TAXES AIN'T FAIR!

Tax reform has become a hot political topic.  Reduce taxes on the middle class, or increase taxes on the “wealthy” simply because they can afford it.

 

I see a great need for substantive tax reform not to reduce, or for some taxpayers increase, the actual amount of taxes paid – but to simplify the Tax Code and make it more fair.

 

Nobody ever said taxes are fair.  There are many inequities in the US Tax Code, some purposeful and some unintended.

 

Among the biggest inequities concerns how the Code treats some aspects of “gross income” and expenses related to generating this income.  I speak specifically of the taxation of gambling winnings and legal settlements.

 

If you have gambling winnings you must report, in most cases (how to report some winnings is a topic for another post), the gross winnings as income on Page 1 of the Form 1040.  This is the amount that is reported on Form W-2G.  So gross winnings are included in Adjusted Gross Income (AGI).  But gambling losses, to the extent of winnings reported, are deducted as a Miscellaneous Deduction on Schedule A if you are able to itemize (although not subject to the 2% of AGI exclusion).

 

Similarly, the gross amount of legal settlements, except for settlements for physical injuries or sickness (any damages or settlement you receive to compensate you for your medical expenses, lost wages, and pain, suffering, and emotional distress is not included in income), is included as income on Page 1 of Form 1040.  The legal fees, often as much as 1/3 of the settlement, and other related are also deducted as a Miscellaneous Deduction on Schedule A if you are able to itemize (in this case the deduction is subject to the 2% of AGI exclusion).

 

A taxpayer can have $5,000 in gross winnings from gambling activities for the year, but $6,000 in gambling losses.  So, the taxpayer’s gambling activity for the year has resulted in a loss.  The taxpayer ended up with no money “in pocket’ from gambling. 

 

If the taxpayer is able to itemize without taking into effect the allowed gambling losses, the Schedule A deduction for $5,000 in gambling losses results in net taxable income of 0 – so, in effect but not necessarily in reality, he/she does not pay federal income tax on the winnings.  But if the taxpayer is not able to itemize, even with the gambling loss deduction, or if he/she is only able to itemize because of the gambling loss deduction (without the deduction his itemizable deductions do not exceed the applicable Standard Deduction), he/she will be paying federal income tax on up to $5,000 of income that was not actually received – in the 25% tax bracket $0 in net gambling income could cost the taxpayer at least $1,250.

 

Similarly, with a taxable legal settlement, the need to deduct legal fees as a miscellaneous itemized deduction subject to the 2% of AGI exclusion could result in federal income tax being paid on more than the actual “in pocket” amount.

 

Of course, a large portion of the inequity comes from the fact that various items of income are increased and deductions and credits are reduced or eliminated based on one’s AGI.  And the fact that most itemized miscellaneous deductions are not allowed in calculating the dreaded Alternative Minimum Tax (AMT).

 

While a taxpayer may be able to wipe out gambling winnings with fully deductible gambling losses, the fact that gross winnings are included in AGI could result in more of the taxpayer’s Social Security or Railroad Retirement benefits (the amount of benefits taxed is determined by a formula that is based on AGI) being taxed – many frequent gamblers in the casinos of Atlantic City for example are senior citizens – or could reduce or totally eliminate allowable tax deductions or credits.  So again, the taxpayer is in reality paying federal income tax on $0 in net income.

 

The same is possible with a taxable legal settlement – except for settlements for discrimination claims, the related legal fees allowed as an “adjustment to income” which reduces AGI.  And, while there may be no excess tax under “regular” income tax rules there may be AMT.  Allowable gambling losses from Schedule A are fully deductible in calculating the dreaded AMT – but because legal fees are a miscellaneous deduction subject to the 2% of AGI limitation they are not deductible in calculating AMT.  So, tax is paid on the full amount of the gross settlement at a flat 26% or 28%.  When adding the federal and state tax to the legal fees the taxpayer may end up with only 1/3 or less of the actual award “in pocket”.

 

And while in many cases net and not gross gambling winnings are taxed under AMT, the fact that gross winnings are included in AGI, and therefore Alternative Minimum Taxable Income (AMTI), could reduce the AMT exemption, resulting in AMT tax on gambling winnings even if the net is 0.  $5,000 in gross winnings can reduce the AMT exemption by $1,250 and result in an additional $325 or $350 in AMT.

 

The AMT issue would go away if tax legislation repeals this tax.  And changing the way Social Security and Railroad Retirement benefits are taxed and no longer allowing AMT to affect tax deductions and credits would also help to remove inequities.  But the best way to do away with the unfairness of the tax treatment of these two types of income would be allowing taxpayers to net gambling losses against gambling wins (still not allowing the deduction of more losses than wins) and net legal fees against gross settlements – either directly by entering the net amount on Page 1 or by allowing the deductions as an adjustment to income reducing AGI – would certainly fix the problem.

 

So, what do you think?

 

FYI – I will post on other inequities in the current Tax Code in future posts.

 

TTFN

 

 

 

 

 

 

A TAX POTPOURRI

(1) One of the reasons I am called the “Wandering” Tax Pro is because once the tax filing season ends I enjoy travel via all methods – car, bus, plane, ship and train (not necessarily in that order). 

 

Over the past 30+ years my annual travel itinerary has often included several totally tax-deductible domestic vacations to attend tax-related conferences, conventions, and other CPE offerings.

 

You can deduct expenses that are “ordinary and necessary” for your business. An “ordinary” expense is one that is common and accepted in your specific trade or profession and a “necessary” expense is one that is helpful and appropriate. 

 

One “ordinary and necessary” business expense for which you can claim a tax deduction is the cost of education that is (1) expressly required by an employer, by law, or by government regulation, or (2) maintains or improves skills required in your current trade or business. If a conference or convention falls under this category the associated registration and travel expenses are deductible.

 

I have written a special report - POSITIVELY TAXES: A TAX DEDUCTIBLE VACATION - that explains in detail how to make your next vacation tax deductible by attending a job or business related conference or convention, and includes worksheets to help you keep track of your deductible expenses.

 

(2) It has always been important for frequent gamblers to keep detailed “contemporaneous” records of gambling activity to minimize the tax cost of winnings, but recent developments have made this even more vital. 

 

Gross gambling winnings must be reported as “other income” on Line 21 of your Form 1040.  Gambling losses, to the extent of reported winnings, are allowed as a “Miscellaneous” Itemized Deduction.  If you report gambling winnings of $10,000 on Line 21 of your Form 1040 the most you can deduct as gambling losses on Schedule A is $10,000.  Allowable gambling losses are deducted in full, and are not subject to the 2% of AGI exclusion.     

 

Losses from any type of wagering transaction can be deducted against your reported gross gambling winnings. If you win in the slots your deduction is not limited to losses from slot machines. You can deduct losses from the lottery, 50-50s, bingo, table games such as poker and blackjack, charity raffles, horse racing, keno, etc., up to the amount of your total winnings.

 

I have also written a special report – POSITIVELY TAXES: MINIMIZING REPORTED GAMBLING WINNINGS - that explains the basics of how gambling activity is taxed describes in detail how recent Tax Court case decisions allow you to reduce the amount of gambling winnings you must report, and reduce the tax cost of your gambling activity to a minimum, via proper documentation of your casino visit wins and losses.  It also contains valuable worksheets.

 

(3) For years now I have been telling clients and readers that it is your “Adjusted Gross Income”, or AGI, and not your net taxable income that is the most important number on your tax return.

 

Why is AGI so important?  Many tax deductions and credits are reduced, phased-out, or altogether eliminated based on your AGI, or in some cases a “Modified” AGI, and several items of income are increased, and some deductible losses are reduced, as this number grows.

 

There are “above the line” deductions and “below the line” deductions.  Above the line deductions reduce your Adjusted Gross Income and your Net Taxable Income.  Below the line deductions, which include the Standard Deduction, Personal Exemptions, and itemized deductions, reduce Taxable Income, but not Adjusted Gross Income.

 

A below the line deduction of $1,000 will reduce your tax liability by the amount of your marginal tax rate.  For a taxpayer in the 25% a below the line deduction of $1,000 will reduce the tax liability by $250.  But an above the line deduction of $1,000 can reduce the tax liability by substantially more than $250.  It is actually possible for a reduction of only $5 in AGI to reduce your tax liability by $500 or more!

 

Guess what?  I have written a special report – POSITIVELY TAXES: REDUCING ADJUSTED GROSS INCOME – that discusses how to reduce your 2016 AGI during the year and when preparing your Form 1040 and minimize your tax liability.  In it I explain how a reduction of $5 in AGI can reduce your tax liability by $500 or more.

 

The above referenced special reports are the first 3 items in MY NEW DOLLAR STORE (a work in process) -  and are available to you, as you might expect, for only $1.00 each sent as a pdf email attachment, or $2.00 each for a print edition sent via postal mail.

 

If you enjoy reading THE WANDERING TAX PRO and have found it helpful to you over the years one way you can say “thank you” is by purchasing one of the above POSITIVELY TAXES reports.

 

To order send your check or money order, payable to TAXES AND ACCOUNTING, INC, for $1.00 or $2.00 for each report you want and your email or postal address to –

 

MY NEW DOLLAR STORE

TAXES AND ACCOUNTING, INC

POST OFFICE BOX A

HAWLEY PA 18428

 

BTW – I also have more extensive and detailed TAX DEDUCTION GUIDES available for $2.00 or $4.00 each.  Click here for more information.

 

TTFN

 

 

 

TRAPPED BY OUR CAPITAL GAINS ARE WE

We all know, or at least many of us know, that long term capital gains (gain on the sale of investments held more than one year and capital gain distributions from mutual funds) and qualified dividends are taxed separately at special lower rates.  Those in the 10% and 15% brackets pay 0% tax on this income, those in the 25% - 35% brackets pay 15%, and those in the top 39.6% bracket pay 20%.  And that these applies to both the “regular” income tax and the dreaded Alternative Minimum Tax (ATM). Right?

 

Well it ain’t necessarily so {wow! 2 Broadway musical lyric references in one post!}.

Long-term capital gains and qualified dividends are reported as taxable income on Page 1 of the Form 1040 and are included in Adjusted Gross Income (AGI).  There are a multitude of deductions and credits that are reduced, phased out, or disallowed based on one’s AGI.  These include:

•  deductible traditional and spousal IRA contributions,

•  the ability to contribute to a ROTH IRA,

•  student loan interest,

•  the deduction for tuition and fees (if extended)

•  medical and dental expenses,

•  charitable contributions,

•  casualty and theft losses,

•  miscellaneous itemized deductions,

•  total Itemized Deductions,

•  the deduction for personal exemptions,

•  the Credit for Child and Dependent Care Expenses,

•  the Credit for the Elderly or Disabled,

•  the American Opportunity and Lifetime Learning education credits,

•  the Retirement Savings Contributions Credit,

•  the Child Tax Credit,

•  the Adoption Credit,

•  the Earned Income Credit, and

•  Coverdell Education Savings Account contributions.      

And as AGI increases so does the taxable portion of Social Security and Railroad Retirement benefits, and the deductible loss from rental real estate is reduced or phased out.

In the case of Social Security and Railroad Retirement benefits, an additional $1.00 of AGI can increase taxable benefits by as much as 85 cents.  So capital gain and qualified dividend income for a taxpayer in the 25% bracket could be effectively taxed at 21.25%, as an additional $1.000 in such income could increase taxable income by $850.

And even $10 in such income could cause a taxpayer to lose a $2,000 deduction for tuition and fees, if extended, and cost $500 in taxes in the 25% bracket.

Even though long-term capital gain and qualified dividend income is taxed separately at the special rates under the dreaded AMT, since this income increases AGI it also increases Alternative Minimum Taxable Income (AMTI), and could reduce the amount of the allowable AMT exemption.  $1,000 of such income could increase income subject to the 26% AMT tax by $250 and cost an additional $65.00.

And we all, or many of us, know that only $3,000 in net capital losses can be currently deducted on the Form 1040.  Any excess losses are carried forward to subsequent years.  If the total net loss for 2015 was $10,000, $3,000 is deducted in 2015 and $7,000 is carried forward to 2016.  So the loss is not lost.

 

But this is not the case on NJ or PA state income tax returns (I don’t know of any other states offhand).  These states do not allow any carryforward of capital losses.  So the $7,000 mentioned above is truly lost when it comes to state income tax.  Actually the entire $10,000 in losses are lost – as these states have a “gross” income tax system and do not allow capital losses from the sale of investments to reduce income in other categories.  

 

I am not saying to avoid long-term capital gains or losses.  The first criteria for evaluating any transaction, strategy, or technique you are considering should always be financial.  Taxes are second.  Never let the tax tail wag the economic dog.  Sell a stock or mutual fund shares for the best possible price.  By postponing a sale to meet the long-term criteria or to avoid having to report the income or losses on your tax return the price of the investment could drop and give you a smaller profit or greater loss.

Just be mindful of what I have discussed above, be aware of the true cost of your capital transactions, and consider increasing estimated tax payments or withholding if appropriate.  And consider harvesting losses to offset gains or engaging in a “wash sale” of investments that would generate a gain to offset losses at year end. 

It would be a good idea to discuss actual and planned investment activity with your tax professional periodically during the year, and especially at year end. 

THE FINAL WORD –

I am sorry – I cannot resist.

Speaking of it ain’t necessarily so.  The things that you're liable to hear from Donald Trump, it ain't necessarily so.

TTFN