After I wrote The Step Transaction Doctrine at my companion site, RothMania, I received a number of emails asking about situations where this might apply. Here’s an example of another disallowed series of transactions:

A) A son and wife are in a high tax bracket. Enough so the AMT effect causes there long term capital gain to be taxed at 22.5% (really 15% plus extra due to AMT). They gift the son’s parents $50,000 in appreciated stock.
B) The parents, who are in a low bracket, sell the shares and have no tax due as there’s no cap gain tax if you are in the 10 or 15% bracket.
C) Parents then gift their son and his wife $50,000, the proceeds of the sale.

In a Q&A a few years back my favorite IRA author Ed Slott offered a definition of the Step Transaction Doctrine:

The step transaction doctrine can be a bit complicated, but essentially, when applied it treats what are actually several independent steps as if they were a single transaction for tax purposes. 

There are three different tests which have been used to determine if the step transaction doctrine should apply. One test, commonly referred to as the “binding commitment test” applies when there is a commitment to complete a later step in an overall transaction at the time the first step is made. Since an IRA contribution (deductible or not) does not require that one convert the contribution to a Roth IRA, this test is a non-factor here.  

Another test that is used to determine if the step transaction doctrine should be applied is the “mutual interdependence test.” This test looks at each step in an overall series of steps and determines if a specific step is meaningless unless the later step(s) actually occurs. Since a non-deductible IRA contribution is clearly beneficial (read “not meaningless”) on its own, this test is also a non-factor.  

The third and final test, known as the “end result test,” is the most applicable for this discussion. Under the end result test, the steps in a transaction are looked at to see whether the series of steps were really just predetermined steps of a single, overall transaction, aimed at achieving a specific outcome. Do clients make IRA contributions with the idea that they will later convert them? Sure. So is it possible for IRS to raise issues with this strategy in the future? Yes, but it’s not a likely scenario.

You can see that each of these events, taken alone, is perfectly legitimate. It’s only when they are combined in this way that the IRS combines the transactions and would go back to our Yuppie couple along with a tax bill.
The key thing to ask yourself is whether each event was legitimate, and in this case, there’s really no bona fide gift to anyone, the transactions are simply tax avoidance. Will you get caught? That’s the wrong question. You see, once you start asking what your chances are, it’s a slippery slope. Best to avoid deals that look like this regardless of what your ‘advisor’ tells you. At RothMania, a reader’s brother has a tax attorney who was encouraging him to skirt this rule, either that or the lawyer was completely ignorant of it. In either case, I’d stay clear of any advisor who makes such proposals.  If it sounds too good to be true, it might just be tax evasion.

written by Joe \\ tags: step-transaction-doctrine, tax-evasion, Taxes

A pre-taxday guest post from Home Daddys’ Mike Freidberg -

Save yourself time and money

April is upon us, and as usual, a majority of Americans are scrambling to get their taxes figured out so they can file on time. As we near the big day, here are 10 of the most common mistakes made by Americans that you shouldn’t be making.

Filing late

One of the biggest mistakes Americans seem to make every year is that they file their taxes late. It’s one of the most talked about dates during the year, rivaling Christmas and New Years in media attention every season. While exact numbers of how many Americans forget to file on time is hard to pin down, the IRS apparently thinks it’s a big enough issue that last year they decided to increase the penalty for filing late, and hire scores of new employees to help enforce it.

Avoiding filing because you can’t pay

You should know that the IRS sets the penalty for not paying and the penalty for not filing separately—meaning even if you can’t pay, you can avoid significant penalties by applying for an “offer in compromise”, or making monthly installments on your tax bill. None of these options are particularly attractive, so you’re better off saving up for tax day, but there’s never a good reason to put off filing.

Under-reporting your income

Whether you use a W-2 or a 1099, there’s absolutely no point in reporting less earnings than you actually received. Your employers and clients have to report what they’ve paid you, and they’ll be sure to declare every penny to keep their own taxes low—so if your numbers don’t match theirs, the government won’t have any trouble finding out about it. Snag every possible deduction you can, but never lie to the IRS.

Incorrect business deductions

The IRS spells it out pretty clearly on their website what can be used as a deduction for your business. Take some time to review it and figure out what deductions apply to you. If you do operate your own business, be prepared by ensure that whoever you use for your merchant card services provides you with annual or quarterly statements for your records.

Claiming phony dependents

It’s hard to see your children leave the home and head off to college, but it’s even harder a couple years later when you realize you can’t claim them anymore. It’s not difficult for the government to cross check your tax returns with those of your dependents, so do yourself a favor and stop claiming them they start paying their own income taxes.

Missing charitable contributions

Turns out America is a pretty generous country when it comes to charitable giving, but many filers forget or neglect to fill out this portion of their taxes. It’s an easy write off and a great way to ensure your money is going to the exact causes you want. Be sure to include any donations you make to Goodwill, as well as any religious organizations or non-profits you support.

Getting your math wrong

Use a calculator. Better yet, e-file. Bad math can not only cost you on getting back all your refund, but it can even spur an audit if you mess up badly enough. Have someone else double check your figures before you file.

Mike Freiberg is a staff writer for HomeDaddys, a resource for stay-at-home dads, work-at-home dads, and everything in between. He’s a handyman, an amateur astronomer, and a tech junkie, who loves being home with his two kids. He lives in Austin.

written by Joe \\ tags: tax, tax-errors

Note – this ‘letter’ is to my mother-in-law, whom I sometimes just call ‘mom,’ even though she’s fine with my using her first name. She’s a widow, and in her 80′s.

Dear Mom,
It’s no burden for me to do your taxes, in fact, I enjoy the process. After you and dad (who passed away almost 8 years ago) told me what you were paying for your tax guy, I thought I could save you that money to spend on something else. The fact that the tax guy wasn’t really a financial planner also gave me the opportunity to offer some advice that would help save on your tax bill each year.

I just looked at the folder of paper to start doing this year’s return. Wow. A lot more than we really need. Here’s why – you don’t itemize. To take any deduction for medical expenses, you need to be out of pocket more than 7.5% of your adjusted gross income. Even though your bills feel like they were in the thousands, the amount you had for copayments didn’t even add up to $1000. Your standard deduction is $7400. Your Condo property tax and interest (you own your unit, but there’s a master mortgage on the property) along with your donations aren’t anywhere near this. A few years ago, when you had one really large donation we used a Qualified Charitable Distribution from your IRA. Since you were going to make that donation anyway, by using money from your Required Minimum Distribution (RMD), it made that distribution tax free. I thought that was pretty cool, but this year it was pages of small donations, so we agreed to pass on the QCD trick.

All in all, there are a handful of numbers to enter. Your pension, dad’s pension you still receive, social security, and the transactions from your brokerage accounts. What makes it even easier is that TurboTax (disclaimer, right here, for FTC, this is an unpaid mention) will pull the yearend data from your Schwab (FTC – ditto) account, so I don’t even type those numbers in.

The other thing I do for you is to convert a bit of you IRA each year to your Roth account. This way you pay 15% on the money, and it keeps growing tax free. If we didn’t do this, your RMDs would keep increasing each year and you might be pushed into the 25% bracket. You’re not even spending your RMD, and the girls and I keep telling you that you should spend more on yourself. But, if you need to withdraw more than your RMD and should start to hit the 25% bracket, you can use the Roth money. If I did two thing right for you, it was this – a balance of stocks and CDs so you were buying in at the bottom, and rebalancing at the tops. You have more now than you did 10 years ago, even after withdrawals. And keeping your tax rate right at 15%. This is one strategy that’s perfect for someone in your situation, just enough income to let you convert a bit each year to top off that bracket.

I hope you understand a bit better why I don’t need all that other stuff every year, but I’m pretty sure it will all be there next year when I look at your 2013 return. And I’ll explain again, ‘you don’t itemize!’

written by Joe \\ tags: IRA, Retirement, RMD, roth ira, Taxes

Take simple steps to reduce your stress on the big day.

Meeting with professionals or doing taxes yourself can prove stressful, as it’s often required to have numerous documents, legal forms, bank account information, tax IDs, and more, all at your fingertips. Here are some tips from professionals that can help you make this tax season a little less stressful.

1. Get organized

Even though we are well into the new year, it’s never too late (or early) to start organizing and collecting forms and documents you’ll need to do your taxes. If you haven’t received a W2 or W9 from last year’s employers, give them a call or send an email requesting a digital copy and a printed copy mailed to your residence. Having the digital copy stored on your computer in an appropriately labeled folder can help you keep documents organized and easily available should you lose the physical copy. In addition to requesting digital copies of forms scan in or take photos with your cell phone of the various physical tax-related forms you’ll be receiving, you’ll thank yourself later.

2. Ask the right questions

As you request and organize your tax forms, be thinking of questions you have about filing taxes for this year. Have you invested more than usual, taken money out of stocks, bonds, or an IRA? Have you spent more than usual on education, your mortgage, a car, or received a large sum of money from a deceased relative? Write down any questions or note-worthy events that happened during the year, and any numbers related to those things for reference when filing your taxes. If you meet with a tax professional, be sure to raise your questions when you begin, and if you’re filing yourself with software, make sure during the process your questions were addressed (if not, email customer support for clarification).

3. Search for deductions

Before you meet with your tax professional or start filing on your own, start looking up deductions related to the questions you’ve written down. Think of anything you spent money on this year that was outside the norm, and search for tax deductions related to your expenses. You may be eligible for reimbursement for home improvement items like roofing, air conditioner repair, or energy efficiency upgrades. Tax incentives for fuel efficient cars, education, starting a business, or donating to a church or other charity are also commonly overlooked by people filing their taxes.

4. Use legitimate software

If you’re going the do-it-yourself route of filing taxes, make sure you use some legitimate software that’s been well reviewed. Especially during this time of year, internet advertisements explode across the web directing users to use foreign, questionable, or insecure tax filing solutions. Most legitimate companies that offer software for filing from home will offer email, phone, and web support to help ensure you have the help you need to get your questions answered. Make sure you look at the beginning of the web address you’re using for “https://” instead of just “http://”which signifies a secure and encrypted connected with the remote server.

5. Plan to e-file

Filing your federal taxes is free and easy when you use the government’s e-file system. Most software based tax companies offer to file your federal taxes for free, as it’s so easy to do already. The main benefit to e-filing your taxes with the federal government is that your return is almost guaranteed to come weeks if not months earlier than if you opt for the mailing method.

Aimee Watts is a staff writer for Mobile Moo. She has spent ten years telecommuting full-time, and loves spreading tips and advice for fellow work-at-home parents. She loves gadgets, new ideas, and skiing with her two favorite people: her husband and teenage son. They live in Evergreen, Colorado.

written by Joe \\ tags: deductions, Finance, irs, Taxes

A few weeks back, a story made the news about a Pastor who received a bill at an Applebee’s that included an 18% tip as the Pastor was part of a group of 20 people. Keep in mind, unless you have been hiding under a rock for the last 50 years, it’s common to see menus state that for a party of usually 6 or more, the tip is automatically added to the bill.  Also note that the party of 20 asked for 20 separate bills, which I can only imagine is a waitress’s worst nightmare. The one customer of 20 refused the tip, crossed it off the receipt and wrote, “I give God 10%, why do you get 18?” The story takes an interesting turn after another waitress put the receipt on the internet.

It came to the Pastor’s attention, she complained to Applebee’s and the waitress that put the receipt out there was fired. The Pastor was quoted elsewhere as saying “The note was “a lapse in judgment that has been blown out of proportion,” adding that she left a smaller tip in cash on the table.
Smaller than the $6 that was on her bill? Hmmm.

That’s my (too) long introduction to today’s message. The IRS asked me to remind you that if your pay from your job includes tips, there are a few things you should be aware of:

• Tips are taxable. Individuals must pay federal income tax on any tips they receive. The value of non-cash tips, such as tickets, passes or other items of value are also subject to income tax.
• Include all tips on your return. You must include all tips that you receive during the year on your income tax return. This includes tips you received directly from customers, tips added to credit cards and your share of tips received under a tip-splitting agreement with other employees.
• Report tips to your employer. If you receive $20 or more in cash tips in any one month, you must report your tips for that month to your employer. Your employer is required to withhold federal income, Social Security and Medicare taxes on the reported tips.
• Keep a daily log of tips. You can use IRS Publication 1244, Employee’s Daily Record of Tips and Report to Employer, to record your tips.

It can’t be easy waiting tables, so if that’s your job right now, I hope these customers are few and far between. I promise you, I won’t be one of them, I go out to dinner to relax, not to give anyone grief.

written by Joe \\ tags: irs, Taxes, tip