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Should You Expense or Depreciate Your Capital Asset?

If you own a business, you know that you may accelerate the expensing of qualified capital purchases. This can be done within two special provisions in the tax code:

Section 179

The annual amount of qualified assets that may be expensed (instead of depreciated) was raised to $1.08 million for 2022. This benefit can be maximized as long as the total assets purchased by your business don’t exceed $2.7 million. Qualified purchases can be new or used equipment, as well as qualified software placed in service during the year.

Bonus Depreciation

There is also an option to chose additional first-year bonus depreciation of 100 percent of the cost of qualified property.

To qualify the property must be purchased and placed in service before 2023. After that, an annual phaseout lowers the bonus deduction percentage. Property can be new or used, but it can’t be in use by you before it was acquired. There are a few exclusions for electrical energy and gas or steam distribution.

Not interested in claiming the bonus depreciation expense? Then you may choose to opt out of this provision for each category (class) of property you place in service.

What should you do?

Taking advantage of these provisions may be good for your business, but that’s not always the case.

Remember, if you use these special asset-expensing provisions, depreciation expense taken this year is given up in future years. How many future years depend on the recovery period of the asset, but the additional tax exposure could be up to two decades! This is especially important to consider if your company is organized as a passthrough entity, like an S Corporation, as more income could be exposed to higher marginal taxes.

The short-term tax savings these two provisions provide is often too good to pass up. However, if you have some predictability in your business, it probably makes sense to forecast your projected pre-tax earnings with and without the accelerated depreciation to ensure you are making the correct long-term tax decision.



Don't Run Afoul of the IRS's Nanny Tax

The IRS is more strictly enforcing rules that determine whether a worker is actually your employee, rather than an independent contractor.

So be careful if you regularly pay a gardener, housekeeper, nanny, babysitter or any other household service provider. You don’t want to run afoul of the IRS’s household employee rules, often referred to as the Nanny Tax.

Do you have a household employee?

Many taxpayers unwittingly establish an employer relationship when they hire someone to help around the house. To decide whether a household worker is your employee, the IRS looks at whether you:

  • Control how and when their work is done
  • Provide them with supplies and equipment

The IRS also considers whether the relationship is permanent, and whether a worker is economically dependent on their employment with you. A worker may be considered an employee whether or not their work for you is part- or full-time, or paid hourly, weekly or by the job.

Tip 1: The more independent the worker is, the less likely they are to be considered your employee. Have your worker set their own hours and use their own tools. Also have them invoice you for their work and provide you with receipts.

Tip 2: If the worker works for another company that issues them a W-2, or they run their own company that offers services to the general public, you are generally safe from having them considered as your employee.

Tax consequences

If you think you have a household employee, here is what you need to know:

  • The $2,400 limit. If you pay less than $2,400 in a year (or $1,000 in any calendar quarter) you generally are not responsible for paying employment taxes. But if your payments are over these limits, you may need to withhold and pay Social Security, Medicare and unemployment insurance taxes.
  • Overtime. You may be required to pay overtime, depending on federal and state laws.
  • Timing is important. Employment taxes must be paid regularly throughout the year or you could face fines and penalties.
  • Other considerations. You may also need to purchase worker’s compensation insurance to cover you should there be any accidents while they are working for you.

If you are going to rely heavily on the services of a domestic worker, it’s worth thinking carefully about the relationship at the outset. Consider getting a formal employment contract in place, and call for help to create a plan to handle your tax obligations.



Inflation Spikes Social Security for 2023- How much you pay and checks received are all going up!

2023 Cost-of-Living Adjustment (COLA) changes are here. This is what you need to know.



Leveraging Your Children's Lower Tax Rate- One of the best places for parents to look for tax savings

If you’re a parent, your dependent children can be a source of tax savings. There are the well-known provisions in the tax code such as the Dependent Child Care Credit and the Child Tax Credit, but there’s also an opportunity to shift some taxable income to your children.

Shifting income to your children works because the tax rate increases as your income rises. This provides an incentive to shift income to your lower-earning dependent children. Here’s how to make it work:

Shifting income rules

In 2022, the first $1,150 of unearned income for each child is not taxed and the next $1,150 in unearned income is taxed at the lowest rate of 10 percent. Typical unearned income includes interest, dividends, royalties and investment gains.

Tip: Transfer enough income-producing assets to each child to approach the annual unearned income limits as closely as possible. Depending on your marginal tax rate you could be saving as much as 37 percent in federal income tax on the transferred amounts.

Tip: In addition to the unearned income, consider purchasing investments that will have long-term capital gain appreciation. This may help manage the timing and rate of capital gains tax when the investment is later sold.

Tip: Remember excess investment income could be subject to the additional 3.8% Medicare Surtax. Any investment income that can be shifted to your children could also save you this additional tax bite as well.

Leverage your children’s earned income

Income your children make from wages is considered earned income. If you own a small business, finding ways to employ your children can be a way to shift income from your higher tax rate to their lower rate. Care must be taken to be able to defend the work being done by your child and the amount they receive for their work. Some ideas include:

  • Use your child in an advertisement for your business.
  • Have your child clean your office a few times per week.
  • Put your child in charge of making local business deliveries.
  • Have your child help assemble items or help with mailings.

Tip: If you are a sole proprietor, you may hire your dependent children under age 18 and won’t be required to pay Social Security and Medicare taxes.

Caution: Moving assets from you to your children could affect their ability to receive financial aid for college. Make sure to consider how your tax strategy affects college financing.

There are many opportunities to leverage the tax advantages of having children. Reach out if you would like help creating a plan for your family.



Effective and Marginal Tax: Know Yours!- Understanding the difference between these two tax rates

The tax code is filled with terms we rarely use in everyday conversation. Two of the more common are Marginal Tax Rates and Effective Tax Rates. Knowing what they mean can help you think differently about your potential tax obligation.

Definition

Marginal Tax Rate: This is the tax rate applied to the next dollar you earn. Since our income tax rates are progressive, the next dollar you earn could be taxed at as little as zero or as high as 37%!

Effective Tax Rate: This is the tax rate you actually pay. It is total taxes paid divided by your total taxable income. Said another way, after taking your income and then applying taxes, deductions, credits, exemptions, and other adjustments, you are left with your true tax obligation. This obligation is a percent of your income.

A Simple Example

Consider two single people; Joe Cool who earns $50,000 and Chuck Browne who earns $500,000. If we had a flat tax of 10%, Mr. Cool would pay $5,000 in tax and Mr. Browne would pay $50,000 in tax. Both of their Effective Tax Rates would be 10% AND their Marginal Tax Rates would also be 10% because each additional dollar they earn would be taxed at the same 10%. However it is a different picture when you apply our progressive tax rates:

If we use the 2022 U.S. tax table for a single filer, Joe Cool pays $6,617 and Chuck Browne pays $148,753 in federal tax. This is because tax rates applied to Joe Cool’s income are (10 – 22%) while Chuck’s income over $50,000 gets Marginal Tax Rates of (22 – 35%). Ignoring other tax factors, our two taxpayers’ tax rates are:

Why Care?

  • Calculating Returns. The true return you receive on any taxable investment will be determined by your Marginal Tax Rate. A $500 profit from a new investment could cost Joe Cool 15% in federal tax, but it could cost Chuck Browne 35% in federal tax.
  • Phaseouts can provide a dramatic impact on Effective Tax Rates. The simple examples above do not account for income limits applied to many tax benefits. Additional income could have a very dramatic impact on Joe Cool if it triggers losing things like an Earned Income Credit, or Child Tax Credit. This could increase Joe’s Effective Tax Rate while not touching his Marginal Tax Rate.
  • Extra work can help the taxman more than you. There have been cases where adding a second job can actually cost you money by not understanding the impact of the income on your Effective Tax Rate. This is especially true for retired workers receiving Social Security Retirement Benefits. That extra job may make your Social Security benefits taxable.
  • It’s not that simple. In addition to all the different income phase-outs for credits and deductions, your Effective Tax Rate could be impacted by the elimination of itemized deductions, the Alternative Minimum Tax, and the marriage penalty.

So look at last year’s tax return and calculate your Effective Tax Rate. Then look at your income and determine the Marginal Tax Rate to be applied on your next dollar of income. Finally, if you anticipate an increase in earnings, consider forecasting the impact on your Effective Tax Rate.



The New $7,500 Tax Credit That Isn't- What you need to know

A highly-touted tax credit in the recently-passed Inflation Reduction Act is meant to incentivize Americans to purchase clean and electric vehicles. The bottom line, however, is that practically speaking YOU CAN’T GET IT.

Why few credits will be seen

As the new legislation is currently written, nearly all the electric vehicles sold today do not qualify for the new credit that begins in 2023. This is because:

  • The vehicle must be manufactured in North America AND
  • Powered by batteries with materials sourced in either the U.S. or from free trade partners AND
  • If by some stroke of luck you find a new vehicle that qualifies, the price must be below $55,000 for a sedan and $80,000 for a van, truck or SUV.

Tax code as behavior modification

The new electric vehicle tax credit is a classic example of the continued shift from using income taxes to pay for federal spending to using the tax code to get us to do what the government wants. In this case:

  • The government is trying to get manufactures to shift sourcing away from countries like China.
  • The government wants to motivate the creation of manufacturing jobs in the U.S.
  • The government wants to incentivize the manufacturing of lower-priced electric vehicles.

What this means for you

What this means for the average consumer is little to anything…right now. If you have your sights set on getting a clean or electric vehicle, make the decision without the influence of the credit. If maximizing the credit is important for you, you now need to pay attention to income limits and will need to wait for some time to see if the credit influences manufacturers to change their sourcing and assembly plans.



Understanding Tax Terms: Contemporaneous Records- Everyone needs to know what this means!

If you have problems getting to sleep at night and you turn to the IRS tax code for help, you might find some vocabulary that is very foreign to you. One of the more uncommon words used by the IRS is the term “contemporaneous.” So what does it mean and why should you care?

Contemporaneous defined

According to the IRS, it means that the records used to support a claim on your tax return are created and originated at the same time as your claimed deduction. In other words, if you realize that you forgot to get a receipt for something, you are out of luck if you try to get one at a later date.

Not fair!

Perhaps you know you had the expense, but you simply forgot to get a receipt. You can cry foul, but time and again the IRS has had tax courts uphold their elimination of a taxpayer’s deduction for lack of contemporaneous documentation. Here are some areas where the term contemporaneous is especially important:

  • Charitable contributions
  • Business deductions for expenses and capital purchases
  • Mileage logs
  • Tip records
  • Gambling losses
  • Business travel expenses

The donation of vehicles, boats and planes is often the most cited area where lack of contemporaneous documentation is a problem because these types of donations have a high estimated market value that changes from month to month. But timely, written acknowledgement from the charitable organization is also required for any donation of $250 or more.

What you need to know

  • Always get a receipt. Before you leave a donated item, always ask for a receipt. In the case of a vehicle, make sure the charitable organization gives you a 1098-C that is fully filled out. In addition, make sure the organization uses your vehicle or is a qualified charitable group that allows you to take the full market value of your donation.
  • If you forget, call right away. As soon as you realize a confirmation or receipt is missing, call to get one sent to you. Request that the receipt be dated as of the date of the service or activity.
  • Think tax year. Understanding the definition of contemporaneous is important, because it is not always precisely defined. If the documentation is received in the same year as the donation or transaction, you are usually in good shape.
  • Keep a log. Many transactions require the correct documentation at the time the activity occurs. This is true with deductible mileage, gambling loses and tip income. So keep a log of your activities as they occur.
  • Wait to file. To meet the IRS definition of contemporaneous, the receipt or acknowledgement must be received the earlier of either when you file your tax return OR the due date (including extensions) of your tax return. This is particularly true with charitable contributions. So if you want to play it safe, do not file until all documentation is in hand.


IRS Audit Rates- Don't get complacent…resurgence is underway

The IRS reported audit rates continue to be low…very low. But that is now changing with thousands of auditors being hired for a post-pandemic scale-up of their reviews.

So don’t get complacent. A closer look at the IRS data release reveals some audit pitfalls you should know about.

Audit Rate Statistics for Individuals

Source: IRS Data Books with 2019 audit figures updated through May 26, 2022

Observations

  • Fewer audit examinations obscure the reality that you may still have to deal with issues caught by the IRS’s automated computer systems. While not as daunting as a full audit, you’ll need to keep your records handy to address any problems.
  • Average rates are declining, but audit chances are still high on both ends of the income spectrum: no-income taxpayers and high-income taxpayers.
  • No-income taxpayers are targets for audits because the IRS is cracking down on fraud in refundable credits designed to help those with low income, such as the Earned Income Tax Credit (EITC). And while not on the charts, 87% of Earned Income tax returns that are audited had additional tax applied!
  • High-income taxpayers have long been a target for IRS audits. This group, however, saw a big decline in audit rates during the pandemic. Still, taxpayers with over $500,000 in income have more than double the chance of being audited than lower-income taxpayers. Not only do these taxpayers tend to have more complicated tax returns, but the vast majority of federal income tax revenue comes from them.
  • Complicated returns are more likely to be audited. Returns with large charitable deductions, withdrawals from retirement accounts or education savings plans, and small business expenses (using Schedule C) are more likely to be the target of an IRS audit.

Stay Prepared

Always retain your tax records and supporting documents for as long as you need them to substantiate claims on a return. The IRS normally has a window of three years from the filing date to audit a return, but this can be extended if the agency believes there’s any fraudulent activity.

If you receive an audit letter from the IRS, it’s best to reach out for assistance as soon as possible.



You Can't Deduct that Loss- How to ensure your business is not deemed a hobby

You’ve loved dogs all your life so you decide to breed them and start a dog training business. Is this a business in the eyes of the IRS or a hobby? Knowing what the IRS is looking for and properly positioning your small business can save taxes and headaches if you are ever questioned by the IRS.

Why you should care

If your activity is a business, your income can be reduced by all your qualified business expenses even if it results in a loss. If your activity is deemed a hobby, no losses are allowed on your tax return, and even worse, after 2018 you cannot deduct expenses against this revenue. So you’re telling me if I knit three sweaters and sell them for $1,000 I cannot deduct the cost of the wool if it is a hobby? Technically, yes! Which is why you need to change how you think about these kinds of activities.

Tips to make it a clear business

Here are some tips to ensure full deductibility of your expenses against your business income.

  1. Profit motive. You must show that you intend to make a profit with your activity. The old rule of thumb was to show a profit at least three out of the past five consecutive years to safely qualify your activity as a small business. But this is no longer the case. Although more difficult to substantiate, you can show profit motive without ever showing a profit by your ongoing activities around the business.
  2. Active participation. You need to be actively involved in your pursuit for success. If you simply invest money in the dog business, but are never there to care for them or give lessons, you will have a hard time justifying the business nature of the activity.
  3. Be professional. Businesses have separate checkbooks, business cards and stationery. They have financial statements and show the same disciplines one would find in a “for profit” venture of the same type of activity you are pursuing. And they are organized as a business, ideally through a simple business structure like a single member LLC.
  4. Pleasure factor management. If your business has a large enjoyment factor, you will need to be even more cautious about having proper records. If you claim to be a golf pro giving lessons, but then spend all your time playing golf, you will have a hard time justifying the activity as a true business.
  5. Have multiple customers. If you only have one or two customers, who also happen to be relatives, your activity may be deemed a hobby. Having a number of customers, even without profits, can make all the difference in allowing for expense deductions.
  6. Showing profit motive without profits – Part II. How else can you show profit motive when no profit is to be found? Advertising is one way to do this. Keep copies of all ads trying to drum up business. Keep a daily diary of business activities, noting who you meet and for what purpose. Create and keep sample product, even if it is not yet sold.
  7. Understand your risk. There are certain business types that are under the IRS microscope when it comes to hobbies. Key among these are multi-level marketing businesses like Amway, Tupperware and Avon. It also includes the thousands of part-time sellers of goods on internet sites like e-bay. If you are in one of these business activities you will need to prove the business nature of your involvement and be prepared to be challenged.

Quick Checklist

Wondering if your business activity may be considered a hobby? Review this checklist. The more yes answers, the better your chances of defending your position.

  • Conducted activity in business-like manner?
  • Created a business entity?
  • Have expertise in your activity?
  • Put time and effort into the activity?
  • History of income/profits?
  • Have had prior success in a similar activity?
  • Is there a low element of pleasure/recreation involved?
  • Are there appreciating assets or an expectation that there will be?

Remember, having a business activity reclassified as a hobby can mean a big tax bite at tax time. But by keeping proper records and pro-actively knowing the pitfalls, you can avoid most problems.



Hidden Back to School Tax Deductions

Summer is coming to a close and the back-to-school advertising blitz is underway. Hidden in some of those school expenses are tax deductions you can take advantage of. Here are some ways you can save:

  1. Watch for tax deductions on the supply list. Schools often send a list of requested supplies for the school year. Some of the items on the list are clearly for personal use (such as an eraser or a ruler) while other items on the list are often for school use and classroom use (such as 24 pencils or paper towels). Keep track of these non-cash classroom/school donations for possible charitable deductions. Or even better, donate cash.
  2. Donate funds versus taking the raffle ticket. Raffles, subscription drives and silent auctions are fun ways schools raise money. To maximize your ability to deduct your donations, forgo the possible prize. Then the entire donation is clearly deductible. Remember to ask for a receipt when making the donation.
  3. Don’t forget your out-of-pocket expenses for your volunteer activities. Perhaps you donate your time at school functions, donate books to the school library, or help assist the teaching staff. Your out-of-pocket expenses and mileage should be tracked for charitable deduction purposes.
  4. Teachers, save your out-of-pocket expenses. A recent survey found that 94 percent of teachers spend their own money on classroom supplies — some as much as $1,000 per school year. On your 2022 tax return, teachers are allowed to deduct $300 on their tax return even if they claim the standard deduction. If you’re married, you can deduct up to $600 of classroom supplies.
  5. Use checks, not cash. If you usually provide donations to the school in the form of cash (like providing additional money to help other kids go on field trips) make those donations in the form of a check. The check will serve to help prove your donation.

Finally, don’t forget to review state rules for educational expenses. There are often credits available for out-of-pocket school and other educational expenses.

Correction: Please note the above-the-line deduction for charitable contributions is currently NOT available for the 2022 tax year. This provision expired at the end of 2021. Last week’s Tax Tip dated 7/29 did not reflect this change. Sorry for any confusion or inconvenience.