Posts Tagged ‘taxes’

Opportunity Funds: Deferred and Tax-Free Gains

An Opportunity Fund can defer or eliminate capital gains taxes. Keep more of your money. #wealthyaccountant #capitalgains #taxes #investments #opportunityfunds
Jump for joy! You get to keep more of your money. Reduce or eliminate capital gains taxes with an Opportunity Fund. #wealthyaccountant #taxes #capitalgains #profits #opportunityfunds

Jump for joy! You get to keep more of your money.

The Tax Cuts and Jobs Act of 2017 brought several new opportunities to reduce your tax burden. A few previous options have been reduced or eliminated. First the bad news.

Like-kind exchanges are now limited to real estate. Capital gains in real estate can be deferred into a replacement property if complicated tax rules are followed. The same cannot be said for business property any more.

The good news comes to us in what is known as §1400Z-2 and §1016(a)(38) as added or modified by the Act. This might sound like a mouthful, but once you understand the implications your mouth is sure to start salivating. In a language normal people understand this means ALL capital gains can be deferred with some gains even tax-free at some point. It also means future gains (for a limited time only as we’ll discuss shortly) can be completely tax-free!

Your favorite accountant has received multiple requests to cover these new Opportunity Funds and Zones in detail due to the conflicting and limited information published elsewhere. In this post we will dig deep into the subject, unveiling the nuances you can use to take a serious bite from your tax liability.

We will also use multiple examples to illustrate available options in utilizing Opportunity Funds.




The Basics

Opportunity Funds were created by the Act to encourage investment in economically disadvantaged areas of the country. To encourage investment in these areas Congress provided for zones that would have special tax advantages.

There are two major advantages when investing in Qualified Opportunity Funds:

  1. Tax deferral: Taxes on capital gains invested in a Qualified Opportunity Funds are deferred while the funds are invested in the Fund.
  2. Partial tax-free capital gains: Some of the capital gains deferred become tax-free in some instances (discussed later).
  3. Tax-free growth: Capital gains on investments in a Qualified Opportunity Fund become tax-free if held for 10 or more years.

Point 3 above comes with caveats we’ll discuss below. Deferred gains of the investment used to fund the Qualified Opportunity Fund need to be recognized on December 31, 2026 (or when the investment is sold, whichever comes first) even while the gains from the Fund investment continue deferring to the 10 year anniversary where they become effectively tax-free. Examples below should clarify.

An Opportunity Fund can defer or eliminate capital gains taxes. Keep more of your money. #wealthyaccountant #capitalgains #taxes #investments #opportunityfunds

An Opportunity Fund can defer or eliminate capital gains taxes. Keep more of your money.

You are allowed one temporary election to defer gain. In other words, you can use a portion or all of a gain to invest in a Qualified Opportunity Fund, deferring the gain, and the remainder is reported as gain with applicable taxes paid in the year realized.

You self-elect. Revenue may produce a new form to report this election which is attached to your tax return when you file. You have 180 days to invest the gains into a Qualified Opportunity Fund. The act of investing these gains into a Qualified Opportunity Fund within the 180 day window is your effective election.  You will probably have a simple election button to click on your tax software to report the deferral instead of an additional form to fill out. Be sure to track your Fund investments manually if you change accountants or switch tax software.

The 180 day window to invest includes weekends and holidays. The Act is unclear on this issue, but it seems to indicate 180 calendar days rather than 180 business days, even if the 180th day falls on a holiday or weekend. There is no extension of the 180 window to the next business day.

Only gains are involved. Like-kind exchanges use a complicated formula to determine the amount required to be invested in the replacement property. With Qualified Opportunity Funds only the gains need to invested.

Example: You buy a piece of land for $100,000 and sell it in 2018 for $250,000. Only $150,000 of the sale is required to be invested in a Qualified Opportunity Fund to defer taxation on the gain.

 

Issues

Before we dig down into the details you should note there are several issues with the Tax Cuts and Jobs Act. In at least one section of the Code there is a reference to another section which makes no sense. We are left to assume what Congress meant if a reconciliation bill doesn’t correct the errors. The IRS will eventually write regulations on the ambiguous issues with the Tax Court determining the actual nature of the issues in question.

Another issues involves the IRS. Revenue promised clarification by late summer. As of this writing the IRS has not provided the form for self-certifying for those wishing to start their own Fund or additional guidance on how to handle many of these issues. The tax profession is left to determine the procedures with the risk regulations and/or the Tax Court may later determine differently.

I will note where the ambiguous issues reside as we review examples below. Taxes by nature have similar issues. Using Qualified Opportunity Funds to defer capital gains is something to consider. Just understand some details may change in the near future. Of course, the Tax Code can be modified at any time so stay tuned for updates.




Tax Benefits

The tax benefits from investing in a Qualified Opportunity Fund are significant with a bonus benefit.

  • Any capital gains invested in a Qualified Opportunity Fund within 180 days of a realized capital gain is deferred until the investment is divested or December 31, 2026, whichever comes first. There is no limit on how much can be deferred. Caution!  While the 10 year rule is still in effect, the tax deferral benefit ends December 31, 2026 and the original capital gain will be reported as income minus the basis adjustment discussed next. You are still required to hold the Qualified Opportunity Fund investment 10 years to receive tax-free status on the Opportunity Fund investment.
  • Investments held in a Qualified Opportunity Fund for 5 years receives a 10% basis adjustment and a 15% basis adjustment for capital gains deferred into a Qualified Opportunity Fund for 7 years. Example: The wording of this tax benefit can be confusing. If you have an income property held for decades with the entire basis (except land) depreciated, the basis is rather low or even zero. However, for this adjustment we use the basis of the deferred capital gain. If $1 million of capital gain is deferred, $100,000 is added to basis after 5 years and $150,000 after 7 years, thereby reducing the deferred capital gain by 10 or 15 percent.
  • There is a 10 year rule when investing in a Qualified Opportunity Fund to receive tax-free treatment of the capital gains from the Fund. Do not confuse this with the original deferred capital gains. Example: Using the above example, assume an $800,000 capital gain while invested in the Qualified Opportunity Fund over a 10 year period. The original capital gain is reduced by the 15% basis adjustment and reported (if held 7 or more years) when divested or on the 2026 tax return for calendar year taxpayers. The additional $800,000 capital gain from the 10 years invested in the Fund become tax-free.
  • While the beauty of investing in Qualified Opportunity Funds involves the deferral of capital gains, there is nothing precluding someone from investing non-capital gains funds for 10 years to receive tax-free capital gains from the Fund. (Jake Drum, a reader, suggested the following edit: You will be able to contribute non-capital gain dollars to the Fund, but only the capital gains contributed will receive tax benefits. See his comment below with my response.)

 

Observations and Examples

The concept is simple in theory, but nothing in the Tax Cuts and Jobs Act is as simple as it seems. (A true statement of the entire tax code.) The details are important when such a long-term investment is required to receive tax benefits. Details of your personal situation can color the benefits of the program.

  • Only one election can be made per sale or exchange. However, a temporary election can be made and a permanent election made later. The temporary election is the one made from gains invested in a Qualified Opportunity Fund where gains are temporarily deferred and the permanent election is made when you the sell an investment in a Qualified Opportunity Fund.
  • Revenue will need to clarify the temporary and permanent election issues. It seems the one election limit prevents reinvestment of gains from the sale of a Qualified Opportunity Fund into another Fund.
  • It is possible the gains from an installment sale would be limited to one temporary election only. This would limit the value of an installment agreement if deferral is desired.
  • Section 1400Z-2(a)(1)(A) of the Code appears to be in error as it references the wrong section of the Code. There is a similar error in §1400Z-2(b)(1)
  • If your investment in the Qualified Opportunity Fund declines the FMV is used to compute the gain after the deferral period ends, allowing for a reduction in the reporting of the deferred gain on your tax return. This effectively reduces your original capital gain.

Example: You defer $100,000 of gain by investing the gain in a Qualified Opportunity Fund. The investment declines by $10,000 at the time of sale. The reported original gain is now $90,000 ($100,000 deferred gain minus the $10,000 loss in the Fund).

  • While nothing precludes an investment in a Qualified Opportunity Fund from non-gain sources, the basis of your investment in the Fund is zero with some exceptions. If the Fund is sold prior to the 10 year period all the sale price is considered gain. If you are considering an investment of non-gain funds you must be certain you will remain invested the entire 10 year period or your original investment will be taxed as well as the Fund investment profit.
  • The only adjustments to basis is a 10% addition to basis after holding the Fund investment for 5 years and 15% after 7 years.

Example: A deferred gain (or non-deferred gain if you choose to do so) is given basis at the 5 and 7 year mark. If you invest $100,000 in a Qualified Opportunity Fund the basis is zero during the first 5 years, less a day. At 5 years the basis would be adjusted to $10,000, and $15,000 at 7 years. It also appears this only applies to deferred gains when the temporary deferral period ends December 31, 2026 and recognition of gain is required. An actual sale of your Fund investment would cause a circular computation negating the basis gains.

  • If you invest gains and non-gains into a Qualified Opportunity Fund it is treated as two separate investments: deferred gains as one and other than gains invested as the other.

Example: You sell an asset with a $100,000 gain. You elect to defer $80,000 immediately by investing in a Qualified Opportunity Fund. Later you decide to invest the remaining $20,000 of the gain. Unfortunately, the one-election limit doesn’t allow deferral of the $20,000 portion on the Fund investment. The $20,000 does not qualify for deferral and must be included in income the year the gain was realized.

Example: Let’s go the other direction. You once again have a $100,000 gain. You instead invest $125,000 into a Fund. Only the $100,000 gain is deferred and considered one investment (the temporary election) and the additional $25,000 as another investment. This is true even if the investment was made in one combined sum.

  • Once again, the temporary deferral period will be different from the permanent exclusion period. Deferred gains (if held to December 31, 2026) are reported on your 2026 tax return while the exclusion period of the Fund gain will continue for 10 years which means most deferred gain will be reported as income prior to the exclusion gains becoming effective due to the 10 year investment requirement.

 

Risks

Qualified Opportunity Funds are new and must invest at least 90% of Fund assets in Qualified Zone property. Qualified Zone property is located in low-income areas of the U.S. These untested investments could suffer significant losses in an economic downturn. There is also the risk new Funds are operated by unseasoned professionals.

Serious levels of due diligence is required before and investment is made in any Qualified Opportunity Fund.




Investment Choices

Several Qualified Opportunity Funds have opened to date. Still, the choices available are lower than in many other asset classes. You can use a search engine to find Funds to invest in. The Fundrise Opportunity Fund is one such example of a Qualified Opportunity Fund.

Fundrise is not an affiliate nor affiliated with this blog, nor have I reviewed their portfolio. I make no claims as to the suitability of investing in Fundrise. It is advised you begin your search for a suitable Qualified Opportunity Fund as soon as possible. The 180 day investment window provides adequate time for in-depth review of Fund choices if you start early.

 

Starting Your Own Qualified Opportunity Fund

You can also start your own Fund to manage your deferred gains.

An Opportunity Fund could be a better choice over a like-kind exchange when it comes to how much money you keep after taxes. Learn the details here to keep more of your money. #wealthyaccountant #taxes #capitalgains #investments #oppoertunityfunds

An Opportunity Fund could be a better choice over a like-kind exchange when it comes to how much money you keep after taxes.

A Qualified Opportunity Fund must be a corporation or a partnership. (An LLC electing to be treated as such for tax purposes should pose no problem as it isn’t specified or excluded in the Code. An S corporation is not an option; only a regular corporation or partnership can be a Fund.)

 

Observation: A Fund can’t be organized for the purpose of investing in other Qualified Opportunity Funds. The IRS may provide future regs modifying this situation. As of this writing a Fund should not invest in another Fund.

 

Here is the best part of starting your own Qualified Opportunity Fund: you self-certify. Do you like that? The IRS will have a form by late summer (not yet available as of this writing) which you fill out and attach to your corporate or partnership return. It’s as simple as that.

 

Observation: Here is a map of the U.S. with all the Qualified Opportunity Zones listed. Starting your own Fund gives you some control over how your money is invested. However, you can only make investments in Qualified Opportunity Zones.  You will need to zoom in to see the actual Zones.

 

What can your Fund invest in? Investments must be tangible property used in trade or business of the taxpayer and meet these three requirements:

  1. The property was acquired after December 31, 2017 in a Qualified Opportunity Zone.
  2. Use begins with the Fund or the Fund substantially improves the property. Substantial improvements are defined as additions to basis for the property after acquisition during a 30-month period where the basis is increased by an amount greater than basis at the beginning of the 30-month period. Example: Property has a $100,000 basis at the beginning of the 30-month period. Substantial improvements would require additions to basis of greater than $100,000 by the end of the 30-month period.
  3. Substantially all the use of the property must be within a Qualified Opportunity Zone.

Intangible property is not a qualified investment for a Qualified Opportunity Fund; only tangible property counts.

If you are running your own Fund you cannot make an acquisition for your Fund from a related party. There also appears to be errors in the Code in regards to related party purchases by a Fund. These errors will not negate the related party prohibition.

Some investments within a Zone are also prohibited: golf courses, massage parlors, hot tub facilities, country clubs, suntan facilities, racetracks and other gambling business and liquor stores.

One final consideration if you plan on starting your own Qualified Opportunity Fund. There are penalties if the Fund has less than 90% of assets  invested in Qualified Opportunity Zones.

 

Final Comments

The IRS has answered some questions on the topic at hand. Keep in mind the IRS is not the final arbiter in these matters: the Tax Court is. You cannot use advise from the IRS as substantial authority. That is only gained from an enrolled agent, CPA, attorney, the Tax Code, Tax Court rulings and other qualified sources.

Turn capital gains taxes into a powerful tax-free income generating income machine. The ultimate in passive income: the Opportunity Fund! Stop paying taxes on gains today. Read more here. #wealthyaccountant #passiveincome #taxes #taxfree #tax #taxes #investments

Turn capital gains taxes into a powerful tax-free income generating income machine.

Deferring capital gains is easier than ever. While the like-kind exchange has been limited to real estate now, investing in a Qualified Opportunity Fund might be the best remaining option.

There is an argument where the like-kind exchange even for real estate might not always be the best choice. Investing gains in a Fund has more flexibility and liquidity in many cases. Coupled with the increases in basis and potential (if held for 10 years) of excluding all the gains from the Fund investment, a like-kind exchange is no longer an automatic choice for deferring gains.

This is a difficult topic with an easy to understand framework (invest capital gains in a Qualified Opportunity Fund for 10 years and defer 85-90% of the temporary gains until 2026 and the the remainder of the gains are excluded from income permanently.)

The details is where the tire meets the pavement. It would be a good idea to either print out this page or bookmark it for future reference. Unless your gains are a simple transaction the details will motivate your decision process.

 

I know this got technical. Regular readers normally expect a bit lighter reading. However, this has to be published. Too many people need the information as the traditional press is glossing over the subject and many tax professionals are still struggling with the implications of all the nuances of the Tax Cuts and Jobs Act. I have one more in-depth tax issue to address before we lighten the reading material for a family audience. Until then, take car, kind readers. May this lighten your tax burden at least a bit.

 

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My Tax Plan If I Were President

Taxes laws are a mess. I have solutions to simplify taxes and lower rates. Using humor, I share tax tips for deductions for individuals and small businesses. I also address the politics behind such required changes. #wealthyaccountant #taxhumor #taxdeductions #taxtips #smallbusiness #funny #politics #presidentIf you’re reading this the day it’s published it means this is the due date for extensions for partnerships and corporations. If you work in a tax office and things are quiet you might want to consider another job. (This is an inside joke directed at a former employee who struck out on her own. If you need bookkeeping in Vegas I know a qualified person to handle that. Seriously.)

I thought today would be the perfect day for me to announce my candidacy for president with a few tax policies I’ll sign into law via executive order if elected. Some of you might be darn excited about this unwelcome event as you think I’m a Democrat. Other might be excited because they think I’m a Republican. The truth is I’m neither. I prefer to waffle between both side of the aisle or as the police call it: walking in a drunken stupor.

As much fun as I’m going to have writing this, I am also dead serious. What follows are tax policies I would like to see instituted. Some things will sound very liberal and some things will sound downright conservative. Basically, I should tick off just about everyone in the room with something.

Welcome to politics.




Ground Rules

Before we start I want to point out some things I plan as president are not completely tax related. For example, I will deal with the minimum wage, but connect it to tax policy. The same with welfare of every kind. Along the way I’ll fix the health care issues of the United States by default and solve trade issues and immigration policy in a way everyone will love until I’m elected. Then a third will love me and two-thirds will hate me until we approach the next election. Then the population polarizes and it ends up a dead heat until I’m assassinated re-elected.

Tax policy controls everything. Al Capone gets away with murder until they called in the Treasury Department. (It worked!) Welfare once required a trip to Social Services. Now it’s handled at the tax preparer’s office. Corporate welfare is even worse.

Trade disputes sometimes result in tariffs, an excellent way to tax your own people while convincing them it punishes the other country. (Don’t underestimate the ignorance of voters.) Once again important issues of national importance end up in a tax bill.

So, let’s get down to business. I’m confident I’ll win your vote.

Simple and Basic

With the exception of my own profession, everyone should love the basic framework of my tax plan. Republicans lowered tax rates to the lowest level since taxes were collected in this country. And I think they’re still too high!

For individuals and families: I propose to raise the standard deduction to $100,000 for joint returns; $75,000 for head of household returns; and $50,000 for single taxpayers. That means a married couple filing jointly can enjoy their first $100,000 of income tax free! (I know! It makes me giddy too.) Exemptions were eliminated with H.R. 1 and I don’t want to rock the boat so all you guys get is a huge standard deduction. In fact, itemizing is gone! If a hundred grand tax-free isn’t enough to stay solvent there isn’t a thing any politician can do to help you.

7 ways your taxes should be lowered. Tax humor might be funny, but also illustrates how taxes must be lowered. Find tax tips and deduction for individuals, the self-employed and small businesses. #wealthyaccountant #politics #president #taxplan #taxhumor #deductions #smallbusinessAs for tax brackets, people like the idea of a flat tax. I propose two brackets so my peers at least have an outside chance of staying in business: 20% and 50%. After the standard deduction, the next $400,000 is taxed at a flat 20%. All income above this level is nailed at a 50% rate with nary a deduction available to reduce the tax.

I hear the howls of protest, my tax obsessed readers. You think President Accountant will bankrupt the nation with such a plan. Au contraire. To pay for this simple tax plan all the welfare tax credits are nixed. The Earned Income Credit: gone. The Child Tax Credit: gone. Savers Credit: nope. Education credits: huh? No, no, and no. No more handouts on the tax return. Let’s turn the tax office back into a tax office and not an unpaid extension of the welfare department of the government.

Also, all income is taxed at the same rate. No more special rate for qualified dividends or long-term capital gains.

Poor people need not complain. The Earned Income Credit was designed to compensate low income workers with a kickback of their FICA taxes. In my tax plan every worker gets the first $20,000 FICA tax free. If you work you get an instant EIC on your paycheck.

HOWEVER. . .

Social Security taxes now are like the Medicare portion of FICA: paid all the way to the sky. And FICA applies to ALL income: dividends, interest, capital gains (long- and short-term) and more. A sports star gets a $20 million bonus. Good for everybody! A CEO of a public company enjoys a windfall of stock options? Good for everybody. The Social Security and Medicare financial problems are solved.

If you think about it (I have) the reduction in tax credits more than offsets the massive standard deduction increase. We may have to institute another round of tax cuts or risk paying off the national debt.

I see fear in the eyes of business owners. Don’t worry. I thought about you guys, too.




Business Taxes

This crazy new tax deduction for qualified business income is insane. All it does is increase complexity in the tax code, lining the pockets of tax professionals and attorneys practicing in tax law. In my plan the QBI is gone.

WAIT!

Don’t shoot! I propose a better solution. Businesses will enjoy their own standard deduction of $1 million. That’s right, my Republican friends, every small business owners will enjoy their first million tax-free on top of their generous standard deduction.

Big business is sweating right now, worried I’ll fill the Treasury at their expense. No way! As a gift for funding my political campaign you get the same $1 million standard deduction, plus a flat tax rate of 15%. You heard that right. The Republican plan of 21% is still waaaaay too high to compete internationally. We will start at 15% and reduce the rate 1% per year until it hits 12%.

Oh, don’t be sad, my liberal friends. To pay for this tax cut we will cut corporate welfare the way we did for individuals. If you think welfare to people is costing taxpayers, you haven’t added up how many handouts are lining the pockets of super-rich corporate executives. Those handouts will be eliminated completely.

To prevent small businesses and the big guys from gaming the system, all businesses controlled by a group only get one $1 million dollar business standard deduction only. In other words, you only get one million dollar deduction per investor. (And you guys thought I didn’t give this adequate thought.)

Tax System

The U.S. is one of only a few remaining nations taxing on a worldwide system. My plan brings us in line with the world by switching to a territorial tax system, where only profits from inside the U.S. are taxed. The tax rate for profits outside the U.S. is 0%, giving a major competitive advantage to American companies operating abroad, something they have to dance around now to compete with other nations. That alone could resolve half the trade deficit.

Americans working abroad would not be taxed unless they earned the money in the U.S. The Foreign Income Exclusion would be obsolete with President Accountant.

To prevent games, corporations could not shift profits outside the country. Strong measures will be in place to avoid such a practice with a 10,000% penalty for offenders. (You’re getting an awesome deal. Don’t get greedy!)

Foreign companies that want to sell in the U.S. would also pay U.S. taxes for their profits earned in the U.S. (Where ya gonna get a fairer deal than that?)




Trade Wars

This is just plain stupid. Tariffs are a tax on your own people! I would open the door to trade with all tariffs eliminated. If other countries don’t follow suit, fine. They can tax their own people more. All the better for our economy.

Looking for a fair tax plan? Then I know the perfect guy to vote for! Taxes are a mess is desperate need of organization. #wealthyaccountant #taxplan #tax #taxes #taxhumor #funny #deductions #creditsThe U.S. and its businesses whine endlessly about free markets. Well, trade wars and tariffs are the exact opposite. Compete or go broke. Under President Accountant we will allow markets to decide the winners and losers.

The one issue we have a right to complain about is the theft of intellectual property. (I’m pointing at you, China.) Our current president has a point on trade issues with China and a few other countries. Policies that strip intellectual property from U.S businesses will be dealt with harshly. If it is determined (China is the worst offender here) that theft has taken place, the government of the country where the offending company resides must compensate for losses and prevent such theft. If the government of said country can’t regulate their own people that country is barred from selling any goods or services in the U.S. until they govern responsibly. No more stealing our stuff and using it to sell against our own hard-working business owners.

The details are more than I can publish right now, but trust me. It’ll be great! The best trade plan this country has ever seen.

Health Care

It is repugnant that the wealthiest nation on the planet can’t provide basic medical care for all its people when other nations do just that. Therefore, I will sign an executive order my first day in office expanding Medicare to cover all U.S. citizens from Day 1 to Day End. No more Medical Premium mandate needed. If you want more than basic coverage; buy additional coverage. There is no additional deduction and businesses are not allowed to provide more health coverage to employees. Businesses are out of the health care business from now on (unless they are a medical business).

To pay for this basic benefit the Medicare portion of FICA will be increased 2%; half paid by the employee and half by the employer. All income, including dividends, capital gains and interest, will pay the additional FICA tax. And remember the FICA exemption above. Nobody gets hurt.

I hear my conservative friends complaining already. “We need to keep government out of our conversations with out doctor,” you say. I agree. Let’s keep your employer out of it, too. I for one am sick to death of telling my employees what kind of medical care they can get. Unless I’m a doctor or hospital, I’m out of the health care business and devoting all my time to my business, which is what I’m good at and the reason I started my business.




Minimum Wage

Is that grumbling I hear at the back of the room? No worries, my liberal friends. Under President Accountant the minimum wage will be abolished! You heard me right. Now holster your weapons.

The reason I’ll eliminate the minimum wage is because if we have a minimum wage to increase the number of jobs, then it stands to reason we must have a maximum wage to create more jobs. Don’t hear that argument too often, do you?

Eliminating the minimum wage will not put you at risk. Your favorite president will guarantee you see $15 per hour minimum on your paycheck each and every week. Rather than force companies to pay a minimum wage, there is a special tax for every hour any employee earn less than $15 an hour. That special tax is 20 times the amount your employee paid under $15 per hour.

I bet there will be no companies paying less the $15 an hour right quick.

Yes, businesses will be encouraged to automate with higher wages. But when has increased productivity been bad for a society? You get more for less. And with the new standard deduction and Medicare-for-all programs you will have a secure safety net.

There will be slightly fewer jobs, but they will pay better. Do I have your vote yet?

Under Cover

There is a lot to love by both sides of the aisle with my plans. Unless you are a tax professional you probably like my proposals.

It is unlikely I’ll actually be elected. Rumor has it a stark-raving mad crowd of accountants are approaching the Accountant farm as I write. With such a simple tax code with no loopholes, tax professionals are out of business. But then again, what did we produce? We manipulated a system created by man with no logical connection to reality. Very unproductive.

HUH!?

Was that gunfire?

 

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SPECIAL SALES TAX REBATE ALERT! for Wisconsin Taxpayers

Wisconsin announced a special one-time $100 (per child) sales tax rebate. It seems the state treasury is overflowing so the legislature decided to get the money divested as soon as possible. This rebate applies to 2017 tax returns!

It is unlikely tax preparers will notify clients since the cost of doing so will exceed the income derived from the work brought in. This article will outline the simple steps necessary to claim your sales tax rebate.

If you have dependent children you probably qualify for the rebate. But, you can only claim the refund from May 15th through July 2nd! After July 2nd the rebate is lost if you haven’t applied by then. You can’t apply before May 15th either as the website only contains program details prior to May 15th.

Who Qualifies?

The sales tax rebate is for sales and use tax paid in 2017 for raising a dependent child. Only one person can claim the rebate! No recordkeeping of actual sales taxes paid is required.

If you claimed a dependent on your 2017 Wisconsin tax return, the dependent was under age 18 on December 31, 2017, is a Wisconsin resident and U.S. citizen, you meet the eligibility requirements for the rebate.

The rebate is $100 per qualified child.

There are two ways to claim your rebate from May 15th through July 2nd:

  • You can call 608-266-5437 Monday – Friday (excluding holidays) from 7:45 a.m. to 4:30 p.m. or,
  • Apply via the internet at https://childtaxrebate.wi.gov.

Note the website only has program details until May 15th when they go live. I’ll add screen shots and a step-by-step guide to this post if it looks like people are having problems claiming their rebate.

When applying for the rebate, have your 2017 tax return handy. Verify you claimed/are able to claim the child/children on your 2017 tax return.

Wisconsin did not provide a timeline for release of funds, but in the past Wisconsin has issued refunds in 8 weeks or less.

Please share this with Wisconsin friends and family. If you have a blog, share with your readers if any are from Wisconsin. Share this page (or the information thereon) on your social media pages.




Final Note

My office will handle rebate requests for clients if they contact my office. Non-clients can also call my office to have us handle the request for rebate as time permits. Since the rebate amount is small I will only ask a donation amount of your choice. All proceeds will go to charity. I’ll update the charities supported on a future Saturday edition of “Stalking the Accountant”.

Stay tuned.

 

Wealth Building Resources

Personal Finance is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Finance is free?

Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to skyrocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.

PeerSteet is an alternative way to invest in the real estate market without the hassle of management. Investing in mortgages has never been easier. 7-12% historical APRs. Here is my review of PeerStreet.

QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. Quickbooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.

A cost segregation study can save $100,000 for income property owners. Here is my review of how cost segregations studies work and how to get one yourself.

Amazon good way to control costs and comparison shop. The cost of a product includes travel to the store. When you start a shopping trip to Amazon here it also supports this blog. Thank you.

 



Filing Status When You Can’t Find Your Spouse

Determining your tax filing status can be tricky at times. I see the same questions on social media and a few times per year in my office where people are confused on what filing status to use when they are estranged from their spouse. On the tax subgroup in Reddit the question popped up a few times this tax season already and with two new clients in the past week.

I included a decision tree to help you determine your filing status. However, there are details that didn’t fit within the decision tree neatly so it is important to read the text of this post to assure you are using the correct filing status.

There are several reasons when you may want to consider filing a separate return from your spouse. In rare instances your combined tax liability is smaller. Example: spouses have widely different incomes and one spouse has a very large uninsured medical expense.

A more important reason to file a separate from your spouse is if you suspect malfeasance. If you file a joint return and your spouse under reports income and/or overstates deductions and/or credits you are liable for the tax debt if the IRS discovers the irregularities.  The only way to sever liability on a joint return is if you signed under threat or duress. Threat or duress is very hard to prove and the IRS has a history of denying relief when there are no reports of abuse to law enforcement.




The final reason to file a separate return is because you have no choice because you don’t know where your spouse is. This is more common than you think. The Reddit subgroup above has similar questions every tax season. As mentioned, two new clients had this issue in my office in the past week.

If you can’t find your spouse or she/he refuses to file a joint return, you have limited options. The decision tree in this post is an easy way to visualize your choices. In short, if you lived with your spouse at any time in the last six months of the year you must file either a joint or married filling separate return. If you lived apart the last six months of the year and provide more than half the support for yourself and child you can file as head of household. Where no children are involved you are limited to MFJ or MFS. If you are legally separated or the divorce is final you can file as single. You will need the services of a competent attorney if you can’t find your spouse to facilitate a legal separation or divorce proceedings.

There are tremendous negatives to filing a MFS return. Many credit are lost (earned income credit, adoption credit and child and dependent care credit are a few). Education credits and the student loan interest deduction are unavailable on a MFS return. If you own income property the passive activity loss limit is reduced to $12,500 ($0 if you lived with your spouse at any time during the year).

If your spouse itemizes on a MFS return you MUST also itemize, regardless if you have any Schedule A deductions or not. If you can’t find your spouse or he refuses to communicate with you, you will not know if he itemizes so you may have no choice other than to itemize.

You report only your income and deductions on a MFS return unless you live in a community property state (AZ, CA, ID, LA, NV, NM, TX, WA and WI). In community property states you report half the community property income and deductions. If income and deductions are not reported to the other spouse the benefits of community property law can be lost. Community property laws can be circumvented fairly easy if the taxpayers live apart.

Let’s review the decision tree and review the notes that follow.

Use the decision tree to determine your filing status. Use the notes below for further explanation of special situations.

Notes to the decision tree: If your spouse died during the year you can still file a joint return for the current year. If you paid over half the costs of keeping a home with dependent child you can file as a qualifying widow/er for the two years following the death of your spouse. A qualifying widow/er enjoys the same advantages of a MFJ return.

Temporary absences for education or military service do not count as living apart.

If you sign a release of exemption as a custodial parent and would otherwise be allowed the dependent exemption you can file as head of household if you lived apart from your spouse the last six months of the year.

A parent does not have to live with you to claim the exemption if you provided more than half the cost of keeping the parent’s home for the entire year.

 

The simplest part of the tax return can become a confused mess when unique situations make an appearance. The raw number of requests involving a missing spouse required me to publish on the subject.

If you have additional questions leave a note in the comments. I’ll try my best to answer questions promptly. During tax season and when on vacation I’ll need more time to respond.



Fixing an Incorrect or Erroneous Refund

It happens more often than you think. The IRS issues erroneous refunds all the time and you suffer the consequences if you handle the issue incorrectly. Missing refunds and reduced refunds are even more common. There is a procedure to handle each situation. Following procedure will avoid penalties due to an IRS error.

We Start with a Missing or Reduced Refund

A surprise refund in the middle of summer from the IRS quickly raises suspicions “this might not be a good thing”. However, refunds for less than anticipated are more common. Missing refunds top the list.

Before you panic, refunds have a general time table. If your refund is AWOL you might need to practice patience first. If it’s been less than three weeks since you e-filed (six week for paper filed returns) you need to wait a bit longer. Calling the IRS will waste a good portion of your day only to hear the friendly IRS employee say you need to wait at least 21 days before they can do anything.

If the allotted time has elapsed you can check on your refund status online. (You can actually check your refund status few hours after e-filed and it should show up as received.) You will need your Social Security Number, filing status and exact amount of your expected refund. Sometimes the IRS tells you to wait a bit more as they continue processing your tax return. This happens a lot with returns containing credits, especially the Earned Income Credit.

If a problem exists with your return the IRS should let you know. If the IRS says your return has been processed and refund issued you will be given a chance to file a dispute in the IRS’ refund status page.

Amended tax returns use a different search tool on the IRS site. Amended returns are always paper filed for individuals and take around four month to process and a refund issued.

If your refund is less than requested on your filed return you should start with the refund status link above. The IRS should tell you why your refund was reduced.

If your refund is lost or you disagree with the offset portion of your refund you have several choices to resolve the problem. Only contact the IRS if the refund offset was for federal taxes. Other offsets issues should be directed to the agency that received the offset funds. Common refund offsets include: child support arrears, delinquent state taxes and unemployment compensation debt. If you really owe the money you’re probably not getting all the refund you expected.




Erroneous Refunds

Surprise IRS refunds are more common than you think. Non-clients stop in the office (or call) several times per year asking what they should do about a refund they didn’t expect. There are set procedures when this happens. If you don’t follow IRS protocol on an erroneous refund you could be on the hook for interest charges and even penalties. If the amount not yours is large enough it could become a criminal issue! And it was the IRS’ fault!

Usually refunds are not larger than expected. If you receive more refund than expected, review your return and the refund status link above for an explanation. Usually you are owed the larger refund. Verify before cashing the check.

When the IRS changes a refund an explanation is mailed to the address of record. A phone number is provided to dispute or verify the change.

The complete surprise refund from the IRS is rare, but happens often enough for a small office like mine to help worried taxpayers unsure what to do with their newfound largess.

IRS procedures cover erroneous refund checks before and after they are cashed and direct deposits.

If the refund check hasn’t been cashed, VOID the endorsement area on the back of the check. Return the Treasury check to the IRS office where the check came from within 21 days. This is found at the bottom of the check and before the words TAX REFUND. I have included addresses at the end of this post. Do NOT attach, staple, bend or tape the check in any way! Include a note stating “Return of erroneous refund check because (and give a brief explanation of the reason for returning the refund check).”

If you got excited and cashed the check, submit a personal check or money order within 21 days to the appropriate IRS office listed below. Since the check is cashed you may not recall which office the check came from. In that case you need to call the IRS at 800-829-1040 for individuals and 800-829-4933 for businesses. Let the operator know you need information to repay a cashed erroneous refund check. Yes, you will be on hold a while so it’s best not to cash a refund check unless you are really owed the money.

Also, write on the check or money order: Payment of Erroneous Refund, the tax period for which the refund was issued, and your taxpayer identification number (social security number, employer identification number, or individual taxpayer identification number). Include a brief explanation why you’re returning the refund. If you cash an erroneous refund check expect to pay interest to the IRS.

Direct deposits of erroneous refunds are problematic. You may not be aware of the erroneous refund until you get your monthly statement from the bank or check your account. Once again, interest probably will accrue for an erroneously direct deposited refund. If the money is promptly returned the IRS may waive the interest due to their error. If you wait more than 21 days the IRS generally assesses interest and expects you to pay.

Contact your bank and have them reverse the erroneous refund immediately. Call the IRS at 800-829-1040 for individuals or 800-829-4933 for businesses to explain why the direct deposit is being returned.




Deeper Refund Issues

Sometimes you end up scratching your head over a refund issue or did all the right things and the IRS persists in penalizing you for their mistake. In these instances it’s time to call out the Taxpayer Advocate.

The Taxpayer Advocate (TAS) works inside the IRS on your behalf. The guys at the 800 numbers are nice enough, but lack the experience, tax knowledge or authority to fix most serious problems. The Taxpayer Advocate office is staffed by knowledgeable tax people able to work directly with the IRS agent handling your file. TAS answers the phone faster and gets the job done sooner. They even call you back with progress reports! The most seasoned staff is reserved for tax professionals.

My office has used the TAS many times with great results. Use the link above and click the Contact Us button to find the closest TAS office to you.

IRS Addresses to Return Erroneous Refunds

ANDOVER – Internal Revenue Service, 310 Lowell Street, Andover MA 01810

ATLANTA – Internal Revenue Service, 4800 Buford Highway, Chamblee GA 30341

AUSTIN – Internal Revenue Service, 3651 South Interregional Highway 35, Austin TX 78741

BRKHAVN – Internal Revenue Service, 5000 Corporate Ct., Holtsville NY 11742

CNCNATI – Internal Revenue Service, 201 West Rivercenter Blvd., Covington KY 41011

FRESNO – Internal Revenue Service, 5045 East Butler Avenue, Fresno CA 93727

KANS CY – Internal Revenue Service, 333 W. Pershing Road, Kansas City MO 64108-4302

MEMPHIS – Internal Revenue Service, 5333 Getwell Road, Memphis TN 38118

OGDEN – Internal Revenue Service, 1973 Rulon White Blvd., Ogden UT 84201

PHILA – Internal Revenue Service, 2970 Market St., Philadelphia PA 19104



Problem Discovered in Tax Bill Will Leave Many Owing the IRS Big Next Year

It’s going to be a cold winter next tax season if people don’t prepare for the antics of Congress and the IRS.

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.)

Prepare your own taxes and support your favorite blog at the same time. What could be better?

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.

Finally, you are welcome to contact me for consulting, a review and/or to prepare your return. I recommend you read the Working with the Wealthy Accountant page before hitting the Contact button.



How and When to File a Superseding Tax Return

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.



Tax Cuts Don’t Create Value, This Does

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.

Tax Heaven

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?

TWO DOLLARS!

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?

Simple. Your return on invested capital (ROIC) in excess of the cost of capital (COC) is the textbook definition of value creation.

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.