6 Facts about Deductions…and some common deductions that just aren’t worth tracking

March 25, 2011

We’re going back to basics with this post, taking a little break from the craziness that has been introduced to tax filing as a result of the IRS recognizing the property rights of same-sex spouses without actually recognizing that they are spouses (more on that here and in the links at the beginning of that post).

People often want to know whether various items are deductible. A better question is often, is it worth tracking this deduction?

The IRS Tip below explains the Standard Deduction (SD–not to be confused with STD, which should be avoided even more than the IRS). Nearly all filers are able to claim the SD without tracking anything. And frankly, for the vast majority of Single taxpayers with income under $50,000/yr, and Married Filing Joint filers with income under $100,000/yr, the Standard Deduction is what you’re going to take if you don’t own a home with a mortgage.

When people itemize their deductions, instead of taking the SD, it’s because their itemized deductions add up to more than the SD for their filing status. And the SD bar is fairly high (see below). Most people will pay some state income tax or sales taxes, which are deductible. But even in a very high tax state, you’ve got to have a pretty significant income before state taxes alone will get you close to the SD amount. If you’re like most of us sinners who don’t faithfully give 10% to charity, the charitable deductions probably won’t be enough to get you to the SD amount, even when combined with state and local taxes.

But what about all those job expenses, medical copays, tax preparation fees, and investment expenses you were told you could deduct? Well, many common deductions are deductible in theory, but not in practice for most people. The reason is because many common deductions are subject to AGI thresholds. In the case of medical expenses, only the amount of expenses that exceed 7.5% of your Adjusted Gross Income (AGI) can be deducted. (The threshold is 10% if you’re subject to AMT, but that’s another post.) Many things go into AGI, but most taxpayers can just think of their total income as their AGI to get a pretty good estimate. So if you earn about $50,000, your medical expenses must exceed about $3,750 before they can *potentially* be deducted. But even then, they have to add up to more than your SD when combined with other itemized deductions. Otherwise there’s no benefit to deducting them.

Most other common expenses–job expenses, investment expenses, tax preparation fees–are subject to a 2% of AGI threshold; i.e. the expenses in this category must add up to more than 2% of your AGI before they can *potentially* offer any benefit. [NOTE: If you are self-employed, your business expenses are directly deductible against income, regardless of whether you itemize or take the standard deduction.]

The upshot of all these different thresholds for most people is that it’s just not worth the trouble of tracking work expenses, medical copays, etc. This is especially true if you don’t own a home with mortgage interest.

Of course, you never know when you might have some huge medical expense or job-related expense near the end of the year, so it’s probably not a bad idea to keep these receipts somewhere you can dig them up if that happens. But if you know you didn’t spend more than a few hundred dollars on deductible expenses, or even a couple thousand dollars in the case of medical expenses, then save yourself some trouble and don’t worry about adding up all those receipts at the end of the year. Just toss that shoe box of receipts in the recycle bin and start a new shoe box for next year.

And now without further ado, here’s a word from the IRS…

IRS Tax Tip 2011-48, March 9, 2011

When filing your federal income tax return, taxpayers can choose to either take the standard deduction or to itemize their deductions. The IRS has put together the following six facts to help you choose the method that gives you the lowest tax.

Whether to itemize deductions on your tax return depends on how much you spent on certain expenses last year. Money paid for medical care, mortgage interest, taxes, charitable contributions, casualty losses and miscellaneous deductions can reduce your taxes. If the total amount spent on those categories is more than your standard deduction, you can usually benefit by itemizing.

1. Standard deduction amounts are based on your filing status and are subject to inflation adjustments each year. For 2010, they are:

Single     $5,700
Married Filing Jointly   $11,400
Head of Household   $8,400
Married Filing Separately  $5,700
Qualifying Widow(er)  $11,400

2. Some taxpayers have different standard deductions The standard deduction amount depends on your filing status, whether you are 65 or older or blind and whether an exemption can be claimed for you by another taxpayer. If any of these apply, you must use the Standard Deduction Worksheet on the back of Form 1040EZ, or in the 1040A or 1040 instructions. The standard deduction amount also depends on whether you plan to claim the additional standard deduction for a loss from a disaster declared a federal disaster or state or local sales or excise tax you paid in 2010 on a new vehicle you bought before 2010. You must file Schedule L, Standard Deduction for Certain Filers to claim these additional amounts.

3. Limited itemized deductions Your itemized deductions are no longer limited because of your adjusted gross income.

4. Married Filing Separately When a married couple files separate returns and one spouse itemizes deductions, the other spouse cannot claim the standard deduction and therefore must itemize to claim their allowable deductions.

5. Some taxpayers are not eligible for the standard deduction They include nonresident aliens, dual-status aliens and individuals who file returns for periods of less than 12 months due to a change in accounting periods.

6. Forms to use The standard deduction can be taken on Forms 1040, 1040A or 1040EZ.  If you qualify for the higher standard deduction for new motor vehicle taxes or a net disaster loss, you must attach Schedule L. To itemize your deductions, use Form 1040, U.S. Individual Income Tax Return, and Schedule A, Itemized Deductions.



A Quick Community Promo –> Oakland Indie Awards!

March 21, 2011
Oakland Indie Awards

Nominate your local favorites today :)

Join One PacificCoast Foundation and East Bay Express as they honor and celebrate Oakland businesses and artists. Save the date and nominate!

Nominate by April 1
Nominate the Oakland businesses and artists that make a difference in our neighborhoods for categories like Oakland Soul, Ripple, Greenie, the new Socially-Responsible Rockstar, and more! Make your nominations here.

Winners will be announced at the party – come help us celebrate! You’ll get to taste Oakland’s global comfort food, wine, beer, tantalizing candy bar, teas, baked goodies, and so much more! Talk to hundreds of other Oakland lovers, and chill to Oakland tunes.

Party – Friday May 13, 2011
6:00pm – Awards Ceremony – Lakeside Theatre
6:30pm to 10pm – Party – Garden Room & Lakeview Terrace
Kaiser Center
300 Lakeside Drive, Oakland

Tickets On Sale Now for $10
Get Your Tickets Here

-Global Comfort Foods – Beloved foods from Oakland’s delicious melting pot: what your Korean, Mexican, Japanese, Italian, Thai, American and other moms would make
– Cupcakes on Roller Skates with the Oakland Outlaws
– Art Before your Eyes- amazing live art demonstrations
– Oakland Candy Bar
– East Bay Express photo booth
– DJ spinning all-Oakland tunes
– Fabulous finds from Oakland Unwrapped! artists and businesses

Sponsorships Available
Be a sponsor and get in front of over 1000 small businesses, artists, civic leaders, community organizations, and Oakland residents!

Want to get involved?
– Be a food or drink vendor
– Musicians – get on the set list!
– Volunteer the day of, help out in the weeks ahead!
– Be an Oakland Indie Ambassador & help spread the word through your social networks!

Connect with the Oakland Indie Awards online:

Find us on Facebook Follow us on Twitter

Add to Your Calendar

Did the IRS intend to give same-sex couples a 50% Self-Employment Tax break?

March 20, 2011

With any luck, this will be my last post for awhile on the strange tax consequences of being a Registered Domestic Partner or same-sex spouse in a community property state. I think the multiple posts to this point cover the topic pretty exhaustively, at least for what you can really learn about a topic from blogs. (See here for the main overview, and here, here, and finally here.) More guidance is available in IRS Publication 555, but as we’re about to see, even that is lacking guidance in crucial areas, one in particular.

Also, the Class 5 Resources page has an updated worksheet to help RDPs/same-sex spouses in community property states (CA, NV, and WA) to correctly allocate their income and deductions for federal tax filing.

So in general, community property rules state that when a spouse earns income, that income belongs equally to both spouses in the relationship. (Historical footnote: this dates back to property law in Catholic Spain, which is why most of the community property states are in territory that used to belong to Mexico when it was a colony of Spain. The community property states are LA, TX, NM, AZ, CA, NV, WA, ID, and (sort of) WI. Don’t ask about the “sort of”… )

For same-sex partners, and other married couples who don’t file joint federal returns, this means numerous adjustments must be made to income and deductions. One area that doesn’t get adjusted, however, is Self-Employment income. This is stated clearly in Publication 555, which says that for Self-Employment Tax purposes, no income is allocated to the spouse. The spouse that actually works for the income pays the Self-Employment Tax on the entire amount.

This is simply a clear statement of Internal Revenue Code (IRC) Section 1402(a)(5). But here’s the catch. IRC 1402(a)(5) refers to a “spouse”. And because of DOMA, same-sex partners are not considered spouses under any federal law, regardless of their relationship status under state law.

So IRS Publication 555 states “RDPs and same-sex spouses in California report community income for self-employment tax purposes the same way they do for income tax purposes.” OK, so clearly this means that the spouse who works for the income allocates half of that income to the spouse, and therefore pays self-employment tax on only half the amount. No problem there. But what about the spouse who didn’t earn the income? The spouse must report half of the income for income tax purposes and for self-employment tax purposes. But does that mean that the spouse who did nothing to earn the income pays tax as though they did?

That might seem unfair, but frankly, fairness doesn’t really matter in this discussion. We’re talking about the tax code. And, in fact, the tax code does not seem to support the notion that a person can pay self-employment tax on income in this situation.

IRC Section 1401 states that self-employment tax is imposed on the “self-employment income” of every individual. IRC section 1402(b) defines “self-employment income” as the “net earnings from self-employment” by an individual meeting certain criteria. And 1402(a) defines “net earnings from self-employment” as the “gross income derived by an individual from any trade or business carried on by such individual (…).”

So following that series of definitions leads to the logical conclusion that an individual can only be subject to self-employment tax if “such individual” actually carried on a trade or business. For a same-sex spouse who receives business income merely from an act of property law, it is difficult to see any reasonable way the spouse could be considered to be “carrying on” the trade or business. The inactive spouse may do nothing to participate in the business. Absent such participation, the only other way an individual can be subject to self-employment tax is to be a “general partner” in a partnership. A “partnership” is not explicitly defined in the tax code, but the consensus legal definition seems to require a relationship entered into with a profit motive. This clearly isn’t the case for Registered Domestic Partners. So there seems to be no rational basis for considering a same-sex spouse to be “carrying on” a business when he or she derives income from the spouse’s business by mere act of property law.

So this seems to leave us with the very surprising result that a same-sex couple with self-employment income may only pay half the Self-Employment Tax as  a heterosexual married couple with one spouse earning the self-employment income. For example, an individual with $100,000 of self-employment income would normally pay just over $15,000 in self-employment tax, but in the case of a Registered Domestic Partner would pay only about $7,500. The other Partner would pay no self-employment tax on their half of the earnings. The RDPs get a $7,500 tax break compared to a heterosexual couple in an otherwise identical situation.

This is not legal advice. I am not advising anybody to take this position on the basis of something you read on a blog. Even if this interpretation is legally correct, you may very well have to go to Court with the IRS to prove it. (Or maybe not…it’s hard to say at this point what the IRS’ intention is.) But it’s certainly something interesting to consider and discuss with your tax advisor.

Of course, taking the other interpretation, that a Registered Domestic Partner IS subject to self-employment tax based on their partner’s income, also produces a rather surprising result. Self-employment taxes are how an individual earns credit in the Social Security system. This credit determines how much SS you will receive up on retirement, and how much you would receive in the event of disability. So if a Registered Domestic Partner does pay self-employment taxes on the partner’s income, you would have the result where same-sex spouses are earning Social Security Benefits based on their partner’s earnings. This does NOT actually violate DOMA (I checked), but it certainly goes against the an underlying principle of DOMA: namely, the belief that same-sex spouses should not receive federal benefits on the basis of their relationship.

And it gets crazier. If an individual can have “earnings” based on their same-sex spouse’s earnings, what does this do in the case of disability claims? Could an individual be denied disability because of the “earned” income they derive from their Partner? Or, conversely, could a disabled individual earn credits, and keep increasing their disability benefit after they become disabled, based on the earnings of their Partner?

The idea that same-sex partners would get a 50% tax break on self-employment tax seems bizarre. But in my mind it’s not nearly as bizarre as the results that would come from a same-sex spouse being able to earn Social Security credits on their partner’s earning record.

This is turning out to be quite the Pandora’s box that has been opened up by the Federal government’s refusal to recognize unions formed at the state level. Sure will be nice when we can put this DOMA thing behind us and end all these crazy games.

California RDP in 2007? Only one month left to claim a tax refund

March 16, 2011

The new tax rules for Registered Domestic Partners in California (and other community property states) have been in the news a lot lately (here and here, for example). Unfortunately, most of the coverage seems to be focused on the complexities and filing issues introduced for 2010 tax returns. What’s not being mentioned is the fact that many California Registered Domestic Partners who began their partnership in 2007 or earlier are running out of time to amend their returns and claim a refund.

California is the only state to extend community-property treatment of income to Registered Domestic Partners in 2007. (Washington and Nevada have since followed suit, but the changes didn’t take effect until later years.) Because of this, individuals who were in an RDP relationship in California in 2007 have the option–but not requirement–to amend their 2007 returns if the rule change is beneficial to them.

However, because the IRS limits the amount of time you have to file and claim a refund, most taxpayers will run out of time to file an amendment for refund for 2007 in April of this year.

How much could it cost you if you don’t amend? Well, it depends on your situation, but generally the biggest factor to consider is how much of a difference existed in the income of the two partners. Generally the bigger the difference, the bigger the refund. The average amount of refund I’ve seen so far has been around $1,000. The largest refund for a single year I’ve prepared was worth around $10,000!!

Don’t leave that kind of money on the table! Talk to a tax professional, and get your 2007 amendment filed before the April filing deadline!

Minimizing tax on pension and IRA withdrawals

March 10, 2011

The IRS recently posted the information below…and at about the same time I was helping an unemployed taxpayer save thousands by showing this person how to avoid penalties on an IRA distribution that was used to get through the lean times. So if you’re under age 59 1/2* and had to take a pension or IRA distribution last year, or you’re considering taking one, make sure to look carefully for all the possible exceptions to the early distribution penalty. There are several ways to get money out of an IRA or pension without penalty even if you’re under age 59. I’ll give you a few of the more common exceptions, but to find a complete list, start with page 3 of the Form 5329 instructions or consult with a well-qualified professional.

[*If you have an employer-based plan and you’re separated from service, you can start taking distributions penalty-free at age 55 instead of 59 1/2.]

First, make sure you have a taxable withdrawal. If you’ve contributed to a Roth IRA, or made non-deductible contributions to a Traditional IRA (or the equivalent employer-based plans), then part or all of your contribution might be tax-free. With Roth IRA distributions, all of your distributions are tax- and penalty-free until you’ve distributed an amount equal to your contributions to the plan. (If you’ve converted Traditional IRA money to a Roth, you’ll have to wait five years before withdrawing these funds without a penalty.) With Traditional IRAs, the formula is more complicated…basically a portion of your distribution is non-taxable based on the portion of your IRA value that comes from non-deductible contributions. See Form 8606 for the details of that calculation. The amount of your distribution that is tax-free will also be penalty-free.

Once you’ve determined some or all of your distribution is taxable, you’ll want to start looking for exceptions to the early withdrawal penalty. Some of the most common ways we find to avoid these penalties relate to education and medical expenses. Unemployed individuals are generally able to avoid the penalty for amounts equal to what they pay for health insurance. And if you had major medical expenses (greater than 7.5% of your income), you may be able to exclude part of these costs from penalty as well. Students are able to avoid the penalty for amounts equal to what they pay for qualified education expenses. And here’s a little known twist on education…if you’re at least a half-time student, you can include an allowance for room and board in your “qualified education expenses”–even though room and board is usually not considered an education expense for most purposes. Your school’s financial aid department should be able to help you determine the official room and board allowance for your school. Some other exceptions exist, and they might be worth looking into depending on how large your penalty might be, but they’re unlikely to apply if you took a withdrawal due to financial need.

If you’re considering a withdrawal, and considering a home purchase, be aware that there’s a $10,000 exception for qualified “first-time home buyers” (which includes taxpayers who haven’t owned their home in the last two years). This exception can be used by both spouses, so it can be used to exclude $20,000 from penalty on a joint return. This exception can be used once in your lifetime. Of if you’re in your 50’s, you might be able to take advantage of an exception that applies to a series of substantially equal payments made over a series of years. The payments must last at least 5 years or until you reach age 59 1/2, whichever is later, so this requires careful planning.

Be aware that some of these exceptions apply to individual retirement accounts like IRAs, some to employer plans like 401k’s, and some apply to both types of plans. Before applying any of these exceptions, or taking any action based on the intent of applying any of these exceptions, make sure you do your homework or consult a professional.

And without further ado, here’s what the IRS had to say on the topic:

Some taxpayers may have needed to take an early distribution from their retirement plan last year. The IRS wants individuals who took an early distribution to know that there can be a tax impact to tapping your retirement fund.  Here are ten facts about early distributions.

  1. Payments you receive from your Individual Retirement Arrangement before you reach age 59 ½ are generally considered early or premature distributions.
  2. Early distributions are usually subject to an additional 10 percent tax.
  3. Early distributions must also be reported to the IRS.
  4. Distributions you rollover to another IRA or qualified retirement plan are not subject to the additional 10 percent tax. You must complete the rollover within 60 days after the day you received the distribution.
  5. The amount you roll over is generally taxed when the new plan makes a distribution to you or your beneficiary.
  6. If you made nondeductible contributions to an IRA and later take early distributions from your IRA, the portion of the distribution attributable to those nondeductible contributions is not taxed.
  7. If you received an early distribution from a Roth IRA, the distribution attributable to your prior contributions is not taxed.
  8. If you received a distribution from any other qualified retirement plan, generally the entire distribution is taxable unless you made after-tax employee contributions to the plan.
  9. There are several exceptions to the additional 10 percent early distribution tax, such as when the distributions are used for the purchase of a first home, for certain medical or educational expenses, or if you are disabled.
  10. For more information about early distributions from retirement plans, the additional 10 percent tax and all the exceptions see IRS Publication 575, Pension and Annuity Income and Publication 590, Individual Retirement Arrangements (IRAs). Both publications are available at IRS.gov or by calling  800-TAX-FORM (800-829-3676).

Some same-sex spouses in California get better tax treatment than married couples

March 7, 2011

Just a quick follow-up to an earlier post about some of the few advantages for same-sex spouses in the tax code. This one generally only applies to same-sex spouses and Registered Domestic Partners in community property states, though it also might apply if both spouses are high earners with similar income in separate property states. (Currently the three community property states that recognize same-sex marriage or registered domestic partnerships are California, Nevada, and Washington.)

If you’re lucky enough to have a high income while in a RDP relationship or same-sex marriage, you can avoid the dreaded “marriage penalty.” The marriage penalty refers to the fact that when taxable income exceeds $137,300 for a married couples, their tax liability is actually higher as a result of being married than it would be if each spouse filed single and reported half of the total income. (Note: Married couples can’t get around this by simply filing separately; the tax brackets are even worse for people using the Married Filing Separate filing status.)

However, if you’re married to a same-sex partner and living in a community property state, then federal law requires you to file using Single filing status, and report half of the combined income of you and your spouse. In other words, you get to use the optimum reporting method for recognizing your joint income…a method that makes your taxes lower than what they would be if the government recognized the marriage. This also works for same-sex partners in separate property states if both partners have relatively high incomes, say above $90,000 or so depending on the deductions claimed.

Here’s a very simple example: Imagine a married couple with total household income of $300,000. To keep this very simple, we’ll assume they have no deductions except the standard deduction and personal exemptions.** In this simple example, the married couple would have a total Federal tax liability of $70,714 if they file a joint return. However, if this married couple is of the same sex, and their marriage isn’t recognized by the federal government, then each spouse reports $150,000 of income on a tax return using the Single filing status. In this case, each taxpayer has a tax liability of $33,091. So the combined household tax liability is only $66,182…a savings of almost $5000 over the couple whose marriage is recognized by the Federal government!! And the higher the income, the more pronounced the effect. As mentioned above, the effect starts when taxable income (total income minus deductions) exceeds $137,300 combined for the couple.

To repeat what I stated in my earlier post on this topic, I must admit I’d much rather be able to simply help my same-sex spouse clients to file a Married Filing Joint return. The benefits of being treated equally I’m sure far outweigh the financial benefits of some loopholes in the tax code. But until that happens, I’m happy to find every loop hole I can to help same-sex partners get every benefit legally available.

Who knows? Maybe those opposed to same-sex unions will be so outraged when they find out about these “benefits” that they’ll realize what a waste of time and energy it is to try and create two separate classes of legal unions between people who love each other.

**If you’re familiar with California and itemized deductions, you probably realize how absurd it is to assume itemized deductions for a household earnings $300,000. Yeah, I know, it’s for simplicity, OK? The principle described here works just as well for a household with a bunch of deductions.

Somebody claimed my dependent! Now what?

March 3, 2011

Every year thousands of taxpayers attempt to e-file their return, only to get a nasty surprise–somebody else claimed one of their dependents. In the IRS e-file system, once a taxpayer appears as a dependent on a tax return, no other return will be accepted with that same person also claimed as a dependent. Unfortunately, some unscrupulous individuals will rush out and claim a dependent, usually a child, that they aren’t legally allowed to claim on a return filed very early in the tax filing season. Most commonly, this occurs among separated parents when a non-custodial parent with no permission to claim a dependent does so anyway.

So what does the person legally entitled to claim the dependent do? Well, while the authorized parent will wind up getting the tax breaks they’re entitled to from the dependent, unfortunately it may take some time.

In order to claim a dependent that has already been “claimed” in the e-file system, a taxpayer will have to file a paper return by mail. With that return, the taxpayer may want to include a brief letter explaining the situation, and include an item of evidence that the taxpayer actually has the right to claim the dependent in question. For example, a parent could include a copy of the child’s report card mailed to the parent’s address as proof of being the custodial parent. Most likely (although I am not aware of any fixed policy on this), the IRS will process the refund for the taxpayer based on claiming the dependent in question. Several months later, both individuals who claimed the dependent will likely get letters from the IRS demanding proof that the child may legally be claimed by the taxpayer. The unauthorized parent, as determined by the evidence provided to the IRS, will have to pay back the difference in taxes resulting from the dependent, and significant penalties as well.

Unfortunately, paper filing means waiting longer to get a refund. For many parents, this money may be urgently needed, and the extra weeks (or possibly months) involved in processing a paper return can cause financial difficulties. In this situation, there is one strategy that may offer some help. If the authorized parent is getting a refund even without the child that has been improperly claimed, then one strategy is to e-file a return claiming all dependents, deductions, and credits except for the dependent who is already claimed. This will result in the taxpayer getting part of the refund very quickly. The remaining refund can then be claimed by filing an amended return that includes the dependent in dispute. Filing the amendment will lead to the same process described above; both taxpayers claiming the dependent will be contacted and asked for evidence of their position.

Unfortunately, this situation is so common that nearly all tax preparers have seen it at some point, often multiple times. But rest assured the IRS will make sure that only individuals legally authorized to claim dependents will actually get the tax benefits from doing so.