More On Tax Planningfrom The Advisor's Professional Library
- Charitable Giving Charitable giving can reduce your clients’ tax liabilities. However, the general and verification rules for the deduction of charitable gifts must be understood in order to take full tax advantage of such gifts.
- Taxation of Real Estate Real estate may be used to shelter income and may offer certain tax benefits. However, the type of real estate investment may result in different tax treatment. Learn how to use these investments to help your clients.
While every year has its changes in terms of new and changed tax laws, the 2006 filing season presents a special challenge to the practitioner who prepares individual tax returns for 2005. From legislative changes to natural disasters, practitioners need to be at the top of their game to identify and address all of the changes that occurred in the past year.
On the December 2005 Webcast of Tax Talk Today, a panel of IRS officials and tax experts (including myself) discussed the most sweeping of those changes that will affect 2005 federal tax returns. Here are some highlights of that discussion.
The panel's tax experts and the IRS agree that the new definition of a qualifying child is the most significant change impacting 2005 individual tax returns. These changes can affect up to five different tax benefits for an individual, including head of household filing status, dependency exemptions, the child tax credit, the child and dependent care credit, and the earned income credit.
According to the new definition, there are now four tests to identify a qualifying child:
Relationship: Is the child the taxpayer's child, sibling, or a descendant of the taxpayer's child or sibling?
Residency: Did the child live with the taxpayer for more than half of the tax year?
Age: Is the child younger than 19 years of age, or younger than 24 if a student, or permanently and totally disabled?
Support: Did the child provide no more than half of his or her own support for the year?
As with any tax law, there are some exceptions and additional requirements for the different tax benefits associated with the qualifying child, but this set of tests applies most of the time. If more than one person claims the same qualifying child, the old earned income credit tie-breaker rules are now used across the board to determine who is a qualifying child for any of these benefits: Filing Status, Dependency Exemptions, Child Tax Credit, Child and Dependent Care Credit, and Earned Income Tax Credit. Special rules apply for the dependency exemption and child tax credit if the parents are divorced or separated.
Because the new definition of a qualifying child affects so many benefits, tax practitioners really cannot use last year's return as a solid base for developing this year's return. In particular, tax experts expect to see big changes in head of household status as the new rules impact who does and does not qualify as a dependent.
"We're going to see some head of household statuses lost this year," said panelist David Morley, a CPA and president of Morley & Associates in Enid, Oklahoma. "You just can't assume that what you claimed last year--that dependent--you're going to be able to claim this year."
Tax practitioners must approach the issue in two tiers: Determine whether you have a qualifying child and, if yes, then you can stop there. However, if the situation in question does not meet the requirements for a qualifying child, then it is time to examine the rules for a qualifying relative in order to determine the dependency exemption.
In a related area, the definition of a foster child has changed as well. In order to qualify, the child must have either been placed by an authorized placement agency, by order of a court of competent jurisdiction, or by a judgment of that court. The child must have lived with the taxpayer for more than half of the year, which is an improvement over the previous full-year residency requirement for foster children.
"That will put them on par with other children," said another panelist, Robert Erickson, senior technical advisor, tax forms and publications, with the IRS.
Even tax practitioners operating well outside the areas affected by Hurricane Katrina will want to pay close attention to the hurricane-related provisions now in place. One far-reaching provision comes in the form of a new deduction: Form 8914, the Exemption Amount for Taxpayers Housing Individuals Displaced by Hurricane Katrina. This new deduction is available for any taxpayer that housed individuals who were displaced by the hurricane. This $500 exemption amount can cover up to four individuals, for a maximum total of $2,000. The displaced person(s) must have lived in the main home of the individual claiming the exemption for at least 60 consecutive days, with no rent charged. The deduction is available in both 2005 and 2006, but can only be claimed one time per individual--and that $2,000 maximum is for both years combined. Additional deduction criteria can be found in instructions on the new Form 8914.
Charitable mileage is also affected by new Hurricane Katrina provisions. Depending on the date of the charitable driving, the per-mile amounts allowed can change for Katrina-related travel as follows:
- January 1, 2005 through August 24, 2005: $0.14 per mile;
- August 25, 2005 through August 31, 2005: $0.29 per mile;
- September 1, 2005 through December 31, 2005: $0.34 per mile;
- After December 31, 2005: $0.32 per mile.
"We struggled just trying to get mileage numbers out to the clients," said Morley. "Now, we're going to be giving them a set of dates and saying we really need to know how many miles you drove in each one of these time periods."
Effective January 1, 2005, new rules govern the charitable donation of a motor vehicle and require written acknowledgement of the donation via the new Form 1098C or the charity's own formal document. This is required within 30 days of either the donation of the vehicle or the sale of the vehicle, and must be attached to the taxpayer's return. If the deduction claimed exceeds $500, the taxpayer may have to rely on gross proceeds instead of fair market value to determine the amount of the deduction.
Three exceptions exist to the gross proceeds requirement for the charitable donation of a vehicle:
- If the charity made a material improvement to the vehicle before selling it, such as a complete engine overhaul;
- If the charity had significant intervening use of the vehicle;
- If the charity gave the vehicle away, or sold it for an amount substantially below the fair market value of the vehicle.
Tax practitioners should advise clients of the importance of understanding exactly what a charity intends to do with the vehicle if it is donated.
"This could be a lot of pressure on charities to really get a good price for the vehicle," said Erickson. "Have a little communication there whenever you make that gift," advised Morley.
On the e-filing front, the IRS examined common e-filing reject codes in an effort to encourage more e-filing participation. Two of the more common reject codes, 501 and 504, relate to the matching of Social Security numbers for dependents. Beginning with the 2006 tax-filing season, the IRS will accept individual tax returns that e-file with a 501 or 504 reject code--as long as the tax practitioner follows through with the following procedure.
When such a return is initially e-filed, it will come back with the applicable reject code. At that time, the tax practitioner has the option to indicate that all corrections possible have been made, and can request that the IRS accept the return. The IRS will then accept the return conditionally, and the tax practitioner will receive an acknowledgement code E, which means "exceptional processing." From there, the IRS will handle the return just as if it were a paper return and will make the appropriate determination to disallow the dependent or the credit as circumstances dictate.
"It's important that the practitioners understand that that doesn't mean that we are accepting it exactly the way it is," said Pamela Walker, chief of IMF
Policy & Procedures Branch of Wage and Investment, Submission Processing, IRS. "It's an exception processing."
The steady increase in the number of e-filed returns has also meant address changes for filing paper returns, as the IRS closes and/or consolidates processing centers. In addition, tele-file has been eliminated and will not be available for the 2006 filing season.
EFTPS and Other Changes
The IRS's electronic payment system, available through EFTPS, has a few improvements for the 2006 filing season. As usual, electronic payment is available for any return filed, and the system allows the taxpayer to file early and pay later by scheduling the deduction of the amount due from the taxpayer's bank account on the due date of the return. Now, the IRS has expanded the credit card option of the electronic payment system to cover balances due on any 1040 return--even delinquent balances--up to five years in arrears. Credit card payments are also accepted for installment agreement payments as well as for any payment due on the 1040ES or an amended return.
Other changes affecting the 2006 filing season include the implementation of an automatic six-month extension to file using only Form 4868; significant changes to elective salary deferrals; and energy tax incentives, including alternative motor vehicle credits for hybrid cars and the 2006 energy tax incentives for home improvements. Additional changes for 2006 taxes are expected as well. Tax practitioners will need to address immediately those changes that will impact 2005 returns and save the rest for examination after the filing season is past.
Raymond McClellan, Enrolled Agent, is co-owner of Mr. Tax of America, Inc., of West Des Moines, Iowa, and can be reached at firstname.lastname@example.org. More information on the December 2005 Tax Talk Today Webcast can be found at www.taxtalktoday.tv.