The Best Way to Avoid an Audit: Preparation

The Best Way to Avoid an Audit: Preparation

by | Feb 6, 2018 | Audit, Financial planning, Tax, Tax Tips

Getting audited by the IRS is no fun. Some taxpayers are selected for random audits every year, but the chances of that happening to you are very small. You are much more likely to fall under the IRS’s gaze if you make one of several common mistakes. So what is the best way to avoid an audit?
That means your best chance of avoiding an audit is by doing things right before you file your return this year. Here are some suggestions:
Don’t leave anything out. Missing or incomplete information on your return will trigger an audit letter automatically, since the IRS gets copies of the same tax forms (such as W-2s and 1099s) that you do.
Double-check your numbers. Bad math will get you audited. People often make calculation errors when they do their returns, especially if they do them without assistance. In 2016, the IRS sent out more than 1.6 million examination letters correcting math errors. The most frequent errors occurred in people’s calculation of their amount of tax due, as well as the number of exemptions and deductions they claimed.
Don’t stand out. The IRS takes a closer look at business expenses, charitable donations and high-value itemized deductions. IRS computers reference statistical data on which amounts of these items are typical for various professions and income levels. If what you are claiming is significantly different from what is typical, it may be flagged for review.
Have your documentation in order. Keep your records in order by being meticulous about your recordkeeping. Items that will support the tax breaks you take include: cancelled checks, receipts, credit card and investment statements, logs for mileage and business meals, and proof of charitable donations. With proper documentation, a correspondence letter from the IRS inquiring about a particular deduction can be quickly resolved before it turns into a full-blown audit.
Remember, the average person has a less than 1 percent chance of being audited. If you prepare now, you can narrow your audit chances even further and rest easy after you’ve filed.
Do You Have a Household Employee? Don’t Ignore the Nanny Tax

Do You Have a Household Employee? Don’t Ignore the Nanny Tax

by | Jan 30, 2018 | Financial planning, Tax, Tax Tips

As you review your filing requirements for 2018, make sure you don’t overlook the nanny tax related to household employees. If you have a housekeeper or any other household employee, you could be liable to pay state and federal payroll taxes.

How to know if you must pay the nanny tax

First, you’ll need to determine whether you have a household employee. Generally, this is someone you hire to work in or around your house. It could be a babysitter, nurse, gardener, etc. It doesn’t matter whether they work part-time or full-time, or whether you pay them hourly, weekly, or by the job.

But not everyone who works around your house is an employee. For example, if a lawn service sends someone to cut your grass each week, that person is not your employee.

As a general rule, workers who bring their own tools, do work for multiple customers and/or control when and how they do the work are not your household employees.

Your responsibilities

If you have a household employee, you’ll generally be responsible for 2017 payroll taxes if you paid that individual more than $2,000 last year. However, federal unemployment tax kicks in if you pay more than $1,000 to all domestic employees in any quarter.

It’s not always easy to tell whether you have a household employee, or whether exceptions apply. If in doubt, don’t hesitate to call our office.

Tax Rules for Small Business: Changes to Pass-Through Entity Rules

Tax Rules for Small Business: Changes to Pass-Through Entity Rules

by | Jan 23, 2018 | Business planning, Financial planning, Tax, Tax Tips

One of the most important – and complicated – changes in the new tax reform act is to the tax rules for small business that are treated as “pass-through entities.”

The good news is that if you own one of these businesses you may get as much as a 20 percent reduction to the taxation of business net income under the new rules.  However, calculating the actual deduction can become very complex. It depends upon several factors, including your level of income, your profession, the amount your business spends on wages and property acquired during the year.

Tax reform background

Most small businesses in the U.S. use pass-through business structures, which pass their profits on to their individual owners. Owners pay tax on those profits at their individual tax rates, in conjunction with other income. The new tax rates range from 10 percent to 37 percent in the 2018 tax year. Pass-through business structures include S corporations, partnerships and LLCs. Sole proprietorships handle business income in a similar way using Form 1040 Schedule C and are also covered by the new rules.

Because the Tax Cuts and Jobs Act signed in late December 2017 changed the corporate tax rate structure to a flat 21 percent rate from a progressive scale with a top rate of 35 percent, that meant many pass-through business structures would pay more than regular C corporations. To offset this, Congress gave pass-through owners the new 20 percent business income deduction.

But Congress also put in place special rules limiting the ability of “specified service trades” to take the full deduction. The list includes health, law, consulting, athletics, financial services, brokerage services, accounting firms, “or any trade or business where the principal asset … is the reputation or skill of one or more of its employees or owners.” An earlier version of the bill included the engineering and architectural professions, but those were later taken off the list, so they are considered exempt from the limits.

How to figure out your deduction – easy cases

First, make a rough calculation of your expected qualified business income (QBI), which is generally your net income other than income in the way of compensation. This figure excludes business losses, as well as factoring in amortization and capitalized expenditures. QBI is figured separately for each business activity, not on a per-taxpayer basis.

Easy Case 1: If your QBI is less than $157,500 as an individual filer, or $315,000 as a married couple filing jointly – you can take the full 20 percent deduction.

Easy Case 2: If your QBI is greater than $207,500 as an individual filer, or $415,000 as a married couple filing jointly, AND you are in one of the specified
service professions (health, law, consulting, athletics, financial services, accounting, brokerage services, etc.) – you can’t take anyof the deduction.

How to figure out your deduction – hard cases

If you don’t fall into either of the easy cases, figuring out your pass-through deduction gets much more difficult.

Who is affected: Small business owners with QBI of more than $157,500 as individual filers ($315,000 for married filing jointly) but less than the phaseout of $207,500 as an individual filer ($415,000 married filing jointly).

After your QBI passes the threshold amount of $157,500 as an individual filer, or $315,000 as a married couple filing jointly, special wage and capital limits that reduce your deduction start to apply.

After your QBI passes the threshold amount PLUS the phaseout amount, which is $207,500 as an individual filer, or $415,000 as a married couple filing jointly, the wage and capital limits are applied fully to reduce your deduction. You’ll still get a reduced deduction (unless you are in one of those specified service professions – then your deduction is eliminated completely).

The formula for calculating the wage and capital limits is based on the greater of 50 percent of the W-2 wages paid by your business, OR 25 percent of the W-2 wages, plus 2.5 percent of the unadjusted basis of all qualified property acquired by your business during the year.
Sound confusing? In most cases the calculation will be straightforward – but not for everyone.

REMINDER: If you’re familiar with the wage and capital limits calculation, it may be because your small business used the Domestic Production Activities Deduction (DPAD) in the past, which uses a somewhat similar calculation. The DPAD was repealed in the Tax Cuts and Jobs Act for 2018 and subsequent tax years, so keep that in mind as you chart your business plans.

The rules are in flux

Every tax reform bill is subject to technical amendments that clarify and adjust what is confusing or not working as lawmakers intended. The Tax Cuts and Jobs Act will likely be no different. The pass-through rules are among the most complicated parts of the act, so many of the moving parts will change over the coming months. We will know more as 2017 taxes are completed and the focus turns to the 2018 rules.
If you own a pass-through business, you will need help navigating the choppy waters of tax reform. When the storm of the recent passage subsides and the details are clarified, reach out to schedule a consultation to chart a course for your business in 2018.
Note: The threshold amounts cited in this memo are for tax year 2018 and are indexed to inflation in subsequent years.

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Bonus Questions and Answers

You likely have more questions about the new 20 percent income deduction rule than anyone can possibly answer right now. Clarification from the IRS is coming in the following months. Until then, here are answers to some common questions businesses are asking.

Q.  Why is there a wage and service business limit calculation in the deduction?

A.  Lawmakers were concerned that the owners of service businesses would change how they pay themselves in order to reduce their tax burden. They said they intended to “deter high-income taxpayers from attempting to convert wages or other compensation for personal services to income eligible for the 20-percent deduction.”

Source: U.S. Congress Conference Report, page 37.

Q.  I’ve heard that rental property owners could possibly get this deduction. Is this correct?

A.  Yes, in all likelihood Schedule E filers will also be eligible for the deduction. While most of these entities do not have wages, the capital portion of the calculation may result in a deduction for these businesses.

Q.  What about losses? Do they affect my ability to get the deduction?

A. Yes, losses will lower your eligible income. Excess losses will carry over to future years, limiting your ability to take the deduction in the future.

Q.  How is qualified property calculated? How does bonus depreciation and Section 179 expensing affect the 2.5 percent property calculation?

A.  These answers can get pretty complicated and will require clarification from the IRS. While we wait for that, here is a short explanation based on what we know now: Qualified property must be tangible property subject to depreciation and available for use in a qualified trade or business. The calculation for businesses subject to limitation will be based on 2.5 percent of the property value. The value of the property appears to be its basis after it is placed into service, and it must be actively used as of the end of the year. There will be provisions to account for the leveling out of different recovery period calculations and the prior use of accelerated depreciation methods. But stay tuned; this area could be full of further clarifications and guidance.

Q.  Where is the deduction taken on Form 1040?

A.  The deduction probably will be taken on page 2 of Form 1040, following the calculation of adjusted gross income.

Q. What about my hobby activity, does it get this deduction?

A.  Probably not. It’s likely that you would need to pass the threshold rules relating to hobby versus business activity. But this area too, could use some help with clarification.

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This brief summary of the pass-through rules in the tax reform act is provided for your information. Any major financial decisions or tax-planning activities in light of this new legislation should be considered with the advice of a tax professional. Call if you have questions regarding your particular situation. Feel free to share this memo with those you think may benefit from it.

The 2018 Tax Filing Season is Almost Here!

The 2018 Tax Filing Season is Almost Here!

by | Jan 8, 2018 | Financial planning, Hawkinson Muchnick & Associates PC, Tax

IRS Announces Delayed Start for Tax Filing Season 2018! This year, the IRS filing season will begin Jan. 29, which is a little later than last year’s filing season, which began on Jan. 23.  The IRS is still updating its systems to prepare for the 2018 tax filing season.

Individual tax returns are due April 17 this year because April 15 is a Sunday and April 16 is a holiday in the District of Columbia.

Although we cannot submit tax returns to the IRS until Jan. 29, we are encouraging all of our clients to get us their information as soon as possible so that we can process them on our end now and file them when the IRS begins accepting them.

It is also important to note that the IRS informed taxpayers that, by law, it cannot issue refunds related to claims for the earned income tax credit or the additional child tax credit until mid-February.

Sweeping Tax Reform Act Will Affect YOU!

Sweeping Tax Reform Act Will Affect YOU!

by | Dec 29, 2017 | Financial planning, Hawkinson Muchnick & Associates PC, Tax, Uncategorized

WHAT THE TAX REFORM MEANS FOR YOU

Congress has passed a tax reform act that will take effect in 2018, ushering in some of the most significant tax changes in three decades. There are a lot of changes in the new act, which was signed into law on Dec. 22, 2017.

You can use this memo as a high-level overview of some of the most significant items in the new tax reform act. Because major tax reform like this happens so seldom, it may be worthwhile for you to schedule a tax-planning consultation early in the year to ensure you reap the most tax savings possible during 2018.

KEY CHANGES FOR INDIVIDUALS

Here are some of the key items in the tax reform act that affect individuals:

  • Reduces income tax brackets: The act retains seven brackets, but at reduced rates, with the highest tax bracket dropping to 37 percent from 39.6 percent. The individual income brackets are also expanded to expose more income to lower rates (see charts below).
  • Doubles standard deductions: The standard deduction nearly doubles to $12,000 for single filers and $24,000 for married filing jointly. To help cover the cost, personal exemptions and most additional standard deductions are suspended.
  • Limits itemized deductions: Many itemized deductions are no longer available, or are now limited. Here are some of the major examples:
    • Caps state and local tax deductions: State and local tax deductions are limited to $10,000 total for all property, income and sales taxes.
    • Caps mortgage interest deductions: For new acquisition indebtedness, mortgage interest will be deductible on indebtedness of no more than $750,000. Existing mortgages are unaffected by the new cap as the new limits go into place for acquisition indebtedness after Dec. 14, 2017. The act also suspends the deductibility of interest on home equity debt.
    • Limit of theft and casualty losses: Deductions are now available only for federally declared disaster areas.
    • No more 2 percent miscellaneous deductions: Most miscellaneous deductions subject to the 2 percent of adjusted gross income threshold are now gone.

Tip: If you’re used to itemizing your return, that may change in coming years as the doubled standard deduction and reduced deductions make itemizing less attractive. To the extent you can, make any remaining itemizable expenditures before the end of 2017.

  • Cuts some above-the-line deductions: Moving expense deductions get eliminated except for active-duty military personnel, along with alimony deductions beginning in 2019.
  • Weakens the alternative minimum tax (AMT): The act retains the alternative minimum tax but changes the exemption to $109,400 for joint filers and increases the phaseout threshold to $1 million. The changes mean the AMT will affect far fewer people than before.
  • Bumps up child tax credit, adds family tax credit: The child tax credit increases to $2,000 from $1,000, with $1,400 of it being refundable even if no tax is owed. The phaseout threshold increases sharply to $400,000 from $110,000 for joint filers, making it available to more taxpayers. Also, dependents ineligible for the child tax credit can qualify for a new $500-per-person family tax credit.
  • Expands use of 529 education savings plans: Qualified distributions from 529 education savings plans, which are not subject to tax, now include tuition payments for students in K-12 private schools.
  • Doubles estate tax exemption: Estate taxes will apply to even fewer people, with the exemption doubled to $11.2 million ($22.4 million for married couples).
  • Kiddie tax: Effective 2018, the “kiddie tax” on children’s unearned income will use the estates and trusts tax rate structure, meaning it will be taxed anywhere from 10 percent to 37 percent.
What stays the same for individuals:
  • Itemized charitable deductions: Remain largely the same.
  • Itemized medical expense deductions: Remain largely the same. The deduction threshold drops back to 7.5 percent of adjusted gross income for 2017 and 2018, but reverts to 10 percent in the following years.
  • Some above-the-line deductions: Remain the same, including $250 of educator expenses and $2,500 of qualified student loan interest.
  • Gift tax deduction: Remains and increases to $15,000 from $14,000 for 2018.
Farewell to the healthcare individual mandate penalty
One of the changes in the tax act is the suspension of the individual mandate penalty in the Affordable Care Act (also known as “Obamacare”). The penalty is set to zero starting in 2019, but remains in place for 2018 and prior years.Tip: Retain your Form 1095s, which will provide evidence of your healthcare coverage. Without it, you may have to pay the individual mandate penalty, which is the higher of $695 or 2.5 percent of income. Beginning in 2019, this penalty is set to zero.
NOTICE: The IRS recently granted employers and health care providers a 30-day filing extension for Forms 1095-B and 1095-C, to March 2, 2018. The IRS clarified that taxpayers are not required to wait until receipt of these forms to file their taxes.

New 2018 tax bracket structures for individuals

Single taxpayer

Taxable income over But not over Is taxed at
$0 $9,525 10%
$9,525 $38,700 12%
$38,700 $82,500 22%
$82,500 $157,500 24%
$157,500 $200,000 32%
$200,000 $500,000 35%
$500,000 37%
Head of household
Taxable income over But not over Is taxed at
$0 $13,600 10%
$13,600 $51,800 12%
$51,800 $82,500 22%
$82,500 $157,500 24%
$157,500 $200,000 32%
$200,000 $500,000 35%
$500,000 37%

Married filing jointly
Taxable income over But not over Is taxed at
$0 $19,050 10%
$19,050 $77,400 12%
$77,400 $165,000 22%
$165,000 $315,000 24%
$315,000 $400,000 32%
$400,000 $600,000 35%
$600,000 37%

Married filing separately
Taxable income over But not over Is taxed at
$0 $9,525 10%
$9,525 $38,700 12%
$38,700 $82,500 22%
$82,500 $157,500 24%
$157,500 $200,000 32%
$200,000 $300,000 35%
$300,000 37%
Estates and trusts
Taxable income over But not over Is taxed at
$0 $2,550 10%
$2,550 $9,150 24%
$9,150 $12,500 35%
$12,500 37%
Key changes for small businesses:
Here are some of these key items in the tax reform act that affect businesses:
  • Cuts the corporate tax rate: Corporate tax gets cut and simplified to a flat 21 percent rate, changed from a multi-bracket structure with a 35 percent top rate.
  • Reduces pass-through taxes: Most owners of pass-through entities such as S corporations, partnerships and sole proprietorships will see their income tax lowered with a new 20 percent income reduction calculation.
  • Beefs up capital expensing: Through 2022, short-lived capital investments in such items as machinery and equipment may be fully expensed as soon as they are placed in service, using bonus depreciation. This now also applies to used items instead of only new ones; they just need to be placed in service for the first time in your business. After 2022, allowable bonus depreciation is then lowered incrementally over the next four years.
  • Strengthens Section 179 deduction: Section 179 deduction limits get raised to enable expensing of up to $1 million, and the phaseout threshold increases to $2.5 million. Section 179 may now also be used on expenses related to improvements to nonresidential real estate.
  • Nixes the corporate alternative minimum tax (AMT): The 20 percent corporate AMT applied to businesses goes away entirely.
  • Expands use of cash-method accounting: Businesses with less than $25 million in gross receipts over the last three years may adopt the cash method of accounting.
  • Reforms international taxation: Treatment of international income moves to the territorial system standard, in which foreign investments are generally only taxed in the place in which they operate. The new laws allow tax deductions for certain foreign-sourced dividends, reduced tax rates for foreign intangible income and reduced tax rates for repatriation of deferred foreign income.
  • Repeals business entertainment deduction: Businesses will no longer be able to deduct 50 percent of the cost of entertainment, amusement or recreation directly related to their trade or business. The 50 percent deduction for business-related meals remains in place, however.
  • Modifies several business credits: Several business credits are maintained but modified, including the orphan drug credit, the rehabilitation credit, the employer credit for paid family or medical leave and the research and experimentation credit.
  • Boosts luxury automobile depreciation: Luxury automobiles placed in service after 2017 will have allowable depreciation of $10,000 for the first year, $16,000 the second, $9,600 the third and $5,760 for subsequent years.

This brief summary of the tax reform act is provided for your information. Any major financial decisions or tax-planning activities in light of this new legislation should be considered with the advice of a tax professional. Call if you have questions regarding your particular situation. Feel free to share this memo with those you think may benefit from it.

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Reduce Your Tax Liability with the Home Office Tax Deduction

Reduce Your Tax Liability with the Home Office Tax Deduction

by | Jul 25, 2017 | Tax

The home office tax deduction is a tricky area of the tax code. Some taxpayers are so wary of the deduction that they simply opt not to take it. If you’re in this group, read the common mistakes and then get help. Don’t miss out on this tax benefit if it applies to you.

If you operate a business out of your home, you may be able to deduct a wide variety of expenses. These may include part of your rent or mortgage costs, insurance, utilities, repairs, maintenance, and cleaning costs related to the space you use.

It can be a tricky area of the tax code that’s full of pitfalls for the unwary. Here are some of the top mistakes people make:

  1. Not taking it. This is probably the biggest mistake those with home offices make. Some believe the deduction is too complicated, while others believe taking a home office deduction increases your chance of being audited. While the rules can be complicated, there are now simple home office deduction methods available to every business.
  2. Not exclusive or regular. The space you use must be used exclusively and regularly for your business.
  • Exclusively: If you use a spare bedroom as a business office, it can’t double as a guest room, a playroom for the kids, or a place to store your hockey gear. Any kind of non-business use can invalidate you for the deduction.
  • Regularly: It should be the primary place you conduct your regular business activities. That doesn’t mean that you have to use it every day nor does it stop you from doing work outside the office, but it should be the primary place for business activities such as recordkeeping, billing, making appointments, ordering equipment, or storing supplies.
  1. Mixing up your other work. If you are an employee for someone else in addition to running your own business, be careful in using your home office to do work for your employer. Generally, IRS rules state you can use a home office deduction as an employee only if your employer doesn’t provide you with a local office to work at.

Unfortunately, this means if you run a side business out of your home office, you cannot also bring work home from your employer’s office and do it in your home office. That would invalidate your use of the home office deduction.

  1. The recapture problem. If you have been using your home office deduction, including depreciating part of your home, you could be in for a future tax surprise. When you later sell your home you will need to account for this depreciation. This depreciation recapture rule creates a possible tax liability for many unsuspecting home office users.
  2. Not getting help. There are special rules that apply to your use of the home office deduction if:
  • You are an employee of someone else.
  • You are running a daycare or assisted living facility out of your home.
  • You have a business renting out your primary residence or a vacation home.

The home office deduction can be tricky, so be sure to ask for help, especially if you fall under one of these cases.

Things to remember

Recognizing the home office deduction complexity, the IRS created a simplified “safe harbor” home office deduction. You simply take the square footage of your office, up to 300 square feet, and multiply it by $5. This gives you a potential $1,500 maximum deduction. However, your savings could be much greater than $1,500, so it’s often worth getting help to calculate your full deduction.

Finally, if you are concerned about a potential future audit, take a photo or two of your home office. This is especially important if you move. That way if you are ever challenged, you can visually attempt to show your compliance to the rules.

 

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