“Tax time” is generally the period after January 1 and before April 16. However, it varies based on which type of tax return is being filed. Your form of entity determines which tax return you will file. While everyone’s individual income tax returns are due April 15 (unless a timely extension is filed), all calendar year corporate returns are due March 15. Thus, all “S” corporations, “C” corporations and LLCs that have elected to be taxed as a corporation are due then. If timely filed, a six-month extension is available. For those of you who operate as an S corporation, preparation of the corporate returns is a prerequisite to preparing your individual returns. The Form K-1 information that is a byproduct of the return is a requisite input for your individual return.
I briefly mentioned LLCs. From a Federal tax standpoint, they don’t exist and there is no Federal LLC tax return. The LLC is treated as a sole proprietorship (for a sole member LLC), a partnership or a corporation. The taxpayer selects the form of entity when filing the initial tax return or by affirmatively filing a Form 8832 (entity selection form).
What filing status will you choose – Single, Married Filing Jointly, Married Filing Separately or Head of Household? The selection affects the amount of tax you pay.
Your marital status at December 31 determines what your status is. If you are unmarried at December 31, unless your spouse died during the tax year, you can only be Single or Head of Household. The latter classification is reserved for a taxpayer who maintains a household as the principal place of abode for him/her self and a dependent. Even if married, by living apart for the final six months of the year and providing the requisite household, a taxpayer will still qualify as a Head of Household.
Most married taxpayers file jointly. For those who choose to file separately, however, the aggregate tax may well exceed what would have been the tax on a joint return.
Unfortunately, there are several draconian penalties applicable to Married Filing Separate tax returns. To name just three: (1) The $ 25,000 allowable rental loss for active participation is not deductible; (2) All Social Security received becomes taxable, from dollar one; (3) No penalty free conversions of an IRA to a Roth IRA is allowed.
Once the filing status hurdle is overcome, we next have to determine who is a dependent. An approximate definition, although not precise, is a close relative (or someone residing with the taxpayer for the entire year) that earned less than $3,400 for the year and over half of whose support is provided by the taxpayer. For a child, he/she must have resided with the taxpayer for more than six months and be under 19 or a full time student who has not turned 24 by year-end.
Each taxpayer gets to claim an exemption for him/herself, as well as an exemption for each dependent. Each exemption equates to a deduction of $3,400. Thus, a married couple with two children gets instant deductions of $13,600.
For those of you who generate tax losses in your business, a basic primer of when those losses are deductible would be most helpful. The two tax concepts that come into play are the “passive loss” rules and the “at risk” rules.
The passive loss rules essentially limit the deduction of business losses to those situations in which the taxpayer materially participates. Essentially, the taxpayer must be significantly involved in the day in and day out operations of the business. This generally equates to more than 500 hours in a business year. This is true no matter what form of entity the taxpayer chooses to operate in – sole proprietorship, partnership, LLC or S corporation. The one exception to the rule pertains to rental losses for property in which the taxpayer “actively” participates. The active standard is a low bar, easy to achieve standard that simply requires some involvement on the behalf of the property owner.
Assuming the property owner meets the active participation standard, losses of up to $25,000 are deemed eligible for deduction, subject to an income threshold test. If the taxpayer’s Adjusted Gross Income (excluding the rental loss) exceeds $100,000, the $25,000 amount is reduced by 50 percent of the amount by which adjusted gross income exceeds $100,000. Thus, at the $150,000 Adjusted Gross Income level, no deduction of rental losses are permitted whatsoever. This is truly social engineering at its finest, exemplified in the heads I win, tails you lose attitude of the government. If you have a profit in real estate, pay tax. If you have a loss, “Sorry Charlie! – not deductible.”
Assuming the taxpayer can prove material, significant or active participation (all three of these words are tax terms with their own sets of rules and meanings, coming into play based on the circumstances at hand), the taxpayer must next prove that he/she is “at risk.” At risk simply means that you have invested capital that could be lost or that you are liable on recourse debt. Generally, one can’t write off losses that exceed one’s economic loss. So, gone are the days of the tax shelter when a taxpayer would invest $1,000 in an investment that generated $10,000 in losses on which the taxpayer had no personal liability. If a creditor, bank or third party can chase you and hold you liable, you probably qualify to utilize the loss. Form 6198 is generally required to be filed for cases in which losses are present. I generally see the form on the individual’s return where losses from S corporations and partnerships (this usually includes LLCs) are present.
Capital gains and losses, interest income and dividend income can also form an integral part of one’s tax return. So, too, can the infrequent sale of one’s principal residence.
Dividends are classified as ordinary or qualified. Those that are deemed “qualified” are taxed at 15 percent. Most dividends paid by publicly traded corporations are deemed qualified. Ordinary dividends, most frequently seen as money market fund dividends, are taxed at whatever incremental tax bracket the taxpayer falls in.
The taxation of interest income is rather mundane. Interest income is not looked on as favorably as dividend income from a tax standpoint. Other than municipal bond interest, which is not subject to tax, interest is taxable at one’s full incremental tax bracket. Since tax brackets go as high as 35 percent, “qualified” dividends, on which tax maxes out at 15 percent, are vastly better planning vehicles.
Interest income also includes the infamous “Original Issue Discount,” most frequently seen where zero coupon bonds are held. The 1099 that the taxpayer receives generally spells out the interest as “OID,” an abbreviation of Original Issue Discount. OID represents the hidden intrinsic interest element in debt securities that are purchased at a discount. U.S. savings bonds are good examples of OID instruments. A $25.00 bond is purchased for $18.75. As the interest germinates, the bond rises in value from $18.75 to $25.00. The $6.25 is interest income. The annual accrual of the interest is subject to income tax even though the taxpayer may not actually see or get to touch the appreciation. The interest is deemed to be “imputed,” a tax term. While the tax law contains an exception to the OID rules for savings bond interest (taxpayers are permitted to pay tax at maturity on all of the interest that has accrued in the U.S. savings bond). This option is not available for OID on corporate securities. Thus, the deemed interest is taxable annually.
Capital gains and losses are not as plain vanilla as interest and dividends. One needs to know the selling price, the cost, the holding period and the type of asset. Long-term capital gains are gains on those capital assets that were held over a year. The rate on most long-term capital gains is a very favorable 15 percent. The long-term capital gains rate on collectibles (stamps, coins, art, etc.), however, is 28 percent and the long term capital gains rate on depreciation recapture on real estate is 25 percent.
It is beyond the scope of this article to delve into options, commodities and straddles. Suffice it to say that if the taxpayer is playing in this lofty arena, there are a lot of tax implications and a meeting with a knowledgeable CPA is warranted.
If selling a principal residence at a gain, the gain may well be non-taxable. For a property held over two years, the first $250,000 of gain for a single or head of household taxpayer and the first $500,000 of gain for a married filing joint taxpayer is tax-free.
The key here is the two-year holding period. This is not pro-rated. You either meet the two-year holding period or you don’t.
However, there are exceptions to this rule for compelling circumstances. The IRS interprets these circumstances liberally. For example – the birth of a child, divorce, combining multiple families, severe financial setback, loss of a job, family health reasons, etc. In these extraordinary situations, a proration of the aforementioned $250,000 and $500,000 exemptions is permitted. The number of months the property was owned divided by 24 (for months in two years) times the exemption will be the amount of gain not subject to tax.
Now, in keeping with the subject of this article, some tax-saving tips. First and foremost, always max out your allowable retirement plan contributions. If the employer matches your contributions, that is just icing on the cake and makes the deal that much sweeter. Regardless, however, retirement plan contributions come off the top. They reduce your Adjusted Gross Income and are a deduction from income whether or not you itemize.
IRAs can be set up until April 15. SEP plans can be set up until the date of filing, including extensions. Thus, it may well be possible to set up a SEP plan on October 15, 2008, and deduct it on one’s 2007 tax return. Most other plans (401K, SIMPLE, profit sharing, defined benefit plans, etc.) are required to be set up on or prior to December 31 of the subject tax year.
The next fertile area of tax savings lies in the area of depreciation. With proper planning, it may be possible to get double the bang for your buck. One dollar of depreciation can save 15.3 percent of Self Employment Tax while concurrently saving income tax. When factoring in state income taxes, where applicable, one could well save more than 50 cents on the dollar. The law allows expensing of assets. For 2007, up to $125,000 of equipment can be written off (i.e. expensed) immediately. Taxpayers can also use accelerated depreciation methods, like double declining balance. For 2007, leasehold improvements can be written off over 15 years. That is a huge break that was scheduled to sunset on December 31, 2007. Thereafter, the depreciable life reverts to 39 years.
One word of caution regarding depreciation – If you don’t need it, don’t take it. The essence of tax planning is paying the least amount of tax over the longest period of time. Never waste deductions in the 10 percent and 15 percent brackets. If you do, when you sell your business you will rue the day. You will then find yourself with gains on the sale and having to contend with depreciation recapture. If, this comes to pass, you will pay substantially higher tax rates than the rate at which you initially benefited. Overindulgence in sheltering is tantamount to frittering away those deductions.
Taxpayers often err when attempting to deduct automobile expense. However, it is rather straightforward. What the IRS looks for is 100 percent predictable. They want an auto log. Render unto Caesar what is Caesar’s. If the IRS wants it, give it to them. I would urge you to maintain it daily. However, there is nothing wrong with putting it together after the fact, as long as it is not a fabrication. One’s calendar, bank statements, repair and supplier bills, etc. will enable you to accomplish this.
The law is simple. Home to office and office to home is deemed commuting. “Commuting” is not deductible. On the other hand, home to Costco and Costco to the store, home to bank and bank to the store, home to post office and post office to the store – all deductible. Store to soap supplier and then to home – fully deductible. Mileage to the office supply store, janitorial supplier, repair companies, laundry seminars, to one’s CPA or payroll service or insurance agent – all deductible.
The IRS allows one to deduct actual auto expenses or use the standard mileage rate method. For 2007, that rate is 48.5 cents. If using the actual expense method, gasoline, repairs and maintenance, tires, car washes, insurance, auto club membership, auto lease expense, depreciation, amortization of extended warranty costs and interest on auto loans all qualify. Only a percentage of the actual expenses are deductible – the business percentage. The business percentage is nothing more than the mileage reflected in one’s log divided by the total miles driven for the year. Try it both ways – the standard mileage method and the actual expense method to see which yield the highest deduction.
I have chosen to omit an in depth discussion of Alternative Minimum Tax (“AMT”) due to the difficulty in avoiding its clutches. The mere payment of state income taxes and real property taxes is sufficient to subject one to the AMT. So is one’s fertility. My client with seven children fell into AMT due to the number of exemptions he had, rather than his modest income. The main controllable input to AMT is depreciation. A portion of accelerated depreciation is subject to the AMT. Thus, this section should be read in conjunction with the aforementioned discussion on depreciation. By electing straight line depreciation or a slower form of accelerated depreciation, it is possible to avoid the tax preference that is a byproduct of that depreciation. One word of caution on AMT that is not widely disseminated by the media: Interest on a home equity line is subject to AMT, unless the taxpayer can prove that the underlying borrowings were used for improvement of the residence. So, the government allows the deduction for regular tax purposes but not for AMT.
A word on interest expense before I conclude. The airwaves and newspapers continuously blare out erroneous information. If borrowed funds have been used in your business, you probably have deductible interest expense. It is irrelevant whether they were borrowed on a credit card or on a personal bank loan. The use of the funds dictates their deductibility, not the source.
Finally, beware of the “Kiddie Tax,” a nefarious fiction created by Congress. Starting in 2008, if you have a child under 24 who is a full-time student whose earned income (salaries and wages and self-employment income) provides less than 50 percent of his/her own support, all of the child’s interest and dividend income, as well as capital gains, will be taxed at the parents’ top marginal rate. The child gets a standard deduction of the greater of $850 or $300 plus the amount of earned income, not to exceed the regular standard deduction ($5,350 for 2007 and $5,450 for 2008). For the year 2007, the operative age is 18. Thus, for 2007 only, amounts earned by children over 18, regardless of their dependency status, are taxable at their own tax rates.