Q:

Subject: Interesting tax question

 

Good one for the blog…..

 

I am in the middle of an IRS audit.  I own a small company, real estate, invest in stocks and have a W-2 job…. they have been into all of these items, with no findings.  I try to be very organzied, use quicken for personal and quickbooks for business, I keep all my receipts.  The auditor was impressed.

 

The last item to be audited was my bank statements in which I had to explain “excess deposits”…. I was easily able to do this, with one exception…. I found a deposit for a personal item I sold and I think I may have needed to report it.

 

Here is the twist, in 2004 I sold a diamond engagement ring for 10,000, I paid 9,000 for it and have the receipt and check I used to pay for it.  I purchased the ring in 2000.  In 2001 I started my company, a jewelry company (sole proprietor).  How do you think the IRS will handle this… capital gain, business income, or other?

 

Appreciate your opinion.

A:

What is a little strange about the way in which you describe your audit is the order of events.  It’s been my experience that the auditors normally begin with an analysis of bank statement deposits and then branch out into other areas.

Either way, it appears that your auditor did find an unreported sale that does need to be added to your 1040.

If you weren’t in the jewelry business, a good case could be made for treating the ring sale as a long term capital gain of $1,000, with the lower tax rates applicable for it.

However, since you have been in the jewelry sales business for a number of years, this one should be added to your Schedule C; $10,000 added to gross sales and $9,000 added to Cost of Goods Sold.  This will potentially increase your regular income tax plus SE tax.

While your Quicken and QuickBooks may have impressed the auditor, it should concern you that $10,000 slipped through the cracks and didn’t show up in your yearly reports.  This flaw in your accounting needs to be corrected ASAP to avoid future such problems, which could just as easily go in the other direction; causing you to miss legitimate deductions. 

You may also have a sales tax issue to deal with if you didn’t report that $10,000 sale to your state. One way to properly balance books and prepare tax returns is to reconcile gross revenues with what was shown on sales tax reports for the year.

From the way in which you described your books, I suspect there is a natural built-in flaw by using both Quicken and QuickBooks.  I’m assuming you are not incorporated; which means that you should have everything entered into one QuickBooks data file, with classes used to keep track of your different businesses and personal items.  Trying to keep track of things in two separate systems is a textbook recipe for items to slip through the cracks.  I have a lot of info on this on my website that you should check out.

My last comment has to do with professional assistance.  It sounds as if you are doing everything yourself without the aid of a professional accountant.  While this will obviously sound self-serving on behalf of my profession, that is a classic example of the “Penny Wise, Pound Foolish” maxim. Any good accountant should be able to help you reduce your taxes by several times as much as their fees, as well as help you stay out of trouble from such things as accidentally unreported income.

Good luck.  I hope this helps.

Kerry Kerstetter

 

Q:

Subject: Donated Goods

Kerry,

I attended a multi-street neighborhood garage sale last week.  It challenged my thinking.

 

If I spent a day selling all that I donate to Goodwill it would generate nontaxable cash that I could self-direct to individuals or groups that are in need or doing good things but not a 501(c)(3).

 

Ironically, I saw the garage sale being beneficial for the neighbors–they were out among each other being very neighborly.

A:

I’m not sure if there’s a question in there or just your observations.

In regard to the observation, they do echo some points I have commented on several times over the years. 

First is the actual in-pocket dollar value of a deductible donation. It never ends up being as much as selling the item and keeping the cash because that would only be the case if one were in the 100% tax bracket.  With most people having an effective tax rate of around 33%, donating an item worth $200 would return them less than $67 in actual tax savings.  If they were to sell the item at a yard sale (assuming at below cost in a non-business manner), they would have $200 in their pocket.

The other point is where the donations go to.  I have long been a very vocal critic of huge national and international charities that spend more of their revenues on internal costs (salaries, benefits, other overhead) than on the actual programs they are supposed to be taking care of.  Whether any of your donations to such groups will every make their way to helping real people is always a mystery.  What is more effective is to either donate to locally run charities with small inexpensive overheads or to just give the money and items to the actual people who need them.  In those cases, you can be much more assured that some good will come out of the donations. 

This is a very common situation here in the Ozarks, where there is a lot of generous giving directly to people whose homes have been damaged by fires and tornadoes, as well as for those who have suffered from unexpected medical tragedies.  As a volunteer firefighter, I do see a lot of such cases.

While there is obviously no income tax deduction for such direct donations, that is the last thing donors care about.  Another point I have been making for decades is that, contrary to popular belief, people do not make charitable donations because of the income tax benefits. They do so because they want to help out a certain cause.  I used to ask that very question in many of my seminars over the years (How many of you make donations because of the tax deductions?) and nobody ever raised their hand.  This is why I don’t trust those who claim that eliminating the estate tax will harm charities.  It’s a bogus argument that has no basis in reality, and anyone making such claims has no credibility on such matters.

A bit of a long rant on this point.  I hope I addressed your points.

Kerry Kerstetter

 

Follow-Up:

Kerry,

 

Thanks for your insights re donated good.  I plan to hang onto my goodwill pile until next garage sale season and will enjoy letting those proceeds go to those needing help in my community.

 

Regarding established charities, I had an experience that made me rethink my charitable giving.  I support the following 501(c)(3) charities:

 

Operation Blessing continues to truly help LA and MI with hurricane cleanup as well as supports its general purpose in foreign countries.  I saw the former Presidents in LA asking you to send money to them while they stood in front of an Operation Blessing truck.

 

Wounded Warrior Project supports the injured soldiers with clothing and articles after coming off a battle field with nothing to making modifications to homes to accommodate injuries to providing ski trips and other events to help the soldier reacclimate.

 

Feed the Children helps from poor USA neighborhoods to children all over the world.  I was most impressed when they were able to convert their general concept to being on the scene within hours of the incidents with support supplies and people to help with the OK City Bombing and World Trade Center and LA/MI.  They had some internal control problems in TN a year back but was very quick to fix.  *Their administrative costs were up last year when they did a lot of TV ads but otherwise is minimal.

 

Taproot Theatre (Seattle) provides touring road shows to Seattle area schools on handling bullying, personal behavior, substance abuse, diet/exercise, as well as provides an acting studio for kids, and has awesome clean, thought-provoking plays on their mainstage.

 

NW Medical Teams

 

The above charities provided me their 990s and the executives receive little compensation and their administrative cost* is very minimal. 

 

I also found Wall Watchers a good source for information.  http://www.ministrywatch.com/mw2.1/H_Home.asp 

 

Thanks for listening to my rant and providing your wise counsel. I think our charitable giving needs to be considered wisely like any other expenditure or investment.

Warm Regards,

 

 

Q:

Subject: question about S vs C corps

Kerry,

I have a question based on what you said in your S vs C Corps topic.

“My philosophy is to look at the overall tax picture for individuals and their companies by smoothing income over the personal (1040) and corporate (1120) tax returns.  For 2000, a married couple’s 15% tax bracket ends at $43,850 of taxable income.  It then jumps to 28%, almost double the rate.  However, if you consider that the couple’s C corporation has its own $50,000 15% bracket, their overall combined 15% bracket has more than doubled to $93,850.  That alone can save several thousands of dollars per year in income taxes.”

Wouldn’t the couple also have to pay an additional 15% dividend tax on whatever $ they took out of the corp’s $50,000 net income? I am not well-versed in taxation – please explain.

 Thank you,

A:

There are a couple of basic concepts that apply here.

I tell my C corp clients to avoid the term “Dividends” because we only want to take money out as a deductible expense for the corp that will avoid double taxation.

Corporations have potentially eternal life; so there is no need to zero out their bank accounts.

You should work with an experienced tax pro to see how these would apply to your particular situation.

Good luck.

Kerry Kerstetter