The Internal Revenue Service has just completed and codified the new rules for 2007.  There are many changes, both personal and business, that will impact all of us, including us and the way tax returns are prepared. Let me start this letter with an ominous tone: AUDITS ARE ON THE RISE.  Over the last couple of months, we have had to deal with no less than ten Internal Revenue income tax and State of Pennsylvania sales tax audits.  The Governments are looking for money wherever they can get it.  The Internal Revenue Service has added at least one thousand auditors in order to get to more and more taxpayers. Be on the lookout over the next couple of years. On another ominous note, the Internal Revenue Service has imposed extremely strict restrictions on tax preparers with seriously harsh penalties on both the taxpayer and the preparer if certain risk management criteria is not followed.  For starters, since many tax issues can be construed many different ways, the IRS has determined that whenever a tax preparer interprets a legal regulation (as opposed to a factual regulation) in a certain way, it must be disclosed on Form 8275.  For example, if the preparer determines that a certain loss is a business loss instead of a capital loss, the tax treatment is different and must be disclosed.  Failure to disclose results in a substantial penalty for both of us, but full disclosure ensures waiver of penalty if the IRS does not allow the adjustment. If you remember in last year’s letter, we stated that more time will be needed to properly prepare most tax returns.  Now, it has come to fruition. Please be advised that, in order to a) properly prepare for a potential audit and b) cover all bases by filing the proper forms, it could take anywhere from one to three extra house to prepare a tax return. Tax preparers are now required to perform a sort of self-audit, where we need to break apart an income tax return as if we were IRS auditors. Alternative Minimum Tax About those IRAs Mortgage Interest Charitable Contributions Let’s talk credits Other Changes “S” Corporations: Wages and Health Insurance Alternative Minimum Tax (AMT), everyone’s favorite demon First, a few statistics: There are 135 million tax returns prepared in the United States every year.  In 2006, 3.8 million paid AMT.  In 2007, that number will rise to 20.5 million and, by 2010, the number is estimated to be 45 million.  It would cost in excess of one TRILLION dollars to repeal this tax… which is why Congress talks of correcting the problem but the Governments collects more from AMT than from regular income tax. Now the scary statistic: In 2007, 65% of married couples with 2 children and adjusted gross income of $ 75,000 - $ 100,000 will pay AMT.  That is most of you …. NOTE: AMT taxes, coupled with more stringent income tax rules, makes it imperative for all taxpayers to review their situation before the end of the year.  Please make an appointment to review your current status. About those IRAs Ok, Ok, I know that we have been a major opponent to the Roth IRA’s for years. However, certain changes in the law have made them extremely appealing. For example, if your child has earned income (and many of the small business owners can easily put their child on the payroll), then you can contribute up to 100% of his earnings, or $ 4,000 to a Roth in his/her name.  This is a way to put money away for college similar to a 529 plan but, get this, does not need to be disclosed for FAFSA purposes.  There are certain formalities that need to be addressed, but not entirely out of the realm of possibility.  Please call to discuss … Mortgage Interest Now, you may feel that mortgage interest is a category that even the IRS could not touch. WRONG!!  Mortgage interest is fully deductible when used for acquisition of the principal abode.  However, home equity loans and lines of credit are only deductible up to the first $ 100,000, unless used for acquisition. That’s $ 100,000 in principal, not interest. It is the burden of the taxpayer to differentiate whether interest is for acquisition or for any other reason.  Therefore, schedules will be needed to be maintained in my office to support our deduction. Be prepared to discuss this when you come in next year. Charitable Contributions Charitable contributions will, for the most part, be eliminated. We spoke a little about is last year, but now it is law.  All cash gifts in 2007 need a receipt from the charitable organization or a cancelled check (credit card is OK). Estimates no longer are usable so do not give to the Santa at the mall ringing the bell unless you cut him a check. All non-cash gifts, along with a formal receipt, needs some sort of substantiation. This means taking a picture of the clothing “in the bag” before giving to a charity. YIKES!!! Let’s talk credits… All of the credits available last year are still available this year with little change.  These include Dependent care, child credit, adoption, education, tuition, energy and foreign tax credits. However, as if you could not guess, only three remain intact for the AMT calculation: child, foreign and adoption. This effectively means that, if you qualify for AMT, the other credits are GONE… Other Changes For the small business owners out there, make sure that your health insurance policy is in the name of the company.  The new laws state that, if the policy is in the individual’s name, then the premiums must get added to the employee’s W-2 and social security taxes will be paid. OK, although there are many other smaller items, we promise that this is the last of the bad news: Limited Liability Companies (LLC) are finally being challenged by the IRS. What does that mean??? Well, in Seattle, a single person LLC that did not pay all of their payroll taxes was deemed to be a “disregarded” entity and held the owner personally responsible for these taxes. I see this as the beginning of the end for the single entity LLC.  Take note to make sure that you get another partner to avoid this problem. Now, what did they do this year to help us.  The quick answer is: NOT MUCH!! However, there are a few items.  Although most of you do not know what this is, the IRS has made it more attractive to invest in Health Savings Accounts (HSA). It is a way to beat the high cost of health insurance. Unfortunately, it is too complicated to discuss here, but feel free to come it and discuss. Also, most rules that center around retirement and retirement plans have been enhanced. This includes IRA (both traditional and Roth), nondeductible IRA’s, qualified retirement plans and 401(k) plans, especially the single person 401(k) plan. It has been a lot of years since the tax laws have changed so dramatically.  Suffice it to say that the Government needs money and is attempting to collect as much as possible. It cannot be stressed enough that proper planning is needed to avoid the pitfalls that Congress has placed all around the taxpayer perimeter.  Remember, Big Brother used to be watching, now he is playing!!! “S” Corporations: Wages and Health Insurance As many of you already know, the Internal Revenue Service has stepped up its auditing of "S" Corporations. There are two main areas that they are looking at: Reasonable compensation for corporate officers and the health insurance for any owner 2% or more of the corporation. It is expected that officers in an "S" Corporation will first receive an appropriate wage for their services prior to distribution of dividends or accumulated profits. For example, suppose the owner of an "S" Corporation worked full-time in the company and paid himself $90,000 in dividends, without taking any wages. That is not permitted under current IRS guidelines. The IRS expects to see a reasonable salary before dividends are paid. If the officer had paid out this money as salary instead of dividends, it would be subject to about $14,000 in employment taxes. Upon audit, the IRS could reverse the dividend and claim all in salary. However, all does not have to be paid in salary if you act proactively instead of reactively. The taxpayer could claim $45,000 in salary and $45,000 in dividends, if done prior to filing the return. This would save the company about $7,000 plus the intangible of audit exposure and extra accounting fee to defend yourself to the IRS. The health insurance tax deduction confuses most entrepreneurs. Although the laws have changed and health insurance for all stockholders in excess of 2% is now deductible, the amount paid must be reported as wages to the stockholder. Therefore, it is reported as wage expense to the corporation and wage income to the individual. But, on the individual's 1040 tax return, there is a line item where the amount is entered as a deduction and reduces income. The net effect is a deduction for health insurance paid. However, the social security office wins because the reclassification of health insurance premiums to wages creates an impact in social security taxes. Although the IRS has increased its exploration of "S" corporations, since there is over 5 million such companies, chances of audit are slim, but nevertheless, we are advocating the proper reporting of these items.