Saturday, January 29, 2011

5 Tax Myths Everyone Should Know

Don't you love a huge refund at income tax time? As it turns out, a big tax refund may make you feel good but it's not actually good for you. It means that way more than necessary was being withheld from your paycheck or, if you're self-employed, that your quarterly tax payments were much too large. 
That's fine for the government because they're essentially getting an interest-free loan in the meantime. But most of us have better uses for our money, like paying off credit cards, making investments or having more cash for routine expenses. So next time you hear someone brag about their big tax refund, you'll know they've bought into one of the oldest tax myths around.
Employees who are getting large refunds should go to IRS Publication 919  for an IRS booklet that shows how to avoid too much withholding; the section you need to read starts on page four. If you're self-employed, have your accountant recalculate your quarterly taxes to prevent overpayment. The notion that large refunds are good is but one of the many enduring tax myths. Here are five others you should be familiar with.
Myth 1: People who file electronically are more likely to be audited.
About 95 million taxpayers e-filed their 2009 income tax returns. In fact, the majority of returns are now filed electronically. Pretty soon, e-filing will probably be mandatory, so people have naturally begun to worry about the new system being more prone to audits. Yet, the IRS audit rate remains steady at less than 2% of all returns. The main audit triggers are the same as always, things like filing late, high self-employment income and math errors.
Myth 2: Paying taxes is voluntary.
Saying that taxes are voluntary or illegal is a favorite argument of tax protesters to justify not filing a return. But to the IRS, "voluntary" simply means you get to do all the tax calculations yourself. We're all required by law to pay taxes. So, if you're thinking of becoming a tax protester, be aware that your chances of avoiding taxes are slim to none - and that you'll probably also be liable for late-payment penalties.
Myth 3: Taxes in America are way too high.
Our income tax system may not always be comprehensible or fair, but Americans don't pay the highest taxes by a long shot. Whereas our highest tax bracket for individuals in the United States is currently 35%, individuals can be taxed at 50% or more in Austria, Belgium, Cuba, Denmark, Japan, The Netherlands and the United Kingdom. The top bracket in Sweden is almost 60%.
Myth 4: Filing for an extension increases your chance of an audit.
Most tax preparers say they haven't seen any link between filing for an extension and getting audited. If anything, filing for an extension reduces your risk of an audit because you buy yourself six extra months to make sure you get your taxes done right. If there aren't any math errors or other red flags, the IRS will be more than likely to pass you over for an audit.
Myth 5: All certified public accountants (CPAs) are income tax experts.
Just because you see "CPA" after someone's name doesn't necessarily mean he or she is an expert tax preparer. Although the CPA curriculum includes extensive income tax courses, not all CPAs go into tax prep or keep up on income tax laws. If you're in the market for a tax preparer and you're looking at CPAs, be sure they've actually got plenty of tax prep experience. 
Tax Myths AboundTo say that the tax laws in America are voluminous and confusing is probably an understatement, so it's no surprise there are so many tax myths. The more aware of these myths you are, the more control you'll have over your own destiny as a taxpayer. 

Wednesday, January 26, 2011

10 Ways to Avoid a Tax Audit

Worried about extra scrutiny from the Internal Revenue Service?
While you can never completely "audit-proof" your business's income tax return, you can take actions that will greatly reduce your chances of being flagged.
Here are 10 ways to avoid a tax audit:
1. Choose your tax return preparer with care. Today, according to the recent National Taxpayer Advocate report, 60% of individuals and even a greater percentage of businesses use paid preparers to do their income tax returns. Yet, preparers now face more intense IRS review. If the IRS believes a preparer is claiming unwarranted deductions or taking other fraudulent steps on clients' returns, then the preparer's clients are at risk for audit.
The IRS has eight tips for choosing a tax preparer. Key among them is to check the preparer's history to see if there has been any disciplinary action. For example, if you use an enrolled agent, check with the IRS' office of Professional Responsibility at (include the preparer's name and address).
2. Report all of your income. The IRS uses information returns, such as W-2s and 1099s, to cross-check income reporting. Under its document-matching program, the IRS' computers compare information on the forms with the income reported by taxpayers on their returns. If the information doesn't match, this leads to an automatic audit. But don't panic; it's merely a correspondence asking about the discrepancy. It can be easily cleared up by submitting an explanation by mail if you think you are correct, or paying the tax owed if the omission was your oversight and the IRS is correct.
Sole proprietors, freelancers and independent contractors who use the cash method of accounting may be vulnerable to year-end payment problems. For instance, a sole proprietor that performed work for a client may have received a payment in early January – but the client might have mailed (and recorded) the payment in December. The client will include the payment on Form 1099-MISC for 2010, but it isn't taxable until 2011. What to do: Include the payment as it is reported on the 2010 return, but then subtract the payment and attach an explanation with the return. Then include the payment on the 2011 return, even though no 1099 will be issued for this year.
3. Provide complete information. All questions should be answered and all required information should be included on the forms and schedules necessary for your return. That means if you're a sole proprietor, include your business code number, accounting method, and, where applicable, inventory valuation method on Schedule C. If information is missing, it could trigger a more extensive look at the return.
Also add information where necessary to explain entries or omissions that are not easily understood—such as in the prior example, when income received in January is reported on a prior year 1099.
4. Avoid claiming deductions that are audit red flags.Advice is easy to give, but unfortunately, the IRS does not say which deductions are likely to provoke a closer look. There are no official audit red flags. While many warn that claiming a home office deduction can prompt an audit, there's no proof of this. If you meet the qualifications for claiming a home-office deduction, there's no good reason not to take the write-off. Check your eligibility in IRS Publication 587, Business Use of Your Home.
A number of years ago, the Government Accountability Office (formerly the General Accounting Office) compiled statistics on deductions claimed by sole proprietors to show the types of deductions relative to the amount of their revenue. Some tax professionals believe that taking more than the "average" can raise an IRS eyebrow, but again, there is no concrete support for this view. A business that is entitled to deductions, even if they are high relative to the amount of their income, should claim them—but be prepared to prove entitlement if the return is questioned.
5. Don't file certain forms or schedules. Some optional forms and schedules virtually guarantee an audit. For example, if you turn a hobby into a sideline and show a business loan, the IRS may question whether some of your deductions are legitimate. If that happens, you might file a Form 5213, which keeps the IRS from auditing you for the first five years of the business. If you can show that you're profitable in at least three of the years, then the business isn't a hobby and the losses in the other years aren't questioned. The problem: Filing the form virtually guarantees an examination at the end of five years.
Better way: If you have loss years, be prepared to prove that you are operating the activity with a profit motive.
6. Pay attention to details. Math errors or incorrect entries of Social Security numbers or tax identification numbers can easily trigger an inquiry into your return. Math errors can be greatly reduced by electronic filing rather than filing paper returns. In the past, the IRS had said that errors are less than 1% on returns that are filed electronically, compared with about 20% on returns submitted via paper. If an e-filed return has a math error, it won't be accepted; instead it is sent back for correction and refiling.
But information on electronically filed returns is only as good as the information you submit. Reporting $2,000 in income when it should have been $20,000 is your mistake and one that likely won't be noticed as a math error by a computer.
7. Mind your personal entries. If there are entries related to the personal side of your return, this can ultimately lead to scrutiny of your return activities. The IRS selects returns for audit in some cases based on a Discriminant Function System or DIF score, which is based on IRS experience with taxpayers claiming certain deductions or credits within set income levels. For example, if you claim charitable contributions that are higher than the average deductions for your income level, this could lead to a personal audit; the personal audit may be expanded to include your business activities.
8. Change your business status. IRS Statistics show that you are 10 times as likely to be audited as a Schedule C filer than if you incorporate your business and elect S corporation status. While it costs a bit of money to incorporate, the move affords you greater personal liability protection and reduces your chances of being audited. In deciding whether to change your business status, include both tax and non-tax factors.
Note: Forming a limited liability company for one owner will not give you any audit protection, because the owner still files a Schedule C.
9. Watch your state tax return. The IRS has information-sharing agreements with the states. If you are audited at the state level and owe additional taxes because of omitting income or for other reasons, this information is shared with the IRS. The information may then prompt the IRS to contact you asking for additional tax payment or to audit your return in more depth.
10. Plan for an audit, just in case. Because the IRS conducts random audits from time to time (such as a three-year random audit program for S corporations in 2007 and a current three-year random audit program for employment tax returns), any return could be selected for review at any time. Be prepared:
  • Compile good books and records for your business activities.
  • Retain required receipts and other documentation.
  • Use separate bank accounts and credit cards for your business and personal activities.
Retain the records and receipts for your tax return for a minimum of three years (the period in which the IRS usually has to audit a return). However, keep in mind that the period becomes six years if 25% or more of income is omitted from the return, and there is no limit when it comes to fraud.

Friday, January 21, 2011

TaxACT Offers Federal Tax Filers Free E-filing

All taxpayers can now e-file a federal return for free with TaxACT, an online service from 2nd Story Software that files returns to the IRS allowing for refunds in as few as eight days with direct deposit.
Users can choose to be notified when the IRS has processed their returns by e-mail or a text message.  They can also check the status of their returns any time at The IRS will begin notifying e-filers whether their returns are accepted or rejected on Tuesday, January 18.
“We work closely with the IRS to give all taxpayers the fastest and easiest way to prepare their return, e-file and get their biggest guaranteed refund,” said 2nd Story Software chief executive Lance Dunn. “If your return includes itemized deductions, the Tuition and Fees Deduction, the Educator Expense Deduction or a few other forms the IRS won’t process until February, you can still prepare and e-file with TaxACT before then.”
A Deluxe edition is also available for $9.95 online or $12.95 for download, as well as a state tax edition for $14.95.
More information about all products is available at

Thursday, January 20, 2011

How to Prepare Now for the Tax Filing Deadline

The IRS officially began accepting returns for most taxpayers, and will allow all returns to be filed in just a few weeks. Although tax filing season has not officially began yet everyone, there are plenty of actions you can take now to help make preparing your return less stressful.
1. Breathe

So many taxpayers get stressed out just at the thought of preparing for tax season. Be sure to take a deep breath, and try not to get too worked up over your tax return. You have plenty of time before the April deadline, and this year you have until the 18th. By getting started now you are going to have a much less stressful tax season.

2. Gather Tax and Financial Documents

It is a good idea to put together a designated folder for your tax and financial documents. That way, when it comes time to prepare your actual return you will have all of your information already organized. Some items you will want to include in this folder ate W2 forms from employers, 1099 forms if you worked as an independent contractor or earned income from investments, receipts from charitable contributions, mortgage interest statements, vehicle registration bills, etc.

3. Get Copies of any Missing Materials

If you are missing any documents, then you will want to get copies as soon as possible. For example, you might need to print out copies of bank or credit card statements for deduction you intend to claim, but can't seem to find the receipt.

4. Toss (or Shred) Unnecessary Documents

You don't really need every single bank statement or pay stub in your tax folder. If you do want to keep all of these documents put them into a different file. That way you will not feel overloaded with paperwork when you sit down and attempt to prepare your return in a few weeks.

5. Be on the Lookout for your Income Statements

You should expect to receive W2 and 1099 forms some time this month. Be sure that you are on the lookout, so that you do not accidentally throw them into the trash with your junk mail. If you do not get your W2 by February then you will want to contact your employer to make sure it was sent to the correct address.

6. Find your Return from Last Year

Make sure that you include your most recent return at the front of your tax file. Unless you changed jobs, or made a major tax move like purchasing a home, then you should be able to use your old return as a guide for completing you new one.

7. Verify the Exact Amounts of Charitable Deductions

The IRS has been cracking down on charitable contributions over the past couple of years. Be sure to look over your receipts and make sure that you can substantiate the market value of your contributions. Additionally, if your contributions exceed $500 you will need to complete IRS Form 8283, and if any item is valued at over $5,000 then you must obtain a written appraisal.  8. Anticipate Errors

There are a few common errors that many taxpayers make on their returns.

9. Think About Hiring a Pro

If you have a complicated tax account, or simply do not want to hassle with preparing your own return then you should think about hiring a tax professional. Check out a few local tax preparation offices in your neighbor hood and make an appointment before they start getting busy.

Wednesday, January 19, 2011

IRS Scrambling to Update Computers

Because it took a contentious Congress until Dec. 17 to agree to extend the so-called Bush tax cuts another two years, the Internal Revenue Service had to scramble to update its computers.
The result is that about 40 million of the nation's 140 million filers will have to wait until mid- to late March to file their returns if they itemize deductions.
"For everyone else, there is no delay," said IRS spokesman Mark Hanson. "But if you are itemizing on Schedule A, you will have to wait until the IRS gives the green light to file."
Returns filed before itemizers get the go-ahead will be rejected and sent back, Hanson said.
Anticipating that Congresss wouldn't extend the tax cuts beyond 2010, the IRS had adjusted its computer programs to exclude them, Hanson said.
Joseph A. Pancerella, a certified public accountant, financial planner and managing partner of Pancerella & Associates LLC, 301 W. Lancaster Ave., Shillington, tried to simplify the issue.
"As the IRS has stated, most filers will not be affected," Pancerella said. "However, most individuals who use tax preparers will be affected.
"The reason: Because, as preparers, we typically prepare complicated returns. And complicated returns typically contain the items that are causing the delay."
Since the tax-filing season for some has been shortened to six weeks, Hanson said the IRS is encouraging taxpayers to file their returns electronically and, if they want to receive their refunds in as little as 10 days, they should elect to have their refund deposited directly into their checking account. Mailed refund checks take six to eight weeks.

Get Tax Credit for Your Retirement Savings

Tax time is coming soon. The IRS starts accepting e-file Friday January 14th and employers are in the process of getting W-2s out. Many people pay more taxes than they need to because they fail to take all the credits that are available to them. One of the most commonly overlooked credits it the Retirement Savings Contribution Credit.
The Retirement Savings Contribution Credit is a tax credit of up to $1000 ($2000 if married filing jointly) that you may be able to take if you make eligible contributions to an employer sponsored retirement plan or an IRA. This credit could reduce the amount of your federal income tax liability dollar for dollar. It is a non-refundable credit so the amount of your RSCC can not exceed the amount of your tax liability.
In order to be able to claim the RSCC you must meet the following conditions. You must be 18 or older and not a full-time student. No one else (such as parents) can claim an exemption for you on their tax return. Your adjusted gross income must not be more than $55,000 if your filing status is married filing jointly, $41,625 if your filing status is head of household or $27,750 if your filing status is single, married filing separately or qualified widow(er).
The amount of your tax credit is determined by how much you contribute to a qualified retirement plan and your credit rate. The credit rate ranges from as low as 10 percent to as high as 50 percent and is determined by your filing status and income. You can find your credit rate using Form 8880 at
Most people whose income is low enough to qualify for the 50 percent rate likely will not be able to contribute enough to their retirement savings to qualify for the maximum credit but their tax liability is probably less than that. Even if you only qualify to receive the 10 percent credit rate the credit is worth taking since you should be saving for your retirement anyway. If you contributed to an IRA or your employer’s retirement plan and your income is within the guidelines be sure to determine whether you qualify for this credit when filing your taxes.

Tuesday, January 18, 2011

How Long to Keep Tax Records

This is a great time of the year to get rid of outdated files and to organize your records in preparation for filing your tax return in the spring. You should be receiving your year-end mutual fund and brokerage statements by the end of January, along with W-2 and 1099 tax forms reporting your income and interest for 2010.
Review your year-end statements to make sure they accurately reflect the monthly statements you received from your bank, broker and other financial institutions. Then you can toss the monthly statements. Keep those year-end statements in your tax files for at least three years after the due date of your return (or six years if you’re self-employed).
You should keep records of your stock and fund purchases for as long as you hold those investments, however. You’ll need to report the date, number of shares and price paid on Schedule D to establish your basis when you finally sell a stock or fund. You’ll only pay tax on the profits above the basis amount, or you can use a loss to offset investment gains and up to $3,000 per year of ordinary income. Also, hold on to year-end statements that show reinvested dividends and capital-gains distributions, so you don’t end up paying taxes on the same money twice when you sell the shares. It’s also a great time to declutter the rest of your financial files. Although it’s recommended that you keep your tax returns for at least six years, you may want to hold on to them forever, because they can provide clues about your income and investments and other tax information that might come in handy in the distant future. You can still weed out and toss supporting documents, such as canceled checks and old receipts, three years after the due date of your return (that’s usually how long the IRS has to audit your return, unless you’ve significantly underreported your income). If you have any self-employment income, keep your receipts for at least six years.
You may also want to hang on to receipts for major home improvements for at least three years after you sell your house. They may come in handy if you want to show potential buyers how much you’ve spent to upgrade the property, and you may be able to use certain home-improvement expenses to lower any tax bill you might have on your home-sale profits. You probably won’t pay taxes on the sale of your principal residence unless you’ve lived in it for less than two years, you rented out part of it, or your profit on the sale exceeded $250,000 if you’re single, $500,000 if you’re married.
Trash your ATM receipts and bank-deposit slips as soon as you match them up with your monthly statement. Ditch your pay stubs as soon as you receive your W-2 for the year. And you can also toss paper copies of your credit-card, utility, phone and cable bills as soon as the next month’s bill acknowledging your last payment arrives (unless you need to keep the bills for tax purposes -- if you deduct home-office expenses, for example). You may also want to hold on to your utility receipts if you plan to sell your house soon, so you can show prospective buyers how much your utilities tend to cost.
Any year that you make a nondeductible contributions to a traditional IRA, you must file Form 8606 to document those contributions. Then hold on to all of those 8606 forms until you withdraw all the money from your IRA, so you won’t end up overpaying your tax bill when you start to take out the money in retirement .And when you do decide to toss any of these papers, be sure to shred them so your garbage doesn’t become a treasure trove for identity thieves.

Monday, January 17, 2011

Study Finds Audited Financial Statements Help Businesses' Loan Prospects

Small businesses whose books are audited—by a hired certified public accountant, not the Internal Revenue Service—improve their chances of getting a loan, and at far better terms, than businesses with less scrutinized financial statements, a new study shows.
Yet even as owners continue to struggle with tight credit, few can afford the time, effort or cost of preparing complex financial statements, let alone having them audited, small-business owners, lenders and accountants say.
"Banks love when you have audited financials because they view it as a form of insurance," says Buzz Rose, a certified public accountant in Pittsburgh. "But audits have become very expensive and to have one done 'just in case' would seem to be a waste of time and money."
But the benefits might outweigh the costs.
Based on data from more than 10,000 closely held companies—about half of which have less than 500 employees—a study by the University of Chicago Booth School of Business found audited businesses save an average of $6,900 for every $1 million in outstanding debt every year as a result of lower interest rates, which were more than half a percentage point below rates paid by nonaudited businesses. For a loan of $3.3 million, the average size of loans analyzed in the study, the savings was about $23,000.
A small-business audit costs anywhere from $5,000 to $75,000, depending on the size of the company, the complexity of its data and other factors—typically double the cost of a financial statement review, the next highest level of CPA-verified assurance after an audit.
An audit provides third-party assurance that a company's financial statements are correctly prepared and based on verified business data, while a review shows the statements are at least internally consistent with data provided by management.
"There appears to be a very real cost benefit to getting an audit, beyond the obvious value of having your financial statements in order," says Michael Minnis, a Booth School assistant professor of accounting who led the study. The Booth School study is expected to be published in the Journal of Accounting Research in May.
Similarly, a joint study last year by Michigan State University and Indiana University found small businesses with audited financial statements were "significantly less likely" to be denied credit from banks.
David Leuthold, chief executive of Century Negotiations Inc., a North Huntingdon, Pa., consumer-debt settlement firm, says he started having his books audited annually in 2005 to double-check his own bookkeeping, paying about $8,000 an audit. The move paid off when he applied for a $100,000 line of credit the following year.
"The bank required audited financial statements," says Mr. Leuthold, whose company made $8 million in revenue last year. Even without audited books, he believes the bank might have approved the loan, though at less favorable terms. "We had what they wanted, so it was definitely worth it," he says.
Still, for many small businesses seeking a loan, lenders say an audit is costly and unnecessary.
"Audits provide good information. The more concrete information a lender can get, the better," says Tom Burke, the director of Wells Fargo's Small Business Administration lending division. But he questioned the necessity of audits for every business.
Mr. Burke says a business with less than $1 million in annual revenue can ask a CPA to prepare a compilation, which is a cheaper, unaudited financial statement based on recorded sales, inventory and other data. Since owners often use these statements to manage daily operations—and they're prepared by CPAs—lenders have some assurance of the statements' accuracy in making loan decisions.
"I'd hate to see people taking steps that aren't necessary, or that they can't afford," Mr. Burke says.
Small-business accountant David Wilke, of Carnegie, Pa., says he helps borrowers and lenders negotiate loan terms based on mutually acceptable levels of assurance, ranging from compilations to audits. He says a CPA "adds value by determining what a bank wants and what a business can provide at an early stage," rather than trying to convince every client to get audited.
Mr. Rose, the accountant in Pittsburgh, says it's only worth going through an audit—which can require days and even weeks of a manager's time—when a business owner has a loan in hand that's contingent on providing audited financial statements.
Audited or not, less than a quarter of businesses with fewer than 500 employees keep financial statements of any kind, according to the Federal Reserve Board's National Survey of Small Business Finances.
"There's a lot of criticism that it's expensive and difficult to prepare and audit your financial statements," says Teri Yohn, an Indiana University associate professor of accounting who sits on the Financial Accounting Foundation's blue-ribbon panel on private-company accounting standards. "But there are clearly benefits."

Sunday, January 16, 2011

Real Estate ownership and taxes

Property values are at an all time low and many investors are taking advantage of this opportunity to purchase rental properties. Probably for the first time in history, investors can enjoy positive cash flow as well as anticipate a future increase in equity. If this is the year you become a landlord, you will want to pay attention to the tax rules governing this investment.

Your rental income and expenses are listed on your individual tax return on Schedule E, available for your perusal at The profit or loss from the activity is included in income and taxed at your ordinary income tax rate. It sounds pretty straightforward, but it can get tricky fast.
First of all, what is rental income? If a prospective tenant pays first and last month’s rent and a security deposit when moving into the property, not all of that is included in current year taxable income. Or is it? Here’s how it breaks down:
1. First and last month’s rent are included in the current year income even if the last month’s rent will be applied in a future year.
2. Advance rent  is all included in income for the current year, regardless of what year the payments are for.
3. Non-refundable deposits are included in current year rent, even if a fee, for example, a non-refundable cleaning fee, won’t be used until the tenant moves out in a future year.
4. Security deposits need not be claimed as income if you intend to return the deposit to the tenant at the end of the lease term.
5. Barter is income.  If, for example, as part of the rent, your tenant agrees to maintain the gardens and pool, you must show the value of these services as rental income. By the same token, you may also deduct the same amount as a rental expense. I know it’s a push, but the IRS loves to see us sharpening our pencils and doing extra paperwork.
6. Expenses paid by your tenant. See barter income above. Say you’re jet setting through Europe and the pipes in the rental spring a leak; your tenant pays the plumber then deducts it from his rent. You must include the full rent in income and write off the plumbing expense against it. Yes, again, it’s a push.
7. Lease cancellation. If your tenant pays you to cancel the lease, include the payment as rental income.
8. Option payments. If your tenant signs a lease with an option to buy, the option payments are generally rental income. But once the tenant exercises the right to buy the property, all payments received after the sale are considered part of the selling price.
9. Here’s a little tax break for you: If you rent out part of your personal residence for fewer than 15 days, you need not include the rent you receive in your income.
10. If you are renting space in your personal residence (including a vacation home) for more than 15 days, you must declare the income. But you should consult with your tax pro to determine how to properly allocate your rental expenses against the income you receive.
Make sure you keep all lease/rental agreements and tenant applications. When under audit, the IRS likes to look at these documents as part of the verification that this is indeed a rental property. Also keep all cancelled checks and credit card receipts for all rental expenses deducted on your tax return. Lease cancellation. If your tenant pays you to cancel the lease, include the payment as rental income.
8. Option payments. If your tenant signs a lease with an option to buy, the option payments are generally rental income. But once the tenant exercises the right to buy the property, all payments received after the sale are considered part of the selling price.
9. Here’s a little tax break for you: If you rent out part of your personal residence for fewer than 15 days, you need not include the rent you receive in your income.
10. If you are renting space in your personal residence (including a vacation home) for more than 15 days, you must declare the income. But you should consult with your tax pro to determine how to properly allocate your rental expenses against the income you receive.
Make sure you keep all lease/rental agreements and tenant applications. When under audit, the IRS likes to look at these documents as part of the verification that this is indeed a rental property. Also keep all cancelled checks and credit card receipts for all rental expenses deducted on your tax return.

Thursday, January 13, 2011

No Wisconsin Estate Tax For 2011 and 2012

As a result of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, approved by Congress and signed into law by President Obama on December 17, 2010, there is no Wisconsin estate tax for deaths in 2011 and 2012 unless action is taken by the Wisconsin Legislature to impose an estate tax.
A federal estate tax is imposed on estates of $5,000,000 or more. The credit for state death taxes paid has been eliminated for deaths in 2011 and 2012, which would have been the basis for Wisconsin's estate tax. The Act allows a deduction for state death taxes paid.
On January 1, 2013, EGTRRA sunset provisions would again apply with federal or state legislative action necessary to eliminate the Wisconsin estate tax for 2013.

Wednesday, January 12, 2011

IRS Delays More Forms for Filing This Season

The Internal Revenue Service said a series of forms will be disabled until mid- to late February with error codes.
In an e-mail alert to software developers, tax return transmitters, and authorized IRS e-file providers and electronic return originators, the IRS said Friday that the following forms would be disabled until mid- to late February with a new error reject code, 0248.

The following forms cannot be electronically filed at this time, according to the IRS:
Schedule A, Itemized Deductions
Form 3800, General Business Credit
Form 4684, Casualties and Thefts
Form 5405, First-Time Homebuyer Credit and Repayment of the Credit (Page 2)
Form 6478, Alcohol and Cellulosic Biofuel Fuels Credit
Form 8834, Qualified Plug-in Electric and Electric Vehicle Credit
Form 8859, District of Columbia First-Time Homebuyer Credit
Form 8910, Alternative Motor Vehicle Credit
Form 8917, Tuition and Fees Deduction
Form 8936, Qualified Plug-in Electric Drive Motor Vehicle Credit
In addition, Error Reject Code 0014 does not allow entries for educator expenses (Form 1040, line 23 and Form 1040A, line 16) or tuition and fees (Form 1040, line 34 and Form 1040A, line 19). In mid- to late February, the record layout for Form 1040 and Form 1040A will be updated to allow entries for educator expenses (SEQ 0623) and tuition and fees deduction (SEQ 0705), according to the IRS.
The IRS said last month after the late passage by Congress of an extension of the Bush-era tax cuts that some of these same forms, especially Schedule A for itemized deductions and other forms for educators and tuition expenses, would not be available until mid- to late February, but it did not list many of the other forms enumerated on Friday at the time

Tuesday, January 11, 2011

IRS Releases new 2011 Tax Brackets and other remaining inflation adjustments

The IRS has updated the tax brackets, personal exemption, standard deduction and several other tax items as part of its annual cost-of-living and inflation adjustments for 2011 (Rev. Proc. 2011-12).
Tax laws require the IRS to adjust the dollar amounts of dozens of tax provisions each year to account for inflation. The IRS updated most of the items - such as pension and retirement plan limits and the annual gift tax exclusion - in mid-October in IR-2010-108 and Rev. Proc 2010-40. But the IRS waited to release updates on several tax items in anticipation of legislation addressing the extension of the 2001 and 2003 tax cuts. Rev. Proc. 2011-12 covers these items.
The tax brackets increased modestly for 2011, reflecting relatively low inflation (See chart for 2011 and future new tax brackets). The new standard deduction increased $200 to $11,600 for married couples filing a joint return and increased $100 to $5,800 for single filers. The personal and dependent exemption increased $50 to $3,700.
Individual tax bracket scenarios under current law
Ordinary income tax brackets
(based on 2011 brackets)*
$0 - $8,500$0 - $17,00010%15%
 $8,501 - $34,500$17,001 - $69,00015%15%
 $34,501 - $83,600$69,001 - $139,35025%28%
 $83,601 - $174,400$139,351 - $212,30028%31%
 $174,401 - $379,150$212,301 - $379,15033%36%
 Over $379,150Over $379,15035%39.6%
Capital gains top rate15%†23%‡**
Dividend top rate15%†43.4%§**
Interest income top rate 35%43.4%**
* Brackets are adjusted for inflation every year and refer to taxable income
† Capital gains and dividends in bottom two brackets have zero rate
‡ The top capital gains rate in 2013 would be 23.8% but 21.8% for property held at least five years**
§ Dividends would be taxed as ordinary income in 2013 up to the top rate of 39.6% (+3.8%)
** Includes new 3.8% Medicare tax on investment income

Monday, January 10, 2011

Planning For A Disappearing Estate Tax Break

Until recently lawyers routinely cautioned their clients that the estate tax exemption is something that belongs to each of us personally and can't be shared. That meant spouses risked losing one of their tax-free opportunities by leaving everything to each other in what are called "I love you wills."
But the federal estate tax system signed into law by President Obama on Dec. 17 changes that with a wonderful new break for married couples. Starting in 2011 widows and widowers can add to their own estate tax exemption the unused exemption of the spouse who died most recently. This provision, plus an increase in the exemption amount to $5 million per person, enables married couples together to transfer as much as $10 million tax-free to their children or other heirs, either by making lifetime gifts or through estate plans.
Portability, as tax geeks call it, is an extremely positive development that can simplify planning for many people. But for others it raises tough choices about whether to abandon more complex estate planning tools that may have other advantages. To further complicate matters, portability only applies to deaths in 2011 and 2012. So until Congress makes it permanent, there's a risk that it will expire before most folks can take advantage of it.
For now, perhaps the greatest benefit of the new provision is for people who didn't plan, and as a result previously would have fallen into a very common trap for the unwary. For example, had it existed in 2009, portability would have made a huge difference for the family of a wealthy Texan who died that year.
This fellow tried to save a few bucks by using a form he copied from a library book to write his own will (not a good idea) and left everything--a cool $7 million--to his wife. There was no estate tax due at that point because assets left to a citizen spouse or to charity generally aren't subject to the tax. But anything left when she died, less her own exemption amount, would have been taxable as part of her estate. Although Texas has no estate tax, the husband had forfeited what was then a $3.5 million federal estate tax exemption.
Since portability only applies to deaths after Dec. 31, 2010, it doesn't help the Texan's family.To fix the problem after the husband died, William Wollard, a lawyer with his own practice in McKinney, Texas, recommended the wife disclaim (or turn down) the entire exemption amount, allowing it to pass under state law to the couple's three adult sons. That meant she no longer has access to the money. But in the future, with portability, others like her will have another option: to add the husband's unused exemption amount to her own, retaining control of the funds until her death.
There are two other ways for couples to each use their full federal estate tax exemption amount, and they both still work. One is to leave assets outright to people other than a spouse--for example, to children. The other, more popular strategy is to use a bypass trust.
Here's how these trusts (also called family trusts) work: When the first spouse dies, the trust is funded with up to the exemption amount. The trust distributes income and principal to the survivor or other family members (usually the couple's children) while the surviving spouse is alive, then passes on whatever is left to family. Funds in the bypass trust are covered by the exemption amount and are not taxed when the first spouse dies. Nor are they considered part of the survivor's estate, so they are not subject to tax when she dies.
Now that portability makes it unnecessary in most cases for spouses to use a bypass trust solely to preserve the federal exemption amount, is this planning device defunct? Not by a long shot. Still, it's never been for everyone, and far fewer people may need it now than in the past. Whether you're one of them depends on various factors, including your net worth, family relationships, investment outlook and tolerance for complexity. Here are some reasons to use, or not use, a bypass trust.

You want to protect the inheritance from creditors.
Preserving resources for your heirs goes beyond sound investment and money management. You also need to guard against the possibility that, sometime in the future, the objects of your bounty could lose assets to their own creditors. They may include everyone from disgruntled spouses and ex-spouses to people who win lawsuits against your family.
Leaving assets to heirs in a family trust, rather than outright, is an excellent means of sheltering family assets from creditors. For many people this is the main reason to set up trusts and to leave assets permanently in this legal wrapper.
Among the many people who might benefit from this asset protection tool are those whose work could generate lawsuits: entrepreneurs, doctors, lawyers, accountants and other professionals; construction contractors and real estate developers; executors and trustees; and directors of public companies. Keep in mind that in tough economic times, people find reasons to sue. It's prudent to ensure your family is not an easy target.
Your spouse might remarry after your death.
This raises a couple of additional concerns. One involves your children if they don't get along with the evil stepmother or stepfather. Picture this: your surviving spouse commingles everything with this great-unknown quantity and your kids get completely cut out. Stranger things have happened. With a bypass trust, you can avoid that result.
Another issue is that under the new law, remarriage cuts off the surviving spouse's ability to use the exemption amount of his or her first spouse, if the new spouse dies first. For example, let's say Harry has an unused exemption amount of $5 million when he dies next year. His widow Sally adds that to her own $5 million exemption amount. Then she remarries to Joe. If his unused exemption is less than Harry's (or if he has no unused exemption at all) Sally is out of luck if she survives him and leaves behind more than $5 million. In this example, using a bypass trust would preserve Harry's exemption amount just as in the days before portability. (Note that if Sally dies before Joe, her estate can still use Harry's unused $5 million exemption and can pass on up to $10 million, but Joe can't carry over more than $5 million from Sally.)
Your spouse might strike it rich.
Putting the funds in trust, rather than leaving them outright, ensures that neither the assets nor any appreciation on them will be considered part of your spouse's estate. A bypass trust reduces the possibility that by time your spouse dies his or her net worth will be more than the exemption amount.

What you lose by using a bypass trust in this scenario is potential income tax benefits down the line. Had the assets been left outright to the surviving spouse and included in her estate, they would get an adjustment in basis to their value at the date of her death, which minimizes the capital gains tax heirs must pay when they are sold--assuming they have increased in value in the years between the two deaths. In contrast, the basis on assets that went into the bypass trust when the first spouse died will not have changed since then.
You have grandchildren (or might someday).
Portability does not apply to the $5 million exemption from generation-skipping transfer tax. This is the 35% levy that applies, on top of estate or gift tax, to assets given to grandchildren and more remote generations (or to trusts for their benefit). So if you don't want to lose the exemption, you must use it, either by making lifetime gifts or by factoring it into your estate plan. There are various ways to do this. One is to include grandchildren as beneficiaries of a bypass trust and to apply at least part of your exemption to that trust.
Your plan already includes a bypass trust.
Given the potential benefits this trust affords, carefully weigh the pros and cons before you revamp your plan and ditch it. But if you haven't revised your documents in a number of years, do make sure they still reflect your intent about how much money is destined for one of these trusts.
Instead of naming a specific sum that will go into a trust, many documents refer to an amount up to the exemption or express the sum as a percentage of whatever the limit happens to be when the person dies. Skim your will and living trust for phrases like "that portion," "that fraction" or "that amount" (without specifying how much). These formula clauses are signs of lawyers trying to take maximum advantage of the estate tax exemption, which kept increasing. In the past, that was a good standard practice. But it's possible that given the current $5 million exemption, less money would now go to your spouse than you would like, or too much would go to your grandchildren. Consult your lawyer about whether amendments may be necessary.
One alternative, in a stable first marriage, is to leave everything to your spouse outright, but give him or her the right to disclaim all or part of the inheritance and have it go into a bypass trust. Be aware, though, that when it comes to disclaimers, the world of estate planning lawyers is divided into two camps: those who like the flexibility a disclaimer affords, and those who joke about the five-word lie spouses routinely tell each other: "Honey, I promise to disclaim."
You live in a state that has an estate tax or own property in one of these states.
Currently 13 states and the District of Columbia have separate estate taxes, and most have exemptions of $1 million or less. Hawaii and North Carolina are two exceptions--they will match the $5 million federal exemption for 2010. None, as of now, have any portability provisions. With tax rates running as high as 16%, married couples in states with a tax may still want to fund bypass trusts, up to the state exemption amount, in order to preserve the first spouse's exemption.

Most of your assets are in joint ownership.
This issue has always made bypass trusts cumbersome, especially for couples of moderate wealth, since the trust must be funded with your own assets.
The ideal assets to put into the trust are cash, bonds or marketable securities held in your own name. But for many people, their homes and retirement accounts are their most valuable assets, or the only ones available to fund a bypass trust. Each presents its own challenges because of special rules that apply.
If you use retirement assets to fund a bypass trust, you may lose certain income tax benefits. Therefore, you need to weigh the potential estate tax savings against the income tax cost.
Using a home to fund a bypass trust is also an imperfect solution. The way to do this with a jointly owned home is for the surviving spouse to disclaim the one-half interest in the property he has inherited. That part of the house then becomes a bypass trust asset, although the spouse could buy it out of the trust and replace it with cash, either all at once or over time.
There are a number of drawbacks to this approach. Unless the spouse is a trustee of the bypass trust, you take away the survivor's sense of ownership. Depending on the arrangement, the trust may need to share the cost of maintenance and repairs, it can't deduct property taxes, and if the house is sold, a valuable income tax break could be lost.
Given the complications and disadvantages of funding a bypass trust with a home or with retirement assets, you will want to look for alternatives. If you don't have any, you might decide to forgo the bypass trust and buy second-to-die life insurance, which covers both members of a couple and pays off only when both of them have died. The proceeds can be used to pay the federal and state estate taxes, if any are owed.
You want to avoid administrative pitfalls.
There's a big one lurking with portability: The executor handling the estate of the spouse who dies first needs to transfer the unused exemption to the survivor, who can then use it to make lifetime gifts or pass assets through his or her estate. This must be done by filing an estate tax return when the first spouse dies, even if no tax is due.

This return is due nine months after death with a six-month extension allowed. Spouses ought to file it even if they're not wealthy today, because someday, who knows? But if the executor doesn't file the return or misses the deadline, the surviving spouse loses the right to use her late spouse's remaining exemption.
You don't trust Congress.
Along with all the other estate tax goodies in the new law, portability is set to expire on Dec. 31, 2012. If Congress doesn't act before then, not only could we lose portability, but the exemption amount will revert to $1 million and the rate will increase to 55% from the current 35%.
If that looks even remotely possible as 2012 draws to a close, widows and widowers who carried over an unused exemption could suddenly feel like Cinderella rushing to get home from the ball before the stroke of midnight. Unless they make lifetime gifts to use up the carried-over exemptions, they risk losing everything they gained through the 2010 tax law.
Uncertainty about what's ahead is enough to make a financial advice wonk's imagination run wild. But as a practical matter, Congress is likely to extend portability; the provision just makes it easier to accomplish something that many couples have been doing anyway.
What to do in the meantime? Howard M. Zaritsky, a Rapidan, Va., estate planning expert who advises other lawyers in the field, says he's telling practitioners not to base estate plans on portability until it becomes permanent. He says "Congress has shown a propensity for surprising us with both bad decisions and good ones, and you just cannot plan on Congress doing the expected or the right thing."

Sunday, January 9, 2011

Business Tax Changes for 2011

Health Insurance Deduction Reduces Self Employment Tax

Self-employed taxpayers who pay their own health insurance costs can now reduce their net earnings from self-employment by these costs. Previously, the self-employed health insurance deduction was allowed only for income tax purposes. For tax year 2010, self-employed taxpayers can also reduce their net earnings from self employment subject to SE taxes on Schedule SE by the amount of self-employed health insurance deduction claimed on line 29 on Form 1040.

Taxpayers can claim the self-employed health insurance deduction if the insurance plan is established under their business and if any of the following are true:

• They were self-employed and had a net profit for the year,

• They used one of the optional methods to figure net earnings from self-employment on Schedule SE, or

• They received wages from an S corporation in which the taxpayer was a more-than-2% shareholder.

During tax year 2008, the most recent year for which data is available, the self-employed health insurance deduction was claimed on 3.6 million tax returns, reducing taxpayers' adjusted gross incomes by $21 billion.

Small Business Health Care Tax Credit

In general, the Small Business Health Care Tax Credit is available to small employers that pay at least half of the premiums for single health insurance coverage for their employees. It is specifically targeted to help small businesses and tax-exempt organizations that primarily employ moderate- and lower-income workers.

Small businesses can claim the credit for 2010 through 2013 and for any two years after that. For tax years 2010 to 2013, the maximum credit is 35% of premiums paid by eligible small businesses and 25% of premiums paid by eligible tax-exempt organizations. Beginning in 2014, the maximum tax credit will increase to 50% of premiums paid by eligible small business employers and 35% of premiums paid by eligible tax-exempt organizations.

The maximum credit goes to smaller employers –– those with 10 or fewer full-time equivalent (FTE) employees –– paying annual average wages of $25,000 or less. The credit is completely phased out for employers that have 25 or more FTEs or that pay average wages of $50,000 or more per year. Because the eligibility rules are based in part on the number of FTEs, not the number of employees, employers that use part-time workers may qualify even if they employ more than 25 individuals.

General Business Credit for Employers

The general business credits of eligible small businesses in 2010 are not subject to alternative minimum tax The new law allows general business credits to offset both regular income tax and alternative minimum tax of eligible small businesses as described in Section 2012 of the Small Business Jobs Act. The provision is effective for any general business credits determined in the first taxable year beginning after December 31, 2009, and to any carryback of such credits. For a list of the general business credits, see Form 3800.

Small Businesses Can Benefit from Higher Expensing / Depreciation Limits

For tax years beginning in 2010 and 2011, small businesses can expense up to $500,000 of the first $2 million of certain business property placed in service during the year.

In general, businesses can choose to treat the cost of certain property as an expense and deduct it in the year the property is placed in service instead of depreciating it over several years. This property is frequently referred to as section 179 property, after the relevant section in the Internal Revenue Code.

Section 179 property is property that you acquire by purchase for use in the active conduct of your trade or business, including:

• Tangible personal property.

• Other tangible property (except buildings and their structural components) used as:

1. An integral part of manufacturing, production, or extraction or of furnishing transportation, communications, electricity, gas, water, or sewage disposal services;

2. A research facility used in connection with any of the activities in (1) above; or

3. A facility used in connection with any of the activities in (1) above for the bulk storage of fungible commodities.

• Single purpose agricultural (livestock) or horticultural structures.

• Storage facilities (except buildings and their structural components) used in connection with distributing petroleum or any primary product of petroleum.

• Off-the-shelf computer software.

The Small Business Jobs Act (SBJA) of  2010 increases the section 179 limitations on expensing of depreciable business assets for tax years beginning in 2010 and 2011 and expands temporarily the definition of section 179 property, for tax years beginning in 2010 and 2011, to include certain qualified real property a taxpayer elects to treat as section 179 property. Qualified real property means qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property.

The $500,000 amount provided under the new law is reduced, but not below zero, if the cost of all section 179 property placed in service by the taxpayer during the tax year exceeds $2 million.

For tax years beginning in 2012, the maximum amount is $125,000; before enactment of the 2010 tax relief legislation, it was set at $25,000.

Depreciation limits on business vehicles

The total depreciation deduction (including the section 179 expense deduction and the 50 or 100 percent bonus depreciation) you can take for a passenger automobile (that is not a truck or a van) you use in your business and first placed in service in 2010 is increased to $11,060. The maximum deduction you can take for a truck or van you use in your business and first placed in service in 2010 is increased to $11,160.  If you do not take any bonus depreciation for the passenger automobile, truck, or van you use in your business and first placed in service in 2010, the maximum deduction you can take for a passenger automobile is $3,060 and for a truck or van is $3,160.

50 or 100 Percent Bonus Depreciation

Generally, businesses can take a special depreciation allowance to recover part of the cost of qualified property placed in service during the tax year. The allowance applies only for the first year you place the property in service.

Businesses that acquire and place qualified property into service after Sept. 8, 2010 can now claim a depreciation allowance of 100 percent of the cost of the property. The property must be placed in service before Jan. 1, 2012 (Jan. 14, 2013 in the case of certain longer-lived and transportation property).   Businesses that acquire qualified property during 2010 on or before Sept. 8, 2010 can claim a depreciation allowance of 50 percent of the cost of the property.  The property must be placed in service before Jan. 1, 2013 (Jan. 1, 2014 in the case of certain longer production period property and for certain aircraft.)

The allowance is an additional deduction you can take after any section 179 deduction and before you figure regular depreciation under MACRS for the year you place the property in service. The types of property that can be depreciated are described in IRS Publication 946, How to Depreciate Property.

Saturday, January 8, 2011

Married Couple's Guide To The New Estate Tax Law

The sweeping tax overhaul that President Obama signed Dec. 17, raising the exemption from federal estate tax to $5 million a person, includes a wonderful new break for widows and widowers. Starting in 2011, they can add the unused estate tax exemption of the spouse who died most recently to their own. This dramatic change enables spouses together to transfer up to $10 million tax-free. It also eliminates the need in many cases for the tax-planning gyrations that lawyers routinely recommended to preserve each spouse's estate tax exemption amounts.
Portability, as tax geeks call it (though that term does not actually appear in the new law), was a surprise goodie. Various estate tax bills proposed in Congress over the years would have permitted it. Many people favored it. But it seemed to be off the table until it resurfaced in the bill Senate Majority Leader Harry Reid, D-Nev., introduced following the Obama-Republican compromise.
The law doesn't change the fact that you can give an unlimited amount to your spouse, during life or through your estate plan (provided she or he is a U.S. citizen) with no tax applied. But until now, without proper planning, when the second spouse died anything above the exempt amount not going to charity would be taxed. In other words, the first spouse's exemption would be lost. Bypass trusts (also called family trusts) addressed that problem.
Here's how these trusts work: When the first spouse dies, the trust is funded with up to the tax-free exemption amount. The trust distributes income and principal to the survivor or other family members (usually the couple's children) while the surviving spouse is alive, then passes on whatever is left to family. Funds in the bypass trust are covered by the exemption amount and are not taxed when the first spouse dies. Nor are they considered part of the survivor's estate, so they are not subject to tax when she dies.
All this is still true, but portability makes it unnecessary for spouses to use bypass trusts solely to preserve the federal exemption amount. However, 15 states and the District of Columbia still have their own estate taxes, and most have exemptions of $1 million or less. None, as of now, have any portability provisions. That means residents of those states may still want to use bypass trusts to preserve their state estate tax exemptions. As with any new process there will be a shakeout period. Portability takes us into uncharted waters, raising financial planning opportunities and potential pitfalls that are new to us all. Here are answers to what are likely to be some frequently asked questions:
Does this provision help me if my spouse died years ago? No. It applies only to deaths after Dec. 31, 2010.
Does portability apply to lifetime gifts as well as assets that pass through an estate plan? Yes. Under the new law, starting in 2011, the lifetime exemption and the estate tax exemption are expressed as a total amount, and it is possible to use this "unified credit" to transfer assets at either stage or a combination of the two. (From 2004 to 2010, the two amounts were different; the gift tax exemption remained at $1 million, while the estate tax exemption went up.)
The estate tax exemption amount is reduced for lifetime taxable gifts. So if, for example, you have used $1 million of the exemption to make taxable lifetime gifts, the unused exemption when you die will be $4 million, rather than $5 million.

Is portability automatic? No. The executor handling the estate of the spouse who died will need to transfer the unused exemption to the survivor, who can then use it to make lifetime gifts or pass assets through his or her estate.
The prerequisite is filing an estate tax return when the first spouse dies, even if no tax is due; one would hope that the Internal Revenue Service will develop a short form for the purpose.
This return is due nine months after death with a six-month extension allowed. If the executor doesn't file the return or misses the deadline, the spouse loses the right to portability. Spouses should file it even if they're not wealthy today, because someday, who knows?
For example, let's say Harry has an unused exemption amount of $2 million when he dies next year (say because he left $3 million to his children outright). His widow Sally has a $5 million exemption amount of her own. As the executor of Harry's estate, Sally can file a return, transferring Harry's unused exemption, so that she will then be able to pass $7 million tax-free (her own $5 million exemption plus Harry's $2 million unused exemption).
Is the amount that's portable adjusted for inflation? No, but the surviving spouse's own exemption amount is after 2011.
What happens if you remarry? This is where things may get complicated. The law clearly indicates that if, for example, Sally remarries after Harry's death, she can no longer use Harry's unused exemption amount--only the one of her new husband (call him Joe), assuming she survives him too. If Joe's unused exemption is less than Harry's (or if he has no unused exemption at all), Sally is out of luck.
What if Sally dies first? Sally came into the marriage with a $7 million exemption amount, including the $2 million unused exemption from Harry. Assume she leaves $3 million to the children she and Harry had together. Posing a similar situation, a report by the Joint Committee on Taxation indicates that Joe can use the remaining $4 million exemption, along with his own.
Can I use my exemption instead to provide for children from a previous marriage? Yes. You can do this with just part of your exemption amount--or the whole thing--by leaving assets to them outright or in a bypass trust.
Is this a subject that should be covered in prenuptial agreements? Macabre as it may sound, inheritances often are the subject of prenups, especially when there are children from a previous marriage. And wills often specify the funds from which estate taxes should be paid (for instance, it's not tax efficient use retirement assets for this purpose). So while this is certainly a new topic, if it concerns you, it's something you should address.

Does portability also apply to the exemption from generation-skipping transfer tax? No. This tax applies, on top of estate or gift tax, to assets given to grandchildren (or to trusts for their benefit). Although there is no portability at death, for transfers during life married couples can combine each of their exemptions to give away a total of $10 million without incurring the tax.
Do I still need a bypass trust? The trust has the advantage of sheltering appreciation and could also be helpful in situations where you want to protect assets from creditors or benefit children from a previous marriage. But for most other cases, where couples have combined estates of $10 million or less, they might be better off just leaving everything outright to each other in what is called an "I love you will."
When outright bequests to the surviving spouse make sense for estate tax reasons, there may also be income tax benefits down the line. When the second spouse dies, these assets, included in her estate, get an adjustment in basis to their date of death value, which minimizes the capital gains tax heirs must pay when they are sold. In contrast, the basis on assets that went into the bypass trust when the first spouse died will not have changed since then.
Is portability here to stay? Along with all the other estate tax rules in the new law, this provision is set to expire on Dec. 31, 2012. Unless portability proves completely unworkable though, Congress is likely to renew it because the new system simply makes it easier to accomplish something that many couples have been doing anyway. But we might expect some refinements or clarifications to be necessary as the law gets applied in real life.

Gift Tax Under The 2010 Tax Relief Act (P.L. 111-312): Different Rules For 2010, 2011 & 2012

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312 (2010 Tax Relief Act), which President Obama signed into law on December 17, 2010, makes significant changes to the gift tax.

Different Years, Different Rules


The 2010 Tax Relief Act keeps the gift tax rate and exemption the same as it was under the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA): 35% tax rate and $1 million exemption for individuals.

2011 and 2012

The 2010 Tax Relief Act keeps the gift tax rate at 35% for 2011 and 2012, but the gift tax will be significantly different in 2011 and 2012.

(1) Higher exemption. The gift tax exemption for 2011 and 2012 is increased from $1 million to $5 million for individuals. So, individuals who used their entire $1 million gift tax exemption prior to 2011 will be able to gift an additional $4 million in 2011 and 2012 without incurring a gift tax.

(2) Unified exemption. The gift tax exemption will be reunified with the estate tax exemption, starting 2011.

(3) Indexed for inflation. Starting 2012, the gift tax exemption will be indexed for inflation.

(4) Portable. In 2011 and 2012, the gift tax exemption will be portable. Portability allows a surviving spouse to use the amount of estate and gift tax exemption not used by the decedent spouse. For an explanation, see Deborah L. Jacobs, Married Couple’s Guide To The New Estate Tax Law, Forbes, Dec. 23, 2010.

Gift Tax Strategies

The changes that the 2010 Tax Relief Act has a number of implications for estate planning.

(1) Changes year-end planning.

Many older, wealthy people were waiting until the end of the year to make large taxable gifts. Under EGTRRA, there was no estate tax in 2010, but it was scheduled to return in 2011 with an exemption of $1 million and a tax rate of 55% (60% in some cases). Also, under EGTRRA, the gift tax rate was scheduled to jump from 35% in 2010 to 55% in 2011 (with an exemption of $1 million). The idea was to make large taxable gifts and pay a gift tax of 35%. A transfer in 2010 under EGTRRA would have saved at least 20% compared to a transfer (either during life or upon death) under the rules that were scheduled for 2011. A 20% tax savings is significant.

The 2010 Tax Relief Act changes this year-end planning. Taxable gifts for clients in the $5 to $10 million dollar range probably should not be made in 2010. The reason for this is that the exemption under the 2010 Tax Relief Act jumps from $1 million in 2010 to $5 million in 2011. So, by waiting just a few days, money can be transferred by gift without incurring a gift tax.

(2) Limits the 2010 GST tax opportunity.

As I wrote in an earlier post, Congress provided the wealthy a tremendous generation-skipping transfer tax opportunity just for 2010. The 2010 Tax Relief Act reinstated the GST tax in 2010. But Congress is providing a GST tax “holiday” because the GST tax rate in 2010 is 0%.

The $1 million gift tax exemption in 2010 acts as a limit or cap to the 2010 GST tax opportunity. At a minimum, it makes decisions regarding whether to take advantage or pass on Congress’ 2010 GST tax gift more complicated.

Still, distributions in 2010 from non-exempt GST tax trusts can generally be made without incurring a gift tax. (If you have further questions about the GST tax opportunity in 2010 and whether it is right for you, you should consult your estate planning advisor immediately. Time is of the essence as this opportunity is only around for a few more days.)

(3) Creates gifting opportunities in 2011 and 2012.

The gift tax in 2011 and 2012 will be levied at a rate of 35% and with an exemption of $5 million that is portable.

(a) People who were once limited by the $1 million gift tax exemption will be able to gift up to the new limit.

(b) The $5 million exemption can be stretched with proper estate planning. Congress did not change the rules for grantor retained annuity trusts or for valuation discounts. It had been threatening to significantly restrict these estate planning tools. So, they can be used in 2011 and 2012 (so far). (Further, planners who make seed gifts before selling to intentionally defective grantor trusts will use the higher exemption to transfer tremendous amounts of wealth. I am planning to discuss this strategy in a separate post.)

IRS Audit Red Flags: The Dirty Dozen

Ever wonder why some tax returns are audited by the IRS while most are ignored? Well, there’s a whole host of reasons to this age-old question. The IRS audits only about 1% of all individual tax returns annually. The agency doesn’t have enough personnel and resources to examine each and every tax return filed during a year. So the odds are pretty low that your return will be picked for an audit. And of course, the only reason filers should worry about an audit is if they are cheating on their taxes.

However, the chances of you being audited or otherwise hearing from the IRS can increase depending upon various factors, including whether you omitted income, the types of deductions or losses claimed, certain credits taken, foreign asset holdings and math errors, just to name a few. Although there’s no sure way to avoid an IRS audit, you should be aware of red flags that could increase your chance of drawing some unwanted attention from the IRS. Here are the 12 most important ones:
1. Failure to report all taxable income.
The IRS receives copies of all 1099s and W-2s that you receive during a year, so make sure that you report all required income on your tax return. the IRS computers are pretty good at matching these forms received with the income shown on your return. A mismatch sends up a red flag and causes IRS computers to spit out a bill. If you receive a 1099 for income that isn’t yours or the income listed is incorrect, get the issuer to file a corrected form with the IRS.
2. Returns claiming the home-buyer credit.
First-time homebuyers and longtime homeowners who claimed the homebuyer credit should be prepared for IRS scrutiny. Make sure you submit proper documentation when taking this credit. First-time homebuyers have to attach a copy of their settlement statement to the return, and longtime homeowners should also attach documents showing prior ownership of a home, including records of property tax and insurance coverage. All claims for this credit are being screened. As of May 2010, more than 260,000 returns had been selected for correspondence audits (examinations done by mail rather than face-to-face) because filers did not attach the necessary documents to their tax returns. And those numbers will continue to grow.
Also, the IRS has ways of policing the recapture of the homebuyer credit. Generally, the credit is required to be recaptured if the home is sold within three years for homes brought in 2009 or 2010 and within 15 years for homes bought before 2009. The IRS is checking public real estate databases for sales of homes for which the credit was taken.
3. Claiming large charitable deductions.
This comes up again and again because the IRS has found abuse on audit, especially with those taking larger deductions. We all know that charitable contributions are a great write-off and help you to feel all warm and fuzzy inside. However, if your charitable deductions are disproportionately large compared to your income, it raises a red flag. That’s because the IRS can tell what the average charitable donation is for a person in your tax bracket. Also, if you don’t get an appraisal for donations of valuable property or if you fail to file Form 8283 for donations over $500, the chances of audit increase. Be sure you keep all your supporting documents, including receipts for cash and property contributions made during the year, and abide by the documentation rules. And attach Form 8283 if required.
4. Home office deduction.
The IRS is always very interested in this deduction, primarily because it has a pretty high adjustment rate on audit. This is because history has shown that many people who claim a home office don’t meet all the requirements for properly taking the deduction, and others may overstate the benefit. If you qualify, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance, and other costs that are properly allocated to the home office. That’s a great deal. However, in order to take this write-off, the space must be used exclusively and on a regular basis as your principal place of business. That makes it difficult to claim a guest bedroom or children’s playroom as a home office, even if you also use the space to conduct your work. Exclusive use means a specific area of the home is used only for trade or business, not also where the family watches TV at night. Don’t be afraid to take the home-office deduction if you’re otherwise entitled to it. Risk of audit should not keep you from taking legitimate deductions. If you have it and can prove it, then use it.
5. Business meals, travel and entertainment.
Schedule C is a treasure trove of tax deductions for self-employeds. But it’s also a gold mine for IRS agents, who know from past experience that self-employeds tend to claim excessive deductions. Most under-reporting of income and overstating of deductions are done by those who are self-employed. And the IRS looks at both higher-grossing sole proprietorships as well as smaller ones.
Big deductions for meals, travel and entertainment are always ripe for audit. A large write-off here will set off alarm bells, especially if the amount seems too large for the business. Agents know that many filers slip in personal meals here or fail to satisfy the strict substantiation rules for these expenses. To qualify for meals or entertainment deductions, you must keep detailed records generally documenting the following for each expense: amount, place, persons attending, business purpose and nature of discussion or meeting. Also, receipts are required for expenditures over $75 or any expense for lodging while traveling away from home. Without proper documentation, your deduction is toast.
6. Claiming 100% business use of vehicle
. Another area that is ripe for IRS review is use of a business vehicle. When you depreciate a car, you have to list on Form 4562 what percentage of its use during the year was for business. Claiming 100% business use for an automobile on Schedule C is red meat for IRS agents. They know that it’s extremely rare that an individual actually uses a vehicle 100% of the time for business, especially if no other vehicle is available for personal use. IRS agents are trained to focus on this issue and will closely scrutinize your records. Make sure you keep very detailed mileage logs and precise calendar entries for the purpose of every road trip. Sloppy recordkeeping makes it easy for the revenue agent to disallow your deduction. As a reminder, even if you use the IRS’ standard mileage rate to deduct your business vehicle costs, ensure that you are not also claiming actual expenses for maintenance, insurance and other out-of-pocket costs. The IRS has found filer noncompliance in this area as well and will look for this.
7. Claiming a loss for a hobby activity.
Your chances of “winning” the audit lottery increase if you have wage income and file a Schedule C with large losses. And, if your Schedule C loss-generating activity sounds like a hobby…horse breeding, car racing, and such…the IRS pays even more attention. It’s issued guidelines to its agents on how to sniff out those who improperly deduct hobby losses. Large Schedule C losses are audit bait, but reporting losses from activities in which it looks like you might be having a good time is just asking for IRS scrutiny.
Tax laws don’t allow you to deduct hobby losses on Schedule C; however, you do have to report any income earned from your hobbies. In order to claim a hobby loss, your activity must be entered into and conducted with the reasonable expectation of making a profit. If your activity generates profit three out of every five years (or two out of seven years for horse breeding), the law presumes you’re in business to make a profit, unless the IRS establishes to the contrary. If audited, the IRS is going to make you prove you have a legitimate business and not a hobby. So, make sure you run your activity in a business-like manner and can provide supporting documents for all expenses.
8. Cash businesses.
Small business owners, especially those in cash-intensive businesses…taxi drivers, car washes, bars, hair salons, restaurants and the like…are an easy target for IRS auditors. The agency is well aware that those who primarily receive cash in their business are less likely to accurately report all of their taxable income. the IRS wants to narrow the tax gap, and history has shown that cash-based businesses are a good source of audit adjustments. It has a new guide for agents to use when auditing cash intensive businesses, telling how to interview owners and noting various indicators of unreported income.
9. Failure to report a foreign bank account.
The IRS is intensely interested in people with offshore accounts, especially those in tax havens. U.S. tax authorities have had some recent success in trying to get foreign banks (such as UBS in Switzerland) to disclose information on U.S. account holders. Also, the IRS had a voluntary compliance program where people came in and reported their foreign bank accounts and foreign assets in exchange for lesser penalties than they would have otherwise been subject to. The IRS has learned a lot from these probes.
Failure to report a foreign bank account can lead to severe penalties, and the IRS has made this issue a top priority. Make sure that if you have any such accounts, you properly report them when you file your return. Keep in mind, though, that if you have never previously reported the foreign bank account on your return, and you decide to do so for the first time in 2010, that might also look suspicious to the IRS.
10. Engaging in currency transactions.
The IRS gets many reports of cash transactions in excess of $10,000 involving banks, casinos, car dealers and other businesses, plus suspicious activity reports from banks and disclosures of foreign accounts. A recent report by Treasury inspectors concluded that these currency transaction reports are a valuable source of audit leads for sniffing out unreported income. The IRS agrees and it will make greater use of these forms in its audit process. So if you are a person who makes large cash purchases or deposits, be prepared for IRS scrutiny. Also, beware that banks and other institutions file reports on suspicious activities that appear to avoid the currency transaction rules (such as persons depositing $9,500 cash one day and an additional $9,500 cash two days later).
11. Math errors.
One of the biggest reasons that people receive a letter from the IRS is because of mathematical mistakes they make on their tax returns. If you make an error in your favor, you are going to hear from the tax man, and there is a greater risk of the IRS pulling the whole return for audit. So take time to ensure all your calculations are correct. Even though math errors may not lead to a full-blown audit, it’s always best to remain under the radar of IRS computers.
12. Taking higher-than-average deductions.
If deductions on your return are disproportionately large compared to your income, the IRS audit formulas take this into account when selecting returns for examination. Screeners then pull the most questionable returns for review. But if you’ve got the proper documentation for your deduction, don’t be scared to claim it. There’s no reason to ever pay the IRS more tax than you actually owe.