Are
You Prepared For The Tax Season?
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This is that dreaded time of year for pulling things together for filing taxes and a good time for considering things you may not have thought of in the past. One of the most common questions taxpayers ask their tax advisors is “what can I deduct?” The answer to that question depends upon the industry of the taxpayer. The Internal Revenue Code (“code”) doesn’t provide a comprehensive list. Rather, the Code simply states that you may deduct what is ordinary and necessary for your business. It is up to you to determine what is ordinary and necessary; and as long as you are reasonable and keep good records, those deductions won’t likely get challenged. This article will focus on deductions that are commonly overlooked or misunderstood. First, it is important to understand the impact of deductions based upon where they are claimed within your tax return. For instance, deductions against wages earned as an employee are reflected on Form Schedule A as miscellaneous itemized deductions and will be limited to amounts exceeding 2% of your adjusted gross income. However, income from self-employment is reported on Schedule C and related expenses will be reported there to offset that income. These deductions are not subject to the same limitations as itemized deductions, so they will result in a larger overall tax impact. In addition, income net of expenses reported on Schedule C is subject to self-employment tax. Since self-employed individuals are considered both the employee and the employer, self-employment tax is Medicare and Social Security tax times two, which is currently 15.3%. It is very common to receive both W-2’s and 1099’s for the same profession—especially in the music industry. In this case, a reasonable allocation of expenses must be made between those two sources. |
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| Now,
let’s focus on some specific deductions:
Auto Deductions: An auto is considered "listed property" which means that it is an item that is used both personally and for business. Listed property is subject to certain limitations for depreciation purposes. To deduct listed property, the taxpayer should log the business usage of the item. For business use documentation, a mileage log is required for all vehicles that are multi-purpose in nature. Auto deductions can be taken in the form of the standard mileage deduction or by taking the business percentage of actual expenses, plus depreciation. The problem for most taxpayers is that you have to keep both the mileage log and keep track of all of the actual expenses to determine which way is best. (Too much paperwork!) Once you've determined your method for a particular vehicle, you've made your election and can't change back and forth. You can’t use mileage for a vehicle depreciated using MACRS or Section 179 (we’ll discuss this later.) The rule-of-thumb is that if you use your auto less than 50% for business, then you may be better off with mileage. That is not always the case, but it is often true. Regardless of which method you use, interest on auto loans is deductible if you are self-employed. You are limited to the business percentage usage of the automobile, which is why you will need to track total miles driven, as well as business miles. The standard business mileage rate for 2008 was 50.5 cents per mile from January 1 through June 30th and 58.5 cents per mile from July 1 through December 31 2008. That rate changed to 55 cents per mile effective January 1 2009. Depreciation and/or Section 179: Deduction for business equipment and furniture is taken in the form of depreciation. The IRS provides tables that determine how long an item is to be depreciated and at what percentage. These items are considered Section 1245 or personal property and qualify for a one-time election to be expensed in the year of purchase. This is an election made under Code Section 179, and you will hear this term used often in business. (Please note that real property does not qualify for Section 179. Real property is considered Section 1250 property.) The 2008 Economic Stimulus Act made several changes enhancing depreciation and Section 179 for 2008. Under Section 179, you can write off up to $250,000 of assets purchased in a given year as long as your total investment is below $800,000 in 2008. If total asset additions exceed that amount, total Section 179 allowed is reduced dollar for dollar for the amount exceeding the investment limitation. In 2009, the maximum write off under Section 179 is $133,000. In 2010, that number goes down to $125,000 and will be adjusted for inflation. In 2011 and thereafter, this amount is reduced to $25,000 and is not adjusted for inflation. However, this will be an area heavily reviewed in the next few years. We expect we will see further changes coming in this category. Bonus Depreciation: The 2008 Economic Stimulus Act revamped bonus depreciation for 2008. Congress has used bonus depreciation several times in the past to encourage business investment. Bonus depreciation is a deduction of 50% of the costs incurred in the first year, plus depreciation on the remaining cost. Bonus depreciation is available for depreciable items that normally are written off in 20 years or less. To qualify, the property must be purchased AND placed in service during 2008. The placed in service date was extended to December 31, 2009 for property placed in service with a recovery period of 10 years or more (i.e. Leasehold improvements!). Example: You spend $100,000 on music equipment in 2008. Normally these costs would be depreciated over 5 years for tax purposes. Under the new Act, you can take $50,000 in bonus depreciation and write off the remaining $50,000 of the cost over 5 years. “Luxury” auto depreciation is increased if bonus depreciation is used to $8,000 (up from $3,060) for a maximum first year depreciation amount of $11,060 ($11,260 for vans and trucks.) Cell Phones and Other Telephone Expenses: Your first telephone line for your home is considered personal. However, any additional lines, additional features or cell phones added for your business are deductible. No doubt, we all use our phones for both business and personal purposes. The IRS can consider a cell phone "listed property." However, if it is your second line, then you may determine that it is business property. Office or Studio in Home: If you have a room in your home that is used for business, you may be able to reduce your taxable income by taking advantage of the office in home deduction. It is most recommended for those who earn self-employment income. Deductions taken against that income reduces self-employment tax which has a larger effect on the bottom line. Beware, however, that if you sell a home and used the office-in-home deduction, you will be subject to recapture on that portion of the sale and may cause a part of the gain on the sale of the home to be taxable. Rule of thumb here is that if you are in higher tax brackets and are paying self-employment tax, you will likely be better off taking the office in home deduction and paying tax on a future gain because of the self-employment tax savings. If you are showing losses or are being compensated through wages, it does not make sense to take this deduction. Internet: Many taxpayers forget to include internet at home in their list of expenses. Most of us work at home and must be able to use our internet service for business. Some write off only a portion of internet expense, but many take the position that they wouldn't have it at home if it weren't for their businesses. Cable TV, Showcases & CD Purchases: All of these items serve as valuable research tools in the entertainment industry. Therefore, a meaningful allocation between business use and personal use is warranted. Your homework is to arrive at a formula that makes sense based on your business usage. For example, if you use Cable approximately 50% of the time for music related purposes, then you would write off 50% of the cost associated with Cable TV. Showcases and CD’s of other artists are also valuable research materials. You may find a more aggressive percentage is appropriate in these categories, but again, that formula should be based upon what you deem ordinary and necessary. Advertising & Promotion: This includes media, internet and any other advertising that promotes your business. Novelty items, shirts with your business name, gifts to clients for promotion all fit within this category. And remember that when you give away business items to a non-profit, if it is within the intent to market yourself, deduct it as advertising. Charitable donations are sometimes limited and don't have as much impact on tax savings as deductions against your business income. Dues & Subscriptions: Don’t forget those magazines, newspapers and publications that help you stay educated and on top of the industry. These are common items overlooked but can add up before you know it. Meals & Entertainment: When you take your colleagues or co-writers out to lunch or dinner to discuss business, you should be tracking these expenses to deduct. They are only 50% deductible but a good deduction non-the-less. You will need to document the business purpose of the meal, however, which makes the paperwork a bit cumbersome. If you have difficulty getting the notes written on the receipt, just keep a good calendar. Your day planner or outlook reports have loads of information. Don't throw those away. Keep them with your tax records so that you can prove deductions for travel, meals, etc. Per Diems: Those of you who travel over-night may want to consider the use of the per diem tables as opposed to keeping all the receipts for meals while traveling. IRS publication 1542 provides details on how per diems may be used. The standard rate for meals in 2008 through September 2008 was $39 per day and beginning October 1, 2008 was increased to $45 per day. However, if you travel to metropolitan areas, use of the table by locality may provide a more realistic deduction. Travel: Business travel is deductible, but often we travel and end up getting some personal time in there, too. If the trip is substantially for business and you just extend it for a day for personal reasons, the trip is fully deductible. However, if you take a trip that is mostly personal and you end up doing business while you are there, the travel expenses taken should be pro-rated for the number of days business was conducted. Best practice is to keep information proving the business nature of the trip. Brochures, listing information, and seminar materials are all good sources of documentation. Summary of Business Deductions: Remember, this is merely a summary of select deductions that are commonly misunderstood or overlooked. There are also other items that are deductible on Schedule A as itemized deductions and are not included in this summary. Here Are Some Items To Note Related To Personal Income Tax Issues: New This Year: Taxpayers can claim an addition to the standard deduction amount, based on the state or local real-estate taxes paid in 2008. Taxes paid on foreign or business property do not count. The maximum deduction is $500 or $1,000 for joint filers. This is available for 2008 only! Mortgage Debt Forgiveness: The Mortgage Forgiveness Debt Relief Act of 2007 was enacted on December 20, 2007. Generally, the Act allows exclusion of income realized as a result of modification of the terms of the mortgage, or foreclosure on your principal residence. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. However, if you continue to own your residence after the cancellation, you must reduce the basis of your principal residence (but not below zero) by the amount excluded from income. This
provision applies to debt forgiven in calendar years 2007 through
2012. Up to $2 million of forgiven debt is eligible for this exclusion
($1 million if married filing separately). The exclusion does
not apply if the discharge is due to services performed for the
lender or any other reason not directly related to a decline in
the home’s value or the taxpayer’s financial condition. First-Time Homebuyer Credit: This credit is a hot topic in the new Economic Stimulus package being voted upon and is expected to be substantially improved from this provision. Currently, those who bought a main home recently or are considering buying one may qualify for the first-time homebuyer credit. Normally, a taxpayer qualifies if he/she didn’t own a main home during the prior three years. This unique credit works much like a 15-year interest-free loan. It is available for a limited time only –– on homes bought from April 9, 2008, to June 30, 2009. The credit is equal to 10% of the purchase price of a home up to $7,500 ($3,750 for married individual filing separately.) The credit begins to phase out for taxpayers with adjusted gross income in excess of $75,000 ($150,000 of a joint return). (It is fully phased out for single individuals with AGI of $95,000 and married individuals of $170,000.) It can be claimed on new Form 5405 and is repaid in equal installments over 15 years as an additional tax. Repayments start two years after the year in which the residence is purchased. If the property is sold before repaying the credit, the balance becomes due in the year in which the residence is sold or is no longer used as the taxpayer’s principal residence. However, the recaptured credit may not exceed the amount of the gain from the sale of the residence to an unrelated person. The credit does not have to be repaid if the taxpayer dies. If the Stimulus package passes the way we anticipate, the repayment provision in this credit will be lifted and the credit is expected to increase to $15,000. Look for more details on this as the Stimulus package unfolds. Non-business Energy Credits: Federal tax credits for energy efficient home improvements have been extended into 2009. The recently-signed “Emergency Economic Stabilization Act of 2008″ included an extension of the residential tax credits for energy efficient improvements. The previous tax credits expired at the end of 2007. The credit is a maximum life time credit of $500. The new tax credits for installing energy efficient improvements are only good for 2009 installations - there will be no tax credits for improvements installed during 2008. Tax credits are available for insulation, replacement windows, water heaters, and certain high efficiency heating and cooling equipment. However, be aware that not all Energy Star rated improvements are eligible for the tax credit. Items that fall within this provision are: windows, doors, metal roofs, insulation, air conditioning, tankless water heaters, cars, solar water heating, solar power, and fuel cells. Be sure to check EnergyStar.gov for rules and more details. Alternative Minimum Tax: The alternative minimum tax (AMT) is a separate method of determining income tax devised to ensure that at least a minimum amount of tax is paid by high-income taxpayers who reap large tax savings by making use of tax deductions. Without the AMT, some of these taxpayers might be able to escape income taxation entirely. The problem with AMT today is that the original thresholds that determine who is subject to AMT were not indexed for inflation the way that many other items in the tax code have been. This has caused many middle income taxpayers to be affected by AMT, and now Congress is in dispute over how to rectify the AMT problem. To calculate AMT, regular taxable income is calculated and then certain items are added back to determine Alternative Minimum Taxable Income (AMTI.) For tax-year 2008, Congress raised the alternative minimum tax exemption to the following levels: $69,950 for a married couple filing a joint return and qualifying widows and widowers, up from $66,250 in 2007; $34,975 for a married person filing separately, up from $33,125 and $46,200 for singles and heads of household, up from $44,350. Under current law, these exemption amounts will drop to $45,000, $22,500 and $33,750, respectively, in 2009, unless they are updated by Congress. Health Savings Accounts: A health savings account is an account established in conjunction with a high deductible health insurance policy. Cash contributions to an HSA account are deductible similar to the health insurance premiums for as self-employed taxpayers. The maximum deduction for self-only coverage is $2,900 and the maximum deduction for family coverage is $5,800 for 2008. In 2009, these limits go to $3,000 and $5,950. Individuals who reach age 55 by the end of the tax year can increase their annual contributions by $900 for 2008 and $1,000 for 2009. Contributions can’t be made after the participant attains age 65, but withdrawals for qualified medical expenses are excluded from income. Any contributions in excess of these limits are subject to a 6% excise penalty. A high-deductible health plan is a plan with a minimum annual deductible of at least $1,100 for self-only coverage and $2,200 for family cover for 2008. These amounts increase to $1,150 and $2,300 for 2009. In addition, annual out of pocket expenses cannot exceed $5,600 for self-only coverage and $11,200 for family coverage. These amounts increase to $5,800 and $11,600 in 2009. Out-of-pocket expenses include deductibles, co-payments and other medical expenses (not including health insurance). Distributions from the HSA account are not included in income as long as the funds are used for qualified medical expenses. Amounts distributed for other purposes are includible income and subject to a 10% penalty. The health savings account is a great vehicle to convert an otherwise limited tax deduction to an “above the line” tax deduction. Medical expenses are typically only deductible for those who itemize and are only deductible to the extent they exceed 7 ½% of AGI. Most taxpayers don’t spend more than 7 ½ % of their AGI on medical expenses and thus are not able to reduce tax for medical related expenses. The deduction for contributions to an HSA is reflected as an adjustment to income on 1040, page 1 and avoids the AGI limitation on Schedule A. Estimating Taxes: Taxpayers are required to pay a certain amount of tax either through withholding from wages or by making quarterly estimated payments. If your tax is underestimated, there are penalties for doing so unless: 1. you owe less than $1,000 for the current year, or 2. You had no tax the prior year. Generally, the amount that should be paid in order to avoid penalties is: 1. 90% of your current year tax (which is impossible to estimate precisely), 2. 100% of the prior year tax (110% if your adjusted gross income is above $150,000), or 3.
Paying exactly what you would owe on a quarterly basis using the
annualized method. (This method is time consuming and least practical.) In order for your CPA to properly advise you, it is good to discuss your expectations for the next tax year. You can agree to set your estimates at a particular level, but then have a mid-year evaluation to be sure you are on track to avoid risk of penalties. Your industry is very unpredictable, which makes it essential for you to stay on top of what you need to do to protect yourself from paying unnecessary penalties. We recommend that you set aside between 20 and 30% of your income into a tax savings account. The more you save, the more likely you will be able to pay your taxes and perhaps even fund a retirement account. Estimated payments are due: April 15, June 15, September 15 and January 15. Retirement Plans It is so difficult with everything one must balance to fit saving for retirement in the mix. However, there are several options available when you reach a point where you are ready to work it in. Below are some of the retirement vehicles that can be used to begin your retirement savings. Traditional IRA: Individuals who received compensation, alimony or other earned income who are below 70 1/2 and eligible to make IRA contributions of up to $5,000 for 2008 ($6,000 if age 50 or older). Contributions must be made by April 15th each year to be deductible in the preceding year. If the individual or individual's spouse is an active participant in an employer-maintained retirement plan, the deduction may be reduced or eliminated. The phase out begins with AGI at $85,000 and is completely phased out at $105,000 for married filing jointly taxpayers. For single individuals, the phase out begins and ends at $53,000 and $63,000 respectively. Roth IRA: Roth IRA contributions of $5,000 for 2008 ($6,000 if age 50 or older) as long as AGI for single individuals is below $101,000. Once above that level, contributions are limited until completely phased out at AGI of $116,000. For married filing jointly taxpayers, the phase out begins and ends at AGI of $159,000 and $169,000 respectively. SEP-Simplified Employee Pensions: A SEP is a plan whereby employers may contribute to an employee's IRA account. However, the limitations of IRA's do not apply and are replaced with rules similar to that of other qualified retirement plans. Contributions of up to 25% of a participant's compensation not to exceed $46,000 are permitted. The annual compensation that may be considered in determining the contribution is limited to $230,000. Self-employed individuals are considered employers. Therefore, a SEP is a popular way to fund retirement accounts for proprietors. Contributions for the preceding tax year must be funded by the due date of the taxpayer’s return, including extensions. This is unlike IRA’s which must be funded by April 15th. Qualified Retirement Plan: These plans are called "qualified" because they are intended to qualify under Section 401(a) of the Internal Revenue Code. These plans are governed by ERISA and basically fall under two major types: (1) defined benefit plan and (2) defined contribution plan. The most popular type of plan is the defined contribution plan which includes profit sharing, money purchase, target benefit and 401(k) plans. Another term you may have heard in this area is the "Keogh" plan which is basically a qualified plan for a self-employed individual. These plans offer large benefit opportunities but require assistance of a qualified professional. Single Member 401(K): This plan is ideal for taxpayers who are making self-employment income below $230,000, have no employees, and don't need the cash until retirement. By having a 401(k), the proprietor can elect to defer his or her salary of up to 100% of pay not to exceed $15,500. In addition, since the proprietor is the employer, he or she may fund up to 25% of pay in the form of a profit sharing contribution. For example, a proprietor who has $152,500 in net income can elect to defer $15,500 as an elective deferral amount and contribute another 25% (20% based on certain limitation = $30,500) as a profit sharing amount, for a total of $46,000. A SEP would have been limited to $30,500, so this plan provides a $15,500 opportunity not available in other plans. (This example is not precise and used for explanation purposes only.) Records To Keep The burden of proof for positions taken on a tax return is on the taxpayer. That is why it is essential to keep documentation of every expense and income item taken on your tax return. There are some items that should be kept indefinitely. There are many ways to do record keeping. Some prefer manual records, others prefer electronic. There are no set requirements for format. The best way to be efficient at record keeping is to choose a method that works for you. Otherwise, the paperwork waits until crunch time, and becomes a dreaded chore. We see everything from shoe boxes, to bags, to envelopes and hand written notes. We work with whatever we are given, but most clients who use a manual system often feel like they are missing out on deductions and leaving money on the table. A computerized system that is used on a regular basis can really improve efficiency and the likelihood that things aren't getting overlooked. Here are a few tips if you prefer using a computerized system of tracking income and expenses: Start by getting Quicken, the easy-to-use record keeping software program. It's simple to learn. Once you've set up the categories you need, recording income and expenses is less cumbersome than writing in your checkbook. You can do it daily, weekly, or monthly. You can also import data on-line eliminating the data entry part and streamlining the process. Please beware--the computerized system doesn't eliminate the need to keep receipts. You'll still need a way to maintain receipts. You could set up an accordion file with one pocket for each of the tax-related categories you created in Quicken. As receipts come in, just slip them into the appropriate pocket of the file. Make sure to keep your receipts that support credit card charges. The credit card statement isn't enough and the IRS can disallow expenses taken without those specific receipts. Keep your day timer or outlook calendar printouts with your tax records too. If you ever need to substantiate a meal or travel, that is your best source of information. For those who have multiple Schedule C businesses, QuickBooks may be better software to use than Quicken. QuickBooks is the business version of the software and has a feature called "classes" that can substantially improve efficiency when tracking income and expense for each business. At year-end, use Quicken to run a final report for each category, and your tax records are in order and ready for calculation. Use QuickBooks to print reports by class. Better yet, make a backup of either and provide them with your other tax records to your CPA so they can extract what they need for your tax return. Hopefully, they can also give you pointers on how to enhance the use of the software in the future as well. If you are really up on technology and want to eliminate paper, you could purchase a scanner and software to scan all of your receipts. Don't eliminate contracts, however. Even in today's technology, an original signature on contracts and wills are still very important documents that must be retained. Also, be sure to have a good backup system if you go paperless. Once the receipts are gone and your computer crashes, there will be no way to recover that data. Even a backup system kept at home can be a problem in the event of a fire or catastrophe. That's why it's important to have backups off sight. There are now services that you can obtain to backup your files on line and they are store in an offsite facility. Technology is moving in amazing directions. Closing Comments: Please remember that the most important deductions lost are those not properly tracked. Be aware of what you can deduct and establish a method to capture those deductions that will work for you. Align yourself with a professional who understands your industry and will spend the time empowering you with knowledge. By Cathy Werthan, CPA Consulting
Group, PLLC |
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©2004, Further Communications |
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