Well, you've reached the halfway mark of 2005, and it's an exciting halfway point at that. The month starts with the fireworks of July 4th and continues on with Major League Baseball's All-Star Game on July 12. And don't forget the fireworks going off at all hours of the night. If that's not enough to keep the heart pumping at a fast pace...well...let's just say you're a sound sleeper.
July, like every month, is also a month to consider carefully what your year-end tax picture will look like. To help you along with your considerations, let's talk about the types and deductibility of various different taxes.
Types of Taxes
Most people are aware of property taxes, sales taxes and income taxes, but these are not the only way federal, state and local authorities finance operations. Here is a short list for your consideration:
- Property taxes - paid on the value of real and personal property owned.
- Sales taxes - paid to the vendor when you purchase materials, equipment, supplies, etc.
- Use taxes - paid directly to the taxing authority for purchases coming from out-of-state on which no tax has been charged by the vendor.
- Franchise taxes - paid on the capital employed in your business. Capital can be defined as just book balance of stocks issued and outstanding, stockholders' equity, or stockholders' equity plus long-term debt. Also known as net worth tax and capital stock tax, franchise tax essentially allows you to do business in a state.
- Excise taxes - paid on purchase of any number of items, including alcohol, tires, etc.
- Income taxes - awww, come on, surely you know what income taxes are.
Deductibility of Taxes
Until 2004, taxes paid by individuals with no business income were deducted on Schedule A of Form 1040, and pretty much limited to income or sales tax (depending on which is higher) personal property tax and real estate taxes. In 2004, a provision was added to the tax code to allow taxpayers to deduct the greater of sales tax paid for the year or income tax paid, depending on which is larger. Unless Congress changes its collective mind, the deductibility of sales taxes will end after December 31, 2005.
There has long been a misunderstanding on the part of many individuals about the deductibility of certain taxes. While it is easy to determine the amount of personal property taxes when the taxing authority tells you that you are paying personal property taxes, but what about taxes levied on things like automobiles and similar items? The easy way to remember if a tax or license fee is deductible is looking at how it is calculated. If all three of these conditions are met, the tax is deductible:
- It is ad valorem (substantially based on the value of the item),
- It is imposed on an annual basis, and
- It is imposed with respect to personal property.
Individuals are also allowed a deduction for "Generation-skipping" taxes paid on income distributions from an estate or trust.
Business entities are generally subject to more and higher taxes. You can look at this month's article in the general business section for ideas on minimizing tax costs.
From the standpoint of deductibility, state, income, franchise and property taxes are generally deductible for federal purposes. Excise taxes paid are also deductible. Penalty taxes are not deductible expenses. The general rule in the case of business entities is to deduct any normal recurring ad valorem (property) taxes. Taxes paid on unimproved property can be capitalized at the owner's election.
The main thing that you, as a business owner (including rental properties), need to remember is to allocate any tax savings from credits to the least deductible item, if your state allows such an allocation. For example, some states with both income and franchise tax allow credits against those taxes for inventory taxes paid. While allocating all the credit against one or the other tax will make no difference at the federal level, the state level is a different story. In general, a state will allow deductibility for franchise taxes, but not for state income taxes. In this case, you are best to allocate the credit against the income tax and reduce the franchise tax as little as possible. This does not hurt deductibility for the total of both packages at the federal level and allows you to deduct more because of a higher franchise tax expense.
Congress has made the identification of deductible taxes difficult over the years, but that shouldn't stop you from trying to maximize your deductions. This article should give you some guidelines in determining where you stand on deductible taxes, but if you still question a particular tax, give us a call. We will be more than happy to assist you with whatever your need may be.
Happy Anniversary America!