Eldercare Can Be a Medical Deduction

Article Highlights:

  • Nursing Homes
  • Meals and Lodging
  • Home Care
  • Nursing Services
  • Caregiver Agencies
  • Household Employees

Because people are living longer now than ever before, many individuals are serving as care providers for loved ones (such as parents or spouses) who cannot live independently. Such individuals often have questions regarding the tax ramifications associated with the cost of such care. For these individuals, the cost of such care may be deductible as a medical expense.

Incapable of Self-Care – For the cost of caring for another person to qualify as a deductible medical expense, the person being cared for must be incapable of self-care. A person is considered incapable of self-care if, as a result of a physical or mental defect, that person is incapable of fulfilling his or her own hygiene or nutritional needs or if that person requires full-time care to ensure his or her own safety or the safety of others.

Assisted-Living Facilities – Generally, the entire cost of care at a nursing home, home for the aged, or assisted-living facility is deductible as a medical expense, provided that the person who lives at the facility is primarily there for medical care or is incapable of self-care. This includes the entire cost of meals and lodging at the facility. On the other hand, if the person is living at the facility primarily for personal reasons, then only the expenses that are directly related to medical care are deductible; the cost of meals and lodging is not a deductible medical expense.

Home Care – A common alternative to nursing homes is in-home care, in which day helpers or live-in caregivers provide care within the home. The services that these caregivers provide must be allocated into (nondeductible) household chores and (deductible) nursing services. These nursing services need not actually be provided by a nurse; they simply must be the same services that a nurse would normally provide (e.g., administering medication, bathing, feeding, and dressing). If the caregivers also provide general housekeeping services, then the portion of their pay that is attributable to household chores is not deductible.

The emotional and financial aspects of caring for a loved one can be overwhelming, and as a result, caregivers often overlook their burdensome tax and labor-law obligations. Sadly, these laws provide for no special relief from these tasks.

Is the Caregiver an Employee? – Because of the way that labor laws are written, it is important to determine if an in-home caregiver is an employee. The answer to this question can be very subjective. Caregivers’ services can be obtained in several ways:

  • Agency-provided caregivers are employees of the agency, which handles all the responsibilities of an employer. Thus, loved ones do not have any employment-tax or payroll-reporting responsibilities; however, such caregivers generally come at a substantially higher cost than others.
  • Self-employed caregivers pay all their expenses, are responsible for their own income reporting and taxes, and are not considered employees under federal or state law. The IRS lists 20 factors that it uses to determine whether an individual is an employee; the main factors are financial control, behavioral control, and the relationship between the parties. The household workers are typically classified as employees.
  • Household employees are subject to Social Security and Medicare taxes. The employer is thus responsible for withholding the employee’s share of these taxes and paying the employer’s share of payroll taxes. Fortunately for these employers, the special rules for household employees greatly simplify the payroll-withholding and income-reporting requirements. Any resulting federal payroll taxes are paid annually in conjunction with the employer’s individual 1040 tax return. Federal income-tax withholding is not required unless both the employer and the employee agree to do so. However, the employer is still required to issue a W-2 to the employee and to file that form with the federal government. The employer also must obtain federal and state employer ID numbers for reporting purposes. Some states have special provisions for the annual reporting and payment of state payroll taxes; these may be like the federal requirements.

    The employer’s portion of all employment taxes (Social Security, Medicare, and both federal and state unemployment taxes) related to deductible medical expenses are also deductible as a medical expense.

You may be thinking, “Wait a minute – the household employers I know pay in cash and do not pay payroll taxes or issue W-2s to their household employees.” This observation may be accurate, but such behavior is illegal, and it is not right to ignore the law. Think about what could happen if one of your household employees is injured on your property or if you dismiss such an employee under less-than-amicable circumstances. In such circumstances, the household employee will often be eager to report you to the state labor board or to file for unemployment compensation.

Note, however, that gardeners, pool cleaners, and repair people generally work on their own schedules, invest in their own equipment, have special skills, manage their own businesses, and bear the responsibility for any profit or loss. Such workers are not considered household employees.

Here are some additional issues to consider:

Overtime – Under the Fair Labor Standards Act, domestic employees are nonexempt workers and are entitled to overtime pay for any work beyond 40 hours in a given week. However, live-in employees are an exception to this rule in most states.

Hourly Pay or Salary – It is illegal to treat nonexempt employees as if they are salaried.

Separate Payrolls – Business owners may be tempted to include their household employees on their companies’ payrolls. However, any payments to household employees are personal expenses and thus are not allowable as business deductions. Thus, business owners must maintain separate payrolls for household employees; in other words, personal funds (not business funds) must be used to pay household workers.

Eligibility to Work in the U.S. – It is illegal to knowingly hire or continue to employ an alien who is not legally eligible to work in the U.S. When a household employee is hired to work on a regular basis, the employer and employee each must complete Form I-9 (Employment Eligibility Verification). The employer must carefully examine the employee’s documents to establish his or her identity and employment eligibility.

If you have questions related to eldercare or about how your state deals with related employment issues – or if you would like assistance in setting up a household payroll system – please contact us.

What to Do If You Receive a Dreaded IRS Letter

Article Highlights:

  • IRS Notices
  • CP Series Notice
  • Automated Notices
  • Frequent Errors
  • ID Theft
  • What You Should Do
  • What We Will Do

Now that most tax refunds are deposited directly into taxpayers’ bank accounts, the dream of opening your mailbox and finding an IRS refund is all but gone. However, the IRS still sends letters that can increase taxpayers’ heart rates; because of extensive computer matching, the IRS does most of its auditing through correspondence.

CP-Series Notice – When the IRS detects a potential issue with your tax return, it will contact you via U.S. mail; this is called a CP-series notice. Please note that the IRS’s first contact about a tax delinquency or discrepancy will never be a phone call or email. Such calls and emails are a common tool for scammers; if you get one, simply hang up the phone or delete the email. If you are concerned about the validity of a given message, please contact us.

Most commonly, CP notices describe the proposed tax due, as well as any interest or penalties. The notice will also explain the examination process and describe how you can respond.

These automated notices are sent out year-round, and they are quite common. As the IRS tries to close the tax revenue gap, it has become more aggressive in its collection efforts. In addition, as many taxpayers now use low-quality tax mills or do-it-yourself software, the number of notices sent because of preparer error have increased. Missed checkboxes, misunderstandings of available credits, and overlooked income all add up to more errors.

The first step in this automated process involves matching what you reported on your tax return to the data that third parties (e.g., employers, banks, and brokers) reported. When this information does not agree, the automated collection effort begins.

Don’t Panic – These notices often include errors. However, you do need to respond before the 30-day deadline or else face significant repercussions. The notice may even be related to suspected ID theft. For instance, someone may have gained access to your tax ID (or that of your spouse or one of your dependents) and tried to file a return using the stolen ID. The first step is to determine which type of notice you have received.

A CP2000 notice is very different from the other CP notices (which deal with issues such as identify theft, audits, and the earned income credit,). The CP2000 notice includes a proposed—almost always unfavorable—change to your tax return, and it gives you the opportunity to dispute the proposed change. Procrastinating or ignoring this notice will only cause the IRS to ratchet up its collection efforts, which in turn will make it more difficult for you to dispute the proposed adjustment.

Sometimes, the IRS will be correct. You may have overlooked a capital gain or income from a second job. It is also possible that the IRS has caught someone else using your SSN to work or otherwise stealing your identity. Quite frequently, however, the IRS is incorrect, simply because its software isn’t sophisticated enough to pick up all the information that you report on the schedules attached to your return.

When you receive an IRS notice, your first step should be to immediately contact us and provide us with a copy of the notice. We will review the notice to determine whether it is correct, and then we will consult with you to determine how best to respond. If you have any questions, please contact us.

Why Tax Basis Is So Important

Article Highlights:

  • Definition of Tax Basis
  • Cost Basis
  • Adjusted Basis
  • Gift Basis
  • Inherited Basis
  • Record Keeping

For tax purposes, the term “basis” refers to the original monetary value that is used to measure a gain or loss. For instance, if you purchase shares of a stock for $1,000, your basis in that stock is $1,000; if you then sell those shares for $3,000, the gain is calculated based on the difference between the sales price and the basis: $3,000 – $1,000 = $2,000. This is a simplified example, of course—under actual circumstances, purchase and sale costs are added to the basis of the stock—but it introduces the concept of tax basis. The basis of an asset is very important because it is used to calculate deductions for depreciation, casualties, and depletion, as well as gains or losses on the disposition of that asset.

The basis is not always equal to the original purchase cost. It is determined in a different way for purchases, gifts, and inheritances. In addition, the basis is not a fixed value, as it can increase as a result of improvements or decrease as a result of business depreciation or casualty losses. This article explores how the basis is determined in various circumstances.

Cost Basis – The cost basis (or unadjusted basis) is the amount originally paid for an item before any improvements and before any business depreciation, expensing, or adjustments as a result of a casualty loss.

Adjusted Basis – The adjusted basis starts with the original cost basis (or gift or inherited basis), then incorporates the following adjustments:

  • increases for any improvements (not including repairs),
  • reductions for any claimed business depreciation or expensing deductions, and
  • reductions for any claimed personal or business casualty-loss deductions.

Example: You purchased a home for $250,000, which is the cost basis. You added a room for $50,000 and a solar electric system for $25,000, then replaced the old windows with energy-efficient double-paned windows at a cost of $36,000. The adjusted basis is thus $250,000 + $50,000 + $25,000 + $36,000 = $361,000. Your payments for repairs and repainting, however, are maintenance expenses; they are not tax deductible and do not add to the basis.

Example: As the owner of a welding company, you purchased a portable trailer-mounted welder and generator for $6,000. After owning it for 3 years, you then decide to sell it and buy a larger one. During this period, you used it in your business and deducted $3,376 in related deprecation on your tax returns. Thus, the adjusted basis of the welder is $6,000 – $3,376 = $2,624.

Keeping records regarding improvements is extremely important, but this task is sometimes overlooked, especially for home improvements. Generally, you need to keep the records of all improvements for 3 years (and perhaps longer, depending on your state’s rules) after you have filed the return on which you report the disposition of the asset.

Gift Basis – If you receive a gift, you assume the donor’s adjusted basis for that asset; in effect, the donor transfers any taxable gain from the sale of the asset to you.

Example: Your mother gives you stock shares that have a market value of $15,000 at the time of the gift. However, your mother originally purchased the shares for $5,000. You assume your mother’s basis of $5,000; if you then immediately sell the shares, your taxable gain is $15,000 – $5,000 = $10,000.

There is one significant catch: If the fair market value (FMV) of the gift is less than the donor’s adjusted basis, and if you then sell it for a loss, your basis for determining the loss is the gift’s FMV on the date of the gift.

Example: Again, say that your mother purchased stock shares for $5,000. However, this time, the shares were worth $4,000 when she gave them to you, and you subsequently sold them for $3,000. In this case, your tax-deductible loss is only $1,000 (the sales price of $3,000 minus the $4,000 FMV on the date of the gift), not $2,000 ($3,000 minus your mother’s $5,000 basis).

Inherited Basis – Generally, a beneficiary who inherits an asset uses its FMV on the date when the owner died as the tax basis. This is because the tax on the decedent’s estate is based on the FMV of the decedent’s assets at the time of death. Normally, inherited assets receive a step up (increased) in basis. However, if an asset’s FMV is less than the decedent’s basis, then the beneficiary’s basis is stepped down (reduced).

Example: You inherit your uncle’s home after he dies. Your uncle’s adjusted basis in the home was $50,000, but he purchased the home 25 years ago, and its FMV is now $400,000. Your basis in the home is equal to its FMV: $400,000.

Example: You inherit your uncle’s car after he dies. Your uncle’s adjusted basis in the car was $50,000, but he purchased the car 5 years ago, and its FMV is now $20,000. Your basis in the car is equal to its FMV: $20,000.

An inherited asset’s FMV is very important because it is used when determining the gain or loss after the sale of that asset. If an estate’s executor is unable to provide FMV information, the beneficiary should obtain the necessary appraisals. Generally, if you sell an inherited item in an arm’s-length transaction within a short time, the sales price can be used as the FMV. A simple example of not at arm’s length is the sale of a home from parents to children. The parents might wish to sell the property to their children at a price below market value, but such a transaction might later be classified by a court as a gift rather than a bona fide sale, which could have tax and other legal consequences.

For vehicles, online valuation tools such as Kelly Blue Book can be used to determine FMV. The value of publicly traded stocks can similarly be determined using Website tools. On the other hand, for real estate and businesses, valuations generally require the use of certified appraisal services.

The foregoing is only a general overview of how basis applies to taxes. If you have any questions, please contact us.

Top Ten Startup Business Questions Every Entrepreneur Should Answer

Starting a small business can be one of the most exciting and rewarding events in someone’s life. But it can also be extremely stressful. If you’re thinking about becoming an entrepreneur, you might have more questions swirling around in your mind right now than you can count. Don’t despair. This is completely normal. After all, it shows you’re serious about your business venture and care enough to want to do things the right way. . Before you move forward with a new business idea, it is crucial to know the answers to ten vital questions.

1. Does your startup idea meet a need?
Before starting a small business, you need to know if your product or service will meet a need those in your target market have. It doesn’t matter how special your potential product or service offerings are to you. If you can’t convince others to care about them, your small business won’t be a success.

2. Is your plan feasible?
Learning things on the fly isn’t smart in the business world. Rather than taking a blind leap of faith, determine if your plan is feasible before moving forward. For instance, will you be able to afford to put your plan into action? Will your loved ones commit to the ways this venture might affect them? Starting a small business isn’t for the faint of heart. Do you have the ambition and determination to see your vision through?

3. How much financing do you need?
Not adequately estimating financing needs is a common mistake of entrepreneurs. To avoid this pitfall, strive to perform an accurate cost analysis. Approximate both foreseen and unexpected expenses for the first year. Also, determine how long it will take you to become profitable. When creating a cost analysis, be realistic. Don’t count on things going perfectly. Despite your best efforts, they most certainly won’t.

4. Where will your company be located?
The type of small business you want to start will largely determine where it should be located. For example, you wouldn’t attempt to open a ski lodge in sunny, balmy Florida. Generally, you’ll want to find a location with lots of foot traffic. If you’re a new entrepreneur looking to break into an already crowded market, locating your business near your competitors might be a good idea, because you’ll already have a built-in market in the location. But if you’re competing in a saturated market with major brand-name competition, locating your business a short distance away from your competitors may be your best bet.

5. Who will comprise your customer base?
If you’re thinking about starting a small business, you likely already have a vague idea about who will comprise your customer base. However, delving into the profiles of potential clients of your company is a smart idea. During this research, you can study characteristics such as age, gender, buying triggers and general preferences. This should help you fine-tune your marketing efforts and target your products or services to the people who would most benefit from them.

6. When can you expect to be profitable?
The adage is that you should expect to wait at least a year until your startup becomes profitable. But times are changing. Innovations in technology and communication mean entrepreneurs can start companies with little to no overhead nowadays. This rings especially true for service-oriented companies. Therefore, having an astute business plan is essential. A good business plan will help you predict when you may start turning a profit.

7. What setbacks can you anticipate?
The road to small business success can be a bumpy one, so anticipating setbacks is important. One of the most common ones is failing to meet revenue expectations. This can sometimes be blamed on overestimating the amount of business your company will generate in the early days of its existence. A second setback startups can face is losing vital employees. If you plan to start a sole proprietorship, this isn’t an issue. But if you’re launching a business venture with one or more partners, someone might decide to jump ship. To prevent your company from disintegrating into shambles, develop an exit plan that can be utilized if a partner wants to get out.

8. Do you need solid advisors?
Starting a small business can be overwhelming. This is especially true if you try to do everything yourself. Surprisingly, the CountingWorks What Small Business Owners Value Most in 2019 survey reveals that 60% of small business owners handle their budgeting themselves. Unfortunately, the U.S. Small Business Administration Office of Advocacy’s 2018 Frequently Asked Questions says only about half of small businesses survive past five years. To boost your chances of long-term success, surround yourself with solid advisors. For instance, your Tarlow accounting and financial advisors can assist you with accurate budgeting and legal advisors can assist you with contracts and permits.

9. How will you lure the best talent to your company?
Obviously, offering prospective employees a competitive salary can help you lure the best talent to your company. But when you’re just starting a business, this might not be an option. To compensate for this, providing employees with growth bonuses is a good alternative. Offering employees flexible scheduling options and wellness perks such as an onsite gym, a break room stocked with healthy snacks, and standing desks may also attract promising talent to your company.

10. Should you start more than one company at once? 
Do you have multiple ideas for new small businesses? Perhaps you’re eager to get more than one startup running at the same time. While this might be tempting, starting out with one company is best. You can put all your energy into getting it profitable and stable. This will prevent you from spreading yourself and your resources too thin. You can always branch out later if your first business takes off.

Starting a business can be quite an undertaking. Therefore, planning correctly and thoroughly is critical. Before you can enjoy small business success, you’ll need to learn the answers to the above questions. Please contact us to discuss your unique situation and how we can be of assistance.

Forget Something on Your 2018 Return?

Article Highlights:

  • Tax Reform Problems
  • Corrected 1099s and K-1s
  • Overlooked Income and Deductions
  • Marital Issues
  • Mitigating Penalties
  • The Need for Prompt Amendments

If you forgot to include necessary information on your 2018 return, you are not alone. Additionally, you may have received a revised 1099 or K-1 since filing your return. The IRS has struggled to deal with the enormity of the changes in the recent tax reform; despite significant pressure to update its regulations, forms, and publications, the IRS could not finish all its tax-reform updates in a timely manner. Some IRS publications still have not been updated for 2018, and others even include errors. The new tax regulations have been dribbling out, but the IRS still has not provided enough guidance for some issues.

As a result of this uncertainty, you may receive a corrected 1099 or K-1. You may also need to update your return because, like most taxpayers, you did not fully comprehend all the provisions of the new tax law thus failing to include an item of income, deduction, or credit. You also may have simply overlooked an item of income or missed a significant deduction. These mistakes happen, which is why the IRS and state tax agencies allow for amended tax returns.

A failure to report an item of income will generate an IRS inquiry; this typically happens a year or so after the filing of the original return—which is after the interest and penalties have built up. On the other hand, if you forgot a deduction and are owed a refund, you should not let that go by the wayside.

In some cases, marital problems lead taxpayers to file incorrectly—for instance, by incorrectly claiming children or not allocating income correctly. These and a myriad of other issues can be corrected by amending the returns. As a warning, please note that if you are married and filed a joint return, you cannot amend to file separate returns. However, a married couple’s separate returns can be amended into a single joint return.

Regardless of the issue, the solution is to file an amended return as soon as possible. This will minimize the penalties and interest in the case of omitted income and will also prevent you from getting those annoying letters from the IRS. Amended returns can also be used to claim an overlooked credit, to correct your filing status or number of dependents, to report an omitted investment transaction, to submit a delayed K-1, or to include any other information that should have been on the original return.

If an overlooked item results in a tax increase, filing the amended return quickly will mitigate the penalties and interest. Procrastination will lead to further complications when the IRS eventually determines that information is missing, so it is always best to take care of the issue right away.

Generally, to claim a refund on an amended return, you must file the amendment within three years of the date when you filed the original return, or within two years of the date when you paid the tax—whichever is later.

If any of these issues apply to you, please contact us so that we can prepare the necessary amended returns.

How QuickBooks Protects Your Data, and How You Can Help

The data in your QuickBooks company file contains some of the most sensitive information on your computer. Make sure it’s secure.

Your customer list is gold. And those Social Security and bank card numbers in your payroll, client, and vendor records need to be protected from intruders and only viewed by authorized employees.

It’s not just large corporations and financial institutions that get hacked. That’s what the bad guys want you to think. Small businesses are often the victims of data breaches because their owners think they’re immune from data theft and destruction.

Even if you’re password-protecting your PCs and running antivirus and anti-malware software, there’s more you need to do when it comes to your accounting records. Here’s what we suggest.

Restrict access by setting up user permissions.

If you have multiple staff members using QuickBooks, don’t share the same user name and password. That obviously gives everyone access to all data and activity. If something goes awry, you have no way of knowing when or how it happened, and who was responsible. To protect yourself and everyone else who logs in, it’s critical that all users have their own unique logins. They should only be allowed to access information and functions that relate to their job duties.

You can restrict QuickBooks users to certain screens and activities.

To assign these permission levels, open the Company menu and click on Set Up Users and Passwords, then Set Up Users. This opens the User List window, where you should be identified as the Admin. Click Add User. Enter a user name and password for an employee who needs access (this can be changed later). Check the box in front of Add this user to my QuickBooks license.

Tip: Not sure how many users are allowed under your current license? Click F2 and look in the upper left corner. If you need to add licenses, let us know.

Click Next. The next screen lists three options. You can grant access to all areas or to selected areas. You can also create a login for us as your external accountant, which lets us see everything except sensitive customer data. Select the second option and click Next. You can see in the image above that you can give the employee different levels of responsibility. When you’ve made your choice, click Next. The subsequent nine screens deal with different areas of QuickBooks and their related activities.

Tip: When you need to change your password, which you should do at a minimum every three months, go to Company | Set Up Users and Passwords | Change Your Password.

Save your company file elsewhere.

You should always be backing up your company file to an external storage device (like a CD or thumb drive). To set this up, open the File menu and select Back Up Company, then Create Local Backup. This window will open:

The Create Backup window

Make sure Local backup is selected, then click the Options button below (not pictured here). Click Browse to see a directory of your PC and select the correct destination. Leave the two boxes below it checked; this will add the backup date/time to the filename and limit the number of backup copies to three.

By default, QuickBooks will remind you to back up your file every fourth time you close your company file; you can change this number if you prefer. Leave the Complete verification option checked and click OK, then Next. Specify when you want to save your backup copy and click Next again. You can schedule regular backups of your company file on the next screen if you’d like. When you’ve completed this screen, click Finish.

You should also consider saving a copy of your company file to the cloud. Intuit offers its own service for this; it costs $9.95/month or $99.95 annually, but it gives you 100 GB of storage space, so you can back up other critical business files, too. If you can’t swing this financially, at least store your backups to a portable device that you can carry offsite.

Warning: If you already pay for cloud storage from another vendor, don’t assume you can copy your QuickBooks file to it. Talk to us.

Other Steps

There are other things you can do to protect your QuickBooks data, including:

  • Insist on strong passwords. Yes, it’s a pain to create and remember them, but it’s critical here.
  • Keep everything updated. That includes your operating system and anything else that requires updates.
  • Minimize web browsing on work computers and remind employees about smart email behaviors.

We strongly recommend that you consult with a seasoned Tarlow tax professional as you’re setting up any kind of backup system for QuickBooks. The software’s instructions are straightforward, but we don’t want you to do anything that would jeopardize the integrity of your company file. Please contact us with any related questions or to schedule a consultation.

So, You’ve Made a Mistake on Your Tax Return. What Happens Now?

Tax return mistakes are a lot more common than you probably realize. Taxes are naturally complicated, and the paperwork required to file them properly is often convoluted. This is especially true if you’re filing your taxes yourself — and all of this is in reference to a normal year as far as the IRS is concerned.

The 2018 tax year, however, certainly does not qualify as a “normal year.”

With the passage of the Tax Cuts and Jobs Act, even seasoned financial professionals are having a hard time digesting all the changes that they and their clients are now dealing with. All of this is to say that if you’ve just discovered that you’ve made a big mistake on your tax return this year, the first thing you should do is stop and take a deep breath. It happens. It’s understandable. There are steps that you can take to correct the situation quickly — you just need to keep a few key things in mind.

Fixing Tax Return Mistakes: Here’s What You Need to Do

All told, you have three years from the date that you originally filed your tax return (or two years from the date you paid the tax bill in question) to make any corrections necessary to fix your mistakes. If nothing about your return ultimately changes, you probably don’t have anything to worry about — in fact, there’s a good chance that the IRS will catch the mistake and fix it themselves. This is especially true in terms of math errors, or if you’ve left out an important document. The IRS will probably send you a letter letting you know what happened and what you need to do to correct it.

If fixing the mistake ultimately results in you owing more taxes, you should pay that difference as quickly as possible. Penalties and interest will keep accruing on that unpaid portion of your bill for as long as it takes for you to pay it, so it’s in your best interest to take care of this as soon as you can afford to do so.

If you’ve made a much larger mistake (like if you understated or overstated your income, for example), you’ll need to file what is called an amended tax return. This is essentially your “second chance” at getting things right, and the timetable above still applies. Understand, however, that ALL errors must be corrected in the amended return. This means that if you find three errors that will reduce your tax liability and two that increase it, you are legally required to correct all five. You can’t correct only the mistakes that benefit you.

An amended return can be used to correct a variety of issues, including but not limited to issues such as:

  • Overstating or understating your income
  • Changing an incorrect filing status
  • Accounting for dependents
  • Taking care of discrepancies in terms of deductions or tax credits

If any of the above apply to the error you’ve just discovered, you can — and absolutely should — file an amended return.

A sudden increase in your tax liability notwithstanding, it’s again important to understand that even “major” errors on your income taxes aren’t worth stressing out about. The IRS understands that sometimes mistakes happen, and they have a variety of processes in place designed to help make things right.

This does, however, underline how valuable it can be to partner with the right financial professional to do your taxes next year. You have a career and a life to lead — you’re probably not going to be up-to-date on every small change that rolls out in the tax code, but our financial professionals will.

If nothing else, this will help generate some much-needed peace-of-mind regarding the accuracy of your return. You won’t have to worry about whether the IRS is going to find a mistake down the road because you’ve dramatically reduced the chances of those mistakes happening in the first place. Please contact us to discuss your unique situation and how we can be of assistance.

Tax Benefits for Members of the Military

Article Highlights:

  • Service Member Residence or Domicile
  • Service Member Spouse’s Residence or Domicile
  • Non-Taxable Allowances
  • Combat Zone Exclusion
  • Home Mortgage Interest Deduction
  • Home Property Tax Deduction
  • Home Sale Gain Exclusion
  • Moving Deduction
  • Death Gratuity Payments
  • Child Credit
  • Earned Income Tax Credit
  • IRA Contributions
  • Reservist’s Travel Expenses
  • Qualified Reservist’s Pension Withdrawals
  • Retired Military Disability Compensation

Military members benefit from a variety of special tax benefits. These include certain non-taxable allowances, non-taxable combat pay, and a variety of other special tax provisions. Here is a rundown on the most prominent of the tax benefits.

Service Member Residence or Domicile – A frequent question by service members is “What is my state of residence for tax purposes?” since one’s duty station may change multiple times while serving. Luckily, the government passed a law to solve this issue. A service member continues to retain his or her home state of residence for tax purposes, even when required to move to another state under military orders. This also applies to other tax jurisdictions within a state, such as for city, county, and personal property taxes. Thus, a service member will continue to file tax returns for his or her home state and not the state where he or she is stationed.

Service Member Spouse’s Residence or Domicile – In order to simplify the tax-filing requirements of military couples, the Military Spouses Residency Relief Act of 2009 allowed military spouses to claim the same state of domicile as their service member for tax purposes, provided they had also established domicile there.

As an example, say Chris resides in California with his spouse, who is in the military, and Chris has earned income in California but had established domicile with his military spouse in Virginia. Chris would be subject to Virginia income tax laws instead of those of California, and the couple would need to file only one state return – in this case, Virginia. They have no obligation to file a California return.

Unfortunately, spouses who had not established domicile in the same state as their service member spouse, and who had earned income in the state where their spouse was stationed, were still required to file with both states (assuming both states have income tax).

More Choices following 2018 – Thanks to the Veterans Benefits and Transaction Act of 2018, an individual married to a military member now has more choices. Under the Act, a spouse can elect to have the same state of domicile as their service member spouse, even if they didn’t previously have the same domicile. If the non-military spouse doesn’t make that election, they can continue to choose to file in their own domicile state.

Making these choices can significantly impact the amount of state tax the spouse might have to pay. As an example, a spouse of a service member stationed in a high-income-tax state can elect to use the state of residency of the service member whose residence state has no or low state income tax and not be subject to the state taxes where his or her spouse is stationed.

Careful – It is tempting for a service member or their military spouse to declare their state of domicile to be without any state income tax such as Texas, Nevada, Florida, etc. That can get them in hot water if they do so without any connections to the state.

Non-Taxable Allowances – Members of the military benefit from several non-taxable allowances including:

  • Living allowances – Basic allowance for housing (BAH), cost-of-living allowances abroad, and overseas housing allowance whether paid by the U.S. Government or by a foreign government.
  • Family allowances – certain educational expenses for dependents, emergencies, evacuation to a place of safety and separation.
  • Death allowances – Burial services, death gratuity payments to eligible survivors, and travel of dependents to burial sites.
  • Moving allowances – Including for relocation, move-in housing, moving household and personal items, moving trailers or mobile homes, storage, temporary lodging and temporary lodging expenses, and military base realignment and closure benefits.
  • Travel allowances – Including annual round trips for dependent students, leave between consecutive overseas tours, reassignment in a dependent-restricted status, transportation for military taxpayers and dependents during ship overhaul or inactivation, and per diem.
  • State benefit payments – Any bonus payment made by a state or political subdivision to any member or former member of the U.S. uniformed services, or to his or her dependent, only because of the member’s service in a “combat zone,” is generally treated as a “qualified military benefit”, excludable from gross income.
  • Other payments – Defense counseling, disability (including payments received for injuries incurred as a direct result of a terrorist or military action), group term life insurance, professional education, ROTC educational and subsistence allowances, survivor and retirement protection plan premiums, uniform allowances, and uniforms furnished to enlisted personnel.
  • In-kind military benefits – Including legal assistance benefits, space-available travel on government aircraft, medical/dental care, and commissary/exchange discounts.

Combat Zone Exclusion – A member of the U.S. Armed Forces who serves in a combat zone can exclude certain pay from income. This pay includes active duty pay earned in any month served in a combat zone; imminent danger/hostile fire pay; a reenlistment bonus, if the voluntary extension or reenlistment occurs during a month served in a combat zone; accrued leave pay earned in any month served in a combat zone; awards for suggestions, inventions, or scientific achievements the service member is entitled to because of a submission made in a month served in a combat zone; and student loan repayments attributable to the period of service in a combat zone (provided a full year’s service is performed to earn the repayment). Any part of a month in a combat zone counts as an entire month. Periods when one is hospitalized as the result of wounds, disease, or injury in a combat zone are also excluded, provided the hospitalization begins within 2 years of combat zone activities. The hospitalization need not be in the combat zone. Generally, combat pay is not included in the individual’s pay reported on Form W-2.

Commissioned Officers – Commissioned officers may exclude their pay; however, the amount of their exclusion is limited to the highest rate of enlisted pay (plus imminent danger/hostile fire pay received).

Home Mortgage Interest Deduction – Military taxpayers who receive a non-taxable housing allowance and own a home can deduct the mortgage interest on their home as an itemized deduction, even if they are paid with the nontaxable military housing allowance pay. However, the home mortgage interest is still subject to the general rules for deducting home mortgage interest, meaning that for years 2018 through 2025, only home acquisition debt interest is deductible. Home acquisition debt is debt used to acquire, build, or substantially improve a home. Equity debt interest is no longer deductible for years 2018 through 2025.

Home Property Tax Deduction – Even though they receive a non-taxable housing allowance, a military taxpayer can still deduct their home’s property taxes as an itemized deduction. However, the tax reform limits real property tax and state/local income or sales tax deductions to $10,000 annually for years 2018 through 2025.

Home Sale Gain Exclusion – Most taxpayers can exclude up to $250,000 ($500,000 if filing married joint) of home gain if the home was owned and used as their main home for 2 of the 5 years preceding its sale. However, a military taxpayer may choose to suspend the 5-year test period for ownership and use during any period when the taxpayer (or spouse) serves on qualified official extended duty as a member of the Armed Forces. This means that the 2-year use test may be met even if, because of military service, the taxpayer did not actually live in his or her home for at least the required 2 years during the 5-year period ending on the date of sale.

For this exception to the usual test period, a taxpayer is on qualified official extended duty when at a duty station that is at least 50 miles from his or her main home, or while residing under orders in government housing for more than 90 days or for an indefinite period.

The suspension period cannot last more than 10 years and can be revoked by the taxpayer at any time. The 5-year period cannot be suspended for more than one property at a time.

Example – Sarge bought and moved into a home in 2011 that he lived in as his main home for 2½ years. For the next 6 years, he did not live in the home because he was on qualified official extended duty with the Army. He sold the home for a gain in 2019. To meet the use test, Sarge chooses to suspend the 5-year test period for the 6 years he was on qualifying official extended duty – he disregards those 6 years. Sarge’s 5-year test period consists of the 5 years before he went on qualifying official extended duty. He meets the ownership and use tests because he owned and lived in the home for 2½ years during this test period.

Moving Deduction – The tax reform suspended the moving deduction for all moves except for certain members of the Armed Forces, for years 2018 through 2025. Military taxpayers who are still allowed a moving deduction are those who are required to move because of a permanent change of station. However, the deduction is limited to the actual cost less any non-taxable moving allowance provided.

A permanent change of station includes a move from home to one’s first post of duty when appointed, reappointed, reinstated, called to active duty, enlisted or inducted; a move from one permanent post of duty to another permanent post of duty at a different duty station, even if the service member separates from the Armed Forces immediately or shortly after the move; and a move from one’s last post of duty to home or to a nearer point in the U.S. in connection with retirement, discharge, resignation, separation under honorable conditions, transfer, relief from active duty, temporary disability retirement, or transfer to a fleet reserve, if the move occurs generally within 1 year or the termination of active duty.

Death Gratuity Payments –Military death gratuity payments and amounts received under the service members’ group life insurance program are not taxable to eligible survivors. In addition, these amounts may be rolled over to a Roth IRA or Coverdell education savings account without regard to the limits that otherwise apply to other taxpayers.

Child Credit – Excluded combat pay is treated as earned income for purposes of determining the refundable portion of the child credit.

Earned Income Tax Credit (EITC) – A taxpayer may elect to treat combat pay that is otherwise excluded from gross income as earned income for purposes of the EITC. Making this election for EITC purposes may or may not be advantageous. If the taxpayer has earned income below the maximum amount of earned income on which the credit is calculated, including the combat pay will increase the credit amount. On the other hand, if the taxpayer’s earned income is already in the phase-out range, electing to include combat pay as earned income will decrease the amount of credit that can be claimed.

IRA Contributions – For 2019, individuals can contribute up the $6,000 ($7,000 if age 50 or over) to their IRA accounts, subject to phase-out limits for certain higher-income individuals. However, any contribution is limited to the individual’s earned income for the year. For service members, their combat pay, even though it is not taxable, is treated as earned income for purposes of an IRA contribution.

Reservist’s Travel Expenses – Armed Forces reservists who travel more than 100 miles away from home and stay overnight in connection with service as a member of a reserve component can deduct travel expenses as an adjustment to gross income. Thus, this deduction can be taken even by taxpayers using the standard deduction. However, the expenses themselves are subject to certain limitations. Transportation, meals (subject to a 50% limit) and lodging qualify, but the deduction is limited to the amount the federal government pays its employees for travel expenses, i.e., the general federal government per diem rate for lodging, meals and incidental expenses applicable to the locale and the standard mileage rate for car expenses plus parking and ferry fees and tolls.

Qualified Reservists Pension Withdrawals – Qualified reservists are permitted penalty-free withdrawal from IRAs, 401(k)s and other arrangements if ordered or called to active duty.

A “qualified reservist distribution” is any distribution to an individual if the individual was, by reason of his being a member of a “reserve component”, ordered or called to active duty for a period in excess of 179 days, or an indefinite period and the distribution is made during the period beginning on the date of the order or call to active duty, and ending at the close of the active duty period.

Retired Military Disability Compensation – Disability compensation, as distinguished from retirement payments, are tax free and made by the Department of Veterans Affairs. Some misinformation has circulated indicating that the disability is included in the retirement benefits paid by the Defense Finance and Accounting Services. That is not true since the disability payments are made by the Department of Veterans Affairs and those amounts are NOT included on a Form 1099-R issued by the Defense Finance and Accounting Services.

If you have questions related to military tax benefits, please contact us.

Tax Treatment of a Room Rental

Article Highlights:

  • Vacation Home Rental Rules
  • Order of Deductions
  • Loss Limitations
  • Expense Prorating

With the shortage of affordable housing these days, many homeowners are renting out rooms in their homes, providing themselves with some additional cash. Questions that are often raised regarding room rentals include: Is the income taxable? If so, how is it reported? What deductions are allowed? Can a loss be claimed? Answers to these questions follow.

If a taxpayer rents rooms or other spaces in a home and the rented portion does not have facilities (a bathroom and a kitchen) that would make it a dwelling unit on its own, the taxpayer and the renter may be considered to be occupying one dwelling unit. Thus, the “landlord” is mixing personal expenses with business expenses, a situation in which the tax code does not permit a loss.

As a result, the income and expenses are treated under the same rules as vacation home rentals and are reported on Schedule E, with prorated expenses deductible against the rental income in a specific order and no loss being allowed.

The deductions are claimed in the following order:

  1. First, mortgage interest and taxes.
  2. Next, operating expenses (examples: advertising, repairs, utilities, maintenance, insurance).
  3. Finally, depreciation.

If the result is a loss, the expenses are only allowed until the income is reduced to zero.

But some unusable expenses may be carried over to the next year, where again they and the next year’s expenses will be limited to the next year’s rental income.

Because the expenses are taken in a specific order, home mortgage interest and property taxes paid for the home (which, for many taxpayers, would be deductible anyway) are first deducted from the rental income. Next come the operating expenses, of which only $1,300 of $1,417 is deductible in this example, because that amount reduces the rental income to zero. Thus, $117 of the operating expenses and the depreciation are not deductible.

Any reasonable method for dividing the expenses may be used. The two most common methods for allocating expenses, such as mortgage interest and heat for the entire house, are based on the number of rooms and square footage of the home.

If you have questions related to renting a room or a vacation home, or about short-term rentals of your home, please contact us.

Tax Reform Muted the AMT: Holders of Incentive Stock Options, Take Note

Article Highlights:

  • Alternative Minimum Tax
  • Deterrent to Tax Shelters
  • Tax Reform Changes
  • Tax Deductions and Preferences
  • Incentive Stock Options
  • Tax Planning Opportunity

Although Congress, as part of the recent tax reform, promised to do away with the alternative minimum tax (AMT), it only did so for C corporations; as a result, the AMT still applies to individuals.

Congress originally developed the AMT in 1969 to prevent high-income individuals from using tax shelters to reduce their taxes. For the AMT, federal income tax is calculated without certain deductions and tax preferences. This tax applies if it is greater than the regularly computed income tax. Although it has since been indexed to inflation, the AMT at one point began to apply to middle-income taxpayers, who are not the intended targets of this punitive tax.

The AMT computation includes a tax-exempt amount, but this amount begins to phase out for taxpayers whose adjusted gross income (AGI) exceeds a certain threshold (depending on their filing status). Although the tax reform did not eliminate the AMT, it did mute that tax considerably by increasing the AMT exemptions and by substantially raising the exemption-phaseout thresholds, as illustrated below. The exemptions and AGI phaseout thresholds will be inflation-adjusted in future years.

AMT EXEMPTIONS ($)
Status 2017 2018
Married Filing Jointly or Surviving Spouse 84,500 109,400
Single or Head of Household 54,300 70,300
Married Filing Separately 42,250 54,700

 

EXEMPTION-PHASEOUT AGI THRESHOLDS
Status 2017 2018
Married, Filing Jointly, or Surviving Spouse 160,900 1,000,000
Single or Head of Household 120,700 500,000
Married, Filing Separately 80,450 500,000

These are the tax deductions and preferences that most often affect the average taxpayer:

  • Some itemized deductions are allowed for the regular tax computation but not for the AMT computation.
  • Tier II miscellaneous itemized tax deductions are not allowed for the AMT computation; in addition, for the years 2018 through 2025, they are also not allowed for the regular tax computation. This category primarily includes employee business expenses, investment expenses, and legal fees. As these expenses aren’t currently deductible in either tax calculation, there is no adjustment for the AMT calculation.
  • The AMT computation does not allow the itemized deduction for interest on home-equity debt; such debt also is not deductible in the regular computation through 2025, which eliminates another difference in the two computations.
  • Employee incentive stock option tax preferences are also handled differently in the two computations, as is discussed in more detail later in the post.

As a result of the increased exemptions, the higher AGI thresholds for the exemption phaseout, and the reduction or elimination of differences in deductions, the AMT typically no longer affects average taxpayers.

Incentive stock options – Employers sometimes grant employees qualified stock options (i.e., incentive stock options), as motivation to become more involved in the company’s success and to share in the company’s stock appreciation.

For these options, the employer grants the employee an opportunity to purchase the company’s stock at a preset price on a future date. An option is usually accompanied by a vesting schedule that details the date when the options can be exercised (i.e., when the stock can be purchased). Once the employees have held these shares for more than a year—and for at least two years after the option was granted—any subsequent gains from sales of the stock are subject to the capital-gains tax instead of the ordinary (less favorable) income tax.

The Catch – The catch for incentive stock options is that, in the year when the employee exercises the option and purchases the stock, the difference (often referred to as the “bargain element”) between the stock’s current market value and the price that the employee paid as part of the option is treated as a tax preference. Thus, this difference is added to the employee’s AMT income but is not included in the regular tax income. In the past, this usually triggered the AMT, which meant that the employee had to pay tax on the phantom income in the year of the option, even though there was no actual stock sale. As a result, many employees have shied away from taking full advantage of incentive stock options; rather than holding the stock for the required qualifying period, they have been selling the stock in the year when they exercised the option, resulting in the profit being classified as ordinary income.

(Note that nonqualified stock options are not eligible for the beneficial tax treatment that incentive stock options are afforded. When a nonqualified option is exercised, the bargain element is included in the employee’s wages as ordinary income for the year when the option is exercised. However, this ordinary income is not a preference item for AMT purposes. Most employees who exercise nonqualified stock options immediately sell the stock so that they have money to pay the payroll taxes related to the resulting ordinary income. The paperwork that the employer provides when awarding the option states whether the option is qualified or nonqualified.)

Opportunity – The changes in the AMT present low to moderate-income taxpayers with an opportunity to exercise incentive stock options without triggering the AMT.

If you hold incentive stock options, it may be possible to develop a plan—perhaps a multiyear plan—that will allow you to exercise your options without incurring phantom income in the AMT calculation. Please contact us for assistance in developing such a plan.