How do I owe taxes?
By David G. Parent, Esq.
In the real world people pay little attention to records, maybe keep receipts in a box and dump the mess on to a tax preparer about two days before the return is due. People then check to see how much of a refund is coming and file or misplace the return somewhere where it cannot be easily located. This becomes a problem when a hastily prepared return is selected by the IRS for an audit. But still many are surprised and ask themselves…. how do I owe taxes? You see, in the ideal world, people would:
- Keep good financial records.
- Tax preparers would use the records to prepare accurate returns.
- Taxpayer would use the records and returns in planning and monitoring his financial course, sailing smoothly to a happy financial future.
But of course, this is not what happens. (Hence the need for taxpayers to get back taxes help).
Why are people so careless? Are they inherently evil?
No! Like many of us, people are too busy going to work to earn the money, taking care of their homes, families and other obligations to spend much time looking at their finances. But, by spending a modest amount of time reviewing the return they can obtain a good idea of where they are heading financially and can make some sound decisions. So, dig out your 1040 return and we are almost ready to begin.
But first. A WARNING. This article may get a little complicated. (we are talking about taxes after all). So if you need owe back taxes sign up for our easy-to-understand taxpayer awareness guide in the box below.
Form 1040 is designed for almost all taxpayers. Thus it has to accommodate all manner of income, and adjustments. For most people Wages (Line 7) and Taxable Interest (Line 8a) are the only lines used. Older folks may have pension and IRA income (Lines 15a and 16a) and Social Security. People in business will have Business income (Line 12) and all of the other lines are used to report particular types of income.
Why do we have so many types? After all, isn’t income, income?
No. Certain types of income are taxed totally differently. A good part of the answer lies in public policy. The people, through its government, wishes to encourage certain types of activity such as investing and savings. Thus only Wage income and Business income are subject to Payroll taxes (Social Security and Medicare.) Note that unemployment compensation is taxed only when it exceeds $2,400 per recipient.
What is the value of listing all of the different types of income that you received?
First, you now have an accounting. You at least know from whence the money came. Second, it helps you to plan. For example if you are running a part time business but are also burdened with payroll taxes, might you be better off spending that time and capital on investments? Is tax exempt interest a better deal than taxable interest? Most importantly, what would this form look like if you were retired? You would have Social Security on Line 20a but what would take the place of Wage income? Maybe you want to ponder that question before continuing.
Total income is total income so let’s pay the tax on it.
Well, not so fast. Again, the people enact public policy through the tax code and so we have adjustments before we can answer the age-old question “how do I owe taxes?” A self-employed person has to pay the entire amount of Social Security and Medicare. Otherwise he would be getting all of the benefits while not paying all of the costs. But, we also want to encourage people to start and operate businesses. The answer is to allow the taxpayer to deduct half of the cost of his self-employment tax on Line 27. We want people to save so there is a deduction for IRS contributions. Health care gets a boost with a health savings account deduction on Line 25. The beauty of having these deductions on these lines is to benefit a person who might otherwise not have deductible expenses that he can list on Schedule A. We step away from the 1040 while we look at Schedule A: Itemized Deductions. This page is pure public policy. The government wants you to pay the money needed to take care of yourself. It partially helps you to do so by allowing medical and dental expenses but limits the deduction to the excess of 7.5 percent of your adjusted gross income. Essentially it wants to help but also wants to temper that help by considering your ability to pay. The government also recognizes that depending on our income and where we live we may pay a substantial amount of state and local taxes. It seeks to maintain a sense of fairness by allowing those taxes as deductions. These lines also give you a chance to ask “am I getting value for the state and local income taxes that I pay? If I am retired, is it worthwhile living in a high tax city and state? Could I run a business more profitably in another locality than where I am? Do I now have a good explanation as to why I enjoy a good income but seem to have little money left over?” Perhaps the most sacred line in all of the IRS forms is Line 10: Home Mortgage Interest and Points. It is the starting point and sticking point of any thought of tax reform. Originally included as a means of encouraging home ownership, it has now become an article of faith for the National Association of Realtors, the banking industry and most home owners. It is also pure bunkum. In order to claim the deduction, you have to pay the interest out of your income. But, what is the tax saving? A taxpayer with a marginal tax rate of 25 percent and an average tax rate of 18 percent would save between $2,500 and $1,800 in taxes on an interest payment of $10,000. But that figure is somewhat illusory because the banks, know full well that you are taking the deduction and set their interest rates upward to compensate. How can reviewing this figure help you? For planning purposes you know that the deduction in future years will be less because as you amortize the mortgage you decrease the amount of interest expense. You also know that your net worth will go up at a higher rate as your mortgage balance decreases. In planning for retirement you can compute what your income (that frightening figure on the income section) would have to be if you owned your property free and clear. Perhaps that figure will not frighten you as much. Also, “unlocking the equity in your home” by refinancing the mortgage might not be such a good idea. You would have to make a very strong case for the additional interest that you would be paying. “It’s tax deductible” doesn’t do it. Gifts to Charity (Line 16) is a nice touch. Again depending if you use your marginal or average tax rate you can determine the true cost of your deductions. Again you have to incur the expense to get the deduction, but if you are inclined to be generous, then a little bit of assistance is the Government’s way of thanking you. You are probably aware that eliminating this deduction as part of tax reform is also a non-starter. Job expenses, etc. are set out separately because the government is not so generous. It will allow the expenses but also limit them only to the amount that they exceed 2 percent of your adjusted gross income. Schedule C applies only to those who operate a business and will be the subject of another discussion. But, if you are planning to start a business it is a useful tool. You can experiment with different revenues and expenses and see what you could reasonably expect to earn if things go according to plan. Returning back to the second page of the return you can see how your adjusted gross income is further adjusted into taxable income (Line 43) and tax (Line 46). But again public policy raises its head with alternative minimum tax and tax credits for retirement savings contributions and child tax credit. Please note that tax credits differ from deductions in that credits reduce the amount of your tax whereas deductions reduce the amount of your taxable income. But again the government is not quite done because it has other taxes to charge: Note Self-employment tax (Line 57). This expense is about 15 percent of the net profit from a business. Now you can see why most businessmen are conservative and hate government. Assume that the business was successful and that the Taxpayer’s marginal tax rate is 25 percent. When he adds in the 15 percent in self-employment tax his rate goes to 40 percent. You can see why the IRS also has a self-employed/small business collection unit and why so many small businesses operate under the table. Payments get a little bit complicated but soon end at the point that you do pay attention to which is the balance due or the amount of refund. If you have used your tax return in following the discussion, you have probably raised more questions in your mind than we have attempted to answer. We hope that reviewing your form has induced you to think about the future. We are sure that we have convinced you that income tax and tax planning are complicated subjects.