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Tax Tip: Deducting Sales Taxes

Sales taxes are generally not deductible, unless paid in connection with a qualified business expense.  Even in a business context, sales taxes paid for the purchase of a capital asset must be added to the cost of the asset and are recaptured through depreciation.

In the 2010 Tax Relief Act, Congress extended a provision that allows individual taxpayers to claim a sales tax deduction in lieu of deducting state income taxes.  This provision is allowable for tax years 2010 and 2011.  Frequently, it is only beneficial to taxpayers who reside in those states that do not have a state income tax. 

The deduction amount is determined by either (1) accumulating actual receipts showing general sales tax paid or (2) using IRS tables.  The tables are published in the instructions to Schedule A (Itemized Deductions).  You can also click here and go to an IRS link that will calculate the deduction for you.  The deduction tables are based upon your state, the number of exemptions claimed on your tax return, and your income.  Carefully review the instructions for calculating your income.  Income for this purpose is your adjusted gross income, plus certain nontaxable income such as tax-exempt interest, nontaxable Social Security benefits, worker’s compensation, etc.

Taxpayers who use the IRS tables can also add the sales taxes paid for certain large purchases, such as vehicles, boats, motorcycles, RV’s, etc.   If you made a substantial purchase of one of these items in 2010, you may receive a larger benefit from claiming the sales tax deduction in lieu of state income taxes, especially if your state income tax liability is not that large. 

You must personally pay the expenses in order for the tax to be deductible. This provision may eliminate a potentially large benefit to taxpayers who engaged in a substantial construction project.  The sales taxes on construction materials are often paid by the contractor, which would prevent you from claiming the deduction.

Some of what Congress gives, they also take away.  Keep in mind that no taxes are deductible for the alternative minimum tax.  Thus, your benefit may be reduced or eliminated as a result of the alternative minimum tax.

Sales taxes paid on personal purchases have generally not been deductible since 1986.  Congress added a benefit in 2005, which was primarily targeted towards those individuals living in states without a state income tax.  Although set to expire in 2009, the provision was extended through 2011. 

No matter where you live, if you made large purchases in 2010 and can document the sales taxes paid, you may benefit from the sales tax deduction.

Tax Tip: Mortgage Interest Deduction

If you have a mortgage on your personal residence, you’re probably well aware of the mortgage interest deduction, but like many tax provisions, a simple rule can be complex.  There are many factors involving the deductibility of mortgage interest. 

Generally, you are able to deduct the interest associated with $1 million of acquisition indebtedness and $100,000 of home equity debt.  The interest can relate to your principal residence (as defined) and one other residence you select. 

Some of the requirements for deducting the interest associated with acquisition indebtedness are as follows.

  • Acquisition debt is associated with acquiring, constructing or substantially improving a qualified residence.
  • The debt must be secured by the residence.  Not a problem if you borrowed money from a financial institution, since they will definitely secure their mortgage.  However, if you borrowed money from a family member, your loan document may not state that the loan is secured by the property.
  • You must own the property on the debt you are paying and must personally make the payments. For example, if parents pay the mortgage for their children, the interest isn’t deductible by either of them.

The following are some of the rules related to deducting interest on a home equity loan.

  • The home equity loan can’t exceed the equity in your house.  You generally can’t borrow more than the value of your home, but this could be problematic given the recent decline in real estate prices.
  • The proceeds from a home equity can be used for any purpose, except to purchase tax-exempt securities. 
  • Interest associated with proceeds used for purposes other than for a residence may be subject to the alternative minimum tax.

Mortgage points are generally deductible when paid for an initial loan to purchase a property.  Points paid upon the refinance of a mortgage must be amortized over the life of the new loan.

The IRS is very strict in apply the $1 million acquisition and $100,000 home equity debt limits.  However, the Service issued a ruling in 2009 in which they stated that acquisition indebtedness in excess of $1 million to acquire, construct or substantially improve a residence could be considered home equity interest.  Thus, taxpayers could deduct interest on $1.1 million of acquisition indebtedness without having to take out a separate home equity loan.

As you can see, a simple deduction has rather complex requirements.  If you have an unusual situation or are unclear about the tax rules, you should consult a tax professional.  A mortgage interest deduction can drastically reduce your tax bill, but it can also be quite costly if your deduction is disallowed.

Tax Tip: Self-Employed Health Insurance

While the debate over health care and health insurance continues in the U.S., there is one thing we call agree on… health insurance is expensive.  If you are paying for health insurance, any tax benefits you receive will help reduce the effective cost of your coverage.

A majority of people in the U.S. receive their health insurance coverage as a tax-free employee fringe benefit.  You may contribute to the expense, but the portion your employer pays is typically tax-free to you.  In order to attain parity between an employer and someone who is self-employed, self-employed taxpayers are allowed to deduct 100% of their premiums in calculating their adjusted gross income.  While it may seem logical and fair, it was not always this way.

In order to take the deduction, you must have self-employment income equal to or greater than your health insurance premiums.  Your salary, wages, interest, dividends, pension and other income are not considered self-employment income.  Thus, the portion of insurance you are contributing to your employee benefits and premiums you are paying while unemployed do not count.  The premiums may be deductible as an itemized deduction, but they do not qualify for the self-employed health insurance deduction.

There are a couple of changes that can affect your 2010 tax liability.

  • Your health insurance premiums are treated as a deduction for calculating your net self-employment income, which will reduce the self-employment taxes you pay.  This benefit is only applicable for 2010, unless otherwise extended by Congress.
  • The IRS has determined that Medicare Part B premiums can be treated as self-employed health insurance premiums.  Thus, if you are over 65 and are having Medicare Part B premiums deducted from your Social Security check, you can deduct the premiums if you have net self-employment income greater than or equal to your Medicare Part B premiums.
  • After March 30, 2010, any premiums paid for a child who is under age 27 will qualify for the deduction.
  • After March 30, 2010, the deduction is not allowed for anyone who is eligible to participate in any subsidized health insurance plan for themselves, their spouse or dependent (i.e., you can’t deduct your portion of the premiums paid as part of a subsidized employer health plan).

If you are self-employed or have self-employed income, the self-employed health insurance deduction may help reduce the cost of maintaining health insurance coverage.  The tax savings may not make get you over the affordability hump, but if you are paying, you might as well take advantage of whatever tax breaks you can.

Tax Tip: Self-Employment Taxes

Self-Employment taxes are Social Security and Medicare taxes.  If you are an employee, half of the taxes are withheld from your paychecks and the other half is paid by your employer.  If you are self-employed, you get to pay all of the taxes yourself.   Lucky you.

Self-employment taxes are assessed upon your net self-employment income over $400.  Without delving into all of the various types of self-employment income, it basically means being paid for your hard work and efforts.  It does not include interest income, dividends, capital gains, pensions or other investment income.  Some of the common forms of self-employed income include:

  • Net earnings from a trade or business
  • Consulting and director fees
  • Tips
  • Payments for any services you provide to another person (e.g., maintenance, repairs, cleaning)
  • Pass through income from a partnership or limited liability company

A portion of your self-employed income may be reported to you on a 1099-MISC or a partnership Schedule K-1, but it’s highly likely that some self-employed income won’t be reported to you.  The income is taxable to you even if you don’t receive a 1099, Schedule K-1 or other tax reporting statement, and getting paid in cash doesn’t mean you don’t have to report the income.

Just like an employee, the tax is divided between Social Security and Medicare.  The Social Security tax portion is assessed at 12.4% on the first $106,800 of income for 2010 and 2011.  Since there is no cap on Medicare earnings, you’ll pay 2.9% on all of your self-employed income, no matter how high it goes.  The good news is that you get to deduct half of the self-employment tax in computing your adjusted gross income.  The bad news is that if you’re married, you and your spouse are subject to the tax separately.

There is one taxpayer favorable provision that you want to take advantage of in 2010.  For this year only, you can deduct your self-employed health insurance premiums in determining your net self-employed income.  It’s a one-year benefit, unless Congress decides to extend it.

Special rules can apply to farmers, real estate professionals, ministers, and investors.  It can get complex rather quickly, and the myriad of potential issues are beyond the scope of this article.  If you have questions or wonder if certain income is subject to self-employment taxes or exempt, you should consult a tax professional. 

With an effective tax rate that can be over 15%, self-employment taxes add up quickly.  Better to get it right, than be surprised with an unexpected tax bill later.

Burdensome 1099 Tax Reporting

The tax gap is the deficiency between the amount of tax that should have been paid and the amount that is voluntarily reported and paid by taxpayers.  The IRS estimates the tax gap to be $350 billion annually.

Underreporting of income is a primary contributor to the tax gap.  Form 1099 reporting is one of the mechanisms the IRS uses to ensure that taxpayers report income they receive.  A 1099 is issued by the payer to the payee.  The IRS will match the income reported on the taxpayer’s return with the 1099, and a discrepancy will generate a notice. 

A Form 1099-MISC must be filed to report the payment of more than $600 for compensation for services.  This would typically involve people who perform independent and subcontract services (e.g., contractors, lawyers, consultants).  Payments to corporations for these services were exempt from 1099 reporting.

For years the IRS has advocated for an expansion of the reporting requirement to include corporations.  Not only did Congress act upon the suggestion last year, they expanded it. Included in the Patient Protection and Affordable Care Act (aka Obamacare) was a requirement for any business to issue a 1099-MISC to any person or entity for the purchase of more than $600 of goods or services during a calendar year, starting in 2012.

Under the old rules, a taxpayer had to track payments made for services rendered by nonemployees.  The new requirement will force businesses to track the purchase of goods and services.  For instance, if you purchase more than $600 of office supplies, lumber or gas from one retailer throughout the year, you must issue a 1099-MISC.  Imagine the paperwork and administrative nightmare this creates for any business to comply with these rules.

Not surprisingly, this expanded requirement has generated a tremendous firestorm of criticism, especially amongst small business owners.  This provision is supposed to generate $17 billion of revenue over ten years, but I doubt anyone quantified the cost of compliance, both for the IRS and for taxpayers. 

Personally, I think the net revenue generated from this provision is greatly overstated.  It might generate $17 billion in new revenue, but the IRS could easily spend more than that amount just to process the mountain of forms that will be filed.  

It’s been rather humorous to watch the politicians handle this issue.  Congress included this provision in the healthcare bill and President Obama signed it, yet over the past six months, there has been a parade of politicians, including the President, who have talked about how bad this requirement is for business and the need to get it reversed.  It’s funny; the same people who created the requirement are now championing its repeal.  Only in Washington is this considered normal.

Despite months of clamoring, Congress still hasn’t repealed this reporting requirement.  Last week, the Senate added it to a bill dealing with modernization and safety issues of the Federal Aviation Administration.  Most commentators and professionals expect it to be repealed; it’s just a matter of when.  I think Congress knows they will eliminate it too, which is why they aren’t rushing to pass the repeal.

To me, it’s just another example of the dysfunction that is prevalent in our nation’s Capitol.  They know it’s bad, and they know they’ll eliminate it.  Rather than having a simple vote to repeal the rule and move on to other business, it gets dragged out for months and wrapped into some political deal.  I ask… what does 1099 reporting have to do with a safety bill for the FAA?

The expansion of the 1099 reporting was a poorly conceived idea with little consideration of the real world compliance implications.  It never should have been enacted, and I expect it will be repealed this year.  If you’re a business owner, you can be thankful that this is one tax reporting requirement you’ll never have to comply with, but the sooner you know for sure, the better.

Is It Bad to Pay Income Taxes?

I’ve been in the tax business for over 20 years.  Having dealt with scores of clients, I’ve talked with all kinds of people and dealt with a myriad of situations.  Although people may accept the requirement and necessity to pay taxes, there is a general disdain for paying taxes and filing tax returns.

I often hear people bemoaning the amount of taxes that need to be paid.  You may have heard someone say that they don’t want to make more money, because they’ll have to pay more taxes.  My response to that statement is rather blunt… that is stupid.  Sorry, if I’ve offended you, but let me explain why I was so brash in my comment. 

As I tell my clients there are worse things in the world than paying taxes.  Income taxes are assessed on income.  Thus, there is a general premise that you must earn income to require the assessment of taxes.  If you don’t pay taxes, it means you aren’t making money. Think about this… if you paid any taxes in 2008, you probably paid more taxes than Ford, General Motors, Chrysler and many of the big U.S. banks combined.  All of those companies lost billions of dollars in 2008.  As they were fighting for their survival, paying income taxes was not the most important concern of the executives, employees and shareholders.

With the extension of the Bush tax cuts, the top federal rate is 35%.  Add in state, local and Social Security taxes, and your top marginal tax rate could be 50-55%.   Even if your rate is 50%, you get to keep 50% of what you make.  Thus, for every extra dollar you make, you have 50 cents to spend.  As long as the tax rate is less than 100%, you will still come out ahead if you make more money and pay taxes. 

Many years ago, one of my wealthy clients told me that he was privileged to pay $1 million in taxes each year.  At the time, he was making over $2 million.  Although he lost over one-third of his income to taxes, he still had more than $1 million to spend.  Would you prefer make $50,000 a year and pay no tax or be in his situation?

Granted, you would probably like to pay less in taxes, as would my client who paid the $1 million, but that is a different discussion. 

The simple fact is that our government raises part of its revenue by levying an income tax.  You may not like the amount of tax that you pay, but there are worse things than paying taxes.  Furthermore, the more that you more you make, the more you pay, and as a result the more you pay, the more you have to spend.

Thus, I am of the opinion that paying income taxes is a good thing.

2010 Tax Return Delay

The IRS has announced that it will delay the processing of certain 2010 tax returns as a result of the tax legislation passed by Congress on December 16, 2010.  As mentioned in a prior article, there is a cost to business owners and taxpayers for Congress’ delay in reaching a compromise.  You may be thrilled with the tax benefits of the legislation, but you may not be pleased about having to wait to file your 2010 tax return or receive your tax refund.

The following taxpayers are affected by this delay:

  • Anyone who files a Schedule A for itemized deductions
  • Taxpayers claiming a deduction for higher education tuition and fees
  • Teachers claiming a $250 deduction for educational supplies
  • Taxpayers claiming a casualty loss
  • Residents of the District of Columbia claiming a first-time homebuyer credit

The delay is a result of the time it will take the IRS to re-program their computer system to incorporate certain provisions enacted by the bill. The IRS expects to be able to process these returns by the end of February.

According to the IRS, approximately 142 million returns were filed in 2008 (the most recent statistics available), and 48 million taxpayers claimed itemized deductions.  Using these stats, one-third of taxpayers can’t file their return until mid to late-February, even if they have their returns complete.

Granted, many people claiming itemized deductions don’t have all of their information gathered or have their returns prepared by this date.  However, for those who do, this is an added aggravation to an already unpleasant task.

Unfortunately, there isn’t much you can do about it, except to wait and check the IRS website for updates.

There is more bad news.  Since many of the provisions from the tax bill will expire at the end of 2012 (another election year), this whole process will probably be repeated again in two years.  These tax provisions make great campaign fodder, so you can expect Congress to replicate this asinine behavior.  It’s sad commentary that once again, the American taxpayers are paying the price of political posturing.

Taxing Rich People: Who Are They?

The debate in Washington rages over whether or not to extend the Bush tax cuts.  Essentially, the debate has come down to whether or not to extend lower tax rates to those individuals in the highest marginal tax bracket. 

President Obama wants the tax rates to increase for individuals making more than $200,000 and couples making over $250,000.  It’s an interesting choice of words.  Presently, tax brackets are determined by taxable income, which is your adjusted gross income less deductions (e.g., mortgage interest and charitable deductions).  By referring to income, is he referring to taxable income or adjusted gross income?

Aside from that question, the debate is centered around taxing the “rich” people.  Some opponents have argued that targeting the wealthy is a form of class warfare.  However, it’s widely understood that we have a progressive tax system, and the more you make, the more you pay.

If you’re going to tax the rich, it’s good to understand who they are.  Being rich is a relative term.  One person’s idea of being rich is quite different than another.  For my grandparents, $100,000 was a fortune, but some people will spend more on a car.  Being rich can also vary dramatically depending upon where you reside.  Making $200,000 a year in west Texas is vastly different than making $200,000 living in Manhattan.

If you consider that one-third of the world lives on less than $2 per day, every American is rich.  In short, most people don’t feel rich. Thus, when we advocate taxing the rich, we’re typically thinking of someone else.

In the debate about extending the Bush tax cuts, a viewpoint of who is rich is an important consideration. President Obama argues that those affected can afford to pay more, and the increased taxes won’t affect their spending.  The proponents of extending the lower rates believe that the government will be taking money away from business owners and entrepreneurs who may invest those dollars into business ventures that will help stimulate the economy.

When thinking of rich people, A-list celebrities and names like Gates, Buffet and Rockefeller often come to mind. You imagine people who live in mansions, travel, shop and generally life a life of leisure. In the world of the rich and famous, paying extra taxes has little impact on their lifestyle.  While these people exist, they are by far the minority of the “rich” people who will be affected by the pending tax increase.

A large majority of the people who are in the highest tax brackets are people who own businesses.  If you look at the IRS statistics, S Corporations and partnerships comprise the majority of all business tax returns filed.  S Corporations and partnerships do not pay taxes at the entity level.  The taxes are paid by their owners.  Thus, the income of the business is included in the owners’ returns, but income doesn’t necessarily equate to cash in the owners’ pocket.  It’s common for the business to retain money for working capital and expansion.

This is the crux of the issue.  The more money the business pays in taxes, the less that is available for economic growth.  An increased tax burden probably won’t put the company out of business, but it might keep the business from hiring additional employees or purchasing new equipment.  Since the government is attempting to spur economic growth and reduce unemployment, whatever hinders business growth is counterproductive to this goal.

Assume a person makes $1 million a year and pays an additional 5% of taxes, which is $50,000.  If the person has the $1 million in cash for their lifestyle, the extra $50,000 of taxes paid probably won’t make a huge difference in their spending.  However, if the $1 million of income is the profit from a business, the extra $50,000 of taxes could be the equivalent of another full-time employee. 

In the debate over extending the Bush tax cuts, I think it’s important to know who is going to be affected by the tax changes.  I believe Congress has a bias in their understanding.  If you look at the background of the members of Congress, very few are business owners or entrepreneurs.  Therefore, I think they have a distorted view of the impact that increased tax rates have on behavior.  Based upon their characterization of wealthy people, it seems most of them think wealthy people have trust funds and large investment portfolios, rather than entrepreneurs running a business.

If it’s all about lifestyle, then the additional taxes probably won’t have much of an effect, but if it’s money associated with operating a business, extra taxes may mean slower expansion and few employees hired.

Who are the rich people?  Hopefully it’s you.

Lame Duck Session and Bad Tax Policy

The 111th Congress resumes session today.  With the recent mid-term elections over and a significant shift of power coming in January, this session has been dubbed a lame duck session.  A lame duck isn’t supposed to accomplish much, yet Congress has a lot of unfinished business and little time.

Two of the biggest issues Congress needs to tackle are the 2011 budget and taxes.

The U.S. Government started a new fiscal year on October 1, 2010, yet none of the 13 appropriation bills that govern federal spending have passed both houses of Congress.  To keep the government from shutting down, Congress passed a continuing resolution that allows federal agencies to continue spending based on the 2010 budget.

The other major issue that has dominated the political discourse for months is the scheduled elimination of lower tax rates, otherwise referred to as the “Bush tax cuts.”  The biggest point of contention is whether or not the lower tax rates should be extended to high income taxpayers (i.e., individuals earning over $200,000 and couples earning over $250,000). 

I will explore the arguments of maintaining the Bush tax cuts in subsequent articles.  Today’s topic is the political process and poor tax policy that is likely to result.

When the current tax rates were enacted in 2001 and 2003, they were scheduled to sunset at the end of 2010.  Thus, if Congress does nothing, tax rates and brackets will revert back to the rules that were in place at the end of 2000. It will literally take an act of Congress to extend the current rates beyond December 31, 2010. 

You may have your opinion of whether or not this is good for the country or the economy.  Irrespective of that issue, it’s bad tax policy to wait until the last minute to make a decision.

Congress has known for at least 7 years that the current rules would expire, but they have not acted.  In my mind, it’s a travesty that we are 46 days away from a new year and no one knows what the rules will be.   That may not seem like a big deal, but it is very challenging for business owners, managers and entrepreneurs, who are planning months or years in advance.  Many of my clients have been asking me for months what tax rules will change in 2011.  All I could tell them was that no one knows, and with six weeks to go, we still don’t know. 

With so much to do in a matter of a few days, I question the veracity of the decisions Congress will be making.  Will they be casting votes for what’s best for the country and the economy, or will their votes be primarily based upon politics and the desire to get out of town quickly?  Granted, these issues are always part of the process, but deferring these major issues to the lame duck session has created more pressure than was necessary.

Tax policy and the 2011 budget affect every person in the nation.  To postpone these major decisions and deal with them in a lame duck session is an indictment of political leaders from all political parties and persuasions. 

Over the past year there has been a lot of frustration with the political process.  Politicians will argue the process is not important, but that’s not true.  The Founding Fathers created a process that was designed to generate good legislation for the nation.  A poor process results in poor legislation.  Additionally, the process is a reflection of the culture of Washington.  Passing major legislation that affects every American in a lame duck session, is an indication that the legislative process is not functioning well, which will result in poor financial decisions and bad tax policy.

The Economic Impact of Tax Uncertainty

Congress has adjourned session for the 2010 midterm elections.  Facing an anti-incumbency mood and a lingering recession, you can understand the urgency for Congress to get out of Washington. 

Unfortunately, they left town without addressing some important issues.  The U.S. government starts a new fiscal year today.  There are 13 different appropriation bills that determine how the government is going to spend money in the coming year.  None of them have been enacted into law.

Additionally, there is the matter of what is going to happen to tax rates on January 1, 2011.  The tax rates that were implemented in 2001 (i.e., the Bush tax cuts) will expire on December 31, 2010.  If Congress does nothing, taxes rates will revert to the 2000 levels, resulting in a tax increase for all taxpayers.

You may have opinions about whether the current tax structure should be extended, allowed to expire or some combination thereof.  There are lots of political and economic issues, ideas and opinions of what is best.  Aside from these issues, one this is clear, uncertainty is not helping people.

My clients continually ask what is going to happen, and all that I can say is that no one knows.  It’s impossible to predict what will happen, if anything, in the lame duck session.  Based on my experience, one thing is clear; the continued ambiguity is not good.  A natural human response to uncertainty is to delay action, while you try to gain clarity and minimize risks.

This certainly applies to business decisions.  It’s hard to commit to aggressive expansion or major capital expenditures, if you don’t know what the future holds, and waiting is probably not beneficial for the overall economy.  As a tax advisor, I’m advising people to delay certain decisions and actions.  From a tax perspective, postpone your decision if you can, which is what a lot of people are doing. 

There is always uncertainty in life, business and taxes.  However, Congress has created a level of unnecessary angst.  This situation wasn’t suddenly sprung on them.  They have known for 10 years that the Bush tax cuts would expire, yet they continued to defer action.

President Obama and the Members of Congress lament the slow pace of economic recovery, but do they recognize that some of their actions are not contributing to a recovery?  To the extent that their inaction on tax policy creates uncertainty, which slows economic growth, they have no one to blame but themselves.

The lame duck session won’t start until November 15th.  Thanksgiving is just 10 days later, which will mean another recess.  In all probability, Congress won’t resolve the tax question until December, less than 30 days before the end of the year; not much time to plan and prepare for the coming year.

Payroll administrators are concerned with their ability to update software in time for the changes that will need to be implemented by January 1.  Do you assume that rates will go up and start programming for those changes?  If the law changes in December will you have time to re-program everything for the new law?  Do you invest time and resources planning for something that may not happen?

Elections are important and Members of Congress should have time to campaign.  However, they should also be responsible enough to complete their work in a timely manner. Not all decisions are easy or popular, but that’s what they are elected to do.  Their inaction on the appropriation and tax bills may be good for their political careers, but it’s bad for taxpayers, the economy and the country.