Tax Tips

Charitable Donations
The Internal Revenue Service requires certain substantiation to support charitable donations in excess of $250.00. In those cases, if not already issued, the recipient charity must send the donor an acknowledgement of receipt of the donation, and must include a statement of the amount contributed and "whether or not the organization gave the taxpayer any goods or services as a result of the donation (other than certain token items and membership benefits)" and if goods or services were given, a description and good-faith estimate of the value of the goods or services.

This acknowledgement must be received on or before the earlier of

(1) the date the taxpayer files a return for the year of the donations, or
(2) the due date, including extensions, for filing the return.

Generally, a charity must give a donor a written statement for a donation of $75.00 or more that involves a benefit.  The statement must include the amount of the donation as well as inform the donor that only the amount in excess of the value of the goods or services is deductible.  The statement must include a good-faith estimate of the value of the benefit.

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Hobby vs. Business
Hobbies provide a great way to relax from the daily grind. For many people, they also offer a way to make extra spending money. Be aware, however, when your hobby produces income, you owe tax on it.

You can reduce your taxable hobby income by deducting your hobby expenses, but this tax break is limited. You can only deduct expenses up to the amount of money you make on the hobby. Even then, hobby expenses, along with other miscellaneous expenses you itemize on Schedule A, must come to more than 2 percent of your adjusted gross income before you can deduct them.

If you find your hobby is regularly making money, it might be to your tax advantage to turn the sideline into a business. It's not as difficult as you might think. If you operate as a sole proprietor, you report the income on your 1040 tax return and you have more options when it comes to deducting your expenses.

The Internal Revenue Service defines a hobby as an activity you pursue without expecting to make a taxable profit. Basically, you do it because you like it, regardless of the cost.

But if you demonstrate that you are involved in an activity with the expectation of making money on it, the IRS will consider it a business. As such, you'll be able to deduct expenses directly from your income. You even can deduct overall business losses in the years you don't turn a profit.

You must, however, make the right moves to convince the IRS that your sideline is a legitimate business.

What Constitutes a Business
The IRS uses two tests in determining whether your activity is a business rather than a hobby.

First, the profit test demands that you show you earned money on the activity in three out of five years.

If you can't meet the profits test, you get another chance to convince the IRS that you are running a business by passing the factors-and-circumstance test. Here, the tax agency takes a subjective, individualized look at your pursuit. Basically, the IRS examines:

• Whether you carry on the activity in a business-like manner. This includes, for example, keeping good books and records, promoting your business and holding down costs where possible.
• How much time and effort you devote to the enterprise.
• Whether you depend on income from the activity for your livelihood.
• If your losses are due to circumstances beyond your control or are normal for a business in its start-up phase.
• Whether you change your methods of operation in an attempt to improve profitability.
• The knowledge and background you (or your advisers) have in running such a business.
• If you were successful in making a profit in similar activities in the past.
• Whether the activity makes a profit in some years and, if so, how much?
• Whether you can expect to make a future profit from the appreciation of the assets used in the activity.
• The element of personal pleasure involved in the activity. That doesn't mean you can't enjoy your new business, but you better be getting more out of it than just a good time.

By successfully transforming your hobby into a business, you'll be able to deduct your associated expenses without worrying about a percentage limitation. You might even find a few more you can take, such as one for the home office you set up to take care of your new endeavor's administrative chores.

And if you have an occasional year where you lose money, the loss can help reduce your other income and lower your tax bill.

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Home Office Deductions
Self-employed people essentially have two hurdles to clear to get their deductions. The first is straightforward: You must use the space regularly and exclusively for business. Regularly means often, rather than occasionally. More important, exclusively means exclusively. You can have absolutely no personal use of it during the year (or at least none that you admit to). If you so much as use the desk in your office to balance your personal checkbook, all your deductions get flushed.

The second hurdle is much higher than the first, but there are three ways to get around it. The rule requires that your home office be your principal place of business, meaning you earn your keep there. This is no problem for people like freelance writers and accountants. But if you make your money outside of your home, you will have to meet one of three exemptions to get the deduction.

I'll start with the newest, which was passed as part of the 1997 tax law but which is effective Jan. 1, 1999. Actually, this rule isn't so much new as revived. The home-office rules were weakened in 1993 by a Supreme Court decision that said an anesthesiologist who did his paperwork at home but who earned his living in hospitals could not deduct his home office.

Now the rule says that your home office qualifies as your principal place of business (meaning it's deductible) if you use it for administrative and management activities -- provided that you have no other fixed location to do these chores. In other words, the doctor in the Supreme Court case would now qualify for a home-office deduction because the hospitals did not provide him with an office. The new rules are a boon to independent salespeople, construction contractors, plumbers, veterinarians, computer consultants and the like, who make their dough out in the field but do their paperwork at home.

The second exemption applies if you use the office to meet with clients. Even if you do most of your work elsewhere, as long as you use your home office for meetings, it's deductible.

If you haven't qualified yet, there's still hope. If your office is in a building that is separate from your home, it qualifies as long as there is no non-business usage. That means setting up your home office in a detached garage or outbuilding could get you a big tax break.

What's It Worth?

Let's assume you pass all the tests. Now you want to add up your write-offs. For sole proprietors, this is done on Form 8829 (Expenses for Business Use of Your Home). The rules go like this.

Deduct 100% of expenses that are directly related to the home-office space -- for example, painting, cleaning and the premium for a home-office rider on your homeowner's insurance policy. Ditto for your office telephone line and utilities, if you have separate hookups.

You are also allowed to deduct a percentage of indirect expenses that relate to your entire residence. These include mortgage interest, property taxes, association fees, rent if you don't own your home, depreciation if you do (over 39 years), utilities, security monitoring, garbage pickup, general maintenance and repairs, insurance and so forth.

Knowing what you can deduct is the easy part, but figuring out how much of your indirect expenses you can write off is harder. Form 8829 leads you to believe you must use square footage, and most people do. Count only living space in figuring the percentage (not your garage, unfinished basement or covered patio). Also, if you have a bathroom adjoining your office that's never used otherwise, treat the square footage as part of your office.

Despite what the form says, you can also use any other "reasonable method" to compute the business use for indirect expenses. The easiest method is to count the number of rooms in your house and divide. If you have 10 rooms, you can deduct 10% of your indirect expenses. But this assumes your rooms are generally the same size. So if your 10x10 office is one of five rooms in your 3,000-square-foot house, deducting 20% for office use obviously won't fly if you get audited. By the way, the office doesn't have to be a separate room, just a defined space that you use for business.

One limitation on home-office deductions is that they can't put your business in the red. But that doesn't mean the deductions are wasted. Any amount that puts you below the break-even point gets carried over to the following year. And the limitation doesn't apply to mortgage interest and property taxes, which are fully deductible no matter how much money your business loses.

Employee Discounts

Sorry, but employees don't fare especially well under the Internal Revenue Service's home-office rules. You have to meet all of the above requirements, and you have to clear one additional hurdle. Your work-at-home arrangement must be for the convenience of your employer. That means telecommuters who work at home for the joy of it don't qualify. But if you spend so much time at home that your boss gives away your office, then you meet the convenience-of-the-employer test and qualify for the deduction.

Don't start counting your money just yet, though. Since you're not self-employed, your home-office deductions are counted as miscellaneous itemized deductions on Schedule A, rather than on Schedule C, where self-employed people calculate their profits and losses. (Mortgage interest and property taxes go on Schedule A, just as they always have.) The bad news is that you can write off your miscellaneous itemized deductions only to the extent that they exceed 2% of your adjusted gross income. So unless you have other miscellaneous itemized deductions (union dues, investment expenses, fees for tax preparation and the like) you will probably end up with a big zero where you thought you were getting a windfall.

A final note on home-office deductions. To defend yourself in case of an audit, take pictures of your office (with the TV safely out of the frame) to back up your claim that the space is used only for business. Stash the photos in your permanent tax file.

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Direct Deposit
Want a faster refund? The IRS says that more taxpayers are choosing direct deposit as the way to get their federal tax refunds. The payment is more secure — there is no check to get lost. And, it’s more convenient — no special trip to the bank to deposit a check. To request direct deposit, follow the instructions for "Refund" on your tax return.

Nearly 40 million people had their tax refunds deposited directly into their bank accounts during the 2002 filing season, a 17 percent increase from the year before. Choosing direct deposit is the best way to guard against having a tax refund misplaced or stolen.

Want an even faster refund? Try e-file. Taxpayers who file electronically get their refunds in about half the time as those who file paper returns. A word of caution — some financial institutions do not allow a joint refund to be deposited into an individual account. Check with your bank or other financial institution to make sure your direct deposit will be accepted. Also, make sure you have the correct nine-digit routing number and your account number when selecting direct deposit. For more information about direct deposit of your tax refund, check the instructions for your tax form.

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Record Keeping
You can avoid headaches at tax time by keeping track of your receipts and other records throughout the year, the IRS advises. Good record keeping will help you remember the various transactions you made during the year, which may help you out on your taxes.

Records help you document the deductions you’ve claimed on your return. You’ll need this documentation should the IRS select your return for examination. Normally, tax records should be kept for three years, but some documents – records relating to a home purchase or sale, stock transactions, IRA and business or rental property – should be kept longer.

In most cases, the IRS does not require you to keep records in any special manner. Generally speaking, however, you should keep any and all documents that may have an impact on your federal tax return. Such items would include bills, receipts, invoices, mileage logs, canceled checks, or any other proof of payment, and any other records to support any deductions or credits you claim on your return.

Good record keeping throughout the year saves you time and effort at tax time when organizing and completing your return. If you hire a paid professional to complete your return, the records you have kept will assist the preparer in quickly and accurately completing your return.

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Payment Plan for Paying Tax Dues
Ask for an installment plan. If you qualify for a “streamlined” agreement -- generally, if you don't owe more than $25,000 and will be able to pay it off within five years -- you can find out about how long the payments will last. The true length of your payments is a function of both how much you owe and the interest rate charged; since that rate changes every three months, these figures are estimates, not guaranteed maximum payments. If the interest rate goes down, you may actually pay over a shorter period of time.

The rate is calculated on the basis of the short-term federal rate plus 3 percentage points, as of the first month of each quarter. The rate on overpayments was 6% for the January-March 2002 quarter, for example. The IRS also charges 6% interest on underpayments (except for large corporate underpayments, which have an 8% rate). The IRS issues a news release in the last month of each quarter announcing its rates for the following quarter.

If you don’t meet the criteria for a “streamlined” agreement, you can compare your monthly expenses to the amounts allowed under the IRS’ Collection Financial Standards to determine an appropriate tax-payment amount.

You can actually print out Form 9465, Installment Agreement Request, from the Web site and mail it to the IRS for review and approval. The Web site doesn’t store or transmit any personal data.

If the IRS approves your request, you will be charged a $43 fee. Don’t submit the fee with the form. The IRS normally will deduct the fee from your first monthly payment.

Even if your Form 9465 request is approved, you still will be charged interest and may be assessed a late-payment penalty on any tax not paid by its due date. To limit interest and penalty charges, file your return on time and pay as much of the tax as you can.

Form 9465 is easy to complete. It asks for your name, address, Social Security number, the name of your bank and your employer. (Relax. Based on your W-2 and the 1099 the bank sends, the IRS already has that information.) It then asks how much you owe and how much you want to pay each month. You don’t need an attorney or an accountant to fill it out. If you can pay the outstanding liability within 12 months and promise to keep current with this year’s taxes, almost all requests are granted.

If you can’t pay what you owe within 12 months, request an installment plan that you can realistically meet. The IRS takes a harder line on longer payment periods, but the government has granted such requests after investigating the individual circumstances.

What if an installment plan just won’t work for you? As in the past, you have the opportunity to ask for an Offer in Compromise. Under this program, you pay the IRS, but less than 100% of what’s due.

In the past, there were only two situations where the IRS would consider an Offer in Compromise:

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Hiring Your Children to Help with the Family Business
If your business is unincorporated and your children are under 18, you won't be liable for any Social Security or Medicare taxes. Moreover, for 2000, you can pay each child as much as $6,400 (each child gets a $4,400 standard deduction plus $2,000 in a traditional IRA), deduct the sum in full, and they will pay zero taxes. If you're in the 31% bracket and hire two minor children, you can save up to $3,968 in taxes ($6,400 x 2 x 0.31). This technique has been allowed for children as young as seven years old. Not only does this save income taxes, but it also reduces your liability for Social Security and Medicare taxes on your own net income. This could save you an additional $1,958.40.

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Gift Giving
If you give any one person gifts valued at more than $10,000 in 2001, it is necessary to report the total gift to the Internal Revenue Service. You may even have to pay tax on the gift. For 2002, the amount rises to $11,000.

The person who receives your gift does not have to report the gift to the IRS or pay gift or income tax on its value.

You make a gift when you give property, including money, or the use or income from property, without expecting to receive something of equal value in return. If you sell something at less than its value or make an interest-free or reduced-interest loan, you may be making a gift.

There are some exceptions to the tax rules on gifts. The following gifts do not count against the annual limit:

– Tuition or medical expenses that you pay directly to an educational or medical institution for someone's benefit

– Gifts to your spouse

– Gifts to a political organization for its use

– Gifts to charities

If you are married, both you and your spouse can give separate gifts of up to the annual limit to the same person without making a taxable gift.

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Make wise retirement plan choices when you change jobs
When you change jobs you're likely to face a decision with major tax consequences - what to do with the balance in your retirement plan.
Generally, you'll have four choices.

• Leave the money in the current plan. You may be able to leave the money invested in your old employer's plan, but this has disadvantages. First, your investment choices will be limited to those offered by that plan. Second, you may find it inconvenient to communicate with the plan administrator when you're no longer employed by the company.
• Roll the money directly into your new employer's plan. If your new employer has a retirement plan, you might be able to transfer balances in, but there's often a waiting period.
• Take a cash distribution. This is usually the least attractive option. You'll owe income tax on the distribution, and you may be liable for an additional 10% early distribution penalty. Moreover, you'll lose the ability to continue tax-deferred earnings on your retirement savings.
• Move the money into a rollover IRA. You can roll your retirement money into an IRA. Later, you may be able to roll the money into a new employer's plan. With this option, it's advisable to do a trustee-to-trustee transfer. If the funds come directly to you, you have 60 days to redeposit them into an IRA. But if you miss the deadline, you'll owe taxes and possibly penalties on the entire amount. Also, the trustee is required to withhold 20% income tax from a distribution made directly to you. Unless you make up the 20% from other sources when you put your money into a rollover IRA, that missing amount will be treated as a taxable withdrawal. A trustee-to-trustee transfer avoids these problems.

Refinancing your home loan may have tax benefits
Have you taken advantage of falling interest rates and refinanced your mortgage this year? If so, don't overlook the following tax deductions.

Deduct loan points. Most lenders charge points, also known as a loan origination fee, on home loans. If you itemize, you can generally deduct points paid on a refinancing, but not all in the first year. Instead you must spread your deduction pro rata over the life of the new mortgage. To qualify, paying points must be an established practice in your area, and the amount paid can't be more than what is normally charged in the area.

If you've refinanced in the past, you could be eligible for another deduction. When you pay off a prior refinancing, you can immediately deduct any remaining points from the previous mortgage.

Maybe your refinancing served two purposes. Perhaps you refinanced your home to get a lower interest rate or shorter loan term and also to tap your home's equity. To the extent that you used the loan proceeds to pay for home improvements, points attributable to the home improvement portion can be deducted immediately. Any remaining points must be deducted pro rata over the loan's term.

Look for other deductions. If the lender charges a prepayment penalty for paying off the previous loan early, you can generally deduct the amount paid. Most other closing costs, such as appraisal or title insurance fees, are not deductible. However, you should bring your loan documents to your tax appointment because there could be additional deductions.

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