tax planning

How to Deduct Travel Expenses

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Travel expenses include transportation, lodging, meals, and related incidentals.  Business travel expenses are fully deductible (except for meal expenses, which are 50% deductible).  The travel expenses must be properly substantiated.

There are different rules for domestic and foreign travel.  There are also different rules depending on whether the travel is exclusively for business, primarily for business, or primarily for personal reasons.

Domestic Travel

Exclusively for Business:  If a taxpayer’s trip is solely for business reasons, all reasonable and necessary travel expenses (travel fares, lodging, transportation, meals, and incidentals) are fully deductible (except that meals are 50% deductible).

Primarily for Business:  the deductible travel expenses include the costs of getting to and from the business destination and any business related expenses while at the business destination.  Personal expenses incurred while at the destination are not deductible.

Primarily for Personal Reasons:  the costs of getting to and from the destination are not deductible because they are considered personal expenses.  However, any business costs the taxpayer pays at the destination will be deductible.

Whether the trip is primarily for business or personal reasons depends on the facts and circumstances of the travel.  The IRS tends to focus on the amount of time spent on business and personal activities.  The primary purpose of the trip is determined based on which purpose (business or personal) exceeds 50% of the time spent on the trip.

Example 1:  Joan has a business in Detroit.  She travels to L.A. for meetings that span four days.  Joan arrives in L.A., spends four days in meetings, and immediately returns home to Detroit.  She spent $500 in airfare, $800 in lodging, and $500 in food.  Since, Joan’s trip is exclusively for business, Joan can claim travel expenses of $1,550 ($500 airfare, $800 lodging, and 50% of $500 food).

Example 2: Same facts as above except Joan spends three days site seeing throughout California.  She spends $600 in lodging, $250 in meals, and $150 in auto expenses while site seeing.  Since the primary purpose of her trip was business (based on 4 days of business versus 3 days personal), she may still deduct the $1,550 travel expenses from Example 1.  However, the expenses for lodging ($600), meals ($250), and auto expenses ($150) she spent while site seeing are nondeductible personal expenses.

Example: Same facts as example 2 except Joan spends 6 days site seeing.  Since the purpose of her trip is now considered personal (based on 4 days of business versus 6 days personal), the costs of getting to and from the destination are nondeductible.  Thus, the $500 airfare to L.A. is no longer deductible.  Her site seeing expenses are also not deductible.  However, Joan may still deduct her business expenses while in L.A. ($800 in lodging and 50% of her $500 food expenses from example 1).

Foreign Travel

Exclusively for Business:  If a taxpayer’s trip is solely for business reasons, all reasonable and necessary travel expenses (travel fares, lodging, transportation, meals, and incidentals) are fully deductible (except that meals are 50% deductible).

Majority of Time on Business:  ALL travel expenses are allocated between deductible business expenses and nondeductible personal expenses.  The expenses should be allocated to deductible and nondeductible categories using a day-to-day allocation method based on business days and personal days.  There are two things to take note of:

  • This differs from the domestic travel rules where the costs of getting to and from and destination are fully deductible if the trip is primarily for business.  For foreign travel, the costs of getting to and from the destination must be allocated if the trip is not exclusively for business, even though the majority of time is spent on business
  • ALL travel expenses (not just getting to and from the destination) must be allocated

Majority of Time for Personal Reasons:  ALL travel expenses (costs of getting to and from the destination, lodging, meals, etc.) are not deductible because they are considered personal expenses.  However, any expenses that the taxpayer pays at the destination will be deductible if they are directly related to business.

While the foreign travel rules require an allocation of expenses if business travel is combined with personal travel, there is a safe harbor.  If the primary purpose of the trip was business AND any of the following exceptions is met, allocation of travel expenses is not required–the trip is treated as being exclusively for business (and 100% of the travel costs are deductible):

  • No more than seven consecutive days are spent outside the U.S.
  • Less than 25% of the total time on the trip is devoted to nonbusiness activities
  • The taxpayer has no substantial control over arranging the trip—a self employed taxpayer is generally considered to have substantial control over his travel and won’t qualify under this exception.  Employees may qualify under this exception.
  • The taxpayer establishes through a facts and circumstances analysis that personal vacation was not a major consideration.
This is just an overview of the travel deduction rules.  They get more complicated.  If you have any questions on how this applies to you, just give us a call.

Comments or questions about this post?  Please let us know through the comment area below!

If you found this article informative, subscribe to our Tax Newsletter.

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

 

The Right Way and The Wrong Way to Reimburse Employees

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When a business reimburses an employee for incurring business expenses, there is a right way and a wrong way to do so.  The right way is through what is known as an accountable plan.  The wrong way is through…wait for it…a nonaccountable plan.

The Wrong Way

If the employer has a nonaccountable plan, when the employer reimburses an employee for business expenses the employer takes a deduction in the amount of the reimbursements.  The deduction is treated as a compensation deduction and the reimbursement is included in the employee’s income.  Payroll taxes on this amount are due.  If the employee has substantiation for the expenses, she can deduct them as an itemized deduction on her personal tax return.  These expenses are reported on Form 2106, and are subject to the 2% of AGI floor.  Additionally, if the employee had meal expenses, she can only deduct 50% of them.

Example:  JoJo Corp employs John and JoJo Corp does not have an accountable plan.  John incurs business expenses of $1,000 for travel and supplies and $500 for meals.  JoJo Corp reimburses $1,500 of John’s expenses.  JoJo Corp takes a $1,500 deduction (JoJo Corp’s deduction for meals is not reduced by 50%).  JoJo Corp pays FICA, FUTA, and state unemployment tax on this $1,500 compensation deduction.  John’s W-2 is increased by the $1,500 reimbursement.  John will also pay his share of FICA tax.  John can take an itemized deduction for $1,000 of the travel and supplies expenses and an itemized deduction of $250 for the deductible 50% of meal expenses.  However, these expenses are reduced by 2% of Jon’s AGI.  If John has AGI of $100,000, the $1,250 deduction is reduced by $2,000 (2% of $100,000 AGI).  Since the deductions are less than 2% of AGI, John cannot take a deduction.

The Right Way

If the employer has an accountable plan, expense reimbursements are deductible by the employer as business expenses rather than as compensation.  The 50% meal limitation now applies to the employer.  The reimbursements are excluded from the employee’s income and are exempt from payroll tax.

Example:  Same facts as above, except JoJo Corp has an accountable plan.  JoJo Corp will have a business deduction of $1,250 ($1,000 for travel and supplies plus 50% of the $500 meal expense).  John will not have to report the amount of the reimbursement as income.  Neither JoJo Corp nor John will owe any payroll taxes on the reimbursement.  Since JoJo Corp takes the deduction for the business expenses, the 2% of AGI floor is irrelevant.

There are three requirements of an accountable plan:

PROVING A BUSINESS CONNECTION

The plan pays reimbursement and allowances only for otherwise deductible business expenses (such as travel, lodging, or meal expenses)

MAINTAINING ADEQUATE SUBSTANTIATION

The employee accounts for the business expenses by submitting to the company a detailed written record substantiating the expense’s time, place, amount, and business purpose.

REQUIRING EMPLOYEES TO RETURN EXCESS ADVANCES

This mainly applies when an employer advances funds to the employee to pay business expenses.  Advances in excess of business expenses must be returned to the employer.

A few years back, the IRS had an audit initiative focused on executive compensation, fringe benefits, and employee reimbursement plans.  IRS found a great deal of noncompliance and, in future audits will spend more time auditing these items.  It is very important to properly comply with the three requirements of accountable plans if you want to take advantage of the benefits they offer.

Comments or questions about this post?  Please let us know through the comment area below!

 If you found this article informative, subscribe to our Tax Newsletter.

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

Getting Schooled—Providing Employee Educational Assistance

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There are two primary methods for business owners to provide tax-free educational assistance to themselves and to their employees.  The methods are:

  • Working Condition Fringe Benefit
  • Section 127 Plan

Working Condition Fringe Benefit

Educational expenses paid under this method are deductible by the employer and are tax free to the employee.  The educational expenses are also excluded from payroll taxes such as FICA and FUTA.  There is no limit on the amount of educational expenses that qualify; however, the educational expenses must be ordinary and necessary business expenses.

To qualify as a working condition fringe benefit, the educational program must relate to maintaining or improving the skills required by the employee’s job.  The education itself must NOT lead to the student qualifying for a new trade or business.  Education required to meet the minimum skill level required for the job does NOT qualify.  Job related education may be furnished directly by the employer or through a third party such as an educational institution or seminar organization.  The educational expenses of the business owner also qualify.

Example:  ABC Corp employees Joan as an engineer.  Joan is climbing the corporate ladder and believes an MBA will help her develop management skills to help her advance her career.  ABC Corp pays for her MBA.  Since the MBA will improve her skills, the educational expenses paid by ABC Corp will not be taxable to her.  In addition, ABC Corp can take a deduction for the educational expenses.

Example 2: John is a law student working in a law firm as a legal assistant.  The law firm offers to pay John’s law school tuition.  These expenses will NOT qualify as a working condition fringe benefit because the law degree is required for John to meet the minimum requirements for his job as an attorney.  However, the tuition may qualify for exclusion as a Section 127 plan.

Section 127 Plan

A Section 127 plan is a qualified education assistance program.  The first $5,250 of qualified educational assistance provided during the year is exempt from tax, including FICA and FUTA.

To qualify under Section 127, a plan is required.  The plan must:

  • Be in writing
  • Provide educational assistance exclusively to employees (possibly including owners)
  • Not provide employees with a choice of education assistance and taxable compensation
  • Provide reasonable notice of the availability and terms of the program
  • Not discriminate in favor of highly compensated employees or their dependents
  • Not pay more than 5% of the benefits to more-than-5% owners or their spouses or dependents

Children of owners can participate in a Section 127 plan if they are at least 21 years of age, are legitimate employees, are not more than 5% owners, and are not dependents of the owner.  Children under age 21 can still participate in Section 127 plans, but their educational expenses are subject to the nondiscrimination rules (which could disqualify the plan).

Example:  ABC Corp is owned by John.  ABC Corp has three employees—Adam (John’s son) and two unrelated employees.  All employees are 22 years old.  John does not claim Adam as a dependent.  ABC Corp pays $5,000 towards each employee’s tuition.  Since Adam is at least 21 years old, is a legitimate employee, is not a dependent, and is not a more-than-5% owner, the tuition paid on his behalf is not counted as being for a highly compensated employee or a more than 5% owner.  All employees may exclude the $5,000 tuition payment from their incomes.

Example 2:  Same facts as above except that Adam (John’s son) is 20 years old.  Since Adam is under age 21, he is attributed ownership from his father (i.e., Adam is considered a 100% owner).  Since 33% of the benefits ($5,000 tuition for Adam divided by $15,000 total tuition paid) are paid for a more-than-5% owner, EACH employee must report the $5,000 tuition payment as income.

Key Difference between a Working Condition Fringe Benefit and Section 127 Plans:

  • A $5,250 cap applies to Section 127 Plans, but not working condition fringe benefits
    • If over $5,250 is spent on educational expenses under a Section 127 plan, the excess may qualify as a working condition fringe benefit
  • The cost of travel, meals, and lodging may qualify as a working condition fringe benefit but not under a Section 127 plan
  • The working condition fringe benefit is not subject to nondiscrimination rules
  • The limitation on expenses that qualify a student for a new job or to meet minimum eligibility requirements will not qualify as a working condition fringe benefit, but may qualify under a Section 127 plan.

These rules are fairly complex.  If you need help navigating through these rules, give us a call and we’ll be happy to help.

 

If you found this article informative, subscribe to our Tax Newsletter.

 

 Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

IRS Provides Relief for Credit Card Sales Reported on 1099-K

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Beginning in 2011, credit card companies were required to report business’ credit card sales to the IRS via Form 1099-K.  This form reported a business’ total credit card sales for the year, and the form broke that sales figure down into monthly totals.

A substantial problem with this form was that the credit card sales reported on the 1099-K included sales tax and employee tips.

Example:  JoJo’s Restaurant has credit card sales (excluding sales tax) of $600,000 for 2011.   At the end of the year, JoJo’s Restaurant received Form 1099-K showing credit card sales of $731,400.  The reason the sales on the 1099-K is much larger than the actual credit card sales is because it includes sales tax of $36,000 plus tips of $95,400 (assuming a 15% tip rate).

Since the sales reported on Form 1099-K will almost certainly exceed actual sales, businesses were required to reconcile the sales reported on Form 1099-K with their actual sales.  The above example was a fairly simple one—imagine if those sales included carry-out sales on which tips are not paid.  A point of sale system should be able to capture this information, but for restaurants using cash registers, it will be very, very difficult to gather this information.

Recognizing the hardship this would cause on businesses (plus the hardship on the IRS to actually audit this information), the IRS waived the reconciliation requirement for 2011 tax returns.  Based on a recent letter from the IRS deputy commissioner for services and enforcement, Steven Miller (not the singer), to the National Federation of Independent Businesses, the IRS is extending indefinitely the waiver of the reconciliation requirement.  Mr. Miller stated, “There will be no reconciliation on the 2012 form, nor do we intend to require reconciliation in future years. (emphasis added)”

Good news!  However, credit card companies will continue to issue Form 1099-K.  If the sales amount on these forms differ substantially from sales reported on tax returns, you may still want to conduct an informal reconciliation (not included on any tax filings) in case of an audit.

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

You’re Still Getting a Bonus (Depreciation) in 2012

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Normally, when you buy long lived property, you can’t deduct the full cost of the property in the year you purchase it.  The purchase price is deducted over the expected life of the property.  In late 2010 through 2011, business owners were allowed to immediately deduct 100% of the cost of certain assets.  This was known as 100% bonus depreciation.  100% bonus depreciation ended on December 31, 2011.  Bonus depreciation is alive and well in 2012; however, it has been reduced to 50% from 100%.  50% bonus depreciation lasts through December 31, 2012.  It is extended to December 31, 2013 for property having a longer production period (discussed later).

What is Eligible Property?

To be eligible for bonus depreciation, the property must meet three criteria:

1.  The asset must be qualified property

  • The asset must have a recovery period of 20 years or less.  This includes most tangible personal property.  It excludes almost all real estate.
  • General purpose buildings used in agriculture, such as machine sheds and shops, are 20 year property and are eligible for bonus depreciation
  • Off the shelf software qualifies
  • Qualified leasehold improvement property qualifies

2.  The ORIGINAL use must commence after December 31, 2007

  • The asset must generally be NEW.  Used property doesn’t qualify.
  • New property initially used by a taxpayer for personal use and subsequently converted to business use meets the original use requirement
  • Expenditures to recondition or rebuild assets satisfies the original use requirement, but purchases of reconditioned or rebuilt assets do not qualify.  However, an asset that contains used parts will not be considered used if the cost of the used parts is 20% or less of the total cost.

3.  The asset must be acquired and placed in service on or before December 31, 2012

  • The placed in service requirement is extended to December 31, 2013 for property that has a longer production period and has an expected life of at least 10 years OR is commercial transportation property or certain aircraft.
  • A longer production period is defined as exceeding two years OR an estimated production period exceeding one year and a cost exceeding $1 million.
  • Only costs attributable to production before January 1, 2013 will qualify for this exception.

Qualified leasehold improvement property also qualifies for 50% bonus depreciation.  Qualified leasehold improvement property meets the following tests:

  • The improvement is to an interior of a building
  • The building is nonresidential
  • The improvement is made pursuant to a lease by either the lessee, sublessee, or by the lessor to property to be occupied by the lessee or sublessee
  • The improvement is placed in service more than three years after the date the building was first placed in service by any person
  • Leases between related parties do not qualify

Call us if you would like to discuss how this applies in your business.

 

Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230

 

There are Still Tax Incentives to Buy Business Assets

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Background

When a business owner buys fixed assets such as machinery and equipment, the business owner cannot deduct the full cost of the asset immediately.  Instead, the business owner deducts the cost of the asset over a number of years through depreciation.  Most equipment purchased by small business owners is depreciated over 3 to 7 years.  A special deduction known as a Section 179 deduction exists that allows business owners to deduct in the year of purchase the cost of certain fixed assets.

Business owners are allowed to deduct up to $139,000 of the cost of eligible property acquired and placed in service during 2012. Eligible property is tangible personal property (e.g., equipment, machinery, computers, furniture) that is used more than 50% in a business.  However, if the business owner purchases more than $560,000 of such property, the Section 179 deduction is reduced dollar for dollar by the amount of assets purchased in excess of $560,000.

Example:  Joan buys $40,000 of furniture and $50,000 of equipment in her business.  Since the $90,000 total cost of these assets is less than $560,000, Joan is eligible to fully deduct the $90,000 purchase price.

Example 2:  John buys $400,000 of furniture and $200,000 of equipment in his business.  Since John’s total purchases of $600,000 exceed $560,000, his Section 179 deduction is reduced by the $40,000 excess of assets purchased over the maximum limit.  John may claim a Section 179 deduction of $99,000 ($139,000 maximum amount reduced by $40,000 of asset purchases over maximum limit).

Another important limitation on the Section 179 deduction is the taxable income limitation.  The Section 179 deduction cannot exceed the total amount of taxable income derived from the active conduct of ANY trade or business of the business owner or his/her spouse during the year.

Active business income includes:

  • Proprietorship income or loss
  • Partnership income or loss
  • S corporation income or loss
  • Wages
  • Certain gains from sales of business assets
  • Interest on working capital loans related to a business

Any Section 179 deduction limited because of inadequate taxable income can be carried forward indefinitely.

Example: Joan buys $40,000 of equipment in her proprietorship.  She has $15,000 income in her business before any Section 179 deduction.  Joan’s Section 179 deduction is limited to her taxable income of $15,000.  Her business will have no profit for the year since her taxable income was sheltered by her Section 179 deduction.  The disallowed Section 179 deduction of $25,000 will be carried forward to offset Joan’s future taxable income.

Example 2:  Same as above except Joan’s husband has $40,000 of wages from his job.  Active business income includes wages earned by a spouse.  The couple’s active business income is therefore $55,000 ($15,000 from Joan’s business and $40,000 from the spouse’s wages).  Joan can now deduct the full $40,000 of equipment purchases.

If the business owner operates through a LLC or S corporation, the taxable income limitation also applies at the entity level.

Example:  John operates his business through an S corporation, ABC Corp.  ABC Corp has $15,000 of taxable income.  ABC Corp buys $20,000 of qualifying property.  ABC Corp’s Section 179 deduction is limited to its taxable income of $15,000.  ABC Corp carries forward the excess $5,000 Section 179 deduction indefinitely.

For S corporations and LLCs, the active business income is increased by shareholder wages and guaranteed payments, respectively.

Example:  Same as above example except that ABC Corp paid John $10,000 in wages during the year.  The $10,000 of shareholder wages is added back to ABC Corp’s taxable income of $15,000.  ABC Corp’s active business income is now $25,000 and it can take the full Section 179 deduction of $20,000.

Of course John must have enough active business income on his personal return to utilize the Section 179 deduction.

Example:  On John’s personal return, the $25,000 of active business income from his S corporation flows through.  If John has a $10,000 loss from a separate business, his active business income is now $15,000 ($25,000 income from the S corporation less $10,000 loss from his separate business).  John’s Section 179 deduction is limited to his $15,000 active business income.  The remaining $10,000 of Section 179 will be carried forward by John.

What Type of Assets Don’t Qualify for Section 179?

Certain types of property are not eligible for Section 179 deduction.  These include:

  • Air conditioning and heating units
  • Property used to furnish lodging (with the exception of hotels and motels)
    • This prevents most taxpayers with residential rental property from claiming Section 179 deductions
  • Property used outside the U.S.
  • Property used by a tax exempt organization
  • Property used by governmental units
  • Property used by an estate or trust

What’s Changed Since 2011?

Before January 1, 2012, the maximum Section 179 deduction was $500,000 and this deduction was reduced dollar for dollar when property exceeding $2,000,000 was purchased during a year.  A special Section 179 deduction of $250,000 was allowed for certain purchases of real property.  The Section 179 deduction was therefore reduced from $500,000 to $139,000 in 2012.  The Section 179 deduction for certain real property purchases was eliminated at the end of 2011.  It is possible that Congress will retroactively reinstate the higher Section 179 deduction of $500,000.  But it remains to be seen.  Finally, unless Congress acts, the Section 179 deduction for 2013 will be $25,000.  A very substantial reduction.

For more information on how these rules apply in your situation, please give us a call.

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

 

 


Not Receiving a Proper Acknowledgment Can be Fatal to a Charitable Deduction

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Congress set strict rules on substantiating charitable deductions.  There is a recent tax court case that disallowed charitable deductions even though the taxpayers had proof of payment through canceled checks.  The purpose of this blog is to list the substantiation requirements for making cash contributions and to review the facts of this recent case.

How to Substantiate Chartiable Contributions of Cash

When making a cash contribution of $250 or less, all that is required is a bank record (e.g., canceled check) or written receipt from the charity showing the charity’s name, amount, and date of donation.

When making a cash contribution of more than $250, no deduction will be allowed unless the taxpayer receives a written contemporaneous acknowledgement from the charity.  The acknowledgment must include ALL of the following:

  • The name and address of the charity
  • The date of the contribution
  • The amount of cash contributed
  • Whether the charity provided the donor with any goods or services in exchange for the contribution; and, if so, a description and a good faith estimate of the value of the goods and/or services provided to the donor.

To be contemporary, the acknowledgement must be obtained by the taxpayer on or before the earlier of:

  • The date the donor files her tax return for the year the donation was made OR
  • The return’s extended due date.

The Court Case

In the Durden case, the Tax Court disallowed a taxpayer’s charitable contribution even though the taxpayer had canceled checks and a written acknowledgement from the charity.  The reason the contribution was disallowed was because the acknowledgement was insufficient.

On their 2007 tax return, the Durdens claimed a charitable deduction of $22,000 for contributions to their church.  The contributions were made by check.  The Durdens received a written acknowledgement from the church; however, the acknowledgement was not sufficient because it did not state whether the Durdens received any goods or services in exchange for the contribution.  In fact, they did not.  The church issued another written acknowledgment stating that the Durdens did not receive any goods or services in exchange for their contribution.  However, this second acknowledgment was insufficient because it was received by the Durdens after they filed their tax return that listed the charitable contribution (remember that the acknowledgment has to be received by the earlier of (1) when the return is filed or (2) the extended due date of the return).

Taxpayers must be sure that the acknowledgment they receive from the charity lists all of the items in the substantiation requirements above.  Even though the Durdens did not receive anything in exchange for their contribution, the Tax Court held that the written acknowledgment had to explicitly state that nothing was received in exchange for the contribution.

Also, don’t forget the timing requirement.  It is important not to file the tax return until you receive the written acknowledgment.

Example:  John donates $1,000 to his church in December 2012 and has a canceled check.  He files his tax return on January 18, 2013.  He receives a written acknowledgment from the church on January 31, 2013.  His charitable contribution will NOT be allowed because he didn’t have the written acknowledgment when he filed his tax return. 

These are very strict rules and can result in very unfair treatment.

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

 

Ugly Changes to Michigan Property Tax Credit

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The Michigan Homestead Property Tax Credit will be subject to new rules beginning in 2012.  This post will review the old rules, then explain how the new rules are different.

Review of Old Rules (Prior to 2012)

A Michigan resident who paid property tax or rent on a Michigan homestead could claim a refundable property tax credit against Michigan income tax.  A claimant must have been domiciled in Michigan for at least six months during the tax year and must occupy the dwelling.  The credit is based on property taxes that were billed (whether or not paid) for the taxable year.  For renters, 20% of rent paid is considered property taxes eligible for the credit.

For non-senior citizens, the credit is 60% of the amount by which the property tax for the year exceeds 3.5% of household income.  For senior citizens and certain disabled individuals, the 3.5% threshold is reduced for those with household income under $6,000.

Household income means all income received by all persons of a household in a tax year while members of a household.  Household income includes several items that are nontaxable such as child support, Social Security income, veterans’ disability benefits, etc.  Household income is reduced by business and rental losses.  Household income is also reduced by medical insurance premiums.  When Household income exceeds $82,650, the credit is no longer available.

The New Rules (effective January 1, 2012)

The property tax credit is now available only for homes with a taxable value of less than $135,000 (this is roughly equal to a home with a sales price of $270,000).

Household income is replaced by household resources.  The difference is that household resources is not reduced by business or rental losses.

Example:  Joan has $90,000 in wages during 2011 and has rental losses of $20,000.  Her household income is $70,000 ($90,000 in wages minus $20,000 in rental losses).  Since her household income during 2011 is less than the limit of $82,650 she is eligible for the property tax credit.  In 2012, her household resources are $90,000 (which is not reduced by her rental losses).  Since her household resources are over the household resources limit, she is NOT eligible for the property tax credit.

For non-seniors, the credit is 60% of the amount by which the property tax for the year exceeds 3.5% of household resources.

For seniors with household resources under $21,000, the credit is equal to 100% of the property tax for the year that exceed 3.5% of household resources.  The 100% amount is reduced by 4% for each $1,000 in additional household resources over $21,000 until $30,000 in household resources is reached.

Example:  John has household resources of $22,000.  His property tax credit is 96% of property taxes that exceed 3.5% of his household resources (100% minus [($22,000 minus $21,000) divided by 1,000 times 4%].

Senior claimants with household resources of $30,000 to $41,000  receive 60% of the credit.

For all claimants, there is a credit phaseout that begins at $41,000 of household resources.  The phaseout equals 10% for each $1,000 increase in household resources between $41,000 and $50,000.  At $50,000 of household resources, the credit is completely phased out.  This is a very significant decrease in the phaseout amount from 2011 ($82,650).

Example:  It is 2012.  Terry (who is not a senior citizen) has $45,000 in household resources.  He was billed $4,000 in property taxes.  Terry property tax credit is 60% of his property taxes in excess of 3.5% of his household resources.  His property tax credit before phaseout is $225 calculated as follows:

60% of property taxes of $4,000 =   $2,400

Less:  3% of household resources =   $1,575 ($45,000 times 3.5%)

Tentative property tax credit =          $    825 ($2,400 less $1,575)

Less: Phaseout =                                       $    412.50  The phaseout is 50% calculated as ([$45000-$40,000] divided by 1,000 times 10%)

Property Tax Credit =                            $    412.50 ($825 minus $412.50 phaseout)

Example:  Same facts as the last example except it is 2011.  Terry would be entitled to an $825 property tax credit.  Since his household income is less than $82,650, he still qualifies for the full property tax credit.

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

 

How to Avoid the 10% Penalty on Early Retirement Account Distributions

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One issue with investing money in a 401k or IRA is that you generally cannot access the funds until you reach age 59½.  If you withdraw funds from these retirement accounts before that age, you will be subject to a 10% penalty on the amount distributed.  This penalty is in addition to the federal and state income taxes you’ll pay on the distribution.

Fortunately, the IRS will waive the 10% penalty in certain circumstances.  However, even if you meet one of these exceptions, you’ll still have to pay federal and state income taxes on the distribution even if the 10% penalty is waived.

The exceptions are:

  • Distributed funds that are rolled over into an IRA or other qualified plan
  • Distributions upon death or disability of the account owner
  • Distributions that are part of a series of substantially equal periods payments over the life of the account owner or the joint lives of the participant and beneficiary
    • Translated into English: when you have a balance in a retirement account, you can calculate an annuity based on the amount in the account payable over your life expectancy (there are a few ways to calculate this annuity).  These annuity payments are exempt from the 10% penalty.  The annuity has to last through the later of:
      • When the account owner turns 59½
      • Five years after the date annuity payments began
  • Distributions after the participant’s separation from service (i.e., quitting/laid off/fired), provided the separation from service occurred during or after the year the participant reached age 55 (or age 50 for government plans to a retired police officer, firefighter, or emergency medical services provider).
    • This exception applies only to qualified plans, it does NOT apply to IRAs
  • Distributions to a former spouse under a Qualified Domestic Relations Order (QDRO)
    • Pension benefits are often divided during divorce.  To properly comply with pension plan rules, retirement accounts can only be split up pursuant to a QDRO.  Otherwise, the plan will have made a disallowed distribution to a nonparticipant.  This could jeopardize the tax-advantaged status of the pension plan.
    • Once a retirement account has been divided pursuant to a QDRO, the nonparticipant spouse can receive distributions without incurring the 10% penalty.  However, the nonparticipant spouse is still subject to the pension plan rules and isn’t entitled to any type or form of benefits that aren’t available in the plan.
    • IRAs do not require QDROs to be divided in divorce.  The division of the IRA does not cause a distribution; however, amounts withdrawn from the IRAs by either spouse will not be exempt from the 10% penalty if it is a disqualifying distribution.
  • Distributions to the extent of deductible medical expenses
    • Medical expenses are reduced by 7.5% of adjusted gross income to arrive at deductible medical expenses.  Early distributions equal to this amount can be distributed free of penalty.
  • Distributions made on account of the IRS’ levy of retirement accounts

The following exceptions apply only for IRAs:

  • Distributions equal to medical insurance premiums for workers who have received federal or state unemployment benefits for 12 consecutive weeks.  The reduction for 7.5% of adjusted gross income does not apply.
  • Distributions used to pay for qualified higher education expenses (college) for the account owner, owner’s spouse or child/grandchild.
  • Distributions up to $10,000 for first time homebuyers.
    • “First time” doesn’t literally mean “first time.”
    • First time homebuyer is defined as not having an ownership interest in a principal residence during the two year period ending on the date the new home is acquired

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.
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Payroll Tax Cut Extended

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Quick Background on Payroll Taxes

The Federal Insurance Contributions Act (FICA) imposes two taxes on employers, employees, and self-employed people.  One tax is the Old Age, Survivors and Disability Insurance (OASDI, commonly known as the Social Security tax).  The other tax is for Hospital Insurance (more commonly known as Medicare A).  The Social Security tax has been 6.2% and the Medicare tax has been 1.45%.  An employee pays the 6.2% Social Security Tax on her first $110,100 of wages (this wage base changes periodically), and pays the 1.45% Medicare Tax on all wages without limit.  The employer must match employees’ Social Security and Medicare Tax contributions.  Therefore, the employee pays a combined Social Security and Medicare tax rate of 7.65% of wages and the employer matches this 7.65% contribution for a combined FICA rate of 15.3%.

Self employed people pay both employer and employee portions of the tax on their self employment income.  The self-employment rate has been 15.3%.  There are two adjustments that self employed people make that are related to self employment tax:

  • The first adjustment is to multiply self-employment income by 0.9235. This adjustment basically allows the employer portion of FICA taxes to be deducted from self employment income.  Notice that the 0.9235 number is equal to 1 – 7.65%.  7.65% representing the employer portion of FICA

Example:  Joan has $100,000 of self employment income from her proprietorship.  She multiplies this income by 0.9235 and the product is $92,350, which is equal to her $100,000 self employment income less the employer portion of 7.65%.  The self employment tax rate of 15.3% is then multiplied by $92,350 to arrive at self employment tax of $14,129.

  • The second adjustment is a deduction equal to one-half of the self employment tax on the self employed person’s tax return.

On Joan’s personal tax return, she would be allowed an above the line deduction of $7,064.50 (one half of the $14,129 self employment tax).

What’s New

During 2011, the employee portion of Social Security was reduced to 4.2% from 6.2%.  The Social Security tax for self-employed individuals was 10.4% (6.2% employer portion plus 4.2% employee portion).  In December 2011, when Congress couldn’t agree on how to fund a full-year extension of the payroll tax cut, it passed the Temporary Payroll Tax Cut Continuation Act of 2011 that provided a two month extension of the 4.2% employee Social Security rate.  On February 17, Congress passed the Middle Class Tax Relief and Job Creation Act of 2012.  This new law extended both the 4.2% Social Security employee portion and the 10.4% Social Security portion of self employment tax until December 31, 2012.

The maximum savings for 2012 will be $2,202 (2% of $110,100) per taxpayer.  If both spouses earn at least as much as the wage base, the maximum savings will be $4,404.

An additional change is made for the above the line deduction for self employment tax.  The deduction is normally one half of the self employment tax to reflect the half that represents the employer portion of the tax.  However, the employee portion of the Social Security tax is 4.2% while the employer portion of the Social Security tax is 6.2%.  Thus, the deduction for Social Security tax is now 59.6% [6.2% employer portion divided by combined employer and employee Social Security tax of 10.4%].  The deduction for the Medicare portion of the self employment tax remains at 50% since the 2% reduction applied only to the Social Security Tax.

Example:  It is now 2012 and Joan still has $100,000 in self employment income.  The first adjustment is still to multiply her $100,000 income by 0.9235.  The product of $92,350 is multiplied by the Social Security portion of self employment tax of 10.4% to arrive at $9,604.40.  The $92,350 is also multiplied by the Medicare portion of self employment tax of 2.9% to arrive at $2,678.15 for a total self employment tax of $12,282.55.  Notice that the self employment tax is less than the first example by $1,846.45.  This difference is due to the 2% reduction in the Social Security portion of self employment tax times the self employment income of $92,350.

To calculate Joan’s above the line deduction:

  • multiply the Social Security portion of self employment tax by 59.6% ($9.604.40 times 59.6% equals $5,724.22)
  • multiply the Medicare portion of self employment tax by 50% ($2,678.15 times 50% equals $1,339.08)
  • Joan’s total above the line deduction for self employment tax is $7,063.30.
Thus, Joan has to cut a check for $12,282.55 to cover self employment tax.  The $7,063.30 above the line deduction for self employment tax is multiplied by her individual tax rate to determine its value.  If Joan is in the 30% bracket, the $7,063.30 deduction will reduce her income taxes by $2,118.99.

Buzzkill Disclaimer: This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230.

 

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