Category Archives: Accounting

Mission Impossible? Last Minute Tax Planning for 2013

mission impossible

While the concept of “tax extenders” is debated by economists and policy wonks, the real fact is that certain provisions of our tax code have for years been written with a self-destruct code imbedded in them.  The reasons for this vary, but the main one is that a budget cannot be balanced without plugging in “sunset” dates for some of these more generous provisions of the code – known as “tax expenditures”.

One example of a tax expenditure is the Section 179 “expensing” provision that allows businesses to deduct, rather than depreciate equipment purchases up to a certain threshold.  In 2013, this threshold is, generally, $500,000, but drops to a mere $25,000 in 2014.  The purpose for the high immediate expensing was to give “small” businesses a tax benefit for investing in equipment, providing in theory a stimulating effect on the economy.

If you are in the mood to do last minute tax planning, here is a brief list of some of the more popular 2013 expiring provisions:

Business Provisions:

  • Section 179 deduction – drops to $25,000 from $500,000 after 2103.
  • 50% bonus depreciation – no longer available after 2013 except for certain long-period property and aircraft.
  • Qualified Leasehold Improvements – depreciable life goes to 39 years in 2014, from 15 years.
  • Section 179 deduction for certain qualified real property – the 179 deduction of up to $250,000 for qualified leasehold improvements, restaurant property, and retail property is gone after 2013.
  • Research credit – expires after 2013.

Individual provisions:

  • Direct charitable contributions from an IRA – no longer permitted after 2013.
  • Sales tax deduction – no longer available after 2013.
  • Tuition and fees deduction – expires after 2013.
  • Cancellation of Debt – the exclusion of up to $2 million of COD income from a qualified principal residence is no longer available after 2013.

Of course, Congress could still act in early January to restore some or all of the expiring provisions, as it might do with the unemployment benefits that have now also expired for the long-term unemployed.  To be on the safe side, though, if any of these provision affect you or your business, this might be a good day to do a little shopping.

And remember that each of these provisions, very briefly summarized above, are actually quite complex, so it’s a good idea to check with your tax professional before taking action to make sure that you qualify for the deductions in question.

Heading Toward Tax Season

xena110708As filing season approaches for the 2012 tax year, I am presenting here a few selected tax tips and updates that are often overlooked by traditional tax sources, hopefully brief enough to not induce boredom but complete enough to give you some valuable information:

The 1099 Matching Nightmare Continues

  • 1099-MISC:  Don’t forget to EXCLUDE payments to vendors made with credit cards from your total 1099-MISC payments.  Those payments will get reported to vendors on Form 1099-K.  If you do get 1099s that are wrong, ask the payer to correct the 1099.  If that is a pain, then report the full amount on your tax return, and then back out the erroneous portion somewhere on your expense lines.  And, make sure you can document why the 1099 you received is wrong.
  • 1099-K:  Even though IRS claims it is not now or ever going to match 1099-K payments into your tax returns, there’s a reason you are getting a 1099-K and that is to tap the underground economy by making sure that all businesses are reporting their gross income.  If you report less gross income than is shown on your Form 1099-K you will be subject to IRS inquiry, for which they have developed new notices related to Form 1099-K.  Be sure to provide all Forms 1099-K to your tax preparer so that they can help you avoid receiving these notices.
  • 1099-B:  If you receive broker 1099s related to your investments, you are by now used to receiving corrected 1099s, often long after you have filed your returns.  Due to new basis matching requirements, you will need to seriously consider whether you are better off extending your tax returns while you wait for all the corrections to come through, rather than having to amend your returns later for the corrections, or having to respond to IRS notices.  IRS plans to match all 1099-B reporting on the new Form 8949, first developed in 2011.  There are now 6 different ways to report capital gains and losses, and there are 21 different codes to use when reporting.  Due to the extra time involved, investors should seriously consider consolidating their brokerage accounts in order to save on accounting fees at tax time.

Charitable Contribution Receipts Must Contain Required Language       

Even if you have a “contemporaneous” receipt (one that you have in hand at the time you file your tax returns), it may be defective and result in the complete disallowance of your charitable deductions.  It MUST contain required language concerning whether or not the donor received any goods or services in exchange for a contribution.  If it doesn’t your contribution deduction will be disallowed in full.

W-2 Reminders to include HSA payments and Health Insurance Premiums

Don’t forget to include ALL H.S.A. payments on the W-2 Form, Box 12, not just payments made by employees through a cafeteria plan.  The purpose of this is to make sure that taxpayers are not contributing beyond the maximum amounts allowed in 2012 to their H.S.A. plans.

For 2012, you don’t have to report the value of health insurance premiums on the W-2s if you issue fewer than 251 W-2s.  If issue more than 250 W-2s, you must report the value of the health insurance premiums on Form W-2.  The reporting is “informational only” and is not subject to income or payroll taxes.

City of Portland Business Tax Rental Property Exemption Is Gone, Gone, Gone

If you own a few rental properties in Portland, but have no other business activities you may be blissfully unaware of the long reach of the City of Portland Business Tax.  Beginning in 2012, the City successfully changed its tax code to include ALL rental activity, not just owners with over 9 rental units within the City.  Don’t panic yet:  there’s a new exemption of $20,000 in gross income with 1 or 2 rentals, but you still have to file a special new Form to receive your exemption.  More info is available at the City’s website.  Remember that the City of Portland has its own special version of taxation without representation:  the gross receipts exemption means gross receipts EVERWHERE, including rentals you own in other states and capital gains on ANYTHING except securities, and includes all activities of your spouse if you file jointly, even if your spouse does not live in the City or have any business interests or activities there.

City of Portland School Arts Tax – You owe the City $35

This was the infamous Measure proposed by Mayor Adams which even arts and education groups such as Stand for Children opposed, mainly because only about ½ of the revenue raised will go to fund arts teachers for our public schools.  It did pass, however, so beginning in 2012 a new form is required of EVERY CITY RESIDENT AGE 18 AND OVER, accompanied by a $35 payment, or an exemption request for those below the poverty level.  The City of Portland is administering the tax, and the filing form has not even been developed yet.  However, the city has designated this link which will go live when the forms are ready:   http://www.artstax.net

Taxes in the Twilight Zone

twilight-zone-spiralI love watching Twilight Zone episodes because it is fun to imagine a world where the usual laws of nature are slightly askew and anything becomes possible.  Fanciful minds can do a lot with that.  Yet, some of those episodes are a bit creepy, even scary and sometimes disturbing.

Congress’ failure to act timely to provide any kind of certainty about tax law both for 2012 and for future years has definitely defied the usual laws which govern rational behavior.  Clearly Republican lawmakers would rather tax the poor and middle class than allow taxes to become progressive again on the top 1%, and it is quite clear that they wish to further the shameful increase in wealth and income inequality in the U.S.

Thanks to this failure, we have wandered across the obscure boundaries of normal reality into twilight zone of taxation.  Here is an overview of our current creepy, scary, and disturbing tax system:

Creepy

  • The zero percent tax rate for millionaires.  How is it possible that millionaires could pay no tax even though they have taxable income?  The zero percent rate was carefully crafted by Bush-era policy makers to permit this by allowing ordinary deductions to first offset ordinary income.  If ordinary deductions, such as charitable contributions, mortgage interest, state income taxes and investment management fees offset an investor’s interest income in full, that investor can be in a position to pay zero percent on all capital gain and dividend income up to the bottom of the 15% bracket.  This is up to $70,700 per year (Married Filing Joint) that is being taxed at zero percent.  The rest of us will pay tax on all of our capital gain and dividend income, because we are working for a living, and can’t possibly manipulate our tax bracket to get below the 15% level.  For investors, this is easy to control, through timing of capital gains, and through investment choices such as the use of municipal bonds or non-dividend paying stocks. And, how many working poor do you know that have an investment portfolio?  Creepier still:  Obama’s tax proposal will not impact this bizarre anomaly – the only hope for this provision to die is for us to fall off the fiscal cliff and keep diving.

Scary

  • The Alternative Minimum Tax affecting some 33 million taxpayers this year, compared to 4 million last year.  Thanks to Congress’ failure to enact the annual “AMT patch” – something it has been doing for decades – means that the AMT exemption amount will revert back to its non-inflation-indexed amount.  This is because the original law failed to index the exemption for inflation.  Rather than fix this permanently, Congress continuously “patches” the exemption amount each year by indexing it to inflation for that year only.  This is because actually fixing the AMT would be far too rational, and remember, we are in the Twilight Zone.  So, millions of taxpayers will see dramatic increases in their tax bills for 2012, and it will especially hit those with incomes between $100,000 and $200,000, with an average increase of about $3,000.  Not only that, failure to patch the AMT has caused IRS to delay being able to finalize its tax forms for 2012.  The latest news from the IRS Commissioner is that one hundred million taxpayers will not be able to file their returns until sometime in March of 2013.

Disturbing

  •  Unfair income matching rules which target low income taxpayers, while failing to tax the bulk of the underground economy.  I have always found it interesting that Congress and the IRS have gone to great lengths to make sure that baby sitters, housekeepers, and child care providers report their income and pay their taxes.  Yet, construction contractors are not subject to 1099 requirements when payments to them are non-business related, such as when they are remodeling your house.  In order to claim a child care credit or compensate your nanny, IRS makes sure that everything gets reported on a W-2 or is otherwise matched to the worker’s tax return.  Also, they are hell-bent on making sure that restaurant servers report their tips.  Why don’t we have these same kinds of requirements for plumbers, builders, and construction contractors.  Ever wonder about how construction workers can be paid “under the table?”  It might be because the contractors themselves are not reporting their income, so paying someone under the table becomes a piece of cake.  Most industry observers are well aware of this kind of outrageous noncompliance, but nothing has been proposed to tax what is probably a huge portion of the underground economy.  I’m not just picking on contractors, though.  A legitimate tax system is one in which all income is taxed, not just the income of the poor and working class.

Fixing variances in general and subsidiary ledgers – Accounting NOT for Dummies

There can be many causes for a subsidiary ledger to go out of balance with the general ledger.  An invoice could have been posted in an incorrect amount, a general journal entry could have been made to correct the general ledger, or a payment could have been posted using a journal entry rather than using the payables or receivables “modules.”

One example from my world of public accounting involves corrections made by the CPA firm at year end which also affect subsidiary ledgers.  For example, as part of year-end tax closing the CPA firm makes an adjustment to accounts payable to correct the balance to the actual payables at year end, which for whatever reason were misstated.  Let’s say the adjustment is a debit of $1,000 to an A/P account, which brings the balance to the new corrected amount of $9,000.  Prior to the adjustment, the subsidiary ledger shows a balance of $10,000.  In this example, we’ll say that the adjustment relates to only one vendor – ABC Corp. – and that it relates to a mis-posted invoice for COGS.

When the journal entry is posted to the general ledger, here is what happens, using T accounts, where the left side of the “T” is a debit, and the right side a credit:

A/P                                                              COGS                                             ABC Corp A/P sub

$1,0000 |   $10,000                           $10,000 | $1,000                                     | $10,000

Above, you can see that the journal entry has corrected the general ledger, but the subsidiary ledger is now out of balance to the general ledger.

I have developed a procedure, using a “dummy cash account” to fix the problem and bring the accounts back into balance.  First, set up a new cash account and call it “dummy cash” or something similar so that everyone knows it’s not a real account.  Then open vendor payables and select ABC Corp.  Now, make a $1,000 payment to ABC Corp using the dummy cash account, not your real bank account.

Here is what has happened:

A/P                                        COGS                             ABC Corp A/P sub   Dummy Cash

$1,0000 |   $10,000     $10,000| $1,000       $1,000 | $10,000              |$1,000

$1,000|

Now, you can see that Accounts Payable is understated by $1,000 and the dummy cash account has a credit of $1,000.  So, you must make one more journal entry to correct both of these accounts, making a credit to A/P and a debit to dummy cash.

A/P                                         COGS                                ABC Corp A/P sub   Dummy Cash

$1,0000 |   $10,000      $10,000| $1,000     $1,000 | $10,000  $1,000|$1,000

$1,000    |   $1,000

                                                                                                                                                                 

              | $9,000        $9,000|                              |$9,000                   -0-

As you can see, now all is right with the world.  The accounts payable general ledger agrees to the subsidiary ledger, the vendor balance is correctly stated, and COGS has the correct amount of expense.  This same process works in reverse for corrections needed to Accounts Receivable and its subsidiary ledger.

You can use debit memos and credits memos to achieve the same result, as long as you can control where the debit/credit memos post to.  You want them to post right back to the G/L account where you are making the correction.  Some software does not permit you to make entries to accounts payable and accounts receivable in this manner, but here is how that would work, using the above example:

Open up ABC Corp and issue a credit memo to the vendor for $1,000.  Set up the credit memo to post directly to Accounts Payable.  When posted, the credit memo will both debit and credit A/P in the amount of $1,000, so it will have no effect on the A/P balance, and the sub-ledger for ABC Corp. will reflect the $1,000 credit memo, so it will now be in agreement with the general ledger.

Accounting Software Set-Up: If It Was Easy, You Did It Wrong

Setting up accounting software and getting it working properly for your business or non-profit organization can earn you a badge of honor.  Or, it can be stumbling block for  bookkeepers, accountants, and CFO’s.

Who should perform the set up and conversion?  Should you run dual systems during the conversion?  Should you ditch your old chart of accounts and start over?  Are you dreading entering in your customer and vendor data bases? Did you budget enough time and money for the conversion?  Or maybe you don’t even know where to start.

I am offering these tips which are based on experience with all kinds and sizes of businesses and non-profit organizations.

Use a checklist

I can’t tell you how important it is to have a roadmap for an accounting system conversion.  Where can you get one?  You can start with the checklist provided by the accounting software manufacturer.  You can ask your CPA for one.  You can go on-line and find one.  Or, you can develop one yourself, a method that I think is best.  However, any checklist is better than no checklist.

Map out a timeline and budget

Do not plan a software conversion during your busy seasons.  Schedule it for the slow times.  Can you import your old data into your new software?  If not, and if you are going to lose your historical data (which these days you should be able to avoid), then you’ll probably need to do the conversion at year end, which may unfortunately also coincide with your busy times.  And, it will probably cost more in time and money than you have in your budget.

Build the bones of the system:  your chart of accounts

The most important detail to attend to is what to do about your chart of accounts.  It needs to be the right size and have the right level of detail.  But how do you know what this is?  A chart of accounts is meant to group your assets, liabilities, equity, income and expenses by broad, commonly accepted categories so that anyone looking at your trial balance can instantly understand the categories used and make meaningful comparisons to other entities.  For example, it is not common practice to have separate general ledger accounts for each employee’s cell phones.  Instead, common practice is to use a general ledger account called “Communications Expense” or “Telephone expense.”  Here is a good overview from Wikipedia.

While there can be an architecture to the chart of accounts, it needs to follow a logical pattern.  If you are going to use departments you need to decide whether you are grouping cost centers or revenue centers.  Revenue centers are true divisions of a company or NPO – both income and expenses are tracked by location, program, or function.  Cost centers involve only tracking costs of a department or function, and not the revenue.  Fund accounting can be even trickier:  if you are using sub-codes to track restricted funds, you can’t use these same codes to track spending by grants.  While a restricted grant may be a sub-set of temporarily restricted net assets, the inverse is not true.   It’s best to think through your architecture before implementation by drawing it out on a piece of paper.

Non-profit organizations have the most complex charts of accounts relative to their size because they are required to report to outside grantors, contributors and governments in ways not required by for profit entities.  Remember:  the more complex your chart of accounts, the longer it will take your bookkeeper to post even “simple” transactions, because each item of income and expense will need multiple sub-codes attached to it.

That is why it is sometimes it is simply not cost effective to try to build an elaborate and integrated chart of accounts that satisfies these requirements.  It can be easier and less time consuming to reserve grant reporting and fund tracking to an off the books solution such as Excel, especially for smaller organizations with limited resources.

Set up your data bases for customers and vendors

Hopefully, you’ll be able to import your customer and vendor data bases from your old software.  But, if not, you’ll need to input all of your vendors and customers names, addresses, and other information into the software, prior to using it.  These data bases form the platform for the accounts payable and accounts receivable subsidiary ledgers.  In some software programs, incorrectly identifying a customer as a vendor, and vice versa, can cause you to lose valuable historical information about that customer or vendor, so it is critical to get these data bases set up in advance, and not input them “on the fly” even though this will be tempting.  You’ll notice that I’ve said nothing about setting up employees.   This is because I rarely recommend that a company or NPO run its own payroll.  A service bureau should be employed to do that for you – it is more efficient, less expensive, and exposes you to far less risk of errors and penalties.  However, you will need to develop a posting journal/process, and you’ll also need controls over the payroll input and output from the service bureau. 

Ready, set, go

Once you’ve got your historical balances, beginning balances and budget information into the chart of accounts, you are ready to start using the system.  Many CPAs recommend using parallel systems for at least the 1st month, but I think that is optional.  As long as you have put in adequate controls and reconciliation processes, you should be able to have confidence in the new system right away.  These controls typically include:  month end bank reconciliations for all bank accounts, month end reconciliations to all subsidiary ledgers (accounts receivable, accounts payable and payroll, typically), daily or weekly management oversight of data entry, user passwords, and control over system access.  Setting up controls is not necessarily intuitive, so it’s usually a good idea to get your accounting firm involved in helping you with this portion of the transition.  Then, you’ll need to train your managers on the new controls and how to implement them.  And lastly, make sure your backup procedures have been tested and are working well – another very important control that is often overlooked.

Why the Portland/Multnomah County Business Tax Needs Reform

Mayor Sam Adams recently announced a tax amnesty for scofflaws who have so far succeeded in not rendering unto the City/County what they owe in business income taxes.  While I am not a big fan of amnesty programs, as they reward the wrong behavior and the wrong taxpayers, it is not surprising that businesses and property owners who have “nexus” within the City/County find themselves out of compliance with the tax code.  Some do so deliberately, while others may simply be blissfully unaware of their tax obligations.

This is because the City/County tax code, unlike its counterparts among other municipalities, taxes only certain businesses and individuals.  It relies on a very narrow tax base, and thus has an extremely high flat rate of 3.65%.  It is essentially a payroll tax on successful business owners, and an income/capital gains tax on successful property owners.

But more importantly, the tax punishes privately held companies who do business within City/County borders while rewarding public companies doing the same.  How can this be?  Well, here’s a real life example from my CPA practice:  Locally owned company with 3 shareholders, nets $4 million before owner salaries, and $1 million after owner salaries.  In my example, none of the shareholders actually live within the City/County boundaries.  What is their City of Portland/Multnomah County Business Tax?   The total tab will be $136,500.  If this same business were to be bought out by a publicly traded company, and management salaries were the same, the business would now have a tab of $36,500.  In this example, that’s a $100,000 punishment for the locally owned company.  Outrageous, no?

This strange phenomenon takes place because wages over $87,000 paid to more than 5% owners are “added back” to business net income to determine the tax.  Basically, you have a payroll tax on owners who pay themselves more than $87,000 per year, a tax that is not paid by companies who do not have more than 5% owners.

Further, the filing requirements imposed by the City are highly invasive (and perhaps illegal?).  Taxpayers who owe no tax whatsoever to the City/County are still required to provide copies of their individual tax returns, along with related Schedules C, D, and E, even though they have no income to report.  The TriMet tax, administered by the State of Oregon has no such requirements.  If you don’t owe the tax, you simply don’t file.

But, this is not so with the City/County.  I have clients who fear their personal financial details are now sitting on some City employee’s desk, and that information that is required by federal law to be kept in strict confidence is being exposed to those who have no need (or right?) to see such information.

But worst of all, the City/County tax is neither a fair tax nor a simple tax.  It relies on a narrow tax base (unfair) and it is one of the most complex and arcane municipal tax codes I have ever encountered.  A fairer and simpler tax would be a payroll tax/self-employment tax similar to the TriMet tax.  It could have a very low rate because of its broad tax base, and would be extremely simple to administer by simply tacking it on to the Oregon quarterly OQ filing. 

A broader tax base would also help to discourage local businesses from the practice of fleeing the City/County boundaries to escape the tax.  Regardless of what City leaders may say about this practice, every CPA I know has experience with clients who have relocated out of the City/County boundaries to avoid the tax.

In the meantime, if you own property or do business within the City/County borders and have not been filing your tax returns, now is the time to find out if the amnesty program can help you get into compliance.

Update June 20, 2012:  This just in from my tax law reporting service: 

“Oregon—Income Tax: Portland Confidentiality Provision Amended

Portland has amended its provision regarding confidentiality of business license tax taxpayers to provide that, in addition to existing prohibitions, it is unlawful for any Portland employee, agent, or elected official or any person who has acquired information to divulge, release, or make known in any manner identifying information about any taxpayer applying for tax amnesty, unless otherwise required by law. Ordinance No. 185312, City of Portland, effective May 9, 2012″

So, what is the penalty for unlawfully disclosing taxpayer information?  From the City Code: 

“7.02.730 Criminal Penalties for Violation of the Business License Law by City Employee or Agent.Printable Version
Anyone knowingly violating Section 7.02.230 may be punished, upon conviction thereof, by a fine not exceeding $500.00 or by imprisonment for a period not exceeding six (6) months, or by both fine and imprisonment.  Any City employee that is convicted will be dismissed from employment and is ineligible for holding any position of employment or office in the City for a period of five (5) years thereafter.  Any agent of the City that is convicted is ineligible for participation in any City contract for a period of five (5) years thereafter.”

Contrast this to the penalty on IRS employees for unlawful disclosure of federal tax information (which is the same information the City employees have about its licensees): 

“Penalties for Unauthorized Disclosure-Internal Revenue Code

Internal Revenue Code Sections 7213 and 7431 describe the penalties for unauthorized disclosure of federal information.

Under Section 7213 of the Internal Revenue Code, a governmental actor’s unauthorized disclosure is a felony that may be punishable by a $5,000 fine, five years imprisonment or both. Under Section 7213A of the Internal Revenue Code, the unauthorized inspection of federal tax information is punishable by a $1,000 fine, one year imprisonment or both. Section 7431 of the Internal Revenue Code permits a taxpayer to bring suit for civil damages in a U.S. District Court, including punitive damages in cases of willful disclosure or gross negligence, as well as the cost of the action.”

As you can see, City employees are subject to far less punishment than IRS employees who unlawfully disclose the exact same confidential information.

To Group or Not to Group: That is the Tax Question

IRS recently came out with new rules regarding how taxpayers must elect to group passive and active business and rental activities together.  Grouping a passive activity with an active one can help taxpayers avoid the dreaded “material participation rules” – designed to blur your eyes and make you sleepy and irritable.  Oddly, the passive activity rules upon which this new required grouping election is based were enacted back in 1987 with the infamous Tax Reform Act.  Um…that was 25 years ago. 

 Importantly, for tax years 2011 and forward, the new guidance from IRS makes it necessary for all business owners with more than one “activity” to consider whether and how to apply these rules to their undertakings.  Here is an overview of how the rules work:

  1.  You can group rental or other passive activities with trade or business activities where one is insubstantial to the other and if they constitute an “appropriate economic unit.”  This involves analyzing factors identified in Regulation 1.469-4:  similarities and differences among the business activities, extent of common ownership, geographic location, and interdependence.  (However, you cannot group rental real estate activities with personal property rental activities.)  Example:  a manufacturing S corporation produces waste metals that can be recycled or sold for scrap.  For business reasons, the corporation’s owners form a separate S corporation to handle the recycled material, either selling it or ensuring its proper disposal.  The recycling company’s revenues are miniscule compared to the manufacturing company, and it tends to generate losses.  The owners don’t spend much time managing the recycling company, but if they elect to group the two companies together, they can treat the recycling company as active, never again worrying about the passive activity rules.
  2. You can group a rental activity with a trade or business activity if the rental is to the business, and all the owners have the same ownership percentages in each entity.  Example:  an LLC owns a building, rented out to a printing company, also an LLC.  The owners of the printing company own the rental LLC in the same proportions as their ownership in the printing company.  Each individual owner can decide whether or not to group the two activities together, which results in converting LLC rental losses and income to active status, and avoids suspended rental losses where the owner’s incomes are too high to take advantage of the losses. 
  3. You can’t change or revoke your grouping election unless there is a material change in the underlying facts, or unless the original grouping was clearly erroneous.  You can, however, add to the group.
  4. If you don’t decide which activities to group for 2011 by attaching the required statement, IRS will take the position that nothing has been grouped (but you may carry on with prior groupings and are not required to disclose prior groupings to IRS.)  Grouping elections can be made in future years, but they cannot be retroactive.  Groupings made prior to 2011 will not be disturbed, so long as the taxpayer consistently maintains the grouping.
  5. You must disclose to IRS, by attaching the required statement from Rev. Proc. 2010-13 all:  new groupings for 2011; additions to prior groupings; changes to ANY groupings.  You do not have to disclose grouping elections made prior to 2011.
  6. Grouping elections can be made first at the entity level and then at the individual level, but an owner in an S corporation or partnership cannot un-group an activity that has already been grouped at the entity level.

Generally, there is no good reason to group rental activities together into one passive group.  Doing so would mean that passive activity losses would remain suspended until each property in the group is finally sold.

Unfortunately, there is neither a bright line test, nor a safe harbor, to help taxpayers determine which activities can be grouped.  So, it’s a good idea to carefully review the rules with your CPA firm to evaluate the best course of action.

My Hideous Tax Reform

(With apologies to economist and author Joel Slemrod, author of the paper, My Beautiful Tax Reform)

As an accountant, I get involved in the practical and tedious task of applying tax laws (and related loopholes) to our clients’ fact situations.  Rarely do accountants get the time to contemplate (or fantasize about) tax reform, nor to consider systems used effectively by other countries.  But, before tax season gets truly underway this year, I have been spending some time educating myself about these matters so that I can combine my practical knowledge with the wisdom of economists and policy analysts around the world.

Professor Slemrod has spent many years evaluating our tax system and expresses the view that a business Value Added Tax (VAT), combined with a highly progressive but simplified individual income tax would deliver the best combination of Fairness and Simplicity (my two objectives for tax reform), and would achieve what he calls “elegance”.  He proposes an individual income tax that would exempt most individuals from filing returns, basically by eliminating all deductions and credits, thus broadening the tax base, and then relying on wage withholding to create the proper and equally applied tax to all labor income.  The VAT tax would apply to ALL business income, and at a flat rate.  Shareholders of corporations would be able to get a credit from the portion of their income already taxed at the corporate level, with the goal being to eliminate all double taxes, and to eliminate all preferential treatment now available through special deductions, credits and business entity selection.

Our current system attempts to tax income (roughly defined as increases in consumption power) by dividing it into 3 pots:  labor income, business income, and income from the employment of capital.  However, there is little consistency in how these different categories actually work.  For example, if I am Mitt Romney and earn my income from “carried interest” I get to pay taxes at a flat capital gains rate of 15%.  If I am Warren Buffet’s secretary, I get to pay taxes at much higher rates, depending on my income and deductions, and I also have to pay social security taxes.  Publicly traded corporations are subject to a double tax whenever they pay dividends to their shareholders, whereas when they pay interest to their bondholders, they are not.  If I lose money on a capital transaction, I can’t deduct the loss unless I have made money on other capital transactions.  If I sell my home at a profit, I can exclude the gain up to $500,000 if I am (legally) married.  If I earn all my income from dividends and capital gains, I might not have to pay ANY taxes.  And, if I am a worker earning a good living, I may be subject to the Alternative Minimum Tax and lose the deductions that my neighbor, who earns less, gets to deduct, thus vastly increasing my marginal tax rate.  These are just a few, selected examples of the way our tax system is both complex and unfair.

Fairness in taxation by definition would have to include progressivity as its underpinning.  In fact, Professor Slemrod rejects consumption taxes outright, as they can never be made progressive enough.  By taxing only consumption, such as through a national sales tax, those who would pay the highest effective rate of tax would be the poor and middle classes, who have to consume certain basic amounts in order to survive.  That would be highly unfair, but would admittedly be a simpler tax to administer than our current income tax.

One reason tax reform is so hideous is that anything that affects the federal system will also affect all the states who are connected to the federal system for purposes of defining and determining taxable income.  Any major reforms at the federal level will require these states to seriously evaluate and reform their own systems of taxation.  Another reason is that by trying to achieve simplicity, one may introduce unfairness, and vice versa.  For example, it might be fairer to measure and subtract inflation before taxing capital gains, but now you have introduced a highly complex calculation into the system.  You can eliminate this problem by using a consumption tax instead of an income tax, but as noted previously, a consumption tax is a regressive tax, and thus, unfair.

In order to restore legitimacy and moral authority to our government and its system of taxation, the current system MUST be reformed, and it must become fairer and simpler, yet still provide adequate funds.  Any steps in those directions are to the good, hideous or not.  President Obama’s recent budget proposals include some movements in the right direction:  indexing and making permanent AMT exemptions,  taxation of carried interest as ordinary income (too bad, Mitt), and simplification of the earned income credit.  However, when you read the summary of the President’s budget (spanning 215 pages) you start to feel pretty queasy.  More and more tax expenditures (credits and deductions) are being proposed in a desperate effort to insert more fairness into the system, but the end result is more, and much more, of the same highly complex and unfair system that we currently have.  Can we give up our favorite deductions and tax credits in exchange for lower and more progressive tax rates?   What might be beautiful is restoring the portion of total income taxes once borne by corporations in 1950 (30% of total revenues) from the shockingly low 7% today, something which could be achieved through a VAT tax.

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The Coming 1099/IRS Matching Nightmare

2011 heralds the beginning of several new 1099 requirements, including the new Form 1099-K, new Form 1099-B, and new requirements for 1099-MISC. 

New IRS Form 1099-K requires 3rd party settlors of merchant credit card and other payment transactions, such as Paypal, to report those payments to all payees who receive at least $20,000 per year in payments and who have more than 200 transactions per year.  The new form requires reporting the totals by month, so that fiscal year filers can still be subject to IRS matching.  It doesn’t matter who the payee is:  a person, a corporation, an LLC, a trust, or a partnership—all of these entities will begin receiving these new forms in early 2012 for amounts paid to them in 2011. 

The amounts reported on these forms MUST MATCH the amounts reported on the entity’s tax returns.  A new line for reporting these totals has been inserted in all relevant IRS schedules and forms.  If the amounts do not match, the payee will receive an IRS notice assessing tax on unreported income.  Which, of course, was the whole purpose of this new requirement – to tap into the underground economy, and very specifically, Ebay and other on-line sellers who have long been suspected of not properly reporting their income to IRS.

Related to this new requirement is a change to the rules for reporting payments to service providers using IRS Form 1099-MISC.  Beginning in 2011, payers must EXCLUDE any credit card or Paypal-type payments made to vendors when reporting their 1099 totals for 2011.  This is because the vendor will theoretically already be receiving a 1099-K which includes all credit card and other 3rd party payments.  IRS has modified its instructions for Form 1099-MISC to reflect this new requirement, but it is highly likely that many 1099 issuers will not bother to read this year’s instructions.  That is why we expect the coming 2012 1099 season to result in many, many unmatched 1099s, and thus many IRS notices to taxpayers.  More work for us accountants, yes?

In addition to these two new requirements, another new 1099 form will be required for 2011 – new IRS Form 1099-B.  The 1099-B has historically been used to report gross proceeds from sales of securities.  Now, the new Form 1099-B will also potentially include cost basis information, separate reporting for “covered securities”, “non-covered securities”, wash sale reporting, short sales, and a number of other items.  It will mean that instead of receiving one 1099-B from your broker, investors will receive multiple 1099-Bs which must be analyzed and reconciled to year-end reports, and then must flow to new Schedule D – consisting now of potentially 6 new types of transactions, separately reported on new Form 8949:  short term sales of securities with cost basis reported, short term sales of securities without cost basis reported, all other short-term securities transactions; and the same break-downs for long-term sales of securities.  In addition, for EACH transaction, taxpayers must indicate one of 21 NEW CODES to tell IRS more information about the transactions.

IRS will then attempt to match the totals reported on the new Schedule D and Form 8949 to the filed 1099-B.  Because these requirements are both new and highly complex, we anticipate many, many matching errors and plenty of IRS notices to deal with.  In addition, investors can anticipate that their tax return preparation fees will increase substantially this year.  Essentially, all broker transactions will be analyzed and reported in 6 separate ways, instead of one, and investors who have multiple brokerage accounts will want to consider whether now is the time to consolidate their accounts.  CPA firms are going to be very busy.  Meanwhile, are you having nightmares yet?

Update (2/24/12):  IRS has now announced that they will NOT attempt to match any 1099-K payments for 2011, 2012, nor into the future.  Here is the quote from their website: “IRS announced in October that separate reporting of these transactions for other business receipts or income payments is not required for 2011. Taxpayers should follow the form instructions for reporting their gross receipts or sales. Report items that qualify as a trade or business expense on the appropriate line item of Schedules C, E and F. There will be no reconciliation required on the 2012 Form 1099-K, nor do we intend to require reconcilation in future years. [Added 2/10/12]” .

 

When Pigs Fly: Waiting for Real Tax Reform

We all know that it is not fiscally possible to cut the national deficit/debt without raising someone’s tax bill.  I’ll include corporations in my definition of someone, since they are now “persons” with free speech rights.  The outlandish and bizarre tax code we currently labor under has been tweaked and pummeled into an unrecognizable amalgam of convoluted provisions, some of them well-meaning, but most not thoroughly or even barely understood by experts, much less by taxpayers.

The growing and shameful income and tax inequality in this country is now finally a topic of conversation among policy makers, thanks to the emerging “Occupy” movement.  Will this new dialogue impact tax policy?

Before the Occupy movement took hold, the showdown staged by Republican politicians over the debt ceiling sent shock waves and uncertainty throughout the financial markets all over the world.  Their insistence on cutting the debt/deficit without “raising taxes” was a frightening spectacle, and its premise was not only cynical and dishonest, but completely out of touch with reality.  Every single federal budget report by every single expert in the field points to the stark and frightening realities of the budget debt/deficit–we can’t grow out of it, we can’t spend out of it, and we may not even be able to tax our way out of it.  It is that bad.

I have been waiting for decades for real tax reform.  I started my career before the advent of the passive activity rules, which I mark as the beginning of the end for sanity in the world of taxation.  While it was important to curb the tax shelter abuses of the early 1980’s, the complexity of the passive activity loss rules opened the door to the idea that, with enough rules, regulations, court cases, and private letter rulings, tax planning can become a game only for the wealthy.  Any poor schmuck who can’t afford my fees is doomed.

While tax complexity was increasing, the income gap between the super-rich and the rest of the population continued to grow, grow and grow.  Then, during the Bush years, the super-rich finally received their blessings from on high.  Many multi-millionaires now find themselves in the ZERO percent tax bracket.  Also, during this time the Alternative Minimum Tax went out of control and began hitting middle and upper middle income taxpayers.  Yet, a family with the just the right mix of tax goodies will have a tax liability that bears no resemblance to another family with the exact same income.

Some people say that fairness is subjective.  No, it isn’t.  Fairness is something that society can agree on, just as we can agree on what is a crime and what isn’t.  The current tax system is patently unfair.  Hence, it has no moral legitimacy.  When this happens, you get the Occupy movement.  So, tonight I’ll count pigs flying while I dream about real tax reform.  Maybe pigs can fly.

Going Postal: Proving You Filed Your Tax Returns On Time

Recently we were alerted by one of our clients that, after waiting in line at the post office, he was unable to get a date stamp from the postal clerk on the tax returns he was posting for mail.  Another client informed us that after waiting in line at the airport post office to drop off her tax returns in the “big blue bag” she was informed by the postal workers that even though she was dropping the returns off before midnight, they could not guarantee that the returns would be date stamped for that day, because there were so many returns, they weren’t sure if they would “get to them.” 

After much investigation, we learned that different things happen to different people depending on which post office you visit.  The USPS still offers “hand canceling” of mail, but apparently only if they are not busy and/or are in a good mood that day.  By obtaining the hand canceled date stamp on your tax return envelope, you might be able to meet one of the IRS’ criteria for proving timely filing of a tax return:  the postmark date on the envelope (assuming the envelope is saved by IRS).  The only other methods accepted by IRS are certified mail and registered mail, more expensive and more of a hassle for most people, but necessary in some cases.

While the advent of e-filing has eliminated this issue for most taxpayers, there are still occasions when one must file a paper return.  Late filing penalties are not an issue if you are filing an individual return and don’t owe any taxes.  However, if you do owe taxes and the IRS determines that you have filed late, you are on the hook for a minimum 5% penalty for each month the return is late, up to a total of 25%.  In addition, you will incur late payment penalties and interest.  So, proof of timely filing a tax return can be critical if you owe taxes.  And, S corporations and partnerships now have substantial penalties for late filing, depending on the number of K-1′s per return ($195 per month times the number of K-1s, up to 12 months total – ouch!).

In addition, you need proof of timely filing if you are close to the end of a statute of limitations period, as in the case of filing amended tax returns.  In this case, we always recommend using certified or registered mail as there could be significant tax or refund issues that necessitate proof of timely filing.  Also, if you file your returns more than 2 years after they are due, but are expecting refunds, you will forfeit those refunds, so any late filed returns within the 2 year statute should be sent certified or registered to prove that you have the right to receive your refunds.

So, if you don’t live near a rural post office, with happy-go-lucky postal employees, you should plan on using certified or registered mail for any documents where proof of the mailing date is critical.

The Postman Cometh: Responding to IRS Notices

The IRS sends out millions of taxpayer notices each year.  However, IRS notices are sent ONLY via the U.S. Postal Service, never by email or any other means of communication.  So if you receive an email purportedly from the IRS, it is bogus. (You can forward these bogus emails to your state’s attorney general for fraud investigation.  Don’t open them!)

There are more than one hundred different kinds of notices that IRS can send out.  The most important thing to do when you get an IRS notice is to IMMEDIATELY open it, read it, and then take action.  Often, you will only have 30 days to respond.

These notices can be audit notifications, requests for payment, or any one of the following more common kinds of notifications, as indicated in the upper right hand corner of the notice:

CP 102: A math error was found on certain forms (such as Forms 941, 942, 943, 944 or 945 returns) that you filed, and the IRS believes you owe more tax.

CP 138: The tax you overpaid on one tax return was applied to another return where you owed tax.

CP 165: Your check for your FTD or estimated taxes was returned. This notice asks for the payment, plus a bad check penalty of two percent (the minimum penalty is $15).

CP 205: You used the wrong taxpayer identification number on your FTD coupon.

CP 2000: Issued for verification for unreported income, payments, or credits.  These are generated when IRS computers cannot match information from 1099s, 1098s, etc. to information on your tax return.

CP 2100: To notify the payer/filer of incorrect information, and to remind them of their obligation to solicit the correct information, so they can file correctly in the future. The notice also reminds them of their responsibility to backup withhold if the information is not provided.

CP 2501: A discrepancy was found between what you reported as your income, credit or deduction and what IRS records show.

We tell our clients to forward all IRS notices to us upon receipt.  We prefer to prepare the response, and we have one CPA in our firm who is our designated “notice responder”.  In our own experience, about 80% of the notices our clients receive are incorrect.  So, definitely do not panic if the IRS says you owe them gazillions of dollars. 

Most of the notices we receive are the CP-2000 (1099 matching) notices and the CP 2400 (incorrect estimated tax payments listed on the return).  These notices are easily resolved with proper correspondence, via regular mail, of course.

What’s the Best Accounting Software?

I hear this question a lot, but it’s kind of like asking:  what’s the best car?  The answer:  it depends on your needs.  So, the first step in evaluating accounting software is to evaluate your needs.  In the old days we called this a “Needs Assessment” and even small companies used to hire CPA firms like ours to perform these needs assessments when they were considering implementing new accounting software systems or upgrading their old software systems.

Today, business owners and non-profit organizations often don’t bother to “waste” time assessing their needs.  We don’t have time for that, do we?  Instead, we prefer to go directly to a solution, not knowing whether that solution has much to do with our needs.  Basic software is so cheap now that we don’t care whether it will work well or not.

Businesses have learned to tolerate inefficiencies in the accounting function because they have allocated so few resources to it that they can afford ignore it.  But they often don’t consider the actual costs of using/misusing accounting software.  These costs are hidden in the extra fees you pay at year-end to have your CPA firm unravel the mess you have created in your accounting software (probably using QuickBooks), and in the sometimes critical mistakes you make managing your business because you are relying on inaccurate and misstated financial information.

These costs are also buried in the extra loan documentation hassles and delays that occur when you try to submit your in-house financial statements to your banker.  You might even be paying a higher interest rate than you should because of these financial inaccuracies.

So, back to the accounting software/car analogy:  think about the software in terms of what you need it for, just as you would weigh whether to buy a convertible or an SUV.  The most critical area to assess is the sales cycle:  if your accounting software doesn’t enhance your sales/revenue function, then it almost doesn’t matter what else it can do well. If you sell inventory, then you need a point of sale system that actually works and that integrates with your accounting software.  If you provide services but need to use job costing, then you need enhanced billing features that allow you to track income and expenses by job, including employee time and expenses.

The next most critical area to assess is how the software will be used and accessed by different users simultaneously, and how or whether the software’s internal controls allow for separation of duties.  If you have an accounting clerk processing purchases and recording invoices, you don’t want that person to have the same access to the entire system that your CFO has.  And, please don’t follow the practice of having one logon name and password and handing that out to everyone who will be using the system!  This happens more often than you can believe, and defeats one of the most stellar internal control applications that software can offer:  determining who did what, and when.

After these two areas have been analyzed, you can move on to other functions, but one decision you will need to make is whether or not to go the “cloud computing” route and purchase an on-line accounting software service.  Cloud versions of traditional accounting software systems have, so far, been stripped down versions of the “real” package, so be very careful when choosing.  On the other hand, some strictly cloud-based software services have been around for years and are worth investigating.   If you do go this route, you’ll be improving your productivity, reducing costs, and making life easier for all the users of the system, including the business owner.  But this is where system security, passwords and log on names must be strictly adhered to, since you are also exposing your business to greater risk.

Once you’ve identified the key features you need, you can get a lot of help using the internet and seeing how other businesses rate their experiences with various software systems.  Ask your CPA firm how they view your accounting system’s needs.  If you do take the time to evaluate your own accounting needs, even if you don’t do a formal needs assessment, you are much more likely to find the best accounting software application(s) for your business or non-profit organization.

The IRS, the AICPA, QuickBooks, and You

Earlier this year the IRS announced that it would begin demanding a business’ QuickBooks data file during all future audits conducted by the agency.  In the past, CPAs and their clients would often export the accounting software’s general ledger and other financial information to Excel, and then provide this information to the IRS during an audit, as a way to limit IRS access to non-accounting information.  IRS was satisfied with this until recently when it began to realize the wealth of information that is contained within a company’s software data file – much of which may be unrelated to the year being audited, but may in fact reveal information that could be useful to IRS in evaluating information reported on tax returns.

The IRS has long regarded electronic records as being suspect:  “Electronic records, are, in general, considered less reliable than their paper counterparts due to the ease with which they can be manipulated” according to the recently updated Internal Revenue Manual.  Bingo.  What is so helpful about having the QuickBooks file to audit is the existence within the file of an “audit trail” – a function which cannot be disabled by the users, and which records every keystroke by date, time, and user name.  By studying this audit trail, IRS can determine whether transactions were altered, deleted, or modified, and how often, by whom, and when.

Many CPAs have expressed concern over this new approach because their clients routinely make errors in QuickBooks which have to be corrected after the fact.  They were worried that IRS would regard these errors and corrections as indicative of deceit or fraud, when in fact they are only indicative of incompetence.

Enter the AICPA.  Earlier this year, the AICPA sent a memo to IRS asking for their clarification on their position regarding providing “an exact copy of the original electronic data file…and not an altered version” to IRS auditors.  The AICPA wanted to know whether such a file could be condensed so as not to provide prior year data, but only the data for the year under audit, and whether CPAs are being exposed to potential malpractice claims by inadvertently turning over unrelated data contained within a client’s QuickBooks file.  Some CPAs have gone ahead and either condensed the QuickBooks file or had a software company perform a “redaction” of the file, to remove prior year information.  Anecdotal evidence indicates that this is okay with the IRS, however, it has yet to officially comment on the AICPA’s questions.

So far, the IRS is only training its auditors on the use of QuickBooks and Peachtree during an audit, but it may expand its training to other software packages if it sees a need.  Since QuickBooks has the market share, with a reported 85% of the total, IRS was smart to choose QuickBooks as its first software package to use in its new approach to auditing electronic records.

Now you can count the IRS as yet one more reason not to use QuickBooks.  But, if you are already using QuickBooks or Peachtree and you are about to be audited, but sure to contact your CPA so that they can help you in providing only the information that IRS is entitled to receive during the audit, and nothing more.  And, since QuickBooks is kind enough to provide you with an audit trail, make good use of it by strictly adhering to user log-ins and passwords for each unique user of the system.