Foreign-Earned Income Taxation

This is a question that comes up a lot with clients that work outside of the country either during portions of the year or are full-time residents of other countries. Estimates suggest that there are around 8 million US citizens living in other countries around the world. 

Some American citizens are there for employment and financial reasons, others are retired, while some may be born in these foreign countries, but they are the children of US citizens.  All these people are most likely required to file a US tax return every year.

The United States tax system is incredibly unique in that it is a citizenship-based tax system. With this system, it does not matter where in the world you live, if you are a US citizen you are required to file taxes by June 15th of each year. There are tax treaties in place with some countries so many citizens living abroad file their taxes and owe nothing. 

Whether you owe taxes or not all US citizens are required to file their tax returns if they have earned income over the minimum thresholds. With others that are living in foreign countries, they find themselves in a situation of double taxation. This is when you must pay taxes in the US because of your citizenship, and you are also required to pay taxes in the country where they are living. 

 

Foreign Earned Income Exclusion

This article will discuss a remedy to the possibility of double taxation. A lot of these taxpayers may qualify for the Foreign Earned Income Exclusion.  This is where a portion of your foreign earned income can be excluded from US taxation.

In 2020 the allowable exclusion cannot be more than the smaller of the following:

  • $107,600 for Single filers or if Married Filing Jointly it can be $107,600 for each spouse if they both qualify and meet the requirements.
  • Foreign earned income for the tax year minus the amount of foreign housing exclusion or housing deduction if taken.

 

How Do I Qualify?

This exclusion is the most common and widely used tax benefit for US citizens living abroad.  It allows Americans to exclude all or a portion of their foreign earned income from their US taxes. With such great benefit, this is not a blanket exclusion for all foreign earned income. There are some specific qualifiers that you must meet. 

The requirements to file minimum income thresholds are the same as for US residents. For Tax year 2020 the thresholds for total yearly income as laid out below as seen on the American Citizens Abroad website.

Minimum Income Requirements for Filing Foreign Earned Income

Marital StatusUnder 6565 or Older
 You are single (unmarried) $12,400 $14,050
You are married filing jointly $24,800 $27,400 (both over 65)
 You are married filing separately $5 $5
 You are filing as “Head of household” $18,650 $20,300
 You are a widow or widower $24,800 $26,100

 

Foreign earned income means wages, salaries, professional fees, or other amounts paid to you for personal services rendered by you. It does not include amounts received for personal services provided to a corporation that represent a distribution of earnings and profits rather than reasonable compensation. 

A qualifying individual may claim the foreign earned income exclusion on foreign earned self-employment income. The excluded amount will reduce your regular income tax but will not reduce your self-employment tax.

There are some forms of income that do not qualify for the exclusion such as:

  • Pay received as a military or civilian employee of the US government or any of its agencies.
  • Pay for services conducted in international water or airspace (not a foreign country)
  • Payments received after the end of the tax year following the year in which the services that earned the income were performed.
  • Pay otherwise excludable from income, such as the value of meals and lodging furnished for the convenience of your employer on the premises.
  • Pension or annuity payments including social security benefits

To claim the foreign earned income exclusion a taxpayer must meet all three of the following requirements:

  1. Their tax home must be in a foreign country. A tax home is a place where a taxpayer permanently or indefinitely engages to work as an employee or self-employed individual. A tax home is not in a foreign country for any period in which a taxpayer’s abode is in the United States. An abode is one’s home, habitation, residence, domicile, or place of dwelling.
  2. The Taxpayer must have foreign earned income.
  3. The Taxpayer must meet either the Bona Fide Residence Test or the Physical Presence Test.

Bona Fide Resident Test

A taxpayer does not automatically acquire bone fide resident’s status merely by living in a foreign country for one year. The length of the stay and nature of the job are additional factors that determine whether a taxpayer meets the test. 

A taxpayer who travels to a foreign country to work on a particular construction job for a specified period of time ordinarily is not a bona fide resident of that country even if working there for more than one tax year.

To be a bona fide resident a taxpayer must be:

A US citizen who is a resident of a freeing country or country for an uninterrupted period that includes an entire tax year.

or

A US resident alien who is a citizen or national of a country with which the United States has an income tax treaty in effect and who is a bona fide resident of a foreign country or country for an uninterrupted period that includes an entire tax year.

Physical Presence Test

A US citizen or a US resident alien physically present in a foreign country or country for at least 330 full days during any period of 12 consecutive months. 

The physical presence test is based only on how long the taxpayer is in a foreign country. The test does not depend on the kind of residence established, intentions about returning, or the nature and purpose of the stay abroad.

 

How to File for the Foreign Earned Income Exclusion?

If you qualify for the foreign earned income exclusion, then you must submit a Form 2555 with your Form 1040 or 1040x. Do not submit this form by itself. Form 2555 shows how you qualify for the bona fide residence test or the physical presence test, how much of your foreign earned income is excluded and how to figure out the amount of your allowable foreign housing exclusion or deduction. 

If you and your spouse both qualify to claim the foreign earned income exclusion, the foreign housing exclusion, or the foreign housing deduction, you and your spouse must file separate 2555 Forms to claim these benefits.

 

What if I do not qualify for the Foreign Earned Income Exclusion?

If you do not meet these requirements for the exclusion, it is not the end of the road. It does not mean you will have to pay tax on all your income. 

Another option is the Foreign Tax Credit. The foreign tax credit is a non-refundable tax credit for income taxes paid to a foreign government because of foreign income tax withholdings. The foreign tax credit is available to anyone who either works in a foreign country or has investment income from a foreign source. Generally, only income, war profits, and excess profit taxes qualify for this credit. You can not claim the foreign tax credit on the same income.

Another option for a US citizen living abroad is the Foreign Housing Exclusion. This deduction was created by the IRS to offset the expenses that go hand in hand with living overseas, this exclusion decreases a taxpayer’s tax liability by allowing certain housing expenses to be deducted from taxable income. This exclusion can be used if your housing costs were over 16% of the FEIE amount for that year. If you live in a city that is identified by the IRS as ultra-high cost, you may be able to use an additional amount for the foreign housing exclusion.

In conclusion, if you had not realized that as a citizen you are still required to file a Federal Tax Return it is not too late to take advantage of the exclusion if you qualify. To take this exclusion you generally must file within one year of the due date of your return or by amending a timely filed return. However, if the IRS has not discovered your failure to file or if you owe no tax after taking the exclusion you may still be able to exclude your foreign earned income from your US taxes. 

As we have recommended in many other articles, any time you are dealing with these more complex filings it is smart to hire a true tax professional who has the education and licensing to take advantage of everything within tax law that can save you money. In a situation like this, an Enrolled Agent or a CPA is a trusted source that you can turn to.

 

IRS Resumes All Tax Collections and Doubles Workforce to Snag Tax Cheats

woman upset over a collection letter from the IRS

Last March the United States and the rest of the world basically came to a screeching halt. The Covid-19 pandemic swept through society forcing the biggest halt to business, government, and people’s lives in modern history. Many people were forced out of work and were in fear of not being able to pay their bills. 

During this time, the IRS took a step back in their collection activity to take some pressure off taxpayers. The IRS since this time has slowly begun to restart many different processes. Now a year and a half later the IRS has announced that it will resume many of the collection processes that have been idle in the past year and a half. 

In this article, I will start by explaining the efforts the IRS took to take this pressure off Americans that owed money to the IRS. I will follow that up by further explaining the collections activities that the IRS is immediately resuming and detail the future and proposals by the IRS and the President to seriously beef up the Investigation and Collections Departments within the IRS.

 

The People First Initiative

On March 25, 2020, the IRS began its People First Initiative to help people facing the challenges of Covid-19. The IRS announces that they would take a series of steps to assist taxpayers by providing relief on a variety of issues ranging from easing payment guidelines to postponing compliance actions. 

IRS Commissioner Chuck Rettig said, ”The IRS is taking extraordinary steps to help the people of our country. In addition to extending tax deadlines and working on new legislation, the IRS is pursuing unprecedented actions to ease the burden on people facing tax issues. During this difficult time, we want people working together, focused on their well-being, helping each other and the less fortunate.”

The IRS made major changes such as postponing the filing deadline from April until July 15th.  They also suspended payments for any taxpayers in agreed-upon Installment Arrangements between April 1 and July 15th, 2020. They agreed they would not default any taxpayers who fail to make these payments during this time. 

They also suspended payments and deadlines for taxpayers in or applying for the Offer in Compromise Program. Also, all liens and levies either through the automated system or in place by active field agents were all suspended as well.

 

Resuming Collections

On July 15,  2020, the IRS slowly began resuming its processes. They announced to taxpayers that if you suspended your installment agreements you must make your first monthly payment due after July 15th. If you had your bank suspend direct debits, then you needed to contact your bank immediately to avoid a penalty. The same was required with all payments for people in the OIC program. At this point, they did resume some involuntary collections, but they kept most of the automated collections systems idle. 

On June 14, 2021, the IRS announced that due to the recent progress the country has made in controlling the Covid-19 pandemic, economic activity is returning to normal. Therefore, the IRS plans to return to its normal collection casework processes in the summer of 2021 to support the integrity of the nation’s tax system. 

Beginning June 2021, the IRS will start mailing balance due notices through the Automated Collection System. If taxpayers fail to respond to these letters they could be subject to levies or notice of Federal Tax Lien Filings beginning August 15, 2021. 

 

Proposal to Double the IRS Workforce

Not only has the IRS resumed their normal collections but there have been proposals made to seriously expand the IRS budget to help reduce what they call the tax gap. 

The tax gap is the difference between what taxpayers should pay and what they pay on time. The tax gap, about $458 billion based on updated estimates, represents the amount of noncompliance with the tax laws. President Biden plans to propose an $80 billion funding boost for the Internal Revenue Service over the next decade. This budget increase would allow the IRS to hire nearly 87,000 new workers which would double its enforcement staffing and give it new tools to combat tax-dodging by wealthy Americans. 

This proposal being a multi-year commitment would allow the IRS to hire and properly train enforcement staff and ramp up audits with less risk of lawmakers stopping such an initiative halfway through. The plan would allocate about $30 billion of this money towards advancements for new tools and technology to execute collections and crackdown on avoidance. 

 

Proposal to Change How Income Is Reported to the IRS

A big change to the system would be how income is being reported. Right now, with the way that individual income is reported, there is almost 100% compliance. Where the problem lies is with self-employed individuals and business income. Estimated compliance with these individuals and entities is around 50%. Under the plan, banks and other payment providers would be required to report to the IRS how much money is coming in and out of an individuals’ and business’ account each year. This information would give the IRS much more information as it decides who to audit.

Also, the proposal would increase oversight on all paid tax return preparers. This would give the IRS explicit authority to regulate all paid preparers of Federal tax returns, including by establishing minimum competency standards. Unfortunately, at this time in our industry, there are people without the educational background needed to correctly file taxes for people. Many of these types of preparers also do a lot on the tax filings to increase one’s tax refunds through erroneous means. 

Most taxpayers are unaware of the methods these tax preparers use to help them get larger refunds and those same methods could get them into trouble with the IRS. Regulating this part of our industry will cut the tax gap down significantly.

 

What the Proposed Changes Would Accomplish

This major investment would be over the long term and the administration projects that the plan would generate over $700 billion over 10 years in net revenue. In the short term, the President included in his 2022 budget proposal $13.2 billion, an increase of 1.2 billion from 2021 for the IRS to administer the nation’s tax system fairly. 

In addition to this base amount the budget also proposes another $417 million in 2022 to fund investments in expanding and improving the effectiveness and efficiency of the IRS’ overall tax enforcement program. This would be a total of $13.6 billion in funding for the IRS. The budget requests a total program increase of $915.5 million including the following:

  • Taxpayer First Act (TFA): $176.1 million for implementing major TFA initiatives, including a Taxpayer Experience Strategy to improve the American taxpayer’s experience with the IRS through expanded digital services, increased multilingual services, and an increased presence in hard-to-reach, historically underserved communities. Another major TFA initiative involves enhancing identity proofing and authentication tools, to ensure taxpayers have secure access to online services.
  • Enforcement: $340 million for continuing to establish enforcement strategies that will ensure a fair tax system, by allowing the IRS eventually to double its compliance efforts on partnerships and high-wealth returns and devote more resources to examining large corporations with balance sheet assets greater than $10 million. Other initiatives supported by this investment include The Cross Border and Treaty and Transfer Pricing Operations; expansion of oversight efforts against cybercrime; increased use of applied data analytics in enforcement activities; and enhancing taxpayer confidence in the tax-exempt sector.
  • Taxpayer Service: $318 million to increase taxpayer assistance via the various communication channels taxpayers use to reach us, including phone calls, correspondence, and in-person visits. This investment provides a projected phone level of service (LOS) of 75 percent in FY 2022, assuming phone demand returns to pre-pandemic levels and the IRS is able to provide in-person services at pre-pandemic levels. These funds will also be used to reduce the current projected FY 2022 ending correspondence inventory by about 400,000 pieces.
  • Modernization: $78.1 million for IT modernization activities. This investment will support IRS efforts to continue implementing its Integrated Modernization Business plan for upgrading IT systems and retiring legacy applications. With this funding, the IRS will be able to take the next steps on such significant modernization initiatives as Enterprise Case Management, Taxpayer Digital Communications, and customer callback on its taxpayer phone lines. 

With all these changes coming to the IRS it is particularly important that all delinquent taxpayers have themselves into some sort of program to protect themselves.  When it comes to owing taxes, a compliant taxpayer has a lot of rights that can be enforced to save them a lot of money. It is important that someone in this situation gets the proper representation. Enrolled Agents and CPAs have the educational background and licensing to best represent you in these types of situations. 

With billions being funneled into the IRS to make sure that these tax dollars are recovered it is especially important that a taxpayer is proactive so the repayment of tax debt can be on their terms and so they are not seriously overpaying on their tax debt. It sounds like with these improvements to the IRS the days of flying under the radar are done and gone.

 

A Guide to Avoiding, Stopping, Fighting, or Settling Tax Levies

screenshot of the webpage about tax levies on irs.gov

Do you owe the IRS back taxes? If so, and you’re unable to pay the debt, you could be in danger of a tax levy. This means losing much more than money.

The government has the power to claim whatever’s needed when settling tax debt. This means utilizing a tax levy to reconcile unpaid taxes. Any property you own can be levied, starting with a hold called a tax lien. Money, property, and many other things can be taken by the government, and it can get serious. It can also become hard to settle the debt and clear a tax levy.

 

What is a Tax Levy?

Basically, a tax levy is used to collect a tax debt by seizing your property or the contents of your bank account by utilizing a lien. A tax levy and lien are two different things. While a lien only secures the property as an option for collection, the levy takes the property to satisfy the money that’s owed to the IRS. It’s a completed process that’s easier to avoid than fix.

 

Requirements of the IRS before a Tax Levy

There are 4 requirements that usually must be met by the Internal Revenue Service before a levy can go into effect. These requirements ensure the taxpayer has a fair chance at paying off the debt without further consequences. After all, everyone deserves an early warning that they’re in debt territory. Here’s what the IRS must do before implementing a tax levy.

  1. A tax bill is sent to the taxpayer. This bill includes a notice and demand for payment of the debt.
  2. After the bill is received, the individual or organization has a choice: Either pay the debt or refuse/neglect the payment request, basically avoiding the responsibility in many causes.
  3. When the payment is refused in any way, this triggers the next step or requirement of the IRS. The Internal Revenue Service sends a Final Notice of Intent to Levy and a Notice to Your Rights to a Hearing. This notice gives you 30 days to decide or amends before the levy starts. There are several ways you may receive this final notice. It may come by registered or certified mail to your last known location address. It can also be delivered to your job or handed to you personally. This depends on the circumstances. However, the IRS may levy your tax refund regardless, and you can request a hearing after the tax levy on this refund.
  4. The IRS contacts a third party concerning the collection of a debt. You will receive notice of this third-party contact from the beginning. This is used to help the government determine your tax liability.

 

How a Tax Levy Affects You

If you’re, unfortunately, hit with a tax levy, you can expect serious consequences that can affect you and your loved ones. Once things pass a threshold, you’ll start losing possessions that are worth more than just money. This can include your home and automobile.

The first hard hit comes from wage garnishment. If you’ve never gone through this process before, you’re in for a big surprise. And it will not be a pleasant one either. While many people do experience wage garnishments, they’re usually not tax garnishments. Many times, old student loan debts or child support debts are garnished from wages and have a limit as to how much they can pull.

With the government, this limit is completely different. If your wages are garnished for back taxes, you can lose more than half your paycheck to satisfy the government.

The IRS can also contact your bank and place a 21-day hold (lien) on your money, all of it. If this happens, they can levy the money from your bank to retain the tax debt that’s owed to them. This could mean all the money in your bank. There is no threshold in this case. However, they won’t take what’s in your bank account if you work out a better plan with the government.

As a last resort, the government can seize your property, including your home and automobile. Although they do not like doing this, it may be necessary to fix the situation. Other property or payments can also be taken by the IRS to settle a debt.

 

Tax Levy Immunities

But some payments are generally immune from this seizure. Although the IRS can sometimes seem harsh, they are lenient when it comes to economic support funds. The following payments are immune:

  • any unemployment benefits
  • annuities
  • disability payments
  • household items, mainly large furniture items
  • personal valuable small items like jewelry
  • child support payments
  • assistance payments from the public
  • pension benefits
  • work or school items necessary to function properly

 

How to Avoid a Tax Levy

One of the easiest ways to avoid a tax levy is to make sure enough money is being withheld from your paycheck. Not doing this properly can cause you to get behind on your taxes. Creating a tax debt is how it starts, so making sure everything is up to date avoids ever getting involved with a tax levying situation.

 

How to Stop a Tax Levy

As soon as you realize you’re in danger of a tax levy, it’s smart to try and remedy the situation before it gets worse, and it can get quite bad. Taking care of this problem early lowers the chances of losing even more money or property. There are steps to stopping a tax levy, and you should take advantage of these options.

First, try your best to pay your back taxes when you’re facing a lien on your assets. The IRS is willing to communicate with you to solve this issue quickly. If they ask for any information, be ready to provide everything they need. Most importantly, cooperation with the IRS shows they can trust you to remedy the debt through collection actions.

 

Working with the IRS to Settle a Tax Levy

There is a way to possibly get the lien taken off your record. If you’re willing to use an IRS payment plan, you must make 3 successive payments from your bank account. This is called a direct debit installment agreement. You can set up this installment plan on the IRS website since there is no need for any professional help. But there is usually a fee of up to $225 associated with the installment plan depending on how much you make in wages and the amount you owe.

There’s always a possibility that you can compromise with the IRS via an Offer in Compromise and the government may be willing to take a lesser amount than what you owe. Unfortunately, the government usually only approves less than half of these applications for reduced debt. You will not be considered if you’re filing bankruptcy or if you’re being audited. To be considered, make sure all your tax returns are filed and current taxes paid.

 

How to Fight an IRS Tax Levy

You can always ask for an appeal and due process hearing from the IRS if you think there’s been a mistake. If you disagree with government employees on a decision for a tax levy, you can speak with the IRS employee’s manager. The office of appeals can review your case if you still don’t agree with the manager’s decision. Although it’s not that common, you can win the case with proof that the debt was indeed paid.

While it’s almost always the last resort, you can file bankruptcy to try and settle your tax debts. I say try because this doesn’t always work, and it takes quite a bit of time and paperwork to complete. Also, a lawyer usually takes care of bankruptcy proceedings, and this costs even more money.

 

How to Request a Tax Levy Release

Once a tax levy has begun, it may be worse than you thought. You may wonder if a tax levy release is possible. The good news is, there is a possibility that you can get the levy released. 

One way to request a tax levy release is to prove that the levy is causing you an economic hardship. 

Here are other ways you could possibly have the tax levy released:

  • Your property may be worth much more than the amount requested by the government.
  • You agreed to a government installment plan that doesn’t include the tax levy
  • You’ve paid the owed amount
  • It would be easier to pay taxes with the levy released
  • When the levy was issued, the collection period already ended

Even with the levy released, if you still owe taxes, you’re required to continue paying what you owe to the government. If you continue to communicate with the IRS and properly pay on your installment plan, this will keep the government from putting a lien back on your property or bank account.

Once money leaves your bank account, going to the IRS for tax payments, it’s extremely hard to retrieve those funds. This is true even if an installment plan was the agreement.

 

Your Best Options

Obviously, it’s best to avoid a tax levy. But should you find yourself engrossed in this process, a tax expert at Innovative Tax Relief can guide you with the next steps you should take. Just request a free tax consultation from us.

In the future, always make sure your taxes are paid to the government because the IRS will eventually come knocking if you don’t.

 

A Guide to the Innocent Spouse Relief Program

divorced woman stressed over her ex's tax debt

Going through a divorce or losing a spouse is a horrible experience to deal with. The emotional toll on any person is more than enough to deal with let alone the task of dealing with assets and liabilities. This situation becomes much worse if one of those liabilities is IRS tax debt. 

Assets and other liabilities can be dealt with and dictated through a state divorce decree. IRS tax debt is a federal debt and federal law supersedes state law. So, in a divorce decree, you can include IRS tax debt, but this does not stop the IRS from coming after you. Having the debt in a decree will allow you to go after the spouse through the state courts though if the IRS collects against you. 

The IRS offers a program that can possibly provide a spouse some sort of relief from tax debt when it is coming from a spouse’s or ex’s income. This program is called Innocent Spouse Relief.

 

What Is the Innocent Spouse Relief Program?

Innocent Spouse Relief is a program where you can be relieved of responsibility for paying tax, interest, and penalties if your spouse or former spouse improperly reported items or omitted items on your tax return. Generally, the tax, interest, and penalties that qualify can only be collected from your spouse or former spouse. 

However, you are still jointly responsible for any tax, interest, or penalties that do not qualify for relief. Innocent spouse relief only applies to individual income or self-employment taxes. These programs apply to tax debts from a spouse not reporting or incorrectly reporting income or improperly claimed tax deductions or credits.

 

How Do I Qualify For Innocent Spouse Relief?

To qualify for this program, you would need to be able to prove that you did not know or had no reason to know about the liability. This may be provable in situations of unreported income, or an incorrect tax deduction, credit, or basis claimed by your spouse. You would seek Innocent Spouse relief from the IRS when you become aware of the tax liability and believe that the tax debt is not yours. In most cases, the taxpayers who are approved for this program are no longer married.

 

The Injured Spouse Allocation Program

There is another program with a similar name that brings a lot of confusion as to which type of situation leads to approval. A lot of people confuse Innocent Spouse with Injured Spouse. These are two separate programs. 

The Injured Spouse Allocation program is a program available for spouses in jeopardy of losing a refund towards a spouse’s tax debt. If you are entitled to Injured Spouse relief, you may be able to get your share of the refund released to you.  

Despite their names, these programs have nothing to do with situations when a person is a victim of spousal abuse.

 

Qualifications for Innocent Spouse Relief

The IRS requires that a taxpayer must meet the following conditions to qualify for Innocent Spouse Relief:

  • You filed a joint return which has an understatement of tax due to an erroneous item, defined below, of your spouse or former spouse.
  • You establish that the time you signed the joint return you did not know and had no reason to know, that there was an understatement of tax. See actual knowledge or reason below.
  • Considering all the facts and circumstances, it would be unfair to hold you liable for the understatement of tax. See indications of unfairness for Innocent Spouse Relief below.
  • You and your spouse have not transferred the property to each other as part of a fraudulent scheme. A fraudulent scheme includes a scheme to defraud the IRS or another third party, such as a creditor, ex-spouse, or business partner.

If you knew about the erroneous item that belongs to your spouse or former spouse, the Innocent Spouse program does not apply to any part of the understatement of tax due to that item. If you had reason to know about the erroneous item, then you would also not qualify. When determining this the IRS will take into consideration a few different factors.

  • The nature of the erroneous item and the amount of the erroneous item relative to other items
  • The financial situation of you and your spouse
  • Your educational background
  • The extent of your participation in the activity that resulted in the error.
  • Whether you failed to ask, at or before the time the return was signed about items on the return or omitted from the return that a reasonable person would question.
  • Whether the erroneous item represented a departure from a recurring pattern reflected in prior years’ returns.

 

What Is Not Covered Through the Innocent Spouse Relief Program?

Unfortunately, the Innocent Spouse Program does not cover every type of tax debt that may result from errors on a tax return. There are many types of taxes that do not qualify for the Innocent Spouse Program which include any tax debts that come from individual shared responsibility payments, business taxes, trust fund recovery penalties for employment taxes, household employment taxes, and any other taxes deemed outside of your relief.

 

Other IRS Tax Relief Programs Available

If you do not meet these parameters there are other programs available for situations similar. One of these programs does not relieve of the tax debt but at least you would only be responsible to pay your own share. This program is called Separation of Liability Relief. To qualify for this program, you must be divorced, legally separated, or widowed to qualify and cannot have lived with the person for the 12 months prior to your request for relief.

If you do not qualify for the Innocent Spouse Program, you may qualify for another program called the Equitable Relief Program. As you have seen, the Innocent Spouse program is very specific on what tax debt can be forgiven through the program. The Equitable Relief Program is the only program where you can seek relief from underpayment of tax debt. This would be a situation when mistakes were not made and your spouse filed their taxes, knew that they owed a tax debt but failed to pay the debt. 

To qualify for the Equitable Relief Program, you would need to prove to the IRS that it is unfair to hold you liable for the debt. This is the program that a victim of spousal abuse could utilize to separate themselves from the ex-spouse’s liability. 

 

How to Apply for the Innocent Spouse Relief Program

To seek Innocent Spouse Relief, you should complete the IRS Form 8857, Request for Innocent Spouse Relief. The IRS will accept a written statement as well as long as it provides the same information the form requires.  You should fill out this form as soon as you become aware of a tax liability for which you feel you should not be held responsible. 

Generally, you must fill out this form and submit it no later than two years after the IRS’s 1st attempt to collect a tax debt. Do not file your Form 8857 with your tax return or submit it to tax court. You may mail it to the IRS directly at:

Internal Revenue Service
PO Box 120053
Covington, KY 41012

Or you may fax the form and attachments to 855-233-8558.

Whether you mail or fax your application, be aware that the IRS will contact your spouse. Unfortunately, there are no exceptions to this rule and the spouse will be informed of the request and the preliminary and final determinations regarding the requested tax relief. 

If determined that you are not liable, the IRS will collect the tax, interest, and penalties from your spouse or ex. If you have already paid some or all the tax debt, the IRS will refund only the tax payments that you made with your own money. If any part of the tax debt does not qualify for the program, then you will still be held liable for that portion of the tax debt.

In conclusion, when dealing with this type of situation it is especially important to understand not only the qualifications of the programs to see if this is something you could utilize but also how the process of applying for a program works. In a situation like this, it is especially important to hire a true tax professional. An Enrolled Agent or CPA are both tax professionals that hold the licensing that requires knowledge of these programs and how to assist the taxpayer. If this is not the right program for you, having such a tax professional in your corner is a must.

You do have a lot of rights when it comes to owing taxes. Having someone who not only knows these rights but can help you enforce them is especially important. As long as you are a compliant taxpayer, meaning you have filed all required years, there is likely a program that meets your financial situation.

 

IRS Audits: What Triggers It and What Happens

an older businessman reading an IRS audit letter

One of the biggest fears of many of my clients is the risk of a tax audit or examination by the IRS. While the actual chances of getting audited are exceptionally low, it is the last thing one wants to go through. 

If you are doing things correctly, then going through an audit is nothing to worry about. If you have done things incorrectly on a tax return either accidentally or intentionally, then you are very right to fear an IRS audit. 

The good news is that IRS audits have been way down in recent years due to budget cuts. In 2019 the IRS only audited 0.4% of individual tax returns. This is about 1 in every 160 returns that gets audited. Many people view this number in different ways. 

Some still see it as a chance to be audited and it keeps them not only filing a squeaky-clean tax return but it sometimes hinders people from taking advantage of some of the credits that they do qualify for in fear of an audit. Others see that as a low number and think it is worth the risk in the attempt to save some money. 

In today’s article, I will not only explain what an audit is, but I will break down the audit process for you.  After that, I will point out some examples of common errors that raise red flags with the IRS and put taxpayers into these audits. Hopefully, this information can help you avoid ever having to deal with this situation.

 

What Is an IRS Audit?

An IRS audit is a review or examination of an organization’s or individual’s accounts and financial information to ensure information is reported correctly according to the tax laws and to verify the reported amounts of tax are correct. In other words, the IRS is double-checking the information you put on your tax return. 

By law, the IRS generally has 3 years after the tax filing deadline to initiate an audit. If you leave out up to 25% of your income or more, they have 6 years. The IRS performs these audits to minimize the tax gap or the difference between what the IRS is owed and what the IRS receives.

 

How Do Taxpayers Get Selected For An Audit?

A tax return is selected for audit by several different methods. Sometimes returns are selected based solely on a statistical formula. The IRS compares your tax returns against norms for similar returns. They develop these “norms” from audits of a statistically valid random sample of returns as part of the National Research Program the IRS conducts. The IRS uses this program to update return selection. 

Another way is called related examinations. This is when your returns are selected because they involve issues or transactions with other taxpayers such as business partners or investors whose returns were selected for audit. The IRS uses a program called the Discriminant Function System. This is a computer software program that gives each tax return a score called the DIF Score. This score is a number that statistically determines the likelihood of the tax return being accurate. The higher the number assigned, the higher the chance to be audited. 

If selected by either of these methods, then an experienced auditor will review the return. They may accept it and move on or if the auditor notes something questionable, they will identify the items noted and forward the exam to an examining group.

 

What Is the Tax Audit Process Like?

At this point, the IRS will either mail you or contact you to set up an in-person interview to review your records. The interview may be at an IRS office (office audit) or at the taxpayer’s home, place of business, or accountant’s office (field audit). Remember, you will be contacted initially by mail. The IRS will provide all contact information and instructions in the letter you will receive.

If the IRS conducts your audit by mail, the letter will request additional information about certain items shown on the tax return such as income, expenses, and itemized deductions. They will provide you with a written request for the specific documents they need to see. Basically, they are giving you the opportunity to prove you had rights to put whatever they are disagreeing with on the return. 

If you can prove your side of it, then you can respond with the requested documentation. 

If you cannot, then you must respond by accepting the IRS’ changes. 

 

Why Did I Get Audited?

There are some key triggers that will raise red flags with the IRS. If your tax return has any of these make sure you have the proper documentation and information to support them if the IRS disagrees with them. In this section, I will lay out and explain some of these triggers so you understand them to help you avoid a possible audit.

Unreported Income

This is probably the easiest way to get yourself into an audit with the IRS. This can happen on accident by not receiving an income from or forgetting other incomes received other than your primary wages. This is why it is so important to keep good records of all income received throughout the year and to keep copies of all income forms received. 

When these income forms, W-2’s or 1099’s are sent to you by your employers or financial institutions that you have done business with they are also sent to the IRS. So if when your return goes through the system and the incomes do not match up with what has been reported to them, this will raise major red flags.

Self-Employment

With self-employment, there are a lot of red flags that can be triggered. With self-employment, most of the income received is reported to the IRS with a Form 1099. So, if your version of your income for the year does not match up with what is reported to the IRS then you may be dinged for underreporting of income. 

Another big benefit of being self-employed is being able to write off portions of that income due to expenses. This can be a benefit and a curse. The IRS does understand that it takes money to make money, but they also understand that people don’t work hard for little or nothing. These types of returns are highly auditable especially when large portions of the income are written off.

Charitable Donations

You can be eligible for deductions from your income if you donated to charity throughout the year. If somebody puts large charitable donations this will raise the red flags especially if they have low income themselves.

Math Errors & Using Neat Round Numbers

Do not make mistakes. If you accidentally do the math wrong or put an 8 instead of a zero you can be hit with fines. Also, when inputting expenses and deductions using round numbers can trigger the IRS to request proof.

Stock Trades & Cryptocurrency Sales

All of this income must be reported. With these transactions, the brokerage or financial institution will send a Form 1099 to the IRS. Right now, cryptocurrency is a hot-button issue. With this income, it is especially important that not only is it reported but also you show on a Schedule D your gains and losses. Forgetting to report information on a 1099-B or any big change in your capital gains income could lead to an audit.

High Income

Statistics show that the more money you make the more likely you will be audited. In 2019 people earning $200,000 to $1 million had an audit rate of less than 1% while people making over $1 million had a 2.4% audit rate.

Claiming the Earned Income Credit

Claiming the EIC is an automatic trigger for an audit. The IRS will make sure that you are entitled to claim the dependents and that the income that you are reporting is correct.

 

How to Avoid an IRS Audit

There is good reason to fear the possibility of an audit. Despite the fact that only a small percentage of people actually get audited by the IRS, that still amounts to a large number that has to go through this process every year. 

As I wrote earlier, do not let the fear of audit hinder you from taking advantage of deductions and credits that you have rights to. If you have done things right and you have the information to prove it then an audit is no problem. If you are doing things that you do not have rights to or cannot prove, then you are rolling the dice and will have to deal with the consequences if selected. 

As I always recommend when filing a more complex tax return and utilizing deductions and credits, it is always well worth hiring a true tax professional. While many call themselves a tax professional, you will want to be sure the person your hire is somebody with the correct education and licensing. 

Unfortunately, there are many tax preparers who may use certain strategies on your tax return to reduce your tax debt and/or maximize your refund but those strategies are also major tax audit triggers. If you hire an IRS Enrolled Agent or a CPA, both have a license and are regulated, so they have something to lose if they make a mistake. An Enrolled Agent will also put their name on the return, backing up their work.

 

Earned Income Tax Credit: What It Is and How to Claim It

father and young son

In tough times the hardest hit is always the low-income earners in our society.  This past year has been one of the toughest times this nation has ever seen. It is important at this time to know all the tax credits available when filing your return to either reduce your tax debt or strengthen your refund. A tax credit is a dollar-for-dollar reduction of the income tax you owe. 

In previous articles, we have covered a few of these credits. I have mentioned this credit in previous articles, but today we will go into further detail about the Earned Income Tax Credit. If you make under $56,844 you may qualify for this and be able to save substantial money.

 

What Is the Earned Income Tax Credit?

The Earned Income Tax Credit (EIC) is a refundable tax credit for low- and moderate-income workers. This credit was first enacted in 1975 to provide financial assistance to working families with children. It was originally conceived as a “work bonus plan” to supplement the wages of low-income workers, help offset the effect of social security taxes, and to encourage workers to steer people off welfare programs. It continues to be viewed as an anti-poverty tax. 

The credit has evolved over the years and now helps taxpayers with or without children.  Since the credit is considered refundable, if your tax credit exceeds your tax liability, you may be eligible for a refund.

 

How Do You Qualify?

The main qualifier for this tax credit is you must be earning income. Earned income includes wages, tips. and net self-employment income. A taxpayer who only has income from unemployment, alimony, child support, or interest is not considered earned income for qualification for the EITC. There are 7 rules the IRS requires taxpayers to meet to qualify for the credit.

  1. You must meet the minimum income requirements. Your 2020 AGI must be below $56,844 if you have three or more qualifying children. $53,330 if you have two or more qualifying children. $47, 646 if you have one qualifying child and $21,710 if you do not have children.
  2. You must have a valid social security number.
  3. Your filing status must be single, married filing jointly, head of household, or qualifying widower. Taxpayers who file married filing separately can not qualify for the earned income credit.
  4. You must be a US Citizen or resident alien.
  5. If you earned foreign income and are required to file form 2555 you will not qualify.
  6. Your investment income must be $3650 or less. Investment income includes interest income, dividends, rents, or royalties.
  7.  You must have earned income to qualify.

What Is the Income Limit?

As mentioned earlier there is an income limit for the earned income credit. The income limit is based on the number of qualifying children that you have. The first important part of that would be to determine what a qualified child is.

Qualifying Child

A qualifying child is a child that meets the IRS requirements to be your dependent for tax purposes. Though it does not have to be your child, the qualifying child must be related to you. There are four tests a person must satisfy to qualify as a qualified child. 

Relationship

The taxpayer’s child or stepchild (whether by blood or adoption), foster child, sibling, stepsibling, or a descendant of one of these.

Residence

Has the same principal residence as the taxpayer for more than half the tax year. Exceptions apply in certain cases, for children of divorced or separated parents, kidnapped children, temporary absences, and children who were born or died during the year.

Age

Must be under the age of 19 at the end of the tax year, or under the age of 24 if is a full-time student for at least five months of the year.

Support

Did not provide more than one-half of his/her own support for the year.

The income limits to qualify for and how much you qualify for adjustments based on how many qualified dependents that you can claim. The EITC ranges from $1502 to $6728 depending on tax filing status, income, and the number of children. Below as seen on Nerd Wallet are the maximum earned income tax credit amounts, plus the max you can earn before losing the benefit all together.

 

2020 Earned Income Tax Credit

(for taxes due in April 2021)

Number of childrenMaximum earned income tax creditMax earnings, single or head of household filersMax earnings, joint filers
0$538$15,820$21,710
1$3,584$41,756$47,646
2$5,920$47,440$53,330
3 or more$6,660$50,954$56,844

 

Taxpayers who are married filing separately can not qualify for the earned income credit. The rules are also different for military members and clergy or ministers. If you or your spouse get nontaxable pay as a member of the Armed Forces, you do not have to include it as earned income on your federal taxes. If you and your spouse do choose to include your nontaxable pay as earned income for the EIC, you may owe less tax and get a larger refund. 

A person who includes their nontaxable income as earned income must include all of it. If you are a clergy member or minister you must include the rental value of the home you live in, or the housing allowance if that was provided to you by the church. You must also include all income provided to you working as a minister if you are an employee.

 

Earned Income Tax Credit Fraud

With substantial amounts of money flowing through the EIC program, it has become a fertile ground for tax fraud. The IRS estimates that between 21-26% of EIC claims are fraudulent. Some of the errors are unintentionally caused by the complexity of the law but some of the claims are intentional disregard of the law. The fraud is so rampant that the IRS has added a clause that if found erroneously claiming the credit you are prohibited from claiming the credit for two years. 

There are many ways that people have defrauded this program. One common scam is that people with no earned income will report cash income right at the level to receive the greatest allowance from the program. 

Another common tactic used is if one person has children but does not have income, they will allow someone else who did not help support those children to use their children for the credit. In a lot of these circumstances, the parent of the children and the person filing with the children will split the money. 

And another common practice is when married couples split their qualifying children and both file as head of household to reap the benefits of the EITC. 

With these known practices of fraud, the IRS has tightened up on their review of returns filing for the EITC. The IRS uses both internal information and information from external sources such as other government agencies. The information of the return is matched with information already on file with the IRS and other government agencies. If the review shows questionable or incomplete information, the IRS holds the EIC portion of the taxpayer’s refund ad contacts the taxpayer to verify the information. 

The IRS also uses a screening process based on historical information to select returns for examination. The IRS can conduct these exams both pre and post the refund. Unfortunately, currently, the IRS does not have the resources to examine all questionable EIC returns. 

In this age of computers, a lot of offenders are caught. At this point not only will you have to pay back the refund and credits received but you will also be assessed interest, penalties, late payment penalties, and possibly under-reported fines. If you don’t pay this amount back they can garnish your wages or freeze your bank accounts.

 

How to Claim the Earned Income Tax Credit

To claim the EIC, you must complete your Form 1040 with a complete EIC schedule attached. The EIC schedule requires you to provide your qualifying child’s name, social security number, date of birth, age, relationship, and residency information. This information is especially important to have correct on the forms because this is verifying your rights to the credit. 

There are many tax software programs and apps available that can assist you with this. When trying to take advantage of all the different credits available to a taxpayer it would usually financially benefit somebody to hire a true tax professional such as an Enrolled Agent or CPA.

In conclusion, if you qualify for the EIC then definitely take advantage of it. It has been found to be an effective program in fighting poverty. If you do not qualify, I would highly recommend not trying to defraud the system that helps so many. Not only is it wrong and takes away from the ones who need it but if you are one of the ones that get caught the consequences are costly.

 

Explaining Capital Gains and Tax Rates

calculating capital gains with charts

During a very tough 2020 year for many, it seems that the values of properties have skyrocketed in many forms. Property is not just relating to real estate or real property. The IRS considers property anything owned by a person or entity. 

Property is divided into two types: real property is any interest in land, real estate, growing plants or the improvement on it, and personal property which is everything else. We have seen a boom in the real estate market since there is a high demand to buy properties with a lot fewer sellers. Also, it has been a good year for stocks and an especially good year for cryptocurrency. These are all considered property and may result in some painful capital gains tax bills. 

This article will discuss what capital gains are, how they are determined, how they are categorized, and how they are taxed. It is especially important that you understand these taxes whenever you sell an asset or property. By learning this basic knowledge, you will be able to better tax plan so at the end of the year you are prepared to report that income correctly.

 

What Are Capital Gains?

A capital gain is what tax laws call the profit you receive when you sell a capital asset, which is property such as stocks, bonds, mutual fund shares, and real estate. Capital gains are categorized into two different categories: short-term capital gains or long-term capital gains. The difference between these two is determined by the holding period of the asset or property. 

Short-term gains and losses are those realized from the sale of property or assets that you have held for 1 year or less. 

Long-term capital gains and losses are realized after selling investments held longer than one year.

 

Capital Gains Tax Rates

Short-term capital gains are taxed as though they are ordinary income. If you hold an asset or property for less, than one year any gains or losses will be treated as short-term gains or short-term losses. They are taxed at your maximum tax rate just like your wages or salary income. The top federal tax rate is 37%If you show a loss you can deduct up to $3000 from your regular income each year and you are also allowed to carry this over the next years if more than $3000.

Long-term capital gains are realized after selling assets or property held longer than 1 year. For long-term capital gains, the capital gains rate applies and it is typically significantly lower than your normal income tax rate. The capital gains rate is anywhere from 0-20%. 

The exact rate at which your gain is taxed is based on the amount of your income. For single tax filers, for anybody with income below $40,400 the capital gains rate would be zero. For anybody who makes incomes between $40401 and $445,850 the 15% capital gains rate would apply. Single filers with income above $445,850 will get hit with the 20% tax rate. For married filing jointly any couple with income of $80,000 or less the capital gain rate would be zero Any married couple with income of $80,000 and 501,600 will have the capital gains rate of 15%. Married couples with incomes above $501,600 will get hit with the 20% long-term capital gains rate. This is shown below on a chart by Fidelity. 

 

Long-term capital gains rate by filing status and income: 2020

Long-term capital gains tax rateSingle tax filersMarried filing jointly
0%$40,000 or less$80,000 or less
15%$40,001 – $441,450$80,001 – $496,600
20%$441,451 or more$496,601 or more

 

 

How Do I Figure Out My Gains and Losses?

This is especially important. When a property is sold, you do not have to pay taxes on all money received. You only must pay taxes on your gain or profit. To determine what your gain on the transaction is you must first determine your cost basis. This is the price you paid to purchase a property or asset. This can also include additional fees such as closing costs, broker fees, or commissions. There are two methods to calculate your cost basis.

Average Cost Method

This method takes the total cost of the shares and divides it by the number of shares in the fund. We use this method to calculate the cost basis for mutual funds and certain dividend reinvestment plans.

Actual Cost Method

With this method, your cost basis is the purchase of each share.

With real- estate the cost basis can be adjusted over time. The cost basis on real estate can be the initial purchase price and then you can increase the cost basis over time with the cost of improvements to the property. This is where it is important to know how to define the difference between a repair and an improvement.

 A general rule of thumb to differentiate is that an improvement would raise the value of the home such as a pool or addition. Repairs are general costs incurred to maintain your property. Repairs are not added to the cost basis but if this is a rental property they can be written off as an expense. So, keep track of all those home improvements or remodeling projects that you spent money on to improve your home because these can raise your cost basis.

A capital gain or capital loss is figured by subtracting this cost basis from the actual sale price plus costs. This will determine the gain or the profit or the loss. If you have multiple gains and losses, then you must do some further math. This is where it can get a little confusing. 

If you have all long-term gains or losses, you just add the gains together and subtract the losses. The result of this combined number will become your long-term gain and will be taxed by the long-term tax rate. The same thing will be done if you have all short-term gains. If you have gains from both long-term and short-term, they will stay separate, and each amount taxed by their own rules.

 If you have losses of both short-term and long-term, then they will stay separate and can be deducted up to $3000 from regular income. If the losses are greater than $3000, they can be carried over in the next years. If you have a combination of short-term losses and long-term losses, you will combine these, and the result will be based on the tax rule of the greater amount. 

With mutual funds, these rules do not apply. Gains from mutual funds are taxed as regular income and can not be offset with short-term losses.

When it comes to real estate transactions there are additional rules, and you may be able to avoid paying a substantial amount of taxes on your gains. If the property was your primary residence and you have lived in the property for at least two of the past five years, then you may be able to exclude up to $250,000 in capital gains if single and up to $500,000 if married.  

So if somebody purchases a property in 2013 for a total of $300,000 with costs included in that number then the $300,000 would be their cost basis. This has been their primary residence during the whole time they owed the property. In 2020 they sold this property for $600,000 and they are filing single that tax year then they would only be reporting a gain of $50,000.  

The math below demonstrates how you come to the actual gain on the property.

$600,000 (Sale price of property) – $300,000 (cost basis) = $300,000 – $250,000 (exclusion for primary residence) = $50,000 taxable long-term gain.

In conclusion, taxpayers have a long-standing responsibility to report gains and losses and related cost basis information when they file their income tax returns. Brokers also have a requirement to report all sales information to the IRS on Form 1099-B. 

To report capital gains on your return you must file a Schedule D with your Form 1040. Most filers need to begin with Form 8949 which provides the format for listing each individual sales transaction.  If you have multiple transactions this can become especially complex. I would highly recommend that with a return of this nature that you hire a true licensed tax professional. An Enrolled Agent or CPA is somebody who has the licensing showing that they have the required education and knowledge to help in a situation like this. 

Any errors in the reporting of the income can be caught by the IRS and they will charge you significant penalties and fees so the tax professional is well worth the money spent to make sure it is done correctly.  

Also, I cannot reiterate enough the importance of tax planning and keeping records throughout the year to make sure nothing it s missed that can either save you money to reduce taxable income or make sure you don’t set yourself up for an audit or examination by missing something.

 

An Introduction to Backup Withholding

a businesswoman handing a paycheck to one of her employees

Is your income subject to something called backup withholding? If you think you may be in this category, it’s important to understand what to expect.

If you think you can avoid payments to the IRS, think again. The Internal Revenue Service has a plethora of tools to make sure taxes are reported correctly and paid to the government. When they’re not, you can be sure the federal government is devising a plan to secure IRS-claimed money.

 

How Backup Withholding Works

Are you familiar with backup withholding? If not, then learning about this keeps you and the Internal Revenue Service on the same page, and that’s for your benefit and the government’s benefit as well. You see, backup withholding is one of those government tools used to get what’s rightfully owed to the IRS. It’s a federal taxation method that protects earnings due to the United States government after certain taxes aren’t paid correctly or on time.

A simple way to look at backup withholding is through non-conventional employers. Some employers do not take taxes from income, expecting employees to pay taxes at the end of the year. But in some situations, the IRS requires the employers or other financial institutions, being used by the investor, to withhold 24% of your wages or earnings as a backup withholding. This is just in case you do not pay those taxes. This happens more often than you may think.

This procedure is required under Chapter 61 of the Internal Revenue Code, and this same 24% is taken every year so the IRS always gets their portion of taxes due. Payers must file a Form 945 which reports all backup withholdings for the year. They also have an obligation to report these same backup amounts to the payee as well.

 

Another Circumstance That Triggers a Backup Withholding

Full-time investors and companies are always earning income, and it’s usually large amounts of money. This could be from dividends, capital gains, and interest payments. While taxes are due on these earnings, it doesn’t come due until it’s time to file taxes – all earnings and payments come due in tax season. Most investors pay taxes when the time comes. But you have those few that do not.

If an investor spends all the money they earned during the year, they have none left to pay taxes on those earnings. When this happens, it’s sometimes incredibly difficult for the IRS to get what’s owed to them. And they give the taxpayer 120 days to settle the situation. Notifications are sent out as well, giving individuals or companies time to rectify the situation.

If the government doesn’t receive their share in taxes, they can set a credit against your next income tax return, simply taking what’s owed to them, or as much as they can. This could mean receiving no refund for years to come.

Because of issues like these, the government thinks ahead. Instead of depending on investors to pay taxes as they should, a backup withholding is levied by financial institutions at the time investors are earning income. The government gets their percentage and investors get what remains.

 

Three Types of Earnings That Cause Backup Withholding

Not all payments, obviously, must have a percentage taken for tax purposes. Only certain conditions and situations are subject to this backup withholding. These reasons include:

  1. The failure to report dividend income that’s received
  2. Under-reporting or not reporting interest payments
  3. Not providing a (TIN) taxpayer identification number or your social security number for filing purposes.

 

Am I Subject to Backup Withholding?

Maybe you’re wondering if you’re at risk for backup withholding. Well, that depends on the type of income you’re receiving or have received in the recent past. There are many forms of payment subject to this withholding process such as:

  • Any government payments that require a 1099-G
  • Rent and other property gains
  • All Dividends
  • Payments from investments
  • Money won from gambling
  • Barter and broker exchange payments
  • Professional fishing boat operators
  • Cash payments of original issue discounts
  • Independent contractor’s fees, commissions, payments
  • Royalty earnings from sales
  • Patronage dividends
  • Third-party network exchanges or transactions
  • Settled disputes with a law firm

Giving the bank your TIN when you first open a business account will help prevent backup withholding as well. Any earnings or payments that require a Form 1099 will benefit greatly by contacting the bank with this information ahead of time. When it comes to dividends and interest, you must certify that you’re not guilty of under-reporting these types of earnings now and in the past. If so, there’s a good chance of backup withholding on investments and dividends in the near future.

 

Payments That Are Not Subject to Backup Withholding

Just as there are many types of transactions that are affected by backup withholding, there are also numerous payments that are not. Some Income or payments are simply immune to this type of tax law. Those include:

  • Income tax refunds
  • Various canceled debts
  • Retirement account distributions
  • Compensation from Unemployment
  • School tuition earnings
  • Abandoned or foreclosed properties
  • Archer MSA distributions
  • Cash payments for fish
  • Employee stock plan distributions
  • Transactions from Real Estate sales
  • Care benefits (long-term)

 

How to Stop Backup Withholding

It isn’t a complicated procedure to stop backup withholding. The ease of putting a stop to these proceedings depends on why the withholding took place. If you’re aware that this is happening because you didn’t provide a TIN or the correct number, simply report the correct TIN or your social security number to halt the process.

If you’ve neglected to report any portion of your income, then remedy this issue by collecting the remainder of your income statements and send them to the IRS. 

If you owe the IRS additional money, paying this debt as soon as possible can stop a backup withholding and stop interest and late fees accrued from the debt, which can add up fast. 

If there seems to be a missing return, then file one as the return as soon as possible.

 

Challenging a Backup Withholding Order

You can also challenge or appeal a backup withholding order from the IRS. You simply ask the Internal Revenue Service to review your case for mistakes or missing information. In rare situations, under-reporting never happened, and it was a mistake on the federal level. Again, this is not a common occurrence.

If you were in the process of filing an amended return, the IRS may consider lifting the backup withholding request from the financial institution that’s retaining 24% of your earnings. In other uncommon situations, the Internal Revenue Service may consider that the backup withholding procedure may cause financial hardship for you or any dependents. In this case, the IRS may stop the withholding for that reason as well.

If you succeed in stopping the backup withholding procedure, the IRS will send you a certificate of proof for the corrected situation. They will simultaneously report this new information to any financial institutions implementing the backup withholding.

At this point, no percentage will be taken from your earnings. Also, if any overpayment of backup withholding was paid to the IRS, you will receive a refund of all earnings due to you. However, you will not receive the refund until you file taxes the next year, as any backup withholdings must be reported on a 1099 form.

Warning

If you purposely give the wrong information to dodge a backup withholding, you could be subject to criminal and civil penalties. Civil court fines are usually around $500, but if you are tried in criminal court, you could pay $1,000 in fines or serve a year in prison. Criminal penalties are always worse.

Businesses or payers are also subject to penalties if they do not adhere to the backup withholding request. If the business fails to record the payee’s TIN to retain tax payments for the government, they could face a $24,000 assessment. There could also be additional penalties and interest.

 

Thinking Ahead to Avoid Backup Withholding

As a taxpayer and a citizen of the United States, it’s important to understand tax laws. The government is required to send an initial warning called the ‘B’ notice. This is your notice to get things in order and rectify the situation before it escalates. This is a prime opportunity to take.

Avoiding backup withholding and penalties is the objective. When you understand laws and penalties, then preparing for paying taxes makes the process much smoother. There are so many tax laws that cover various ways of earning money and collecting profits. Understanding these laws prevents mistakes during the year, and also during tax season.

To better prepare, learn the basic laws pertaining to your line of work or investment. If you do this, everything should fall into place when it’s time to pay or calculate taxes on your return. Or better yet, work with a tax professional to help you calculate your true tax liability. Whether you pay quarterly, or during tax season, just make sure to contribute honestly. 

And remember, the government will always retain what’s due to them. And it is your responsibility to make sure you pay your part.

 

Taxable Income: What You Should Report to the IRS

man reporting his earned income on his tax return

A quite common question that I hear a lot of is “Do I have to file taxes on my income?”. This question comes from a lot of different types of people. The confusion comes because some income is taxable, and some income is not. Also, for low-income earners there are minimum filing requirements. This can get even more confusing because these numbers change based on one’s filing status, age and the type of income received. 

A good example of a type of income with different minimum standards for filing is Social Security income. We will further explain this later in the article, but we will start by discussing these minimum filing requirements and explaining how they change with your filing status. After that we will go through the common types of income that are taxable and then the common nontaxable sources of income. 

This information is especially important and can save you a lot of money and hassle in terms of dealing with the IRS. The most highly detected error by the IRS on a tax return is unreported income.

 

What Is Taxable Income?

The IRS says income can be in the form of money property or services you receive in the tax year. The two basic forms of income are earned and unearned. Most income that you receive is fully taxable and must be reported on your federal income tax return unless it is specifically excluded by law.  

Earned income includes money received from an employer in exchange for work or money you make working for yourself. Unearned income includes money that you did not directly work for such as interest or dividends, Social Security payments or alimony.

 

Minimum Income Requirements

The minimum income requirements differ based on how you plan to file. There are five different status’ that you can use to file. They are single, married filing jointly, qualifying widower, married filing separately and head of household.  If you earn up to or less than the minimum income as determined by your filing status, you are not required to file a tax return.

Single filers are taxpayers who file their federal income tax return with the IRS under the filing status of “single”. This filing status is used by a taxpayer who is unmarried and does not qualify for any other filing status.

  • Single under age 65: $12,400
  • Single and 65 or older: $14,050 

 

Married filing jointly refers to a filing status for married couples that have wed before the end of the tax year. When filing taxes under married filing jointly status a married couple can record their respective incomes, deductions credits, and exemptions on the same tax return.

  • Married filing jointly, both spouses under 65: $24,800
  • Married filing jointly, one spouse age 65 or older: $26,100
  • Married filing jointly, both spouses 65 or older: $27,400

 

Married filing separately is a tax status used by married couples who choose to record their incomes, exemptions, and deductions on separate tax returns. Although some couples might benefit from filing separately, they may not be able to take advantage of certain tax benefits.

  • Married filing separately, any age: $5 

 

Head of household is generally an unmarried taxpayer who has dependents and paid for more than half the costs of the home. This filing status commonly includes single parents and divorced or legally separated parents by the last day of the year with custody.

  • Head of household under age 65: $18,650
  • Head of household age 65 or older: $20,300 

 

Qualifying widow is a filing status that allows you to retain the benefits of the married filing jointly status for two years after the year of your spouse’s death. You must have a dependent child to file as a qualifying widow or widower.

  • Qualifying widow(er) under the age of 65: $24,800
  • Qualifying widow(er) age 65 or older: $26,100

 

What Types of Income Are Taxable?

To figure out where you fall in terms of the above minimum requirements once you have figured out your filing status you would next need to calculate your taxable income. Remember taxable income can be earned and unearned income. Below I will break down each category of taxable income.

  • W-2 Wage or Salary or Independent Contractor
  • Alimony received if divorce decree was made on or before 12/31/2018
  • Bartering Income
  • Canceled or Forgiven Debt
  • Gambling
  • Pension and Annuity Income
  • Retirement Plan Income
  • Social Security Benefits if you had additional income on top of social security, this can become taxable. I will further discuss this later in this article.
  • Tips and Gratuities
  • Unemployment benefits
  • Awards
  • Back Pay
  • Bonus Benefits
  • Business Income
  • Capital Gains
  • Clergy Pay
  • Commissions
  • Disability Benefits
  • Dividends
  • Interest
  • IRA or 401k Distributions

 

What Types of Income Are Nontaxable?

As most income is taxable there are a few exceptions. This is very important to know. As important as it is to make sure that all taxable income is reported so you do not raise red flags with the IRS it is also important to know what income does not have to be reported. The last thing that you would want to do is pay taxes on income that you did not have to. Not to mention the more income reported the higher tax bracket you put yourself at.

Some examples of nontaxable income are:

  • Workers Comp Benefits
  • Child support
  • Life Insurance Proceeds
  • Social Security Benefits (Can be non-taxable based on if you have additional income and how much)
  • Capital Gains on the sale of primary home
  • Money received as a gift or inherited assets, go fund me accounts or other personal fundraising sites
  • Canceled debts intended as a gift
  • Scholarships or fellowship grants
  • Foster care payments
  • Federal Income Tax Refund
  • Money Rolled over from one retirement account to another

 

Are Social Security Benefits Taxed?

There is a lot of confusion when it comes to when social security benefits are taxable and when they are not. A lot of people believe that social security is 100% not taxable. This is not true. If a taxpayer receives additional income, then a portion of the social security can become taxable. 

The next confusing part of this equation is it is not straight based on the full amount of income that you have. To figure out if or what amount of your social security benefits become taxable with the additional income you must first figure out your provisional income. 

Provisional income is determined by taking one-half of your social security benefits and all other income you receive. This does include tax-exempt interest. The percentage of benefits a taxpayer includes in income is limited to zero when below the minimum base amount, 50% when provisional income is in between the lower base amount and the upper base amount, and 85 % when provisional income is above the upper base amount.

 

Filing Status50% Lower Base85% Upper Base
Single$25,000$34,000
Head of Household$25,000$34,000
Qualifying Widow(er)$25,000$34,000
Married Filing Separately$25,000$34,000
Married Filing Jointly$32,000$44,000

 

All this income must be reported on your Form 1040 every year. It is especially important that not only all the income is reported on this form but also it is put in the right spots. You need to include W-2 income, taxable interest, and ordinary dividends on the 1040. 

Schedule 1 allows you to report other types of income such as alimony, unemployment, and business income. Schedule 1 also allows you to make adjustments to income such as contributions to health and savings accounts, contributions to a traditional IRA, interest paid on student loans, alimony paid if the divorce decree is before 2019, and more. 

For more information on where income goes on the 1040 form, visit the 1040 form page on the IRS website. 

In conclusion the more different types of income that you have the more complex the tax filing becomes. Obviously, the more sources of income that you have the more money you are making so don’t stop making money to make your tax filing easier. 

When you have multiple sources of income I would highly recommend hiring a true tax professional, a CPA or Enrolled Agent, that has the knowledge of tax law to assist you in your filing. Not only will they save you money in keeping that income down as low as legally possible but they can make sure not to set you up with the possibility of an examination or audit with the IRS because they can make sure things are done correctly.

 

How Solar Tax Credit Works

installation of residential solar panels

With the science showing indications that there is a necessity to change the way energy is provided, many people are making the change towards renewable energy. 

Renewable energy is useful energy that is collected from renewable resources, which are naturally replenished on a human timescale, including carbon-neutral sources like sunlight, wind, rain, tides, waves, and geothermal. These forms of renewable energy generate energy without producing any greenhouse gas emissions from fossil fuels and reduce some types of air pollution. Also, they can help pull our country away from dependence on imported fuels. 

With all this necessary benefit the government has put forth tax credits to incentivize people to utilize renewable energy and make investments into their properties to make their residences more energy efficient.  These incentives are coming in the form of tax credits. 

One of the most popular and the ones we will discuss further today is the Solar Tax Credit. I will start off by explaining exactly what the solar tax credit is and the benefits it provides. I will also give a little bit of the history of this credit.

 

What Is a Tax Credit?

A tax credit is a sum that can be subtracted from the total payable tax and offsets the overall liability. If an individual is charged more tax, then the excess tax is given as a tax credit which can be adjusted against future liabilities. So, if you owe $1000 in taxes and you qualify for a $1000 tax credit your net liability would be zero. It is an actual dollar to dollar reduction.

 

What is the Solar Tax Credit?

The Solar Tax Credit is also known as the investment tax credit and allows you to deduct 26% of the cost of installing a solar energy system from your federal taxes. The Solar Tax Credit was first introduced in 2005 as a 30% reimbursement credit. The credit was a part of the Energy Policy Act of 2005 during the Bush Administration. It has been extended annually since then up to 2015. 

In 2015 it got a long-term extension with a dropdown. The plan dropped the credit down to 26% in 2020, 22% in 2021, and down to zero after 2021. Fortunately, new legislation signed last year would keep the credit at 26% for 2021 and 2022 then drop it to 22% in 2023. This means that you are reimbursed 26% of the actual cost of the full cost of purchasing and installing the solar power system. 

Since this credit was introduced the U.S. solar industry has grown by more than 10,000% not only helping our environment but it has also helped create hundreds of thousands of jobs and investing billions in the economy in the process.

 

Do I Qualify for the Solar Tax Credit?

The major form of solar energy that can be installed and qualify for reimbursement through credit is solar panels. Solar energy property is recognizable for the solar array on its roof or on its grounds. They are typically black panels that are filled with solar PV &photovoltaic) cells. These cells convert sunshine into useable electricity. 

The tax credit is not only good for personal taxes and residential property it can also be used on a business filing with a commercial property. If you are trying to utilize the credit on a personal tax return the property must be one that you own not one that you rent. It must be a property that you live in for at least part of the year, so vacation homes are eligible. These residences can include a house, a houseboat, condominium, cooperative, mobile home, and prefabricated homes. 

Also, the solar equipment must be owned not leased. If a new homebuyer buys a newly built home with solar and owns the system outright, the homeowner would be eligible for the credit the year they move into the house.

Solar panels are not the only equipment that qualifies for the tax credit. Geothermal heat pumps, small wind turbines, fuel cell property, energy-efficient heating and air conditioning systems, water heaters, and biomass stoves also qualify. If this equipment or solar panels are used to heat a swimming pool or hot tub they do not qualify. 

Rental properties that are not lived in throughout the year by a taxpayer also do not qualify. But if you live in the house part of the year and rent it while you are not there it will qualify. If you live in the house part-time you will have to reduce the credit for a vacation home or rental to reflect the time when you are not there. If you live there for 3 months of the year, then you can claim 25% of the credit.

Unfortunately, the solar tax credit is a nonrefundable credit. This means if the credit is more than the taxes owed the remainder will not be sent out as a refund as some other credits do. The credit can be carried back 1 year and forward 20 years. This means if you had a tax liability last year, but you do not have one this year you can still claim the credit.

 

How Do I File For The Solar Tax Credit?

To claim the solar tax credit, you must complete an IRS Form 5695 and include the result on your IRS schedule 3 on the 1040 form.  This form calculates tax credits for a variety of qualified residential improvements. These steps as seen on energysage.com break down how to fill out this form.  

  • First, you will need to know the qualified solar electric property costs. That is the total gross cost of your solar energy system after any cash rebates. Add that to line 1.
  • Insert the total cost of any additional energy improvements, if any, on lines 2 through 4, and add them up on line 5.

filing for a Solar Tax Credit step 1

  • On line 6, multiply line 5 by 26%. This is the amount of the solar tax credit.

filing for a Solar Tax Credit step 2

Note: this is from the 2019 form when the ITC was still 30%.

  • Assuming you are not also receiving a tax credit for fuel cells installed on your property, and you aren’t carrying forward any credits from last year, put the value from line 6 on line 13.

Now you need to calculate if you will have enough tax liability to get the full 26% credit in one year.

  • Complete the worksheet on page 4 of the instructions for Form 5695 to calculate the limit on tax credits you can claim. If you are claiming tax credits for adoption expenses, interest on a mortgage, or buying a plug-in hybrid or electric vehicle, you will need that information here. (For this example, the total federal tax liability is $7,000.)

screenshot of the Solar Tax Credit worksheet

  • Enter the result on line 14 of Form 5695. Review line 13 and line 14, and put the smaller of the two values on line 15.
  • If your tax liability is smaller than your tax credits, subtract line 15 from line 13, and enter it on line 16. That’s the amount you can claim on next year’s taxes.

filing for a Solar Tax Credit step 3

Add the credit to Schedule 3/Form 1040.

The value on line 15 is the amount that will be credited to your taxes this year. Enter that value into Schedule 3 (Form 1040 or 1040-SR), line 5, or Form 1040NR, line 50.

filing for a Solar Tax Credit step 4

The steps above outline all you need to do to have 26% of the cost of your solar panel system credited back to you! If you did energy efficiency improvements to your home in the same year, you may also need to complete page 2 of Form 5695. Either way, be sure to include Form 5695 when you submit your taxes to the IRS.

In conclusion, if you are ever thinking about installing any of this equipment to make your home more energy-efficient now is the time. It seems that this credit keeps on getting extended, but it has been reduced so you never know what the future will bring. At this point, it expires in 2024. 

Obviously, for some people it is just not affordable but if it is the 26% credit and the savings over time in reduced energy bills seem to make it a great investment. Currently, estimates show the average national cost to purchase and install panels on a residence is $16,860. This would result in a tax credit of $4618. 

This is still an excessively big investment so the next thing to consider is the savings on energy cost. Studies show that solar panels will pay for themselves after three years. Also, some states and counties offer additional credits as well. In some areas, if your equipment produces excess electricity that you do not use it can be sold to your electric company. 

Of course, one of the most important reasons to go solar is so that you can do your part for our environment. With the present administration and their push for more green energy, the credit could get better but acting now you know you will get huge savings.