Filing your federal income tax return can be a huge source of anxiety.
Accountants spend a great deal of time encouraging people to plan for their tax liability before the end of the year. Yet every April, it’s inevitable there’s still some confusion that needs clearing up.
Here are ten things that every tax accountant wished you knew about tax liablity.
1. High Earners May Be Subject to Alternative Minimum Tax
Alternative minimum tax(AMT) was introduced in 1969 to prevent high-income earners from abusing tax credits and deductions. Prior to AMT, certain tax benefits allowed many high earners to pay very little income tax, or none at all during tax time. AMT reduced the level of tax benefits for some taxpayers.
When you calculate the tax on your income, you need to perform an extra calculation for AMT. AMT adds back certain items that are not included in your original taxable income. Interest on certain types of municipal bonds, for example, is added back to income.
If your new income is high enough, you may need to pay tax based on the AMT income. Many people are surprised when their tax software includes AMT and reports a higher tax liability.
The IRS has created an ATM Assistant to help determine whether you’ll owe Alternative Minimum Tax
2. Your Business And Personal Tax Liability Might Be Different
Many business owners don’t clearly understand how their share of business profits is taxed, and how the that affects their personal tax liability come tax time.
There are many ways to structure your company, and that causes confusion for many taxpayers. The best way to understand the differences is to compare C corporations (C Corps) to all other business structures:
- C Corporation: C Corps are subject to double taxation. The C Corp files a tax return and pays taxes on the profit. Owners can keep after-tax earnings to use in the business or to pay shareholders a cash dividend. When a dividend is paid, the income is added to other sources of income on the shareholder’s personal tax return.
- Pass-through: business structures pass the company profits and losses through to the owners. Pass-through entities include Sole proprietorships, partnerships, S Corporations, and many other businesses. Assume, for example, that your share of a partnership’s profit is $10,000. The partnership files a tax return, and issues you a Schedule K-1, which reports the $10,000 in income. The $10,000 is added to your other income sources on your personal tax return. The partnership tax return documents the partners, the percentages of ownership, and the partnership’s profit- but no taxes are calculated.
There are exceptions, but generally a business faces double taxation as a C Corp or single taxation as a pass-through entity.
3. Filing For an Extension Does Not Change Your Tax Payment Due Date
This one is worth repeating. Filing for an extension does not change your tax payment due date.
Extensions are granted when you need more time to get your paperwork in order, not to defer when you have to pay.
Many people request extensions when taxes are more complicated than in previous years.
April 15th is the due date for filing a personal tax return, assuming that the date falls on a weekday. If you request an extension to file your return later, your tax liability is still owed on April 15th.
Make the effort to estimate your tax liability and make payments before April 15th. If you don’t pay roughly 90% of your tax liability by the due date, you may be subject to interest and penalties later.
4. Mortgage Interest May Not be Fully Deductible
A number of tax deductions are phased out, based on your total income and other factors. Limiting the dollar amount of deductions has a huge impact on your tax liability, and one of the most-used tax deductions is home mortgage interest.
Taxpayer itemized their deductions on Schedule A of Form 1040. One type of deduction is interest expense incurred on a home mortgage. At the bottom of Schedule A, you’ll note that your deductions may be limited, depending on your total adjusted gross income. If you are considering a new home loan, note that your mortgage interest may not be fully deductible.
The instructions for Schedule A provide a Total Itemized Deductions worksheet so that taxpayers can calculate their itemized deductions. Take a look at that worksheet before year-end, or ask a CPA to help you with the calculation.
5. You Should Estimate Your Tax Liability Based on Operating Income
If you’re a business owner, you want to calculate your tax liability correctly and file on time. However, tax accountants also want you to consider how you generated profits for the year, because that will impact your results in future years.
Assume, for example, that you manufacture a line of sporting goods equipment. Your 2016 profit is $200,000 on sales of $2 million. In 2017, sales are much slower, and you generate $150,000 in profit on $1.5 million in sales. However, you also sell a building for a $50,000 gain, so your total income is $200,000.
The challenge is to estimate your income and tax liability for 2018. Sales to customers generate operating income, which is income from day-to-day operations. A building sale, on the other hand, produces non-operating income, which is unpredictable.
Your tax estimate should be calculated based on operating income, not on non-operating income. Operating income may vary, but it is more predictable over time than non-operating income.
6. Understanding The Difference Between Realized Gains and Recognized Gains
If you buy an asset and sell it for more than you paid for it, you have a realized gain. If, for example, you buy 100 shares of IBM common stock at $10,000 and sell the shares for $15,000, your realized gain is $5,000.
A recognized gain, on the other hand, refers to only the taxable portion of the gain.
Not every realized gain is recognized for tax purposes, and there are dozens of examples. In some cases, you can offset a realized gain with a realized loss and not owe taxes on the gain. This can impact both business and personal tax returns, and is worth having a discussion with your CPA to ensure you’re paying the appropriate amount each time.
7. Prepare Ahead of Time For Retirement Plan Withdrawals
It’s critically important to work with your financial advisor and a CPA to plan any retirement plan withdrawals, because they can have a big impact on your tax liability. The tax rules for withdrawals are complex, and you should consult with experts who can help you plan for the tax impact.
8. There’s a Big Difference Between Tax Credits And Tax Deductions
Think of a tax credit as a “gift certificate”, because a credit reduces your tax liability dollar-for-dollar. If you have a $5,000 tax liability and a $500 tax credit, for example, the credit can reduce your liability to $4,500.
A tax deduction, on the other hand, reduces your taxable income. If you have $50,000 in income and $5,000 in tax deductions, your taxable income is $45,000. You then compute the tax liability on the $45,000.
Because tax credits are so valuable to taxpayers, they are often promoted as an inducement to get taxpayers to donate to charity, or to make a certain type of investment. Keep in mind that the tax laws related to tax credits changes frequently, and that your income level may limit or eliminate the use of a particular tax credit.
9. Many Tax Laws Have An Expiration Date
Many tax laws, including aspects of the tax cuts passed in 2017, have a sunset provision. This provision place an expiration date on the tax cuts, which means that tax rates will increase when the cuts expire.
Tax laws change constantly, but some tax laws that remain in place for years have an expiration date.
10. Marginal Tax Rates Apply To The Next Taxable Dollar in The Next Tax Bracket
Your income is taxed using several tax rates, not just one rate.
When you hear someone ask an accountant about his or her “tax bracket”, that person is usually referring the highest rate paid on income, or the marginal tax rate.
Instead, the marginal tax rate is the tax you pay on your next dollar of income.
The IRS tax tables provide a different tax rate for different levels of income. For 2017, taxpayers pay at 10% tax rate on income from $0 to $9,325, and a 15% rate on income from $9,326 to $37,950. Assume, for example, that your salary was $37,950. If you earned $10 more, you would pay 25% on those next $10. Your marginal tax rate is 25%.
Bonus: Plan in Advance As Much As Possible
The best way to address all of these issues is to plan for your tax liability in advance.
Review your tax return for the prior year, so that you can understand how your tax liability was calculated. If something unusual happens during the year, such as a large bonus payment or you inherit money, take some time to consider how the additional income will impact your tax return. Find a CPA who can help you estimate your tax liability.
A good plan can help you to maximize your tax credits and deductions, avoid late penalties, lower your tax liability, and reinvest into your business for the upcoming year.