Home Office Deduction Challenges You Should Know

Tuesday, 31 March 2009 07:45

If you are planning to take a home-office deduction on your tax return this year, consider carefully the advantages and disadvantages.  This deduction has an interesting and often conflicting history.

Tax Court Ruling 1990

In 1990, the U.S. Tax Court ruled that if “a taxpayer’s home office is essential to his business, he spends substantial time there, and has no other location available to perform the office functions of the business,” the taxpayer is entitled to a deduction.

The case the Tax Court ruled on involved a Washington, D.C. area anesthesiologist, Nader E. Soliman, who practiced at three hospitals but who had office space at none of them.  He spent a third of his time at his home office doing billing, arranging hospital admissions, maintaining financial and medical records and keeping up on his professional reading.  The Tax Court felt he was justified in writing off his office since it was essential to his practice.

The ruling liberalized the old, so-called “focal-point test,” which forced the taxpayer to show that the home office was the focal point of his or her business.  Under the focal-point test, the room set aside in the home had to be used exclusively and regularly as a principal place of business, or as the place where the taxpayer met clients.

None of this sat well with the Internal Revenue Service (IRS).  They appealed the Soliman decision all the way to the Supreme Court, and won a reversal.

Taxpayer Relief Act 1997

The Taxpayer Relief Act of 1997 eased requirements for deducting expenses of a home office, effective starting with 1999.  To qualify as a home office today it must be “a principal place of business”.

Outside Offices

Under the new rules, you may qualify to claim the deduction, even if you never qualified before.

Beginning in 1999, it became easier for your home office to qualify as your principal place of business.  Your home office will qualify as your principal place of business for deducting expenses for its use if you meet the following requirements.

• You use it exclusively and regularly for administrative or management activities of your trade or business
• You have no other fixed location where you conduct substantial administrative or management activities of your trade or business

If you are an employee, the business use of your home must be for the convenience of your employer.  The limitation of your deduction may be less if your gross income from the business use of your home is less than your total business exp

Pros & Cons

The advantages of a home office are the availability of certain “above the line” deductions that would either ordinarily be personal and unallowable, or if business, subject to 2% of Adjusted Gross Income (as an employee).  Other advantages are an increased transportation deduction, a reduction of Self Employment tax and a reduction of Adjusted Gross Income resulting in increased deductions dependant on a percentage of AGI floor (medical, casualties, miscellaneous deductions, etc.).

Disadvantages include part of the home sale exclusion becoming subject to capital gains, and reduced benefits from retirement plans and social security.

The advantages and disadvantages must be weighed to determine the greatest tax advantage, i.e., will home office deductions (including an increased transportation deduction), taken over a number of years, reduce taxes more than the increase caused by capital gains tax on the office part of the residence.

In many instances the transportation deduction, computed from the home office to the customer or clients’ place of business, is the major advantage of having a home office.  Consider a very small home office, i.e., a very small percentage of the home sale deduction lost, and still retain the ability to deduct transportation costs.

If you plan in advance to sell your residence you can terminate your home office for the final two years before sale and meet the two year principal residence out of the final five years test and not lose any of the home sale exclusion.

An IRS Alert!

Home-office deductions tend to be big red flags to the IRS.  If the IRS audits you, you could end up owing back taxes and interest on the office expense, if disallowed, plus anything else they found while conducting the audit.

Summary

Talk with your tax and financial professionals before you make any decisions that have important tax consequences.  Your planner cannot change the laws, but he or she can help you be flexible in your planning so you do not unexpectedly get a tax door slammed in your face.

Brock and Associates, LLC is a fee-based financial planning firm specializing in tax and business planning.  For more information on other tax planning topics, be sure to visit our article archive.

How Pareto's Law Applies to Insurance Planning

Tuesday, 10 March 2009 08:49

You are probably familiar with Pareto’s Law.  It says, in effect, that almost everything in life somehow breaks down to an 80/20 ratio.  For example, 20% of the people accomplish 80% of the work, or that 20% of the people earn 80% of the money, and that losers outnumber winners by 4 to 1.

Vilfredo Pareto was an Italian economist who died in 1923.  More than sixty years later, we are finding ever-new applications of his “law” in modern economic circumstances.

No one really knows how Pareto’s Law holds up under scientific scrutiny.  However, we do know one place where it seemingly does have validity and that is in a mortality table.  We know, for example, that about 20% of males who reach adulthood will die before age 65 and the remaining 80%, of course, will die thereafter.

The only thing we do not know is which people are going to end up in that 20% category.  Not knowing into which group a person is destined to fall, makes it necessary to prepare for both the short term and long term problems.

Those who fall in the 80% category - who are going to make it to retirement age - have a more complex, but no less acute problem.

This larger group needs money for two reasons:

• To provide income during retirement years
• To provide for the inevitable event, death after age 65

They need to create an estate, conserve an estate or provide income to a surviving spouse.  In planning one’s estate, there are two kinds of death to contend with:

• Premature death (the 20% problem)
• Death somewhere around life expectancy (the 80% problem)

Term insurance can be a most effective way of solving the 20% problem.  Unfortunately, it is completely ineffectual in solving the death-at-life-expectancy problem.  Not only does the cost of term insurance become prohibitive over the years, worse yet, the coverage runs out.

Term insurance is actuarially calculated to expire about five years before the holder.  In New York, for example, term insurance is available only to age 70.  Just when the insured is getting ready to expire, the insurance company by law must take the coverage away.  To guarantee that term life insurance will be in force at death, no matter when it may occur, one had better make it a point to die before age 70!

Contrary to a popular misconception, life insurance companies make a lot of money on term insurance, because rarely are they at risk when the time for the pay-off of a death claim arrives.

In some states, a product called “Term to Age 100” is available.  Not only is this a most expensive form of term insurance, it is essentially a graded premium Whole Life contract without any of the inherent advantages of Whole Life, such as guaranteed cash values.

Application of Pareto's Law

How can one, with any degree of certainty, protect against both the 20% problem and the 80% problem and gain some important tax advantages along the way?  Well, that is precisely what permanent insurance is all about.

Financial advisors can now fashion life insurance policies that use both term (for high initial death benefit) and permanent (for cash accumulation and long term cost) elements at the same time.  The underlying investments (cash values) can be based on either an equity (variable) or fixed investment account.

The newest policies are children of the computer age.  Before cheap calculation was available, it was impractical to custom design a policy with precisely the death benefit, outlay and cash accumulation desired for each customer.  Now the consumer no longer must settle for a standard package, but may have a policy crafted for specific, personal needs.

In response to Pareto’s Law, it is now very easy to allocate 80% of the premium for the cash accumulation portion of an insurance policy, yet allow the 20% to pay for a full 80% of the death benefit!

Brock and Associates, LLC is a St. George, Utah based financial planning firm specializing in asset protection and generational wealth preservation.

0 Comments

Power of Attorney Rationale - Can Someone Act For You?

Friday, 06 March 2009 09:56

Most of us have wills that will conclude our circumstances after death.  Have we also provided for the eventuality that often precedes death - incapacitation?  Insurance records reveal that a 35-year-old is four times more likely to become disabled than to die before reaching 65.

If injury or illness struck you, could your family gain access to bank accounts and the safe deposit box?  Is someone empowered to cash checks payable to you?  How would they pay pressing bills?  Could they take care of your investments, make claims on your behalf or otherwise manage your assets?  A local court could appoint a guardian, or conservator, of course, but the legalities might consume time and money.

Those who have done a great deal of work with older citizens recommend granting a power of attorney to a trustworthy individual, authorizing that person to act in his or her place in such a situation.  An ordinary power of attorney will not be sufficient, because it becomes ineffective just when it is needed most, when the grantor becomes incapable of independent actions.

Either a durable power of attorney (“valid notwithstanding my incapacity”) or a spring power of attorney (“becomes effective only when I become incapacitated”) is needed.  Not just older people need this power of attorney.  Younger individuals can also be struck with disabling afflictions or accidents.

It is important to give a power of attorney only to someone who can be trusted completely.  The power of attorney can be canceled upon recovery, but in practice, you would have to get back all copies.  That may not be easy, considering there can be copies of which you may be unaware.  If the person who held the canceled power were to go to your bank to take out your savings, it is possible that bank officials may not have received notice the arrangement had been voided.

In addition, your bank, insurance company or other institution will recognize a power of attorney only if it follows a special format.  A Living Will or Medical Power of Attorney is a different matter, having to do with medical decisions, and does not replace the critical need for a durable or spring power of attorney.  It is best to consult your attorney about this issue.

 

Brock and Associates, LLC is a financial planning firm specializing in retirement, estate, and tax planning.

0 Comments

Understanding the Stimulus Bill

Written by Anonymous
Wednesday, 04 March 2009 09:25

Shortly after class, an economics student approaches his economics professor and says, "I don't understand this stimulus bill. Can you explain it to me?"

The professor replied, "I don't have any time to explain it at my office, but if you come over to my house on Saturday and help me with my weekend project, I'll be glad to explain it to you." The student agreed.

At the agreed-upon time, the student showed up at the professor's house. The professor stated that the weekend project involved his backyard pool.

They both went out back to the pool, and the professor handed the student a bucket. Demonstrating with his own bucket, the professor said, "First, go over to the deep end, and fill your bucket with as much water as you can." The student did as he was instructed.

The professor then continued, "Follow me over to the shallow end, and then dump all the water from your bucket into it." The student was naturally confused, but did as he was told.

The professor then explained they were going to do this many more times, and began walking back to the deep end of the pool.

The confused student asked, "Excuse me, but why are we doing this?" The professor matter-of-factly stated that he was trying to make the shallow end much deeper.

The student didn't think the economics professor was serious, but figured that he would find out the real story soon enough.

However, after the 6th trip between the shallow end and the deep end, the student began to become worried that his economics professor had gone mad. The student finally replied, "All we're doing is wasting valuable time and effort on unproductive pursuits. Even worse, when this process is all over, everything will be at the same level it was before, so all you'll really have accomplished is the destruction of what could have been truly productive action!"

The professor put down his bucket and replied with a smile, "Congratulations. You now understand the stimulus bill."

0 Comments

The One Life CRUT (Charitable Reminder Unitrust)

Friday, 27 February 2009 10:06

In the case of a charitable remainder unitrust (CRUT) for the life of one beneficiary, a transfer is made of cash and/or property to a trust.  The donor reserves (either for himself or for some other non-charitable beneficiary) an interest in the property for life.  The trust must provide that the remainder interest in the property will pass at the death of the specified life to a qualified charity.

The major distinction between a charitable remainder unitrust and a charitable remainder annuity trust is that the donor reserves a varying annuity in the case of a unitrust.  In other words, the income received by the non-charitable beneficiary of a unitrust can and typically will vary from year to year.  As is the case for a gift to an annuity trust, a gift to a unitrust will result in income and gift tax charitable deductions, or an estate tax charitable deduction.  Gifts to a unitrust must meet highly complex and stringently enforced rules.  The unitrust pays a variable amount to the income beneficiary based on annual fluctuations in the value of trust assets.  This unitrust for life will qualify as such only if it meets the following requirements:

1. A fixed percentage (not less than 5%) of the net fair market value of the assets must be paid for the life of an individual living at the time the unitrust is created.


2. The fixed percentage amount must be paid at least annually (which means the unitrust assets must be revalued each year).


3. The payment must last for the life of the individual.


4. No amount can be paid to anyone other than a qualified charity at the termination of the retained interest.


5. At termination, whatever assets are in the trust must be transferred to (or for the use of) the qualified charity or retained by the unitrust for the charity’s use.

Tax Deductions

In the case of a charitable remainder unitrust gift, an immediate income tax deduction for the value of the remainder interest is allowed.  When the donor has retained a varying annuity, there is a deduction for the present value of the remainder interest that ultimately will pass to the charity.

The present value of the remained interest is based on tables in the income tax regulations specifically designed to value a remainder interest in a charitable remainder unitrust.  The donor receives an immediate income tax deduction but can continue to enjoy income from the property transferred to the trust.

 

Brock and Associates, LLC specializes in retirement, estate, tax, and business planning.  For more information, we encourage you to schedule a time for your free consultation.