"all of these causes actually share a common foundation. What is it?"
Have you ever gotten flustered trying to talk about taxes with your accountant? Does it seem like your accountant speaks a foreign language? You are probably not alone. The terminology is confusing. I will try to help here by defining some basic terms and then explain why using the terminology is … problematic.
A little help?
These are items that are subtracted from total income to arrive at “Adjusted Gross Income” on your tax return. The defining characteristic of an adjustment is its location on the tax return – nothing else. This is where things like retirement plan contributions show up. It might be helpful before going on to lay out a tax return formula using the basic terms I will be defining:
Total Income - Adjustments = Adjusted Gross Income (AGI)
AGI - Deductions & Exemptions = Taxable Income
Tax (from Taxable Income) - Tax Credits (non-refundable) = Tax Liability
Tax Liability - Tax Payments and Refundable Tax Credits = Tax Refund or Tax Due
While most people use deductions and credits interchangeably, they are not the same. You will either claim the “Standard Deduction” allowed based on your filing status, or the total of personal “Itemized Deductions”, whichever is higher. With the new tax code very few people will be itemizing anymore due to the increased Standard Deduction. Itemized deductions include non-business expenses you deduct, like property taxes, mortgage interest, and charitable giving.
In this category I will lump “Exemptions”, because they function like deductions. Exemptions are a flat dollar amount per person in the household that is subtracted from Adjusted Gross Income, along with deductions, to arrive at taxable income. In the new tax code these are gone.
These will be listed on a Schedule C if you have self-employment income and don’t file a separate entity tax return. These are expenses related to your business income, and they reduce the business income that shows up on page 1 of your 1040 as part of total income. They are not part of your Itemized Deductions, and you don’t have to itemize to claim business deductions (that’s a common area of confusion).
These are dollar for dollar reduction in taxes from the tax based on taxable income. Things like the child tax credit and some of the education credits show up here. Tax credits can reduce tax liability down to zero, but not below.
Refundable Tax Credits:
These are called “refundable” because they can result in a refund. They are treated as if you actually made a tax payment. The Earned Income Tax Credit and Additional Child Tax Credit are common refundable credits.
Why it all Gets jUMbl3d
That would be enough to remember, but then we have to throw in the fact that the terminology isn’t perfectly consistent. For example, the “credit” for half of self-employment tax paid, the IRA contribution “Deduction”, and Student Loan Interest “Deduction” are actually all Adjustments.
Getting Practical: How to Talk Tax
I never expect my clients to speak “tax”. If they say “deduction” or “credit” I know they could mean anything. And the only time I really define one of these terms is if it’s necessary for understanding a planning issue or to answer a question a client has. I find it’s more helpful to talk about how different items functionally impact taxes.
Ultimately it is our job as tax professionals to do the translation and make sure we get the correct and complete information. But hopefully this little insight helps you realize the confusion you may feel at times is for good cause - and also that you don't need to stress about it too much if you are working with someone who knows your situation.
In your corner,
Lots of hubbub and mostly positive press on the new Tax Cuts and Jobs Act lately - but unless you’re a tax pro, reading all of it is dizzying. I wanted to provide a couple of representative examples of families that could be surprised by how the new tax code may change their taxes, since reading the specifics is hard to grab onto without examples.
Enter the Blissful Family
They are a very common family, working parents, three young kids, with pretty simple tax situations. They normally don’t take itemized deductions since the standard deduction has been higher for them, and all their income is from wages. Combined they earn $115,000 per year (I am intentionally selecting an income amount that would not trigger Alternative Minimum Tax, and assuming no other adjustments or credits for simplicity).
Under the old code as it would have been in 2018 without any changes, they would have reduced their taxable income as follows:
$13,000 Standard Deduction
$20,750 Personal exemptions (5 x $4,150 for parents and dependents)
These result in $33,750 subtracted from gross income to arrive at $81,250 in federally taxable income. This income is broken into chunks that are taxed at different rates, but their highest bit of income ($3,850) would have been taxed at the 25% rate, and most of the rest at 15%. Their tax bill would have been $21,196, but they will get a Child Tax Credit of almost $2,250 to offset the tax, so it ends up at about $18,946 – or about 17% of total income.
What will that look like under the new code?
In the new plan, their reductions for taxable income include ONLY the standard deduction, with a larger amount of $24,000, but NO EXEMPTIONS. So they gained $11,000 in income reduction via standard deduction, but lost $20,750 in income reduction via exemptions. Their taxable income is now $91,000 - almost $10,000 more than under the old plan. BUT, with the changes in brackets (their highest is 22% on $3,850 of income and 12% on $58,350) – their tax bill is $9,754. This reduced further by an increased Child Tax Credit AND the fact that they now do not have it reduced due to larger income thresholds, so they get the full $2,000 per child credit for a $6,000 reduction, yielding a tax of $3,754 – about 3% of total income.
Verdict: The Blissful Family reduces their tax bill by $15,000 dollars, an 80% drop in taxes and a 14% drop in effective tax rate! They now love this Congress… maybe.
Enter the Bothered Family
...with a total income of $140,000. Mr. Bothered is a long-haul trucker who works as an employee, earning $80,000 per year. He deducts his travel expenses as unreimbursed employee expenses with other itemized deductions, and these usually total $30,000. Mrs. Bothered is a sales person who travels a lot and uses a dedicated home office to telecommute often, which gives her a $1,500 itemized deduction using the simplified method. She earns $60,000 per year. Combined they have a sizeable nest egg that is actively managed, and typically have investment expenses of about $20,000 in fees per year that are deducted with other itemized deductions. They also deduct about $17,000 in mortgage interest, property taxes, and charitable contributions. They have no children or other dependents.
Under the old code, they would have reduced their taxable income as follows:
$67,825 in itemized deductions
$8,100 personal exemptions
Their taxable income after reductions of $75,925 would be $64,075. They are subject to Alternative Minimum Tax, and their total tax would have been about $11,000 with no offsetting credits – or about 8% of total income.
What will that look like under the new code?
They are no longer allowed to deduct any of the unreimbursed employee / miscellaneous expenses like unreimbursed travel, home office and investment expenses. They will therefore not itemize, but take the new increased standard deduction of $24,000 for married couples. They have LOST almost $52,000 in income reduction for taxable income. Their taxable income is therefore $116,000. They will NOT be subject to Alternative Minimum Tax thanks to the new much higher income thresholds. Their total tax will be $17,400 – an effective rate of 12% on total income.
Verdict: The Bothered family increases their tax bill by $6,400, a 58% increase in tax and a 5% increase in effective tax rate! They can’t wait until mid-term elections?
MANY people are going to come away realizing a real tax cut. Others could get a nasty surprise.
This article focused on families rather than corporations, which is an entirely different discussion (for example, it may make sense for some S-Corps to elect to be taxed as a Corporation now?). How many kids you have, the makeup of your income and itemized deductions, and your income level will all play into how the new code affects you. Lots changed with this new code, more than is reflected in this brief example.
Bottom line – talk to your tax pro so you know what adjustments you may need to make in 2018.
In your corner,
For tax year 2016, taxpayers had an option to file a return opting not to report the health coverage information that is used to show compliance or calculate health coverage penalties ("Individual responsibility payment"). That option is going away for tax year 2017 returns which will be filed in 2018. The IRS announced that returns not reporting the information will not be able to be e-filed, and paper-filed returns that leave it out could be delayed until the information is provided.
The penalties were scheduled to increase again this year, and they can be severe. Be aware also that those who receive a premium tax credit (PTC) advance to help pay for exchange purchased policies may have to pay some or all of that advance back if in fact they do not qualify for the PTC. I have seen a number of these scenarios the last couple years that surprised people. For example, lets say you got marketplace policy and they anticipated you would qualify for a PTC of $1200 for the year. They issue an "advance" that pays part of your premium, and you are paying $400 a month. Your premium is actually $500 a month, and you are borrowing $100 a month from the US Treasury that is being applied against your premium. If at filing time because of income you don't actually qualify for the PTC, you have to pay the $1200 back.
There are certain exemptions allowed that would eliminate penalty. These include short coverage gaps between coverage of two months or less, low income exemption, being a member of a cost sharing ministry, being a member of certain religious sects, living abroad, and unaffordable coverage to name a few. In the event of unaffordable coverage, you must be aware that this is a Marketplace exemption that must be granted ahead of filing time. You cannot simply base this on the cost of premiums you have shopped.
ACA is up in the air in Congress still, but as of this time the law stands as is and the IRS sets the reporting requirements. If you have any questions, please feel free to call for clarification on your situation.
In your corner,
We're all about a thousand percent smarter when we look in the rear view mirror. If we could go back in time and re-do some things, we'd avoid some land mines and surprises. But as yet, time travel is still theoretical, so we live in the present.
Every tax season I talk to people who had major events happen in their lives. Many of these people forget to think about the tax consequences of events until it's filing time. Some will call me during the year, and say "Dave, thinking about selling this property, or changing this ... what would that look like?" I love it when I get those calls because we have a chance to plan for what is likely to come in an informed way, rather than crossing our fingers and hoping for the best. And every so often I can present an idea the client had not considered that may provide greater advantage. "Maybe a seller-financed deal would make sense for you here, so you can spread out the capital gains" ... "Perhaps we should change your business' tax election this year" and so on. (The moral of that story is, if you only talk to your accountant at tax time you are missing the boat in a big way!)
Financial foresight is something we talk about with clients a lot. Hindsight is only helpful if we use past experience to inform present decisions. But with good historical information, foresight is possible. This concept can be used for any business or financial issue you may face. Foresight should always be the goal, because it is what puts you in control.
What gets in the way of financial foresight? Sometimes businesses lack the proper systems or processes to capture the information that is needed as it happens to create real hindsight. You first must understand what has happened in the past and why. Once you know these things, that knowledge can yield foresight for current issues you may be facing. There are other obstacles to financial foresight, but in my experience that is the most common problem.
I'm not going to spell out 4 magic steps to financial foresight here. My goal now is just to encourage you to think about your relationship with information. Do you know what is relevant? Do you have enough of it? Set your standards high and strive for financial foresight in all areas of your life. Get the right help, the right tools, the right systems, until you have it. It is when you refuse to settle for less that you will make the best decisions with greater confidence.
In your corner,