Monday, June 25, 2007

Taxpayers Beware?

Tax preparer penalties are on the rise and you, as a taxpayer, may think this will either not affect you, or help you. The law was passed because they believed that it would promote more accurate tax returns.

However, as usual, they didn't think this law out very well before they passed it.

What this law has actually done (or will do, as it is not yet effective), is make the disclosure requirements for tax preparers higher than that of taxpayers.

This means that if you pay to have your return prepared, and the person who prepares your return is not 100% sure that the position you are taking is "more likely than not" to be upheld upon audit, then they are required to disclose this on your tax return. This disclosure is required even if the tax preparer doesn't believe you will be audited or is not sure if the IRS would even bring this
question up, if you were audited.

What this will actually do is alert the IRS that they may want to take a look at your return.

As a simplistic example of how this law may play out is whenever a taxpayer wishes to take a deduction for which they do not have adequate documentation. Taxpayers are required to have adequate documentation for all deductions that they claim. If a paid preparer is aware that:

  • a taxpayer does not have adequate documentation OR
  • if the paid preparer suspects that the taxpayer may not have adequate documentation (did you show your mileage log book to your paid
    preparer?) OR
  • the paid preparer should have known that the taxpayer did not have adequate documentation,
then paid preparer is required to disclose this fact to the IRS on the taxpayer's return or the paid preparer will be assessed a penalty. In order to avoid this disclosure taxpayers will be asked by
their paid preparers to provide them much more information than they were ever required to provide to their paid preparers. The paid preparers will have to review much more documentation than they were previously required to review; thus the time it will take them to prepare your return will increase. If the paid preparer must spend more time on your return, then your fee will be higher.

My second simplistic example of how this law may play out is whenever a taxpayer wishes to take a position that is not specifically supported by substantial authority. Since the tax code is so large, most taxpayers that I encounter assume that everything that they, being a typical taxpayer, are doing has been documented, as "everyone" is doing it.

Not necessarily so.

For example, many taxpayers are using a very popular, relatively inexpensive, software package by Intuit, called QuickBooks to keep track of their books and records. One of the flaws in QuickBooks is the way QuickBooks keeps track of inventory. The ONLY method that QuickBooks allows to value inventory is by "Average Cost". The IRS allows you to value, for tax purposes, inventory based on one of three methods:
  • Specific Identification
  • Last-In, Last-Out (LIFO)
  • First-In, First-Out (FIFO)

There is not substantial authority to support the use of average cost for valuing inventory for IRS purposes. Thus, if you use QuickBooks to value your inventory for financial reporting purposes, your tax preparer will have to determine if by doing so, upon audit, would the value and method that you are using be "more likely than not" upheld by the IRS? If your paid preparer is unsure, then they will be required to disclose to this to the IRS. Again, in this example, the tax preparer will be spending more time and money recalculating your inventory and determining, not only if the "value" is more likely than not to be upheld, but also if the "method" is more likely than not to be upheld.

Above I only stated two, somewhat simplistic examples....there are many more examples in real life. How will this ultimately affect the taxpayer? In my opinion, one of three ways:
  • More taxpayers will self-prepare their return, as there is no required disclosure if you prepare your own return.
  • More taxpayers will seek out questionable tax professionals, who will not prepare the necessary disclosures.
  • The fees to prepare your tax return will increase, as the work performed by the paid preparer will increase.
So as you can see, requiring paid preparers to disclose information that taxpayers are not required to disclose will not necessarily make tax returns more "accurate" in the eyes of the IRS. Instead it will just add to the time and cost in preparing your return.

If the IRS wants more accurate tax returns, make both the taxpayer and the paid preparer equally responsible.

As for what would need to be disclosed, Revenue Ruling 2005-75, may provide some guidance. You can read the Small Business and Work Opportunity Act of 2007 online at TaxAlmanac.

Sunday, June 24, 2007

Fewer Partnership Returns

One of the many changes made in the Small Business and Work Opportunity Tax Act of 2007
reduces the number of partnership returns that will need to be filed for 2007.

Under the old law, if both a husband and wife were sole owners of their unincorporated business they were required to file a partnership tax return (Form 1065). Partnership tax returns can quickly become complex and are generally expensive to have professionally prepared. In addition, the income and expenses from the partnership are reported on Schedule K-1, which needs to be reported on your Individual tax return, making your individual tax return more complex.

Beginning in 2007, a married couple, who files jointly and are the sole owners of their unincorporated business can file two Sole Proprietorship schedules (either Schedule C or F, whichever is applicable) on their individual tax return, instead of filing a partnership return (Form 1065). One sole proprietor schedule will include the income and expenses of the husband and the other will include the income and expenses of the wife. Each will be subject to their own self-employment taxes.

This won't reduce the amount of bookkeeping that should be done or the amount of taxes that will need to be paid, but it will reduce the filing requirements.

Friday, June 22, 2007

Shares Transfered from IRA

Jeff writes:
I over contributed to my Roth IRA and was required to removed the excess contribution and associated earnings which was done last year. Rather than selling shares of stock and moving cash out of the account, the brokerage let me transfer shares of stock from my Roth account into a taxable account.

Is the cost basis for the shares in my taxable account, the value of the stock on the day it was transferred to the taxable account?

I had held the stock for over a year in my Roth account, but it has been in my taxable account for less than a year. If I were to sell the shares tomorrow would it be considered a short term taxable gain since they have been in the taxable account for less than a year?

Thank you in advance,

My reply:

Hello Jeff!

You are correct on both accounts. Shares distributed from any IRA have a basis of their value when distributed and an acquisition date of the date of distribution.

For more information please see IRS Publication 590.

Best wishes,

Sunday, June 17, 2007

Nondeductible IRA to Roth in 2010

Julie writes:
I am thinking of making non-deductible IRA contributions this year and on and then convert to Roth IRA in 2010, as described here:

I already have a deductible Rollover IRA and Roth IRA. However my income is over the limit for Roth IRA contributions. Also my company has a 401K to which I contribute. Up to now I saw no advantage to making non-deductible IRA contributions.

To make non-deductible IRA contributions do I need to open a new non-deductible IRA account, distinct from my rollover IRA?

If I can make non-deductible contributions to the Rollover IRA and keep a single IRA account, what records do I (or the custodian) need to compute the value of the non-deductible contributions in 2010?

By when do I need to open a non-deductible IRA and fund it with 2007 contributions: before Dec 31, 2007 or April 15, 2008?

In 2010 can I rollover the non-deductible IRA into my current Roth IRA or do I need a separate Roth IRA?

Thanks in advance for your expertise and time.

My Reply:

First, one Roth IRA is sufficient. You do not need to open a separate Roth IRA for this maneuver.

Second, you could convert your entire Traditional IRA beginning in 2010, assuming that Congress doesn't change the law. If you did this, you would owe income taxes (no penalties) on your deductible contributions and earnings. Thus, if you have a sizable amount in your Traditional IRA, you may want to convert a portion at a time so you don't throw yourself into a higher tax bracket. For what is converted in 2010, you can spread the tax over 2 years. For amounts converted after that, the tax will need to be paid with taxes for that tax year.

Third, since you already have a deductible IRA, you need to be aware that you cannot convert only the nondeductible IRA. It's important to be aware that conversions are done on a percentage allocation only. For example, if you have $10,000 in nondeductible contributions and $90,000 in earnings and deductible
contributions between your Rollover IRA and your nondeductible IRA and you convert $10,000, you will be converting $1,000 of nondeductible contributions and $9,000 of deductible contributions and earnings.

Again, you will owe tax on the $9,000 (the portion of your conversion which were deductible contribution and earnings).

Please note: In order to obtain the maximum benefit from this strategy you should have adequate funds to pay the taxes due outside of your IRA account. If you take money from your traditional IRA to pay the tax on the conversion, it's a taxable distribution subject to the premature distribution penalty (if you're under 59 1/2).

You have until the due date of your tax return to make your nondeductible contributions for the prior year; thus you will have until April 15, 2008 to make your 2007 nondeductible IRA contributions.

When you make nondeductible contributions to an IRA you file Form 8606 with your tax return. You will need this form in order to compute the value of the nondeductible contributions.

Best wishes,

Wednesday, June 13, 2007

U.S. Tax for U.S. Citizens living abroad

George asks:
I thought bonafide foreign nonresident status exempted a U.S. citizen from 100% of federal income tax. So my wife and I did not pay our federal income or state income taxes on April 15, 2007. I thought the $82,400 foreign earned income exemption applied only to the physical presence test. I mean why should a nonresident pay taxes?? Now, the internet is full of information on the subject and the tax programs
default at $82,400 and I owe the IRS at least $15,000 and the Commonwealth of Virginia tax and penalties. What can I do to mitigate my situation? My wife is really upset. Any assistance is appreciated.

Thank you!

My response:


I do not know why you thought that U.S. citizens were exempt from U.S. taxes as this have never been the case. As U.S. citizens and being a married couple in 2006, you would be required to file a U.S. Individual tax return if your joint income, regardless of it's source, was at least $16,900. Where you are living has no relevance for this test. The only two important factors are whether or not you are a U.S. citizen and how much your joint income was for the year.

All U.S. citizens are required to pay U.S. taxes because no matter where they live they are still entitled to the benefits of such citizenship. However, U.S. citizens who choose to live abroad have the ability to reduce their taxable income to much lower levels.

U.S. citizens living abroad may be able to exclude from income up to $82,400 of their foreign earnings. In addition, they may be able to exclude or deduct their foreign housing costs and the value of any meals or lodging that were provided by their employer. You did not tell me the source or amount of your income, but this area of taxation is much too complex for this medium anyway. U.S. citizens who have paid foreign taxes or who have worldwide income have put themselves into a very complex area of the tax law, much more complex then I will be able to explain in full here; thus, I highly recommend that you seek a qualified tax professional to help you prepare your U.S. tax return and I strongly advise you to at least file an extension immediately, as this will either stop or eliminate the late filing penalty.

You did not say what country you were living in, nor did you say the reason for your travels outside of the U.S; thus, I do not know for certain if you qualify for the automatic two month extension that the U.S. gives to certain U.S. citizens living abroad, but I have a suspicion based on your signature and email address that you may. You are allowed to take this extension by simply attaching a statement to your tax return explaining that you were outside the U.S. and Puerto Rico because that is your main place of business or post of duty or you are in the military or naval service which has taken you outside of the U.S. and Puerto Rico. If this automatic extension applies to your
situation then your filing due date for your 2006 tax return would be due June 15, 2007. Please note that even if you are allowed this extension, you will have to pay interest on any tax not paid by April 17, 2007, you would just not have to pay the late filing penalty.

When you seek the help of a qualified tax professional they will be able to review your situation completely and hopefully help you minimize your taxes and penalties.

Best wishes,

Sunday, June 10, 2007

Professional Gambler?

Andy writes:
I am an early retiree who has no wages, but I spend as much time as I can playing poker. I wouldn't say I'm a professional poker player, but I play 2 - 3 days a week for about 10-15 hours. If I declared $2,500 in winnings, and my total income is under $95,000, could I contribute $2,500 in a Roth IRA? I've tried to research this on the web, but the sources were vague as to whether or not gambling income is acceptable.


My response:

Hello Andy! I'm so glad you wrote as there seems to be more and more gamblers around now-a-days, many with similiar questions to yours.

In order to contribute to any type of IRA you need to have "earned income". Earned income includes income from wages, net earnings from self-employment and alimony. Thus, in order to utilize your gambling winnings to contribute to a Roth IRA, you would have to be a professional gambler and report your earnings as self-employment

In my experience, reporting your gambling income as a professional gambler, especially the first year you report your gambling earnings in this fashion, your chances of receiving a letter from the IRS Automated Underreporting Unit is very high. Thus, I do not recommend that anyone file a return as a professional gambler without the assistance of a qualified tax professional.

In order to legitimately report your gambling income in this fashion you must be in the business of gambling. If you're considering doing this, you may wish to read a couple of articles I wrote about a Business vs. Hobby and Hobby Loss Rules.

If you are not a professional gambler then your gambling winnings are reported on line 21 miscellaneous income. Losses, limited to reported winnings, are a Schedule A miscellaneous itemized deduction.

Best wishes,

Saturday, June 9, 2007

Your Pet's Medical Expenses

Cindy asks:
My two beloved cats have had a lot of medical bills this year......close to $6000. Sometimes I pay with a check to the vet and the check is written payable to "Dr. Lastname". Other times I pay with a credit card and it shows up "Medical Center". Can these fees be deducted as medical expenses.

Thanks alot,

My reply:

Hello Cindy. I'm reading into your message that you realize these bills are not medical expenses that you incurred for yourself, spouse and/or dependents; thus they would not be deductible on Schedule A as an itemized deduction. Just because you cannot tell by simply reading who the payment was made to does not make it deductible.

If however you normally file a Schedule F and have appropriately reported these cat as assets of your profit earning farm business, then they would be deductible; however, based on your email it appears these cats are your personal pets and not assets of a profit earning farm business.

I wrote an article last Feb. regarding Deductible Medical Expenses, which you may be interested in reading.

Best wishes,

Monday, June 4, 2007

Basis and Holding Period of Distributed Assets

Bill asks:
My mother had a number of securities in an irrevocable trust. I am the sole primary beneficiary (and trustee) on the trust. Under the terms of the trust, the trust ended when she died and I am to receive the contents of the trust.

My mother died last month and I am in the process of transfering the assets of the trust to me as per the terms of the trust. My questions are:

1) Do I take a stepped-by costs basis in the insvestments?
2) Do I use the date of her death as the cost basis date? Or, do I use the date the investments are actually transfered to me as the cost basis date?

My response:

Hello Bill, my condolences for the loss of your mother.

The answers to your questions are going to depend on how the initial funding of the trust was treated for tax purposes. You did not supply enough information. If you were to ask your tax adviser this question, they would follow up with these questions:

  • How did the trust become irrevocable? Was it always irrevocable, or did it become irrevocable upon her death, or possibly on your father's death?
  • Were these securities purchased by the trust, or were they given to the trust by your mother?
  • Did the trust recognize a capital gain or loss on the distribution of the securities to you?
Making some assumptions, which very well be incorrect, if the initial transfer of the securities to the trust was a gift, the recipient of the gift (the trust), would have taken over your mother's basis and holding period and you'd continue with that basis and holding period.

Best wishes,