Inheritances Can Be Tricky

If you have received an inheritance or anticipate receiving one in the future, this article may answer many of the questions you might have. The process of claiming an inheritance can be quite complex, and it helps to understand the basics and be aware of potential tax liabilities. NOTE: Special rules, not covered in this article, will apply if the decedent’s death occurred during 2010 and the executor elected to apply the “no estate tax” rules available at that time (usually this occurred only if the estate was valued at more than $5 million). If you are a beneficiary under this condition, the executor should provide you with additional information as to the basis of the property you inherited.

An inheritance is generally received after all applicable taxes have been paid, along with any outstanding liabilities the decedent may have had. Exactly how the estate is handled will depend upon whether the assets were owned individually or in a trust. Without going into the intricacies of estates, trusts, and probate, the result for a beneficiary will generally be the same. Inherited items on which the decedent had already paid taxes and which the estate tax (if any) has been paid will pass to the beneficiary tax-free. On the other hand, items of income that have not previously been taxed to the decedent, as well as any appreciation or depreciation of assets acquired from the decedent, will have tax implications. Some possible scenarios are provided below:

• Bank Account – Take for instance, an inherited bank account worth $25,000, where the funds are not immediately distributed to the heir. The $25,000 account earns $375 of interest income after the decedent’s date of death. Out of the $25,375 that is received, the $25,000 is tax-free but the $375 is taxable as interest income. Any future earnings on the $25,000 inheritance are also taxable.
• Capital Asset – The basis for gain or loss resulting from the sale of an inherited capital asset, such as stock, real estate, collectibles, and so forth, is generally based on the value of the asset at the time of the decedent’s death. That is one reason that qualified appraisals are so important.

To explain this further, let us assume that a vacant parcel of land is inherited, with a date of death appraisal that values it at $15,000. If that property is sold for a net price of $15,000, there will have been neither gain nor loss and the $15,000 is tax-free to the beneficiary (the transaction, however, must still be reported by the beneficiary on his or her tax return). If, on the other hand, the net sales price is more or less than the $15,000, there would be a reportable capital gain or loss. For capital gains tax purposes, the holding period is important. Assets held for over one year are generally taxed substantially less than those held for shorter periods of time are. However, for inherited property, the beneficiary receives long-term treatment immediately, whether or not the decedent or the beneficiary has held it for over one year. If there are expenses associated with selling the asset, then those expenses are deductible in calculating the gain or loss.

• IRA or other Qualified Plan – Suppose the decedent had a traditional IRA account and the distributions from that account were taxable to the decedent. If you were to inherit that account, the distributions would be taxable to you as the beneficiary. Why is that? Because the decedent never paid taxes on the income that went to fund the traditional IRA, and therefore you, the beneficiary, will be stuck with the tax liability. The good news is that there are options for payment over a number of years, which can soften the tax blow.
• Life Insurance Proceeds – Generally, the proceeds from a life insurance policy are tax-free to the heirs. However, if the policy is not paid immediately, as most are not, the insurance company will include interest. That interest is taxable to the heirs.
• Annuities and Installment Sale Notes – If the decedent purchased an annuity or had an installment sale note from the property he previously sold, the decedent’s basis would be tax-free but the heirs would be obligated to pay the tax on any amount received in excess of the decedent’s basis. For an annuity, the decedent’s basis would be what he or she paid for it. For an installment note, payments include: (1) a return of a portion of the asset’s cost (basis) which is not taxable, (2) a portion from the prior sale of the asset that is taxable as a capital gain, and (3) taxable interest on the note.

A trust or estate is required to file an income tax return and to report income earned by the estate or trust after the decedent’s passing and prior to distribution of the assets to the heirs. Each heir will generally receive a form called Schedule K-1(1041), which will include specifications regarding the heir’s share of income that must be included on the heir’s individual tax return. Although infrequently occurring (because the taxes are generally higher), the trust or estate may pay the income tax on the income. The executor or trustee is responsible for making sure the required tax returns are filed, and for sending K-1s to the heirs.

There may be taxable income to the heir even though the inheritance has not yet been received. In addition, there are other factors to consider that have not been discussed.

If you have questions regarding the treatment of an inheritance you’ve received or are expecting to receive, please contact our office.

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How the Health Care Law Will Impact Your Taxes

There has been a great deal of media coverage related to the US Supreme Court upholding the Affordable Care Act, also known as the Health Care Law. The media coverage was generally political and failed to explain the details of how the law will impact individuals. If you are interested in political rhetoric as to whether it is a tax, penalty, or a forced purchase, look no further. The intent of this article is to explain how the Affordable Care Act will impact your pocketbook in 2013, when the health care taxes kick in, and in 2014, when the mandatory insurance requirement becomes effective. Here are the details for 2013:

• Increased Hospital Insurance Tax—Part of the taxes withheld on employees’ wages covers the Hospital Insurance (HI) portion of their contribution to Medicare; self-employed individuals pay the HI tax as part of the self-employment tax that is included in their tax return. The HI tax rate (currently at 1.45% for employees and 2.9% for self-employed individuals) will increase by 0.9 percentage points on individual taxpayer earnings (wages and self-employment income) in excess of compensation thresholds for the taxpayer’s filing status. Thus, the wage withholding HI rate will be 1.45% up to the income threshold noted below and 2.35% (1.45 + 0.9) on amounts in excess of the income thresholds. The hospital insurance portion of the SE tax rate will be 2.9% up to the income threshold and 3.8% (2.9 + 0.9) on amounts in excess of the threshold. The income threshold at which this increase begins is $250,000 for married taxpayers filing jointly, $125,000 for married taxpayers filing separately, and $200,000 for all other taxpayers. Impact: Higher income working families.For married taxpayers, this additional tax is based upon their joint income. However, if both spouses work, their employers will only base the withholding on the employee’s individual earnings. Thus, married taxpayers who both work may find themselves under-withheld on HI taxes and will therefore be required to pay the uncollected HI tax on their income tax return when it is filed. They may need to take steps to increase income tax withholding or pay or increase estimated taxes in order to compensate.
• Surtax on Unearned Income—A new surtax called the Unearned Income Medicare Contribution Tax is imposed on the unearned income of individuals, estates, and trusts. For individuals, the surtax is 3.8% of the lesser of:
1. The taxpayer’s net investment income or
2. The excess of modified adjusted gross income over the threshold amount ($250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others).
   
   "Net” investment income is investment income reduced by allowable investment expenses. Investment income includes income from interest, dividends, annuities, royalties, rents (other than those derived from a trade or business), capital gains (other than those derived from a trade or business), trade or business income that is a passive activity with respect to the taxpayer, and trade or business income with respect to the trading of financial instruments or commodities. For surtax purposes, modified adjusted gross income does not include excluded items, such as interest on tax-exempt bonds, veterans' benefits, and excluded gains from the sale of a principal residence. Impact: Higher income families.In order to avoid or minimize this new tax, higher income taxpayers may wish to alter their investment portfolios to include more of the non-taxable investments mentioned above.
   
   Homeowners should be aware that the gain from the sale of their primary home in excess of the homeowner’s gain exclusion or gain from selling a second home is treated as investment income and would be subject to this new tax.
• Deductible Medical Expenses Threshold Increases—Beginning in 2013, for taxpayers under the age of 65, the AGI threshold percentage for claiming medical expenses on a taxpayer’s Schedule A will increase from 7.5% to 10%, which is the same as the current threshold percentage for alternative minimum tax (AMT) purposes. Individuals (and their spouses) age 65 (before the close of the year) and older will continue to use the 7.5% rate through 2016. Thus, it may be appropriate to pay outstanding medical bills or pre-pay such things as orthodontics for a child before the AGI threshold increases to 10%. In addition, if you are considering elective deductible medical procedures, such as laser eye surgery, it may be beneficial to have the procedure and pay for it in 2012. Impact: All taxpayers (except seniors for now) who itemize their medical expenses.
• Employer Health FLEX-Spending Plan Contributions Limited—In order for a health flexible spending account (FSA) to be a qualified benefit under a cafeteria plan, the maximum amount available for the reimbursement of incurred medical expenses of an employee, the employee's dependents, and any other eligible beneficiaries with respect to the employee under the health FSA for a plan year (or other 12-month coverage period) cannot exceed $2,500. Impact: All taxpayers participating in health FSAs.
  Some taxpayers or employers may wish to consider establishing Health Savings Accounts or Medical Expense Reimbursement Plans to write off newly-disallowed medical expenses as a result of the increased medical deduction AGI limitation and the reduced benefits from the employer’s health flex-spending plans.

Beginning in 2014, all U.S. citizens and legal residents, except for those who are exempt from the requirement, will have to maintain minimum essential health insurance coverage or pay a penalty. Generally, individuals who are covered by health insurance through their employers will have met the mandate. Impact: Lower income individuals and families not exempt from the requirement.

Those exempt from this requirement include low income individuals and families (for whom the cost of minimum required coverage exceeds 8% of their annual income), those not required to file a Federal tax return because their income is below the filing threshold, those who are unlawfully present in the United States, incarcerated individuals, Indian tribal members, religious objectors, and individuals with hardship waivers.

Minimum essential coverage generally includes:

• Private market plans
• Government sponsored programs (e.g., Medicare, Medicaid, Veterans Administration, etc.)
• Eligible employer-sponsored plans
• American Health Exchange “bronze” coverage (pays 60% of covered expenses)

According to the American Health Benefit Exchange, by 2014, each state must establish an Exchange to help individuals and small employers obtain coverage. Benefit options will be in a standard format, and a single enrollment form will be used for all policies. Plans offered through an Exchange must provide essential health benefits, limit cost sharing, and provide specified accrual benefits (i.e., the percentage amount paid the insurer). Out-of-pocket deductibles are limited to the same amounts as the caps for Health Savings Accounts and are further limited to $2,000 ($4,000 for families) in the small group market. Plans in the individual and small group markets use a metallic designation for the accrual benefits provided:

• Bronze 60%
• Silver 70%
• Gold 80%
• Platinum 90%

The law provides a premium assistance credit for low-income families whose household income is at least 100%, but not more than 400% of the federal poverty line, and who do not receive health insurance under an employer plan, Medicaid, or other acceptable coverage. Based upon the 2011 poverty levels, the credit would phase out at $43,560 for individuals and $89,400 for a family of four. Eligibility for the premium assistance credit will be based on the individuals income for the tax year ending two years prior to the enrollment period.

 

The credit, which will be paid by the government directly to the insurance company, is based on the taxpayer's household income level relative to the federal poverty line. The calculation is computed on a sliding scale starting at 2.0% of income for taxpayers at or above 100% of the poverty line and phasing out to 9.5% of income for those at 400% of the poverty line. The reference premium will be the second lowest cost silver plan available in the individual market in the rating area in which the taxpayer resides.

 

The penalty for individuals required to purchase insurance who fail to do so will be phased in beginning in 2014 and will be fully implemented in 2016. The penalty for noncompliance is the greater of:

• The sum of the monthly penalty amounts for months in the taxable year during which 1 or more such failures occurred, or
• An amount equal to the national average premium for qualified health plans that have a bronze level of coverage, provide coverage for the applicable family size involved, and are offered through Exchanges for plan years beginning in the calendar year with or within which the taxable year ends.

The monthly penalty amounts are based upon a complex formula (what else would one expect?) and is equal to the greater of an inflation adjusted flat dollar amount, which is $95 for 2014 and increases to $625 in 2016, or 1% of income increasing to 2.5% in 2016. However, in either case, the annual family penalty cannot exceed 300% of the individual maximum penalty for the year ($1,875 in 2016).

Household income refers to the sum of the incomes of the taxpayer and all individuals accounted for in the family size required to file a tax return for that year. Income includes all tax-exempt interest and foreign earned income.

The penalty will be included on the taxpayer’s individual income tax return for each year in which the individual has not complied with the insurance coverage requirement. Although the IRS is charged with the responsibility of collecting the penalty, the law prohibits the IRS from jailing taxpayers or seizing their property if they fail to pay it.

The foregoing is a very brief overview of the health care provisions for individuals and of how your pocketbook may be impacted beginning in 2013. However, the health care provisions not yet cast in stone. In fact, this is a hot political issue, so be sure to watch for further developments.

If you have questions or would like to schedule a tax planning appointment, please give our office a call.

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Important Due Dates to Remember in August

August 2012 Individual Due Dates

August 10 - Report Tips to Employer

If you are an employee who works for tips and received more than $20 in tips during July, you are required to report them to your employer on IRS Form 4070 no later than August 10. Your employer is required to withhold FICA taxes and income tax withholding for these tips from your regular wages. If your regular wages are insufficient to cover the FICA and tax withholding, the employer will report the amount of the uncollected withholding in box 12 of your W-2 for the year. You will be required to pay the uncollected withholding when your return for the year is filed.

August 2012 Business Due Dates

August 10 - Social Security, Medicare and Withheld Income Tax

File Form 941 for the second quarter of 2012. This due date applies only if you deposited the tax for the quarter in full and on time.

August 15 - Social Security, Medicare and Withheld Income Tax

If the monthly deposit rule applies, deposit the tax for payments in July.

August 15 - Non-Payroll Withholding

If the monthly deposit rule applies, deposit the tax for payments in July.

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What to Do If You Receive an IRS Notice

It’s a moment many taxpayers dread. A letter arrives from the IRS and it’s not a refund check. But don’t panic; many of these letters can be dealt with simply and painlessly.

Each year, the IRS sends millions of letters and notices to taxpayers to request payment of taxes, notify them of changes to their accounts, or request additional information. The notice you receive normally covers a very specific issue about your account or tax return. Each letter and notice offers specific instructions on what you are asked to do to satisfy the inquiry.

However, the letters also have to advise you of your rights and other information required by law. Thus, these letters can become overly lengthy and sometimes difficult to understand.

Here are dos and don’ts to follow if you receive correspondence from the IRS or state tax authority:

• Do immediately get a copy of the correspondence to this office so it can be reviewed and timely responded to.
• Don’t respond if the correspondence requests personal information. There has been substantial identification theft related to scam artists pretending to be the IRS or another authority, especially correspondence by e-mail. Let this office take a look before responding.
• Don’t procrastinate or throw the letter in a drawer, hoping the issue will go away. Most of these letters are computer-generated and, after a certain period of time, another letter will automatically be generated. And, as you might expect, each succeeding letter will become more aggressive and less easily dealt with.
• Don’t automatically pay an amount the correspondence is requesting unless you are positive you owe it. Quite often, you will not owe what is requested, and it will be difficult to get your payment back.

Most notices are computer-generated after comparing the income items reported on your return with those reported by the payers. For example, your employer sends you a W-2 every year and also sends a copy to the government so that your wages are on the IRS computer. Your bank sends the 1099-INT to the IRS showing how much interest you earned. Your brokerage firm reports your dividends with Form 1099-DIV and stock transactions with 1099-B forms. If you are self-employed, those who pay you $600 or more during the year are required to send you and the IRS a 1099-MISC, and if you have credit card transactions, the clearing house will issue a 1099-K. If you are retired and collecting a pension or drawing on your own IRA, a 1099-R will be sent to you. Lenders report how much interest you paid on your home loan during the year. If you are lucky enough to hit it big in Vegas, you will receive a 1099-G for your winnings. The list goes on and on, and if what you reported on your return doesn’t match what is on the IRS’s computer, you will receive a computer-generated notice.

One big problem that has developed over the years is the IRS’s willingness to allow payers to use substitute forms that are unrecognizable as income-reporting documents. Many of the brokerage firms are now providing their substitutes in letter-size documents printed front and back on multiple sheets that almost take a financial expert to understand. This results in frequent errors.

There are times when you may receive an income item and it appears to be taxable to the IRS, when in fact it is not. Here are some frequently encountered situations.

• Sold a security with no profit − Whenever you sell a security, the brokerage house will report the gross proceeds of sale to the IRS. In other words, the IRS has on their computer what you sold it for. For purchases made before 2011, they have no clue what you paid for it, which means you must report the sale on Form 8949 and Schedule D on your tax return. If you fail to report it, the IRS treats the entire sales price as a profit. Let’s say you sold 200 shares of stock, which originally cost you $5,050, for $5,000. You actually have a loss of $50. Unless you report the transaction and show that you paid $5,050 for the shares, the IRS is going to assume you had a $5,000 profit. This frequently occurs when taxpayers overlook a transaction or simply omit it because there was no profit. If this is what caused the notice, you will need to respond to the IRS to explain the mistake and provide verification of the stock’s original cost.
• Rollovers − Another frequent error is when you rollover an IRA, 401(k), etc. from one plan to another or one trustee to another. If you don’t show on the tax return that the distribution was rolled over, the IRS assumes the entire amount to be taxable. If these funds are transferred between trustees, a 1099-R is not supposed to be issued, but sometimes they still are. It is better to make sure. On the other hand, if you take possession of the funds and then redeposit them into another IRA, a 1099-R will be issued, and the rollover must be accounted for on the return. If this is what caused the notice, you will need to provide verification of the rollover to the IRS with your response.
• Shared accounts − Generally, banks and other financial institutions only have the capability of having one taxpayer ID as the primary owner on an account, even though it may be a joint account with others. These financial institutions will issue the 1099 or other reporting documents under the social security number (SSN) of the primary owner, and the total will be reported to the IRS under that SSN. This also will affect married or separated taxpayers who do not file jointly. The IRS expects to see the same amount that was reported on the 1099 on the return of the individual whose SSN was used on the 1099. When there’s a mismatch, the IRS will send out a notice of unreported income. When responding to the IRS notice, you will need to provide the names, addresses, and SSNs of the other owners and a statement to the fact that they each reported their appropriate share.

The foregoing are just a few of the more common examples of computer mismatches that can cause computer-generated notices. Even though the IRS feels the notices are readily understandable, experience has shown that taxpayers can become confused and that the experienced eye of a tax professional is usually required to decipher the notices. That is why we highly recommend that this office review any notice you receive prior to your taking any action or responding.

A Word of Caution − The IRS routinely provides state tax agencies with the results of the correspondence audits. Generally, if the IRS’s notice proves to be correct, the results of the correspondence audit will need to be dealt with on the state level through an amended state return, or you can wait to receive the state notice. However, if you wait for the state notice, additional interest and penalties may possibly accrue for the state return.

Please give our office a call if you have questions related to a correspondence you received from the IRS or state authority.

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Social Security Administration Launches New Online Tool

If you go back a few years, you may remember that every year, about three months before your birthday, you received an earnings and benefits statement from the Social Security Administration providing you with a history of your earnings and projected benefits. Then, along came a recession and the accompanying budget cuts and the mailing out of the statements stopped, except for workers age 60 and over.

The earnings and benefits statements provided a valuable annual reminder of what you can expect to receive and how benefits are calculated. It also prompts us all to make Social Security part of our long-range retirement plans.

New Retirement Tool Now Available - On May 1st, Michael J. Astrue, Commissioner of Social Security, announced that an online version of the Social Security Statement is now available at the Social Security Website. The new online statement provides eligible workers with secure and convenient access to their Social Security earnings and benefits information. The online statement also provides estimates for disability and survivors benefits, making the statement an important financial planning tool. People should get in the habit of checking their online statement each year, around their birthday.

In addition to helping with financial planning, the online statement also provides workers a convenient way to determine whether their earnings are accurately posted to their Social Security records. This feature is important because Social Security benefits are based on average earnings over a person’s lifetime. If the earnings information is not accurate, the person may not receive all the benefits to which he or she is entitled. The online statement also provides the opportunity to save or print the personalized statement for financial planning discussions with family or a financial planner.

To get a personalized online statement, people age 18 and older must be able to provide information about themselves that matches information already on file with Social Security. In addition, Social Security uses Experian, an external authentication service provider, for additional verification. People must provide their identifying information and answer security questions in order to pass this verification. Social Security will not share a person’s Social Security number with Experian, but the identity check is an important part of this new, robust verification process.

Once verified, people will create a “My Social Security” account with a unique user name and password to access their online statement. In addition, the portal also includes links to information about other online services, such as applications for retirement, disability, and Medicare.

It is important to note, however, that Social Security anticipates some members of the public will not be able to be verified through this process. Some people may not correctly answer the security questions based on information on file with Experian, and others may supply identifying information that does not match their Social Security records. In instances where this occurs, people will have the option to request that a hard copy of their Social Security Statement be mailed to them. People who cannot verify online initially also may visit their local Social Security office and present an identity document in order to create an account and gain access to the online version of the statement.

In February 2012, Social Security resumed mailing paper statements to workers age 60 and older if they are not already receiving Social Security benefits. Later this year, the agency plans to mail paper statements to workers in the year they reach age 25. For more information about the new online statement, please go to www.socialsecurity.gov/mystatement.com.

If you need more information related to Social Security credits and taxation of Social Security benefits please give our office a call.

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IRS Liberalizes Position on Local Lodging

In the past, a business deduction was allowed only for lodging when a taxpayer traveled away from his or her “tax home.” A taxpayer’s tax home is generally the location (such as city or metropolitan area) of a taxpayer’s main place of business (not necessarily the place where he/she lives).

This has long created problems for individuals attending conferences and training sessions within their tax homes that include extended-hour events that preclude traveling back home between days of the events. In 2007, the IRS announced that it would amend the regulations to allow certain temporary local lodging expenses to be treated as business expenses; now, five years later, the proposed regulation changes have recently been announced.

Proposed Changes - The IRS has issued proposed reliance regulations permitting certain non-away-from-home lodging expenses to be treated as deductible business expenses by employers and tax-free working condition fringe benefits or accountable-plan reimbursements to employees. The proposed regulations provide a safe harbor; local lodging expenses are treated as ordinary and necessary business expenses if all of these conditions are met:

1. The lodging is necessary for the individual to participate fully in or be available for a bona fide business meeting, conference, training activity, or other business function.
2. The lodging is for a period that does not exceed five calendar days and does not recur more frequently than once per calendar quarter.
3. If the individual is an employee, his or her employer requires him or her to remain at the activity or function overnight.
4. The lodging is not lavish or extravagant under the circumstances and does not provide any significant element of personal pleasure, recreation, or benefit.

Example: A business conducts business-related sales training sessions at a hotel and conference center near its main office. The employer requires both its field and in-house sales force to attend the training and stay at the hotel overnight for the bona fide purpose of facilitating the training. If the company pays the lodging costs directly to the hotel, the stay is a working condition fringe benefit to all attendees (even to employees who live in the area who are not on travel status) and the company may deduct the cost as an ordinary and necessary business expense. If the employees pay for the lodging costs and are reimbursed by the company, the reimbursement is of the accountable plan variety and is tax-free to the employees and deductible by the company as an ordinary and necessary business expense.

Example: If a locally-based self-employed consultant were required by a company to attend the sessions and stay at the hotel, he or she could deduct the expense if he or she paid for it himself or herself or exclude the expense if he or she were reimbursed by the company after accounting for it in full for his or her costs.

The new rules apply to expenses paid in prior years in cases in which the statute of limitations for claiming refunds is still open (generally, after 2008). Thus, returns can be amended for refund where a lodging deduction would have been allowed.

If you have questions related to how this change affects prior filed returns or how it will affect your business deductions going forward, please give our office a call.

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Do You Have a Financial Interest in or Signature Authority over a Foreign Financial Account? Better Read This! June 30 Is a Critical Date

Every U.S. person who has a financial interest in or signature or other authority over any foreign financial accounts (including bank, securities and other types of financial accounts in a foreign country), if the aggregate value of these financial accounts exceeds $10,000 at any time during the calendar year, must report those relationships to the U.S. government each calendar year.

The government uses this reporting mechanism as a means to uncover hidden foreign accounts and ensure that investment income earned in foreign countries by U.S. taxpayers is included on their U.S. tax returns. The Treasury Department has placed a new emphasis on foreign accounts, and taxpayers with a financial connection to a foreign country should determine whether they have a reporting requirement.

Reporting is accomplished by filing a Report of Foreign Bank and Financial Accounts form—more commonly referred to as the FBAR—which must be received by the IRS at its Detroit office on or before June 30 of the succeeding year. Thus, the FBAR filing for the 2011 year must be received by the IRS no later than June 30, 2012. This report is filed separately from the taxpayer’s income tax return, and no extensions of time are available for filing this form. In addition, taxpayers generally are required to answer “yes” or “no” to questions related to foreign bank and financial accounts on their tax returns.

Penalties for failing to comply can be draconian. For non-willful violations, civil penalties of up to $10,000 may be imposed; the penalty for willful violations is the greater of $100,000 or 50% of the account’s balance at the time of the violation. A reasonable cause exception to the penalty is available for non-willful violations but not for willful violations.

Overlooked Accounts — Many taxpayers overlook the fact that they have a reporting requirement in situations such as the following:

• Family Accounts — Recent immigrants to the U.S. may still have parents or other family members residing in the “old” country, and those relatives may have included them on an account in the foreign country. This is common practice for some ethnic groups. The taxpayer does not really consider the account his or hers, but it falls under the reporting requirement if he or she has signature or other authority over the account and the value exceeds $10,000.
• Inherited Accounts — Inherited accounts in a foreign country fall under the FBAR reporting requirement even if the funds are subsequently transferred to the U.S. The FBAR rules state that reporting is required if at any time during the year the foreign account exceeds $10,000.
• Business Accounts — An officer or board member may have signature authority over a business account held in a foreign country and overlook the need to meet the FBAR reporting requirements.

In addition to including any reportable foreign income on his or her tax return, the taxpayer must ensure that the foreign account questions are completed correctly on the tax return and that the FBAR is filed when required.

If you have questions regarding this reporting requirement, please contact our office.

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Are You an Employee or an Independent Contractor?

The distinction has significant implications for both the employer and the employee. Employers like to treat individuals as independent contractors because they avoid having to match the employees’ payroll tax, pay benefits, pay unemployment insurance, etc. This results in a significant savings for employers.

When you are an employee, the employer pays you a net amount after making all the required tax withholdings and provides you with a W-2 for tax reporting that shows your taxable wages and details all of the withholding amounts. If you are an independent contractor, the employer will pay you a gross amount without any withholding and will issue you a 1099-MISC. 

Independent contractors must pay self-employment (SE) tax instead of having FICA (Social Security and Medicare program contributions) deducted from their wages. The SE tax rate is generally twice the amount of the FICA rate. Independent contractors are generally treated the same as self-employed individuals, so the SE tax and income tax are based on their net earnings after deducting any allowable expenses incurred to earn the income.

The problem here is that employees generally do not have tax-deductible expenses related to their jobs, so employees who are incorrectly classified as independent contractors find themselves essentially paying both the employer’s and their own share of the Social Security and Medicare taxes. To make matters worse, as an independent contractor, no federal or state income tax was withheld, leaving the independent contractor with a sometimes unexpected tax liability.

Classifying a worker as an employee or independent contractor is not discretionary for the employer. The employer must follow federal guidelines when making the determination. Basically, it boils down to whether the employer has direction and control over the individual, which includes, among other guidelines, specifying working hours, how to perform the work tasks, the right to fire, etc. If the employer does have direction and control, the individual is probably an employee.

If you have been treated as an independent contractor and think that you are really an employee, you do have recourse. You can file Form 8919. If the IRS agrees with you, you only have to pay the employee share of FICA/Medicare not the self-employment tax. You still have to pay the income tax. The filing will make life miserable for your presumably former “employer,” so it might turn into a bridge-burning exercise. 

If you have questions, wish to explore alternatives, or need assistance filing Form 8919, please give our office a call.

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Forgot Something on Your Tax Return? It’s Not Too Late to Amend the Return

If you discover that you forgot something on your tax return, you can amend that return after it has been filed. The need to amend can include a number of issues:

• Receiving an unexpected or amended K-1 from a trust, estate, partnership, or S-corporation.
• Overlooking an item of income or receiving a corrected 1099.
• Forgetting about a deducible expense.
• Forgetting about an expense that would qualify for a tax credit.

These are among the many reasons individuals need to amend their returns, whether it is for the just-filed 2011 return or prior year returns.

Here are some key points when considering whether to file an amended federal (Form 1040X) or state income tax return.

1. If you are amending for a refund, you should be aware that refunds generally won’t be paid for returns if the three-year statute of limitations from the filing due date has expired. Thus, with the exception of amending a return to carry back a business net operating loss (NOL), the IRS will pay refunds only on returns from 2009 through 2011. Some states have a longer statute.
2. Generally, you do not need to file an amended return to correct math errors. The IRS or state agency will automatically make those corrections. Also, do not file an amended return because you forgot to attach tax forms such as W-2s or schedules. The IRS or state agency will send a request asking for the missing forms.
3. If you are filing to claim an additional refund, wait until you have received your original refund before filing Form 1040X. You may cash that check while waiting for any additional refund.
4. If you owe additional 2011 tax, file Form 1040X and pay the tax before the due date to limit interest and penalty charges that could accrue on your account. Interest is charged on any tax not paid by the due date of the original return, without regard to extensions.
5. When amending multiple returns, send them in separate envelopes. Sometimes when filed together, they are mistaken for a single return, and the additional returns filed in the same envelope are not processed.
6. If the changes involve another schedule or form, it must be completed and included with the amended return. In addition, it may be appropriate to include documentation to avoid subsequent correspondence from the IRS or state agency.
7. A detailed explanation of the changes must also be attached. This is required to explain to the processing staff the reason for the amendment. In insufficient explanation can lead to additional correspondence and delays.
8. Depending on why you file an amended federal return, you may be required to amend your state return. However, if the federal amendment is filed to claim or correct a tax credit that the state does not have, no state amended return will likely need to be filed. In most other circumstances, you will need to amend the state return as well as the federal.

An amended return can be more complicated than the original, so please contact our office for assistance in preparing your amended returns.

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How Business Website Expenses Are Deducted

With the explosion of online businesses, one would think that there would be a standard method of deducting the cost of your business website. But some questions still exist as to what part of a website is considered software, and to date, the IRS has not fully clarified that issue for tax purposes.

Purchased Websites – If the website is purchased from a contractor who is at economic risk should the software not perform, the design costs are amortized (ratably deducted) over the three-year period, beginning with the month in which the website is placed in service. For 2012, non-customized computer software placed in service during the year qualifies as Sec 179 property and can be written off in full up to the limits of this special expense deduction.

In-House Developed Websites - If, instead of being purchased, the website design is “developed” by the company or designed by an independent contractor who is not at risk should the software not perform, the company launching the website can choose among alternative treatments, one of which is deducting the costs in the year that the costs are paid, or accrued, depending on the taxpayer's overall accounting method. Or, as an alternative, the costs may be amortized under the three-year rule.

Non-Software Expenses – Some website design costs, such as graphics, may not be classified as software and must be deducted over the useful life of the element. Non-software portions of the design with a useful life of no more than a year are currently deductible.

Advertising Content – Advertising costs are generally currently deductible. Thus, the costs of website content that is advertising are generally, currently deductible.

Cost Before Business Starts – Business expenses that are incurred or accrued prior to the actual activation of the business are generally not deductible until the business is terminated or sold. However, a taxpayer can elect to deduct up to $5,000 of the costs in the year that the business starts and amortize the costs in excess of $5,000 over a period of 180 months (15 years), beginning with the month that the business starts.

As you can see, deducting the expenses of a website can be complicated. Please call our office if you have questions.

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Is Your Hobby a For-Profit Endeavor?

The tax treatment for a hobby is substantially different than it is for a business, which sometimes makes it difficult to distinguish one from the other. The IRS provides appropriate guidelines when determining whether an activity is engaged in for profit, such as a business or investment activity, or is engaged in as a hobby. Internal Revenue Code Section 183 (Activities Not Engaged in for Profit) limits deductions that can be claimed when an activity is not engaged in for profit. IRC 183 is sometimes referred to as the “hobby loss rule.”

This article provides information that is helpful in determining if an activity qualifies as an activity engaged in for profit and what limitations apply if the activity was not engaged in for profit.

Is your hobby really an activity engaged in for profit? In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business or for the production of income. Trade or business activities and activities engaged in for the production of income are activities engaged in for profit.

The following factors, although not all-inclusive, may help you determine whether your activity is an activity engaged in for profit or a hobby:

• Does the time and effort put into the activity indicate an intention to make a profit?
• Do you depend on income from the activity?
• If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
• Have you changed methods of operation to improve profitability?
• Do you have the knowledge needed to carry on the activity as a successful business?
• Have you made a profit in similar activities in the past?
• Has the activity made a profit in past years?
• Do you expect to make a profit in the future from the appreciation of assets used in the activity?

An activity is presumed to be for profit if it made a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses). If an activity is not for profit, losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts and S corporations. It does not apply to corporations other than S corporations.

Hobby deductions – If it is determined that your activity is not carried on for profit, allowable deductions cannot exceed the gross receipts for the activity.

Deductions for hobby activities are claimed as itemized deductions on Schedule A. They must be taken in the following order and only to the extent stated in each of three categories:

• Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
• Deductions that don’t result in an adjustment to the basis of property, such as advertising, insurance premiums and wages, may be taken next, to the extent that gross income for the activity is more than the deductions from the first category.
• Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent that gross income for the activity is more than the deductions taken in the first two categories.

If you have questions related to your specific business or hobby circumstances, please give our office a call.

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Is Your Child a Full-Time Student?

If you have a qualified child you can claim an exemption for that child on your tax return, which results in a $3,800 deduction for 2012 (up from $3,700 in 2011). Depending upon your tax bracket, that deduction can produce a substantial tax savings. To be treated as a qualified child, a child must be under the age of 19 or a full-time student under the age of 24.

Generally, children under the age of 19 who have investment income, such as interest and dividends, are also subject to the so-called “kiddie tax,” which, except for small amounts, causes the child’s income to be taxed at the parent’s marginal rates. The “kiddie tax” was implemented several years ago to curtail parents from shifting income to a child to take advantage of the child’s lower tax rates. Full-time students under the age of 24 who are not self-supporting are also subject to the “kiddie tax” rules.

So what is the definition of a full-time student? Well, the tax law definition is more liberal than you might imagine. A full-time student is one enrolled for some part of five calendar months (whether or not consecutive) in a given year for the number of hours or courses considered full-time attendance by the school that the student is attending.

The enrollment in school needn't be for full months—or for five consecutive months. So, if the student is enrolled from mid-February to mid-June, the five-month qualification is met. On the other hand, if the student is enrolled from September to December or February to May, the student has been enrolled for only four months, and there must be full-time enrollment during at least one other month during the calendar year to meet the definition.

The full-time student designation also applies when claiming the lucrative American Opportunity Education Credit, which is based on payment of college tuition and related fees. For all but certain qualified children, claiming the credit only requires attendance for an academic period (semester, quarter, etc.). In order for parents to claim the credit for a qualified child who is over the age of 18 and under the age of 24, the qualified child must also be a full-time student.

If you have questions, please contact our office.

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Identity Theft and Tax Fraud Are Growing Problems

Cyber criminals have been using stolen identities to file tax returns and obtain fraudulent refunds. Tax preparers have reported an increase in e-file rejections because the taxpayers’ or their children’s SSNs have already been used in a previously e-filed return, which results in the e-filed return being rejected.

Generally, identity thieves use personal data to steal financial accounts and run up charges on the victim’s existing credit cards. However, identity theft can also affect your tax records as follows:

• Undocumented workers or other individuals use your Social Security number to get a job. The employer then reports W-2 wages the workers earned under your Social Security number to the IRS. When you file your return based on your real W-2 income, it appears that you failed to report part of your income on your return.
• An identity thief files a return using your Social Security number to claim refundable credits. This can be lucrative for cyber thieves who take advantage of the Earned Income Credit or the American Opportunity Education Credit, both of which are refundable credits. Generally, credits can only be used to offset a tax liability. However, these two credits are refundable even if the taxpayer has no tax liability.
• An identity thief may also use your Social Security number or your children’s SSN to claim additional tax return exemptions. Each exemption claimed on a return provides a deduction worth $3,800 (2012) and can be used to claim head of household status.

How do the thieves obtain this information? Some buy it from other thieves who collect identity information by hacking into firms that have those records or by using ingenious ways to trick you into disclosing the information. This is often done by sending you an e-mail disguised to look like an e-mail from a trusted source. This practice is referred to as “phishing.” An example of phishing is an e-mail with a fake IRS header claiming to have a refund for you and directing you to a site that requires you to enter your SSN and other information to verify your claim for the refund.

Don’t be a cyber-victim. Here are some tips you should know about phishing scams.

1. The IRS and legitimate businesses never ask for detailed personal and financial information such as Social Security numbers, PIN numbers, passwords or similar secret access information for credit card, bank or other financial accounts.

2. The IRS does not initiate contact with taxpayers by e-mail to request personal or financial information. If you receive an e-mail from someone claiming to be a representative of the IRS or directing you to an IRS site:

• Do not reply to the message.
• Do not open any attachments. Attachments may contain malicious code that will infect your computer.
• Do not click on any links.

If you clicked on links in a suspicious e-mail or phishing website and entered confidential information, you may have compromised your financial information. If you entered your credit card number, contact the credit card company for guidance. If you entered your banking information, contact the bank for the appropriate steps to take. The IRS website provides links to additional resources that can help. Visit the IRS website (www.irs.gov) and enter the search term “identity theft” for additional information.

3. The address of the official IRS website is www.irs.gov. Do not be confused, misled or respond to sites claiming to be the IRS but ending in .com, .net, .org or other designations instead of .gov.

4. If you receive a phone call, fax or letter in the mail from an individual claiming to be from the IRS, but you suspect he or she is not an IRS employee, contact this office immediately. You should also call the IRS at 1-800-829-1040 to determine if the IRS has a legitimate need to contact you. Report any bogus correspondence. You can forward a suspicious e-mail to phishing@irs.gov.

If you receive a notice or letter from the IRS or state tax authorities, you should always contact our office. This is especially true if you believe someone may have used your Social Security number fraudulently or stolen your identity.

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Read This before Tossing Old Tax Records

Now that you’ve completed your taxes for 2011, you are probably wondering what old records can be discarded. If you are like most taxpayers, you have records from years ago that you are afraid to throw away. To determine how to proceed, it is helpful to understand why the records needed to be kept in the first place.

Generally, we keep “tax” records for two basic reasons: (1) in case the IRS or a state agency decides to question the information reported on our tax returns; and (2) to keep track of the tax basis of our capital assets so that the tax liability can be minimized when we actually dispose of the assets.

With certain exceptions, the statute for assessing additional tax is three years from the return due date or the date the return was filed, whichever is later. However, the statute of limitations for many states is one year longer than the federal. In addition to lengthened state statutes clouding the record keeping issue, the federal three-year assessment period is extended to six years if a taxpayer omits from gross income an amount that is more than 25% of the income reported on a tax return. And, of course, the statutes don’t begin running until a return has been filed. There is no limit on the assessment period where a taxpayer files a false or fraudulent return in order to evade tax.

If an exception does not apply to you, for federal purposes, most of your tax records that are more than three years old can probably be discarded; add a year or so to that if you live in a state with a longer statute.

For example: Sue filed her 2011 tax return before the due date of April 17, 2012. She will be able to dispose of most of her records safely after April 15, 2015. On the other hand, Don files his 2011 return on June 2, 2012. He needs to keep his records at least until June 2, 2015. In both cases, the taxpayers may opt to keep their records a year or two longer if their states have a statute of limitations longer than three years. Note: If a due date falls on a Saturday, Sunday or holiday, the due date becomes the next business day.

The big problem! The problem with discarding records indiscriminately for a particular year once the statute of limitations has expired is that many taxpayers combine their normal tax records and the records needed to substantiate the basis of capital assets. They need to be separated, and the basis records should not be discarded before the statute expires for the year in which the asset is disposed. Thus, it makes more sense to keep those records separated by asset. The following are examples of records that fall into this category:

• Stock acquisition data — If you own stock in a corporation, keep the purchase records for at least four years after the year the stock is sold. This data will be needed in order to prove the amount of profit (or loss) you had on the sale.
• Stock and mutual fund statements — Many taxpayers use the dividends that they receive from a stock or mutual fund to buy more shares of the same stock or fund. The reinvested amounts add to the basis in the property and reduce gains when the stock is finally sold. Keep statements at least four years after the final sale.
• Tangible property purchase and improvement records — Keep records of home, investment, rental property or business property acquisitions AND related capital improvements for at least four years after the underlying property is sold.

Have questions about whether or not to retain certain records? Give our office a call first. It is better to be sure before discarding something that might be needed down the road.

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May 2012 Dates to Remember

May 2012 Individual Due Date Reminders

May 10 - Report Tips to Employer

If you are an employee who works for tips and received more than $20 in tips during April, you are required to report them to your employer on IRS Form 4070 no later than May 10. Your employer is required to withhold FICA taxes and income tax withholding for these tips from your regular wages. If your regular wages are insufficient to cover the FICA and tax withholding, the employer will report the amount of the uncollected withholding in box 12 of your W-2 for the year. You will be required to pay the uncollected withholding when your return for the year is filed.

May 31 - Final Due Date for IRA Trustees to Issue Form 5498

Final due date for IRA trustees to issue Form 5498, providing IRA owners with the fair market value (FMV) of their IRA accounts as of December 31, 2011. The FMV of an IRA on the last day of the prior year (Dec 31, 2011) is used to determine the required minimum distribution (RMD) that must be taken from the IRA if you are age 70½ or older during 2012. If you are age 70½ or older during 2012 and need assistance determining your RMD for the year, please give this office a call. Otherwise, no other action is required and the Form 5498 can be filed away with your other tax documents for the year.

May 2012 Business Due Date Reminders

May 10 - Social Security, Medicare and Withheld Income Tax

File Form 941 for the first quarter of 2012. This due date applies only if you deposited the tax for the quarter in full and on time.

May 15 - Employer’s Monthly Deposit Due

If you are an employer and the monthly deposit rules apply, May 15 is the due date for you to make your deposit of Social Security, Medicare and withheld income tax for April 2012. This is also the due date for the non-payroll withholding deposit for April 2012 if the monthly deposit rule applies.

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