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.

Tax Strategy: Bunching itemized deductions

You always seem to have a lot of expenses that you think could help cut your tax bill if you itemize. But every year, they go to waste.

The problem: Your costs regularly fall just short of the income thresholds they must meet in some deduction categories.

Get around this tax-reduction roadblock by bunching your expenses. And now, with several months left in the tax year, is the perfect time to set up this strategy to ensure that your "nearly" deductible expenses become full-fledged tax breaks next filing season.

Deduction thresholds

The IRS allows some deductions only after they exceed a minimum amount tied to your adjusted gross income.

Medical expenses, for example, are of no use for most filers until they total more than 10% of your adjusted gross income. The 7.5% threshold remains for taxpayers age 65 or older, but only through the 2016 tax year.

Similarly, miscellaneous deductions, such as unreimbursed employee expenses, must surpass 2%.

If your adjusted gross income is $50,000 and you're younger than 65, these limits mean your medical costs must be more than $5,000 and your miscellaneous expenses have to exceed $1,000 before you get any Schedule A deductions in these categories.

Pay attention to these costs throughout the year. If you find you're getting close to the limits, think about bunching as many deductible costs as you can into this tax year.

In the example above, if your medical costs are at $4,750, get to your optometrist's office by Dec. 31 for that second pair of reading glasses you've been meaning to buy. If your out-of-pocket expenses for the eye exam and new glasses exceed $250, you'll be able to claim the excess as a medical deduction on your next tax return.

Many deduction options

For miscellaneous expenses, think about prepaying any business magazine subscriptions or professional dues early to help you over the 2% mark.

If you looked for a new job this year, be sure to count your job-hunting expenses here, too. Just remember that your job search has to be in the same field in which you're already employed.

Do you have a hobby that nets you a bit of extra spending money throughout the year? Any costs you had toward that hobby can be totaled up as a miscellaneous expense. But you can't deduct more than you made on the hobby.

Write off your taxes, too

And if this whole deduction process is just too taxing for you and you pay a professional to figure it out, here's a final itemizing gift from the IRS: Fees paid to tax preparers are also deductible as a miscellaneous expense that can further cut your tax bill.

There are, however, a couple of downsides to this tax strategy.

Some items you might bunch into one tax year could cost you if you end up facing the alternative minimum tax. Some prepaid items, such as property and state income taxes, aren't deductible under AMT rules.

Not an annual advantage

Also, bunching deductions usually helps you out only every other year.

Generally, if you bunch your expenses into one year, you will find you don't have enough to be of use the following year. In those "off" tax years, your itemized expenses will just be smaller or, for some taxpayers, it might be more worthwhile to claim the standard deduction those years.

But getting the breaks only on alternate tax filings is still much better than missing out on them every year.

College Savings Demystified: The Devil Is in the Details

College tuition can present one of the largest pre-retirement expenses that a client will encounter—and the methods for funding those expenses extend far beyond the typical savings account. The tax and non-tax considerations that arise in determining how to pay, and who will pay, for higher education expenses are as varied as the available funding options. 

Regardless of whether a client has been planning to fund a child’s education costs for years or has unexpectedly decided to return to school, it’s important to be prepared for the detailed situations that will round out your client’s individual funding scenario—and those scenarios may involve a 529 plan or require a more creative approach.

529 Plan Scenarios

IRC Section 529 college savings plans are essentially accounts that are funded with after-tax dollars that are permitted to grow on a tax-free basis, so that distributions from the account are not taxed when received so long as they are used to pay for qualified higher education expenses.  Anyone can set up a 529 plan and anyone can be named as beneficiary, though the beneficiary designation can be changed without penalty (for example, if one child decides not to attend college, those funds can be used to fund a sibling’s education without penalty).

If the client anticipates that a third party (such as a grandparent) will be making contributions to the 529 plan, it is important to check to ensure that the plan allows these contributions. While some plans allow anyone to contribute, others restrict contributions to the account owner.

In general, contributions are limited to the amount of education expenses that the beneficiary will incur because amounts over and above those expenses will be taxed upon distribution. However, regardless of who contributes, it is important to remember that the contribution is a gift that will generate gift tax liability if the annual contribution of any individual exceeds the annual gift tax exclusion amount (currently, $14,000).

However, in the case of 529 plans only, a taxpayer is eligible to make a large gift to the 529 plan and elect to treat that gift as though it was spread over a five-year period for gift tax purposes. Therefore, in 2015, a taxpayer could contribute $70,000 ($140,000 for a married couple) without gift tax liability to a beneficiary’s 529 plan if he or she files a gift tax return and makes the election on that return.

While a state tax deduction may be available for 529 plan contributions, if a grandparent or other relative is making the contribution, it is important to check to see whether the state permits a non-account owner to take the deduction.

Funding With Retirement Plan Dollars

Funding with IRA or 401(k) dollars can, at first glance, seem to be an attractive option—especially for clients who have unexpectedly decided to return to school later in their careers. However, it’s important to note that these funds will be taxed at the client’s ordinary income tax rate. Further, these distributions can also impact the client’s ability to qualify for financial aid dollars that might be available absent the extra income from retirement account distributions.

Perhaps most importantly, the client’s eventual ability to replenish the retirement accounts should be considered, as he or she could lose years’ worth of earnings on previously earmarked retirement funds while completing his or her degree.

A Grandparent’s Direct Funding

If a grandparent or other relative funds the student’s tuition expenses directly, the gift tax considerations that are important in the 529 plan context cease to apply.  However, no tax deduction is available because the relative is making the payments to the school in exchange for the student’s education (i.e., such payments do not qualify as charitable donations).

Additionally, these “contributions” will impact the student’s eligibility for financial aid, as they are counted as support payments regardless of who makes them.

Conclusion

Funding a college education can raise a variety of questions—as these expenses can be some of the largest that your clients will face during their working years, it’s important to be prepared with the details necessary to make the smartest funding choices.

Teens and taxes: What you need to know

If your teen has a job this summer, you’re probably thankful. No more begging for money! Uncle Sam is happy, too. While summer jobs have expected tax implications for the working teen, parents may bear a surprise impact on their tax returns. Let’s look at some questions you may run into.

Can I claim their income on my tax return? If your teen is working or receiving income other than interest, dividends and capital gains, they must file their own tax return. The taxes on their wages or self-employment income are based on their own low tax rate.

What age do you have to start filing a tax return? There is no minimum age to start filing a tax return, but there is a minimum filing requirement. Generally, a dependent child must file a tax return if their unearned income exceeds $1,000 or gross income tops $6,300. However, if your teen earns as little as $400 in self-employment income, they may be required to file an income tax return.

Can I still claim my working teen as a dependent? Tax rules for a dependent child are different than any other type of dependent. If your dependent child is under age 19 or is a full-time student under age 24, your child can have any amount of income and still be claimed as your dependent as long as they do not provide more than half their own support. This includes gifts, food, shelter, clothing and school expenses to name a few. Note that if your teen can be claimed as a dependency exemption on your tax return, they cannot claim their own exemption. Additional rules apply for divorced parents.

What is the kiddie tax and does it affect me? The “kiddie tax” can wreak havoc on unprepared taxpayers. This tax is designed to prevent parents from shifting investment income to their kids to take advantage of lower tax brackets. The kiddie tax applies to children under 19 years of age and qualifying dependent children ages 19 to 23 who are full-time students. Under the kiddie tax, children pay tax at their own tax rate on unearned income they receive up to $2,100. Here’s the hitch – all unearned income kids receive above the threshold amount is taxed at their parent’s highest income tax rate. Unearned income comes from investments such as interest, dividends and capital gains. Any salary or wages that a child earns through employment are not subject to the kiddie tax rules – that income is taxed at the child’s tax rate.

Can I still claim the child tax credit? Each dependent child under the age of 17 can qualify you for the $1,000 per child tax credit. The credit is available even if your child is working and files a tax return. Your filing status and income may reduce or eliminate the credit.

Why would you file if there is no requirement? Sometimes a young earner should file a return to retrieve income taxes withheld, even when there’s no filing requirement. If you don’t expect annual earnings to exceed the filing requirement, note “exempt” on line 7 of form W-4, instead.

Can I file on a smartphone? No matter how convenient, do not prepare and file a tax return on a smartphone. Identity theft, lost records and errors are common issues if you cut corners on tax return preparation and filing. Steer clear of using smartphone applications.

Bottom line: Taxes are complex and even more so when you have a working dependent. Seek the advice of a tax professional to understand which tax implications may affect you.

Your money: Wealthy or not, you need an estate plan

Many people believe that they're not "rich enough" to have an estate plan, but this couldn't be further from the truth. We believe that estate planning isn't necessarily about how much money you have; it's about reducing the burdens on your heirs. The real focus of an estate plan should be to help ensure that your assets are distributed in precisely the manner you wish.

We contend that everyone should have an estate plan. Here are four tips to help you get started:

1. Don't assume that a will is all you need to make wishes known. A will is merely one part of an estate plan, and in many cases, it's actually not the most important piece. You may also have durable powers of attorney, health care directives, life insurance policies and trusts. In fact, many retirement savings accounts, such as 401(k) plans and IRAs, have beneficiary designations assigned to them, and these supersede what's in your will. An estate plan will help to ensure your beneficiary designations are up-to-date and in alignment with what's in your will to avoid any confusion.

2. Choose a personal representative -- and do so wisely. When you die without having named a personal representative (called an executor in some states), a court-appointed person will typically helm the charge of meting out your assets. This could be a good thing or a bad thing, but why leave it to chance? Having a personal representative allows you to ensure that all stipulations in your estate plan are met.
The person you choose needs to know that they'll assume this role upon your passing and you must make sure they're up to the task.

3. Understand the consequences of NOT having an estate plan. If you die without a will or estate plan, your estate will be turned over to the state probate process. This can be time-consuming and very expensive -- the taxes and fees involved can absorb a large portion of the assets you had intended to leave to your heirs. In fact, they may have to sell off additional portions of your estate just to pay for these taxes and fees. Aside from the costly probate process, dying without a will or estate plan also means your estate may be left to someone whom you would have not preferred to receive your assets.

4. Review your estate plan on a regular basis. While you likely don't need to review the entirety of your plan every year, it's important to check in every three to five years, or when you experience a major life event (birth, death, marriage, divorce, etc.).

Aside from these basic tips, there are additional ways that working with a professional tax adviser and estate planning attorney may help you reduce taxes and address fees associated with passing down an estate. After all, when your heirs are coping with the emotional stress of your passing, the last thing you'd want them to deal with is a financial burden.

Estate planning for business owners

Many business owners are so consumed with day-to-day operations they don’t feel they have time to consider estate planning, particularly since it can raise emotionally charged issues. Estate planning for a business owner requires thinking about business succession planning. Will the business be sold when the owner is ready to retire, or will a spouse or one or more of the children continue to run the business after the owner’s retirement or death? If the business is to continue, who will own it and will those who are expected to run the business have the necessary knowledge and ability to do so successfully? If there are multiple owners/partners, is there a mechanism in place to allow a deceased owner’s estate to be paid a fair price by the surviving owners for the deceased owner’s interest?

Unfortunately, only a small percentage of family-owned businesses are successfully transferred to the next generation. Attempted transfers fail for many reasons. The next generation may not have the necessary skills to keep the business going. If ownership of the business is divided equally among the owner’s children but not all of the children work in the business, this can lead to disputes among the co-owners that can scuttle the enterprise. If the owner’s estate is large enough to trigger an estate tax, there may not be sufficient cash to pay the tax without a forced sale of the business.

One important planning tool where the business has more than one owner is a buy-sell agreement that will allow a retiring owner, or a deceased owner’s estate, to receive fair value for his or her ownership share. This agreement can provide for a fair market purchase by a promissory note at a reasonable rate of interest when one owner retires, or it can be funded by life insurance policies on each owner that will allow the policy proceeds to be used to buy out a deceased owner’s share, in both cases without forcing the liquidation of the business.

A business owner who hopes to pass his or her business to the next generation needs to think and plan carefully. If possible, the best plan may be to give the ownership of the business to the child or children working in the business who will take over its management, and to leave other assets of equal value to the non-participating children. Where the business comprises the bulk of the owner’s estate, this may not be possible. In that case, the owner might consider purchasing life insurance to provide cash to give to the non-participating children, if this is an economically viable option.

Another option might be to structure the transfer of ownership so that the children actively involved in the operation of the business end up with complete control over the management of the enterprise and the non-participating children receive their interests in a form that allows them to receive their share of the net profits of the business but without the ability to control or interfere with the control of the business.

If the business comprises more than 35% of the owner’s estate, after the owner’s death the estate may qualify (under Internal Revenue Code Section 6166) for a deferral of the estate tax attributable to the business and elect to pay the tax in installments over as many as 15 years. This election is intended to avoid the forced liquidation of the business and to allow future profits to be used to pay the estate tax.

In short, business owners have unique estate planning issues and planning early, while the owner is still hearty, is the best way to improve the odds that the company will thrive after the owner is gone.

Tax Secrets: Why do the rich buy so much life insurance?

FROM NAPLESNEWS.COM

The answer: Favorable tax law makes life insurance tax-free. This law gives everyone, but mostly the rich — who are always in the highest income tax and estate tax brackets — an easy way to create more wealth. Tax-free. No risk. Guaranteed!

Is $1 million a lot of money?

Can you guess how many dollars you must earn to leave your family $1 million?

Try this:

• You must earn $2.78 million.
• Less income tax (state/federal) on $2.78 million at 40 percent: $1.11 million.
• Balance: $1.67 million
• Less estate tax on $1.67 million at 40 percent: $.67 million
• Balance to family $1 million

A lousy deal: The tax collector gets $1.78 million (64 percent) and your family only $1 million (36 percent).

The tax law allows you to perform magic tax tricks

1. Insurance premiums are deductible for estate tax purposes

For example, suppose you pay a total of $500,000 in premiums on a $2 million dollar policy. The $500,000 is gone, it can’t be taxed by the estate tax monster. Result: For a net $300,000 cost ($500,000 premium less $200,000 of estate tax saved) your family gets $2 million tax-free (guaranteed) — a great tax-advantaged investment.

2. At death

A. So we have a $2 million death benefit, with a premium cost of $500,000, leaving an excess of $1.5 million, which is a clear profit. Yes, this profit is tax-free; no income tax.

B. The $2 million death benefit is structured (easy to do) to be estate tax-free.

3. And even after death

Say you die with a $10 million policy on your life owned by an irrevocable life insurance trust (ILIT) and your wife is beneficiary. No estate tax at your death.

Your wife dies many years later — the amount in the ILIT has grown to $12 million. Every penny of that $12 million will pass to her heirs (probably your kids and grandkids) tax-free. No estate tax. No income tax.

Three little-known strategies to enrich your heirs, while avoiding the estate tax monster.

Following are three (actual cases from my private client files) strategies used many times in real life. Read carefully. Chances are you’ll see an opportunity.

1. Funds in a qualified plan (like a 401(k) or IRA)

Sadly, funds in a qualified plan are double taxed (income and estate tax). This strategy, Retirement Plan Rescue (RPR), turns the tables on the IRS.

Example: Sam, married to Sue, has $900,000 in an IRA. Using a RPR to purchase a $5 million second-to-die policy avoids every penny of the estate tax. WOW! $900,000 (only $324,000 after the double tax) turns into $5 million (tax-free).

2. Existing life insurance policies with a cash surrender (CSV)

Frank had a second-to-die policy (insuring him and his wife Faye and owned by an ILIT), acquired in 1996 with a current CSV of $850,000 and a death benefit of $1.53 million. We did a tax-free exchange raising the death benefit to $3.48 million. No out-of-pocket cost to Frank, Faye or the ILIT. Do you have a CSV policy that is 8 years old or older? You must take a look at this strategy.

3. The annuity strategy

This two-step real-life example is a jaw dropper.

Step No. 1. Matt (married to May) bought an immediate joint life annuity for $1 million (will pay $43,843 every year for as long as either Matt or May is alive).

Step No. 2. The after-tax amount of the annuity will pay the premium on a $5.68 million second-to-die policy on their life. Everything — the annuity and death benefit — is guaranteed.

Remember the after-estate tax-value of $1 million is only $600,000. So Matt turned $600,000 into $5.68 million — guaranteed. And tax-free. Smart planning, Matt!