FEDERAL INCOME TAX LAW ADVICE
PART 2
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I have a national tax advice consulting practice. I charge $150/hour for tax advice, tax research, and problem resolution.
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ANSWER: The IRC allows for the exclusion of income paid as alimony to another person. The client's problem in this case is that he made maintenance payments that were not part of any court-ordered alimony. The IRS would not interpret alimony broadly to include payments to an ex-spouse prior to divorce. The client could have resolved this problem by having the ex-wife agree to allow him to exclude that income on his return in exchange for her declaring the income and paying taxes on it. However, no such agreement was ever reached. In addition, the payments are complicated by the fact that he paid for a mortgage directly to a bank and for insuranc premiums directly to an insurance company, rather than making checks payable to his ex-wife. These payments make it appear to be more of an ongoing bargain that formed the basis for the final divorce, rather than as agreed upon "pre-alimony" payments.
I recommended that the client, if he insisted on trying to find some way of getting back these taxes, go back into his state court that granted him a divorce and seek a court order declaring that he can exclude the nine months of payments made to the wife, and the wife must report that as income on her return. However, I told him that he stands less than a 25% chance of success on this motion. The wife would be hit by surprise by his request and would not have a pile of money stored away to pay the taxes. She could argue that she was more generous with him in the divorce, because he paid the mortgage and insurance and other payments. If she had to pay taxes on that support then she would have bargained for a tougher divorce on him. Also, she can argue that if the tax treatment of the income was important to him, he or his lawyer should have brought that up during the divorce settlement. It is too late now to go back and disturb the divorce. In any event, if a state court orders the income exclusion and declaration, the IRS typically assumes the state court has weighed the equities and decided upon a fair distribution of income. It would then refund the taxes overpaid by the ex-husband and seek payment from the ex-wife on an amended tax return.
Mike Guth
Tax Advisor
QUESTION 6: My 80 yr old mother-in-laws family trust (she is sole survivor, I handle the trust and personal tax under her Social Security number. Only one business property with $750 per month income, her Soc Sec income, and some interest from stocks / bonds) is in the process of selling its business property rental for $525k (before realors fees, repairs for clossing.). It was purchased in 1965 for $45k (plus some closing costs).
Her 2007 income will Soc Sec (less than $25,000), and resulting from the sale, well invest the proceeds in a CD for total interest income of aprox $25k.
Question, it appears we will have aprox $440,000 in capital gains for 2007. What should we project for 2007 Fed and 2007 Ca State state consequences of this sale? Thanks
ANSWER:I can only address the federal income tax portion of your question. I am not familiar with California's tax code provisions, but I assume they would follow the federal model.
Under the facts stated, you anticipate that you will have approximately $440,000 in capital gains from the sale of business property. You should use Form 4797 to report the income from the sale of this property, and follow the instructions for that Form to learn more about the tax treatment of the capital gains. It will be added to your mother-in-law's Schedule D under long-term capital gains filed with her 1040 form.
The tax treatment of long-term gains is somewhat complicated, and depends on the taxpayer's income. Long-term gains are taxed at 5% if the taxpayer is in the 10% or 15% federal tax brackets (for tax year 2004, up to about $58K for married filing jointly, and less for others). Long-term gains are taxed at 15% if your mother-in-law falls in one of the higher income-tax brackets (e.g., 25%, 28%, and so on). The long-term gains are included when figuring out your bracket. However, the 5%/15% rate doesn't apply to all long-term gains. Long-term gains on collectibles, some types of restricted stock, and certain other assets are instead subject to a different rate, which may be as high as 28%. And certain kinds of real estate depreciation recapture are taxed no higher than 25%.
Based on the facts given, you did not mention that this business rental property has been depreciated over the years. If it has, the capital gains of $440,000 will be taxed at a marginal rate of 25%. If the property has not been depreciated, then it appears it will be taxed at the 15% marginal rate for long term capital gains.
Mike Guth
Federal Income Tax Advisor
QUESTION 7: I am an insurance broker. My wife worked for me last year while she was studying for her insurance license which she received in September. She did filing, office supply procural, accounting, accounts payable, getting the mail, etc. We want to write off our daughters childcare and my wifes car. I did not have her on payroll nor did I pay her. I did not know the rules. Now that she has her license and is selling insurance its not an issue this year. But we need the writeoffs for last year. Do we have until April 15th 2007 to pay her a salary for 2006 and thus get her car written off and the childcare? Is there another way to legitimately write these off at this time? We did the same thing in 2005, but she was not on payroll then. Maybe to late to do anything then.
ANSWER: If you wanted to deduct the expense of paying your wife a salary, then you had to make actual payments to her in 2006. You would have had to have filed a W-2 information return with the IRS showing payments made and FICA taxes withheld from her pay.
You have not provided any facts that would suggest your wife's car or daycare expenses were in any way related to your insurance business. The IRS has aggressively litigated and won court cases in which the agency challenged the lack of "busines purpose test" applied to the deducted expense. It seems to me that you are treading on dangerous ground by seeking to save on taxes for ordinary living expenses. The IRS assumes people need a car to commute to work and get groceries, etc. Such ordinary expenses of living are not deductible.
For 2007, you are going to run into trouble trying to deduct your wife's car. You cannot simply expense the car payments, unless that car is used 100% for business, and all other personal mileage is done on another car. Even if that were the case, the IRS requires you to keep a written record of each trip made and the exact mileage of each trip and the business purpose of the trip. It sounds like you have inadequate record keeping to take a vehicle deduction in 2007, but you may be able to set up records for the calendar year if you have some way of proving what business trips were made with her vehicle.
You need to investigate IRS Publication 535 BUSINESS EXPENSES, and Publication 583 STARTING A BUSINESS AND KEEPING RECORDS. There are a variety of ways to deduct daycare expenses -- whether you own a business or not. Daycare expense could be an employee fringe benefit. It could be expensed through a flexible savings account. You can also receive a TAX CREDIT (much better than a deduction) on line 48 of the 1040 form for child care expenses. You will have to file Form 2441 to receive the credit. For any vehicle expenses, you will have to file Form 4562 and attach it to your 1040 annual return.
Mike Guth
Federal Income Tax Advisor
QUESTION 8: I cashed out a 401k in August 2006 for $45,000 and had to have them take out 10% in taxes at that time. When I went into TurboTax to do my taxes and input the info from my 1099-r as well as all my deductions (property tax, etc), it came back that I owed $4013 to Federal and $2983 to State. Totalling $6996 which is more than I have. I also have to pay property taxes (which are KILLING me) on my condo which is $1784.92 on 4/10. So Im in a world of hurt right now and I am looking for any help I can get. I also need to talk to someone about any way I can reduce the property taxes I have to pay each year. I am just being killed every 6 months and I need to get this under control.
ANSWER:
When you made an early withdrawal of funds from your 401K plan, your 401K Plan Administrator withheld 10% of your proceeds as the IRS penalty for early withdrawal of your funds. That early withdrawal penalty of 10% is separate from paying federal income taxes on the $40,000 remainder of your 401K plan. If you are taxed at the 10% bracket, then $4013 sounds about right for this additional income you received.
You should have realized that the 401K money was contributed with pre-tax dollars, so you would have to pay income taxes on your subsequent withdrawals. But I won't lecture you after the fact. Instead, I suggest you contact the IRS and explain you lack funds to pay all these taxes at once. The IRS is HAPPY to negotiate a payment plan with you, because they do this with thousands of other taxpayers.
The IRS would much prefer to have someone make payments on a tax debt than to ignore the debt completely.
Your state income tax and property tax issues are beyond the scope of my federal income tax advice. However, like most people who live in CA, you are finding that you are being eaten alive with the high cost of living there all stemming from the inflated real estate prices (and inflated taxable values of those properties). Abbot Labs has a large presence north of Chicago. You may have to trade off colder weather for a cheaper cost of living.
QUESTION 9: The client deposited $4,000 into a Roth IRA in 2005 in the first part of the year. He then got married and decided to file an income tax return as "Married, Filing Separately." That filing status automatically disqualified his Roth IRA contribution. He contacted the account administrator and requested that the deposit be refunded to him. The administrator sent him back the $4,000 contribution and also sent him a 1099-R for 2006. The client is wondering if he needs to file an amended return for tax year 2005 and where to report the 1099-R income.
ANSWER: The client deposited funds to his IRA Roth account using after-tax dollars. Accordingly, when he received his $4,000 back, he did not have to declare this as income, because he had already paid tax on it. Thus, he will not have to file a 1040X Form (Amended Return) for 2005. The interest income shown on the 1099-R form for 2006 should be reported on Line 16(b) (pension income) on his Year 2006 1040 Form. With that, everything will be properly reported and paid.
QUESTION 10: The client's wife works as a physician for a hospital. She is apparently employed as an "employee" of a medical group, but the hospital considers her as an independent contractor. For 2006, she earned approximately $93,000. She has received both a W-2 form from the medical group as well as a 1099-MISC form from the hospital for this same income. Her husband contacted me and tried to convince me that there were no errors, and this procedure is how physician income is reported to the IRS. In addition, the hospital is going to repay the physician's educational loans, but they are obligated to pay back this loan from the hospital unless she works there a certain number of years.
ANALYSIS: I advised the husband that it is improper and illegal for an employer to report income as both W-2 wages and 1099 independent contractor earnings for the same service. A person can be either an employee or indep. contractor, but not both, in providing a particular service. As a result of the information returns reported for his wife, this couple will have to pay income tax on $93,000 x 2 = $186,000 for Tax Year 2006, even though she only received $93,000 in compensation.
The rather obvious error here is that the hospital paid $93,000 to the medical services group, which in turn released $93,000 to the physician as wage income. However, the hospital did not report the $93,000 payment to the medical services group but instead filed an information return with the IRS that implied it separately paid his wife $93,000.
The husband thought there was some federal regulation that allows physicians to cancel out income from one form (W-2) as against another (1099). I told him that both forms are used to report positive income to the IRS, neither is negative, and the IRS is expecting taxes to be paid on $186,000 unless he obtains a corrected 1099 form for his wife.
He thanked me for the advice, but he remains convinced both W-2 and 1099 forms are correct, and he is not going to pursue a corrected 1099 form from the hospital. In that case, the IRS will likely flag his married-filing jointly income tax return, because he is going to try to cancel out income reported as wage income from the income reported as business income on the 1099 form. The business income will be declared on Schedule C, and there is no line there to exclude income that was previously reported as wage income on the 1040 form.
I gave this client my best tax advice, but if he does not want to obtain a corrected 1099 form, then he will have to explain to the IRS why he did not pay taxes on the $186,000 reported income. QUESTION 11: The client just began trading in the stock market in 2006. He called to ask if the various brokerage fees and exchange fees and administrative fees are tax deductible.
ANSWER: Yes. All of the costs of earning investment income are deductible from those earnings. I explained that the brokerage firm had reported the net gains from proceeds of sales to the IRS using form 1099-B. These proceeds are to be reported in the column called "proceeds" on Schedule D of the 1040 form. However, from the proceeds, the taxpayer must subtract his basis. Each individual taxpayer must keep records to support his basis calculation. In this case, the client says he has all his records showing the fees he paid, although they are not organized yet. He will need to figure out exactly what fees he paid for each transaction and add those fees to his basis. Those fees, through the basis, get deducted from his reportable capital gain income.