Can a state or local government tax your income that was earned and already taxed in another state? That was the question before the U.S. Supreme Court over the past few years and an opinion was finally issued this week.
“NO” says SCOTUS in a 5-4 decision. The surprise to me was that it was such a close decision with sharply divided opinions among the Justices. But in Comptroller vs. Wynne, the Supreme Court decided that Maryland’s tax was in violation of federal law because its county tax effectively “double-taxes”some income that was already taxed in another state.
This decision is important to people like me who maintain legal residency in more than one state. Dual residency could have been suddenly a lot more expensive if the decision had gone the other direction. I suspect that this decision will also impact local earned income taxes but the Court decision does not address the question of what options are left open to the states. Other media reports speculate that we will see a wave of new tax laws designed to replace the tax revenue that will potentially be lost be this Court decision.
For more information see: Bradley Joondeph, Opinion analysis: Maryland’s personal income tax violates the Commerce Clause, SCOTUSblog (May. 19, 2015, 10:20 AM), http://www.scotusblog.com/2015/05/opinion-analysis-marylands-personal-income-tax-violates-the-commerce-clause/
When it comes to providing care in the home for a parent or relative, the tax implications can quickly become complicated. The IRS issued some guidance last year when payments come from Medicaid or similar programs under section 1915(c) of the Social Security Act. In short, these payments are not subject to self-employment tax but are taxable income to the family caregiver.
We also know that payments made through insurance policies receive favorable tax treatment. An increasing number of long term care policies include provisions for in-home care provided by a relative as an alternative to other care.
But what about when multiple family members contribute to the cost of providing in-home care? The possibilities expand for tax planning. In order to arrange the most favorable tax treatment it is necessary to consider the tax position of each person involved and design the home health care arrangement accordingly.
In some cases, I suspect, the highest income family members may pay a larger share of the cost and the amounts might be considered to be compensation to a household employee. Yet the family may achieve the best overall tax treatment if the payments are made by gift rather than compensation for services.
In any event, it makes sense to consider this issue as part of the overall tax planning process because in-home health care can be a significant and ongoing major expense. More on this tax planning process is posted at my web site http://www.tonynovak.com.
Philadelphia area newspapers have been following a high-profile tax evasion prosecution of the owners of South Jersey’s most successful pizza shops. The owners of Manco and Manco pizza are accused of failing to report almost a million dollars of cash receipts over a period of years. I have no intent to comment on the details of the case itself or the problems facing this family that are prominent members of our community. This post is not an endorsement, excuse or condemnation. The sole purpose of my post here is to use this case as an example of two important tax compliance points that affect many small business owners. This is a rare “teachable moment” in small business tax compliance.
A 5% margin of error in cash reporting is unacceptable
When we read that almost a million dollars was unreported income, that sounds like a lot. Yet it is important to consider that number represents less than 5% of the gross income of the businesses for the five-year period under investigation. It other words, the tax accountant for Mack and Manco got it 95% right and had an error rate of less than 5%. Consider that with many thousands of cash transactions, scores of employees handling cash and most likely several layers of cash management practices in effect we presume that the end result was that the owner was successful in properly collecting and reporting more than 95% of these transactions. In many other areas of business and mathematics we would consider an error rate of less than 5% to be acceptable and in some cases even admirable. Even under the audit procedures of small businesses with multiple locations that deal in cash, some rate of accounting error is expected.
Consider that most small business owners draw cash from the business for personal expenses and plan on doing the tax accounting later. Whether the intent was to intentionally evade taxes or some lesser flaw, the fact is that this practice happens everywhere. Any small business accountant finds examples where owners fail to report all income for a wide range of reasons. All reasons are equally illegal but the vast majority are not based on pure criminal intent. In my own practice, I would say that the busy pace of business and life is the #1 reason that some business receipts are not properly recorded. It is simply too easy to grab cash from the register on your way out the door to an expensive personal engagement and then fail to properly record the transactions.
This raises a series of questions from a tax accountant’s perspective:
So what is an acceptable level of accuracy in cash receipts reporting? It is an interesting question that every business owner should consider. We know that 100% accuracy is simply not attainable in a business of this nature. We know that 95% is unacceptable. So logically we know that the acceptable goal is between these two: somewhere between 95% and 100%. If we hire five different accountants to calculate the gross cash receipts, there will be five different amounts of gross income. It is naive to think that there is a single number that is the only acceptable result for income tax reporting. Increasing the level of accounting accuracy is certainly possible but it costs significant time and money. Given this perspective, we need to consider what level of reporting accuracy that our small business cash accounting systems be designed to achieve.
What could the accountant have done to detect to under-reporting problem earlier and avoid the audit investigation? The fact that all the unreported cash reportedly came from one store location is a red flag on numerous levels. My guess is that is could have been pretty easy for the accountant to avoid this mess long before it made headlines. In my own experience, business owners typically do not wish to pay the accountant for these additional tax accounting procedures that would have detected and corrected the problem – not because they are trying to hide illegal activity but simply because they don’t want a higher accounting bill.
What can be done to tame owners’ use of cash? The fact is that use of cash is “out of control” in many businesses. Getting owners (and often their spouses and adult children) to change their habits is very difficult. I know business owners that want to improve their cash handling procedures and have no intent to under report income but they simply can’t seem to get away from old habits. When faced with this type of dilemma, I often conclude that a degree in psychology would be more useful than a degree in accounting.
Do not make statements to investigators
Newspapers report that the business owners made multiple statements to investigators. This is simply wrong! Business owners need to know that they should never give a statement to a tax auditor. If any value is gained from this case, it should be that business owners should let professionals handle audits and investigations. A CPA will handle non-criminal investigations and a tax attorney must be retained when a criminal investigation is indicated.
Presuming that successful business owners are smart enough to know that they should not give statements to tax investigators, why do they do it? I see three main problems: 1) ego (i.e. “I an handle this”), 2) a momentary mental/emotional lapse that may be a stress reaction, or 3) desire to avoid paying a professional. In any case, the answer is simple: hire a professional immediately before any contact with IRS and then let the professional handle it.
In this Manco and Manco case, it seems likely that we would never have known about the tax investigation because the professional representative would have settled it long ago.
I noticed that all of my Pennsylvania tax clients who took a deduction for unreimbursed expenses (UE) received an audit response letter from the PA Department of Revenue. The problem is that the cost of responding to the audit exceeds the economic value of the deduction. In that case, the most reasonable economic response is simply to pay the additional assessment rather than attempt to spend time and money to prove this small value deduction.
Conversely, this development also means that the Commonwealth of Pennsylvania is spending more of its resources on these UE audits that it could possibly recover in additional tax revenue for the state.
When I posed a question on this topic to tax professional peers, I was surprised with the response. These are some of their paraphrased comments:
- The audit rate has risen sharply since 2013 and is now believed to be 100% among tax filers who take substantial deductions for UE. Prior years’ audit rate was high but less than 100%. Tax filers who were audited in 2013 are being audited again in 2014 if they take the deduction again. Tax filers who were not audited in 2013 are being audited for 2014.
- The cost of responding to the audit is usually more than the cost of just paying the additional tax assessment. Few, if any, tax filers have the documentation required to sustain the deduction.
- PA Department of Revenue knows that the ‘deck is stacked in its favor’, that the burden on the taxpayer in responding to the audit is substantial, and that its chances of prevailing on this audit are very high.
- The PA Department of Revenue’s cost of prosecuting these audits exceeds the revenue collected.
- Tax preparers who warned their clients of this risk were largely ignored.
- Clients usually believe that since this deduction is allowed be law and they have always taken it in the past without challenge that they should continue to take the deduction
- PA law on receipt documentation is tougher than federal law. PA doe not allow per diem expense allowances.
- Tax professional believe that PA Department of Revenue is acting unreasonably and is using the cost of audit response to assert an improper tax position.
- This problem issue has been brought to the attention of Department of Revenue officials by many individual tax professionals and professional associations including loud complaints at last year’s “Eastern Working Together Conference” but no there has been satisfactory response yet.
This past tax season I warned clients that taking UE would increase the risk of audit. My tax service includes audit response included in the basic tax preparation fee, so this issue directly affects my work load and liability. My included response would be to amend the tax return without the deduction. If a client wished to to the accounting required to fully respond to the audit, the cost would be higher or, of course, they could handle the response on their own.
I conclude that this is a “lose/lose/lose’ issue from the perspective of the taxpayer, the state, and the tax preparer and the best approach is avoidance.
This coming year I will change my tax engagement letter to say that taking this UE deduction is a known audit trigger (not a risk but a trigger) and that this known audit trigger is not covered in the audit response included in the basic tax preparation fee.
I do not have adequate information to comment on this issue in other states outside Pennsylvania.
The Democrat-led Finance Committee of the Connecticut General Assembly voted yesterday (4/29/2015) to expand its state sales tax to include accounting services. The Senate President Pro Tem said that he supports the changes but there appears to be opposition to the move beyond that.
Three states currently tax professional services: New Mexico, Hawaii and South Dakota. The AICPA covers this complicated topic but it is not clear whether its published guidance is up to date. Other news sources say that about half of all states are considering proposals to tax accounting services.
It is unclear how the proposed tax applies to services provided online by an accountant in one state (that taxes accounting services) for a client in a different state (that does not tax accounting services), or vice-versa as is more likely to be the case in my own practice.
My small online accounting practice typically provides services across state lines yet I am not actually even sure where my clients are when I provide services since most, like me, maintain homes and offices in more than one state. There is currently no built-in technology to track where I am actually providing these services. I presume that the location of the accountant – the taxpayer in this question – is the controlling factor in determining applicability of theses taxes. Yet states are attempting to expand sales taxes to online purchases made from out-of-state vendors. The entire topic is a potential mess that I hope we can avoid.
The average income tax preparation fee in the mid-Atlantic region was $314 this year; an increase of about 4% over last year. That average rate is calculated as a benchmark for a tax return with a Schedule A for itemized deductions and on state income tax return. Average fees for other tax schedules are listed below. These rates are the average of all preparers including CPAs and non-professional preparers. In general, CPA rates would be higher than this average and non-professional preparers would be a little less. The nation’s largest national tax preparation firm is priced higher than smaller firms however the fees are boosted by selling supplemental services like refund advances.
These statistics are calculated by the National Association of Accountants (NSA) that compiles the largest database of tax return preparation data in the country. The NSA notes that the amount of time required to prepare a tax return is rising faster in recent years than the fees charged. Specifically time-consuming are tax returns with an Earned Income Credit, Home Office Deduction or individuals who purchase their own health insurance. This means that tax preparation services represent a growing value for consumers.
Average fees for other tax forms:
$174 for a Form 1040 Schedule C (business)
$634 for a Form 1065 (partnership)
$817 for a Form 1120 (corporation)
$778 for a Form 1120S (S corporation)
$457 for a Form 1041 (fiduciary)
$688 for a Form 990 (tax exempt)
$68 for a Form 940 (Federal unemployment)
$115 for Schedule D (gains and losses)
$126 for Schedule E (rental)
$158 for Schedule F (farm)
This past tax season my pricing strategy was to position a little lower than the average fee (that includes both CPAs and non-professional preparers). Next year I expect to set prices a little higher than the regional average because of client feedback about providing a higher level of personal service and attention. In other words, it turns out that the majority of clients in my natural affluent niche market is would prefer to pay a bit more for premium service.
I learned a simple lesson today dealing with a client’s bank:
In this situation, I am the new online bookkeeper and there is another outside CPA involved. The bank needed unaudited financial statements. I am not allowed to prepare them for this purpose under the online bookkeeping agreement.The client produced them and sent them to the bank.
The banker complained that the income and equity sections of the statements did not match up. I re-ran the reports for my own purpose and they looked fine. Then I realized that the bank asked the client for an income statement first on one day and then followed up with a request for a balance sheet on a later date. Transactions occurred in their interim, so the income and equity sections did not match.
I asked the client to rerun them on the same day/time and they looked fine. I just had to explain why I am not allowed to send the statement directly to the bank.
In the end it was a little embarrassing (to me because it first seemed like I might have caused the error, to the banker because she did not recognize the source of the problem) but no harm done and it is now corrected.