In this edition of our ‘Ask The Experts’ series, we turn to experts in the fields of accounting and taxation to answer some popular questions from consumers about income taxes
The issue of taxation is deeply engrained in the fabric of America, and while it continues to illicit stark emotions to this day, the anger it now inspires has less to do with pure ideology than simple confusion. Not only are many people understandably clueless about the maze of rules, loopholes, and forms that comprises the modern day tax system, there are also doubts about its fairness for various consumer segments as well as the role tax revenue will have to play in solving the current budget crisis.
It’s therefore no wonder a lot of folks develop a bit of a complex when it comes to April 15 and the IRS. It also speaks to the value of accurate information from trusted sources. Getting clear answers to some of the most pressing tax questions may just give you the confidence necessary to rise to the occasion on Tax Day and come away unscathed.
That’s why, after reaching out to national experts in tax policy for advice on how to best improve the tax code in the future, we sought answers to the types of questions that are likely at forefront of your mind right about now.
The questions falls into 10 distinct categories – New Rules, Small Business, Investments, International Income, Deductions/Filing Procedures, Inability to Pay, Policy, Legal Issues, The Sequester, and Free Assistance – and you can find the answers as well as information about the experts who provided them below.
Grace AllisonQualified Tax Expert for the University of New Mexico School of Law’s Business & Tax ClinicAre there any new rules or procedural directives that people filing their returns should be particularly aware of this year?
In my view, the biggest personal income tax change for 2013 is the implementation of the 3.8% net investment income tax. This will catch many investors and trustees by surprise!
Francine LipmanWilliam S. Boyd Professor of Law at the University of Nevada, Las Vegas School of LawAre there any new rules or procedural directives that people filing their returns should be particularly aware of this year?
Well, 2012 — of course that’s what we’re talking about when we’re talking about tax filing — is pretty similar to 2011. Not too many changes on the horizon. Congress effectively kicked the can and extended a lot of things that were supposed to expire. They did extend them. The biggest change for 2012 maybe is people weren’t able to file their returns until a little bit later than typical because Congress delayed so much, so refunds are coming later and there has been this tax season—I think again it was because of the delay and then people were kind of scrambling to get things done as soon as possible because Congress delayed their decision-making process so of course the IRS couldn’t start accepting returns until you know what the laws are; obviously it’s not they decide the laws, the IRS needs a little bit of time to get forms together and get software programs, it’s a huge machine when you’re talking about 140 million individual income tax returns. There seems to have been some sort of snag with the educational tax credits where a box has been, for hundreds of tax returns, checked inaccurately and so those refunds are going to take a lot longer to get, so that’s a bit of a snag and I think that has just come to people’s attention. So I think part of the story of 2012 tax season is just everything was delayed. But generally, it’s similar to 2011.
What are the basic differences between filing as an individual and filing as a small business owner?
That is an interesting question and the answer depends upon how they are operating their business. Many individuals operate their business as a sole proprietor, and that is not a separate legal entity from you as an individual, so your income and expenses from that business are going to be reported on your individual income tax return. So it isn’t that different. It just adds some complexity to your individual income tax returns.
But what a lot of people don’t quite understand is if you work for yourself, and you are hopefully successful so that you have a profit, you’re going to report that profit on your individual income tax return. And you do give a lot of detail, meaning you have your gross receipts from the business, plus any returns if you have any, and then all of your individual expenses like rent, advertising, repairs and maintenance, supplies, equipment rental, whatever you have. Then the net profit is included in your income, and it’s included in your income for federal income tax purposes as well as on your federal income tax return you have to pay for payroll taxes because you’re self-employed. So, not only do you have to pay the employee’s portion, you have to pay the employer’s portion because you’re employing yourself, effectively. That can be a surprise for people because they’re paying 15.3%, which is Social Security and Medicare taxes in addition to income taxes.
When you’re a sole proprietor, you don’t have withholding because you don’t have a paycheck. So the typical way you pay your taxes is through estimated quarterly payments. So the first year that you’re in business you might not have made those payments because you’re not sure if you’re going to have a profit or not, you haven’t talked to an accountant. Hopefully if you’re profitable, which of course is the goal, you might have a large tax liability due simply because you didn’t have any withholdings. So it’s something you need to think about and plan for. As the profits are coming in, you need to save for your income taxes and for any self-employment taxes, which are really payroll taxes which you might not think about. And of course if you are in a state that has a state tax liability, you need to be thinking about that as well.
Now, if you operate your business through a corporation – where you incorporate your business, and you might do that if you’re concerned about liabilities as an individual – then the corporation files its own individual tax return. And the corporation is probably going to hire you as an employee, so you would probably receive a W-2 with withholding and with payroll taxes paid. But forming a corporation takes legal expenses and accounting expenses to file a separate tax return, so it’s not always the best path, and so many small businesses are just operated as sole-proprietors. If you’re concerned about liabilities, there might be some risk but not extreme risk. Obviously, if you’re a brain surgeon you probably are very concerned about risk, or if you were operating a toxic waste dump, you know. Most of us aren’t engaged in risky businesses, so you can just get adequate insurance, and that might be the more prudent path than creating a separate legal entity.
Are there any unique tax issues that may apply to immigrant workers?
The issue is undocumented immigrants don’t qualify for a Social Security number so they have to get a different number called an Individual Taxpayer Identification Number – they call it an ITIN. And so they get an ITIN from the federal government and that’s the number they’re supposed to use to file their tax return with. But unfortunately, as you know, they can’t use that number to get work so they often use a Social Security Number that is not theirs – and it might not be anybody’s, it could just be made up or whatever – but they give that to the employer and that’s what’s on their W-2. But they file their tax return with the ITIN and attach the W2 and report that income and withholdings. That’s how you file the return for federal purposes, but apparently the District of Columbia is rejecting those returns saying the numbers don’t match, our computers can’t process it and they’re not issuing refunds. Then they’re actually sending notices to these people saying, ‘You need to file a tax return.’ But we can’t, you’re not allowing us to because the numbers don’t match. The IRS demands that people file tax returns and they want the revenue. They want people to file, so we’ve got this problem now in D.C. where there are more and more immigrants who are being tax compliant because, of course, immigration reform is potentially coming and so they want to get their tax situation in order, but the District of Columbia is not allowing this. They’re basically rejecting these returns, and there’s no way to fix it.
Brad BordenBrooklyn LawAre there any new rules or procedural directives that people filing their returns should be particularly aware of this year?
As far as new rules are concerned, last week, Representative Dave Camp [R-MI] introduced legislation that would change the way Congress taxes small businesses. Currently small businesses can choose between partnership taxation and S corporation taxation. The proposed legislation would create a unified tax system that applies to all such businesses. There has been a lot of chatter about changing the tax on small businesses, so people believe that aspects of this proposed legislation may make it into law. Most of the provisions are favorable to business owners, so, if enacted, they may affect some practices of business owners, but shouldn’t result in significant tax increases.
David MacKusickJD, CPA, Assistant Professor in the College of Business at Ashford UniversityAre there any new rules or procedural directives that people filing their returns should be particularly aware of this year?
Just like most years, for 2012 tax returns, there is a wave of changes that taxpayers should pay close attention to. Personal and dependent exemptions and standard deductions have all gone up between $100.00 and $300.00. The contribution limits to certain retirement plans, such as 401(k)s and 403(b)s, have increased $500.00 and the phase out range for Roth and traditional IRA deductions has increased. Congress tweaked dozens of other provisions so taxpayers should be sure to verify that they are following the latest tax rules.
The tax season started late this year to allow the IRS enough time to update certain tax forms to comply with last minute tax changes. Congress did not pass the American Taxpayer Relief Act until January 2, 2013 which caused a delay in the revision of a number of tax forms. The IRS has announced in Notice 2013-24 that it will waive the late payment penalties for taxpayers who are required to file one of the tax forms that were delayed due the Taxpayer Relief Act.
Are there any unique tax issues that may apply to immigrant workers?
Undocumented workers face challenges when filing tax returns because they are not eligible for a Social Security Number (SSN). Employers are required to ask for an employee’s SSN and most undocumented workers get around the requirement by supplying their employer with a fake SSN that either belongs to another person or has never been issued by Social Security. When tax time comes, the employer issues the worker a W-2 with the fake SSN which creates a problem for the worker who wants to comply with the tax laws and file a tax return.
Since the mid-1990s, the IRS has been encouraging compliance with the tax laws by issuing Individual Taxpayer Identification Numbers (ITIN) to taxpayers who are ineligible to receive an SSN. An undocumented worker can file a tax return using their ITIN and staple a copy of their W-2 to the tax return. In most cases, the undocumented worker can pay their taxes or receive a refund of any overpayment using this method.
Responding to criticism about undocumented workers receiving other refundable tax credits, for 2013, the IRS has toughened up the requirements for obtaining an ITIN. The IRS will no longer accept notarized copies of documentation necessary to obtain an ITIN such as passports and birth certificates. Instead, applicants must provide original documentation or certified copies of documentation obtained from the issuing authority. In addition, an ITIN will only be good for five years. In the past, an ITIN was good for an unlimited period of time.
In addition, it is important to note that an undocumented worker filing a tax return using an ITIN is not eligible for the Earned Income Tax Credit and an ITIN does not give anyone the right to work in the US.
Charles EnisAssociate Professor of Accounting in the Pennsylvania State University’s Smeal College of BusinessAre there any new rules or procedural directives that people filing their returns should be particularly aware of this year?
One thing is that the IRS is really pushing hard this electronic filing. Most of the states are too. In fact, anyone who is a paid preparer and who is a professional tax person, they’re required to e-file for all their clients if they file more than 10 returns a year. Of course there are ways that if a client insists that they want to file a paper return themselves, they have to sign a form acknowledging that they were offered e-filing but turned it down. But the e-filing program has been very successful. I think the majority of returns now are electronically filed, and I imagine those that still use the paper returns are those that might not be very computer literate or might not even own a computer or use a paid preparer. Also, there’s been more stringent regulation of paid preparers. They have to get different ID numbers now called PTINs. You have people that are professional preparers that are not licensed attorneys or CPAs have to pass now competency examinations and things like that.
Barbara WeltmanAuthor of “J.K. Lasser’s Tax Deductions for Small Business”What are the most underrated tax breaks for small business owners?
There are a number of tax credits exclusively for small business that can be overlooked. Each dollar of tax credit saves the owner one dollar in taxes, so the credits are valuable. The Treasury Inspector General identified the small employer health credit as one that is grossly overlooked. Another is the tax credit for starting a qualified retirement plan; the credit is for administrative costs (including employee education about the plan).
Nathan OestreichProfessor of Accountancy in San Diego State University’s College of Business AdministrationWhat are the most important things for self-employed individuals to keep in mind when filing their returns?
To be sure to not overlook any legitimate business deductions. For unincorportate enterprises, these deductions reduce both the income tax and the self-employment tax.
Then, do whatever possible to maximize contributions to retirement accounts. These deductions reduce the income tax, but not the payroll taxes for unincorporated individuals. Some accounts, like some Solo(k)’s, allow the individual to borrow up to 50% of the balance if they have a critical cash crunch. Generally, these must be repiad within 5 years, and they are limited.
James HardinChair of the Accounting Department at the University of South Alabama How can both businesses and individuals minimize their tax liability on investments?
The simplest way to minimize tax on investments for individuals is to invest the maximum possible in tax sheltered/tax deferred accounts or in municipal bonds which generate tax free interest.
Businesses have a harder time because Corporations are taxed at the same rates on all income. Building subsidiaries overseas in low tax countries (like Switzerland) and leaving the money overseas is probably the best way to shelter the money.
What unique income taxation issues do people who work both domestically and abroad encounter?
- If certain requirements are met over $95,000 can be earned in a foreign country that is not taxed (tax free) in the U.S.
- There is a foreign housing allowance available (also tax free)
- Moving Expenses may be deductible.
- If one is an employee in the foreign country (instead of an employee of a U.S. company) the person will generally not earn Social Security credits.
- If an U.S. citizen has $10,000 or more in a foreign bank account there are special detailed reporting requirements.
William KulsrudCPA, Associate Professor of Accounting in the Kelley School of Business at IUPUIHow can both businesses and individuals minimize their tax liability on investments?
Everyone should be maximizing the amount they contribute to tax-sheltered retirement/savings plans (IRAs, Roth IRAs, 401k, 529 plans for college, employer retirement plans). Get it while you can, before Congress repeals the opportunities. Housing has historically be a good bet. Where else can you get a $250,000 ($500,000 gain for joint filers) tax free? For those who will be hit by the new § 1411 tax of 3.8% on net investment income (the tax imposed as part of the legislation to create Obamacare) on net investment income, tax sheltered plans, including nondeductible IRAs work well.
Douglas ShacklefordAssociate Dean of MBA@UNC and Meade H. Willis Distinguished Professor of Taxation at the University of North Carolina, Chapel Hill’s Kenan-Flagler Business SchoolDo taxpayers have to list last year’s state tax refund as income for this year?
Yes, state tax refund is income this year (assuming your received benefit from the deduction last year).
Raquel AlexanderAssociate Professor of Accounting in the Williams School of Commerce, Economics and Politics at Washington & Lee UniversityDo you have to claim a child as a dependent in order to qualify as the head of a household?
HOH does not require taxpayer to claim a child as a dependent. One example is common for divorced parents: the custodial parent can file HOH even when the non-custodial parent claims the child as a dependent. Another example is for taxpayers who claim their elderly parents as dependents. Surprisingly, HoH can be filed in this case even if the dependent parent lives in another residence.
David NeighborsCPA, Partner at the accounting & consulting firm Gallina Is there an age limit for claiming a child as a dependent? How much does an unmarried dependent student have to make before he or she has to file an income tax return?
To be claimed as a qualifying child, the person must meet four criteria:
1. Relationship — the person must be your child, step child, adopted child, foster child, brother or sister, or a descendant of one of these (for example, a grandchild or nephew).
2. Residence — for more than half the year, the person must in your home.
3. Age— the person must be:
o Under age 19 at the end of the year, or
o Under age 24 and a full-time student for at least five months out of the year, or
o Any age and totally and permanently disabled.
4. Support — the person did not provide more than half of his or her own support during the year.
An unmarried dependent student must file a return if any of the following apply:
1. Unearned income was more than $950.
2. Earned income was more than $5,950.
3. Gross income was more than the larger of: A) $950, or B) Earned income (up to $5,650) plus $300.
Jay SoledProfessor of Accounting and Information Systems in the Rutgers University Business School What’s the most common tax question that people ask you?
A lot of people always want to know if they take aggressive deductions, what their chances of being caught [are]. What I mean by aggressive, they take deductions for what I’ll call mixed-use property. Automobiles that they use for business and for pleasure, meals and entertainment, all those things are the traditional hotspots where people want to know, ‘What if I take this deduction?’ They want to know if they’re going to get away with it. … My general response is you should be forthcoming and pay the taxes that are due and owed.
Nancy AbramowitzDirector of the Janet Spragens Federal Tax Clinic at American University’s Washington College of LawWhat are the most common questions you hear from people at AU Law’s Janet Spragens Federal Tax Clinic?
Common issues include family status issues (dependency exemptions, family status related credits, filing status) that may sometimes result from a legal presumption about a cultural perspective of families that does not necessarily comport with the realities of a twenty first century mutli-cultural society with different understandings about living arrangements and responsibilities. We also see cases involving fallout from our economic times such as income asserted on the cancellation of indebtedness, unemployment, etc. We see cases involving Schedule C business income for individuals struggling to make a living and less than adept at recordkeeping. We see cases fo employees mischaracterized as contractors by the employer who have a rude awakening abbout owing self employment taxes in addition to any income tax due at the end of the year and who have not earned enough to feed their families and saved enough to meet that obligation (which exceeds the employee share of FICA that would have been withheld if treated as an employee). These individuals are not willing to challenge their status if their source of work remains the same ‘payor.’
What are the best sources for free tax help?
Filing Choices for low income individuals include free filing services from the many Volunteer Income Tax Assistance sites around the country (VITA) staffed by trained volunteers. Also, for those who are computer literate, there are free filing services online. For tax advice, the free filing sites may be able to help or the Internal Revenue service has guidance available. For non-English speakers, there is an array of “ESL Clinics” for low income earners around the country to advise about income tax responsibilities. For individuals going to paid preparers, they should understand that they are responsible for understanding the factual underpinnings upon which the return is prepared.
Richard PompAlva P. Loiselle Professor of Law at the University of Connecticut School of Law What are the pros and cons of paying your taxes with a credit card? What other options do people have if they can’t immediately fulfill their tax obligations?
Well, the 1.89% or 2.35% [processing fee one incurs when paying taxes with a credit card] is certainly going to be less than not paying your taxes and incurring the fees and penalties that the IRS will impose, so that’s the easy part. If you do not have the money, then you are better off paying with a credit card.
Now, let’s just think about it; we’re looking only at the fees, what about the interest on your credit card? After the grace period you’re going to start getting charged interest at 12% or more. It depends on how much you owe and how sophisticated you are and whether you’re going to need a lawyer – all that. But you can set up an installment payment plan with the IRS. There is a $52 set-up fee for doing that and you arrange for automatic payments out of a checking account. Then the IRS will charge you on what you owe 0.5% a month, which is 6% annually. And that can change every quarter. So, 6% annually is going to be cheaper than the at least 12% that your credit card company is going to charge you, not to mention the so-called ‘convenience fee.’
The cheapest way to go is to set up an installment payment plan with the government, and there is a form if you want to look at it, it’s 9465. Now, if you have a credit card with a low APR, that’s probably cheaper if you pay off what you’re charging in a reasonable amount of time. I would say that if you could get 0% then that becomes the cheapest way to pay the IRS, assuming you’re going to have it paid before it jumps. That’s fine for people who know they’re going to have the money. Scenario #1 for people who know that they can pay it off during the teaser-rate period would be to charge it, and then you’re subject to only the convenience charge of let’s call it 2% on average. That wouldn’t be terrible.
If you knew you weren’t going to pay it off, and you didn’t have a teaser-rate and you’re going to incur credit card interest at, let’s say 18%, then what I would suggest is you file a Form 9465, which gets the ball rolling for the installment payment plan. That’s a $52 set-up fee which is going to be less than the convenience fee, depending—you could figure out where the ‘break even’ is. If you owe $5,000, then 2% of that would be $100 and that would be the average convenience fee, this is $52. But, if I remember correctly, this requires automatic payments out of your checking account, and the interest is 0.5% a month which comes to 6% but can change. We’re in a low interest rate environment right now so it’s probably not going to change dramatically any time soon, but that would certainly be one way to go. Another way – you can get a brief additional amount to pay from the IRS.
John SwainProfessor of Tax Law at the University of Arizona’s James E. Rogers College of LawWhat are the pros and cons of paying your taxes with a credit card? What other options do people have if they can’t immediately fulfill their tax obligations?
It’s like dealing with any other creditor, you have to work it out, or you get sued and they enforce a judgment against you, including garnishing wages, attaching bank accounts, enforcing the judgment lien against your property, and so on. Bankruptcy is the last stopping point for persons in these situations, but taxes are generally non-dischargeable in bankruptcy, unlike many other debts.
What are the most common questions you hear from people about their taxes?
The most common question from the man in the street is, “What do I do if I haven’t filed returns for the past x years?” Often, my answer is that this is a big mistake, becuase your employer has probably withheld more than you owe, so you are probably due a refund!
Are there any particularly notable court cases pitting taxpayers against the IRS? What lessons can we learn from them?
There are a few cases where taxpayers have claimed deductions for expenses for researching a book they are writing on prostitution. Vitale v. Comm’r is the most well-known. The lesson is, ‘If it’s too fun, it’s probably not deductible.’
Kenneth MilaniProfessor of Accountancy in the University of Notre Dame’s Mendoza College of Business
Scott ShumacherDirector of the Graduate Program in Taxation at the University of Washington School of LawTo what extent is the sequester affecting the tax collection process?
I have not seen any impact of the sequester on tax collection. A substantial portion of the collection process is automated, and I am unaware of any layoffs at the IRS as a result of the sequester. Thus, the people and the systems are still in place and performing as before (which is both good and bad). That said, the data is pretty clear that an increase in investment in tax enforcement pays for itself exponentially in tax collection. Congress would be well-advised to increase the IRS enforcement budget.
John SpryAssociate Professor of Business Economics at the University of St. Thomas Opus School of Business To what extent is the sequester affecting the tax collection process?
Not that much. The fiscal cliff deal delayed the ability of tax related companies like Intuit, which makes Turbo Tax, and other tax prepares to get started on the tax year 2012 returns which are due April 15, 2013.