Edward A. Lyon, JD
TaxTuneup.com, Inc.
3416 Shaw Ave #5
Cincinnati OH 45208
513.321.2821
elyon@taxtuneup.com
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Damages
Damages you win from a lawsuit
or settlement are generally nontaxable, except for damages received to
replace lost income:
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Damages you receive for
personal injury, including sickness, other bodily injuries, and other
personal wrongs, are generally nontaxable.
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Damages for libels and
defamation against your business are taxable because those offenses damage
your ability to earn taxable income.
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Damages you receive under the
Age Discrimination in Employment Act are taxable.
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Damages you receive for
emotional distress are generally taxable.
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Damages you receive to
compensate for the loss or destruction of property are nontaxable up to
your adjusted Basis in the property.
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Punitive damages are generally
taxable, except for punitive damages arising out of injury or sickness.
Your attorney can give you
more information regarding taxes on specific types of damages. In some
cases, it may make sense to structure settlements, or even accept a
smaller settlement, to allocate as much as possible to a nontaxable
source.
Day Care
Day care costs for your dependent child or adult may qualify for the
Dependent Care Credit. They may
also qualify for pre-tax reimbursement through a dependent care
Flexible
Spending Account. These include costs for a day-care center, day camp, or
nursery school. They also include an in-home babysitter, nanny, or au pair.
Day Trading
Day trading used to be America's
favorite indoor sport. When tech stocks boomed, stock talk replaced baseball
chatter around office coolers. And CNBC's daytime ratings regularly topped
CNN's. All this is in spite of studies suggesting that 80% of day traders
lost their shirts--even before the tech stock crash. You just didn't hear
about them until they shot up their broker.
If you still have the fever,
your deduction for day-trading expenses--commissions, software, online
services, and the like--turn on whether you qualify as an "investor" or a
"trader." If you're an investor, you deduct day-trading costs like any
other Investment Expense,
up to net investment income, subject to the 2% floor on
Miscellaneous Itemized Deductions. But if you qualify as a trader, you
can deduct 100% of your costs as a
Business Expense on
Schedule C.
Avoiding the 2% floor beats
losing deductions. The trick is qualifying as a trader. To qualify, you'll
need to meet three specific tests:
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You trade full-time in lieu of
a regular job. In other words, trading is your job.
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You've established a regular
and continuous pattern of trading nearly every day the market is open. You
can certainly take vacations--in fact, you'll need them! But you can't
trade in spurts.
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Your intent is to profit from
short-term market swings, not long-term gains or dividends. (You can
maintain long-term stock investments. But you'll have to
segregate them in a separate account to avoid disqualifying your trading
activity.)
If you qualify, you can deduct
100% of your expenses, not just up to net investment income, and not just the portion that exceeds 2% of adjusted
gross income. You can use
First-Year Expensing to deduct capital
equipment (Computers, etc.), rather than
Depreciating them over time. And you can claim the
Home Office Deduction.
You'll still report profits
and losses as capital gains and losses on
Schedule D. So you can't use
day-trading gains as the basis for retirement plan contributions. But, on
the bright side, you don't owe
Self-Employment Tax
on day-trading gains.
If all that sounds like a lot
of effort to deduct just 2% of your income, you're right. If you generate
$100,000 in net gains and you wind up in the 28% bracket, qualifying as a
trader saves you just $560 in federal tax.
However, there's one last
strategy for avoiding the 2% floor without the hyperactivity needed to
qualify as a trader. You can form a separate legal entity, such as an
S
Corporation or
Limited Liability Company, to hold your
portfolio. The separate entity then deducts your day-trading costs as a
business deduction, bypassing the 2% floor, and passes the income through
to you. This strategy makes sense if your portfolio is large enough that
the tax savings justify the cost of establishing and maintaining the
separate entity.
Day trading isn't as easy as
some of its promoters would have you believe. But disciplined day traders
can make money--and lots of it. So the dream lives on, even when the
market doesn't.
De Minimis Fringe Benefit
“De miminis” fringe benefits are property and services
(not cash) that the IRS doesn’t tax because their value is “so small as to
make accounting for it unreasonable or administratively impractical.” The
generally accepted threshold for these items is $25.
If you operate your business as a
Sole Proprietorship
or Limited
Liability Company, you're considered "self-employed," so you don't
qualify for these employee benefits. (If you're married, you can hire your
spouse and pay benefits through them. You don't need to pay your spouse
any salary; however, you should be able to show that the benefits are
'reasonable compensation" for the services they provide.) If you operate
as an S Corporation or
C Corporation, you'll generally qualify yourself.
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Occasional meals or “supper money” to let employees work
"late" (10 or more hours in a day). The generally accepted threshold here
is $20 twice weekly. Employees don't need to account for their use of the
money.
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Occasional cocktail parties, group meals, or picnics for
employees and guests.
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Traditional birthday or holiday gifts of property (not
cash) with a low fair market value ($25 or less).
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Occasional theatre or sporting event tickets.
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Coffee, juice, and doughnuts you provide for employees at
the office.
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Flowers, fruits, books, or similar property you provide to
employees under special occasions, such as illness, outstanding
performance, or family crisis.
These may be mere rounding errors for the Microsofts of
the world. But they can really add up! Most months have at least one
holiday. And, while you can’t write off season tickets as a block, those
trips to the ballet or local amusement park can add up.
Demolition
Costs you pay to destroy and remove an existing structure aren't deductible
and don't qualify for Depreciation or
First-Year Expensing. Instead, include
them in the nondepreciable "land" portion of the property's
Basis.
Dentist
Deductible Medical
Expense subject to the 7.5% floor.
Dentures
Deductible Medical
Expense subject to the 7.5% floor.
Dependent Care Assistance
Dependent care assistance your
employer provides to help defray day-care costs is nontaxable up to the
lower of $6,000, your income, or your spouse's income. Payments you make to
your own dependent child don't qualify for reimbursement under this
break--you can't pay your 12-year-old to watch your infant.
Dependent Care Credit
The dependent care credit is a
credit against your tax for day care expenses that let you (or both you and
your spouse) work or look for work. This includes an in-home au-pair,
babysitter, or nanny, as well as outside day-care costs. Here's how to claim
the credit:
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The credit is available for
these "qualifying persons": a child under age 13, your incapacitated
spouse, or any other incapacitated dependent.
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If the incapacitated person
has gross income of $3,500 or more, so that he or she doesn't qualify as a
dependent, you can still claim the credit for the cost of his or her care.
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Expenses outside the home
include a day-care center, day camp, nursery school, or care in the home
of a babysitter. Expenses inside the home include ordinary domestic
services such as laundry, cleaning, and cooking plus Social Security,
Medicare, and unemployment taxes on household employees.
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Your day-care provider can't
be your child, your spouse, or anyone else you can claim as a dependent.
The credit is available for any dependent, including adults and parents as
well as children.
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Expenses that qualify for the
dependent care credit may also be subject to the
Nanny Tax.
The credit itself equals 20%
to 30% of qualifying expenses up to a base of $3,000 (one dependent) or
$6,000 (two or more dependents). If you're married and one spouse's income
is below the base, the base is limited to the lower-paid spouse's
income.
If your employer offers a
dependent care flexible spending account, any reimbursements you claim
from the account cuts your $3,000 or $6,000 base amount. If you have a
choice, simply figure which strategy saves you more. Generally, as your
tax bracket rises, the flexible spending account grows more valuable. The
credit can also land you in
Alternative Minimum Tax
hot water by cutting your final tax bill below AMT levels.
Example 1:
Your adjusted gross income is $25,000 and you're in the 15% bracket. If
you put $4,800 into a dependent-care FSA, you'll save just $720, $336 less
than the maximum $1,056 credit.
Example 2:
Your adjusted gross income is $80,000 and you're in the 28% bracket. If
you put the same $4,800 into a dependent-care FSA, you'll save $1,344,
$384 more than the maximum credit.
Figure the credit on
Form 2441
and carry the amount to
Form 1040. For more information, see
IRS
Publication 503, "Child and Dependent Care Expenses."
Dependent
(See
Personal Exemptions)
Depreciation
Depreciation lets you write off the
cost of a capital item (real estate, equipment, etc.) over a period intended
to approximate the useful life of the property. A
Computer, for example,
qualifies as five-year property, which lets you write off one-fifth of
the purchase price each year. The IRS publishes numerous depreciation
schedules for various asset classes.
Many capital items qualify for
"accelerated" depreciation, which lets you deduct a larger portion of the
item's cost during the first years of ownership. The "modified accelerated
cost recovery system," or MACRS, governs most accelerated depreciation
schedules. A regular depreciation schedule for five year property might
let you write off 10% in year one, 20% in years two through five, and 10%
in year six, with the six-year period intended to keep you from writing
off a full year's depreciation the year you buy the property. The MACRS
150% double-declining system, in contrast, lets you write off 20% in year
one, 32% in year two, 19.2% in year three, 11.52% in years four and five,
and 5.76% in year six.
Depreciation reduces a capital
asset's Basis for figuring gain
or loss on a later sale. If you sell an asset for more than that basis,
you'll owe tax at ordinary rates on any "recapture" when you sell. (Real
estate investors get a slight break; there's a special 25% rate for
recapture of depreciated real estate.)
Example:
You buy a truck for your business for $30,000. You depreciate $12,000 of
the cost over the first two years, then sell the truck for $20,000. You'll
owe tax at ordinary rates on the $2,000 "recaptured" in the sale.
You can depreciate any sort of
capital equipment you buy for your business: computers and office
equipment, cars and trucks, furniture. You can also use
First-Year
Expensing to deduct property immediately rather than depreciating it
over time.
Cost Segregation is the
process of allocating your investment in real estate among structural
components such as walls, windows, and roofs (depreciable over 27.5 or 39
years) land improvements such as driveways, parking lots, and landscaping
(depreciable over 15 years) and personal property such as carpets,
cabinets, countertops, and appliances (depreciable over 5 years).
Cost Segregation is one
of the best-kept secrets in the Tax Code; be sure you understand how to
use it to maximize deductions for your property.
Report depreciation and
First-Year Expensing
expenses on
Form
4562, then carry the total to
Schedule C,
Form
1065, or your corporate return.
For more information, see
IRS
Publication 946, "How to Depreciate Property."
Dialysis
Deductible
Medical Expense subject
to the 7.5% floor.
Diaper Service
Deductible
Medical Expense, subject
to the 7.5% floor, for incontinence resulting from severe neurological
disease (e.g., Alzheimer's).
Diets
Deductible
Medical Expense, subject to the 7.5% floor, for diets prescribed for
specific medical conditions, to the extent the prescribed diet costs more than a regular diet.
Disability Insurance
Disability premiums you pay for your own coverage are a nondeductible personal expense.
If you own your own C Corporation, the corporation can deduct premiums for
yourself and your employees.
Disability income insurance
benefits you receive from a policy your employer pays for are taxable
income. Benefits you receive from a policy you pay for personally are
nontaxable income.
Dividends
(See
Life Insurance,
Mutual
Funds, and
Qualified Corporate Dividends)
Dividends-Received Deduction
The dividends-received deduction
lets a C Corporation (but not an
S Corporation) exclude 70% of the dividend income it receives from another
corporation (80% if it owns at least 20% of the paying corporation). The
purpose is to avoid taxing the same income twice at the corporate
level--ironic, considering the Tax Code eventually whacks the income again
at the individual level.
Dividend Reinvestment Plans
Dividend reinvestment plans, or DRIPs, let you reinvest stock dividends paid in cash into additional
shares. More than 1,000 publicly-traded companies offer these plans. Account
fees are deductible as an Investment Expense, up to
net investment
income, subject to the 2% floor on
Miscellaneous Itemized
Deductions. And if
the plan gives you a discount on new shares, the discount is taxable income
the year you buy the shares.
DRIPs can be a cheap way to
boost your holdings over time. But make sure plan fees and commissions
don't overwhelm the benefits of buying in such small quantities. And
recordkeeping can be a nightmare if you invest over time, then find
yourself having to sell a block of shares with dozens of different cost
bases.
Dogs of the Dow
The "dogs of the Dow" is a popular investment strategy based on the theory that high dividend
yields indicate undervalued stocks. The mechanics are simple. Each year,
rank the 30 stocks comprising the Dow Jones Industrial Average according to
dividend yield. Buy equal dollar amounts of the 10 stocks with the highest
yield. Hold the stocks for a year, and repeat the process annually. (There
are several variations on this theme. Aggressive investors buy the five
lowest-priced stocks from within the same group. The Motley Fool web site,
at
recommends a four-company variation called the "foolish four." And the
newest version looks for the 10 Dow components with the highest "shareholder
return," a figure that includes stock buybacks.) If you can't afford to buy
individual stocks, you can buy mutual funds, unit investment trusts, and
variable annuity subaccounts that use the dogs strategy.
Results appear impressive.
From 1972 to 1989, the dogs returned an average of 19.03% per year,
compared with 12.66% for the Dow Jones Industrial Index and 12.79% for the
S&P 500. The dogs have beaten the Dow just 4 times in the 1990s, although
I suspect this is due to the general underperformance by value stocks, and
not any failure of the strategy. But, impressive as they are, do you see
how these dogs practically sit up and beg the IRS to take your gains?
First, the high dividends are taxed as ordinary income in the year you
receive them. And second, the strategy forces you to realize capital gains
each time a stock drops out of the high-yield group. You can hold your
stocks for a year and a day to take advantage of lower rates on long-term
capital gains. But you still whack your profits with each substitution.
(There are generally two to five per year.) After taxes, the dogs lag a
plain-vanilla S&P 500 index fund. The popular Dow 10 UITs sold by Merrill
Lynch, Paine Webber, and other Wall Street firms are especially deadly
because they sell all 10 stocks as each trust matures. This forces you to
pay tax on all of your gains, not just those that drop out of the top 10
dividend yields. So kennel the dogs in your tax-deferred accounts.
For more information, see
www.dogsofthedow.com.
Donor-Advised Funds
Donor-advised funds are an alternative to
Charitable Trusts for
donors who don't want the administrative headaches involved in setting up a
trust. You give cash or securities to the fund--generally, $5,000 or
more--and deduct the gift now. The fund manages your gift, and perhaps
allows you to invest your principal among a group of "mutual fund" options.
You can direct the fund to make gifts to your ultimate beneficiaries at any
time.
Drug "Rehab"
Deductible Medical
Expense, subject to the 7.5% floor (including meals and lodging
during treatment). Even if you make eight trips to Betty Ford and still wind
up in the can, like Robert Downey Jr.
Dry Cleaning
(see Uniforms and Work
Clothes and Travel)
Dues
Dues you pay to business,
professional, and social groups may be deductible under these rules:
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Dues you pay to professional
organizations, chambers of commerce, and civic organizations (Kiwanis,
etc.) are a deductible
Business Expense on
Schedule C,
Form 1065,
or your corporate return.
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Dues you pay to charitable,
religious, or educational organizations are a deductible
Business Expense if
you reasonably expect to gain some business benefit from your membership.
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Dues you pay to those same
organizations on behalf of your employer are a deductible
Employee
Business Expense subject to the 2% floor on
Miscellaneous
Itemized Deductions.
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Union dues are a deductible Employee
Business Expense subject to the 2% floor on
Miscellaneous
Itemized Deductions.
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Personal dues you pay to
charitable, religious, or educational organizations are a deductible
Charitable Gift.
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Health club dues are a
deductible Medical Expense,
subject to the 7.5% floor, if prescribed for a specific medical condition.
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There's no deduction for
private club dues such as lunch clubs and country clubs. However, you can
deduct Meals and Entertainment you pay
for at the club so
long as the occasion qualifies for the deduction.
You can't deduct any part of
union or professional group dues used for lobbying or political
contributions. The organization should be able to furnish the amount of
your dues used for this purpose.
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