A major tax bill late in the year followed by a bill of extenders February 9th and we have the perfect recipe for problems.
My initial reaction to the tax bill in December was that most of my clients would see some benefit since my clients tend towards the upper end of the income scale. I also have lower income and older clients who are not benefiting as I expected. Certain taxpayers are even seeing a tax increase, most notably, those with large unreimbursed employee business expenses like on-the-road sales people and rock band members.
The tax software used in my office estimates what the new tax rules will mean for clients if the rules applied to their 2017 return. This has been a powerful planning tool early in the tax season. But as an accountant I always look under the hood and when I did found a disturbing problem.
From Joy to Tears
Taxes cause pain in two ways. First, the actual tax dings the household budget. Second, if not properly prepared for the changes, the timing of when the remaining taxes are paid can cause exquisite pain.
Adding to the mess, the IRS didn’t have time to update withholding tables until the end of January. Most clients didn’t see a change in their paycheck reflecting the new tax law until their first paycheck in February.
Also problematic is the issue of exemptions. For this calendar year personal exemptions are eliminated while the standard deduction is increased. As expected, this change was a big yawn for most clients. A few were able to capitalize on this particular change.
Without exemptions it is harder for the IRS to estimate the tax liability of household size. Yes, the child tax credit has been increased and the phase-out level pushed higher, but the age of the child and if they attend college now plays a bigger role than in the past.
Late January and early February tax returns delivered in my office presented our estimate of how the tax change will affect the client. A few people saw a tax increase, but most had either a small change or a larger refund.
One thing bothered me as we shared the news. I worried how the updated withholding tables would affect my results. I warned clients my estimate assumed everything was exactly the same as their 2017 return when we know the updated withholding tables would mess with my estimate.
Now that we are on the backside of February and most clients picking up in the last week have seen a paycheck with the new withholding, I can ask an additional question: How much did your paycheck change with the new withholding?
I expected a modest adjustment to my software’s estimate. What I got made me light-headed.
Every single client I met in the last week or so with a new withholding amount is under withholding by a large margin! People expecting a $3,000 reduction in their tax bill are seeing a $4,000 or more reduction in withholding. Clients who already owe money or like to keep it close to breakeven are in for a rude surprise if I don’t intervene.
An Imperfect Solution
I have a solution to fix the problem, but it entails a lot of screwing around. You can either reduce your exemptions on your W-4 or fill in an extra amount to be withheld each pay period above the withholding table amounts.
Unfortunately, most people don’t have a clue what is about to hit them. If their accountant doesn’t figure this out fast they will be steamrolled next tax season when the miscalculation bites. DIYers are at greatest risk as they tend to believe what the computer tells them. Computers are great for grunt level computing in preparing a tax return, but ill equipped to fix this new problem.
Here is what I consider the only appropriate option. When tax season is over you need to speak with a tax professional that is willing to crunch the numbers by hand to adjust for the tax and withholding changes. There is no other way.
My guess is online programs will become available as the year goes on. It still requires taxpayers to understand they even have a problem.
A Busy Off Tax Season
Tax professionals will be busy this year. I can’t imagine 140 million people are going to show up at the tax office this summer. First, many tax offices close or have reduced staff over the summer, and second, tax offices will focus on their regular clients if they address the issue at all. About half of taxpayers prepare their own return. Next spring, after the mid-term elections, taxpayer will have a hangover from the antics of Congress and the IRS. The reduced refunds and increased balance dues could chill the economy. (At least the guys who created the mess got re-elected. Man, if they lost their cushy government jobs they’d be unemployable, except as lobbyists.)
Your favorite accountant already has a plan. Originally I planned on reviewing all returns in my office with a business or income property. If we find an issue we’d give the client call to set up a meeting. This has been expanded to all clients! I estimate I’ll communicate with 600-700 clients over the summer out of a book approaching 1,000.
Readers of this blog will also feel uneasy as my discovery is copied by other news outlets. (Note to news outlets: Let your readers know where you learned this nugget of information as a gift to a wayward accountant from Backwoods, Wisconsin.) My regular clients have preference. Openings in my schedule are available to non-clients. That means most of you, kind readers.
It’s nothing personal. I have to focus my time as it will be at a premium this year. The amount of tax planning necessary this year will trump (pun intended) anything I’ve experienced in my 36 year career. The business income deduction alone would be enough for a comfortably busy summer. All these extra issues will overwhelm any tax office brave enough to remain open after April 17th.
I’m not bailing on you guys! Normally I block one day per week for consulting. This year I will open two days per week with the option some weeks for a third day. Keep in mind consulting takes prep work before we speak. I need to see your 2017 return and any expected changes.
To make this work will require specialized training in my office so I’m not a lone soldier. As a lone wolf I’d never make it through my client list, not even considering even one non-client from my list of awesome readers.
Late April will be a recovery period as I train and take some time with family. Clients reading this can set a summer appointment already. Some have. Clients picking up from now to the end of tax season will be reviewed for a summer appointment.
From May 1st on it will be full speed forward with consulting and tax planning. Clients with a business and landlords really need to make it a priority to see me this summer or fall.
How Much of My Tax Savings are Going to You, Mister Accountant?
And then we get to fees. In my office I will charge a flat $50 for clients to have their withholding reviewed. Before you pay me a cent (or I do a stitch of work) I’ll pull up your file to determine if a review is warranted. If it makes sense for me to review your records I will. If it is obvious you don’t have a tax issue I’ll inform you so you can save fifty bucks. Retired persons and those with low income generally fall into this group.
Businesses and landlords all require a review this year no matter what! There are too many additional moving parts to abscond a detailed review. My hourly fee will apply. I doubt anyone will lose on the deal as the advantages this year will far exceed anything you pay me (or most other accountants).
All non-client reviews are based on my hourly rate of $275 per hour. Regular clients have an advantage since I already know their tax situation and have their return on file. I need more review time with non-clients to acquaint myself with their tax situation.
I encourage you to begin a dialog with a tax professional early this year due to higher demand on their services. Your withholding is almost certainly wrong and to the government’s benefit. If you never consulted with a tax pro this is the one year you might want to consider it anyway.
I can see all your hands up. Yes, I will handle as many as humanly possible. However, I have a strong feeling my larger public presence will crimp the percentage of non-clients I can accept compared to demand.
The forum on this blog and Mr. Money Mustache are a great resource if you don’t have a tax professional on speed dial. I also expect many local accounting firms to add hours to handle the extra consulting this year.
There is no question the tax code is massive. No matter how knowledgeable or experienced you are, mistakes will happen. The consequences of such mistakes can be minor or they can cost serious amounts of additional tax, interest and penalties.
Filing an amended return is your only option after the due date, including extensions. An amended return solves most problems. Interest and penalties may apply. In some cases even an amended return can’t fix an error; you could lose entire deductions forever.
The number of elections available is large. Some are irrevocable. Making, or failing to make, an election is set in stone in some cases with the original return. Failure to check one little box can cost you a large deduction permanently.
A superseding return may be the only option if you file it on time.
Amended or Superseding Return
A superseding tax return incorporates the new information into the original tax return if filed by the due date, including extensions.
A superseding return is filed after a subsequent return and before the due date, plus extensions. (That was worth repeating.) The second return is a superseding return. A superseding return it generally treated as the original return, incorporating the new information and modifying (superseding) the earlier return.
Here is a small example where a superseding return is valuable tool.
A common error involves the Section 1.263(a)-1(f) de minimis safe harbor election. Most tax professionals (and readers of this blog) know they can deduct assets up to $2,500 rather than depreciate these expenses over a number of years if they make the appropriate election. The election is required every year. (The IRS says the election must be made “timely”. I take this to mean the election must be made on an original return filed by the due date, plus extensions. A late filed return may not allow the election.) The election is irrevocable.
In my office we automatically make this election for all returns with rental properties or a small business. (All corporate and partnerships returns also automatically get the election.)
Making the safe harbor election covers items a client may have neglected to inform the tax preparer of. If the election is made and not necessary, no harm done. If the election is necessary and forgotten, serious potential harm exists.
The IRS is less than clear when it comes to superseding returns. Corporations (S-corps, too) have a nifty box to check when e-filing a superseding return. Only corporations can electronically file a superseding return. Be sure to check the appropriate box or the IRS will probably reject the return as duplicate.
There are IRS instructions on when a superseding return must be filed on an individual income tax return. Unfortunately there are no instructions how to do it!
Superseding personal returns MUST be paper filed. Some tax professionals prefer filing a superseding personal return in the format of an original return and writing “SUPERSEDING RETURN” across the top of the first page. Because this will probably be flagged as a duplicate return another method is advised.
A superseding personal return should be prepared as an amended return on Form 1040X. (There is no superseding box to check.) All amended personal returns filed before the due date, including extensions, are automatically treated as superseding, incorporating the new data and modifying the original return. This means a forgotten irrevocable election CAN be made and is treated as if made on the originally filed return.
If a superseding return is filed before the due date (without consideration for extensions) interest and penalties are also avoided.
Amended returns filed after the due date, including extensions, are not incorporated into the original return. A required “timely” election is not allowed at this point.
In English, What Does This Mean?
The concept is short and simple, but often forgotten. A business owner may discover forgotten deductions for her business return when filing her personal return. The superseding return is a simple and fast solution for a previously filed corporate return. Add the new data, check the box marking the return as superseding and electronically file.
Individuals file an amended return for the same result, which must be mailed.
It sounds like a minor issue. When I review returns from outside my firm I need a powerful tool to make changes, especially when elections are involved. The tax code doesn’t automatically grant you preferred treatment. Special treatment must be requested in writing. Many elections are irrevocable. Many elections are required on an originally return filed by the due date, including extensions.
In English, filing an amended return before the due date (including extensions) on a personal return supersedes the originally filed return and solves most election issues. You can add a forgotten election if you catch it in time. Waiting for the IRS letter is too late. Consider the superseding return an amended return with a really tight due date, allowing you full sway in how the original return looks. It also eliminates or reduces interest and penalties.
It’s been an exciting week in the accounting world. The first full week of the traditional tax season is in the books with nine more left to go. As far as I can tell there have been no casualties.
Your favorite accountant is happy to report this is the smoothest tax season in years in his office. Three or four years ago I met Mr. Money Mustache and he put me on the map (Thank you, Pete!) it created a deluge of demand I was ill prepared to handle. The problem was I had no idea what I was getting into. Those problems seem to be fully resolved.
The added challenges nearly killed my practice. I had to learn new skills PDQ if I wanted to survive. Hiring more employees was a problem since nobody local had experience in what I was going through.
But, I am proud to say after several mental cramps I turned the corner. New policies and massive increases in technology have the office humming like a well oiled machine with stress reduced to a minimum. I’ll let you know if the psychosis returns.
Until then . . . I’m feeling much better now.
The smooth operation of our tax functions means I am still accepting new clients selectively. The bottleneck now is in processing the requests. To that end I hired a new team member to help with the follow-up of requests.
If you sent a request in the last few months without a response you should resend the request. Please include your phone number. Most do not. Amy will send an email with a follow-up phone call if we feel it’s a good fit.
The reason for the additional screening is to make sure it works for all parties involved. Sometimes expectations are different from what we can handle with our current structure. I’d rather discover early if there is a conflict or issues before we start. This is easier on both of us.
Don’t feel bad if you don’t get in. My team has managed to get things running smooth again after I overwhelmed the machinery. To keep it smooth we have to make sure we can do the job right.
Another Tax Bill
When you were looking the other way Congress passed another tax bill Friday. Yes, as in yesterday if you’re reading this the day I published.
The hoopla about the latest government shutdown was resolved with a major spending bill with lots of tax nuggets.
Here is why the spending bill is so important. The tax part of the bill retroactively renewed many expired tax provisions! This means many of the returns filed early are wrong!
The IRS is busting heinie to implement the changes. My software provider will update as soon as the IRS has their end fixed and ready to accept returns with the updates.
Here are some of the more common changes:
- Mortgage insurance premiums are back and will be the number one reason we will need to amend.
- Discharged mortgage debt is excluded from income again.
- The provision to deduct education expenses (qualified tuition and related expenses) up to $4,000 above-the-line is restored.
The remainder of the thirty or so renewed provisions generally affect businesses.
Because the IRS will need time to implement these changes you either have to wait to file (including possible filing an extension) or filing now and amending later. It’s your call.
I kindly ask readers to spread the word on the DIY tax software offered by 1040.com. This is the same software I use in my office. If you use the link on this page it supports your favorite blog.
This is a project close to my heart and means a lot. Thank you for considering the option. Many returns also qualify for free-file.
Remember we have a drawing for two cash giveaways next week Wednesday. Details are available on the Where Am I page. Be sure to open those emails with the latest TWA post to win!
Now let’s have some fun!
What I’m Reading
Every year at this time I make myself a promise as I head to the office each day that I will take an hour or two to read. This year, as in past years, the promise is unfulfilled.
I still read some early in the morning and at night after writing if I can keep my eyes open. The weekends are nirvana!
This week I worked on a book in progress, but mostly read from The Daily Stoic by Ryan Holiday.
When I need to perform at my best I always look to my Stoic literature. If you don’t keep a copy of The Daily Stoic next to your bed you don’t know what you’re missing.
What I’m Watching
Just as time is tight for reading, time spent watching videos is also curtailed. As important as learning and relaxation are, tax season is a time when accountants sacrifice some of these hedonic pleasures.
SpaceX launched their Falcon Heavy Rocket this week and I watched it live from my desk. It was the coolest thing ever! Enjoy if you haven’t already.
I also watched a few videos in the vein of the selection provided here. Mysteries intrigue me even if they are somewhat contrived. Old stuff grabs my attention hard. Here we see mysterious monuments from around the world.
What I’m Listening To
My listening tastes turn unique during these intense times. I think you’ll enjoy Beethoven’s Symphony 7 selection. The calming sound emanated from my office more than once this week.
When the coffee started to wear off I got silly. Something to break up the classical sounds.
Finally, as you read this your favorite accountant is probably sleeping it off or reading voraciously with drool running from the left side of his mouth.
I’m also planning a special post for Monday. We have enjoyed p/e ratios in the upper teens, 20s and higher on the broad indexes for so long people forget it wasn’t that long ago when the S&P sported a single digit p/e ratio and the average stock in the index threw off over a 6% dividend yield with many sporting even higher payouts!
Monday we will discuss what would need to happen to go back to those days of the late 1970s and early 1980s and the late 1940s and early 1950s. It’s been a while since we enjoyed such a market. I promise an engaging read.
Won’t you join me.
Tax season is still early in the tooth but patterns are starting to emerge.
My software allows me to use current year data to estimate results based on the Tax Cuts and Jobs Act changes. With a couple hundred returns under the belt already the impact of the changes are mostly expected with a few surprises thrown in.
Since planning will be so important this year I wanted to share my findings. Please understand these are estimated results. Several factors are hard to nail down in these estimates as the accounting industry is still deciding how to handle certain issues and the IRS still has to write regulations interpreting the changes.
One of the biggest issues not accounted for is the business income deduction as it is adjusted for guaranteed payments to partners and reasonable compensation to S corporation owners. If you aren’t familiar with these terms you can still benefit from my early findings.
Some results were expected. High income taxpayers are doing rather well with the new rules. My original thought was the biggest benefits would go to those well up the tax bracket ladder.
That has been the case, but significant tax reductions are being felt by those down to $100,000 of income and even lower!
My reading of the tax bill led me to believe lower income taxpayers wouldn’t benefit much. Eliminating personal exemptions while increasing the standard deduction was mostly a wash on the surface as the amounts generally offset.
The child tax credit enhancements are helping families with children. In the end, families in the upper middle class are doing well based on estimates.
The reason for this post is the unexpected results. Common knowledge on how the tax changes will affect taxpayers has been written about ad nauseam. There are plenty of surprises I do want to share.
As the first tax returns came in it started to look like the majority of clients would see nickels and dimes to their tax savings or additional tax next year. These early clients also tend to have very simple returns with lower income (at least for my client list).
My team and I review the expected changes with every client. We quickly discovered the tax savings frequently crawled lower down the income ladder. I personally find this a pleasant surprise. If a tax cut is going to work you need to give the break to those who will spend it. People like me only add it to the investment heap without helping the nation’s economy much.
Eliminating personal exemptions and replacing it with a higher standard deduction didn’t hurt as much as feared, especially if children are involved. Households without children are seeing minor changes unless their income is higher where they benefit from the lower tax brackets and longer time spent in lower brackets.
Retired clients were expected to see modest adjustments. However, because many retired persons can control their income stream somewhat due to timing of withdrawals from retirement accounts, they can react to the changes and plan for an overall lower tax liability.
The most unexpected result was the percentage of clients who will see a tax reduction. My client base is not a typical cross-section of the country. Low income taxpayers generally seek a different type of tax professional.
Of those facing a higher tax liability the numbers can be large. Most tax increases are nominal, but a few are significant. The worst part is I can’t tell you what to look out for. It always involves something unusual that affects the return negatively. All I can do is encourage a consultation with a tax professional after tax season. My guess is most taxpayers will find more value in a consulting session than they have for many years.
Two expected changes that turned unexpected are having a serious effect. Miscellaneous deductions on Schedule A, subject to 2% no longer apply in 2018 and after. These deductions had no affect for most taxpayers since the deductions in this category had to exceed 2% of adjusted gross income before it counted.
As a good accountant I studiously entered the information from clients even if I knew it wouldn’t count so they could see I didn’t miss it.
The things in the “subject to 2%” area of Schedule A include tax preparation fees, safe deposit box, union dues and specialty work clothes (uniform, safety glasses, steel tipped boots, et cetera). Most of these items are small enough not to change the amount itemized.
Certain education expenses fall into this category, too, along with certain legal fees from protecting or increasing taxable income.
But the biggest losers involve unreimbursed employee business expenses. Sales people top the list. I also have a rock band where equipment and travel not reimbursed by the band are no longer deductible.
Miles add up fast for traveling sales people. When I say traveling it usually involves local clients. Distant travel is more likely to be reimbursed by an employer.
There are a few planning tips. First, it’s best if the employer reimburses expenses. They’re not reported by the taxpayer receiving the reimbursement and deductible by the employer.
For the rock band and a few other clients I might recommend changing from an S corporation to a partnership. Before making this change it is vital to have your tax situation reviewed by a competent tax professional.
The reason for my recommendation to change to a partnership is that unreimbursed partnership expenses are fully deductible on page two of Schedule E and listed as UPE. The downside is the possibility of higher self-employment taxes.
The final Schedule A issue relates to the limitation on the so-called SALT (state and local taxes) deduction. In 2018 and after the SALT deductions are limited to $10,000. Most people assumed this only affected high income taxpayers from high tax states. Think again.
I have several clients from low tax states facing the cap. One Texas client saw a reduced estimated deduction because real estate and sales taxes pushed him above $10,000. And Texas doesn’t have an income tax!
The more returns my office prepares the more I’m convinced clients will need to sit with me this summer and plan. You, kind readers, need to do the same.
I’m setting some appointments already. Due to the demands tax professionals will face this summer I recommend setting an appointment early. My office will accept consulting sessions from the beginning of May until the end of December. (The two weeks after the due date are for “me” time.)
One more thing before you prepare for the weekend.
There is a lot of confusion about the ACA (Obamacare) penalty for not having health insurance. The penalty applies for the current 2017 tax return being filed AND the 2018 return. The healthcare coverage penalty disappears in 2019!
My advice is plan. Of all years, this will be the one that gives you more bang for the buck than you’ve enjoyed for a long time.
Now go and have some fun. See y’all tomorrow for Stalking the Accountant.
Recent tax law changes have gutted many itemized deductions. State and local taxes are limited starting with tax year 2018. What many people are forgetting is that certain miscellaneous deductions and job expenses are also no longer deductible.
Schedule A has suffered many changes. Miscellaneous deductions, subject to 2%, are eliminated. Common deductions in this area include tax preparation fees, safe deposit box fee, legal expenses to protect income, certain job related expenses and unreimbursed employee business expenses.
Most people paid no attention to this area of their tax return because most of these deductions are small even when added together. Since these deductions only count when the total exceeds 2% of AGI, most people received no deduction.
Certain taxpayers made heavy use of these deductions. It’s common for sales people to have large out-of-pocket expenses. Mileage and other travel expenses can add up fast. The only option for these taxpayers is to have the employer reimburse the expenses. The income received from the employer for reimbursed expenses is not reportable income if paid under an accountable plan where the taxpayer provides the employer with evidence of the expense (mileage logs, receipts, et cetera).
Exceptions to the Rule
Unreimbursed business expenses aren’t always claimed on Schedule A. Sometimes the deduction can be reported on page two of Schedule E.
Whereas, the only option remaining for regular employees is to have the expenses reimbursed (or the deduction is lost), small business owners have unique opportunities to claim (and benefit from) all business related expenses.
One-owner firms can easily deduct expenses on the business return since the single owner will want to have a policy of reimbursing all expenses paid for the business.
The problems begin when there are multiple owners.
Partnerships (or LLCs treated as partnerships for tax purposes) can have partners with an office in the home, phone expenses and mileage. These expenses are probably disproportionate among partners. One partner may work on the road in sales while another works from a home office and the remainder working at the company office building.
Partners can disagree as to the amount of deduction that should be reimbursed. One partner may feel the mileage rate is an added benefit to one particular partner since it could contain a non-cash deduction portion. The office in the home might cause friction between partners because the partner with the home office has a more expensive home.
In such situations the partner (if she is a general partner) can deduct unreimbursed expenses on page two of Schedule E. The deduction is reported and listed as “UPE”. Do NOT adjust the K-1. Report the K-1 information from the partner exactly as received. The UPE adjustment listed separately will reduce self-employment tax on Schedule SE automatically.
One final point. To deduct general partner unreimbursed expenses the partnership agreement MUST require these expenses be covered by the partner.
Confusion Accountant’s Sometimes Have with This
This summer a client came in off the street from another tax firm. They deducted expenses exactly as I outlined above with exception of the company reporting as an S corporation.
This does NOT work for regular or S corporations. Unreimbursed expenses, even from shareholders, are considered an unreimbursed “employee” business expense. This means no deduction for 2018 and after or until the tax code is changed allowing the deduction again.
The only way to solve this is to have the company reimburse the expense. The UPE adjustment outlined above is for partnerships ONLY!
For the new client the fix was easy since it was a sole-owner business.
What happened at the previous tax firm was the S corporation filed by the due date which is March 15th. The individual return was filed later, a normal occurrence since the business return has to filed first to file an accurate personal return. Additional expenses for the business were discovered after the S corporation was filed, but before the personal return was.
Rather than amend the S corporation return (the correct answer), the tax preparer took the deductions on page two of Schedule E. The IRS promptly disallowed the deduction. This brought the taxpayer to my office.
Since the company really reimbursed the expenses it was easily resolved with an amended return. If the error were discovered prior to the due date, plus valid extensions, a superseding return could have been filed. (I’ll have an article on superseding returns this tax season.)
My new client was lucky. He was able to deduct the entire amount through amended returns. However, it could have ended poorly if the circumstances were different.
Over the years I’ve acquired several rock bands as clients. Once a reasonable level of profitability is reached it usually makes sense for the band to organize as an S corporation, replacing the self-employment tax with FICA taxes on only the reasonable compensation of the owners with the rest of the profits avoiding FICA and SE taxes.
Band members frequently have unreimbursed out-of-pocket expenses, such as: mileage, meal per diems, hotels and repairs and maintenance of their instruments. Guitar players need strings periodically and drummers need new sticks.
Each player is usually responsible for their own instrument purchases. Musical instruments aren’t cheap! And now they can’t deduct the expense on Schedule A as they have in the past.
For bands and similar types of businesses the S corporation may no longer be the preferred method of organization.
Regular corporations pay a flat 21% tax now, while S corporations pass all the profits through to the shareholders where income taxes can rape the shareholder of as much as 29.6%! With the loss of unreimbursed expenses, the S corporation structure may prove, ah, taxing.
Deducting Unreimbursed Employee Business Expenses or Unreimbursed Partnership Expenses.For more information to reduce your taxes:https://wealthyaccountant.com/2018/01/29/how-to-deduct-unreimbursed-business-expenses-without-itemizing/
Posted by The Wealthy Accountant on Friday, November 30, 2018
The partnership has its place among business structures. The big issue with partnerships is general partners pay SE tax on all their proration of profits, plus guaranteed payments to the partner.
Since general partners are NOT employees, they don’t get a deduction for unreimbursed employee business expenses. And good thing! That avenue evaporated faster than morning mist.
But they do get to deduct unreimbursed partner expenses in full on page two of Schedule E!
Tax professionals have a perfect opportunity this year to earn their keep. More than ever the tax professional must review business client’s data for restructuring of their businesses.
The default for many years was to encourage our business clients to become S corporations (or LLCs treated as such) when profits reached a level where the savings would justify the additional cost.
This is no longer the case. The choice is more than sole proprietor or S corporation. Partnerships and regular corporations are real possibilities for our clients.
My office prepared fewer than 25 regular corporation and partnership returns combined in recent years. There is no doubt that will change this year!
An honest tax professional will review all the options and present them to her clients. We will prepare more partnership and C corporation returns in the next years than ever in my career.
To do any different would be malpractice.
It’s been a long time since we’ve seen such draconian tax changes. Tax professionals have become complacent in recent years with fewer new opportunities available to save clients money.
This all changed with the TAX CUTS AND JOBS ACT of 2017. This is our moment to shine, tax professionals. We can’t let the public down. We can, and must, do this.
Right, the first time.
Tax season is here with concerns about tax law changes effective this year while we still use the old rules for preparing the 2017 return. Several new tools are available to help you determine how the tax code changes will affect you.
Drake Software, the program I use in my office, has developed a Tax Planner incorporating the changes in the TAX CUTS AND JOBS ACT. If we prepare your return you will get a copy of this diagnostic automatically at no additional cost showing what your taxes would have been if the changes applied to 2017. No more guessing.
I am also officially opening my doors for additional tax clients! This is important. This summer will be busy as serious planning is needed for all taxpayers with rental properties or business income. Past advice is out the window as new rules mean new advice! Some people will need to consider different entity structures to take advantage of the new rules. Regular clients will have first pick of consulting sessions. If slots are available after serving clients I will open the doors for non-clients. I’ll keep you informed.
If you prepare your own return you should consider Drake’s DIY program with the link below and in the right column. You will receive the same diagnostic tax professionals using Drake provide.
If your tax professional uses software without an effective planner or you prepare your own return outside this blog you might consider the Tax Proposal Calculator offered by the Tax Policy Center. I’ve played with the calculator and find it helpful.
[After I published, Jeff from Maximum Cents (a blog you should consider reading) left a comment with a link to an even better tax calculator than I provided above.
This is what I love about the blogging community. Our group intelligence blows away anything I can do on my own. Thanks for sharing, Jeff.]
The stock market has been on a tear. Now is the time to consider monitoring your wealth building with Personal Capital. The easy money has been made with the massive market run-up. Having a plan and clear visual of where you stand financially is a powerful resource. Clicking the image below takes you to Personal Capital. Remember, you can’t manage what you don’t know.
Concerns over the market also have people thinking about different places to invest their money. Lending Club and Prosper were a great alternative until issues arose a year or so ago. I’m currently withdrawing all my funds from Lending Club and Prosper due to the high level of risk compared to the declining returns. This is a slow process, but nearing the end.
A similar investing model backed by real estate is offered by Peer Street with comparable returns. Lending Club and Prosper are unsecured loans with a higher level of risk. Peer Street isn’t a perfect answer, but certainly a consideration for a limited percentage of your portfolio. Clicking the image below takes you to Peer Street. Kick the tires and let us know what you think in the comments.
Student loans came up in the comments this week. Debt is the number one enemy of wealth and student loans are structured with serious risks to the borrower. I’ve pasted a link below to SoFi. At the very minimum kick the tires. Before interest rates climb higher you want to get your loans under control.
Before we get to the fun stuff, remember next week is our drawing for $100! The drawing is open to all subscribers. Check the Where Am I page calendar for more drawing dates and details.
Now for the fun stuff to enjoy the rest of your weekend!
What I’m Reading
Richard Branson has made a name for himself doing business differently and having fun in the process. I bought several of his books a few weeks ago and cracked open The Virgin Way: If It’s Not Fun, It’s Not Worth Doing.
Richard’s style is different and it resonates with me. I fell in love with the FIRE community for their frugal ways. Early retirement always sounds nice, but retirement in its traditional form isn’t for me. Enter Sir Branson.
Branson convinced with his words and lifestyle you can have the best of both worlds: free time with family and doing the things you enjoy, plus keeping the business. He also provided me with ample evidence I need to listen more and better. I tend to talk too much. (If you’re reading this dad do not comment. We, ah, you can laugh about this at the card table.)
Branson has a refreshing style I enjoyed more than I originally thought. If you want a fun, entertaining and informative read, I recommend The Virgin Way.
What I’m Watching
Natural history and science are common threads in my viewing habits. My guess is you’ll enjoy as much as I did this YouTube video on how the Earth’s landmasses moved over millions of years. [240 million years ago to 250 million years in the future]
Professor Brian Cox is a favorite. In the video embedded below Cox explains The Biggest Threat to our Civilization.
All that serious talk requires balance with a humor piece. Jim Jefferies is a riot. His humor reminds me of George Carlin with an Australian accent. Here Jefferies explains the situation between North Korea and the U.S. Enjoy.
What I’m Listening to
Talking about Australia, here’s a song from Midnight Oil I listened to this week. [Beds are Burning]
Finally, I rarely listen to recent music releases. The following video of Somebody That I Used to Know played at the gym ad nauseam a while back and YouTube must have heard about it. Now I can’t get the darn tune outta my head. I’m passing the blessing on to you.
Enjoy your weekend, kind readers! Can’t wait to get back with you again Monday.
The latest tax cuts have sent the eight year old stock market rally on a steeper trajectory after 300% gains to date. Tax cuts and interest rate reductions have a habit of sparking market rallies, but only one has anything to do with value.
To understand why the market is rallying so hard you have to understand what people expect the corporate tax cuts to do. You also need to understand if these gains are based on real increases in value or only a mirage.
The corporate tax rate for regular corporations dropped from a top rate of 35% to a flat rate of 21%. For most corporations this means a 40% reduction in federal income taxes.
With all this extra money sticking around the corporate coffers there is ample reason to think this is really something to behold. The extra money can be used to retire debt, buy back stock, pay out dividends or invest for future growth.
But are these companies really worth more? Is there more value just because one expense will decrease for one year?
If a company is earning :
- $10.00 per share
before the tax reduction and if everything remains exactly the same will see a:
- $2.00 per share
increase in profits due to lower taxes, what value has been created?*
The company has $2 more per share in cash lying around and that does have value in a manner of speaking, but it’s not repeatable.
The corporation earns $10 per share in year one, $12 per share in year two and again $12 in year three even if the company is bloated and slow. Worse, incompetent management could spend the money on stupid stuff!
Our corporate illustration shows a company with 20% growth over a three year period, but only treaded water in reality. The tax cut makes it easier to hide problems for longer before it becomes apparent to shareholders they are getting screwed.
The Value of a Dollar
Shareholders might not care one iota as long as the money keeps rolling their way. The extra money the corporation enjoys from the tax cut can prop up the stock price if they buy back shares. Additional dividends also put a mischievous grin on the faces of shareholders.
Now think about this for a moment. How much is that $2 per share extra from tax savings worth?
The value of the cash is $2. Period. How much will you pay for the $2 of cash? No more than $2, I hope.
By looking at the stock market it appears as if investors are paying more than $2 for the $2 per share tax benefit!
The tax cut isn’t repeatable either! People wrongly think the tax cuts help the next year. It doesn’t! Earnings are now stuck at $12 per share instead of $10 unless there is real growth. There is no growth in our example. How much would you pay for $12 per share if there is no growth with the risk management screws it up and ruins a bad game to start with?
The value of those earnings is based on interest rates. If the risk-free interest rate (U.S. Treasuries) is 3%, then the value of the $12 of stagnant earnings is no more than $396 per share ($396 x 3% = ~$12). If the risk-free rate rises then the value of the future earnings declines.
So why is the market rallying so hard? Because the extra $2 times the risk-free rate translates into $60 or so!
The Bad News
Unfortunately interest rates are not static. They are currently rising at a slow rate. It can only be guessed what inflation (the ultimate factor driving interest rates) and interest rates will do in the foreseeable future.
With an economy near full employment and stimulated with massive tax cuts, my guess is rates will go higher. This means those earning are worth less. And that assumes the extra $2 goes to the owners (investors)!
In the early 1980s the top brass in corporate America earned about 30 times the wage of an average worker. That number now stands well into the 200s. With more cash than ever, corporate America might be seduced into skimming a bit for themselves. I’m not suggesting anything, only making an observation.
Dividends are real cash you can count in your paw. Stock buy-backs are a bit more elusive. Stock buy-backs can mask stock grants and options to insiders.
It is safe to say only a portion of the extra $2 per share in profits due to the tax cuts will actually find its way into shareholders’ pockets. Depending on how you look at it, that could be a blessing.
Creating Real Value
If tax cuts don’t create real value, what does?
As stated before, the quality of future earnings is based on the risk-free interest rate. If you can’t earn more than that, why bother. Just drop your money into the risk-free asset and enjoy a few Mai Ties on the beach.
We discussed in April 2016 how companies create true value. Now is a good time to revisit the issue before your money gets a value lesson of its own.
Tax cuts provide the opportunity to create value; they don’t in and of themselves create anything! If tax cuts are not fully spent and the government lowers spending to offset the lost revenue, the economy will actually decline. If the government keeps spending while reducing taxes they do so with borrowed money. Knowing this, tax cuts have the same stimulus as the government just spending extra money themselves.
And tax cuts have historically not been 100% spent by those receiving the cut. Some people reduce debt or invest some of the newfound wealth. And since tax cuts are only good for one cycle their benefits are fleeting unless you keep cutting taxes every year.
This doesn’t mean we shouldn’t have tax cuts. Heck, no! I love keeping more of my money!
What I’m getting at is this: your income hasn’t increased solely because your tax bracket declined! And once you digest the reduced taxes into your budget you’re going to look for a pay increase to keep feeling warm and fuzzy inside.
So how do you get a raise? Well, inflation can mask any “real” wage increase if it doesn’t exceed the inflation rate. Or, you can increase your productivity so the company has more profits for your labor from which to pay you. (Now you need the corporation to part with a percentage of those additional gains you generated. That hasn’t happened much over the last 30 years.)
If tax cuts don’t create real value, what does?
If the stock market rally is going to have real legs corporations will need to invest the tax savings in a productive way!
Corporate America has experienced record levels of profitability for some time now so the question begs to be asked: If they didn’t invest the extraordinary profits before, why will they be encouraged to do so now?
Good question. Wish I had an answer.
Personally, I don’t think corporations will increase investing anywhere near the levels of the tax break. We see headlines listing a token few major corporations granting a small 2% or so bonus to the rank and file for one year while announcing layoffs a few days later. (Kimberly-Clark announced 5,000 layoffs in their diaper division as I write. Tax cuts will not increase demand for things people don’t want. But automation, which the new tax bill encourages, will make human capital less necessary.)
Only businesses that invest the tax savings wisely will create real lasting value. By investing in increased production which yields more than the cost of capital, value is only realized.
The ROIC must exceed the COC or value is destroyed. Automation and technology make it easier than ever to do more with fewer people. This increases quality of life. But if the process is too quick it becomes a painful transition.
Now that most assets can be deducted currently versus being depreciating over a number of years or the life of the asset, businesses are incentivized more than ever to increase their use of technology and automation.
If these investments return more than the cost of capital, even capital derived from tax savings, real and lasting value is created.
And that will keep the stock market riding high, providing us with the warm and fuzzy feeling inside.
* I took liberty with the math for easier reading. A company at the top tax bracket of 35% under the old tax law would pay about $3.50 per share on $10 of profits before tax. Cutting their tax by 40% would not be $2 per share. (40% of $3.50 is $1.40.) In reality it would take ~ $16.67 of profits to pay ~ $6.67 in tax to arrive at $10 of reportable gains to shareholders. Rather than get bogged down in the math I kept it clean, as a family-oriented blog should be.
It started with a simple request for an update to my personal net worth.
Over the years I’ve been mum about the subject, only exposing myself due to the Rockstar Finance Net Worth Tracker. I’m still undecided about discussing my *exact* net worth publically. It’s really nobody’s business and is only public because I write a personal finance blog.
(As an example: Recently I was told point-blank if this blog failed it would be no big deal since I could always do something else and I’m already rich enough. This remark was a jab at the hopeful opportunity to watch something I enjoy crumble. If I really felt that way I would never have started the project.)
The reader kept the emails coming fast and furious when I dodged the net worth question. I had a duty, I was informed, to share my personal life — details and all — since I was a business owner and have a semi-successful blog.
There was a hint of humor beneath the requests so I delayed blocking said intruder. Eventually we started a civil dialog with some serious questions about the current tax law and how it might ripple through the economy.
A week ago I was working in the barn and began formulating a post using many of the questions my intruder asked. I worked myself into a frenzy until it started coming out as a rant. I went to the house and took notes on all the topics I wanted to cover.
So this is it. I promised my intruder a nice post covering a large portion of his questions he had surrounding the TAX CUT AND JOBS ACT. Some of this is tongue in cheek so don’t take this post as hard and fast predictions of the near future.
Then again, I do have a point.
Doubling the estate tax exemption is industrial strength stupid. All this worry about farmers and small businesses losing a lifetime of work due to estate taxes is the dumbest thing ever thrust upon the people.
With the old tax law only a few thousand estates were subject to the estate tax in any given year. Now even fewer will pay the tax.
You can count the farmers subject to the estate tax on your fingers with fingers left over! Some small businesses pay an estate tax, but even that is rare.
What the adjustment to the estate tax did was line the pockets of the uber-rich! Even this blog with a very wealthy readership will not have much to worry about when it comes to estate taxes!
It’s time to stop calling the estate tax a death tax. It’s not a death tax; it’s a welfare tax!!! We keep hearing politicians complain about welfare draining the public coffers. Well, the estate tax is the biggest welfare tax there is.
I see some raised eyebrows. Let me explain. The estate tax is not a death tax; it’s a welfare payment to all the people getting a free ride due to the genetic lottery.
I don’t care what they do to the estate tax personally, but stop calling it what it’s not!
No amount of tax cuts will offset the accelerating wealth accumulation at the top. As the top keeps more due to lower taxes there is less available to spread around to the middle class. The middle class pie gets smaller and smaller as the middle class gets squeezed like never before.
Tax cuts don’t trickle down. And stop with the politics. If trickle down worked it should have leveled some of the income inequality by now. Remember, President Reagan came up with the idea back in 1981.
Tax cuts can stimulate the economy, however, and have been used as a tool to spur the economic growth on a regular basis in the past.
The latest tax cut is a bit weird. Normally the government lowers taxes to encourage economic growth when the economy is sputtering or in recession. This time we spiked the Kool-Aid after six or seven years of modest economic growth.
Cutting taxes with unemployment at a 4-handle (unemployment is 4 point something percent) could actually harm the economy as interest rates and inflation could accelerate destroying any gains from the tax cuts.
Time will tell.
The labor participation rate will collapse if a technical corrections bill doesn’t fix the myriad problems with the latest tax bill. Savers will be able to exit the workforce faster and the FIRE (financial independence/retire early) movement will make it easier than ever for people to check out early, further exacerbating the labor shortage.
Also, the tax code now punishes added payroll expenses significantly since if you didn’t spend on payroll the extra profits are barely taxed (big corps) or you get 20% of profits as a deduction without spending a penny (small business and landlords).
There is no doubt in my mind any increase in the labor participation rate will be short-lived. Also, businesses are more incentivized than ever to lay off workers at the first hint of slower demand.
Automation is cheaper than ever with bonus depreciation increases. Include the 20% business income deduction and I foresee plenty of staff reductions.
The automation was coming regardless. Now we don’t have time to adjust as the changes will come faster. Once installed the jobs are gone forever.
Major corporations will benefit most as the cost benefit calculations will favor more automation up front. Wal-Mart is a perfect example recently announcing a few bonuses and a higher internal minimum wage while experimenting with over 200 of their stores by replacing all cashiers with automation. Total payroll expenses to Wal-Mart will probably fall. So much for their altruism.
Don’t be fooled by the token pay bonuses either. Many companies are giving a one-time $1,000 bonus to select staff. This is less than a 2% temporary pay increase. If you paid attention, many of these companies announced a few days later layoffs which will reduce payroll by more than the bonuses.
Big business and the very wealthy know exactly what they’re doing (to you).
Now we get to my net worth. Know this, your favorite accountant will do rather well in this environment. Complex tax laws are always good for people with tax knowledge and a pulse.
We came into this story talking about a certain someone’s net worth. Here I confess I might have adlibbed a bit. The issue was net worth, but more to the point, how much was I going to haul home with all the tobacco company shares I own?
It’s true I own a lot of shares in tobacco companies. Unfortunately only my Altria shares will benefit from the tax cuts. Foreign tobacco companies — Phillip Morris International in my case — will not see a benefit from U.S. tax rate reductions for corporations since they derive all their profits outside the U.S.
This led to a discussion on how many shares of Altria I own. Ah, a lot.
Let’s look at what Altria might do to my net worth. The tax reduction could increase their reported earnings by about $2 per share from the tax reduction alone. Assuming a 10 P/E ratio this will eventually be reflected in the stock price increasing $20 per share. Bad news, kind readers. A twenty dollar increase in MO’s share price will get me a bit more than two-thirds of a million only.
Altria also likes to distribute about 80% of profits to shareholders. Currently MO pays 66 cents per share per quarter or $2.64 annually. Eighty percent of an additional $2 profit increase due solely to tax reductions is $1.60 extra per share per year for me (my favorite person) in dividends.
Your favorite accountant expects the tax reduction for Altria to add a bit north of $50,000 per year to his pocket on top of the current dividend. Not bad for a broke farmer in 1982.
On December 26th my net worth crossed the $14 million mark. Here, less than a month later, I reached $15 million. It took 14 years to amass the first million (age 18 to 32). Now I’m bumping off a million in less than a month. I can’t wait for the day I can brag I lost a million between sunup and sundown!
I am sooooo smart! I doubt anyone has seen their net worth climb in the current environment.
(Okay, the last part is total BS. I didn’t add my stuff up the day after Christmas. A back of the envelope calculation says I’m getting close to $15 million, however. Yes, even your favorite accountant can’t resist looking as his stash when it’s growing so fast. I keep reminding myself, “This too shall end.”)
This tax cut is different than the 1981 cut. Inflation and unemployment were double digits back then; now we have inflation and interest rates near zero with a 4 and change unemployment rate. Dropping a line of crack will not solve a meth heads issues! Stimulating an economy after 7 – 8 years of modest growth with the labor force fully or nearly fully employed is asking for problems.
At least I’ll be okay. I’m not so sure about you.
I could offer solutions, but there are none I can think of. There will be pain a head. You might want to keep that job for a while and eliminate debt. (Always eliminate debt.) For a few years (as long as the economy holds) it will be easier than ever to build a significant net worth and retire early (if that’s your goal).
Don’t worry. The government will print and borrow enough money to fund the upcoming inflation tax.
This entire post is opinion, of course. Many of these questions have come up again and again so I feel it is easier addressing them here for everybody to enjoy, ahem.
If any of these predictions comes true I take full credit.
If I’m off, let it be known I was only predicting the future and we all know the best we can do is guess at the future.
(Note: The light-hearted nature of this post is due to the flu epidemic affecting the nation. Some people are down and out. Your favorite accountant has been only modestly lucky so far. Some days I feel great only to spend several days so tired and exhausted I can barely think. Since I’m writing at a down point I felt it best to leave the serious discussions for a day when my head doesn’t feel like a balloon. There are actually people who follow my advice! Best to assure the advice has a reasonable chance of being right.)