Wednesday, April 8, 2009

Extensions, Tax Planning, IRS Indebtedness

I have been swamped with extensions. Federal Form 4868 is my new best friend.

It is true that there are too many returns to finish all before April 15th, but some clients either want to go on extension or must go on extension.

Some clients can try to avoid paying all the tax they owe by the deadline, but the IRS is smart. Taking a look at this informational page, you can see that the penalties are stiff for both failing to file and failing to pay adequate tax in time. People can't just not pay tax and then expect to collect interest on whatever they owe while their extension gives them 6 months to think about what they're doing.
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On the other hand, some clients have yet to receive all their tax documents from sources of income or expense. It is possible to complete a tax return with only the information that is known at the time of filing, but then an amended return must be completed at a later date, once all the paperwork is in order and the return can be regenerated. It's easier just to "go on extension."

Extensions are really tricky though. Sometimes big pieces of the puzzle are missing and it can be very difficult to determine whether a client needs to write the government a check by April 15th just in case, or if the client has actually already paid enough tax through W-2 withholding.
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---Explanation of Form W-4---
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Withholding of tax from an employee's paycheck is something that Form W-4 helps people figure out each year. This "Employee’s Withholding Allowance Certificate" has a worksheet attached which asks questions about a person's living status (dependents, etc.). Based on the answers to these questions, a person can determine their number of exemptions. It is this number which helps a company determine the right amount of tax to withhold from an employee's paycheck. Because people have other sources of income besides their job and can have really huge deductions, the Form W-4 is not the solution to determining a total tax figure. Rather, tax planning professionals, like at the place where I work, help in determining what someone's projected tax liability looks like.

---Transition from W-4 to Estimated Tax Payments---

Some people have to make "estimated tax" payments based on what they think they'll owe the IRS at the end of the year. I would venture to say that at least the simply majority of high net-wealth clients make quarterly estimated tax payments.

I see these commercials on television all the time reaching out to people who are in debt to the IRS. They say, "Do you owe the IRS $10,000 or more? $50,000? $100,000 or even more???" ... NO, I don't owe the IRS a hundred-thousand dollars!!! I used to ask myself, 'how can there be people out there--like these seemingly average looking people on the television--who owe the IRS anything more than $10,000?' I used to legitimately wonder, but since working at the tax firm, it's become very clear to me at least one way in which someone can stack up IRS debt of n dollars and beyond. Read on...




Something I've noticed about the W-2s of people who make a LOT of money is that the company never withholds and remits nearly enough tax to the IRS. For example, a W-2 showing $1,000,000 in salary payments might only have withholding of federal income tax of $210,000, which isn't nearly enough, especially since the tax rate caps off at 35% for all income above $357,700 for 2008. Assuming 'married filing jointly' and deductions (expenses, taxes paid, charitable contributions, etc.) of $200,000, this big earner is still going to owe $251,575 in federal income tax.

The IRS will assess a penalty at the end of the year if this person really owes $41, 575 ($251,575 - $210,000). So, anticipating this underpayment of tax, the client should divide the estimated amount owed by 4 quarters, and submit a payment every 3 months, roughly, so that total tax liability and total tax paid come out as close to even as possible at year end. This is tax planning in its simplest form.

Imagine this though:

Joe the Plumber starts working in 2007 and earns $40,000. Then in 2008 he discovers a way to work 10 times as fast. All of a sudden, it's December 31st and Joe's made a ton of money. He didn't anticipate earning this much (because inspiration strikes like lightning and can't be anticipated), so he didn't make any estimated tax payments to the IRS throughout the year. Joe spends all his newly attained wealth before March 25th (an arbitrary date) when his tax accountant tells him he owes the IRS a huge amount.

THIS is how someone can suddenly owe the IRS an enormous sum of money. They don't have enough withheld to begin with, and then they spend what they've earned before realizing they owe lots of tax.


Epiphany:

Tax withholding is the only way the income taxation system in this country is able to function. If tax wasn't withheld, not enough people would have the discipline to set aside their estimated tax payable until year end.

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