Author Archives: c06578806

How to Deduct Automobile Expenses

The Internal Revenue Service frequently audits deductions for auto expenses, and the documentation requirements are fairly complex. This should not discourage you from taking all the deductions to which you are entitled, however, since we have had great success at defending auto expense deductions in IRS audits. What is important is to keep the necessary records — then you have nothing to fear.

The proof of your auto expense is straightforward. You need to document:

  • Car ownershipRegistration and/or purchase contract
  • Your total miles drivenRepair bills from the beginning and end of year showing odometer readings, and
  • Your business miles drivenContemporaneous records listing business appointments, etc., and the mileage incurred.

The above items are sufficient to claim the “standard mileage” deduction which is set at regular intervals by the IRS (57.5 cents per mile for 2015 and 24 cents as of 1/1/2016). If you elect to us the “actual expense” method, you must also document:

  • The cost of your vehicle or value when you placed it in business useTo calculate the depreciation deduction allowed by the IRS
  • Gas, oil, repairs, registration, insurance, payments, and any other vehicle expensesThe actual expense method is appropriate for a relatively expensive vehicle that is not driven a lot of miles during the year. The standard mileage method is more appropriate when an inexpensive car is driven a lot. If you want to elect the standard mileage method in any year you use your car, you must use it in the first year. Then you can use either method in the subsequent years.

There’s a simple way to maintain all the necessary documentation:

  • Have your car serviced in December or January of each year to prove odometer readings.
  • Write all your appointments in your calendar, even business shopping trips, trips to workshops and classes — all driving that is business related.Record the addresses of the place you go.
  • Periodically look up all the addresses on Yahoo.maps or Mapquest and record the mileage in your calendar.We suggest doing this once a month.
  • Use the same credit or debit card for all your automobile-related expenses.Add up the totals from your monthly statements (and then save them for 3 years). Do not pay cash for gas because you might miss the deduction.

Note: Business driving is defined as mileage between business locations. Unless you have a home office, driving to the first place of work is not deductible. If you are not self-employed have your employer require you to maintain an office-in-home as a condition of employment, and get a letter proving the requirement. Then on days when you legitimately work at home before or after going to the office or to a client, you can deduct the mileage from/to your home.

Lease or Buy

This is a complicated decision and depends on many of your personal factors — income bracket, miles driven per year, percentage of business use, frequency of getting a new vehicle, cost of the vehicle, etc. You may find the following link helpful in making your decision: http://www.leaseguide.com/lease03.htm.

Deductible Unreimbursed Employee Expenses – Yes, even you!

 

Many taxpayers think that because their employer reimburses them for business expenses that they cannot claim a deduction on their tax return, so they don’t even bother to try.  The truth is that you may be incurring deductible expenses above and beyond the ones being reimbursed.  If you think you don’t qualify, read on anyway.

You are the “Chairperson of the Board” when it comes to your own career.  Only you are qualified to decide what expenses are necessary for you perform your job.  Your employer’s company policy strictly limits reimbursable expenses to items authorized by your employer.  But you may recognize the need for a lot of other things that your employer won’t reimburse.  For example, suppose you have a good friend who works for one of your competitors, but in another city.  Visiting your friend to share your experiences is certain to be beneficial to your job performance, but your employer is unlikely to reimburse you for the travel.

Here is a list of common unreimbursed expenses:

  •             Travel (airfare, lodging, ground transportation)
  •             Auto Mileage
  •             Meals and entertainment (including a per diem for out-of town travel)
  •             Education (classes, workshops, seminars)
  •             Books, publications, and subscriptions
  •             Dues for membership in unions or professional organizations
  •             Computers and internet access
  •             Tools and supplies
  •             Cell phone usage
  •             Uniforms, laundry, and special clothing
  •             Job searching expenses (your employer certainly would not reimburse these!)

Additional miscellaneous itemized deductions include:

  •             Tax advice and tax preparation costs
  •             Investment expenses and advice
  •             Costs to maintain or recover income-producing property

The best tax benefit is derived when you can deduct expenses that are normally personal in nature, but which you can qualify as business deductions with a little advanced planning.

For example, a teacher who grew up in Cleveland was invited back to attend his niece’s wedding.  He hadn’t been home for a while and also wanted to see his parents for a few days.  Normally this would be completely a personal expense and not deductible.  But being very tax-mindful and having gone to college in Cleveland, our client contacted a couple of his old teachers to get together and discuss his work on Thursday before the wedding.  He also registered for a ½-day workshop at his old school on Saturday, and promised to participate in a round table discussion for students at the college the following Monday.  So while he was travelling on business to Cleveland, he found himself with nothing to do on Sunday, and took the day off to go to his niece’s wedding.  The tally:  round trip airfare, 5 days per diem, all deductible.

Each of these deductions may have specific rules for record keeping and substantiation, so we recommend keeping all receipts and recording all you activities in a journal or appointment calendar.  IRS Publication 590 is a good roadmap for taking advantage of these deductions.  We suggest that as Chairperson you call a Board meeting and adopt a budget of deductible unreimbursed business expenses for 2016

The S Corp Check List

S Corps are a popular choice for operating a small business.  But they have some peculiarities that are commonly overlooked and could dramatically impact your tax liability.  If you have an S Corp, or want one, read on.

S Corp Checklist

  1. S Corps are frequently formed for the purpose of avoiding SE tax on a portion of the profits.  Has the owner received reasonable compensation for services provided (through payroll) so that the IRS would not be likely to classify all profit as payroll?  The IRS in particular looks to see a number for Compensation of Officers in Box 7 on the 1120S, and frequently audits if there isn’t one.  Some S Corps take a shortcut by sending the owner a 1099 and still reporting the payment in Box 7, and then further complicating the matter by claiming more business deductions on the personal return.  While this may seem to mitigate the problem by having a number in Box 7 and at least paying some self-employment tax, there is still a great chance of being caught and the downside consequences are enormous.  Both the IRS and state will assess penalties which could be in the tens of thousands of dollars.  So:  pay reasonable compensation.  Of course, if the S Corp doesn’t have the profits to afford reasonable compensation, then no payroll is required.
  2. Dividend distributions (or more appropriately, net profit flowing through to the owner on the K-1) are appropriate if not all of the income is derived from personal services, but rather from goodwill, machinery, intellectual property, or other capital.  Is this appropriate?  Has the owner paid out part of the profit in dividend distributions so as to take advantage of this legal tax avoidance?  The payroll should not be set so high that the Corporation has a loss on the K-1, since this would create a higher tax bill than a sole proprietorship.  Payroll taxes would have to be paid on the entire salary, instead of on the lower net profit figure.
  3. Special procedures apply to for deducting Healthcare Premiums of S Corp shareholders.  The premiums must be paid or reimbursed by the Corporation and included in W-2 wages for the shareholder (although not subject to Social Security, Medicare, or SDI).  This procedure is peculiar and requires special handling on the payroll, the W-2, and the K-1.  Has this been done?
  4. Reimbursements for home office, auto, travel, meals, cell phone, interest on loans to the company, etc., must be made before year end if the Corporation is to receive a deduction.  Otherwise these are deductible on the owner’s Schedule A, as miscellaneous itemized deductions reduced by 2% of AGI.  Has reimbursement been made?  It is best to reimburse monthly (contemporaneously).  Business miles should be reimbursed on the last day of each month at the mileage rate in effect ($0.575/mile in 2015, $0.54/mile in 2016) or actual expenses, whichever method produces the higher result.  We recommend using the standard home office allowance (maximum $1500) to avoid creating depreciation recapture. The home office must be used for vital tasks that cannot be performed at the main office, if there is one.
  5. Per diem reimbursement may be used for meals while travelling out of town on business.  If the Company paid for some of the meals, the Company may reimburse the shareholder for any days in which the actual expenses were less than the per diem.  In a way, this creates tax-free income for the shareholder who eats cheaply.  Should this be calculated and reimbursed regularly?
  6. The S Corp produces flow-through income for the owners.  Has this effect been predicted and the owners prepared?  Have estimated tax payments been made?  Have minority shareholders been informed?  We recommend that S Corps write into their bylaws that they will regularly distribute 50% of the net K-1 earnings to each shareholder, so that the shareholders can make regular estimated tax payments.
  7. S Corps only permit certain eligible shareholders – have there been any changes in shareholders that might terminate S Corp Status?
  8. Section 179 limitations apply at both the Corporate and Shareholder levels.  The limit was permanently raised to $500,000 in 2015 for businesses that purchase $2 million or less in qualifying equipment.  Before filing the S Corp return, the shareholders should confirm that they can use all the Section 179 deduction elected by the S Corp.  If one or more shareholders have used their Section 179 limit in another business, claiming the bonus depreciation instead will give them a deduction (but not as large) that they can use.
  9. Transfers of property into an S Corp by its owners is generally a tax-free transaction with the corporation receiving a carry-over basis from the owner.  There are exceptions when liabilities are transferred and when there is “boot” (cash or property other than stock) received in exchange by the shareholder.  However, property transfers by S Corps to their owners may have tax implications.  This is one reason we do not recommend that an S Corp own appreciating property.  Furthermore, the S Corporation cannot claim a depreciation deduction on property that is still owned by the owners.  Have property transfers been made that need to be recorded?  Should property be purchased, sold or transferred before year end to generate deductions?
  10.  If the S corp began this year, its predecessor may have a short tax year and the return may be due early.  Has this been considered?  If the S corp terminated during the year, it may have a short tax year and an early filing requirement.  The late-filing penalty for S Corps is $195/month per K-1, up to a maximum of 12 months.  Accordingly, we do not recommend S Corp elections to flakey taxpayers who regularly file late.
  11. One class of shareholders is permitted for S corps.  This means all dividend distributions must be made pro-rata to every shareholder in proportion to their ownership interest.  Has this been done or does it need to be equalized before year end?
  12. Built-in gains (BIG) tax recognition period exists for former C Corps.  This tax applies to the sale of an asset that appreciated in the hands of the C Corp and is sold within 5 years of making the S Corp election.  Does BIG exist and should proper records be maintained to estimate the tax bite for selling BIG assets?
  13. C-Corp NOL and Capital loss carryforwards are suspended during periods of S Corp existence.  Are there substantial carryforward that could reduce taxable income if the S Corp status were revoked?  Should the S corp status be revoked to activate any of these carryforwards?  Remember that changing back and forth may only be done after 5 years.
  14. Distributions in excess of basis may create capital gain income for the shareholder.  This frequently happens when the S Corp has liabilities other than to the shareholders.  Basis could be restored if the shareholders loan money to the S Corp.  Does basis need to be restored before year-end to avoid an inadvertent tax on excess distributions?
  15. Hobby loss rules apply to S Corps.  Is this a consideration here?  Should the owner document the profit motive by updating the business plan or making changes to the operation to more effectively pursue profitability?
  16. Is the S Corp adequately insured and carrying workers compensation if there are employees?  Should the owner who has multiple risks purchase an umbrella policy?  This is a good time to review all insurance coverage.
  17. There may be licensing issues related to S Corps in the trades and professions.  Is the S Corp in compliance with licensing?
  18. There is an $800 minimum Franchise Tax in California, to be credited against a 1.5% tax on profits, requiring prepayment.  Has this estimate been paid?  Considering the 1.5% tax or any other consideration, should consideration be given to changing the entity status?
  19. For S corp owners who own multiple businesses and offer employee benefits like pension plans and health insurance coverage – have the benefits been co-ordinated with the other businesses to avoid running into a “controlled group” issue with the IRS?
  20. Have the books and records been maintained in a professional manner with a clear segregation of the operations of the business from the personal assets of the owners, like the use of a separate, corporate checking account from which only business bills are paid?  (This protects the treatment as a corporation and preservers personal liability protection).

Awakening the Heroes Within

In January 2006, when the 29-year old Blake MyCoskie vacationed in Argentina, he discovered the “alpargatas,” a canvas shoe worn by Argentine farmers.  He also noticed the extreme poverty and lack of shoes (particularly for children).   Inspired, he reminisced on this inspiration in a 2011 article for The Business Insider saying “….the intense pockets of poverty just outside the bustling capital. It dramatically heightened my awareness. Yes, I knew somewhere in the back of my mind that poor children around the world often went barefoot, but now, for the first time, I saw the real effects of being shoeless: the blisters, the sores, the infections.”  Blake hit upon a business plan for a new company, Tom’s Shoes, which would bring the alpargatas to the world market with the promise that for every pair of shoes sold, a pair would be given to disadvantaged children.  The first shoes were sold in May, 2006.  On August 20, 2014, Bain Capital acquired half the company in a transaction that valued the company at over $600 Million.

After hearing this story I purchased a pair of Tom’s alpargatas, and I have to say they were just about the most uncomfortable shoes I have ever worn.  The flat rubber sole provided no arch support and the canvas body squeezed my toes together like a vice.  Yet Blake is a multi-millionaire.  It couldn’t be the product that made the company successful – it had to be the inspiration, the story.  You know the old saying, “We don’t sell the steak, we sell the sizzle.”

What Blake has done for his customers is to awaken the hero within.   Whatever your product or service, your marketing process goes into hyper-drive when it has a hero story behind it.  You know the hero feeling – that tingling inside you that you only feel when you know you are doing exactly the right thing – the thing you were born to do and do better than anyone else – and you are rising to a challenge on behalf of others instead of yourself.  Imagine how Tom Brady or Steph Curry feel when they enter the arena to compete for their team, for their city, for their sport.  Think Steve Jobs or Bill Gates announcing a new revolutionary product that will benefit all mankind.  A business that can inspire that feeling (for the owners and employees, as well as the customers) has unlimited potential.   Do you want this type of inspiration supercharging your life and your business?  Invoking this feeling is done with what I call a Metastory.

What are the qualities of a good metastory for you?

  • Grand Mythological Back Story.  Stories from mythology never really happened.  But they are true, nevertheless, and often more true than the truth.  They are true on the cosmological level of pure truth.  There is an ordinary person, there is a conflict, there is a tragic flaw that must be overcome, first there’s denial, then surrender, then suffering, the suffering gets worse, and finally the hero takes up the call…..and you know the rest.  Rescue the girl, kill the bad guy, save the world.
  • Ties into your personal History. Make an inventory of your past.  Look at your parents, your siblings, your childhood experiences, and find the natural series of plot points that tossed you around but eventually lead you to what you are doing now.
  • Complements your professional activity. The story must have themes from outside your profession but that draw easy comparisons and metaphors.  For example, the dentist who builds miniature sculptures or the attorney who volunteers helping veterans access their benefits.
  • Your story must be something you can “do” and you can document with actions, pictures, videos, and it must invite participation.
  • It must be something you already like to do, so you will persist and have passion.
  • It’s best if it’s something you already spend money on it so that these expenses become tax-deductible.  It’s even better if you can enroll supporters in your cause.
  • Acts as a “dog whistle.” You can create subtle bonds with prospects by enlisting key words, images, and subliminal messages.  For example, if my story includes serving in the Army, sustaining a service-connected disability, and being helped by the VA through rehabilitation and re-training for a new career, my story enrolls everyone who has a Vet or someone with a disability in the family. The following paragraph may be awkward, but look at the underlined segments:  “If you’re looking for help with your trust, Charles Wilson law firm is for you.  If bill collectors are after you and you don’t know who to call, Charles Wilson is there for you. If you have employees or are looking to hire, Charles Wilson can help.   If you’re hiring employees but don’t know how much to pay, Charles Wilson will guide you.”
  • Has Broad Appeal. Your story must appeal to a broad range of people who seek a hero.
  • Suits your Time and Your Era. Be trendy.  Tie into local cultural memes.  Veterans Benefits are a hot item now.  Hippie memorabilia is not.
  • Distinguishes you from All Your Peers. Steven Subotnick is a very successful foot surgeon.  His book, “The Running Foot Doctor,” established him as more than just a podiatrist, he was the expert in foot care for the runner (very broad appeal) because he was a runner himself.  His involvement in homeopathy (trendy) also set him apart from other surgeons as one who would not go to the knife before less invasive treatments were tried.  In my rehab, Arnica didn’t work for me, so he recommended and performed surgery.
  • Your metastory should enable you to create a richly-embroidered tapestry out of a variety of content, from activities to metaphors to office decor.

Now that you know the basics of a metastory, use them!  Build your business around them.  Enroll your friends and family.  Re-design your branding around it.  Take action regularly to advance your story and add content.  Co-ordinate your actions with complementary organizations (Co-branding).  Make a list of the most important personality traits that set your hero apart from the ordinary – courage, persistence, compassion, wisdom, mastery, etc.  Keep that list with you and whenever you are feeling discouraged or are tempted to perform at less than 100%, take out the list and read it.  Visualize yourself as the hero you are.  You will find your second wind and maintain your excellence.  After all, you are the hero.  Ordinary people can act when the going is easy.  When the going gets tough, that’s when the hero is needed.

A real hero put’s his own feelings aside and acts in the best possible way to advance the cause.  So you haven’t got time for resentment or self-indulgence.  When you are about to meet with a difficult person, forgive that person in advance for all the rude things they might say.  This will aid you in responding in the most effective way to get to the best outcome, instead of reacting emotionally in the moment.  Make the assumption that the other person has a positive intent and is not wrong, but rather that they know something that you don’t know, which makes them act in a way you don’t yet understand. Then try to find out what that something is.

The best referral sources are difficult people.  “Gosh, if RAMONA likes you, you must be really great, because she doesn’t like anybody.”

Give up on being right.  Humbly take the blame even when you don’t deserve it.  Validate your clients and customers’ ideas, even if they appear misguided.  People are not used to being treated this way and they will feel a connection with you.

Now, as your tax advisor, I’ll give you some professional tax coaching about how to weave your metastory into your business plan to make sure that all your fun is ALL TAX DEDUCTIBLE.

  • Get to know the tax game (and it IS a game). A game is an activity with a goal toward which play is directed.  When you know the rules of the game, you can masterfully bend them to your will, set and attain ambitious goals, and make the process playful.  For example, travel is either deductible or not based on clear rules outlined in IRS Publication 463.  Do you know the rules?  Use ‘em!
  • Learn how to “spin.” Deductibility is primarily determined by your intent (spin).  If you fly somewhere to attend your son’s wedding, the trip is not deductible.  But if the primary purpose of the trip was to attend a valuable 3-hour association meeting on Thursday night and visit colleagues on Friday and Monday, you are taking a business trip.  It’s deductible even if you take a weekend break from your busy work schedule to attend the wedding.  All deductible:  airfare, lodging, car rental, meals – everything.  Everything except that round of golf on Sunday.  These rules for both business owners and employees.
  • Keep a diary. The IRS adores “contemporaneous: recordkeeping. Write down where you go and what you do (for your business or career), and what you spend every day. You will avoid overlooking any deductions and you will have all the evidence required to substantiate your ‘spin’. One of my clients sold a screenplay and used his diary to go back three years and document expenses directly involved in developing the story line. Build your own sorry line for your business or career that converts previously personal expenses into tax deductions. Black Mycoskie started Tom’s shoes with the promise of giving a pair of shoes to a child in need for every pair he sells. Given that story line, whenever Black hops a plane for anywhere, it’s a business trip f he packs a box of give-away shoes. What’s your story?
  • Save stuff. Yes – all those receipts may be useful one day. Start a fresh box each year. To substantiate a tax deduction you need to prove two thigs: that you paid for it, and that it was an “ordinary and necessary” business expenses. Even if the expenditure appears on your credit card statement, you may need the actual receipt to identify the items purchased and prove that you bought was used in your business or career.
  • Maintain good IRS hygiene. File on time, open IRS mail, respond promptly, and forgive the IRS in advance for everything they are going to do. (This practice is helpful with your weird cousin, too). You really do earn a participation grade with the IRS. There is a new IRS program called “first-time abatement” (FTA) – see the internal Revenue Manual section 20.1.1.3.6.1. This provision went into effect on 8-5-14. If you have filed all your returns on time for the last 3 years, and paid or arranged to pay (on a payment plan) your taxes, you automatically qualify for a penalty relief if the IRS disallows some of your metastory expenses.

My metastory:

My parents always hoped I would be an entertainer on Broadway.  I learned to sing and play several musical instruments.  I won a scholarship to a private school for the arts, and I started by adult life playing woodwinds professionally in the Army Band.  Even though I showed early evidence of an affinity for keeping records (scorekeeper on the baseball team, treasurer for the stamp club, etc.), I pursued the musical path.  But it never felt right.  Not until a service-connected disability called a halt to my musical career.  The VA sent me through vocational rehabilitation testing and told me I should be an accountant.  At first I objected, but after my first class I was hooked.  The VA paid for my MBA.  I owe a great debt to the Army and the VA for righting my path.  Now I give back the gift that I was given by dedicating my life to helping clients overcome their challenges and find their own melody, harmony, and rhythm.

Taxlish

As a long-time tax preparer, I have learned that there is a special language sometimes used in dealing with the IRS. I call this language “Taxlish.” I am not encouraging the use of this language, because it can lead to problems in an IRS audit examination, but I have assembled a Lexicon that translates common English words and phrases into Taxlish.
This is provided exclusively for educational purposes and should not be construed as tax advice.

Taxlish

I bought a house – what do I deduct?

I recently wrote this letter to a client of mine who purchased a house and wanted to know what to deduct:


Q:  I bought a house – what do I deduct?


A:  “Dear Andrew…

Congratulations on your home purchase.   Your home mortgage interest and property taxes are tax-deductible so you are now going to be able to itemize deductions instead of claiming the standard deduction on your tax return.  You must attach Schedule A to your tax return.  You should go to www.irs.gov and print out Part Five of IRS Publication 17 to familiarize yourself with what is deductible.  Here are the categories of itemized deductions:

Medical Expenses– Most likely your will not qualify for a medical expense deduction because unless you are self-employed (and therefore can deduct health insurance premiums), medical expenses must exceed 10% of your income before they trigger a deduction.  Health insurance premiums paid by your employer with pre-tax dollars or with HAS funds cannot be deducted – only your after-tax out-of-pocket expenses qualify. But save your cancelled checks just in case they add up to enough.

Taxes – This category includes state and local income tax withheld from your paycheck, any amounts you paid the state when you filed your return last year, and any state estimated tax payments made.  You also get to deduct property taxes on your home and the VLF portion of the DMV registration fee on your cars.  Be sure to look on your escrow closing statement to find the amount of pro-rated property tax you were charged when you bought (or sold) your home.  If your taxes are paid by a mortgage impound, deduct the amount paid by the mortgage company to the county, not the amount you paid to the mortgage company.  Unique to some cities in California is a deductible 6.5% ‘utility user tax” on the PG&E bill.   This tax is not a sales tax, but goes to the City so it is deductible.

Interest – Your mortgage interest on your principal and one second residence is deductible here.  There are some limits – if you borrowed more than $1.1 Million to buy your home or you have refinanced your home and taken out more than $100,000 in equity, you may only be able to deduct a portion of your interest.  Points paid to purchase a principal residence are usually deductible in the year of purchase, but points on a re-finance must be deducted ratably over the life of the loan.   Any remaining points on a previous re-finance are written off when you re-finance a second time.  You also may deduct investment interest (like on a margin account) to the extent of your investment income.

Charity – Cash and non-cash contributions to 501(c)(3) organizations are deductible.  Make regular trips to the thrift store to build your deductions.  Check the IRS Publication for record-keeping requirements.

Miscellaneous – This is the catch-all category of itemized deductions.  Included are unreimbursed business and investment expenses, education in your profession, and your tax-preparation fees.   The instructions for Schedule A describe these deductions in detail.   Only expenses in excess of 2% of income generate a deduction, but if you keep good records you will be surprised how easy it is to exceed 2%.   Business expenses for self-employed individuals are claimed elsewhere, but since you are an employee and you work in internet multimedia, you should be able to reasonably deduct some of your home computer expenses, internet access, purchases of software, CDs, and DVDs, and attendance at concerts and movies.   You may also qualify for office-in-home deductions if you maintain the office for the convenience of your employer.

Home Improvements – Alas, except possibly as medical expenses, home improvements are not tax-deductible.  They do, however, add to the basis of your home.  The basis is used to calculate your capital gain when you sell your house.  You are entitled to an exclusion of capital gain up to $250,000 per person provided you meet certain requirements, but anything over that would be subject to tax, so it is best to save your receipts for home improvements until 3 years after you sell your house.

 

Congratulations on your new tax-deduction.  Now how about some grandchildren?

 

Love, Dad”

Ask Rob Kirby, CPA Santa Rosa tax and investment advice

Should I Pay Down My Mortgage? – Ask Rob Kirby CPA

Welcome to the  first of what I plan to be a long series of Question and Answer posts.  More than anything else, I love answering your questions.  I hope that you find these to be of value and if you have questions you would like to see featured here, please email me at Rob@TaxOasis.com.


Q:  So, John and I have a question for you.  We did not put any money into our retirement account and we aren’t sure if we should.  As you may or may not be aware, we are looking to purchase a home.  We would like to put a large down payment with the hopes of paying it off as quickly as  possible.  Is this a wise choice or should we deposit some money into our retirement account instead.  Since we aren’t sure mathematically what is more beneficial, we figured we’d ask the math guru.  What is your expert recommendation? Our income is about the same as the previous year. I can put about $12,500 into my retirement account, but I’m not sure if that money would be better dumped into a home down payment since our plan is to pay it off as quickly as possible. Any thoughts?


A:  In general, I do not recommend paying down your mortgage. Our economy revolves around the principle residence mortgage – it is the cheapest way to borrow money. In most metropolitan markets, you can get a long term rate that is less than the average annual appreciation.

By financing a large percentage of the purchase price, you are leveraging your investment and increasing the rate of return on your money. Your house will appreciate at the same rate whether you have a mortgage or not. So the key factor should be “what else can we do with the money, and how much return do we get on that?”

Investing in your retirement plan provides you with an immediate tax savings of 37%. So $12,500 into your retirement plan saves you $4,625. That means it only cost you $7,875 to have $12,500. That’s a gain of $4,625 on an investment of $7,875 which equals 58% return on the first day. Plus you get the appreciation on the investment over time. Compare that with saving only 3 or 4% per year on mortgage interest if you paid down the mortgage with that money.

Best,

Rob

Rob Kirby, CPA
1220 N Dutton #103
Santa Rosa, CA 95401
707-545-8297 (appointments)
707-888-3676 (mobile)
707-541-2381 (fax)
ROB WILL LEAVE NO MONEY IN THE STADIUM SEATS

IRS CIRCULAR 230 — DISCLOSURE NOTICE:
Effective Jun 12, 2014, the IRS has changed the rules for written tax advice and the previous circular 230 disclosure is no longer appropriate. So now I can tell you that my advice must be based upon reasonable assumptions about the facts or the law, and reasonable representations, statements, findings or agreements. I am required to make reasonable efforts to ascertain and consider all relevant facts. When evaluating a tax matter, I may not take into account the likelihood of an audit or settlement. I hope you feel better about this, too.

Business Category

Avoiding an IRS audit (part 2 of 2)

Beating the computer and avoiding an IRS audit:

(Read Part 1 Here)

  1. List a Conservative Occupation

Right next to your signature you are requested to list your occupation. Some occupations attract conservative and law-abiding individuals, who help keep the DIF score low for everyone who lists that occupation on their 1040. From accountants, auditors, bank tellers, pre-school teachers, journalists, peace officers, and politicians (presumably low DIF), to real estate salespeople, entertainers, artists, marketing consultants, and horse trainers (presumably high DIF), each occupation has its own unique fingerprint indicative of either a conservative or liberal approach to filing taxes. I’m guessing (but I’m not sure) that the IRS even has statistics for persons listing no occupation or certain vague descriptions like “self-employed,” “business” and “manager.” NOTE: the author recommends that you do not use the occupation “Administrative Assistant” which changes meaning when the second word is truncated to only 3 letters by the IRS computer.

How can this work for you? That’s easy – put a spin on your occupation or job title to point out the more conservative and tax-law-respectful version of yourself. Or leave out the occupation if you believe there is no way to describe what you do without alarming the FBI. It is important that your occupation bears a close relationship with the types and amounts of your income and deductions; your DIF score will be lower if the relationships are within normal limits for your occupation. Common sense suggests that the occupation “accountant” would be the least frequently audited, not only because accountants tend to be more conservative and knowledgeable about the tax law, but they have the skills to read tax form instructions and produce proper supporting documentation in the event of an audit. I have reported myself as an accountant for 35 years, and even in years when my income and expenses were way outside normal figures for my occupation, I have never been audited, at least up to this date. Perhaps the writing of this book will change my luck. Bring it on, I have the records!

2.  Match 3rd Party Reporting

Match all 3rd Party Reports and then some. Never miss a 1099 or W-2. Be sure to include interest income on all bank accounts, and be especially careful to check that you received a 1099 from all accounts, even the one from that savings account you closed last March and might have gone to the wrong address. If you had a savings account with a small balance you may not have received a 1099 (not required if the interest is under $10). Be sure to report some interest for that account. Reporting income that you are not forced to report may lower your DIF score.

If you received a 1099 that is in error – it doesn’t belong to you or reports more income than you received, try to get the issuer to correct the 1099. If you cannot make this happen, report all the income on the 1099 in the correct place as if you had received it, and take a deduction on the same form to reduce the net income on your return to the amount that you actually received. An example of this is found in the sample return in Appendix

3.  Moderate Certain Targeted Deductions

Certain items on tax returns are frequently targeted by the IRS because they are frequently abused and auditing them produces results. Here is a list of these items and the reason the IRS looks at them:

Automobile Expenses. There are specific record-keeping requirements of which many taxpayers are unaware and often fail to follow. The records must be “contemporaneous” so the taxpayer must be able to produce them at the first audit meeting. If you go into an audit not knowing this and you make the mistake of saying “no, I don’t have a log of my business miles,” you have been blind-sided into losing the deduction, even if you really deserve it. The ability to claim a standard mileage allowance tempts many (the majority of) taxpayers to pull a number of out thin air rather than keep clipboards in their cars and meticulously track changes in their odometer reading. When given the opportunity to “estimate” business miles, who wouldn’t be tempted to overestimate to some degree? The prevalence of inadequate record-keeping and overestimation makes this category ripe with low-hanging fruit.

Meals and Entertainment. Once again the record-keeping requirements promote overestimation and inadequate record-keeping. In addition, the IRS reserves the right to disallow some meals as “lavish and extravagant,” although this term is not objectively defined.

Mortgage Interest. Amounts in excess of $50,000, even when they match the electronic reporting of the lender, raise the possibility that the mortgage balances may exceed the maximum amount ($1.1Million) on which interest may be deducted. If your mortgage interest is higher than $50,000 you may wish to deduct some amount slightly than that to give the impression that you have calculated the non-deductible portion.

Non-cash Charitable Contributions. Be sure to attach Form 8283 if your noncash contributions exceed $500. Provide an elegant description of each item donated, along with the words “exc cond”. “11 silk blouses” is more elegant than “clothing.” List an original cost that is at least 4 times the fair market value.

Travel Expenses. The temptation exists to deduct travel for vacations, weddings, and other non-deductible purposes. In addition, many travelers erroneously include their meals as travel expenses, which is incorrect, since the deduction for meals is only 50% of the amount spent, even if the meals are incurred while travelling. And again, there are specific record-keeping requirements.

Office Expenses. Many taxpayers erroneously include the cost of office equipment in this category. Equipment is an asset and must
be depreciated to be deductible. While it is acceptable to have a minimum dollar-amount “cut-off” for assets (say, anything under $100 goes in office expenses, anything over is treated as an asset), your DIF score may be lower if you reduce your office expense to an amount that flies “under the radar” by depreciating all assets, even those costing under $100.   In fact, depreciating a long list of inexpensive assets may also reduce your DIF score, because it is indicative of a more conservative taxpayer.

Miscellaneous Expenses. This catch-all category tends to accumulate significant dollar amounts, appears on both individual and business returns, and provides the taxpayer with an opportunity to include a supporting statement. But because of the variability in the supporting statements, the IRS computer does not evaluate the detail statement, just scores the return based on the total in “miscellaneous.”

What can you do to protect yourself? First of all, avoid overusing these categories. If your automobile expenses are high, you could transfer some of them to advertising, travel, or education. There is no penalty for mis-classifying your expenses, as long as you can properly defend them. The Service will simply decrease one category and increase the other in the course of an audit, resulting in a change to your return, but with no additional tax assessed.

If you have large deductions in these categories, you may avert attention by classifying some of them as the less-frequently used category “cost of goods sold.” Any expenditure that was directly related to the production of income could be considered cost of goods sold. This category is used by retailers to deduct the cost of products sold in the store, and by contractors to deduct labor and materials that went into their jobs. Many other businesses may use this category, which is frequently a large percentage of gross receipts. On the other hand, be sure that your cost of goods sold is not too high in relation to your gross receipts, or you will run into another audit flag. While it is possible (especially for a contractor) to pay more for materials and labor than the revenue on the job, it is a sure audit flag if your cost of goods sold exceeds your revenue. Better to claim some of the labor as overhead on Schedule C line 26.

4.  Look Closely at the Relationships

The relationships between income and expenses have a great bearing on the DIF score. For example, losses from self-employment (reported on Schedule C) result in more frequent audits than losses from rental properties (reported on Schedule E). Rental property is not as profitable as a business, the actual ownership of a rental property is often verified by third party reporting of mortgage interest, and rental losses are subject to a limit of $25,000 per year for most taxpayers, a limit which is frequently reached.   Self-employment losses are less common, do not always have third-party verification, have no annual limit, and there is a much greater frequency of audits resulting in additional tax assessment. A business loss is especially inviting to the IRS when it appears on a return with a lot of other income (wages, interest, etc.). It is more tempting for a high-income taxpayer to exaggerate expenses when there is real savings.

Here is a list of relationships that should be approached with care:

1)      A business loss (Sch C) that exceeds 10% of other income on the return

2)      A service business without payroll expenses that shows a loss

3)      Medical deductions over 10% of total income

4)      A large deduction for pension contributions when there is little income.

5)      Claiming head of household with 5 children in a high-rent zip code and little or no income.

(Read Part 1 Here)
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Santa Rosa tax services - audits

Avoiding an IRS audit (part 1 of 2)

The first defense against an IRS audit is to avoid them in the first place – and knowing how IRS audits are triggered in the first place can equip you to take steps to avoid them. The secret IRS program

The IRS runs a top-secret computer program (the “discriminate income function” or DIF) that analyzes the millions of tax returns filed each year. The program has been developed over many years based on research studies performed by auditing selected returns in varying industries with differing attributes, and carefully analyzing the results to determine which returns are most likely to produce a positive cash flow to the IRS. That is, what characteristics on a tax return indicate that the Service is more likely to collect more than enough income tax to justify the cost of the audit. In other words, find the big trees with low-hanging fruit. The higher the DIF score, the

After the IRS computer “kicks out” the returns with the top DIF score (roughly the top 10%), the returns are screened by IRS personnel. This personal screening process pares down the selection subjectively based on the judgment of the screeners. Human screeners are capable of much finer discernment than the computer, and they eliminate returns containing high DIF features that nonetheless appear reasonable and appropriate to the human screeners. For example, a large deduction for “party balloons” which triggered a high DIF score might be evaluated as unworthy of audit by a human screener if it appeared on the return for a birthday clown or new car dealer, but would more likely look like low-hanging fruit on the return of a mortgage broker.

Jan, an accounting clerk making $25,000 in wages and who claims the standard deduction, is not likely to get an audit letter.   The income is well documented by the employer, so there is little opportunity for the taxpayer to be under-reporting income, and the standard deduction is automatically available for any person who takes a single breath in any tax year. The Service is not likely to generate any revenue from auditing Jan. Carmen, however, a dentist who earned $300,000 in her practice and who claimed 55,000 business miles as a deduction, is a much more likely candidate. Not only is the 55,000 miles excessive compared with other dentists (indicating that an adjustment may be made resulting in additional tax) but Carmen makes a lot of money so she will have the ability to pay the additional tax assessed. The computer program is much more likely to select Carmen (in fact, certain!).

While the exact contents of the DIF program are unknown, accountants over the years have learned to identify certain characteristics of tax returns that have been audited that re-appear frequently and are most likely to have increased the DIF score:

1)      The higher the income, the higher the DIF score. The Service does not want to waste time auditing taxpayers who would just end up in Collections, so low-income taxpayers generally get a lower DIF score. One exception to this is taxpayers receiving the Earned Income Credit, a welfare payment to low income parents, which is subject to a lot of abuse and generates a lot of

2)      Failing to include income reported by 3rd party payers increases the DIF score.

3)      If your deductions do not match 3rd party reporting (e.g., you report $39,000 of alimony paid but your ex-spouse only reports receiving $29,000) or if your deductions are excessive in relation to the other items on the return (55,000 business miles would be more likely to appear on the tax return filed by a long-distance freight hauler than by a dentist), you are going to get a higher DIF score. Make sure the mortgage interest you deduct matches Form 1098 from the lender.

4)      Unusual or excessive deductions, particularly in relation to your income or your stated  So it is possible for just about any income or deduction item to affect your DIF score, depending

Beating the Computer

Managing your DIF score is the first defense against the IRS computer. So what can you do about your DIF score? Stay tuned for the next article

(Read Part 2 Here)

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