Tax Tips Blog

I wrote earlier about everyone being able to receive a refund for the amount of Federal Excise Tax they previously paid, plus interest, on your long distance bills (including cell phone bills) Since March 1, 2003. Today the IRS announced standard amounts individuals are allowed to claim as a refund. Here are the standard amounts for individuals:

• 1 exemption claimed on your 2006 return = $30 refund
• 2 exemptions claimed on your 2006 return = $40 refund
• 3 exemptions claimed on your 2006 return = $50 refund
• 4 or more exemption claimed on your 2006 return = $60 refund

The IRS believes this method and amount is “fair and reasonable”. I won’t comment on whether or not I believe these standard amounts are “reasonable and fair”, but I will say that using the standard amount will be easier than adding up the amount from old phone bills. However, if you think that you paid more Federal Excise Taxes March 1, 2003 through July 31, 2006 then the IRS is willing to give you; you are free to add up what you paid and request that amount as a refund. I am glad to hear that the IRS will be creating a special short form, Form 1040EZ-T, for those who otherwise would not need to file a tax return. Not only that, but the IRS is also considering establishing an easier way for businesses and nonprofits to claim this refund. As of right now, they need to go through all their old phone bills and add up the amount they actually paid. For more information please visit the IRS website.

Mike Mattison wrote: Hi Gina, Thanks for a great site. I do financial planning, and I’m trying to help a client (married filing joint) with financial planning, but they have a tricky question. In short, they want to know how to calculate how much each should pay towards their IRS tax bill of $4,060.

Summary: He’s working on building a software utility program (he is not employed), and had about $13,000 in 2005 “business expenses” on Schedule C last year. But he had about $30,000 in investment income on Schedule D. She had about $90,000 W2 income, and paid $10,125 payroll taxes in Washington State (no state taxes). Their total income (1040, line 22) was $103,629. After total deductions ($10,000) and exemptions ($6,400), their taxable income (1040, line 43) is $87,229. And their total tax was $14, 110 less $10,125 (her payroll taxes paid) = IRS due $4,060. Who pays how much?

I actually have other clients who fight about this, but I try to stay out of this subject. Is there a defined process to calculate who pays how much in the above situation? Thanks!! - Mike

My reply:Mike, Thanks for visiting my site.

By signing a joint return, both husband and wife become equally responsible for paying the IRS the amount due, in your example, $4,060. But, I’m sure that’s not the answer either you, nor your client wanted to hear (as I don’t recall a client ever being happy with that answer).

If they were to file separately, then yes there is a “defined process to calculate who pays how much”, but the total due to the IRS is usually greater than if they would file married filing jointly.

The “process” that you would use to divide the joint return into two separate returns is based on state law, and I am not familiar with Washington state law. Since WA is a community property state, there is the possibility that all business expenses, investment income, W-2 income, payroll taxes, deductions and exemptions are treated as if each earned and spent all income and expenses equally, but I do not know if that is how Washington treats each of these items or not.

Sorry I couldn’t be of more help.

According to an article published by AccountsWorld, Kevin M. Brown, who is in charge of the IRS small businesses division, believes that taxpayers have been taking advantage of the IRS.

Due to the IRS Restructuring and Reform Act of 1998, the IRS reduced it’s enforcement staff and increased and improved their customer service division. It is Mr. Brown’s contention that this has caused an increase in taxpayers cheating on their taxes. What does Mr. Brown plan to do about that? He wants to hire more enforcement staff so he can do more audits. He wants to screen more tax returns with their new computer program. This program is designed to help the IRS figure out who might not be reporting all their income or who is reporting more deductions then they are actually entitled to take. The article did not say where Mr. Brown plans on getting the funds to increase his enforcement staff.

Will they cut expenses in customer service in order to beef up their enforcement staff? What’s the honest taxpayer suppose to do? Make sure your records are in order. As long as you can substantiate the deductions you are claiming and the income you are reporting, don’t waste your time worrying. Even if Mr. Brown does hire more staff and perform more audits, they are still limited by the amount of work they can do. Audit rates are low and even with the changes that Mr. Brown hopes to make, they will still be relatively low.

A reader would like to know: I have a short term stock loss (held under 1 year). Can I apply this loss against a long term stock gain or must the short term stock loss be applied to a short term gain? Thanks.

My reply: Stock sales can be quite confusing, as evidenced by a recent report from the General Accounting Office (GAO). The GAO estimated that 8.4 million individual taxpayers with securities transactions incorrectly reported their capital gains or losses on their tax returns for the 2001 tax year. I strongly recommend that anyone who has any stock transactions hire a qualified tax professional to help them determine their correct basis and reporting requirements.

Once the appropriate basis and gain or loss has been determined then they are usually netted in the following order:

1. Short-term capital losses are applied against short-term capital gains while Long-term capital losses are applied against long-term capital gains.
2. Any remaining short-term capital loss (from number 1) is applied against any remaining long-term capital gains (from number 1) while any remaining long-term capital loss (from number 1) is applied against any remaining short-term capital gains (from number 1).
3. You can apply up to $3,000 of any remaining capital losses (from number 2) against regular income and carryforward any remaining loss (from number 2).

In addition to finding a qualified tax professional to help you, you may be interested in reading IRS Publication 550.

If you think the Pension Protection Act of 2006 (H.R. 4) that President Bush just signed into law won’t apply to you, think again. Here’s a brief introduction to some of what’s hidden within the 993 pages of legislation:

• You can tell the IRS to deposit your refund into your IRA.
• The Saver’s Tax Credit for low income workers is permanent. Eligible individuals will receive a non-refundable tax credit of up to 50 percent on up to $2,000 in contributions to an IRA, 401(k), 403(b), SIMPLE or 457 plan. That means you can save up to $1,000 in taxes above and beyond the tax deduction already associated with these contributions.
• No deduction is allowed for used clothing or household goods unless they are in “good condition”. How do you prove “good condition” to the IRS? I have no idea, but I’m advising my clients to take pictures of what they intend to donate before they make the donation and keep the pictures with their tax records. This rule begins today, August 17, 2006.
• No deduction is allowed for ANY cash contribution to any charity unless the taxpayer has a canceled check (or bank statement) or receipt from the charity stating the date of donation, amount of donation and the name of the charity. This rule also begins today. Does this mean that the Salvation Army will start handing out receipts when you put money in their bucket this Christmas? If they don’t, there’s no deduction for donating.
• If you make a donation (not to exceed $100,000 of donations a year), to a charity directly from your IRA or Roth IRA the distribution is tax-free.
• Employers can automatically enroll their employees in the Company’s 401(k)
• New penalties for bogus appraisals used for tax purposes.
• New information reporting requirements for exempt entities (churches, charities, and other non-profits) who previously were not required to file a return or report.
• Until December 31, 2007, C-Corporations can donate books they have in their inventory (bookstores or anyone who sells books) to schools (K – 12) and receive the lessor of twice their basis or their basis plus one-half of their appreciated value, IF the schools use the books in it’s educational program.

Email from Daniel Chambers: Greetings Gina! I recently subscribed to your blog and have found it quite useful (thank you!) I have a small business and a product line we are currently developing is for small business owners, so your site is doubly important. As one of our potential markets, I was researching the Direct Selling industry and came across a new (as of last August) Audit Technique Guide on the IRS site (http://www.irs.gov/businesses/small/article/0,,id=141724,00.html). Thought it might be appropriate to share with your Business or Hobby thread as it seems to alter the way the IRS applies the 9 points you mentioned. I am not a tax professional (or tax expert, or play one on TV) but I think you would find it of particular interest. My apologies if you have posted about it before.

Thank you again for your site,keep up the good work,

Dan

My response:Thank you Dan. I’m glad that you have found my blog useful.

I agree that the link you provided may be useful to some taxpayers. Just to be clear, the guide that you are linking to was posted on the IRS website last August, but the 9 points have been around and tested for quite some time.

Each time the IRS goes to court with a new specific case the result may appear to alter the way the IRS applies the points, but in actuality it just clarifies it. I’m sure you noticed, when you read the guide, that they are quoting tax cases from as far back as 1928.

As with all IRS codes, rules and/or regulations they are often tested through audits and in our court system and based on the results and interpretations we begin to understand how our complex tax code really works. Trying to figure this out is more of an art, than a science, and is exactly why anyone who has a business should have a tax professional at their side, helping them to interpret the complex web of our tax code.

Thanks again for reading and your email.

Gina

Eva from California wrote:Dear Gina, I found your blog by accident and boy am I glad! Big question…early this year I tried to start a small business. Within 3 months I figured out I wasn’t going to make any money so I quit. Am I still entitled to the deductions? I was also thinking of starting this other business. It’s a no brainer but if the same thing happens should I deduct the expenses? How many times does the IRS let you do this? Thanks! Eva

My reply:Eva, I’m glad you found my blog.I’m sorry I didn’t respond sooner, but as you probably noticed from my last blog entry I was pretty busy last week.

The sad truth is that most businesses fail to make money. This in and of itself, does not mean that you will not be able to deduct your business expenses.

The fact that you only spent 3 months trying to make it succeed may make the IRS believe it was only a hobby. The rules for determining whether or not an activity is a business or a hobby are quite complex and you should seek the advise of a qualified tax professional to see how your activities should be classified.

In general, the IRS uses the following 9-Point Test to determine if your activity is a business or a hobby:

1. The manner in which the activity is conducted

2. The expertise of the taxpayer

3. The time expended on the activity

4. The expectation of profit

5. The success in other similar or dissimilar activities

6. The history of income and losses

7. The amount of “occasional” profits

8. The financial status of the taxpayer

9. How personal pleasure or recreation contribute to the business.

If you intended to make a profit and a tax professional (and the IRS) concurs that your activity is a business, you can claim all your applicable business expenses. If your business expenses exceed your income for the tax year, you can claim a loss for the year, up to the amount of your taxable income from other activities. Any remaining losses may be carried over into other years.

If your tax professional (or the IRS at a later date) believes that your business never intended to make a profit your activity will be classified as a “hobby” and your losses will be limited to the amount of income generated by the activity. “Hobby Income” is reported as “other income” on your Form 1040, Individual Income Tax Return. “Hobby Expenses” are only deductible if you itemize deductions on your tax return. They are considered “miscellaneous itemized deductions” and you may only deduct the portion of them that, along with any other miscellaneous deductions, exceeds 2 percent of your adjusted gross income.

Depending on your particular tax circumstances this can result in all income form the hobby being taxable income with no offsetting deduction for hobby expenses. The IRS does not put a limit on the number of businesses a person can own or hobbies that a person wishes to engage in.

I am not familiar with any specific rules that California may have, please see a tax professional who is familiar with California taxation.

Best of luck with your next venture,

Gina

Alice writes: hello, gina. i enjoy your clear, chatty, blog and think you are one of the few people who might know the answer to my question: i’m a successful freelance writer who is just about to start a blog that will involve heavy travel to various theater events around the country. While it is going to be hosted on a very popular, often-visited website in the field, it won’t be paid (I am doing it for higher name visibility). Will any or all of my travel expenses be tax-deductible? Would it matter if I could get the website to pay me some small nominal amount? Thanks!!!

My response:Hello Alice! Thanks for your kind comments about my blog. Congratulations on being a successful freelance writer! As to your question, you can deduct “ordinary and necessary” expenses you have when you travel away from home on business. You must be able to prove a real business purpose.

In trying to determine if your travel to various theater events around the country is for a real business purpose you might want to ask yourself the following questions:

1. What do you write about now?

2. Who are your current clients?

3. How many clients do you have now?

4. Have you been paid for this type of writing before?

5. Do you have a marketing plan that shows how you will increase your client base or profitability by going to these theater events?

If you do determine that the travel to these theater events are deductible, but you also stay around for a few extra days to enjoy the city you’re in, you may want to check out my article on “Deducting Your Vacation” as you may be able to deduct more than you think.

Thanks again and good luck,

Gina

Your business is expanding and it’s time to hire someone to help you out. Will they be an employee or an independent contractor? When answering that question, the important point is whether or not they are working independently. There are 20 common law tests that determine whether or not a worker is an employee, but I’ve found that most employers can figure it out by answering these five questions:

1.Will you be providing a place for the person to work (office, desk, etc.)?

2.Are you planning on providing the person with tools to do their job (paper, pencils, computer, calculator, hammers, etc.)?

3.Will you be telling the person how to do their job or providing a training program for them?

4.Will you be taking responsibility for their work?

5.Do you want to be able to fire this person whenever you see fit?

If you answered yes to all of the above questions, then you are about to hire an employee. If you answered no to any of the above questions, then they may be an independent contractor. To be sure you can take a look at Form SS-8, which is what the IRS uses to classify workers, or ask your tax consultant. Just remember, the distinction between employee and independent contractor is not a matter of choice, it’s a matter of law.

Ron from Jacksonville, TX asks: I am considering using $50,000 worth of a new home as a home office for 20 years. My personal and business tax rates are identical. I’ll ignore expenses that are business deductible in both cases. With a home office I estimate I can write off $25,000 in depreciation, another $1,000 in home repair, and $4,000 in general utilities that are not business deductible (heating, water…). This means a savings of $39,000 times my tax rate or about $10,800. Assuming I sell this house after the 20 years, for 150% of the original price then I will be facing a capital gain of ($50,000 * 1.5 – 25,000) of $50,000 in capital gains with a tax consequence of $10,000. A net gain of $800 for 20 years of record keeping and form filing. Of course the result could be better or worse depending on the appreciation. I think the home office deduction is a loser. What am I missing?

My answer: I believe that establishing a home office can provide significant tax benefits for the sole proprietor. Since you asked about it, you obviously thought so as well and your gut was right. The home office deduction is not an easy calculation and is best left up to a tax professional.

You haven’t supplied all the necessary information for me to tell you exactly what you would be able to deduct (or if you are actually allowed to claim a home office deduction), but I will attempt to explain in general how the home office deduction might work.

The first step is to figure out how much space you will be using in your home exclusively for businesses purposes.

• Office area (desk, printer stand, file cabinets, etc.) is 15′ X 15′ or 225 sq. feet
• Office closet (storage of office supplies, more filing cabinets, etc.) is 4′ X 4′ or 16 sq. feet
• Garage (one car slot is 10′ X 20′, car is used 60% for business) is 120 sq. feet (200 X 60%)

The total business area of your home is 361 sq. feet (225 + 16 + 120). Assuming that your home is 2,000 sq. feet plus you have a two car garage (800 sq. feet), then your total home square footage is 2,800 and your business use percentage is 12.9% (361/2800).

Assuming the cost of your home is $125,000 and your land is valued at $25,000 then your assumed basis would be $100,000. Your business use portion of your basis would be $12,900 (100,000 X 12.9%). You can deduct this $12,900 over 39 years, in the form of depreciation, which amounts to $331 a year.

Assuming your utilities (electric, water, trash, etc.) are $3,000 per year you can deduct $387 (3,000 X 12.9%). If you make any repairs (replace the broken overhead light) or have any maintenance costs (carpet cleaning) specifically for your home office they are fully deductible.

If you make repairs or have an improvement for the whole house then you can only deduct the business percentage. I will assume you have no repairs.

Assuming that your property taxes are $5,000 you can deduct $645 as a home office deduction and $4,355 as an itemized deduction.

Assuming your mortgage interest is $7,000 you can deduct $903 as a home office deduction and $6,097 as an itemized deduction.

Insurance is also deductible. All business insurance is completely deductible. The business portion of your homeowners insurance is deductible as part of the home office deduction. We’ll assume that is $2,000 X 12.9% = $258.

If you have a qualified home office you can deduct expenses that you are already paying (since you’re living in house). These expenses reduce the profit on your business. A lower profit on your business reduces the amount of Self-Employment and Federal Taxes that you pay with respect to that business.

In the above example you would save $386/year in self-employment taxes and $342/year in Federal taxes for a total yearly tax savings of $701.

If you were to subsequently sell your house, any gain on the sale of your property up to the amount of depreciation you have taken will be taxable at your regular tax rate up to a maximum long-term capital rate of 25% as long as you have owned the property for at least one year. otherwise it’s taxed at your regular income tax rates. In this example that would be a potential recapture of $83/year in taxes.

The potential tax savings indicated above exclude increases in utility costs, homeowners insurance and property taxes. It also excludes the gain you receive in benefiting from the depreciation deduction now and not paying the tax on it until you sell – in this case 20 years later. This has to do with the time value of money and is beyond the scope of this article.

Having a true home office is a great way to keep your overhead low since you are already paying for the space. If you don’t use your home office you will have to buy or rent space elsewhere which is a cost you aren’t currently incurring and didn’t include above.

Could the home office deduction be a red flag? Possibly, however, considering the fairly low percentage of all returns that are audited, you probably don’t have reason for concern unless you claim an outlandishly high deduction.

Whenever the issue of “red flags” come up with my clients, I always point out that if you are legitimately entitled to a deduction, the fear of an audit should not be an issue. It is your legal right to take advantage of every possible deduction that the Internal Revenue Code makes available to you. If you keep good records, and file an accurate return, you have nothing to worry about.