Ask CPA Sam

Arizona has done it again.  Currently, anyone who is being paid in Arizona must select from several percentages on the A-4.  Arizona withholding is based on a percentage of federal withholding.  The percentage you pick will be multiplied times the federal withholding number on your paycheck to arrive at Arizona withholding.  If you selected 24.5%, and your federal withholding was $112, then your Arizona withholding would be .245×112 or $27.44.

This created a problem with all the federal withholding changes that have happened over the last 10 years.  Each time there was a withholding decrease, Arizona’s revenue decreased as well.  The Making Work Pay Credit last year decreased checks for everyone and was the last straw in the problem.  Arizona’s legislature had to increase the percentages on this form each time the federal government decreased withholding  just to keep withholding even. Finally, last year, the legislature directed the AZ Department of Revenue to develop a new withholding system to be put into place by July 1, 2010.

There are other glaring problems with this method.  Arizona’s tax rates are based on a formula.  By requiring employees to pick a flat percentage, they are forced to determine a marginal (or average) tax rate for their tax situation.  This can change based on events in a person’s life like marriage, divorce, new children, home purchase, a second job or a spouse begins working that didn’t before.  Any of these events change the marginal rate.  Most people never adjust their A-4.  This obviously causes frequent confusion.

Another problem is that many people simply have no federal tax liability.  With no federal withholding, there was no way to have any Arizona withholding and inevitably, these individuals would end up paying extra every year at tax time.

Yet another problem is those that move into the state mid-year.  As a Tax Preparing CPA, I found it very difficult to advise my clients when they move in mid- year which percentage to pick.  The problem still exists in the second year (first full year of residence) since they have no history to draw from in selecting their percentage.

So…..Arizona’s new method was recently announced and here is the form.  All employees must complete a new one of these by July 1, 2010.  Guess what? They solved none of the above mentioned problems and even made some new problems.  Now, the percentage you select is percent of gross pay.  This decouples the state from federal withholding changes but still does not give employees who are new a clue to which rate to select.  Now instead of new employees only being confused, any person working in the state gets to be confused and not just for half a year, but for next year as well.  There is still no basis in the actual tax rates with these percentages.

Instead of providing some rates that anyone can pick, there are still three lines for employees to select based on income level.  This should have been removed.  If you have very low tax liability but a higher than $15,000 income, you cannot select the lowest rate.  On the back of the new form, there is a worksheet provided.  Notice in line 10 of the worksheet that there is no provision in the instructions for selecting anything other than line 1 (front side) percentages.  What if the calculation result is lower than the percentages on the form?

Employees are not able to determine their “target” withholding without digging into last year’s tax return or contacting their tax preparer.  Again, changes in taxable life events make last year’s number irrelevant.  What are you supposed to choose? This value is difficult for those without a tax background to understand.

Supposedly, payroll “experts” were used to help develop this form.  Unfortunately, they chose to tweak the existing system enough to only make things more confusing.   I hope that the state will make some wholesale changes to this form to more closely match what other states are doing and what the Arizona tax system actually looks like.  It’s not bad to use withholding allowances and marital status.  We are forced to use that on the tax form.   Let’s get this right next time.

Q. My husband and I are looking to buy our first home.  We are currently renting and that lease is up at the end of May.  Our credit scores are not terrible but they are not really good either.  We have been looking at buying a HUD home and really have no money to put down on a house purchase.  What can we do?

A. These are very good questions.  The biggest red flag I see from your question is your lack of funds for a down payment.  If you can’t afford a simple 3% down, how will you manage the added expenses that come with maintaining a home?  Think about what is NOT included when you own the home:

1. Taxes
2. Homeowner’s insurance
3. Mortgage insurance
4. Maintenance
5. Appliances and furnishings

The last two items are normally the most expensive.  If you are not a “handy” person and can perform a lot of normal maintenance yourself (I am included in this category), then you will need to pay contractors to bring the home up to a livable condition first.  Keep in mind that HUD homes are foreclosed homes that were insured by FHA loans.  FHA loans are normally for first time home buyers.  During the last2 or 3 years, many home owners in this program suddenly found themselves unable to keep up with payments on their homes, let alone keep up the homes themselves.  For that reason, many of these houses are not well maintained. More about HUD homes here.

Before anyone launches into the home buying process, it is important to understand what you can afford.  This will involve two  steps.  First, you need a personal budget.  What are you spending your money on now?  How much of your cash is spent on home-related purchases while you are renting?  Are there any “leaks”, which is my term for money that could be more efficiently spent?  Once you have followed this path for a couple months, you will be ready to determine the amount that you can comfortably spend in housing.  Your situation is complicated by the quick lease termination.  In this housing market, there are plenty of homes available that are sitting empty with great rates waiting for you.

The second step in the home buying process is pre-qualifying.  You can’t buy a home if you don’t know how much you can borrow.  Your circumstances affect this pre-qualification number. Do you have good credit? Do you have new outstanding loans?  Does your outstanding credit limit your ability to repay a mortgage loan?  As you can see, it is better if you can get your house in order (no pun intended) before looking to buy a house.  There was a very good article recently on CNNMoney.com about steps to take before going after a home.  The better financial position you can get before applying for that loan, the better interest rate you will qualify for.  This directly affects your payment.

Get started on that budget.  I wrote an article about the process a couple years ago.  It should help you get started.

Q. I have a pretty new business in Arizona and will soon be hiring my first employees for a big job.  They will be temporary only.  What do I do?  Should I just call them contractors and give them a 1099?

A. Good question and probably one  of the most frequent questions from new employers.  You need to determine the level of control you will have over the workers to decide if these are contractors or really employees.  In most cases, you have employees.

Some of the items to keep in mind when hiring your first employees.

• You will need a federal Employer ID Number if you don’t already have one. You can apply for this online.
• You will need a withholding/unemployment account set up with the state. In Arizona, that happens here. Click on License a New Business and complete the application. This needs to be done soon but not necessarily before the job.
• Submit a new hire report to the state.  This helps the state locate the individual if they owe child support, www.az-newhire.com
• Run e-verify using I-9 data to ensure verify they are eligible to work in the US. Click E-verify enrollment under Tools on the right side. You do need to register before using this service.
• Each new employee needs to complete a form W-4 (federal withholding)
• (In Arizona) Each new employee needs to complete a form A-4 (Arizona withholding). Many states have an equivalent withholding form.
• I-9 (verification of right to work)
• Get Publication 15 from IRS.  This well-written document gives employers the instructions to properly handle withholding and employees.

There are many labor laws that apply as well depending on your number of employees.  To find answers to questions surrounding overtime and other labor laws, you have two options.

1. The Department of Labor website, http://www.dol.gov
2. Your state Labor Department website.  There is a list of those here.

This is a lot of information to absorb for a small business owner.  One other option you may wish to pursue is to contact a local CPA or payroll firm to help you stay compliant.  Your specialty is the industry that you are in, not running payroll.  Connecting with someone who already knows how to do this via outsourcing can make your task much easier.

Today is a special edition targeted to those who are still in the education system.  The consensus this time of year is “spring fever” and “I can’t wait until summer is here.”  Before you start the 2-month brain checkout however, let’s keep some things in mind.

One of my favorite bloggers, Jeff Thredgold, publishes a regular weekly economic new update.  While I don’t always agree with his thoughts, it is fascinating to read the updates of statistics published by the government relating to all facets of our economy.  In the most recent edition, he discusses the job market and the associated unemployment rate.  One of the facts published is:

“It comes as no surprise that one’s educational attainment typically has a direct impact on employment. The jobless rate for those workers with less than a high school diploma was 14.5% in March. For those with a high school diploma, but no college, the rate was 10.8%.

For those workers with some college or an Associate’s degree, the jobless rate was 8.2%. For those with a Bachelor’s degree and higher, the average unemployment rate was 4.9%.”

My blog topics focus mainly on personal finance, tax and accounting.  In this case though, economic statistics point out a very important concept.  The best way to gain control over your finances is through education.  Many other studies promote the fact that educated employees tend to earn higher incomes over their lifetime as well.

A combination of education, higher wages, less job loss and responsible financial moves can lead to a happier and more successful life.  Those that look forward to getting out of high school and never going back to school are setting themselves up for a much more difficult life financially.  As we move ever closer to the close of another school year, keep these facts in mind as you make plans for the future.  The financial and educational choices made early in life have dramatic effects on the later years of life.

You can sign up to receive the weekly economic news for free from essentially any page on Mr. Thredgold’s website.

Q. A 2% shareholder of an s corporation is also an emploeye.  The corporation offers health insurance under a premium only 125 cafeteria plan.  Is the shareholder/employee eligible to participate?  If so should the corporation’s contribution be reported as wages?

A. There are lots of good articles already on the web about 2% shareholders of S corporations. These would of course be secondary resources on the topic but they can provide coverage from the perspective of those who work in this field every day.

The key is that the IRS considers an S corp to be a partnership when dealing with employee fringe benefits.  If the company pays for the health insurance of a 2% shareholder, it is allowed to take a deduction for that benefit.  The full amount of that premium would be considered taxable income to the shareholder/employee.  So…yes, a shareholder can participate in the plan, but cannot get pre-tax treatment like the rest of the employees would under a section 125 or “cafeteria plan”.

Some states do not allow single person health plans to be purchased as a business.  If the 2% shareholder is the only shareholder in the S corp, then perhaps he should consider hiring his spouse to enable them to purchase a business plan.  Otherwise, health insurance must be purchased as an individual and can only be deducted once it passes 7.5% of AGI on the tax return if the individual itemizes.

The IRS published a bulletin about this topic that goes into much more detail.  It is IRB 2008-2 and can be found here.

Q.  I am having a difficult time trying to figure how much I owe in state tax.  I lived and worked in California from 1/1/2009 through 8/7/2009.  I began living in Colorado on 8/8/2009 through the end of the year and worked from home for the same company I worked for back in California.  State taxes were withheld for each state on the income made while living in each state (California withholding stopped when I moved to Colorado)  Do I owe California state income tax on the income I earned while living in Colorado?  If so can I get a credit as I was also taxed by Colorado on that income? Thanks!

A. Multi-state tax situations are always so much fun to decipher.  Over the last several years of my tax practice, I’ve prepared multi-state returns for Iowa, Missouri, Oklahoma and Montana in conjunction with Arizona.  Each state has different laws regarding what income must be counted.  However, residency is the most important.  In your case, if you have documentation showing that you physically relocated on the date you mentioned, then it becomes much easier to prove that your residency changed.  The company you work for is irrelevant to the solution.

California is one of those states with huge budget problems right now.  In an audit, they will try to prove that you did not change states completely.  Residency involves switching your drivers license, sale of the old home or cancellation of the lease, change of mailing address, car title address changes, voter registration changes etc.  If CA is able to prove that you only will be in CO temporarily, then they may determine that you owe CA tax on everything. I don’t know the tax law as well in CA, but they may provide a credit to you for tax paid to CO if it is determined that you actually owe CA tax on everything earned last year.  Check with your tax preparer.

Good documentation is key.  For this reason, I would visit a licensed tax preparer this year.  The complexities of dividing up income and maintaining adequate documentation as well as the right questions to ask to determine your true residency status is worth the price of the professionally prepared return.

Q. My husband works for a large company, and I receive disability and do not work.  We just had our taxes done this week and got quite a shock!  We had a federal income tax refund of over $4000, but owed state tax of $1000 and local taxes of $600.  We are in PA.  How can we adjust our withholding so that this does not happen again next year?

A.  When payroll people hear the Pennsylvania, they run screaming from the room.  The local tax debacle there is the stuff legends are made of.  In most states, when someone has too little withholding, an employee can simply get a copy of the state’s W-4 equivalent, and reduce the number of allowances claimed.  This has the effect of increasing the amount of income subject to tax and thus increasing the tax withheld.  Unfortunately, in PA, there is no W-4 equivalent.  PA is calculated as a flat percentage of taxable income, 3.07% to be exact.  I’m not sure where to point you on this one.  Did you have non-wage income like dividends or capital gains that were not taxed?  Do you have a small business on the side where there were no estimated payments made?  Perhaps the payroll system at your husband’s employer has a way to allow for additional withholding beyond the standard percentage.

For the local tax, there is again no W-4 equivalent in most cases.  However, there is very likely an obvious cause for this under withholding.  In PA, employers are required to withhold where the employee works.  If he works in a different jurisdiction than the one he lives in, then the withholding rate will be lower.  He will have the non-resident rate applied to his wages.  In most cases for PA, the resident rate is 1% (could be higher) and the non-resident rate is half of that.  Therefore, he could have only half as much tax taken from his check as was required.  If an employer opts to withhold at the higher resident rate, it is called courtesy withholding.  Not all employers wish to do this because of the extra record keeping requirements.  Check with your employer to see what is possible with regards to increasing the local tax withholding as well.

After watching the stories about the new credit card rules this week, I decided to do some digging and see exactly what options are available for those wanting to open new credit accounts.  One story I heard was from a man with a long-time Macy’s credit account.  He said his account is now charged interest from the day of purchase.  Once he pays the balance, and if he pays on time, the interest charges are credited back to the account.  That means, he will never have a zero balance.  Upon visiting the Macy’s online credit application, I found another disturbing number, 24.5% interest!  I think we should all pass on that one.

Next, I visited Bank of America curious about their Major League Baseball cards, Since I am a baseball fan, it would be fun to open a card showing my fan spirit.  An interesting item here is that the fee for balance transfers is now 4% of the amount transferred.  The interest rate is variable and goes from 12.99 to 20.99%!  Apparently, the days of the old fixed rate cards are over.  New card holders get anywhere from 7 to 10 months to pay off balance transfers interest free upon opening the card.  After the initial opening period, further balance transfers begin accruing interest from the day they are transferred.  Definitely don’t transfer unless the new percentage is less than the old card!

Many financial experts recommend that people simply quit the big banks and switch to a regional banking institution or a credit union.   For an example, I went to the Desert Schools FCU website, and looked at their credit card terms.  When you click around the site, it is apparent that they do not underwrite their own cards.  This is important because the fees schedule and onerous terms found with Bank of America look nearly identical to the ones found with this credit union card.  The big difference is the rate range.  It goes from 9.99 to 17.99% which is significantly lower if you plan to carry a balance.

The next stop was to find a regional bank that offered a card.  But…I could not find one.  Many seem to contract with an other third-party issuer to underwrite credit card for their members if they offered them at all.

The new rules issued by the government attempted to reduce some of the most egregious acts committed by credit card issuers.  Unfortunately, we all know that the vast majority of the members of Congress are not financially trained.  That means that any rules they produce will stop the practices they intended to stop.  However, the minds within the big banks are financially trained and very creative.  The new terms received in the mail from anyone who has open credit accounts show just how little the Congressional action did to stop high fees as new ones were created.

The best advice is always to pay them off as quickly as possible.  There is always some way to get ahead.  When you are trying to reduce debt, simply work account by account to pay off the balances.  Any sacrifices that you can make to pay off your debt faster will be well worth it in the end when you can be debt free.

Q. How do I know which 1040 I’m allowed to use? Does it really make a difference?

A. Yes! Each form has specific requirements that a taxpayer must meet in order to use it. IRS Tax Tip 2010-05 contains instructions on which form you should select.  Your options are:

1040EZ Requirements
Your taxable income must be below $100,000 and your earned interest below $1,500. You can only use the Single or Married Filing Jointly filing status. You must be under age 65 and not claim any dependents. You will not be claiming any of the special additional deductions for real estate taxes, motor vehicle purchase or disaster losses.

1040A Requirements
Your taxable income still must be below $100,000 to use this form. You want to claim the credits disallowed on the EZ form. You have capital gain distributions. You contributed to and IRA, paid student loan interest or higher ed tuition.

1040
Anyone can file with this form. However, if you have a simple tax situation, why go through the trouble of the long 2-page form if you don’t have to?

If you are confused about which form to file, you may wish to use the services of a professional tax preparer or CPA. Professionals are trained to help you understand your tax situation and can often make recommendations to help you improve your take home pay or lessen your tax bill in the upcoming year. Make sure you interview your tax preparer carefully. Not all of them are as prepared for any situation as you hope they will be.

The IRS recently released a new list of Frivolous Tax Arguments.  This list shows all the ways people try to avoid paying their tax bills.  The problem is that most have been disproved in court many times.  In 2006, the U.S. Congress increased the penalty for filing a tax return with one of these or some other frivolous argument from $500 to $5000!  Is it really worth the risk?

I recommend reading through this document just so you are aware if anyone tries to pull one of these on you.  Many of these arguments are so ridiculous that they could be used in late night comedy programs.  Sometimes even tax preparers attempt these unfortunately.  If that is the case, you know it is time to find a new one.  Many times, water cooler conversations with fellow employees lead to a mistaken belief that some position is legitimate when it is in fact already in this document.

Some of the more famous ones are:

-The tax system is voluntary
-My income does not fall under the definition that requires taxation
-The United States consists of only DC, territories and enclaves.

In short, these claims simply don’t work.  If you don’t like the tax laws the way they are, contact your Congressman or woman.  They write the laws that the IRS enforces.  If enough support is garnered from people wanting a change, Congress will listen.  If they don’t, they don’t win at the next election cycle.  There are many legal ways to reduce taxable income.  Talk to your tax preparer before filing any returns yourself.  They can help you find the hidden legal deductions for your situation.