Tuesday, July 28, 2015

Your Home: 4 Tax-Smart Moves

For many people, a home is one of their most valuable assets. As such, it needs to be factored into your estate plan. Traditionally, homeowners have focused on limiting estate tax. Now, they need to shift their focus to saving on income tax. The reason: The estate tax exemption has climbed to $5.43 million per person (or $10.86 million for married couples), thereby making estate taxes less of an issue. Meanwhile, capital gains tax rates are at their highest in many years, and many people nearing or in retirement are living in homes that have increased enormously in value.
For example, assume Harry, 65, and Sally, 67, paid $300,000 many years ago for a house that's now worth $2 million. If they sell today, they would owe tax on a $1.7 million gain.

If Harry and Sally have lived in the house for at least two of the five years before the sale, they qualify for a special tax break that is available to homeowners who sell their principal residence (but not vacation homes): The first $250,000 (or $500,000 for married couples) of their gain on the sale is not subject to tax. That still leaves Harry and Sally with a taxable gain of $1.2 million. Including the 3.8% net investment income tax that took effect as a part of the Affordable Care Act, Harry and Sally would be taxed on that gain at a 23.8% rate, and owe Uncle Sam $285,600.
Various tax-saving maneuvers can help this couple--and others like them--reduce that bite.

If You Can Afford to Keep the HouseIf you leave the house to your heirs, they can avoid most, if not all, of the capital gains tax you would have to pay if you sell the house yourself. That's because with most assets, including real estate, inheritors can "step up" their tax basis to whatever an asset was worth at the original owner's death. This enables them to sell a highly appreciated home without being taxed on the gains that occurred before they inherited it.

If you need to move out of the house--say it has become unmanageable, or you want to relocate--consider renting your house. Renting would provide an income stream to help cover current living expenses--and avoid capital gains tax.

If One Spouse Is in Poor HealthBecause of health issues or a significant difference in age, sometimes you are fairly certain whether you or your spouse is more likely to die first. If your home has appreciated significantly in value, it might make sense to have it owned solely by the spouse whose death is more likely to occur first. This enables the spouse who inherits the home to take advantage of the step-up in basis.

Provided your spouse is a U.S. citizen, you can give an unlimited amount to him or her during your life or through your estate, with no tax applied--this is known as the unlimited marital deduction. If a couple owns the home jointly, the healthy (or younger) spouse ought to transfer his or her interest to the other.

One important condition applies: If your spouse transfers the assets, you die within a year, and your spouse inherits the same assets back, there is no step-up. This provision in the Internal Revenue Code prevents a healthy spouse from transferring everything to a dying spouse (with no gift tax) and getting it back with a basis step-up (and no estate tax).

In this respect, spouses have an advantage in community property states: When the first spouse dies, both halves of community property get a step-up in basis. There are nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Two other states, Alaska and Tennessee, also have community property, but you have to "opt in" to it, and in Tennessee the property must be held in trust.

If You Want to Become a RenterBy converting your personal residence or vacation home into a rental property, you can position yourself to do what's called a Section 1031, or like-kind, exchange, and avoid paying capital gains tax.

This strategy, named for a section of the Internal Revenue Code, involves a swap of one investment asset for another--something that would ordinarily be taxable as a sale but isn't if you meet certain conditions, says Stephen J. Small, a Boston lawyer and the author of books on preserving family lands. First, you must move out of the house and rent it for a decent period of time (more about that below). After that, if you sell the rental property and buy another one of equal or greater value, you don't have to pay capital gains tax. (If the house you're selling has a mortgage, the mortgage on the new house must be for the same or a greater amount.) Any differential creates some gain--what's called "boot"--that's generally taxed as capital gain.
Not surprisingly, those who try to get cute with the rules tend to lose their battles with the IRS, so it's best to have a tax pro to guide you through the formalities. Nor is this a strategy for the sharing economy--for instance, when people rent their homes temporarily while they travel, says Stefan F. Tucker, a lawyer with Venable in Washington, D.C. Rather, "you must be able to show it's a bona fide investment property" and no longer your personal residence. He advises clients to rent the home for at least a full calendar year and part of another (for example, from September until the following December). Likewise, the new property that you buy must also be an investment, rather than a personal residence.

If You Anticipate a High-Income YearLet's say you expect your income will be higher than usual--perhaps because you plan to sell a business, exercise employee stock options, start drawing on retirement funds, convert a traditional IRA to a Roth, or take deferred compensation. Donating your home to charity in the same year as this income spike saves capital gains tax and entitles you to a tax deduction, which can reduce what you owe. For real estate, that deduction can equal up to 30% of your adjusted gross income, and any deduction that can't be taken in the year of the donation can be carried forward up to five years.

People who want to create an income stream for themselves or family while benefiting charity might consider a FLIP unitrust, says Lawrence P. Katzenstein, a lawyer with Thompson Coburn in St. Louis. Here's how it could work, again with Harry and Sally: They put their house into a charitable remainder trust. The trustees sell the house and invest the proceeds in a diversified portfolio. Starting in the year after the sale, the trust, as provided for in the original trust document, starts paying Harry and Sally, as trust beneficiaries, annual income expressed as a percentage of the fair market value of the trust assets revalued each year; in today's investment environment, 5% would be typical, Katzenstein says. This income stream continues until both Harry and Sally have died, at which point whatever assets remain in the trust go to charity.

Because the trust is a tax-exempt entity, it doesn't pay tax when it sells the house, so Harry and Sally save the capital gains tax they would otherwise have to pay. In addition, when they make the donation to the trust, they would get a current income tax deduction for the value of the charity's remainder interest, which in their case is $702,020, says Katzenstein. The deduction is based on their ages, the number of life beneficiaries (the older you are, the larger the deduction), the value of the property, and an assumed interest rate set by the IRS. If the house is sold for $2 million and the assets, as invested, hold steady at that amount, the 5% yearly payout to Harry and Sally would be $100,000. If the value of the trust assets fluctuates, so will the dollar amount paid to Harry and Sally each year.

A few caveats apply. To steer clear of various tax law restrictions, the property that is being donated should not be mortgaged, and you must move out before putting the house in the trust. In addition, beware of what's called the pre-arranged-sale rule. It prohibits you from making a commitment to sell a noncash asset, including real estate, before giving it to charity. If you violate the rule, you must pay tax on the gain.

Sunday, July 26, 2015

Divorce Has Tax Traps - Get Some Advice


When Christina Mehriary entered into a marital settlement agreement with Bradley Williams, the agreement included language that advised the parties to seek the opinion of a tax professional as to the tax ramifications of the agreement.  Talk about closing the barn door after the horse has left.  At any rate the $4,000 per month for 60 months that Ms. Mehriary was required to pay Mr. Williams as non-modifiable alimony, does appear to pass muster as deductible to the payor and taxable to the payee and lasts long enough to not trigger the alimony recapture rule.

In the marital settlement, Mr. Williams had received the marital residence and Ms. Mehiary had received another residence.  She transferred the second residence to Mr. Williams in lieu of $80,000 in alimony payments.

Unscrambling An Egg

I’m sure glad she wasn’t my client, because I still have a headache trying to figure out the right way to account for that transaction.  Ms. Mehriary took an $80,000 deduction on Schedule A, because the insurance company had indicated that the property was an investment property.  Not only is that clearly not the right answer, it is not even the most beneficial answer.  If you were going with that sort of theory, you would need to consider the basis in the property, but of course this is in conjunction with a marital dissolution, so no gain or loss is to be recognized.

Ms. Mehriary’s fallback position was to take an alimony deduction for the $80,000.  I’m still getting a headache trying to do the debits ad credits of that one, but Tax Court judges are not accountants and don’t have to trouble themselves about such thing.  The reason that it does not work is simple. Alimony to be deductible has to be paid in cash or its equivalent and a house is not a cash equivalent.

Petitioner’s argument that the transfer of $80,000 (the fair market value of the Sweet Briar property) was deductible as an alimony payment fails because it was not a payment in cash. Instead the transfer was a transfer of property and therefore does not constitute an alimony payment. Although petitioner and Mr. Williams agreed that petitioner’s transfer of the Sweet Briar property would replace $80,000 of petitioner’s alimony obligation, the intent of the parties does not determine the deductibility of a payment as alimony under section 71. See Okerson v. Commissioner, 123 T.C. 258, 264-265 (2004). Instead the test for [*7] whether a payment is deductible as alimony is a straightforward, objective test that rests entirely on the fulfillment of explicit requirements set forth in section 71, including that the payment be made in cash or a cash equivalent.

The bottom line ends up being a property transfer incident to the divorce.  No deduction for Ms. Mehriary and no income pickup for Mr. Williams.  Of course, we don’t know how Mr. Williams accounted for the transaction.  Hopefully the taxpayers did not get whipsawed.

Insult To Injury

The IRS asserted the accuracy penalty and the Tax Court backed them up.

Petitioner set forth no specific facts to show that she acted with reasonable cause and in good faith. Petitioner was advised to seek the opinion of a tax professional when she signed her marital settlement agreement, but she did not offer any testimony or other evidence to show that she relied on professional tax advice. See sec. 1.6664-4(b)(1), Income Tax Regs. Petitioner merely testified that [*9] she relied on her insurance company’s characterization of the Sweet Briar property as investment property. The insurance company did not provide tax advice, and the record does not reflect that it ever represented itself as a competent professional.

 Thoughts On Return Presentation

The AICPA standards of tax practice prohibit me from giving audit lottery advice, but you are not my client, so I think I am safe in making this observation.  If Ms. Mehriary had taken an alimony deduction on her originally filed return, there is a very good chance she would have slid through even if Mr. Williams had not picked up income equal to her deduction.  The IRS computers match up the alimony deductions to the income pickups, but the Service cannot  just send out a bill for a mismatch, since it doesn’t know who is right.  According to a TIGTA report, in 2010 there were over a quarter million mismatches and the IRS opened examination in just over 10,000 cases.

On the other hand, a nice round $80,000 deduction on Schedule A sticks out like a sore thumb.  Ms. Merhriary represented herself in Tax Court, which makes me suspect that she prepared her own return.  I think that almost any preparer, even one who is technically weak, would not have gone with Schedule A.  I have to admit that I’m not sure where I would have ended up.  I do think the Tax Court has it right, but I am curious as to how another preparer might have handled this situation if Ms. Mehriary had plopped it on his or her desk.

You’ve Come A Long Way Baby

You youngsters will have to forgive me for this observation.  You have to remember that I am old enough to remember the “Want Ads” being divided into three section – “Help Wanted Male”, “Help Wanted Female” and a generally smaller gender neutral section.  At any rate for many years I have at least looked at every single Tax Court decision and those concerning divorce have been of particular interest to me.  This is the first time I have noted a decision about a woman paying alimony and being denied a deduction .  I’d have to do more research than I am inclined to do to determine whether this is an actual milestone, so I will leave it at that.

Saturday, July 25, 2015

4 keys to Roth conversions

In recent years, vast numbers of people have become eligible to 
consider Roth conversions. They include high-income people who were not eligible for Roth conversions prior to 2010 and millions of people who have become eligible to convert money to employer-sponsored Roth 401(k) accounts since they became available in 2006.
At least once every two years, financial advisors should have a “conversion conversation” with clients, to review and evaluate conversion options:
·       From Traditional IRAs and SEP-IRAs to Roth IRAs and From SIMPLEs to Roth IRAs, after two years of plan participation

The conversation need not be complex or lengthy, because there are just four key points that usually prevail in conversion decisions. Here’s the conversation, in a nutshell:
“Mr. and Mrs. Client, if you would like to consider converting part or all of your plan money to a Roth, there are four key issues you should evaluate.
Key #1 – Liquidity – To make the conversion work, you generally need enough liquidity to avoid tapping the Roth IRA for at least five years. To keep all your retirement plan assets working, you may want to pay the income taxes (on the conversion) with other money.
Key #2 – Income Tax Rates – If you think income tax rates will go higher in the future, a conversion can be attractive because it lets you lock in today’s tax rates. It’s important to plan conversions so that they don’t push your taxable income into a higher bracket, or subject your net investment income (excluding retirement plan income) to the 3.8% Medicare tax.
Key #3 – Retirement Freedom and Flexibility – How do you want to spend retirement? Choice A: You can estimate the required minimum distributions due each year (after age 70 ½). Choice B: You can write yourself a tax-free check from your Roth if and when you need it, and never face a required distribution as long as you live. How important is the quality and simplicity of retirement living for you?
Key #4 – Leaving Your Heirs “No Tax Strings” – With a Roth conversion and a little planning, you can make sure your beneficiary inherits an IRA with no income tax strings attached. This is opposed to leaving the beneficiary a Traditional IRA or 401(k) that could be fully taxable as ordinary income.
To brush up on the rules for Roth conversions, you may want to check the IRS FAQs on Roths.

Friday, July 24, 2015

8 Ways to Avoid a Nanny Tax Nightmare


Want to know how people who pay domestic helpers under the table get caught for dodging the IRS? They run for office. Or get put on a list of potential nominees for a high-profile cabinet position.
At least that's what brought into spotlight the tax laws related to employing domestic workers -- as in, there are actually laws about this stuff: In the early 1990s, we were reminded that if you hire a home helper that qualifies as your "employee" (according to IRS rules) but fail to pay employment taxes, your nomination for U.S. attorney general is pretty much toast.
So learned Zoe Baird, Bill Clinton's nominee for the position, when it was discovered that she and her husband had employed undocumented immigrants as domestic workers and -- on top of that hot-button issue -- failed to pay employment taxes.
Baird's name was subsequently crossed off the short list, as was Clinton's second choice for the job for similar reasons.
The term "nannygate" entered the popular lexicon and eventually Janet Reno (who had no children and, evidently, did her own dishes and yard work) was confirmed. 
"But everybody's doing it!" is not a good excuse in courtPerhaps you don't have political aspirations. Or you don't often apply for jobs where potential employers comb through your tax returns and probe into your household staffing business. Most people don't, and maybe that's why it's estimated that 75% to 95% of people who employ nannies, sitters, housekeepers, and home health aides don't bother paying employment taxes.
Still, it is the law. And even if the prospect of getting caught is slim, no one wants to intentionally run afoul of the IRS.
So, you need to figure out if the helpers you hire qualify as employees:
First, the good news: Your spouse, your parents, your child under the age of 21, and the neighbor's kid who is under the age of 18 generally aren't considered formal "employees" in the IRS's eyes, even if you pay them cash (on top of your deep gratitude and undying love) and they do the work of a small army.
Now, the other news: With respect to complete strangers, acquaintances, friends, and people who are old enough to vote: If in 2015 you pay someone $1,900 or more annually for household help, pay them directly (and not through an agency), dictate when and how they do the job and provide the tools they need for the work, and they are not operating as a small business, sole proprietorship, or contractor and don't offer the same services to the general public, then you, my friend, are an "employer." And like any employer, you're responsible for paying Social Security and Medicare taxes on the wages you pay your household help. (Here's more on what qualifies someone as a household worker and the rules straight from the source, IRS Publication 926.)
The price of breaking nanny tax lawsWhile many people inadvertently (or "unknowingly") ignore the rules and pay their home helpers under the table, you're doing yourself and your employee a disservice. And if weak moral fortitude and sleepless nights caused by living a life of lawlessness aren't reasons enough to follow the nanny tax rules, perhaps the following will change your mind.
According to Sittercity.com, failure to pay employment taxes (e.g., the nanny tax) can cost on average $25,000 in penalties and interest. Not only that, but when you don't report the wages you pay, your employee has a harder time building their employment history, will have a less comfortable retirement because they won't get all the Social Security and Medicare benefits they've earned, and when you no longer need their services, they may not qualify for unemployment benefits.
 8 rules to prevent a personal nannygate scandalThe goal here is to avoid doing something stupid that will trigger an IRS audit, ignite tabloid headlines, or generate an exorbitant bill from the IRS for back taxes and penalties. Here are eight things to do to keep your hiring practices aboveboard:
Make your status as an "employer" official: Establish yourself as a law-abiding employer with the state and the IRS by applying for an Employer Identification Number via Form SS-4to use for all employee-related paperwork, reporting, and tax returns.
Decide how you will pay Social Security and Medicare taxes: Uncle Sam's cut of employment taxes is 15.3% of cash wages. You are required to pay at least half of that tab (7.65%) with your employee paying the other half (which is done by withholding it from their paycheck). However, many employers pay the worker's share. So determine how you want to handle that. Also, find out if you are on the hook for state income taxes.
Keep good records of when you paid and how much: Depending on when you pay your employee, you might owe more in taxes. IRS rules stipulate that if you pay $1,000 or more of their salary in any calendar quarter, you'll owe federal unemployment tax (and perhaps state unemployment tax) on top of the Social Security and Medicare taxes you're required to pay.
Fill out and file the right forms: Welcome to the world of being a boss! Part of the job is making sure Uncle Sam is kept in the loop. That means completing a bunch of forms for yourself and submitting some for your employee. All of these forms are available atIRS.gov's employment tax form area:
  • Form I-9: When you hire someone, have them show you their Social Security card and fill out this form to establish their employment eligibility. If they don't have a Social Security number, they must file Form SS-5 to get one.
  • Form W-2: This is the wage and tax statement. Copy A (along with Form W-3) gets filed with the Social Security Administration. Copies, B, C and 2 go to your employee for their records and to file with their tax return.
  • Form W-3: This is essentially a summary of what you, as an employer, paid out in wages during the tax year and also amounts that were withheld for (for Social Security and Medicare). The numbers should match what is reported on the W-2 (if you had only one employee) or, if multiple people were on the payroll, the totals from all W-2 tax forms should equal the amounts reported on the W-3 statement.
  • Schedule H: This lets the IRS know which employment taxes were withheld from the employee's paychecks (if you did not cover the full amount) and which ones you paid. File it along with Form 1040 when you send in your federal tax return.
  • Form 1040: This is the basic form where you report your annual income taxes. When you file your federal tax return, attach Schedule H to this form 1040.
Pay your tax tab to the IRS throughout the year: Yes, in most cases you can pay all the taxes you owe at one time. But a better idea to avoid underpayment penalties or getting socked with a bigger-than-expected tax bill is to pay the IRS its due throughout the year. You can do this either by withholding more from your paycheck if you're earning income (via your W-4) or making estimated tax payments during the year using Form 1040-ES.
Mark your calendar for January: Just like your boss mails you a W-2 showing what you earned and what taxes were paid for the previous year, you must provide the same for your employee so they can do their taxes. You must deliver this in a timely fashion so that your employee can complete their tax return by the April deadline. As noted above, you'll also send a copy of the W-2 and W-3 to the Social Security Administration.
Don't try to dodge the issue with Form 1099: Form 1099 is how employers report what they paid to independent contractors. Trying to pass off your live-in nanny as an independent contractor isn't going to fly. IRS rules are pretty clear that nannies are almost always employees, not contractors.
Don't assume you won't get caught: Look into the future to a day when someone who worked for you files for unemployment, Social Security retirement, or disability benefits or Medicare. That's when your nonpayment into those programs may come back to haunt you. And if they do come to light, you'll be forced to pay back taxes, penalties, and interest. 

Thursday, July 23, 2015

The importance of tax planning for retirement

For most Americans, the two largest sources of income during retirement are Social Security benefits and retirement savings account, such as their 401(k) and Individual Retirement Account (IRA).
Most people are aware that withdrawals from a traditional IRA and 401(k) are fully taxable as normal income in the year these funds are distributed.
What may not be apparent is that there are special rules for determining if Social Security benefits are taxed, and by how much.
Under the tax rules, Social Security benefits will be subject to tax if the taxpayer’s provisional income exceeds certain income levels.
Provisional income, by definition, is the Adjusted Gross Income from the IRS Form 1040 plus nontaxable interest plus half of of Social Security Benefits. The end result determines whether there is no tax on the Social Security benefits, or if 50 percent or 85 percent of these benefits will be taxed. Under current tax law, 15 percent of Social Security benefits are tax free for everyone.
A taxpayer filing as single with a provisional income between $25,000 and $34,000, and married taxpayers filing jointly with a provisional income between $32,000 and $44,000 will pay taxes on 50 percent of their Social Security benefits.
A single taxpayer with provisional income over $34,000, and married taxpayers filing jointly with a provisional income over $44,000 will pay taxes on 85 percent of their Social Security benefits.
It should be noted that these income thresholds are not indexed for inflation and have been at these levels for many years.
So what is the problem?
If an individual is receiving both Social Security and income from a qualified retirement plan, he or she may be creating more tax liability than anticipated.
For example, if a single taxpayer withdraws just $2,000 monthly from his or her retirement plan in addition to Social Security, this taxpayer automatically causes 50 percent of their Social Security benefits to be taxed.
Married taxpayers filing taxes jointly have the same problem if they’re withdrawing about $2,500 monthly in addition to Social Security.
The more that’s withdrawn from a retirement plan, the higher likelihood of up to 85 percent of Social Security benefits being taxed.
For this reason, it is important for an individual or married couple to do some serious retirement and tax planning. With careful planning, it may be possible to significantly reduce or eliminate the taxation of Social Security, and perhaps even on retirement plan withdrawals.
Roth conversions
Re-characterizing IRA and other pre-tax retirement account funds to a Roth involves withdrawing these funds and re-depositing them into a Roth. The conversion requires paying taxes on the funds that are being re-characterized, so this wouldn’t necessarily be a step done in a single lump-sum, but rather gradually over time.
For this same reason, the taxpayer would not want to make this conversion the same tax year they were starting to receive Social Security benefits.
A second tax planning strategy involves postponing Social Security and subsequently “Spending Down” the IRA or other pre-tax retirement plan.
This strategy may be best suited for those individuals retiring early and who were considering drawing Social Security prior to their full retirement age (FRA), since any additional employment income prior to FRA could be penalized.
Spending down an IRA
Delaying Social Security can result in higher payments in the future, which could be advantageous to both the Social Security beneficiary and could have potentially higher benefits for his or her spouse.
The reduced retirement account balances could result in lower required minimum distributions after age 70 ½ as well, which could result in lower overall future income which would then include Social Security.
The drawbacks of this strategy include the fact that Social Security is only payable for the life of the beneficiary, whereas the retirement account values can be passed on to beneficiaries.
Should an individual not live long enough to realize the benefits of postponing Social Security, the overall result could be less overall income being passed to a surviving spouse or other beneficiary. Life insurance, however, could be built in as a replacement for these lost benefits in the event of a premature death.
Retirement planning has traditionally involved determining how much income would be needed at retirement, and creating a program of saving. The potential impact of taxes into this planning equation requires extra steps and consideration to be included in this process.
No taxpayer wants to pay more taxes than is necessary, and that is especially true in retirement when sources of income are limited.
We do not know what changes may take place with respect to the tax laws in the future. Every pre-retiree should build this tax planning into their retirement plans.
Speak with your tax professional and financial planning professional and create a plan for your retirement.

A little planning now may save you a lot of tax grief in the future.

Wednesday, July 22, 2015

Tax Secrets: Get a second opinion


Sometimes writing this column is a joy.  The joy expands into fun when the reader/caller wants a second opinion.
Well, following is the fun story or a reader (Joe), who called with a problem. Joe has been working on a combination lifetime/estate plan for years with his professional advisers. The plan just couldn’t seem to get done. Joe wanted to get a second opinion on what was in place and finally finish the plan.
Joe’s goals have two time frames — (1) during his life and (2) after his death. His lifetime goals are: keep working, but at a slower pace, until the day he dies; keep the business (Success Co., a C Corp.) growing; build his management team that handles day-to-day operations; minimize income taxes; and not sell the business. His afterlife goals are: keep the business in the family (his two business sons would own it 50/50 after Joe’s wife Mary died) and minimize estate taxes. One of Joe’s sons, a doctor, will never be active in the business.
Joe’s present tax plan would beat him up in two ways: (1) income tax wise and (2) at his death, Success Co. would probably have to be sold to pay taxes and to avoid putting the bulk of his wealth (Success Co. currently represents about 65 percent of his wealth and grows in value every year) at economic risk. Success Co. was professionally valued at $16 million.
Following is a list of some of the tax-saving techniques — with the help of my network of professionals — used to help Joe accomplish his goals. Most of the techniques are designed to keep Joe in control (including Success Co.) of his personal wealth, for as long as he lives, reduce the value of Success Co. for estate tax purposes, and slash overall taxes.
1. Success Co. elected S Corp. status. Joe will get S Corp. dividend via an IDT (see 4 below) each year without suffering a second income tax, supplemented by withdrawals from his profit-sharing plan, to assure maintaining his and Mary’s lifestyle.
2. All new equipment (to be purchased by a new LLC, owned by Joe) will be leased to Success Co.
3. All insurance policies (over $4 million) on Joe’s life owned by Success Co. were transferred to Joe and then to an irrevocable life insurance trust, (Both transfers are income tax-free and get the insurance out of his estate and Mary’s estate).
4. Success Co. was recapitalized: 100 shares of voting stock and 10,000 shares of nonvoting stock. After various discounts allowed by the tax law, Success Co.’s value was reduced by 40 percent, reducing the $16 million valuation to $9.6 million (really the value of the nonvoting stock) for tax purposes. Joe sold the nonvoting stock to the intentionally defective trust (IDT) for $9.6 million. He was paid with a note from the IDT for $9.6 million (to be paid from future earnings of Success Co.). Under crazy American tax law, all payments received by Joe to pay off the note (both principal and interest) will be tax-free.
5. Joe will control Success Co. for life via the voting stock.
Joe’s family will save about $160,000 a year in income taxes and payroll taxes. The potential estate tax liability will be reduced from over $4 million to under $500,000 (will be paid with the tax-free life insurance proceeds).

Friday, July 17, 2015

Tax record keeping rules and tips

Why should I keep tax records?
On the individual tax side, documentation will help ensure that you don't miss any tax breaks. More importantly, thorough records will prove to the IRS that your tax deduction and credit claims are legitimate.
Remember, when it comes to tax questions from an IRS examiner, the burden of proof is on you, the taxpayer.
Uncle Sam goes into the process assuming you're trying to put one past him, so you have to show that you are on the tax up-and-up. If you can't, the auditor can disallow the tax breaks in question. But if you have good records, that will speed up the IRS examination process, something both the IRS and taxpayers want. 
Comprehensive record keeping also is critical to business taxpayers. Not only will good company records help you track deductible expenses and complete your tax returns, the documentation also can help you identify sources of income, prepare financial statements, track basis in property, prepare your tax returns, and generally monitor the progress of your business.
And diligent record keeping applies not just to big businesses, but also smaller companies and sole proprietors.
What record keeping system should I use?For personal tax filing purposes, the IRS doesn't care what type of record keeping system you use as long as it fits your needs and clearly shows your income and expenses. The same generally is true for corporate filers, too, although the type of business you have affects the type of records -- for example, payroll, inventory, depreciated equipment -- you need to keep for federal tax purposes.
What kinds of records should I keep?OK, so it's up to me to decide how to keep my records. Surely the IRS has some ideas on the types of records I should keep. You're right. Here are some considerations.
If you receive money from several sources, such as salary from a main job or freelance income as an independent contractor or from side jobs, you'll need the documents showing those earnings. You records should clearly identify the pay sources and amounts.
And don't forget your investment income. Those records are critical not only for keeping track of how they're doing, but what taxes you might owe. If you receive dividends, that's taxable, even if the payments are reinvested in the asset that is creating the payments. And if you sell, you need the records to figure the proper taxable basis.
In work and investment related income, you should receive some sort of third-party documentation, such as a W-2 or 1099 form. The IRS gets these copies, too.
Other payments, however, that don't trigger such documentation mean the burden of substantiating the income falls on you, even without an official tax statement.
Ditto for expenses. Here you need hang onto all tax-related expenses, such as business expenses, educational costs, charitable and disaster losses.
A good cheat-sheet of the type of records to hold onto is your annual filing checklist. Basically, all the things you need to fill out your Form 1040 and associated schedules are the same documents should keep, at least for a while, after April 15.
How long should I keep records?OK, you know which basic records to keep. Now the big question: How long? As with most tax answers, it depends.
The IRS says that the length of time you should keep a document depends on the action, expense, or event that the document records. The agency's rule of thumb is that you should keep your records as long as needed to prove the income or deductions on a tax return.
And "as long as needed" generally is until the period of limitations on auditing that return expires.
So what are those audit statutes of limitations? They range from two years to forever. Here are the specifics on those wide-ranging time periods:
  1. Keep records for three years if situations 4., 5. and 6. below do not apply to you.
  2. Keep records for three years from the date you filed your original return ortwo years from the date you paid the tax, whichever is later, if you file a claim for credit or refund after you file your return.
  3. Keep records for seven years if you file a claim for a loss from worthless securities or bad debt deduction.
  4. Keep records for six years if you do not report income that you should report, and it is more than 25 percent of the gross income shown on your return.
  5. Keep records indefinitely if you do not file a return.
  6. Keep records indefinitely if you file a fraudulent return.
A timing note for early filers: If you send in your tax return before April 15, it's treated as filed on the due date.
So basically, as the numbered list above shows, three years is the general time frame for most taxpayers.
But if you blow off your tax filing responsibilities or file a blatantly wrong 1040, the IRS can come after you any time. When that happens -- and yes, I say "when," because even tough audit rates have been dropping in the past few years, I'm a worrier and like to be ready for the worst-case scenario -- you'll need any records you can dig up to deal with the situation.
The IRS also has one more time frame for businesses to note. If your company has employees, keep those worker tax records for at least four years after the date that the tax (generally payroll tax payments) is due or is paid, whichever is later.
Finally, while you generally can throw out substantiating tax documents after the audit statute of limitations expires, when it comes to the 1040 and related schedules, you should keep those documents forever.