Category: Blog

If you hire a domestic worker to provide services in or around your home, you probably have a tax liability that you don’t know about – or one that you do know about but are ignoring. Either situation can come back to bite you. When the worker is your employee, your liability includes both withholding and paying payroll taxes as well as issuing a W-2 after the close of the year.

Sure, it is a lot easier simply to pay your worker in cash so as to avoid federal and state payroll taxes – and all the paperwork that goes with them. Your domestic worker will likely be fully cooperative with a cash deal because he or she can also avoid paying taxes. However, if the IRS or your state employment department finds out about these payments, the result could be very unpleasant for you.

Some families may be paying their household help via a third-party payment processor such as PayPal, Venmo, etc. Beginning for the 2023 tax year these payment processors must begin reporting those payments (on Form 1099-K) when the total for the year exceeds $600.

Not everyone who performs services in or around your home is classified as an employee. For instance, a plumber or electrician who makes repairs in your home will generally be a licensed contractor; the government does not classify contractors as employees.

On the other hand, the IRS has conclusively ruled that nannies, housekeepers, senior caregivers, some gardeners and various other domestic workers are employees of the people for whom they work. It makes no difference if you have a written contract with the worker; similarly, the number of hours worked, and the amount paid do not matter.

You are probably thinking, “Wait a minute” – perhaps ­­everyone you know pays in cash, and none of them has paid payroll taxes or issued a W-2 for a household employee. However, if a worker gets injured on your property or if you dismiss the worker under less-than-amicable circumstances, it’s a pretty sure bet that your household employee will be the first one to throw you under the bus by reporting you to the state labor board or by filing for unemployment compensation.

Generally, an unemployment insurance claim form requires the worker to list all employers and wage amounts to get benefits. That, in turn, creates a letter audit to collect state employment taxes and a referral to the IRS to collect federal employment taxes (FICA and FUTA). Some individuals try to circumvent the payroll issue by treating a household employee as an independent contractor, incorrectly issuing the household employee a Form 1099-NEC.

The easiest way to comply with the law, both federal and state, is to engage a payroll company to make the payroll payments and take care of the paperwork and required filings.

If you are a do-it-yourselfer, here are the correct actions you should take for domestic employees:

• Obtain a Federal Employer Identification Number (FEIN), which you will use in lieu of your Social Security Number when filing the required reporting forms. Note: If, as the owner of a sole proprietorship business, you already have a FEIN, you should use that number instead of requesting a separate one as a household employer.
• Obtain a state ID number for unemployment insurance and state tax withholdings.
• Withhold Social Security and Medicare taxes from the employee’s pay if it exceeds the annual threshold ($2,600 for 2023).
• Withhold income tax from the employee if requested by the worker and if you agree to do so.
• File state employment tax returns as required – generally quarterly (although beware that some states require monthly returns) – and make the required deposits for state employment taxes.
• Prepare a W-2 for the employee and a W-3 transmittal; file them by the end of January.
• File Schedule H with your federal individual income tax return and pay all the federal payroll and withholding taxes (i.e., the federal taxes that you withheld from the employee’s pay, plus your matching share of Social Security and Medicare taxes plus federal unemployment tax, which is entirely your responsibility). Limited exception: If you operate a sole proprietorship with employees, you may include the payroll taxes of your household workers with those of the business’s employees, but you cannot take a business deduction for those taxes. Generally, it is better to keep the personal and business reporting separate.

Some additional issues to consider are as follows:

Overtime – Under the Fair Labor Standards Act, domestic employees are nonexempt workers and are entitled to overtime pay after working 40 hours in a week. Live-in employees are an exception to this rule in most states.

Hourly Pay or Salary – It is illegal to treat nonexempt employees as if they are salaried.

Separate Payrolls – If you own a business with a payroll, you may be tempted to include your household employees on the company’s payroll. The payments to the household employees are personal expenses, however, and are not allowable deductions for a business. Thus, you must maintain a separate payroll for household employees; in other words, you must use personal funds to pay household workers instead of paying them from a business account.

Eligibility to Work in the U.S. – It is illegal to knowingly hire or continue to employ an alien who is not legally eligible to work in the U.S. When hiring a household employee who works on a regular basis, you and the employee each must complete Form I-9 (Employment Eligibility Verification). You will need to examine the documents that the employee presents to establish the employee’s identity and employment eligibility.

Other Issues – Special situations not covered in this overview include how to handle workers hired through an agency, how to gross up wages if you choose to pay an employee’s share of Social Security and Medicare taxes, and how to treat noncash wages.

Please call this office if you would like assistance with your household employee tax and reporting requirements or with any special issues that apply to your state.

You’d be hard-pressed to find someone who actually enjoys the process of filing taxes. Having said that, it’s absolutely something that you’re supposed to do like clockwork every single year.

Of course, there is a myriad of different reasons why you may have fallen behind. You could be going through something of a major life transition and simply were unable to meet the filing deadline. Maybe you filed for a much-needed extension and then other things got in the way (as they often do), causing you to fall behind even further.

Regardless of the reason, it’s important to take meaningful steps to get yourself back on track before it’s too late. Thankfully, this isn’t necessarily a difficult process – but it will require you to keep a number of important things in mind along the way.

The Consequences of Not Filing Your Taxes for Multiple Years

But first, it’s important to understand the actual consequences of what can happen if you don’t file your taxes for multiple years in a row – or even for ten years or more in some situations.

The most immediate impact you’re likely to experience will come by way of the IRS itself. If you have income that you haven’t reported on your taxes, you will be charged various penalties and fees on everything that you should have been paying up until now. These can and often do quickly add up to significant sums of money, which is why it is always important to get on track as soon as you’re able to.

Keep in mind that the IRS will charge you those fees and penalties on all taxable income, not taking into consideration any credits or deductions that you would have enjoyed had you filed taxes on time. They don’t have records pertaining to expenses like your rent or other things that you need for your job like essential equipment. Because of this, any fees will be assessed based on what they think you owe – not necessarily on what you actually owe.

If it is determined that you have been “willfully” failing to file taxes, you could potentially be punished with up to five years in prison. Likewise, you could get hit with a fine of up to $100,000 if your situation is considered to be “tax evasion.” These are all consequences that you would do well to avoid at all costs.

There are other consequences involved with not filing your taxes for a lengthy period of time, too. Sometimes when you file for a passport, for just one example, you may be asked to show your recent tax returns as a form of income verification. Obviously, you can’t do that if you haven’t been filing them. The same is true if you were planning on applying for a mortgage or car loan.

If retirement is coming up, it could also impact the types of benefits that you will receive like Social Security and Medicare. All of these are crucial aspects of life that you do not want to jeopardize, so you should get your taxes taken care of sooner rather than later.

Getting on Track With Your Taxes: A Plan of Action

The first thing you should do to get back on track with your taxes involves checking on the current status of your account with the IRS. At the very least, this will give you an indication of what the IRS thinks you owe. You can do so at the official website via irs.gov, or by calling 1-800-829-1040 to speak to a live representative.

At that point, you have two options available to you. The first involves paying what the IRS currently says you owe, along with both the original taxes and any fees or penalties that have accrued, to settle your account. If you can’t pay the full balance in one lump sum, you could always attempt to get on a payment plan.

The second involves gathering all the financial information you need to complete the tax forms you did not file. You’ll need to compile several important documents, including but not limited to things like:

• Any information pertaining to the income you made during the missing years, along with any expenses that you had so that you can claim deductions and credits that apply to you.
• Any supporting documentation like receipts and income statements that are necessary to complete the aforementioned financial records. This may require you to perform some forensic accounting so that you have the most complete picture to work from.

At that point, the next step is clear: you should file your missing tax returns at your earliest convenience. Thankfully, there is no time limit associated with filing those old tax returns. However, the sooner you do it, the better.

Oftentimes, this is absolutely the way to go as once all documents and other financial information have been properly recorded, you’ll likely end up owing less than the IRS thinks you do. You’ll still owe money, but you’ll save a bit in the long run.

Finally, you should pay your taxes as soon as you can. Again, you can do this either through a lump sum or get on some type of payment plan to bring your account up to date. You may also choose to look into a settlement agreement or any type of income tax forgiveness that may apply to you. You could even choose to make what is known as an “offer in compromise,” which allows you to pay something towards your balance to consider everything settled. The IRS would have to agree with whatever offer you make, of course.

At that point, you should prepare for future taxes so that you don’t find yourself in the same position down the road. If you need help doing precisely that, or if you have any additional questions about this process that you’d like to see answered, please don’t delay – contact us to speak to a tax professional today.

All of us dream of one day being able to retire – to finally be able to relax and enjoy the lifestyle we worked so hard for. However, you’ll need a significant amount of money to do it, which is where a lot of Americans begin to worry.

Saving for retirement is a constant fear for many out there, especially during periods when the economy is hurting. The good news is that not everyone needs to save the same amount for retirement. By performing a few simple calculations now, you can help get yourself on the right path to financial success later on.

Calculating Your Retirement Needs: Breaking Things Down

First, you need to sit down and ask yourself several important questions that are specific to your situation. These include:

• How much money will you need to spend in retirement in order to maintain the lifestyle you see for yourself?
• Between now and retirement, how much money do you expect to earn from things like your savings and other potential income sources? How much do you plan on bringing in via Social Security?
• If you don’t have enough money in your savings at that time, what are you going to do?

To answer the first question accurately, make a list of the two types of expenses: both essential and discretionary. Essential, as the term implies, are those things that you absolutely cannot live without. Things like food, shelter, health insurance, etc. Discretionary expenses are things like entertainment and travel.

One simple theory is that after you retire, you’ll need between 75% and 80% of your current income to maintain the lifestyle you enjoy today. So, if you made $90,000 per year right now, you would need to earn between $67,500 and $72,000 to continue on as you are as far as spending is concerned.

Another theory is that you should simply take what you are currently earning and subtract the amount of money that you are currently saving towards retirement to arrive at that ideal spending number. So if you’re currently making that same $90,000 and you’re saving $8,000 per year, you would need to make $72,000 to maintain your current lifestyle.

In this example, they happened to provide similar estimates. But that won’t always be the case, so try both formulas out and see which one makes the most sense for you and your goals.

Next, you’ll want to help shed even more light on the subject by figuring out how much non-portfolio income you can expect to earn during your retirement years. For the sake of example, let’s say that you want to earn $80,000 per year during retirement. If you can expect to receive about $20,000 per year from non-portfolio situations like Social Security, then you would need to make up $60,000 from elsewhere – meaning from your retirement portfolio.

So how does all of this relate back to the amount of money you should be saving right now? Many rely on what is referred to in the industry as the “25x Rule.” It simply states that if you want to get $60,000 from your retirement portfolio every year, and you assume that you are going to live an estimated 25 years beyond retirement age, then that would mean that the value of your retirement portfolio needs to be $1.5 million or more.

If you’ve performed these calculations and realize that you aren’t near your current goals yet, there are a few key steps you can take. First, it’s never too late to start contributing more money to your 401(k). You could also invest in an IRA if you haven’t already done so, contribute to a SEP-IRA (which is used by people who are self-employed), and more.

You also always have the option of simply working longer to help preserve your savings, but if you don’t necessarily want to do that you don’t have to. You might want to consider at least working until you’re eligible for Medicare, as this can help cut down on your essential expenses because you wouldn’t need private health insurance coverage.

In the end, saving for retirement is something that a lot of people worry about so if you’re among them, rest easy knowing that there are many, many others. It can be a challenging process, but by following best practices like those outlined above you can help make sure you’re on the right path. You should also consult with a financial professional to help come up with a specific plan that makes the most sense for you.

S corporation compensation requirements are often misunderstood and abused by owner-shareholders. An S corporation is a type of business structure in which the business does not pay income tax at the corporate level and instead distributes (passes through) the income, gains, losses, and deductions to the shareholders for inclusion on their income tax returns. If there are gains, these distributions are considered a return on investment and therefore are not subject to self-employment taxes.

However, if stockholders also work in the business, they are supposed to take reasonable compensation for their services in the form of wages, and of course, wages are subject to FICA (Social Security and Medicare) and other payroll taxes. This is where some owner-shareholders err by not paying themselves reasonable compensation for the services they provide, some out of unfamiliarity with the requirements, and some purposely to avoid the payroll taxes.

The Internal Revenue Code establishes that any officer of a corporation, including S corporations, is an employee of the corporation for federal employment tax purposes. S corporations should not attempt to avoid paying employment taxes by having their officers treat their compensation as cash distributions, payments of personal expenses, and/or loans rather than as wages.

If the S corporation does not pay it’s working stockholders a reasonable compensation for their services, then the IRS generally will treat a portion of the S corporation’s distributions as wages and impose Social Security taxes on the deemed wages.

There is no specific method for determining what constitutes reasonable compensation, and it is based on facts and circumstances. Generally, it is an amount that unrelated employers would pay for comparable services under like circumstances and based upon the cost of living in the area where the business is located. The following are just some of the many factors that would be considered in making this determination:

• Training and experience
• Duties and responsibilities
• Time and effort devoted to the business
• Dividend history
• Payments to non-shareholder employees
• Timing and manner of paying bonuses to key people
• What comparable businesses pay for similar services
• Compensation agreements
• The use of a formula to determine compensation

The problem here, of course, is that it is easy for the IRS to list contributing factors used by the courts in determining reasonable compensation and leave it to the corporation to quantify these factors into a reasonable salary but still can challenge the selected amount later if an auditor, off the top of their head, decides the compensation is unreasonable.

The IRS has a long history of examining S corporation tax returns to ensure that reasonable compensation is being paid, particularly if no compensation is shown being paid to employee-stockholders.

Reasonable Compensation in the Spotlight – With the passage of tax reform, reasonable compensation will be in the spotlight because of the new deduction for 20% of pass-through income. This new Sec. 199A deduction is equal to 20% of qualified business income (QBI) and will figure into the shareholder’s income tax return. The QBI for the stockholder of an S-corporation is the amount of net income passed through to the stockholder and designated as QBI on the K-1, but the stockholder may not include the reasonable compensation (wages) he or she was paid as QBI. Thus, wages paid to stockholders reduce the QBI because the S corporation deducts the wages as a business expense, therefore reducing the corporation’s net income and QBI. But that does not mean wages can be arbitrarily adjusted to maximize the Sec. 199A deduction.

IRC Sec. 199A Deduction – Here are some details about how the 199A deduction works and the impact of reasonable compensation wages on the Sec. 199A deduction.

• The S corporation’s employee-stockholder’s wages are NOT included in qualified business income (QBI) when computing the 199A deduction. Thus, the larger the wages, the smaller the K-1 flow-through income (QBI) and thus the smaller the 199A deduction, which is 20% of QBI. In this case, an S corporation would tend to pay the stockholder a smaller salary to maximize the flow-through income and, as a result, the 199A deduction.
• If married taxpayers filing a joint return have taxable income that exceeds $364,200 ($182,100 for other filing statuses), the 199A deduction begins to be subject to a wage limitation, and once the taxable income for married taxpayers filing a joint return exceeds $464,200 ($232,100 for other filing statuses), the 199A deduction becomes the lesser of 20% of the QBI or the wage limitation. For these high-income taxpayers, an S corporation will tend to pay stockholders less wage income for them to benefit from the Sec. 199A deduction.
• If an S corporation is a specified service trade or business, the Sec. 199A deduction phases out for married taxpayers filing a joint return with taxable income between $364,200 and $464,200 (between ($182,100 and ($232,100 for other filing statuses). And although the wage limitation is used in computing the phase-out, once the taxpayer’s taxable income exceeds $464,200 ($232,100 for other filing statuses), the taxpayer will receive no benefit from the wage limitation and therefore would again want to minimize their reasonable compensation to minimize FICA taxes. Specified service trades or businesses (SSTBs) include those in the fields of health, law, accounting, actuarial science, performing arts, athletics, consulting, and financial services (for more information on what constitutes an SSTB, please call).

Of course, taxpayers cannot pick and choose a reasonable level of compensation to minimize taxes or maximize deductions. Therein lies a trap for taxpayers who do not consider the factors related to reasonable compensation. There are commercial firms that have the data necessary to determine reasonable compensation and specialize in doing so. These firms can be found by searching the Internet for “reasonable compensation.” Even the IRS has employed these firms to provide reasonable compensation data in tax court cases.

If you want additional information related to reasonable compensation, please give our office a call.

With tax season upon us, documents reporting income, sales and other items needed for your 2022 tax return should have arrived or will be arriving soon. Be on the lookout for them and be careful not to accidently discard any. Here are some of the common tax forms you need to be watching for depending upon your particular circumstances. 

Form W-2 – If you were employed in 2022, you will receive a W-2 from each of your employers. Not only does this form report your wages, but also the income tax that was withheld from your paychecks and which will be a credit against your tax liability.

Form W-2G – If you had gambling income more than the IRS gambling winning reporting thresholds, you will receive one or more Form W-2Gs. In fact you may have already received one from the gambling entity at the time you won.

Form 1099-G – This form is used for reporting income and refunds from several sources including:

If you received a state income tax refund in 2022 from your 2021 return, the state will issue a Form 1099-G reporting the refund amount, which may or may not be taxable income on your 2022 federal return. If you itemized your deductions on your 2021 federal return, the state refund will most likely be taxable for federal.

You will also receive a Form 1099-G showing the amount of any unemployment benefits you may have received in 2022, which are taxable for federal purposes. Some states also tax these payments.

Form 1099-MISC – You may receive a Form 1099-MISC for miscellaneous income received during 2022. This income will need to be reported on your tax return, but in some cases expenses may be deductible against this income.

Form 1099-DIV – If you have stocks or mutual funds that pay dividends, they are typically reported on Form 1099-DIV.

Form 1099-INT – If you received interest income in 2022, typically from bank savings accounts, or other investments, you will receive a 1099-INT showing the taxable amount of interest you earned. Although banks and other financial institutions aren’t required to issue a 1099-INT form if the interest you earned is less than $10 for the year, you are still required to report the interest income on your tax return.

You may receive a 1099-INT reporting interest paid to you by the IRS because of a delay in their processing your 2021 tax return. This interest is taxable on both your federal and state returns.

If you cashed in U.S. savings bonds during 2022 through an account with the government’s TreasuryDirect, you will need to retrieve your 1099-INT from your TreasuryDirect online account since the government is not sending paper 1099-INT forms for these redemptions. This interest is taxable on your federal return but not your state return.

Form 1099-B – Where you sold securities during 2022 you should receive a 1099-B providing all the details of your sales for the year.

NOTE: If your investments are with a brokerage firm, you will generally receive a substitute reporting form, listing all the stock and security sales, interest, dividends, and other investment information needed for your 1040 preparation.

Form 1099-S – If you sold your home during the year, you may receive a Form 1099-S showing the sales price. Sometimes the escrow company issues the 1099-S at the closing of the sale, so check your closing documents to see if you already have the form.

Form SSA-1099 – If you received social security benefits during 2022, you will be receiving a Form SSA-1099 showing the amount received, any social security benefit adjustments, and the amount of Medicare insurance premiums withheld from your monthly benefits.

Form RRB-1099 – Is the equivalent of Form SSA-1099 for railroad retirement benefits.

Form 1099-R – Reports retirement plan benefits you received, including IRA distributions. Generally, the taxable amount is also included on the Form 1099-R.

Form 1098-T – If you paid college tuition for yourself or a dependent, you will generally need the Form 1098-T that will be sent to you by the educational institution to claim an education credit.

Form 1095-A – If you obtained your health insurance through a government marketplace, you should receive a Form 1095-A that is needed to reconcile your advance premium tax credit, and used to reduce your 2022 premiums.

Form 1099-NEC – If you were self-employed in 2022, businesses that paid you $600 or more will be issuing you a Form 1099-NEC, some even if the amount they paid you is less than $600.

Form 1099-K – If your business accepts credit cards, debit cards, as well as PayPal or other third-party payments, you may receive a Form 1099-K showing those sales for the year. Even if you don’t have a business, you may receive a 1099-K, if you received income through one of these or similar sources, such as when you sold items online or the income was reimbursement for personal expenditures or a gift to you from a friend or relative. These non-business-related payments may need to be reported on your return, but may not be taxable or may be only partly taxable.

Schedule K-1 – If you are a partner in a partnership, shareholder in an S-Corporation, or a beneficiary of a trust, you will also receive a Schedule K-1 from the entity, showing information from the entity that will be needed to prepare your personal return. You may also receive Schedules K-2 and K-3. These forms may be delayed, since they won’t be available until after the partnership, S-Corporation, or trust’s tax return has been prepared.   

The IRS also receives copies of these documents. If the information on these documents is not reported correctly on your tax return, you will hear from the IRS at a later date.

If you don’t receive an income-reporting Form 1099 or schedule that you were expecting, you should check to see if it is available from the payer online. Even if you don’t receive the form, you are still required to report on your tax return the income that you received from that payer or business.

Please call this office if we can be of assistance.

The type of business that you’re running has major implications in virtually all areas of your operations, especially when it comes to federal taxes. An S Corporation (or S Corp for short) is one that passes corporate income, losses, deductions, and credits to its shareholders. A C Corporation (or C Corp for short) is one where the owners are taxed separately from the business itself.

Having said that, just because you chose one type of legal structure at the outset of your business doesn’t mean that you have to live with that decision for the remainder of your career. Converting from an S Corp to a C Corp is possible, but it’s a process that requires you to keep a few key things in mind along the way.

The S Corp and C Corp Conversion Process: Breaking Things Down

Generally speaking, converting from an S Corp to a C Corp is something that happens for a few key reasons. Sometimes, it’s voluntary. Maybe a corporation wants to broaden its investor base, or its leaders have their eyes set on going public in the future. Sometimes, an S Corp is terminated by law, causing it to automatically transition into a C Corp. In this context, the corporation may have failed to meet its eligibility requirements, or it has earnings, profits, and passive investment income that is greater than 25% of its gross income for three consecutive years.

If yours is a business that falls into the former category, know that you need to start this process by March 15 of the current tax year. Once shareholders agree to the change, things will move along fairly quickly.

For starters, you need to file what is called a “Revocation of S Corporation Status” with the IRS Service Center. You’ll need to do this where you filed for an S Corp in the first place. On the document, you’ll give critical information like the name of the corporation, the tax ID number that you’re currently using, the total number of outstanding shares that you have, and more.

Once the document is completed, it needs to be signed by the same individual who is authorized to sign the corporate tax returns for the company. In most situations, this will be the president. In some contexts, it may be a corporate officer.

Note that the filing of this document will also need to include what is known as a statement of consent. This document needs to be signed by any shareholder that has more than 50% stock in the company. This includes people who have nonvoting shares, too.

During this time, you should make a copy of all documentation to store with your records. Most experts recommend that you store them with all of your other tax documents should you need to refer to them in the future.

There’s not much more to the actual process itself than that – but there are some potential consequences that you need to be aware of. Chief among them is the fact that a business only has a specific amount of time to distribute any earnings to shareholders when this process is complete. Once you’re outside of that window, all distributions will then be taxed as dividends.

Likewise, if you happen to convert halfway through the year, your business will need to file two tax returns. This can greatly complicate things, which is why it’s always important to make sure that everything is finalized by that March 15 date.

Finally, know that when you convert from an S Corp to a C Corp, you won’t be able to go back again for at least five years. The only exception to this is if you get approval to do so from the IRS itself. So be absolutely certain that this is the best move to take for your corporation before you go through the process.

In the end, converting from an S Corp to a C Corp is a decision that can definitely have its benefits – but there are also long-term implications that you need to be aware of. Before you go through the process of changing the tax status of your company, it is always recommended that you speak with a financial professional so that they can shed insight and help you avoid potentially costly mistakes in the future.

If you’d like to find out more information about how to convert from an S Corp to a C Corp, or if you have any additional questions, you’d like to go over with someone in a bit more detail, please don’t delay – contact us today.

Married taxpayers generally have the option to file a joint tax return or separate returns, a filing status commonly referred to as married filing separate (MFS). If you are married and you and your spouse are filing separate returns, or are considering doing so, you should read this article before making that decision.Depending on whether the taxpayers are residents of a separate or community property state, their separate returns may include just the income and eligible expenses of each filer or a percentage of their combined income and expenses.

Couples choose the MFS option for a variety of reasons:

• They want to avoid the joint and several liability for the tax from a joint tax return.Joint and several liability is a legal term for a responsibility that is shared by two or more parties to a lawsuit. A wronged party may sue any or all of them, and collect the total damages awarded by a court from any or all of them.
• They have children from a prior marriage and want to keep finances separate.
• They only want to keep their taxes separate.
• The marriage is tenuous.
• The taxpayers are separated and don’t want to cooperate in filing a joint return.
• One spouse might get a larger refund by filing separately (the other will pay more).
• They think they can save money by filing separate returns, and a variety of other reasons.

The fact of the matter is that tax laws are carefully written to keep married taxpayers from filing separately to manipulate the tax laws to their benefit. The following is a list of the more commonly encountered tax disadvantages – some might call them tax penalties –when filing as MFS. Unless otherwise noted the amounts shown are for 2023:

Filing Threshold – For all filing statuses except MFS the income threshold where a return must be filed is equal to the standard deduction for that filing status. For an MFS return the filing threshold is $5.

Community Property State Income – Unlike most states where each spouse claims their own earned income on an MFS return, in community property states the earned income is evenly split between the spouses. However, FICA payroll withholding, self-employment tax, and IRA contributions apply separately to the spouse who earned the income.

Joint & Several Liability – On a joint return both spouses can be held responsible for payment of the tax, while the spouses filing as MFS are only responsible for payment of the tax on their individual MFS returns.

Social Security Benefits Taxation Threshold – Social Security (SS) income is not taxable until taxpayers filing married joint have modified AGI (MAGI) that exceeds a threshold of $32,000. MAGI is regular AGI (without Social Security income) plus 50% of their Social Security income plus tax-exempt interest income, and plus certain other infrequently encountered additions. However, the threshold is zero for taxpayers filing as MFS. Thus taxpayers filing as MFS are taxed on 85% of every dollar of SS income.

Capital Loss Limitation –Where married couples filing jointly can annually deduct up to $3,000 of capital losses, those filing as MFS can only deduct up to $1,500.

Sec 179 Limitation – Taxpayers can elect to expense the cost of qualifying property used in the active conduct of a trade or business. The portion of the cost not expensed under Sec 179 is depreciable. The maximum amount that can be expensed is inflation adjusted annually and is $1,160,000 for 2023 (up from 1,080,000 in 2022). For MFS taxpayers the annual maximum amount must be allocated between the spouses.

Rental Loss Limitation – Generally, most taxpayers cannot deduct rental losses. However, there is aspecial rule that allows a deduction of aggregate losses from rental real estate activities up to $25,000 per year for taxpayers who are an active participant in the activity. It means that the taxpayer must participate in management decisions, and at least arrange for others to provide the necessary services such as repairs.

However, this special allowance only applies to lower income taxpayers with an AGI, without regard to passive losses, of $150,000 or less. In addition the $25,000 loss allowance begins to phase out 50 cents for each $1 of income over $100,000. Thus the allowance is fully phased out for joint filers when the AGI exceeds $150,000.

Phase out applies to gross income without considering passives, taxable Social Security benefits, or deductions for IRA.

Taxpayers filing as MFS must live apart the entire year or they get no relief under this rule. If they lived apart all year, the allowance is $12,500, and phase out begins at income of $50,000.

Traditional IRA – For taxpayers filing joint returns, a Traditional IRA is tax deductible except that the deductibility is phased out for higher income taxpayers who are active participants in an employer retirement plan. Where both spouses are active participants in an employer retirement plan the deductibility of IRA contribution in 2023 phases out for AGIs between $116,000 and $136,000. Where only one spouse is an active participant the phase out is between $218,000 and $228,000. However, for those filing MFS the phaseout is between $0 and $9,999.

Roth IRA – The ability to contribute to a Roth IRA phases out for those couples filing jointly between $218,000 – $228,000. However, for those living together and filing MFS the phase-out is range is $0 and $9,999.

Savings Bond Interest Exclusion – An individual who pays qualified higher education expenses with redemption proceeds from Series EE or I bonds issued after ’89 can potentially exclude from income the bond interest. No exclusion is available to a taxpayer filing married separate.

Higher Education Interest – An “above-the-line” deduction is allowed for interest payments due and paid on any “qualified student loan,” regardless of when a taxpayer first incurred the loan. The maximum deduction per year is $2,500. However, for those filing MFS, no deduction is allowed.

Standard Deduction – The deduction for those filing as MFS is ½ of the standard deduction for married filing joint taxpayers plus the age 65 and blind add-on amounts.

Standard Deduction vs Itemized Deductions – Generally taxpayers can choose between taking the standard deduction or itemizing deductions. However, where both spouses are filing as MFS if one itemizes, then both must itemize, a tax trap often overlooked by MFS filers.

Medicare Premiums – For taxpayers who qualify forMedicare, the premiums are based upon their modified adjusted gross income (MAGI) and filing status from the tax return two years prior. The rates for individuals filing MFS are substantially higher than for other Medicare participants.

Home Mortgage Interest – MFS spouses are treated as if they are one taxpayer and must split between them the amount of mortgage interest deduction they would be entitled to jointly. If two homes are involved, each spouse can only claim interest on one home unless they agree one can claim both.

State and Local Taxes Deduction – When itemizing deductions, the tax code limits (referred to as the SALT limitation) the deduction for state and local taxes, such as state income or sales tax and property tax, to $10,000 for all filing statuses except MFS, which is limited to $5,000.

Alternative Minimum Tax (AMT) – For MFS taxpayers the AMT exemption amount is only half of the amount for those filing jointly and the income threshold for the 28% tax rate is half of what it is joint filers.

Tax Rates – The marginal rates for MFS are twice that of married taxpayers filing jointly.

Child & Dependent Care Credit – MFS taxpayers cannot claim this credit unless legally separated. Where it can be claimed, the AGI credit phaseout threshold is $75,000 (half of that allowed for joint filers).  

Earned Income Tax Credit (EITC) – The EITC is a tax credit for low-income taxpayers. Where one spouse can file as head of household (HH) instead of MFS and lives in a community property state, earned income for the credit does not include amounts earned by the other spouse. For a spouse to claim HH instead of MFS, he or she must have lived apart from their spouse at least the last six months of the year and paid more than one-half of the cost of maintaining a household which is the principal place of abode for more than one-half the year of a child, stepchild, or eligible foster child for whom the taxpayer may claim a dependency exemption.

Adoption Tax Credit – Allowed for an MFS taxpayer only if the spouses lived apart for the last 6 months of the year and the child lived with taxpayer more than half the year and the taxpayer provided over half the cost of maintaining the home.

Elderly & Disabled Tax Credit – Not allowed for those filing as MFS.

Retirement (Saver’s) Credit – The maximum AGI to be eligible for any Saver’s Credit for those filing jointly in 2023 is $54,750 while for those filing MFS it is $36,500.

Tax Withholding – MFS taxpayers only claim their own income tax withheld unless they are residents of a community property state where they each claim half.

Estimated Tax Allocation – When taxpayers make joint estimated tax payments, they can allocate the payments between themselves in any amounts they can agree upon. If they cannot agree, they must divide the payments in proportion to each spouse’s individual tax as shown on their separate returns for the year.

Estimated Tax High Income Safe Harbor – Taxpayers are subject to an underpayment penalty when their tax liability less the sum of their withholding and estimated tax payments is more than $1,000. However, there is a high income exception to the penalty when the AGI for the previous year is over $150,000, in which case the required estimated payments are the smaller of 90% of the current year’s tax, or 110% of the previous year’s tax. If filing MFS the AGI for the previous year need only be over $75,000.

Premium Tax Credit – The premium tax credit is a refundable credit available to lower income taxpayers to help them offset the cost of purchasing their health insurance from a government marketplace. Taxpayers filing MFS cannot claim this substantial credit unless they are a victim of spousal abuse or abandonment.

Automatic 2-month Extension When Out of the Country – Taxpayers who are out of the U.S. on the tax filing due date are granted an automatic 2-month extension to file their tax return. This provision applies to both spouses when filing a joint return even if only one spouse is out of the country. When filing MFS, the extension will only apply to the spouse that is out of the country.

Many of the consequences listed interact with others and generally require professional tax software to account for all of interactions and to accurately compare the results for a couple filing jointly or each filing separately.

If you have questions or would like to schedule an appointment to see how the consequences of filing separate returns might apply to your situation, please give the office a call.  

Individuals are always looking for tax deductions that can reduce their tax liability. But what is the actual tax benefit derived from a tax deduction? There is no straightforward answer because some deductions are “above the line”, others must be itemized, some must exceed a threshold amount before being deductible, and certain ones are not deductible for alternative minimum tax purposes, while business deductions can offset both income and self-employment tax. In other words, there are many factors to consider, and the tax benefits differ for everyone, depending on their particular situation and tax bracket.

For most non-business deductions, the savings are based upon your tax bracket. For example, if you are in the 12% tax bracket, a $1,000 deduction would save you $120 in taxes. On the other hand, if you are in the 32% tax bracket, the $1,000 deduction will save you $320 in taxes. Even so, if your taxable income is close to transitioning into the next-lower tax bracket, the benefit will be lower.

You also need to consider whether the deduction is allowed on your state return and what your state tax bracket is to determine the total tax savings. Currently, the maximum federal tax bracket is 37%, meaning the most benefit that can be derived from a $1,000 income tax deduction is $370. Some individuals justify making discretionary purchases just because they are tax-deductible. Even in the highest tax bracket, you are still paying $630 out of pocket ($1,000 − $370), so it does not make sense to incur a tax-deductible expense just for the tax deduction.

Some deductions, such as IRA and self-employed retirement plan contributions, alimony, and student loan interest, are adjustments to income or what we call above-the-line deductions. These deductions, to the extent permitted by law, provide a dollar deduction for every dollar claimed. On the other hand, deductions that fall into the itemized category must exceed the standard deduction for your filing status before any benefit can be derived. In addition, medical deductions are reduced by 7.5% of your adjusted gross income (AGI), and most cash charitable deductions are limited to a maximum of 60% of your AGI. Under the tax reform that became effective in 2018, the deduction for state and local taxes is currently capped at $10,000 per year.

The most beneficial deductions are business deductions that offset both income tax and, depending upon the circumstances, self-employment tax. For 2023, the self-employment tax rate is 12.4% of the first annually inflation adjusted $160,200 of net self-employment income plus 2.9% for the Medicare tax, with no cap. Contact this office for rates applicable to other years. Some high-income taxpayers may pay an additional 0.9% Medicare tax. For self-employed businesses with less than $160,200 of net income, the self-employment tax rate is 15.3%. Thus, for small businesses with profits of less than $160,200, the benefit derived from deductions generally will include the taxpayer’s tax bracket plus 15.3%. For example, for a taxpayer in the 24% tax bracket, the benefit could be as much as 39.3% (24% + 15.3%) of the deduction. If the deduction were $2,000, the tax savings could be as much as $806 or more, when the taxpayer’s state income tax bracket is included.

In addition to deductions, taxpayers also benefit from tax credits. Tax credits reduce the tax, not the taxable income, dollar for dollar. These credits come in different varieties. Some, referred to as non-refundable will only reduce a taxpayer’s tax liability to zero while refundable credits will reduce the tax liability to zero and any balance is refunded. In addition, some unused non-refundable credits can be carried to other years. The following are examples of 2023 tax credits:

• Earned Income Tax Credit (EITC) – This inflation adjusted credit is for lower income taxpayers based on their earned income and overall income for the year. The credit can be as much as $7,430, and is a refundable credit.
• Home Solar Credit – Is 30% of the cost of a home solar electric system put into service in 2023. The credit is non-refundable, but unused credit carries over to future years.
• Credit for Energy Efficient Home Modifications – This credit is 30% of the cost ofmaking qualifying energy saving improvements to your existing home. The costs, and thus the credit, is limited by the type of home improvement and the annual maximum credit is $1,200. However, this is a non-refundable credit and there is no carryover.

So when evaluating the tax benefit of a tax credit one must consider whether it is a refundable credit; if any unused amounts carry over to be used in other years; and whether there are any limits on the dollar amount of the credits.

If you are planning an expenditure and expect the tax deduction or tax credit to help cover the cost, please call before making the purchase to ensure that the tax benefit will be what you anticipate.