin loans.  The interest on these loans would certainly qualify as investment interest expense if the proceeds were used to buy more stocks and bonds.  Borrowing money to buy the right to royalty income or to buy property held for investment gain, such as vacant land, art, or even baseball cards would also qualify, among other things.

Due to passive activity rules which limit or even eliminate current deductions on passive rental activities such as a home you rent out, many people would like to be able to deduct the interest as investment interest instead.  However, interest on passive activities is specifically excluded from being classified as investment interest expense.  The interest on vacant land can usually escape this clause, even if small amounts of rent are collected since the rent is incidental to the paramount investment purpose of appreciation.  To be considered incidental, the principal purpose must be to realize gain from appreciation AND the gross rents received for the year must be less than two percent of the lesser of the property’s unadjusted basis or its fair market value.

The rub with investment interest expense is that it is only deductible to the extent that you have investment income!  If you have no investment income, you can’t deduct the expense, and it gets suspended until a year you actually do have investment income.  So what qualifies as investment income?  Well, all of the things we just discussed for which you borrowed  money and can deduct as investment interest expense – so interest, dividends, gains from property held for investment, etc.  Prior to being applied against investment interest expense, the investment income figure is reduced by other investment expenses that you may have reported on Schedule A – such as investment advisory fees, safe deposit boxes, investment subscriptions, etc.

By default, your net capital gains (meaning net long-term capital gains in excess of net short-term capital losses) as well as qualified dividends are not included in investment income.  This is done because both of these already get taxed at favorable lower capital gains rates, so the thinking is, “Why would you want to waste a deduction to offset income that is already getting a lower capital gains rate, when you could instead use it to offset ordinary income taxed at higher rates ?”  The answer is that sometimes you may not be able to ever foresee having much ordinary investment income taxable at higher rates.  And instead of just suspending the deduction and getting n0 current tax benefit, you elect to include your net capital gains and qualified dividends as investment income and use the deduction to help wipe that income out, thus saving you current taxes.

The Form 4952 itself is a rather simple form – only a half page in length.  Part I is a summary of the gross investment interest expense including any current interest and past interest that was carried over.  Part II helps you calculate the net investment income  from interest dividends, gains, capital gains, less investment expenses from Schedule A.  Part III compares parts I and II and calculates the investment interest expense that will be currently deductible, as well as the part that is being suspended to the future if there is not enough investment income to absorb the expenses.

As for the card collecting Justin and I did, I sure am glad we didn’t go into debt buying baseball cards and having to file 4952s! Now about that gift – how about a box of wax packs or a factory sealed set – I know just where to get them…

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 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.

New Tax Impacts for Trusts with Capital Gains – Part II

Originally published in the Cedar Street Times

November 15, 2013

Two weeks ago I laid the groundwork of some of the basics on revocable and irrevocable trusts in order to start discussing new implications due to law changes in 2013.  Revocable trusts such as the common revocable living trust most people use for estate planning is disregarded for tax purposes as separate from the owner – in other words all of the income generated by its assets gets reported on your personal 1040 tax return.  Irrevocable trusts, such as a bypass trust commonly used in estate planning, or a gifting trust, are treated as separate tax paying entities, get their own taxpayer identification number, and file their own tax returns.

In early 2013 new laws were passed that increased the personal income tax rates from 35 percent to 39.6 percent on people in the highest tax bracket ($400,000 filing single or $450,000 married filing joint).  It also raised the capital gains rate to 20 percent for these same people (up from 15 percent).  In addition, a new 3.8 percent Medicare surtax is assessed on net investment income (think interest, dividends, capital gains, among others) for people making over $200,000 single or $250,000 filing joint.  Most people do not make $450,000 or even $250,000 a year, so this seems innocuous to many.

However, many people making less than these thresholds do have irrevocable trusts – most commonly after a spouse has passed away.  The problem with irrevocable trusts is that the thresholds to be impacted are so much lower.  Once your trust has just $11,950 (2013) of income, you have hit the top bracket and will be subject to the 39.6 percent income tax rate, 20 percent capital gains rate, and the 3.8 percent Medicare surcharge!  One stock sale could easily put you in the top bracket!  This effectively means an 8.8 percent tax increase on capital gains and 4.6 percent to 8.4 percent increase on other types of income.  That is a big hit every year, and will be something new to battle.

If you can avoid having the income taxed to the trust, and instead have it distributed out and taxed to the beneficiaries, you can probably save a chunk of taxes since it will be taxed at the lower rates on the beneficiary tax returns – assuming your individual beneficiaries are not in the top tax bracket!

Whether or not you have discretion or are required to distribute income to beneficiaries is defined in your trust document.  Even the very definition of “income” itself, for trust accounting purposes, is governed by your trust document primarily and the state’s principal and income act, secondarily.  The proper allocation of income and expenses to trust accounting income or principal is very important to beneficiaries (whether they realize it or not), since trust accounting income generally goes to one beneficiary, and the principal often goes to a different beneficiary down the road…so it determines the amount the beneficiaries receive.  Many common irrevocable trusts are written to require the distribution of trust accounting income each year to the current beneficiaries with rights to dip into principal as needed to maintain an ascertainable standard of living.  Upon death, the remaining principal goes to the remainder beneficiaries.

The California Uniform Principal and Income Act does not define capital gains as income, but as a principal transaction – basically an asset changing form – for instance from real estate to cash.  I hardly ever see trusts that even mention capital gains, much less defining it as a part of income.  In the absence of trust language, the principal and income act governs, therefore many trusts in California are not permitted to distribute capital gains to the beneficiaries.

It is amazing to me how many trust tax returns I have seen over the years that violate this – often because the preparer does not really understand trust taxation rules.  I have even run into cases where the prior preparer has never even asked for the trust document, and thus relies on the default settings in their tax software in conjunction with “the way we’ve always done it” to govern!  This would be analogous to creating a detailed shopping list and asking your neighbors to go shopping for you; in lieu of taking your list, they go on the internet and print out a list of common things people buy, and then supplement it with things they have bought for other neighbors in the past! Chances are pretty good; you will not get what you need!  Enforcement of correct trust income tax preparation comes much more often by threats of lawsuit against the trustee than by IRS audit. Keep in mind the remainder beneficiary’s attorney would be happy to sue the trustee for shorting his client’s share by not following the terms of the trust.

In two weeks we will conclude our discussion.

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

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

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.

IRS Affected by Government Shutdown

Originally published in the Cedar Street Times

October 4, 2013

Due to the inability of Congress to come to terms regarding the government shutdown (or just about anything for that matter), I have a pretty good chance that this article will still be worth reading by the time it is published in the newspaper on Friday!

Everyone is aware by now that over 800,000 federal employees are on furlough. I read that this is more than all the employees of Target, General Motors, Exxon, and Google combined.  That is a lot of people!  Included in these 800,000 are most of the Internal Revenue Service employees.

Many of you may be cheering right now, but certainly not anyone that is waiting on a refund or currently trying to work out any problems with the IRS.  Prior to the furlough, telephone wait times to speak with an IRS agent have been 15 – 45 minutes, or sometimes you would get the message that they were too busy to even put you on hold, and then hang up on you.  Right now you will have an indefinite wait since the call centers are completely closed.  All local IRS offices are also closed to the public as well.  The shutdown will of course put even more pressure on wait times when funding is restored, and there is a backlog of problems to resolve.

This is an interesting time to be shutdown considering that extended personal tax returns are due on October 15.  The IRS still expects individuals and businesses to file all tax returns on time, keep making income and payroll tax payments, etc.  Presumably, they have some essential employees still on-the-clock to let the mailman in and to make deposits!  They are encouraging electronic filing since those returns are processed automatically by computers.  Paper returns will not be processed, however any payments enclosed will still be processed!  All tax refunds are suspended until normal operations resume.

Computer generated IRS notices will continue to be mailed out, but all audits, appeals, and taxpayer advocate cases are suspended.  If you had meetings scheduled they will be rescheduled.

The IRS website will still be up and running, but certain services may be unavailable.  The IRS automated telephone system will also still be working (800) 829-1040.

I can only assume that penalties and interest will still accrue even if you are waiting on the IRS to resolve an issue.

I called the IRS employee emergency hotline for kicks.  They are informing employees that they cannot perform any work, even if they want to volunteer their time to keep certain cases moving, and they cannot use any government computers, equipment, or other resources.  If they were en route traveling when the furlough began, they were to immediately return home.

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

IRS Circular 230 Notice: To the extent this article concerns tax matters, it is not intended to be used and cannot be used by a taxpayer for the purpose of avoiding penalties that may be imposed by law.

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.