I am working on setting up and customizing the Lacerte organizer for 2004 income tax returns and wanted to discuss the resurrection of a deduction that we haven’t seen since 1986, sales tax.  This was intended to be a fairness remedy for people who live in states without any income tax and are thus supposedly paying more in sales taxes than do people in states with income taxes.  That logic isn’t really accurate, since there are some states with both very high income and sales taxes.  However, it’s close enough for government work, so we do have a new opportunity for Federal income tax savings. 

While the stated intention of this deduction was to benefit those living in tax free states, I have seen nothing forbidding people in taxable states from choosing to deduct sales taxes if they are higher than the state income taxes they have paid for the year, which could very easily be the case for many people.

Before I add my suggestions and advice, here is how QuickFinders described this part of the new tax law:

Deduction of State and Local Sales Taxes

At the election of the taxpayer, an itemized deduction for state and local general sales taxes may be claimed in lieu of the itemized deduction provided under present law for state and local income taxes, effective for 2004 and 2005.

Taxpayers have two options for determining the sales tax deduction. They can deduct the total amount of general state and local sales taxes paid by accumulating receipts showing general sales taxes paid. Or, they can use tables created by the IRS that are “based on average consumption by taxpayers on a state-by-state basis taking into account filing status, number of dependents, adjusted gross income and rates of state and local general sales taxation.” Taxpayers who use the tables can also deduct eligible general sales taxes paid upon the purchase of motor vehicles, boats and other items specified by the IRS.

 

Some additional things to keep in mind.

State tax laws differ as to whether they are consistent with Federal tax law.  Some states automatically just piggyback their tax rules on Federal law, while others require them to pass their own legislation making any changes in their tax laws.  At this late date in 2004, chances are that most of the latter states won’t have time to enact a law authorizing the deduction for sales taxes on their individual income tax returns before the end of the year.  There is a chance that they could pass such legislation in early 2005 and make it retroactive to 2004, something I have seen happen on previous similar occasions. 

IRS tables of sales taxes paid by average consumers are intended to ease the burden of bookkeeping for most people.  They will most likely be used by more people for 2004 than in future years since it was only a month ago that this law was enacted and most people don’t have the time to go back and pick up this info for the first part of the year. 

I have seen some comments on some tax related discussion boards that IRS won’t have the tables out until March 2005.  Even considering IRS’s legendary slowness in doing lots of things, I don’t see them taking that long to issue their official tables.  That would hold up millions of taxpayers, plus the software companies that produce tax return programs, much too far into the normal filing season.  I would expect the tables to be out by the beginning of January, at the latest.

For those folks wise enough to keep their records on QuickBooks or similar accounting software, you should start splitting the posting of personal purchases up between the items bought and the amounts for sales tax.  Set up an Expense account called “Sales Tax” if your chart of accounts doesn’t already have such an account.  If your detailed total for the year is higher than the IRS’s average table, you can claim your higher amount. 

Big unusual purchases.  Those of us who were preparing and filing income tax returns before 1987 will probably remember that it was important to keep track of purchases made during the year of big dollar items, such as vehicles, furniture and jewelry, because those sales tax amounts could be added to the IRS table amounts, which are intended to reflect only the normal day to day purchases.  I noticed that the standard questionnaire included in the 2004 Lacerte organizer only asks about purchases of motor vehicles and boats during 2004.  While IRS hasn’t officially announced what other kinds of big-ticket items can be considered for the additional sales tax deduction, I feel safe in assuming that it will be similar to what we had before 1987.  Back then, any purchases of several thousand dollars at a time qualified.  Besides boats and motor vehicles, those included purchases of furniture, appliances and expensive jewelry.  With some of today’s home theater systems costing over $10,000, I would count those purchases as well.   

Since the way this new deduction has been set up, it gives us an either-or choice between deducting state income or sales tax on a person’s 1040.  I can very easily see this switching back and forth for some people from year to year depending on their big purchases.

Business Purchases – I hope it came across that all of the above discussion was aimed at sales taxes paid on personal non-business related purchases.  Sales taxes paid on the purchases of items used for business purposes are treated differently.  This goes for both the purchases of consumable items which are expensed right away, as well as for capital assets which are depreciated over several years.

I review hundreds of QuickBooks files each year, including those prepared by accounting professionals, as well as by individuals for their own books.  One very common mistake I have often encountered from both kinds of users is the treatment of sales taxes paid.  Rather than include the sales tax as part of the cost of the item being purchased, which is the correct accounting treatment, they post sales taxes to separate expense accounts.  Many use a “Sales Tax” expense account to accumulate sales taxes on normal day to day purchases.  The most common mistake is posting sales tax paid on vehicle purchases to the “Vehicle Expense” account rather than adding it to the cost basis of the vehicle, which is depreciated over its useful life, or expensed under Section 179.

I am constantly having to remind people that deductions claimed on a business schedule (C, E or F) will often result in as much as twice the income tax savings as the same amounts being deducted on Schedule A due to the additional reductions in self employment tax, as well as the ripple effect of reducing adjusted gross income (AGI), since so many deductions, exemptions and credits are reduced based on the AGI.  I mention this once again for anyone who may feel deprived by the requirement to depreciate sales tax paid on a business vehicle over five years rather than being able to expense it all at once on Schedule A.