Minimizing the Impact of the 2013 Tax Increases

My last blog post, “Planning for the 2013 Tax Increases,” discussed the significant tax rate increases starting Jan. 1, 2013 under current tax law. For further information on those changes and an excellent table summary, see 2013 Tax Changes Require Thorough Year-End Tax Planning.

This blog post will focus on opportunities to minimize the impact of the 2013 tax increases.

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Planning for the 2013 Tax Increases

Unless our Congressional representatives, Senators and President agree to extend the Bush tax cuts federal tax rates will increase on Jan. 1, 2013, and other tax increases will take effect. Given the current political climate, these tax increases are unlikely to be postponed again, though things could change after the November elections. As a result, the only way to “lock in” the current, historically low federal tax rates is to act before the end of the year. Generally, we don’t believe that tax minimization should be the only matter to consider in making financial decisions. However, this year, its importance as one of the key factors to consider should not be under-estimated.

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Reporting For Managers and Owners – Less is More

After working with owners and managers of our client firms for over 30 years, I’ve learned a great deal of time and attention is spent trying to learn what is going on in their companies by carefully reviewing company financial statements. In most cases these statements are based on Generally Accepted Accounting Principles, or GAAP. This set of rules and guidelines has been developed by the accounting profession over many years to ensure that reporting is consistent, theoretically sound, and meaningful. However, many managers and owners overlook who the intended reader is for GAAP statements. And this can lead to incorrect, even dangerous assumptions about financial information. Continue reading

$5.12 Million Estate and Gift Tax Exemption: Going, Going … Nearly Gone

While preparing to write this blog post, I stumbled across the term “Taxmageddon” to describe the expiration of the so-called “Bush tax cuts” at the end of this year. Equating the expiration of tax cuts to Armageddon is clearly hyperbole. However, the opportunity to take advantage of current generous estate and gift tax benefits is going away, and failing to act could cost you – A LOT. Taking advantage of those benefits requires time and the services of professionals. Unfortunately, time is running out, and the closer we get to the end of the year, the busier those professionals get.

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Your Most Under-Appreciated Sales Person…You!

For the past 30 years, the single question I have received more than any other is “Can you help me find any good sales people?” Generally speaking, my answer is “yes and no.”

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How $4,000 Saved $1 Million

We recently had an interesting case of why businesses need to work with professionals who have knowledge of their business. It’s a perfect illustration of how we are able to add value to what our clients do. In this case, the return to our client may quite literally be better than 25,000% when compared to the cost of the work! Here’s what happened.

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Recordkeeping for Federal Tax Purposes

When most people think about tax compliance, they think about tax returns. The purpose of this post is to remind us all that a tax return is only a summary of the information on the underlying records of taxable income and deductible expenses. Those records are more important than the return itself for several reasons.

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Your Chances of an IRS Audit

Every year we have clients asking us, what’s the chance of being audited by the IRS?  And every year, our answer is pretty much the same.  The chances of an audit are not very high, unless your return contains an item that the IRS has identified as a major area of taxpayer errors.  Now, the new IRS annual data book for 2011, just released, supports that position.

Of the 140,837,499 total individual income tax returns with a filing requirement, 1,564,690 were audited, roughly 1.1%, which is the same as the rate for the previous year.  An area that many individual filers make mistakes with is the Earned Income Tax Credit, or EITC.  Consequently, of the total number of individual income tax returns audited in FY 2011, 30.9% were for returns with an EITC claim, a slight increase from the 30% of all audited returns for FY 2010.

Only 25% of the individual audits were conducted by revenue agents, tax compliance officers, tax examiners and revenue officer examiners. That’s higher than the 21.7% figure for the previous year. The 75% balance of the audits were correspondence audits, down from 77.1% for the previous year.

Following are selected audit rates for individuals not claiming the EITC, including those with business returns included, such as proprietorships or single member LLC’s, etc:

… For individuals with business returns other than farm returns showing total gross receipts of $100,000 to $200,000, 4.3% of returns were audited in FY 2011, down from 4.7% in FY 2010.

… For individuals with business returns other than farm returns showing total gross receipts of $200,000 or more, 3.8% of returns were audited in FY 2011, an increase from 3.3% in FY 2010.

… Of the individual returns showing farm (Schedule F) income, .6% were audited in FY 2011 versus .4% in FY 2010.

… For individual returns showing total positive income of $200,000 to $1 million, 3.2% of returns not showing business activity were audited, and 3.6% of returns showing business activity were audited. The audit rate for such returns was higher than the 2.5% and 2.9% respective rates for the previous year.

… For FY 2011, the audit rate for individual returns with total positive income of $1 million or more was 12.5%, close to forty nine percent higher than the 8.4% rate for FY 2010.

Not surprisingly, examination coverage increased for higher income earners. For example, the percentage was 1% for those returns with adjusted gross income (AGI) between $100,000 and $200,000 (up from .71% for FY 2010), and 2.66% for those with $200,000 to $500,000 of AGI (up from 1.92% for FY 2009). Exam coverage jumped to 11.8% for those with at least $1 million but less than $5 million of AGI (up from 6.67% for FY 2010). Similarly, coverage increased for those with at least $5 million but less than $10 million of AGI, as well as for those with AGI of $10 million or more.

These results indicate pretty clearly that for individuals, at least, the likelihood of being audited by the IRS on any given year is not very high.  However, as your income increases, so does the likelihood of an audit.  So for those with higher levels of income, including those with “flow-through” income, such as from partnerships or S Corporations, in which the business’ income is included on the owners/shareholders personal returns, this is an issue.  Also, it’s sometimes a bit deceptive to look at just one year’s audit results.  Generally speaking, the returns of any individual are subject to audit and adjustment by the IRS for three years.  When a return is audited, it’s not at all uncommon for an auditor to ask for copies of all returns filed by the taxpayer that remain “open” to audit, to at least review them briefly, and if they determine it’s appropriate to open the examination on those years as well.  So realistically, a better way to estimate your likelihood of an audit of any single year, is to add the likelihood of an audit for the most recent three years.  Here’s an example.

Assume that an individual owns an S corporation, and has income that varies quite a bit from year to year, as a result of the swings in S corporation income shown on their return.  So in 2009, the likelihood of an audit, based on the IRS, might have been 3.5%, in 2010 1.7%, and in 2011, 2.8%.  Rather than look at the individual year’s chances of an audit, a more realistic way to understand the risk here, is to add the three numbers up, because of the three-year “open period” for any return.  In this case, any of these returns probably has an 8% (3.5% plus 1.7% plus 2.8%) likelihood of being subjected to an audit, or roughly 1 in 12.  Still long odds, but not as long as it would appear, if looking at only the annual results.

Our recommendation on this is that all taxpayers should approach their annual tax returns assuming that their return will be audited, but to be realistic that the odds of not being audited are still in their favor.  We can discuss with any individual the specifis of their own returns that may increase the likelihood of an audit, but generally speaking, as you can see the likelihood, even when all open years are included, is still pretty small.

Next time, we’ll talk about business returns, and the likelihood of an audit there…definitely a different picture.

– Gerry

Can you claim your adult child as a dependent?

I’ve received a lot of questions recently about claiming adult children as dependents.  If your child is over 18 years old at the end of the year, you can no longer safely assume that you can claim him or her as a dependent for tax purposes.  The following table, from IRS Publication 501, Exemptions, Standard Deductions and Filing Information, provides a concise summary of the rules for claiming someone as a dependent.

Table 5.   Overview of the Rules for Claiming an Exemption for a Dependent
Caution.
This table is only an overview of the rules.

  • You cannot claim any dependents if you, or your spouse if filing jointly, could be claimed as a dependent by another taxpayer.
  • You cannot claim a married person who files a joint return as a dependent unless that joint return is only a claim for refund and there would be no tax liability for either spouse on separate returns.
  • You cannot claim a person as a dependent unless that person is a U.S. citizen, U.S. resident alien, U.S. national, or a resident of Canada or Mexico.
  • You cannot claim a person as a dependent unless that person is your qualifying child or qualifying relative.
Tests To Be a Qualifying Child Tests To Be a Qualifying Relative
  1. The child must be your son, daughter, stepchild, foster child, brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of them.
  2. The child must be (a) under age 19 at the end of the year and younger than you (or your spouse, if filing jointly), (b) under age 24 at the end of the year, a full-time student, and younger than you (or your spouse, if filing jointly), or (c) any age if permanently and totally disabled.
  3. The child must have lived with you for more than half of the year.
  4. The child must not have provided more than half of his or her own support for the year.
  5. The child is not filing a joint return for the year (unless that joint return is filed only as a claim for refund).

If the child meets the rules to be a qualifying child of more than one person, only one person can actually treat the child as a qualifying child. See the Special Rule for Qualifying Child of More Than One Person described later to find out which person is the person entitled to claim the child as a qualifying child.

  1. The person cannot be your qualifying child or the qualifying child of any other taxpayer.
  2. The person either (a) must be related to you in one of the ways listed under Relatives who do not have to live with you, or (b) must live with you all year as a member of your household (and your relationship must not violate local law).
  3. The person’s gross income for the year must be less than $3,700.
  4. You must provide more than half of the person’s total support for the year.
  1. There is an exception for certain adopted children.
  2. There are exceptions for temporary absences, children who were born or died during the year, children of divorced or separated parents or parents who live apart, and kidnapped children.
  3. There is an exception if the person is disabled and has income from a sheltered workshop.
  4. There are exceptions for multiple support agreements, children of divorced or separated parents or parents who live apart, and kidnapped children.

If, after reviewing the table above, you have any questions about whether or not you can claim your adult child as a dependent, please call us.

-Dante

To capitalize or expense? That is the question. New regulations hit us on 12/23/2011.

A Sweet 2011 Christmas Gift:  A pile of capitalization and repair regulations from the Department of the Treasury.

A little history may be in order.

Since forever, accountants have grappled with the question of whether you capitalize or expense repairs of various sorts.  Repairs are deducted immediately.  Capitalized items must be recovered over time using depreciation, sometimes a long time (such as in the case of real estate).  In recent years, these concepts were less important, due to stimulus incentives allowing immediate write-offs, even with capitalization.

There has historically been some judgment involved in deciding what to expense and capitalize.  For many years, we used the old regulatory 1958 language, in its brevity, which said:

The cost of incidental repairs which neither materially add to the value of the property nor appreciably prolong its life, but keep it in an ordinarily efficient operating condition, may be deducted as an expense, provided the cost of acquisition or production or the gain or loss basis of the taxpayer’s plant, equipment, or other property, as the case may be, is not increased by the amount of such expenditures. Repairs in the nature of replacements, to the extent that they arrest deterioration and appreciably prolong the life of the property, shall either be capitalized and depreciated in accordance with section 167 or charged against the depreciation reserve if such an account is kept.

Admittedly, this gave us quite a bit of latitude in our decision-making.  It was also fodder for controversy.

For financial reporting, under Generally Accepted Accounting Principles, businesses capitalized a repair under similar principles.  Often, companies would adopt a capitalization policy, which might be disclosed in financial statements, which determined the methodology by which they might make capitalization decisions.  Capitalization makes a balance sheet look better.  Sometimes, as auditors, we required balance sheet items to be expensed or expense items to be capitalized, based upon judgment of the facts.

Of course, capitalization usually slows down tax deductions and increases tax.  Usually, capitalization decisions were treated the same way for financial and tax reporting.  Since capitalization decisions make balance sheets look better and taxes higher, there was some “give and take” in making the decisions.

Taxpayers have argued about this issue with revenuers since taxes were invented.  Sometimes, revenuers determine that a taxpayer’s capitalization threshold is too high.  For example, a taxpayer might declare in its capitalization policy that nothing with a cost of less than $1,000 will be capitalized.  A revenue agent might decide that this amount is too high and could propose adjustment.  We would argue about the language in the regulatory paragraph, above.  Often the issue would be settled in exam, appeals, or in the courts.

In an effort “to provide clarification”, the new regulations, called Temporary Regulations (indicating a transitory nature, but often standing for decades) are IRS’s third attempt to provide comprehensive guidance. Proposed regulations were issued in 2006, and then modified in 2008.  The new Temporary Regulations build on the concepts introduced in the 2008 regulations, but make many changes along the way in response to commentators. This body of regulations, a 250-plus page package, becomes effective for tax years beginning after 2011.

To some extent, the “pain” (tax) caused by these regulations will be subdued in 2012, due to stimulus depreciation.  However, the regulations apply to many items not given stimulus benefit.

It should be noted that there are certain, deminimus provisions in the regulations, which could potentially provide taxpayers benefit, but the writer generally views these regulations with a bit of fear.  I would suggest they provide a bunch of new “hooks” that could hang up taxpayers in new ways, under exam.  Repairs are here to stay and the regulatory compliance burden has certainly increased with this issuance.

We will be reviewing these regulations in much more detail, as 2012 enfolds.  If you have questions or readily apparent issues, please contact the tax person assigned to your account and we will address your specific situation.  There is much more to come on this issue.

Signing off,

Joel