TAX TIPS AND TRAPS
© 1996 Frank E. Fogg - All Rights Reserved
- Why A Professional Should Prepare Your Tax Return
- How To File Amended Returns
- Charitable Contribution Law Changes
- Deducting Automobile Expenses
- Estimated Taxes - Avoiding The Penalty
- Dependent Care Deduction
- Reducing The Tax On Your Investments
- Buying and Selling Your Home
- Where To Get Help
Nobody likes to pay tax. Yet taxes are a daily occurrence in our lives. Taxes are paid at the Federal, State and Local levels on income. Most areas impose a sales tax on purchases. Real estate and personal property taxes are applied to homeowners. Businesses pay payroll, real estate, sales and franchise taxes.
The United States Tax Code is a vast labyrinth of rules and regulations that has evolved over the years. Although it is quite intricate, it is designed so that all will share in the tax burden. Personal income taxes accounted for about 1/3 of the Federal Government's income in 1992. Social Security, Medicare and unemployment taxes were about another 1/3 of 1992 income. The combination of personal income taxes, Social Security tax, Medicare and unemployment taxes provided about $900 billion in 1992(1).
For 1992, about 1/3 of the U.S. Government spending was for Social Security, Medicare and other retirement programs. Another 1/4 was spent for national defense. Social programs and community development accounted for another 1/4 of cash outlays(1).
Why A Professional Should Prepare Your Tax Return
There are a number of professional tax preparers in the United States. Professional groups include Tax Preparation services, Certified Public Accountants and Enrolled Agents. There are advantages to having these professionals prepare your tax return.
Most professional tax preparers regularly attend classes and seminars to learn about the latest tax law changes. They are familiar with how the forms are to be prepared and what forms are required for each situation. Tax planning services are also offered in which recommendations are made to reduce future tax liabilities.
Many tax preparers now offer electronic filing. Once a return is prepared, a computerized version is transmitted to the Internal Revenue Service via a telephone link. Electronic filing decreases the time it takes to process a return and improves its accuracy, so a refund is issued much sooner.
Several factors should be considered when selecting an organization to deal with tax matters:
What services are offered?
- Tax Preparation
- Tax Planning
- Estate Planning
- Investment Counseling
What will the services cost?
- Printed price schedule
- Reasonable or similar to other organizations
Will the Organization meet all needs?
- Knowledgeable about Tax and Investment Matters
- Organized and Professional
- Can represent client if audited
Tax preparers are subject to special rules in the United State Tax Code. These rules are designed to protect the taxpayer from unscrupulous practices by professional tax preparers. Penalties can be accessed to the tax preparer by the Internal Revenue Service for violations of the rules.
Tax preparers cannot divulge your personal information, tax return or refund status to other parties without your permission. A copy of your return must be supplied by the preparer. Fees based on results are prohibited, therefore the preparation charge is not based on the amount of the refund. The preparer must not substantially understate the amount of tax liability.
Organized recordkeeping can help reduce the amount of tax liability for the year. Well organized records can help to uncover deductions that would otherwise be overlooked.
Recordkeeping is required to support income and deductions. The length of time to keep records varies with the type of record.
Tax Tip # 1 - Record Storage
- All tax returns, receipts and other information should be stored in the same place. Collect the tax returns, informational returns, receipts, credit card statements and checking account statements. Place all of the information for the tax year into a sealed envelope, bag or box and mark the box with the tax year it contains. If you are audited, all records to prove your income and deductions will be in the same place.
Records can be organized by using a personal computer. There are a number of checkbook accounting programs available to record income and expenses. The programs operate much like a checkbook. The information from the check is recorded in the computer program. Most of these programs also offer features that allow credit card information to be tracked. The information that is entered is totaled and summarized in monthly and yearly reports.
There are additional beneficial features of personal accounting software. Budgets can be prepared at the beginning of the year. Performance using the budget figures can be measured throughout the year. In some programs home assets are organized. This is an advantage in case of fire or other disaster in providing proof of insured items and cost.
Computer based spreadsheet programs are another useful tool in organizing personal records. Spreadsheets programs use a large grid similar to graph paper. Each block or "cell" may contain a number, text or a calculation formula. Information is entered into the various cells. The calculation formulas sum the information to provide subtotals and totals. Many of the popular spreadsheet programs also provide financial functions that are useful in analyzing loan and mortgage interest.
Amended Tax Returns
There may come a time when an amended income tax return is necessary or desirable. An amended income tax return may be filed up to 3 years after the due date of the original return(2). It is used to change the original tax return when new information or errors are discovered or a change in filing status or exemptions is desired.
Use Form 1040-X to change the original return. The information from the original return is presented first. The changes are listed. Finally the corrected figures and shown. Space is provided on Form 1040-X to provide an explanation of the changes that are made. Attach the corrected Form 1040 return and all supporting forms and schedules related to the change.
An amended return can also be filed when the wrong tax form was originally used. For example, Form 1040-EZ was originally filed but Form 1040 was required because more than $ 400 in interest income was received.
Charitable Contribution Law Changes
New rules apply to charitable contributions beginning in 1994. For many contributions, the organization must provide written documentation to the taxpayer confirming the contribution. Another new rule concerns benefits received. If anything is received in return for a charitable contribution such as a dinner, prize or other item, the amount of the deduction allowed is reduced by the value of the item received.
Tax Trap # 1 - Proving Your Charitable Contributions
- Starting in 1994, a canceled check is no longer sufficient proof for large charitable deductions. Insist that your church or charity provides you with the required documentation.
Tax Tip # 2 - Charitable Contributions Through Payroll Withholding
- Many taxpayers make charitable donations at work by withholding a portion of their wages. Check your paystubs to identify and total the amounts that you can use as deductions.
Taxpayers may also claim a deduction for non cash items donated to charities. Non cash contributions may include gifts of personal property and appreciated assets. This type of donation can be subject to abuse so the Internal Revenue Service will closely scrutinize this deduction. There are several things that must be done to protect your deduction when making non cash contributions of more than $ 500.
Schedule an independent appraisal of the item prior to making the donation. This will prove the fair market value of the item and help with deciding to proceed with the donation.. The appraiser should complete Part III of Form 8283 for you when the appraisal has been completed.
For donated items with lesser value such as used clothing or old furniture, a trip to the local surplus store to compare prices of items similar to the donated property will be sufficient.
Get a written confirmation from the charity for your donation. The charity should acknowledge receipt of your donation by completing Part IV of Form 8283.
Tax Trap # 2 - Deductible Amount of Non-Cash Contributions
- Some non-cash contributions are not deductible at their Fair Market or Appraised values. Items that have been owned one year or less and items that are put to an unrelated use by the charity are deductible at a reduced amount.
The time donated to a charitable cause is not deductible. Out of pocket expenses and mileage related to performing work or donating services to the charity are deductible expenses.
Deducting Automobile Expenses
Expenses for your car may be deductible. There are four major categories of automobile expense that are deductible:
- Business Use - Self employed individuals
- Business Use - Employees - Not reimbursed by employer
- Medical Use - To and From Doctors, Hospitals etc.
- Charitable Use - Performing charitable services
Automobile expense for tax purposes can be computed based on actual expenses or on mileage. When using either method it is imperative to keep a mileage log for all miles driven during the year. The totals from the log will be used to figure your deduction when your return is prepared. Mileage logs are readily available at most office supply stores for several dollars.
Some expenses are used in calculating your deduction when either method is used. Parking and tolls costs are included using either method. Most taxpayers will use the standard mileage rates to compute their deduction.
Self employed individuals may want to consider using the actual expenses in arriving at a deduction. The deductible expenses are:
- Cost of the car - This expense is usually spread over a 5 year period
- Loan interest
- Gasoline and Oil
- Repairs and Maintenance
When a vehicle is used for both business and personal use the percentage of business use is multiplied by the expenses to arrive at the proper deduction. The percentage of business use is derived from the miles driven for business divided by all miles driven.
Tax Trap # 3 - Using The Standard Mileage Rate
- When the standard mileage rate is used by self employed taxpayers in the first year a car is placed into service, MACRS depreciation can no longer be claimed for the vehicle over its life.
Estimated Tax Penalty
Estimated tax payments can be made to reduce year end tax liability and penalties associated with underpayment of tax. The amount to pay is calculated on Form 1040-ES. The payments are divided into four equal amounts over the course of the tax year.
Everybody does not need to make estimated tax payments. If a refund is expected or if the tax due at the end of the year is less than $ 500 then no penalty will apply. Estimated tax should be calculated and paid when the expected tax due will be greater than $ 500. Some of the situations that may cause this include:
- Individuals with self employment income
- Large amounts of unearned income such as interest and dividends
- Income is expected from sale of assets such as stocks and bonds
Tax Tip # 3 - The Safe Harbor
- When determining the amount of estimated tax payments required , the taxpayer may use 110% of the current tax year liability and avoid penalties due to underpaying the estimated tax.
Tax Tip # 4 - Increasing Withholding
- Payroll withholding can be increased instead of making estimated tax payments. A new Form W-4 can be filed with the employer to increase the amount of tax withheld. This method can be used when the amount of tax liability for the coming year is reasonably certain. A penalty will still apply if the tax due at year end exceeds $ 500.
If estimated tax payments were required and not made then several options are available to handle the discrepancy. The return can be filed with no computation for tax liabilities. The Internal Revenue Service will calculate the amount due. Alternately, the penalty due can be determined by filing Form 2210 with the return. The taxpayer can also request a waiver of the penalty. The circumstances that may allow waiving the penalty include underpayments due to disaster, retirement and changes in the tax law and the underpayments were due to reasonable cause.
Estimated taxes must be paid when the year end tax liability is expected to exceed $ 500. The best way to avoid paying the penalties is to use the Safe Harbor method to calculate estimated tax payments for the coming year.
Dependent Care Deduction
Tax Tip # 5 - Documenting The Child Care Expense Deduction
- Parents with children can deduct a portion of daycare expenses on Form 2441. To prove the deduction and get the necessary information, ask your daycare provider to complete Form W-10 and return it to you. Form W-10 contains the daycare provider's name, address and identification number.
Reducing The Tax On Your Investments
Most taxpayers have put aside money for the future. There are several strategies that can reduce the amount of income tax that is paid on the interest received for these investments.
Tax Tip # 6 - Open An Individual Retirement Account
- An IRA is an easy way to defer paying taxes on your investments. Up to $2,000 can be contributed each year for people with earned income. Non-working spouses can contribute an additional $250 per year. If you are not covered by any other retirement plan, your contribution and any interest is tax deferred. Even if you must make non-deductible contributions, all of the earnings from the account will still be tax deferred until withdrawn.
Self-employed individuals should also investigate the IRA-SEP retirement plan. These plans are simple to start and allow you to contribute up to $22,500 per year based on your earnings from self-employment.
An IRA account may be established at most banks. Many mutual funds also offer an IRA option as well. A few companies allow investors to purchase their stock through an IRA arrangement too.
Tax Tip # 7 - Stock Selection
- Select stocks that are likely to appreciate in value instead of distributing dividend income. No tax is paid on the increase in the stocks' value until the shares are sold. When sold, the amount of gain is taxed at the capital gains tax rate.
Tax Tip # 8 - Mutual Fund Selection
- Select mutual funds that distribute most of their income as capital gains. The current capital gains tax rate is 28% while upper income tax rates are 36% plus additional surcharges. Most income from the fund will be taxed at the lower 28% rate.
Tax Tip # 9 - Mutual Fund Dividends
- Mutual funds may derive a portion of their income from investments in various government securities. This portion may be exempt from income tax at the federal or state level.
Buying and Selling Your Home
Buying a home is the largest purchase most Americans will make. There are several important strategies to use in planning for the eventual sale of the home.
Tax Tip # 10 - The One Time Exclusion
- Taxpayers over the age of 55 should consider using the one-time exclusion. This rule allows the sale of the home with no tax on the capital gain (increase of the sales price over the purchase price.) The amount that can be excluded is limited. Consult a tax professional about the ramifications of using the exclusion.
Tax Trap # 4 - The Two Year Rule
- Most taxpayers will purchase a new home when the old home is sold. The capital gains tax on the sale of the old home can be avoided when the basis is rolled over into the basis of the new home
Where To Get Help
The Internal Revenue Service has a number of publications to assist you. These are available at no charge. Contact your regional forms ordering center and ask for the publication you want.
1 Your Rights as a Taxpayer
17 Your Federal Income Tax
334 Tax Guide for Small Business
463 Travel, Entertainment, and Gift Expenses
501 Exemptions, Standard Deduction, and Filing Information
502 Medical and Dental Expenses
505 Tax Withholding and Estimated Tax
508 Educational Expenses
521 Moving Expenses
523 Selling Your Home
525 Taxable and Nontaxable Income
527 Residential Rental Property
529 Miscellaneous Deductions
550 Investment Income and Expenses
554 Tax Information for Older Americans
575 Pension and Annuity Income
586 Earned Income Credit
590 Individual Retirement Arrangements (IRAs)
910 Guide to Free Tax Services
917 Business Use of a Car
929 Tax Rules for Children and Dependents
936 Home Mortgage Interest Deduction
1)1993 Form 1040EZ instruction booklet.
2)Form 1040X may be filed up to 7 years after the due date of the original return when the correction is based on bad debt or worthless securities.