My goal here isn't to give you everything you need to file your own taxes, that would be absurd to try and do in an Instructable. And do not construe this as advice- I take no responsibility for anyone getting into trouble by getting in over their heads with a little information, basically like all the people who say in their Instructables if you cut your finger off it's not my fault... well you get the idea. What I am trying to do here is to give you enough information that you will be able to ask the right questions when you see your tax accountant so that they can save you the most money on your taxes. Unlike most of my colleagues I'm a big fan of educating my clients because I feel that the people who know more about how taxes affect their own situations are more likely to ask smart questions when I see them allowing me to save them money.
So you might be asking who is this crazy woman and why should I listen to her? I've been a tax specialist for the last six years and I figured I would share some of my expertise with the Instructables crowd because I've so been enjoying the projects I've been making on this site and the great ideas I've discovered, so this is my chance to give back. I'm an Enrolled Agent- meaning that I am enrolled to practice tax law in all 50 states. I can represent clients before the IRS in essentially the same manner as an attorney in addition to the tax preparation and advising activities that I do. I got into this line of work through a round about way. I got really into drag racing and I had seven cars on the streets of SF and I needed to find somewhere to keep them, so I got into owning investment real estate. Then I started having some real tough tax questions about the real estate that nobody could answer for me, so I took a tax class just so I could learn enough to talk to my accountant and research laws for my own curiosity, but did so well the company I took it with begged me to work for them, and it turned out I enjoyed doing it for work. I spent the next five years working for other companies preparing returns for high net worth individuals and small businesses, and then last year I started my own firm so I could focus on the types of tax work I really enjoy doing.
I specialize in very complex tax issues, it is why I got into the business in the first place and really is what interests me. Most potential clients that approach me are far too simple for what I care to work with and I wind up referring them to colleagues or telling them to DIY. I enjoy solving problems- multiple years of unpaid taxes that need to be filed so a person can remove the overwhelming stress of the government breathing down their neck, business entity formation and sales, real estate investment and entertainment industry issues are always fun. Basically I like doing the work that few others in my field enjoy, and that is really all I want to work with if I have my way. But I hope you benefit from the information in this Instructable, and if you run across unusual issues either in your own life or through a friend, feel free to send them my way.
One word of advice about working with an accountant: don't just hand your information over to someone and then trust them on blind faith that it is prepared correctly, and never sign a tax return if you don't understand what it says inside. There are a lot of scam artists out there that will get you big returns by putting a bunch of bogus numbers in your tax return, everything seems great until sooner or later the IRS stumbles across that dishonest firms and audits all their clients- that means you. Suddenly you will find out that it is you- not your accountant- that is on the line for the money owed to the government. I would assume that most of the people out there preparing returns are honest, but if someone doesn't seem on the up and up, or is rushing you through signing, go elsewhere. Lying on a tax return just isn't worth the stress and worry that comes along with it- being honest and working within the legitimate loopholes for saving money on taxes always works out for the best for the preparer and the client in the long run.
I will end this intro page with my favorite quote about taxes:
Over and over again courts have said that there is nothing sinister in arranging one's affairs to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands.
- Judge Learned Hand (1872-1961)
Step 1: How Complicated Are You?
If you have kids then things get a whole lot more complicated. Depending on how much you earn there are many credits that can help out parents and some will actually give you more money back as a refund than you paid in. Yes it is possible to get a tax refund even if you paid zero taxes in under certain circumstances. Most accountants are fully capable in getting big refunds back using these credits and the franchised firms are built around doing this kind of work. The rules for these credits are complicated and you might be well off to hire someone to prepare your return if you have children, just ask about fees first because most preparers charge per form and can wind up become unconscionably expensive.
If you are an independent contractor (meaning you get a form 1099 at the end of the year from your employer instead of a W-2) your life is a lot more complicated and you really should find a good accountant because they will be worth their fees for you. Independent contractors are essentially business owners and therefore have many deductions they can take to offset their tax burden. However the flipside of that boon is that you are responsible for your own Social Security and Medicare taxes that normally your employer pays half of. This is known as the dreaded self-employment tax, and it is a flat tax on your net earnings of approximately 13.5%. Because this is based on net earnings you can beat it down by your expenses, but you probably will owe money still- if this is your situation see step 4 where I go into business deductions in detail. Here are a bunch of calculators that can help you figure out your income and SE taxes: Tax Calculators
Then we get into the more complicated issues- if you own rental real estate, dabble in day trading, get royalties, have a farm, earn enough to get into Alternative Minimum Tax territory, make money off your instructables.... you get the idea. Then you need a lot more specific info and should find yourself a good tax accountant because they will more than make up for what they charge you in legitimate tax savings and audit risk management.
Step 2: Getting Organized
The first thing you need to do is sorting. Take some large envelopes and label each one with the categories you will be using (*see the itemized, business deduction, and real estate pages for figuring out the categories that will apply to you). Sort all your receipts into the categorized envelopes and then tally the amounts up (preferably with a printing calculator- save the printed calculations!) and write the total on the envelope. Then add the receipts up a second time and double check your number you wrote on the envelope.
Next make sure you have received all the tax forms you should get- if you have worked multiple jobs did you get a w-2 or 1099 for each one? Did you move during the year and possibly not update your address with an employer or bank? Make sure you've opened all your mail and that you have kept an eye out for corrected forms. If you do get two forms from one company check to see if one of them is a "corrected" form (it will have a box checked showing it is corrected hidden somewhere on the face of the form) if not check to see if the account numbers are different. If in doubt call the company that issued you the tax form- whatever they sent you they also sent the IRS so you have to report those numbers exactly on your return and if the company screwed up (it happens a lot) then getting them to fix it now is a lot easier than getting it resolved once the IRS sends you an audit letter....
Next make up a list of questions for your tax adviser, put together any articles you have printed of tax law changes you have questions about, and think about if anything has changed in the last year or will change this year that you need to talk about the tax implications. Changing jobs, unemployment, self-employment, buying or selling a house, foreclosure, debt issues, investment decisions, all good things to ask about when meeting with you accountant.
A question I always get asked is how long should you keep the records you've just put together? That is way more than I can go into on this instructable, but I have compiled a list to answer that question on my website: http://crystalcleartax.com/taxretention.html
Step 3: Filing a Basic Return
I strongly suggest you use a basic tax program to file and never try doing it by hand- you're more likely than not to make mistakes, and how much is your time worth? I think the IRS figures that the average person filing their own return will put in something like 24 hours worth of time learning the laws- ouch! Let the glorious oracle help you by making things easier- and a couple of the big name companies even offer federal self-filing online for free.
The most important things to remember when filing your own return are:
Report EVERY NUMBER on a form. If you can't find where to put it ask someone... call the software company- don't guess. (How many times I've had to even tell accountants that you have no idea!)
Double check the information you put in- I personally use colored check-marks next to every number I put in to show myself I verified it a second time. Takes two seconds to double check but hours-if not months- to fix a mistake.
Don't get over-complicated. There are thousands and thousands of tax laws out there, if you have basic questions most answers can be found in the IRS Pub 17- this is the bible that most tax preparers use and you can view it on the IRS website for free. Or I have a list of IRS forms and publications as links I've compiled here: http://crystalcleartax.com/taxpublications.html
Be careful filing state taxes- they often are more complicated than the IRS and harder to find information to file properly. Most software programs will file state automatically and have done the research for you to make sure things go in the right places. Also remember that just because you don't owe the IRS doesn't mean that you won't owe the state, I've seen a lot of people get into trouble with thinking that they don't need to file and then getting audit letters with huge penalties a year or two later- don't let this happen to you!
After you've filed your tax return you can track your refund status- here is a links page that will take you to the IRS and your state to check on the status of your refund: http://crystalcleartax.com/taxrefunds.html
Step 4: Itemized Deductions
Medical deductions have a 7.5% Adjusted Gross Income (AGI) floor. AGI is the money you got from all sources minus a few "above the line" deductions that I'm not going to get into now. And a "floor" means that you don't get a dollar below that amount as a deduction. Anyways take a look at your AGI and then multiply it by .075 and then take a look at your expenses and see if you have more medical bills than that. Basically unless you have been extremely sick this last year and paid a huge amount out of pocket for medical care it's unlikely that you will have more than this amount and it won't be worth digging through every receipt to find out you just wasted hours of your time on a deduction you won't get a dollar for.
Charitable contributions are deductible- with certain limitations. The main thing is to make sure that the company you are donating them to is a charity registered with the IRS and get receipts even for small donations. For non-cash contributions it gets more complicated- don't trust those charitable contribution estimators that software like TurboTax has built in- the IRS hasn't approved that as a way to estimate the value of your goods and it over-values items in my opinion! For clothes and household items you have to know approx. how much you paid for the items, then I usually use an estimated value of what the thrift store would sell them for as a contribution amount. The more detailed of a receipt you can get from the organization the better- pictures and itemized lists of what you are donating help too. Sure you know exactly what you gave away now- but would you remember every item three years from now if the IRS asks you to document it?
Donating large items like cars gets more complicated- this used to be a great tax deduction but the IRS has closed the loophole on this in recent years and you cannot write off the bluebook value of the vehicle unless very specific conditions are met! This gets very complicated and I have a lot of info about it here: http://crystalcleartax.com/le-propertycharity.php if you want to read more about it.
Gambling losses are only deductible to the amount of gambling winnings- so don't put a higher amount down even if your losses are higher- you will get audited for that one guaranteed. FYI most of the gamblers I've known belong to those "player clubs" type of things that the casinos run. If you do get a big win go and ask them for a breakdown of your losses that year so you have a record, they are more than willing to help out their regular gamblers. Oh and one more thing- losses and gains only average out each year so losing money for twenty years and then hitting the big jackpot, well those twenty years of losses didn't help you worth zip- just one reason gambling on the stock market can be more tax friendly than gambling in Vegas, although recently the stock market's odds probably wouldn't beat any casino.
Employee expenses- these can add up quick but you have to be careful not to take too much off or you will have to substantiate it in an audit- probably not something you're looking forward to. So my advice here is to be conservative on how much you use as a deduction, especially when it comes to auto expenses. As a rule of thumb my personal opinion is that it starts seeming questionable if employee expenses are more than 10% of your wages from that job. When someone brings me higher expenses than that I raise an eyebrow because I know realistically that most people just don't spend that much on their jobs- with one big exception: salespeople.
If you work in sales you probably have very high employee business expenses and because there is a high likelihood these will trigger an audit you need to stay on top of documenting your expenses and I would highly recommend you hire a competent accountant used to working with salespeople to file your returns.
Whatever your occupation, be sure to ask about home office deductions- often you need to have a home office in order to make your auto expenses deductible, otherwise they are considered commuting expenses. Commuting is never considered deductible. A home office has a whole bunch of rules it needs to fit into to qualify- i.e. it can't be the room that you watch tv and hang out with your pals on the weekends, unless that is specifically part of your job....
Step 5: Children and Education
While this concept is confusing at first glance it really makes sense when you think about the "Robin Hood Theory" a little more. The people who are rich are that way mainly because they don't spend their money on foolish things like the newest consumer goodies, whereas the poor stay poor because somebody gives them a couple thousand dollars and instead of investing it for the future they go out and spend it on a 42" flat screen television. This consumer spending is what everyone seems to think "stimulates the economy" leading to welfare packages being called economic stimulus packages. See now when you hear the economists on the media fretting over low consumer spending numbers and that the government needs to do something you will understand what they are talking about.
Now let's get down to details. Earned Income Credit (EIC) is the big one that will pay out thousands of dollars if you happen to fall in the right income bracket and have a couple kids you are supporting. At real low incomes it goes up and then reaches a climax point somewhere around $15,000 income, then goes down again and is fully gone around $20,000 in income. I don't know very many urban areas where people can afford to live on such little money, so I personally don't deal with EIC much although any major chain is well equipped to file these returns, and the outlandish fees that H&R Block and friends charge they get away with because the people getting EIC are getting thousands of dollars back from the government that they didn't pay in, and would rather pay hundreds more and get their money now than wait a few weeks and get hundreds of dollars more.
Child tax credit is one that more people I know fall into, but less dramatic. Basically you get a thousand dollar tax credit for each kid, also subject to income minimums and limits- or "phaseouts" as the government calls them- basically the amounts you get of these credits decrease as the income goes up through a certain dollar range.
Child and Dependent Care Credit is a more interesting one. Basically if you pay for daycare you may be able to get some of what you pay as a tax credit. This gets interesting because "Summer Camp" is considered day care, yet classes are not. So I try to tell the parents I know to get their kids Karate teachers to do "Summer Camp" intensive classes that the kids can do because those are the ones that will give them a credit. Or if you teach children's classes- say arts and crafts, this is a good thing to know, hold a crafts "Summer Camp" and your clients can get a tax benefit from what they pay you to teach their kids projects off this website.
Educational issues start getting slightly more complex- no private grade school does not count for any tax credits. The credits start in at college level education, and there are three choices: Hope (for the first two years only) and Lifetime Learning are credits and then there also is an educational expenses deduction. Depending on your gross income and how much you paid in educational expenses will determine which credit is best- probably something to consult an accountant for maximum savings. If you are interested in learning more about the complicated aspects or want more information for your own knowledge here are some resources: http://crystalcleartax.com/le-highereducation.php
Step 6: Do You Have a Business?
Be sure though that your business can really be classified as a business and not a hobby. The IRS will audit you if you have really high losses or carry losses on the same business for more than a few years in a row. If you lose money at something for too long they will come in and say your business was really a "hobby" and then you get hobby loss rules where not only do you lose all the write offs against other income but because of the way the income and deductions are reported on hobbies you will wind up paying a bit of tax on the hobby income- not something you want to happen. Businesses really can be anything- as long as the business activity is legal. There was a case a few years ago where a guy won in tax court that his business losses were legitimate- and his business losses were amounts he paid prostitutes in Nevada for sex. How did he do this- his losses were "research" because he was writing a book about legal prostitution. As far as I know he never made a dime off the book, but it was legal and legitimate as far as the tax court was concerned.
So the question then becomes how can you legitimize your business to protect yourself from this happening? The first thing that seperates a business from a hobby is showing that you have potential and desire to profit at it. For example, if you're racing motorcycles just for the sake of racing motorcycles it is hard to show that you have profit making potential unless you're ten years old, but if you are racing motorcycles in order to advertise your motorcycle race engine building service then it becomes a whole different logic behind why you have to race.
The next thing that will legitimize a business is creating a business entity separate from the individual, a Partnership, LLC, or Corporation. The simplest to create is a partnership- you actually can form a partnership for last year until April 15th of this year! There is almost no cost to form a partnership, but once you form it you have to stay on top of filing returns for it or you can get dinged large fines. LLC's and Corporations start getting more expensive to set up and maintain- especially in a state like California that charges a $800 minimum tax. But they have the added advantage of limiting liability in addition to creating a nearly bulletproof legitimate business structure. In the example above of the ten year old motorcycle racing champ I would probably recommend a family partnership for his racing business for a few reasons: one, the kid is too young to legally manage his money so it makes it more legitimate for him to be getting paid for his wins, and second, there is a good chance that someone that age can make it big time, and third the kid probably has little reason to need the write-offs from the racing losses, but the parents could probably use it against their income. It is common in Hollywood for people to set up these kinds of structures for their child stars, even for their pets that have film roles.
The next aspect of business legitimization is record keeping. If you keep detailed in clear records in a business like manner then you have a way better chance of your business proving itself. Financial records on Excel or Quickbooks are great, but not critical, written books are just as good. Things like keeping mileage logs in your car to keep track of miles driven for business are a great start. But more than that when it comes to a business your records should show the plans you are implementing and how the business can turn a profit at some point. There is some great business plan software out there that makes it real easy to create a business plan, or I've used the templates in PowerPoint before just to make up a quick, easy business plan for either considering new business ventures or re-evaluating where we stand on our current businesses.
So now you've heard all of the ways to make your small business more legitimate, you might be asking me why you would want to go through all that. In addition to being able to safely take greater losses in a business entity, you also can get group health insurance for your business. For people who have had major health problems regular individual insurance won't give you the time of day, but group plans are not allowed to discriminate against individuals because of health history. If you have a group health plan you have to cover all your employees or partners, and they are covered for all pre-existing conditions! Yes it is a huge pain in the ass to set up, but the prices are only slightly higher than individual coverage once you are on it and you can get on the best plan.
I am a big believer in owning businesses and your own health plan for very personal reasons. My husband had cancer before we were married and I couldn't get him on my Kaiser plan for anything, we formed a group plan and now we have a copay plan that is incredible. It did take us around six months to jump through all the hoops with Kaiser to get our group plan set up, but it is the best thing we have ever done, his only other choice would have been the government insurance plan, which would have cost more than both of us are paying now for a fraction of the coverage.
If you want more information on starting up a business or making the one you have legitimate here are some resources that could help you out: http://crystalcleartax.com/cat-startbusiness.html Yes it's on my website, but it's not content that I wrote on these pages- I pay for one of those accountant specific services that gives me a lot of content written by their experts so my clients and I have access to it. A word of warning- it makes things sound scarier than they are. Most accountants seem to like that for some reason- I think that they feel if their customers are scared that they will keep coming back to them, that ideology really bothers me, but isn't the point of this I-ble so I should leave it there. Anyways someday I will replace it with writing on every individual subject in my own style, but I'm spending my time writing this instead.... It is useful information nonetheless, just remember all the steps they talk about are actually easier than they make it sound.
Step 7: Business Deductions
Depreciation gets more complicated because you have four choices of what to do with the items that are depreciable:
1: You depreciate it using the "straight line" method which in the computer example would mean you get to write off 10% the first year of the cost of the computer against your income, then 20% each additional year for the next four years, then 10% again on the sixth year.
2: You depreciate it using the "macrs" method which is an accelerated method to recover your depreciation- and this is actually the defaulted method of depreciation in most computer systems. Using this system you would write off 20% the first year, then 32% the second year, 19.20% the third year, 11.52% the fourth and fifth years, and 5.76% the sixth year.
3. You can choose an alternate system of depreciation "ads" and depreciate the computer over a seven year period starting with 10.71% the first year and going up to 19.13% the second year and then down again to 15.03% the third year and 12.25% from years four through seven, then 6.13% on the eighth year.
4. You can expense the total purchase price of the computer against your current income by using section 179 of the tax code, as long as you meet certain requirements.
You can see just how complicated depreciation gets. This is where your tax adviser really earns their money if you have a good one because all of the above choices can be good tax strategies in different situations. Let's say you didn't make much income this year but you think you will make more next year, then straight line or macrs would be your best bet, and this is a legitimate reason to go on extension and not file until September because then you will have a better idea of if you are going to profit next year. If you are trying to show higher net earnings for loan or sale purposes, ads will help keep your income looking higher by depreciating a tiny amount over many years, leaving more "income" in your pocket now on paper, if you earned a lot of money this year and are getting hit hard with SE tax, expensing your depreciable items will lower the amount of money you have to pay now.
Also there are other rules that complicate depreciation more. Our computer example above would be further complicated with the fact that it is "listed" property, meaning if you don't use it 100% for business purposes you run into a whole new set of rules. Autos get even more difficult, depending on the weight of the vehicle, the purchase price, and business use. Then we have "special depreciation" that will be voted in during recession years like now, that will complicate matters further when it hits in again for 2009 returns. Even for those of us in the business depreciation keeps us on our heels. So now you can probably see why with running a business you are best off hiring a good accountant- even so the more you know the better your accountant will be able to help you save money. If you are curious about learning more about common business deductions, on my site I have a page with a bunch more links to articles on business deductions that you can read: http://crystalcleartax.com/cat-taxbusiness.html
Step 8: Real Estate
Being a "Real Estate Professional" does not mean you are a real estate agent. Quite the contrary, most real estate agents would not be considered "Real Estate Professionals" via IRS rules. Why would you want to be a Real Estate Professional? When you meet those requirements suddenly all your passive losses in real estate are fully deductible against all other income. Normally passive losses from real estate investments are limited to $25,000 and the amount you can deduct goes down dollar for dollar every bit over $100,000 your AGI is at, meaning that most anyone who can afford to buy rental real estate can't take the deductions for these losses.
But thanks to the down economy if you or someone you know is in this position you might now qualify as a Real Estate Professional even though you didn't previously. To qualify you have to meet two tests: You spend at least 750 hours per year on real estate investment activities, and that at least half of the personal services you perform is in real estate investment activities. Basically this means you can't have a full time job and call yourself a Real Estate Professional. But say you are married and one spouse works full time but the other one is laid off and collecting unemployment or a severance package- wouldn't this be a great time to spend all that extra time you have off fixing up your rentals, or looking to purchase more? Keep a log of the hours you spend and it would be easy to come up with 750 hours, and suddenly you have a huge deduction available- plus you get to write off all previously unallowed passive losses.
Ok, this is getting a bit fancy. Time for me to stop calling this an Instructable and finish writing this for my site. Hopefully I've given you all some ideas of how you can save more money on your taxes and even if these things didn't apply to your particular situation, maybe they will apply for someone you know. I have more info on my site at: http://crystalcleartax.com/realestatestrategies.html and I will be adding more articles as I get time to write them....
Step 9: Future Tax Law Changes
The February 2009 stimulus package is far more conservative than I was expecting to see, but I'm waiting for the tax increases to come in for certain items- especially capital gains that have been so favorable tax-wise over the last decade. It is hard to predict what the government will do, and the challenging financial times we are facing often lead to some very peculiar laws as desperate attempts to bail out the sinking ship. We have seen some already but my bet would be that far stranger laws lurk on the horizon.
The laws being written are only one piece in the puzzle. Congress writes the tax law, the IRS interprets it and then designs forms to make the laws applicable. There have been a lot of changes recently and keeping on top of them will be challenging even for the best of us in the field. I have been doing some research on the new stimulus package and it has a lot of changes in it that will benefit many people, and a lot of complex new laws that will affect everyone filing their taxes next year.
Signing up to tax newsletters can help keep you up to date on the newest changes that are happening. Kiplinger's Tax Newsletter is one of the best in my opinion- they cover a lot and explain the laws well, but it is pricey. Quickfinder is one of them that I've used in the past; it is about $60 a year and is a very user friendly, clearly written, and accurate guide. Their books are also well regarded and used by the vast majority of tax accountants. It is however written for tax accountants and not the general public so you might struggle some with some of the more complex issues in there. Most of the free ones I've been able to find will be sending you more ads than useful articles- isn't that typical of internet newsletters though? The IRS has a decent one: IRS Tax Tips- albeit written in that robotic IRS language that is hard for most humans to understand. But if you are trying to wade through filing your return it might help you. I have a free monthly newsletter that I put out for my clients. Even if you file your own taxes or have another accountant, feel free to sign up for it. I will at least try to break the new changes down to English when I send mine out...
Hopefully this has helped open your eyes to some ways you can save money on taxes and if you have questions please feel free to ask them either as comments here or contact me directly.