Generally, we keep “tax” records for two basic reasons: (1) in case the IRS or a state agency decides to question the information reported on our tax returns; and (2) to keep track of the tax basis of our capital assets so that the tax liability can be minimized when we actually dispose of the assets. 

With certain exceptions, the statute for assessing additional tax is three years from the return due date or the date the return was filed, whichever is later. However, the statute of limitations for many states is one year longer than the federal. In addition to lengthened state statutes clouding the recordkeeping issue, the federal three-year assessment period is extended to six years if a taxpayer omits from gross income an amount that is more than 25% of the income reported on a tax return. And, of course, the statutes don’t begin running until a return has been filed. There is no limit on the assessment period where a taxpayer files a false or fraudulent return in order to evade tax.

If an exception does not apply to you, for federal purposes, most of your tax records that are more than three years old can probably be discarded; add a year or so to that if you live in a state with a longer statute.

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Long-Term Capital Gains Rates Increase – Taxpayers have enjoyed reduced long-term capital gains rates for several years as a result of the Bush era tax cuts.  However, without Congressional action, which is not expected, those reduced rates will return to the higher rates in effect prior to 2003. 

The table below compares the current long-term capital gains rates to the anticipated rates for 2013 and subsequent years.

Taxpayers with unrealized long-term capital gains may wish to review their holdings and consider whether it is appropriate to sell during 2012 at the lower rates or whether to continue to hold for additional increases in value.  Where future increases in value are anticipated, a taxpayer could sell and realize existing gains in 2012 and then repurchase the investment for future anticipated increases.  Investment strategies depend on a variety of issues, including existing capital loss carryovers, growth potential of individual investments, and other factors related to each individual, and should be carefully analyzed before taking action.

Regular Tax Rates – In addition to lower long-term capital gains rates, the regular marginal tax rates have been declining since 2001. However, without Congressional action, those reduced rates will return to higher rates in effect prior to 2001.  The table below compares the current marginal individual tax rates to the anticipated rates for 2013 and subsequent years.

These increased rates will apply to all varieties of ordinary income including interest, dividends, short-term capital gains, employment income, etc.   Marginal tax rates increase as a taxpayer’s overall income increases, taxing the first block of income received at the lowest rate and each subsequent block at ever-increasing rates until the maximum rate is reached. As with assets eligible for the long-term capital gains rates, it may be appropriate for some taxpayers to accelerate ordinary income into 2012 to take advantage of the lower rates.

Surtax on Investment Income – Depending upon what the Supreme Court ultimately decides about the Health Care Law, starting in 2013 a new surtax, called the Unearned Income Medicare Contribution Tax, will be imposed on individuals, estates, and trusts. For individuals, the surtax is 3.8% of the lesser of:

1. The taxpayer’s net investment income or
2. The excess of modified adjusted gross income over the threshold amount ($250,000 for a joint return or surviving spouse, $125,000 for a married individual filing a separate return, and $200,000 for all others).

Thus, this surtax will only impact higher income individuals.

“Net” investment income is investment income reduced by allowable investment expenses. Investment income includes:

• Income from interest, dividends, annuities, and royalties,
• Rents (other than derived from a trade or business),
• Capital gains (other than derived from a trade or business),
• Trade or business income that is a passive activity with respect to the taxpayer, and
• Trade or business income with respect to trading financial instruments or commodities.

For surtax purposes, the net investment income does not include excluded items, such as interest on tax-exempt bonds, veterans’ benefits, and excluded gain from the sale of a principal residence.

For planning purposes, existing law favors tax-exempt bond interest, which avoids both the surtax and the regular income tax.  However, you should be aware that President Obama’s tax plan would also tax the income from “tax-exempt” bonds for higher-income individuals at generally the same threshold as this surtax kicks in.

It is not too early to start planning for the 2013 tax increases. Prudent planning can significantly reduce the tax bite.  At the same time, keep a watchful eye on Congress. Since this is an election year, tax changes are most likely to come after the November elections.  Please call our office if we can be of assistance in your investment tax planning.

Generally, identity thieves use personal data to steal financial accounts and run up charges on the victim’s existing credit cards. However, identity theft can also affect your tax records as follows:

• Undocumented workers or other individuals use your Social Security number to get a job. The employer then reports W-2 wages the workers earned under your Social Security number to the IRS. When you file your return based on your real W-2 income, it appears that you failed to report part of your income on your return.
• An identity thief files a return using your Social Security number to claim refundable credits. This can be lucrative for cyber thieves who take advantage of the Earned Income Credit or the American Opportunity Education Credit, both of which are refundable credits. Generally, credits can only be used to offset a tax liability. However, these two credits are refundable even if the taxpayer has no tax liability.
• An identity thief may also use your Social Security number or your children’s SSN to claim additional tax return exemptions. Each exemption claimed on a return provides a deduction worth $3,800 (2012) and can be used to claim head of household status.

How do the thieves obtain this information? Some buy it from other thieves who collect identity information by hacking into firms that have those records or by using ingenious ways to trick you into disclosing the information. This is often done by sending you an e-mail disguised to look like an e-mail from a trusted source. This practice is referred to as “phishing.” An example of phishing is an e-mail with a fake IRS header claiming to have a refund for you and directing you to a site that requires you to enter your SSN and other information to verify your claim for the refund.

Don’t be a cyber-victim. Here are some tips you should know about phishing scams.

1. The IRS and legitimate businesses never ask for detailed personal and financial information such as Social Security numbers, PIN numbers, passwords or similar secret access information for credit card, bank or other financial accounts.
2. The IRS does not initiate contact with taxpayers by e-mail to request personal or financial information. If you receive an e-mail from someone claiming to be a representative of the IRS or directing you to an IRS site:

• Do not reply to the message.
• Do not open any attachments. Attachments may contain malicious code that will infect your computer.
• Do not click on any links.

If you clicked on links in a suspicious e-mail or phishing website and entered confidential information, you may have compromised your financial information. If you entered your credit card number, contact the credit card company for guidance. If you entered your banking information, contact the bank for the appropriate steps to take. The IRS website provides links to additional resources that can help. Visit the IRS website (www.irs.gov) and enter the search term “identity theft” for additional information.

3. The address of the official IRS website is www.irs.gov. Do not be confused, misled or respond to sites claiming to be the IRS but ending in .com, .net, .org or other designations instead of .gov.
4. If you receive a phone call, fax or letter in the mail from an individual claiming to be from the IRS, but you suspect he or she is not an IRS employee, contact this office immediately. You should also call the IRS at 1-800-829-1040 to determine if the IRS has a legitimate need to contact you. Report any bogus correspondence. You can forward a suspicious e-mail to phishing@irs.gov.

If you receive a notice or letter from the IRS or state tax authorities, you should always contact our office. This is especially true if you believe someone may have used your Social Security number fraudulently or stolen your identity.

Generally, children under the age of 19 who have investment income, such as interest and dividends, are also subject to the so-called “kiddie tax,” which, except for small amounts, causes the child’s income to be taxed at the parent’s marginal rates. The “kiddie tax” was implemented several years ago to curtail parents from shifting income to a child to take advantage of the child’s lower tax rates. Full-time students under the age of 24 who are not self-supporting are also subject to the “kiddie tax” rules. 

So what is the definition of a full-time student? Well, the tax law definition is more liberal than you might imagine. A full-time student is one enrolled for some part of five calendar months (whether or not consecutive) in a given year for the number of hours or courses considered full-time attendance by the school that the student is attending.

The enrollment in school needn’t be for full months—or for five consecutive months. So, if the student is enrolled from mid-February to mid-June, the five-month qualification is met. On the other hand, if the student is enrolled from September to December or February to May, the student has been enrolled for only four months, and there must be full-time enrollment during at least one other month during the calendar year to meet the definition.

The full-time student designation also applies when claiming the lucrative American Opportunity Education Credit, which is based on payment of college tuition and related fees.  For all but certain qualified children, claiming the credit only requires attendance for an academic period (semester, quarter, etc.). In order for parents to claim the credit for a qualified child who is over the age of 18 and under the age of 24, the qualified child must also be a full-time student.

If you have questions, please contact our office.

Internal Revenue Code Section 183 (Activities Not Engaged in for Profit) limits deductions that can be claimed when an activity is not engaged in for profit. IRC 183 is sometimes referred to as the “hobby loss rule.”

This article provides information that is helpful in determining if an activity qualifies as an activity engaged in for profit and what limitations apply if the activity was not engaged in for profit.

Is your hobby really an activity engaged in for profit? In general, taxpayers may deduct ordinary and necessary expenses for conducting a trade or business or for the production of income. Trade or business activities and activities engaged in for the production of income are activities engaged in for profit.

The following factors, although not all-inclusive, may help you determine whether your activity is an activity engaged in for profit or a hobby:

• Does the time and effort put into the activity indicate an intention to make a profit?
• Do you depend on income from the activity?
• If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
• Have you changed methods of operation to improve profitability?
• Do you have the knowledge needed to carry on the activity as a successful business?
• Have you made a profit in similar activities in the past?
• Has the activity made a profit in past years?
• Do you expect to make a profit in the future from the appreciation of assets used in the activity?

An activity is presumed to be for profit if it made a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses).

If an activity is not for profit, losses from that activity may not be used to offset other income. An activity produces a loss when related expenses exceed income. The limit on not-for-profit losses applies to individuals, partnerships, estates, trusts and S corporations. It does not apply to corporations other than S corporations.

Hobby deductions – If it is determined that your activity is not carried on for profit, allowable deductions cannot exceed the gross receipts for the activity.

Deductions for hobby activities are claimed as itemized deductions on Schedule A. They must be taken in the following order and only to the extent stated in each of three categories:

• Deductions that a taxpayer may claim for certain personal expenses, such as home mortgage interest and taxes, may be taken in full.
• Deductions that don’t result in an adjustment to the basis of property, such as advertising, insurance premiums and wages, may be taken next, to the extent that gross income for the activity is more than the deductions from the first category.
• Deductions that reduce the basis of property, such as depreciation and amortization, are taken last, but only to the extent that gross income for the activity is more than the deductions taken in the first two categories.

If you have questions related to your specific business or hobby circumstances, please give our office a call.

Purchased Websites – If the website is purchased from a contractor who is at economic risk should the software not perform, the design costs are amortized (ratably deducted) over the three-year period, beginning with the month in which the website is placed in service.  For 2012, non-customized computer software placed in service during the year qualifies as Sec 179 property and can be written off in full up to the limits of this special expense deduction.

In-House Developed Websites – If, instead of being purchased, the website design is “developed” by the company or designed by an independent contractor who is not at risk should the software not perform, the company launching the website can choose among alternative treatments, one of which is deducting the costs in the year that the costs are paid, or accrued, depending on the taxpayer’s overall accounting method. Or, as an alternative, the costs may be amortized under the three-year rule.

Non-Software Expenses – Some website design costs, such as graphics, may not be classified as software and must be deducted over the useful life of the element. Non-software portions of the design with a useful life of no more than a year are currently deductible.

Advertising Content – Advertising costs are generally currently deductible. Thus, the costs of website content that is advertising are generally, currently deductible.

Cost Before Business Starts – Business expenses that are incurred or accrued prior to the actual activation of the business are generally not deductible until the business is terminated or sold.  However, a taxpayer can elect to deduct up to $5,000 of the costs in the year that the business starts and amortize the costs in excess of $5,000 over a period of 180 months (15 years), beginning with the month that the business starts.

As you can see, deducting the expenses of a website can be complicated. Please call our office if you have questions.

In addition, the April 17, 2012 deadline also applies to the following:

• Tax year 2011 balance-due payments – Taxpayers that are filing extensions are cautioned that the filing extension is an extension to file, NOT an extension to pay a balance due.  Late payment penalties and interest will be assessed on any balance due, even for returns on extension.  Taxpayers anticipating a balance due will need to estimate this amount and include their payment with the extension request.
• Tax year 2011 contributions to a Roth or traditional IRA – April 17 is the last day contributions for 2011 can be made to either a Roth or traditional IRA, even if an extension is filed.
• Individual estimated tax payments for the first quarter of 2012 – Taxpayers, especially those who have filed for an extension, are cautioned that the first installment of the 2012 estimated taxes are due on April 17.  If you are on extension and anticipate a refund, all or a portion of the refund can be allocated to this quarter’s payment on the final return when it is filed at a later date.  Please call this office for any questions.
• Individual refund claims for tax year 2008 – The regular three-year statute of limitations expires on April 17 for the 2008 tax return.  Thus, no refund will be granted for a 2008 original or amended return that is filed after April 17. Caution: The statute does not apply to balances due for unfiled 2008 returns.

If this office is holding up the completion of your returns because of missing information, please forward that information as quickly as possible in order to meet the April 17 deadline.  Keep in mind that the last week of tax season is very hectic, and your returns may not be completed if you wait until the last minute.  If it is apparent that the information will not be available in time for the April 17 deadline, then let the office know right away so that an extension request, and estimate tax vouchers if needed, may be prepared.

If your returns have not yet been filed, please call our office right away so that we can schedule an appointment and/or file an extension if necessary.

To assist those most in need, a six-month grace period on failure-to-pay penalties will be made available to certain wage earners and self-employed individuals. The request for an extension of time to pay will result in relief from the failure to pay penalty for tax year 2011 only if the tax, interest, and any other penalties are fully paid by October 15, 2012.

The penalty relief will be available to two categories of taxpayers:

• Wage earners who have been unemployed at least 30 consecutive days during 2011 or in 2012 up to the April 17 deadline for filing a federal tax return this year.
• Self-employed individuals who experienced a 25 percent or greater reduction in business income in 2011 due to the economy.

This penalty relief is subject to income limits. A taxpayer’s income must not exceed $200,000 if he or she files as married filing jointly or must not exceed $100,000 if he or she files as single or head of household. This penalty relief is also restricted to taxpayers whose calendar year 2011 balance due does not exceed $50,000.

Taxpayers meeting the eligibility criteria will need to request the penalty relief by filing the new Form 1127A on or before the April 17^th deadline. Form 1127A is not to be attached to the income tax return, but is filed separately. CAUTION: Form 1127-A does not extend the time to file your 2011 income tax return. To get an extension of time to file, you must file Form 4868, Application for Automatic Extension of Time to File U.S. Individual Income Tax Return.

The failure-to-pay penalty is generally half of 1 percent per month with an upper limit of 25 percent. Under this new relief, taxpayers can avoid that penalty until October 15, 2012, which is six months beyond this year’s filing deadline. However, the IRS is still legally required to charge interest on unpaid back taxes and does not have the authority to waive this charge, which is currently 3 percent on an annual basis.

If you have questions related to deferring your tax payment until October and the financial implications of doing so, please give our office a call.

• Payroll withholding for employees;
• Pension withholding for retirees; and
• Estimated tax payments for self-employed individuals and those with other sources of income not covered by withholding.

Determining how much tax to pre-pay through withholding and estimated tax payments has always been difficult, but thanks to Congress’ constant tinkering with the tax laws, usually in late fall, ensuring there are no underpayment penalties or tax surprises when the tax return is prepared next year merely adds complexity.

One of the biggest unknowns for 2012 is the alternative minimum tax (AMT). Beginning in 2001, the exemption to the amount of income not subject to AMT was substantially increased and inflation-adjusted in subsequent years. However, the increased exemption amounts are not permanent and must be extended by Congress on a year-by-year basis. So far Congress has not acted for 2012, and if they do not, the AMT exemption will revert to 2000 levels, roughly one-half of the current amount. Without Congressional action an estimated 30 million taxpayers, approximately 20% of all taxpayers, will be hit by the AMT in 2012. Compare this to the roughly 600,000 taxpayers in 1997 (approximately 1% of all 1997 taxpayers) who were affected by the AMT.

When a taxpayer fails to prepay a safe harbor (minimum) amount, he or she can be subject to the underpayment penalty. This penalty is the short-term federal rate plus 3 percentage points and the penalty is computed on a quarter-by-quarter basis. So, even if you pre-pay the correct amount for the year, if the amounts are not paid evenly you could be subject to a penalty. Interestingly enough, withholding amounts are treated as paid ratably throughout the year, so taxpayers who are underpaid in the earlier part of the year can compensate by bumping up their withholding in the later part of the year.

Federal tax law does provide ways to avoid the underpayment penalty. If the underpayment is less than the $1,000 de minimis amount, no penalty is assessed. In addition, the law provides “safe harbor” prepayments. There are two safe harbors:

1. The first safe harbor is based on the tax owed in the current year. If your payments equal or exceed 90% of what is owed in the current year, you can escape a penalty.
2. The second safe harbor is based on the tax owed in the immediately preceding tax year. This safe harbor is generally 100% of the prior year’s tax liability. However, for a higher income taxpayer whose AGI exceeds $150,000 ($75,000 for married taxpayers filing separately), the prior year’s safe harbor is 110%.

Example: Suppose your tax for the year is $10,000 and your prepayments total $5,600. The result is that you owe an additional $4,400 on your tax return. To find out if you owe a penalty, see if you meet the first safe harbor exception. Since 90% of $10,000 is $9,000, your prepayments fell short of the mark. You can’t avoid the penalty under this exception.

However, in the above example, the safe harbor may still apply. Assume your prior year’s tax was $5,000. Since you prepaid $5,600, which is greater than 110% of the prior year’s tax (110% = $5,500), you qualify for this safe harbor and can escape the penalty.

If your state has a state tax, the safe-harbor amount may be a different percentage.

This example underscores the importance of making sure your prepayments are adequate, especially if you have a large increase in income. This is common when there is a large gain from the sale of stocks, sale of property, when large bonuses are paid, when a taxpayer retires, etc.

If you have questions regarding your pre-payments or would like to review and adjust your W-4 payroll withholding, W-4P pension withholding, and estimated tax payments to provide the desired tax result for 2012, please give our office a call.

The IRS encourages you to pay the full amount of your tax liability on time by imposing significant penalties and interest on late payments if you don’t. So if you are unable to pay the tax you owe, it is generally in your best interest to make other arrangements for paying your taxes rather than be subjected to the government’s penalties and interest. Here are a few options to consider.

• Family Loan – Obtaining a loan from a relative or friend may be the best bet because this type of loan is generally the least costly in terms of interest.
• Credit Card – Another option is to pay by credit card with one of the service providers that work with the IRS. However, since the IRS will not pay the credit card discount fee, you will have to pay it and pay the higher credit card interest rates.
• Installment Agreement –If you owe the IRS $50,000 or less, you may qualify for a streamlined installment agreement where you can make monthly payments for up to six years. You will still be subject to the late payment penalty, but it will be reduced by half. Interest will also be charged at the current rate, and there is a user fee to set up the payment plan. In making the agreement, a taxpayer agrees to keep all future years’ tax obligations current. If the taxpayer does not make payments on time or has an outstanding past due amount in a future year, they will be in default of their agreement and the IRS has the option of taking enforcement actions to collect the entire amount owed. Taxpayers seeking installment agreements exceeding $50,000 will need to validate their financial condition and need for an installment agreement by providing the IRS with a Collection Information Statement (financial statements). Taxpayers may also pay down their balance due to $50,000 or less to take advantage of the streamlined option.
  • Tap a Retirement Account – This is possibly the worst option for obtaining funds to pay your taxes because you are jeopardizing your retirement and the distributions are generally taxable at your highest bracket, which adds more taxes to your existing problem. In addition, if you are under age
    59^½, the withdrawal is also subject to a 10% early withdrawal penalty that compounds the problem even further.

Whatever you decide, don’t just ignore your tax liability because that is the worst thing you can do. Please call our office for assistance.