Dependents: What are the tax rules?

Most taxpayers believe that a "dependent" is a minor child that lives with them. While that is essentially correct, dependents can include parents, other relatives and nonrelatives, and even children who don't live with you. There is really much more to the dependent deduction than you might at first imagine.

* Exemptions and your taxable income. For 2012, each dependent deduction is worth $3,800, reducing your taxable income by this amount. In 2013, the deduction increases to $3,900 and is phased out for high-income taxpayers.

* Dependents defined. It's impossible to present all of the rules relative to dependents here, since they are so complicated. Generally speaking, if somebody lives with you and you provide more than half of that individual's support for the entire year, there is a good chance that person is a dependent. There are many exceptions. For example, parents don't have to live with you if they otherwise qualify, but some other relatives do. A child of divorced parents doesn't necessarily have to live with the noncustodial spouse for the dependent deduction to apply.

* People who can't be claimed. Generally, you may not claim a married person as a dependent if that person files a joint return with a spouse. Also, a dependent must be a U.S. citizen, resident alien, national, or a resident of Canada or Mexico for part of the year.

* One dependent deduction per individual. If you claim yourself as your own dependent, anybody else who can truly meet the tests and claim you as a dependent will lose out. This is common for college students who file their own tax returns for their part-time jobs, while mom and dad really meet all of the qualifications to claim the dependent exemption.

While the dependent deduction might seem relatively minor, it can lead to other deductions on the tax return. In order to claim the child tax credit, the education credits, the dependent care credit, for example, you must claim the dependent deduction for the child that qualifies for the deduction or credit.

Finally dependent deductions can be negotiated, which is especially important for divorced taxpayers. In the past, the IRS would accept the language of the divorce decree to allow the noncustodial parent the dependent deduction. However, under the current rules, the IRS will no longer accept a divorce decree in lieu of IRS Form 8332 (Release of Exemption).

New Medicare taxes take effect in 2013

The 2010 health care reform legislation included several provisions that go into effect this year. Among them is the increase in Medicare taxes for taxpayers with incomes above certain levels. Here is an overview of these two new taxes.

FIRST, the payroll Medicare tax will increase from 1.45% of wages to 2.35% on amounts above $200,000 earned by individuals and above $250,000 earned by married couples filing joint returns. The tax increase will also apply to self-employment income exceeding the threshold amounts.

Employers are required to withhold the additional tax from wages exceeding $200,000, regardless of the individual's filing status. They are not required to inform the employee when they begin the additional withholding, nor are they required to match the additional withholding.

SECOND, there is a new 3.8% Medicare tax on unearned income for single taxpayers with adjusted gross income over $200,000 and married couples with income over $250,000. The tax will apply to the lesser of (a) net investment income, or (b) the amount by which modified adjusted gross income exceeds the $200,000 / $250,000 thresholds. The tax may require adjustments to the estimated taxes paid by an individual, but it does not have to be withheld from wages.

Examples of unearned income include interest, dividends, capital gains, royalties, and rental income. Social security benefits, alimony, tax-exempt interest, and distributions from most retirement plans are examples of unearned income not subject to this new tax.

Pay attention to restored deductions for 2012

A number of tax breaks that had expired at the end of 2011 or were to expire at the end of 2012 were extended by the recently passed law, the "American Taxpayer Relief Act of 2012." Keep these deductions and credits in mind as you gather the paperwork for filing your 2012 tax return. Those that apply to you or your business could cut your 2012 tax bill.

FOR INDIVIDUALS. The law restored for 2012 through 2013 the following tax breaks:

* The optional deduction for state and local sales taxes instead of deducting state and local income taxes.

* The above-the-line deduction for up to $4,000 for qualified tuition and related expenses.

* The deduction for mortgage insurance premiums.

 * The above-the-line deduction for up to $250 for classroom supplies purchased by teachers.

* The exclusion from income for cancellation of mortgage debt of up to $2 million on a principal residence.

FOR BUSINESSES. Included in the law's provisions were the following items that could affect your business:

* The Section 179 first-year expensing option was increased retroactively for 2012 and extended through 2013 at $500,000 for the purchase of new and used equipment. The investment limit is set at $2,000,000.

* 50% bonus depreciation, which applies only to new equipment purchases, was extended through 2013.

* Both the research tax credit and the Work Opportunity Tax Credit were extended through 2013.

For assistance in identifying and utilizing all the tax deductions, both new and old, to which you are entitled, please give us a call.

"Chained CPI": What's it all about?

As the politicians in Washington start once again to tackle the same old problems, you're likely to hear more about a new way of measuring inflation called the "chained CPI."

The standard way to measure inflation has been with the consumer price index (CPI). The CPI has been used to calculate annual adjustments to social security benefits, federal pensions, military and veterans' benefits, and tax brackets, exemptions, deductions, and credits. According to some experts, the consumer price index currently used overstates increases in the cost of living.

So how is the "chained CPI" different? It makes different assumptions about how people spend. An oversimplified example: If a severe freeze drives up the cost of oranges and orange juice by 20%, people are likely to switch to a cheaper alternative, say, apples and apple juice instead of continuing to pay the higher price for oranges. This keeps spending more level than the regular consumer price index would indicate.

A switch to the chained CPI would mean that those government payments linked to inflation would rise more slowly. Applied to the tax code, the chained CPI would mean smaller inflation adjustments to tax brackets and other tax numbers, resulting in higher taxes than by using the regular CPI.

Home office recordkeeping simplified

The IRS is reducing the recordkeeping required for the home-office deduction, effective for 2013. Taxpayers who qualify may use a new optional deduction calculated at $5 a square foot for up to 300 square feet of an area in a home that is used regularly and exclusively for business. The deduction is capped at $1,500 a year.

Taxpayers opting for the simplified deduction cannot depreciate a portion of the home as they can under the other method. However, business expenses not related to the home, such as advertising, supplies, and employee wages, are still fully deductible.

This simplified option is available starting with the 2013 tax return which will be filed in 2014.

IRS extends deadline for farmers and fishermen

The IRS had to delay the start of this year's tax filing season until it completed programming changes made necessary by the late passage of the "American Taxpayer Relief Act of 2012" (signed into law on January 2, 2013).

Normally, farmers and fishermen are not required to make quarterly estimated tax payments if they file their tax return and pay taxes due by March 1 of the following year. The filing delay created by the new law meant that several tax forms needed by these taxpayers would not be ready on time.

As a result, the IRS has announced an extension of the March 1 filing deadline for farmers and fishermen to April 15.

The filing extension will apply to all farmers and fishermen, not just to those who use late-released IRS forms.

To qualify as a farmer or fisherman for 2012, at least two-thirds of the taxpayer's gross income for 2011 or 2012 must have come from farming or fishing.

New law causes filing season delay

The delayed passage of the "American Taxpayer Relief Act of 2012" has put the IRS behind schedule. Due to several provisions of the law affecting 2012 tax returns, the IRS could not open the Form 1040 filing season for the majority of taxpayers until late January.

Those taxpayers filing Form 5695 (Energy Credit), Form 4562 (Depreciation), and Form 3800 (General Business Credit) will not be able to file until late February or possibly not until March. Apparently a large percentage of taxpayers in this group typically file later in the season because they have more complex returns.

The IRS must complete the updating of forms and computer programming and testing before it is ready to accept any filings either on paper or electronically. The IRS said that taxpayers will receive refunds faster by e-filing and using direct deposit.

If we can be of assistance to you in preparing any of your 2012 tax filings, please contact us.