However, I think that tax-prep software does a disservice to people, especially freelancers and folks who own their own businesses.  I’m not talking about how it prepares the forms. (Although, I have seen people mis-interpret questions and then get a love letter from the IRS.)My husband commented this morning that one of the people he follows on Twitter said they had spent 4 hours preparing their taxes.  Now let’s get to my favorite part: math.  This guy is a freelancer, he bills out at $90/hour.  That means the 4 hours he spent preparing his taxes equals $360 of his time.  Since he is a freelancer, he needs the business version of the tax software, which costs $50.  Right now, his taxes just cost him $410 in lost revenue from the time he spent and in tax software.  Then there’s the little things like: how long did it take him to go get the software?  Did he research which software he was going to use? How long did that take?

So let’s say he brought them to a preparer.  A normal return will take me 1-3 hours, depending on the complexity of the return.  Most CPAs and EAs are comparable in prep time.  So, basic return, with a business starts at $250 for me.  Time-wise, I saved him 4 hours.  Money-wise, I saved him $160.

Granted, if you’re not that busy, then I haven’t saved you anything…

“My client didn’t pay me, can I claim a loss?”The short answer is sort of.  You can claim the expenses that you incurred while working on the client’s project or producing the product order.  Likewise, if you have a rental, the months that the rental is empty is not a loss.  Your “loss” in both of these is simply that you did not receive the income.  You get to claim the expenses of supplies, equipment, cleaning, or whatever you’ve incurred in the course of business or renting.

So what about your time?  Do you get anything for that?  Sadly, the answer is no,the IRS doesn’t care what you bill your time at.  The fact of the matter is, it’s extremely easy to overinflate your time or rate and take a loss.  So easy, in fact, that it’s just not allowed.  The only way to claim your own time and hourly rate is if you pay yourself wages, even then, it’s the business claiming the loss and can’t be used for a business that does not pay wages or subcontractor costs.

So can we claim any bad debt from deadbeat clients?  No, UNLESS, you use accrual accounting and the loss spans from one tax year to the next.  Even then, the only reason is because you already claimed the income.  Here’s how accrual (as opposed to cash or a hybrid method) method works: you recognize any income or expenses at the time that they are billed as opposed to when you receive or send out money.  This is based on an accounts payable or accounts receivable.  The exception is that you claimed the income in the prior year (let’s say 2007) because you use accrual accounting and recognized the income at the time that you billed the client.  The money, let’s say $500, was claimed as income in 2007 when it was billed.  When you get to the end of 2008, you realize that the client didn’t pay the bill.  So, you’ve claimed the income and you never received it.  To make matters worse, let’s say the client skipped town and just can’t be found anymore.  You know you’re not going to see the $500.  This is where ” bad debt” comes in.  You have a bad debt.  In good faith, you claimed the income and it never materialized.  Now it’s a “bad debt.”  In 2007, you said you had $500, and in 2008 you recoup the taxes you paid on the $500 in the prior year.

All in all, it sucks that there’s nothing else to do.

Secondly: don’t go running to an EA, lawyer, or CPA.  There is a due date on the letter when they expect a response by.  Do some research, read carefully what they are looking at.  You can then get all the information requested together and bring all of that to the EA/CPA/lawyer.  This will save you time in the long run and since these type of services usually charge by the hour, you just saved yourself money.  However, be sure to get the letter and information to your representative with plenty of time.

Finally:  If you decide to go meet with the IRS, don’t volunteer any information that is not specifically asked for.  This applies to all steps of the process.  Don’t write a letter volunteering info, don’t call and complain and offer info.  Only provide what is requested.  Any more than that might lead to a more intense scrutany.  Don’t give the IRS a reason to look deeper than they believe they should.

So what’s the deal?  Why are people so convinced that audit red flags exist?

There are parameters that the IRS uses in order to determine if a taxpayer will get a audit letter.  But the audit decision is computerized–no one knows exactly what the  computer selection is based on.  Yes, there are certain items that do seem to come up for audit more often than others, but they are also items that people tend to overestimate or abuse.  (In home office, for example, or a small business loss.)

If you have a preparer who is more concerned about an audit than about doing your taxes accurately, you should find a new preparer.  A good tax preparer will make sure that you pay the lowest amount of taxes legally possible.  If your preparer refuses to take legal deductions that you are entitled to, they are doing you a disservice by having you pay more in taxes than you legally should.

• According to the U.S. Treasury Department, the compliance costs of the income tax system amounts to about $140 billion each year—$100 billion for individuals and another $40 billion for businesses. This is roughly 10 percent of individual and corporate income tax revenues.
• The compliance burden also works out to about $1,000 per family every year.
• On average, Americans spent more than half a work week—26 hours—on their taxes each year.
• About 60 percent of taxpayers don’t even prepare returns themselves, but pay tax preparers to complete returns on their behalf.  Another roughly 15 percent of taxpayers use tax preparation software.  That is, only about a quarter of taxpayers do their own taxes.
• According to the IRS, individual taxpayers (including sole proprietors) spent roughly 3.5 billion hours to comply with the tax system.  This is equivalent to hiring almost two and one-half million ”hidden” IRS employees and 20 times the agency’s current work force.
• Businesses spent over 3 billion hours complying with the tax system at a total cost of roughly $40 billion annually.

It will be interesting to see, if confirmed, whether Mr. Geithner will be able to make any significant changes to simplify the tax code.

The first thing to do is to determine why it is that your accountant wanted to get rid of you.  For this, there are two options: Either it’s you or it’s not you.

Is it YOU?

Do you complain about your bill?  Are you constantly asking for changes to your accounting or taxes once you have them?  Do you give your accountant really short deadlines?  Are you just rude?  There was one client we had in particular that wold only give us half the information necessary to complete their return and once they had filed the tax return, they came back with additional info and asked to have the return amended.  It happened three years in a row.  Inevitably, they came back to us and asked why the bill was so high!  We prepared two returns for them–the original and the amended–that’s why!  That’s really being unreasonable.

No, it’s not you.

Sometimes, accountants just want to downsize–they don’t want as many clients as they currently have.  If you’ve just started with an accountant and find yourself being fired within a year, they might not want to have such a big client base and cut out the newer clients in order to preserve the loyalty they have to the older clients.  Another option is that you accountant is up-scaling.  I saw this at each CPA firm I’ve been with–they instituted a minimum annual billing and anyone falling below the fee had to find somewhere else to go.  With one firm, it was a minimum of $250, with another it was a minimum $1,000.  Accounting practices do change, too, and alter their focus.  Several practices I know have decided to drop a key service they provided in order to focus on more lucrative or less restrictive services.  I have to say, being fired for not meeting the minimum is a lot nicer because it means that they didn’t want to hike your bill to meet the new fee floor.

If you’re on good terms with an accountant–ask them about clients they’ve fired.  We all have a few stories to tell.

I.) Elements of personal pleasure or recreation
While I hate to beat a dead horse, a lot of businesses I’ve seen disallowed have to do with something that started out as a hobby. Do you garden and sell your plants at a farm stand? Are you a antique collector who sells antiques on eBay? A while back I posted a quote in Do you have to suffer for your business? where I mentioned that the Tax Court has actually mentioned in a a ruling that suffering doesn’t have to be part of a business in order to make it a viable business. One thing to keep in mind is that if you do breed poodles and refer to them as “your babies” in the court, your chances just got a little smaller of claiming that your kennel is an actual business.

And with that…I’m done! Next series–freelancing businesses and it’s many intricacies. See you tomorrow.

This falls into the previous categories where the question was about the success of the business.  Are you making money in this business?  There is a 3-out-of-5 rule where the cannot be losses for more than 3 years in any given timeframe.  An additional qualification might be–do your gains in the non-loss years exceed the losses in the years you have a loss?  There are a couple of tax court cases out there that cover this.  I’ve seen a case where the court ruled that the taxpayer did not have a business simply because, while they had gained $15,000 between the two gain years, it did not exceed the losses in the three loss years which totaled $40,000.  The ruling stated that the business was a hobby because the profit would never allow for the business to break even over the five years.

H.) The financial status of the taxpayer

This is a tricky one.  They want to know if this is just a rich person’s hobby.  If you get into breeding prize poodles and you just keep losing money at it (by giving the puppies away to friends or selling them inexpensively) seemingly have losses to offset your income, the IRS will take that into consideration.  It’s basically asking “why are you doing this? Is there a loss motive to your ‘business instead of a profit motive?’”  Believe it or not, much like tax shelters, some folks invest into ‘businesses’ in order to have a loss.