Are You an S Corporation Stockholder? Are You Taking Reasonable Compensation in the Form of Wages?

S corporation compensation requirements are often misunderstood and abused by owner-shareholders. An S corporation is a type of business structure in which the business does not pay income tax at the corporate level and instead distributes (passes through) the income, gains, losses, and deductions to the shareholders for inclusion on their income tax returns. If there are gains, these distributions are considered return on investment and therefore are not subject to self-employment taxes.

However, if stockholders also work in the business, they are supposed to take reasonable compensation for their services in the form of wages, and of course, wages are subject to FICA (Social Security and Medicare) and other payroll taxes. This is where some owner-shareholders err by not paying themselves a reasonable compensation for the services they provide, some out of unfamiliarity with the requirements and some purposely to avoid the payroll taxes.

The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.

If the S corporation does not pay its working stockholders a reasonable compensation for their services, then the IRS generally will treat a portion of the S corporation’s distributions as wages and impose Social Security taxes on the deemed wages.

There is no specific method for determining what constitutes reasonable compensation, and it is based upon facts and circumstances. Generally, it is an amount that unrelated employers would pay for comparable services under like circumstances and based upon the cost of living in the area where the business is located. The following are just some of the many factors that would be taken into account in making this determination:

  • Training and experience
  • Duties and responsibilities
  • Time and effort devoted to the business
  • Dividend history
  • Payments to non-shareholder employees
  • Timing and manner of paying bonuses to key people
  • What comparable businesses pay for similar servicesCompensation agreements
  • The use of a formula to determine compensation

The problem here, of course, is that it is easy for the IRS to list contributing factors used by the courts in determining reasonable compensation and leave it to the corporation to quantify these factors into a reasonable salary but still have the ability to challenge the selected amount later if an auditor, off the top of their head, decides the compensation is unreasonable.

The IRS has a long history of examining S corporation tax returns to ensure that reasonable compensation is being paid, particularly if no compensation is shown being paid to employee-stockholders.

Reasonable Compensation in the Spotlight – With the passage of tax reform, reasonable compensation will be in the spotlight because of the new deduction for 20% of pass-through income. This new Sec. 199A deduction is equal to 20% of qualified business income (QBI) and will figure intro the shareholder’s income tax return. The QBI for the stockholder of an S-corporation is the amount of net income passed through to the stockholder and designated as QBI on the K-1, but the stockholder may not include the reasonable compensation (wages) he or she was paid as QBI. Thus, wages paid to stockholders actually reduce the QBI because the S corporation deducts the wages as a business expense, therefore reducing the corporation’s net income and QBI. But that does not mean wages can be arbitrarily adjusted to maximize the Sec. 199A deduction.

IRC Sec. 199A Deduction – Here are some details about how the 199A deduction works and the impact of the reasonable compensation wages on the Sec. 199A deduction.

  • The S corporation’s employee-stockholder’s wages are NOT included in qualified business income (QBI) when computing the 199A deduction. Thus, the larger the wages, the smaller the K-1 flow-through income (QBI) and thus the smaller the 199A deduction, which is 20% of QBI. In this case, an S corporation would tend to pay the stockholder a smaller salary to maximize the flow-through income and, as a result, the 199A deduction.
  • If married taxpayers filing a joint return have taxable income that exceeds $315,000 ($157,500 for other filing statuses), the 199A deduction begins to be subject to a wage limitation, and once the taxable income for married taxpayers filing a joint return exceeds $415,000 ($207,500 for other filing statuses), the 199A deduction becomes the lesser of 20% of the QBI or the wage limitation. For these high-income taxpayers, an S corporation will tend to pay stockholders less wage income for them to benefit from the Sec. 199A deduction.
  • If an S corporation is a specified service trade or business, the Sec. 199A deduction phases out for married taxpayers filing a joint return with taxable income between $315,000 and $415,000 (between $157,500 and $207,500 for other filing statuses). And although the wage limitation is used in computing the phase out, once the taxpayer’s taxable income exceeds $415,000 ($207,500 for other filing statuses), the taxpayer will receive no benefit from the wage limitation and therefore would again want to minimize their reasonable compensation to minimize FICA taxes. Specified service trades or businesses (SSTBs) include those in the fields of health, law, accounting, actuarial science, performing arts, athletics, consulting, and financial services (for more information on what constitutes an SSTB, please call).

Of course, taxpayers cannot pick and choose a reasonable level of compensation to minimize taxes or maximize deductions. Therein lies a trap for taxpayers who do not consider the factors related to reasonable compensation. There are commercial firms that have the data necessary to determine reasonable compensation and specialize in doing so. These firms can be found by searching the Internet for “reasonable compensation.” Even the IRS has employed these firms to provide reasonable compensation data in tax court cases.

If you want additional information related to reasonable compensation, please call to schedule an appointment.

If You Are a Recreational Gambler, Here Are Some Tax Issues You Need to Know

Gambling takes many forms: casino games, horse racing, sports book betting, lotto tickets, scratchers, bingo, etc. For virtually everyone, gambling is a recreational activity and, as such, is done for fun. For most gamblers, their losses for the year will exceed their winnings, and since losses in excess of winnings are not deductible, most gamblers don’t bother to report either, which isn’t in line with the tax law’s filing requirements.

If your winnings at one time hit certain levels, the government requires the gambling establishment to collect your Social Security number and report your winnings to Uncle Sam on a Form W-2G. Gambling establishments will issue a Form W-2G if you:

  • Win $1,200 or more on a slot machine or from bingo.
  • Win $1,500 or more on a keno jackpot.
  • Win more than $5,000 in a poker tournament.
  • Win $600 or more from all other games, but only if the payout is at least 300 times your wager.

Reporting Winnings – Many individuals believe that they only have to report the winnings for which they receive a Form W2-G. Unfortunately, the IRS has a different viewpoint. Although you may be able to offset your reported gains with gambling losses, the IRS anticipates that you will also have had gambling winnings that were under the W2-G reporting threshold and will raise this issue during an audit.

Gambling Losses – The good news is that you can deduct gambling losses if you itemize your deductions but only to the extent of your gambling income. In other words, you can’t have a net gambling loss on your tax return. Bad news: if you don’t itemize your deductions, you will have to pay taxes on the entire winnings, even if you have a net gambling loss, as is the case for most individuals.

GAMBLING GOTCHA #1 – Since you can’t net your winnings and losses, the full amount of your winnings ends up in your adjusted gross income (AGI). The AGI is used to limit other tax benefits, as discussed later. So, the higher the AGI, the more the tax benefits may be limited.

GAMBLING GOTCHA #2 – If you don’t itemize your deductions, you can’t deduct your losses. Thus, individuals taking the standard deduction will end up paying taxes on all of their winnings, even if they had a net loss. The recent tax reform brought us significantly higher standard deduction amounts and, for itemized deductions, limited the deduction for state and local taxes and eliminated the deduction for unreimbursed employee business expenses and investment expenses, among other changes. The anticipated result is that fewer taxpayers will be itemizing their deductions and more gamblers will be paying taxes on their winnings.

Documenting Losses – The next logical question is: how are you going to document your gambling losses, if audited? Don’t rush down to the track and start collecting discarded tickets, since they generally aren’t acceptable documentation because of their ready availability. The IRS has published guidelines on acceptable documentation to verify losses. They indicate that an accurate diary or similar record that is regularly maintained by the taxpayer, supplemented by verifiable documentation, will usually be acceptable evidence to substantiate wagering winnings and losses. In general, this diary should contain at least the following information:

(1) the date and type of each specific wager or wagering activity,
(2) the name of the gambling establishment,
(3) the address or location of the gambling establishment,
(4) the names of other persons (if any) present with the taxpayer at the gambling establishment, and
(5) the amounts won or lost.
Save all available documentation, including items such as losing lottery and keno tickets, checks, and casino credit slips. You should also save any related documentation such as hotel bills, plane tickets, entry tickets, and other items that would document your presence at a gambling location. If you are a member of a slot club, the casino may be able to provide a record of your electronic play. You might also obtain affidavits from designated gambling officials at the gambling facility. With regard to specific wagering transactions, your winnings and losses might be further supported by:
  • Keno – Copies of keno tickets you purchased and that were validated by the gambling establishment.
  • Slot Machines – A record of all winnings by date and time for each machine that was played.
  • Table Games – The number of the table at which you were playing as well as casino credit card data indicating whether credit was issued in the pit or at the cashier’s cage.
  • Bingo – A record of the number of games played, the cost of the tickets purchased, and the amounts collected on winning tickets.
  • Racing – A record of the races, entries, amounts of wagers, and amounts collected on winning tickets and lost on losing tickets. Supplemental records can include unredeemed tickets and payment records from the racetrack.
  • Lotteries – A record of ticket purchase dates, winnings, and losses. Supplemental records can include unredeemed tickets, payment slips, and winning statements.

Other Tax Side Effects of Gambling – Because gambling income is reported in full as income and the losses are an itemized deduction, gambling winnings increase a taxpayer’s AGI for the year. An individual’s AGI is used to limit other tax benefits, and having gambling income can have an adverse impact on your taxes. Here are some examples:

  • Social Security Income – For taxpayers receiving Social Security benefits, whether those benefits are taxable depends upon the taxpayer’s AGI for the year. The taxation threshold for Social Security benefits is $32,000 for married taxpayers filing jointly, $0 for married taxpayers filing separately, and $25,000 for all other filing statuses. If the sum of AGI (before including any Social Security income), interest income from municipal bonds, and one-half the amount of Social Security benefits received for the year exceeds the threshold amount, then 50–85% of the Social Security benefits will be taxable.
    GAMBLING GOTCHA #3 – So, if your gambling winnings push your AGI for the year over the threshold amount, then your gambling winnings – even if you had a net loss – can cause some (up to 85%) of your Social Security benefits to be taxable.
  • Health Insurance Subsidies – Under Obamacare, lower-income individuals who purchase their health insurance from a government marketplace are given a subsidy in the form of a tax credit to help pay the cost of their health insurance. That tax credit is based upon the AGIs of all members of the family, and the higher the family’s income, the lower the subsidy will become.
    GAMBLING GOTCHA #4 – Thus, the addition of gambling income to your family’s income can result in significant reductions in the insurance subsidy, requiring you to pay more for your family’s health insurance coverage for the year. Additionally, if your subsidy was based upon your estimated income for the year, your premiums were reduced by applying the subsidy in advance, and you subsequently had some gambling winnings, then you could get stuck paying back part of the subsidy when you file your return for the year.
  • Medicare B and D Premiums – If you are covered by Medicare, the amount you are required to pay (generally withheld from your Social Security benefits) for Medicare B premiums is normally about $130–$134 per month and is based on your AGI two years prior. However, if that AGI is above $85,000 ($170,000 for married taxpayers filing jointly), then the monthly premiums can more than triple. If you also have prescription drug coverage through Medicare Part D and your AGI exceeds the $85,000/$170,000 threshold, then your monthly surcharge for Part D coverage will range from $13.30 to $74.80 (2018 rates).
    GAMBLING GOTCHA #5 – The addition of gambling winnings to your AGI can result in higher Medicare B and D premiums.
  • Online Gambling Accounts – If you have an online gambling account, there is a good chance that the account is with a foreign company. All U.S. persons with a financial interest or signature authority over foreign accounts with an aggregate balance of over $10,000 anytime during the prior calendar year must report those accounts to the Treasury by the April due date for filing individual tax returns or face draconian penalties.
    GAMBLING GOTCHA #6 – Regardless of whether you were a winner or loser, if your online account was over $10,000, you will be required to file aFinCEN Form 114 (Report of Foreign Bank and Financial Accounts), commonly referred to as the FBAR. For non-willful violations, civil penalties up to $10,000 may be imposed; the penalty for willful violations is the greater of $100,000 or 50% of the account’s balance at the time of the violation.
  • Other Limitations – The forgoing are the most significant “gotchas.” There are numerous other tax rules that limit tax benefits based on AGI, as discussed in gotcha #1. These include medical deductions, child and dependent care credits, the child tax credit, and the earned income tax credit, just to name a few.

If you have questions related to gambling and taxes, please call this office.

2019 Standard Mileage Rates Announced

The Internal Revenue Service (IRS) computes standard mileage rates for business, medical and moving each year, based on a number of factors, to determine the standard mileage rates for the following year.

As it does annually around the end of the year, the IRS has announced the 2019 optional standard mileage rates. Thus, beginning on Jan. 1, 2019, the standard mileage rates for the use of a car (or a van, pickup or panel truck) are:

  • 58 cents per mile for business miles driven (including a 26-cent-per-mile allocation for depreciation). This is up from 54.5 cents in 2018;
  • 20 cents per mile driven for medical or moving* purposes. This is up from 18 cents in 2018; and
  • 14 cents per mile driven in service of charitable organizations.
    * For years 2018 through 2025, the deduction for moving is only allowed for members of the armed forces on active duty who move pursuant to a military order. 

The business standard mileage rate is based on an annual study of the fixed and variable costs of operating an automobile. The rate for medical and moving purposes is based on the variable costs determined by the same study. The rate for using an automobile while performing services for a charitable organization is statutorily set (it can only be changed by Congressional action) and has been 14 cents per mile for 20 years).

Important Consideration: The 2019 rates are based on 2018 fuel costs. Based on the potential for substantially higher gas prices in 2019, it may be appropriate to consider switching to the actual expense method for 2019 or at least to keep track of the actual expenses, including fuel costs, repairs and maintenance, so that the option is available for 2019.

Taxpayers always have the choice of calculating the actual costs of using their vehicle for business rather than using the standard mileage rates. In addition to the potential for higher fuel prices, the extension and expansion of the bonus depreciation as well as increased depreciation limitations for passenger autos in the Tax Cuts and Jobs Act may make using the actual expense method worthwhile during the first year when a vehicle is placed into business service.

However, the standard mileage rates cannot be used if you used the actual method (using Section 179, bonus depreciation and/or MACRS depreciation) in previous years. This rule is applied on a vehicle-by-vehicle basis. In addition, the business standard mileage rate cannot be used for any vehicle used for hire or for more than four vehicles simultaneously.

Employer Reimbursement – When employers reimburse employees for business-related car expenses using the standard mileage allowance method for each substantiated employment-connected business mile, the reimbursement is tax-free if the employee substantiates to the employer the time, place, mileage and purpose of the employment-connected business travel.

The Tax Cuts and Jobs Act eliminated employee business expenses as an itemized deduction, effective for 2018 through 2025. Therefore, employees may no longer take a deduction on their federal returns for unreimbursed employment-related use of their autos, light trucks or vans. Members of a reserve component of the U.S. Armed Forces, state and local government officials paid on a fee basis and certain performing artists continue to be allowed to deduct unreimbursed employee travel expenses, including the business standard mileage rate, because they are deductible from gross income rather than as an itemized deduction.

Faster Write-Offs for Heavy Sport Utility Vehicles (SUVs) – Many of today’s SUVs weigh more than 6,000 pounds and are therefore not subject to the limit rules on luxury auto depreciation. Taxpayers who purchase a heavy SUV and put it into business use in 2019 can utilize both the Section 179 expense deduction (up to a maximum of $25,500) and the bonus depreciation (if the Section 179 deduction is claimed, it must be applied before the bonus depreciation) to produce a sizable first-year tax deduction. However, the vehicle cannot exceed a gross unloaded vehicle weight of 14,000 pounds. Caution: Business autos are 5-year class life property. If the taxpayer subsequently disposes of the vehicle before the end of the 5-year period, as many do, a portion of the Section 179 expense deduction will be recaptured and must be added back to the taxpayer’s income (self-employment income for self-employed individuals). The future ramifications of deducting all or a significant portion of the vehicle’s cost using Section 179 should be considered.

If you have questions related to the best methods of deducting the business use of your vehicle or the documentation required, please call us.

Don’t Overlook Tax Credits

Tax credits are a tax benefit that offsets your actual tax liability, as opposed to a tax deduction, which reduces your income. Congress provides tax credits to individual taxpayers for a number of reasons, including as a form of assistance for lower-income taxpayers, to stimulate employment, and to stimulate certain investments, among other things.

Tax credits come in two types: non-refundable and refundable. A non-refundable credit can only reduce your tax liability to zero; any excess is either carried forward or is simply lost. In the case of a refundable credit, if there is excess after reducing your tax liability to zero, the excess is refundable. The following is a summary of some of the tax credits available to individual taxpayers:

Childcare Credit – Parents who work or are looking for work often must arrange for care of their children during working hours or while searching for work. If this describes your situation and your children requiring care are under 13 years of age, you may qualify for a childcare tax credit.

The credit ranges from 20% to 35% of non-reimbursed expenses, based upon your income, with the higher percentages applying to lower-income taxpayers and the lower percentages applying to higher-income taxpayers.

Applicable Percentage of AGI for the Childcare Credit
AGI Over But Not Over Applicable Percent AGI Over But Not Over Applicable Percent
0 15,000 35 29,000 31,000 27
15,000 17,000 34 31,000 33,000 26
17,000 19,000 33 33,000 35,000 25
19,000 21,000 32 35,000 37,000 24
21,000 23,000 31 37,000 39,000 23
23,000 25,000 30 39,000 41,000 22
25,000 27,000 29 41,000 43,000 21
27,000 29,000 28 43,000 No Limit 20

The maximum expense amount allowed is $3,000 for one child and $6,000 for two or more, and the credit is non-refundable, which means it can only reduce your tax to zero, and the excess is lost.

As an example, say your adjusted gross income (AGI) is between $33,000 and $35,000. Your credit percentage would be 25%. If you paid childcare expenses of $4,000 for two children under the age of 13, your tax credit would be $1,000 ($4,000 x 25%). If your tax for the year was $5,000, the credit would reduce that tax to $4,000. On the other hand, if your tax for the year was $800, the credit would reduce your tax to zero, and the $200 excess credit would be lost.

This credit also applies when a taxpayer or spouse is disabled or a full-time student, in which case special “earned income” allowances are provided for months when the taxpayer or spouse is disabled or a full-time student. Please call this office for additional details if this situation applies in your case.

Earned Income Tax Credit (EITC) – Congress established the EITC as an income supplement for working individuals in lower-paying employment. If you qualify, it could be worth as much as $6,431 in 2018. It is a refundable credit.

The EITC is based on the amount of your earned income (income from work for wages and/or self-employment) and whether there are qualifying children in your household. Qualifying children are those who live with you for over half the year, are related, and are under the age of 19 or a full-time student under the age of 24. The credit increases as your earned income increases. The table below shows the earned income at which the maximum credit is achieved for 2018.

Qualifying Children Earned Income  Maximum Credit
None 6,780 $519
1 $10,180 $3,461
2 $14,290 $5,716
3 or more $14,290 $6,431

The credit amount phases out after reaching the maximum based on filing status and number of qualifying children. The 2018 phase-out ranges are shown in the table below.

Qualifying Children

Filing Status Phase-out Range
None Married Filing Joint $14,170–20,950
Others $8,490–15,270
1 Married Filing Joint $24,350–46,010
Others $18,660–40,320
2 Married Filing Joint $24,350–51,492
Others $18,660–45,802
3 or more Married Filing Joint $24,350–54,884
Others $18,660–49,194

In addition, there are some qualification requirements: you, your spouse (if married and filing jointly), and each qualifying child must have a valid Social Security number, and you cannot use the filing status married filing separately. You cannot be a qualifying child of another person, your investment income for the year cannot exceed $3,500 (2018), and you cannot exclude earned income from working abroad. If you do not have a qualifying child, you must be at least age 25 but under 65 at the end of the year.

Even though this credit can be worth thousands of dollars to a low-income family, the IRS estimates as many as 25 percent of people who qualify for the credit do not claim it, simply because they don’t understand the criteria. If you qualified for but failed to claim the credit on your return for 2015, 2016, and/or 2017, you can still claim it for those years by filing an amended return or an original return, if you have not previously filed. Please call for assistance.

Members of the military can elect to include their nontaxable combat pay in their earned income for the earned income credit. If that election is made, the military member must include in their earned income all nontaxable combat pay they received for the year.

Child & Dependent Tax Credit – As an aid to families with children, the tax reform increased the child tax credit from $1,000 to $2,000 for each qualified child. A qualified child for this tax credit is one who is under age 17 at the end of the year, is related, is not self-supporting, lived with you over half the year, has a Social Security number, and is claimed as your dependent. The refundable portion of this credit is equal to 15% of your earned income but limited to $1,400.

Beginning in 2018, you are also able to claim a non-refundable credit of $500 for each of your dependents who do not qualify for the child credit.

For both the child and dependent credits, the credit begins to phase out for married taxpayers with an AGI of $400,000 ($200,000 for others).

Saver’s Credit – Congress created the non-refundable saver’s credit as a means of stimulating retirement savings among lower-income individuals. It helps to offset part of the first $2,000 that workers voluntarily contribute to traditional or Roth individual retirement arrangements (IRAs), SIMPLE-IRAs, SEPs, 401(k) plans, 403(b) plans for employees of public schools and certain tax-exempt organizations, 457 plans for state or local government employees, and the Thrift Savings Plan for federal employees. The saver’s credit is available in addition to any other tax savings that apply as a result of contributing to retirement plans. The credit is a percentage of the first $2,000 contributed to an eligible retirement plan. The following table illustrates the percentage based upon filing status and AGI for 2018.

Adjusted Gross Income Range  Credit 
Married Filing Joint Head of Household Others Percentage
$0–$38,000 $0–$28,500 $0–$19,000 50
$38,001–$41,000 $28,501–$30,750 $19,001–$20,500 20
$41,001–$63,000 $30,751–$47,250 $20,501–$31,500 10
$63,001 & Over $47,251 & Over $31,501 & Over No Credit
Example – Eric and Heather are married, both age 25, and filing a joint return. Eric contributed $3,000 through his 401(k) plan at work, and Heather contributed $500 to her IRA account. Their modified AGI for 2018 was $28,000. The credit is computed as follows:

Eric’s 401(k) contribution was $3,000, but only the
first $2,000 can be used………………………………………………………………….. $2,000
Heather’s IRA contribution was $500, so it can all be used……………. 500
Total qualifying contributions…………………………………………………………… $2,500
Credit percentage for a MFJ AGI of $28,000 from the table……………. X .50
Non-refundable saver’s credit…………………………………………………………….$1,250

Vehicle Tax Credits – If you are considering purchasing a new car or light truck (less than 14,000 pounds), don’t overlook the fact that Congress included a substantial tax credit for the purchase of the many electric vehicles currently being offered for sale, providing a tax credit worth as much as $7,500.

To be eligible for the credit, you must acquire the vehicle for use or lease and not for resale. Additionally, the vehicle’s original use must commence with you, and you must use the vehicle predominantly in the United States.

Congress did include a phase-out provision for this credit that applies by vehicle manufacturer. The credit begins to phase out once the manufacturer sells 200,000 electric vehicles. To see if the make and model you are considering qualify, visit the IRS website.

The credit is available whether you use the vehicle for business, personally, or a combination of both. The prorated portion of the credit that applies to business use becomes part of the general business credit, and any amount not used on your return for the year when you purchase the vehicle can be carried back to the previous year and then carried forward until used up, but for no more than 20 years. The personal portion is non-refundable.

Adoption Credit – If you are an adoptive parent or are planning to adopt a child, you may qualify for the adoption credit. The amount of the credit is based on the expenses incurred that are directly related to the adoption of a child under the age of 18 or a person who is physically or mentally incapable of self-care.

This is a 1:1 credit for each dollar of qualified expenses up to the maximum for the year, which is $13,810 for 2018. The credit is non-refundable, which means it can only reduce your tax liability to zero (as opposed to potentially resulting in a cash refund). But the good news is that any unused credit can be carried forward for up to five years to reduce your future tax liability.

Qualified expenses generally include adoption fees, court costs, attorney fees, and travel expenses that are reasonable, necessary and directly related to the child’s adoption, and they may be for both domestic and foreign adoptions; however, expenses related to adopting a spouse’s child are not eligible for this credit. When adopting a child with special needs, the full credit is allowed, whether or not any qualified expenses were incurred.

The credit is phased out for higher-income taxpayers. For 2018, the AGI (computed without foreign-income exclusions) phase-out threshold is $207,140, and the credit is completely phased out at the AGI of $247,140. Unlike most phase-outs, this one is the same regardless of filing status. However, taxpayers filing as married filing separately cannot claim the credit.

Residential Energy Efficient Property Credit – This tax credit was created to reward individuals for investing in equipment that uses alternative energy sources to create electrical power for use in a taxpayer’s home or second home. It includes alternative power sources such as fuel cells, wind energy, and geothermal heat pumps, for which the credit expires after 2021.

However, the credit is most commonly associated with the home solar credit, which is equal to 30% of the cost of the solar electric system for an individual’s primary and second homes, with no limit on the cost of the solar system. Even though the credit is non-refundable, any amount not used in the first year carries over to subsequent years.

The credit percentage is phased-out as shown in the table.

Home Energy Credit Percentage
Year 2018–2019 2020 2021 2021
Percentage 30 26 22 None

Before deciding to add a solar electric system to your home, you need to consider if you can actually afford the system and whether it is worth having one, after taking into account the system’s cost, the financing interest, the reduced electricity costs, and the tax credit. You should make an objective analysis without pressure from a salesperson. These credits are substantial, but the one thing salespeople and contractors typically fail to mention is that the credit is not refundable, and even though it carries over through 2021, there is a good chance you will never use it all. It may be appropriate for you to consult with this office before entering into a contract for a home solar system.

If you have questions or would like additional details related to any of these credits, please call us to speak to your tax advisor.

Twelve Common Tax Problems to Avoid

If you’re one of those who gets worked up over filing your tax return, there are specific steps you can take to help ease the struggle and avoid the most common tax issues that are reported each year.

Here are the top 12 tax issues, broken down into categories for business owners and individual taxpayers, and how everybody can minimize their impact this year.

If you own your own business:
1. Avoid penalties and fines by understanding the rules about deductions.
Though tax deductions are a great way to minimize taxes when they’re used the right way, they are frequently abused and overused. The whole point of deductions is to provide businesses the ability to eliminate taxes for items they purchased in the furtherance of their business. Though this includes capital expenditures, client gifts, and business travel, it does not mean that you can include expenses that you incur while talking about your business while you’re on vacation with your family. The IRS has published rules about how much of each expense can be deducted, what type of expense can be deducted and under what circumstance. If you include something that is questionable, you’re going to be asked to justify it, and if you can’t, you’re going to end up worse off than if you hadn’t made an attempt in the first place.

2. Failing to keep track of business expenses that can be deducted.
The flip side of people try to game the system by taking expenses to which they’re not entitled is people failing to deduct expenses that they could have because they’re not careful about keeping track. This frequently happens when people don’t have a credit card or account that is dedicated specifically to their business expenses, or when cash is used when traveling or attending business meetings. When you don’t deduct legitimate expenses, you’re cheating yourself out of tax savings, so start keeping all receipts, and talk to a tax professional so that you understand exactly what you can write off, and what you can’t.

Individual taxpayer problems:
3. Failing to choose a reputable professional tax preparer.
It’s nice of your cousin or next-door neighbor to offer to help, and you might save money by going to a storefront tax preparer that claims they will do the whole job quickly and at a low cost, but an awful lot of taxpayers end up in big trouble as a result of these types of offers. Whether the issue is incompetence or fraud, plenty of people are finding themselves facing penalties and fines or having their refund money stolen as a result of choosing the wrong tax preparer. Do your homework and be willing to spend the money to have your return prepared by a legitimate professional. The things to watch out for include promises of specific refund amounts prior to reviewing your documentation, fees that are based on the amount of your refund, and fly-by-night operations that appear right before tax season and then are gone on April 16th. If you do find a fraudulent tax preparer has victimized you, contact the IRS and attorney right away who will pursue justice and act as your advocate.

4. Filing after the deadline.
If you were late in filing last year, you had plenty of company – the IRS reported that almost 45 million taxpayers waited until April. But filing late is a mistake. You are likely to end up paying extra money in fines and penalties, and the later you are, the more likely you are to make errors that will make the entire process take longer and may lead to audits and delays. More importantly, if your lateness is a recurring theme and you still haven’t gotten in paperwork from previous years, it affects the accuracy of your current return and may impact your ability to get any refund or credit that you’re owed.

5. Failure to file a return at all.
Plenty of people disregard the tax laws and don’t submit a return. Many of them may not actually owe any taxes, while others reason that since they can’t afford to pay what they owe, they’re better off not submitting anything. This is absolutely wrong. If you are anticipating a problem with submitting the tax that you owe, you can file an installment agreement request that will help you set up a schedule of periodic payments instead of submitting the amount in full at tax time. This is a much better option than not filing, as even though you may have to pay some interest or penalties, they won’t be as punishing as the fees you’ll pay for failure to file a return. You can also choose to file an application for an automatic extension, which gives you more time to get the documentation together, if not the payments. Again, penalties and interest rates are much lower when you avail yourself of this option rather than failing to file.

6. Simple mathematical errors
Remember when you were a kid in math class and you’d get a quiz back with mistakes that you’d have spotted if you’d just double checked? Same is true with your taxes. Take the time to go back over your math before you sign on the dotted line or send your return in. It just takes a few extra minutes, and it can save a lot of time and aggravation. Alternatively, use a professional tax preparer and then you don’t have to worry about it at all.

7. Administrative errors
Just as you need to check that you’ve done your math computations correctly, you also need to take the time to take a second look at the forms that you’re filling out to make sure that you’ve filled in every box, used all the appropriate forms, and filled in your information correctly. You’d be amazed at how many people transpose the numbers of their social security number or whose handwriting is so bad that it can’t be read by the IRS and gets sent back. Take your time, be careful and do it right to save yourself a headache in the future. A few areas worth double-checking include:

  • Social Security Number
  • Bank Account Numbers and Routing Numbers
  • Signature and Date Lines

8. Not staying current with updates to tax laws.
Every year, there are new updates to the tax code that can make a big difference, and every year there are taxpayers who fail to take advantage of them because they simply weren’t aware that they existed. If you’re going to do your taxes yourself, take the time to stay up-to-date. Alternatively, you can work with a tax professional: part of their job is to know all the new laws and apply them to your best advantage.

9. Don’t use the wrong filing status.
Single. Head of Household. Married filing jointly. Married filing single. It can be very confusing to know which benefits you most, and choosing wrong can make an enormous difference. There are a lot of things that married couples are entitled to if they file jointly, and a lot of disadvantages to filing single. Take the time, do the math so that you know you’re doing the right thing.

10. Clutter may be bad, but you should hold on to your old tax returns.
No matter how much you try to keep it simple and purge old paperwork, your past tax return is one thing you really need to hold on to in case the IRS comes back and asks questions or you realize that you’re entitled to a refund if you file an amended return. Having the paperwork handy means you can give it to attorneys, mortgage brokers, accountants and the IRS itself in case they ask for it or if providing it would help your situation.

11. Learn about and take advantage of every potential deduction
Of all the painful mistakes that taxpayers make, overpaying is at the top of everybody’s list. What could be worse than giving the government more of your hard-earned money than you needed to? The best way to avoid this mistake is to go through the lists of possible deductions and write down every one you might be able to take, then see if you can use it.

12. Not using the right tax forms for your needs or status.
Though most people are familiar with the 1040 form, it’s not necessarily the right one for everyone. While the 1040 works for those who itemize or who own their own business, people who are W-2 employees without a lot of complicating factors may be better off using the 1040EZ form. Likewise, you need to make sure that there aren’t mistakes on any of the paperwork that you’re handing in, whether it’s your W-2 or information from any of your banks. Finally, many people are taking advantage of electronic filing to get their returns in on time and get their refunds more quickly, and if you’re doing that too, make sure that you’ve input the correct.

If there are errors on your W-2 Forms or other financial forms, make sure you address them sooner rather than later, or else the IRS will become involved. If you’re filing electronically, double check every digit of your information to avoid delays.

What if you can’t avoid a tax issue?
No matter how hard you try, at some point, you may find yourself facing one or more of the issues cited above (or something entirely different that we haven’t included). If that happens to you, contact us immediately for expert professional help.

Big Changes to College Savings Plans

Tax reform added some new taxpayer-advantageous changes to college savings plans. These plans are also known as qualified tuition programs (QTPs) or Sec. 529 plans, named after the part of the Internal Revenue Code that established them.

Background: Sec. 529 plans allow taxpayers to put away larger amounts of money than other tax-advantaged education savings plans do, limited only by the contributor’s gift tax concerns and the contribution limits of the intended plan. There are no limits on the number of contributors, and there are no income or age limitations. The maximum amount that can be contributed per beneficiary (the intended student) is based on the projected cost of college education and will vary between the states’ plans. Some states base their maximum on the projected costs of an in-state four-year education, but others use the cost of the most expensive schools in the U.S., including graduate studies. Most have limits in excess of $200,000, with some topping $370,000. Generally, additional contributions cannot be made once an account reaches the state’s maximum level, but that doesn’t prevent the account from continuing to grow.

Although the plans are authorized by the various states, it is not necessary for the plan to be set up in the future student’s home state, and the student isn’t restricted to using the funds to attend college in their home state or the state where the plan was set up. Some states provide state income tax incentives to the plan’s contributors, such as a state income tax deduction or a tax credit for contributions to the state’s 529 plan.

When the time comes for college, the distributions will be part earnings/growth in value and part contributions. The contribution part is never taxable, and the earnings part is tax-free if used to pay for qualified college expenses. In addition to a tax-free distribution from the 529 plan, a taxpayer may claim an education credit – such as the American Opportunity Tax credit, which can be as much as $2,500 – in the same year, provided the same expenses aren’t used for both benefits and the taxpayer’s income level does not phase out the credit.

The big advantage of a Sec. 529 plan is tax-free accumulation, so the sooner the account is established and funded, the better. A special provision of Sec. 529 allows those who are concerned with the annual gift tax limitations, currently $15,000, to contribute five years’ worth of contributions ($75,000) up front. These limitations apply to each contributor, but if there are multiple contributors, such as parents, grandparents, aunts and uncles, huge amounts can be contributed up front and provide the greatest long-term growth.

Tax Reform Changes: Under the recent tax reform, the use of Sec. 529 plan funds was expanded to include:

Elementary and Secondary School Tuition – As of 2018, tax-free distributions of up to $10,000 per year per designated beneficiary are allowed for tuition (no other expenses are allowed) in connection with enrollment or attendance at elementary or secondary schools, including public, private and religious schools. However, this option should be considered cautiously, since Sec. 529 plans work best when the money put into the plan is allowed to grow for a long period of time. For less well-to-do families who can’t afford to frontload their 529 plan contributions, making pre-college withdrawals will defeat the long-term tax-free accumulation benefit and could deplete the account before the student even starts college. It should be noted that while this tax reform change applies for federal purposes, some states are still limiting qualified distributions from their plans to only those used for college expenses.

Sec 529 to ABLE Account Transfers – Tax reform also provides that a distribution from a Sec. 529 qualified tuition plan account is tax-free and penalty-free if it is rolled over within 60 days to an ABLE account of the same designated beneficiary or a member of the designated beneficiary’s family. This rollover provision is only available through 2025. The amount of the rollover is limited, when combined with other contributions, to the annual maximum.

Qualified ABLE programs provide the means for individuals and families to contribute and save for the purpose of supporting individuals who became blind or severely disabled before turning age 26, in maintaining their health, independence, and quality of life.

Example: Bill, who finished school and graduated, still has $8,000 in his Sec. 529 qualified tuition plan that his parents had set up to pay his college tuition. Bill will no longer have any education expenses, so he rolls the balance of his Sec. 529 plan into his 14-year-old blind niece’s ABLE account within the 60 days allowed. There are no taxes or penalties on the rollover. However, since contributions to the ABLE account are limited to $15,000 (2018), others may only contribute an additional $7,000 ($15,000 − $8,000) to the niece’s ABLE account. 

If you have any questions about how Sec. 529 plans and the changes made to them by tax reform might affect your specific circumstances, please contact us.

Wonder What a Tax Deduction Is Worth?

Individuals are always looking for tax deductions that can reduce their tax liability. But what is the actual tax benefit derived from a tax deduction? There is no straightforward answer because some deductions are above the line, others must be itemized, some must exceed a threshold amount before being deductible, and certain ones are not deductible for alternative minimum tax purposes, while business deductions can offset both income and self-employment tax. In other words, there are many factors to consider, and the tax benefits differ for each individual, depending on his or her particular situation and tax bracket.

For most non-business deductions, the savings are based upon your tax bracket. For example, if you are in the 12% tax bracket, a $1,000 deduction would save you $120 in taxes. On the other hand, if you are in the 32% tax bracket, the $1,000 deduction will save you $320 in taxes. Even so, if your taxable income is close to transitioning into the next-lower tax bracket, the benefit will be lower. You also need to consider whether the particular deduction is allowed on your state return and what your state tax bracket is to determine the total tax savings. Currently, the maximum federal tax bracket is 37%, meaning the most benefit that can be derived from a $1,000 income tax deduction is $370. Some individuals justify making discretionary purchases just because they are tax-deductible. Even in the highest tax bracket, you are still paying $630 out of pocket ($1,000 − $370), so it does not make sense to incur a tax-deductible expense just for the tax deduction.

Some deductions, such as IRA and self-employed retirement plan contributions, alimony, and student loan interest, are adjustments to income or what we call above-the-line deductions. These deductions, to the extent permitted by law, provide a dollar deduction for every dollar claimed. Deductions that fall into the itemized category must exceed the standard deduction for your filing status before any benefit can be derived. In addition, medical deductions are reduced by 7.5% of your adjusted gross income (AGI) in 2018, and most cash charitable deductions are limited to a maximum of 60% of your AGI. Under the tax reform, the deduction for state and local taxes has been capped at $10,000.

The most beneficial deductions are business deductions that offset both income tax and, depending upon the circumstances, self-employment tax. For 2018, the self-employment tax rate is 12.4% of the first $128,400 of net self-employment income plus 2.9% for the Medicare tax, with no cap. Some high-income taxpayers may pay an additional 0.9% Medicare tax. For self-employed businesses with less than $128,400 of net income, the self-employment tax rate is 15.3%. Thus, for small businesses with profits of less than $128,400, the benefit derived from deductions generally will include the taxpayer’s tax bracket plus 15.3%. For example, for a taxpayer in the 24% tax bracket, the benefit could be as much as 39.3% (24% + 15.3%) of the deduction. If the deduction were $2,000, the tax savings could be as much as $806 or more, when the taxpayer’s state income tax bracket is included.

If you are planning an expenditure and expect the tax deduction to help cover the cost, please consult with us in advance to ensure that the tax benefit will be what you anticipate.

Expecting Your Taxable Income to Be Low This Year? Take Advantage of It

If your taxable income is exceptionally low this year, or even if you expect not to be required to file a tax return this year, a number of tax opportunities may be available to you. But time is running short, since these opportunities will require action on your part before year’s end.

However, before we consider actual strategies, let’s look at key elements that govern tax rates and taxable income.

Adjusted Gross Income (AGI) – This is the sum of all of your income that’s subject to tax, such as wages, interest, dividends, gains from sales, net self-employment income, retirement income, minus items that are specifically deductible without having to itemize your deductions, including contributions to traditional IRAs and self-employed retirement plans, interest paid on student loans, contributions to health savings plans, and a limited number of others.

Taxable Income – To be simplistic, taxable income is your AGI less the greater of the standard deduction for your filing status or your itemized deductions:

AGI
XXXX
Deductions – XXXX
Taxable Income
XXXX

If the deductions exceed your AGI, then you can end up with a negative taxable income, which means that to the extent it is negative, you can actually add income or reduce your deductions without incurring any tax.

Graduated Individual Tax Rates – Ordinary individual tax rates are graduated. So as your taxable income increases, so does your tax rate. Thus, the lower your taxable income, the lower your tax rate will be. Your income tax is the result of multiplying your tax rate by your taxable income (but to simplify the computation for those with taxable income up to $100,000, the IRS figures the tax by income range and provides look-up tables, so for most taxpayers, their tax rate is not apparent). Individual ordinary tax rates range from 10% to as high as 37%. For 2018, the taxable income amounts for the three lowest tax rates – 10%, 12%, and 22% – are:

Filing Status
Single
Married Filing Jointly
Head of Household
Married Filing Separate
10%
$0–9,525
$0–19,050
$0–13,600
$0–9,525
12%
$9,526–38,700
$19,051–77,400
$13,601–51,800
$9,526–38,700
22%
$38,701–82,500
$77,401–165,000
$51,801–82,500
$38,701–82,500

So for instance, if you are single, your first $9,525 of taxable income is taxed at 10%. The next $29,174 ($9,526 to $38,700) is taxed at 12%, and the next $43,799 ($38,701 to $82,500) is taxed at 22%.

Here are some strategies you can employ for your tax benefit. However, these strategies may be interdependent on one another and your particular tax circumstances.

Take IRA Distributions – Depending upon your projected taxable income, you might consider taking an IRA distribution to add income for the year. For instance, if your projected taxable income is negative, then you can actually take a withdrawal of up to the negative amount without incurring any tax. Even if your projected taxable income is not negative and your normal taxable income would put you in the 22% or higher bracket, you might want to take out just enough to be taxed at the 10% or even the 12% tax rate. Of course, those are retirement dollars; consider moving them into a regular financial account set aside for your retirement. Also, be aware that distributions before age 59½ are subject to a 10% early-withdrawal penalty even if there is no tax liability, so this strategy isn’t recommended for those younger than 59½.

Redeem Government Bonds – If you have invested in U.S. government bonds, such as Series EE or I bonds, and you’ve been deferring paying tax on the interest from these bonds until they mature, you may want to cash in the bonds prior to the year when they mature, if that maturity date is within the next few years and to the extent that adding the bond interest to your other income for the year won’t push you out of the zero or 10% tax bracket and into a higher bracket. This strategy isn’t advisable if the interest you would earn on the bonds if you held them to maturity would be more than the tax you can save by cashing in the bonds during a low-income year.

Defer Deductions – When you itemize your deductions, you may claim only the deductions you actually pay during the tax year (the calendar year, for most folks). If your projected taxable income will be negative and you are planning on itemizing your deductions, you might consider putting off some of those year-end deductible payments until after the first of the year and preserving the deductions for next year. Such payments might include house of worship tithing, year-end charitable giving, tax payments (but not those incurring late payment penalties), estimated state income tax payments, and medical expenses.

Convert Traditional IRA Funds into a Roth IRA – Roth IRAs provide tax-free accumulation and tax-free retirement distributions. So to the extent of any negative taxable income or even just for the lower tax rates, you may wish to consider converting some or all of your traditional IRA into a Roth IRA. The lower income results in a lower tax rate, which will provide you with an opportunity to convert to a Roth IRA at a lower tax amount.

Zero Capital Gains Rate – There are three capital gains rates depending upon your taxable income. When your taxable income is in the lowest range, as shown in the table below, you will actually pay no tax on your long-term capital gains. Thus, if your taxable income is within the zero percent long-term capital gains rate bracket, this is an opportunity for you to sell some appreciated securities that you have owned for more than a year and pay no tax on the gains.

Long-Term Capital Gains Rates (2018)
Filing Status
0%
15%
20%
Single
$0–38,600
$38,601–425,800
$425,801 & Above
Head of Household
$0–51,700
$51,701–452,400
$452,401 & Above
Married Joint
$0–77,200
$77,201–479,000
$479,001 & Above
Married Separate
$0–38,600
$38,601–239,500
$239,501 & Above

Business Expenses – The tax code has some very liberal provisions that allow a business to currently expense, rather than capitalize and slowly depreciate, the purchase costs of certain property. In a low-income year, it may be appropriate to capitalize rather than expense these current-year purchases and preserve the depreciation deduction for higher-income years. This is especially true when taxable income is negative in the current year.

Affordable Care Act – On the negative side, if you have obtained your medical insurance through a government marketplace, employing any of the strategies mentioned above will increase your taxable income and could impact the amount of your allowable premium tax credit. As a result, you would likely have to repay some or all of any advance premium tax credit that was used to reduce your health insurance premiums; the credit is reconciled on your tax return.

If you would like to discuss how these strategies might provide you with tax benefits based upon your particular tax circumstances or would like to schedule a tax-planning appointment, please give us a call.

Legitimate Tax-Deductible Charity or Scam?

With the holiday season approaching, and with the great need for aid in the wake of the recent hurricanes and wildfires, you no doubt are being solicited for donations. However, do not be fooled by the scammers who come out from hiding whenever there is a disaster and during the holiday season. The last thing you want to do is get ripped off; not only will your charitable dollars go to waste, but you will also lose your tax deduction, as contributions are only tax-deductible if they are to qualified charities.

Soon, your physical and electronic mailboxes – not to mention your voicemail box – will be filled with charitable solicitations. Before you break out your checkbook, however, be sure to do your homework, especially if you are contemplating a donation to an organization that you are not already familiar with. The Federal Trade Commission suggests avoiding any charity or fundraiser that:

  • refuses to provide detailed information about its identity, mission, and costs, as well as how your donation will be used;
  • will not provide proof that your contribution would be tax-deductible;
  • uses a name that closely resembles that of a better-known (more reputable) organization;
  • thanks you for a pledge that you do not remember making;
  • uses high-pressure tactics to get you to donate immediately;
  • asks for donations in cash or asks you to wire money; or
  • offers to send a courier or overnight delivery service to collect a donation immediately.

Numerous websites can help you to check the validity of a charity. The IRS provides one, but it is rather cumbersome to use. Charity Navigator allows you to search for a charity name and provides details about that charity’s function. When in doubt, take the time to verify a charity’s legitimacy.

If you plan to itemize your deductions – after you have determined that you are not contributing to a scam operation – ensure that your charitable donations meet the requirements for being tax-deductible. The recipient organization must be one or more of the following:

  • a church, synagogue, mosque, or other place of worship;
  • a tax-exempt educational institution or hospital;
  • a federal, state, or local governmental unit, if the contribution is used for public purposes;
  • a publicly supported corporation, trust, fund, foundation, or community chest that is organized and operated only for charitable, religious, educational, scientific, or literary purposes; to prevent cruelty to children or animals; or to foster certain national or international amateur sports competitions; or
  • a certain type of private operating foundation or agricultural research organization.

Substantiation – First and foremost, you must receive substantiation of your cash gift in order to deduct it on your tax return; you also must itemize your deductions rather than use the standard deduction. Cash contributions include those paid by cash, check, electronic fund transfer, and credit card. However, you cannot deduct a cash contribution, regardless of the amount, unless you can document the contribution in one of the following ways:

  1. A bank record that shows the qualified organization’s name, as well as the date and amount of the contribution. Eligible bank records include a. a canceled check, b. a bank or credit union statement, or c. a credit card statement.
  2. A receipt (or a letter or other written communication) from the qualified organization showing the organization’s name, as well as the date and amount of the contribution.

Cash contributions of $250 or more – To claim a deduction for a contribution of $250 or more, you must provide a written acknowledgment of the contribution from the qualified organization. This acknowledgment must include the following details:

  1. The amount of cash contributed
  2. Whether the qualified organization gave the taxpayer goods or services (other than certain token items and membership benefits) as a result of the contribution, including a description and good-faith estimate of the value of those goods or services (not counting intangible religious benefits)
  3. A statement that you received no benefit (other than an intangible religious benefit)

The value of any goods or services received in exchange for a donation must be subtracted from the amount claimed as a contribution. If the acknowledgment does not show the date of the contribution, then you must also supply one of the bank records described above to verify the contribution date. If this acknowledgement includes the contribution date and meets the other requirements, it is not necessary to provide other records.

The acknowledgment must be in your hands before the date you file your tax return but not later than the April due date for return (or the extended due date of October if you filed an extension).

Christmas Kettles – It is quite common for charitable organizations to collect cash donations at malls during the holiday shopping season. Consider writing a check to place in these kettles rather than using cash so that you will have the substantiation required for a tax-deductible contribution.

Needy Individuals – You may wish to help out a needy family; although that is a very kind thing to do, no charitable deduction is allowed for such gifts to private individuals (either directly or as through a charitable organization).

GoFundMe – Through this website (and others like it), people raise funds for good causes such as starting a business, paying medical bills or funeral costs, replacing damaged or destroyed homes. However, these websites are not qualified charities for the purposes of claiming a charitable contribution on your tax return.

Special Contribution Rule for Taxpayers Age 70½ and Over – The tax code includes a special provision that allows taxpayers who are at least 70½ years old to directly transfer up to $100,000 from an IRA account to a qualified charity. Instead of receiving a charitable deduction, that person instead gets the benefit of the IRA distribution being nontaxable and counting toward the required minimum distribution for the year. This is especially beneficial for people who receive Social Security benefits and those who take the standard deduction. Although this is generally considered a good tax-saving strategy for those who can afford to make large donations, there is actually no minimum for this rule, so it will likely even benefit individuals in lower tax brackets.

Bunching – When taxpayers’ itemized deductions are only marginally different from the standard deduction, they can consider the method known as bunching. In this technique, the taxpayer make two years’ worth of donations in a single year and then skips making donations in the next year. For example, if you annually contribute $5,000 to a house of worship but have total itemized deductions that are consistently a few hundred dollars less than the standard deduction, you can instead double up by donating $10,000 in a single year. That way, you will be able to claim itemized deductions for the year when you make the donation and can then take the standard deduction in the following year.

For large donations, there are limitations based on adjusted gross income, and there are other available techniques, such as donor-advised funds. This article also did not covered donations of noncash items, such as used furniture or household goods; these have additional substantiation requirements. Please call us if you have questions, or if you would like to set up an appointment to strategize about maximizing the tax benefits of your charitable contributions.

Year-end Tax Planning Is Not Business as Usual: Things You Need to Know

This has been a tumultuous year for taxes, with the tax reform that passed in late 2017 generally becoming effective in 2018, often with significant changes for both individuals and businesses. This is the first major tax reform legislation in more than 30 years. To implement it, the IRS will have to create or revise approximately 450 forms, publications and instructions and modify around 140 information technology systems. All of these changes are to ensure it can accommodate the newly revised or created tax forms, not to mention writing tax regulations for all of these changes – a daunting task for sure. The following issues could affect you and you may need to plan ahead.

Refund or Tax Due? – Most taxpayers are equating the recent tax reform to a larger refund when their 2018 tax return is prepared. However, that may not be the case because your tax refund is the difference between what you prepaid through payroll withholding and estimated tax payments and what you owe. Even if your tax bill is lower, if your prepayments were also lower, then your refund may not be as expected.

The passage of tax reform came on December 20, 2017, just days before employers needed Form W-4 – the Employee’s Withholding Allowance Certificate – for 2018 withholding information from their employees, which did not give the IRS time to adjust the form and withholding tables for the new law. It was not until late February that the IRS published revised withholding tables and an updated Form W-4. Even then, there was concern that some employers might be using the old W-4 with the new tables. On top of that, many taxpayers and tax professionals were finding that the revised W-4 and withholding tables did not produce an accurate result. The bottom line is that there is a real concern that many taxpayers are in for an unpleasant surprise at tax time – so much so that the IRS has been issuing almost daily notices warning taxpayers that they may be under-withheld. This is a real concern for 2018 returns, and you may wish to fine-tune your withholding before year’s end.

Underpayment of Taxes: Should your liability be greater than your prepayments by $1,000 or more, you may also be subject to underpayment penalties. This could simply be the result of under-withholding on your wages or underpaying estimated tax if you are self-employed, or of out-of-the-ordinary income, such as stock gains, sale of a business or rental or even winning big from the lottery. There are safe harbor prepayments to avoid a penalty, which require prepaying:

  • 90% of the current year’s tax liability,
  • 100% of the prior year’s tax liability, or
  • 110% of the prior year’s tax liability, if the prior year’s AGI was over $150,000.

If you are underpaid, there is still time to make adjustments and avoid or mitigate the penalty. Adjusting your payroll withholding is the best option, since withholding is treated as being paid ratably throughout the year, and the penalty is computed on a quarterly basis based on the prepayments through that quarter. However, as the end of the year gets closer, there is less and less time for revised withholding to kick in, so don’t delay in notifying your employer if you need to increase your withholding.

Alternative Minimum Tax (AMT): Although Congress had promised to repeal both individual and corporate AMT, they only repealed the corporate AMT. However, even though they didn’t repeal it for individuals, the tax reform act did increase the exemption amounts and phase-out thresholds, and it eliminated certain deductions that triggered the AMT, so that the AMT will impact fewer taxpayers, giving rise to these possible strategies:

Exercise Incentive Stock Options – These changes to the AMT may allow larger blocks of incentive stock options to be exercised, and the stock that’s issued can be held long-term and thus enjoy the lower capital gains tax rates without triggering the AMT. Some tax planning may be required, which may be a multi-year endeavor.

Recapture AMT – The higher exemptions and phase-outs provide a greater opportunity for taxpayers with AMT tax credit carryover to recapture AMT paid in prior years. If the current year’s regular tax exceeds the AMT, a taxpayer can claim the AMT credit carryover for the difference.

Avoid the Minimum Required Distribution Penalties: Once taxpayers reach the age of 70.5, they are required to take what is known as a “required minimum distribution” from their qualified retirement plan or IRA every year. If this is the first year that this rule applies to you and you haven’t taken your money out yet, there’s no need to panic – you don’t have to do so until some time during the first quarter of next year. Of course, if you wait until 2019 to take your 2018 distribution, you’re going to end up having to take two distributions in one year: one for 2018 and one for 2019. For those who fell into this category before 2018, you only have until December 31st to withdraw your 2018 distribution to avoid penalties.

Convert into a Roth IRA: If you have a traditional IRA and your income for 2018 has been very low, you may want to consider converting your traditional IRA into a Roth IRA and taking advantage of the tax-free distribution benefits of a Roth IRA in the future, especially if you can do so with little or no tax on the conversions. This will probably require a tax projection to determine an amount to convert and the tax cost, if any, of the conversion. However, the tax reform made conversions permanent, and once made, the conversion cannot be undone.

Review Portfolio for Losses: The conventional strategy is to offset as much of your gains as possible with losses from selling other assets in your portfolio. If you have an overall loss, the loss that can be used to offset income other than capital gains is limited to $3,000 ($1,500 for married taxpayers filing separately), and any excess loss carries over to the next year. Keep in mind that losses from the sale of business assets are generally separately allowed in full in the year of sale and are not mixed with the losses from the sale of capital assets.

Assets that are sold and not held long-term, referred to as short-term capital gains, do not receive the benefit of the special rates afforded to long-term capital gains. Taxpayers achieve a better overall tax benefit if they can arrange their transactions to offset short-term capital gains with long-term capital losses.

Make the Most of Higher Education Tax Credits: Both the Lifetime Learning education credit and the American Opportunity Credit allow qualified taxpayers who prepaid tuition bills in 2018 for an academic period that begins by the end of March 2019 to use the prepayments when claiming the 2018 credit. That means that if you are eligible to take the credit and you have not yet reached the 2018 maximum credit for qualified tuition and related expenses paid, you can bump up your credits by paying early for 2019 now. This may not apply to you if you’ve been paying tuition expenses for the entire 2018 tax year, but it will probably provide you with some additional help if your student just started college this fall.

Optimize Health Savings Account Contributions: Did you become eligible to make contributions to a Health Savings Account this year? If so, then you can make deductible contributions into that account up to its maximum amount, no matter when you became eligible. For 2018, the maximum deduction for self-only coverage is $3,450; for family coverage, it is $6,900. Empty Flexible Spending Accounts: If you have a flexible spending account, double-check to see if any remaining account balance can be used for medical expenses, including eyeglasses and/or other health care items covered by the FSA. Remember: funds not used by the account deadline will be forfeited.

Bunch Charitable Deductions: Many people who itemize take advantage of the ability to take a deduction for their donation to their favorite charity or house of worship. Did you know that you can choose to pay all or part of your 2019 planned giving in 2018 to increase the amount you deduct in 2018? Though this may not be appealing to those who itemize every year, you may find this to be an effective strategy if you only marginally itemize every year. Implementing this strategy means you will alternate between taking the standard deduction one year and itemizing the next, giving you a big boost in deductions on the year when you itemize.

Additionally, those who are required to take a required minimum distribution from their IRA because they are 70.5 or older can have their RMD paid directly to a qualified charity, and instead of getting a charitable deduction, the distribution is tax-free, which in turn might reduce the amount of your taxable Social Security income. If this strategy appeals to you, don’t wait until the last minute to implement it, as your IRA trustee or custodian will need time to process the paperwork and make the distribution to the charity or charities you designate.

Deductions – Although the tax reform increased the standard deduction, possibly making it a better choice for the federal return for some, most states did not conform to the federal changes, making it business as usual for itemizing on the state return.

Remember the Annual Gift Tax Exemption: One of the best ways to ultimately reduce your estate taxes and at the same time give to those you love is to take advantage of the annual gift tax exemption. Although the gifts are not tax-deductible, for tax year 2018, you are able to give $15,000 to each of as many people as you want without having to report the transfer to the government or pay any gift tax. If this is something that you want to do, make sure that you do so by the end of the year, as you are not able to carry the $15,000 over into 2019.

Home Equity Debt: The interest on home equity debt is not allowed as an itemized deduction for years 2018 through 2025. (Note: the term equity debt has a different meaning for tax purposes than for lenders. For tax purposes what lenders refer to as equity debt can actually be acquisition debt and may still be deductible if used to purchase or substantially improve a taxpayers home or second home.) But that doesn’t mean equity interest can’t be deducted somewhere else on your return as investment interest or business interest, if you can trace the use of the loan funds to a deductible use.

Retirement Savings: Be sure to maximize your retirement plan contributions before year-end. Once the year is gone, you have forever lost an opportunity to make this year’s annual tax-advantaged addition to your savings for future retirement, which won’t be all that pleasant without a substantial retirement nest egg. If your employer matches some of the amount you contribute to your 401(k) or another eligible retirement plan, be sure to contribute as much as you can to take full advantage of this perk. If the contributions are tax-deductible, such as to a traditional IRA, or made with pre-tax income, maximizing the contributions may also cut your tax bill.

Divorce in the Future: If you or someone you know is contemplating divorce, you should be aware of a big tax change related to alimony. For divorces finalized by the end of 2018, alimony payments are deductible by the one paying them and considered income to the one receiving them. However, for divorces finalized after 2018, alimony is no longer deductible by the payer and is no longer taxable for the recipient. This can have a significant impact on the terms negotiated during a divorce.

Maximize Business Expenses: Beginning in 2018, business owners are able to write off most business purchases using the very liberal 100% bonus depreciation and the Sec. 179 expensing allowance. But to benefit, the business asset must not only be purchased before year’s end, it must also be placed into service by year’s end.

New Flow-Through Deduction: Individuals with taxable incomes (net of capital gains) less than $157,500 and married couples filing jointly with taxable incomes less than $315,000 will enjoy the benefits of the new 20% pass-through deduction from business entities other than C-corporations. Taxpayers with higher incomes will want to determine if any change in compensation structure might increase the deduction.

Additionally, S-corporation employee-stockholders will need to make sure their salary meets the “reasonable compensation” requirements, since the wages are a critical factor in determining the flow-through deduction from an S-corporation.

Every taxpayer’s situation is unique, not all of the suggestions offered here may apply to you, and by no means does the list include all the changes brought about by tax reform. However, they cover many of the major issues for taxpayers and small businesses. If you had any major business, income, or family changes or if any of the issues discussed affect you, a year-end tax planning appointment may be appropriate. The best way to ensure that you are putting yourself into the best tax-advantaged position is to consider all of your tax options. Please call us with questions or to schedule an appointment.