It was surprisingly a warm day in 2009 in Minnesota, Minneapolis, USA which ranks among the coldest states, when I got a telephone from a young lady, by her talk, I presumed, that her checking account with a local bank in California, USA was frozen by local tax authorities. Just on 3rd September 2016, in Delhi, where I am currently practising, another telephone call from somewhere in India from an American citizen but of Indian origin, perhaps in his 60s, again criticised Indian income tax for charging Tax Deduction at Source, on his investment invested in India but earned in U.S.A. He was of high net worth tax payer category. These incidences during my international professional career has again and again emphasized the fact that I have failed to educate an average tax payer about American tax system though I am a Certified Public Accountant from USA. This article is partly a panacea for my faults. I shall describe in simple terms what does an American taxation system demands from its tax payer(an individual) and how simple or otherwise its tax forms who have been used by nearly 144 million Americans last year are in nature.
To understand the tax system which is progressive in nature, indicating its increase in value for higher income, income tax slabs as published by IRS on page 102 of its publication titled 1040 instructions is enclosed as annexure 1. This is applicable for individual tax return 1040 which is again enclosed as annexure 2. An attempt has been made to quote from IRS website which is the authoritative one for tax purposes for the past nearly 150 years in U.S.A.
Explaining the individual tax return 1040 from the common tax payer’s eyes
Let us have the above form which has been taken from irs.gov website for the year 2015(the latest available form). It has 79 lines starting from 1) single and ending with 79) Estimated tax penalty. These lines are run on the following formula:
Individual Income Tax
Adjustments( above the line)
=Adjusted Gross Income (AGI)
Greater of itemised deductions or standard deduction
= Taxable Income * Tax rate
= Gross tax liability
= Net Tax Liability or Refund Receivables
Let us proceed with our understanding of the return. Our gross income appears as line 22. Our AGI appears as line 37. Itemised deductions(Schedule A) or Standard deduction appears as line 40. Total tax appears on line 63. The final figure appears as line 75) or line 78).
One can easily ask what one presumes by the words “gross income“. It is consisting of wages, taxable interest, ordinary dividends, taxable refunds from state or local income taxes, alimony received on account of dispute between couple for maintenance of child, business income or loss (Schedule C), Capital gains or loss (Schedule D), IRA distributions, pensions and annuities, rental real estate, royalties, partnerships, S corporations, trusts (Schedule E),Farm income (Schedule F), unemployment compensation, social security benefits and other income.
We may need to understand Schedule A, B, C, D, E, and F. Some of them are used by many tax payers in their returns.
This is mainly used by tax payers who own the residential houses, pay property taxes, incur medical expenses and incur other expenses which are analysed below;
i. Medical and dental expenses
ii. Taxes paid
iii. Interest paid
iv. Charitable contributions
v. Casualty and theft losses
vi. Charitable contributions
vii. Casualty and theft losses
viii. Other miscellaneous deductions – not subject to 2% limit and reported on line 28, Schedule A, 2015 Form 1040.
Since filling up of Schedule A involves many factors to be considered and has evolved over a period of time, an expert help like a CPA can effectively handle this matter.
Form for Schedule A may be seen as https://www.irs.gov/pub/irs-pdf/f1040sa.pdf
This schedule is used in case of taxable interest received from bank accounts, loans made by a tax payer to another person, and other sources. This schedule is completed if the tax payer has taxable interest income more than $1500, has a foreign account, receives interest as a nominee since the interest belongs to someone else, etc. It can be downloaded from https://www.irs.gov/pub/irs-pdf/f1040sb.pdf . Detailed instructions have also been given.
Schedule C is used to calculate profit or loss from business. A sole proprietor generally reports all self- employment income and expense on Schedule C. Gross Income(GI) includes all income from a trade or business. GI means gross income.
GI that sells products or commodities is Gross sales (receipts) –cost of goods sold + other GI (e.g. rentals) = GI from business.
Cost of goods sold is treated as a return of capital, which is not income for tax reasons. COGS for a tax year, generally, is
(Beginning inventory+ Inventory purchased during the year )- Year-end inventory = COGS. Obviously, COGS would be determined with the accounting method used in the business. It can be cash method, accrual method or others to be specified under column (F).
The schedule expects the expenses are directly related or associated with the active conduct of business. The detailed list of expenses that can be entered are advertising, car and truck expenses, commissions and fees, contract labour, depletion, depreciation under section 179 deduction, employee benefits programme, insurance(other than health insurance), mortgage, interest, legal and professional expenses, rent or lease, repairs and maintenance, taxes and licenses, travel, meals and entertainment, utilities and wages. The expenditures are expected to be reasonable and Internal Revenue Service during the last 150 years of its existence is well aware of the pattern of expenses expected in most of the business and the computer would red flag unusual ones and the returns may be subject to audit. Entertainment really means those related to business only and spent during the business meetings. Overnight travel expenses include transportation, lodging, and meal expenses in business related context. I have seen during my stay abroad that private contractors from many industries, ignorantly include travel to their mother land on private reasons as official ones.
Actual expenses are incurred for automobiles with vouchers duly kept or standard mileage@54 cents for mile for the total miles travelled during the year with duly logged in a register. An employer can deduct his share of FICA or FUTA taxes related to its employees. A business bad debt is treated as business loss not eligible for deduction.
Overall, the deductions are seriously monitored by tax authorities both at federal and state levels but millions of self- employed enjoy the pleasure of doing business in USA by properly adhering to the tax rules and regulations.
A copy of Schedule D can be seen as https://www.irs.gov/pub/irs-pdf/f1040sd.pdf .
Capital losses are fully deductible against capital gains on Schedule D and if losses exceed gains, the same can be deducted up to Rs3000 of ordinary income on Form 1040.Net losses over Rs3000 are carried forward to future years. On a joint return, Rs3000 is applied towards the combined losses of both the spouses. While handing over one’s return to a CPA, details of all the capital gains or losses are to be given so that proper reporting can be done. Non- reporting of capital gains/losses may invite the attention of Internal Revenue Service.Invariably, letters can be expected in mail.
A copy of Schedule E can be seen at https://www.irs.gov/pub/irs-pdf/f1040se.pdf .
Schedule E is used to report income or loss from rental real estate, royalties, partnerships, S corporations, estates and trusts. It is not to be used to report income from rental of personal property unless the personal property is leased with the real estate. Similarly, the income of an author, artist and an inventor is not reported in Schedule E but under Schedule C which is also subject to self- employment tax.
A copy of Schedule F can be seen at https://www.irs.gov/pub/irs-pdf/f1040sf.pdf.
Profit or loss from farming is reported under Schedule F which consists of Part 1 and Part 2, covered under the heads Farm income – cash method and Farm expense – Cash and accrual method. If a tax payer is engaged in farming or fishing, he/she may be able to average all or some of his/her current year’s farm income by shifting it to the 3 prior years. An individual, a partner in a partnership firm or a shareholder in S corporation may elect farm averaging if IRS permits. The farmer may postpone the gain realised by unnatural weather conditions may postpone the gain by 4 years. Since it is a complicated return with various interpretations from inputs of agriculture, an expert’s help may be sought to file the return.
Generally asked questions about form 1040
1. What form to use, whether 1040, 1040ez or 1040A? Depending upon the complexity of the tax return, the form to be used changes. Most of the tax payers with houses, small businesses, small investments or rental units use 1040. But kindly leave it to experts who would handle your return.
2. Can I anyway get the help of a CA in USA to avoid the taxes totally? Most of the CAs in USA get their credentials as CPA and legally practice. A CA can not practice in USA unless he registers as a tax preparer which is a simple position and can’t appear before IRS and it does not help a tax payer. Kindly engage a CPA to get the returns properly done and have a regular follow up, if needed.
3. Many Indian IT professionals feel that they can handle tax issues themselves since even the programming of these software may be vaguely known to these professionals. I have come across so many IT experts who fail to report capital gains since they had capital losses, repeatedly shown hobby losses as a tool to reduce the taxes and show abnormal travel expenses including their travels to India as part of travels. This is due to primary lack of tax knowledge about prior court cases or IRS rulings.
4. What should be my filing status and who are my dependents?
5. What are exemptions and how does one claim them?
6. Whether to use itemised deductions or standard deduction?
7. What are the credits available for reducing the taxes?
8. I am a self- employed person, an artist or have a small agricultural land for production of honey and how to use Schedule C. Can I show regularly loss in my tax return?
9. How to use charitable contributions and whether my contribution every day in the cash box of the temple after totalling $10,000 can be claimed under Itemised deductions, charitable contribution. I actually met a lady doctor in Minneapolis who claimed charitable contributions for the said amount requesting every devotee to come to IRS to testify. No one was coming forward for this illegal work. Instructions on charitable contributions are very clear and their misuse always attracts IRS attention.
10. Questions 4-9 are easily answered by a CPA who would take care of your return while being engaged for this purpose. It is generally said in USA that one should specialise in his area of expertise and leave other experts to handle their problems.
As the article starts with the presumption of giving simple lessons about American individual tax return, it has attempted to cover many areas popularly used by a tax payer. It carries one from Form 1040 line by line to get familiarised but fails to educate totally about a tax return which is used by nearly 144 million tax payers in USA and abroad. Intentionally, it has not touched form 2555(Exclusion of foreign income) and foreign tax credit (Form 1116). These forms are complicated and would be covered in future articles.
i. Form 1040 instructions https://www.irs.gov/pub/irs-pdf/i1040gi.pdf
ii. Filing status IRS Pub.501 https://www.irs.gov/pub/irs-pdf/p501.pdf
iii. Investment income and expenses including capital gains and losses IRS Pub 550 https://www.irs.gov/pub/irs-pdf/p550.pdf
iv. Charitable contributions IRS Pub 526 https://www.irs.gov/pub/irs-pdf/p526.pdf
v. Itemised deductions Schedule A https://www.irs.gov/uac/about-schedule-a-form-1040
vi. Deluxe edition 2015 Tax year The Tax Book by Tax Materials, Inc.MN 55435 USA, the most authoritative book on USA taxes on 1040, small business, estates and trusts.
vii. J.K. Lasser’s book titled “ Your Income Tax 2015”, having completed 75 years of publication and one of the most widely read by tax professionals (USA)
About the author : Subramanian Natarajan C.P.A. (USA), M.Sc., CAIIB took voluntary retirement in 2000 from Punjab National Bank after handling various facets of banking like deposit mobilization, foreign exchange, auditing and borrower accounts. After living in USA for 12 years during which period he worked in international auditing firms specializing in international tax, auditing, IFRS etc. He can be reached at email@example.com. Tel: 7503562701, 9015613229. He currently lives in Delhi. His name appears as tax consultant in web site of American embassy, New Delhi.