This topic is not meant to give you a detailed class on doing your own income tax return, your own estate tax return or your own gift tax return. Instead, it is designed to alert you to those things you must watch out for. In short, it contains some basic information on how the system really works. We will explain, by sections, how the individual tax return is structured and when it is necessary for you to file a return. Something we have always preached is that you should know enough about taxes to know when you should ask a question. We will also talk about the dreaded tax audit and how to handle it.

Income taxes
You must file a return if your income is above a certain level. This filing requirement level varies every year so each year you will need to check if you are close to the following numbers. If you have always filed, you will likely receive a letter from the IRS asking about your missing return,. Don't panic, just write back and explain that you no longer meet filing requirements. You must file if you have a refund due and would like it back because there is no other way to get your money refunded. The income level that requires you to file, whether or not any tax is due, is determined by adding your personal exemption(s) and standard deduction together. In 2004 as an example, that amount was around $14,300 for a married joint return with each spouse under age 65. This amount included the standard deduction for a married joint return and two personal exemptions. If that couple had more income than that figure for that year, they would need to file. A single under age 65 in 2004 had a filing requirement at about $7,150. There are always potential complications, so if you are in doubt about filing, call the IRS. In spite of what you may have heard, that does not put you on any kind of list.

The individual tax filing is done on a Form 1040, 1040A or 1040EZ, based on how complicated your individual income tax return has become. If you are required to include attachments, plan on using the Form 1040.

All three 1040s begin by having you list your income items. Some of those entries may require a computation form, such as the reporting of capital gains (Schedule D). If used, this needs to be attached as part of your tax return. You may need to use a worksheet to compute taxable SS, but it does not need to be attached. More on some of these forms later. As you move down the front page of the Form 1040, you get to Adjustments to Gross Income. You started by listing your Gross Income and now you can start listing your deductions for some of your outgoing expenses. In this category you would include IRA contributions, moving expenses, and alimony payments, among other items. This is the best possible place to begin reducing your tax burden. (Not withstanding the alimony.) The resulting figure, Gross less Adjustment, is called Adjusted Gross Income (AGI). This AGI figure is frequently used in the computation of other deductions so, the smaller the AGI, the better.

The Form 1040 now takes you to page two where you continue your computations by entering either your itemized deduction from Schedule A or the allowed expense deduction called the Standard Deduction. You choose the larger of the two. You then subtract your personal exemption(s), one for just you or add one for the wife/husband and each of the qualifying children. That gives you Taxable Income, the number that determines how much your tax bill is going to be. If you have taxable income, you will owe income tax. You next refer to the tax tables, provided by the IRS to determine the actual tax bill. At this time you compare the amount of tax you paid through payroll deductions etc, to the tax bill. If you had paid in more than the amount specified in the tax bill, a refund is in order. If not? Whoops, a check written to the IRS is highly appropriate. Now, on to the nuances of our American tax system.

Our income tax system in the USA is called a progressive tax system: the higher your income, the higher the rate of taxation. It is important to note that we all pay the same rate on the first of our taxable income. Then we all move to the next higher tax bracket and so on. The highest bracket that you have reached is called your marginal tax rate. In 2005, the lowest bracket is taxed at 10% of your taxable income (TI) from zero to $14,600 when you file as a married couple; the amount from $14,600 to $59,400 of taxable income for a married couple costs 15%. Then the rate jumps to the next marginal tax rate. A single person starts paying 10% at a taxable income from $1 TI to $7,300. Remember, taxable income starts after we have taken all of our allowable deductions. As our income grows we move through each marginal tax rate to a maximum of 35%. One of our goals is to keep you in the lowest tax bracket possible.

Not all kinds of income are taxed the same way. Historically, long term capital gains have been taxed at a lower rate. Now dividends have been added to our list of tax preference items and are taxed at long term capital gains rates. Social Security benefits were not taxable a few years back, but Congress has changed that. At first they made Social Security 50% taxable, if your income was above a certain level. That worked so well that they added an 85% level which is likely to catch most of us.

Dividends and long term capital gains qualify for the capital gains rates, if the asset is held for more than year, and are taxed at 5% for the taxpayer in the 10% and 15% tax brackets. The rates on capital gains items go to 15% for taxpayers in the 25% bracket and above. Note that these rules apply to gains on stocks, bonds and real estate. If you have gains on collectibles, certain small business stock or section 1250 recapture, the cap gains rates will very. Short term capital gains, those held for less than one year, are taxed just like regular income at your marginal rate. Also in this category of being taxed at a marginal rate are withdrawals from your IRA or retirement account, and the taxable portion of your Social Security benefit.

Now we need to explore the attachments to your Form 1040 that we might want to use. Remember that we have already discussed those Adjustments in arriving at AGI. The Schedule A form is where we can deduct items that tend to be of a personal nature. These expenses include medical and dental, certain taxes we paid such as property tax, state and local income taxes and a few others. We can also include interest on our home mortgage, and investment interest expenses. Gifts to qualifying charities round out the principal items for this Schedule. There are other possible items but if you don't get close to that allowable standard deduction with taxes and interest, you probably will not be using this form. Those other line items can add some to your total Sch. A deductions, but typically they are not large.

One of the reasons we prefer AGI adjustments is demonstrated under medical deductions on Schedule A. It says there that qualified medical expenses must be reduced by 7.5% of your AGI before you can start counting them as a deduction. This limit can substantially reduce your deduction. Job and other miscellaneous deductions suffer a 2% AGI restriction also. Still, using a Schedule A may well be worth the effort.
Ways that we might manipulate this form include bunching your deductibles. I have a friend who is right at the margin to itemize or not. To strengthen his ability to itemize, he makes substantial charitable contributions, every other year with a two year gift at the end of the year for the current and next year, using the standard deduction every other year. You can make an extra payment to the State Tax Commission which is deductible in the year made, even if I get a refund from the State the following April.

As always, good record keeping is important. A calendar with travel records for business or charitable purposes will work. Contemporaneously prepared records carry a lot of weight with your IRS auditor, just incase of an audit. The time you spend on keeping records will be well rewarded. Just do it! If you are financially successful, income taxes are likely to be your largest expense. You should always make the correct business decision but be mindful of the tax consequences and therefore plan to execute your decisions in the most tax efficient way. Don't be intimidated; make the dollars and pay the taxes. It doesn't’t hurt to check with your advisors ahead of final decisions so your transactions can be properly structured. It is easier to get it right the first time, and some things can't be fixed later.

There are a few things to look out for, and among the most hazardous is the alternative minimum tax (AMT). This is a relatively recent invention. It was originally designed to catch high income people but nowadays it catches too many of us. Congressional thinking was that the wealthy had too big a tax advantage, paying mostly on capital gains at a lower rate while the working man is paying at the marginal rate. To fix this inequity, Congress added the AMT which enabled the wealthy to pay more taxes. This additional tax is computed by including some Schedule A deductions and capital gains. The AMT rate is 26% and can be as high as 28%. While the AMT doesn’t kick in until your income is fairly high, but more and more of us are moving toward that level. If you are married in 2005 and have less than about $58,000 total AGI or are single or a surviving spouse and your AGI is around $40,000 the AMT is not an issue for you. But, it is not unusual these days to go above those amounts. Planning for this ahead of time can keep you from being caught unaware.

One of the ways to help control AMT is to harvest your losses. This is a nice way of telling you to go ahead and sell your investment losers. Schedule D is where you report most of your capital transactions, and where you can offset gains and losses. To accomplish this, you net the gains and losses to arrive at the total gain or loss for your Schedule D, which is reported on Form 1040. The tax law allows us to have a negative number (loss) up to $3,000 as a non-business deduction. If your loss was greater than that you may carry it over to next year to offset future gains. If your losses were business related, that $3,000 limit does not apply.

I have seen people convert their rentals to a business for a greater loss but we do urge caution here. If you should become profitable, self-employment tax is due when your Sch. C (individual business return) has a bottom line of $400 or more. That creates a self employment tax of over 15% that you pay in addition to income taxes. The other point to look out for is when you retire and want to draw Social Security prior to full retirement age. When a client retired and wanted to draw Social Security (SS) prior to full retirement age, he found out that there were earned income limits which restricted his ability to draw SS. This circumstance required him to sell the rentals in order to collect SS. These laws have been eased and we hope this concept of law will be abolished soon.

Planning for your projected income tax expense is crucial. To ease the pain, there are several things that can be done to legitimately help control this expense. On a practical level: if you are working for wages your options are more restricted, but by learning what is deductible, keeping good expense records and being smart about your Sch. D you can trim your tax expense. It is not illegal to be creative. For example, by converting a hobby to a Sch. C business, you can claim some losses that can come with a new business. But you must have a profit motive for the IRS not to fuss about it. Other bits of wisdom, personal and second hand are listed below.

A few of our thoughts on this matter

• Judge Learned Hand (a federal judge years age) once said to the effect, "You need not arrange your affairs in such a manner as to pay maximum tax". To us, a thought to live by.
• If you fail to claim a deduction to which you are entitled, it will be lost forever. We are not advising you to be abusive, but if a deduction is reasonable, claim it. The worst that can happen is that it is disapproved. Then you pay the tax you would have paid anyway. There will be interest on the amount which is reasonable and possibly a penalty, but not if your position is reasonable.
• In my former life, when I would speak to people who were under audit, they would often say "I don't know anything about taxes; I leave it all to my accountant". That is absolutely the wrong answer. Taxes are your responsibility. You need to know enough to ask questions of your CPA.
• Those new computer driven tax programs seem to work quite well, but if you are not comfortable doing it yourself, hire a CPA. Getting help in preparing a fairly complex return will save you more money than you pay in fees.