Understanding taxes for Dummies or Why you should always use a tax consultant.
A few thoughts on taxes.
A few thoughts on taxes.
Understanding Tax BasisIncome tax is a topic that is perhaps fresh on everyone's mind during this time of year. Few people, if any, look forward to the process of getting information together and the trip to the tax preparer. Dreaded even more is the trip or letter back from the preparer informing you of the results of their calculations and amount, if any, of tax you owe. If what your preparer tells you is a surprise, you might benefit from either better records, more current records, preparing a tax estimate before the end of the year, better understanding of the tax laws or maybe all of the aforementioned.
The mission of the Internal Revenue Service (IRS) is to collect the proper amount of tax revenue at the least cost to the public and in a manner that warrants the highest degree of public confidence in the Service's integrity. The IRS does not make tax laws. The United States Congress does that.
The IRS is basically only a collection service. It is each United States citizen's responsibility to pay their share of government via the correct and truthful reporting of their income and deductible expenses and calculation and payment of any tax due. A citizen is not required to pay more than what is mandated by tax law. The burden is the taxpayer's to make sure they pay only their share and not more than what the law requires.
In many instances there is a difference between what the "true" tax liability is and the amount that is voluntarily paid. The difference can be in IRS's favor if an individual or their preparer is not current on tax law. It is important for each individual to know what IRS's function is and what our obligation and rights are as taxpayers. On occasion more tax could be paid if we fail to take advantage of deductions and management opportunities allowed by the tax law.
One of the best ways to minimize the possibility of a surprise at income tax filing time is to complete a tax estimate a month or two prior to the end of your tax year. The information needed to prepare a tax estimate is an account summary of all income and expenses to date and a projection of what income and expenses you expect for the remainder of the year. It sounds rather simple.
However, the account summary of all income and expenses to date requires you to record your business transactions as they occur or at least have them all recorded by the time you prepare a tax estimate. I realize the record keeping wheel does not screech very loud during the year and therefore receives very little grease or amount of your time.
The screeching normally starts toward the end of January or the end of the next month after your tax year ends. At that time very little other than maybe an Individual Retirement Account contribution can be done to change your tax situation. This is the reason for preparing a tax estimate prior to the end of the tax year.
The tax law in 1998 will allow each family of two married filing jointly $12,500 of tax-free income. For each additional dependent add $2,700. If you do not generate or manage your business to have at least that much income you are missing out on an allowance the tax law is giving us.
Another opportunity in 1998, 1999, and 2000 available only to individuals engaged in farming is the averaging of farm income. An election is available to add one-third of the "elected farm income" (it does not have to be all the farm income) to each of the three preceding tax years.
The increase in taxes in those years are totaled and added to the tax computed on income less elected farm income for the current year. If the tax is less than the tax without averaging the election can be made and the lessor tax paid.
These are only two examples of ways to manage your taxable income. Be careful not to "over manage" to the point where we miss out on tax free income. It is not necessarily bad to pay some income tax. In most situations it requires making a profit before any tax is due. And most of us like to make a profit. With current records, some knowledge of tax laws and the preparation of a tax estimate, you can reduce the surprises from your preparer while minimizing your tax obligation over time.
Source: http://www.noble.org/ag/economics/taxbasis/index.htmThe importance of basis is best understood when it comes time to settle up with Uncle Sam each year. The basis one has in capital assets affects how much tax he or she will owe. Basis is the term the tax law uses to refer to the amount of investment a taxpayer has in business assets. The expense or investment in some business purchases such as feed, seed, and fertilizer can be deducted completely the year of purchase. The Internal Revenue Service (IRS) refers to this as expensing, which is allowed on these items because they do not have a useful life beyond one production season, unlike other items called capital assets, such as tractors, cows, and most machinery. The IRS requires businesses to capitalize the cost of these items.
Each item or asset has an assigned life, often referred to as tax life. During each year of the asset's tax life, you can deduct or recover a portion of the initial investment as a depreciation allowance. The remaining investment or unrecovered cost is the asset's adjusted basis. If an asset is sold before the end of its tax life, the difference between the purchase price and the adjusted basis is subject to income tax. If the asset is sold for more than its purchase price, the portion above the original purchase price will be taxed at the capital gain rate. The IRS adjusts the basis for depreciation allowable, even though it may never have been deducted.
There is a provision in the tax law that allows a taxpayer to expense an asset rather than treat it as a capital expenditure the year the asset is placed in service: a Section 179 Expense Election. The maximum Code Sec. 179 deduction is $19,000 for tax years beginning in 1999 and $20,000 for those beginning in 2000. For example, if you are a calendar year taxpayer, you could purchase a $30,000 tractor this year and expense or deduct $20,000 this year as a depreciation allowance. You could then deduct a portion of the remaining $10,000 each year throughout the tax life, leaving a zero basis in the tractor at the end of the tax life.
An item used solely for personal use may later be converted to business use – for example, an automobile, refrigerator, lawn mower, or other asset adaptable to both personal and business use. The proper basis for depreciation in such a case is the fair market value on the date of conversion to business use or the adjusted basis, whichever is lower.
There are some interesting twists to the tax law concerning basis when it comes to receiving property by gift or by bequest or inheritance. If property is acquired by gift, the basis for depreciation is the donor's (the person making the gift), which passes to the donee (the person receiving the gift). If the property is later sold by the donee, the basis for determining gain on the sale of the property is the same as it would have been in the hands of the donor. On the other hand, if property is acquired by bequest or inheritance, the new owner uses the fair market value of the property at the death of the previous owner as the basis. If the property is later sold, there could be a significant difference in the amount of tax owed, depending on how the title to the property was received. An example may help to clarify the difference. Let's say a farmer gives his child a piece of land that cost $20,000 and is worth $50,000. If the child later sells the land for $50,000, he or she would have to pay tax on $30,000, the difference between what the father gave for the land ($20,000) and the selling price ($50,000). Now if the child inherited the land, the basis would be the fair market value at the time of the father's death. The child would receive what is referred to as a stepped-up basis in the land. Later, if the child sold the land for $50,000, there would be no tax due because the basis in the land was the same as the selling price. Land cannot be depreciated because it has no distinguishable life–it is never considered used up, so the basis in the land stays the same.
Difference in basis and potential gain to be taxed
Method of Land Receipt Basis ($) Sale Price ($) Taxable Gain ($)
Gift 20,000 50,000 30,000
Inheritance 50,000 50,000 0
I should mention that when land is transferred by will, there are probate costs that vary with the will's complexity and can often be avoided by using trusts.
Many things can complicate the simplicity of this example, such as mortgages assumed by the new owner and possibly probate procedures. In addition, the tax law has limits, exceptions, and certain quirks that are applicable. However, the principles discussed here are still relevant. It is advisable to seek the counsel of a professional competent in farm taxation or intergenerational transfer before making any decisions. As demonstrated here, though, there can be substantial tax savings with proper planning.
