Tarlow & Co., C.P.A.s

Dear Valued Client,

2009 has seen many tax law changes, with the government doing its best to provide tax incentives to those in need. Despite their efforts, the unemployment rate continues to rise and many are struggling to make ends meet. To help keep your tax liabilities to a minimum, we have provided important tax strategies in this month's edition.

Please call for an appointment if you need help with any of the strategies discussed here.
Sincerely,

Tarlow & Co., C.P.A.'S

Technology Expenses Make the Grade for Qualified Tuition Programs

Taxpayers who purchase computer technology for higher education purposes may be eligible for a special tax break. The American Recovery and Reinvestment Act of 2009 added computer equipment and technology to the list of college expenses that can be paid for by a Qualified Tuition Program commonly referred to as a Sec. 529 plan.
A qualified, nontaxable distribution from a Sec. 529 plan during 2009 or 2010 now includes the cost of the purchase of any computer technology, equipment or Internet access and related services. To qualify, the beneficiary must use the technology, equipment or services while enrolled at an eligible educational institution.
Here are some highlights about Sec. 529 plans.

• A Sec. 529 plan is an educational savings plan designed to provide tax-free earnings for the benefit of a student. Withdrawals must be used for qualified higher education expenses at an eligible educational institution.

• Qualified higher education expenses include tuition, reasonable costs of room and board, mandatory fees, computer technology, supplies and books.

• An eligible educational institution includes any college, university, vocational school or other post-secondary educational institution eligible to participate in a student aid program administered by the Department of Education.

• Contributions to a Sec. 529 plan cannot be more than the amount necessary to provide for a student’s qualified education expenses.
For more information about Sec. 529 plans and how they might fit into your family’s education needs, please give this office a call.

Who Gets The Credit?

Grandparents or other relatives will sometimes assist or even pay the entire cost of the college education for a child. This leads to a frequently asked question; who gets the tax benefits for the tuition paid?

Tax regulations provide that solely for education credit purposes, if a third party makes a payment directly to an eligible educational institution for a student’s qualified tuition and related expenses, the student would be treated as receiving the payment from the third party, and, in turn, paying the qualified tuition and related expenses. Furthermore, qualified tuition and related expenses paid by a student would be treated as paid by the taxpayer if the student is a claimed dependent of the taxpayer. Thus, the child’s parent will generally be treated as the one who paid the tuition, making them qualified to claim the American Opportunity, Hope or Lifetime education credits if they otherwise meet the requirements.

Borrowing Money From Employee Plans

Employers and employees should be reminded that only qualified plans, such as profit-sharing, 401(k) and money purchase plans may allow participants to borrow money from their accounts, and only if the plan document specifically permits such loans to be made. IRA-based plans, such as SEPs, SIMPLE IRAs and SARSEPs, and traditional and Roth IRAs cannot provide loans to participants.

The amount participants may borrow is limited to the lesser of $50,000 or 50% of their vested account balance (the amount that actually belongs to a participant, even if he terminates employment). Loans need to be repaid back to the account at least quarterly, over a period not exceeding five years. An exception to the five-year rule applies for loans taken out for the purchase of a participant's principal residence.

Loans that initially don't meet the Code requirements (because they aren't limited to 50% of the vested account balance or they exceed $50,000) are treated as a distribution when the loan is made and are taxed accordingly. Missing payments cause the loan to go into default and therefore be taxed as a distribution.

The number one taxability issue with plan loans occurs when a participant terminates employment with an outstanding loan balance. In this situation, plans usually offset the distribution of the participant's account by the amount of the outstanding loan balance. For tax purposes, the amount of the distribution includes the loan balance at the time of the offset. If the participant wants to roll over his entire benefit, then he must come up with money that represents the loan offset as well as money to cover the 20% mandatory federal income tax withholding that applies to the full amount, including the loan offset. The 10% additional early distribution tax also applies if the participant is under age 59-1/2 unless an exception to the early withdrawal tax applies.

Borrowing by owner-employees - An owner-employee may borrow from the company's plan but must follow the same rules that apply to other participants. It must be a formal loan meeting all of the loan requirements dealing with amounts and repayment; otherwise, it may be tagged as a prohibited transaction.

In tough economic times, employers may be tempted to dip into plan assets just to tide it over, to meet payroll or pay other bills and then pay it back later. This is strictly prohibited as employers are never allowed to dip into plan assets for any reason. Another “no no” is when an employer withholds salary deferrals from his employees' pay with the intention of depositing the money in its 401(k) or SIMPLE IRA plan, but doesn't actually do it. The employer “borrows” the money, maybe to cover payroll, or rent, thinking that it won't hurt to wait a few weeks until the withheld salary deferrals are deposited into the plan's funding vehicle. The Department of Labor looks very harshly on this fiduciary violation. The money must be deposited in the trust or IRAs as soon as the money can be reasonably segregated from the employer's assets.

Please call this office for additional information.

Things You May Not Know About Farm Income and Deductions

If you are in the business of farming, here are some things you may want to know before filing your federal tax return.

1. Crop Insurance Proceeds - Include in income any crop insurance proceeds that you receive as the result of crop damage. The proceeds are generally included in the year they are received.

2. Sales Caused by Weather-Related Condition - If there is more livestock sold than you normally would in a year because of weather-related conditions (including poultry), you may be able to postpone reporting the gain from selling the additional animals until the next year.

3. Farm Income Averaging - You may be able to average all or some of your current year's farm income and refigure your tax over the three prior years. This may give you a lower tax if your current-year income from farming is high, and your taxable income from one or more of the three prior years was low.

4. Deductible Farm Expenses - The ordinary and necessary costs of operating a farm for profit are deductible business expenses. An ordinary expense is an expense that is common and accepted in the business. A necessary expense is one that is appropriate for the business.

5. Employees - Reasonable wages paid for labor hired to perform your farming operations can be deducted.

6. Items Purchased for Resale - You may be able to deduct the cost of livestock and other items purchased for resale in the year of sale. This cost includes freight charges for transporting the livestock to the farm.

7. Net Operating Losses - If the deductible loss from operating your farm is more than your other income for the year, you may have a net operating loss. If you have a net operating loss this year, it can be carried to other years and deducted. You may be able to get a refund of all or part of the income tax you paid for past years, or you may be able to reduce your tax in future years.

8. Repayment of Loans - The repayment of a loan cannot be deducted. However, if the proceeds of a loan are used for farm business expenses, the interest paid on the loan can be deducted.

9. Fuel and Road Use - You may be eligible to claim a credit or refund of excise taxes on fuel used on a farm for farming purposes.

10. Post-2009 Farm Losses May Be Limited - For tax years beginning after 2009, the Farm Act limits the farming loss of a taxpayer, other than a C corporation, for any tax year in which any applicable subsidies are received. The losses are limited to the greater of (a) $300,000 ($150,000 for a married person filing separately), or (b) the taxpayer's total net farm income for the prior five tax years.

For more information regarding income and expenses for farming and farm rentals, please give this office a call.

Taxes & Worker Status: Employee vs. Independent Contractor?

If you are a small business owner, whether you hire people as independent contractors or as employees will impact the amount of taxes you withhold from their paychecks, as well as the amount and types of taxes you pay. Furthermore, it will affect how much additional cost your business must bear, what documents and information must be provided to you, and what tax documents must be given to the individuals you are hiring.

The obvious advantage to treating an individual as an independent contractor is avoiding the added expense of payroll taxes and employee benefits. Unfortunately, the decision is not an optional one, and employers must be careful when making the decision, lest they set themselves up for a payroll audit and back taxes, penalties and interest.

According to industry sources, the IRS will begin auditing companies in early 2010, focusing their efforts on businesses failing to pay taxes on fringe benefits and misclassifying workers as independent contractors instead of W-2 employees.

Here are some things every business owner should know about hiring people as independent contractors versus hiring them as employees.

• Three characteristics are used by the IRS to determine the relationship between businesses and workers: Behavioral Control, Financial Control, and the Type of Relationship.

• Behavioral Control covers facts that show whether the business has a right to direct or control how the work is done through instructions, training or other means.

• Financial Control covers facts that show whether the business has a right to direct or control the financial and business aspects of the worker's job.

• The Type of Relationship factor relates to how the workers and the business owner perceive their relationship.

• If you have the right to control or direct not only what is to be done, but also how it is to be done, then your workers are most likely employees.

• If you can direct or control only the result of the work done, and not the means and methods of accomplishing the result, then your workers are probably independent contractors.

• Employers who misclassify workers as independent contractors can end up with substantial tax bills. Additionally, they can face penalties for failing to pay employment taxes and not filing required tax forms.

• Workers can avoid higher tax bills and lost benefits if they know their proper status.

• Employers can request the IRS to make a determination on whether a specific individual is an independent contractor or an employee by filing a Form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. A worker may also file Form SS-8, requesting an IRS determination. IRS does not issue determinations for proposed or hypothetical situations.

If you need more information about the critical determination of a worker’s status as an independent contractor or employee, please give this office a call.

Get Ready for Liberalized IRA-to-Roth-IRA Conversions in 2010

Next year will be a pivotal one for retirement planning, as it will be the first year in which taxpayers will be able to convert funds in regular IRAs (as well as qualified retirement plans) to Roth IRAs regardless of their income level.

This new conversion option poses significant tax planning challenges and opportunities for 2009, 2010 and 2011. Presently (in 2009), taxpayers with modified adjusted gross income (AGI) (1) in excess of $100,000 may not convert investments in traditional IRAs into investments in Roth IRAs. This includes converting amounts from SEP-IRAs or SIMPLE IRAs.

There are two big advantages of the Roth IRA: all future earnings and distributions at retirement will be tax-free, and the Roth IRAs are not subject to the required minimum distribution rules. Although conversions are taxable, except for previously nondeductible amounts, they are not subject to the 10% premature distribution tax.

Big Changes Coming Next Year - For tax years beginning after 2009, the $100,000 modified AGI limit on conversions of traditional IRAs to Roth IRAs is eliminated. Additionally, married taxpayers filing separate returns will be able to convert amounts in a traditional IRA into a Roth IRA (currently, they are barred from doing so).

There are other tax advantages. Because distributions from Roth IRAs are tax-free (if they are qualified distributions), they may keep a taxpayer from being taxed in a higher tax bracket than would otherwise apply if he were withdrawing taxable distributions, which do not enter into the calculation of tax owed on Social Security payments, and have no effect on AGI-based deductions. Even better, the benefits flow through to beneficiaries of Roth IRA accounts, who also can make tax-free withdrawals from such accounts (they are, however, subject to the same annual post-death minimum distribution rules that apply to beneficiaries of regular IRAs).

Should You Make an IRA-to-Roth-IRA Conversion? Generally taxpayers with the following tax profiles should consider making a conversion:

• Taxpayers that still have a number of years to go before retirement and time to recoup the conversion tax dollars;

• Are in a lower than normal tax bracket in the year of conversion;

• Anticipate being taxed in a higher bracket in the future; and

• Can pay the tax on the conversion from funds other than non-taxed retirement funds.

Complicating Factor for 2010 Conversions - A unique income inclusion rule will apply for IRA-to-Roth-IRA conversions occurring in 2010. Unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012. This requires some careful planning since, without Congressional action, the current lower tax brackets of 35%, 33%, 28% and 25% will revert to their pre-2001 levels of 39.6%, 36%, 31% and 28% after 2010.

What to Do This Year - Taxpayers who intend to take advantage of the new conversion option next year should consider the following strategies:

• Non-high-income taxpayers who are able to make deductible IRA contributions this year should do so. They will reduce their 2009 tax bill and, if they make the conversion to a Roth IRA next year, they won't have to pay back the tax savings until 2011 and 2012.

• High-income taxpayers should consider making nondeductible IRA contributions this year. They can then roll over the accounts into Roth IRAs next year at no tax cost.

• High-income taxpayers planning to make large conversions in 2010, and pay the tax in 2010 rather than deferring the tax until 2011 and 2012, should avoid the standard year-end-planning wisdom of accelerating deductions and deferring income. Instead, they should consider doing the reverse, accelerating income into 2009 and deferring deductions until 2010 to help reduce the conversion tax in 2010.

Conversions can be tricky! So if you are considering a conversion in 2010, it might be appropriate to call for an appointment so this office can help you properly analyze your conversion options.

(1) With respect to conversions to Roth IRAs, the AGI is modified by eliminating a number of income exclusions, but does not include the income resulting from the conversion itself, nor does it include any required minimum distributions.

2010 Tax Brackets Change Little Due to Inflation

To keep taxpayers from being pushed into higher tax brackets or from losing tax benefits simply because of inflation, the federal tax code since the 1980s has included inflation adjustments for tax brackets, exemptions, high-income phase-outs of various deductions and limitations, allowable retirement savings and the annual gift-tax exclusion, just to mention a few. For example, indexing tax brackets lowers tax bills when there is inflation by including more of one's income in a lower bracket, such as the 15% rather than the 25% bracket.

In 2010, for the first time ever, those inflation adjustments will be virtually nil because of a very low inflation rate. This means that taxpayers with the same taxable income in 2010 as in 2009 will not see much of a tax savings due to inflation. For example, joint filers with a taxable income of $100,000 will pay approximately $13 less in income taxes in 2010 than on the same income for 2009, compared with a $313 savings between 2008 and 2009. A single filer with taxable income of $50,000 will owe $6 less next year, compared to a $156 savings due to the significantly higher inflation rate between 2008 and 2009.

The lack of change for 2010 creates a level playing field for taxpayers from all brackets, but those with high incomes actually stand to benefit in 2010 because "stealth taxes," those that don't involve changing tax rates, are being phased out. Among them are limits on itemized deductions and personal exemption amounts.

American Opportunity Credit Helps Pay for the First Four Years of College

The American Opportunity credit modifies the existing Hope credit for tax years 2009 and 2010, making it available to a broader range of taxpayers. Income guidelines are expanded and required course materials are added to the list of qualified expenses. Many of those eligible will qualify for the maximum annual tax credit of $2,500 per student.

The American Opportunity credit, in many cases, offers greater tax savings than existing education tax breaks. Here are some key features of the credit:

• Tuition, related fees, books and other required course materials generally qualify. In the past, books usually were not eligible for education-related credits and deductions.

• The credit is equal to 100 percent of the first $2,000 spent and 25 percent of the next $2,000. That means the full $2,500 credit may be available to a taxpayer who pays $4,000 or more in qualified expenses for an eligible student.

• If you otherwise qualify, you can take this credit even if you have previously taken the Hope or Lifetime Learning credit in years prior to 2009.

• The full credit is available for taxpayers whose modified adjusted gross income (MAGI) is $80,000 or less (for married couples filing a joint return, the limit is $160,000 or less). The credit is phased out for taxpayers with incomes above these levels. These income limits are higher than under the existing Hope and lifetime learning credits.

• Forty percent of the American Opportunity credit is refundable. This means that even people who owe no tax can get an annual payment of the credit of up to $1,000 for each eligible student. Existing education-related credits and deductions do not provide a benefit to people who owe no tax. The refundable portion of the credit is not available to any student whose investment income is taxed at the parent’s rate, commonly referred to as the kiddie tax.

Though most taxpayers who pay for post-secondary education will qualify for the American Opportunity credit, some will not. The limitations include a married person filing a separate return, regardless of income, joint filers whose MAGI is $180,000 or more and, finally, single taxpayers, heads of household and some widows and widowers whose MAGI is $90,000 or more.

There are some post-secondary education expenses that do not qualify for the American Opportunity credit. They include expenses paid for a student who, as of the beginning of the tax year, has already completed the first four years of college. That’s because the credit is only allowed for the first four years of post-secondary education. However, for those students, who qualify, the Lifetime Learning credit is still available.

To maximize your credit for 2009, it may be appropriate for you to prepay certain expenses that apply to the first quarter of 2010. For additional information on this tax strategy or other issues relating to education tax benefits and credits, please give this office a call.

Facts about the New Vehicle Sales and Excise Tax Deduction

Taxpayers who buy new motor vehicles this year may be entitled to a special add-on tax deduction for the sales or excise taxes on those purchases when they file their 2009 federal tax returns next year.

Taxpayers in states that do not have state sales taxes may be entitled to deduct other fees or taxes imposed by the state or local government.

Here are important facts you should know about this special add-on deduction.

1. State and local sales and excise taxes paid on up to $49,500 of the purchase price of each qualifying vehicle are deductible. In other words, you can deduct the sales tax on multiple vehicles but only the taxes paid on up to the $49,500 limit for each vehicle is allowed.

2. Qualified motor vehicles generally include new cars, light trucks, motor homes and motorcycles. “Used” vehicles are not eligible.

3. To qualify for the deduction, the new cars, light trucks and motorcycles must weigh 8,500 pounds or less. Motor homes are not subject to the weight limit.

4. Purchases must occur after February 16, 2009, and before January 1, 2010.

5. Taxpayers who purchase new motor vehicles in states that do not have state sales taxes may be entitled to deduct other fees or taxes assessed on the purchase of those vehicles. Fees or taxes that qualify must be based on the vehicles’ sales price or as a per unit fee. These states include Alaska, Delaware, Hawaii, Montana, New Hampshire and Oregon.

6. This deduction can be taken regardless of whether buyers itemize their deductions or choose the standard deduction. Taxpayers who do not itemize will add this additional amount to the standard deduction on their 2009 tax return. Those who itemize may deduct it as a separate item in the Taxes Paid section of Schedule A.

7. The amount of the deduction is phased out for taxpayers whose modified adjusted gross income is between $125,000 and $135,000 for individual filers and between $250,000 and $260,000 for joint filers.

8. The add-on deduction for qualified motor vehicle taxes is not available to a taxpayer who elects to deduct state and local sales and use taxes in lieu of state/local income taxes as an itemized deduction. Thus, it will be necessary to decide which option best serves the taxpayer. This can be a complicated issue for higher-income individuals where the deduction might be phased out or where the vehicle is very expensive.

For more information on this topic and other key tax provisions of the Recovery Act, please give this office a call.

The Life of an Inventory Item

2009 is soon drawing to a close. Do you know where your physical inventory items are? Whether you keep them in a closet, in an unused office, or a warehouse, you need to keep a close watch on how many products you have, how many have been ordered, and when it’s time to reorder. Fortunately, QuickBooks has tools that help you track all of those numbers. If you’re conscientious about making use of them, you should have a good sense of the state of your inventory, wherever you store it.

(Note: These tools are not available in Simple Start or QuickBooks Online.)

Inventory 101
Let’s take a look at the life of an inventory item. First, you have to tell QuickBooks that you will be selling products. It asks for this information during the EasyStep interview, but if for some reason you didn’t set this up, you can still do it. Click Edit/Preferences, then Items & Inventory, and then Company Preferences. Make sure the first line is checked, as well as any others you want active, as seen in Figure 1.

Figure 1: You can have QuickBooks track your inventory by selecting this option in the Preferences window.

Next, check your Chart of Accounts to see if you need to add any accounts to meet your inventory needs. This is easy. Go to Lists/Chart of Accounts, or click the icon on the home page. The Chart of Accounts is simply a list of the accounts your company uses, and the balance for each. QuickBooks sets a chart up for you based on the type of company you have, but as your business grows, you may need to add more. Figure 2 shows an example of the Chart of Accounts window.

Figure 2: The Chart of Accounts window shows you the balance for each of your accounts.

To add a new account, click on the arrow next to Account and click New. Select the correct type of account, and answer the questions in the Add New Account window. If you have any questions here, consult QuickBooks’ help file.

See your Inventory in High Definition
Next you’ll have to define your company’s products. Click Items & Services on the home page. The Item list opens. You can always come back here when you need to edit an item, but you may want to create one now. So click Item/New. You’ll see a screen similar to the one pictured in Figure 3, but its fields will be blank. Item records in QuickBooks contain a good amount of information about each item, which will be used in forms like invoices and documents like reports.

Figure 3: An item record allows you to define your company’s product.

Fill out the information in each item record for each item you sell. You won’t be able to alter the numbers in the lower right corner; these come from other parts of the program. As for the other values, the need to make changes depends on the field. When you defined the item, you entered an On Hand amount. This of course will change as you sell, so you can change the reorder point. Conversely, the average cost (value of your inventory) is calculated by the program; it’s the total cost of items in stock divided by the number of items in stock. On P.O. and On S.O. simply indicate how much of your inventory is promised on purchase orders and sales orders.

Get better organized
QuickBooks lets you create assemblies, groups of items that are sold together as a kit. If you want to create one, click Lists/Item List, then click the arrow next to Item and click New. Click the arrow under Type, and select Inventory Assembly. Fill in the blanks on the window as you would for a single item, and select the individual inventory items in the box at the bottom. This box is pictured in Figure 4.

Figure 4 An item assembly.

Once you’ve defined your items and assemblies, you can use them in two places primarily: transactions forms and records. Let’s say you’re creating an invoice. As you’re filling out the form, you’ll be able to click the arrow under ITEM and view a list of the items you’ve created. Click on one, and the details you’ve entered (like price) will appear. Click Reports/Inventory to customize and run the reports available.

Maintaining an adequate inventory—not keeping too much or too little on hand—is critical to your company’s financial balance. QuickBooks’ tracking tools can help you meet that ongoing goal.

Using the Economic Downturn for Your Benefit

Although 2009 has been a tumultuous year for most people, there are some positive actions that can be taken to benefit in the current economic conditions.

• Make Gifts - For 2009 and 2010, you can gift up to $13,000 of value ($26,000 if married and both spouses make a gift) to as many individuals as you would like without affecting your lifetime gift tax exclusion, paying any gift tax, or even having to file a gift tax return.

• Traditional IRA to Roth IRA Conversions – When one converts a conventional IRA to a Roth IRA, the conversion is taxed at the individual’s marginal tax rate, as if the individual withdrew the funds without being subject to any penalties. Thus, for 2009, if your taxable income is negative, your marginal tax rate is very low or you have tax credits that are not being fully utilized, it might be appropriate to convert some or all of your traditional IRA funds into a Roth IRA at no or a very small cost. The benefit is not immediate, but in the future at retirement time, the Roth IRA withdrawals, unlike traditional IRA withdrawals, will be tax-free.

• Use Up Capital Loss Carryovers – If you are one of the lucky investors who has benefited from the recent market upswing and would like to reduce your position in a security or realign your portfolio, and you have unused capital loss carryovers, you might consider selling some of your existing holdings with gains. By utilizing the unused capital loss carryovers to offset those gains, you may pay little or no tax on the profits.

• Relinquish Dependency Rights – If you are the custodial parent of a child, have the right to claim the child as a dependent, but have no need for the tax benefits associated with the dependency this year, you might consider relinquishing the exemption to the child’s other parent.

• Exercise Options – Employee stock options, when exercised, produce either ordinary income (non-qualified options) or alternative minimum tax preference income (qualified options) equal to the difference between the exercise price and the market value of the shares at the time of exercise (purchase). Employees who have stock options with a non-publicly-traded company, where the value is depressed because of the current economic climate but is expected to recover in the near future, should consider exercising their options while the stock value is low. In doing so, the employees will be able to acquire the stock at a preferential price and hold it for future appreciation with a minimum, or perhaps zero, current tax bite.

• Deduct IRA Losses – A traditional IRA account often contains only contributions that were previously deducted, so if the account’s value declines, no additional loss deduction can be claimed. However, if you have made nondeductible contributions to a traditional IRA and the value of all of your IRA accounts combined is less than the sum of your nondeductible contributions, you can take a loss — but to do so, you must take withdrawals from (close out) all of your IRA accounts. The result is a miscellaneous itemized deduction equal to the total of the nondeductible contributions less the sum of the withdrawn amounts. However, this loss is beneficial only if your deductions are itemized, and the loss, along with your other miscellaneous deductions, exceeds 2% of your income (AGI) for the year.

• Cash in Savings Bonds – Two options are available for tax reporting of interest income from certain U.S. savings bonds, such as EE Bonds and I Bonds: include the increase in redemption value each year as interest, or postpone reporting any of the interest until the return for the earlier of the year the bonds mature or are cashed in. Typically, most people choose the latter method. If you are holding savings bonds that are approaching their maturity and your taxable income for the year will be negative or lower than it normally is, and you haven’t previously reported the interest, you may want to cash in some or all of these bonds to take advantage of your lower tax bracket. If you don’t want to cash in the bonds, you can make an election to switch to the annual interest reporting method, but if you do so, on the return for the year of the change, you will have to include all of the interest accrued to date for all Series E, EE or I savings bonds that you hold, and then report the annual interest in each succeeding year for those and any bonds of these series that you may acquire in the future.