ask matt cpa we are free agents nation …

Having a child gets a lot of tax empathy.  Parents are getting dependent exemption ($3,650), child tax credit ($1,000), child care credit.  Other benefits such as earned income credit, education credits, and head-of-household tax status are hinged on having a “qualifying child”.

A child has to be under 19 or 24 for full-time student.  If one is over the age limit, you still have the chance to claim dependent via “qualifying relative”.  The key is that they have income less than the dependent exemption ($3,650).

For parents in divorcing situation, the custodial parent usually gets to claim the dependent.  A form can be filed otherwise to release the claim and assign the various credits.  If both parents want to claim, the tie-breaking rule is that the parent with whom the child stays the longest, or the parent with the highest adjusted gross income wins.

For the limited income, your children are at the lowest tax brackets.  You may give them appreciated stocks as gift.  They could end up with tax-free gain because the rate for capital gain is 0% for the low brackets. Keep an eye on the kiddy tax.

If your children who are over 18 (not a dependent) and have some income, you may give money (tax-free gift) to open a Roth IRA on their names.  Not only can they start an early investment and grow  it with tax-free earnings, they also qualify for the saver’s credit and get refund right now.

Unemployment benefits are normally taxable, but 2009 is special, you can exclude $2,400 from income.  For a married couple, the exclusion can be double (but applied separately).

If you are part of the growing trend of people working abroad, you can safely exclude a big trunk of your earned income ($91,400) and a set amount of housing costs if qualify as living abroad for a full year. (Pub 4732)

If you have an employer matching 401(k), or 403(b), it is a no brainer to contribute to the max ($16,500, or 22,000 for people over 50) to reduce your current taxable income.   Don’t get so hung up about 101(k) joke.  Just move to more conservative funds, but remember do not investment more than 10% in your own company’s stocks.

If you lost your job during 9/2008 and 12/2009 and qualify for COBRA (a transitional health insurance coverage), you will get a 65% discounted rate due to federal subsidy.  Even you quit the job yourself, under certain circumstances, you are still qualified for that.  This may get extended during 2010.

Employee Stock Options

Stock options are becoming more popular again.  If you get the NQO (Non-Qualified Options), brace yourself when you exercise the shares because the lump-sum you receive will be taxed as ordinary income.  It will be included in your W-2 with payroll taxes withheld.

The ISO (Incentive Stock Options) gets more favorable tax treatments.  You may choose exercise-and-hold, exercise-and-sell, or a middle ground.

Exercise-and-hold gives you the  lowest possible tax result but comes with the downside risk of stock price.  Exercise-and-sell eliminates the downside risk but produces the highest tax.

Conservatively, cash now is better cash tomorrow, so you may exercise and sell only enough shares to cash in on it and pay the taxes,  then hold the rest for the upside potential and the surely lower tax.

State Taxes & AMT

State income tax withheld on W-2 is a nice tax break for itemizers, but do you know this is one of the preference items to trigger AMT calculation?

If you live in an areas such as San Francisco Bay Area, with higher salaries or double incomes, you get very high state tax deduction, but it could be wiped out because AMT rules kicks in due to high state tax  (yes, it is some kind of loop).

Sorry to ruin the fun of the party.  As always, tough luck, so count your other blessings!  AMT rules won’t get revised until our congress finishes their fights around health care.

Home Purchase Credit

By now you should know about the $8,000 first-time home buyer credit for 2009.  This is extended to home purchases signed by April 2010.

It has been known that many rich folks from China came to grab cheaper properties here, but as foreigners (non-resident aliens), they won’t get this credit.  Even a Martian in the midst of us has a better chance to claim the credit (as resident alien!).

If the “first time home buyer” requirement bumps you out of the deal, listen! a new credit of $6,500 just came out for those who had owned a home for 5 continuing years during the last 8 years.

Mortgage Interest

The biggest deduction for many people are the home mortgage interest.  You may claim the interest deduction for your second or vacation home.  No more than one second home  is allowed at a time.

You can deduct only if you name is on the loan, so if you pay for your parent’s mortgage, you should get an award for being a good kid, but not from IRS.

There is an exception to this if you can prove yourself as the vested owner even thought you are not on the loan.  The keyword is the proof, and you have quite a convincing job to do.

Also, watch out for the overall debt limit if you claim for multiple properties.  The limit is $1 million for all debts related to home purchase/improvement.  For home equity loans, the limit is $100,000.   If you argue that there are multiple owners so the quota should be $1 million per owner.  Nice try, but it won’t fly.

Why many limitations? Mortgage interest deduction accounts for $80 billion loss of tax revenue for the government.  That is almost double the budget for the Department of Homeland Security.  This deduction is on the IRS’s enforcement radar now,  so if you feel lucky, think harder.

Property Tax

For seniors or people who have paid off mortgages and new home owners, an extra $500 ($1,000 for MFJ) is added to the standard deduction if you do not have enough itemized deductions.

For people living in areas like San Francisco Bay Area, you must be well aware of  the AMT (alternative minimum tax).  Willingly or not, you fall into that due to our high living standard here.  Do you know your property tax is a preference item that will trigger the AMT tax calculation?  That means, this deduction could be meaningless to you as a tax break when AMT kicks in.

Energy Efficient Home

Being conscious about home energy efficiency is a good thing.  The lower future utility bills, plus a tax credit from IRS equaling 30% of your costs or up to $1,500, should make it worthwhile.  This is the generous ever for this kind so far because IRS used to pick and set low credit limit for each improvement items.  Time to check up your windows, doors, skylights or anything related to home and water heating and air-conditioning.  (The credit is still good in 2010).

If you are the risk taking kind, advance yourself into the alternative energy equipments such as solar electric systems, solar hot water headers, etc.  Your will be rewarded with 30% of the total costs, no cap, no limitation, as tax write-off.  With such big saving potential, make sure your manufacture is certified on the product as credit-qualified.

Sale of Home

A large portion of your gain ($250,000 or 500,000 for MFJ) from the sale of your home can be excluded if you live there for at least 2 years during the last 5 year.  Sweet and simple!

Simplicity is never the IRS’s cup of tea.  If you ever rented your property before, you will still get some tax bites.  Your exclusion amount will be proportionally reduced for the rental period.  The deprecation that you would have taken (don’t even have to be actually taken) will be counted as income by the rules of depreciation recapture.

Rental Property

Real estate is a nice way to retain value and generate cash flow as investment.  Yes, I can hear your argument.  I am fine if you don’t believe so.

But this one is not disputable – it gives the best deduction – depreciation – as the only sizable deduction you do not have to spend your own money to get.

This generosity does not go far.  The rules of “passive loss limitation” is a high bar erected to stop the rental losses from crossing over and offset the ordinary income.  Rental is by default classified as passive activity.

There is a special rule, and the keyword is “active participation”.  With that you can claim a max of $25,000 passive loss to offset other income.

If that is still chicken feed to you, you may try to prove that more than 750 hours and above 50% of your services are real estate services as real estate professional (broker or agent; agent is allowed in recent court case), your rental is then qualified as a business, and you will be out of the “passive income” territory.

Yes, you have heard the buzz right.  Sales tax for new car purchase can be an extra amount added to your standard deduction this year.  It has to be a purchase for new car, and only for the sales tax related to the $49,500 costs (for one of multiple cars).  For us living in the California, that is almost like a $5,000 reduction in taxable income.

Even for itemizers, you can claim this special single item sales tax in Schedule A only if you opt out of the gross sales tax deduction.   Since last year, you have the choice to claim total sales tax paid or state income tax on your Schedule A.   Tip:  If your total sales tax, including the car purchase, is larger than your state income tax, it only makes sense to pick the total sales tax option.

Again, remember, only original or new cars!

Debt Reduction

If you had a mortgage workout, a short-sale, or even foreclosure during the year, take a deep breath, let me tell you that the canceled or reduced debt amounts are taxable as income.

You listen it right, you have income that you don’t get to spend.  Go figure, but don’t kill me as the messenger.  Each lender involved will send you a 1099-C at the end of the year anyway.

Good news, until 2012, if the property involved is your home, up to $2 million of the debt canceled is exempt from tax.

For business or investment properties, the discharged debts are also excludable for non c-corporation owners if they make such election.  There is no free lunch though, the exclusion is only a temporary relief, and it will be subtracted from the costs basis.  The property will have less depreciation and larger capital gain when it is sold in the future.

Six Things You Need to Know About Mortgage Workouts (Summertime Tax Tip 2009-09)

Don’t Fall for the Debt Consoliators

Debt consolidation may not be a good idea if you are considering one  solicitation in the mail.  Such companies negotiate with the lenders for lower monthly payments on behalf of you, but you will pay at least 20% to them for the reduction, you will pay tax on the credit card debt reduction,  and your credit score will be affected negatively.  To work on your loan, an old fashion home budget will be more realistic.

Refinance Costs

There have been refinance opportunities through out 2009.  You have to pay higher points now, but low rates give you lower monthly payments, so that is a big plus for the home budget.

Many may not know that most of the refinancing costs are not deductible.  Even the deduction on loan fee (points) has to be amortized over the life of the loan (yes, 30 years usually).  Worse yet, such costs are not allowed to be added to the cost basis unless the business or investment properties are involved.  Well, tough luck. So count your other blessings!

Gifts received is not taxable, and gift given is not tax deductable either.  The annual gift limit is $13,000 for each recipient.  You can give any number of people, each with the amount below the annual limit.  It is okay to give more than $13,000 for each person each year.  You just need to file Form 709 to report the excess just for the record.  Each person has a $1 million gift limit for the life time.   For regular folks, that is a huge stock of Santa’s socks to give out in order to use it up.

For people with decent assets, especially if you own a home in the San Francisco Bay Area, estate planning is a must.  Your assets will be taxed when you pass it down to your children.  Gifting is a great way to reduce the gross asset with no tax impact as long as it is below the annual limit.

Grandparents may open college tuitions saving plan (529 accounts) for grand kids.  A lump sum contribution to such account is allowed, up to five times of the annual gift exclusion amount.  If your children or grand children have some income, open a Roth IRA for them.  They get their seed money for early investment.  Earning in Roth IRA is tax free.  They may claim saver’s credit for the IRA contribution this year.   (I am not sure if Santa is doing it for estate tax planning purpose.)

There is an unlimited tax break if you pay tuition directly to the schools (see detail here about prepaid tuition).  Similar rules apply for direct medial payments.

Parents may give appreciated shares of stocks to their children.  Children will pay no or low tax on the gain due to their low tax bracket.  As long as their investment income is less than $1,900, they are off the radar of the kiddie tax rules.

For business and self-employed, gift to another can be claimed as expense.  Business gift to a person is limited to a ridiculous $25, but business gift to the  company is not limited.

It is little known but it is required that you file a form to report gifts or inheritance from foreign persons or trusts, if the combined value is over $100,000.  Just an information return with no tax due.  Failure to file will be penalized (up to 25% of the value).   If you are getting overseas money for tuition or medical expense,  you are exempted.

These are not the kind of gifts to your children or relatives.  It is tax deductible donations to the 503(c) exempt organization,  or charity/religion organizations.  IRS started looking harder on this.   A client of mine got notice questioning the names on their donation receipts.  There were court cases that disallowed donation deductions due to insufficient supporting documents.

Charity donation from a business is still considered personal contribution by owners.  You can not write it off as business expenses.  Claim the deduction in your 1040 Schedule A if you are a partner or member in LLC.

If you have traditional IRA, and you are over 70-1/2,  you are required to take money out annually (required minimum distribution).  This year, donation is allowed to be given direct out of IRA and counted as your required minimum distribution.  (Note:  this year the required minimum distribution is temporarily suspended)

Ten Tips for Taxpayers Making Charitable Donations (Summertime Tax Tip 2009-21)

For a college student (in any one of the 4 years) in your family,  you can take up to $2,500 American Opportunity Credit (the modified HOPE credit) for the tuition and books costs.  If you are taking classes yourself, you may qualify Lifetime Learning Credit.

If you do not qualify for any of these education credits, you may still subtract the qualified education expenses up to $4,000 as adjustment to income.

The state sponsored 529 tuition accounts now allow the fund spend on computer and internet related expenses.

Grandparents or any body may contribute to 529 college tuitions plan.  A lump sum contribution can be as large as five times of the annual gift exclusion amount ($13,000 currently).

There is an unlimited tax break if you pay tuition directly to schools (see detail here about prepaid tuition).

Those who look for stability in our current economy condition may have invested in municipal bonds, Treasuries, or high-dividend yield funds.

Dividends & Interests

Dividends are taxed at 0% for people in lower tax brackets and 15% for the higher brackets (higher than 15% marginal rate).  Interest in municipal bonds are tax-exempt.  Even investing in taxable government bonds that qualify the Build America Bonds Program will get 35% credit on the interest income.

Capital Gains

If you have mutual funds, it is very possible you’ve seen capital gain distributions in your year-end brokerage consolidated statement.  Even though you do not receive any actual money or “distribution”,  it is counted as taxable income.   That is because your fund managers have to trade or sell very often to steer the fund out of low performance.   Fortunately, the current long term capital gain rate is not too bad, 0% for lower bracket and 15% for higher brackets investors.

Rates for capital gain are on the rising track to the level of 10%/20% in 2011 by the current laws.  The current congress may introduce increases even sooner than that.  It is more important to invest in tax-efficient mutual funds, index fund or ETF because you will have less phantom capital gains caused by frequent manager trading.

Capital Losses

It is a traditional strategy to harvest losses, by selling low performers in your portfolios in order to bring down the adjusted gross income and qualify for lower tax rates.   However, with recently accumulated investment losses, the annual loss deduction ($3,000) does not seem very productive.

It may be a time to harvest gains.  If you need to rebalance your investments, consider selling the good performers to cash out the gain and absorb the prior capital losses as well.   If you have been thinking about exit for your real estate investment, your capital losses available to offset the gain could be a one of the incentive to do it, but do consider other factors.

Investment in classic sense is about saving for the future.  Even though you do not have the aspiration to be another Warren Buffett, you still need a basic retirement plan, and Uncle Sam is giving you reasons to do that.

For starter, contribution to retirement accounts may qualify for saver’s credit.  You earn a return immediately as tax refund when you put aside, say $2,000 to a traditional IRA.   Also, traditional IRA gives tax deduction (deferral) up to $5,000.  Roth IRA may not give you current tax deduction, but is a best tool to grow your saving because earnings are totally tax free.

Money in IRA is locked up until the age of 59-1/2 because the worse enemy of long-term saving is your impulse to use the fund on something else.  However, you can withdraw for qualified reasons.  For example, you may take $10,000 for purchase of a home.

There are more powerful retirement plans for self-employed and small business. They are SIMPLE IRA, SEP IRA or Solo 401(k).  SEP IRA is the easiest way to get a large reduction against your business income.  Your business can contribute 25% of your salary or 20% of the business profit up to $49,000.  If you do not mind more paperwork,  Solo 401(k) plan lets you enjoy the benefit of both SEP contribution ($49,000) as employer, and the 401(k) ($16,500, plus $5,500 if over 50 of age) as employee.

With such whopper tax-deferral benefits, being self-employed really seems like a better way to control your own destiny.

Corporate tax rates are no longer lower than personal rates.  A corporation entity for your small business will no longer give you tax rate advantage.  For new start up, consider pass-through type of entities, such as LLC, Partnership, or S-corporation.  According to IRS statistics, S-corporation is getting very popular and audit rate on S-corporation returns are very low so far.

C-corporation is taxed twice, so a shareholder of a closely-held corporation tends to draw big salary to avoid double-taxation (dividend in disgust).  S-corporation is a pass-through entity, a shareholder tends to take very little salary in order to avoid additional payroll taxes.  To stay under the IRS audit radar, make sure the compensations are reasonable.

Top Seven Tips for Taxpayers Starting a New Business (Summertime Tax Tip 2009-02)

IRS got an idea that a big chunk of revenue loss is attributed to the loss of payroll taxes due to employees being classified as 1099er or independent contractors.  While IRS is on hot pursuit of payroll taxes and beefing up their employment audits, please check out these IRS provided criteria and do some “house-keeping” before getting a notice.

Employee vs. Independent Contractor – Ten Tips for Business Owners (Summertime Tax Tip 2009-20)

Form 1040 Schedule C for business of self-employed is increasingly getting IRS’s attention.  Audit rates for people with Schedule C are climbing.  IRS will look closely and classify your activities as hobbies unless you show a serious motive for profit.   For example, if you’ve joined a direct marketing program (MLM) and kept showing losses, your Schedule C will be under a lot of questions.

Eight Important Questions for Hobbyists (Summertime Tax Tip 2009-18)

Self-employment tax are calculated  as 12.4% on the $106,000 of income (FICA) and  2.9% on all income (Medicare).  Sole proprietor, LLC members, and partners, are subject to self-employment taxes.

Equipment & Auto

One big business deduction is the Sec 179 first year write-off ($250,000) for purchase of equipments.  Or 50%  first year bonus depreciation can be taken on top of regular depreciation.  For small business, the usual big-ticket item is car.  As expected, there are many strings attached to write-off related to car.

Write-off is limited to $25,000 for most cars or SUVs. You have to maintain more than 50% business use in any following years.  You can use Sec 179 only if you have net income.  You can choose to use the bonus depreciation instead, but the catch is that only new (original, no used) equipments are allowed for the bonus depreciation. Furthermore, if your car falls in the “luxury” category, meaning over $15,100 in cost (What?! – I know),  there is more limit on the deprecation each year.  Bottom-line, they really want to kill the thrill of having large deduction for your car.

Compensation

LLC has been a popular form of business entity.  There is a misunderstanding that payments to members/partners are deductible compensation.  Such payments are treated as “guarantee payments”.  They are not subject to payroll withholding.  There will be no W-2, but K-1 is used to report the total payments.  Each member/partner will figure out the self-employment tax on their own 1040.

To avoid under payment penalties, it is very important to pay sufficient estimated tax payments thought out the year for the members or partners.

Office in Home

It is a free agent nation, a new world of independent workers.  As so it is declared, there are estimated 34 million business people working out of their homes.  As long as you have a full time business, and part of your home is the principal office you use regularly, you can safely claim home office related deductions.   The key word is principal (no other fixed office outside).

It will be a stretch if you claim home office because you spend time reading Wall Street Journal or trading with Scottrade or Forex at home.  Personal investment activities are bound to be ruled out because it is likely to be treated as passive activities.  There are other rules for part of your home used for storage (such as being a little warehouse for your e-commerce) or daycare facility.  Employees using home office are subject to even more restrictions.

Five Facts about the Home Office Deduction (Summertime Tax Tip 2009-16)

Fringe Benefits

Health insurance premiums are deducible for self-employed.   A younger self-employed person may find additional bargain by using HSA.  It is a high-deductible health insurance combined with a medical savings bank account.  You get the savings from lower insurance premium,  the benefit of tax deduction for the actual  premium paid, and the another deduction up to $3,000 when you put money into a special bank savings account.  The contribution date is the due date of the tax return, just like a traditional IRA.

Net Operating Losses (NOL)

2008 and 2009 NOL can be carried back 3, 4 or 5 years. If you have business losses from Schedule C, Schedule K-1 (Partnership, S-corporation, or LLC), you have a gold mine to dig.  Just apply the losses to any of the prior 5 years that has profit and file a refund request.

Loans to the Company

If you have loans to your own business, even no interest is being charged by you,  but IRS will still assume you have collected interest.  It is called imputed interest calculated with current IRS rate, about 5%, and you will have to report the income.  Time to take care of that outstanding loan balance.

Filing deadline for Partnership and LLC (taxed as partnership) is April 15.  A 6-month extension was allowed before, but it was changed to 5 months now and no future extension is allowed.  (Note: This applies to fiduciary 1041 return for trust as well).

Here comes the stick.  Late filing penalty for partnership(1065) is $89 per partner per month for 12 months.  Each partner is facing penalty up to $1,068.  Read on for the surprising change for 2010.

S-corporation (1120S) is due on March 15, but 6-month extension is still available.  Similarly, the $89 per shareholder per month for 12 month late filing penalty is also applied.  Read on for the surprising change for 2010.

As I am writing, here comes the new change:  For tax years beginning in 2010, the penalty is increased to $195 per shareholder/partner per month up to 12 months.  If you have an S-corporation, partnership, or LLC, be sure to file those extensions.

When a donation receipt or acknowledgement letter is issued to your donor, make sure to indicate that “No goods or services were provided by the organization for the contribution”.  This was a quoted reason in a court case in which a pastor’s donation to a church was disallowed.

To keep the exempt status, a church is prohibited to issue donation receipt for money passed through the organization to benefit a specific person.

IRS just released new audit guide during 2009 for cases involving ministers or pastors.  Expect more inquiries regarding the classification of ministers.  Ministers have the hybrid status.  They are now more defined an employee of the church, so they will receive W-2, but portion of their income, the parsonage or housing allowance, which is income tax free, will be reported and pay the self-employment tax on 1040 at year end.  It is important for pastors to make enough estimated taxes.

Get expanded discussion here.

Gifts given to a non-retired pastor is required to be included in W-2 as compensation income.  I’ve heard a real story that one pastor complained about the accountant of his church being unkind to him.  It turned out the accountant reported the money specifically donated to him in his W-2.  Lesson of the story?  Would someone bring words to IRS please? “Give back to Caesar the things that are Caesar’s, and to God the things that are God’s.”  Oops, maybe the joke is on that pastor.

To avoid penalties, make sure you pay enough estimated tax up to 90% of last year’s total tax.  This should concern the self-employed and the 1099 people more than the W-2 folks.

For W-2 people, unless you are extremely patriot, you need to adjust your withholding and submit a new W-4 every year to reduce your free loan or excessive withholding to the IRS.  There will be an option in the upcoming new tax forms to let you choose I-Bond as your tax refund.  Use this withholding calculator provided by IRS to prepare your W-4.

If you have problem paying your tax in full right away.  You may request a 120-day payment extension and IRS will response within 10 days.  IRS also provide an online installment application for those with less than $25,000 tax to apply for payment plan.

Eight Tips for Taxpayers Who Owe Money to the IRS (Summertime Tax Tip 2009-15)

Have you heard? IRS is going international.  For whatever reasons, if you have financial account(s) in foreign countries, there have been an requirement to file a simple report on that.  Many people have ignored that for years, but now IRS is seriously pursuing this.  It is all UBS’s fault.  Actually, this is an on-going 30-year effort to break the offshore account tax sheller.  (Here is an interesting alternative point of view)

As long as you have a combined value over $10,000, you are required to file TD F 90-22.1 with the Department of the Treasury on or before June 30 of the succeeding year.  The penalties are quite scary (See other post for detail).

For those who follow the progress of health care reform, the battle ground is around the “pubic option” now.  There is an emerging proposal for the “public option” to put everybody in the existing Medicare system, so maybe soon, Medicare is no longer the exclusive right for the the members of AARP at large.

IRS will be tasked of policing the healthcare system.  By 2013, everyone has to confirm on their tax return they have health coverage, or pay a penalty.  IRS has the big computing power to do the matching check.  Credit of healthcare will be provided to lower income family and companies who do not provide coverage will be asked to pay fees to fund the credits.