Keeping finances separate in a community property state

June 29, 2011

This year has been the year many California preparers, including myself, have become far more familiar with the legal intricacies of community property law than we ever imagined we would be.

This was the first tax season in which the IRS has required same-sex married couples and Registered Domestic Partners to use community property law if they live in a community property state that recognizes their relationship (currently, California, Nevada, and Washington are the 3 this applies to). Community property law is nothing new–it’s been around for centuries–but the tax implications of it have not been greatly explored for a simple reason: Couples subject to community property rules have historically been allowed to (and nearly always do) file a joint tax return with all income from both members of the “community” reporting their income on one tax return.

Because same-sex couples aren’t legally allowed to file joint Federal tax returns, they must sort out who gets what under the sometimes nearly incomprehensible rules of community property so they know what to report on each person’s individual return. The basic idea is simple: In a marriage or other relationship in which community property applies, all income earned while the union exists belongs equally to both members of the relationship. But like many basic principles in taxes and the law in general, what sounds simple at first becomes very complex in the real world.

[One of my favorite examples of a simple thing becoming highly complex is how to treat pension income. Legally, when one partner receives pension income, a portion of the income is “community income” and a portion is “separate income.” The way you determine which is which is by looking at all the money that ever went into that pension and determining how much of that money was earned prior to the community property union, and how much was earned during the union. You’ve kept all your pay-stubs for your entire working life, haven’t you?! (If you have, I want you as a client! So far all my clients are real, normal people who don’t have documentation for every transaction in their entire life…)]

So while most couples who’ve been together a long time have their own ideas of what’s mine, yours, and ours, when it comes time to do taxes, everything must be categorized as either mine or yours and it must be done according to specific rules. So you might think it makes sense for the higher earning spouse to deduct all the mortgage interest that came from a shared account, but the reality can be much more complex. For starters, the “higher earner” usually isn’t the higher earner after half of the earnings are allocated to (and reported on the tax return of) the other partner. More to the point is the fact expenses that are paid from “community” funds are almost always deemed to be paid one half by each partner.

This rule can be problematic for certain expenses. For instance, medical expenses are best paid from “separate funds” for two reasons–one reason is related to tax calculations, but the other reason is a simple matter of the IRS may disallow the deduction for the partner who didn’t actually incur the medical expenses because the other partner is not legally “family”.  Many expenses could potentially become partially non-deductible if paid from community funds, or could offer better tax benefit if paid from separate funds.

Most student expenses can be paid from community or separate funds (because school expenses paid by somebody other than the student are generally deemed to be paid by the student anyway), but student loan interest payments should probably be paid with separate funds. Investment and tax preparation expenses should generally be paid from separate funds for maximum tax benefit.  Child care expenses should also be paid from separate funds to avoid having half the credit potentially disallowed. There are far too many areas to list them all, but that’s just some of the more common expenses that are best paid from “separate” funds.

Now that brings us to the question of what are “separate” funds, or “separate” assets, or “separate” property? Legally separate property includes any assets or property a partner brings into a community property relationship, as well as any property acquired during the relationship by gift or inheritance. As long as such property is not significantly intermingled with “community” property–such as earnings from a job–the property will remain separate. So, for instance, both partners may bring their own savings accounts into a relationship, and both partners have their paychecks deposited into those savings accounts. The accounts start out as separate property, but since they are intermingled with community income, they will become community assets over time. (How much time? There’s some real grey area here, but the key is how large the paychecks are relative to the account balance at the beginning of the relationship.)

So let’s say a couple has been together a long time and all of their assets are so intermingled that everything is community property at this point. If this couple wants to establish “separate” funds for the purposes above (and others), how do they do that? Unfortunately, it’s not as simple as just putting only one partner’s name on a bank account. If the funds in the bank account are community income (like most earnings), then the account is community property. To have separate property, remember, the property must have been brought into the relationship, or acquired by one partner through gift or inheritance. Establishing a separate account after the relationship requires you to fund the account with either income from separate property (e.g. funds from Social Security or a pension earned before the relationship, or income from a rental property owned ahead of time) or property received by gift or inheritance.

If there weren’t significant assets brought into the relationship, that seems to leave you waiting for a rich uncle to give you a fat birthday check or an inheritance.  However, there is one nice trick I learned from a lawyer (who regularly works with community property issues) that makes this much easier.  One partner can simply give a gift to the other partner. Write a check for $10,000 from one partner to the other out of a community account. $5,000 is deemed to be a gift (the other $5,000 belonged to the recipient already under community property law) and therefore the separate property of the recipient. You can do this with up to $26,000 each year (half the total, $13,000, is deemed to be a gift) without having to file a gift tax return.

Using this simple method, as well as keeping other separate items such as pension income in separate accounts, will allow partners to truly determine who paid what for tax purposes. There are many advantages to this, depending on your tax situation. You should probably consult with a tax professional about your specific situation, but there are some general rules of thumb.

  • Any personal deductions that clearly relate to one partner or the other (e.g. medical expenses, education expenses, etc.) should be paid by that partner from separate funds.
  • Any deductible expenses related to a child should be paid from separate funds by the partner who claims the deduction for that child.
  • Any deductible expenses related to property that is titled in only one partner’s name (e.g. Real Estate taxes and mortgage interest on the home the couple lives in, but only one name is on the title) should be paid with separate funds by the person on the title.

(A community property lawyer might  take issue with the last one since there’s a good legal argument that even the person who is not on the title should still legally be able to claim the deduction…but just because you think you can win an argument in court doesn’t mean you shouldn’t avoid the argument in the first place if possible. My advice is use separate funds and have the partner on the title take the entire deduction in order to avoid a dispute with the IRS.)

Look for a follow up post at some point enumerating more examples of what expenses are best paid from separate funds along with a little more explanation. For now, hopefully that gives you some basic pointers on when to use separate funds to pay for deductible expenses, and how to establish what is “separate” if you’re in a community property state.

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IRS increases the deduction for mileage

June 24, 2011

If you drive a lot for business purposes–or medical purposes–the IRS is offering a little bit of relief to offset rising gas prices. The IRS just announced the standard mileage rate for travel for business or medical purposes is going up by almost 5 cents/mile. It might not sound like a lot, but if you drive a lot for business, it can easily add up to hundreds, possibly thousands, in additional deductions. The new rate will be 55.5 cents per mile for business travel and 23.5 cents per mile for medical travel.

One thing to note is the new rate goes in affect July 1, 2011, so it will only apply to mileage driven in the latter half of the year. It’s a good idea requirement when deducting mileage that you keep a log of your mileage that includes the purpose and the date. So you’ll need to pay attention when adding up mileage this year to make sure you take the larger deduction for all your miles after July 1.

Another thing to keep in mind is if you take the standard mileage rate for business travel, that means you don’t deduct your cost of gas, maintenance, insurance, etc. You must choose to either deduct the standard mileage rate, or add up all of your actual expenses and deduct a portion of those expenses that corresponds to your business usage.

For those who drive for charitable purposes, you might be wondering if this will increase your charitable deductions at all. Unfortunately, no. The current charitable rate remains at 14 cents a mile. So the IRS doesn’t like charities, huh? Actually, no, this is a case of the IRS giving the break, while Congress is being stingy. The deduction rate for charity is set directly by the IRS, and they haven’t touched it in a long time. However, Congress left it up to the IRS to set the rate for business and medical miles, and the IRS has regularly adjusted the rate to keep up with rising costs. So who would have thought…the IRS is the good guy here ;-)


So you want to be a tax preparer?

June 21, 2011

A reader writes in:

I have a question for you that is a little outside what you normally answer (I think). I “retired” ([laid off]). However I am only in my late 50s, feel 30 and feel like I can work for 20 or more years. I have a Masters degree (…) but there are NO jobs. My question to you is, do you think it is wise for me to go and take classes (H&R Block or some other training) to do become a tax preparer? I am reasonably bright, excellent on computers and have good people skills. I like the idea of having very busy times and then slow times (I like to travel so I could take advantage of the slow times). On doing research, it appears I can probably make $30 to $40 thousand a year (I live in Northern CA) at a minimum, which while not being a lot would keep me from touching my 401k. Any suggestions/warnings/ideas would be appreciated (especially if you have an idea on which places training is the best).
-Gary

Thanks for your question, Gary. I can definitely relate to this one, as a significant factor in my decision to become a tax preparer was the lack of jobs in my field at the time. The seasonal nature of the work was also appealing, and I continue to enjoy having more flexibility in the summer for travel and other interests.

So here are some thoughts informed by my own personal experiences. I did start out in one of the well-known chains. It’s not a bad way to go, but in retrospect I might have gone a different route.  Here’s the pro/con from what I experienced:

Pro:

  • You’ll get to complete tax returns start to finish in your first season.
  • The chain I started with, and I think this is true of all of them, have a wealth of on-line resources available to employees for continuing education purposes. This was the key to my success in the field…I took advantage of as many course offerings as I could and within 2-3 years had more tax knowledge than many of the far more experienced veterans I worked with.

Con:

  • The chain stores tend to train you to follow a computer program. (The resources are available to learn the tax knowledge, but the initial training is more focused on following computer prompts.) They also tend to get clients with very simple returns. You could do a lot of work for a chain store without gaining a lot of experience that increases what you know.
  • I was never very comfortable with the way chain stores tend to push expensive financial products on typically low-income people who could least afford the fees. My one “weakness” in my performance reviews was a relatively low take rate on some of these items. Of course, other employees felt that if people willingly signed up for these products that was their free choice. Fair enough. Just something to be aware of and make your own decision about.
  • The starting pay is quite low. The chains typically start you at little more than minimum wage. There are incentive bonus plans that make it possible to make more (much more in some cases), but at the beginning, when you’re the last preparer to get new clients that walk in, and you have no return clients, you probably won’t get much of a bonus. You might get lucky and be in a busy office that keeps you busy, but I wouldn’t count on a large bonus the first season.
So basically, my experience with large chains is that they’re a good way to get your foot in the door,  so to speak. I’ve known of a few (very few) people who’ve stayed with the chains for a long time and now make something in the $30k-40k range you refer to (and more in some cases) just working tax season, or more if they work at year-round offices and have other duties like training new preparers. But I’d consider them the exception more than the rule. They invariably will have a large base of return clients (part of compensation is based on return clients), so your people skills are considerably more important than tax knowledge if you stay in that environment. While I don’t deny people skills and service are a critical part of any tax practice, or any business for that matter, I personally wanted something a little more intellectually challenging.
[As an aside, when I have prospective clients who are considering going to a tax chain, I usually point out that preparers just starting out there make about the same amount of money and have little more time in training than many fast-food workers. Your most significant financial transaction of the year probably shouldn’t be left in the hands of a fry cook ;-) ]
The alternative to the chains is working for a CPA or Enrolled Agent firm. I moved into working for a CPA firm after the chain. And now I have my own firm as an Enrolled Agent. (And just to round things out, I also have done software testing for a tax software company. So I’ve seen the field from every angle :-) ) If I had to start over again, I would probably start by taking the mandatory training classes at a community college. Many community colleges offer the necessary course at very reasonable prices. These courses will focus on the nuts and bolts of the tax forms, not simply following a computer program. With a solid grade in one of these courses, you should be able to find seasonal work for a CPA or Enrolled Agent in your area. Just about every firm I know needs to hire additional people during tax season. You’ll be preparing the more basic returns (though still probably as complex or more complex than what you’d generally see in a chain), and your employer will probably review and sign off on your work. This is good because you get immediate feedback if you’re doing something wrong.
The potential downside is a small firm likely won’t have the training resources of a big chain. But many education providers are now offering “buffet” options for firms, allowing employees of firms to take as many online offerings as they want and pay only a small fee for the courses they want to “count” as part of the ongoing Continuing Professional Education requirement. That’s definitely something to inquire about.
Realistically, either way you go it will probably be quite some time before you make $30k-40k per year working just during the 3-4 month tax season. I don’t know of anybody who has achieved that in less than 5-10 years, and it’s far from guaranteed even then. You may be able to find an accounting firm that will have year round work for you doing various administrative tasks, which would make the $30k-40k starting figure entirely reasonable. Or they may need you during tax season, and then for short periods like when quarterly payments or due or the extended filing deadline is approaching. This would also allow you to reach $30-40k sooner. (I think I’ve seen some of those same sites you refer to indicating starting salaries of $30k-40k. The only thing I can figure is they’re taking the starting hourly rate from tax season and projecting it out over an entire year of full-time work.)
Hope that helps provide some useful information about the field. If you decide to take the training class, check back in about November when I’ll probably be hiring ;-)

2 out of 3 paid tax preparers have no professional credential at all

June 2, 2011

Wow, where did the month of May go? I just realized I’ve only posted one article for the entire month of May…how did that happen? Well, I’ve got a few articles in process on tax strategies, including at least one more on the popular Registered Domestic Partners in Community Property states topic, but this is just a quick post on something that hit my Inbox recently.

According to IRS Return Preparer Office Director David Williams, nearly 2/3 of all paid tax preparers have absolutely no professional credential whatsoever!

In an interview with Taxanalysts’ Nicola White on May 26, David Williams discussed the IRS’ new requirement for all paid tax return preparers to register for a Preparer Tax Identification Number (PTIN). Out of over 700,000 individuals who registered, 62% had no professional certification at all! Not CPA’s, not Enrolled Agents, and probably in many cases not even college graduates.

The new PTIN efforts by the IRS are definitely a step in the right direction. Finally, people who get paid to help others with the most significant financial transaction of the year for most people–filing an annual income tax return–are at least required to be registered and demonstrate basic proficiency. But let’s be clear this is only a very small step. The new requirements demand only that such individuals complete 60 hours of training and pass a basic proficiency test. It’s roughly the equivalent of passing a single 4 credit-hour freshman college class. Better than nothing, but still…

Just goes to show that if you’re going to pay a professional to handle your taxes, or even (as we always suggest) review your work, you need to make sure that “professional” is truly an expert. Turns out 2 out of 3 “professionals” have nothing to demonstrate this kind of knowledge or experience. When considering a tax preparer, make sure you’re working with a CPA, Enrolled Agent, or Tax Attorney. Mistakes on a tax return routinely cost thousands of dollars. With stakes that high, you can’t afford to work with somebody who lacks one of those critical professional designations.