The Six Biggest Tax Mistakes THE BLUNDERS YOU MOST WANT TO AVOID ARE THE ONES YOU DON'T EVEN KNOW YOU'RE MAKING.
By David Whitford Reporter Associate Natasha Tarpley

(FORTUNE Magazine) – Not all tax mistakes are created equal. There are, for example, the kind that drive the IRS crazy. The revenuers say that nearly eight million 1998 tax returns contained at least one error, some of them the kind of slip-up that a moderately alert third-grader could avoid--a missing signature, a misplaced decimal, or a forgotten W-2. Indeed, you'd be surprised at just how many problems resulted from paid preparers submitting returns with incorrect or illegible Social Security numbers: nearly a million so far this year, according to the IRS.

The goofs you really want to avoid, though, are often things the IRS might not even consider mistakes. Like naming the wrong beneficiary to your $2 million IRA, which could cause it to go poof when you die. Didn't know that could happen? Well, it can, and it's just one of a number of strategic blunders, missed opportunities, and colossal oversights that the IRS would be happy to exploit and could end up costing you and your family big-time. With that in mind, we interviewed some of the nation's leading accountants, tax lawyers, and financial planners to help identify six of the biggest, not to mention most expensive, gaffes that people make. Avoiding even one of these by the time you sit down to do your taxes could mean the difference between getting a big refund and owing thousands more to Uncle Sam.

WHAT, ME QUALIFY FOR THE ALTERNATIVE MINIMUM TAX?

Yes, you. The alternative minimum tax (AMT) was designed to ensure that even the very wealthy contribute something to the public purse, no matter how many tax shelters they've constructed. Fair enough. "The problem is, our economy is growing," says Bob Doyle, a CPA with Spoor Doyle & Associates in St. Petersburg. "People are making more money. Deductions are getting larger. However, a lot of the information in the AMT code has not changed since the code was written. So it's starting to catch a lot more people off guard."

Take the case of David and Margaret Klaassen, an ordinary middle-class couple from Marquette, Kan., with an unusually large brood. The Klaassens started with an adjusted gross income of $83,000, whittled down their tax liability with $11,000 in medical expenses and $3,000 in state and local taxes, and claimed a whopping 12 personal exemptions covering them and their ten children. That computes to about $5,000 in ordinary federal income tax, which the Klaassens cheerfully paid. Turns out, however, they still owed an additional $1,000 under the provisions of the AMT.

"That's a perfect example of an average Joe who has a lot of kids," says Doyle. "Nothing fancy. No real estate partnerships. Nothing out of the ordinary. Who would think that having too many children would cause you problems with the AMT?" (The Klaassens, by the way, went to court, claiming that the tax code inhibited their religious obligation to "be fruitful and multiply." They lost.) Others at risk from a surprise AMT bite: people who pay a lot in state and local taxes (not deductible under AMT code) and people with incentive stock options (ISOs), who used to be very rare creatures, but are not so rare anymore.

Indeed, it's the options crowd that should be especially wary of the AMT. Incentive stock options are wonderful in many ways, not the least of which is their favorable tax treatment. That sudden, thrilling increase in net worth that comes with exercising ISOs is a nonevent as far as the IRS is concerned, right? Not exactly. On your Form 1040, it's true, ISOs don't generate any tax liability until such time as you sell your shares and realize your gains. If the AMT kicks in, however, paper gains from ISOs are taxed immediately.

That's a problem--especially if, like most people who benefit from such a windfall, you had to borrow to exercise your options. "So you owe money to the bank," says Alex Salomon, managing partner of Salomon & Co., a midtown Manhattan accounting firm. "You have the stock in hand, you don't have cash, and I come along and say, 'By the way, it's tax-free, but here's the alternative minimum tax'--and now you've got to come up with the money."

Pity the poor option exerciser who's finding that out just now, on the brink of the Oct. 15 extended filing deadline, in the midst of what--for many dot.com stocks, at least--is a droopy phase. The hard choices: sell into a dead market or borrow on margin--which, of course, can result in further problems if the market slips some more. "It's a major issue for these people," says Salomon.

DIFFICULTIES AT HOME

For years one of the best things about owning your own home was that no matter how much money you made when you sold it, as long as you plowed all the proceeds back into your next home, you didn't owe any tax. Alternatively, if you were at least 55, you could claim a one-time tax exemption on the first $125,000 of capital gains from the sale of your home, no matter what you did with the money.

Starting with 1998 returns, however, the law changed. First the good news: The new exclusion is $250,000 in gains per person ($500,000 for a married couple); you don't have to be 55 years old to take advantage of it; you don't have to reinvest the proceeds in another home; and you can claim it as many times as you want (subject to certain restrictions, but you already knew that). Now the bad news: That's $250,000, period. Anything beyond that and you're going to have to pay some tax.

Sound like a high threshold? Not if you've been riding the inflation train for the past 20 or 30 years. "A lot of elderly people who are retiring and selling their homes, with the real estate market having gone up as it has, have substantial gains," says Salomon. "They think that if they move to warmer climates and they reinvest the proceeds, there's no tax. Under the current law, that option no longer exists."

Even so, most would agree that the new tax law is a vast improvement over the old. If nothing else, it's a lot simpler. The problem is that because the old law was in existence for so many years--unchanged--some people have no idea what they're in for until they've already sold their homes and it's too late to plan. "We're coming across a lot of people who assume they don't owe any taxes, and they do," says Salomon, "and the tax can be quite substantial."

THE UNKNOWN PERILS OF ESTIMATING

One of the most hazardous realms in the whole tax code is the briar patch of rules, regulations, formulas, and exceptions thereto pertaining to estimated tax payments. You can always make what the IRS calls a safe estimate--that is, 100% of your prior year's tax, payable in quarterly installments--but you won't always be safe as a result. Not if your adjusted gross income in 1998 was more than $150,000, in which case the IRS will be looking for estimated payments this year totaling 105% of last year's tax (on the assumption, you see, that the rich get richer). Come up short on your estimate, and you could owe not just taxes but also penalties and interest. Ouch!

Of course, when it comes to figuring your tax return, it's not always smart to play it safe. Especially if your income jumps around a lot, you might choose to ignore what you made last year and base your estimated payments on current income instead. That can be even trickier, though. Not all income is treated the same way. Social Security benefits, for example, may be taxable (a portion of them anyway) or may not be taxable. To find out, you'll need to calculate something called your modified adjusted gross income, which is no fun at all. "When it's done by hand," says Doyle, "it's very prone to error." Again, mangle the math and it doesn't matter if it's an innocent mistake--you still have to pay, with interest.

Now, in most cases the IRS will be happy to figure exactly how much you owe in tax and penalties and send you a bill. But you still have to be careful, says Alan Straus, an attorney and CPA in private practice in New York. "If you get a huge bonus in January," Straus says, "and there's a large amount of withholding, you might be exempt from making estimated payments for several quarters."

The IRS, however, will assume you're a scofflaw. To disabuse them of that notion, you need to complete Form 2210 using the annualized income installment method, taking pains to establish that your whopping January bonus was in no way predictive of your income stream for the rest of the year. Straus did just that for a Wall Street client whose salary last year was $250,000 but whose bonus was $1.2 million. "He could have faced a penalty of $2,400," says Straus.

TOO SHY FOR YOUR OWN GOOD

Talk to enough accountants and you'll hear plenty of stories about clients who seem bent on provoking a violent response from the IRS. One person we heard about wanted to deduct a prorated portion of his mortgage and utility payments to account for the fact that his aged mother-in-law was living in his house. Another honestly believed that hair-transplant surgery was a deductible medical expense. Still another asked his accountant, "If I invite a few key clients to my daughter's wedding, can I deduct the entire bill as a business expense?" He was serious. "I didn't say yes or no," says Doyle, chuckling. "I just advised him that would be an extremely aggressive approach." Accountants have no trouble dealing with those kinds of clients. They simply apply the brakes.

But there's not much anyone can do with a client who, for whatever reason, is too timid to claim the deductions or exemptions that he rightfully deserves. Salomon says that most of his clients "understand there is no honor in overpaying taxes. They want to pay what is required, but they really do not want to pay a penny more." There are exceptions, though: "I do have some foreigners who are so concerned about doing the right thing in the U.S. that when I tell them, 'I'm going to deduct this because it qualifies,' they say, 'Well I don't want to have any problems, so don't.' "

As a rule, taxpayers shouldn't make a priority out of problem avoidance, especially if it means leaving money on the table. You can't write off the electricity your mother-in-law consumes, but you may be able to claim her as a dependent. Likewise with the home-office deduction. When the IRS raised the bar on that one a few years back, it spooked everybody, including genuine home workers with a solid claim.

That's too bad, says Doyle. His most valuable piece of advice: Never let your fear of being audited inhibit you from claiming deductions that are rightfully yours. "The IRS publishes averages every year for itemized deductions," he says. "The average medical deduction, the average home mortgage interest, the average charitable contribution, and so on. I have seen taxpayers reluctant to exceed that threshold on the unwarranted concern that it may send up a red flag, and it shouldn't. The most important thing I can tell my clients is to substantiate your deductions. With adequate substantiation you can stand up to an audit very easily."

THE DISAPPEARING IRA

If you work for a living, one of the easiest ways to make a monumental goof--one for which your spouse, your children, and your children's children might never forgive you--is on the beneficiary form for your 401(k) plan, IRA, or any other tax-advantaged retirement account.

"People don't take it seriously," says Jere Doyle, first vice president of Mellon Private Asset Management in Boston. "They fall into these tax traps because they're not naming the right beneficiary. There are income tax consequences; there are estate tax consequences; there are all sorts of property disposition consequences. The rules are extremely, extremely complicated."

Too complicated for our purposes. So please, seek professional advice, just as you would in completing your will. But keep this in mind: If for some reason you fail to choose a beneficiary, your plan administrator will choose one for you. Unfortunately, most plans default to your estate. And in many cases, experts agree, that's the worst possible choice.

Mellon's Doyle would have us consider the fictional example, admittedly extreme, of a wealthy Massachusetts man who dies and leaves a $2 million IRA to his estate. First thing the executor does is liquidate the IRA. That's $1.1 million--Bam!--right off the top, because of estate taxes. Then comes federal income tax ($392,000), then state income tax ($119,000), and by the time the suffering widow gets her check, all that's left is $389,000. Pretty sad, but it could be worse. Had he named his grandkids as beneficiaries instead, there would be generation-skipping tax to pay, leaving just $196,000.

And had he named his wife the beneficiary? "She'd have $2 million," says Doyle. "She could roll it over to her own IRA. She could swing for the fences and grow that sucker." You make the call.

JUST PAY IT!

Look, nobody likes paying taxes. If most of us do so willingly (more or less), it's because we have no choice. Besides, there are plenty of more important things to worry about--truth, beauty, love, the Phillies, and this: making the smartest possible investment decisions. It seems a lot of us may be making investment choices based more on tax issues than on fundamentals. Or to put it another way, when you're deciding what to hold and what to fold, don't let tax rage get in the way.

Case in point: The investor who buys a stock, holds it for ten months, watches it hit his target price, but refuses to sell. Not because he still believes in the stock--that, at least, would make sense. No, he just refuses to pay the 39.6% short-term capital gains tax when he knows that in two more months the same investment will qualify for the long-term rate of 20%. "What he's doing there is letting tax-motivated greed override prudent investment decisions," says Robert Eckhardt, an accountant in Melville, N.Y. "He doesn't know what the stock will be worth if he holds it for another two months, especially in this volatile market."

Here's another one ("I can't believe how often this happens," says Eckhardt): the couple that buys a vacation home just so they can take out another mortgage and double their interest-payment deductions. "Does that decision have anything to do with economics?" says Eckhardt. "No. Did they really look at what the annual cost would be and weigh that against renting a place? No. They did it for tax-motivated greed, just to reduce their tax bill."

One last example: the bozo who buys tax-free money funds even though his tax bracket probably isn't high enough to compensate for the lower yield. What kind of fool does that? Well, there's a guy I know. Writes for FORTUNE. Ordinary middle-class income. Borrowed some money for a home-renovation project. Didn't feel like paying tax on his little stash while he was waiting for the contractor's bills to come in, so he parked it in a tax-free money market fund.

Eckhardt has seen it before, many times: "People get caught up in 'I don't want to pay any tax,' and sometimes they're right. But more often than not, especially for the unsophisticated, it's wrong." Yeah, okay. I'll make sure he gets the message.

REPORTER ASSOCIATE Natasha Tarpley