Business Expenses
Posted on | December 18, 2009 | 8 Comments
TIS THE SEASON
TO DO TAX PLANNING
TAKE ALL THE LEGITIMATE
BUSINESS EXPENSES YOU CAN
Some might say that the list of potential business expenses is limited only to what the mind can perceive. That would be a big stretch. Believe it or not, the IRS knows your business better than you do. That is to say, they know what expenses are ordinary and acceptable for your type of business. After all, they have audited millions of businesses over the years. So, when it comes to deciding what business expenses you can legitimately take, why not start with IRS publications and other documents to find out what the IRS will allow. You may even find some expenses you never thought of taking.
To be deductable, expenses must be “ordinary” and “necessary.” That is, to be deductable, the expense must be normal, usual and customary for the type of business you are in (that’s the ordinary part) and it must be necessary for your specific business.
I have created a generic list for you to use as you prepare to do your taxes. Use this as a checklist to make sure you have not forgotten anything. I will be updating the list from time to time to insure it is as complete as possible although I’m not trying to cover every niche business. I’m sure there are some unique expense items that I haven’t even thought of, but this list will be a good starting point for all of you to review to ensure you don’t miss any of the big ticket items. If any of you want to add to the list, send me an e-mail and I’ll be glad to do so.
Sometimes, depending on your business entity, expenses are handled differently, that is to say, they might do on a different part of your return. Feel free to contact me if you have any questions.
Let me start by giving you links to some IRS publications that you might find useful:
- Pub 538 – Accounting Periods and Methods – http://www.irs.gov/pub/irs-pdf/p538.pdf
- Pub 535 – Business Expenses – http://www.irs.gov/pub/irs-pdf/p535.pdf
- Pub 587 – Business Use of Your Home – http://www.irs.gov/pub/irs-pdf/p587.pdf
- Pub 463 – Travel, Entertainment, Gift and Car Expenses – http://www.irs.gov/pub/irs-pdf/p463.pdf
- Pub 334 – Tax Guide for Small Businesses – http://www.irs.gov/pub/irs-pdf/p334.pdf
- Pub 583 – Starting a Business & Keeping Records – http://www.irs.gov/pub/irs-pdf/p583.pdf
So here’s the list:
Cost of Goods Sold (generally for those who make or build something)
Cost of products or raw materials
Storage
Direct labor – labor involved in manufacturing the product
Factory overhead – the costs of running the factory
Capitalization of direct costs for certain production activities
Inventory
Freight in
Dump fees
Employees pay including certain fringe benefits
Owner’s salary – only if the business entity is a corporation or subchapter S corporation.
Owner’s draws, per se, are not a deductible expense
Independent Contractor fees
Consultant fees
Advertising
Commissions and fees
Generally, penalties are not deductible
Professional services
Bookkeeping
Accounting
Tax preparation
Legal
Professional photographer
Web designer
Partnership guaranteed payments (only in partnership returns)
Rent
Taxes on leased property
Cost of getting a lease
Improvements by lessee (generally amortized)
Equipment rental
Interest
Mortgage interest (for business real estate)
Vehicle loan interest (business vehicles; to extent used in the business)
Capitalization of interest
Prepaid interest
Credit line and business loan interest
Taxes & licenses
Real estate taxes (business assets)
Employment taxes
Other business related taxes
Business licenses
Building permits and fees
Insurance
Business insurance (for example, E&O insurance)
Auto insurance (prorated for business use)
Self employed health insurance
Capitalized expenses (amortizing or depreciating them over a proscribed period of time)
Business start-up costs
Business organizational costs
Business assets
Improvements
Capital vs. Deductible expenses
Amortization
Intangibles such as Goodwill
Business bad debts are handled differently depending on the accounting method you use
Cash basis – not deductible – income is not recognized until money received
Accrual basis – deductible because income recognized when earned
Repairs (vs. capital improvements) and maintenance
Repairs keep the property in good working condition without materially adding to the properties’ value. Examples include painting, fixing a leak, replacing broken items, etc.
Personal vs. business expenses – be very careful not to intermingle the two.
Personal expenses are never deductable as business expenses, although many people try
Charitable expenses
With the exception of a C Corporation, charitable expenses will carry to your Schedule A.
Depreciation
MACRS
ADS
Assets to be depreciated
Software
Office equipment
Furniture
Automobile
Manufacturing equipment
Buildings
Capital improvements
Bonus depreciation – only used when allowed by IRS
Section 179 depreciation
Allows full amount to be taken in current year – subject to limits
Depletion
Pension & profit sharing plans – treatment depends on business entity
SEP
IRA
401K
SIMPLE
Employee benefit programs – treatment depends on business entity
Insurance
Health and welfare programs
Reimbursable business expenses through a formal reimbursement plan
Domestic production activities credit
Business credits – there are many types of business credits
Travel (must be for a business purpose)
Airline tickets
Rental car
Hotel/motel
Taxi
Meals and Entertainment (generally limited to 50% of actual expenses)
Travel
Entertaining customers or meeting with colleagues
Office in home (OIH) expense
Business must be profitable before you can take OIH expenses in current year
Special rules apply See my blog http://www.professionaltaxservicesinc.net/2009/08/office-home-expense/
Automobile and truck expenses
Mileage vs. actual (allowable expenses to maintain and operate vehicle)
Actual almost always exceed mileage but you must keep good records
You must keep written records either way
Auto loan interest
Leasing expenses
Parking fees and tolls
Miscellaneous Expenses
Bank charges
Business start-up expenses (if under $5000 and not amortized)
Business Bond
Consulting fees
Credit and collection costs
Credit card processing fees
Damages
Delivery (Freight out)
Discounts
Documents
Dues and subscriptions
Dump fees
Exposition (show) fees and expenses
Equipment rental
Federal (FUTA) and State (SUTA) unemployment taxes
Ferry fees
Gifts
Limited to $25 per client or customer
Internet fees
Janitorial
Labor & Industry taxes
Laundry & dry cleaning
Only for specialized clothing
Maintenance
Marketing
Meeting expenses
Miscellaneous
Office expenses
Organizational expenses (if not amortized)
Pay pal fees
PO Box
Postage and delivery
Printing
Professional memberships (special rules apply)
Professional education (Continuing professional education)
Professional supplies and publications
Real estate agent fees
Sales & promotion expenses
Security
Small tools & equipment
Staging costs
Storage
Supplies
Surety bond
Telephone
Cell phone
Second phone in home for business
Fax line
Training & professional education
Utilities
Waste disposal
Web hosting
Website costs
Work clothing (special rules apply)
IRS AUDITS
Posted on | December 11, 2009 | No Comments
IRS AUDITS
The IRS is stepping up audits of taxpayers at a rapid pace. Each of the past several years there has been a significant addition of Revenue Agents (RA) and Revenue Officers (RO); those responsible for auditing returns and collecting taxes. In addition, the IRS has been improving its already sophisticated computer programs, resulting in much more thorough and accurate reviews of tax returns, including comparisons to documents forwarded to the IRS by third parties; W-2s, 1099MISC, 1099INT and many, many others.
The number of audits has increased steadily each year for the past eight years in all categories, both personal and business tax returns. Of significant concern is that the IRS recognizes that small business owners, especially those who file Schedule C are prone to making mistakes and keeping poor records. Guess what? This is one of the areas where they are focusing their attention. Over recent years the IRS has received a lot of money in additional taxes, penalties and interest by auditing small Schedule C businesses.
So, why does the IRS audit tax returns? The IRS wants you to comply with the tax code by filing and paying on time. The IRS wants you to be intimidated. Our U.S. tax system is a voluntary one. The vast majority of us play by the rules; we file and pay on time. But, in order to get us to do that, the IRS puts the “fear of God” in us by auditing tax returns and getting maximum publicity on those high profile cases where they throw a celebrity or ordinary citizen in jail. The result is that most of us fear the IRS more than just about anything else. We get an IRS letter in the mail and many of us are paralyzed. We don’t want to open it!
The IRS has a sophisticated system of computer programs that it uses to determine who gets audited. Obviously, they don’t have the staff to audit everyone, so they have to select the ones that they think will be the most fruitful, i.e., result in the largest amount of taxes, penalties and interest. All individual tax returns are computer scored by the IRS DIF system. Discriminate Function (DIF) is a highly secretive mathematical technique used to score income tax returns as to their examination potential. Generally, the higher the DIF score, the higher the potential for audit. Once the IRS selects returns to be audited, it then determines what kind of audit it will do. One thing I want you to always remember.
The first type of audit is a CORRESPONDENCE AUDIT. This is the simplest form of audit, but has proven to be very lucrative to the IRS in terms of return on investment. The taxpayer receives a computer generated letter from the IRS saying the IRS is proposing to make an adjustment(s) to their tax return unless the taxpayer can substantiate (prove) the expenses he/she claimed on their tax return. The letter gives you 30 days to do so. As I’m sure you all know by now, when you are dealing with the IRS, in the vast majority of issues, the burden of proof is on you. You must respond to the IRS with documents that show you actually incurred the expense. Common issues handled by correspondence audits include mortgage interest, taxes, contributions and many more. Correspondence audits are usually focused on a few specific items in your tax return and are limited to that.
The next type of audit is the OFFICE AUDIT. An office audit means that you are summoned to the office of a local IRS Revenue Agent who will look at your return in more depth. These audits are generally focused on specific areas of your tax return but a RA can look are the entire return and even open up other tax years if he/she feels warranted. Many times small businesses are selected for office audits. As with the correspondence audit, the burden of proof is on the taxpayer. These audits are generally completed in one visit, just a few hours, assuming the taxpayer is prepared when he/she comes to the office.
The final type of audit and by far the most comprehensive is the FIELD AUDIT. As suggested by the name, in this case the RA comes to your home or place of business. In a field audit, expect to have a very experienced Revenue Agent and expect he/she to look at all aspects of your return, your personal financial life and, if warranted, other tax years as well.
So, what should you do if you are notified your tax return is being audited? First of all, if your return is selected for an audit, that in no way implies that you made a mistake on your return. Selection simply means that the IRS has one or more questions about your return. If it is a correspondence audit and if the audit is focused on a specific issue and you have substantiation for your deduction, go ahead and handle the audit yourself by following the instructions in the letter. If, after you have done so, the IRS still says you owe money, I highly recommend you hire an Enrolled Agent, CPA or attorney to represent you; someone with experience in dealing with the IRS.
If you are facing an office or field audit, I recommend you immediately hire an Enrolled Agent, CPA or attorney to help represent you. They will generally attend the audit in your behalf, but will require you to supply the substantiation required to prove your deductions/income in question. Someone experienced in dealing with the IRS can save you a lot of money and give you peace of mind especially in office and field audits.
IRS Stepping up Audits
Posted on | November 20, 2009 | No Comments
I expect to see a significant increase in the number of audits by the IRS. The trend has been upward for several years now and I expect that to continue. As I have previously stated, one of the primary areas of interest by the IRS is Schedule C businesses. The IRS is in the process of hiring another 2200 auditors and collectors and it is looking to find every tax dollar it can.
With the economy still in bad shape that means tax revenues are way down. You would think the government would slow it’s spending. No, just the oposite, spending is increasing at an alarming rate. So, with spending up and tax revenues down, the Congress and the Administration have asked the IRS to work harder to find as many tax dollars as possible.
I expect the IRS to continue to look hard at mortgage interest deductions. There are specific limits on what can and what cannot be taken as a mortgage interest deduction. The IRS has already begun to focus on this and I expect them to do even more. I will write a blog on mortgage interest deductions sometime in the next few weeks.
Another area of emphasis by the IRS is to coordinate with states to look hard a small businesses to find those businesses that have misclassified workers as Independent Contractors (IC) to avoid paying employment taxes. When they find those companies I expect the IRS to go back several years and to apply hefty penalties to those they determine are misclassifying employees as IC’s.
There will be other things the IRS will focus on as well, so taxpayer beware! Know the rules and follow them. This is not the time to be bending or breaking the rules. If your not sure what the rules are, talk to a professional. If you are operating in a gray area, clean up your act before it is too late.
FIRST TIME HOMEBUYER’S CREDIT EXTENDED
Posted on | November 6, 2009 | No Comments
The much used first time homebuyer’s tax credit has received congressional approval and has just been signed by the President . The measure was included in H.R. 3548, extension of unemployment benefits. According to the National Association of Realtors, as many as 1.2 million new and resale home transactions were completed as a result of the first time homebuyer’s credit. The extension of this credit, which has proven very popular amongst first time homebuyers, will continue to help the struggling home market. The $8,000 credit was due to expire on November 30th but will instead be extended for all first time homebuyers who enter into contracts prior to April 30th, 2010 and closed by June 30th, 2010. Also included in the bill is a new credit of up to $6,500 for some existing homeowners. To qualify for this new credit, homeowners must have been in their current residence for a consecutive five year period. The new bill also raises the qualifying income limits to $125,000 for single taxpayers and $115,000 for married filing joint taxpayers. The current limits are $75,000 and $150,000.
LUCKY DUCK!
Posted on | October 30, 2009 | 1 Comment
How many times in your life have you said something like “wow, why does she get all the luck?” Or, I sure wish I had her luck. No matter what she does, she makes money. No matter what he does, he comes out smelling like a rose.
Well, I’m not going to tell you that there is no such thing as luck. There certainly is. But what if I told you there are things you can do to help make your own luck? Let me tell you about luck. On one particular night mission in Vietnam, my airplane was suddenly surrounded by tracers; bullets being fired in front of me and on both sides. And to make matters even scarier, only one bullet in five is a tracer. I quickly maneuvered the airplane in a Split S (rolled inverted pulled hard until I was headed in the opposite direction) and to my surprise, when I landed, and thoroughly checked out the airplane, I had not been hit by a single bullet. Now that’s luck! Or maybe I made the right move just in the nick of time. Regardless of what it was, I know God was my copilot that night.
Some years ago, I was very envious of a peer of mine who always seemed to get the breaks. No matter what that guy did, he always seemed to come out on top. It wasn’t just once, or twice, but this went on for quite some time. I was having a discussion with a mentor of mine, someone who had been around the block a few times and was a lot wiser than I. I happened to let it slip that I was jealous of so-and-so because he always got the breaks. My mentor’s response surprised me. He said “Bill, luck is when preparedness meets opportunity. Bob is just better prepared than you and the others are.” Wow, that was really an eye opener. I had never thought of it that way.
After hearing what my mentor had to say, I realized that to a certain degree, I could control my own luck. I could at least be better prepared to handle situations before they happened. Here is a good analogy. When US Air flight 1549 lost both engines and “Sully” Sullivan ditched his Airbus 320 into the Hudson River, was that luck? Maybe a little, but Sully was prepared for such an emergency. Through hours and hours of emergency procedures practice in the simulator, Sully had the experience to deal with a very serious situation. Had he practiced that particular emergency before? No. But because he practiced many different kinds of emergencies, he was able to maintain calmness and a level head as he dealt with this new situation. Not only that, but Sully thought through those kinds of scenarios in his own mind to mentally prepare himself. Was there any luck involved? Of course there was some, everything had to be just right for this to happen, but if it weren’t for Sully’s preparedness, no one would have survived that ditching in the Hudson. You can bet that pilots are now practicing something similar in their simulator training now.
So what can you do to prepare yourself for the unknowns in your life and business?
- There is an old adage, “plan for the worst and hope for the best.” In the flying business this is exactly what we do. Most emergencies cannot be practiced in the airplane, for obvious reasons. They are, instead, practiced in the simulator. Modern day simulators are so realistic that pilots quickly forget they are in the simulator and think they are in the airplane. By practicing the worst possible emergency situation in the simulator, when a pilot is faced with a real life emergency in the airplane, he/she is able to deal with it in a calm, level headed manner. Most of the time, the emergency is far less severe that what has been practiced in the simulator and can be handled with apparent ease. Yes, I know, I got off track a bit there. I realize you don’t have a simulator for your business. So what do you do? Know your business well. Know what is important and what will keep your business on track and growing. Concentrate on those things. Don’t let life’s little emergencies sidetrack you in your efforts. Think about what you are going to do and say when you finally meet that one big client have been hoping to land. Think through how you are going to respond to that client in various scenarios. In other words, be prepared. Don’t leave anything to chance.
- Have a business plan. Understand your business and know what is important to move your business forward. Think about what can go wrong. Have a contingency plan for all those things that could go wrong. Every now and then, climb up to 30,000 feet and take a total view of your business. Remember, it’s hard to see the forest through the trees. While at altitude, so to speak, make a calm assessment of your business. In your day to day operations, whatever you do, don’t let the mundane, unimportant things bog you down. When you see you are getting off track, make adjustments to your plan.
- Stay focused. One of the airplanes I flew in my Air Force career was AWACS. It is a four engine 707 with a large rotodome on top and is the USAF equivalent to a Navy aircraft carrier; always being sent to the hot spots. I was the chief pilot for the AWACS program in both the USAF and NATO. That meant that I had the responsibility to evaluate other pilots and flight crews. During the evaluation flight we always threw in a simulated emergency or two. On occasion, we experienced an actual emergency. Sometimes I could see the entire four man flight crew focus totally on the emergency, leaving only the autopilot to fly the airplane. This is how a simple emergency can be turned into a disaster. It is so easy to get caught up in the moment and forget about the big picture. You must remain focused on the important things in your business.
So next time you start to get envious of someone else who always seems to have good luck, know that good luck can be yours as well by preparing yourself properly.
FIRST TIME HOMEBUYER’S CREDIT EXPIRING
Posted on | October 23, 2009 | No Comments
The American Recovery and Reinvestment Act included up to an $8,000 credit for first time homebuyers (the credit is actually 10% of the value of the home purchased, up to $8,000). A first time homebuyer is someone who has not owned a house in the three years prior to the purchase. Unlike the 2008 homebuyer’s credit which has to be paid back, this credit does not have to be paid back if the homebuyer remains in the home for at least three years.
The credit can be claimed on either the 2008 or 2009 tax return, however, the home must be purchased prior to December 1, 2009 to qualify for the credit. That means that closing must occur prior to that date. So, those of you considering buying a house and taking advantage of the credit, you need to move very quickly if you are still early in the buying process.
There is some talk in Congress about extending the credit, but my advice is to close on a house prior to Dec 1, 2009 if you want to take advantage of the credit.
Who’s Afraid of the Big Bad Wolf?
Posted on | October 6, 2009 | No Comments
I just attended an intensive training program on dealing with the IRS. One of the instructors, at prominent tax lawyer, said that, based on his experience, about 15% of the U.S. population becomes functionally illiterate when they receive an IRS letter. Another 5 – 10% breaks out in a cold sweat and many are afraid to open the letter. What causes all this fear? Should you be afraid?
Since our income tax system in the U.S. is a voluntary one, the IRS wants us to believe they are watching our every move and will come knocking on your door if you make even the smallest error on your tax return. They want the image as the Big Bad Wolf. Does it work? For the most part, you betcha!
Let’s look more closely at how the IRS operates and some of the statistics to see if you have good reason to be afraid. The IRS sends millions of letters to taxpayers every year. Many of the letters they send out are straight forward and are administrative in nature. They may be correcting a math error, advising that you left something off the return and giving you a chance to fix it. Or they may be more serious, assessing a penalty if you filed late or notifying you that your tax return is being audited. Unfortunately, they never send you a letter saying you are doing great, keep up the good work.
So, what are your chances of being audited? Actually they are very small. On average, a little over1% of filed tax returns get audited each year, however that number has been going up in the past decade and as you will see a little later, the odds increase depending on the type of return you file. Several years ago an IRS research study showed that there is an underpayment of taxes of about $300B (B as in Billion) per year, known as the “Tax Gap.” About $250B of that comes from underreporting income and/or overstating expenses.
Congress has asked the IRS to aggressively try to close the “Tax Gap.” One way they are doing it is by hiring more employees and conducting more audits. Let me analyze this a little bit further. Financially, most taxpayers lead rather uncomplicated lives. They work for someone else, get paid by W-2, earn interest from their bank or brokerage, buy and sell a few stocks, put some money in a 401K or similar plan, pay their mortgage or are retired drawing a pension and social security. Virtually everything financially in their lives is reported to the individual and to the IRS on one form or another. For this large segment of taxpayers, it is a simple matter for the IRS to know who has filed and accurately reported their income and deductions. In many cases, if a taxpayer does not file a return, the IRS will file a substitute tax return for the taxpayer. This will only occur only if they taxpayer owes money. If the taxpayer is due a refund, the taxpayer will probably never hear from the IRS. Why? By law, after three years the IRS no longer has to refund the money.
So, how does the IRS know who to audit? The IRS scores every tax return filed; known as the DIF score. Through research, the IRS knows what types and how much a taxpayer should be taking in deductions based on his/her Adjusted Gross Income. If the computer review of the tax return finds some of the numbers outside the norm, it assigns a higher DIF score to the return. The higher the DIF score the more likely the return will be audited.
I’ll give you one guess where the majority of the $250B shortfall comes from. It comes from small businesses and self employed folks; that’s you and me. Research and IRS experience from past audits have shown that there is a significant underreporting of income as well as overstating of expenses on many business returns. This is especially the case with sole proprietorships and single member LLC’s that report their business income on Schedule C on their 1040 return.
As a self employed taxpayer, you are about 10 times more likely to have your Schedule C audited than you would be if you filed a Form 1065 (partnership or LLC return) or 1120/1120S (corporation or subchapter S return). Based on years of audits the IRS knows that those small businesses who file on Schedule C probably don’t keep sufficient records and frequently can’t prove the income and expenses claimed. On the other hand, small businesses who file Form 1065, 1120 or 1120S generally keep better records and frequently use a bookkeeper or accountant and a tax professional. As a result, the IRS knows that the “low hanging fruit”, so to speak, is in Schedule C businesses. So take the hint. For those of you who are filing on Schedule C, you might want to consider another type of business entity.
The IRS uses education of the public and audits to keep people in compliance. Lately the IRS has been putting most of its emphasis on audits and is expanding its audit force. Audits are the subject of another article, but, briefly, there are three types of audits, Correspondence, Office and Field, with a Field audit being the most comprehensive one. The IRS makes sure it gets a lot of publicity on its high profile audits and criminal actions.
So, how do you protect yourself from the Big Bad Wolf?
- First of all, keep excellent records. If you are not good at recordkeeping, hire a bookkeeper or accountant to help you or at least be on your team of advisors. See: (http://biznik.com/articles/ive-got-your-six). Use a software program like QuickBooks to track income and expenses so you can create financial statements. This will not only help you at tax time, it will help you immensely if you are audited. These reports are also essential to understanding and managing your business.
- Keep your personal and business finances separate. Always! Have separate bank accounts and credit cards for the business and for you personally. By the way, if you are one of those people who does not believe cash is money (in other words, not reportable to the IRS as income), the IRS has ways to determine when you are not reporting income. In a Field audit, they always do this analysis and sometimes in an Office audit as well.
- Have documentation to back up expenses you claim. Cancelled checks are not considered adequate proof, although they are better than nothing; it’s always best to have a receipt for each item you claim.
- Keep good automobile records if you use your car for your business. I know it’s a pain, but keep a log in your car and annotate every business trip you take with the miles you drive and the reason for the trip. This only takes a minute or two and it is well worth the effort. If you are seeing a client, note who that client is. If you are constantly going to the same place, for example you are in construction, you can use Map Quest to determine the mileage, but you still need to keep a log of the number of trips to that location.
- File your tax return(s) on time. On time includes an extension if you file for it. Remember, the extension is to file your return, not to pay what you owe. If you owe money, the IRS expects it all to be paid no later than April 15th.
- Lastly, if you get that dreaded letter from the IRS, open it immediately! Not dealing with it quickly will only lead to more trouble later. IRS letters can be long and difficult to understand. If you used a tax professional to do your tax return, contact him/her immediately for their help. If you did not use a tax professional and the issue seems serious, contact an Enrolled Agent (http://www.professionaltaxservicesinc.net/enrolled-agent/) or CPA who has experience dealing with the IRS. I would not recommend contacting a tax lawyer unless you suspect the IRS is after you for fraud or you are under criminal investigation. If agents show up at your door with a badge, it’s usually very serious. That is when a tax lawyer should be consulted.
Should you be afraid of the Big Bad Wolf? Absolutely not! If you follow the simple guidelines I laid out above, you really should have nothing to worry about. That doesn’t mean you won’t get an IRS letter or be audited, but if you are you will be prepared. Adding a tax professional to your team of advisors will give you extra peace of mind as well.
Tags: audit chances > Enrolled Agent > IRS audit > IRS letter > small business taxes > Tax Gap > team of advisors
IRA CONVERSION STRATEGIES
Posted on | September 25, 2009 | No Comments
TRADITIONAL IRA TO A ROTH IRA CONVERSION STRATEGIES
As the end of 2009 approaches, a significant opportunity awaits many individuals. Beginning in 2010, taxpayers will be able to convert their traditional IRA (and funds that have been rolled over from a qualified plan) to a Roth IRA, regardless of their income level or filing status. What’s more, the tax on the taxable income generated from a 2010 conversion may be deferred until 2011 and 2012. This new conversion option presents both tax planning opportunities and challenges for 2009, 2010 and 2011.
Before 2010, only individuals with modified adjusted gross incomes (AGI) of $100,000 or less can convert amounts in the traditional IRA to a Roth IRA. Moreover, married taxpayers filing separate returns have also been prohibited from converting their traditional IRA to a Roth IRA as well. However, beginning in 2010, the $100,000 AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated completely. This special treatment gives everyone, regardless of his or her income level the opportunity to convert a traditional IRA to a Roth IRA. Additionally, filing status restrictions are also lifted, allowing married taxpayers filing a separate return to convert a traditional IRA to a Roth IRA.
It is important to understand that an IRA conversion is treated as a taxable distribution, taxed as ordinary income at your marginal tax rate. This, in effect, accelerates that taxable income that you would eventually pay on distributions from a traditional IRA once you retire, but does so in exchange for never taxing any future appreciation in the value of your account from what it is today. That is often a significant tax advantage. You should also note that unlike a withdrawal from an IRA, a conversion does not trigger any 10 percent early withdrawal penalties.
Although conversion to a Roth IRA does trigger immediate taxable income, Congress provided a special incentive in 2010 to jump-start Roth conversions. In 2010 (and 2010 only), individuals will have the choice of recognizing their conversion income in 2010 or averaging it over 2011 and 2012. The latter option, which the taxpayer must elect to put into effect, allows you to pay taxes on the converted amounts ratably over two years, instead of recognizing it all as income in one ear. You will be taxed at the rates in effect for 2011 and 2012.
For some taxpayers, their tax rate may rise after 2010 even if their income does not. President Obama has proposed, and Congress is expected to enact, legislation to restore the top two pre-2001 marginal income tax rates after 2010. This means that the top two brackets will be 39.6 percent and 36 percent after 2010. Consequently, if you do not want to take the chance that your income tax rate will be higher in 2011 and 2012 than in 2010, you may want to elect to pay the full tax on the Roth conversion on your 2010 income tax return, at 2010 income tax rates.
Higher-income individuals, who plan to pay the entire conversion tax in 2010 instead of ratably in 2011 and 2012 because of the anticipated increase in the top marginal tax rates, may want to avoid, for year-end 2009, the traditional year-end-planning techniques of accelerating deductions and deferring income. Alternatively, consider doing the opposite this year to avoid being pushed into the highest brackets by a large IRA to Roth IRA conversion.
Taxpayers are expected to convert their traditional IRAs to Roth IRAs for a variety of reasons. Roth IRAs have two major advantages over traditional IRA’s:
- Roth IRA distributions are tax-free if they are qualified distributions. To be qualified, they must be made after a five-year holding period has passed and after the accountholder reaches ate 59 ½ or on account of death, disability, or the qualified purchase of a first home.
- Roth IRAs are not subject to the required minimum distribution (RMD) rules that apply to tradition IRAs (as well as individual qualified plans). Therefore, a Roth IRA accountholder who reaches age 70 ½ does not need to begin taking distributions; instead, the funds can continue to grow tax free until they are needed or are passed on to heirs.
The tax-free nature of qualified Roth IRA distributions may prevent individuals from being taxed in a higher tax bracket that would otherwise apply if he or she were withdrawing taxable distributions from a traditional IRA. Moreover, these distributions—unlike those from traditional IRAs—do not affect the calculation of tax owed on Social Security payments and do not affect AGI-based deductions.
An IRA to Roth IRA conversion should be considered by individuals who:
- Can afford the tax on the converted amounts;
- Anticipate being in a higher tax bracket in the future than they are currently in; and
- Have a significant amount of time before reaching retirement to allow assets to grow tax-free and recoup dollars that may have been lost due to the conversion tax.
If you are planning on taking advantage of the Roth IRA conversion opportunity next year, consider some of the following strategies this year:
- Because of the economic slowdown, many individuals are postponing retirement. Roth IRAs, unlike traditional IRAs, generally have no age limitation on contributions from earned income or on mandatory payouts. This is an advantage for individuals who are extending their careers beyond traditional retirement age.
- If you are able to make deductible traditional IRA contributions this year, do so. This can help you reduce you 2009 tax bill and, if you convert to a Roth IRA in 2010, you will not have to pay back the tax savings until 2011 and 2012, if you elect to ratably pay the tax over the two-year period.
- If you anticipate being below the $100,000 AGI level this year, consider converting to a Roth IRA right away while your traditional IRA account balance is still low because of stock market declines. If your situation is different from what you anticipated before you filed your 2009 return, you might consider “recharacterizing” your 2009 Roth conversion back to a traditional IRA and then converting to a Roth IRA in 2010 instead.
There are a significant number of tax and financial considerations that come into play when determining whether to convert your traditional IRA to a Roth IRA. If you have any questions about traditional IRA to Roth IRA conversions and the new 2010 planning opportunity, please contact me.
I’ve Got Your Six
Posted on | September 18, 2009 | No Comments
In the fighter business, when you go into combat, you go as flight of four aircraft to provide each other mutual protection. When you are in a three dimensional environment it is very difficult to keep an eye on everything you must in order to protect yourself. Fighters in combat fly in a tactical spread formation. This allows each pilot to keep an eye out for the entire formation; checking the other pilot’s six o’clock position, high, low and on the horizon. I’m a retired USAF pilot, having flown many aircraft during my career, including fighters. However, in Vietnam I flew a light, unarmed airplane as a Forward Air Controller (FAC). I flew alone which made it very difficult to watch everything I needed to. I would have loved to have a wingman with me on my missions, but it was not the way we operated.
So, why in the world would I be talking about flying in combat in a multi-aircraft formation when I should be talking about business? Whether you know it or not, as a business person you are in a type of combat, because you are in stiff competition with others, everyone competing for the same customers and dollars. A recent article in the Wall Street Journal, “With Lobster Prices Low, Things Get Ugly in Maine,” by Simmi Aujla, points out the hazards of competition. Lobster prices are so low the fishermen are actually fighting one another. This is certainly an extreme situation, but we in small business are fighting for our survival, against our competition while dealing with a myriad of other factors. For example, we fight on a daily basis to keep up with local, state and federal regulations. So why are you going it alone? Just like fighters going off to combat, you need to arm yourself with a team of advisors. A good team of advisors can be “checking your six”, so to speak, and keeping you and your business out of trouble.
How do you go about forming a team of advisors and how should you use them? Each business and business owner is unique. The first thing you should do is assess your strengths and weaknesses and in any area you rate yourself as weak or even average, I would consider having an advisor.
What kind of advisor should you look for? You should look for a professional who has experience in small business and is at least familiar with your business.
I assume you are an expert at what you do or you would not be in your business. But perhaps you have decided to branch off into a new field. In that case I would definitely find someone, in the same field, who is not a direct competitor, to use as a resource. Pick that person’s brain to find out as much as you can about your business.
If you are strong in recordkeeping and enjoy doing it, that’s great. If not, bring a bookkeeper on board to do your bookkeeping for you, review your books periodically or, if not that, at least be available to give you advice how your books should be set up and kept. Good bookkeeping is critical to a successful business. Why would you want to cut yourself short here?
The same thing goes for taxes. Perhaps you have been operating your business long enough to know what you need to file and how to plan for your taxes, but if this is an area of weakness, bring a tax professional on your team to be there when you have a question. A tax professional experienced in small business can provide invaluable advice. For example, are you in the right business entity? Are you doing proper tax planning? Are you taking all the deductions you can legally take and does the business entity you have chosen help to minimize your taxes? You may be surprised what you learn.
If you are in a business that requires capital, get to know a banker or other source of capital. Even if your business does not require a lot of capital, you need to make sure you have a line of credit, a credit card or some other source of money to get you through the low income, high expense periods.
What about your E&O or similar insurance. Do you have someone you can call to give you straight forward advice and who will shop around for the best price for you?
The same thing could be said for: Marketing, legal, website development, retirement plans and other benefits for you and your employees.
Speaking of employees, that brings up one final consideration. Dealing with payroll is complicated and can get you in a lot of trouble with both the state and IRS if not done properly. (see my article, “So Far, So Good” http://biznik.com/articles/so-far-so-good ) Don’t be afraid of payroll. My advice, hire a professional to do your payroll for you or at least to get you set up properly. This could be your bookkeeper or a professional payroll service. If you do it yourself, make sure you know what you are doing and/or follow the advice of the advisor to the letter. Remember, if you are a Subchapter S Corporation, you are an employee of the Corporation and must pay yourself a reasonable salary, assuming you are making a profit in the business.
I could go on and on, but I think you get the picture.
Take a few minutes and do a self assessment. Try to think of everything you need to do to make your business successful, including the not-so-fun stuff like bookkeeping and taxes. Look at your list to see where you have rated yourself as weak or average, then try to think of someone you could call on as a resource in that area. Perhaps it’s a friend, perhaps an acquaintance or someone you have met through Biznik.
You will use some of your advisors more frequently than others. In those areas where you know you need help and will need frequent advice and assistance, consider an arrangement where you negotiate with the professional to pay an hourly rate, an annual amount for continuous advice, or hire that person to do everything and get their advice with it. For example, if you hire me to do your taxes, you get my advice free for the year. If you don’t want me to do your taxes, you could hire me for an annual fee or pay me by the hour. There are lots of choices. Remember, you get what you pay for, so if you want advice from an expert, expect to pay for it.
Depending on your business, you could also have your team of advisors set up so that you can refer a client to them if he/she needs that type of professional advice or service. It’s great when a group of professionals refers clients to one another. Clients who trust you will tend to take your referral.
Fly safe, your team of advisors has your six!
Tags: recordkeeping > save money on taxes > small business > small business taxes > tax planning > team of advisors
Experience Level of IRS Auditors
Posted on | September 12, 2009 | No Comments
I went to a party the other day and asked a man to whom I had just been introduced, what he did. His response was very telling. He said, “Don’t get mad at me, but I have just recently gone to work for the IRS.” When I said it didn’t make me mad, that I was an Enrolled Agent and worked with the IRS all the time that opened the door for a good discussion about the IRS.
He told me that he had been in training as a Revenue Officer in the Large & Medium Size Business unit since he joined. However, he had already done two solo audits. This was August, only four months after he joined the IRS.
The IRS has seen a tremendous loss of experienced people over the last several years. Part of that occurred in the late 1990’s when the IRS was significantly downsized and became a “friendlier” organization. However, since early 2000 the IRS has been steadily increasing its’ hiring and is becoming the IRS of old.
The experience level of many of the people in the IRS who conduct audits is very low. Many of the agents have minimal training before they are told to “go get em tiger.” This is disconcerting if you are on the receiving end of an IRS audit.
Those conducting Correspondence Audits are the least trained, often getting the bare minimum training and only in the areas they need to know to conduct the audit. As I indicate above, this also seems to be the case for Revenue Officers conducting Office and Field Audits as well.
So what does that mean for those of us who get audited?
- Don’t arbitrarily accept what the auditor is telling you. Calmly and professionally fight the battle with the auditor.
- If you think or suspect the IRS is wrong, hire an EA or CPA to represent you; or better yet, bring one onboard before the audit begins. At any time in an audit, you have the right to tell the auditor that you are going to get a representative. At that point the audit will cease and resume when the representative is onboard.
- Be prepared to challenge them with the facts and/or the IRS code.
- Don’t hesitate to elevate the issue to the auditor’s supervisor. Often you will get a much more seasoned and experienced person who will listen to both sides and make a decision or even negotiate with you.
- If you believe you are right and you can’t get satisfaction from the auditor or his/her supervisor, consider taking the matter to appeals. Going to appeals must be carefully considered and certainly cannot be done frivolously. Often you will get a very seasoned and experienced person who is interested in resolving the case. He/she will do an assessment as to how the IRS would do if the case goes to tax court. In many cases, it is in the IRS’s best interest to resolve the matter in appeals. While the Revenue Officer has little or no authority to negotiate, an appeals officer has total authority.
The IRS can be very persuasive and forceful. I highly recommend you immediately contact an Enrolled Agent or a CPA to review the IRS correspondence and hire him/her to represent you in the case. This will give you peace of mind of knowing you have someone in your court who will not be bullied by the IRS Revenue Officer and who knows the IRS code and can advocate in your behalf.
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