IRS Accepting ITIN Renewal Applications

According to the PATH Act (Protecting Americans from Tax Hikes), ITIN’s that have not been used on a federal tax return at least once in the last three consecutive years will expire on December 31, 2017. ITIN’s with middle digits 70, 71, 72 or 80 will also expire at the end of the year. If you have an ITIN and expect to file a tax return in 2018, you must submit a renewal application.

If your ITIN has middle digits of 78 or 79 and you did not renew, your ITIN expired last year and you can renew at any time.

Tax returns submitted with an expired ITIN will be processed, but exemptions and certain credits will not be allowed until you renew the expired ITIN. Filing with an expired ITIN will cause months of delays.

Our office serving Bonita Springs and Naples, Florida has a Certified Acceptance Agent who can help you with your application.

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Hobby Loss Rules

When it comes to hobbies you can generally deduct expenses up to the amount of income you received from your fun.

Background: Assume that a taxpayer likes to race motorcycles on the weekends. Once every year our friend manages to come in at 4th place and wins some money. At the end of the year they receive a Form 1099-MISC for $600 of taxable income. The total amount our friend spends on racing each year is $5,000 (includes equipment purchases).

According to so-called Hobby Loss Rules our friend reports the income on Schedule C, and then reports $600 of related expenses, effectively eliminating the taxable income from their hobby; perfectly acceptable – no taxes on the occasional good fortune that came from the hobby. Keep in mind that if you receive any payee statement such as a 1099 or W-2, that the IRS also receives a copy, and if you fail to report that income they will come after the tax in about a year, with penalties and interest of course.

Problem: The tax court regularly considers cases of hobby losses, and regularly we read about taxpayers losing. What if our friend gets the idea to deduct 100% of their expenses? The effect would be a $4,400 business loss that will reduce the income from their W-2 job, and decrease their total tax due. The problem is that our friend has a hobby, not a business.

The IRS estimates that incorrect hobby expenses account for up to $30 billion per year in unpaid taxes, so you can bet that they are looking out for scofflaws.

So does our friend have a business or a hobby? The number one question is, “Did our friend have a profit motive?” The list of general IRS considerations is:

  1. Does the time and effort put into the activity indicate an intention to make a profit?
  2. Does the taxpayer depend on income from the activity for necessary living expenses?
  3. If there are losses, are they due to circumstances beyond the taxpayer’s control or did they occur in the start-up phase of the business?
  4. Has the taxpayer changed methods of operation to improve profitability?
  5. Does the taxpayer or his/her advisors have the knowledge needed to carry on the activity as a successful business?
  6. Has the taxpayer made a profit in similar activities in the past?
  7. Does the activity make a profit in some years?
  8. Can the taxpayer expect to make a profit in the future from the appreciation of assets used in the activity?

The IRS will presume that the activity was carried on for a profit if it makes a profit during at least three of the last five tax years. Token profits are not going to cut it; remember the part about supporting necessary living expenses? The IRS has algorithms to spot patterns like that.

Sometimes we have clients engaged in legitimate “Fun” businesses and they are just having trouble gaining market share. There are different options to prevent being classified as a hobby by the IRS.  If you find yourself in this position you should consult with your licensed tax professional for advice and tax return preparation so that you can avoid any pitfalls.

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IRS Audit Update

Think the IRS has cut back on their audits? Don’t let the click-bait lure you to the dark side because that’s just not true. Old style IRS audits where an agent parks at your kitchen table or in your conference room for a week, are reserved for special cases. They have been mostly replaced with Correspondence Examinations.

We call them letter audits because you get a letter asking for a lot of proof. Correspondence Examinations, or Corr Exams, are produced by the Automated Underreporter Program. Between 2008 and 2012 the IRS conducted roughly 5.7 million Corr Exams. In 2013 the IRS conducted more than 1.4 million total audits, with Corr Exams making up 1,060,779 of those.

Corr Exams have resulted in $40.4 billion in additional tax revenue for the 2008-2012 period that may have gone uncollected. This method has become the preferred examination tool because it allows the IRS to reach more taxpayers, and with far less investment in human resources.

Don’t let the letter part fool you because these examinations are every bit as challenging as the in-person audits, and can be just as expensive. If you run into this sort of trouble do not hesitate to contact your licensed tax preparer.

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The Owner was the Employer

Many business owners seek to escape the burdens of payroll or a workforce by using payroll leasing companies, or professional employer organizations (PEO). If you intend to be free of worry and liability, two very important considerations are, “Who ultimately is in control of the work force, and who retains control of the payment of wages?” These are the most profound factors in determining who is legally responsible for satisfying a company’s payroll tax liabilities. Satisfying payroll tax liabilities is so very important because the IRS can come after owners and other responsible parties personally for the business’ unpaid payroll taxes.

If your company uses a professional employer organization (PEO) to control its workforce it would be better to use a certified PEO (CPEO). The Tax Increase Prevention Act of 2014 (TIPA) enacted a rule that a “certified professional employer organization” (certified PEO), and no other person, is to be treated as the employer liable for employment taxes with respect to wages paid by the certified PEO to a work site employee performing services for any customer of the certified PEO. If the PEO is not certified, then the responsibility for the payroll tax liability is up for interpretation should those liabilities go unpaid.

In a recent Chief Counsel Advice where a payroll tax liability went unpaid, the IRS ruled against a business owner who argued that the responsibility for paying the payroll liabilities rested with his PEO. The owner lost because the PEO was not certified, and the IRS concluded that the PEO was not a statutory employer under the tax codes, and hence the business owner was not relieved of the duty to pay over employment taxes.

The PEO was not certified, and the owner maintained control over the payment of his workforce. The contract the business owner had with their PEO stipulated that the owner assumed the responsibility for the day-to-day supervision and control of the workforce, that the owner had to pay the PEO at least one day prior to payday so that the PEO could meet the payroll obligations, the owner maintained a security deposit with the PEO, the PEO could terminate the contract at any time without notice, and the contract also provided that in the event of termination the owner would be responsible for all wages and related tax liabilities. This PEO sounds more like record-keeping mechanism than an organization in control of the payment of the workforce, and that is basically the position that the IRS took in this case.

This is the kind of pitfall that can cripple a small business. Payroll liabilities are a complex subject with far-reaching consequences. It is worth consulting with your CPA or EA about payroll related matters because the investment in a consultation can prevent tens of thousands in penalties and interest in the future.

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Sunk Cost Logic

This is a peculiar yet profound concept that many people fail to benefit from. It can go by different names; sunk capital, sunk cost bias, sunk cost fallacy and others. Some explanations go into great detail. I’ll make mine simpler.

Imagine a business traveler who is a type 2 diabetic, just finished a big restaurant meal, and orders cake before paying the bill. The cake arrives, and our subject realizes, wisely, that they are no longer hungry. What to do with the cake?

Sunk cost teaches us that since the cake is already paid for, and there is no way our subject can get their money back, that they would be better off abandoning the cake than they would be if they ate it. Some people will think that since they paid $5 for cake, that unless they eat it they will loose the five bucks.

Remember; the five bucks is already gone. Our diabetic subject who has already had enough to eat would be better off not eating the cake. The $5 is a sunk cost.

Watch for it because sunk costs are all around you.

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Federal Tax Liens

If you owe the IRS and you are unable to pay, you may be end up with a Federal Tax Lien filed against you. It will be part of the public record in the county where you live. There are a lot of tax services that watch the public records for new liens. Then they come after you.

An existing client we represented recently got a tax lien as a routine part of the IRS collections process. He received 11 solicitation letters, and an especially persistent caller. He saved the letters for me. They range from forthright to downright sinister.

The most honest ones start with something like, “If you have already retained a representative then please disregard this letter. I obtained your name from the official records.” Then they go on to explain how they can help.

If you ever receive a solicitation for back taxes that uses scare tactics, or presses you to take action immediately, now, now, you better or else; be very wary.

We charged our client $550 to negotiate and establish an Installment Agreement. To us it was all in a days work. That pesky caller told our client that for a retainer of $750 their company would take care of it, “But you need to act now or else you will get in trouble.” That caller did not want our client to have time to think, time to realize that he already had a tax accountant. Most seemingly hopeless IRS problems have simple answers. Of course some do not.

Always contact your licensed tax professional first. If you don’t know anybody feel free to contact us for a consultation.

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Some Information on Deducting Lawyer Fees

If legal fees are for business then they are deductible. If your business incurs legal fees for intangible reasons, such as forming your business or protecting your reputation, you will likely need to capitalize the expense and amortize it.

If legal fees are for personal reasons some are deductible, some are not, and if your income is higher the AMT will wipe out your deduction. Nonbusiness legal fees are generally deductible on Schedule A, subject to the 2% of adjusted gross income floor. There are some exceptions.

Legal fees paid for divorce or personal lawsuits are not deductible.

Personal legal fees in connection with the production of wages or other incomes, or compensation for sickness or injury are deductible. Discrimination defense fees are deductible. Whistleblower legal fees are deductible.

Contingent fee lawyers that only take their fee if they prevail are deductible. Beware that if your award is $100,000 and the attorney takes their 40%, that you will still need to report $100,000 of income, not just $60,000. If the award is compensatory then none of it is taxable. If any portion of the award is punitive, that portion is definitely taxable.

If you go to court over an employment case, the taxable amount of the award is reduced by the necessary attorney’s fees.

Legal fees for tax advice are all deductible, regardless of the type of tax.

This is a fickle area and legal fees can easily run into the tens of thousands. Paying your licensed tax adviser for accurate information in properly treating them can make a big difference.

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Thinking like an Accountant

Accountants see the world differently than most people. Here are three easy ways to start thinking more like an accountant.

1. Always round up. Whenever you see a price, $4.98 for instance, the accountant sees five bucks.

2. Always add in the after tax conversion. For this model you and your spouse collectively earn about $90,000 a year; we will assume 40 cents to each dollar. Now we’re up to $7.

3. When it is a periodic charge/expense always multiply by 12 months to arrive at the annual cost. Now we are at $84. So that app that is on your phone that only costs $4.98 a month is costing you 84 bucks a year.

Let us put this into a more profound example, like going out for dinner and a movie once every week. The price of a movie with snacks is $30. The price of dinner with drinks is $120 with the gratuity. Now we’re at $150. Add the after tax amount and we get $210 (150 X 1.4 = 210). Times 52 weeks a year = $10,920. To go out for dinner and a movie each week you will have to earn eleven grand a year. $110,000 every ten years.

Now consider economic substitution. If we forgo this behavior, how else might we put our $11,000 a year to use for other wants?

Let’s twist this model a little more and account for utility (Remember Bentham and Mill?). What if going out once a week is a really big reason you are still married? That may be worth more than the boat you are considering. Or not…

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After-tax dollars and price versus cost

If you are a wage earner, and your income is reported to you each year on payee statement form W-2, you should be aware of the concept of after-tax dollars. I’ll keep all of these numbers round and simple.

Let us assume that if you divide the total tax from line 63 of your 2016 Form 1040, by your total wages on line 7, and you get 18% (forget the brackets – we’re using the effective rate). That means the Federal government gets $.18 of every dollar you earn. If you live in a state with a state income tax add another 5%. Now we’re at $.23. Wage earners also pay into FICA; Social Security and Medicare funds at the rate of 7.65%. All total, the various taxing agencies have so far taken $.3065 of your dollar – lets round that to $.31.

By that logic, in order to spend $1, you will need to earn $1.31. To buy a $1 wash cloth at the store, add another 6% of sales tax. Now you are at $.39 in taxes. You would need to earn $1.39 to buy a $1 wash cloth.

Now what was the price you think you paid to buy that spanky new F-150; $52,000 on the sticker? Just multiply by 1.39 = gives us a cost of $72,280. Think about it.

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Valuing Rental Real Estate for Depreciation

We have recently been on the subject of Rental Real Estate and depreciation, and a related Tax Court Summary Opinion has come to light.

When it comes to allocating cost basis between the depreciable structure, and the non-depreciable land I have always used the information available from the county Property Appraiser’s web site. The tax court is in general agreement.

The taxpayer’s made an allocation based on a private appraisal. The Tax Court rejected the taxpayers’ allocations in favor of the apportionment of value between improvements and land based on the L.A. Assessor. Although the court acknowledged that the owner of the property was qualified by their ownership to testify as to its value, it was unaware of any authority that suggested that this qualification extended to an allocation of the value of property between land and improvements.

If you try to tackle depreciating rental real estate without the help of your accountant, always remember that the land is not a depreciable asset.

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