Yet Another Preparer Penalty Starting In 2018

We have spoken before of social-worker duties the tax Code expects of a professional preparing a return with an earned income credit, a refundable child credit or the American Opportunity (that is, the college) credit.

Take the earned income credit, for example. If you have two children, that credit can be $5,616; have three and the credit can reach $6,318. Remember that the credit is refundable – meaning the IRS will write you a check – and no wonder this provision is rife with fraud.  

If the IRS wanted to push-back on the fraud, it could require a preparer to review documentation that a child (or several) actually lives with the parent/taxpayer.

To be certain to get the preparer’s attention, the IRS could also impose a penalty if the preparer failed to do so.

Let’s have the IRS tighten this up a notch by also requiring a form or schedule with the return requiring the preparer to declare that he/she did all of this Sherlocking.

Which is why I will not prepare a return with these credits unless I have known (or, alternatively, my partner has known) the client for a while.

This rule is expanding in 2018 to include head of household filing status.

Oh boy.

Let’s go through a Tax Court case I was reviewing recently.

(1)  Joe and Cerice lived together and had a child in 2006.

(2)  The relationship went south either late 2014 or early 2015.

(3)  Cerise moved in with her mother.

(4)  Joe and Cerise started sharing custody, although Joe’s parents also took care of the child while he was working.

(5)  There was a custody proceeding in 2015, and the Court order gave each parent equal time. For some reason, the Court came back in 2016 and reduced Joe’s share of parental time.

(6)  The Court stated that Cerise could claim the child in 2015 and all odd-numbered years. Joe could claim the child in even-numbered years.

QUESTION: Who claims the child in 2014?

The technical detail here is that head-of-household status requires the child to spend more than one-half of the year with the claiming parent.

Let’s say that I have never met Joe or Cerise. I meet with either one, who asks me to prepare the 2014 return. Whoever I meet with wants to claim the child, of course, as it will power head of household status, an earned income credit and a child credit. I suspect either Joe or Cerise could present a formidable argument that the child was with him/her for more than one-half of the year.

What am I supposed to do?

I would of course look at the custody agreement, but that doesn’t start until the following year. No help there.

I could get assurance from the other parent that he/she is not claiming the child.

Let’s say that fails.

I could get a letter from the pediatrician, I suppose.

Or the school, if the child were old enough.

Or maybe the landlord where either Joe or Cerise lives.

Here I am social-working this situation. If I don’t, the IRS can penalize me $510. For each instance. Miss both the head of household and refundable child care credit and the penalty is $1,020.

Which might be more than I am charging to prepare the return.

How keen would you be to accept Joe or Cerise as a client?

That is my point.

Saying Goodbye To Employee Business Expenses

Let’s talk about miscellaneous itemized deductions - likely for the last time.

These are the deductions at the bottom of the form when you itemize, and you probably itemize if you own a house and have a mortgage. Common miscellaneous deductions include investment management fees (if someone, such as Simply Money, manages your savings) and employee business expenses.

These are the “bad” expenses that are deductible only to the extent they exceed 2% of your income (AGI), because … well, because the government wants more of your money.

I am reading a case concerning a bodyguard and his employee business expenses.

His name is Rick Colbert and he retired after 30 years from the Long Beach, California Police Department. He gigged-up with Screen International Security Service Ltd (SISS) in Beverly Hills. They assigned him celebrities. He chauffeured them, deflected paparazzi, installed and monitored security devices, patrolled their estates, performed access point control and responded to distress calls.

SISS had a reimbursement policy. It did not cover everything, but it did cover a lot. Colbert did not seek any reimbursement.

He filed his 2013 tax return and reported SISS income of $25,546.

He then deducted employee business expenses of $23,965.

COMMENT: One can tell he is not in it for the money.

Those numbers are out-of-whack, and the IRS audited him. Like the IRS we know and love, they bounced all of his employee business expenses, arguing that he had not substantiated anything.

On to Tax Court they went.

The Court went through the list of expenses:

(1) $211,154 for a pistol and target practice.

Looks legit, said the Court.

(2) $86 for earbuds

To avoid annoying celebrities.

The Court grinned. OK.

(3) $1,711 for clothing and dry cleaning

Nope said the Court.

We have talked about this before. If you can wear the clothing about town and day-to-day, there is no deduction. It is just another personal expense, unless our protagonist wanted to dress up like “Macho Man" Randy Savage.

(4) $1,609 for a gym membership, weight loss pills and other stuff.

Uhh, no, said the Court, as these are the very definition of “personal, living, or family expenses.”

(5) Office in Home

This would have been nice, be he did not use space “exclusively” for the office, which is a requirement. This would hurt a send time when the Court got to his …

(6) iPad and printer

Computers are like cars when it comes to a tax deduction: you have to keep records to document business use. The reason you never hear about this requirement is because of a significant exception – if you keep the computer in an office you can skip the records requirement.

When Colbert lost his office-in-home, he picked-up a record-keeping requirement. He lost a deduction for his iPad, printer and supplies.

(7) $5,003 for his cellphone

It did not help that his internet and television were buried in the bill.

The Court disallowed his cellphone, which amazes me. Seems to me he could have gone through his bills and highlighted what was business-related.

He won some (primarily his mileage) but lost most.

And his case is now among the last of its kind.

Why?

The new tax bill does away with employee business expenses, beginning in 2018. There is NO DEDUCTION this year.

If you have significant employee business expenses, you really, really need to arrange a reimbursement plan with your employer. Your employer can deduct them, even though you cannot. Why the difference?

Because, to your employer, they are just “business expenses.” 

Roth IRA Recharacterizations Are Going Away

You may have heard that there has been a tax change in the land of Roth IRAs. It is true, and the change concerns recharacterizations.

And what does that seven-syllable word mean?

Let’s say that you have $50,000 in a traditional (or “Trad”) IRA. “Traditional” means that you got to deduct the money when you put it in. You did so over several years, and you now have – after compounding - $50 grand. Congrats.

You read that this thing is a tax bomb waiting to go off.

How?

Simple. It will be taxable income when you take it out. That is the bargain with the government: they give you the deduction now and you give them the tax later.

You decide to convert your “Trad” into a Roth. That way, you do not pay tax later when you take the money out.

You find out that it is pretty easy to convert, irrespective of what you hear on radio commercials. Let’s say your money is with Vanguard or T Rowe Price. Well, you call Vanguard or T Rowe and explain what you are up to. They will explain that you need a Roth IRA account. You will then have two IRA accounts:

          CTG Reader Traditional IRA, and

          CTG Reader Roth IRA

There is $50 grand in the Traditional IRA account.

You convert.

There is now $50 grand in the Roth IRA and $-0- in the Traditional IRA accounts.

You did it. Good job.

BTW you just created $50 grand of taxable income for yourself.

How? Well, you converted money from an IRA that would be taxable someday to an IRA that will not be taxable someday. The government wants its money someday, and that someday is today.

You didn’t think the government would go away, did you?

Let’s walk this thing forward. Say that we go into next year and your Roth IRA starts tanking. It goes to $47 grand, then $44 grand. The thing is taking on water.

It is time to do your taxes. You and I are talking. We talk about that $50 grand conversion. You tell me about your fund or ETF slipping. I tell you that we are extending your return.

Why?

That is what changed with the new law.

For years you have had until the date you (properly) file your return to “undo” that $50 grand conversion. That is why I want to extend your return: instead of having to decide on April 15, extending lets you wait until October 15 to decide. You have another six months to see what that mutual fund or ETF does. 

Let's say that we wait until October 8^th and the thing has stabilized at $43 grand.

You feel like a chump paying tax on $50 grand when it is only worth $43 grand.

I have you call Vanguard or T Rowe and have them move that money back into CTG Reader Traditional IRA. Mind you, this has to be done by October 15 as the tax extension will run out. We file your return by October 15, and it does NOT show the $50 grand as income.

Why? You unwound the transaction by moving the money back to the Traditional account. Think of it as a mulligan. The nerd term for what we did is “recharacterization.”

It is a nice safety valve to have.

But we will soon have recharacterizations no more. To be accurate, we still have it for 2017 returns but it goes away for later tax years. Your 2017 return can be extended until October 15, 2018, so October 15, 2018 will be extinction day for recharacterizations. It will just be a memory, like income averaging.

BTW there is a variation on the above that will continue to exist, but it is only a distant cousin of what we discussed. Let’s go to your 2018 tax return. In March, 2019 you put $5,500 in a Roth IRA. You will still be able to reverse that $5,500 back to a regular IRA by October 15, 2019 (remember to extend!).

But the difference is that the distant cousin is for one year’s contribution only. You will not be able to take a chunk of money that you have accumulated over years, roll it from a Trad to a Roth and have the option to recharacterize back to a Trad in case the stock market goes wobbly.

Sad in a way.

Individual Changes In The New Tax Bill

We have a new tax bill, and it is considered the most significant single change to the tax Code over the last 30 years. Here are some changes that may affect you:

·     Your tax rate is likely going down. A single person making $150,000, for example, will see his/her rate dropping from 28% to 24%. A married couple making $250,000 will see their rate drop from 33% to 24%. Whether married or not, the top rate has gone from 39.6% to 37%.

·     You will lose your personal exemptions next year. For 2017 the exemption amount is $4,050 for you, your spouse and every tax dependent. 

·      To make up for the loss of the personal exemptions, your standard deduction is going up in 2018. A single taxpayer will increase from $6,350 to $12,000. A married taxpayer will go from $12,700 to 24,000.

·      Many of your itemized deductions will be limited or go away altogether next year:

o   For 2017 you can deduct interest on up to $1 million on a mortgage used to buy your home.  In 2018 that limit will drop to $750,000.

o   For 2017 you can deduct interest on (up to) $100,000 of home equity loans. In 2018 you will be unable to deduct any interest on home equity loans.

o   For 2017 you can deduct your state and local income and real estate taxes, without limit. In 2018 the maximum amount you can deduct is $10,000.

o   For 2017 you can deduct a personal casualty loss (such as a car flooding), subject to a $100-deductible-per-incident and-10%-of-income threshold. You will not be able to deduct such losses in 2018, unless you are in a Presidentially-declared disaster zone.

o   For 2017 you can deduct contributions up to 50% of your income. In 2018 that increases to 60%.

o   If your contribution provides the right to purchase seat tickets to an athletic event – say to Tennessee or Ole Miss – you can presently deduct a percentage of that contribution.  In 2018 you will not be able to deduct any portion.

o   In 2017 you can deduct employee business expenses, certain similar or investment expenses, subject to a 2% disallowance. Starting in 2018 no 2% miscellaneous deductions will be allowed.

·     Medical expenses – for some reason – go the other way. Congress reduced the threshold from 10% to 7.5%, and it made the change retroactive to January 1, 2017. It is one of the few retroactive changes in the bill, and it will exist for only two years – 2017 and 018.

·     Get divorced and you might pay alimony. For 2017 you can deduct alimony you pay, and your ex-spouse has to report the same amount as income. Get divorced in 2019 or later, however, and your alimony will not be deductible, and it will not be taxable to your ex-spouse.

·      Move in 2017 and you may be able to deduct your moving expenses. There is no deduction if you move in 2018 or later.

·      You still have the alternative minimum tax to worry about in 2018, but the exemption amounts have been increased.

·      If you own a business, chances are the new tax law will affect you. For example,

o   If you own a C corporation, you will now pay tax at one rate – 21%. It does not matter how big you are. You and Wells Fargo will pay the same tax rate.

o   If you are self-employed, a partner or a shareholder in an S corporation, you might be able to subtract 20% of that business income from your taxable income. There are hoops, however. The new law will limit your deduction if you do not have payroll or have no depreciable assets, although you can avoid that limit if your income is below a certain threshold.

·     Your kid will provide a larger child tax credit. The credit is $1,000 for 2017 but will go to $2,000 in 2018.

What can you do now to still affect your taxes?

·      Rates are going down. Delay your income if you can.

·      For the same reason, accelerate your expenses, especially if you are cash-basis.

·      Prepay your real estate taxes. Yes, that means pay your 2018 taxes by December 31.

·      Pay your 4^th quarter state (and city) estimated tax by December 31. You may even want to sweeten it a bit, although the tax bill does not permit one to prepay all of 2018’s state tax by December 31.

·      Remember that you are losing your 2% miscellaneous deductions next year. If you use your car for work and are not reimbursed, you will lose out. It is the same for an office-in-home. 

·   Congress is limiting or taking away many popular itemized deductions and replacing them with a larger standard deduction. This means your remaining deductions – mortgage interest, taxes (what’s left) and contributions are under pressure to exceed that standard deduction. If you do not think you will be able to itemize next year, you may want to accelerate your contributions to 2017. Remember that the check has to be in the mail by December 31 to claim the deduction in 2017.

There are some surprises to be had, folks. I was looking at an estimated 2018 workup for a routine-enough-CPA-firm client. The result? An over 16% tax increase. What caused it? The loss of the personal exemptions. It was simply too much weight for the increased standard deduction and slightly lower tax rates to pull back up. 

I hope that is not the norm. This is a hard-enough job without having that conversation.