Frequently Asked Questions - Tax Assistance

Real Estate Tax

Protect Against Residence Capital Gains Tax with Private Annuity Trust

If you are thinking of selling a highly appreciated asset and are reluctant to cash-out because of the tax consequences, consider utilizing a private annuity trust (PAT). An annuity trust allows property owners to accomplish the deferral of capital gains tax and depreciation recapture without entering into a risky installment sale. There is no maximum transaction size and the PAT can be used on any kind of real estate such as a primary residence, rental properties, vacation homes, commercial properties, and raw land. Back to Top

IRS relaxes sale of home exemption requirements.

Until 2003, business use including home office, day-care, and partial rental activity limited capital gain exemptions on the sale of a residence. Business use no longer puts constraints on home exemption rules - as long as use falls within the primary residence (as opposed to a separate structure).

Additionally, IRS offered guidance on unforeseen circumstances--- allowing partial exemption. Background: In order to qualify for full exemption limits, homeowners must occupy the residence for 24 months within a five-year period prior to date of sale.

If occupancy requirements are not met, several safe harbor rules now provide partial exemption. 1) Loss of employment 2) divorce or legal separation 3) multiple births from single pregnancy 4) man-made or natural casualty 5) death. Other exceptions include job change, poor health and partial sales. Back to Top

Real Estate Professionals.

Real property professionals who satisfy certain participation requirements are entitled to offset wage and other nonpassive income with their rental real estate losses. However, real estate appraisers and mortgage brokers are excluded from the unlimited rental loss deduction. Qualifying taxpayers must meet the following criteria annually: 1) Actively engaged in real property trade/businesses defined as any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business. 2) Expend more than 750 service hours in your real estate business activities. And 3) More than 50% of your services must be performed in real estate businesses and meet "material participation" guidelines as defined by the IRS. Material participation often disqualifies taxpayers that don't elect to aggregate each rental property into one activity. Consult your advisor for elections and rules pertaining to your situation. Back to Top

Transferring Property Tax Basis.

Many homeowners, when they become age 55 or older decide to sell their residence and move into a smaller home. California permits homeowners at least age 55, or disabled to transfer their existing property tax-base to the replacement residence. Like all loopholes, there are burdens and constraints that must be satisfied to achieve the tax-base transfer. For instance, county-to-county transfers are allowable but only among 10 counties; the replacement home purchase price may not be greater than 110% of the original property sale price (105% if the replacement residence is purchased within the first year following the date of sale), and the replacement home purchase must be completed within two years (from the original sale date). The state’s backlog for evaluating applications is currently exceeding seven months. Back to Top

Maximizing Use of Capital Losses

You can deduct capital losses from sale of investment assets to the extent they equal your capital gains. But if your losses exceed your capital gains, you can only deduct up to $3,000 of those losses in a given tax year against ordinary income, with the excess carried over to subsequent years. Due to the change in the capital gains tax rules, you may want to consider disposing of your capital losses only in the years when you have little or no capital gains, or only short-term capital gains. For taxpayers in the highest tax bracket, the capital losses are better used to offset ordinary income rather than long-term capital gains, which are taxed at 15%. Back to Top

Like Kind Exchanges.

There is a misconception among some taxpayers that a tax-free like-kind exchange simply means the sale of property followed by reinvestment into another piece of property within a designated period of time.

While this may be the turn of events in certain situations, there are more specific rules to follow in order to protect the tax-free nature of the transaction. A simple like-kind exchange exists when two individuals exchange pieces of property with no additional payments. More sophisticated transactions involve the exchange of liabilities or unlike property in addition to the like-kind property. If a sale of property followed by the repurchase of new property is to qualify as a like-kind exchange, an intermediary (third party) must be involved to orchestrate the exchange. The transferor must not receive the cash from the transaction and use it to purchase new property. If cash or unlike property is received, the smaller of the gain on the exchanged property or the value of the cash or property received will be taxable.

The tax-free treatment will only apply when the property is used for the business or investment purposes. The property must be of like kind based on the IRS classification of depreciable assets. The real property category is far more generous than other categories. Under the real property designation, land may be exchanged for an apartment house or a storefront and still qualify as a tax-free exchange.

The time period associated with the tax-free exchange refers to an exchange where the transferor gives up a piece of property and must identify the property to be exchanged within 45 days. The exchange must be completed within 180 days to insure tax-free treatment. If a third party is not involved, the exchange may take place simultaneously.

The key issue to remember is that if a transferor takes physical or constructive possession of sale proceeds, a like-kind exchange will not exist. Back to Top

"Secure" That Home Mortgage Interest Deduction.

To deduct interest as home mortgage interest expense, the underlying loan must be secured by your residence; if it isn't the interest deduction may be disallowed. In some instances, case law has refuted IRS regulations if the taxpayer can prove benefits and burdens of home ownership.Back to Top

Real estate holding in an IRA

Can you do it? Yes, but you must comply with several restrictions. A minor deviation can cause the entire IRA to be assessed for income tax and penalties. Disallowed transactions include holding property for personal use such as a principal residence or vacation home. Beyond that, you need an IRA custodian willing to purchase and manage investment property. You’re also required to fund the IRA with sufficient assets not only to purchase the property, but cover unanticipated expenses (since your annual contributions are limited). Should all that work out, you may end up increasing your tax liability. You'll defer income and capital gains tax, but when distributions commence, all proceeds will be taxed as ordinary income. Since a substantial part of rental property gains are likely to be long-term and taxed at 20%, you may be converting capital gain income to ordinary income--- taxed at 35%. For investors looking to add real estate to their IRA portfolio, consider professionally managed real estate investment trusts or REITs as a viable alternative; they avoid tax pitfalls and allow for meaningful diversification within the sector. Back to Top

Business Tax

New business venture?

If you are filing do business as a corporation, defining equity elections and dilution exposure often moves front and center. One often over-looked election - to protect against potential loss - is the 1244 election. This code section allows you to take an ordinary deduction for a loss of up to $100,000 (married, filing joint) on qualifying stock. If the company prospers, the tax protection is immaterial. However, if the company fails, without the election you'll be looking at a capital loss limitation of $3,000 each year for a long time. Section 1244 treatment is only available to stock acquired under its original issuance. Back to Top

Deducting international travel.

You may deduct travel outside the United States even if you don’t spend your entire time on business. If you meet any of the following exceptions, travel expenses are fully deductible:

1) You were outside the United States no more than one week (7 consecutive days)
2) You were outside the United States and less than 25 percent of the time was spent on non-business (personal) travel
3) You can establish that a personal vacation was not a major consideration, even if you have substantial control over arranging the travel. Back to Top

Car deductions.

You may deduct expenses for your car, van, or truck when used for business purposes using either actual expenses or the standard mileage rate. Generally, the standard mileage rate will prove more beneficial with older vehicles or when business use remains less than 50%. When using the actuals method, deductible expenses include business percentage of gas and oil, insurance, licenses, parking fees, registration fees, repairs, tires, tolls and even garage rent. The cost of the vehicle is depreciated over a five-year schedule – but subject to annual limitations. If your newly purchased vehicle weight is greater than 6,000 pounds, up to $25,000 may be deducted in the first year! Back to Top

Travel & Entertainment Tax Traps.

Conventions. In order to be deductible, any convention or seminar has to be deductible as a trade or business expense. Expenses related to seminars for investment purposes are not deductible. The nondeductible expenses include travel, lodging, meals, and the cost of the seminar itself. Thus, none of the costs associated with seminars related to investments, financial planning, or income producing activities (rental of property where it's not a trade or business) are deductible.

Seminars for job-related education are deductible, but you must meet certain tests. First, there must be bona fide educational seminars and they must be for more than a nominal portion of the stay. For example, the IRS will disallow a deduction if you spent 1 hour per day in education and the rest lounging on the beach. When Congress wrote the law, they gave an example of situations where a deductionwould be denied if participants simply showed up and received a videotape to take home.

Second, the seminar must meet the other tests for deducting education expenses. That is, if your company pays the expense and the topics are related to your current job, the company can take a deduction. If you pay for the seminar personally you can deduct the expenses on your personal tax return (subject to the 2% floor), but only if the course work is to maintain skills in your present job. If it could qualify you for a new job, no deduction is allowed. Conventions on cruise ships. You can deduct conventions and seminars on cruise ships, but only if: the cruise ship calls on ports in the U.S. or its possessions, is registered in the U.S.; and the convention is directly connected to the active conduct of your trade or business. Back to Top

Partnerships, S-Corporations and LLCs--Computing Your Basis.

While computing your basis in a partnership, S-Corp or LLC may sound like an esoteric subject, it's vitally important. Your basis will determine whether a distribution to you is taxable or nontaxable, or losses incurred by the business are deductible or nondeductible on your personal return. It will also determine your gain or loss if you sell all or a portion of your interest in the entity. Unfortunately, while the theory is similar, the rules for computing basis are more complex for partnerships and LLCs than they are for S corporations.

Here's a quick example of what type of problem you can encounter.
Example--Fred Flood owns a 50% interest in Tight-Seal LLC. His basis in the LLC at the beginning of 1999 is $5,000. Sue Sharp is the other 50% owner. Her basis at the beginning of the year is $100,000. During the year Tight-Seal has losses of $40,000 ($20,000 for each partner) and distributes $30,000 to each partner. The result? Sue's starting basis is so high she doesn't have a problem. The distribution isn't taxable to her and she can deduct her share of the $40,000 loss. Fred's not so lucky. He can only deduct $5,000 of his $20,000 share of the loss. The remaining $15,000 can be carried forward. But he's got a bigger problem. The loss reduces his basis to $0. That means the $30,000 distribution is taxable income to him.

If your equity investment is small and your basis low, you should compute your basis regularly or at least before the entity makes distributions and certainly before the end of the tax year. Back to Top

Losses or Bad Debts.

Losing money can be a devastating experience, but the loss of that money does not always create a tax loss. For instance, if you work for an employer who skips town before you can get your paycheck, the lost earnings are not tax deductible. You may have grounds for legal action, but that does not give you a tax write-off. If you offer a non-refundable deposit on a house and the financing doesn't go through, you have lost money that is not tax deductible.

On the other hand, if make a down payment to a contractor to complete work and the work is never completed, you have a tax loss. If you have a building demolished, the remaining basis of the building is added to the basis of the land that will influence the gain or loss upon sale of the land.

You may also have a loss if you hold a delinquent promissory note. However this is a nebulous area. In order to take the loss, you must have a "bona fide" debt. To further complicate the matter, if the loan is to a related party, the IRS is reluctant to allow the loss. The exchange of money may be viewed as a gift. An individual must prove that the non-business debt is totally worthless in order to take the loss. This means that all measures to collect the debt have been taken. It does not, however, require court action. Back to Top

There are two basic requirements to claiming a deduction - expense validity and documentation.

In the case of a business expense, you must show the expense was incurred for a business reason. Sometimes that's obvious; sometimes it isn't. The IRS is unlikely to question the business purpose of tax books purchased by an accountant. However, if there's any possibility of personal use (e.g., supplies purchased by a contractor could be used for work done on his or her home), make sure you can prove business use. Documentation – keep copies of your payments (canceled checks, credit card receipts, etc.) and a receipt, invoice, bill, etc. for the item. In Nicholas M. Romer (T.C. Memo. 2001-168) the taxpayer (a CPA) used his airplane for business and claimed a deduction for the fuel. The IRS disallowed some of the expenses because he did not have receipts and could not show business use. The Court also disallowed some travel and entertainment expenses for lack of substantiation and a failure to demonstrate a business purpose. Back to Top

Investor or trader?

If you're an investor, any losses you incur are limited to offsetting your gains or up to $3,000. If you're a trader, your losses are fully deductible against ordinary income. In a recent case, a taxpayer was employed full-time as an engineer earning $75,000 per year. The taxpayer engaged in 323 trades during the first six months of the year, but 303 of those trades occurred during a three-month period. The taxpayer held most of the securities for less than a month. The taxpayer claimed trader status and deducted an $85,000 loss from the trades as a fully deductible ordinary loss incurred in a trade or business. The Court disagreed. It noted in order to qualify as a trader (as opposed to an investor) the taxpayer's transactions must have constituted a trade or business. In determining whether a taxpayer who manages his own investments is a trader, and thus engaged in a trade or business, relevant considerations are the taxpayer's investment intent, the nature of the income to be derived from the activity, and the frequency, extent, and regularity of the taxpayer's securities transactions. The taxpayer's transactions were frequent, regular and continuous only for a three-month period while he kept his full-time job as an engineer. Back to Top

Estate Tax and Gift Tax

Reciprocal gifts between relatives won't work.

Making gifts to relatives can still be a smart way to reduce your estate. You can make up to $12,000 ($24,000 if your spouse joins in) in gifts to any person annually without gift tax consequences. Thus, even if you're single, you could give $12,000 to each of your four children, reducing your estate by $48,000. Some individuals however have tried to stretch the limit by making gifts not only to their children, but relative's children in return for an agreement that the relative would do likewise. For example, you not only give $48,000 to your children; you give $12,000 to each of your sister's 3 children. She, in turn, makes gifts of $12,000 to 3 of your children. In effect, you've increased your gifts to your children by $36,000. The IRS will challenge this technique of "reciprocal gifting". In one recent court case the Court agreed with the IRS. The judgment doesn't preclude you from giving property to your sister's children, but you must be careful if she gives you or your children gifts in return. Back to Top

Family loans.

If you're loaning money to a child or other relative for a home purchase, be sure to establish a formal mortgage or gift-loan and record the document with the county clerk. This affords protection for the both of you. You protect yourself should the loan go into default by way of a "bad debt" tax deduction. The borrower ensures interest paid will be deductible but only if the loan is secured by the residence. Back to Top

Income from property given to a child.

Property you give as a parent to your child under the Model Gifts of Securities to Minors Act, the Uniform Gifts to Minors Act, or any similar law, is a true gift for federal gift tax purposes. Income from property transferred under these laws is taxable to the child unless it is used in any way to satisfy a legal obligation of support of that child. The income is taxable to the person having the legal obligation to support the child (the parent or guardian) to the extent that it is used for the child's support. Back to Top

Savings account with parent as trustee.

Interest income from a savings account opened for a minor-child, but placed in the name and subject to the order of the parents as trustees, is taxable to the child if, under the law of the state in which the child resides, the account legally belongs to the child and the parents are not legally permitted to use any of the funds to support the child. Back to Top

Is an Inheritance Taxable?

In most cases, an inheritance is not taxable to you. But there are exceptions…

At some point in your life you may inherit money or property which, in most cases, is not taxable to you. Life insurance proceeds are included in the deceased person’s estate, and not taxable to the beneficiaries. Bank accounts and other income-producing assets such as stocks are not taxable to you when received, but the income these assets generate is taxable to you.

If you are not sure if something was included in the decedent’s taxable income, check with the administrator, tax accountant or attorney handling the estate. You may get a K-1 form for items that are allocated to you from the estate. If you inherit a pension or IRA, you must pay tax on the amounts received in the same way that the deceased would have paid tax. Only the spouse of the decedent can roll over funds tax free to a plan in his/her own name. There are special withdrawal options for recipients of inherited IRAs. Consult your tax advisor for additional details on distribution options associated with an inherited IRA.

Have you heard of the term "stepped-up basis"? This means that your investment in inherited property is considered to be the value as of the date of death. When you sell property that you inherited, you only pay tax on the difference between the amount you sold it for and the value of the property as of the date of death (or six months thereafter, as determined by the estate administrator). There can also be a loss if you sell the property for less than this date of death value. Back to Top

IRS Clarifies When Gift is Complete.

Jim decides to make a cash gift to his son Junior in December. He writes the check and gives it to Junior, and Junior brings it to his bank on December 30. But the check doesn't clear Jim's bank until early January. When is the gift considered complete for gift tax purposes? The IRS addressed this question in a Revenue Ruling.

The IRS says the gift will be considered complete in December. Applying a 1994 decision by the Fourth Circuit Court of Appeals (Metzger v. Commissioner), the IRS agrees that the gift "relates back" to the date on which the check was presented for payment, even if is not paid until the following year. However, according to the Service, this rule applies only if certain conditions are met:

1. The check is paid by the drawee bank (Jim's bank, in our example) when first presented for payment;
2. The donor is alive when the bank pays the check;
3. The donor intended to make a gift;
4. The delivery of the check was unconditional; and
5. The check was deposited, cashed or presented within a reasonable time of issuance, and within the same calendar year.

Comment: This ruling does not address the situation in which a check is not deposited in the bank until after the first of the year. The IRS maintains that such a gift is not complete until January, because the donor could stop payment.

Tip: Consider using certified or cashier's checks for year-end gifts. The IRS agrees that a gift is considered complete if the gift-giver has "parted with dominion and control," and has no power to change or revoke the transfer.

Note: A different rule applies to charitable donations, which are considered complete when the check is written and placed in the mail.Back to Top

Gift of future interest may not be a valid gift

For example, you deed your vacation home to your two children, but with the understanding that you are the only one who is allowed complete access, you pay the real estate taxes, upkeep, etc. Under the law, your gross estate includes the value of property transferred by you if you reserve or retain for your life (or for a period which does not end before your death) the use, possession, right to the income, or other enjoyment of the transferred property. The same rule holds if you have the right to designate the person or persons who will possess or enjoy the transferred property. What if you retain less than the full rights to the property? For example, you share title to your child’s residence, but you provide all of the down payment. Your estate retains the property’s equity to the extent of your equity interest – irrespective of joint ownership. Back to Top

Personal Tax

Standard Mileage Rates for 2007

Business mileage 48.5 cents/mile; charitable mileage 14.0 cents/mile; medical and moving mileage 20.0 cents /mile. Back to Top

Disaster Loss Election Carryback

If you suffer a casualty loss in a presidentially declared disaster area, you can either deduct the loss in the year it occurs, or carry the loss back to the prior year. Deducting the loss in the prior year can make sense if you were in a higher bracket (often the case). The deadline for making the election is the due date of your return, without extensions, for the year the loss occurs. For example, you had a $26,000 loss in 2006 from a fire or natural disaster. You can take the loss on your 2006 return or on your 2005 return by filing an amended return. But you must make the decision by the due date of your 2006 return, April 15, 2007. Back to Top

Employee participation in an employer’s Employee Stock Purchase Plan (ESPP) allows company stock to be purchased at a discounted grant price - up to 15% below its market value. If the shares are sold at least eighteen months beyond the purchase date and two years beyond the grant date, the tax bite may be narrowed by as much as 20.0%. Satisfying these holding periods will limit the ordinary income generated to the lessor of the initial discount given on your grant date or your sale price minus your cost per share. Selling sooner will trigger ordinary income equal to the share’s fair market value on the date of purchase less the purchase price. In other words, the total discount received on the date of purchase. Back to Top

Incentive Stock Options (ISO).

ISOs work similar to the ESPP, except they’re not issued at a discount. The grant price must equal the stock’s fair market value on the date of grant. If you don’t meet the holding period (defined above under ESPP), the ordinary income is reported in the same fashion as the ESPP disqualifying disposition. Satisfying the holding period converts all your profit into capital gain income. This latter scenario makes ISOs more favorable in comparison to the ESPP. Keep in mind– if you exercise and hold your shares beyond December 31st, the bargain element (or market value on date of exercise less your option price) is added to your income for alternative minimum tax (AMT) purposes. Consult a competent tax advisor to best manage your AMT exposure. Back to Top

New deduction for Higher Education Expenses.

Unlike education credits which are woefully constrained by income limitations, qualifying education expenses up to $4,000 are deductible without phase outs subject to income limitations of $160,000 for married couple filing a joint return. Back to Top

A charitable contribution of appreciated property can produce substantial tax savings.

If you donate appreciated stock (held for more than a year) to a qualified charity you may take a deduction for the asset's fair market value. You receive a substantial deduction and avoid taxes on the appreciated value. In contrast, selling the shares and contributing the cash creates a tax liability and limits the deduction to your after-tax proceeds. Caution--- if the stock is not publicly traded on an established exchange, special appraisal requirements will apply. Donating appreciated patents fall under more restrictive rules. The donor may only deduct patent expenses (cost basis) if less than market value and a percentage of subsequent royalties (to the extent they exceed cost basis. Back to Top

Is Commuting Ever Deductible?

Expenses you have for driving between your home and your job everyday generally are not deductible... EXCEPT the IRS and the courts have allowed them in certain cases...

CASE ONE: A taxpayer got a favorable decision because he had an office at home which was the principal (main) location of his particular business. The costs he incurred for transportation to other locations to handle dealings for the business were deductible.

CASE TWO: A self employed tree cutter got to deduct his costs for travel from home to timber sites though his home was used only "regularly" for his business (but was not his principal place of business). The court, in its favorable decision for the taxpayer, cited an IRS ruling made several years ago which said that taxpayers can deduct transportation costs for traveling from home to temporary work sites.

Now the IRS has "clarified" the commuting issue with a new ruling - they have also indicated they won't follow the court's determination in the tree cutter's case. The new ruling describes the circumstances that can produce deductible commuting mileage:

A) Driving from home to a local temporary work site when your regular work location is a place other than your home. You must have one or more regular work locations away from home.

B) When your home office is your principal business place, driving between home and other business locations (regardless whether you go to these other business locations regularly or just once or twice).

C) Transportation from home to temporary work locations outside the area where you normally live and work (e.g. a temporary job 60 miles from home).

Terms like "temporary", "regular" and "principal" will not help to change commuting from the confusing and touchy issue it has always been. However, beginning January 1999 taxpayers have been allowed a much friendlier definition of "home office"; this change will expand the number of sole proprietors qualifying for mileage deductions beginning from home. If you use your car for business, you may need to do a little extra planning when considering deductions for car expenses from now on. If you have questions about the latest rules, be sure to consult your tax advisor. It's best to act soon to make sure your transportation deductions are not jeopardized. Back to Top

IRS to Collect Overdue Tax Obligations Through Social Security Benefit Reductions.

Did you know the IRS is authorized to collect Social Security benefit payments against recipients who owe federal taxes. Benefits exempt from collection can be found in the IRS fact sheet at www.ssa.gov/enews/irsoverdue.htm. Back to Top

Distribution of federal income tax liability.

Wonder how your income stands relative to other taxpayers? Here are the results from the 2001 tax-filing season as reported by IRS. You may be surprised by the results. Back to Top

Rolling Company Stock into IRA Can Mean Loss of Tax Advantages.

When you leave your company you can take your company stock (held in a qualified plan) in several ways. You can cash it out, you can roll it into an IRA, or you can walk away with a stock certificate. Cashing it out is a bad idea: you will owe income taxes on all the money, and maybe a 10% penalty. Transferring it to an IRA makes some sense, because you defer taxes. But there’s a third alternative, and it’s a good idea for some people with a large amount of highly appreciated stock. Ignore the IRA and hold onto the stock certificate.

You will owe taxes - but only on the value of the shares at the time you purchased them, or whenever the company added them to your account. If your company’s stock is a winner, the "cost basis" is usually much less than the stock’s current price. You will continue to defer taxes on all the share-price gains since the stock was initially purchased - until you sell the stock. When the shares are ultimately sold, you will pay taxes on the appreciated value at long-term capital gains rates - usually 15% - rather than at income tax rates of as much as 35.0% if the stock were sitting in your IRA. (Many of you may not realize that all taxable distributions from IRAs or other qualified plans do not qualify for capital gains tax rates - they must be taxed as if the income were wages).

Your heirs will also benefit from this tax planning strategy. They will receive a step-up in cost basis, relieving them of a tax bill based on the difference between the stock’s purchase price and share value at the time of death. If the stock was rolled into an IRA, the heirs will owe tax on all of the stock’s value—at ordinary income tax rates, to boot. Back to Top

If You Are Audited.

In this country, we have a voluntary compliance system of taxation. This means we each report to the government our income and deductions and compute the amount of tax due. To insure that the tax laws are followed and the deductions on a return are legitimate, the Internal Revenue Service has the authority to audit tax returns.

Types of Audits. There are generally three types of audits. Each begins with the taxpayer receiving a letter from the Internal Revenue Service.

Correspondence audit.

The IRS requests that certain information be provided by mail. If it is necessary for you to provide any documentation, be sure that you mail only copies (never originals). If the IRS finds that you owe tax and you don’t agree, you may request an office-audit.

Office audit.

The letter you receive from the IRS will ask you to call for an appointment. The items the IRS is questioning will be listed in the letter. You or your representative will call for an appointment by the date indicated and take the documents supporting your income and deductions to that appointment. At the IRS office, a tax auditor will review these documents and discuss points of law that are relevant to your tax return. If an agreement is reached with the auditor, your case will be closed. If you don’t reach an agreement you may appeal.

Field audit.

This type of audit is normally used to audit business returns. The auditor may come to your home or business to examine all the books and records for that business. A field audit may also be conducted in your Enrolled Agent’s (EA’s) office, an especially good idea if your bookkeeping was done there as well.

How is a return selected for audit?

Normally a tax return is selected for an audit based on a combination of factors including the amount and type of income and deductions. For example, if you operate a business or have rental property, your chances of being audited are slightly higher. In addition, taxpayers with large casualty losses, medical expenses, charitable contributions, or employee business expenses have a greater chance of being audited.

You should never omit legitimate deductions simply because you’re afraid of being audited. First, only about two percent of tax returns are audited and, second, you could still be audited even if you don’t take advantage of all the deductions to which you are entitled.

What should I do if I am audited? If you get a letter from the Internal Revenue Service about an audit, the first thing you should do is to inform your tax advisor. He or she can advise you on the things that need to be done and the procedures for any type of audit.

For an Office Audit, you will need to gather all the documentation to prove the amount of income you received and the amount and legitimacy of your deductions. You will need to put the receipts and related documents into categories so they can be presented in an organized manner to the auditor. It will not be to your benefit to simply take a large bag of receipts and dump them on the auditor’s desk.

Who can represent me at the IRS?

Remember: It isn’t necessary that you go to the IRS office yourself. With a properly executed power of attorney, Enrolled Agents, CPAs or Attorneys can represent you at an audit. Any of these three types of professionals may present your records and argue points of law with the Internal Revenue Service. These individuals are familiar with tax law and IRS procedures and can often do a better job of defending your position than you would be able to do alone. If you choose to go to an audit alone and become uncomfortable, you may stop the audit at any time by telling the revenue agent you want to get representation.

What if I don’t agree with the IRS?

If you don’t agree with the auditor, you have the right to appeal your case using the following procedures: First, you may appeal to the auditor’s supervisor. If you do not reach agreement with the supervisor, you may take your case to the Appeals Division of the IRS. An agreement can often be reached at this level. Appeals officers are often more knowledgeable of tax law than auditors and, if appropriate, want to avoid unnecessary litigation. If you don’t agree with the appeals officer, the IRS will issue a Statutory Notice of Deficiency. You have 90 days from the date this notice is issued to file a Tax Court petition and have your case heard. To do this you do not need to pay the tax in question. Depending upon the amount owed, you may elect to file your case in Small Case Tax Court where an attorney is not needed. Otherwise, you would file your case in regular Tax Court. As an alternative to Tax Court, you may pay the amount of tax in question and file a suit for refund in either a U.S. District Court or U.S. Claims Court. Most cases are settled before they reach the Tax Court. An EA or CPA can handle your case from the audit through the appeals process, up to the point where you elect to file in Tax Court, the U. S. District Court or U. S. Claims Court. Back to Top

Avoiding Tax Traps In A Divorce

Tax law changes have made significant modifications to the tax treatment of dependents, alimony, child support, property settlements, and other divorce related issues which can produce unintended results for divorced individuals. Failure to understand these rules can be very costly.

Child Dependency Exemption. The custodial spouse is entitled to the outright exemption for the dependent child for any divorce or separation agreement granted since 1985. There are certain exceptions that allow the non-custodial spouse to claim the child exemption:

1. A multiple support agreement which designates the non-custodial parent to take the exemption.
2. The custodial parent releases the exemption of the child(ren) to the non-custodial spouse.
3. There is a pre-1985 divorce agreement, whereby a completely different set of rules and regulations are in effect.
4. The Internal Revenue Service has taken the position that the custodial parent may release the exemption(s) in the divorce or separation agreement. As a result, custodial parents should take care to include in the agreement some protections against default or other limitations if they plan to agree to such a condition.

Beginning in 2005 non-custodial parents are entitled to the (child) dependency deduction as long as the couple's separation agreement stipulates the noncustodial parent entitlement. Prior law required the custodial parent to waive the deduction irrespective of settlement agreement terms.

Child Care Tax Credit. If, under the terms of the divorce or separation agreement, you may not claim your child as a dependent, you are nevertheless entitled to the childcare tax credit. To be able to claim this credit these criteria must be met:

1. You must file a separate return;
2. Provide your home as the home of the qualifying child for more than half the year;
3. Pay more than half the cost of keeping up your home for the year;
4. Your spouse may not live in your house for the last six-months of the year.

Alimony. Payments of alimony made under a decree of divorce or separation are deductible by the payor spouse and taxable to the payee spouse. In order to qualify as alimony, the payment must be in cash and cannot be a transfer of property or assets. There must also be a requirement that these payments will cease upon the death of the payee. If the individuals are either divorced or separated, they must not be living together when the cash payments are made. Single payments of cash may qualify as alimony if the amount is $15,000 or less. Payments exceeding $15,000 per year are subject to a recapture rule if they do not continue for 3 years or more unless ended because of the death of either spouse or the remarriage of the payee.

Any cash payments made to a third party, if required by the agreement on behalf of the payee spouse, will still qualify as alimony payments. Thus, payments made for rent, mortgage, tuition, or living expenses of the payee spouse under the terms of the divorce or separation instrument can qualify as alimony payments.

The agreement may also call for alimony (or property settlement) payments to be made from pension or retirement funds under a Qualified Domestic Relations Order (QUADRO). Payments made under a QUADRO are exempt from the 10% penalty on premature distributions from qualified retirement plans.

Disposition of Principal Residence. What happens to a jointly owned principal residence is usually a key item in a divorce agreement. The three most frequent provisions chosen are:

1. Sell the house and divide the proceeds with each spouse reporting his or her share of the sale on separate returns,
2. Transfer the house to one spouse or the other,
3. Retain joint ownership allowing the custodial parent to live in the home until the children reaching specific ages, etc.

Recent tax changes make option two or three more favorable in view of the home sale capital gain exclusion rules.

Child Support. Child support is neither taxable to the recipient nor deductible by the payor. If part of an alimony payment is based on a child’s situation (such as coming of age, marriage, and college), that portion of the payment is presumed to be non-deductible child support.

IRA Deduction. Alimony payments received by a payee are considered to be "earned income" for the purpose of allowing alimony recipients to contribute to an Individual Retirement Account. This is true even if the alimony recipient is not employed and, therefore, not earning wages.

Deductibility of Legal Fees. Legal fees paid in connection with obtaining a divorce are not deductible. Fees paid for obtaining and/or maintaining alimony or income producing property and for tax advice are deductible. In order to qualify as deductible legal fees, the attorney must stipulate, on the invoice, the amount or percentage of fees attributable to tax matters. Legal fees are miscellaneous itemized deductions subject to the 2% of AGI limitation. Fees allocated to capital assets increase the asset's cost basis and are recovered upon the sale of the asset. Back to Top

Those Darn Quarterly Tax Payments: How Do They Work ---Anyway

Estimated taxes are the pay-as-you-go levy on income that escapes withholding. Many unsuspecting taxpayers trigger this liability by selling stock for a taxable capital gain or starting to earn freelance dollars subject to income and self-employment taxes. Most of the public believe they can make up the difference with their tax return, without late payment penalties.

Other income subject to estimated taxes includes dividends, interest, alimony, gambling winnings and children's income reported on the parents' return. Bonuses and stock options may be under withheld. Unemployment compensation, pensions, retirement-account withdrawals and, for some, Social Security benefits may also require estimated tax payments.

Not one penalty, but four? The hidden stinger is that a penalty doesn't depend just on your total tax payments. That is, you must pay the right prorated share of tax for each of four payment periods. Otherwise, you could end up paying enough tax in total and still be penalized for an underpayment.

The payment periods are commonly referred to as "quarters," even though only the first period corresponds to a calendar quarter: Jan. 1 through March 31. The other three periods are April 1 through May 31, June 1 through Aug. 31 and Sept. 1 through Dec. 31. Payments are due 15 days after the end of each period, unless a weekend or holiday delays the due date.

According to IRS statistics, more than 17 million 1992 tax returns reported income solely from sources not subject to tax withholding, yet fewer than 13 million reported estimated-tax payments.

The IRS' own taxpayer advocate recently told Congress that the penalty rules are "extraordinarily complex" and frustrating for taxpayers and "very difficult for the IRS to administer." Many people can avoid estimated taxes by increasing paycheck withholding or by having tax withheld from unemployment compensation or retirement income.

Generally, you must make estimated payments if you expect your tax bill each April to be at least $1,000 and you expect your withholding plus credits to fall below a minimum level. The minimum is either 90% of the tax you will report this year or 100% of your prior tax liability-- whichever is less (110% if your prior year adjusted gross income exceeded $150,000). Back to Top

A Penalty-Free Way To Tap Your IRA.

The IRA is intended as a long-term investment vehicle, which is why Federal law ordinarily slaps a 10% tax penalty on money withdrawn before reaching age 59 1/2. However, there are exceptions including an "escape hatch", or annual withdrawals taken as a series of substantially equal periodic payments over life expectancy. In essence, this converts the investment into an annuity. Of course, regular income taxes are due on the withdrawals.

The annual withdrawals must represent a series of substantially equal payments of at least one per year; withdrawals must continue for five years or until your reach age 59 1/2, whichever is later. So, a 55-year-old must take withdrawals for five years, while a 51-year-old must take them for eight-and-a-half years. Like many taxpayers, you may own several IRAs; in this instance you may select the IRA or IRAs earmarked for the periodic distributions.

In order to maximize your withdrawals, you should utilize the annuity factor method for determining periodic withdrawals. Basically, this involves dividing the IRA balance by an annuity factor or the present value of $1 per year for your life expectancy, based on reasonable mortality tables and interest rates. It is important to consult with your tax advisor for specific details. Mistakes are costly; any change in the payment schedule after you've begun making withdrawals creates a 10% tax penalty--- applied retroactively to all previous withdrawals. Back to Top

Performing artists

Performing artists may be entitled to deduct their business expenses to arrive at adjusted gross income. That's much better than taking the expense as an itemized deduction. However, in order to do so you must work for at least two employers, have total business deductions that exceed 10% of the income and have adjusted gross income of $16,000 or less. In Jack A. Fleischli, a.k.a. Jack Forbes (123 TC--, No. 3) the Court held the income from all sources had to be included when determining the $16,000 AGI threshold. The Court dismissed the taxpayer's arguments that the law was flawed for a number of reasons. Back to Top