Stuff You Want to Know

Frequently Asked Questions

What is an Enrolled Agent?

An enrolled agent (EA) is a federally-authorized tax professional who has technical expertise in the field of taxation and who is empowered by the U.S. Department of the Treasury to represent taxpayers before all administrative levels (examination, collection, and appeals) of the Internal Revenue Service. They are licensed to practice anywhere In the United States and are unrestricted as to which taxpayers they can represent, what types of tax matters they can handle, and which IRS offices they can represent clients before. In addition to taxpayer representation, enrolled agents often provide tax consultation services and prepare a wide range of federal and state tax returns. An EA must pass a comprehensive exam on taxation, and accounting as it relates to taxation in order to get their license. They must also satisfy annual continuing education requirements in taxation.

What Is a CPA?

A CPA is a certified public accountant and is licensed by the state. In California, to earn the prestige associated with the CPA license, individuals are required to demonstrate their knowledge and competence by completing a program of study in accounting at a college or university, passing the Uniform CPA Exam, and obtaining a specific amount of professional work experience in public accounting.

CPAs provide a wide range of services and are employed in public accounting and other professional services firms, business and industry, government and education. CPAs in public practice are engaged by their clients for a variety of services including accounting, auditing, tax, personal financial planning, technology consulting and business valuation. CPAs employed in business, industry and government are likewise responsible for activities from accounting and financial reporting, implementing and managing internal controls and information systems, to compliance with tax and other laws and regulations and other areas of business and financial management.

When the public thinks of CPAs, they often think of auditing: the process of examining, testing and verifying a publicly held company’s financial records. But the number of CPAs in California who perform audits, reviews and other attest-type services is dwindling. Bottom Line does not perform this type of work either, but has relationships with CPAs who do. These are naturally complimenting relationships as a CPA who performs either a certified audit or a review must remain independent from the client and their day-to-day transactions – which is why Bottom Line is an ideal choice for managing a company’s books. The CPAs at Bottom Line specialize in taxation and small business accounting and bookkeeping needs.

How is an enrolled agent (EA) different from a certified public accountant (CPA)?

CPAs are licensed by their state to practice accounting and taxation. They must pass an exam on accounting, of which only a portion relates to taxation. The emphasis of their education is primarily on accounting for public corporations and issuing certified accounting (financial) statements that the public can rely on for various purposes -- hence the initials CPAs. From a practical standpoint, however, most of this work goes to large firms, so most CPAs generally do the same work as EAs but have a heavier bookkeeping practice.

By definition: EAs specialize in taxation.
CPAs specialize in accounting. Taxation is only their specialty if they make it so. Many EAs do bookkeeping as an accommodation to their tax clients. CPAs do taxes as an accommodation to their bookkeeping clients. Both can do management, financial consulting, bookkeeping, payroll, and financial statements for small businesses.

How our federal income tax system REALLY works.

We Americans are hearing more and more about the American tax system and what’s allegedly wrong with it. And I’m sure there are more than a few positive changes that can be made to make it better. Let’s not forget, although it was originally devised solely to collect revenue necessary to fund the operation of our government and the various programs it provides its citizens… somewhere along the way, it occurred to economists that they could also use it as a tool to manipulate and regulate the economy. So it is indeed an imperfect system – and I suspect it always will be, because it attempts, as best as possible, to address the numerous and specific needs and circumstances of 313 million Americans, plus the foreigners who work with us.

My experience is that even though most Americans have to file an income tax return every year during their entire adult lives, they know painfully little about how our individual tax system actually works. They hear about loopholes being closed and tax brackets being lowered, and they believe that doing so is definitely a good thing – when most of the time it actually isn’t. They are hearing about the notion of flat tax – and they don’t understand that the ramifications of converting to that system, would actually increase most people’s tax liabilities. Many Americans prepare their own tax returns, either by hand or with the aid of tax software such as Turbo Tax. They don’t realize that a conceptual understanding of how our individual tax system works is a different dynamic than understanding which numbers go on which lines of which forms.

Our clients don’t experience these feelings. It’s been a good couple of decades since a client of ours got angry because he owed more than he thought he would or got less of a refund than he hoped he would. They may feel disappointment – but they don’t feel anger. The reason for this: I educate my clients. Folks… if you continue to earn money… you’re going to be filing tax returns for a really long time. Particularly if you want to criticize the process… shouldn’t you have at least a basic idea of how our tax system actually works ? I think you should. A lot of accountants don’t feel this way. They attempt to maintain a mystique around the process so you won’t leave them for another accountant, or worse still, Turbo Tax. Our practice takes a different approach… an educated client, is a happy and proactive client.

So I’m going to tell you a story this morning that illustrates the basic concepts of how the American individual tax system actually works. It’s not a true story – it’s one I made up. This story, is not the way it was. But, I’m telling it because it is, the way it is.

The first thing I’m going to tell you, however, actually is true. And that is in the year of our lord 1913, the individual income tax return was introduced into American culture. It was three pages long with one page of instructions and it basically said: folks… tell us how much you earned and we’ll tell you how much to pay. It was very simple. It required no risk taking on the part of the taxpayer, no effort, no energy. Just give us basic information and we’ll tell you how much to hand over.

And this went on for a while. But somewhere along the line, a group of people approached the government and said “Government, we understand what you are doing here. This is the United States of America. We have social programs, diplomatic programs and security programs to implement and maintain, and to pay for these services, our government needs to earn income, or in government lingo, collect taxes. But, there’s a group of people over here, that we feel deserve a break on their taxes that the general population doesn’t deserve. And the government said, “tell us what’s on your mind.” And the group said “the general population takes on no discernable positive risk, and puts out little if any effort or energy to make America a better place. But, there’s a group of people over here who take on a low amount of positive risk, and put out some positive energy and effort to make America a better place, and we feel these low risk, low energy and low effort people, deserve a break on their taxes over what the no risk, no energy and no effort people get. And the government said, “tell us more.”

“Well,” they said, “in their own way, these people are investing in America by building community. They are starting and raising families and that requires a bigger roof to put over their heads. So they’re going out and buying homes which requires builders to build them and banks to lend on them. They are paying banks mortgage interest and tax authorities property taxes. Sometimes their parents move in as well and become their dependents. These people are incurring medical, dental, orthodontia and long term care expenses on behalf of themselves and their families. They are contributing to their local churches, Red Cross, Girl Scouts and Goodwill. Some of them are police officers and firefighters who actually have to spend their own money to maintain their uniforms and skills in order to do a better job on the job. Some are in outside sales and they incur auto, telephone, travel and marketing expenses to do a better job on the job, and they aren’t reimbursed by their employers. Some are teachers who spend their own hard earned money on books and supplies for their classroom, to supplement what their underfunded schools lack, in an effort to provide our children a higher quality learning experience.

These people are taking on a low amount of positive risk, and putting out a low amount of positive energy and effort, at a grassroots community level, to make America a better place. And because of that, we feel these low risk, low energy and effort people should get a break on their taxes over the no risk, energy and effort people.”

And the government agreed and invented what we tax accountants call itemized deductions and what many taxpayers affectionately refer to as “the long form”, giving them credit for the positive risk they take on and the positive energy and effort they expend while building America at the grassroots community level, by allowing them to deduct a portion of their mortgage interest, property taxes, charitable donations, medical expenses and employee business expenses from their income before calculating their tax liability.

And this went on for many years. Meanwhile, there was a group of people sitting way up on a hill looking down and jealously eyeing these people getting a break. When they could stand it no more, they jumped down off the hill and said to the government, “government: we understand what you are doing with these people. They absolutely deserve a break on their taxes for their contribution to society and the economy. But, there are two other groups of people that we believe deserve even bigger breaks on their taxes.” And the government said “We’re listening. Tell us what’s on your mind.”

“Well” they said, ”In life, there comes a time when you have to take a hard assessment of where you are, versus where you want to be. And in order to get from where you are, to where you want to be, you have to take a giant leap of faith across that proverbial line in the sand. And there are two groups of people who have done just that. The first group of people are investors. These people take money out of their own pockets and put it into IRA’s and SEPs. They have their employers put some of their earnings into 401ks or 403bs. Some of them actually take even more of their money and purchase investment properties that they rent out to families and businesses. Others buy stock in American corporations and loan money to the government. Each of these people take on a moderate amount of positive risk and put out a moderate amount of positive energy and effort to make America a better place. Consequently, we think these moderate risk, energy and effort people deserve a bigger tax break over the low risk, energy and effort people, who deserve a break over the no risk, energy and effort people.” And the government agreed.

So, if you’re a high but positive risk taker and own your own business, every expense you legitimately incur on behalf of that business is a deduction, with only three exceptions. Country club dues, are not a deduction. Business gifts are limited to no more than $ 25 per person, and meals and entertainment expenses are only 50% deductible. But every other expense that is legitimately related to your business, is a deduction. You can even incur a loss two out of five years… but not more than that. The government’s position is that when a business incurs more than two out of five years of loss, the prospect of profit potential appears diminished, so its level of risk taking is no longer construed to be positive. And they only reward positive risk taking.

If you’re a moderate but positive risk taker and invest money in a rental property, you can deduct up to $ 25,000 of loss per year. But once your income exceeds $ 100,000, this deductible loss is limited and when it exceeds $ 150,000 your deduction doesn’t get lost or marginalized, but gets deferred to a future year when either your income drops below $ 150,000, or you dispose of the property.

In this story, you heard how the investors and business people crossed that proverbial line in the sand. In the tax world, we accountants refer to that line as adjusted gross income or AGI, which is the last line on the first page of the Form 1040 tax return. Investors and business people live most of their financial lives above this line. The low and no risk people live most of their lives below this line.

And why are the tax benefits for low risk people less than the moderate or high risk people ? Schedule A, the form that accommodates itemized deductions is what we accountants refer to as the land of: yes-buts. Are medical expenses a deduction ? Yes… but… only to the extent that they exceed 10% of AGI. So if your income is $ 100,000, the first 10% of your $ 100,000 income or $ 10,000 of medical is thrown out and if your medical expenses are $ 12,000, you only get to deduct the remaining $ 2,000. Is mortgage interest deductible ? Yes… but… only interest on the first one million dollars of home acquisition debt and the first one hundred thousand dollars of equity. Are charitable deductions deductible ? Yes… but… only up to 50% of your income. Are theft losses deductible ? Yes… but… only to the extent that they exceed 10% of AGI. Are employee business expenses deductible ? Yes… but… only to the extent that they exceed 2% of AGI. And after passing the 2% test, their deductibility, as well as that of state taxes and property taxes can be further limited by alternative minimum tax, also known as AMT.

So… now that you’ve heard this story, reasonably, you can’t really feel angry that you owed more than you thought or got less of a refund than you hoped. You can feel disappointment, but not anger. You can complain about it… but legitimately, only to your Congressperson. Because now that you’ve heard this story, you understand that how much you pay in taxes under our current system, is a lifestyle choice. How much you pay in taxes directly correlates to the extent that you are willing to take on positive risk and put out positive energy and effort, to make America, a better place. You understand that from the perspective of the United States federal income tax code, if you want to be, the best American you can be, you are living your life in all three of these areas. You own your own business, you are putting away money for retirement and investing in corporate America and the government, you are raising a family, putting down roots by owning a home and contributing to local charities and by doing so, building community. One of the wonderful things about being an American, is that you can do all of these things, some of these things or none of these things. The choice is yours. Perhaps you have no plans to own your own business; you’re fulfilled as an employee. But you put money into retirement and own a home. Perhaps you own a home and a business but don’t have the resources to fund retirement. The choices and challenges are yours to choose from and contend with, based on your choice of lifestyle. But from the perspective of the tax code, they indicate the level of your tolerance for positive risk taking, as well as the amount of energy and effort you are willing to put out, and this directly correlates to the size of your tax liability.

And for better or for worse, this is how our current federal income tax system works.

“I didn’t sign up for this” you say ! This must be the fault our current president and Congress!

Actually, that is barely true.

The first federal tax code was written under Democratic president Woodrow Wilson in 1913. That code was put aside in 1934 by Democratic president Franklin Roosevelt. That code was once again put aside in 1954 by Republican president Dwight Eisenhower. And finally, that code was put aside once more in 1986 by Republican president Ronald Reagan. Presidents Bush one and two, Clinton and Obama and their Congresses have certainly made modifications to it, but the bulk of the current tax code is the Income Tax Code of 1986 written by President Reagan and his Congress.

Why flat tax is NOT a good idea.

The traditionally held concept of flat tax says “make investment income tax free”. But in comparison to the high income people, the lower and middle income people, are earning very little investment income. If their average $100 or even $1,000 of investment income is not subject to tax, sure, that seems like a help. But the wealthy are earning hundreds of thousands if not millions of dollars of investment income. Governor Mitt Romney for example earned over 20 million dollars of this kind of income during 2010 and 13.5 million dollars of this kind of income during 2011. If that kind of income becomes tax free, rates on income from employment or business, has to rise to make up the difference. It has to.

Flat tax says, in exchange for eliminating tax on investment income, eliminate or reduce itemized deductions. As I illustrated earlier, itemized deductions are mostly a way of rewarding lower and middle income Americans who are building families and community. Eliminating itemized deductions, eliminates a significant reward and incentive for them to continue building families and community. One of the most important tax deductions to middle income people is the mortgage interest deduction. The wealthy, would love to exchange the mortgage interest deduction for tax free investment income. Why? Because the deduction for mortgage interest is limited to interest paid on no more than the first $1.1 million of acquisition and equity debt. $1.1 million. Consider this. A wealthy celebrity (you hear this all the time) buys a home for $6.8 million dollars. He puts down 25% or $1.7 million. So his remaining debt is $5.1 million. The mortgage interest on only the first $1.1 million is deductible. So the interest on the remaining $4 million is not. It helps him not one penny on his taxes. And if the interest on the $1.1 million that is deductible is at 4.5% or roughly $50,000 of mortgage interest per year, he only saves a maximum of $17,500 in federal taxes with that deduction. $17,500. That’s nothing, in comparison to the amount of taxes he would save by not having to pay taxes on hundreds of thousands, or in the case of someone like Governor Romney, millions of dollars of investment income. Tax free investment income in exchange for loss of the mortgage deduction, is definitively an uneven trade off. The mortgage deduction is there only somewhat for the poor and the wealthy. It’s really there for the middle class. It’s stuff like this, which makes flat tax a horrendous idea. If the federal government is setting the mortgage deduction limit at interest on the first $1.1 million dollars of mortgage, you know the average American mortgage is somewhere between that amount and zero. Imagine all of the home owners throughout the United States that have mortgages in that range. Take away that deduction and you take away a major incentive to plant community roots supported by investment. When that occurs, the wealthy become substantial land owners and the rest of the nation becomes tenants. And America becomes a feudal state. The wealthy cry socialism at the notion of shifting tax dollars from their pockets to the less privileged. But they actually lobby for the concept of shifting assets from the less privileged to themselves.

And there’s a misconception that flat tax eliminates all deductions. Not so. It only eliminates itemized deductions. Rental expenses, including mortgage interest expense, aren’t affected. Business expenses, including mortgage interest on business property, aren’t affected. It’s only the expenses that lower and middle income people rely on to reduce their taxes, that are eliminated. The rewards for risk taken to build families and community are the only deductions eliminated by flat tax, in order to give the wealthy a tax break on their investment income at the expense of the rest.

Conversely, when wealthy people solicit the government, or worse, become part of the government in an effort to gain greater tax benefits for themselves, that, feels like an entitlement. It sends a message that because they have money, they should be catered to. It’s an attitude of, why should they pay towards TSA when they have their own private jets and security. They seem to be ignoring the notion that while wealth may have its privileges, most religious belief systems hold that those blessed and empowered with great resources, have a great responsibility towards helping those who don’t. Providing tax breaks to the wealthy, doesn’t create new business opportunities or new jobs. That only occurs when wealthy people are willing to invest, their own money. Being wealthy should not entitle anyone to a tax break. Conversely, taking a positive risk to build America should.