My 9 pound 11 ounce tax deduction

So you became a new, second, third+ parent in 2013?  Congratulations!  We welcomed our first child in April at a healthy 9 pounds and 11 ounces, and sometimes late at night or early in the morning between diaper changes and feedings, I would find myself wondering "just how much is this kid going to save me on my taxes?" It is a common misconception that the tax benefits of having a child outweigh the actual costs of raising said child.  After accounting for diapers, wipes, food, clothes, carseats, bouncers, bumbos and boppys, the costs of raising a child year over year are higher than the tax benefits received by adding a dependent to your tax return.  But, there are tax benefits to take advantage of if you have become a new parent in 2013.

Personal exemptions

The personal exemption is an automatic exemption for everyone on their Form 1040 individual income tax return.  The personal exemption amount is $3,900 (for 2013) per qualifying individual.  A qualifying individual is you, your spouse (if filing a joint return), and each dependent you list on page 1 of your 1040.  For example, if you are married and filing jointly and have 1 dependent child, your personal exemption for 2013 is $11,700 ($3,900 x 3).  Personal exemptions are deducted from adjusted gross income (AGI) to arrive at taxable income on the 1040, meaning that the personal exemption is not a reduction in tax, but is a reduction in the income that determines how much tax you pay.  However, if you have a high income, you might not get full benefit of your personal exemptions due to the personal exemption limitations brought back by Congress beginning in 2013.

Child tax credit

The child tax credit is a potential credit of up to $1,000 per qualifying child.  Notice that this is a credit instead of a deduction, which means that it directly reduces tax instead of reducing income.  To be a qualifying child, the child must:

  • be your son, daughter, foster child, brother, sister, stepchild, grandchild, niece, or nephew
  • be under the age of 17 at the end of 2013
  • not have provided half of their own support during 2013
  • have lived with you for at least half of 2013
  • be claimed as a dependent on your return
  • the child cannot file a joint return for 2013
  • be a US citizen, US national, or US resident alien

Married taxpayers with AGI of $110,000 or less and single taxpayers with AGI of $75,000 or less may claim the credit on Form 8812 and attach to their 1040.

Child and dependent care expenses

Taxpayers may be able to claim a credit related to expenses they paid during the year for dependent care.  Qualified expenses are for household services such as a nanny, or outside services such as daycare, that were provided so the taxpayer can work or look for work.  The taxpayer will need to have the name, address, and social security number or employer identification number of the care provider to claim the credit.  The credit can be claimed for dependent care expenses for each child under the age of 13.  The credit is up to 35% of expenses paid for care, and the credit is limited to $3,000 for one child or $6,000 for two or more.  However, there are stipulations.  If the taxpayer's employer paid the care provider directly on the taxpayer's behalf, the care was provided by the employer, or the expenses were paid by the taxpayer from pre-tax contributions to a flexible spending arrangement (FSA), then the credit will be limited.  The credit is claimed on Form 2441.

Children are a blessing, and thanks to the credits and deductions listed above, they can also provide some marginal tax benefits.

Am I a dependent?

Pop quiz: I am married and live with my wife and 2 children, ages 28 and 14, along with my elderly mother-in-law who has no income and my brother who has been unemployed for 2 years, draws $7,500/yr in unemployment yet never offers to pay for anything.  How many dependents can I claim on my Form 1040 individual income tax return?  The answer might surprise you. Determining the correct number of dependents to claim on a 1040 for most families is simple. For example, a married couple with two children under the age of 18 has two dependents (the two children).  But, in family situations like the one laid out above, the number of dependents is not so obvious.  Claiming the correct dependents is important to the taxpayer because it gives them the opportunity to take advantage of tax benefits tied to those dependents, such as personal exemptions, the child tax credit, the child and dependent care credit, education expense deductions and credits, and the earned income credit.  Claiming the correct dependents is also important to the IRS, because they will match the social security numbers listed on the 1040 to their system to make sure the dependency claim is valid.

So who qualifies as a dependent?  Let's start with children first.

Dependent children

To qualify as a dependent, the child must meet the following criteria:

  • Must be your son, daughter, stepchild, foster child,  brother (biological, half, or step), sister (biological, half, or step), or a descendant of any of these (grandchild, niece, etc.).  Adopted children are always treated as your own children.
  • Their age at the end of the tax year must be 1) under 19, 2) under 24 if a student, and 3) younger than you (and your spouse if filing a joint return). However if the child is permanently or totally disabled, their age does not matter.
  •  The child must have lived with you for half of the tax year
  • The child must not have provided more than half of their own financial support
  • The child is not filing a joint return for the tax year

If the child meets these criteria for the tax year, they are a dependent child.  If the dependent child has to file their own tax return in the same year that they are claimed as a dependent, they cannot claim a personal exemption for themselves.

One note on this topic: mentioned above are brothers and sisters.  In the event that the taxpayer has a much younger sibling, and the taxpayer provides the siblings care (in the event of the death, disability, or absence of the parents), then it is possible for a sibling to be a dependent child.

Dependent relative

In some cases, a relative can qualify as a dependent on someone else's tax return.  To qualify as a dependent, the relative must meet the following criteria:

  • The person cannot be a qualifying child or the qualifying child of another taxpayer (a child that meets the criteria in the section listed above)
  • The person lived in the home for the entire year and is not a relative, or is a relative (brother, sister, father, mother, niece, nephew, uncle, aunt, or any of these as half, step, grand, or in-law)
  • The person's gross income for the year must be less than $3,900 (because that is the amount of the personal exemption).
  • The person does not provide more than half of their own support for the tax year.

Just like for children, if a dependent relative files their own tax return in the same year that they are claimed as a dependent, they cannot claim a personal exemption for themselves.

Now back to the example from the beginning.  The correct number of dependents is two.  Here's how:

The 14-year-old child is a dependent, but the 28-year-old is not, because they are over 24 and not a full-time student.

The mother-in-law is a dependent relative because she had no income and she did not provide over half of her own support.

The brother is not a dependent relative because the unemployment he draws makes his gross income above the threshold, even though he did not provide more than half of his own support.

In unique family situations, determining dependency exemptions can be complex.  Taxpayers should consult the IRS website or their tax professional for additional guidance.

To pay or not to pay, that is the question

For taxpayers that make estimated tax payments throughout the year, the payment for the fourth quarter is due on January 15 of the next year. Even though this payment is made in the following year, it is still credited as a payment for the tax year in which it applies. But, if the taxpayer lives in an "income tax state" (a state with its own income tax, like Arkansas or Louisiana, but not Texas) and makes estimated tax payments to the state, there is a catch to when these payments are deductible on a Federal return.

Allowable itemized deductions for individuals on a Federal 1040 include state and local taxes paid. These taxes include income, real estate, and personal property taxes as well as some other taxes paid to a state or local government. The deductible portion of these taxes is the amount actually paid during the year, not amounts assessed or paid in other years. Here are a few examples:

Bob, who does not live in an income tax state, pays his personal property taxes for 2012 in October of 2013 for $500. At the same time, he receives his assessment for 2013 of $600 which will be due in October 2014. Bob's deduction for personal property taxes in 2013 is $500, because that is what he actually paid even though it was related to the previous year.  The $600 will be deductible to him in 2014 when it is paid.

Peggy lives in an income tax state and makes state estimated tax payments quarterly. In January 2013, she made her 4th quarter payment for 2012 for $500. Then, in April, June, and September of 2013 and in January 2014 she made quarterly payments of $600 each for her 2013 state taxes. Peggy's state tax deduction on her Federal return for 2013 is $2,300 ($500 + 3 $600 payments) which is the total of the payments made during 2013, even though one of them was related to a previous year.

This example leads us to the point of this article. If Peggy makes her state fourth quarter payment for 2013 in December 2013 instead of January 2014, her state tax deduction on her Federal return will be $2,900 instead of $2,300. As a result, her Federal tax liability would be decreased slightly because of the added deduction. It is for this reason that taxpayers living in income tax states should always consider paying their final estimated tax payment before the end of the year.

But, as is usually the case, there are caveats with this plan - the Alternative Minimum Tax and the time value of money.

Taxpayers subject to the Alternative Minimum Tax (AMT) will not realize the benefit of paying their state estimated tax payment early because those payments will be added back as a preference item on Form 6251.  Therefore if taxpayers are close to or already subject to the AMT, they should make their payments as scheduled (not early).

Taxpayers must also consider the time value of money when paying estimated tax payments early.  For example, if the funds needed to make the estimated tax payment will be accessed by selling investments at a gain, then the net effect of the transaction might be zero because the additional benefit from the payment could be offset by the additional income recognized from selling the investments in the same year.  Furthermore, the funds used to pay taxes earlier by 15-30 days may lose investment earnings which could be large if the estimated tax payment is large.

In closing, taxpayers should consider making their 4th quarter state estimated tax payment in December (now!) as long as they are not subject to the AMT and they have liquid funds to make the payment without creating additional income.

All I want for Christmas is a new bulldozer

Beginning in 2010, businesses have been afforded beneficial tax breaks via fixed asset additions and depreciation. These breaks are primarily Bonus depreciation and Section 179 expensing. Absent further action by Congress, Bonus is scheduled to go away and the 179 limits will be greatly reduced after 2013. Taxpayers can make an election to expense 100% of the cost of a new asset in the year of purchase under code section 179 of the Internal Revenue Code.  This method, commonly known as "179", has both cost and income limits.  In 2013, taxpayers can expense up to $500,000 under Section 179.  If the taxpayer's acquisitions exceed $2 million, their allowable expense is reduced and the taxpayer's 179 deduction cannot exceed taxable income for the year.  However, in 2014 the allowable expense drops to $25,000, with an acquisition limitation of $200,000.

Similarly, in 2013 taxpayer's can expense expense 50% of an acquisition up front, and then take normal depreciation on the other 50% for the year.  For example, taking bonus on a $1,000 asset would result in a $500 expense up front, plus regular depreciation for the year on the remaining $500.  It does not matter if the asset is new or used, there are no income or acquisition limits, and bonus can still be taken even if the taxpayer has no taxable income or the depreciation causes the taxpayer to have a net operating loss.  But, in 2014, bonus depreciation will "retire".

Now that we've discussed the rules, take a look at this bad boy.

This is a fine bulldozer made by Caterpillar, one of the largest heavy machinery manufacturers in the world.  Let's say that a taxpayer is in the market for this bulldozer and finds one at their local heavy machinery dealer with a list price of $250,000 (not actual list price, hypothetical only).  We can now look at how making that purchase in December 2013 vs. January 2014 will affect the taxpayer's situation.

If the bulldozer is purchased in December 2013, the taxpayer can either expense 100% of the cost assuming they had < $2 million in total additions and taxable income of at least $250,000, or the taxpayer can expense $125,000 of the bulldozer under bonus depreciation regardless of their other acquisitions and taxable income.

If the bulldozer is purchased in January 2014, the taxpayer will not be permitted to expense any of the addition under 179 because their acquisitions will exceed the limit.  The taxpayer will not be able to take any bonus depreciation either.

In this case, assuming a 39% tax rate, delaying the purchase to 2014 will cost the taxpayer savings in tax dollars of $97,500 if 179 could be taken, or $48,750 if bonus could be taken.

Although it is likely that Congress might pass some kind of extension to these depreciation rules, at this time there is no indication that the rules will be changed.  Taxpayers that have been considering making fixed asset additions, from bulldozers to printers to office furniture, should take advantage of the tax benefits in 2013 while they last.

Harvest time

December is a good time of year for taxpayers to take a look at the performance of their investments over the past year.  During that time taxpayers might consider selling some assets, either to free up cash for future investments or living expenses, or to harvest capital gains in their account.

The basic harvest

 Before a taxpayer can properly plan their capital gains harvesting, it is important to understand capital assets and how gains/losses are determined.  A capital asset includes just about everything a taxpayer owns for personal use (not business) such as a home, stocks, bonds, cars, etc.  When capital assets are sold, the difference between the proceeds received and the original cost basis of the asset is the resulting gain or loss.  If the proceeds are more than the cost, the result is a gain, and vice versa a loss.  Once the gain/loss is calculated, the next step is to determine if the gain/loss is long-term or short-term.  If the asset had been owned by the taxpayer for 1 year or more when it is sold, then the gain/loss is long-term.  Otherwise, the gain/loss is short-term.

Basic capital gains harvesting attempts to offset capital gains against capital losses.  For example, let's say a taxpayer has $10,000 worth of investments in their account.  $5,000 of the investments have an unrealized gain of $1,000, and the other $5,000 have an unrealized loss of $1,000.  The taxpayer can sell all of the investments, generate $10,000 in cash, but have zero capital gains, because the $1,000 gain offsets the $1,000 loss.

Tax rates

Unfortunately, if the taxpayer's investment account has significant gains, 2013 might not be the best year to start liquidating large portions of their portfolios.  As has been the case for several years, long-term capital gains are only taxed at 15%, but beginning in 2013, taxpayers with income in excess of $400,000 (single) or $450,000 (married) could be subject to a 20% capital gains tax rate.  Of course this applies only to long-term capital gains; short-term capital gains are always taxed at the ordinary tax rate.

Reap what you sow

Taxpayers often ask themselves "if I sell assets at a gain and other assets at a loss, don't I lose money?"  The answer is yes and no.  Yes, the taxpayer loses money on the assets sold at a loss, because they spent more on the initial purchase than they received from the sale.  At the same time, the answer is no because the taxpayer still receives cash from the sale.  This cash can be used to make additional purchases and investments, without any tax consequences because the capital gains and losses offset each other.

Another aspect to consider is the capital loss carryover.  Individual taxpayers are allowed a maximum of $3,000  in net capital losses be reported on their tax return.  The good news is that the capital losses not used in that year can be carried forward to future years.  Therefore, if a taxpayer has long-term capital gains of $1,000 and long-term capital losses of $5,000 (net capital loss of $4,000), the maximum net capital loss they can report on their tax return is $3,000, but the other $1,000 can be carried over to future years.  This means that in the next year, $1,000 in capital gains could be taken without taking any corresponding losses, because the $1,000 could be used from the previous year.

December is a good time to review investment holdings and consider harvesting capital gains in order to generate cash with minimal tax consequences.  At the same time, taxpayers should also consider if they have any capital loss carryovers on their Schedule D from the previous year.

Happy harvesting!

The not-so-Alternative Minimum Tax, Part 1

The Alternative Minimum Tax (AMT) for individuals, enacted by Congress in 1969, is becoming less of an alternative for some taxpayers.  The AMT was originally targeted at approximately 150 taxpayers that had high adjusted gross income (AGI), but paid zero tax due to the types of income and structuring of deductions.  In effect, under the current structure the AMT almost guarantees that once taxpayers reach a certain level of income, their effective tax rate will be at least 26% or higher.

The Tax Cheat

The AMT is calculated by both businesses and individuals, but under different circumstances.  This post will discuss the AMT as it applies to individuals.

Individuals subject to AMT

Individuals calculate their share of the AMT on Form 6251.  That taxpayer begins with their AGI after itemized deductions, and then adds back the following:

  • Medical expenses
  • State and local income, real estate, and property taxes
  • Miscellaneous deductions

The taxpayer must also add back or reduce by the difference between their income tax and AMT amounts for the following:

  • Investment interest expense
  • Depletion
  • Basis in exercised incentive stock options
  • Depreciation expense

Taxpayers may also have to report AMT adjustments passed through on K-1's from their other activities (partnerships, trusts, or S-corporations).

Once all of these adjustments have been considered, the taxpayer arrives at their alternative minimum taxable income (AMTI).  Taxpayers are allowed an exemption amount, which has been indexed for inflation thanks to acts by Congress at the end of 2012.  This exemption amount is $51,900 S / $80,800 MFJ for 2013.  The exemption amount is subtracted from AMTI, and the resulting amount is multiplied by either 26% or 28% depending on whether the amount is above or below $179,500 MFJ / $89,750 S.   If income is above that amount, it is multiplied by 28%, and 26% if not.

Once the AMT is calculated, it is compared to the regular tax calculated on the taxpayer's Form 1040.  This is where the AMT earns the name "alternative": once the taxpayer compares their AMT to their regular tax, the higher amount becomes their income tax.

Why?

Why does the AMT work?  Because it attacks two types of tax situations and makes them less beneficial.

First, the AMT true's up the tax rate for taxpayers that have high incomes from sources that are not taxed at regular tax rates, such as long-term capital gains, qualified dividends, and tax-exempt interest.  If a taxpayer has $10 million in AGI, but it consists completely of long-term capital gains and qualified dividends, their tax rate is only 15% (20% in 2013) as opposed to 35% (39.6% in 2013).  The AMT would require this taxpayer to pay a higher rate due to their high income.

Second, the AMT penalizes taxpayers with certain higher-than-normal deductions.  As mentioned above, one deduction added back for AMT purposes is state and local taxes from Schedule A.  For a taxpayer living in an income tax state (a state that has their own income tax, such as Arkansas or Louisiana, but not Texas), a deduction is allowed on their Federal return for state tax payments made during the calendar year.  The difference between paying the state 4th quarter estimated tax payment on Dec 31 instead of Jan 15 of the following year is that the payment will be allowed as a deduction Schedule A in the year of payment.  However, making that payment before year-end will not matter if the taxpayer will be subject to AMT, because those amounts will be added back.

Can it be avoided?

Unfortunately, the AMT is a "do not pass go, do not collect $200" situation.  One simple way to forego the calculation is for the taxpayer's income after itemized deductions to stay below the AMT exemption amounts.  Also, if the majority of the taxpayer's income is taxed at regular rates, the AMT will not be a problem because the regular tax will most likely exceed the AMT.  If a taxpayer, because of their types of income, will be subject to the AMT, they should try to avoid certain deductions (if possible) in order to minimize their AMTI.  Simple planning maneuvers such as paying state taxes on Jan 15 of the following year and staggering the exercise of incentive stock options can minimize the amount of AMT adjustments in a given year.  Taxpayers with depreciable property can elect depreciation methods that do not create large tax to AMT differences.

In all, taxpayers that are subject to the AMT can contact their tax preparer and run a projection before year-end to see what impact the AMT could have on their situation, and what measures can be taken now in order to minimize the AMT's impact.

Stay tuned for The not-so-Alternative Minimum Tax, Part 2, which will address the AMT as it pertains to businesses.  

2013 taxes and rates

When taxpayer's see their 2013 Form 1040, they will notice a few changes to the taxes and rates from previous years.  Following is a summary of the major tax rates and taxes that will be applicable for 2013. For the purposes of this article, MFJ = married filing jointly, S = single, O = any other filing status.

Regular tax rates

Here are the tax brackets for 2013:

Tax rate Single filers Married filing jointly or qualifying widow/widower Married filing separately Head of household
10% Up to $8,925 Up to $17,850 Up to $8,925 Up to $12,750
15% $8,926 - $36,250 $17,851 - $72,500 $8,926- $36,250 $12,751 - $48,600
25% $36,251 - $87,850 $72,501 - $146,400 $36,251 - $73,200 $48,601 - $125,450
28% $87,851 - $183,250 $146,401 - $223,050 $73,201 - $111,525 $125,451 - $203,150
33% $183,251 - $398,350 $223,051 - $398,350 $111,526 - $199,175 $203,151 - $398,350
35% $398,351 - $400,000 $398,351 - $450,000 $199,176 - $225,000 $398,351 - $425,000
39.60% $400,001 or more $450,001 or more $225,001 or more $425,001 or more

When calculating tax using this table, taxpayers must work "up the ladder".  This means if a MFJ taxpayer has taxable income of $100,000, they will pay tax at 10% on the first $17,850, then tax at 15% on the amount between $17,851 and $72,500, and then tax at 25% on the remaining amount.  As far as water cooler conversation goes, this taxpayer is "in the 25% bracket", but that doesn't mean they pay a flat 25% on $100,000.

3.8% Medicare surtax

Taxpayers with modified adjusted gross income in excess of $250,000 MFJ / $200,000 S might find themselves completing Form 8960 with their 2013 income tax return.  Taxpayers with this level of income potentially will be subject to the 3.8% Medicare surtax on their net investment income.  Net investment income is loosely defined as all taxable interest, dividends, capital gains, rental/royalty income, and other business activities that are considered passive.  The 3.8% tax is calculated on Form 8960 and added to the taxpayer's regular tax.  For example, MFJ couple has $300,000 modified adjusted gross income that includes $1,000 of taxable dividends.  The couple will pay an additional 3.8% tax on the dividends.  The IRS has recently issued final regs on what is subject to the Medicare surtax.

Higher capital gains rates

Taxpayers with modified adjusted gross income of $400,000 S / $450,000 MFJ will see their long-term capital gains taxed at 20% instead of the 15% rate from the past several years.  This applies to both long-term capital gains and qualified dividends, but short-term capital gains will still be taxed at regular rates.

Personal exemption (PEP) and itemized deduction (Pease) phaseout

Once taxpayers reach a certain level of income, they can potentially be subject to a phaseout of allowable personal exemptions and itemized deductions, which has been discussed in a previous post.

As can be seen, there are several changes to individual tax rates, deductions, and exemptions for 2013.  With proper planning, some of these issues can be either minimized or avoided altogether.

Employee vs. contractor

A hot topic with the IRS right now is classifying workers between employees and independent contractors.  There can be both positive and negative results on how a worker is classified, both for the company/employer and the worker.  The IRS considers three factors when determining whether a worker is an employee or an independent contractor. Behavioral control

This characteristic deals with how the company/employer behaves towards the worker and the work they are performing.  If the employer/company has the right to direct or control how the worker does the work, then they are most likely an employee.  The business does not actually have to direct or control the way the work is done, as long as they still have the right.  Also, if the company/employer requires the worker to attend any kind of training, this suggests that the worker is an employee.  If the business does not have the right to direct how the work is done, but merely suggests timing and deadlines, then the worker is most likely an independent contractor.

Financial control

This characteristic deals with how the company/employer directs or controls the financial and business aspects of the work.  If the worker has a significant investment in their work, has unreimbursed expenses related to the work, or has the opportunity to realize a profit or loss on the work, then they are most likely an independent contractor.  Employees typically do not incur expenses that are not reimbursed by their employer, including significant investments such as vehicles or computers.  Employees also do not realize a profit or loss from performing their work since they are paid their same hourly/salary rate.

Relationship of the parties

This characteristic deals with the relationship the parties have and includes written contracts, benefits, the term of the relationship, and whether the services provided are a key part of the company’s/employer’s business.  If the worker is provided any kind of benefit by the company/employer, such as health insurance or participation in a retirement plan, they are most likely an employee.  If the services provided by the worker are at the core of the business’ operations, then they are most likely an employee.

The terms of the worker’s relationship can be easily defined in a written contract, which will also serve as evidence if the worker’s status is called into question.  The worker and employer/company can use the contract to pass or fail all of the tests listed above in order to classify the worker as expected.  A word of caution – if the signed contract says one thing but the actual work performed is different, the classification of the employee or independent contractor can be reversed based on what actually occurred.

In closing, with the IRS calling into question employment status more often, both employers and employees are encouraged to revisit their staffing arrangements and verify that workers are properly classified based on the characteristics above.

Education credits

As discussed in a previous post, paying for higher education can be a stressful task for a parent and/or student.  Unfortunately, expenses for higher education cannot be claimed as deductions on a tax return outright, but there are four available deductions and credits that can help at tax time.

First, it is important to distinguish the difference between a deduction and a credit.  A deduction reduces a taxpayer's taxable income, while a credit reduces a taxpayer's tax.  Therefore a deduction does not reduce a taxpayer's tax dollar-for-dollar like a credit.  Also, some credits are refundable, meaning that if they exceed the amount of tax owed, the taxpayer can receive the difference as a refund.  In all, a credit is better because it reduces tax and could result in a refund.

The American Opportunity Credit (AOC) is a credit available for each eligible student enrolled at least half of the year for the first four years of postsecondary schooling (college).  The credit is the maximum of qualified education expenses or $2,500, and is available to taxpayer's with adjusted gross income (AGI) of $180,000 MFJ / $90,000 S or less.  On top of that, 40% of the credit can be refundable.

The Lifetime Learning Credit (LLC) is a credit available per return, not per student, up to the maximum of qualified expenses or $2,000.  This credit can be claimed for an unlimited number of years which makes it great for students attending law or medical school.  The credit is available to taxpayer's with AGI up to $127,000 MFJ / 63,000 S.  This credit is completely nonrefundable.

Taxpayer's that pay student loan interest can benefit from the Student Loan Interest Deduction (SLID).  The student loan must be taken out solely to pay qualified education expenses and the student must be the taxpayer, spouse, or a dependent.  The student must be enrolled at least half-time.  A deduction is allowed up to the maximum of $2,500 or the amount of interest paid during the year for taxpayers with AGI less than $155,000 MFJ / $75,000 S.  This deduction is an "adjustment to income" on page 1 of the 1040 and reduces AGI before other deductions.

Finally, the Tuition and Fees Deduction (TFD) is available as an "adjustment to income" up to the maximum of $4,000 or qualified tuition and fees.  Note that this deduction is available only for tuition and fees, not other expenses such as room and board, meal plans, or books.  This deduction is available to taxpayers with AGI less than $160,000 MFJ / $80,000 S.  The catch is that the tuition and fees deduction cannot be claimed if the taxpayer is already claiming the American Opportunity or Lifetime Learning credits.

These are four of the most popular education benefits offered to individual taxpayers, and their benefits are maximized in certain situations.  The AOC maximizes its benefits during the first four years of college because it has a high AGI limit and is a credit to reduce tax.  The LLC is beneficial for students that go past the first four years, but is limited in that it has a lower AGI threshold and can only be claimed per return.  The SLID removes some of the sting from paying interest on student loans, but the maximum $2,500 deduction usually pales in comparison to the total amount of interest that is paid in a year.  The TFD is beneficial for someone that goes back to school and only pays tuition, is no longer eligible for the AOC, and has a higher AGI than the threshold for the LLC.

Information from the IRS on benefits for education can be found here. Education benefits can be confusing, but seeking the advice of a professional on the best use of these credits during the college years can help reduce tax liability during years of high expenses.

Ordinary and Qualified Dividends

When a taxpayer receives a form 1099-DIV at the end of the year, a common question they have is "what is the difference between an ordinary and qualified dividend?".

A taxpayer that owns or is the beneficiary of an investment that pays dividends will typically receive a form like this at the end of the year.  The dividends they received during the year are reported in box 1a "Total ordinary dividends" and any of those dividends that are qualified will be reported in box 1b "Qualified dividends".  If dividends are received through a passthrough entity such as a trust or partnership, they will be reported on the Form K-1.

Dividends are the most common way for a corporation to distribute profits to its shareholders.  All of the dividends paid to a shareholder during the year are reported as ordinary dividends and are taxable to the taxpayer.  Qualified dividends will be included in the amount of ordinary dividends, but are subject to capital gains tax rates.

Qualified dividends are subject to the 15% capital gains tax rate if the taxpayer's regular tax rate is 25% or higher.  But, if the taxpayer's regular tax rate is less than 25%, then the qualified dividends are subject to a 0% tax rate.  For 2013, the 25% bracket kicks in when adjusted gross income hits $72,500 MFJ / $36,250 S.

In order for dividends to be considered qualified, they must meet three criteria.  First, the dividends must have been paid by a US or qualified foreign corporation.  Second, the dividends must not be considered capital gain distributions, payments in lieu of dividends, or payments from a tax-exempt organization or a farmer's cooperative.  Third, the taxpayer must meet the holding period for the investment.

For a dividend to be considered qualified, the taxpayer must have held the investment for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.  So if an investment's ex-dividend date (first day someone can own the investment without receiving the dividend) is September 1, then the taxpayer would have had to own the investment for at least 60 days during the period of July 1 to Nov 1 (121-day period beginning 60 days before ex-dividend date).

Confusing?  It can be, but in theory the investment should be owned for a longer term in order for the dividends to qualify for capital gains tax rates.

In all, taxation of qualified dividends with capital gains tax rates is an attractive reason to own domestic, qualified, dividend paying investments for the long-term, as long as the taxpayer is familiar with how the qualified dividends are calculated and whether or not their investments meet the characteristics for qualified dividends.

Bonus

One of the better moves made by Congress at the end of 2012 was to extend the 50% bonus depreciation allowance to 2013. This is a great resource for businesses, but is often confused with its less beneficial counterpart, the Section 179 depreciation allowance. Bonus depreciation allows a business to expense 50% of the original cost (depreciable basis) of a qualified asset in the year of acquisition. The taxpayer can then take normal depreciation on the remaining 50%, beginning in the first year. For example, if a business buys a $5,000 piece of equipment, they can expense $2,500 in the first year plus the normal depreciation on the remaining $2,500. This is why it's called "bonus" depreciation - because you get your normal depreciation, plus a "bonus" of 50%.

Bonus depreciation has benefits that make it more useful than Section 179 in some cases. There is no income limitation, which means a business is eligible to take advantage of bonus depreciation no matter their level of income (or even loss). As a matter of fact, bonus is considered to be automatic, and the taxpayer actually has to elect not to take it. Bonus is also elected by "class life" instead of by specific asset.

Bonus can be helpful because, unlike Section 179, it can be used to reduce taxable income below zero. Using bonus to create a loss can be an especially helpful planning tool for 2013. With the 50% special bonus depreciation allowance slated to go away in 2014, a taxpayer can take advantage of the special allowance in 2013 by making as many planned PP&E acquisitions as possible. By utilizing bonus depreciation, the taxpayer can push their company into a loss for 2013, and the net operating loss (NOL) can be carried forward to 2014 (and future years) and used to offset ordinary income.

In some cases, electing out of bonus is a better decision for a business. For businesses that do not turn over PPE very often and count on depreciation each year to keep their taxable income down, bonus might not be ideal. It will provide a 50% write-off in year one, but the depreciation expense in each subsequent year will be significantly lower. Also, some states (such as my state of Arkansas) do not conform to the same rules as the IRS, which can create a Federal to State difference in depreciation. Although this is not a reason in itself to elect out of bonus, it does require the taxpayer to keep a record of the Fed to State difference in future years.

Thanks to my colleague for suggesting this topic. Have something you want to hear about? Email me.

Haircuts

How often do you get a haircut?  On average, I get a haircut every two weeks.  If I don't get a haircut regularly, I start to look funny.  Although the frequency with which you visit the barber or hair salon is at your discretion, if you are a high-income taxpayer, you might be getting an extra haircut in 2013 that you didn't know about. As a part of the new tax laws implemented at the end of 2012, the IRS will be giving high-income taxpayers their own haircut through the provisions known as PEP and Pease.  This refers to the phaseout of personal exemptions (PEP) and certain itemized deductions (Pease) when adjusted gross income (AGI) reaches a certain amount.  The AGI limit is different based on your filing status, which can be Single (S), Head of Household (HOH), or Married Filing Jointly (MFJ).

Personal exemptions

Personal exemptions are allowed to reduce adjusted gross income (AGI) in arriving at taxable income.  Taxpayers typically receive one exemption for themselves, their spouse, and dependents.  For instance, if you are a married taxpayer with two dependent children, you are allowed four personal exemptions.

The personal exemption amount for 2013 has been set at $3,900.  However, the exemption amount will begin to phase out when AGI reaches $250,000 (S) / $275,000 (HOH) / $300,000 (MFJ) and phases out completely at $372,500 (S) / $397,500 (HOH) / $422,500 (MFJ).  The exemption is reduced by 2% for every $2,500 over the AGI limit.

Example: Bonnie and Clyde are married taxpayers with three children.  Their AGI is $330,000 and their personal exemption amount is $19,500.  Their AGI exceeds the limit by $30,000 and therefore their personal exemptions are reduced by $4,680 ($30,000 / $2,500 x 2% x $19,500).

Itemized deductions

Itemized deductions consist of specific expense items that are permitted to be deducted on an individual tax return, the most common of which are medical expenses, state taxes paid, charitable contributions, and mortgage interest.

Itemized deductions will be limited when AGI reaches $250,000 (S) / $275,000 (HOH) / $300,000 (MFJ).  When these limits are reached, itemized deductions will be reduced by an amount equal to the lesser of 1) 3% of AGI or 2) 80% of certain itemized deductions.  All itemized deductions are subject to the 80% calculation except for qualified medical expenses, interest expense, and casualty/theft losses.

Example: Bob is a single, unmarried doctor.  His AGI is $285,000 and he has total itemized deductions of $50,000.  Of these deductions, $10,000 is interest expense.  His itemized deductions are therefore reduced by $8,550, which is the lesser of 3% of his AGI ($285,000 x 3% = $8,550) and 80% of certain itemized deductions (($50,000 total itemized deductions - $10,000 interest expense) x 80% = $32,000).

Conclusion

If you are a high-income taxpayer, you will most likely be affected by one or both of these provisions.  There are still 3 months left in the year, which is plenty of time to consult a tax professional on ways to reduce the impact of the PEP and Pease on your individual situation.  This will ensure that the only haircut you have to worry about is the one you get every two weeks.

Charity

An area that can be considered as one of the most hotly contested on a tax return is charitable contributions. Charitable contributions can be made to qualified organizations in either monetary or non-monetary form. This could be as simple as putting a check in the offering plate at church on Sunday morning, or more complex, such as a charitable remainder trust. Following are some things to keep in mind as you select a charity to contribute to, how to determine what to contribute, and your recordkeeping responsibilities to justify your deduction. Type of charity

When donating to a charity, it's important to know what kind of charity it is. Most charities that you will contribute to are qualified non-profit organizations under the proper Internal Revenue Code section, such as 501(c)(3). Large national/international charities like the American Cancer Society or the United Way, and the majority of organized churches, fall under this category. But there are other types of organizations, like private operating foundations, that do not fall in the same category. Knowing the kind of charity you're giving to is important because contributions are limited to a certain level of your adjusted gross income (AGI). The deduction for contributions to qualified organizations are typically limited to 50% of AGI, whereas contributions to private operating foundations can be limited to 30% or 20% of AGI.

Cash is king

When contributing to a charity, cash is king for two reasons. First, this is the easiest way for you to keep up with your contribution; you write the check, and the charity will send you a receipt saying that you contributed $xx, and that no goods or services were received in exchange for the contribution. Second, cash is the best asset for them to support their programs. With cash they can buy supplies and pay their employees, as opposed to if you contributed a car, which they would have to maintain or sell.

What do I keep?

As mentioned above, when making a contribution to a qualified charity, they should issue you a receipt. You should keep these with your tax documents to support your deduction if you are ever audited by the IRS. Charities that receive non-cash contributions are getting pretty good about issuing receipts as well, such as Goodwill or Habitat ReStore.

There are some contributions that, regardless of what kind of paperwork you come up with, are not deductible. For example, payments to individuals and support of political organizations are usually not deductible.

Benefits of a paid preparer

The United States of America is a great country.  We have many freedoms, a democratic government, and as a population we have to opportunity to chase the American dream and live our lives as we please.  But those benefits come with a price.  As I like to say, "America is the greatest country club in the world, and the membership fees are the taxes that we pay." For most Americans, getting together tax information, figuring out how to report it to the IRS, and filing a tax return can be a cumbersome and stressful process.  To alleviate some of this stress, consider hiring a paid tax preparer.  There are many benefits to engaging a paid preparer to do your taxes.

We know the rules

The tax code is complicated.  Without a full knowledge of the code, you are likely to report income incorrectly or miss deductions.  CPAs know the code and know how to report your information.  They also know the differences between Federal tax code and states in which you might have to file.  They can also help if you get a nasty letter from the IRS and amend previous tax returns if necessary.

We can help you through life changes

Whether you just bought a house or had a child, got divorced or had a death in the family, CPAs know how to guide you through life changes.  They can make sure that you report your situation transparently and accurately, and also explain to you what it all means.

We keep you up to date

Not a day goes by when I don't read something or see something on the news and think "wow, that really might affect my client."  We worry about your taxes so you don't have to, and we keep you up to date on the changing landscape to help you plan during the year.

It's important to find a tax preparer that you trust, that understands your business and family, and that takes a genuine interest in your situation.  Don't be afraid to be honest with your preparer, especially about deadlines and fees.  Instead of stressing about your taxes, let a CPA help and rest easy knowing you are taken care of.

Simplify my home office

workingfromhomedistractionsBeginning in tax year 2013 (returns which will be filed during 2014), the IRS is offering a simplified option for the Home Office Deduction.  If the space in your house that is used exclusively for business on a regular basis is <= 300 square feet, then long gone are the days of keeping track of your cleaning, insurance, utilities and other household expenses. In previous years, the benefit of the deduction usually did not outweigh the trouble for getting together the information needed to make the calculation, especially when you have a self-employed person using a very small part of their house as an office (< 10% of the home).  The calculation also confused taxpayers because some parts of the deduction, like mortgage interest and real estate taxes, were allocated between the Schedule A Itemized Deductions and the Form 8829 Expenses for Business Use of Your Home.  Then there is the added headache of depreciation, which potentially was recaptured if you later sold the residence that housed the home office (meaning it had to be added back when you sold the house).

The simplified option is as its name implies: simple.  Take the square footage of your home office (not to exceed 300 square feet), multiply by $5, and that's your deduction.  There is no depreciation allowed and no splitting of household costs - all of your mortgage interest and real estate taxes go to the Schedule A.  Some of the characteristics of the deduction will remain the same, such as the space in the home must be exclusively used for business and the deduction cannot exceed your income from the business activity, but overall this simplified method will be much easier for some taxpayers.

It is important to note that the regular (original) option is still available, and can be beneficial to taxpayers that use a significant portion of their home exclusively for business.  The benefits of the deduction will be different for a consultant that has a 150 square foot office in their 3,000 square foot home than for a landscaper that has a 1,000 square foot garage used as a shop in a 2,500 square foot home.  It would also be beneficial for the taxpayer to do a rough calculation to see if the $5 per square foot is consistent with what they would be getting under the regular method.

College

We were just dumb kids with a six-pack that a bad fake ID bought, sitting on the living room couch, hoping that we didn't get caught.  And when we did, my Dad had some good advice for me.  He said "son, there's a time and place for just about everything - it's called college."   "College" by Brad Paisley with Pat Green

If you haven't heard the song, "College" offers a great synopsis of the college experience from packing up his car to having empty pizza boxes covering the floor of a dorm room and ultimately meeting the love of his life.  The song corresponds pretty closely to my college experience, but he did leave the listener with one question - how do you actually pay for college?

According to CollegeData.com, the average cost for in-state public education for the 2012-2013 school year is $22,261, and the average cost for a private college is $43,289 (see full story here: https://www.collegedata.com/cs/content/content_payarticle_tmpl.jhtml?articleId=10064).  This is a serious chunk of change, and it's only for one year!  Stretch that to four years and then add the potential for a Masters degree, Law school, or even Medical school and the resulting stress of sending a kid to college can be overwhelming.

Fortunately, there are a variety of tools out there to help the normal taxpayer save for college and provide a small tax benefit at the same time.  The most popular option is the 529 plan, which are commonly offered by states individually.  The 529 plan in its simplest form allows for a person to make contributions to an account for the benefit of a soon-to-be college student.  Once the student starts college, funds can be withdrawn from the account to pay for qualified education expenses with no tax ramifications.  Also, most states offer a benefit to a taxpayer that makes contributions to a 529 plan offered in that state.  For example, in Arkansas (my state), a taxpayer is allowed a credit on their Arkansas return for contributions to a state-sponsored 529 plan.  To find a list of 529 plans in your state, look here: http://www.savingforcollege.com/529_plan_details/

If you already have a child attending college, there are also some income tax benefits to take advantage of for payments made related to the education.  Student loan interest is allowed to be taken as an adjustment to arrive at AGI for taxpayers meeting certain income limits.  There are also credits available for education, such as the American Opportunity Credit, the Lifetime Learning Credit, and the tuition and fees deduction - see IRS Publication 970 for an overview of these credits and deductions (http://www.irs.gov/pub/irs-pdf/p970.pdf).  Keep in mind that there are many rules for these deductions, such as only being able to take one per student and qualifications related to the type of education.  If you are supporting children in college, consult with your tax adviser on which credits/deductions you might qualify for.

The underlying theme is this - it's never too early to start saving, and even saving a little is better than none at all.  By opening a 529 and saving for your child's education and taking advantage of tax benefits once they are enrolled you can ensure that you can breathe a little easier financially while your child, like Brad Paisley, is having "the best days of my life...in college."

Summertime tax tips

As the summer comes to a close we find ourselves at a transitional point in the year.  The kids are trading in their swimsuits and long days at the pool for backpacks, school supplies, and sack lunches.  I know with the temperatures hanging out in the 90's and 100's it's hard to believe, but fall will be here before you know it.  As this transition in the year happens, it also presents a good opportunity for people to do a little mid-year tax planning.  Below I have listed out a few things to consider as we enter the last five months of the year.

Clean out your closet

Take a look at your closet right now.  Do you see anything hanging up that you haven't worn all summer?  Maybe since last summer?  This is a great chance to go through your closet and bag up any clothes, shoes, and accessories that you feel comfortable passing along to a new owner.  Put all those clothes in a box or a bag and drive them down to your local charity (such as Goodwill) and make your donation.  Don't forget to get a donation receipt, fill out your personal information, list your donated items and assign a conservative value to them.  

Look at your FSA and HSA balances

There are five months left in the year.  But in those five months, you will probably go to the doctor and the dentist at least once, maybe the eye doctor, and possibly have to fill a prescription.  If you have sporty kids at home, you'll probably also been spending some time getting physicals for their various activities.  If you participate in an FSA, HSA, or flex spending account with your employer, this is a good time to see what your balance is, how much you expect to contribute for the remainder of the year, and compare that to your expected expenses.  Remember, in most of these plans you have to use it or lose it.  

Amended tax info

Is there an ominous envelope sitting on your counter at home with the words "IMPORTANT TAX INFORMATION ENCLOSED" that you haven't had a chance to open?  There's a good chance it is from your investment broker with corrected tax reporting information regarding your investments.  Or, it could be from your mortgage company discussing private mortgage insurance premiums.  Either way, you should take a look and discuss with your tax preparer to see if you need to amend your tax return.  

Changes in tax situation

Has 2013 been a year of change for you?  Maybe you bought your first (or third) house, maybe you had your first (or third) kid, or maybe you got nervous and sold a big part of your investment portfolio to avoid the ups and downs of the market.  All of these changes could have an impact on your 2013 tax return which could result in you getting a big refund or having a big balance due in April 2014.  To avoid this, talk with your tax preparer about the changes in your situation, your year-to-date withholdings from your paycheck, and any estimated tax payments you might have already made.  

Get up to date

The "fiscal cliff", "Obamacare", QE3, DOMA...there has been a barrage of news stories about all of these topics and you probably find yourself saying "I feel like this should affect me somehow?"  Well your intuition is correct.  For example, if you expect to make at least $250,000 this year, or you have significant income from investments such as interest, dividends, capital gains, partnerships, etc., or you are a small business owner with employees, then you are right in the crosshairs of several of these changes.  Touch base with your CPA to discuss your situation and consider any planning moves you can make in the closing months of the year.