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.  

Moving Expenses

When I finished high school, I chose to attend Hendrix College in Conway, Arkansas to pursue my degree.  Being a liberal arts school, Hendrix attracted many students wanting to pursue advanced degrees such as medical doctors, PhD's, and attorneys.  As graduation neared, I watched as many of these friends packed up to move to other schools to pursue these degrees.  They moved all over the country, places like Corpus Christi, Baton Rouge, Houston, and even as far as Palo Alto.  

Now, these friends are completing their advanced degrees and getting jobs, some of which are located even further away.  We're talking California to Maryland or Texas to Massachusetts, and when I hear about these moves, after offering congratulations, I always remind them to keep their receipts.  Here's why.

The IRS allows an adjustment to income for qualified moving expenses.  An adjustment to income is a reduction in the taxpayer's gross income to arrive at adjusted gross income (AGI) and is reported on page 1 of the 1040.  For expenses to qualify, they have to meet three simple criteria: the move must be closely related to work, meet a distance test, and meet a time test.  

Criteria

First, the move must be closely related to the start of a job.  This can be a new job, or a relocation for an existing job.  The IRS considers moving expenses incurred within 1 year of the start of a new job to be closely related to the start of work.  This means if a move in June for a job that starts in August would qualify.  However, if a taxpayer moves in 2010 and is unemployed until 2013, then the moving expenses would not qualify for the deduction.  

Second, the move must satisfy the distance test.  This basically means that your new job must be at least 50 miles away from your old home.  If a taxpayer that currently lives 5 miles away from their current job takes a new job, the new job will have to be at least 55 miles away from their old home.  Pretty easy to satisfy this test if the taxpayer is moving from Florida to Oregon, but not so much if they are moving within the same city or state.  

Third, the taxpayer must meet the time test.  This means the taxpayer (if an employee) must work full time for at least 39 weeks of the first 12 months after moving.  A taxpayer that moves from Louisiana to Wyoming for a job but quits after a month cannot deduct their moving expenses.  This same test applies to self-employed taxpayers, but doubled, meaning they must work full time for at least 78 weeks of the first 24 months after moving.  Taxpayers may claim the deduction if they have not satisfied the test but expect to, and if the circumstances change they are required to go back and amend that return.  

Qualified expenses

Taxpayers that meet the criteria can claim the moving expenses adjustment for moving and storage of household goods and travel.  This includes hiring movers, renting moving vehicles (trucks or trailers), storage units, and lodging along the way.  Taxpayers that use their own vehicles to transport their belongings can also take a deduction for the greater of 1) actual expenses for gas and oil or 2) mileage at a rate of 24 cents per mile.  This deduction will most likely depend on how far the move is, and whether the taxpayer drives a Suburban or a Prius.  

There is NO deduction for meals and entertainment, and the travel expenses must be reasonable.  For example, if during a cross-country move the taxpayers decided to spend 2 nights at a luxurious spa, that lodging is not reasonable and does not qualify as a moving expense.  

Reimbursement by employer

In some cases, the employer will provide an allowance or reimbursement to the employee for moving expenses.  This amount is usually reported on the employee's W2 and must be used to reduce the amount of moving expenses incurred by the taxpayer.  

Taxpayers claim moving expenses on Form 3903 which will accompany their Form 1040 for that tax year.  Because of the amount of subjectivity involved in this deduction, it is recommended that taxpayers keep copies of all of their receipts and mileage logs.  

The perils of tax withholding

Determining the proper amount of income tax withholding can be a confusing issue.  This is mostly due to the Form W-4, which is filled out by wage earning taxpayers when they start a job or have a change in their family situation.  But, for the majority of taxpayers that rely on their withholding to cover their taxes for the year (as opposed to other taxpayers that make quarterly estimated tax payments), an error in the W-4 can result in bad news on April 15.  

Allowances

The W-4 revolves around the number of allowances a taxpayer elects.  The withholding tables work on averages that assume taxpayers in certain income ranges with a specific family situation will need to withhold certain amounts.  For example, a married couple that both work and have two children will have a different number of allowances than a single taxpayer.  However, this is also where the number of allowances can be tricky, especially for married couples that both work, or when a wage earner has more than one job.  Reading and completing the Personal Allowances Worksheet on page 1 of the Form W-4 will help taxpayers select the proper number of allowances.  

Working couples

For married couples where both spouses work, or one spouse has more than one job, the taxpayer will find it helpful to complete the Two-Earners/Multiple Jobs Worksheet on page 2 of the Form W-4.  This worksheet will ensure that, once the wages from all jobs are added together, there will be enough withholding.  For example, a working couple where both make $60,000/year will have taxes withheld during the year based on a 25% tax bracket.  However, when both sets of wages are added together, the couple is actually in the 28% tax bracket.  The result is that the taxes withheld might not cover the actual tax liability on the couples 1040.  

Credits

Another important factor to consider when calculating withholding amounts is how many tax credits the taxpayer will claim on their 1040.  The best example is the credit for child and dependent care expenses.  Remember that credits are a reduction in tax, meaning that if a taxpayer expects a credit on their return, they might not need to withhold as much during the year.  

Manual method

Some taxpayers that have consistent income and deductions from year to year can calculate their withholdings manually.  If a taxpayer knows that their tax liability will approximate $10,000 for the year, they can direct their payroll representative to withhold that amount evenly throughout the year.  This is more complicated than completing the worksheets included with the Form W-4, and consulting with a tax adviser is recommended.  

The IRS also has a helpful tool for taxpayers to calculate their withholdings online.  The taxpayer can enter some simple information regarding their income and family situation and the website will recommend an amount of withholding for the year.  It is helpful to have a copy of the most recent paystub handy when using this tool.