Audit Target: The Sole Proprietor

Are you prepared?

Each year the IRS publishes their activities in a publication called the Data Book. And each year for the past number of years the number one target of audits are those tax returns with a Schedule C for small business activity. So how to prepare yourself for a possible audit? Here are some tips.

• Keep records separate. The quickest way to get a deduction for your business disallowed is to blend your personal bills with those from your business. Open a separate checking account and use a separate credit card for business expenses.
• Keep logs. Keep a logbook for business miles. Keep receipts for business meetings and meals. Include the date, time, subject, and who was present at the meeting.
• Ordinary and necessary. Two key words to use to qualify legitimate, deductible business expenses per the IRS are;
• Ordinary: an expense that is common and accepted in your industry.
• Necessary: an expense that is helpful and appropriate for your business.
• Business not hobby. A qualified business activity allows for direct deductibility of appropriate expenses, where-as hobby activity expenses are only allowed as a miscellaneous itemized deduction subject to passing a 2% adjusted gross income threshold. There are many facets here, but key among them is a profit motive and active participation in the activity to qualify your activity as a business.

Just because the IRS focuses their audit activities in this area does not mean you should be reluctant to take appropriate deductions. Just be prepared to defend your position with excellent records.

Tax Surprises for Newly Retired

5 surprises to know about

You’ve got it all planned out. Your retirement savings plans are full, you have started receiving Social Security benefits, and your Pension is ready to go. Everything is planned, what could go wrong? Here are five surprises that can turn your plan on a dime.

1. Health emergency and Long-term Care. When a simple procedure could cost thousands, health care costs can put a huge dent in your plan. Long-term care can cost thousands per month. Have you planned for this? If your health insurance is not adequate you may need to pull money out of your retirement plan to pay the bills. While this withdrawal may not be subject to a penalty, it might be subject to income tax if the funds are from a pre-tax account.

Tip: Look into creative ways to enhance your health insurance coverage including supplemental health insurance and prescription drug cost coverage. Consider long-term care insurance and other alternative ways to reduce your potential living needs.

2. Taxability of Social Security benefits. If you have excess earnings, your Social Security benefits could be reduced. Even worse, if you are still working, your benefits could be subject to income tax.

Tip: If this impacts you, consider conducting a tax planning session to better understand your options including the possibility of delaying the receipt of Social Security benefits.

3. Your pension plan. Understand if your pension is in good financial health. Often pensions will offer a lump-sum payout option for you. Should you take it?

Tip: Review your pension plan’s annual statement. How solid is it? If there are risks, consider cash out alternatives and planning for the potential drop in future income.

4. Minimum Required Distribution (RMD). Forgot to take your minimum required distribution from your retirement plans this year? The tax bite could be quite a surprise as the penalty on the amount not withdrawn is 50%!

Tip: Select a memorable date (like your birthday) to review your RMD and take action so this tax surprise does not impact you.

5. Future Tax Rates. The federal government is spending over $1 trillion more than it brings in each year. Cash starved states are looking for new tax revenue. Don’t be surprised when future tax rates continue to rise during your retirement.

Tips:

• Create a retirement plan with higher state and federal tax rates
• Plan for increases in health care costs through Medicare
• Plan for more tax on Social Security benefits

Plan for higher capital gain and dividend taxes (now 20% versus 15%)

Is Being Effective Better Than Being Marginal?

Understanding the difference between these two tax rates

The tax code is filled with terms we rarely use in everyday conversation. Two of the more common are Marginal Tax Rates and Effective Tax Rates. Knowing what they mean can help you think differently about your potential tax obligation.

Definition

Marginal Tax Rate: This is the tax rate applied to the “next” dollar you earn. Since our income tax rates are progressive, the next dollar you earn could be taxed at as little as zero or as high as 39.6%!
Effective Tax Rate: This is the tax rate you actually pay. This is simply taxes you pay divided by your total taxable income. Said another way, after taking your income and then applying taxes, deductions, credits, exemptions, and other adjustments you are left with your true tax obligation. This obligation is a percent of your income.

A Simple Example

Consider two people; Joe Cool who earns $50,000 and Chuck Browne who earns $500,000. If we had a flat tax of 10%, Mr. Cool would pay $5,000 in tax and Mr. Browne would pay $50,000 in tax. Both of their Effective Tax Rates would be 10% AND their Marginal Tax Rates would also be 10% because each additional dollar they earn would be taxed at the same 10%. However it is a different picture when you apply our progressive tax rates:
If we use the 2013 U.S. tax table for a single filer, Joe Cool pays $6,608 and Chuck Browne pays $151,065 in federal tax. This is because tax rates applied to Joe Cool’s income are (10 – 25%) while Chuck's income over $50,000 gets Marginal Tax Rates of (25 – 39.6%). Ignoring other tax factors, our two taxpayers’ tax rates are:

Joe Cool Chuck Browne Diff +/- Comment Effective Tax Rate 13.2% 30.2% +17.0 Chuck pays 30.2% of his income in tax; Joe 13.2% Marginal Tax Rate 15% 39.6% +24.6 The next dollar each earns will be taxed at this rate.

Why Care?

• Calculating Returns. The true return you receive on any taxable investment will be determined by your Marginal Tax Rate. A $500 profit from a new investment could cost Joe Cool 15% in federal tax, but it could cost Chuck Browne 39.6% in federal tax.
• Phase-outs can provide a dramatic impact on Effective Tax Rates. The simple examples above do not account for income limits applied to many tax benefits. Additional income could have a very dramatic impact on Joe Cool if it triggers losing things like an Earned Income Credit, or Child Tax Credit. This could increase your Effective Tax Rate while not touching your Marginal Tax Rate.
• Extra work can help the taxman more than you. There have been cases where adding a second job can actually cost you money by not understanding the impact of the income on your Effective Tax Rate. This is especially true for retired workers receiving Social Security Retirement Benefits. That extra job may make your Social Security benefits taxable.
• It’s not that simple. In addition to all the different income phase-outs for credits and deductions, your Effective Tax Rate could be impacted by the elimination of itemized deductions, reduction of exemptions, the Alternative Minimum Tax, and the marriage penalty.

It is a good idea is to understand your Effective Tax Rate and your Marginal Tax Rate. Look at last year’s tax return and calculate your Effective Tax Rate. Then look at your income and determine what your Marginal Tax Rate is if you earn additional income. If you anticipate an increase in earnings, consider forecasting the impact on your Effective Tax Rate.

Avoid Common Tax Filing Mistakes

With the backlog of tax return filing due to late changing tax laws, want to ensure your refund gets to you in the shortest amount of time? More importantly, how can you avoid receiving a letter from the IRS? Here are some of the most common tax filing mistakes:

Forgetting a W-2 or 1099: The IRS does an effective job in comparing W-2s and 1099s they receive from organizations to the amounts you claim on your tax return. If they do not match, rest assured you will receive a notice in the mail asking for clarification.

Duplicate dependent reporting: If more than one tax return claims the same person as a dependent, the second return will be rejected. The IRS does not try to determine which tax return is correct. They leave that up to you.

Forgetting a name change: If you fail to change your name with Social Security after marriage and you file a tax return with your "new" last name, be prepared for either a rejected tax return or an adjusted tax return.

Other missing information: When preparing your tax return, often the return is held up because key information is missing. These missing items range from property tax and mortgage interest statements, to 1099s and W-2s.

Signing the e-file authorization form: Your tax return cannot be e-filed without proper authorization. After reviewing your return, a properly signed Form 8879 must be received.

New Safe Harbor for Home Offices

Beginning in 2013 there is a simplified way to take a home office expense for a portion of your home. This new 'safe-harbor' option greatly simplifies how to record valid expenses for business use of your home. Here is how it works.

• You may opt to take your office space square feet times $5 and use this as a valid home office expense up to $1,500 (300 sq. ft.).
• This replaces the cumbersome allocation of valid home expenses like electricity, heat, depreciation, and other home expenses that are allocated by a % of the home devoted to your office space.
• You may still take property taxes, mortgage interest deductions and casualty losses as itemized deductions on your personal tax return. Better still, you no longer need to allocate these expenses between personal and business use.
• Your home office must still qualify for the deduction using current home office standards in the tax code. Foremost among these is that your home office must be used regularly and exclusively by the business.
• The deduction may not be taken in excess of available business revenue.
• You may still take other qualified business expenses unrelated to the home. This “safe-harbor” calculation is meant to simplify the household expense allocation process only.

What you should know

• The IRS estimates 3.4 million taxpayers used 1.6 million hours to calculate the home office deduction’s 43 line form to allocate their home office use.

• If the IRS reviews these returns in the future it hopes to save a tremendous amount of time and effort used in prior years to confirm the accuracy of the old home office allocation.

• Since 2013 is the first year of this new provision, you will probably need to conduct the home office use calculation using the old method to ensure the safe-harbor opportunity makes sense for you.

One of the nice benefits of this new safe-harbor rule is that your home value (basis) is not reduced by depreciation. This should help reduce risk of a tax surprise from depreciation recapture calculations when you sell your home.