This month we’ll be covering:
CLICK HERE to learn more about tax withholdings, a checklist of key issues to consider as your child become independent and how the IRS treats S-Corp owners differently than any other business owner or employee
This year we found more clients owed money to the IRS as did other accountants we spoke with. Starting in June we are going to be sending Taxucation videos to explain how to prevent a repeat of this nasty surprise next year.
CLICK HERE to learn more about tax withholdings, a checklist of key issues to consider as your child become independent and how the IRS treats S-Corp owners differently than any other business owner or employee
There seems to be more and more scams. Click here to read our post outlining some of the newer scams http://eepurl.com/inyMFs
In the era of reality TV, aspiring entertainers often look to talent competitions to gain renown, visibility, and of course, the cash prize that comes with winning. In fact, a variety of industries and academic disciplines offer prizes and awards through competitions that may or may not be widely publicized. Whether the contest is associated with the winner’s main profession or not, the question that comes around every tax season is whether competition prizes and awards are taxable. The answer is more nuanced than a simple “yes” or “no.” The taxes a competition winner must pay depends on a number of factors, such as the conditions under which the prize or award is received and what is done with the earnings. This is where the help of a Certified Tax Planner is essential to identify tax planning and savings opportunities.
COULD YOUR PRIZE OR AWARD BE TAX-FREE?
Your gross income includes amounts received as prizes and awards, but a broad number of exceptions apply. For instance, qualified scholarships and fellowship grants used to cover tuition and related expenses are not considered taxable income. Other exclusions include certain prizes and awards transferred to charities, employee achievement awards, and Olympic and Paralympic medals and prizes.
Overall, once these exclusions are taken into consideration, most prizes and awards still fall under the category of taxable income. You may be tempted to designate these proceeds as non-taxable gifts, but a competition-based prize is unlikely to meet the definition of a “gift.” According to a Supreme Court Case ruling, a gift must proceed “from a ‘detached and disinterested generosity…’ out of affection, respect, admiration, charity, or like impulses.”
The tax implications of a prize or award can also depend on how it was received and how the funds are used. Prizes and awards also differ in their mode of receipt. Some involve an extensive application or audition process, while others have no formal application and may even come as a surprise to the recipient—think of the MacArthur “Genius Grant.” Some have specific parameters or “strings attached” to the winnings, but others have no restrictions or guidance on how the money can be used. Similarly, a contest winner who receives an unrestricted cash prize may choose to donate that money to charity, place it in a trust, or take another action that could change the tax consequences.
A prize or award qualifies as tax-exempt if it is made in recognition of religious, charitable, scientific, educational, artistic, literary, or civic achievement, the recipient took no actions to enter the contest, the recipient is not required to render substantial future services as a condition for the prize, and the prize is transferred to a governmental unit or organization as a charitable contribution. This was the case with former President Barack Obama who donated his $1.4 million Nobel Peace Prize winnings to 10 different charities.
PREPARING TO REPORT A PRIZE ON YOUR RETURN
For those who do not fit the exceptions described above, prize winners should expect to be liable for some amount of tax. Assuming that you received a taxable prize of cash, property, goods, or services with a readily determined fair market value (FMV), here are some basic questions to evaluate your situation:
In addition to understanding the basics, you will also want to determine if the prize counts as self-employment income. Generally, self-employment tax applies to net earnings from a trade or business, and both gross income and related expenses should be reported on Schedule C (or Schedule F for a farm). If you are in the business of entering and winning competitions, the IRS could make this argument. However, prizes and awards are not typically compensation for goods and services and therefore would not count as regular income.
On the other hand, could prize winnings be considered hobby income? IRC §183 discusses activities not carried on for profit, which do not qualify for tax deductions due to loss of income. Though not officially authoritative, the IRS revised Audit Technique Guide Publication 5558 (9- 2021) serves as a handy point-of-reference. The purpose of this guide is to help IRS agents conduct “hobby loss” audits to determine whether taxpayers can deduct losses (trade or business) or not (hobby)—taxpayers can consult this IRS playbook and their collective research as a guide on what is likely fair to claim on their tax return.
HOW TO REPORT PRIZE-RELATED INCOME
Taxpayers filing a 1040 form can use the “Other Income” line flowing from Schedule 1. For 2021, the IRS expands Schedule 1 line 8 to include subcategories a-z (skipping from r-z) with Prizes and awards on line 8h.
Where can taxpayers deduct any relevant expenses? Artists often use their prize winnings to launch new projects and therefore have expenses to deduct against the prize income. After the Tax Cuts and Jobs Act (TCJA) of 2017, most of the miscellaneous Schedule A deductions were eliminated. However, one promising ruling occurred in the case of Jorge Quintanilla v. Commissioner (TC Memo 2016-5). The US Tax Court determined that the taxpayer (a stage technician) could deduct his business expenses on Schedule C even though the bulk of his income came from W-2/union contracts. Judge Holmes states: “The big issue is whether Quintanilla correctly reported his business expenses on Schedule C (the schedule that people who are in business for themselves use to report their expenses) and not on Schedule A (the schedule that people who work for somebody else use to report business expenses). The distinction matters because the Code limits Schedule A deductions more than limits Schedule C deductions.” This ruling is especially significant since TCJA eliminated the miscellaneous itemized deduction option.
To take an example of how this ruling might be applied, let’s say there is a composer who enters her work in a competition and wins $70,000. The competition does not restrict how or when she can use the funds, so in the same tax year, the composer uses $35,000 to finance a new project. She hires musicians, engages a publicist, rents a concert venue, and pays for catering and other services related to the performance. The composer reports the $70,000 as “Other Income” and deducts the $35,000 spent as Schedule C business expenses, thus reducing her net profit and associated self-employment tax. Reporting Schedule C expenses effectively reduces the composer’s overall tax liability.
SUMMARY
Competition winners benefit from an income boost, as well as the acclaim and opportunities that come with public recognition of their talents. To ensure as much of a profit as possible, prize recipients need to be aware of the tax implications of a sudden influx of cash or other winnings. Focus on celebrating your accomplishments and leave the tax planning to us.
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In 5 minutes we cover the main sections of your tax return ending up at what is most important to you, your refund.
Click here to watch – https://bit.ly/arefundisborn
If you need help with your accounting, payroll or taxes contact us at https://myfiscaloffice.com/connect/
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In 3 minutes we cover what you need to know adjustments, deductions AND credits.
Click here to watch – https://bit.ly/ADCohmy
If you need help with your accounting, payroll or taxes contact us at https://myfiscaloffice.com/connect/
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In just over six minutes we cover what you need to know about standard vs itemized deductions.
Click here to watch – https://bit.ly/taleoftwodeductions
If you need help with your accounting, payroll or taxes contact us at https://myfiscaloffice.com/connect/
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The pandemic forced businesses to adapt in many ways. The economic recovery has highlighted supply chain issues exacerbated by strong demand and leading to overall inflation. Businesses are now continuing to adapt to higher prices. Those with inventory may be able to realize tax benefits to help with this inflationary effect through the Last-In, First-Out inventory method (LIFO).
LIFO inventory methods are hardly a new tax concept but often may have been ignored due to complexity or periods of marginal inflation. This strategy deserves a second look during a year of high inflation. Read on to learn more about this tax savings strategy and the simplified calculation methods available.
Under the TCJA most businesses with less than $25 million in gross receipts are able to write off the inventory expenses at the time of purchase. For our clients with inventories, they were all able to make the appropriate elections so LIFO or FIFO no longer matters. But if your business has over $25 million in gross receipts or could not meet the safe harbor election rules, read on.
WHAT IS LIFO INVENTORY?
LIFO is a valuation method for inventory that is allowed instead of the common first-in, first-out (FIFO) method. FIFO assumes the oldest items of inventory purchased are the first items sold. In contrast, LIFO assumes the most recently purchased items of inventory are the first sold. Neither method will reflect the actual flow of inventory but instead will assume a consistent flow according to the method.
Practically speaking, the actual physical flow of inventory is never quite FIFO or LIFO. The grocery store will have a mix of workers rotating stock well or poorly. Workers may pay closer attention to the rotation of the short-lived yogurt than they do to the three-year-before-expiration canned goods. Even if complete rotation is achieved in stocking, perfect FIFO is ruined by customers who understand to dig deeper into the shelves to get those longer expiration dates. This is okay though. The grocery store can select an overall method of accounting for inventory even though it will never match the flow of goods. While the store ideally wants their inventory to flow FIFO, the store probably should consider LIFO methodology for tax purposes.
HOW LIFO SAVES TAX DURING INFLATION
During a period of rising costs, LIFO will produce a tax savings in the form of higher cost of goods sold and lower ending inventory.
The LIFO method is not without risk. Additional taxable income may be realized if periods of deflation and lower costs occur which leaves older, higher cost inventory on the books under the LIFO method. Once the method election is made, you may revoke it but must wait five years before re-electing LIFO (unless they receive specific consent from the IRS commissioner under non-automatic procedures). So you cannot simply bounce back and forth between methods that suit the direction of your inventory’s value for tax purposes. As a result, those with highly volatile inventories are likely not good candidates for LIFO. The best candidates for LIFO are profitable taxpayers with significant inventories and consistent inflation in their industry.
CONCLUSION
In a time of higher-than-average inflation, LIFO inventory methods deserve a second look as a tax reduction strategy. LIFO can be simpler than many realize through the use of BLS published inflation indexes and grouping many items into 10% categories. As the costs of inventory continue to inflate over time, the LIFO method will continue to produce higher costs of goods sold and lower tax bills.
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One of the most common non-tax questions I get is “How long should I keep this?” ‘This’ could mean bank records, copies of tax returns, or virtually any other piece of business information.
Here are some best practices for keeping business records for tax compliance. Specifically, what to keep and how long to keep it in case a taxing authority ever decides to examine (audit) a business return.
THE WHY OF BUSINESS RECORD KEEPING
Obviously, keeping good books and records is ‘just good business,’ but why? The answer to that isn’t as simple as “in case you are audited.” The answer is often evident when a business owner needs to substantiate profits to borrow money.
WHAT IS ‘GOOD’ RECORD KEEPING
Good record-keeping for tax compliance is, like most things tax-related, proactive. First and foremost, it is contemporaneous. It is not cobbled together at the end of the year, or worse when a problem occurs (e.g., an audit letter). Contemporaneous, however, can have different meanings depending on the size and type of the business. For example, busy realtors should keep their mileage logs daily. Even trying to reconstruct them at the end of the week may prove too cumbersome. For small business owners in less mileage-intensive industries, a weekly or monthly recap of business trips may be perfectly fine.
WHAT TO KEEP AND HOW LONG TO KEEP IT
Understanding the different types of business records necessary for tax compliance is important. In general, these records can be classified into the following four categories:
1 – Documents that Substantiate Income – —In general, all income is taxable unless it isn’t. In other words, unless there exists a specific exception in the code that excludes it, all items of income are taxable. Some items that aren’t income that accountants commonly see included in client books and records as income are borrowed money, money gifted to help you start your business that does not represent an actual investment in the business, and the owner’s own cash contributions to the business. Keep the following documents for three years after the return is filed:
2 – Documents that Substantiate Deductions— Many clients often, and wrongly, think that simply paying an expense from a business account magically converts it to a business expense. Deductions are allowed for “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Certain business deductions (e.g, travel expenses, meals, and mileage) are subject to heightened substantiation rules. But all business deductions should show The amount of the deduction, the date of the deduction and the business purpose of the deduction. Here is a list of some common items to keep:
3 – Documents Related to Assets and Liabilities—As mentioned above, booking and reporting loan proceeds as income is a common mistake. You should keep loan documents to help substantiate deposits from loan proceeds. As a best practice loan proceeds should not be deposited on the same deposit ticket as sales revenue. Loan documents, amortization schedules, and end-of-year payment statements should also be kept for three years to substantiate the amount of business interest paid for a given tax year, unless the loan is related to the purchase of a specific asset, in which case keep reading.
4 – Documents That Substantiate Ownership Interests—These documents should be kept for at least three years after a given shareholder or partner’s interest is terminated. The documents should clearly show what was given in exchange for the partnership interest or shares (money, property, etc.) and the shareholder or partner’s basis as well as the fair market value of the property contributed. The documents should also clearly state what was received in terms of shares or percentage interest in exchange for the contribution.
CONCLUSION
While this article focuses on record keeping for income tax compliance, the general principles apply to other tax and administrative compliance as well. You should be made aware of their various state requirements and other administrative compliance requirements that apply to the business entity type. Additional tax records could include sales or gross receipts tax, excise taxes, and payroll taxes. Administrative compliance requirements could include payroll documents such as Forms W4 and I9, corporate minutes and annual report filings, safety compliance documents, etc.
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Cryptocurrency has spiked in popularity in recent years, but the tax reporting process has struggled to keep up with the changing times. The IRS considers it property, which means that gains and losses from receiving, sending, selling, or exchanging cryptocurrency must be reported on your tax return. Currently, there is no 1099 form that functions to fully report cryptocurrency transactions. The IRS has yet to issue third-party reporting requirements to exchanges who are therefore left on their own to determine what information to report to the IRS and what forms to use.
COMMON TAX FORMS USED FOR CRYPTOCURRENCY
Some exchanges will attempt to report transactions on a traditional 1099-B, the form used by brokerages and barter exchanges to record customers’ gains and losses during a tax year. However, the easy transferability of cryptocurrency makes it nearly impossible for an exchange to correctly report tax basis information. As a result, the IRS may see inconsistencies in the amounts reported by exchanges versus cryptocurrency users. In response, the IRS may send you a CP2000 notice for underreported income which can be expensive and time-consuming to resolve.
Other exchanges will issue a 1099-MISC for certain transactions, but the same problem can come up where the amounts reported may be inaccurate.
A third option is the 1099-K, an information return that shows only the gross proceeds from crypto transactions. Again, this form may be missing key details to paint a full financial picture, resulting in you receiving a CP2000.
WHAT IS A 1099-K?
The 1099-K is generally only used by businesses accepting credit card payments or payments from a money transmitting service such as PayPal. The form will show the gross proceeds from that tax year and that amount broken down by month. In the tax document matching process, the IRS computer will scan for that first total—the gross proceeds for the year.
Since the 1099-K is typically used for credit card payments, the IRS will look for the gross payment amount on Schedule C (Profit or Loss from Business), while you most likely listed the amount on Schedule D (Capital Gains and Losses). This could result in a mismatch, which the IRS could read as underreported income. The IRS has recently begun to address this mismatching error, but for the time being, taxpayers still need to be aware that this could trigger a CP2000.
One potential problem is that the 1099-K was historically not issued unless gross payments exceeded $20,000, and there were more than 200 distinct transactions. However, the American Rescue Plan Act of 2021 significantly changed this threshold: a 1099-K will now be issued for gross payments over $600, and there is now no transaction minimum. If the IRS does not provide additional guidance on cryptocurrency reporting by the end of 2021, these changes to the threshold may substantially increase the number of 1099-K forms issued by exchanges.
Another potential problem is that the 1099-K does not communicate tax basis information to the IRS. Unlike with other forms, the IRS may not be able to verify if the amount on that 1099-K is accurate without requesting additional information from you. On the flip side, many cryptocurrency users may not realize they are required to report their transactions to the IRS. If the IRS received a 1099-K and you did not report anything, a CP2000 will almost certainly be sent.
WHAT IS A CP2000 Anyway?
Even though the CP2000 is automatically generated, the notice can be intimidating for taxpayers. Some people may simply assume the IRS’ calculations are correct and pay the amount listed as owed. DO NOT DO THIS. In the case of cryptocurrency, the possibilities for errors abound, so taxpayers should always investigate their own records to see if they can account for the discrepancy and demonstrate to the IRS that no additional tax is owed.
A CP2000 should be viewed as a PROPOSED adjustment to tax and not a formal assessment. You have an opportunity- an obligation really – to respond to the IRS with an explanation and supporting documents if necessary. For instance, you can send in a letter explaining that the 1099-K shows gross proceeds and that Schedule D shows net proceeds. If available, they can also include a report from the cryptocurrency exchange showing the amount that went toward fees. Keep in mind that the arrival of a CP2000 does not mean that you should respond with an amended return, which will just delay processing.
CONCLUSION
Not all exchanges issue 1099s, so you should not rely on these to keep records of their crypto transactions. Taxpayers will simply want to provide thorough documentation to account for all gains, losses, and differences caused by fees in order to avoid the CP2000 notice.
Until the IRS provides a form that accurately accounts for third party reporting for cryptocurrency transactions, taxpayers must educate themselves on the challenges they could run into and be prepared to defend the amounts they are reporting. Taxpayers also should not be alarmed if they do receive a CP2000, since this is a common problem for cryptocurrency users and can sometimes be resolved without incurring any additional taxes.
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