Tax Tips Blog

Jacob asks:My daughter’s was just informed that her firm is moving to another state. She she will not be moving with them and she has worked for them for over ten years, they are going to give her severance pay. I would greatly appreciate your help with the following questions: 1. Does her employer have to deduct Federal/State withholding tax and social security and Medicare from her severance paycheck? 2. If her payment were called a “bonus” instead of severance pay, would there be any difference in the deductions taken from it or in the amount of taxes she would have to pay? 3. Will her receipt of severance pay (or a bonus) affect her eligibility to apply for and receive unemployment benefits as soon as her employment ends? Many thanks in advance for any advice you can give me on these three questions. Jacob

My reply:Hello Jacob! Thanks for visiting.

Severance pay is treated as a continuation of her wages; therefore, as with wages, it is mandatory that her employer withhold Federal, State, Social Security and Medicare taxes, as applicable.

A bonus, is also part of a worker’s wage and her employer would be required to withhold accordingly for that as well.

The potential difference between a bonus payment and severance pay is that severance pay is usually paid out on the same “schedule” that her wages were previously paid out. A bonus is usually a one time payment. If all the payments (whether severance or bonus) are paid out in the same calendar year, then the final tax due will be the same no matter if it is classified as severance pay or bonus pay. However a bonus payment may be subject to a flat 25% withholding rate, instead of the rate your daughter indicated on her W-4. The difference between these two rates may make your daughter either owe or receive a refund come tax time.

Unemployment benefits are determined on a state level. Some states allow immediate unemployment insurance benefits; others do not. It is best to discuss this with her state’s unemployment office.

Best wishes, Gina

Question from Ted:Sweet site! I’m doing my own taxes with Tax Cut and I have a question. I have a regular job, but I worked part-time, as a fitness instructor for a local gym. They sent me a 1099 with the amount they paid me reported as “non-employee compensation”. I’m not self-employed, do I just put this amount on Line 21, Other Income? Thanks, Ted

My response: Hello Ted. I’m glad you found my site too.

Although you might not think of yourself as self-employed, it sure sounds like it to me. You may want to read my article, “Employee or Independent Contractor” and the IRS’s frequently asked questions regarding non-employee compensation.

But don’t let being self-employed get you down, having your own business has benefits. If you have the time and are willing to do this work on a more regular basis, make some business cards and drop them off at other fitness centers. Hire a qualified tax professional, who works with small businesses and is available to help you year round.

These tax professionals can help you make sure you are appropriately documenting and maintaining your records in order to take advantage of all available deductions. He/she will help you determine when it’s time to incorporate, start retirement plans, hiring employees, etc.

Until then, you should report this income on Schedule C (or Schedule C-EZ) as well as any expenses you may have incurred and can substantiate. The most common expense I see for fitness instructors is the cost of their certification.

Best wishes, Gina

It appears that there’s a local tax preparer who is/was advising taxpayers that they should have cosmetic surgery in order to increase their medical expenses to reduce their taxes. Not only that, this tax preparer is/was also allowing taxpayers to deduct the cost of medical and dental insurance paid with pre-tax income. Neither of these are legitimate deductions.

Assuming you can benefit from deducting your medical expenses (or those of your spouse or dependents), the following is a general, but not inclusive, list of what is allowed, if paid to a doctor, surgeon, dentist, chiropractor, psychiatrist or psychologist. Please consult a qualified tax professional if you have incurred items that are not on this list that you believe may be deductible:

1. Medical, dental, accident and health and a limited amount of qualified long-term care insurance
2. Medical and dental expenses paid to diagnosis a condition
3. Medical and dental expenses to treat, prevent, or cure a condition – this includes hospital services, qualified long-term care services, nursing services, laboratory fees, acupuncture treatments and inpatient treatment at a center for alcohol or drug addiction
4. Prescription drugs, prescription eyeglasses or prescription contact lenses
5. Insulin
6. The cost of a program to help you stop smoking
7. The cost of a weight-loss program IF you are participating in the program because your physician diagnosed you with a specific disease such as obesity or diabetes AND told you to participate in the weight-loss program in order to help treat this disease
8. False teeth
9. laser eye surgery
10. hearing aids
11. crutches, wheelchairs, and guide dogs for the blind or deaf
12. Transportation cost incurred to obtain deductible medical care

The following are some expenses, which are NOT deductible medical expenses:

1. most cosmetic surgery
2. Insurance premiums paid by your employer-sponsored health insurance plan (cafeteria plan) unless they are included in your gross wages
3. diet food
4. over–the–counter medicines and vitamins
5. any medical or dental expense for which you were reimbursed for or that was paid directly to the doctor or hospitalhealth club dues
6. non-proscription nicotine gum and non-proscription nicotine patches

Please keep in mind that in order to benefit from payment of medical and dental expenses you must itemize your deductions. In addition, the amount of your medical and dental expenses must exceed 7.5% of your adjusted gross income (AGI) before it is potentially deductible. And, your total itemized deductions must exceed your standard deduction for you to obtain any benefit.

Richard asks:My father passed away earlier this year. He was 86 when he died. I am the sole beneficiary of his Traditional IRA. He was taking distribution for some time. I think I understand correctly that I may set up a beneficiary distribution IRA from which I must continue to make withdrawals (starting by Dec 31 of next year) based on my lifetime, and this is what I intend to do. My question pertains to the RMD for this year. IRS Publication 590 indicates that a distribution must be taken, but is silent about who actually receives the distribution, his estate or his IRA beneficiary. Hence, the difficulty. Thanks for your help. Regards, Richard

My response:Hello Richard, thanks for writing. My condolences on your father’s passing.

It’s impressive that you tried to research this issue by reading IRS Publication 590. As you have now come to realize, IRS Publications can be very helpful, but they do not contain everything that is written in the code (or they’d be just as long and complicated!) or that you may need to know.

The actual authority which states who is to receive the distribution is located in regulation 26 CFR § 1.401(a)(9)-5, A-4(a).

You are correct in how you will be setting up your inherited IRA. Since your father died after he turned 70 1/2, which is when he started taking his required minimum distributions (RMD) from his IRA and assuming he did not take his RMD already this year, then you, as his sole beneficiary is required to take what would have been his distribution this year (the year of his death).

This is one of the times that the IRS rules actually make sense. If the distribution were to be made to his estate it would no longer be in the IRA and would be subject to the provisions of your father’s will. If your father’s will said his estate would be split between 5 people, then all 5 people would get part of this IRA distribution, when you were named as the IRA’s sole beneficiary. So it’s actually fair and logical that you, as the sole beneficiary, would receive your father’s RMD in the year of his death.

Best wishes, Gina

Denise asks: My daughter in law has her teaching degree but she is staying at home and home schooling their 2 sons. Can they claim any of their expenses or is their a credit for home schooling? I have looked and can’t find anything I really understand re this issue.

My response: Hello Denise! The short answer is no.

The educator deduction was extended at the last minute, but it is only available for teachers who taught at a public or private school, so it would not apply to your daughter-in-law.

Since your daughter-in-law does not charge her children for their education then her intent is not to make a profit and only benefits her own children; therefore, this is not a business nor a hobby.

All of her expenses relating to homeschooling her children are considered nondeductible personal, living and/or family expenses. If your daughter-in-law were to speak to a qualified tax professional they would certainly discuss alternatives for future years, such as setting up a tutoring business, establishing a Coverdell Education Savings Account , etc.

Best wishes, Gina

Carl asks: The past two years I have listed some charitable donations on our Schedule A, but they have been cancelled by the AMT. Since my wife retired in 2006, I expect to avoid the AMT this year. Can we use those same donations from previous years this year, since they did us no good in the years they were made? I didn’t think so.

My response: Carl, you seem to be pretty confused about how AMT works, but don’t feel bad, it’s yet another complicated layer in our tax system. The AMT is a completely separate calculation from your regular tax calculation, but in order to make things “simple” we have one form to compute the difference between the two different taxes.

The “differences” on the AMT form are referred to as “adjustments” or “preferences”. As far as itemized deductions are concerned this adjustments include:

1. State and local income taxes

2. Home equity loans and lines of credit, if not used for home improvement

3. Medical expenses must exceed 10% of AGI instead of 7.5% to be deductible

4. Miscellaneous itemized deductions Contributions are not disallowed with the AMT calculation; therefore, even if you were paying AMT, you were still receiving the benefit of any deductions that you made.

Anyone who pays AMT should seek the advice of a qualified tax professional, because not only is the calculation itself complicated, you may be entitled to a Minimum Tax Credit in future years. The Minimum Tax Credit (MTC).

The MTC was created in an attempt to avoid double taxation when a preference item on AMT reverses itself. This calculation should only be done by a qualified tax professional.

Best wishes, Gina

Jim asks:Hello! I was wondering if you can help me understand the IRS policy on foreign tax credits? From what I understand there’s a cap, but there’s also a deduction available? Thanks, Jim

My response:Hello Jim! The foreign tax credit can get very complicated very fast, which is why, if you paid foreign taxes (or they were withheld from your foreign income) you should have a qualified tax professional help you.

It’s much more complicated than my answer here, but hopefully this will provide you with a general idea of the concepts.

In general, if you are married, and are filing jointly, the IRS allows you to deduct up to $600 of foreign taxes you paid each year on page 2 of Form 1040. If you want to deduct more than $600 you must file Form 1116.

Form 1116 generally limits the credit you can take on your foreign taxes withheld or paid to about the same percentage of net foreign income as your income tax bears to your total income, on a per-country basis. This roughly means that if the foreign tax, or withholding, rate is 25% and you are in the 15% tax bracket you’re not going to get more than about 1/2 your withheld foreign taxes back on Form 1040 page 2 using Form 1116. The good news is that you can carry forward your unused credits if you use Form 1116. The bad news is that in a year that you have no foreign income, you cannot take any foreign taxes as a credit on Form 1116 nor can you use any previously denied credits and you can’t switch to the flat $600 to include any carryovers from previous years.

And then to make it more complicated there’s the dreaded AMT. If you claim foreign tax credits on your regular tax, those credits are subtracted from pre-credit tentative AMT liability, yielding tentative AMT liability.

And to make it even more complicated foreign tax credits can reduce pre-credit tentative AMT liability by no more than 90 percent. It is well worth it to have a qualified tax professional prepare your return if you are dealing with the foreign tax credit.

Best wishes, Gina

Todd writes:I am having a terrible time trying to figure out my son’s income tax. He received form 1099-Q for his educations expenses dispersed from the texas tomorrow fund. I looked up publication 970 Chapter 8 and I have read it and figured it but still don’t get it. If he is still my dependent how does this work. Surely I did this last year but i am clueless this year. I don’t think that my wife and I will qualify for the educational credits this year but then again I am not sure. Any help? Thanks, Todd

My response:Hello Todd!

Based on your first sentence I would say you should hire a tax professional to help you out. Don’t be embarrassed as Form 1099Q can be confusing.

Before I write a bit about it I want to say congratulations for getting into the Texas Tomorrow Fund before they closed it. As I’m sure you’re aware It was a very wise investment.

As to whether or not your son is your dependent, you haven’t provided enough information for me to tell you. Perhaps if you read IRS Publication 501, you’ll be able to figure it out.

If not a qualified tax professional should have no trouble doing so. In general, if you had “qualified” educational expenses equal to the amount in Box 1 of the 1099Q (distributions), then you don’t do anything, it is not taxable. If there is something in Box 2, then the amount in Box 2 may be taxable if you did not use them for qualified educational expenses.

If your qualified educational expenses were greater than the amount on the 1099Q, then the difference can be claimed as either an education credit or tuition and fees adjustment. If the 1099Q amount is higher than your expenses, then things get more complicated and it’s best to speak to a qualified tax professional.

Qualified education expenses are the tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible college, university or other educational institution. They also include some room and board costs. If you’re not sure it’s best to consult IRS Publication 970.

Best wishes, Gina

Roger asks: I put money into my flexible spending account at work for both medical and dependent care. The money goes into the account pre-tax. Any money left in my account at the end of the year I forfeit. If a medical bill is paid out of my flexible spending account can I still deduct it on my taxes as a medical expense? What about the Dependent Care? Can I take the Credit for Child and Dependent Care Expenses? Thanks, Roger

My response: If you paid for your medical expenses out of your flexible spending account, then you paid for them with pre-tax dollars; therefore you don’t get to deduct them again. For more information please see IRS publication 502.

As for your dependent care expenses, again you are not allowed to deduct anything that you already received a pre-tax benefit on; however you may have a credit if you had expenses in excess of the amount you paid out of your flexible spending account.

For more information please see IRS publication 503 and Form 2441.

Best wishes, Gina

Karen from Michigan asks: I just read your post about hobby income. The rules seem somewhat bizarre, in that it seems as if someone who is deliberately trying *not* to make a profit — merely asking to be reimbursed for the cost of raw materials for something she makes to give to another person — would end up paying income tax on what is essentially a reimbursement. I desktop-publish fanzines — amateur collections of stories and art. The standard price in the fanzine community is calculated at 10 cents per black and white page plus one dollar for every full-color page: in other words, people are charged just the cost of running one off at Kinko’s (not counting the binding). No one is supposed to make a profit off of the community. I didn’t mind putting in hundreds of hours on a labor of love — even though I definitely spent more on ink and toner and paper than I took in –, but it’s disconcerting to find that because I’m the one who did the copying work, the payments I got — essentially reimbursements — are “income.” The next time someone asks me to run off a copy of one of the zines I publish, I may have to decline — I can’t afford to pay the government $3 for each zine. Yet I can’t declare that it’s a business, because on the first page of each zine, it clearly states that there’s no intention to make a profit. Is this really the way it is? If a jewelry maker makes a necklace for a friend and asks the friend to just pay her back for the raw materials, is the jewelry maker stuck with having to pay taxes on that “income”? If an amateur photographer photographs a friend’s wedding for free, but the friend pays him back for the film, the photographer has to pay taxes on it? Something about this doesn’t seem right.

My reply:Hello Karen! Thanks for writing.

I agree that I don’t think the rules for reporting hobby income and expenses are fair. Your income would be reported as “Miscellaneous Income” and you expenses would be reported as “Miscellaneous Itemized Deduction”, which has various limits and most do not receive a benefit from it. This usually results in exactly what you stated, you’re reporting the income (the reimbursements) and no expenses. This is just one of the reasons why, in my opinion, a good tax consultant is worth their fees.

They will tell you how to make the most of situation such as this. The advice I provide my clients who are in a situation such as yours is to convert your hobby into a legitimate business, because that is the best way to get around these rules (in my opinion and yes there is another way). I realize you said that this publication is not for profit and that is not their intent, but YOUR intent can be to make a profit. Once your intent is to make a profit from doing the same thing, in your case, desktop publishing, then you can report your income and expenses on Schedule C, showing a loss and taking a loss until you do finally make a profit. I consider it my job to help my clients find ways to try and make a profit (or increase their profit) in the future and make sure they document their efforts trying to make a profit.

For your situation, these things would include (the rest of which you read in my other article): 1. Finding someone who has made a profit from desktop publishing and asking them to be your mentor. 2. Make yourself some business cards and disperse them, documenting as best as possible where they have been dispersed. 3. Advertise your business and skills seeking additional work. Obviously more than the 3 things above would need to be done, but that is an excellent start.

Best wishes, Gina