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The first week of tax season is in the books as I write this. Most tax seasons bring the same problems with a few notable new ways to mess up a tax return. New employees frequently bring bad habits from previous jobs we work hard to break. A new CPA in my office has reminded me how important it is to address problems quickly.
Communication between accountants in the office and with clients can either make or break the client relationship. Clients will ask for things that will really harm them in the end. Today I want to address two areas of concern: injured spouse and deductions (business and personal).
All too often a client wants an immediate benefit without regard for the future. The most difficult task in training new employees is to get them to think about the effects on all tax returns affected. Clients generally get it when I explain it to them. For some reason the tax pros want to tenaciously hang onto the old destructive habits.
A quick definition: An injured spouse is where one spouse owes back taxes or child support and the other does not. As a result the refund will be seized by the IRS to satisfy the child support arrears or the state or federal back taxes owed. To protect the spouse not responsible for the payments, the injured spouse can file for relief (receive their portion of the refund on a joint tax return). You can even marry into such a situation.
The rules for injured spouse are complex and not the focus of this post. Instead, I want to focus on why it may be harmful to claim injured spouse even if you qualify.
To make this easier I will assume our hypothetical married couple is exactly equal in every regard: both have exactly the same income, deductions, credits, etc. This should result in half the refund due to each.
Our injured spouse is married to a man in arrears on his child support or owes back taxes from before they were married. The IRS will take the entire refund unless injured spouse relief is requested. The question is: Should the injured spouse file for relief and get her half of the refund?
I argue the injured spouse should NOT file for relief in most cases. If the couple is headed for divorce or are separated it is probably a good idea to request relief and get half of the refund for the injured spouse. For a happily married couple, injured spouse relief harms the finances of the household. By taking the partial refund interest and penalties continue accruing (interest and penalties do not accrue on money no longer owed). By claiming relief and getting half the refund, the debt is larger. Over time, the wealth of our married couple is less because they delayed payment of the debt. This can be significant. If the issue is back taxes, interest and penalties can reach and even exceed 18%. And you owe it to the world’s largest debt collector, the IRS (or state taxing authority). Back taxes/child support will probably result in a wage garnishment at some point. The household will have less money (wealth) in the end due to the additional fees!
Injured spouse relief should not be automatic for tax preparers or taxpayers. Too many tax professionals get it wrong. You must have a long and hard talk with your tax pro (and with your spouse) before deciding what is best for you. If you prepare your own taxes you still need to have the same long talk with your spouse.
Individuals can use the information/philosophy in this section when considering charitable deductions and the timing of property tax and estimated tax payments. I will write more about those issues in the future. Today I want to focus on a bigger deduction affecting small businesses and rental property owners.
Have you seen the ads out there claiming to review your tax return and get you more money back? Some of these companies charge you a portion of the refund from an amended return they file. This can be a really bad idea. Remember the old adage: figures don’t lie, but liars figure. A bigger refund today can cost you significant future wealth.
Businesses and rental property owners have several options when improving a property or buying a depreciable asset. For most people, getting the biggest refund/lowest tax liability now is the right choice. In some instances it can cause an over 100% increase in your tax bill the following year. I call that a stiff loan. The facts and circumstances determine the correct course of action.
Let’s say you bought a $100,000 piece of equipment for your business. A small business can depreciate the asset, write-off the entire asset under Section 179 (with limitations), or use bonus depreciation (if it exists when you read this). Landlords cannot use Section 179. If the business has a profit, writing off the asset as fast as possible is the way to go. In some cases the repair regulations could allow for faster write-off as well. More in a future post.
A $100,000 piece of equipment with a 5-year class life will generate $20,000 in depreciation the first year. The remaining $80,000 will be claimed in future years. If you choose to claim the entire $100,000 you should consider you tax bracket. Will the full deduction reduce your tax bracket? Will you pay taxes at a higher rate the following year/s if you take the full deduction today?
When accelerating deductions it is important to consider all years affected. A small Schedule C business could reduce the current year tax liability, even creating a loss to be used against other non-business income, taxed at a lower rate. Remember, with a sole proprietorship you pay self employment taxes on business profits. If you accelerate depreciation items causing a loss for the business, you only save the income tax portion when the deduction is applied against other income, such as wages. When you return to a profit in following years you will pay income AND self employment taxes on the profit. In other words, you saved 15% (income tax bracket) and the next year pay 15% income tax on the gain AND 15.3% in self employment tax, effectively turning a deduction into a 100% interest rate loan.
Schedule C business has a $10,000 profit before depreciation and has $20,000 in first-year assets to depreciate. Assume 15% income tax bracket and $40,000 in wages, therefore, this taxpayer could claim the full accelerated depreciation without creating a net operating loss.
Regular depreciation: $4,000
Accelerated depreciation: $20,000
Choice one: accelerate depreciation.
$16,000 additional depreciation over regular depreciation. Business shows a $10,000 loss in year one only; no depreciation in future years.
$10,000 avoids SE tax = $1,530
$20,000 avoids income tax = $3,000
Choice two: Use regular depreciation only, $4000 per year (will use straight line for easier calculation).
Business never shows a loss. Instead, business shows a $6,000 gain each year.
$20,000 avoids SE tax = $3,060
$20,000 avoids income tax = $3,000
Because the accelerated depreciation causes a loss to the business, the additional SE taxes in years after year one increases the tax liability by $1,530. A wealthy accountant will forego the extra tax deduction in year one for the total tax benefit of $1,530.
You can see why communication between a tax professional and client is so important. The tax savings can get large fast. Taking a quick benefit can cost you significantly more in time. The same process can apply for charitable contribution or estimated tax payments, too.
Injured spouse relief can help in some situations, but can cause harm in others. Business planning requires consideration of all tax years involved.
Use this guide if you prepare your own tax return. If you have a business you should consider a tax professional. Not all tax pros are created equal. Just because they have letters after their name does not make them competent. CPAs are accounting professionals; attorneys are legal professionals; and EAs (enrolled agents) are tax professionals. All these professionals have a strong presence in the tax industry. Let’s forget about the unlicensed guys.
Question any tax pro you hire. If they can’t give straight answers, find someone else. Your retirement, including early retirement, is on the line. It is all about building wealth.
I accept a limited number of new clients per year in my office. I practice a quasi-retired lifestyle (for about 20 years now) and run a small tax office. If you have a unique or difficult tax situation, use the Contact page to send me a message. I generally do not answer specific questions due to time constraints. I’ll reply if I have an opening for a new client. Also, you are welcome to use my services for one year only to get you on the right course. Then you can go back to a local accountant or prepare on your own return with my template.
I understand this is a complex tax issue and probably not the wisest choice to start this blog since I want to focus more on lifestyle (living life right) rather than bog down in deep tax issues. However, it is important to minimize taxes to build net worth. The tax code can help you retire early and live better in retirement. It is really about having the freedom to spend more time with family and doing the things you want.