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The Tax Code: More Welfare for the Well Off

May 26, 2011 in Tax Issues by DJ | No comments

Dan4th Nicholas image

A tax client asks,

“Our income for the 1st quarter dropped dramatically. Can I base my estimated payment for the 2nd quarter on actual income, and if so what is the formula?”

The short answer is, yes.  The law requires that a taxpayer pay in 90% of the tax due for the year, or 110% of the tax due for the previous year; either amount will satisfy the requirement.  Except that if the taxpayer earned $150,000 or more, he/she must pay in 100% of the tax due this year.  This is all covered in IRS Publication 505, which for 2011 contains 69 pages explaining how to calculate what you need to pay.

In this taxpayer’s situation, where income is expected to be significantly less than last year, possibly as much as 75% less.  Obviously he wants to pay in based on this year’s tax, whihc will be dramatically less than last year’s.  That means he has to know how much this year’s tax will be.  The first challenge is that both he and his wife are currently unemployed.  He expects to start work again this summer.  He has no idea whether or not his wife will find work.  So he has to make a ballpark guess as to what their income will be before they have made it.

The second challenge is even more formidable: assuming X dollars in income, what will their tax be?  All he has to do is start with his best-guess taxable income, deduct his itemized deductions, and figure in any credits.  Except that last year his itemized deductions were phased out and he was ineligible for any credits.  Looking at last year’s tax return will not help him.  His itemized deductions are likely to be d=significantly different, and he may or may not be eligible for the Child Tax Credit, Higher Education Credits, and/or the Retirement Savings Credit.

In effect, he’s going to have to pay me to prepare a tax return based on fictitious numbers in order to have any idea what his tax liability will be.  Then he’ll have to pay me again when the year is over to prepare a tax return based on the actual numbers.  This by a couple that is currently unemployed.

How can we live with a tax code under which a reasonably intelligent taxpayer has no idea how much he will owe?  We talk about corporate welfare; the tax code is a form of welfare for accountants and lawyers who would otherwise have to find gainful, productive employment.  As an accountant, I am embarrassed to make my living this way.  It isn’t right, and it needs to change.

Of course, with Congress full of lawyers as usual, change isn’t very likely.

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Weird Tax Law

May 20, 2011 in Tax Issues by DJ | No comments

State income tax paid by an individual cannot be considered a business expense (except in very unusual circumstances).  Instead, it is deducted on Schedule A as an itemized deduction.  This means it doesn’t reduce self-employment taxes, and only reduces income taxes if the taxpayer can itemize his/her deductions.  (The tax can be deducted if it is directly attributable to a business, for example in the case of a gross receipts tax like those found in Indiana or on California LLCs.)

But that same state income tax can be considered a business expense for purposes of calculating Net Operating Loss (NOL), which is carried back or forward and used to reduce income taxes for other years.  (See Rev. Rul. 70-40.)  Why?  Because, unlike the law governing business expenses, the law governing NOL doesn’t specifically say it can’t.

Weird, huh?  That’s our tax code in action.

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You Owe Back Taxes – April Fools!

April 8, 2011 in Letters and Rants by DJ | No comments

Today one of my clients received a notice from the State of Utah telling him he owed $3,561 in back payroll taxes. He’s paranoid about taxes, and immediately called me (several times) to find out why he owed the money. He’s a small business person and, as he reminded me several times, he can’t afford to pay that much.

I called the Utah State Tax Commission and learned that in fact the client didn’t owe any back taxes. Their records show that he failed to file one return (although they cashed the check that accompanied it) and failed to attach copies of his Forms W-2 to another return that he did file. This isn’ty unusual – I field these calls from clients several times a year. Each time they’ve been assessed ridiculously large amounts that in fact they didn’t owe.

“Why,” I asked the rep today, “did you assess him over $3,500 when your own records show he doesn’t owe it?”

The rep replied, “We do it so they’ll call us.”

Excuse me? This hardly seems like a way to encourage good relations! It’s not only rude, it’s dishonest. And it discourages small businesses, already burdened with both payroll taxes and the cost of compliance, from putting people on payroll. Some will avoid hiring people altogether. Others will hire them under the table instead. For a generally friendly state, Utah has really blown it on this one.

Fear not: I have written a letter to the person the rep says is responsible for this practice. And I copied the Executive Director of the Utah State Tax Commission, as well as the Governor. Let’s see what happens next…

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Why I Don’t Offer E-Filing

March 26, 2011 in Tax Issues by DJ | No comments

The IRS wants us to e-file our tax returns.  In fact, starting this year, a preparer who does more than 100 tax returns is required to e-file.  Next year, a preparer who does more than eleven tax returns will be required to e-file.  But most of my clients could care less about e-filing.  Paper feels much more secure to them, as it does also to me.

Two years ago, I submitted my application to become an e-file provider, complete with fingerprints and background information.  Yes, you have to submit fingerprints to e-file a tax return!

I’m still not set up to e-file.  Every time I try to log into the system (about once a year), I get locked out and have to start over.

Today was a perfect example.  I had two (out of my 93) tax clients ask me about e-filing.  So called to find out what I still had to do to become an e-file preparer.  I need a copy of my acceptance letter, which (because I got it two years ago and don’t know where it is), I can only obtain by logging into the IRS E-Services website.  This requires a username, password, and PIN.  But not just any PIN, this requires a special 5-digit PIN, so it’s not one of the normal numbers I use for my bank or for other IRS websites.

I don’t remember my pin.  After 3 permutations of likely numbers, I got a message telling me I was locked out of their site for an hour.  Brilliant.

An hour later, I was back on the website.  This time I decided to get smart: there’s a link to reset the PIN.  Okay, I can do that.  All I need to provide is my name, social security number, username, and AGI for one of the three previous tax years.  I can do that.

Rather, I thought I could do that.  A cryptic message told me my name did not match my social security  number.  Excuse me?  I tried again… and again.  Then I called the helpline for assistance.  The rep wasn’t able to tell me why I couldn’t log in, but she was able to tell me that I’d been locked out of the site again – this time for 48 hours.

“It didn’t tell me I was locked out,” I complained.  “It just told me there was an error.”

“I don’t know why it does that,” she said.  “But you’re locked out and there’s nothing we can do about it.  Call back on Monday and we’ll help you.”

Monday?  There are 20 days left until April 15.  I won’t come up for air again for another three weeks.

“I’ll try again next year,” I told her.

Now I remember: This is exactly what happened last year, I got locked out for 48 hours and gave up.   For something the IRS mandates must be done, they sure don’t make it easy!  This is a very unfriendly system.

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Lactation Taxation

March 5, 2011 in Tax Issues by DJ | No comments

Wikimedia image: Slovakia folk art

You would think a tax break that promotes breast feeding might be favored by those promoting family values, and vilified by those science-loving progressives. Not this time. As a New York Times article points out, the IRS recently permitted breast pumps and related supplies to be treated as medical equipment, deductible on Schedule A and payable through HSAs and FSAs. For it: Michelle Obama. Against: Michele Bachmann. Go figure.  Perhaps politics is more important than principle.

This tax break only favors those who have HSAs and FSAs, or who file Schedule A to itemize their deductions. So it does nothing for the majority of Americans who don’t have these avenues for savings. It benefits the upper middle class and the wealthy. Nevertheless, it’s a common sense change that might actually save the fed money by reducing its costs for buying baby formula.

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The Absurdity of Our Tax Code

March 1, 2011 in Tax Issues by DJ | No comments

The taxpayer owns a business, converted an IRA to a Roth-IRA, has two children, a mortgage, is subject to the AMT, and lives in a state that also collects income tax.  Still, I can think of no reason an individual ought to have a tax return that is over 3/4″ thick.  Our tax code is absurd.

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Tax Changes for 2011

January 20, 2011 in Tax Issues by DJ | No comments

Il trembla un peu quand la call arriva: elle était bien plus grande que lui
(Pichenettes photo.)

Congress, in its infinite wisdom, decided that the rich should continue to pay less tax in 2011.  Coincidentally, the majority of Senators and Congresspeople will benefit from that decision, but I’m sure that had nothing to do with it.

There were other changes in contained that tax bill.  The Kiplinger Tax Letter summarizes them (Vol. 86 No. 1) – here are a few of the more ridiculous provisions:

  • Social Security taxes will decline for 2011.  That’s right: the same program that is on a path to go broke before I collect from it will now receive less money for 2011 – and there’s no provision to make that shortfall up by finding money elsewhere.  The employee portion of social security tax will fall from 6.2% to 4.2%, putting an extra 2% in the pockets of workers.  The employer portion will not change, making it just as costly to actually hire a worker.  Self employeds will get the same benefit, with their self employment tax rate falling 2% from 15.3% to 13.3% – still a lot of tax for those who work for themselves!
  • The tax credit for saving energy gets chopped by 2/3, dropping from 30% to 10%, with the maximum credits being cut proportionately.  With energy costs rising, it may still make sense to make energy saving home improvements.  But you’ll notice that coal, oil, and natural gas subsidies didn’t get cut while conservation incentives did.
  • Credit and debit card companies will be required to file Forms 1099 to report amounts paid to merchants.  This despite the fact that such payments are made directly to the merchant’s bank account, never in cash.  And 1099 filing for outside contractors, formerly limited to businesses, gets expanded this year to include rental properties owned by individuals.  If Granny owns a rental property, she’s going to have to figure out how to print 1099s.

And if you’ve already talked to your tax preparer about getting your return done early, you’ll know that it’s not possible.  The tax bill passed so late in the year that finalized tax forms are not expected for weeks, and the IRS won’t accept returns until at least mid-Febuary.

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The Tax Code at Work

January 11, 2011 in Small Business, Tax Issues by DJ | No comments

One of my businesses is raising goats and making cheese.  Like every other business, at year-end we have to figure out whether we owe taxes.  For a manufacturing business like ours, that’s not always easy.

During the course of a business year, we paid for cow milk,goat feed, cheese making supplies, and so forth.But we don’t get to deduct the full amount of pour purchases, because some of the cheese we made has not yet been sold.  It remains in inventory.    We are required to count the cheese inventory at year-end, which we did.  We had 1,688 pounds of cheese on hand when we counted.

How much is that cheese worth?  Well, last year it cost us more to produce the cheese than its market value, so we chose a method of inventory called “lower of cost or market.”  That means if the cheese is worth less than it cost, we use the market value; if it cost less than it is worth, we use cost.  So we have to figure out how much the cheese would be valued using each method, and use the lower.

To figure out the market value of the cheese, we tally up the total sales for the year and divide it by the number of pounds sold.  To figure the cost of the cheese, we tally up the costs of the purchases we made to make the cheese and divide that by the total amount produced for the year.  That is the total number sold, plus the total number in inventory, less the total number we had in inventory last year (because that cheese was produced in a prior year, not the year in question).

It turns out that we will be valuing our cheese at cost this year.

We need that number because the deductible amount of the purchases, called Cost of Goods Sold or COGS, is calculated by taking the beginning inventory, adding the purchases, and subtracting the ending inventory.

Are you with me so far?

But here’s where it gets really fun: the federal government has determined that a manufacturing industry must determine how much other expense went into the production of our cheese.  This is Section 263A of the tax code, so these expenses are typically referred to as 263A expenses.  In our case, they include labor, supplies, vehicle expense, security (the livestock guardian dog), equipment rental, repairs, and veterinary expenses.  We add all those up to get the “Total Attributable Expenses.”

Now we find the attribution rate, which is the number of pounds of cheese in the ending inventory, divided by the total number of pounds of cheese produced, rounded to 5 decimal places.  Yes, the tax code says how many decimal places to use.

Take the total attributable expense and multiply it by the attribution rate to get the amount of expense that needs to be capitalized– in other words, expense that isn’t deductible in the current year.

But we’re not done yet: last year we had 263A expense that had to be capitalized.  This year, we take that amount as an expense, while removing the current year number from expense.

So our COGS calculation looks something like this:

Beginning Inventory (last year’s ending inventory)

Add: Last Year’s 263A Expense

Add: Purchases

Subtract: Ending Inventory

Subtract: Current Year 263A Expense

————————————————–

Equals: Cost of Goods Sold

Is it simple?  Not at all.  But the actual tax code, as written by Congress, is worse:

In general
        In the case of any property to which this section applies, any
      costs described in paragraph (2) -
          (A) in the case of property which is inventory in the hands
        of the taxpayer, shall be included in inventory costs, and
          (B) in the case of any other property, shall be capitalized.
      (2) Allocable costs
        The costs described in this paragraph with respect to any
      property are -
          (A) the direct costs of such property, and
          (B) such property's proper share of those indirect costs
        (including taxes) part or all of which are allocable to such
        property.
      Any cost which (but for this subsection) could not be taken into
      account in computing taxable income for any taxable year shall
      not be treated as a cost described in this paragraph.

Excuse me?

It goes on like that for about 3 pages.  Then there are pages more of regulations issued by the Treasury Department on how this rule should be applied.

One thing is for sure: tax code like this ensures that accountants, auditors, and tax attorneys stay gainfully employed– at the expense of the businesses that have to hire them to get these calculations right, and then justify their calculations to the IRS.

My other business is preparing tax returns.  The fact that I make my living from the complexity of government regulation is an embarrassment. I would much rather see a simpler tax code and find another line of work!

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Dear Senator Hatch: Revenues Must Be Raised

January 9, 2011 in US Politics by DJ | No comments

Dear Senator Hatch,

Thank you for your newsletter. I would like to point out that the GOP-proposed spending cuts are barely a rounding error in the bloated federal budget.

The top four line items in the budget are Social Security, defense, Medicare, and interest on the national debt. Revenues from taxes and other sources don’t even cover these four items. That means everything else in the budget, from school lunches and highway maintenance to oil subsidies and foreign aid, is spent on credit. In 2009, the federal government spent an astounding 67% more than it took in– with no realistic expectation that it will ever be paid back.

If I ran my business like that, they would send me to prison for fraud, and rightly so.

Unless the GOP has serious cost-cutting proposals they have not yet disclosed– about $1.4 trillion in cuts would be needed to balance the budget– it is imperative that Congress get serious about raising revenues. Otherwise, both parties are complicit in bankrupting this great nation.

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The Tax Bill: The Opposite of What They Promised

December 22, 2010 in Economics, Tax Issues by DJ | No comments

With both parties blaming the other for our financial woes, you might have expected a dose of fiscal responsibility in the latest tax bill to come out of Washington.  You’d be disappointed.

Kiplinger (The Kiplinger Tax Letter 85:25) reports that the “compromise” tax bill includes all the income tax cuts, plus a reduction in Social Security taxes for 2011.  Yes, that same Social Security plan that is desperate for funding will get even less next year– $120 billion less for each year the tax cut remains in place.

And while I can’t argue with extending unemployment benefits, the bill comes through with more expenses and less income than ever.  It’s expected to add $700 billion to the already-bloated deficit.

If I ran my business this way, they’d send me to jail!

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