Tax Deductible Expenses

I’m often asked if a particular expense is tax deductible. Everyone is looking for a deduction! In general, only expenses incurred in a trade or business (IRC §162) or those incurred in the production of income (IRC §212), will be deductible on an individual tax return. I once had someone ask me if a new washer and dryer was deductible. It would be if it were used in a trade or business, for example in a hair salon to wash towels. However, this person was using the appliances at her home, so the cost would not be deductible. (Hard to believe someone would ask, but true story.) In addition, the expense must meet several criteria. It must be ordinary, necessary, reasonable, and incurred by the taxpayer.

Ordinary Expense

An expense is ordinary if it is normally incurred in the type of business the taxpayer is involved in. For example, let’s say Jim Jones owns ABC Newspaper and he is sued for liable based on a story he ran on the front page. ABC Newspaper has never been sued for liable before, but the legal fees involved in defending the paper would certainly be considered an ordinary expense for the newspaper business.

Necessary Expense

The Supreme Court has held that an expense is “necessary” if it is “appropriate and helpful” in the taxpayer’s business. Again, what may be appropriate and helpful in one line of business may not be in another. Dump fees are appropriate and helpful for a tree trimming business but are not appropriate and helpful for a CPA firm.

Reasonable Expense

In practice the reasonable standard is most often applied in situations involving salary payments made by a closely held corporation to a shareholder/employee. This is a frequent abuse of the tax system, the shareholders pay themselves a very large salary, in an effort to avoid the corporation paying a dividend. But, it doesn’t apply just to salary expense. Overdraft fees are an ordinary expense of doing business, and may be necessary to keep the checking account open. However, if overdraft fees occur daily, they may fail the reasonableness test and not be considered a deductible expense.

Expense Must be Incurred Directly by the Taxpayer

If a taxpayer pays an expense on behalf of someone else, it’s considered a gift and not a deductible expense. When the sales tax deduction was first enacted, people would go to retailers’ parking lots and find receipts so they could use them for their sales tax deduction. This rule prohibits such behavior. The one exception is for medical expenses paid for a dependent, and those are deductible.

Social Security Benefits for Widows & Widowers

What happens to Social Security benefits when a spouse dies? Let’s use an example of Bill and Ann Jones. Bill and Ann are both receiving Social Security benefits when Bill dies suddenly of a heart attack. Ann can keep her own Social Security benefit payment or she can claim a survivor benefit based on the benefit Bill received prior to his death.

Let’s assume Ann was 61 when Bill died, and not receiving Social Security benefits. At Bill’s death, Ann would qualify for widow benefits because she is age 60 or older. Of course, once she reaches 62, she can receive benefits based on her own work record if that is greater than the amount she receives based on Bill’s record.

What if Ann, age 40, and Bill, age 45 had a child, Charlie, at home when Bill died? In this scenario, as long as the Charlie is younger than 16 and entitled to benefits, Ann would also receive Social Security benefits as long as she continues to care for Charlie, or until Charlie reaches age 18 (or up to age 19 if he is still a student in high school).

Takeaway

A spouse can increase his surviving spouse’s benefits by 20% if he claims benefits at age 66 and by 60% if he claims benefits at age 70. An older spouse with adequate income from other sources should defer claiming Social Security benefits until later in life, in order to provide a higher Social Security benefit to his or her surviving spouse.

Social Security Benefits

Nearing retirement age?  Not sure when to start receiving your social security?  These are common questions among Americans in their 60s.  Unfortunately, due to insufficient savings, in 2014 Social Security provided 100% of the retirement income for 15% of individuals 65 and over.  It’s important to understand how Social Security works and your options under the program.

Receive Benefits Earlier or Later?

In order to qualify to receive Social Security, an individual must have worked a minimum of 40 quarters (10 years). The Social Security Administration calculates an individual’s benefit amount based on average earnings over 35 years, not on the number of credits or how much an individual paid in Social Security taxes.  Delaying benefits past the individual’s full retirement age, producers larger payments starting later in time.  For individuals born in 1937 and prior, full retirement age is 65.  For individuals born between 1938 and 1960, full retirement age ranges from 65 years 2 months up to 66 years and 10 months.  Individuals born in 1960 and later have a full retirement age of 67.  Basically, each year of delay past the full retirement age will increase benefits by 6%-8% up to age 70.

What Effect Does Working Have on My Benefits?

If an individual is at their full retirement age and works, he may keep all of his Social Security benefits, no matter how much he earns.  However, if the individual is younger than full retirement age, there is a limit to how much he can earn.  In 2015, Social Security will deduct $1 from benefits for each $2 earned above $15,720.  If you reach full retirement age in 2015, the Social Security Administration will deduct $1 for each $3 earned above $41,880.

What are the rules for married couples?

A spouse is entitled to receive up to 50% of the other spouse’s Social Security benefit payment if that amount is higher than the Social Security benefit the individual would be eligible to receive based on their own working record. This can be beneficial for couples where one spouse had low earnings, or no earnings.  Important to note, the spouse must wait until attaining full retirement age to collect 50% of the other spouse’s Social Security benefit.

In addition, a divorced individual can receive Social Security benefits based on her ex-spouse’s work if they were married for 10 years or longer and the individual is unmarried and the individual is 62 years of age or older.  The maximum benefit a person can receive through a living or ex-spouse is 50% of the ex-spouse’s benefit at his full retirement age.  Of course, if the divorced person’s benefits are greater than that which would be received based on their ex-spouse, they would be entitled to receive Social Security based on their own earnings record.

Tax Return For A Deceased Taxpayer

What are the income tax consequences if Grandpa dies on June 30, 2014?  If a taxpayer dies during the tax year, the IRS still expects a tax return to be filed on behalf of the decedent.  In general, it is the executor’s responsibility to ensure the final tax return is prepared and filed.

When preparing the final return, write the word “Deceased” and the date of death across the top of the tax return.  If the return reflects a refund due the decedent, a Form 1310, Statement of Person Claiming Refund Due a Deceased Taxpayer, may be required to be filed.  This form is not required if the decedent was married on his date of death and is filing a joint return with his surviving spouse.

What to include?

The income earned by the decedent from January 1 until date of death should be reported on the decedent’s final Form 1040.  Income earned from the assets owned by the decedent after the date of death is reported on a Form 1041, U.S. Income Tax Return for Estates and Trusts.  To continue our example of Grandpa above, the income earned by Grandpa from January 1, 2014 through June 30, 2014 would be reported on his final Form 1040.  If Grandpa left behind rental real estate, stocks and bonds, the net rental income, dividends and interest earned after June 30, 2014 on those assets would be reported on a Form 1041.

Closing the estate

In general, an estate should not remain open longer than 2 years.  This gives enough time for the executor of the estate to distribute the decedent’s assets and get them re-titled in the beneficiary’s names.  Once an asset is distributed to the beneficiary, the estate no longer pays income tax on the income generated from the asset; it becomes the responsibility of the beneficiary.  A common misconception is that inheritances are taxable income.  The inheritance itself is not taxable; however, the income generated on the inherited assets is taxable income to the beneficiary.

SEP Plans

Many times I’m asked, “How can I reduce my tax bill?”  One of the best ways for small business owners to reduce their taxes is to create and contribute to a retirement plan.  There are many low cost options available for small employers; however, I believe the best option may be the SEP IRA.

SEP IRAs

Simplified Employee Pension plans are an easy and low-cost way to save for retirement.  Under a SEP plan, the employer contributes directly to traditional individual retirement accounts for all employees, including themselves.  Sole proprietors, partnerships and corporations, including S corporations, can set up SEPs.  Contributions to the SEP are tax deductible and earnings grow tax-deferred.

Contribution limits to a SEP IRA are 25% of wages or $53,000, whichever is lesser.  Traditional and Roth IRAs have contribution limits of $5,500 (or $6,500 for those aged 50 or older), so the SEP IRA allows you to save more for your retirement each year.  The downside, perhaps, is that the business must contribute the same percentage for each qualified employee.  Employees are eligible to participate in the SEP IRA plan if they are at least 21 years old, have worked for the company for at least three of the past five years and have made at least $550 per year working for employer.

How do I set it up?

Contact your broker or any financial institution that offers retirement plans and select the IRS model SEP, Form 5305-SEP, Simplified Employee Pension—Individual Retirement Accounts Contribution Agreement.  The SEP may be established as late as the due date, including extensions, of the company’s income tax return.  For example, if a corporation has a December 31, 2014 year end and an automatic extension was timely filed, the SEP would need to be established on or before September 15, 2015 in order to be effective for the 2014 tax year.

Advantages

I prefer the SEP IRA because it is easier to administer.  With the SIMPLE IRA, employees have the option of making contributions through withholding from their wages, which is a little complicated.  The SEP IRA does not allow for employee contributions, the employer simply funds the SEP IRA with a check.  In addition, the SEP IRA allows for higher contribution limits, so you are able to save faster and entitled to a larger deduction on your taxes.

As mentioned earlier, a possible disadvantage of the SEP IRA is required contributions for all qualifying employees.  This does not have to be a disadvantage. Many employers use retirement benefits to attract and retain high quality employees.