Grossbach Zaino & Associates, CPA's, PC


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Are You Serious?

Turning a hobby into a business can be an exciting proposition. But don’t get tripped up by the IRS’s “hobby loss” tax rules.

 

What’s the Difference?

 

Basically, a trade or business is an activity you engage in to make a profit (whether or not a profit actually results). A hobby, on the other hand, doesn’t have a profit motive. If the IRS views your activity as a hobby rather than a business, your tax deductions for business expenses generally will be limited to the extent of income from the activity.

 

What Does It Take?

 

The IRS will presume your activity is a trade or business if you’ve shown a profit in three of the past five years (two out of seven years if the activity involves breeding, showing, training, or racing horses). If your profit “picture” isn’t conclusive, there are nine subjective factors the IRS then uses to determine whether a profit motive exists.

 

A Tale of Two Court Rulings

 

A law firm partner who produced a documentary film in her spare time was found by the U.S. Tax Court to have a profit motive because she conducted the activity in a businesslike manner. Specific points in her favor included that she created a production company with separate bank accounts, obtained proper liability insurance, and spent numerous hours a week working on the project.

 

An individual who was a photographer, however, did not pass the profit motive test, said the court, because the activity was not conducted in a businesslike manner. Key factors included the photographer’s failure to keep a separate bank account and to make significant efforts to improve profitability.


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Avoid “Taxing” Moves When You Retire

Relocating after retirement may be one of your dreams, but make sure you’re wide awake when you do your planning. Not all states are created equal when it comes to taxes. Before you make a move, check out state and local tax laws to avoid unpleasant — and potentially costly — surprises.

 

Less Is More in Your Pocket

State income taxes can take a bite out of your retirement savings. Moving to a low- or no-tax state could save you a substantial amount of money. If you relocate to a state with an income tax, find out in advance how much you can expect to pay.

 

Less Is More for Your Heirs

The federal estate-tax exemption is $5.43 million for 2015. But some states also impose estate taxes, often with a much lower exemption amount than at the federal level. If estate taxes are a concern, check state laws before you move.

 

Look at Everything

Income and estate aren’t the only taxes you need to consider. Look at state and local sales and property taxes as well. States that are popular relocation destinations may experience rising property values, which can mean higher property taxes. Be sure to evaluate the whole tax situation, not just one aspect of it.

 

Some States Give You a Break

A number of states offer tax breaks to retirees, such as excluding distributions from qualified retirement plans or individual retirement accounts from state income taxes. Your tax advisor can help you research the rules.


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Avoid Mistakes: Inheriting Your Spouse’s IRA

No one wants to think about losing a spouse, but it’s good to understand how finances work when one does. For example, inheriting an IRA from your spouse can get complicated. Consider the following points.

 

Age is important

 

It generally makes sense to roll over an IRA inherited from a spouse to your own IRA if you’re age 59½ or older when you inherit it. Why? You can withdraw money from your IRA if you need to without worrying about the 10% early withdrawal penalty. And the rules for taking annual minimum distributions from the IRA won’t apply until you turn age 70½.

 

If you’re younger than age 59½, you may be better off setting up an inherited IRA in your deceased spouse’s name. Withdrawals from an inherited IRA aren’t subject to the 10% early withdrawal penalty regardless of the beneficiary’s age.

 

With an inherited IRA, most beneficiaries must take required minimum distributions every year based on their life expectancies (generally starting the year after the IRA owner dies). However, with an IRA inherited from a spouse who dies before age 70½, the surviving spouse can postpone taking required minimum distributions until the year the deceased spouse would have turned age 70½.

 

In either scenario, withdrawals will be subject to federal (and possibly state) income tax unless they’re qualified Roth IRA distributions.

 

Look at the big picture

 

Before making any decisions, meet with your financial professional to review your overall financial situation. For example, maybe you’d be better off spending life insurance proceeds than taking money from an IRA prematurely. And for your family’s future financial security, your financial professional can help determine if you have sufficient life insurance coverage. Also, work together to review how the IRA assets are invested in terms of your financial needs and overall investment program.


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Are Annuity Payments Taxable?

Typically, at least a portion of an annuity payment is taxable.* Taxpayers should be careful to distinguish between the portion that represents a nontaxable return of the amount paid for the annuity and the taxable portion.

 

General Rule

 

To do this, the taxpayer generally divides the original, after-tax contribution by the expected return on the date the annuity begins. The cost/payout ratio, or “exclusion ratio,” is then multiplied by each installment payment to determine the nontaxable amount.

 

Example. Mary paid $10,800 for an annuity that will pay her $100 per month for 20 years. Mary’s expected return is $24,000. The exclusion ratio is 45% ($10,800/$24,000). For each $100 installment, $45 will be nontaxable, and the remaining $55 will be taxable.

 

Note that the expected returns on annuities may vary with the amount and the measuring term. Where the measuring term is someone’s lifetime or joint lifetimes, the IRS has tables for determining the expected return.

 

With variable annuities, the payout may vary based on such things as investment performance or changes in a particular index. Generally, the exclusion ratio is calculated by dividing the cost of the annuity contract by the total number of anticipated payments. However, if the nontaxable portion exceeds the actual payment, the taxpayer may elect to recompute the exclusion ratio for later years.

 

“Qualified” Annuities

 

Individuals sometimes receive all or a portion of the money in their qualified retirement plan accounts as an annuity. Such annuities are referred to as “qualified” annuities, and the method for calculating the exclusion ratio is similar to those described above. Note, however, that if the account assets consist entirely of pretax salary contributions (and earnings on those contributions), the exclusion ratio will be zero, and each installment will be fully taxable.

 

* Different rules apply to withdrawals, dividends, and loans from annuity contracts.


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Alimony and the IRS

If you and your spouse are ending your marriage, you’ll have many decisions to make. You will have to divide your belongings in a fair and equitable way. If you have children, you’ll have to work out custody arrangements. You may even have to decide who keeps the cat or the dog.

Another important decision you’ll face is whether alimony payments will be part of your divorce decree. This decision can have significant tax consequences for both of you. The IRS rules regarding alimony payments are complex. Before your divorce agreement becomes final, both you and your spouse should understand the tax implications of your arrangement.

The Rules

Alimony payments are tax deductible by the person who pays them and are considered taxable income to the recipient. However, to be tax deductible, alimony payments must meet certain requirements. For one thing, payments can’t be voluntary — they must be required by your divorce or separation agreement. Payments must also be in cash. You can’t, for example, do yard work or buy your ex a new TV and have that count as alimony, although you can agree to cover a specific expense such as the rent or mortgage.

You and your former spouse must be living apart for payments to qualify as alimony. And payments must stop if the recipient dies. If payments are to continue, none of the payments — even those made while the recipient is living — are deductible. However, if alimony payments stop because your ex remarries, their deductibility is not affected.

Child Support Is Different

Unlike alimony payments, payments made for child support are not tax deductible by the person paying them, nor are they considered taxable income to the person who receives them. If alimony payments will decrease once a child reaches a certain age, the differential is treated as nondeductible child support.

Your tax situation and that of your spouse may affect your decision to designate payments as tax-deductible alimony or nondeductible child support. See your tax advisor for guidance.


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Above-the-Line Deductions

Any deductible expense is useful because it reduces the amount of income subject to tax. But for individual taxpayers, deductions that can be claimed in arriving at adjusted gross income (AGI) — referred to as “above-the-line” deductions — are especially significant. By lowering AGI, above-the-line deductions increase your chances of qualifying for various other deductions and credits.

 

Here are some of the above-the-line deductions available for the 2015 tax year.

 

Alimony. Generally, payments are deductible if they were made in cash pursuant to a divorce or separation instrument. Other requirements may apply.

 

Traditional IRA contributions. Contributions of up to $5,500 ($6,500 for individuals age 50 or older) to a traditional individual retirement account (IRA) are potentially deductible on your 2015 return. AGI-based limitations apply if you (or your spouse) are an active participant in an employer-sponsored retirement plan.

 

Rental property/trade or business expenses. Expenses associated with property held for the production of rents are deductible above the line on Schedule E, whereas sole proprietors deduct their trade or business expenses above the line on Schedule C.

 

Student loan interest. Taxpayers may deduct up to $2,500 of interest expense on qualified higher education loans, though phaseouts apply to those at higher levels of modified AGI.

 

Moving expenses. Subject to certain requirements, a taxpayer who moves as a result of a change in his or her principal place of work may deduct certain costs of moving and traveling to the new residence.

 

Health savings account contributions. The 2015 deduction limits are $3,350 for those with self-only coverage under an eligible high-deductible health plan and $6,650 for those with family coverage. An additional $1,000 deduction is available to those 55 and older who are not enrolled in Medicare.

 

Self-employed taxpayers. The self-employed also may be able to deduct retirement plan contributions, qualified health insurance premiums, and a portion of their self-employment taxes.


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ABCs of Saving for College

It’s no secret that college costs have risen dramatically in recent years. Setting up an education savings program as early as possible can help you manage the ever-rising costs of post-secondary education for your children or grandchildren. Two types of college savings vehicles — qualified tuition programs, also called Section 529 plans, and Coverdell education savings accounts (ESAs) — offer income-tax benefits.

 

529 Plans

Most states offer some form of 529 plan. There are two types of programs — prepaid tuition programs and college savings plans.

 

Prepaid tuition programs let you lock in today’s tuition rates by purchasing credits or units of tuition in “today’s dollars” for your children’s use when they actually attend college at some future date. Typically, the units purchased are based on the average public school tuition rate in the state offering the plan. Generally, you may purchase amounts of tuition through a one-time, lump-sum purchase or monthly installments.

 

College savings plans, however, are the more common type of 529 plan. Minimum contribution requirements are generally very low. Once an account is set up, you typically may choose among several investment options.

 

For federal tax purposes, earnings on 529 plan investments accumulate on a tax-deferred basis. Distributions used to pay qualified education expenses* are excluded from taxation. Many states also exempt earnings and distributions from income taxes, and some even allow a deduction for contributions. Certain state benefits may not be available unless specific requirements (e.g., residency) are met.

 

Coverdell ESAs

You can establish an ESA at a bank, brokerage firm, insurance company, or other financial institution. ESAs are self-directed and must be funded with cash.

 

Subject to income limitations, you can make nondeductible contributions of up to $2,000 per year to ESAs for each child younger than 18 years old (and for special needs beneficiaries of any age). Your eligibility to contribute to an ESA is phased out with adjusted gross income (AGI) from $95,000 to $110,000 if you are an individual taxpayer or from $190,000 to $220,000 if you are a married taxpayer filing a joint return.

 

ESA distributions that are used to pay qualified education expenses are not subject to federal income taxes. Qualified education expenses include not only tuition and fees, but also books and supplies and, for students enrolled at least half-time, certain room and board charges. In addition to undergraduate and graduate-level education, ESAs can cover elementary and secondary public, private, or religious school tuition and qualified expenses.

 

 

* Includes tuition, fees, room and board, books, and supplies and equipment required for enrollment.