nce again, it is that time of year when some of us might choose death as the more preferable of life's two certainties. Yes, tax time is upon us. But there is some reason to celebrate.
STATE TAXES
| | Don't forget to see our guide to filing your state taxes. |
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With the signing of the Taxpayer Relief Act of 1997 by President Clinton on Aug. 5, 1997, many of us now face a reduced tax burden. The legislation is touted as providing particular ''relief'' for families, students, homeowners, and investors. Some of these savings may be realized in your 1997 return through reduced taxes on capital gains and the sale of one's primary residence. You may realize further savings in 1998 if you can weave your way through perhaps the most complex provisions ever focused at middle-income taxpayers.
Despite these changes, the 1997 Form 1040 is almost identical to the 1996 return, which will be a valuable guide to assist most taxpayers in preparing their 1997 returns. This article will highlight the important changes to the law and the forms. If you want a summary of the 1997 tax law changes, refer to the 1040 instruction booklet or get the more in-depth Publication 553. Both publications also highlight the many 1998 tax changes.
Each year, the Form 1040 instruction booklet emphasizes a different feature, and this year's booklet invites taxpayers to explore e-file, the IRS electronic filing program. It requires special tax-preparation software that is available at computer retailers or is downloadable at various Web sites. E-file, combined with the direct deposit of refunds, may greatly reduce your wait for a refund. A few e-filers may be able to file over the phone.
The booklet also details the many alternatives available to get tax help and forms, including the IRS Web site (at www.irs.ustreas.gov), a source for forms, instructions, and IRS publications. On the inside front cover, the IRS has again included a valuable tool, a ''Tax Return Page Reference,'' to help you use the booklet to answer your questions.
The reference consists of pages one and two of Form 1040. On each line, a page number in the booklet is indicated in a blue circle; the instructions in the booklet that correspond to that particular line will be found on that page. If you get stuck on a particular line of Form 1040, refer to this valuable reference.
You should review the entire instruction booklet because it covers most of the important information you need to complete your return. Pay attention to a special section on ''How to Avoid Common Mistakes.''
Once again, the booklet includes pie charts that detail the allocation of federal income and outlays. Congress mandated that the booklet include this information. In fiscal 1996, the government's deficit totaled $107 billion, a decrease of $57 billion from the prior year. Personal income taxes generated 42 percent of the federal government's $1.453 trillion in revenue. If you wish to contribute more than your individual taxes, you can also find instructions for making gifts to the government to reduce this debt; these gifts may be tax-deductible.
Each year, the IRS includes in the instruction booklet its estimate of the time needed to learn about the law or its various forms. The IRS estimates it will take 2 hours, 7 minutes to learn about the law and Form 1040, a surprising 25 minutes less than in 1996.
If you have any comments about the accuracy of these time estimates, and apparently some taxpayers do, the IRS invites you to write or call. The address and an 800 telephone number are provided in the instructions for Form 1040.
No matter how long the IRS figures it will take you to do your return, take all the time you need to get it right. Even the IRS concedes there may be wide variances in the time needed to prepare your return.
To begin our sample 1997 return, we call on our taxpayers, Philip and Grace Sandblom, ages 43 and 40, respectively. Philip is an executive who was employed by Tech Corp. for the entire year and Grace is a self-employed computer consultant.
In 1996, they filed Form 1040, and the IRS sent them Form 1040 and the accompanying instruction booklet. The instruction booklet does not provide specific instructions that detail which form to use. Because they itemize deductions, they know they must use Form 1040 instead of the simpler Form 1040A or Form 1040EZ.
If you are uncertain what form to use, Tele-Tax, the IRS recorded phone information service, addresses this question; look for Topic 352. Tele-Tax information is now also available by fax or through the Internet.
Be sure to check your booklet to see if it has all of the forms you require. The booklet the IRS mailed may not contain the forms that best meet your needs, because the IRS sends the booklet based on last year's return. Use the simplest form that meets your situation.
If you need additional forms, go to any IRS office, post offices, or libraries; use the order blank included in the Form 1040 instruction booklet; or try the toll-free number (1-800-TAX FORM). The IRS says it will take 7 to 15 work days to receive the forms.
You can also use the order blank and phone number to get IRS publications. Alternatively, you may download forms and instruction booklets from the IRS Web site or by a new ''Forms by Fax'' program described in the instruction booklet.
The Sandbloms moved during the year but they still use the preprinted label that is included in the instruction booklet; you should, too. This label will speed up the processing of your return and receipt of a refund.
If the label has errors, cross out and correct them. If you do not use the label, be sure to carefully complete your name, address, and Social Security numbers. In this year's instruction booklet, the IRS cautions filers of joint returns to make sure the order in which Social Security numbers appear on the label matches the order of your names. Correct Social Security numbers enhance the IRS's ability to improve service to taxpayers.
If you moved during the year, the IRS requests that you notify it in writing; you can use Form 8822, Change of Address. Filing this form is especially important if you are awaiting a refund or are in engaged in correspondence with IRS about your returns.
After completing this information, Philip and Grace check the Presidential Election Campaign boxes. If you check ''yes,'' $3 of your tax will go into the fund. As always, your choices do not affect your tax liability.
The Sandbloms have elected to file jointly; therefore, they have checked box 2. Remember: Check one box only. The couple have two children, John, age 12, and Susanna, age 10. On Lines 6a and 6b, Philip and Grace claim the exemption for themselves. On Line 6c, they list the permitted exemptions for their two children. On Line 6d, they add together their four exemptions.
Note that they list Social Security numbers for their children on Line 6c. Beginning in 1997, you must report SSN's for all living dependents regardless of age. To obtain a Social Security number, complete and file Form SS-5 with your local Social Security office.
The Sandbloms are now ready to record their income on Page 1 of Form 1040. The line numbers on Page 1 are almost identical to the 1996 form; we will point out when they change.
Only Philip received a Form W-2 to report his wages earned during 1997 and the taxes withheld; Grace was self-employed and so does not have an employer from whom to receive a Form W-2.
In addition to federal and state income tax withholding, Philip checks the withholding for Social Security and Medicare tax. Check your Form W-2 carefully; it is supplying increasingly more information and is becoming more complex.
For example, boxes indicate if an employee is a participant in a pension plan; if so, tax-deductible contributions to individual retirement accounts could be limited or not allowed.
Philip's W-2 includes his salary for the entire year. His W-2 indicates that he participated in a qualified retirement plan during the year and it indicates the amount of 401(k) contributions made during 1997. This amount is not included in compensation.
Form W-2 also indicates the amount of taxable fringe benefits an employee receives; these benefits should already be included in total wages. Philip's salary was $65,000 and this is the amount that they enter on Line 7.
Line 8a, 8b, and 9, Dividends and Interest
If either interest or dividends exceed $400, Schedule B is required. The Sandbloms must complete this form.
Interest income is typically reported to taxpayers on Form 1099-INT. They enter these items on Part I, Schedule B. The Sandbloms earned $400 from a savings account with Massachusetts Bank and $100 from an account they had maintained at New Hampshire Bank. They also cashed in US Savings Bonds accumulated over the years, earning $400. The total, $900, is reported on Line 4, Schedule B, and carried to Line 8a, Form 1040.
If you purchase US Savings Bonds, you have two options to report the income. You may report the interest income in the year that you cash in the bonds, which is the method adopted by the Sandbloms.
Alternatively, each year you may report the increase in the bond's value as income. Also, certain taxpayers may be able to exclude the income from Savings Bonds if they are paying the costs of higher education.
The Sandbloms also received dividends, reported on Form 1099-DIV, as follows: Utility Co, $100; a money market mutual fund, $150; a tax-exempt money market mutual fund (all of the income is from states outside of Massachusetts, according to information sent by the fund), $175; and a mutual fund distribution from the D&I fund, which consists of a capital gain distribution of $600.
Schedule B, Part II is required. All of these dividends except the tax-exempt fund are listed on Line 5 and totaled on Line 6 ($850). The capital gain distribution is then subtracted from the total (Line 7) and the remaining taxable amount, $250, is totaled on Line 10 and carried to Line 9, Form 1040. The Sandbloms also answer ''no'' to Questions 11 and 12 on Schedule B regarding foreign back accounts and trusts.
Income from mutual funds, including money market funds, should be reported as dividends, not interest. If you do not do this properly, you may receive a notice from the IRS. The tax-exempt mutual fund is not taxable for federal purposes as other types of dividend; it will be treated specially when doing the Massachusetts return. This amount, $175, is reported on Line 8b of Form 1040.
The instruction booklet includes a listing of the various types of information on reporting forms such as Form W-2 or various types of Form 1099. The chart explains where on Form 1040 or other tax forms to report the information. If you are uncertain how to handle a particular type of Form 1099, consult this chart.
Line 10, State Tax Refunds
The Sandbloms' 1996 Massachusetts return showed an overpayment of $300, which they applied as payment toward their 1997 liability. This overpayment must be reported as a state tax refund although they will treat this amount as tax paid when they itemize deductions. Since they itemized their deductions in 1996, this amount is taxable. The Commonwealth sent Form 1099-G reflecting this amount.
State tax refunds are not automatically taxable. It depends upon your circumstances. For example, if you did not itemize deductions in the prior year, a current year refund would not be taxable. Complete the worksheet contained in the instruction booklet to determine if your refund is taxable.
The Sandbloms determined that they must report the refund, and reflect it on Line 10. High-income taxpayers should also review the instructions since their entire refund may not be subject to tax; get Publication 525 to assist you.
Line 12, Business Income; Schedule C
Grace has been a self-employed consultant for several years. She performs her work in the offices of clients and works on a number of assignments during the year. She maintains her business records, manuals, and professional materials in the family room of her home. Her income and expenses must be reported on Schedule C.
She collected fees totaling $30,000 from customers that sent her Forms 1099-MISC, the form a business uses to report its payment for this type of service. She received $3,000 from one client who did not send the form; she still must report the income.
She also sent bills to customers who still hadn't paid as of Dec. 31. She has opted to report her income and expenses on a cash basis and need not report this income until she is paid.
She paid expenses for office supplies, professional fees, and business lunches with prospective referral sources. In addition, she drove 6,000 miles in her car traveling between client locations and in promoting her business.
Grace may deduct the business use of her car. She must maintain records documenting this business usage as well as other expenses. Rather than trying to detail all automobile expenses, she used the IRS prescribed mileage rate for business use in 1997, 31.5 cents per mile.
This rate was 31 cents in 1996. If you use your car for business, get Publication 463. Only 50 percent of the amount that is spent for the business meals is deductible, but she is permitted to include the cost of her meal in determining the deduction.
Grace's total expenses were $3,040, and therefore she is unable to file the simpler Schedule C-EZ because her expenses are more than $2,500. The C-EZ is designed for those with small service businesses. The requirements to file are found on the face of the form. However, this year Grace is required to use the more involved Schedule C.
Net profit, $26,960, is computed on Schedule C and is carried to Line 12, Form 1040. This amount is also reported on Schedule SE for computation of the Social Security Self Employment Tax.
The Sandbloms also incurred expenses to care for their children while working. These amounts are neither deductible on Schedule C nor as a reduction to wages. However, they will be considered in computing the allowable child care credit.
Although Grace maintains business records at home, she is not permitted to claim a home-office deduction. The law requires that she devote a room of the house exclusively for business. Further, since she works at clients' offices, the Supreme Court's guidelines deny a deduction since the focal point of her business is outside the home.
The new tax law has eased this limitation imposed by the court, but these new rules are not effective until 1999, when more taxpayers may qualify for a home-office deduction. The rules for claiming home-office deductions are stringent. For those taxpayers who file Schedule C and claim deductions for the business use of an office in their home, be certain to use Form 8829 to determine your home-office deduction.
But beware of the stringent standards the IRS will apply in testing your qualifications for this deduction.
Line 13, Capital Gain or Loss; Schedule D
The capital gains changes in the new tax law generate much of the tax savings and even more of the complexity. The provisions reduce the maximum rate on long-term capital gains to 20 percent but impose a new 18-month holding period to achieve this benefit.
You must pay careful attention to the exact date you sold property to determine how it is taxed; for stock, you should use the trade date. The key dates are on the bottom of Schedule D.
One of the most interesting aspects of this year's tax forms is that they contain key provisions that are not even part of the law.
When Congress passed the new law, it neglected to consider provisions for handling capital losses. As a result, the IRS delayed preparing Schedule D until it received congressional guidance.
Since there was insufficient time to pass a law, the IRS relied on a letter from congressional leaders and committee action that explained what the law on losses will say when it is eventually passed.
The expected provisions are the most favorable interpretation. Because of these delays, the IRS announced that processing of tax returns with Schedule D may also be delayed.
As a result, Schedule D for 1997 is quite different from the same schedule in 1996. This year, this article will detail the entire Schedule D. But the example does not cover all alternatives, so be careful.
The Sandbloms incurred the following capital gains transaction in 1997, which they report on Page 1 of Schedule D:
On Jan. 15, 1997, the Sandbloms purchased shares in High Growth fund for $1,200 which they sold on April 1, 1997 for $1,000. This results in a short-term capital loss, since the shares were held less than 12 months. The loss goes on Line 1 of Schedule D.
On March 1, 1996 they purchased shares in Utility Co. for $2,000, which they sold on July 15, 1997 for $3,000. Although they held the shares for less than 18 months, this sale occurred during the special transition period from May 7, 1997 to July 28, 1997, and will therefore be taxed at the 20 percent rate. They report this transaction on Line 8 and they enter the gain in column (f). Note that in all cases, the total gain or loss goes in column (f).
On Jan. 1, 1995 they purchased shares in Microhard Corp. for $1,000, which they sold on Sept. 20, 1997 for $2,000. The gain on these shares, which were held longer than 18 months but sold after the special transition period, qualifies for the 20 percent rate. They report this transaction on Line 8 and they enter the gain in column (f).
On May 1, 1996 they purchased shares in XYZ Mutual fund for $3,000, which they sold on Oct. 1, 1997 for $3,500. These shares were held for 16 months and sold after July 28, 1997; the gain is called a mid-term gain and will be taxed at 28 percent. They report this transaction on Line 8 and they enter the gain in column (f) and column (g).
In addition, they received the capital gain dividend reported on Schedule B. The information from the fund indicates that $400 of the dividend qualifies for the 20 percent rate and $200 qualifies for the 28 percent rate. They put the total $600 on Line 13, column (f), and the $200 in column (g).
Mutual fund owners should pay special attention this year to the tax information they receive. Because of the changes in the tax law that affect capital gains dividends, Form 1099 must include supplemental information. Review all of the material that accompanies Form 1099 and do not discard anything until you are certain that you will not need it.
Because of the complexity of the tax-law change, the IRS did not require mutual funds to change the actual Form 1099 to report capital gains information; you may have to refer to supplemental information.
Another important change applies to taxpayers whose only capital gains are from capital gain dividends from mutual funds. In prior years, inserting this dividend on Page 1 of Form 1040 was sufficient. In 1997, you must complete Schedule D.
The rules for determining how to measure gain or loss on the sale of mutual funds are difficult, particularly if you have opted to reinvest dividends. Moreover, mutual funds are increasingly providing information to assist you in determining the tax cost of shares sold.
You should review this information and be certain that it is accurate and is the best strategy for you. If you have sold or invested in mutual funds, you should get Publication 564.
The Sandbloms complete Page 1 of Schedule D by totaling their total short-term loss of $200 on Line 7 and their total long-term gain of $3,100 on Line 16. On the next page, they net the gains and losses, $2,900, and report the total on Line 13 of Form 1040. They also total column (g), $700, but will not use this number until later to compute their tax.
On Sept. 1, Philip and Grace sold their home in Newton for $300,000, which they had purchased in 1990 for $100,000. On Sept. 2, 1997, they bought a house in Brookline for $275,000. During their ownership, they had spent $25,000 on improvements in Newton. After incurring $5,000 in sale expenses, the Sandbloms have a net gain of $170,000.
Because of the new tax law, the entire $170,000 gain is excluded since they sold the property after May 6, 1997, and they had used the house as their residence for more than two of the prior five years before the sale.
The purchase price of their new home no longer matters in determining the federal tax treatment of the gain, and the tax cost of the new house is $275,000. When they prepare their Massachusetts return, however, the rules will differ. This information must be reported on Form 2119. Under the new law, up to $500,000 of gain may be excluded.
Line 15a and 15b, IRA Distributions
Over the years, Philip has accumulated $12,000 in an IRA and, during 1997, he selected a new mutual fund group. Therefore, he decided to ''roll over'' from one IRA to another. Instead of receiving the amount by check, he asked that the payor make a ''direct transfer'' of the entire balance into the new IRA that he established to accept this rollover contribution.
If he had received a check for the distribution, he may still do a tax-free rollover within 60 days. However, the custodian of the IRA would be required to withhold tax on the distribution. The direct transfer avoids this withholding.
This distribution is reported on Form 1099-R. The $12,000 rollover is not currently taxed; this amount plus any income it subsequently earns are tax-deferred. To report this transaction, the Sandbloms enter $12,000 on Line 15a and write ''Rollover'' next to Line 15b. Philip must wait 12 months from receipt before he may roll over these funds to another IRA account.
If you receive an IRA distribution or maintain an IRA account, get IRS Publication 590. Also, many important new IRA provisions take effect in 1998 and you should pay close attention to them.
Line 21, Other Income
Grace won $1,000 on the Massachusetts lottery; she purchased $650 of lottery tickets during the year. She reports the income on Line 21. She will be entitled to a deduction for the ticket purchases on Schedule A.
Line 22, Total Income
The Sandbloms' total income, the sum of Lines 7 through 21, is $97,310. At this point, the line numbers in the 1997 form will begin to differ from the prior year's form.
Line 26, One-Half of Self Employment Tax
To compute this deduction, the Sandbloms must first complete Schedule SE, Self-Employment Tax, which is imposed on Grace's consulting income as determined on Schedule C. The self-employment tax totals $3,809; one-half of that amount ($1,905) is allowed as a deduction on Line 26.
Line 32, Adjusted Gross Income
The Sandbloms' adjusted gross income is $95,405.
The Sandbloms are not eligible to make a deductible IRA contribution (Line 23) because Philip was covered by a qualified retirement plan during the year and their AGI exceeds $50,000. His employer marked the appropriate box on Form W-2 indicating this fact.
Grace would be allowed to make deductible contributions to a self-employed (Keogh) retirement plan if this plan had been created before the end of the year.
The Sandbloms are eligible to make nondeductible IRA contributions of up to $2,000 each. Form 8606 is required. A new rule for 1997 allows both spouses on a joint return to each contribute $2,000 when only one spouse has earned income; the prior limit for contributions for a nonworking spouse was $250. But your contribution cannot exceed your earned income.
Page 1, Form 1040 is complete. The Sandbloms start Page 2 by simply copying adjusted gross income, Line 32, to Line 33 at the top of Page 2.
Line 35, Itemized Deductions, Schedule A
When they reach Line 35, the Sandbloms must complete Schedule A since they itemize their deductions. This year's form is identical to the 1996 Schedule A.
Medical expenses: Most taxpayers are unable to deduct medical costs since only the amount that exceeds 7.5 percent of adjusted gross income is allowable. All types of medical expenses are grouped together on Line 1 of Schedule A.
The Sandbloms paid out the following medical expenses during 1997: health insurance premiums deducted from Philip's salary in connection with his employer's plan, doctor and dentist bills, eyeglasses, prescriptions, and hospital costs.
Medical expenses for both children also count. In addition, they include travel expenses incurred to obtain medical care; the total is based on miles driven at 10 cents per mile plus parking and tolls.
Total medical expenses were $2,500; this sum is their out-of-pocket amount and does not include any amounts directly paid for or reimbursed by the insurance carrier. The total expenditures do not exceed the 7.5 percent of their AGI ($7,155), so no amount is deductible. Line 4 of Schedule A is ''None.''
For a full discussion of the types of expenses that may be deductible, refer to IRS Publication 502.
Taxes: Massachusetts income taxes are deductible. State income taxes of $3,600 withheld from Philip's salary are shown on Form W-2. In addition, Grace made estimated tax payments to the Commonwealth to ensure that sufficient taxes had been paid; these payments totaled $1,600, which includes the $300 overpayment from 1996 that was applied to 1997. The total, $5,200, goes on Line 5.
You should check your prior-year Massachusetts return and deduct any balance due paid in 1997. State tax deductions are allowed in the year paid. If you have a balance due with your 1997 state return, claim the deduction on your 1998 federal return.
Real estate taxes are also deductible. The Sandbloms paid $2,500 in real estate taxes on the Newton house; they obtained this amount from the information report from their mortgagee. The amount they paid to their escrow account is not the amount to deduct; deduct the amount of taxes paid from your escrow account.
However, since they sold their house, they must adjust the taxes paid by any real estate tax proration adjustment on the closing statement prepared in connection with the sale.
They received a credit for real estate taxes on the closing statement so that their net deduction is $2,000. They also review the adjustment on the closing statement of the house they purchased. The taxes paid for the new house including this adjustment are $1,000. When you buy or sell a house, always check the closing statement on the sale.
In addition, the Sandbloms paid real estate taxes of $1,500 on a second home they own in New Hampshire; they are deductible even though it was not their principal residence.
This total, $4,500, is entered on Line 6.
The Sandbloms also paid $500 in local personal property taxes on their cars (Line 7). Total taxes, $10,200, go on Line 9.
Interest expense: The Sandbloms paid mortgage interest on their homes.
They receive Form 1098 from the mortgage lender, which shows that they paid $7,000 of mortgage interest on the Newton home. They also took out a mortgage of $120,000 on the purchase of the Brookline home and paid interest of $2,700 during the year; they received a second Form 1098 that reflects this amount. They also paid interest of $300 on the New Hampshire home, receiving a third Form 1098. All of this interest is deductible, including the interest on the second home.
They paid one point ($1,200) on the purchase of the Brookline home; points on the purchase of a principal residence may be immediately deducted, and the lender has reflected this amount on Form 1098. If you have paid deductible points, be sure to determine if they have been included in the total of Form 1098. The total interest deduction, $11,200, goes on Line 10.
In July, they refinanced the New Hampshire mortgage and paid $300 in points. The new mortgage has a 15-year term. Points on refinancing and on the purchase of second homes must be deducted over the term of the mortgage. They enter the appropriate amount, $17, on Line 12.
As this example illustrates, the rules on home mortgage interest deductions are extremely complex. Get Publication 936.
Total interest expense, $11,217, goes on Line 14.
Grace paid interest on education loans during the year. This interest may not be deducted, but a new provision effective in 1998 will allow deductions to some taxpayers.
Charitable contributions: The Sandbloms paid contributions, by cash, check, and credit card, of $1,225. In addition, the Sandbloms traveled 300 miles in connection with charitable activities; the IRS allows a deduction for this travel at 12 cents per mile. In addition, they incurred parking and tolls of $25. The total amounts paid to or on behalf of charity, $1,286, goes on Line 15.
One of these contributions exceeded $250. If you make a single contribution payment that equals or exceeds $250, you must obtain a receipt from the charity documenting that amount. A canceled check is not sufficient proof of your donation. Charities are required under the tax law to provide these receipts and you should have them by the time you file your return.
Do not attach the receipts; retain them for your records. Also, be certain to reduce the amount of your deduction by the value of any benefit you received in connection with your gift; the value of the meal you receive attending a fund-raising dinner is a typical example.
Finally, during the year the Sandbloms donated clothing to charity. They valued the gifts at $400; this amount goes on Line 16. The Sandbloms are responsible for determining its fair market value.
The receipt requirements have increased the complexity of claiming charitable contribution deductions. If you have questions, get Publication 526.
Total deductible contributions of $1,686 go on Line 18.
Miscellaneous deductions: Like medical expenses, the availability of miscellaneous deductions depends on the level of your adjusted gross income; to obtain a tax deduction, the sum of most miscellaneous deductions must exceed 2 percent of adjusted gross income.
There are many different types of these deductions, so they must be carefully reviewed and categorized to maximize tax savings. The instruction booklet lists many permitted deductions; also, obtain Publication 529. But before you spend hours accumulating this information, be certain you are close to the AGI limit.
The form divides Miscellaneous Deductions subject to the 2 percent limitation into categories. Those related to employment go on Line 20. If you incur employment-related expenses for travel, meals, or entertainment, or if you receive certain reimbursements from your employer and your expenses exceed the 2 percent limit, you must complete Form 2106 before completing Line 20.
You may be able to use Form 2106-EZ to complete this information. You should check the instructions to determine if this form fits your needs.
Other miscellaneous deductions go on Line 22. The Sandbloms list the expenses they incurred for investment publications and related expenses. The miscellaneous deduction total does not exceed 2 percent of adjusted gross income and no deduction results.
Certain itemized deductions, such as gambling losses, are not subject to the 2 percent limit; these go on Line 27. Grace bought $650 of lottery tickets. Gambling deductions are limited; do not deduct more that the amount of winnings. Grace may deduct the entire $650, less than the amount she won.
All of the itemized deductions, Line 28, total $23,753, and this amount carries to Line 35, Form 1040.
Line 37, Exemptions
The Sandbloms subtract itemized deductions, Line 35, from AGI and then determine personal exemptions. On Page 1, they reported four exemptions; the value of each exemption for 1997 has been increased to $2,650.
Note the caution at Line 37 if your adjusted gross income exceeds $90,900; if so, complete the worksheet in the instruction booklet to determine the amount of deduction to which you are entitled. If your adjusted gross income exceeds certain levels, a portion of personal exemptions is phased out. In this case, the deduction is not limited and the Sandbloms enter $10,600 (four times $2,650) on Line 37.
They then determine their taxable income on Line 38, $61,052, by subtracting Line 36 from Line 35.
Line 39, Computing the Tax
Because of changes in the tax law, computing your tax will be more difficult if your taxable income includes income from long-term capital gains. Since the Sandbloms have long-term capital gains, they compute their tax using an alternative tax computation to take advantage of the lower rates. They will compute their tax on Page 2 of Schedule D.
The computation required is a tedious one that takes you from Line 19 to Line 54. Its purpose is to tax your gains at the 28 percent rate for mid-term gains and gains on sales prior to May 7, 1997, and to tax the remaining long-term gains at 20 percent.
In this example, the short-term loss of $200 is netted against the $700 gain subject to the 28 percent rate, and the net amount of $500 is taxed at 28 percent. (See Line 51 of Schedule D.) The remaining gain, $2,400, is taxed at 20 percent. (See Line 41 of Schedule D.) The remaining ordinary income is taxed at ordinary rates.
Determining the tax on ordinary income is simple since the Sandbloms must use the tax tables included in the instruction booklet; the tax tables are required for taxable incomes up to $100,000. The steps on Schedule D tell them when they must refer to the tax tables, and they use the column that corresponds to their married filing jointly status.
Their regular tax on ordinary income is $11,745, but Schedule D computes the correct tax of $11,553, which reflects the benefits of capital gains rates. The new 20 percent capital gain rate saved them $192.
There are infinite combinations and hopefully this explanation will help you by defining the objectives of the computation.
Line 40 to 46, Credits
The Sandbloms hired a baby sitter to stay with Susanna and John after school while the couple worked. They paid her $3,000 in child care costs. They must complete Form 2441 to compute the child care tax credit of $600, which they enter on Line 40. The child care credit only applies to the care of children under age 13.
You must identify the recipient's name, address, and taxpayer identification or Social Security number as part of Form 2441 or your credit may be disallowed. In addition, the Sandbloms complied with all federal and state payroll tax requirements, which will be discussed below.
Lines 47 to 53, Other Taxes
Line 47, Self-Employment Tax: The Sandbloms already completed Schedule SE, Self Employment Tax; this tax satisfies Grace's Social Security tax liability on consulting income. The tax, $3,809, goes on Line 45.
Line 52, Household Employment Taxes: Taxpayers are required to report and pay their federal payroll tax obligations on Form 1040 by using Schedule H. These rules dictate that all federal payroll tax obligations for household employees are satisfied by paying the tax with Form 1040.
The Sandbloms paid more than $1,000 in one calendar quarter in 1997; they must pay FICA and Federal Unemployment Tax. At their employee's request, they did not withhold federal income taxes.
In the case of household employees, employers are not required to withhold income taxes and may do so only if the employee requests and the employer agrees.
To report these amounts, the Sandbloms must include Schedule H with their return; they must pay $483 in federal payroll taxes. Schedule H does not satisfy state filing or payment requirements. Filings separate from their federal return are required to pay and report state taxes. This amount is reported on Line 52.
The Sandbloms total tax liability, Line 53 is $15,245.
Payments
Federal income tax withheld from Philip's W-2 is $11,500. Philip compares the amounts to the pay stubs he received during the year. You should make sure you check all of the information on your W-2. Inform your employer about discrepancies. The total withholding, $11,500, goes on Line 54.
Because Grace is self-employed, no tax is withheld on her income and she must satisfy her income and self-employment tax liability by making quarterly estimated tax payments using Form 1040-ES.
During the year, she estimated their joint tax liability and determined that payments of $1,000 each quarter were required. Her objective was to ensure that total tax payments exceeded 90 percent of their joint tax liability.
Another alternative would have been to base quarterly payments on their 1996 tax liability. Her total estimated payments of $4,000 go on Line 55 and total payments go on Line 60.
Since their payments exceed 90 percent of their liability, which is figured without the Schedule H tax for this purpose, they are not subject to penalties for having insufficient amounts of tax paid during the year.
If you expect that your income tax not satisfied by withholding will exceed $1,000 (up from $500 in 1997) and will not equal 90 percent of your current tax, you should make estimated tax payments or revise your withholding. Determining the exact amount of estimated tax payments can be difficult.
Alternatively, you will incur no penalty for underpayment of tax if your withholding plus timely estimated tax payments exceed your 1997 tax without regard to your AGI; the level of required 1998 payments is not determined by the amount of your AGI, a change effective in 1998 under the new law. Get Publication 505 for details on these requirements.
The result
Total payments, $15,500, are more than the tax liability of $15,245, and the Sandbloms are owed a refund of $255, which they apply to their 1998 estimated tax payment requirements. The IRS requests that if you make a payment, use Form 1040-V, Payment Voucher. Attach Form W-2 to the return, but do not attach the Payment Voucher or check; leave it loose in the envelope.
If you are entitled to a refund, the IRS encourages you to request direct deposit of your refunds. On Line 62, the form provides a place to insert information about your bank account that the IRS will use to direct deposit.
Before filing Form 1040, the Sandbloms check their math, verify their Social Security numbers on each schedule, write in their occupations on Page 2, assemble the forms behind Form 1040 in the order of the attachment sequence shown at the top of each form, attach Form W-2, make a copy for their files, sign and date the return on Page 2, and send it to Internal Revenue Service Center, Andover, MA 05501-0002. You should use the envelope the IRS provides with the instruction booklet. Many tax advisers suggest using certified mail.
Effective for this filing season, the IRS will accept tax returns using private delivery services so that the mailing date qualifies as the date of filing. Prior to this year, only the US Postal Service qualified as ''timely mailed means timely filed.'' The IRS designates certain delivery services that qualify for this new rule and they are listed in the instructions.
How long should it take to do this return based on IRS estimates of keeping records, learning about the law and forms, preparing the forms, and assembling and filing them? Thirty-four hours exactly.
If you run out of time, use Form 4868 to obtain an automatic extension to Aug. 17, 1998. Any tax due should accompany this extension to avoid penalties. Of course, filing an extension delays your refund.
Michael Carona is a tax partner with Coopers & Lybrand LLP in Boston.
Find extensive information on filing your 1997 taxes at Boston.com's Your Taxes, sponsored by Ernst & Young.
