Ask Liz Weston

Get smart with your money

Taxes

Q&A: Student loan forgiveness and taxes

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Dear Liz: You recently wrote about student loan forgiveness. After 15 years as a public defender, my wife was diagnosed with multiple sclerosis and could no longer pursue her career as a lawyer. She applied for forgiveness of the federal student loans she used to attend law school. About three years later, the loans were forgiven. The caveat is that she was required to pay income taxes based on the balance that was erased. The taxes amounted to $63,000. Getting the loan forgiven was easy compared with coughing up the money for the IRS. I thought this should be mentioned.

Answer: The IRS generally considers forgiven or canceled debt as income to the borrower. There are several exceptions, however.

Borrowers don’t have to pay income taxes on student loans forgiven through programs that require them to work for a specific number of years in a certain profession. So public service loan forgiveness, law school repayment assistance, teacher loan forgiveness and the National Health Service Corps’ loan repayment program won’t trigger taxes. Forgiven debt also may be excluded from income if the borrower was insolvent at the time.

Student loan discharges for death, disability, closed schools, false certification and unpaid refunds typically are considered taxable income, however. Forgiveness of remaining balances under income-based repayment programs after 20 or 25 years of payment is also considered taxable.

The taxes owed will be a percentage of the amount forgiven, based on your tax bracket. If you’re in the 25% federal bracket, for example, you’d pay $25,000 for $100,000 of forgiven debt, plus any state and local income taxes. It’s less than the tab you owed, of course, but as you note it can still be a tough bill to pay.

Q&A: How to calculate your estimated quarterly taxes

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Dear Liz: I recently retired and started my own consulting business, which is doing very well. My question is on taxes. I have been told that I must pay quarterly taxes, but I have no idea if I will make $10 this month or $10,000. How do I estimate my income if I have no idea? Can I just wait till the end of the year and figure it out then?

Answer: You don’t want to do that. If you owe a significant amount at the end of the year, you’ll owe a substantial penalty on top of your tax bill.

The good news: The IRS requires you to figure your estimated quarterly taxes, not your “guesstimated” taxes. You’ll make the calculations based on what you actually earned that quarter, not what you expect to earn in the upcoming quarter.

Tax software programs such as TurboTax and TaxAct can help you make the calculations, but you’d be smart to hire a tax pro with experience advising small-business owners. The pro will have ideas about how to minimize and manage your tax bill. He or she also will be available to answer the many questions you’ll have about taxes, incorporation and other matters as your business grows. If you should be audited, a tax professional such as an enrolled agent or a certified public accountant would be able to represent you. (Even the most avid do-it-yourselfer should understand that representing yourself in an audit is not a good idea.)

You can get referrals from the National Assn. of Enrolled Agents at http://www.naea.org and the American Institute of CPAs at http://www.aicpa.org.

Q&A: Independent consulting and taxes

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Dear Liz: I am a full-time employee who just started independent consulting work on the side. I have submitted my W-9 with the company with which I am a consultant, but I know the onus will be on me to set aside federal tax payments. Here’s my question: Will I pay state taxes on my consulting income? And if so, will those taxes be paid in the state where I live or the state where the company is based?

Answer: If you live in a state that taxes income, and you have income to tax, then yes, you’ll probably have to pay state income taxes on your net income — your gross revenue minus your expenses.

“Since you are in business for yourself, contracting with another company, you will pay taxes in the state where you do the work,” said enrolled agent Eva Rosenberg of the TaxMama.com site. “If you perform the services in your own state, that’s where your taxable responsibilities lie. However, if you frequently go to the client’s location and do work there, you will be liable for taxes in that state as well.”

A good rule of thumb is to set aside half of any money you make to cover the various taxes you’ll owe, Rosenberg said.

“Payroll taxes are 15.3%. If you’re making enough to live on, you’re in the 25% bracket at least. That’s 40%,” she said. “Depending on the state, that could be another 5% to 10%.”

You probably should make quarterly estimated tax payments to avoid a penalty. Business owners, especially newly minted ones, would be smart to hire a tax pro to help them navigate their obligations.

Q&A: What to do with a big tax refund?

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Dear Liz: I got a big tax refund this year and am trying to figure out what to do with the money. Right now I have school loans with a 4% interest rate that I do not need to make a payment on until 2024 with my current payment plan, but the amount I owe is pretty hefty and I know it’s going to compound more over time. I also have a very low-interest car loan (1.9%) that will be paid off in 31/2 years. I also could put that money in the market in hopes that it will grow. I should add I am 27 years old. Any advice?

Answer: Yes: Please review the terms of your student loans, because it’s likely you’ve misunderstood your obligation.

Federal education loans typically don’t allow you to go 10 years without payment, said financial expert Mark Kantrowitz, publisher of Edvisors Network.

“With federal education loans, the economic hardship deferment has a three-year limit and most forbearances have a three-year limit, with one or two having a five-year limit,” Kantrowitz said.

“One could potentially consolidate the loans after getting a deferment and forbearances to reset the clock and thereby get a new set of deferments and forbearances on a new loan. But most of the forbearances aren’t mandatory, so one can’t count on stacking deferments and forbearances to get a 10-year suspension of the repayment obligation.”

Another possibility is that you’ve signed up for an income-based repayment plan that has reduced your payment to zero, but your eligibility is determined year by year. “2024 is a very specific date, so it seems unlikely that this is [income-based repayment],” Kantrowitz said.

“The most likely scenario is this borrower is misunderstanding the terms of his loan,” Kantrowitz said. “The next most likely scenario is that this borrower is not referring to a qualified education loan, but to a particular personal loan that he was able to obtain that few other borrowers would be able to obtain.”

Whatever the case may be, one of the best uses for a windfall is to boost your retirement savings. Even if you don’t have a workplace plan, you could set up an IRA or a Roth IRA as long as you have earned income.

Once you’re on track for retirement, your next goal would be to build your emergency fund, since you don’t have any high-rate debt. Once those goals are met, you can start paying down lower-rate debt (such as your student loans).

Independent contractor clarity

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Dear Liz: I was taken aback by your answer to the receptionist whose employer was paying her as an independent contractor although she should have been paid as a W-2 employee. I believe your response was to lie on her tax returns and hide the fact that her employer was doing something illegal. I cannot say in how many ways that is wrong. As a human resources professional, I would advise this person to contact regulators under her state’s whistle-blower protections and let them know what has happened and take the advice that they give. If the writer has been given a 1099, you can be assured that others in the company have too. Her name remains anonymous. Even if her employer finds out it was her, she has recourse if she’s fired. I’ve always enjoyed your column and look forward to reading it each Sunday, but this response was totally off the charts.

Answer: Actually, the advice was exactly the opposite. Tax pro Eva Rosenberg recommended telling the truth by filing new forms, which would alert the IRS to the employer’s deception. Rosenberg said that it probably would take the tax agency a couple of years to get around to auditing the employer, which would give the receptionist time to find a new job.

Also, not all states have laws protecting whistle-blowers, and some of those that do apply only to public employees. No one should assume she is protected by such a law without during further research.

Employee secretly reclassified as contractor

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Dear Liz: I just received my tax forms from my employer for last year. I was originally a W-2 employee, paid hourly, as a receptionist. But it seems that at some point during the year, my employer changed me to a 1099 employee without telling me or having me fill out paperwork. After researching the characteristics of a 1099 employee, I found I do not qualify at all. I am upset that I will have to pay taxes on this income, since I thought they were being withheld from my pay. Do I have any recourse?

Answer: Your employer has put you in an impossible situation. If you tell the truth, you’ll tip off the IRS to the company’s deception, which could put your job in danger. If you go along with the lie, you’ll have to pay your boss’ share of taxes in addition to your own.

“The good news is the IRS is really busy and probably won’t [audit your employer] for a couple of years,” said Eva Rosenberg, an enrolled agent who runs the TaxMama site. “By then, you should have a better job elsewhere.”

To fix this, first report your income from this job as “other income” on line 21 of your 1040 tax return, Rosenberg said.

If you got both a W-2 and a 1099, you can use IRS Form 8919 to pay only your share of the Social Security and Medicare taxes. You’ll pay 7.65% instead of the 15.3% you normally would pay with 1099s, Rosenberg said. You’ll have to select a “reason code” for why you’re using the form. You can use code H, which says that the amount on the 1099 form should have been included as wages on Form W-2.

If you got only a 1099, you’ll need to fill out Form SS-8 to explain why you’re an employee, not a contractor, Rosenberg said. Then use Form 4852 as a substitute for your missing W-2. Use the data from the last pay stub that shows your year-to-date withholding as a W-2 employee so you can get credit for those taxes paid. This process is complicated but is the approach a tax pro “would and should use” when an employee is misclassified as an independent contractor, Rosenberg said.

The forms you’re filing will alert the IRS to your company’s chicanery. Some employers pretend that their employees are independent contractors as a way to reduce the company tax burden and perhaps dodge new health insurance requirements. It’s a scam that tax authorities are keen to uncover and penalize