Going on extension

Including today, there are 22 days left to file a Form 1040 individual tax return.  But what about taxpayers that have complex transactions, are still waiting on some information, or simply "ain't got time fo dat"?

Filing an extension is not a bad thing.  In fact, depending on the complexity of the taxpayer's transactions and the availability of information, filing an extension might be the best option to avoid filing an inaccurate or incomplete tax return.  

What does an extension do?

An individual that needs additional time to file can file Form 4868 by April 15, 2014.  Now let's dispel a few myths about extensions:

Do I get in trouble or does my account get flagged if I file an extension?

No, extensions are perfectly legal and do not cause a taxpayer to get extra special attention from the IRS.  

Do I have to wait for my extension to get accepted?

No, by filing Form 4868 by April 15, the taxpayer's return is automatically extended for 6 months, making the new due date October 15.  However, this is only an extension of time to file, not an extension of time to pay (discussed later).  

What is the benefit?

The benefit of an extension is that the taxpayer will have the time needed to file an accurate and complete return.  Failing to do so could result in penalties, interest, IRS notices and possible IRS examinations.  

Why get an extension?

There are a variety of reasons for taxpayer's to consider getting an extension.  The most common is delays in receiving necessary information to prepare the return.  Taxpayer's that have significant investment accounts might received "amended" 1099's late in tax season, or even during the summer or later in the year.  Taxpayers that have investments in passive activities such as partnerships or S-corporations might not receive their Schedule K-1 until after the filing date.  In these cases, the taxpayer will need to file an extension until they have all the information needed to file an accurate return.  

Taxpayers that have complex transactions might consider filing an extension in order to verify their calculations are correct.  For example, significant sales of assets, inheritance, death, or even moving could be reasons to file an extension.  

Another common reason for taxpayer's to file an extension is time, or lack thereof.  If a taxpayer prepares their own taxes, they might be too busy to devote the attention necessary to file an accurate return.  But if a taxpayer uses a paid preparer and takes their information in during the last week of tax season, be prepared to file an extension.  

Paying with an extension

As mentioned above, filing an extension is an automatic extension of time to file, but not an extension of time to pay.  If the taxpayer expects to owe taxes on their return, they will need to pay those taxes when filing their Form 4868.  The taxpayer must also consider that filing an extension does not exempt them from making quarterly estimated tax payments for the next year, the first one being due on April 15.  

Idea$ 2014 - March: Taxes

As a part of the continuing Idea$ 2014 series, the month of March is dedicated to taxes. Specifically, this topic will address organizing tax documents, types of information to communicate to your paid preparer and ways for taxpayers to DIY if so inclined.  

The basics

Business returns for C Corporations (Form 1120) and S Corporations (Form 1120S) are due on March 17, 2014 (typically this is March 15, but since that falls on a Saturday this year, the due date is pushed to the next Monday).  Other returns including Partnerships (Form 1065), Fiduciary/Trust (Form 1041) and Individuals (Form 1040) are due on April 15, 2014.  

If the taxpayer cannot file by these dates, an automatic extension can be obtained.  The extension for corporations and partnerships extends the deadline to September 15, and the extension for individuals and trusts extends the deadline to October 15.  However, it is important to note that this is an extension of time to file, not time to pay.  If a taxpayer expects to owe tax on the return, a payment should be made with the extension in order to avoid penalties and interest.  

Income

Common income documents include:

• W2's - taxpayers that work for an employer should receive this showing their income and withholding amounts.
• 1099's - these are catch all documents for interest (1099-INT), dividends (1099-DIV), capital gains (1099-B), self-employment income (1099-MISC), social security (SSA-1099) and retirement income (1099-R).  
• Schedule K-1's - will be received if the taxpayer has an interest in a partnership, S-corporation, or trust.  

Deductions

Common deduction documents include:

• Tax payments for real estate and personal property
• Mortgage interest (Form 1098) - this form will include mortgage interest paid and possibly real estate taxes if they are paid through escrow
• Charitable contributions - for both cash and non-cash contributions, the taxpayer should have a receipt from the organization.  
• Medical expenses not reimbursed from a flexible spending account or other insurance program
• Tuition, fees and student loan interest
• Expenses for dependent care
• Contributions to retirement plans

Why the rush?

A taxpayer may wonder, if the return is not due until the middle of April, why get in a rush to organize their documents in March?  If the taxpayer is using a paid preparer, then it's safe to assume the preparer is working on several returns at one time, which can create a time lag between when information is submitted and the return is done.  If the taxpayer expects to owe tax, the earlier the return is done, the better they will be able to do cash flow planning to make a tax payment by April 15.  On the other hand, if the taxpayer expects a refund, then the same holds true in that the earlier the return is done, the earlier the taxpayer gets their refund.  Finally, it is always safe for the taxpayer to leave some time in case there are questions or additional documents that need to be obtained.  

D.I.Y

Taxpayers that have simple tax situations or are familiar with preparing tax returns already might want to prepare their own taxes.  There are a variety of options for taxpayers that want to go this route.  Most of the programs on the market now are easy to use and will walk the taxpayer through the return in an "interview format".  The most popular programs are TurboTax and TaxACT, both of which are available on CD or as an internet download.  There are pros and cons to the DIY method.  The pros are that it is relatively inexpensive ($25-$50 for software and efiling), the returns can be done at the taxpayers convenience, and the taxpayer does not have to share sensitive personal and financial data with anyone else.  However, the cons are that the taxpayer could report an income or deduction item incorrectly and helpful, reliable information is hard to come by on the internet.  Both of these could result in the taxpayer paying too much tax or filing an incorrect tax return.  Depending on the complexity of the taxpayer's situation, a professional tax preparer should be consulted.

The "be your own boss" tax

Being your own boss can be fun and rewarding.  But, whether you own a small business, run a custom quilting operation from your home or write editorial articles for fun, taxpayers need to be aware of the self-employment (SE) tax.  

The SE tax is imposed on taxpayers that report SE income on their individual Form 1040.  The purpose of the SE tax is to recoup Social Security (FICA) and Medicare taxes from taxpayers that do not pay these through paycheck withholding.  When a taxpayer is an employee, it is their employer's responsibility to withhold these taxes from their paycheck and remit them to the government.  But, since self-employed taxpayers do not receive a "paycheck" per se, they must pay these taxes when they file their individual Form 1040.  

What types of income are subject to the SE tax?

Before calculating SE tax, the taxpayer must first determine how much SE income they have.  Common types of SE income include:

• Rental income
• Net profit from sole-proprietorship or single-member LLC (reported on Schedule C)
• Nonemployee compensation received and reported on Form 1099-MISC, such as contract labor, commissions, or bonuses.

Note that rental income is included above.  If rental income is passed through to the taxpayer on a Schedule K-1, then the K-1 should indicate whether the activity is passive.  If it is passive, then it is subject to the SE tax.  

How much is it?

As mentioned above, the purpose of the SE tax is to recoup Social Security and Medicare taxes.  The Social Security rate is 12.4% on all SE income up to $113,700, and the Medicare rate is 2.9% with no upper income limit.  The total amount of tax will be reported in the "Other Taxes" section of the Form 1040, but 50% of the amount reduces the taxpayer's AGI as an adjustment to income on page 1 of the Form 1040.  Here's an example:

Marty makes and sells custom coffee cups at his home.  He is not incorporated, and his net profit for the year was $75,000.  He will pay total SE tax of $11,475, made up of $9,300 in FICA (75,000 x 12.4%) and $2,175 in Medicare (75,000 x 2.9%).  He will get an adjustment to income in the amount of $5,738 ($11,475 x 50%)

But what if Marty makes really awesome coffee cups?  

Marty had the most successful year of his coffee cup career, showing net profits of $200,000.  Marty will pay total SE tax of $19,899, made up of $14,099 in FICA (113,700 x 12.4%) and $5,800 in Medicare (200,000 x 2.9%).  Notice how the FICA taxes are capped at $113,700, but Medicare is charged on the full amount.

Options to reduce or eliminate SE tax

Taxpayers can reduce their SE tax burden in various ways.  One way is through business structure.  Taxpayers that have substantial business income, such as Marty above, can consider incorporating and filing an S election.  As an S-corp, Marty could pay himself a reasonable salary for the year which would have the required payroll taxes withheld, and the remaining profit would be passed through to him on a Schedule K-1 as ordinary income not subject to SE tax.  If his salary was $100,000 and the other $100,000 was passed through to him on a K-1, Marty would save almost $10,000 in SE taxes.  Marty could also elect to be a normal C corporation, and all the profits from the business would be taxed at the corporate level.  Although this would eliminate the SE tax for Marty, corporate rates are not as favorable as individual rates and the taxpayer could end up paying more in corporate taxes.  

Taxpayers that generate SE income from their home should consider the Home Office Deduction.  The IRS now offers a simplified calculation for smaller operations, but taxpayers with a significant home office should go through the full calculation to reduce their SE income.  

Taxpayers can also reduce their regular tax burden associated with SE income by making contributions to retirement plans.  A traditional IRA is the easy way to go, but taxpayers with higher amounts of income and cash flow should consider a SEP (simplified employee pension).  The SEP will allow contributions up to 25% of SE income, with a maximum of $51,000.  However, the retirement contributions reduce the amount of taxable income, but not the amount of SE income.  In Marty's case above, he would have regular taxable income of $50,000 less after making a SEP contribution, but his SE tax would not change.  

Fed to AR tax differences

All but seven states in the USA have their own form of individual income tax separate from Federal reporting required to the IRS.  Unlike the Federal system, which applies a uniform tax system to everyone regardless of what state they live in, states with an income tax all have their own way of doing things.  For example, some states start with Federal adjusted gross income (AGI) and work down to state AGI.  Other states require taxpayers to start from the beginning and calculate their state AGI on its own.  Still other states calculate income tax based on other factors, like Tennessee, which only taxes interest and dividends over a certain amount.

Arkansas has its own individual income tax system.  It is similar to the Federal system, but has intricacies that taxpayers should be aware of so that they don't over- or under-pay.

Married filing separately on same return

This is a filing status available to married Arkansas residents.  This form has two columns, one for the taxpayer and one for the spouse.  Joint income is divided between the two columns, but income allocated to one or the other goes in its respective column.  This is beneficial to married taxpayers where the taxpayer or spouse has a higher income than the other, because tax is calculated by taxpayer and spouse separately, then added together.  The tax is usually lower than if calculated on joint income, like a Federal return.

Income differences

There are several types of income that are taxed differently by Arkansas than at the Federal level:

• Social security benefits - not taxable to Arkansas
• Distributions from qualified retirement plans - if they are taxable, Arkansas allows a $6,000 reduction in the taxable amount, both for taxpayer and spouse.
• Capital gains - only 70% of net capital gains are reported on the Arkansas tax return.  However, up to $3,000 of losses can still be taken.
• Tax exempt interest - interest earned from municipal bonds is not taxable at the Federal level.  However, in Arkansas it is taxable unless it is from an Arkansas source.  For example, interest received from a New Orleans, Louisiana municipal bond is taxable in Arkansas, but interest received from a Little Rock, Arkansas municipal bond is not.  Neither is taxable on the Federal return.
• Depreciation differences - Federal depreciation benefits such as Section 179 and bonus are different at the Arkansas level.  Arkansas does not recognize bonus depreciation, and the Section 179 limits are much lower.  Therefore, income from S-corps, partnerships, or farms could be different for Arkansas than Federal.  Taxpayers should refer to an Arkansas-equivalent Form K-1 received from these entities.

Deduction differences

There are also several types of deductions that are different for Arkansas than on a Federal return:

• 529 plans - taxpayers that contribute to an Arkansas 529 plan for college savings are allowed an adjustment to income of up to $5,000 each for taxpayer and spouse.  The contributions have to be made during the tax year, and they must be to an Arkansas 529 plan (not just any 529 plan).
• State tax deduction - unlike the itemized deduction schedule for Federal returns, Arkansas taxpayers cannot deduct state tax payments on their Arkansas income tax return as an itemized deduction.  They can still deduct personal property and real estate taxes, but not estimated tax payments or withholding.
• Foreign taxes paid - instead of calculating the foreign tax credit like on the Federal return, all foreign taxes paid can be added in total as an itemized deduction on the Arkansas return.

Each state is different, so taxpayers should consult their tax advisor or their state department of revenue website for more information.

IRA tax on MLP earnings

Investing in a publicly-traded Master Limited Partnership (MLP) can be a savvy move for some investors.  This is because the MLP, unlike a common or preferred stock, is taxed as a partnership.  In doing so, the earnings of the MLP are distributed to its members on a Form K-1, instead of through dividends or capital gains.  What's even better is that most MLP's make a distribution on a regular basis.  This distribution might appear to be a dividend, but it is not, because the taxpayer is paying tax on the earnings, not the distribution.  Here is an example:

Randy owns 100 units of ABC MLP, a publicly-traded partnership.  The taxpayer receives four quarterly distributions of $100 each, for a total of $400.  At the end of the year, Randy receives a K-1 from ABC which shows $50 of ordinary income.  On Randy's tax return, he will report $50 of passive income on his Schedule E.  The $400 from a tax perspective is basically forgotten, to be deposited into Randy's brokerage account for other investments or reinvested in more units of ABC MLP.

MLP's are also commonly known to have high distribution yields, such as in Randy's situation above.  He received $400 of cash during the year for his investment, but only had to report $50 on his tax return.  How do they do it?  Many MLP's take advantage of tax deductions such as depreciation and domestic production activities in order to reduce their taxable income below their book income.  These deductions are not cash expenses, which allows the MLP's to distribute high amounts of cash even though their taxable income is low.  Good for the MLP, and good for the investor.

Because of their high distribution yields, many investors choose to hold MLPs in their retirement accounts.  From a tax perspective, this is where the situation gets a little dicey.

Retirement accounts, such as IRAs and 401(k)s are technically considered tax-exempt entities.  There is a little known rule that if these entities earn something called Unrelated Business Taxable Income (UBTI) over a certain threshold, they are required to report that income to the IRS and pay tax.  The threshold is $1,000, and the tax rate is 39.6% (gasp)!

Let's go back to Randy, and now he owns 5,000 units of ABC MLP in his IRA.  He receives $20,000 in distributions during the year, and his IRA receives a K-1 with $2,500 of ordinary income.  The IRA is the partner in the MLP, not Randy, so the IRA will have to file a Form 990-T and pay tax of $594 ($2,500 - $1,000 exemption = $1,500 x 39.6% = $594).  It is not Randy's responsibility to file this return; the custodian of the account will do the filing and use money from the IRA to pay the tax.  This scenario shows how a tax-savvy investment in a tax-exempt account just became taxable.

In summary, individuals that hold MLPs in retirement accounts should monitor their positions to ensure that they are not losing any of their retirement savings to taxes.  Those that are interested in making significant investments in publicly-traded MLPs should consider doing so in taxable accounts, the main reason being that the individual tax rate will most likely be lower than 39.6%.