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| The Basics | 5 truly nasty tax surprises
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Sure, you may think youre a responsible taxpayer, but the U.S. tax code is filled with complexities that can blindside you and cost a ton of money.
By Jeff Schnepper
Im a guy who doesnt like surprises, especially nasty surprises.
The Internal Revenue Code is full of nasty surprises. When you least expect it, the tax law can hit you with a lot of taxes that, in your wildest dreams, you didnt even know you might owe.
Here are five to keep your eye out for.
The responsible party surprise
Congratulations! Youve been invited to serve on a prestigious nonprofit's board of directors.
Surprise! Youve just exposed yourself to potential taxes that cant even be discharged in bankruptcy. Its called the responsible party rule. If your charity has employees, then income, Social Security and Medicare taxes have to be withheld on the compensation paid to them. Those taxes are held in trust by the charity/employer for the IRS.
If those taxes arent paid to the government, the IRS can not only go after the charity but anybody serving that organization who qualifies as a responsible party.
Theres the rub. You can be a responsible party without even knowing it. Thats because a responsible party is anyone who is under a duty to collect or account for and pay over a tax. If you can tell the bookkeeper which check to pay, youre a responsible party. Were not just talking about a charity like the SPCA. The rule extends to boards that run churches, synagogues, schools and the like.
All is not lost. Theres a special exemption for unpaid volunteer board members of charities. But, to get the exemption, you cant be involved in the day-to-day financial activities of the organization, and you cant have any knowledge of the failure to fork over the taxes due the government. In other words, you have to be uninvolved and unaware.
Thats not normally the kind of board member charities are looking for, especially when you can be liable for fiduciary failure if you dont get involved. Otherwise, youre responsible.
The rule also extends to the for-profit world. Lets say youre the company bookkeeper. Your boss tells you theres a cash-flow problem, and you should pay suppliers rather than payroll taxes.
Heres the nasty surprise! Youre a responsible party. Youre either going to put your job on the line, or youre going to be personally liable for any unpaid taxes. Dont look for fairness in our Internal Revenue Code.
The debt-discharge surprise
Congratulations again! You convinced your credit card companies that, unless they reduce your debt balances, youre going to file for bankruptcy, and theyre going to get nothing. They generously lowered you liability by $5,000 so you can pay off the balance over the next 24 months.
Heres the nasty surprise: That $5,000 reduction is now ordinary income to you and could cost you as much as $1,750 in additional income tax -- if you're in the 35% bracket in 2005 and 2006. So much for getting your cash flow in order.
Unless it was sheltered by the umbrella of bankruptcy, debt reduction represents accession to wealth, clearly realized, and it is considered taxable income.
The Social Security surprise
You worked all your life and spent over 45 years contributing to Social Security. Every dollar you contributed was taxed when it was earned.
Youd think that your money coming back from Social Security would be tax-free. Years ago, it was-tax free. After all, you already paid tax on those dollars.
Wrong, O Aged One. Depending on your income, as much as 85% of what Social Security pays you may be subject to income tax. Some people call that double taxation. The government disagrees and says that you are getting your contributions returned tax-free in the 15% not taxed.
I see their position. Now I just have to live to age 168 in order to fully get my own money back.
The unemployment surprise
Like many others when the economic boom of the 1990s turned to bust, you lost your job. At least you have some unemployment compensation to help pay the rent and put food on the table.
Historically, unemployment compensation was meant to provide a cash-flow floor to keep you off welfare. But welfare is a state expense. So, its really not a major concern of the IRS.
Heres the nasty surprise. The IRS wants a piece of your unemployment check. Unemployment compensation is taxed like any other ordinary income.
The marriage surprise: Joint and several liability
Most married couples file joint returns. Thats because joint returns normally provide a lower total tax for a couple than they would pay if they filed separately. And, if youre married on or before Dec. 31, those usually are the only filing options you have.
Filing jointly, however, creates what the tax pros call joint and several liability. What that means is that both, or either spouse, is responsible for the full tax. Its not apportioned based on who earned it or who had the deductions. The IRS can come after either party for the full amount owed.
Heres the nasty surprise. Two years ago, you filed a joint return with your spouse. Last year, you divorced, and you have no idea where he moved.
The IRS audits your joint return and discovers that he had an under-the-table job while you were married and didnt report $20,000 in cash income.
Because you either knew about the unreported income, or should have known, the IRS now wants all of the taxes owed -- perhaps as much as $7,000 -- paid by you.
He got the money; you got the shaft! Since you signed the joint return, youre fully liable for the taxes owed.
You can ask the IRS for relief as an innocent spouse. You can qualify as an innocent spouse and be relieved from some or all liability from a deficiency on a joint return if:
- You did not know about the understatement of income and tax.
- You had no reason to know about the understatement of tax.
- It would be inequitable to hold you responsible for the deficiency.
The item at issue need not be grossly erroneous, nor does the understatement have to be substantial.
You apply using Form 8857. (You can also get to the form by going to the IRS Web site and search for the form.) You must apply within two years from the date the IRS begins collection actions. For more, see "Don't let a cheatin' spouse stick you with the tax bill."
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