Here's a heads-up for financial advisors who prepare federal and state returns for clients or enlighten them about techniques that trim their taxes. Advisors should help clients take maximum advantage of a fairly lucrative break that is relatively new and, therefore, easy to overlook.
The Internal Revenue Code includes a provision that allows taxpayers who itemize on Schedule A of the 1040 form to choose between deducting state and local income taxes or state and local sales taxes. However, Section 164(b) of the code states clearly that itemizers cannot write off both state income and sales taxes in the same year. They must "elect"-IRS-speak for decide-only one for inclusion with their other deductibles on Schedule A.
Do advisors who tell clients to elect sales taxes for one year irrevocably commit clients to the same election in other years? No, because each year stands on its own. Thus, clients retain the option to deduct sales taxes in one year and income taxes in another year-meaning, for example, they are able to deduct sales taxes for 2008 and income taxes for 2009 or vice versa.
Sales-tax deductions are the only game in town for residents of states that do not levy income taxes-a group that includes Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. Similarly, this is the correct choice for people in states that assess low income taxes-Tennessee, among others.
When a decision is in order, clients may assume that they are better off taking the higher deduction, an assumption that is usually-but not always-true. That noted, advisors should make clients aware that sales-tax deductions may also be advantageous for many residents of states that impose income taxes.
For starters, some states that forbid deductions for their income taxes permit deductions for sales taxes: New York, Maryland and Missouri are in that category. This distinction is why it might pay to determine whether New Yorkers, say, should itemize on federal Schedule A for their payments of state and city sales taxes-notwithstanding that those outlays are less than their state income taxes-because they then qualify for sales tax deductions on their New York returns.
Another consideration for New Yorkers is their long-standing exemption from income taxes on payments from such sources as Social Security benefits and the first $20,000 of pensions or distributions from traditional IRAs and other kinds of tax-deferred retirement plans. Consequently, many retirees in New York who pay relatively little or nothing in state or local income taxes are able to deduct more for sales taxes-a benefit similarly available to retirees in some other states.
Chalk up another potential break for affluent individuals who shell out sizable payments for state and local general sales taxes on big-ticket purchases of such items as autos, aircraft, yachts, furs and jewelry. First and foremost, they must be diligent about saving records that show their actual expenditures. For clients who live in states with both taxes, you may find these big-ticket purchases make the deduction for sales taxes more attractive than the deduction for income taxes. For individuals who live in states without income taxes, the sales tax deduction becomes even more valuable when those items are included in the mix.
IRS statistics reveal that for the years 2004 through 2007, millions of taxpayers who paid little or no state income taxes and would have been better off claiming sales-tax deductions-especially big-ticket purchasers-failed to do so, causing them to miss out on billions in tax savings. (For Congress' role in this, see Sidebar on page 78).
For some, it may not be too late. Affected taxpayers should review their returns for those years and decide whether it makes sense to recover their overpayments by filing amended returns. Of course, the tax code does not grant them unlimited time to amend. The usual deadline is three years from the due date (including filing extensions) for their original returns. The three-year limit generally prohibits amendments of returns for years before 2005. In the case of 1040s for 2005, April 15, 2009 would be the deadline, assuming no filing extensions. Do the paperwork on Form 1040X (Amended U.S. Individual Income Tax Return).
According to IRS officials, submitting amended returns does not mean that original returns are automatically flagged for examination. Nevertheless, amending for any reason might prompt the IRS not only to question other items on original returns, but also to look at returns for other years.
To illustrate the way the rules work, let's apply them to a representative couple we'll call Harold and Shirley Lazer.
For example, consider the fine print detailing what is or is not permissible when the Lazers file separate returns and both spouses itemize. IRS regulations allow each one to deduct state and local income or sales taxes, irrespective of the other's decision. But suppose Harold and Shirley both deduct sales taxes, and he uses the IRS "Optional Sales Tax Tables" that come with the 1040 instructions. In that case, she too must use the tables.
Or, as is even more common, the couple files a joint return, and they decide to deduct sales taxes. They then have two options for calculating their write-off. One is to total up the actual taxes on all of their purchase throughout the year, assuming they retained the receipts. The other is to use the amounts found in the tables.
Like most itemizers, Harold and Shirley use the tables. They show the allowable deduction, determined by income level, family size and state of residence. The advantage for the Lazers of taking the deduction from the official tables is that ordinarily, the IRS will not ask them to break down sales tax payments in the event of an audit.
For purposes of using the tables, the couple starts with adjusted gross income (AGI), plus certain nontaxable income that increases their purchasing power. The IRS defines this income as "any nontaxable items, such as tax-exempt interest; veterans' benefits; nontaxable combat pay; workers' compensation; nontaxable part of Social Security and railroad retirement benefits; nontaxable part of IRA, pension, or annuity distributions (except rollovers); and public assistance payments." The amounts authorized by the tables increase by income increments of either $10,000 (up to the first $100,000 of income) or $20,000 (from $100,000 to as high as $200,000). Consequently, boosting their AGI with the addition of nontaxable items may make it possible for the Lazers to move into a higher income range.
The instructions that accompany the 1040 form allow Harold and Shirley to add to the authorized amount from the tables their actual payments on the purchase (or lease) of the following listed big-ticket items.
?motor vehicles-a category that includes cars, motorcycles, motor homes, recreational vehicles, sport utility vehicles, trucks, vans and off-road vehicles;
?boats or aircraft; and
?materials to build homes (including mobile and prefabricated homes) or make substantial additions to or major renovations of homes, provided they pay the taxes directly-that is, they act as their own contractor. There is no deduction when the Lazers hire contractors who pay the taxes on the materials notwithstanding that the taxes are indirectly reflected in what the contractors charge the couple for the materials.
One caveat: The law allows the Lazers to claim these additional payments only up to the amount they paid at the general sales tax rate. On the plus side, they are entitled to the deductions even though car payments, for example, extend well beyond this year.
The IRS Web site offers an online tool designed to help perplexed taxpayers like Harold and Shirley-or even paid preparers, for that matter-calculate the deduction authorized by the tables. It can be found at irs.gov by clicking on "More Online Tools,?" then choose "Sales Tax Calculator." After answering a few online questions, the system does the rest.
Clients should think of the Calculator as a sort of virtual confessional, where everything is done anonymously; the IRS does not ask for names, Social Security numbers or any other identifying information. In the event of a potential IRS audit, they should print out a copy of the results to explain how they arrived at the deduction.
But the Lazers should dispense with the Calculator if they want to itemize sales tax payments for items not mentioned in the tables, no matter how expensive-for instance, appliances, computers, flat-screen TVs, furniture, furs and jewelry. The IRS warns that taxpayers cannot use the tables and then increase the deduction by adding payments for art work and other items not listed in the tables.
The United States Tax Court upheld this restriction in a dispute that pitted the IRS against Carl Worden. For the year under review, Carl claimed a total sales tax deduction of $1,498, which he broke down as follows: $429-the amount authorized by the tables; $540 for sales tax on a car; and $529 for sales taxes on "major purchases" of furniture and other household items.
Unfortunately for Carl, the Tax Court imposed a limit on his allowable deduction-either the table amount plus the tax on the car, or the total amount of actual tax payments. True, the table guidelines authorize specific additions. Nevertheless, noted the court, "these are the only items that the Internal Revenue, as a matter of administrative convenience, has permitted to be added to the optional table amount." Translation for advisors: Caution clients that the burden is on them to prove the entire amount of the sales tax paid during the year, assuming that-unlike most of us-they had the foresight to retain records that substantiate those payments. Otherwise, the cap on the deduction is the amount in the tables increased only by the specific items mentioned in the tables.
The IRS further advises taxpayers to "keep their actual receipts showing general sales taxes paid to use this method." Indirect proof, such as annual credit card statements showing purchases for which sales taxes presumably were paid, may not be sufficient.
The lesson for advisors? Knowing the complexities of the tax code is important, but not enough. Tax planning, along with other aspects of the engagement, is dependent on each client's particular situation.
Julian Block, an attorney based in Larchmont, N.Y., conducts continuing education courses for financial planners and other professionals. Information about his books can be found at www.julianblocktaxexpert.com