Divorced, Separated, Married or Widowed This Year? You May Face Complications at Tax Time

Article Highlights:

  • Separated Taxpayers
  • Divorced Taxpayers
  • Recently Married Taxpayers
  • Widowed Taxpayers
  • Filing Status
  • Joint and Several Liability
  • Who Claims the Children
  • Alimony
  • Community Property States
  • Affordable Care Act

Taxpayers are frequently blindsided when their filing status changes because of a life event such as marriage, divorce, separation or the death of a spouse. These occasions can be stressful or ecstatic times, and the last thing most people will be thinking about is their taxes. But the ramifications are real, and the following are some of the major tax complications for each situation.

Separated 

Separating from a spouse is probably the most complicated life event and is undoubtedly stressful for the family involved. For taxes, a separated couple can file jointly, because they are still married, or file separately.

  • Filing Status

     If the couple has lived apart from each other for the last 6 months of the year, either or both of them can file as head of household (HH), provided that the spouse(s) claiming HH status paid over half the cost of maintaining a household for a dependent child, stepchild or foster child. A spouse not qualifying for HH status must file as a married person filing separately if the couple chooses not to submit a joint return. The married filing separate status is subject to a host of restrictions to keep married couples from filing separately to take unintended advantage of the tax laws.

  • In most cases, a joint return results in less tax than two returns filed as married separately. However, when married taxpayers file joint returns, both spouses are responsible for the tax on that return (referred to as joint and several liability). What this means is that one spouse may be liable for all of the tax due on a return, even if the other spouse earned all of the income on that return. This holds true even if the couple later divorces, so when deciding whether to file a joint return or separate returns, taxpayers who are separated and possibly on the path to a divorce should consider the risk of potential future tax liability on any joint returns they file.
  • Children

     Who claims the children can be a contentious issue between separated spouses. If they cannot agree, the spouse with custody for the greater part of the year is entitled to claim the child as a dependent along with the associated tax benefits. When determining who had custody for the more significant part of the year, the IRS goes by the number of nights the child spent at each parent’s home and ignores the actual hours spent there in a day.

  • Alimony

    Alimony is the term for payments made by one spouse to the other spouse for the support of the latter spouse. Under tax law before tax reform, the recipient of the alimony includes it as income, and the payer deducts it as an above-the-line expense, on their separate returns. The tax reform rule is that alimony is non-taxable to the recipient if it is received from divorce agreements entered into after December 31, 2018, or pre-existing agreements that are modified after that date to treat alimony as non-taxable. Therefore, post-2018 agreement alimony cannot be handled by the recipient as earned income for purposes of an IRA contribution and can’t be deducted by the payer.

  • Payment for the support of children is not alimony. To be treated as alimony by separated spouses, the payments must be designated and required in a written separation agreement. Voluntary payments do not count as alimony.
  • Community Property

    Nine U.S. states – Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin – are community property states. Generally, community income must be split 50–50 between spouses according to their resident state’s community property law. This often complicates the allocation of income between spouses, and they generally cannot file based upon their income alone.

Divorced 

Once a couple is legally divorced, tax issues become clearer because each former spouse will file based upon their own income and the terms of the divorce decree related to spousal support, custody of children and division of property.

  • Filing Status

     An individual’s marital status as of the last day of the year is used to determine the filing status for that year. So, if a couple gets divorced during the year, they can no longer file together on a joint return for that year or future years. They must, unless remarried, either file as single or head of household (HH). To file as HH, an unmarried individual must have paid over half the cost of maintaining a household for a dependent child or dependent relative who also lived in the home for more than half the year. There is an exception: a dependent parent doesn’t need to live in their child’s home for the child to qualify for HH status). If both ex-spouses meet the requirements, then both can file as head of household.

  • Children

     Normally, the divorce agreement will specify which parent is the custodial parent. Tax law specifies that the custodial parent is the one entitled to claim the child’s dependency and associated tax benefits unless the custodial parent releases the dependency to the other parent in writing. The IRS provides Form 8332 for this purpose. The release can be made for one year or multiple years and can be revoked, with the revocation becoming effective in the tax year after the year the revocation is made.

  • Most recently, family courts have been awarding joint custody. If the parents cannot agree on who can claim a child as a tax dependent, then the IRS’s tie-breaker rule will apply. This rule specifies that the one with custody the more significant part of the year, measured by the number of nights spent in each parent’s home, is entitled to claim the child as a dependent. The parent requesting the dependency is also eligible to take advantage of other tax benefits, such as childcare credits and higher education tuition credits.
  • Alimony

    See alimony under “separated.”

Recently Married

When a couple marries, their incomes and deductions are combined, and they must file as married individuals.

  • Filing Status

    If a couple is married on the last day of the year, they can either file a joint return combining their incomes, deductions and credits or file as married separately. Generally, filing jointly will provide the best overall tax outcome. But there may be extenuating circumstances requiring them to file as married separately. As mentioned earlier, married filing separate status is riddled with restrictions to keep married couples from taking undue advantage of the tax laws by filing separate returns. 

  • Combining Income

     The tax laws include numerous provisions to restrict or limit tax benefits to higher-income taxpayers. The couple’s combined incomes may well be enough that they’ll encounter some of the higher income restrictions, with unpleasant tax results.

  • Affordable Care Act

     If one or both spouses acquired their insurance through a government marketplace and were receiving a premium supplement, their combined incomes may exceed the eligibility level to qualify for the supplement, which may have to be repaid.

Widowed

When one spouse of a married couple passes away, a joint return is still allowed for the year of the spouse’s death. Furthermore, the widow or widower continues to use the joint tax rates for up to two additional years, provided the surviving spouse hasn’t remarried, and has a dependent child living at home. This provides some relief for the survivor, who would otherwise be straddled with an unexpected tax increase while also facing the potential loss of some income, such as the deceased spouse’s pension and Social Security benefits.

If any of these situations are relevant to you, please contact us for additional details that may also apply concerning your specific set of circumstances.

Congress Passes Last-Minute Tax Changes

Article Highlights: 

  • Discharge of Qualified Principal Residence Indebtedness
  • Mortgage Insurance Premiums
  • Above-the-Line Deduction for Qualified Tuition and Related Expenses
  • Medical AGI Limits
  • Residential Energy (Efficient) Property Credit
  • Employer Credit for Paid Family and Medical Leave
  • Maximum Age Limit for Traditional IRA Contributions
  • Penalty-Free Pension Withdrawals in Case of Childbirth or Adoption
  • Increase in Age for Required Minimum Pension Distributions
  • Difficulty of Care Payments Qualifying for IRA Contributions
  • Expansion of Sec. 529 Plan Uses
  • Required Distributions Modified for Inherited IRAs and Retirement Plans
  • Increase in Penalty for Failure to File
  • Major Change to Kiddie Tax Rules

Congress, at almost the last minute, has passed a large number of tax changes, including retirement plan issues that will become effective in 2020, as well as extensions through 2020 of several tax provisions that had expired or were about to end. The list of changes is quite large, so we have only included those that are most likely to affect individual tax returns. Here is a run-down on some of the new tax provisions: 

TAX EXTENDERS 

The tax changes retroactively revive several provisions that had previously expired or were going to at the end of 2019 and extend them through 2020. So, review them carefully to see if any of them provide you with an opportunity to amend your return for a refund. 

Discharge of Qualified Principal Residence Indebtedness – When an individual loses his or her principal residence to foreclosure, abandonment, short sale, or has a portion of their loan forgiven under the HAMP mortgage-reduction plan, they will generally end up with cancellation-of-debt (COD) income. COD income is equal to the amount of debt on the home that is forgiven by the lender. To the extent that the mortgage debt becomes COD income, it is taxable income unless the taxpayer can exclude it based on specific provisions in the tax code. 

After the housing market crashed a few years back, Congress added the qualified principal residence COD exclusion. The COD exclusion allowed taxpayers to exclude up to $2 million ($1 million if married filing separately) of COD income, to the extent it was discharged debt used to acquire the home, termed acquisition debt. Equity debt was not eligible for the exclusion. However, equity debt is deemed to be released first, thus limiting the exclusion if both equity and acquisition debt is involved in the transaction. 

This COD exclusion that was temporarily added in 2007 was extended and then expired at the end of 2017. Under the current legislation, the exclusion for qualified principal residence indebtedness is retroactively extended through 2020. Thus, if you paid taxes on primary residence COD income in 2018, be sure to call attention to that fact so your return can be amended for a refund. 

Mortgage Insurance Premiums – For tax years 2007 through 2017, taxpayers could deduct the cost of premiums for mortgage insurance on a qualified personal residence as an itemized deduction. The premiums were deducted as home mortgage interest on Schedule A. To be deductible: 

  • The premiums must have been paid in connection with acquisition debt (note: acquisition debt includes refinanced acquisition debt).
  •  The mortgage insurance contract must have been issued after December 31, 2006.
  • It must be for a qualified residence (first and second homes).
  • The deductible amount of the premiums phases out ratably by 10% for each $1,000 by which the taxpayer’s adjusted gross income (AGI) exceeds $100,000 (10% for each $500 by which a married separate taxpayer’s AGI exceeds $50,000).
  • Qualified mortgage insurance means mortgage insurance provided by the: 
  • Dept. of Veterans Affairs (VA),
  • Federal Housing Administration (FHA)
  • Rural Housing Services (RHS)
  • Private mortgage insurance.

This deduction was previously allowed through 2017 and has retroactively been extended through 2020. 

Above-the-Line Deduction for Qualified Tuition and Related Expenses – An above-the-line deduction for qualified tuition and related expenses for higher education has been available since 2002 and was previously extended through 2017. For purposes of the higher education expense deduction, “qualified tuition and related expenses,” has the same definition as for the American Opportunity and Lifetime Learning credits for higher education expenses – that is, with certain exceptions, tuition, and fees paid for an eligible student (the taxpayer, the taxpayer’s spouse, or a dependent) at an eligible higher education institution. The deduction – up to $2,000 or $4,000, depending on AGI – is not allowed for joint filers with an AGI of $160,000 or more ($80,000 for other filing statuses), except no deduction is allowed for taxpayers using the married filing separate status. The phase-out amounts are not inflation-adjusted. The same expenses can’t be used for both an education credit and the tuition and fees deduction. 

This deduction was previously allowed through 2017 and has retroactively been extended through 2020. 

Medical AGI Limits – For 2017 and 2018, individuals could claim an itemized deduction for unreimbursed medical expenses, to the extent that such costs exceeded 7.5% of their AGI. For the post-2018 years, the percent of AGI increased to 10%. The provision retroactively extends the lower threshold of 7.5% through 2020. 

Residential Energy (Efficient) Property Credit – This non-refundable credit has been available in one form or another since 2006 through 2017, with credit amounts varying from 10% to 30% and the maximum credit ranging from $500 to $1,500. Most recently, the credit percentage was 10%, with a lifetime credit amount limited to $500. This credit is best described as an energy-saving credit since it applies to improvements to the taxpayer’s existing primary home to make it more energy-efficient. Generally, it applies to insulation, storm windows and doors, certain types of energy-efficient roofing materials, energy-efficient central air-conditioning systems, water heaters, heat pumps, hot water systems, circulating fans, etc.

The recent legislation extends this credit through 2020, with a lifetime credit cap of $500. 

Caution: The lifetime credit extends to returns going back to 2006. 

Employer Credit for Paid Family and Medical Leave – This credit provides an employer with credit for paid family and medical leave, which permits eligible employers to claim an elective general business credit based on eligible wages paid to qualifying employees with respect to family and medical leave. The maximum amount of family and medical leave that may be taken into account for any qualifying employee is 12 weeks per taxable year. The credit is variable and only applies if the leave wages are at least 50% of the individual’s normal wages. The credit percentage is 12.5% and increases by 0.5%, up to a maximum of 25%, for each percentage point that the payment rate exceeds 50%. 

The credit was originally only for 2018 and 2019 but has been extended through 2020. 

RETIREMENT PLAN AND IRA CHANGES 

Maximum Age Limit for Traditional IRA Contributions – The legislation repeals the maximum age for making traditional IRA contributions, which prior to this legislation, prohibited traditional IRA contributions after an individual reached the age of 70½. The provision is effective for contributions made for taxable years beginning after December 31, 2019. 

Penalty-Free Pension Withdrawals in Case of Childbirth or Adoption – The legislation allows a penalty-free but taxable distribution of up to $5,000 from a qualified plan made within one year of birth. Or, in the case of a finalized adoption of an individual aged 18 or younger, or an individual who is physically or mentally incapable of self-support. You can repay distributions later to avoid the tax on the distribution. 

Increase in Age for RMDs – For decades, individuals were required to begin taking distributions from their traditional IRAs and qualified plans once they reached age 70½. These distributions, commonly referred to as a required minimum distribution or RMD, have never been adjusted to account for increases in life expectancy. The legislation changes the required beginning date for mandatory distributions to age 72, effective for distributions required to be made after December 31, 2019, with respect to individuals who attain the age of 72 after this date. 

Special Rule – Difficulty of Care Payments – Many home health-care workers do not have a taxable income because their only compensation comes from “difficulty of care” payments that are exempt from taxation under Code Section 131. Because such workers do not have taxable income, they cannot save for retirement in a defined contribution plan or IRA. This provision will allow home health-care workers to contribute to a qualified plan or IRA by amending the tax code so that tax-exempt difficulty of care payments are treated as compensation, for purposes of calculating the contribution limits to defined contribution plans and IRAs. This is effective for plan years after December 31, 2015, and IRA contributions after the act’s date of enactment (December 20, 2019). 

Sec. 529 Plan Modifications – Sec. 529 plans (also referred to as qualified state tuition plans) were originally created to allow tax-free accumulation saving accounts for a child’s education but generally limited the funds’ use to post-secondary education tuition and certain college fees. Since then, Congress has continued to expand the use of funds to include supplies, books, equipment, and reasonable room and board expenses for attending college. With the passage of the tax reform at the end of 2017, Congress allowed up to $10,000 a year to be used for elementary and secondary school tuition expenses. This new legislation adds the following to the list of qualified expenses: 

  • Qualified higher-education expenses associated with registered apprenticeship programs certified by the Secretary of Labor under Sec. 1 of the National Apprenticeship Act 
  • Payment of education loans, up to a maximum of $10,000 (reduced by the amount of distributions so treated for all prior taxable years), including those for siblings

These changes are effective for distributions made after December 31, 2018. 

RMDs for Designated Beneficiaries – The legislation modifies the required minimum distribution rules with respect to defined contribution plan and IRA balances upon the account owner’s death. Under the legislation, distributions to individuals other than the surviving spouse of the employee (or IRA owner), disabled or chronically ill individuals, individuals who are not more than ten years younger than the employee (or IRA owner), or a child of the employee (or IRA owner) who has not reached the age of majority must generally be distributed by the end of the tenth calendar year following the year of the employee’s or IRA owner’s death. A special rule for children requires any remaining undistributed funds to be distributed within ten years after they reach the age of maturity. 

This is a significant change since beneficiaries previously had options to take certain lifetime payouts. This will require careful planning to minimize the tax on the distributions. The change applies to distributions for employees or IRA owners who die after December 31, 2019.

Penalty for Failure to File – The legislation increased the minimum penalty for failure to file a tax return within 60 days of the return’s due date to $435, up from $330, for returns with a due date (including extensions) after December 31, 2019. Thus, the $435 penalty will apply to 2019 returns and will be inflation-adjusted for future years. 

Kiddie Tax – The tax reform enacted late in 2017 changed how the income of dependent children is taxed, causing a child’s unearned income to be taxed at fiduciary rates that very quickly reach the maximum tax rate of 37%. That change created an unintentional tax increase for survivors of service members and first responders who died in the line duty. This last-minute change reverts the kiddie tax computation to the pre-tax reform method for years beginning in 2020. It also allows taxpayers to choose whichever method provides the lowest tax for 2018 and 2019. Taxpayers can amend their 2018 return if doing so will provide a better outcome. 

The changes are extensive and, in many cases, open the door to amending prior years’ returns. If you have any questions or think any of these changes might benefit you for a prior year, please contact us

Employer-Offered Benefits That Can Save You Money and Taxes

Article Highlights:

  • Health Insurance
  • Retirement Plans
  • Qualified Transportation Fringe Benefits
  • Flexible Spending Accounts (FSAs)
  • Group Term Life Insurance
  • Qualified Employee Discounts
  • Employer-Provided Education Assistance
  • Adoption Expenses
  • Child and Dependent Care Benefits
  • Health Savings Accounts

Tax law includes several tax- and financially favored benefits that employers can offer or provide to their employees. This article is intended to make you aware of these perks, with the caveat that all employers, especially small businesses, may not provide all, or perhaps any, of these covered perks. But whichever of these benefits your employer offers, you should seriously consider taking advantage of them, if you haven’t already.

Health Insurance – The Affordable Care Act (also known as Obamacare) requires businesses with over 50 employees to offer at least 95% of its full-time employees, and their dependents, with affordable minimum essential health care coverage. Companies that do not meet this requirement are subject to penalties. If you work for one of these larger employers and the company picks up the entire health insurance premium cost, consider yourself lucky, as the prices of health insurance coverage have risen dramatically over the last few years. More likely, you may have to pay part of the premium costs, and the plan may have a high deductible or co-pays. Even so, the tax-free benefit of what the employer covers is valuable. While not required to, businesses with fewer than 50 employees may offer health care coverage, often for competitive purposes in retaining employees. The health insurance premiums paid on your behalf by your employer are tax-free to you. If you aren’t aware of the value of this nontaxable employee benefit, you can look at your Form W-2, box 12a, code DD, which shows your share of the cost of employer-sponsored health coverage. You can claim the part of the coverage that you pay for with post-tax dollars as a medical expense if you itemize your deductions.

Retirement Plans – Although some larger employers may provide a company-funded retirement plan that will pay you a monthly benefit when you retire, most generally offer 401(k) plans with which an employee can save for retirement by making pre-tax contributions up to $19,000 for 2019. If the employee is age 50 or over, they can qualify to make a catch-up contribution of up to $6,000, bringing the total to $25,000. Some employers also match their employees’ contributions up to a certain amount, which means an employee should endeavor to contribute at least the amount that the employer will match.

Qualified Transportation Fringe Benefits – Certain transportation-related fringe benefits that an employer may provide to employees are tax-free to the employee. Before the passage of the tax reform in late 2017, employers were able to provide employees with tax-free reimbursement for parking, transit passes, commuter transportation, and bicycle commuting, subject to certain limits, and the employer could deduct the cost. The tax reform had a significant impact on these benefits. It eliminated the $20-per-month bicycle benefit and no longer allowed the employer to deduct reimbursements made to employees for other transportation benefits, making some employers less likely to offer any transportation fringe benefits. However, they remain tax-free to the employee; for 2019, the limit on tax-free employer reimbursements is $265 per month each for qualified parking, transit passes, and commuter transportation.

Flexible Spending Account (FSA) – This is a unique account established by an employer that allows employees to contribute to the account through salary-reduction contributions. The benefit is that the contributions are pre-tax, meaning the employee doesn’t pay taxes on the money contributed to the account. This allows employees to pay for individual out-of-pocket health care costs with pre-tax dollars. The health care expenses can be used for health plan deductibles, co-payments, and even some over-the-counter-medications. The annual limit on contributions is inflation-adjusted and is $2,700 for 2019. However, if you don’t use the money in your FSA, you will lose it.

Group Term Life Insurance – The cost for the first $50,000 of group term life insurance (GTLI) coverage provided by an employer is excluded from the employee’s taxable income. However, the employer-paid cost of group-term coverage in excess of $50,000 is taxable income to the employee, even if he or she never receives it (i.e., it is “phantom income”). So, while the tax-free coverage of the first $50,000 is a good perk, an employee shouldn’t automatically sign up for more than $50,000 of GTLI coverage without considering whether they genuinely need the coverage and what the extra cost will be. In some cases, an employee who wants more than $50,000 in coverage may be able to privately acquire a policy that will cost less than the tax on the imputed income for the extra coverage through the employer’s plan.

Qualified Employee Discounts – A certain amount of an employee discount on purchases from an employer or on services provided by an employer is excludable from the employee’s income. The exclusion is limited to the employer’s gross profit percentage for property or 20% of the price at which the employer sells services to non-employee customers for services.

Employer-Provided Education Assistance – An employee doesn’t have to include, in his or her income, amounts paid by the employer for educational assistance under a qualified education-assistance program. The maximum amount of educational support that an employee can exclude is $5,250 for any calendar year. Excludable assistance under a qualified plan includes, among others, tuition, fees, books, supplies, and equipment. The education is any training that improves an individual’s capabilities, whether or not it is job-related or part of a degree program.

Adoption Expenses – An employee may exclude amounts paid or expenses incurred by the employer for qualified adoption expenses connected to the employee’s adoption of a child, if the amounts are furnished under an adoption-assistance program in existence before the costs are incurred. If the adopted child is a special needs child, the exclusion applies regardless of whether the employee has adoption expenses. The maximum exclusion amount is inflation adjusted annually and is $14,080 for 2019 per child, for both non-special needs and special needs adoptions. The exclusion phases out when the employee’s modified adjusted gross income is between $211,160 and $251,160 for 2019. Taxpayers can claim a tax credit for qualified adoption expenses, subject to the same phaseout range as for the exclusion. Still, any employer-paid excludable expenditures can’t be used for the credit.

Child and Dependent Care Benefits – Qualified payments made or reimbursed by an employer on behalf of an employee for child and dependent care assistance are excluded from the employee’s gross income. The amount of the exclusion is limited to the lesser of $5,000 ($2,500 for married individuals filing separately), the employee’s earned income, or the income of the employee’s spouse. A child and dependent care tax credit is available to taxpayers. Still, no credit is allowed to an employee for any amount excluded from income under his or her employer’s dependent care assistance program.

Health Savings Accounts – Employees who have a high-deductible health plan through their employer can open a health savings account (HSA) and make annually inflation-adjusted pre-tax contributions, which, for 2019, can be up to $7,000 for families and $3,500 for a single individual. When you make distributions for medical expenses, the money comes out tax-free. However, distributions not used to pay qualified medical expenses are taxable, and if the plan’s owner is under the age of 65, nonqualified distributions are subject to a 20% penalty. Some individuals let the account grow and treat it as a supplemental retirement plan, waiting until after age 65 to begin taking taxable but penalty-free distributions.

If you have questions on how job-related benefits might apply to you or if you are an employer interested in providing any of these benefits to your employees, please contact us.

3 Common Personal Income Tax Problems and How to Respond

Common tax problems can go far beyond the numbers that you report, and they can require additional evidence that your bank statements and paychecks can’t provide. Additionally, the IRS isn’t the only source of those problems. State tax authorities are hungry for revenue, and if you divide your time among different states, you may find it challenging to establish nexus and may even have to file taxes in multiple states.

Below are some of the most common personal income tax issues people are likely to face.

1. You didn’t make (or underpaid) estimated tax payments.

Self-employment is the most common cause of this. When you’re used to having taxes withheld from your paychecks at work, it can be a shock to have to pay taxes yourself. You can end up owing not just a large amount of self-employment and income taxes, but also penalties for not making tax payments on time. Estimates must be deposited quarterly, or you will face an underpayment penalty.

If your total tax due when you go to file is under $1,000, you won’t have to worry about getting smacked with an underpayment penalty. However, it’s a good idea to set aside at least 25%-30% of your income for estimated tax payments and commit to paying this amount every month if quarterly taxes are too complicated to figure out.

Other situations like freelancing on the side or rental income while you’re still employed can also cause you to fall short at tax time, so make sure to have extra taxes withheld from your paycheck if you don’t want to make estimated payments. State tax payments also shouldn’t be neglected.

2. You didn’t correctly file state tax returns after moving.

Moving to a state with little or no income taxes like Nevada or Florida can be appealing if your bank account feels squeezed in high-tax states like New York or California. Many people divide their time between multiple states for work or personal reasons. If it’s not just a two- or three-week creative retreat or corporate assignment, it can make nexus challenging to determine in some cases.

With the prospect of a lower tax burden becoming even more appealing, it seems logical to move to the tax-haven state you’ve been eyeing. But even after you file for a change of address with the postal service, change your voter registration, and get recognized as a resident by your new state, the high-tax state that you left is likely to also still treat you like one.

Typically, you must spend at least 183 days of the year in the other state and maintain a primary residence there. Merely owning property in another state won’t do if your family doesn’t also live there while you work or travel. Where you spend time outside of work also matters because where you sleep every night is what ultimately matters.

If your move is indeed permanent and your residency is valid, you may have to file a part-year resident tax return for the final months you stayed in the old state. You won’t need to worry about it for following years, but keep track of how many days you spent in each state before and after moving day.

3. You neglected to file state income tax returns as a non-resident.

If you have a business or rental income in another state, you may be required to file state tax returns as a non-resident. If this income is significant, it can end up producing a large tax bill if you’re unprepared.

If you have an out-of-state job, your payroll provider may also be incorrectly withholding taxes for the appropriate state or city. In concentrated regions like the tri-state area, especially for New York City and Philadelphia residents, ensure that city taxes are being correctly withheld if you are a resident, and that withholding curtails if that is no the longer the case. There are usually reciprocity agreements among states and municipalities in areas where state lines cross. Still, you should carefully check to make sure you don’t owe non-resident taxes in addition to what you owe your home state.

Failure to make tax payments on time, and to the right agency, are income tax problems that are often overlooked and can quickly spiral out of control. To avoid these issues and many more, please contact us so we can consult you on your state and local taxation, as well as rules for establishing nexus.

Is It Better to Have a Tax Credit or a Deduction?

Article Highlights:

  • Itemized Deductions
  • Above-the-Line Deductions
  • Business Deductions
  • Asset-Sale Deductions
  • Refundable Credits
  • Nonrefundable Credits
  • Carryover Credits
  • Business Tax Credits

People often say that an expense is a tax write-off and interpret this to mean that the expense will have a tax benefit. Generally, such a benefit takes the form of either a deduction or a credit.  The effects of these benefits are quite different; however, and each type has various categories. As a result, the tax implications may not be as expected. This is especially true when the write-off claim comes from a salesperson who is touting the tax benefits of a product or service, as such individuals often leave out key details. In general, a deduction reduces taxable income, whereas a credit reduces the tax itself.

Tax Deductions – In one way or another, tax deductions reduce the taxable portion of an individual’s income, which thus reduces the tax on that income.

Itemized Deductions – When taxpayers think of deductions, they typically think of the itemized deductions that are claimed on Schedule A. This is the only way to deduct personal expenses such as medical costs, state and local tax payments, investment and home-mortgage interest, charitable contributions, disaster-casualty losses, and various rarely encountered expenses. In some cases, itemized deductions are limited. For instance, medical expenses are only deductible to the extent they exceed 10% of the taxpayer’s adjusted gross income (AGI). Similarly, state and local tax payments (including those for income, sales, and property taxes) are capped at $10,000. On top of that, itemization only reduces taxable income to the extent that the total of the itemized deductions exceeds the standard deduction. When the sum does not exceed the standard deduction, the itemized deductible expenses provide no tax benefits at all.

Above-the-Line Deductions – Certain deductions reduce income. These are commonly called above-the-line deductions because, when applied, they reduce the income figure that is used to calculate AGI. Thus, their benefits apply regardless of whether the taxpayer uses itemized deductions. Above-the-line deductions include educators’ expenses; contributions to health savings accounts, traditional IRAs, and certain qualified retirement plans; deductible alimony payments; and student-loan interest. Most of these deductions have annual maximums.

Business Deductions – Taxpayers who operate noncorporate businesses can deduct from their business income any expenses that they incur when operating their businesses. These deductions (which cover advertising fees, employee wages, office-supply costs, etc.) are used to reduce profits, which in turn reduces taxable income and, ultimately, income tax. In addition, most self-employed taxpayers pay Social Security and Medicare taxes on their net business income, so any reduction in their business profits also reduces their Medicare taxes and possibly their Social Security taxes.

Asset-Sale Deductions – An individual who sells an asset is allowed to deduct that asset’s cost from the sale price to determine the taxable profit. Good recordkeeping is helpful here because the original expense may have been incurred years prior, even though it is only deductible when the asset is sold. For example, any improvements that an individual makes to a home over years of ownership are not deductible until the home is sold. At that point, the individual can reduce the taxable gain from the sale by counting the improvements as part of the home’s cost.

Tax Credits – Tax credits come in several varieties, and the amount of benefit can vary:

Refundable Credits – A refundable credit offsets current tax liability; it is so-called because any amount of unused credit is refunded to the taxpayer. Refundable credits include the Earned Income Tax Credit, the Additional Child Tax Credit, and the Premium Tax Credit (net of any advances received), as well as the American Opportunity Tax Credit (an education credit that is 40% refundable). As a matter of general interest, these credits are subject to significant filing fraud because of their refundability. The IRS also considers prepayments such as income-tax withholding and estimated tax payments to be refundable credits.

Nonrefundable Credits – A nonrefundable credit only offsets tax liability; any unused amount is lost (unless it can be carried over to another year; see below). Over time, Congress has become more generous with credits; most credits that are not refundable now carry over for a given period. Nonrefundable credits include the Saver’s Credit, the Lifetime Learning Credit, and the personal portion of the Electric Vehicle Credit.

Carryover Credits – For some nonrefundable credits, any unused current-year credit can be carried over to the next tax year (or for a longer period) until the carryover amount is used up. These credits include the Adoption Credit (which can carry over for up to five years) and the Home-Solar Credit (which carries over through at least 2021; tax law is unclear on whether it will expire then).

Business-Tax Credits – Numerous business-tax credits are available; however, they are grouped into the General Business-Tax Credit, which is nonrefundable but which carries forward for twenty years and back for one year. (This allows a business owner to amend the prior year’s return to claim the credit.) This category includes the business portion of the Electric Vehicle Credit.

If you have questions related to how you might benefit from tax credits or deductions, please contact us.

Child Daycare and Taxes

Article Highlights:

  • Daycare Providers
  • Simplified Food Deduction
  • Special Rules for Business Use of the Provider’s Home
  • Home Sale Consequences
  • Other Expenses
  • Other Daycare Provider Issues
  • Daycare User Credit
  • Employer Dependent Care Benefits
  • Other Credit Criteria

When discussing daycare for children so their parents can work, there are two primary areas of discussion: one from the viewpoint of the individual providing the daycare services and another from the parents using a daycare provider’s services. Tax law provides exclusive benefits for both.

DAYCARE PROVIDERS

Daycare providers are generally self-employed individuals who provide care in their home, and like other self-employed individuals conducting a business, they are allowed to deduct business expenses, including the following:

  • Business Use of a Vehicle – Examples of business-related use of a personal vehicle by a daycare provider include taking the kids to the park, on field trips, or the movies. Also eligible are miles used to purchase supplies and other business-related travel. What’s deductible is the standard mileage rate of 58 cents per business mile (2019) or the prorated business portion of the actual operating expenses for the vehicle. In either case, daycare providers should maintain a contemporaneously prepared log detailing all business-related trips.
  • Food – Daycare providers can deduct the cost of meals provided to the children, not including meals for their own children. The simplest method, which does not require documenting food purchases, is to use the simplified meal deduction. The simplified meal deduction does not preclude a care provider from using the actual expenses if the actual cost is higher, and the provider is willing to document the costs without including food purchased for his or her own family’s use. The simplified meal deduction amounts for 2019 are illustrated in the table below. 
Year States Breakfast Lunch Dinner Snack
2019 Contiguous States
Alaska
Hawaii
$1.31
$2.09
$1.53
$2.46
$3.99
$2.88
$2.46
$3.99
$2.88
$0.73
$1.19
$0.86

The rates do not include the cost of nonfood supplies (e.g., utensils), which may be deducted separately. The number of meals per day per child is limited to the amounts below. (The table uses the amounts based upon the rates for contiguous states and will be higher for Alaska and Hawaii.)

Meal Rate 2019 Allowance
One Breakfast $1.31 $1.31
One Lunch $2.46 $2.46
One Dinner $2.46 $2.46
Three Snacks $0.73 $2.19
2019 Daily Maximum Per Child $8.42

If the provider receives some form of reimbursement or subsidy, then the provider may deduct only the part of the simplified rate that exceeds the reimbursed amount.

Business Use of the Home – Self-employed individuals may take a business deduction for the business use of a portion of their home if that portion is used exclusively for business. Daycare facilities are not subject to the exclusive use requirement that applies to other home offices. However, that special rule only applies to providers who:

  1. Are licensed, certified, registered, or approved as a daycare provider under state law;
  2. Have a pending application for licensing, certification, registration, or approval under state law as a daycare provider that has not been denied; or
  3. Are exempt from licensing, certification, registration, or approval under state law.

Any daycare provider not meeting one of these three requirements is still subject to the exclusive use rules. These rules will generally preclude them from the deduction unless they use some portion of the home exclusively for daycare purposes, such as a bedroom or a storage area. The daycare facility exception does not apply if the services performed are primarily educational or instructional (e.g., musical instruction). However, the limitation does apply if the services are mostly custodial and if the educational, developmental, or enrichment activities are only incidental to the custodial services. The services must be provided for individuals age 65 or older, children, or individuals who are physically or mentally incapable of caring for themselves.

When calculating the percentage of the business use of the home, both the space used to operate the daycare business and the amount of time that space is used to provide daycare, including preparation and cleaning time, are factors.

Example: Edna uses her living room, kitchen, and bathroom ten hours a day, five days a week, to provide licensed daycare services. The home is 2,400 square feet, and the living room, kitchen, and bathroom are a combined 1,400 square feet. The exclusive use requirement doesn’t apply. Edna’s percentage use of her home for business is determined as follows:

Once the percentage is established, all of the home expenses, including interest, taxes, home insurance, maintenance, utilities, and depreciation, are summed up and multiplied by the percentage to determine the deduction for the business use of the home. If an individual rents the home, the rent expense replaces the interest, taxes, and depreciation. After determining the deduction, it is further limited to the gross income from the daycare. If limited by the total income, there is a specific order in which the home expenses can be used (not discussed in this article).

Claiming the business use of the home deduction will also impact any future sale of the home. For taxpayers who own and use their home for two years out of the five years before the sale, they can generally exclude up to $250,000 ($500,000 if married filing jointly) of any resulting gain. However, any depreciation claimed, or that could have been claimed after May 15, 1997, cannot be excluded and, as a result, will be taxable to the extent of any gain from the sale.

Example: A care provider is entitled to claim $1,000 per year of home depreciation, and she operates that business for ten years, claiming a total of $10,000 in depreciation. Whenever she ultimately sells her home, the $10,000 cannot be included in the excluded gain and will always be treated as a taxable capital gain to the extent of any home sale gain.

  • Other Expenses – Other expenses include just about any cost that has to do with operating the daycare facility, including, for example:
    • Advertising
    • Business banking account fees
    • Daycare licensing
    • Daycare organization membership expenses
    • Seminars and education related to managing a daycare center
    • Business insurance
    • Games and toys
    • Supplies, diapers, wipes, and cleaning supplies
    • Phone services
    • Prorated internet service
    • Field trip expenses
    • Payroll for employees
    • Additional important tax issues apply to daycare providers:

Self-Employment Tax – Like all self-employed taxpayers, daycare providers must pay self-employment tax, which is made up of the Social Security tax of 12.4% on the first $132,900 (2019) of profit from the business and a 2.9% Medicare tax on all of the profits. In addition, there is an additional 0.9% Medicare tax on the extent to which the profits exceed $200,000 for single taxpayers, $250,000 for married taxpayers filing jointly, and $125,000 for married taxpayers filing separately. Also, daycare providers can deduct half of the self-employment tax from their gross income.

Retirement Plan Contributions – Profits from a daycare business qualify for IRA contributions and self-employed retirement plans, allowing daycare providers to put away substantial amounts for their future retirement.

Medical Insurance Above-the-Line Deduction 

While most taxpayers must itemize their deductions to deduct the cost of their medical insurance, self-employed taxpayers, including daycare providers, can deduct the premiums from their adjusted gross income and avoid the 10% medical expense haircut when itemizing deductions.

Employer Identification Number – Most daycare clients can claim a tax credit for the cost of daycare. However, to do so, they must include either the daycare provider’s Social Security number (SSN) or an employer identification number (EIN) on their tax returns. It is a best practice in this age of ID theft not to use the SSN and instead obtain an EIN.

DAYCARE USERS 

Individuals who use the services of daycare providers may qualify for a tax credit if the expense is an “employment-related” expense. For example, it must enable a taxpayer or spouse, if married, to work, and it must be for the care of a child, brother, sister, or stepsibling (or a descendant of any of these) who is under 13, lives in the taxpayer’s home for more than half the year, and does not provide more than half of his or her own support for the year. Married couples must file jointly, and both spouses must work (or one spouse must be a full-time student or disabled) to claim the credit.

The qualifying expenses are limited to the income from working and, in the case of a married couple, are limited to the lower of the spouse’s income from working. However, under certain conditions, when one spouse has no actual income from working and that spouse is a full-time student or disabled, that spouse is considered to have a monthly income of $250 (if the couple has one qualifying child) or $500 (for two or more qualifying children). This means the income limitation is mostly removed for a spouse who is a student or disabled all year.

The qualifying expenses can’t exceed $3,000 per year for those who have only one qualifying child, while the limit increases to $6,000 per year for those with two or more qualifying persons.

If there are two children, the care expenses are not divided equally. For example, if the taxpayer paid $2,500 in qualified expenses for the care of one child and $3,500 for the care of another child, the $6,000 can be used to determine the credit. The credit is computed as a percentage of qualifying expenses, in most cases, 20%. See the table below for the credit percentages based on the taxpayer’s adjusted gross income.

AGI Adjusted Applicable Percentage

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

 

Example: Al and Janice both work with combined earned income in excess of $50,000 for the year. Janice has a part-time job, from which she earns $10,000 for the year. Her work hours coincide with the school hours of their 11-year-old daughter, Susan, so while school is in session, Al and Janice incur no childcare expenses for Susan. However, during the summer vacation period, they place Susan in a day camp program that costs $4,000. Since the expense limitation for one child is $3,000, their childcare credit would be $600 (20% of $3,000).

The credit reduces a taxpayer’s tax bill dollar for dollar. Thus, in the above example, Al and Janice would pay $600 less in taxes by the credit. However, the credit can only offset income tax and alternative minimum tax liability, and any excess is not refundable. The credit cannot be used to reduce self-employment tax if a taxpayer is self-employed, or the taxes imposed by the Affordable Care Act.

Employer Dependent Care Benefits – Some employers provide dependent care assistance programs to help their employees with the cost of daycare. Payments under these plans used by employees to pay dependent care expenses are excludable from employees’ income, up to the lower of:

  1. The employee’s earned income (for married employees, this is the earned income of the lower-paid spouse) or
  2. $5,000 ($2,500 for married filing separate).

Because reimbursement up to these limits is excludable from income, the benefits the employee receives are treated as reimbursement for daycare expenses that reduce the expense limits of $3,000 for one child and $6,000 for two or more children. Compensation above these limits is taxable to the employee and does not reduce qualified expenses for the credit.

Other Credit Criteria:

  • Age of the Child – If the qualifying child turned 13 during the year, count only the care expenses paid for the child for the part of the year when he or she was under age 13.
  • Day Camps – Many working parents must arrange for care for their children under 13 years of age (or any age if disabled) during school vacation periods. A popular solution, with a tax benefit, is a day camp program. The cost of day camp can count as an expense toward the child and dependent care credit. However, it’s essential to note that fees for overnight camps do not qualify. Also, not eligible are expenses paid for summer school or tutoring programs.
  • Both Parents Working in an Unincorporated Business – When both spouses of a married couple are jointly involved in an unincorporated business, it is relatively common, but incorrect, for all of that business’s income to be reported as just one spouse’s income. As a result, they lose the benefits of the childcare credit, which requires both spouses to have income from working.
  • School Expenses – Only school expenses for a child below the kindergarten level are considered qualifying expenses for this credit.
  • In-Home Care Providers – If a taxpayer provides daycare in their home, the daycare provider is considered a household employee.

This article provides an overview of the various tax issues related to daycare from the perspectives of both the provider and the recipient of daycare services. However, as in everything taxes, many more rules and issues exist than could be included in this article. For additional information about daycare and how it impacts your taxes, please contact us.

Life-Changing Events Can Impact Your Taxes

Article Highlights:

  • Marriage
  • Buying a Home
  • Having or Adopting Children
  • Getting Divorced
  • Death of Spouse

Throughout your life, there will be significant occasions that will impact not only your day-to-day living but also your taxes. Here are a few of those events:

Getting Married – If you are getting married, it is essential to understand that once you are married, you no longer file returns using the single status. Instead, you will file as married taxpayers filing jointly (MFJ). When you file MFJ, both spouses combine their income on one return. When both spouses have substantial income, your combined incomes could put you in a higher tax bracket. However, when filing MFJ, you benefit by being able to claim a standard deduction equal to twice that of the standard deduction for a single taxpayer. It may be appropriate for newly married couples to estimate the differences of filing as unmarried and filing as married before tax-filing time. Depending on your situation, you may decide to adjust withholding to compensate for the MFJ status.

Keep in mind that filing status is determined on the last day of the tax year. Regardless of when you get married during the year, you will be considered married for the entire year for tax purposes. In addition, when a spouse is changing names, the Social Security Administration should be notified, and the IRS should be informed of any address change by either or both spouses.

Buying a Home – Buying a home, especially your first home, can be a trying experience. Without a landlord to take care of repairs and upkeep of the property, those tasks will become your responsibility as a homeowner. When you rent, you are responsible for making a rental payment, which is not tax deductible. On the other hand, when you own a home, in addition to being accountable for its maintenance, you have to make homeowner’s insurance, mortgage, and property tax payments. While the routine upkeep costs aren’t tax deductible, the interest on the mortgage and the property taxes you pay may be tax deductible, providing you with a significant saving in income tax. However, if the standard deduction amount for your filing status exceeds the total of all itemized deductions the law allows you to claim, you won’t get a tax benefit from the home mortgage interest and property tax payments. So, when determining if you can afford a home, it’s important to consider whether you’ll benefit from those home-related tax savings. Also, consider the long-term benefits of homeownership. Homes have generally appreciated in the past, so you can look forward to your home gaining value. When you sell it, the gain up to $250,000 ($500,000 for a married couple) can be excluded from income if the property has been owned and used as your primary residence for any two of the five years just before the sale.

Having or Adopting Children – Besides the loss of sleep, changing diapers, middle of the night feedings, and constant attention, a newborn also brings some tax benefits, including a maximum $2,000 child tax credit, which can go a long way in reducing your tax liability. If both spouses work, you will no doubt incur childcare expenses, which can result in a maximum (can be less) credit of between $600 and $1,050 for one child or twice those amounts for two or more children. The credit amounts are based on a maximum childcare expense of $3,000 for one child and $6,000 for two or more multiplied by 20 to 35 percent of the expense based upon a taxpayer’s income.

Of course, the medical expenses are deductible if you itemize your deductions, but only to the extent that the medical expenses exceed 10% of your adjusted gross income. Although rarely encountered, the expense of a surrogate mother is not deductible.

If you adopt a child under age 18 or a person physically or mentally incapable of taking care of himself or herself, you may be eligible for a tax credit for the qualified adoption expenses you paid. The credit, which is a maximum of $14,080 for 2019, is not refundable, but if the credit is more than your income tax, you can carry over the excess and have five years to use up the credit. If the child is a special needs child, the full credit limit will be allowed for the tax year in which the adoption becomes final, regardless of whether you had qualified adoption expenses. The credit phases out for higher-income taxpayers.

It is also time to begin planning for the child’s future education. The tax code offers two tax-favored education savings accounts. The Coverdell account allows a maximum contribution of $2,000 per year, and the Qualified State Tuition plan, more commonly known as a Sec 529 plan, allows large sums of money to be put aside for a child’s education. There is no tax deduction for contributing to either of these programs. However, the earnings from the plans are tax-free if used for qualified education expenses, so the sooner the funds are contributed, the more significant the benefit from tax-free earnings.

Getting Divorced – If you are recently divorced or are contemplating divorce, you will have to plan for significant tax issues such as asset division, alimony, and tax-return filing status. If you have children, additional issues include child support; claiming of the children as dependents; the child, childcare, and education tax credits; and perhaps even the earned-income tax credit. Here are some details:

  • Filing Status – As mentioned earlier, your filing status is based on your marital status at the end of the year. If on December 31, you are in the process of divorcing but are not yet divorced, your options are to file jointly or to each submit a return as married filing separately. There is an exception to this rule if a couple has been separated for all of the last six months of the year, and if one taxpayer has paid more than half the cost of maintaining a household for a qualified child. In that situation, the spouse can use the more favorable head-of-household filing status. If each spouse meets the criteria for that exception, they can both file as heads of household; otherwise, the spouse who doesn’t qualify must have the status of married filing separately. If your divorce has been finalized and if you haven’t remarried, your filing status will be single or, if you meet the requirements, head of household.
  • Child Support – This is support for the taxpayer’s children provided by the non-custodial parent to the custodial parent. It is not deductible by the parent making the payments and is not income to the recipient parent.
  • Children’s Dependency – When a court awards physical custody of a child to one parent, the tax law is particular in awarding that child’s dependency to the parent who has physical custody, regardless of the amount of child support that the other parent provides. However, the custodial parent may release this dependency to the non-custodial parent by completing the appropriate IRS form.
  • Child Tax Credit – A federal credit of $2,000 is allowed for each child under the age of 17. This credit goes to the parent who claims the child as a dependent. Up to $1,400 of the credit is refundable if the credit exceeds the tax liability. However, this credit phases out for high-income parents, beginning at $200,000 for single parents.
  • Alimony – The recent tax reform also impacts the tax treatment of alimony. For divorce agreements that were finalized before the end of 2018, the recipient (payee) of the alimony must include their income for tax purposes. The payer, in such cases, is allowed to deduct the payments above the line without itemizing deductions. This is technically referred to as an adjustment to gross income. The recipient, who includes this alimony income, can treat it as earned income to qualify for an IRA contribution, thus allowing the recipient to contribute to an IRA even if he or she has no income from working. For divorce agreements that are finalized after 2018, alimony is not deductible by the payer and is not taxable income for the recipient. Because the recipient isn’t reporting alimony income, he or she cannot treat it as earned income to make an IRA contribution.
  • Tuition Credit – If a child qualifies for either of two higher-education tax credits, (the American Opportunity Tax Credit [AOTC] or the Lifetime Learning Credit), the credit goes to whoever claims the child as a dependent even if the other spouse or someone else is paying the tuition and other qualifying expenses.

Death of Spouse – Losing a spouse is painful emotionally. Unfortunately, it can be accompanied by several tax issues that may or not apply to the surviving spouse. Here is an overview of some of the most frequent problems:

  • Filing Status – If a spouse passes away during the year, the surviving spouse can still file a joint return for that year if the surviving spouse has not remarried. However, after the year of death, the surviving spouse will no longer be able to file with the deceased spouse jointly and will have to use a less favorable filing status.
  • Notification – If the deceased spouse is receiving Social Security benefits the Social Security Administration must be immediately notified. This would also be true of pensions and retirement plans of the deceased spouse.
  • Estate Tax – Where the deceased spouse’s assets and prior reportable gifts exceed the current lifetime inheritance exclusion ($11.4 million for 2019), an estate tax return may be required. However, the lifetime inheritance exclusion can be changed at the whim of Congress. Even when an estate tax return isn’t needed because the value of the deceased spouse’s estate is less than the exclusion amount, it may be appropriate to file the estate tax return. There could be an impact on the estate tax of the surviving spouse when he or she passes.
  • Inherited Basis – Under normal circumstances, the beneficiary of a decedent’s assets will have a tax basis in those assets equal to the fair market value of the assets on the date of death. Thus, generally, a qualified appraisal of the assets is required. However, for a surviving spouse, this can be more complicated depending upon whether the state of residence is a community property state and how title to the property was held.
  • Changing Titles – The title to all jointly held assets needs be changed into the survivor’s name alone to avoid complications in the future.
  • Trust Income Tax Returns – Many couples have created living trusts that, while they are both alive, don’t require a separate tax return to be filed for the trust and can be revoked. But upon the death of one of the spouses, this trust may split into two trusts, one of which remains revocable and the other becomes irrevocable. A separate income tax return for the latter trust will usually have to be prepared and filed annually.

These are just a few of the issues that must be addressed upon the death of a spouse, and it may be appropriate to seek professional help from your Tarlow tax advisor.

If you have questions about the tax impacts of life-changing events or situations, please contact us.

In a Divorce, Who Claims the Children: You Or Your Ex-Spouse?

Article Highlights:

  • Custodial Parent
  • Dependency Release
  • Joint Custody
  • Tiebreaker Rules
  • Child’s Exemption
  • Head of Household Filing Status
  • Tuition Credit
  • Child Care Credit
  • Child Tax Credit
  • Earned Income Tax Credit

If you are a divorced or separated parent with children, a commonly encountered, but often misunderstood issue is, who claims the child or children for tax purposes. Parents often dispute this issue; however, tax law includes some particular but complicated rules about who profits from the child-related tax benefits. Under consideration are many benefits, including the children’s dependency, child tax credit, child care credit, higher-education tuition credit, earned income tax credit, and, in some cases, even filing status.

This is one of the most complicated areas of tax law, and inexperienced tax preparers or taxpayers preparing their returns can make serious mistakes, especially if the parents are not communicating well. If parents cooperate, they often can work out the best tax result overall. Even though it may not be the best for them individually, it’s possible to compensate for it in other ways.

Physical Custody (Custodial Parent) – If a family court awards physical custody of a child to one parent, tax law is particular in awarding that child’s dependency to the parent with physical custody, regardless of the amount of child support provided by the other parent. However, the custodial parent may release that dependency to the non-custodial parent for tax purposes by completing the appropriate IRS form. The release can be granted every year or for multiple years at one time. But once made, it is binding for the specified period.

CAUTION – The decision to relinquish dependency should not be taken lightly, as it impacts several tax benefits.

Joint Custody – On the other hand, if the family court awards joint physical custody, only one of the parents may claim the child as a dependent for tax purposes. If the parents cannot agree between themselves as to who will claim the child and the child is actually claimed by both, the IRS tiebreaker rules will apply. Per the tiebreaker rules, the child is treated as a dependent of the parent with whom the child resided for the greater number of nights during the tax year. Or, if the child lives with both parents for the same amount of time during the tax year, the parent with the higher adjusted gross income will claim the child as a dependent. Parents in the process of divorcing should be aware that for tax purposes, the IRS’s rules as to who can claim a child’s dependency takes precedence over what a divorce decree says or what a judge may have ruled. So, for example, if the family court awards full custody of a child to Parent A but says that Parent B can claim the child as a tax dependent, the IRS’s position is that the child is a tax dependent of Parent A unless Parent A releases the dependency to Parent B, as explained above.

Child’s Exemption Allowance –While there is no longer (through 2025) a monetary tax deduction, or an “exemption allowance” for a dependent child, it still matters who claims the child as a dependent because certain tax credits are only available to the taxpayer claiming the child as a dependent.

Head of Household Filing Status – An unmarried parent can claim the more favorable ‘head of household’ filing status if he or she is the custodial parent, and pays more than half of the costs of maintaining a household that is the child’s principal place of abode for more than half the year. This is true even when the child’s dependency is released to the non-custodial parent.

Tuition Credit – If the child qualifies for either the American Opportunity or the Lifetime Learning higher-education tax credit, the credit goes to whoever claims the child as a dependent. Credits are significant tax benefits because they reduce the tax amount dollar-for-dollar, while deductions reduce income to arrive at taxable income, which is then taxed according to the individual’s tax bracket. For instance, the American Opportunity Tax Credit (AOTC) provides a tax credit of up to $2,500, of which 40% is refundable. However, both education credits phase out for higher-income taxpayers. For instance, the AOTC phases out between $80,000 and $90,000 for unmarried taxpayers and $160,000 and $180,000 for married taxpayers.

Child Care Credit – A nonrefundable tax credit is available to the custodial parent for childcare while the parent is gainfully employed or seeking employment. To qualify for this credit, the child must be under the age of 13 and be a dependent of the parent. However, a special rule for divorced or separated parents provides that if the custodial parent releases the child’s exemption to the non-custodial parent, the custodial parent can still qualify to claim the childcare credit, and the noncustodial parent can not claim it.

Child Tax Credit – A $2,000 credit is allowed for a child under the age of 17. That credit goes to the parent claiming the child as a dependent. However, this credit phases out for higher-income parents, beginning at $200,000 for unmarried parents and $400,000 for married parents filing jointly.

Earned Income Tax Credit (EITC) – Lower-income parents with earned income (wages or self-employment income) may qualify for the EITC. This credit is based on the number of children (under age 19 or a full-time student under age 24) the custodial parent has, up to a maximum of three children. Releasing the dependency of a child or children to the noncustodial parent will not disqualify the custodial parent from using the children to qualify for the EITC. The noncustodial parent is prohibited from claiming the EITC based on the child or children whose dependency has been released by the custodial parent.

Many complex rules are surrounding the tax benefits provided by the children of divorced parents. If you are a divorced parent with children, it is highly recommended that you consult with your Tarlow tax advisor to prepare your return. If you are the custodial parent, you should contact us before deciding whether to release a child as a tax dependent.

Disaster-Related Tax Losses May Be Less Than Expected

Article Highlights:

  • Limitation to Losses within Disaster Areas
  • Cost versus Market Value
  • Home Tax Losses
  • Home Tax Gains
  • Replacement Properties
  • Home Gain Exclusion

The late-2017 tax-reform package changed the rules for personal casualty losses, which now are only deductible if they occur in a federally declared disaster area. As a result, if a home is destroyed in a forest fire or other disaster within a declared disaster zone, the homeowner can claim a casualty loss on that year’s tax return. However, if a home is destroyed as a result of a normal accident, or is destroyed in a natural disaster but lies outside of a disaster zone, the homeowner cannot claim a casualty loss. Currently, the rules are only in effect for the years 2018 through 2025. Because of these rules, you should also make sure that your home insurance coverage is adequate.

Even those who have deductible losses may quickly find out that they cannot claim as much in tax losses as they expected. This is because the losses are not based on the cost of replacing the home; instead, they are based on the original cost of the home (plus any improvements prior to the date of the casualty). For those who have owned their homes for a long time before a casualty, the tax benefits of the resulting loss are greatly diminished.

This all stems from the fact that a casualty loss on a home is valued at the lesser of the home’s cost or its current market value (minus any insurance reimbursements). Because real estate generally appreciates in value, most casualty losses are based on the original cost of the home rather than on its current value or its replacement cost.

Example #1: Joe and Susan purchased their home many years ago for $125,000, but its current market value is $400,000. Their home is then destroyed as a result of a federally declared disaster. They did not have insurance. Thus, their casualty loss is only $125,000 (the original cost), as that is less than the current market value. Thus, even though they suffered a $400,000 financial loss, the tax loss is only $125,000. (Even worse, the actual deductible loss is even less, as reductions of $100 per casualty and 10% of adjusted gross income must first be applied.)

If a home is insured, then an actual financial loss due to a disaster can actually result in a tax gain.

Example #2: The circumstances are the same as in Example #1, except Joe and Susan’s homeowners’ insurance paid them 100% of the home’s current value. For tax purposes, the $125,000 original cost must be used; the insurance reimbursement is then subtracted from that cost to determine the casualty loss. As a result, after the $400,000 reimbursement, Joe and Susan actually have a $275,000 tax gain ($400,000 minus $125,000) instead of a loss.

Luckily, the new tax law includes a provision in which the homeowner can treat the involuntary conversion of a principal residence due to destruction (among other situations) as a sale. Such sales are eligible for the home-sale gain exclusion, provided that the taxpayers meet certain requirements for length of ownership and occupancy. Married taxpayers who file jointly can exclude up to $500,000 of home-sale gain after such a disaster, provided that they have owned and lived in the destroyed home for at least 2 of the prior 5 years. (For a single taxpayer, that exclusion is $250,000.) Thus, in Example 2, if Joe and Susan meet these requirements, they can exclude all of their $275,000 gain (because it is less than $500,000). If the gain is greater than this limit, the remaining amount can be deferred, provided that the taxpayer purchases a replacement residence.

The insurance proceeds that homeowners receive for a destroyed residence (or its contents) are treated as a common pool of funds. If those funds are used to purchase a property that is similar to lost property, then the taxpayer must recognize the gain only to the extent that the funding pool exceeds the cost of the replacement property. The period for replacing damaged or lost property is four years, starting with the end of the first taxable year when any part of a gain due to involuntary conversion is realized.

Under all circumstances, homeowner’s insurance is appropriate; in fact, mortgage lenders generally require it. Be sure that your home is insured for an appropriate amount that includes any appreciation.

As you see, disaster-related casualty losses can be tricky, and the results can be unexpected. Please contact us if you have experienced a disaster-related loss or if you have any questions.

What Is the Statute of Limitations on Unpaid Taxes?

If you have unpaid taxes that you haven’t yet been making payments toward, it might make you fearful that the IRS will come a-knocking one day to collect on what you owe. Tax debt can quickly snowball from interest, penalties, late fees, and the amount of the taxes due.

However, a lot of the scaremongering surrounding the IRS is largely sensationalized in media and daily conversation. Agents won’t come bursting through your door just because you have tax debt. Instead, they must follow due process in accordance with the Internal Revenue Service Restructuring and Reform Act of 1998 (RRA). This means that you will always receive written notice concerning your balance due as well as collection actions and any requests for payment plans or settling your account.

However, if you haven’t received further notification concerning what you owe, you may be able to ride out the little-known statute of limitations on tax debt collections, which is 10 years.

What the 10-Year Statute of Limitations Entails

Your tax debt can actually be canceled in 10 years if the IRS makes no efforts to collect on your account – and if you also don’t contact the IRS. However, it’s not as simple as just waiting a decade without ever paying the taxes you owe. There are conditions that must be satisfied. The first is that this 10-year time frame doesn’t begin when you filed that tax return with a balance due or when you realized you owed taxes you couldn’t pay.

The official statute of limitations date begins once you receive written notice from the IRS concerning what you owe. You may receive a notice of deficiency with an actual tax bill or a substitute tax return if you didn’t file by the due date. So, if you filed your tax return on June 15, 2019, and got a notice in the mail dated September 1, your statutory period would begin September 1, not June 15. This date is called the CSED (Collection Statute Expiration Date), and if you make it to September 1, 2029, without further collection actions, then you can actually get your entire tax bill from this period canceled. (Note: Future tax bills, such as next year’s taxes you also can’t afford to pay on the due date, do not count toward this.)

However, the IRS will not notify you of this. While the date of assessment is also generally when that notice is received, the IRS has argued over when the assessment date actually was. Some situations can also delay the CSED by halting the clock on the 10-year time frame, such as:

  • Filing for bankruptcy
  • Being outside the U.S. for at least six months
  • Military deferment
  • Submitting an offer in compromise to settle back taxes
  • Filing a lawsuit against the IRS
  • Having your assets held in court custody due to divorce, judgments against you, etc.

It takes six months after bankruptcy cases settle to get the clock restarted on the CSED, so this means the IRS has more time to take collection actions against you, and the IRS will tend to ramp up these efforts before the statute of limitations expires.

State Tax Debt

Unlike the IRS, state tax departments do not have reciprocity with the RRA or the Taxpayer Bill of Rights. Taxpayers who are subject to state income tax need to find out what options, if any, are offered by their state tax department. State tax departments may actually take harsher collection actions since they don’t have to have oversight committees and the option for taxpayers to settle back taxes or make payment plans, and they do not have a statute of limitations on collections. The IRS tends to get a bad rap in movies and on TV, but it’s actually the state tax departments that are more likely to show up unannounced or issue liens a lot sooner.

It’s very rare than anyone rides out the statute of limitations, and it’s usually due to extenuating circumstances like disability or a debilitating business closure. If enough time has passed that you think you might be able to go the whole 10 years without payments or responses to collection actions, you must keep fastidious records of all correspondence with the IRS. If the IRS sent you little or no mail in the time period after the time you think the CSED kicked off, you may qualify for the statute of limitations but should not intentionally try to ride it out without the guidance of a tax professional specializing in tax relief and resolution issues.

If you have any questions about the statute of limitations on unpaid taxes, please contact us.