The gap between taxes owed and taxes collected by the Internal Revenue Service could be approaching $1 trillion, IRS Commissioner Charles Rettig told members of the House Committee on Oversight and Reform’s Government Operations Subcommittee as he advocated for more funding for the agency.

The gap between taxes owed and taxes collected by the Internal Revenue Service could be approaching $1 trillion, IRS Commissioner Charles Rettig told members of the House Committee on Oversight and Reform’s Government Operations Subcommittee as he advocated for more funding for the agency.

During an April 21, 2022, hearing of the subcommittee, Rettig noted updated tax gap figures for the three-year period of 2012-2014, along with projections through 2019, will be released this summer. However, those projections do not account for the growth in cryptocurrency, which could be widening the tax gap beyond the current calculations and projections.

"What is not in those estimates is virtual currencies, and there is over a $2 trillion market cap for virtual currencies," Rettig testified before the committee. "Last year, there was over $14 trillion in transactions in virtual currencies and the United States, if you view relative GDP, is somewhere between 35 and 43 percent of that $14 trillion."

He said that knowledge generated from John Doe summons activity in these space reveals "that the compliance issues in the virtual currency space are significantly low."

"The tax gap estimates that the IRS prepares are based on information that the IRS is able to determine, not information that we know is out there but we are not able to determine," Rettig said, adding that the agency is trying to get more information about virtual currencies through adding questions on the Form 1040, first on Schedule L and then moving it to page one of the Form 1040 last year "to try to enhance compliance."

He added that the agency is looking to get more into that area.

The comments on the tax gap and the need to be able to tackle compliance in the cryptocurrency space underscores the agency’s need for more funding as requested in the White House budget request for fiscal year 2023.

In his written testimony submitted to the committee, Rettig noted that the agency "can no longer audit a respectable percentage of large corporations, and we are often limited in the issues reviewed among those we do audit. These corporations can afford to spend large amounts on legal counsel, drag out proceedings and bury the government in paper. We are, quite simply, ‘outgunned’ in our efforts to assure a high degree of compliance for these taxpayers."

He wrote that it is "unacceptable" that corporations and the wealthiest individuals have such an advantage to push back on the nation’s tax administrator.

"We must receive the resources to hire and train more specialists across a wide range of complex areas to assist with audits of entities (taxable, pass-through and tax-exempt) and individuals (financial products; engineering; digital assets; cross-border activities; estate and gift planning; family offices; foundations; and many others)," his written testimony states.

Rettig wrote that the agency current has fewer than 2,000 revenue officers, "the lowest number of field collection personnel since the 1970s," to handle more than 100,000 collection cases in active inventory.

He continued: "In addition to our active inventory, we have over 1.5 million cases (more than 500,000 of which are considered high priority) awaiting assignment to these same 2,000 revenue officers. We have classified roughly 85 percent of those cases as high priority, many of which involve delinquent business employment taxes."

The lack of funding is also hampering criminal investigations.

"Much like other operating divisions in the IRS, CI is close to its lowest staffing level in the past 30 years. With fewer agents, we have fewer cases and fewer successful convictions," he stated in the written testimony.

Much of this also is compounded by the ancient IT infrastructure at the agency, another reason Rettig advocated during the hearing for more funding.

"Limited IT resources preclude us from building adequate solutions for efficiently matching or reconciling data from multiple sources," he wrote. "As a result, we are often left with manual processes to analyze reporting information we receive."

Retting specifically highlighted the Foreign Account Tax Compliance Act, which Congress enacted in 2010 but, according to Retting, has yet to appropriate the funding necessary for its implementation.

"This situation is compounded by the fact that when we do detect potential non-compliance or fraudulent behavior through manually generated FATCA reports, we seldom have sufficient funding to pursue the information and ensure proper compliance," he wrote. "We have an acute need for additional personnel with specialized training to follow cross-border money flows. They will help ensure tax compliance by improving our capacity to detect unreported accounts and income generated by those accounts, as well as the sources of assets in offshore accounts."

Internal Revenue Service Commissioner Charles Rettig remained positive that the agency will be able to return to a normal backlog of unprocessed returns and other mail correspondence by the end of the year and noted progress on hiring more people to help clear the backlog.

Internal Revenue Service Commissioner Charles Rettig remained positive that the agency will be able to return to a normal backlog of unprocessed returns and other mail correspondence by the end of the year and noted progress on hiring more people to help clear the backlog.

"With respect to our current 2022 filing season, we are off to a healthy start in terms of tax processing and the operation of our IT systems," Rettig told members of the Senate Finance Committee during an April 7 hearing to discuss the White House budget request and update the panel on the current tax filing season. "Through April 1, we have processed more than 89 million returns and issued more than 63 million refunds totaling more than $204 billion."

Getting that backlog cleared has been bolstered in part by a direct hiring authority given to the agency in the recent passage of the fiscal year 2022 omnibus budget, Rettig told the committee.

The effectiveness of that hiring authority was highlighted in his written testimony submitted prior to the hearing, where Rettig stated that in-person and virtual job fairs near processing facilities in Austin, Kansas City, and Ogden, Utah, attracted eligible applicants for more than 5,000 vacancies and "we have been able to make more than 2,500 conditional offers at the conclusion of the interviews."

Rettig said the direct hiring authority is only related to those lower paygrade processing/customer service positions and the agency is going to ask Congress to expand that authority, although he did not specify what types of positions would be hired as part of that expansion.

The IRS addressed the following common myths about tax refunds:

The IRS addressed the following common myths about tax refunds:

• Myth 1: Calling the IRS or visiting an IRS office speeds up a refund. The best way to check the status of a refund is online through the “Where’s My Refund?” tool. Taxpayers can also call the automated refund hotline at 800-829-1954.

• Myth 2: Taxpayers need to wait for their 2020 return to be processed before filing their 2021 return. Taxpayers generally will not need to wait for their 2020 return to be fully processed to file their 2021 tax returns. They should file when they are ready. Individuals with unprocessed 2020 tax returns, should enter zero dollars for last year's Adjusted Gross Income (AGI) on their 2021 tax return when filing electronically.

• Myth 3: Taxpayers can get a refund date by ordering a tax transcript. Ordering a tax transcript will not inform taxpayers of the timing of their tax refund, nor will it speed up a refund being processed. Taxpayers can use a transcript to validate past income and tax filing status for mortgage, student and small business loan applications and to help with tax preparation.

• Myth 4: "Where’s My Refund?" must be wrong because there is no deposit date yet. While the IRS issues most refunds in less than 21 days, it is possible a refund may take longer for a variety of reasons. Delays can be caused by simple errors including an incomplete return, transposed numbers, or when a tax return is affected by identity theft or fraud.

• Myth 5: "Where’s My Refund?" must be wrong because a refund amount is less than expected. Different factors can cause a tax refund to be larger or smaller than expected. The IRS will mail the taxpayer a letter of explanation if these adjustments are made.

• Myth 6: Calling a tax professional will provide a better refund date. Contacting a tax professional will not speed up a refund. Tax professionals cannot move up a refund date nor do they have access to any special information that will provide a more accurate refund date.

• Myth 7: Getting a refund this year means there is no need to adjust tax withholding for 2022. Taxpayers should continually check their withholding and adjust accordingly. Adjusting tax withholding with an employer is easy and using the Tax Withholding Estimator tool can help taxpayers determine if they are withholding the right amount from their paycheck.

As of the week ending April 1, the IRS has sent out more than 63 million refunds worth over $204 billion. The IRS reminded taxpayers the easiest way to check on a refund is the "Where’s My Refund?" tool. This tool can be used to check the status of a tax return within 24 hours after a taxpayer receives their e-file acceptance notification. Taxpayers should only call the IRS tax help hotline to talk to a representative if it has been more than 21 days since their tax return was e-filed, or more than six weeks since mailing their return.

The IRS has informed taxpayers that the agency issues most refunds in less than 21 days for taxpayers who filed electronically and chose direct deposit. However, some refunds may take longer. The IRS listed several factors that can affect the timing of a refund after the agency receives a return.

The IRS has informed taxpayers that the agency issues most refunds in less than 21 days for taxpayers who filed electronically and chose direct deposit. However, some refunds may take longer. The IRS listed several factors that can affect the timing of a refund after the agency receives a return. A manual review may be necessary when a return has errors, is incomplete or is affected by identity theft or fraud. Other returns can also take longer to process, including when a return needs a correction to the Child Tax Credit amount or includes a Form 8379, Injured Spouse Allocation, which could take up to 14 weeks to process. The fastest way to get a tax refund is by filing electronically and choosing direct deposit. Taxpayers who don’t have a bank account can find out more on how to open an account at an FDIC-Insured bank or the National Credit Union Locator Tool.

Further, the IRS cautioned taxpayers not to rely on receiving a refund by a certain date, especially when making major purchases or paying bills. Taxpayers should also take into consideration the time it takes for a financial institution to post the refund to an account or to receive it by mail. Before filing, taxpayers should make IRS.gov their first stop to find online tools to help get the information they need to file. To check the status of a refund, taxpayers should use the Where’s My Refund? tool on IRS.gov. The IRS will contact taxpayers by mail when more information is needed to process a return. IRS representatives can only research the status of a refund if it has been: 21 days or more since it was filed electronically; six weeks or more since a return was mailed; or when the Where's My Refund? tool tells the taxpayer to contact the IRS.

Additionally, taxpayers whose tax returns from 2020 have not yet been processed should still file their 2021 tax returns by the April due date or request an extension to file. Those filing electronically in this group need their Adjusted Gross Income (AGI) from their most recent tax return. Those waiting on their 2020 tax return to be processed should enter zero dollars for last year's AGI on the 2021 tax return. When self-preparing a tax return and filing electronically, taxpayers must sign and validate the electronic tax return by entering their prior-year AGI or prior-year Self-Select PIN (SSP). Those who electronically filed last year may have created a five-digit SSP. Generally, tax software automatically enters the information for returning customers. Taxpayers who are using a software product for the first time may have to enter this information.

The IRS reminded educators that they will be able to deduct up to $300 of out-of-pocket classroom expenses when they file their federal income tax return for tax year 2022. This is the first time the annual limit has increased since 2002.

The IRS reminded educators that they will be able to deduct up to $300 of out-of-pocket classroom expenses when they file their federal income tax return for tax year 2022. This is the first time the annual limit has increased since 2002. For tax years 2002 through 2021, the limit was $250 per year. The limit will rise in $50 increments in future years based on inflation adjustments. For 2022, if an eligible educator is married and files a joint return with another eligible educator, the limit rises to $600 but not more than $300 for each spouse.

Educators can claim this deduction even if they take the standard deduction. Eligible educators include anyone who is a kindergarten through grade 12 teacher, instructor, counselor, principal, or aide in a school for at least 900 hours during the school year. Both public- and private-school educators qualify. Educators can deduct the unreimbursed cost of:

• books, supplies, and other materials used in the classroom;
• equipment, including computer equipment, software, and services;
• COVID-19 protective items to stop the spread of the disease in the classroom; and
• professional development courses related to the curriculum they teach or the students they teach.

Qualified expenses do not include expenses for homeschooling or nonathletic supplies for courses in health or physical education. The IRS also reminded educators that for tax year 2021, the deduction limit is $250. If they are married and file a joint return with another eligible educator, the limit rises to $500 but not more than $250 for each spouse.

Taxpayers who may need to take additional actions related to Qualified Opportunity Funds (QOFs) should begin receiving letters from the IRS in April. Taxpayers who attached Form 8996, Qualified Opportunity Fund, to their return may receive Letter 6501, Qualified Opportunity Fund (QOF) Investment Standard. This letter lets them know that information needed to support the annual certification of investment standard is missing, invalid or the calculation isn’t supported by the amounts reported. If they intend to maintain their certification as a QOF, they may need to take additional action to meet the annual self-certification of the investment standard requirement.

Taxpayers who may need to take additional actions related to Qualified Opportunity Funds (QOFs) should begin receiving letters from the IRS in April. Taxpayers who attached Form 8996, Qualified Opportunity Fund, to their return may receive Letter 6501, Qualified Opportunity Fund (QOF) Investment Standard. This letter lets them know that information needed to support the annual certification of investment standard is missing, invalid or the calculation isn’t supported by the amounts reported. If they intend to maintain their certification as a QOF, they may need to take additional action to meet the annual self-certification of the investment standard requirement.

To correct the annual maintenance certification of the investment standard, taxpayers should file an amended return or an administrative adjustment request (AAR). If an entity that receives the letter fails to act, the IRS may refer its tax account for examination. Additionally, taxpayers may receive Letter 6502, Reporting Qualified Opportunity Fund (QOF) Investments, or Letter 6503, Annual Reporting Of Qualified Opportunity Fund (QOF) Investments. These letters notify them that they may not have properly followed the instructions for Form 8997, Initial and Annual Statement of Qualified Opportunity Fund (QOF) Investments. This may happen if it appears that they may not have properly followed the requirements to maintain their qualifying investment in a QOF with the filing of the form.

Finally, if these taxpayers intend to maintain a qualifying investment in a QOF, they can file an amended return or an AAR with a properly completed Form 8997 attached. Failure to act will mean those who received the letter may not have a qualifying investment in a QOF and the IRS may refer their tax accounts for examination.

The IRS informed taxpayers that it will send Notices CP2100 and CP2100A notices to financial institutions, businesses, or payers who filed certain types of information returns that do not match IRS records, beginning mid-April 2022.

The IRS informed taxpayers that it will send Notices CP2100 and CP2100A notices to financial institutions, businesses, or payers who filed certain types of information returns that do not match IRS records, beginning mid-April 2022. These information returns include:

• Form 1099-B, Proceeds from Broker and Barter Exchange Transactions
• Form 1099-DIV, Dividends and Distributions
• Form 1099-G, Certain Government Payments
• Form 1099-INT, Interest Income
• Form 1099-K, Payment Card and Third-Party Network Transactions
• Form 1099-MISC, Miscellaneous Income
• Form 1099-NEC, Nonemployee Compensation
• Form 1099-OID, Original Issue Discount
• Form 1099-PATR, Taxable Distributions Received from Cooperatives
• Form W-2G, Certain Gambling Winnings

These notices inform payers that the information return is missing a Taxpayer Identification Number (TIN), has an incorrect name or a combination of both. Each notice has a list of payees or the persons receiving certain types of income payments with identified TIN issues. Taxpayers need to compare the accounts listed on the notice with their account records and correct or update their records, if necessary. This can also include correcting backup withholding on payments made to payees. The notices also inform payers that they are responsible for backup withholding. Payments reported on these information returns are subject to backup withholding if:

• The payer does not have the payee’s TIN when making the reportable payments.
• The payee does not certify their TIN as required for reportable interest, dividend, broker and barter exchange accounts.
• The IRS notifies the payer that the payee furnished an incorrect TIN and the payee does not certify its TIN as required.
• The IRS notifies the payer to begin backup withholding because the payee did not report all of its interest and dividends on its tax return.

The IRS has issued a guidance stating that government employees who receive returns or return information pursuant to disclosures under Code Sect. 6103(c), are subject to the disclosure restrictions, like all designees who receive returns or return information pursuant to taxpayer consent. Further, government employees who receive returns or return information pursuant to disclosures under Code Sec. 6103(k)(6) or (e), other than Code Sec. 6103(e)(1)(D)(iii) (relating to certain shareholders), are not subject to the disclosure restrictions with regard to the returns or return information received.

The IRS has issued a guidance stating that government employees who receive returns or return information pursuant to disclosures under Code Sect. 6103(c), are subject to the disclosure restrictions, like all designees who receive returns or return information pursuant to taxpayer consent. Further, government employees who receive returns or return information pursuant to disclosures under Code Sec. 6103(k)(6) or (e), other than Code Sec. 6103(e)(1)(D)(iii) (relating to certain shareholders), are not subject to the disclosure restrictions with regard to the returns or return information received.

Background

Section 2202 of the Taxpayer First Act (TFA), P.L. 116-25, amended Code Sec. 6103(a)(3) and (c) to limit redisclosures and uses of return information received pursuant to the staxpayer consent exception. Code Sec. 6103(c), as amended by the TFA, explicitly prohibits designees from using return information for any reason other than the express purpose for which the taxpayer grants consent and from redisclosing return information without the taxpayer’s express permission or request. Further, Code Sec. 6103(a)(3), as amended by the TFA, imposes disclosure restrictions on all recipients of return information under Code Sec. 6103(c). The TFA did not amend Code Sec. 6103(e) or (k)(6), or Code Sec. 6103(a) with respect to disclosures under Code Sec. 6103(e) or (k)(6).

Disclosure Restrictions

The IRS cited seven situations where disclosure restrictions of Code Sec. 6103(a) would or would not be applicable with regard to returns or return information received as a result of disclosure under:

• Code Sec. 6103(c) with the consent of the taxpayer (taxpayer consent exception),
• Code Sec. 6103(e) as a person having a material interest, but not under Code Sec. 6103(e)(1)(D)(iii) relating to disclosures to certain shareholders (material interest exception), or
• Code Sec. 6103(k)(6) for investigative purposes (investigative disclosure exception).

Effect on Other Documents

Rev. Rul. 2004-53, I.R.B. 2004-23, has been modified and superseded.

The IRS has provided a waiver for any individual who failed to meet the foreign earned income or deduction eligibility requirements of Code Sec. 911(d)(1) because adverse conditions in a foreign country precluded the individual from meeting the requirements for the 2021 tax year. Qualified individuals may exempt from taxation their foreign earned income and housing cost amounts.

The IRS has provided a waiver for any individual who failed to meet the foreign earned income or deduction eligibility requirements of Code Sec. 911(d)(1) because adverse conditions in a foreign country precluded the individual from meeting the requirements for the 2021 tax year. Qualified individuals may exempt from taxation their foreign earned income and housing cost amounts.

Relief Provided

The countries for which the eligibility requirements have been waived for 2021 are Iraq, Burma, Chad, Afghanistan and Ethiopia. Accordingly, an individual who left the following countries beginning on the specified date will be treated as a qualified individual with respect to the period during which that individual was present in, or was a bona fide resident of the country: (1) Iraq on or after January 19, 2021; (2) Burma on or after March 30, 2021; Chad on or after April 17, 2021; (4) Afghanistan on or after April 27, 2021, and; (5) Ethiopia on or after November 5, 2021. Individuals who left the above mentioned countries must establish a reasonable expectation that he or she would have met the requirements of Code Sec. 911(d)(1) but for those adverse conditions. Further, individuals who established residency, or were first physically present in Iraq, after January 19, 2021, are not eligible for the waiver. Taxpayers who need assistance on how to claim the exclusion, or how to file an amended return, should consult the section under the heading "Foreign Earned Income Exclusion" at https://www.irs.gov/individuals/international-taxpayers/us-citizens-and-resident-aliens-abroad; consult the section under the heading How to Get Tax Help at the same web address; or contact a local IRS office.

The Supreme Court reversed and remanded a Court of Appeals decision and held that Code Sec. 6330(d)(1)’s 30-day time limit to file a petition for review of a collection due process (CDP) determination is an ordinary, nonjurisdictional deadline subject to equitable tolling in appropriate cases. The taxpayer had requested and received a CDP hearing before the IRS’s Independent Office of Appeals pursuant to Code Sec. 6330(b), but the Office sustained the proposed levy. Under Code Sec. 6330(d)(1), the taxpayer had 30 days to petition the Tax Court for review. However, the taxpayer filed its petition one day late. The Tax Court dismissed the petition for lack of jurisdiction and the Court of Appeals for the Eighth Circuit affirmed, agreeing that Code Sec. 6330(d)(1)’s 30- day filing deadline is jurisdictional and thus cannot be equitably tolled.

The Supreme Court reversed and remanded a Court of Appeals decision and held that Code Sec. 6330(d)(1)’s 30-day time limit to file a petition for review of a collection due process (CDP) determination is an ordinary, nonjurisdictional deadline subject to equitable tolling in appropriate cases. The taxpayer had requested and received a CDP hearing before the IRS’s Independent Office of Appeals pursuant to Code Sec. 6330(b), but the Office sustained the proposed levy. Under Code Sec. 6330(d)(1), the taxpayer had 30 days to petition the Tax Court for review. However, the taxpayer filed its petition one day late. The Tax Court dismissed the petition for lack of jurisdiction and the Court of Appeals for the Eighth Circuit affirmed, agreeing that Code Sec. 6330(d)(1)’s 30- day filing deadline is jurisdictional and thus cannot be equitably tolled.

Nonjurisdictional Nature of Filing Deadline

The Supreme Court analyzed the text of Code Sec. 6330(d)(1) and stated that the only contention is whether the provision limits the Tax Court’s jurisdiction to petitions filed within the 30-day timeframe. The taxpayer contended that it referred only to the immediately preceding phrase of the provision: a "petition [to] the Tax Court for review of such determination." and so the filing deadline was independent of the jurisdictional grant. The IRS, on the contrary, argued that "such matter" referred to the entire first clause of the sentence, which includes the deadline and granting jurisdiction only over petitions filed within that time. However, the Supreme Court held the nature of the filing deadline to be nonjurisdictional because the IRS failed to satisfy the clear-statement rule of the jurisdictional condition. It also stated that where multiple plausible interpretations exist, it is difficult to make the case that the jurisdictional reading is clear. Moreover, Code Sec. 6330(e)(1)’s clear statement—that "[t]he Tax Court shall have no jurisdiction . . . to enjoin any action or proceeding unless a timely appeal has been filed"—highlighted the lack of such jurisdictional clarity in Code Sec. 6330(d)(1).

Equitable Tolling of Filing Deadline

The Supreme Court remanded the case to the Court of Appeals for the Eighth Circuit to decide whether the taxpayer was entitled to equitable tolling of the filing deadline. However, the Supreme Court did emphasize that Code Sec. 6330(d)(1) did not expressly prohibit equitable tolling, and its 30-day time limit was directed at the taxpayer, not the court. Further, the deadline mentioned in the provision was not written in an emphatic form or with detailed and technical language, nor was it reiterated multiple times. The IRS’ argument that tolling the Code Sec. 6330(d)(1) deadline would create much more uncertainty, was rejected. The Supreme Court concluded that the possibility of equitable tolling for relatively small number of petitions would not appreciably add to the uncertainty already present in the process.

The Government Accountability Office (GAO) has issued a report on IRS’ performance during the 2021 tax filing season. The report assessed IRS’ performance during the 2021 filing season on: (1) processing individual and business income tax returns; and (2) providing customer service to taxpayers. GAO analyzed IRS documents and data on filing season performance, refund interest payments, hiring and employee overtime. GAO also interviewed cognizant officials.

The Government Accountability Office (GAO) has issued a report on IRS’ performance during the 2021 tax filing season. The report assessed IRS’ performance during the 2021 filing season on: (1) processing individual and business income tax returns; and (2) providing customer service to taxpayers. GAO analyzed IRS documents and data on filing season performance, refund interest payments, hiring and employee overtime. GAO also interviewed cognizant officials.

Report Findings

GAO found that the IRS faced multiple challenges and struggled to respond to an unprecedented workload that included delivering COVID-19 relief. The IRS began the 2021 filing season with a backlog of 8 million individual and business returns from the prior year. The IRS reduced the backlog of prior year returns, but in December 2021, had about 10.5 million returns to process from 2021. The IRS suspended and reviewed 35 million returns with errors primarily due to new or modified tax credits. GAO found that some categories of errors occur each year, however, the IRS does not assess the underlying causes of taxpayer errors on returns. Additionally, the IRS paid nearly $14 billion in refund interest in the last 7 fiscal years, with $3.3 billion paid in fiscal year 2021. However, the IRS does not identify, monitor, and mitigate issues contributing to refund interest payments.

Recommendations

GAO made six recommendations, including that the IRS should assess reasons for tax return errors and refund interest payments and take action to reduce them; modernize its “Where's My Refund” application; address its backlog of correspondence; and assess its in-person service model. The IRS agreed with four recommendations and disagreed with two. The IRS said its process for analyzing errors is robust and that the amount of interest paid is not a meaningful business measure.

Q:  One of my children received a full scholarship for all expenses to attend college this year.  I had heard that this amount may not be required to be reported on his tax return if certain conditions were met and the funds were used specifically for certain types of her expenses.  Is this true and what amounts spent on my child's education will be treated as qualified expenses?

Q: One of my children received a full scholarship for all expenses to attend college this year. I had heard that this amount may not be required to be reported on his tax return if certain conditions were met and the funds were used specifically for certain types of her expenses. Is this true and what amounts spent on my child's education will be treated as qualified expenses?

A: Any amount received as a "qualified scholarship" or fellowship is not required to be reported as income if your child is a candidate for a degree at an educational institution. For the college that your child attends to be treated as an educational organization, it must (1) be an institution that has as its primary function the presentation of formal instruction, (2) normally maintain a regular faculty and curriculum, and (3) have a regularly enrolled body of students in attendance at the place where the educational activities are regularly carried on. Your child has received a qualified scholarship if he or she can establish, that in accordance with the conditions of the scholarship, the funds received were used for qualified tuition and related expenses.

Qualified tuition and related expenses include tuition and fees required for enrollment or attendance at the educational institution, as well as any fees, books, supplies, and equipment required for courses of instruction at the educational institution. To be treated as related expenses, the fees, books supplies, and equipment must be required of all students in the particular course of instruction. Incidental expenses, such as expenses for room and board, travel, research, equipment, and other expenses that are not required for either enrollment or attendance at the educational institution are not treated as related expenses. Any amounts that are used for room, board and other incidental expenses are not excluded from income.

Example: Assume this year your son received a scholarship in the amount of $20,000 to pay for expenses at a qualified educational institution. His expenses included $12,000 for tuition; $1,100 for books; $900 for lab supplies and fees; and $6,000 for food, housing, clothing, laundry, and other living expenses.

The $14,000 that your son paid for tuition, books and lab supplies and fees are considered to be qualified educational expenses and therefore would not have to be reported as income. The $6,000 that he spent on housing and the other living expenses is considered to be incidental expenses and would have to be reported in his income.

Note: This tax exclusion for qualified scholarships should not be confused with the Hope Scholarship Tax Credit, which has been temporarily renamed the American Opportunity Tax Credit and enhanced for 2009 and 2010 by the American Recovery and Reinvestment Act of 2009. The American Opportunity Tax Credit can reach as high as $2,500 for 2009 and 2010 for tuition expenses paid by you for yourself, a spouse or a dependent. Scholarship money that is excluded from income cannot be used in computing your costs for the American Opportunity Tax Credit (i.e. Hope Scholarship Tax Credit). "Financial aid" in the form of student loans, however, is not counted as a scholarship and any money applied to pay tuition can qualify for the Hope Scholarship Tax Credit.

There can be all sorts of complicating factors in assessing whether a particular scholarship will be taxed, such as the treatment of work-study scholarships, educational sabbaticals, scholarships paid by an employer, and stipends to cover the tax on the non-tuition portion of attending a university. If you need additional assistance in determining the taxability of scholarships funds, please contact the office.

Q:The holidays are approaching and I would like to consider giving gifts of appreciation to my employees. What kinds of gifts can I give my employees that they would not have to declare as income on their tax returns? I also would like to make sure my company would be able to deduct the costs of these gifts.

A:First of all, anything given in the business setting is presumed, until proven otherwise, not to be a gift (e.g., is taxable income) -- that is, you are either rewarding an employee for work done or providing an incentive in which he or she will be inclined to do more work in the future. However, the Tax Code and related IRS regulations still allow many gifts to remain tax-free to the employee while being tax deductible to the business. Here is a short list of the rules:

$25 gift rule

A business may deduct up to $25 in gifts given to each recipient during any given year. However, you can't get around this limit by giving to each family member of the intended recipient: they all share in one $25 limit. Items clearly of an advertising nature such as promotional items do not count as long as the item costs $4 or less.

No dollar limit exists on a deduction if the gift is given to a corporation or a partnership. The cost of gifts such as baseball tickets that will be used by an unidentified group of employees also qualifies for the unlimited deduction. However, once again, if the gift is intended eventually to go to a particular individual shareholder or partner, the deduction is limited to $25.

Separate "de minimis" rules

A "de minimis" fringe benefit from employer to employee is considered to be made tax-free to the employee. "De minimis" fringe benefits are not restricted by the $25 per recipient limit otherwise applicable outside of the employer-employee context. However, de minimis fringe benefits must be small "within reason." Typical de minimis gifts include holiday gifts such as a turkey or ham, the occasional company picnic, occasional use of the photocopy machine, occasional supper money, or flowers sent to a sick employee.

The general guidelines for de minimis fringe benefits are:

• the value of the gift must be nominal,
• accounting for all such gifts would be administratively nitpicking,
• the gifts are only occasional, and
• they are given "to promote health, good will, contentment, or efficiency" of employees.

Unfortunately, "gifts of nominal value" exclude such perks as use of a company lodge, season theater tickets, or country club dues. These cannot be given tax-free to an employee. But they do include occasional theater or sports tickets or group meals.

What's more, fringe benefits such as the use of an on-premise athletic facility or subsidized cafeteria are specifically included under IRS rules as de minimis fringe benefits. The traditional gold retirement watch -- or similar gift-- to commemorate a long period of employment is also treated as de minimis. However, cash or items readily convertible into cash, such as gift certificates, are taxable, no matter what the amount.

Dual-income families are commonplace these days, however, some couples are discovering that their second income may not be worth the added aggravation and effort. After taking into consideration daycare expenses, commuting expenses, the countless take-out meals, and additional clothing costs, many are surprised at how much (or how little) of that second income is actually hitting their bank account.

Dual-income families are commonplace these days, however, some couples are discovering that their second income may not be worth the added aggravation and effort. After taking into consideration daycare expenses, commuting expenses, the countless take-out meals, and additional clothing costs, many are surprised at how much (or how little) of that second income is actually hitting their bank account.

Before you and your spouse head off for yet another hectic workweek, it may be worth your time to take a few moments to do a few simple calculations. After assessing what expenditures are necessary in order for both parents to work outside of the home, many couples quickly realize that their second income is essentially paying for the second person to be working.

Crunch the numbers. To determine whether your second income is worth the energy, you will need to calculate the estimated value of the second income. First determine how much the second income brings in after taxes. Then subtract expenses incurred due to the second person working, such as dry cleaning expenses, childcare bills, transportation costs, housecleaning services, landscaping services, and outside dining expenses. The result will be the estimated value of the second person working.

Consider the long-term. Even if your result turns out to be small, you may find that having the second person working will be beneficial to the household in the long run. However, don't forget to consider that, by losing the second income, you may also be losing future retirement benefits and social security earnings.

Take a "dry run". Before reducing down to one income, try living on the person's income you intend to keep for six months, stashing the other income into an emergency savings account. If you are able to do this, chances are you will be able to endure for the long haul.

Many different factors can affect a family's decision to have both parents work - including the fulfillment each parent may get from working regardless of whether their income is adding significantly to the household. However, if trying to make ends meet is the major reason, it may pay off to spend some time analyzing the real net benefit from that second income. If you need any assistance while determining if both spouses should work or not, please feel free to contact the office.

Employers are required by the Internal Revenue Code to calculate, withhold, and deposit with the IRS all federal employment taxes related to wages paid to employees. Failure to comply with these requirements can find certain "responsible persons" held personally liable. Who is a responsible person for purposes of employment tax obligations? The broad interpretation defined by the courts and the IRS may surprise you.

Employers are required by the Internal Revenue Code to calculate, withhold, and deposit with the IRS all federal employment taxes related to wages paid to employees. Failure to comply with these requirements can find certain "responsible persons" held personally liable. Who is a responsible person for purposes of employment tax obligations? The broad interpretation defined by the courts and the IRS may surprise you.

Employer's responsibility regarding employment taxes

Employment taxes such as federal income tax, social security (FICA) tax, unemployment (FUTA) tax and various state taxes (note that state issues are not addressed in this article) are all required to be withheld from an employee's wages. Wages are defined in the Code and the accompanying IRS regulations as all remuneration for services performed by an employee for an employer, including the value of remuneration, such as benefits, paid in any form other than cash. The employer is responsible for depositing withheld taxes (along with related employer taxes) with the IRS in a timely manner.

100% penalty for non-compliance

Although the employer entity is required by law to withhold and pay over employment taxes, the penalty provisions of the Code are enforceable against any responsible person who willfully fails to withhold, account for, or pay over withholding tax to the government. The trust fund recovery penalty -- equal to 100% of the tax not withheld and/or paid over -- is a collection device that is normally assessed only if the tax can't be collected from the employer entity itself. Once assessed, however, this steep penalty becomes a personal liability of the responsible person(s) that can wreak havoc on their personal financial situation -- even personal bankruptcy is not an "out" as this penalty is not dischargeable in bankruptcy.

A corporation, partnership, limited liability or other form of doing business won't insulate a "responsible person" from this obligation. But who is a responsible person for purposes of withholding and paying over employment taxes, and ultimately the possible resulting penalty for noncompliance? Also, what constitutes "willful failure to pay and/or withhold"? To give you a better understanding of your potential liability as an employer or employee, these questions are addressed below.

Who are "responsible persons"?

Typically, the types of individuals who are deemed "responsible persons" for purposes of the employment tax withholding and payment are corporate officers or employees whose job description includes managing and paying employment taxes on behalf of the employer entity.

However, the type of responsibility targeted by the Code and regulations includes familiarity with and/or control over functions that are involved in the collection and deposit of employment taxes. Unfortunately for potential targets, Internal Revenue Code Section 6672 doesn't define the term, and the courts and the IRS have not formulated a specific rule that can be applied to determine who is or is not a "responsible person." Recent cases have found the courts ruling both ways, with the IRS generally applying a broad, comprehensive standard.

A Texas district court, for example, looked at the duties performed by an executive -- and rejected her argument that responsibility should only be assigned to the person with the greatest control over the taxes. Responsibility was not limited to the person with the most authority -- it could be assigned to any number of people so long as they all had sufficient knowledge and capability.

The Fifth Circuit Court of Appeals has delineated six nonexclusive factors to determine responsibility for purposes of the penalty: whether the person: (1) is an officer or member of the board of directors; (2) owns a substantial amount of stock in the company; (3) manages the day-to-day operations of the business; (4) has the authority to hire or fire employees; (5) makes decisions as to the disbursement of funds and payment of creditors; and (6) possesses the authority to sign company checks. No one factor is dispositive, according to the court, but it is clear that the court looks to the individual's authority; what he or she could do, not what he or she actually did -- or knew.

The Ninth Circuit recently cited similar factors, holding that whether an individual had knowledge that the taxes were unpaid was irrelevant; instead, said the court, responsibility is a matter of status, duty, and authority, not knowledge. Agreeing with the Texas district court, above, the court held that the penalty provision of Code section 6672 doesn't confine liability for unpaid taxes to the single officer with the greatest control or authority over corporate affairs.

Suffice it to say that, under the various courts' interpretations -- or that of the IRS -- many corporate managers and officers who are neither assigned nor assume any actual responsibility for the regular withholding, collection or deposit of federal employment taxes would be surprised to find that they could be responsible for taxes that should have been paid over by the employer entity but weren't.

What constitutes "willful failure" to comply?

Once it has been established that an individual qualifies as a responsible person, he must also be found to have acted willfully in failing to withhold and pay the taxes. Although it may be easier to establish the ingredients for "responsibility," some courts have focused on the requirement that the individual's failure be willful, relying on various means to divine his or her intent.

An Arizona district court, for example, found that a retired company owner who had turned over the operation of his business to his children while maintaining only consultant status was indeed a responsible person -- but concluded that his past actions indicated that he did not willfully cause the nonpayment of the company's employment taxes. Since he had loaned money to the company in the past when necessary, his inaction with respect to the taxes suggested that he believed the company was meeting its obligations and the taxes were being paid.

A Texas district court found willfulness where an officer of a bankrupt company knew that the taxes were due but paid other creditors instead.

The Fifth Circuit has determined that the willfulness inquiry is the critical factor in most penalty cases, and that it requires only a voluntary, conscious, and intentional act, not a bad motive or evil intent. "A responsible person acts willfully if [s]he knows the taxes are due but uses corporate funds to pay other creditors, or if [s]he recklessly disregards the risk that the taxes may not be remitted to the government, or if, learning of the underpayment of taxes fails to use later-acquired available funds to pay the obligation.

Planning ahead

Is there any way for those with access to the inner workings of an employer's finances or tax responsibilities -- but without actual responsibility or knowledge of employment tax matters -- to protect themselves from the "responsible person" penalty? It may depend on which jurisdiction you're in -- although a survey of the courts suggests most are more willing than not to find liability. Otherwise, the wisest course may be to enter into an employment contract that carefully delineates and separates the duties and responsibilities -- and the expected scope of knowledge -- of an individual who might find himself with the dubious distinction of being responsible for a distinctly unexpected and undesirable drain on his finances.

The laws and requirements related to employment taxes can be complex and confusing with steep penalties for non-compliance. For additional assistance with your employment related tax issues, please contact the office for additional guidance.

How quickly could you convert your assets to cash if necessary? Do you have a quantitative way to evaluate management's effectiveness? Knowing your business' key financial ratios can provide valuable insight into the effectiveness of your operations and your ability to meet your financial obligations as well as help you chart your company's future.

How quickly could you convert your assets to cash if necessary? Do you have a quantitative way to evaluate management's effectiveness? Knowing your business' key financial ratios can provide valuable insight into the effectiveness of your operations and your ability to meet your financial obligations as well as help you chart your company's future.

Step 1: Calculate your ratios.

Acid Test: determines your company's ability to convert assets to cash to pay current obligations.

Cash & near cash

Current liabilities

Current Ratio measures your company's liquidity and ability to pay short-term debts.

Current assets

Current liabilities

Debt to Assets Ratio determines the extent to which your company is financed by debt.

Total debt

Total assets

Gross Profit Margin Rate: measures how much of each sales dollar can go for operating expenses and profit.

Gross Profit

Net Sales

Return on Assets (ROA): measures how much income is generated from your company's assets.

Net profit

Total assets

Step 2: Evaluate results.

Once you have calculated the ratios, you will need to be able to translate the numbers into results that relate to your business. Below are some examples of how you can use these ratios in your business:

Acid Test: A result of 2:0:1 means you have a two dollars' worth of easily convertible assets for each dollar of current liabilities.

Current Ratio A ratio of 2.0:1 means that the value of your current assets are twice that of what your current obligations are, a good indicator to a potential lender that your company is in sound financial condition.

Debt to Assets Ratio This ratio shows how many cents per dollar of assets are financed. An 82% ratio would indicate that your company's assets are heavily financed and may be a troubling sign to a potential lender.

Gross Profit Margin Ratio A ratio of .45:1 indicates that for every dollar of sales, your company has 45 cents to cover operating expenses and profit. This information can be used when setting pricing for your company's products and services.

Return on Assets Ratio (ROA): A ratio of .08:1 would mean that the company is bringing in 8 cents for every dollar of assets. These results can be used to determine the effectiveness of management's efforts to utilize assets.

Step 3: Compare to previous periods' results.

Take the results from the current period (e.g., this month) and deduct from the results of the previous period (e.g., last month). The result will be the net change in the ratio from one period to another. Because increases from period to period are good for one ratio (e.g., acid test) but maybe not so good for another (e.g., debt to assets ratio) it's important to analyze each ratio separately.

While changes in ratios don't always mean your company is getting off track, analyzing the cause of the changes can help uncover potential problem areas that need your attention.

There are many applications for key financial ratios to help you and your management team identify your company's strengths and weaknesses. If you would like any additional assistance with the calculation or analysis of your company's ratios, please contact the office.

Q. I have a professional services firm and am considering hiring my wife to help out with some of the administrative tasks in the office. I don't think we'll have a problem working together but I would like to have more information about the tax aspects of such an arrangement before I make the leap. What are some of the tax advantages of hiring my spouse?

Q. I have a professional services firm and am considering hiring my wife to help out with some of the administrative tasks in the office. I don't think we'll have a problem working together but I would like to have more information about the tax aspects of such an arrangement before I make the leap. What are some of the tax advantages of hiring my spouse?

A. Small business owners have long adhered to the practice of hiring family members to help them run their businesses -- results have ranged from very rewarding to absolutely disastrous. From a purely financial aspect, however, it is very important for you as a business owner to consider the tax advantages and potential pitfalls of hiring -- or continuing to employ -- family members in your small business.

Keeping it all in the family

Pay your family -- not Uncle Sam. Hiring family members can be a way of keeping more of your business income available for you and your family. The business gets a deduction for the wages paid -- as long as the family members are performing actual services in exchange for the compensation that they are receiving. This is true even though the family member will have to include the compensation received in income.

Some of the major tax advantages that often can be achieved through hiring a family member -- in this case, your spouse -- include:

Health insurance deduction. If you are self-employed and hire your spouse as a bona fide employee, your spouse -- as one of your employees -- can be given full health insurance coverage for all family members, including you as the business owner. This will convert the family health insurance premiums into a 100% deductible expense.

Company retirement plan participation. You may be able to deduct contributions made on behalf of your spouse to a company sponsored retirement plan if they are employees. The tax rules involved to put family members into your businesses retirement plan are quite complex, however, and generally require you to give equal treatment to all employees, whether or not related.

Travel expenses. If your spouse is an employee, you may be able to deduct the costs attributable to her or him accompanying you on business travel if both of you perform a legitimate business function while travelling.

IRA contributions. Paying your spouse a salary may enable them to make deductible IRA contributions based on the earned income that they receive, or Roth contributions that will accumulate tax-free for eventual tax-free distribution.

"Reasonable compensation"

In order for a business owner to realize any of the advantages connected with the hiring family members as discussed above, it is imperative for the family member to have engaged in bona fide work that merits the compensation being paid. Because this area has such a high potential for abuse, it's definitely a hot issue with the IRS. If compensation paid to a family member is deemed excessive, payments may be reclassified as gifts or as a means of equalizing payments to shareholders.

As you decide on how much to pay your spouse working in your business, keep in mind the reasonable compensation issue. Consider the going market rate for the work that is being done and pay accordingly. This conservative approach could save you money and headaches in the event of an audit by the IRS.

Hiring your spouse can be a rewarding and cost effective solution for your small business. However, in order to get the maximum benefit from such an arrangement, proper planning should be done. For additional guidance, please feel free to contact the office.

Stock options have become a common part of many compensation and benefits packages. Even small businesses have jumped on the bandwagon and now provide a perk previously confined to the executive suites of large publicly held companies. If you are an employee who has received stock options, you need to be aware of the complicated tax rules that govern certain stock options -- several potential "gotchas" exist and failing to spot them can cause major tax headaches.

Stock options have become a common part of many compensation and benefits packages. Even small businesses have jumped on the bandwagon and now provide a perk previously confined to the executive suites of large publicly held companies. If you are an employee who has received stock options, you need to be aware of the complicated tax rules that govern certain stock options -- several potential "gotchas" exist and failing to spot them can cause major tax headaches.

Over the past few years, the rules governing stock options have become increasingly complicated. More than ever, it is important that employees who receive stock options have a good understanding about how they are taxed -- on receipt of the option, at its exercise, or pursuant to the sale of the underlying stock -- as well as the potential consequences of their decisions regarding the timing of the taxation of those options.

NSOs vs ISOs

The most common type of stock option that employees receive is called a nonstatutory stock option (NSO). The other, less common type of stock option is generically referred to as an incentive stock option (ISO). ISOs are governed by very specific rules and are subjected to strict statutory requirements; NSOs, on the other hand, are subject to more general rules and guidelines.

Incentive stock options (ISOs) give the employee the right to purchase stock from the employer at a specified price. The employee is not taxed on the ISO at the time of its grant or at the time of the exercise of the option. Instead, he or she is taxed only at the time of the disposition of the stock acquired through exercise of the option. Note, however, the exercise of an ISO does give rise to an alternative minimum tax item in the amount of the difference between the option price and the market price of the stock.

Note. The IRS temporarily suspended the collection of ISO alternative minimum tax (AMT) liabilities through September 30, 2008.

NSOs also give the employee the right to purchase stock from the employer at a specified price. When and how an NSO is taxed depends on several factors including whether the underlying stock is substantially vested, and whether or not the fair market value of the stock is readily ascertainable.

Vesting. If an employee receives options from his employer, the tax consequences depend on whether the stock is vested. Stock you receive from your employer is "substantially vested" if it is either "transferable" by the employee or it is no longer subject to a "substantial risk of forfeiture". Property is "transferable" if you can sell, assign or pledge your interest in the option without the risk of losing it. A "substantial risk of forfeiture" exists if the rights in the property transferred depend on the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a certain condition related to the transfer.

Readily ascertainable fair market value. An NSO always has a readily ascertainable fair market value when the option is publicly traded. When an option is not publicly traded, it can have a readily ascertainable fair market value if its value can be measured with reasonable accuracy. IRS rules spell out when fair market value can be measured with reasonable accuracy.

Generally, an employee who receives an NSO that has a readily ascertainable fair market value is subject to special tax rules under the Internal Revenue Code that apply to property received by a taxpayer in exchange for services when the option is granted. Under these rules, the option must be included in the employee's income as ordinary income in the amount of the fair market value in the year the option becomes substantially vested. If the employee paid for the option, he recognizes the value of the option minus its cost. The employee is not taxed again when he exercises the option and buys the corporate stock; he is taxed when the stock is sold. The gain or loss recognized when the employee sells the stock is capital in nature.

No readily ascertainable fair market value. Employees who receive NSOs from privately held companies are most likely to receive an NSO without a readily ascertainable fair market value. In general, when an NSO does not have a readily ascertainable fair market value, taxation occurs at the time when the option is exercised or transferred. The employee will recognize ordinary income in the amount of the value of the stock when it becomes substantially vested minus any amounts paid for the option or stock. The gain or loss recognized when the employee sells the stock is capital in nature. However, employees who have NSOs without a readily ascertainable fair market value also have the ability to elect to have the transaction taxed differently,

Section 83(b) election: Elector beware

Employees who exercise options that did not have a readily ascertainable fair market value when they were granted may elect to report income from the stock underlying the option at the time of the exercise rather than waiting until the stock is substantially vested. This election is referred to as a "Section 83(b) election" and is non-revocable. Once the election is made, any later subsequent appreciation when the stock becomes substantially vested would not be includible in income.

As you can see, the rules and tax laws related to stock options are indeed complicated and require some advance planning in order to avoid a big tax "gotcha". If you are contemplating entering into any transactions that involve stock options, please contact the office for additional guidance.

All of us will, at one time or another, incur financial losses - whether insubstantial or quite significant -- in our business and personal lives. When business fortunes head South -- either temporarily or in a more prolonged slide, it is important to be aware of how the tax law can limit the actual amount of your losses and your ability to deduct them. Here are some of the types of losses your business may experience and the related tax considerations to keep in mind in the event of a business downturn.

All of us will, at one time or another, incur financial losses - whether insubstantial or quite significant -- in our business and personal lives. When business fortunes head South -- either temporarily or in a more prolonged slide, it is important to be aware of how the tax law can limit the actual amount of your losses and your ability to deduct them. Here are some of the types of losses your business may experience and the related tax considerations to keep in mind in the event of a business downturn.

Bad debts

One loss that occurs frequently when business slows down is bad debt. A bad debt is simply a technical term used to describe a debt that has become totally or partially worthless. Different strategies apply depending upon whether you are the borrower or the lender.

As borrower. If you are the borrower, the "forgiveness" of all or part of the debt by the lender will generally trigger taxable income on that amount, unless the business is insolvent (debts exceed liabilities).

Note. The American Recovery and Reinvestment Act of 2009 (2009 Recovery Act) allows some business to elect to recognize cancellation of indebtedness income over five years, beginning in 2014. The temporary benefit applies to specific types of business debt repurchased by the business after December 31, 2008 and before January 1, 2011. Under this provision, an applicable debt instrument includes a bond, note, certificate, debenture, or other instrument that constitutes indebtedness issued by a C corporation or any other "person" in connection with the conduct of trade or business by that person. This election is irrevocable. Moreover, the liquidation or sale of substantially all the taxpayer's assets can result in acceleration of deferred items.

Although recognizing income may not be an immediate problem for a business that has plenty of losses to net against current income, additional income may wash out a net operating loss carryover that can either provide an immediate refund for a past tax year or shelter from income in the future. As a result, some businesses re-define debt "forgiveness" into a non-taxable event, such as a refinancing or a business-generated settlement.

As lender. If you are the lender, your major tax concern will be proving that a real debt exists, and then determining how fast you can deduct the bad debt and whether the deduction can offset ordinary income, as opposed to just capital gains.

Loans between corporations and their shareholders are scrutinized to make sure that they are really debts rather than disguised dividends or contributions to the corporation's capital. You can protect yourself by taking the steps that an arm's-length lender would take, such as putting it in writing and charging a reasonable rate of interest.

The IRS sometimes requires taxpayers to play a guessing game about which tax year a debt becomes sufficiently worthless to support the deduction. Because of potential statute of limitations problems, tax experts generally recommend that you claim the loss in the earliest possible year that it can reasonably be argued to be worthless.

Finally, you must determine whether a business or nonbusiness bad debt exists. A business bad debt must be created or acquired, or become worthless, in the course of your trade or business. If you conduct a business in the form of a corporation, generally any debt held by the corporation is a business debt. Any debt not falling into the business category is a nonbusiness debt.

As guarantor. If you take out a loan on behalf of your corporation or you personally guarantee the loan and then must make good on it, you are usually considered to have either made a contribution to capital or created a nonbusiness bad debt to protect your position as an investor. A nonbusiness debt must be completely worthless before a loss can be taken. Furthermore, nonbusiness bad debts are subject to limits on capital losses. Business bad debts, on the other hand, are deductible as ordinary losses in full against your other income.

Net operating losses

If you show a net operating loss for the year, it normally may be carried back two years or carried forward up to 20 years until it can be netted against current taxable income. A net operating loss (NOL) for this purpose has some complexity built in to strip it of most personal tax characteristics. An individual's NOL, for example, does not include any offset for personal or dependency exemptions, for net nonbusiness capital losses, or for nonbusiness itemized deductions that exceed nonbusiness income. Another choice in dealing with an NOL is to elect to immediately carryforward the loss. This can be advantageous when high rate-bracket income is anticipated in the following year.

Note. The 2009 Recovery Act provides a five-year carryback of 2008 NOLs for qualified small businesses only. These are small businesses with average gross receipts of $15 million or less. Businesses can choose to carryback NOLs three, four or five years. This treatment applies only to NOLs for any tax year beginning or ending in 2008. The normal NOL carryback period returns in for NOLs incurred in 2009.

Pass-through losses

One of the advantages of investing in a business as a partner or a subchapter S shareholder is that losses on the business level get passed-through to your individual tax return. Regular corporations, on the other hand, file separate returns and the shareholder cannot "realize" a tax loss until he or she actually sells stock.

For both partners and S shareholders, however, the ability to deduct pass-through losses is determined by the amount of tax basis the partner has in his partnership interest or the S shareholder has in his shares. This, in turn, depends upon a variety of factors, including the original price paid, the amount of losses already passed through, cash or property distributed, and any later contributions.

If you have such a stake in a business, a tax strategy for both adding to basis and preventing its diminution is critical to your ability to be able to deduct business losses as a partner or S shareholder.

Section 1244 Stock

If you sell stock at a loss and that stock had been designated on its issuance to be "Section 1244 stock," you are more fortunate than most investors who bail out during a business downturn. Reason: you are entitled to an ordinary loss deduction rather than a capital loss. This special loss treatment is limited to $50,000 for any one year ($100,000 for joint returns). Other requirements are that the stock was issued for no more than $1 million, less than 50% of corporate receipts were from passive sources for the first five years of operation, and the shareholder claiming the treatment must be an individual.

Dealing with and making the most of losses related to a business downturn can get complicated. Because the preceding discussion is meant to be general, is limited in nature and does not cover all the tax rules involved, you are encourage to contact the office for additional guidance with this issue.