Tax Preparation gets harder for same-sex domestic partners…but there’s probably an upside

June 29, 2010

A memo issued by the IRS earlier this month clears up some lingering questions about community property laws and same-sex partners. Since this blog is for individuals and not other tax preparers, I’ll spare the details here. The upshot is this: Same-sex registered domestic partners who live in community property states (i.e. California) must now use community property rules when preparing their federal tax returns…even though they continue to be prohibited from using Married filing status. And they have the option to amend previously filed returns to use community property rules if it’s more advantageous.

(One additional note: the memo addresses a case involving Registered Domestic Partners specifically, and not same-sex spouses who married during one of the periods when same-sex marriage was allowed. Since the community property rules are the same for RDPs and same-sex married partners, presumably the reasoning applies equally in both cases.)

The legal justification pretty much works out like this: Established case law has upheld the principal that state law trumps federal law in areas of property ownership. Community property laws in states that recognize same-sex marriage dictate that income must be treated as equally earned by both spouses (unless it is derived from “separate property”, but that’s another discussion). Since property laws of states trump federal law, the IRS has determined that same-sex married couples must use community property laws. However, the Defense of Marriage Act declared that under Federal law only marriages between opposite sex partners are recognized, and (so far) there is no legal basis for state marriage laws trumping federal marriage laws. Therefore, the federal rule prohibiting same sex marriages applies for purposes of determining filing status even though it doesn’t matter for purposes of determining property (and therefore income) ownership.

On that note, I’ll share a brief political commentary. Funny how the conservative, “states’ rights” people don’t seem to have any problem with the Federal government telling states who can and can not marry even though the authority to define marriage at the Federal level is found nowhere in the Constitution. Just how ridiculously complicated are things going to have to get before certain people decide it’s best for the government to just stay the hell out of individuals’ relationship decisions?? But I digress…

So what does this latest IRS ruling mean for same-sex couples in community property states? Well, good news and bad news.

First, the bad news–doing your taxes just got a little more complicated than it already was. All of your income and many deductions and credits will now have to be adjusted so that they are equally split between both spouses. Two negative issues (besides the basic matter of increased complexity) may arise from this. First, same-sex partners can expect a lot of IRS letters attempting to “adjust” their returns as they report income, deductions, and withholding that do not match what is on forms reported to the government such as W-2’s and 1099’s. This will be an annoyance as same-sex couples will have to deal with additional unnecessary correspondence with the IRS to explain their tax calculations. Second, and more troubling, is the possibility some deductions and credits may only be allowed at a 50% level. As an example, let’s say one spouse is a student who qualifies for the Lifetime Learning credit on $8,000 of school expenses, which would be a $1600 credit. Under the latest rules, the IRS may determine that only $4,000 was paid by the spouse in school, and $4,000 paid by the spouse not in school. The spouse in school can claim a credit on only $4,000 in expenses, while the spouse not in school is ineligible to claim a credit at all due to not being a student and the spouse not being a “spouse” on the Federal return. This would be grossly unjust if the IRS rules this way, but there’s certainly room within the rules as they’re now being applied for the IRS to take this stance.

Now, the good news. In most cases, the community property rules will probably result in tax savings, especially for spouses with significantly different levels of income. The simple reason is that if two spouses are in different tax brackets, the community property rules effectively move some of the income from the higher tax bracket spouse to the lower tax bracket spouse. Furthermore, because same-sex spouses have the option, but not the obligation, to amend prior year returns, they can amend their returns in order to get additional money back, or choose not to amend if there’s no savings to be found. Not often does the IRS allow you to follow the law only when it’s in your favor, but this is one of those cases.

In summary, tax preparation just got a little more complicated for same-sex spouses, but I expect in most cases same-sex couples will see some tax savings as a result. Same-sex spouses should only do their own return if they are very well-versed in community property rules. But given the complexities involved, I definitely recommend same-sex partners seek out a tax advisor who is very knowledgeable about the unique taxation issues faced by same-sex spouses.

Top 10 “saves” for tax year 2009 – Part Two

June 16, 2010

In my last post, I shared the first half of my Top Ten list for most valuable savings I found from reviewing tax returns that clients had prepared using tax software. All of the savings so far have been in the $2,000-$5,000 range. This time, the savings get quite large.

5) $8,000. Use an amended return to claim Homebuyer Credit when AGI was too high in year of purchase. Many taxpayers take distributions from retirement accounts to purchase a new home. Of course, these distributions get treated as income, which increases your Adjusted Gross Income. Numerous taxpayers, as a result of these distributions, suddenly found themselves with an AGI too high to qualify for the Homebuyer Credits. Fortunately, the IRS allows homebuyers to claim the credit for the year prior to the year of purchase. For many taxpayers, this is the difference between qualifying for $8,000, and getting nothin’.

4) ~$8,000-9,000. Avoid stock purchases within a retirement account during wash sale window. This one’s kind of cheating because the client didn’t come to me in time; I include it to point out the value of consulting a tax advisor before making big financial decisions. In a nutshell, the client sold a lot of stock, put the proceeds in a retirement account, and then bought the exact same stock within 30 days. Bad move. The original stock sale is now considered a “wash sale” and the loss on the stock can’t be taken as a capital loss. Long story short, the taxpayer lost over $8,000 in tax benefit by purchasing the stock too soon after selling. And unlike an ordinary wash sale, because the replacement stock was bought in a retirement account, he doesn’t even get benefit from the stock when it’s later sold. (I suspect this may one day be challenged in tax court, and the disallowed loss may be treated as basis in a retirement account…but the fact that one day a court case *might* allow him to receive some benefit is small consolation.)

4a) (OK, 4 wasn’t quite a save, and I remembered this one after publishing the first half of the list.) $4,000. Claim the full Homebuyer Credit even when you’re only a partial owner of a home. Unmarried individuals who purchase a home together may split up the Homebuyer Credit any way they want. I’ve talked to several people who thought each person could only claim half the total. If one person didn’t qualify for the credit, that part of the credit was just lost. Fortunately, wrong. If two unmarried people buy a home, and only one qualifies as a First-Time Homebuyer, that person can claim the entire $8,000 credit, not just $4,000.

3) ~$12,000. Use the best filing status when married. Most tax preparers, myself included, advise married couples it’s nearly always better to file jointly than separate. However, this couple had, in previous years, been in one of those rare situations where separate filing was better…and I saved them several hundred dollars at the time by pointing that out. A couple years later their situation changed, dramatically. Had they continued filing separately, it would have cost around $12,000 extra in 2009. Fortunately for them, they always have me review their return.

2) $15,000-$20,000. Used Section 121 (Primary Residence gain exclusion) to exclude gain on sale of rental property. This one’s not nearly as straight-forward as it sounds. In this situation, the taxpayer had converted a personal residence to a rental property, and then sold it at a gain. Naturally, he wanted to take the Primary Residence exclusion that he qualified for on the property. However, he noticed he reduced his taxes MORE by NOT taking the exclusion. He almost filed this way, but then decided to get a second opinion to understand why this was the case. The details are messy, but it basically came down to the types of losses freed up from other properties, and the fact his gain on the property sale was a long-term capital gain. While it was true he could save a few thousand dollars in the current year by not using the exclusion, in the long-term this was clearly the wrong move. The losses he “freed up” from other properties would remain available if he used the exclusion, and when those were later used they would be worth around $20,000, as opposed to only a few thousand now. (Yeah, the details would take several pages to explain, so I’ll just leave it at that.)

1) ~$30,000. Step-up basis in inherited property. Most people, when they inherit property, are advised that they can use the fair market value when the property was inherited as the basis of the property. This usually means the gain when the property is later sold is much lower. However, in some cases this advice is missed. In this case, a widow sold the home she and her husband had bought decades earlier. She had a taxable gain (after exclusion) of over $200k. Even at favorable capital gains rates, this still amounted to a tax bill of about $30,000. What she didn’t realize is that, living in the community property state of California, she received an increase in basis in the property when her husband died to the fair market value at that time. Based on the increased value, her gain on the sale was small enough to be excluded using the Primary Residence Exclusion, and she has $0 in additional tax as a result of the sale.

I review hundreds of returns every year, so you shouldn’t expect to save thousands just by having a professional review your tax return. But, my experience suggests that about 5-10% of taxpayers are leaving $1,000 or more on the table based on how they handle their taxes. Is that a risk worth taking to save $100 or less? All of the clients described above are certainly glad they didn’t take the risk.

Top 10 “Saves” for Tax Year 09 (part 1)

June 11, 2010

To give an idea of what you can save by having a professional review your work, I’m going to post the ten largest examples of savings I found when reviewing self-prepared returns this past tax season. Actually, some of the items where I caught the same mistake on multiple returns are condensed into one entry, so this probably represents 20 or so returns. Plus I compiled this list from memory, so I’m probably forgetting a few. To keep this from getting too obnoxiously long, I’ve split it into two parts. Without further ado, here are the biggest savings I found, numbers 6 through 10:

10) ~$2,000. VA educational benefits treated as taxable, allowing the American Opportunity Credit to be claimed. (Saw this multiple times.) VA educational benefits are generally non-taxable, but some types may be treated as taxable, allowing the American Opportunity Credit to be claimed. When a few thousand dollars in VA benefits are received, the taxes on that income will typically only be a few hundred dollars, while the American Opportunity Credit can be worth up to $2,500. It’s well worth it to recognize the income and pay a few hundred bucks in exchange for $2,500.

9) ~$2,000. QTP distribution treated as taxable, allowing the American Opportunity Credit to be claimed. (Saw this multiple times.) The rationale is basically the same as #10. As an added benefit to this approach, QTP distributions are typically only partially taxable (and not taxable at all when applied to room & board costs), so the tax you pay is reduced but the American Opportunity Credit remains the same.

8 ) ~$2,500. HSA contribution after Dec 31 and passive losses/depreciation corrected. This taxpayer was was doing their own return after having a professional prepare the prior year return. Several items were missed in transferring information (would have been caught if they’d used our Data Conversion service!). By correcting the depreciation information and picking up the passive losses, I helped this person save ~$1500. I also pointed out that with a family HSA, he could contribute another $2950 to the HSA before April 15 and have it apply retroactively to 2009, saving another ~$1000.

7) ~$4,000. Savings found via education credits and early withdrawal penalty exceptions. This one was very rewarding because of how much it meant to the client, who was recently unemployed and trying to support a child in college. This forced them to take an early withdrawal from a retirement account incurring substantial penalties. In addition to the QTP treatment described in #9, I also pointed out that they were eligible for a number of exceptions to the penalty for early withdrawals. By using the exception for room & board expenses related to education, and for health insurance costs for an unemployed individual, I helped them knock another $2000 off their tax bill. The total savings of around $4000 were a huge help to this family.

6) ~$5,000. Avoiding early withdrawal penalties can result in big savings. This couple bought a home qualifying as a “first-time purchase” at the same time they were putting a child through college. They knew they could exclude $10,000 of the distribution from penalty because of the home purchase. They didn’t know they could each exclude $10,000, or that they could use their child’s educational expenses to offset the penalty even though the distribution was actually used for the home purchase. The extra $10,000, plus nearly $40,000 in educational expenses, resulted in savings of almost $5,000.

That’s all for this post. Part 2 will be posted in a few days and the smallest savings amount on the rest of the list is about $8,000.

Tips for the newly self-employed

June 7, 2010

In these uncertain economic times, I find a very high number of clients and people I talk to about taxes are either starting or considering starting a small business. For most, this takes the form of something in addition to a regular job, often a hobby that they would like to turn into something profitable. Sometimes in response to a lay-off, individuals decide to strike out on their own, either because they’ve been wanting to or it’s simply a necessity in the current job market. For those individuals, here’s some important tax considerations for your new business.

One side note just for those who have found themselves working as “contractors” in a position similar to what they did for their previous company. As contractors, you are now “self-employed” and for tax purposes you have your own business…that is, assuming you are actually a “contractor”, not an “employee”. What’s the difference? you might ask. Well, there are a number of defining characteristics, that the IRS defines here. However, for practical purposes, being a contractor means you pay more taxes and have fewer legal protections and benefits (no workman’s comp, no unemployment insurance, etc.). If you’ve been hired back by a previous employer to do something similar to your previous job, but as a “contractor” rather than an “employee”, this may well be an illegal attempt by the employer to get out of their legal obligations as an employer. Just a heads-up for people in that situation. If you think you may be in this situation, the IRS provides guidance and procedures for handling this situation.

So, on to the tips for new small business owners…

1) Make sure you have a business, not a hobby. There is no hard and fast rule for what constitutes a business, but the IRS does have some guidelines for determining whether you have a business or a hobby. In short, you need to demonstrate you have a plan for being profitable within a specific time frame. If the IRS doesn’t think you legitimately have a business, you may lose all the deductions while still having to pay tax on the income you did receive. Example: “I like detailing cars and I’m pretty good at it. I’d like to start my own detailing business someday. Can I deduct the car shows I go to as a business expense?” Probably not. If you’re incurring more expenses than you have income, make sure you can demonstrate a clear business plan and intent to ultimately profit.

2) Document, document, document. Keeping records is always a good idea for any business regardless of tax implications. Having a separate business bank account & credit card should be one of your first steps when establishing a business. For tax purposes, you must be able to substantiate all business expenses–and sometimes a bank statement is not good enough, the IRS may require a receipt. Documentation is especially important when it comes to travel expenses, meals, and entertainment. Anything spent on these three items should have not only a receipt, but a record of what business was discussed at the event. In addition, if you want to deduct expenses for using your personal vehicle for business, you must keep a contemporaneous mileage log documenting the date, destination, where you travelled, and what the business purpose was. Mileage logs constructed long after the fact from estimates have been disallowed by the IRS in many audits and court cases.

3) Deduct your health insurance premiums. Large businesses don’t pay taxes on the health insurance they provide for employees; as a small business owner, you don’t have to pay income tax on your health insurance. If you have a health insurance plan established under your business–and the IRS has consistently held that for sole proprietors this includes a health insurance plan in your name–you may deduct the entire cost of your premiums under the Self Employed Health Insurance deduction (Line 29 on Form 1040). Long-term care insurance can also be deducted under this rule.

4) Know the rules for home office deduction. Many people are afraid to take the home office deduction because at various times the IRS has carefully scrutinized this deduction. Other people think they can take this deduction because they sometimes work on their laptop while watching TV in their living room. To deduct home office expenses, you need to have an area of your home set aside for exclusive, regular use by your business. By IRS rules, a spare bedroom that you sometimes let company stay in would not count–it must be exclusively for business use. On the other hand, the IRS does not require an entire room be used for business purposes, so if you only use half of a storage space as your office while the other half stores personal items, you may still take the home office deduction (as long as the business space is clearly delineated). It’s a good idea to review the IRS website for specific details if claiming this.

5) Know how to categorize your expenses. You do NOT have to be concerned about whether a particular item is categorized as “Supplies,” “Office Expense,” or “Other.” Generally speaking, if you have a system for categorizing your expenses that makes sense to you, use it. When filling out tax forms, it’s perfectly legal to put all your expenses under “Other” and then use whatever category names makes sense to you…with certain exceptions. It’s a good idea to always categorize meals and entertainment as a separate expense. The reason is meals and entertainment are only 50% deductible as a business expense. The second, and more important, exception is the costs incurred in purchasing “assets”. Assets are items with an expected useful life of more than a year. For example, computers are considered to have a five-year class life. These items should be categorized separate from normal expenses because they are usually deducted ratably over the length of their class life. There are ways to deduct the entire cost of an asset in the first year, but special rules apply. Always keep asset purchases in a separate category and your tax preparer can discuss your deduction options with you.

6) Take advantage of more favorable retirement plan rules. Individuals who don’t participate in a 401k through work usually have very limited options for contributing to a tax-favored retirement plan. The maximum amount that can be contributed to a Traditional or Roth IRA is $5000 ($6000 if over age 50). However, if you are self-employed, you may choose to establish retirement plans under your business such as a SIMPLE IRA or a SEP-IRA. SEP-IRA’s allow you to contribute up to 20% of your business income to a tax-favored account, up to a maximum contribution of $46,000. If your business is not very profitable yet, you could establish a SIMPLE IRA which would allow you to contribute up to $10,500 ($13,000 if over age 50) to the plan without having to worry about the 20% cap. The rules for these plans vary, consult your tax advisor.

7) Finally, make estimated payments to avoid a nasty surprise during tax season. You may not have to worry about making estimated payments at first, but once your business is making more than a few thousand dollars, you’ll need to consider making quarterly estimated payments of tax based on your expected income at the end of the year. By not making payments through the year, you can get hit with a large unexpected bill at the end, plus penalties from the IRS for not making timely estimates. Many married couples with one spouse self-employed and the other working a traditional job find it easier to simply increase the withholding for the spouse receiving a regular paycheck.Again, consult a tax advisor about your specific situation to find out whether you need to make estimated payments and how best to make them.