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Repairs vs. Improvements

Internal Revenue Code section 162 generally allows a current business deduction for the cost of repairs and maintenance incurred during the year. On the other hand, Internal Revenue Code section 263 requires the capitalization of amounts paid to acquire, produce, or improve tangible property. Since repairs and improvements often have very similar characteristics, it can be tricky to classify the expenditures. However, correct classification is important because the cost of repairs can generally be deducted in the year paid, while improvements must be capitalized and the deduction taken over several years through depreciation.

An improvement requiring capitalization occurs with an addition to or partial replacement of property that results in a betterment of the unit of property, restores the unit of property, or adapts the unit of property to a new use. The cost of an improvement must be capitalized and depreciated over a certain number of years as if the improvement were separate property.

Example: Nina has a truck she uses for her contracting business. Her truck was damaged and the cost to repair it is considered a deductible repair cost. Routine maintenance on the truck such as engine tune-ups and oil changes are also currently deductible expenses. Nina added a hydraulic lift to her truck, which improved its functionality. The expense of adding the lift is an improvement that must be capitalized and depreciated over the truck’s remaining useful life.

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Example: Glen owns a rental house and the roof on the unit is leaking. Glen is comparing the costs and benefits of fixing the leaking roof with replacing the entire roof. Glen can deduct the cost of repairing the leak as a rental repair expense. However, if Glen completely replaces the roof, the new roof is an improvement because it increases the value and lengthens the life of the property. Glen must capitalize and depreciate the cost of a new roof.

Business Use Requirement

Repairs are deductible only on business-use or rental property. A homeowner with no business use of the home does not benefit when an expenditure is classified as a repair rather than an improvement. Repairs are nondeductible personal expenses, while an improvement increases the basis of the home and reduces any potential gain on the sale of the home.

Example: Olive repaired a hole in the wall in her living room, replaced a few broken tiles in her bathroom, and sealed some cracks in her windows. She spent $1,200 making repairs to her home. Because Olive does not use her home for business purposes, the $1,200 is a personal expense and is not deductible.

Recordkeeping

Keep good records and ask contractors to provide an itemized list showing repairs and separately stated improvements and costs. If repairs and improvements are all completed at the same time, the IRS may classify the entire cost as improvement, even if some of the expenses were for repairs.

Court Case: The taxpayer incurred expenses to add a lunch area, restrooms, and a loading and unloading ramp to his existing manufacturing plants. In addition, the interior of the plants were painted and ‘fixed-up.’ The taxpayer claimed a repairs and maintenance deduction for all of the expenses. The IRS disallowed the deduction, explaining that the additions/improvements were made under a proposal and were required to be capitalized. The court agreed with the IRS, noting that the additions of the lunch room, restrooms and ramps constitute nondeductible capital expenditures that were more than merely keeping the property in an ordinarily efficient operating condition. The additions and improvements not only increased the value of the plants, but also aided in adapting them to a different use. The painting of the facility would qualify as a deductible repair if those expenses were standing alone, however, when made as part of an entire capital investment in the improved property, as they were in this case, they must be treated as a capital expenditure. In addition, the court noted that it was not possible to determine from the evidence submitted what portion, if any, was attributable to deductible repairs. Without a segregation of expenses, the deduction cannot be allowed and all expenditures must be capitalized. (Rutter, T.C. Memo 1986-407, August 28, 1986)

Saving for College

Custodial Accounts (UTMA/UGMA)

Assets in a custodial account belong to the minor. A
custodian, usually an adult relative, controls the assets
until the minor reaches the age set by state law (21 in
most states).
Assets in a custodial account can be used to pay for education expenses for the minor.

Savings Bond Interest Exclusion

Exclusion Rules

Interest from qualified savings bonds redeemed by the
taxpayer can be excluded from income if:
• The taxpayer paid qualified education expenses during the year for the taxpayer, spouse, or a dependent
claimed on the taxpayer’s return.
• Filing status is not Married Filing Separate.
If proceeds from the redemption (interest and principal) are more than adjusted qualified education expenses, only a percentage of the interest is excludable.
Example: Marty redeemed qualified bonds for $10,000, including accrued interest of $5,500. He paid $8,000 of qualified
education expenses during the year. His excludable interest is:

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Income Limit

The exclusion is limited by adjusted gross income.
Check with your tax preparer for income limitations.

Qualified Savings Bonds

• Series EE bonds issued after 1989 and Series I bonds.
• Issued to a person who was age 24 before the bond’s
issue date. The issue date is the first day of the month in which the bond was purchased (for example, a bond purchased on May 25 has a May 1 issue date). The issue date is printed on the front of the bond.
• Issued in the name of the taxpayer and/or spouse. There can be no other co-owners, including the taxpayer’s child. The bond can have a pay-on-death
(POD) beneficiary, including a child.

Qualified Education Expenses

• Tuition and fees required for enrollment or attendance at an eligible educational institution. Qualified expenses do not include courses involving sports, games, or hobbies, unless part of the student’s degree program.
• Contributions to a qualified tuition program.
• Contributions to a Coverdell education savings account.

Qualified Tuition Plans (529 Plans) & Educational Savings Accounts (ESAs)

QTP and ESA Tax Benefits

Contributions to a QTP or ESA are not deductible. Earnings accumulate tax free. Distributions are not taxable if less than the beneficiary’s adjusted qualified education expenses in the year of distribution. Contributors can contribute to both a QTP and an ESA in the same year for the same designated beneficiary.

Qualified Expenses
• Tuition, fees, books, supplies, and equipment required for enrollment or attendance of the designated
beneficiary at an eligible institution.
• Expenses for special needs services of a beneficiary
with special needs incurred in connection with enrollment or attendance.
• Room and board for students enrolled at least half
time in a degree or certificate program. Expenses are
limited to the room and board allowance included in
the cost of attendance set by the school for financial
aid purposes or the actual cost of campus housing, if
greater.

Did You Know? Most colleges and universities
set room and board allowances for students who live
on campus, off campus, and with parents. Check the
school’s financial aid website for costs of attendance.
For ESAs, the following additional expenses are allowed.
• Expenses for enrollment or attendance at any public,
private, or religious school that provides K– 12 education as determined under state law.
– Tuition, fees, books, supplies and equipment, academic tutoring, special needs services.
– Room and board, uniforms, transportation, supplementary items and services, including extended day
programs if required or provided by the school.
• Purchase of computer technology, equipment, or internet access and related services to be used by the
beneficiary and family during elementary or secondary school years. Does not include computer software
unless predominantly educational.
• Contributions to QTPs for the designated beneficiary.
Adjustments

Qualified expenses are reduced by:
• Tax-free assistance (scholarships, fellowships, grants,
employer-provided assistance, veterans benefits,
and any other nontaxable payments except gifts or
inheritances).
• Amounts used to figure an education credit.

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Education Tax Benefits

If you pay tuition, fees, and other costs for attendance at an eligible educational institution for yourself, your spouse, or your dependent, you may be able to take advantage of one or more of the education tax benefits.

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You can claim more than one education benefit in a tax year as long as you do not use the same expenses for more than one benefit.

Exception: Qualified expenses used to claim education benefits can also be used to eliminate the 10% penalty on premature IRA distributions.

You may claim only one of the following education tax benefits for the same student per year: tuition and fees deduction, American Opportunity Credit, or Lifetime Learning Credit.

Education Deductions.
Deductions reduce the amount of income subject to income tax. Deductions for education expenses include:
• Tuition and fees deduction up to $4,000 from gross income. Income limitations apply.
• The provision for deducting tuition and fees expires for tax years after 2016.
• Student loan interest deduction up to $2,500 from gross income. Income limitations apply.
• Business deduction on Schedule C or F. You can deduct the cost of education related to the business or farm activity.
• Miscellaneous itemized deduction on Schedule A, subject to the 2% AGI limitation. You can deduct the unreimbursed cost of education required to keep your current job or maintain and improve skills needed for your job. You cannot deduct the cost of education that qualifies you for a new trade or business.

Education Tax Credits
Tax credits reduce the amount of income tax you may have to pay. Income limitations apply. The education credits are claimed on Form 8863, Education Credits (American Opportunity and Lifetime Learning Credits).
• American Opportunity Credit, $2,500 maximum per student per year.
• Lifetime Learning Credit, $2,000 maximum per tax return per year. Note: The Hope Credit applied to 2008 and earlier years. It was replaced by the more generous American Opportunity Credit for tax years after 2008.

Penalty-Free IRA Distributions
If you withdraw money from your IRA before you are age 59½, you are generally subject to a penalty of 10% of the distribution, in addition to any tax that may be due on the distribution.
• The 10% penalty does not apply to traditional IRA or Roth IRA withdrawals, if you use the money to pay qualified education expenses for yourself, spouse, or for any child or grandchild of yourself or your spouse.
• Qualified education expenses include tuition, fees, books, supplies, equipment, and special needs services required for enrollment or attendance at an eligible educational institution. Room and board for students enrolled at least half-time in a degree or certificate program may also qualify.
• Reduce qualified expenses by scholarships and other tax-free assistance the student receives, but not by gifts or inheritances.

Education Savings Plans
Contributions that you make to education savings plans are not deductible, but the earnings accumulate tax free. In addition, no tax will be owed on distributions if they are less than the beneficiary’s qualified education expenses. Qualified expenses are reduced by scholarships, other tax-free assistance, and amounts used to figure education credits.
• Qualified Tuition Programs (QTPs). States sponsor QTPs to allow prepayment of a student’s qualified higher education expenses. For information on a specific QTP, you need to contact the state agency or eligible educational institution that established and maintains it. Note: QTPs are also called 529 Plans because they are authorized under section 529 of the Internal Revenue Code.
• Coverdell Education Savings Accounts (ESAs). A Cover dell ESA can be used to pay a student’s eligible K-12 expenses, as well as higher education expenses. Coverdell ESA contributions are limited to $2,000 total per year for each beneficiary, no matter how many accounts have been established or how many people are contributing. Unless the beneficiary is a person with special needs, contributions to a Coverdell ESA must stop before the beneficiary reaches age 18 and the account balance must be distributed within 30 days after the beneficiary reaches age 30 (or dies, if earlier).

Exclusions From Gross Income.
An exclusion from income means you don’t report the benefit you receive as income and you don’t pay tax on it, but you also can’t use that same tax-free benefit for a deduction or credit.
• You may exclude the part of scholarships, fellowships, and grants that you use for qualifying education expenses while you are a degree candidate.
• You may exclude up to $5,250 paid for you under a qualifying educational assistance plan. Additional amounts are included in your W-2 income, unless they are a working condition fringe benefit. A working condition fringe benefit is an amount that you could have deducted as an employee business expense, had you paid for it instead of your employer.
• If you cash in qualified U.S. Savings Bonds to pay for eligible education expenses for yourself, spouse, or your dependent, you may exclude the bond interest from income. Income limitations apply.

There are many events that occur during the year that can affect your tax situation. Preparation of your tax return involves summarizing transactions and events that occurred during the prior year. In most situations, treatment is firmly established at the time the transaction occurs. However, negative tax effects can be avoided by proper planning. Please contact us in advance if you have questions about the tax effects of a transaction or event, including the following:
• Pension or IRA distributions.
• Significant change in income or deductions.
• Job change.
• Marriage.
• Attainment of age 59½ or 70½.
• Sale or purchase of a business.
• Sale or purchase of a residence or other real estate.
• Retirement.
• Notice from IRS or other revenue department.
• Divorce or separation.
• Self-employment.
• Charitable contributions of property in excess of $5,000.

Employee or Independent Contractor

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Employee or Independent Contractor?

In order for a business owner to know how to treat payments made to workers for services, he or she must first know the business relationship that exists between the business and the person performing the services. A worker’s status determines what taxes are paid and who is responsible for reporting and paying those taxes. A worker performing services for a business is generally an employee or an independent contractor. If a worker is classified incorrectly, the IRS may assess penalties on the employer for nonpayment of certain taxes.

Penalties and Interest

When the IRS determines that a worker is actually an employee rather than an independent contractor, the employer is subject to penalties for failure to withhold and remit income, FICA (Social Security and Medicare) and FUTA (federal unemployment tax) taxes, interest on the underpaid amounts, and penalties for failure to file information returns. The state will also seek to collect workers’ compensation and unemployment compensation premiums for unreported wages.

Independent Contractor

An independent contractor is self-employed and is generally responsible for paying his or her own taxes through estimated tax payments. A business issues Form 1099-MISC, Miscellaneous Income, to any one independent contractor, subcontractor, freelancer, etc., to whom the business made $600 or more in payments over the course of the tax year. The business is not generally responsible for withholding income tax or FICA.

Employee

A worker treated as an employee will be issued Form W-2 for wages paid. The business hiring the worker is responsible for withholding income tax and FICA. The employer is also liable for FUTA and various state employment taxes. Also, the employee may be eligible for certain fringe benefits offered by the employer, such as health care.

Factors to Determine Worker Status

The general rules for classifying workers as independent contractors or common-law employees center on who has the right to control the details of how services are to be performed. The factors can be grouped into three categories.
1) Behavioral control. Factors that indicate a business has the right to control a worker’s behavior include the following.
Instructions that the business gives to the worker. Employers generally control when and where work is to be done, what tools or equipment to use, what workers to hire or to assist with the work, where to purchase supplies and services, what work must be performed by a specified individual, and what order or sequence to follow.
Training that the business gives to the worker. Employees may be trained to perform a service in a particular manner. Independent contractors generally use their own methods.
2) Financial control. Factors that indicate a business has the right to control the business aspects of a worker’s job include the following.
Extent of the worker’s unreimbursed business expenses. Independent contractors are more likely to incur expenses that are not reimbursed, such as fixed overhead costs that the worker incurs regardless of whether work is currently being performed.
Extent of the worker’s investment. Independent contractors often have significant investment in facilities used to perform services for someone else, such as maintaining a separate office or other business location.
Extent to which the worker makes his or her services available to the public. Independent contractors are generally free to offer their services to other businesses or consumers. They often advertise and maintain a visible business location.
Method of payment for services performed. Employees generally are guaranteed a regular wage and work for an hourly fee or a salary. Independent contractors are generally paid a flat fee for a specific job. Exceptions apply to some professions, such as accountants and lawyers who charge hourly fees for their services.
Extent to which the worker can make a profit. Independent contractors can make a profit or a loss.
3) Type of relationship between the parties. Factors that indicate the type of relationship include the following.
Written contracts that describe the relationship and intent between the worker and the business hiring the worker.
Employee-type benefits provided to worker. Employers often provide fringe benefits to employees, such as health insurance, pensions, and vacation pay.
Permanency of the relationship. Employer-employee relationships generally continue indefinitely.
Extent services performed by the worker are a key aspect of the business hiring the worker. A worker who is key to the success of a business is more likely to be controlled by the business, which indicates employee status. For example, an accounting firm hires an accountant to provide accounting services for clients. It is more likely that the accounting firm will present the accountant’s work as its own and would have the right to control or direct that work.

Incorrect Treatment of Employees as Independent Contractors

A worker who receives a 1099-MISC instead of a W-2 has two options.
1) Agree with the way the business has classified the worker, file Schedules C and SE, and pay self-employment tax on the earnings, or
2) File Form SS-8, Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding. The IRS will then decide if the worker should have been treated as an employee, subject to income and FICA tax withholding. If the IRS agrees that the worker really is an employee, the employer will be liable for employment taxes. However, if the IRS determines that the worker is really an independent contractor, the worker will be liable for paying SE tax.

Example: Harold owns a restaurant and hires Jim, a gardener, to mow the lawn and weed the landscaping once a week. The contract states that Jim will arrive at the restaurant on Monday mornings, mow the lawn, pull weeds, and tend to the landscaping. In exchange, Harold agrees to pay Jim $50 for this service each week. Jim supplies his own lawnmower, weed eater, and hedge clippers. Jim decides what time he arrives and how long the job will take him. Harold does not supervise Jim in his tasks or dictate to him how they are to be done. Jim is an independent contractor.

Example: Jeffrey owns Jeffrey’s Gardening Service and employs three gardeners to perform services for his business. Jeffrey pays his gardeners a fixed wage and withholds taxes, FICA, and various benefits and remits those withholdings to the appropriate government agencies. In addition, Jeffrey provides his employees with the tools and equipment they need to perform their work, instructs his employees which jobs to go to, and supervises them while they are doing their work. Jeffrey’s workers are employees.

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There are many events that occur during the year that can affect your tax situation. Preparation of your tax return involves summarizing transactions and events that occurred during the prior year. In most situations, treatment is firmly established at the time the transaction occurs. However, negative tax effects can be avoided by proper planning. Please contact us in advance if you have questions about the tax effects of a transaction or event, including the following: • Pension or IRA distributions. • Significant change in income or deductions. • Job change. • Marriage. • Attainment of age 59½ or 70½. • Sale or purchase of a business. • Sale or purchase of a residence or other real estate. • Retirement. • Notice from IRS or other revenue department. • Divorce or separation. • Self-employment. • Charitable contributions of property in excess of $5,000.

This brochure contains general information for taxpayers and should not be relied upon as the only source of authority. Taxpayers should seek professional tax advice for more information.

Taxpayers Who Receive an IRS Notice

Tips for Taxpayers Who Receive an IRS Notice
Receiving a notice from the Internal Revenue Service is usually no cause for alarm. Every year the IRS sends millions of letters and notices to taxpayers. In the event one shows up in the mailbox, here are ten things you should know.
1) Don’t panic. Many of these letters can be dealt with very simply.
2) Don’t ignore it. Most of these letters have a “reply by” date. Inaction can lead to additional interest and penalties or more aggressive action from the IRS.
3) Call your tax professional. Your tax professional is available to help you, is familiar with your situation, and has experience dealing with the IRS. Utilize his or her expertise. He or she will generally want to see a copy of the letter to determine the next course of action. Some letters can be resolved simply by having you contact the IRS directly. Other, more complicated issues may require you to sign Form 2848, Power of Attorney and Declaration of Representative, to allow your tax professional to deal with the IRS on your behalf.
4) There are a number of reasons the IRS sends notices to taxpayers. The notice may request payment of taxes, notify you of a change to your account, or request additional information. The notice you receive normally covers a very specific issue about your account.
5) Each letter and notice offers specific instructions on what you need to do to satisfy the inquiry.
6) If you receive a notice about a correction to your tax return, you should review the correspondence and compare it with the information on your return.
7) If you agree with the correction to your account, usually no reply is necessary unless a payment is due.
8) If you do not agree with the correction the IRS made, it is important that you respond as requested. Respond to the IRS in writing to explain why you disagree. Be courteous and respectful. Include any documents and information you wish the IRS to consider, along with the bottom tear-off portion of the notice. Mail the information to the IRS address shown in the lower left corner of the notice. Allow at least 30 days for a response from the IRS.
9) Most correspondence can be handled without calling or visiting an IRS office. However, if you have questions, call the telephone number in the upper right corner of the notice. When you call, have a copy of your tax return and the correspondence available.
10) Keep copies of any correspondence with your tax records. As with any tax issue, contact your tax professional to help you navigate your own unique situation.

Avoid Future Problems
You can minimize the likelihood of encountering future problems with the IRS by:
• Keeping accurate and complete records,
• Waiting to file your tax return until you receive all your income statements,
• Checking the records you receive from your employer, mortgage company, bank, or other sources of income (W-2s, 1098s, 1099s, etc.) to make sure they are accurate,
• Including all your income on your tax return,
• Following the instructions on how to report income, expenses, and deductions, and
• Filing an amended return for any information you receive after your return has been filed.

Consider filing your taxes electronically. Filing online can help you avoid mistakes and find credits and deductions that you may qualify for. Find a tax preparer whom you trust to prepare and e-file your return. An experienced tax preparer who is familiar with your personal situation is in a position to help you file a complete and accurate return. In addition, he or she will be able to advise you on the best course of action for responding to a notice should you receive one.

Taxpayer Rights
IRS employees are required to explain and protect your rights as a taxpayer throughout your contact with them.

Privacy and Confidentiality
The IRS will not disclose to anyone the information you give them, except as authorized by law. You have the right to know why they are asking you for information, how they will use it, and what will happen if you do not provide the requested information.

Professional and Courteous Service
If you believe that an IRS employee has not treated you in a professional, fair, and courteous manner, you should tell that employee’s supervisor. If the supervisor’s response is not satisfactory, you should write to the IRS director for your area or the center where you file your return.

Representation
You may either represent yourself or, with proper written authorization, have someone else represent you in your place. Your representative must be a person allowed to practice before the IRS, such as an attorney, certified public accountant, or enrolled agent. If you are in an interview and ask to consult such a person, then in most cases, the IRS agent must stop and reschedule the interview.

You can have someone accompany you to an interview. You may make sound recordings of any meetings with the IRS’ examination, appeal, or collection personnel, provided you tell them in writing 10 days before the meeting.

Payment of Only the Correct Amount of Tax
You are responsible for paying only the correct amount of tax due under the law—no more, no less. If you cannot pay all of your tax when it is due, you may be able to make monthly installment payments.

Help With Unresolved Tax Problems
The Taxpayer Advocate Service can help you if you have tried unsuccessfully to resolve a problem with the IRS. Your local Taxpayer Advocate can offer you special help if you have a significant hardship as a result of a tax problem.

Appeals and Judicial Review
If you disagree with the IRS about the amount of your tax liability or certain collection actions, you have the right to ask the Appeals Office to review your case. You may also ask a court to review your case.

Relief From Certain Penalties and Interest
The IRS will waive penalties when allowed by law if you can show you acted reasonably and in good faith or relied on the incorrect advice of an IRS employee. The IRS will waive interest that is the result of certain errors or delays caused by an IRS employee.

This brochure contains general information for taxpayers and should not be relied upon as the only source of authority. Taxpayers should seek professional tax advice for more information.

North Carolina and South Carolina residents and business owners are welcome at the offices of Franklin P. Sparkman, CPA. A locally trusted name for accounting, bookkeeping, tax preparation for businesses and personal finances.

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