It's Tax Time

Don't overpay Uncle Sam

It's baaaack—your 1040—and as usual, you get to itemize your own tax tab. Here's a guide to keeping it to the minimum.

By Brad Burg
Senior Editor

If you believe no news is usually good news, here's a comforting thought: This year, the tax rules aren't greatly altered.

Still, preparing your return will likely prove challenging anyway, particularly if you're determined to find new tax savings. The tax code remains a labyrinth, and changing times have made your understanding of certain ins and outs more crucial. For example, maybe you're among the doctors who've realized a lot of capital gains in recent years. How well do you know the rules on figuring the cost basis of stocks—and of mutual funds?

Keep in mind, too, that tax preparation, like medicine, can be more art than science. You may find yourself weighing where or how to report certain income or expenses— and even accountants sometimes differ in what they prescribe. You may not always be aware of such differences, so we'll single out a couple of illustrative examples.

Ready to make your way through the maze? Grab your coffee and a flashlight, and follow us.

The good ship Nest Egg hasn't quite sailed yet

Are you sorry you didn't put more into a Keogh plan last year? Or, worse, are you regretting that you had no plan at all? Not to worry: With most plans, you can still contribute for 2000. Even more surprisingly, you can still set up a Simplified Employee Pension plan, and then contribute as much as $25,500 to it for last year. That's why internist Susan Brown, who's just starting in practice and had no plan last year, can still show a large deduction on line 29: She just wrote a check to her new SEP.

If you're among the doctors who haven't been able to contribute because you had an old "overfunded" plan, be aware that the law hampering you became ineffective as of last year. So you should review your situation right away; maybe you can stash some cash after all.

Check the rules carefully, though, because deadlines vary for different plans, cautions CPA Tom Ochsenschlager of Washington, DC. "Suppose you get an extension to file as late as Oct. 15, 2001. That would be your cutoff date to establish and fund an SEP. The same date would apply to contributions into a defined-contribution Keogh that existed last year. But an IRA follows different rules, as does a defined-benefit plan."

Form 1040

When the going gets taxing, the tax-wise read the fine print

Welcome to Schedule A, the Valley of Lost Deductions. Here, medical expenses are invisible until they exceed 7.5 percent of your adjusted gross income. With casualty and theft loss, the threshold (after small exclusions) is 10 percent of AGI. Miscellaneous expenses are hit two ways. None of them count until they top 2 percent of AGI. Moreover, some are reduced by 3 percent of AGI over $128,950 on a joint return (or AGI over $64,475 for those filing separately). But check the fine print; sometimes it helps you.

Here we see the tax return of John Smith, a single doctor in good health, with an AGI of almost $203,000. Because of that high income, the first $15,000 or so of his medical costs don't count; yet he has a health care deduction of more than $9,000. How? Last year, he paid almost $23,000 in medical bills for his ex-wife, Melissa, for an operation she had before their divorce. Smith learned you can deduct expenses for a spouse if you were married either when you paid the bills or incurred the expenses. The tax code is full of such unpredictable quirks; it pays to look around.

Be prepared to prove the value of that donation

This year, Smith donated his used car to a charity. That was faster and easier than selling it or trading it in, he figured, and the charity gave him a very generous allowance for the car's value, which he's using on line 16.

Of course, the IRS knows that charities get more donations if their written valuations of donated goods tend to be—let's say—charitable, so Smith is prepared to support his figure. Before donating, he looked up the car's value on the Web (www.edmunds.com/used ) and printed the page showing its worth. He even photographed the car to document its condition, in case he's ever audited. Probably most important, though, he got a written appraisal, even though technically he didn't need one. "The rules say you need such an appraisal only for any gift over $5,000, " says CPA Leonard Bailin of Great Neck, NY.

Schedule A—Itemized Deductions

Avoid fencing in write-offs here—but if you can't, feed 'em well

With expenses that may not receive full value on Schedule A, your best bet is to put them elsewhere, if possible. "Doctors are frequently involved in sideline businesses or investments," says CPA Mary McGrath of Champaign, IL, "and when I discuss the professional fees they've paid personally, I often find expenses that can be allocated to such business or investment activities." Doing that will make those expenses fully deductible (for example, on Schedule C, for a medical practice, or Schedule E, for real estate partnerships). "In such cases, have your advisers prepare invoices to show the breakdown of their fees," McGrath says.

Second-best tactic: Find every possible deductible item, to get over any threshold below which deductions don't count, such as that 2 percent rule for miscellaneous expenses. So after listing her CPA's fee for tax preparation on line 21, surgeon Linda Williams includes in her total for line 22 every investment expenditure she can find in her records—including her financial-planning software and the backup drive she bought to protect her computerized financial files.

Those costs add up to less than $1,000. But Williams' line 22 also includes $4,000 of the $10,000 fee she paid a divorce lawyer—the part of the fee that was for tax advice. "In fact, like tax-preparation fees, all fees for tax counseling matters are deductible," says Robert Baldassari, a CPA in McLean, VA. Obviously, lawyers you've consulted for other reasons may provide you with advice related to taxes, so this rule may help you find some major deductions. But like Williams, back yourself up: She didn't estimate that $4,000 number; she had the lawyer send a bill breaking out the tax-counseling fee, separate from any other legal work. And for clarity, she decided to include the expense on line 22—not line 21, which refers to tax preparation work—and she'll explain it, as well as all of line 22's other deductions, in an attachment.

Schedule A—Itemized Deductions

Don't overpay on dividends that aren't even dividends . . .

Some schedules help you a lot; others, like Schedule B, a bit less. If you ignore the way your 1099s break down corporate distributions, you may enter everything as dividend income. But among those figures, there might well be capital gains from your mutual funds, and those gains are taxed at a lower rate.

For years, Schedule B led you by the hand in this area, providing you with lines that required you to enter capital gain figures separately and subtract them, preparatory to moving them to Schedule D, where capital gains should be reported. Currently, though, you're only referred to the instructions for line 13 on the 1040. Moreover, if your capital gains came only from mutual funds, you can forgo Schedule D completely.

Still, don't be in a hurry to skip any steps; you don't want to miss separating out any capital gains. The tax on long-term capital gains, 20 percent, is only about half of the nearly 40 percent neurologist Amy Jones pays on ordinary income.

. . . and don't pay tax on dividends that aren't yours

Although 1099 forms may look impressively official, they can be dead wrong. Last year, Jones set up a brokerage account for her 14-year-old daughter, establishing it for "Amy Jones as custodian for Sarah Jones." She got a 1099 form, however, for just plain "Amy Jones."

Ideally, Jones should get a corrected 1099 from the brokerage firm before filing her return for this year. But even if she can't get it before filing, she should still do so soon, and keep it with her copy of this tax return. "If you're ever questioned, you'll need that paper, and it's easy to get right now," says CPA Gregory Goergen of Arlington Heights, IL. "It may not be easy, though, a few years down the road—and that's when that IRS notice will arrive."

What if the wrong form is all you've got in the meantime? Do what Jones does: She lists the 1099's taxable dividend amount, but indicates it was a "nominee distribution," and subtracts it from her total. She includes Sarah's Social Security number so the IRS can trace what happened, and she'll annotate her daughter's return, too. Later, Jones should also issue her own 1099 showing a distribution to that custodial account, and file a special form with the government.

Schedule B—Interest and Ordinary Dividends

Employing a spouse may make a big expense fully deductible

Like many physicians, FP Frank Green provides health insurance for his small staff. As line 14 shows, that's expensive; but the perk helps him hold on to good employees. Since his wife works in his practice as a nurse, he also gets a tax break by listing her, rather than himself, as the insured. "As a business owner, the doctor can't have his practice deduct the cost of insuring his own family as a business expense," says CPA Ronald J. Knueven of Clayton L. Scroggins Associates in Cincinnati. "But the cost of covering an employee's family is a business expense—even if that employee is the doctor's spouse."

So Green and his family can be covered as dependents of his wife, and the $5,000 cost of his family coverage is included with other business expenses here on Schedule C, where it's fully deductible. Otherwise, the doctor could deduct only 60 percent of his health insurance cost on the 1040, leaving the rest for Schedule A—where restrictions on deductions often mean health care expenses don't count.

Put outsized expenses where they can be explained

On line 27, for "Other" expenses, Green is including $6,300 for painting and redecorating the office. He might have added that to his total for repairs and maintenance, on line 21. But then the amount on that line would be more than you'd expect to see for a doctor grossing about $300,000. Anytime you claim a Schedule C expense that's well above the norm, you risk raising an IRS eyebrow. Who needs that? So Green will annotate this expense on page 2 of the form, which asks for more details—to satisfy federal curiosity right away.

Schedule C—Profit or Loss From Business

Free up expenses paid long ago

Internist Joan Gray moved to a larger office last year. Naturally, she remembers to deduct the cost of the move (among the "Other expenses" on line 27). But by checking recent returns—a good habit at tax time—she locates a break worth even more. In recent years, she has been depreciating the $50,000 cost of the leasehold improvements she put into her former office, but a large undepreciated balance remains.

"Normally, you depreciate that kind of cost over 39 years," says CPA Sherman Doll of Walnut Creek, CA. That long write-off period had kept Gray's annual depreciation deduction down to $1,266. But now that Gray is in her new premises, she can take the remaining depreciation for the year 2000. That totals $43,670. Together with Gray's normal depreciation costs, that makes line 13 unusually hefty, so some accountants say declaring the $43,670 among "Other expenses" on line 27 would be less likely to arouse IRS interest. And some would instead report the amount on form 4797, as a disposal of business property.

You can also accelerate depreciation if your office is damaged by fire, flood, or other disaster. In that case, you may speed up your write-offs of furniture and equipment, too. "But in that situation, the write-off will be restricted by the casualty loss rules and by your insurance recovery," says Sidney Blum, a CPA in Northbrook, IL.

Schedule C—Profit or Loss From Business

Don't overstate your taxable gains

Last year, Mary Johnson sold some stocks and mutual funds. Like many physicians, she can't always manage to cross every "t" in her financial life. In years past, for example, she bought several lots of Cornfield Co. stock at 10, 18, 30, and 45—and when she sold some last year at 50, she didn't specify which lot to sell. So she must report this as if she'd sold her earliest holdings first. (Yes, Uncle Sam has noticed that stock prices typically rise, over time.) That makes her gain $40 per share, but it would have been $5 if she'd specified that the batch bought latest be sold.

Fortunately for Johnson, the mutual-fund rule is less rigid. Before last year, she'd bought shares of the Newton Hi-Tech Fund at various times: 200 shares at 14, 150 at 21, and 200 at 32. Then, last November, she redeemed 100 shares at 44, again without specifying which ones. If she had to follow the first-in-first-out rule again, she'd have to assume a cost basis of $14 and report a $30 gain per share. But with mutual funds she can calculate her average cost, which is $22.45, and use that to determine her gain. That shrinks it to just $21.55 per share.

If you don't know your basis, it's best to get the information from the fund company or your broker, if possible. And if Johnson hadn't been able to do that, it might have been wiser for her to donate the appreciated stock to charity, notes CPA Leah Wolf of San Francisco: "That way, she could deduct its market value and never pay tax on the gain."

Home, sweet tax-favored (sometimes) home

With tax breaks, optimism can pay off. Many doctors know they can exclude a large amount of taxable gain on a house sale—up to $500,000 on a joint return—if the couple owned and occupied the house for at least two years. However, in Taxland, exceptions flourish, so it's wise to check the rulebook.

"One doctor-client of mine asked me about this and got good news," says John V. O'Connor Jr., a CPA in Albany, NY. "When you have to sell because of a move for business or health reasons, you can use the exclusion even if you haven't owned the house two years. You just prorate the break, based on what percentage of two years you were in residence." Mary Johnson took a job in a new city after staying in her house one year, so she got 50 percent of the exclusion. (We're rounding for simplicity.)

Johnson declares the full amount of the gain right on this Schedule D (there's no longer a special form for gain on a home sale), and below it she subtracts the excluded amount, noting the relevant tax code section.

The regulations on this break may become even more flexible, so stay tuned.

Schedule D—Capital Gains and Losses

Write off an expense before you spend the money

When you depreciate a business asset, you usually pay for it up front. But you must take the write-off in small pieces, over many years. So doctors should jump at the chance to reverse that: For equipment used in your business, the tax code's friendly Section 179 gives you a $20,000 break.

Cardiologist Alice Wilson bought more than $36,000 worth of treadmills and monitors last year, and she can immediately deduct $20,000 of that on line 12. That's true even though she took out a loan for the whole purchase price and hasn't yet paid much out of pocket. She'll depreciate the rest using a typical half-year (HY) declining-balance (DB) schedule; that's good for $3,000 more, as line 15 (b) shows.

If you're not careful, though, you might lose part of this break, cautions CPA Gregory Goergen. "You should start depreciating an asset the year it's placed into service; if you miss a year, the rules may not let you catch up later," he warns.

Form 4562—Depreciation and Amortization

There will be a quiz—and a chance to win $2,001!

We'd like to thank the following experts for their help in preparing this article:

Leonard Bailin, CPA, JD, Great Neck, NY

Robert Baldassari, CPA, Matthews, Carter and Boyce, McLean, VA

Sidney Blum, CPA, Successful Financial Solutions, Northbrook, IL

Sherman Doll, CPA, Thomas, Doll & Co., Walnut Creek, CA

Gregory Goergen, CPA, Professional Service Consultants, Arlington Heights, IL

Ronald Helle, CPA, Honkamp Kreuger & Co., Dubuque, IA

Ronald J. Knueven, CPA, Clayton L. Scroggins Associates, Cincinnati

Mary McGrath, CPA, Cozad Asset Management, Champaign, IL

Thomas Ochsenschlager, CPA, JD, Grant Thornton, Washington, DC

John V. O'Connor Jr., CPA, O'Connor & O'Connor, CPAs, Albany, NY

Leah Wolf, CPA, Boas & Boas, San Francisco

 

Brad Burg. Don't overpay Uncle Sam. Medical Economics 2001;3:37.