Tales From a Tax Preparer

Education tax breaks - which one is best?

2012-02-16T09:07:00.000-08:00

There are a lot of great tax breaks for folks in college. But they can be confusing. How do you know which one is best for you? I'll try to run through the basics.

A few generalities with education credits. All tuition must be for an accredited college. The student can't have been convicted of a felony for possession or distribution of a controlled substance (I guess first degree murder felony would be okay, though). There are some income limitations, as noted below. Lastly, if you are married, you must file jointly to claim any education credits or deductions.

You only can claim one tax break for dollars spent - that means you can't get both a credit and a deduction for the same tuition or the student. Similarly, you can't get a credit or deduction for tuition that was covered by a grant or scholarship, or that was paid from a 529 or other college savings plan. However, you can claim a credit for tuition paid for with student loans. You can also claim a credit for tuition paid for by a friend or relative - the tax break goes to the taxpayer who is the student, spouse or who claims the student as a dependent.

American Opportunity Credit - this is the best credit by far. It's up to a $2,500 credit, which means it goes directly in your pocket (or reduces what you owe dollar for dollar). The student must be in their first four years of college (i.e., not grad school) and they have to be a full-time student. It's 100% of the first $2,000 of qualified tuition and 25% of the next $2,000. That means you only have to spend $4,000 to get the maximum credit. It's the only education credit that is partially refundable. That means if your tax liability is reduced to zero, you can still receive a refund of up to $1,000 from this credit. And it's the only credit that allows you to use your book expenses as part of your qualified expenses. Most college tuition is more than $4,000, so the book expenses don't always help you. But if you have some grants or scholarships that are covering your tuition, you may benefit by including those book expenses. This credit phases out if your income is above $90K single and $180K married. It's just a fantastic credit.

Once you have four years of college under your belt, or if you are no longer a full-time student, the following education tax breaks may suit you.

Lifetime Learning Credit. This credit is generally for the part-time college student or grad student in the 15% or lower tax bracket. The credit is 20% of qualified tuition (not books) up to $2,000 maximum credit. If you or your dependent are just taking a class or two at a time, this is the credit for you. This credit phases out earlier than the other two breaks: at income above $60K single and $120K married.

Tuition and Fees Deduction. This is an above-the-line deduction, meaning it lowers your taxable income. The maximum deduction is $4,000, but the dollar amount of the benefit to you depends on your tax bracket. The above-the-line piece means you don't have to itemized to take it and it also lowers your Ohio income, thus saving some tax dollars there. This deduction can be used by virtually any college student, full or part-time, undergraduate or graduate school. This credit phases out if your income is above $80K single and $160K married.

The above should be considered a summary of the rules for each education tax break and is not meant to be all-inclusive. That would be a really boring blog. Please consult the IRS Publication 970 or other sources for all the rules regarding the various education tax breaks.

Many tax software programs will optimize the education credit that's right for you, factoring in what you qualify for and your income level. Most are not sophisticated enough to include the Ohio savings on the tuition deduction, so you might have to factor that in by hand. The bottom line is that education tax breaks are generous and plentiful. Did you take the right one this year?

What will you do with your refund?

2012-01-27T09:01:00.000-08:00

Many people think tax preparers are boring accountants, mired in numbers from dawn 'til dusk. While that may be true for some, I think there is a large human component as well. We meet so many people, from all walks of life, with all sorts of occupations and family situations, that you never know who you'll meet next.

One of my favorite things during tax season is asking what someone will do with their refund. Whether it's their usual refund amount, or an unexpected windfall, most people have a plan for at least part of it.

Many people use their refund for a home improvement. Some have the philosophy is that since the refund is largely due to the house and related deductions, the refund goes back into the house. Either a necessary repair or some type of improvement, they now have a chunk of funding for their project. I've heard about a lot of plans and they run the gamut from building a dream man cave to just keeping the water out. The least exciting repair has to be the new garage door, followed closely by a new roof. The most fun are the plans for a kitchen or bathroom remodel. Even new appliances are fun to think about.

Some people will use their refunds for vacation. I love to hear about travel plans. One client had been going through some really tough times, raising three children on her own. An unexpected refund of several thousand dollars practically brought her to tears. She had always wanted to take her kids to Disney World. But things were very uncertain and she didn't know what would happen from one day to the next. She decided to hold off, and if she still had the money at Christmas, she would surprise her kids with the trip then. And she did it. She told me about it the next tax season. What an inspiration. She held on to the refund for almost a whole year and made a wonderful family memory.

There are always a some folks who will wisely save their refund, either in an IRA or for emergencies. Many people will pay off bills, pay down credit cards or a car loan, or even just make rent for that month. More and more folks mention some type of gambling adventure as part of their plans.

The worst refund story (and you know who you are) has to be a young lady working her way through college. She got an unexpected refund of over $1000. When I asked her plans for it, she said she could now afford to get her wisdom teeth removed. Her insurance didn't cover it, but she need to get it done. Yikes! While any refund is a good refund, wisdom tooth removal has to be about the worst thing I could think of to do with my refund.

What will you do with yours?

Oh, the funny questions...

2012-01-23T07:43:00.000-08:00

We get a lot of questions at the tax office at this time of year.

Some are specific: I took money out of my 401(k), am I still going to get a refund? What's this 1099A I just received? Do I have to report that? Will I still get a refund? We had a baby this year - how much more refund will we get? By the way, there are no easy answers to refund questions. We can explain the general trend, but to get specific, we have to run the numbers.

Some are sad: My son's in jail, can I claim his little girl?

Some are frustrating: I don't have my W2 but I have my last paystub and I really need my refund now. Can't you prepare my taxes? Answer: NO! By law, we can't prepare a return based on only a paystub, we have to have the W2. I believe H&R Block used to allow their clients to bring in a pay stub and advance a refund based on that. But that was not a tax return, nor was it a refund, it was an advance, a loan. Now if your employer has skipped town and didn't issue any W2s, you can file after February 15 using the paystub figures and Form 4852.

One of the funniest questions we've had is the guy who received a $7000 bonus. He didn't tell his wife about it. He's afraid if she knew about it she'll just go spend it. So he wanted to hide it. He had several ideas and schemes for how to hide it from his wife. He had no problem reporting it and paying his fair share of taxes, but just didn't want her to see it. Other than filing separately, which would not be to his benefit taxwise, there was nothing he could do, except hope she didn't notice it when she signed the returns.

Don't be afraid to ask questions of your tax preparer. I'm sure we've heard them all before!

New Requirements for Tax Preparers

2012-01-17T08:27:00.000-08:00

Beginning last year the IRS required all paid tax preparers register with the IRS (and pay $64.25 for the privilege.) As part of the registration process, they checked to make sure tax preparers were current on their own taxes. They now have an exam that all preparers must pass by the end of 2013, as well as continuing education requirements. Background checks and fingerprinting are planned but have not yet been implemented. They want to ensure a "basic competency" in the profession - which is great. There are some preparers out there who just shouldn't be doing taxes. Now perhaps they will either get the knowledge they need or get out of the business.

I have difficulty with the next step in the process - making the tax preparer comply with due diligence requirements and stiffly penalizing them if they do not. Tax preparers will have to start asking some potentially prying questions of their clients.

In case you weren't aware, there is a big "tax gap" out there. Latest release from the IRS (IR-2012-4, January 6, 2012 at http://www.irs.gov/newsroom/article/0,,id=252038,00.html?portlet=107) estimates the tax gap at $385 billion. That's what the IRS thinks should be paid in taxes if everyone fully and accurately reported all of their income and expenses. Essentially, it's what they think cheaters cost the government. People who use someone else's child as their own so they can claim the kid. Businesses that don't report all of their income or exaggerate their expenses. Or even people who bump up their charitable contributions. The IRS also estimates that these cheaters make up about 16.9% of us (i.e., about 83.1% of us are in compliance with tax laws.) The IRS has struggled for years trying to reduce this tax gap. They have a new approach now. Make tax preparers find it.

I've always been of the philosophy that a taxpayer is responsible for their own tax return. I will prepare the return based on what they tell me. I can get all the numbers on the right forms and lines and help them find legal deductions and credits. If the client says they made $10,000 in their landscaping business, that is what I'll report. I will gently educate about keeping good business records, mileage logs, etc., but I will not audit their records. The IRS due diligence requirement now says that if I know, or have reason to know, that a client's information is incorrect, inconsistent, or incomplete, I have to ask and document additional questions. For example my landscaper, who's only income is the $10,000 (an awfully round number, isn't it?), is driving a brand new truck and has four children, I have to ask how they are paying for their living expenses. If I don't ask, I can be penalized up to $5000 for negligence.

This is a big change for many tax preparers. This will be a big change for some taxpayers (perhaps that 16.9%). If you don't want your tax preparer asking prying questions, make sure you have good records and your information is complete and consistent. Don't say anything in front of your tax preparer that could be misleading. Just like you can't joke around at the airport about having a gun, you can no longer joke about your Swiss bank account at the tax office.

I would like everyone to be honest on their tax return, and most are. I pay every dime I owe and recognize that if some are cheating, the rest of us are paying their way. I'll do what I reasonably can to eliminate cheaters. I just hope the IRS doesn't take this due diligence thing too far against honest tax preparers. I'd much rather spend my time with clients finding legal tax savings. That's what's fun about doing taxes!

Don't ignore the IRS

2012-01-11T07:35:00.000-08:00

No one likes to get a letter from the IRS, unless it's with their refund check. But if you do happen to get a letter, what should you do?

Basically there are three types of taxpayers. When Taxpayer A receives a letter from the IRS, he can't imagine why, so he opens the letter, reads it, and takes appropriate action. Now Taxpayer B knows he's done something wrong, or knows he owes taxes or penalties. He immediately tosses the IRS letter aside when it arrives. Taxpayer C receives his letter, can't imagine why, so he opens it. He reads the letter, but it doesn't make any sense, so he just tosses it aside. Which taxpayer are you?

We all know we should behave like Taxpayer A. But what if it doesn't make any sense? Or when the IRS says you owe $90,000, and there are 14 encrypted pages of small print? That just can't be. Maybe if I just ignore it, it will go away. Maybe we intend to investigate later, but the days keep passing us by and we never get to it. It happens.

I had a client who received a letter from the IRS stating they thought she owed them $89,000+. Imagine getting that in the mail! She didn't ignore it. She brought it in and we figured out why they thought she owed that much. She had sold some bonds and other securities and did not report them on her return. IRS doesn't know what she paid for the bonds and securities (cost basis). Since you only have to pay tax on your gain on sales of securities, we figured that out, and reduced her $89,000 bill to a couple thousand dollars. I've seen other cases, particularly in this economy, when the sale is actually for a loss, and the taxpayer ends up getting a refund!

You should address any correspondence from the IRS They will not go away. It will just get worse and more difficult to resolve. Follow the steps below.
Step 1 - Open the letter.
Step 2 - Read it.
Step 3 - If it makes sense, take appropriate action. Generally this will either be to send them information or money.
Step 4 - If it doesn't make sense, investigate. Call the IRS and ask them to explain. Yes, you will have to wade through various menus to get to an actual person. If it still doesn't make sense, contact a professional. They should be able to tell you exactly what the IRS is looking for.
Step 5 - If you owe, pay it.
Step 6 - If you can't pay it, set up an installment plan. This is a crucial step! The IRS actually does have some sympathy for you when your chips are down. Call them. Depending on your situation, they might put your account on hold and stop bugging you for a while.

A last note on installment agreements. Your penalties and interest continue to accumulate while you have a balance due, but the IRS has different rates depending on your error. The lowest penalties are for those who set up an installment agreement. If you don't want to pay at all, why would you pay more than you have to? Set up the installment agreement, select an amount to pay that you can pay every month, and stick to it. It takes a phone call.

Should I file jointly or separately?

2011-12-27T13:39:00.000-08:00

Often married couples aren't sure if they should file their taxes jointly or separately.

Rule #1 - If you are estranged from your spouse or don't trust your spouse, you do not want to sign a return with their possibly bogus information. Once you file a joint return, you are liable for any errors and the balance due.

Rule #2 - If rule #1 does not apply, you want to save as much tax as you can. The only way to truly know is to run the numbers. Figure the taxes both ways. It is important to compare the results for both the Federal as well as the Ohio returns. This is the part of preparing taxes that I just love. It's such a puzzle and it's tax savings when it works out right.

Before doing all this work, it may help to know some general guidelines. In Ohio, if both spouses have similar incomes, they will save taxes on the Ohio return by filing separately. So, if only one spouse has income, you'll always want to file a joint return (unless rule #1 applies).

But what about the Federal? On the Federal return, most couples' taxes will be the same whether they file jointly or separately (exceptions noted below). However, there are certain deductions and credits that are disallowed if you file separately. What? Yes, you must file a joint return to claim some very popular credits such as; Earned Income Credit, Dependent Care Credit, and all the Education Credits and deductions. Also, in most cases you cannot contribute to either a traditional or a Roth IRA if you file separately. Finally, Social Security income will be taxable at the maximum rate if you file separately. But there are many couples that do not qualify for any of these credits. They can save hundreds of dollars by filing separately.

There are some situations where you can save on your Federal taxes by filing separately. The most obvious cases are those returns with large amount of Miscellaneous or Medical deductions. These deductions are subject to a floor, based on a percentage of income, and only the deductions over the floor lower your taxable income. By filing separately, your floor is much lower and more of your deductions will help you. Another area for potential savings are for couples with children, where they phase out of the child tax credit when the file jointly. By filing separately and shifting children and other deductions, the spouses' incomes are such that one spouse can claim the full child tax credit. They'll save on Ohio tax, and hopefully will have limited adverse effects from the tax tables and AMT. These returns can be very tricky to maximize savings, but done correctly, they can yield thousands in tax savings.

To sum up, if there are no deductions or credits that will be lost on the Federal return by filing separately, and income is similar for both spouses, you probably want to file separately. If you have Education Credits or want to contribute to an IRA, you will probably want to file jointly.

Can't I file jointly on the Federal, but separately on the Ohio return? No. Ohio law requires your filing status to be the same as your Federal return.

Who is RITA and why is she bugging me?

2011-12-12T19:18:00.000-08:00

I once had a client who's wife accused him of having an affair because of the checks he kept writing to "Rita". She apparently was not aware that RITA is the abbreviation for the Regional Income Tax Agency. My client was simply trying to comply with the tax laws of his city by paying his quarterly estimates.

Ohio is one of the few states where cities impose their own income tax. There are approximately 600 different city income taxes in Ohio. RITA administers city taxes for 198 municipalities in Ohio. Another large company that administers city taxes is the Central Collection Agency (CCA). The city of Columbus administers several neighboring cities in addition to their own. In northeast Ohio, RITA and CCA dominate. And many cities choose to administer their own tax returns; among these are Euclid, Eastlake, Solon, Parma, and Lakewood.

You are required to file your city income tax return based on where you live. Most taxpayers work for someone else and receive a W2. Employers must withhold city income tax based on where the employee performs the work. But what if you work in a different city than where you live? That's where we get to the idea of reciprocity - a fancy word to tell us how much credit your residence city gives you for work performed in another city. If your hometown has 100% reciprocity you get full credit for withholding or payments to another city.

You are also required to file an income tax return if you are self-employed or own rental property. Profit on these endeavors is taxable to the city in which the business or rental property is located.

Townships don't have any city tax; no tax return is required for residents. How about that?

A Christmas Wish About Tax Law Changes

2011-12-08T08:52:00.001-08:00

I love to do taxes. But I don't love last-minute tax law changes.

This is the time of year tax preparers are gearing up for tax season. To be ready, we have to educate ourselves. What new laws are in effect? What old laws have expired? What is Congress doing right now that may change the laws currently in place? What might happen for 2012?

For the past two years, Congress passed tax legislation in December, effective for the current calendar year.
While these changes were of great benefit to most taxpayers, it makes quite a scramble for tax preparers, software developers, and the IRS. Most people don't think too fondly at the mention of "IRS", but my guess is they were not too happy about these last minute changes. It's just so inefficient.

Perhaps you remember that last year e-file was delayed about a month for some tax returns. Certain deductions and credits that expired were extended and the IRS had to update their software to reflect current laws. It took the IRS several weeks to get those new tax laws programmed into their system. That's really isn't too bad if you consider the scope of the project. The cost must have been enormous. Private software companies had to make the same last-minute changes to their software. No doubt the cost is passed to the consumer. Tax preparers were left with unhappy clients and unfinished returns until the changes were implemented. Again, it's inefficient and unnecessary.

Though I wouldn't give up the tax changes that were passed at the last minute, I do wonder why they couldn't have been passed earlier. My Christmas list this year includes a rule that all tax laws should be in place before the tax year begins. I know it won't always happen, and in certain cases it shouldn't. But wouldn't it be nice?