Copyright 2015-16 - CalCPA

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Individual Tax Planning Topics Karen Brosi, EA, CFP

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Copyright © 2015 Karen Brosi, EA, CFP

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© 2015 Karen Brosi, EA, CFP® Individual Tax Planning i

Individual Tax Planning Topics

WHAT IS TAX PLANNING? ......................................................................................... 1

WHERE TO LOOK FOR PLANNING OPPORTUNITIES ........................................................... 1 Change in Marital Status ............................................................................................ 1 Change in Family Structure ........................................................................................ 1 Change in Earned Income .......................................................................................... 1 Change in Assets ......................................................................................................... 1 Change in Health ........................................................................................................ 1

THE STRUCTURE OF THE TAX PLANNING ENGAGEMENT .................................................. 2 A Word About Software .............................................................................................. 3 Gathering the Data ..................................................................................................... 4 Projecting for the Year................................................................................................ 4

FILING STATUS .............................................................................................................. 5

COMMON LAW MARRIAGE STATUS ................................................................................. 5 Common Law Marriage Jurisdictions ........................................................................ 6

SAME-SEX MARRIAGES ................................................................................................... 7 Same-Sex Marriage States in the US .......................................................................... 7

THE DEFENSE OF MARRIAGE ACT (DOMA) .................................................................... 7 SUPREME COURT HEARS ARGUMENTS ON THE CONSTITUTIONALITY OF DOMA ............ 8

The 2015 Supreme Court Cases .................................................................................. 9 Community/Separate Property.................................................................................... 9 IRS Reverses Decision Regarding Community Property .......................................... 10 Confusion Reigns ...................................................................................................... 11

DEPENDENTS.................................................................................................................. 11

GROSS INCOME ........................................................................................................... 12

WAGES .......................................................................................................................... 12 Employee or Independent Contractor? ..................................................................... 12 Maximizing Deferrals ............................................................................................... 14

INTEREST AND DIVIDENDS ............................................................................................. 14 Tax-Exempt Interest .................................................................................................. 14 Obligations That Are Not Bonds ............................................................................... 15 Registration Requirement ......................................................................................... 15 Indian Tribal Government ........................................................................................ 15 Tax-Exempt Bonds Purchased at Original Issue Discount ....................................... 15 Tax-Exempt Bonds Purchased at Market Discount .................................................. 15 Planning with Tax-Exempts ...................................................................................... 15

DIVIDENDS ..................................................................................................................... 16 Dividends & JGTRRA 2003 ...................................................................................... 16 Mutual Funds ............................................................................................................ 16 Tax-Efficient Funds ................................................................................................... 17

CAPITAL GAINS.............................................................................................................. 18 Harvesting Losses ..................................................................................................... 18 The 2015 Planning Opportunity – Harvesting Gains ............................................... 19

©2015. These materials are copyrighted and may not be reproduced or distributed in whole or in part without permission of the author/CalCPA Education Foundation.

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© 2015 Karen Brosi, EA, CFP® Individual Tax Planning ii

Playing the Spread .................................................................................................... 19 Planning for Gains in 2015 and Beyond................................................................... 20 Installment Sales ....................................................................................................... 21 3.8% Medicare Tax Imposed on Net Investment Income - Starting 2013 ................ 22 What Investment Expenses Are Deductible in Computing Net Investment Income (NII)? (§1.1411-4) ..................................................................................................... 24 Can Rental Real Estate Income Be Derived in the Ordinary Course of a Trade or Business?................................................................................................................... 26 A Real Estate Professional’s Rental Income May Not Be NII .................................. 27 Planning for MAGI May Involve the Installment Sales Provision in the Future ...... 28

SOLE PROPRIETORS ........................................................................................................ 30 Bonus Depreciation Expired in 2014 ........................................................................ 30 Bonus Depreciation Chart ........................................................................................ 31 Maximum Amount and Phase-out Threshold under §179 ........................................ 31 §179 Chart ................................................................................................................ 31 Taxable Income Limitation ....................................................................................... 32 Comparing §179 and Bonus Depreciation ............................................................... 32 Section 179 is Recaptured as Ordinary Income at Sale ........................................... 32 §179 Cannot Create or Increase a Loss ................................................................... 33 Business Related Health Benefits .............................................................................. 34 IRS Changes Its Mind on Medicare Premiums as Self-Employed Health Insurance 35 Office-in-home Rules ................................................................................................ 38 Home Office Definition of “Principal Place of Business” ....................................... 38 Simplified Option for Claiming Home Office Deduction Starting with 2013 Returns................................................................................................................................... 39

PASSIVE ACTIVITIES ...................................................................................................... 41 Releasing Passive Losses .......................................................................................... 41 Self-Charged Interest ................................................................................................ 43

SOCIAL SECURITY .......................................................................................................... 44 When Should I Retire? .............................................................................................. 44 Full Retirement Age .................................................................................................. 44 Early Retirement ....................................................................................................... 45 Late Retirement ......................................................................................................... 46 How Work Affects Benefits........................................................................................ 47 What Are The Year 2015 Earnings Limits? .............................................................. 47 Work Can Increase Benefits Too .............................................................................. 48 Social Security Changes Rule Revising Withdrawal Policy ..................................... 49 Taxing Social Security Benefits ................................................................................ 49 Medicare Part B Premiums ...................................................................................... 53 Married couples ........................................................................................................ 54 Planning around Medicare Part B Premiums .......................................................... 54

ADJUSTMENTS TO INCOME ............................................................................................. 55 Qualified State Tuition Programs §529 .................................................................... 55 Coverdell Educational Savings Accounts §530 ........................................................ 57

DEDUCTION PLANNING ............................................................................................ 58

BUNCHING STRATEGIES ................................................................................................. 58


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© 2015 Karen Brosi, EA, CFP® Individual Tax Planning iii

TAX PAYMENTS ............................................................................................................. 58 MORTGAGE INTEREST .................................................................................................... 59

Secured Debt ............................................................................................................. 59 Collateral Must Be Correct ...................................................................................... 60 Choice to Treat the Debt as Not Secured by Home .................................................. 60 The “10-T” Election ................................................................................................. 61 Collateral Chart ........................................................................................................ 63 Is Acquisition Debt Allocated Per Person or Per Property? .................................... 63

CHARITABLE CONTRIBUTION PLANNING ....................................................................... 65 Donor Advised Funds ............................................................................................... 66 Charitable Remainder Trusts .................................................................................... 67 Charitably Minded IRA Owners Waiting for Extender for 2015 .............................. 68

GAMBLING LOSSES ........................................................................................................ 70 Recordkeeping Regarding Wagering Winnings and Losses (Rev. Proc. 77-29) ...... 70 Requirements to Become a Professional Gambler ................................................... 71 Professional Horse Racing Gambler Permitted to Deduct Business Expenses That Create a Loss ............................................................................................................ 71

SPECIAL INCOME AND DEDUCTION TOPICS .................................................... 74

PARENTS NEED CHILDREN’S HELP ................................................................................ 74 TAX-DEFERRED EXCHANGES ......................................................................................... 74

Basic Exchange Rules ............................................................................................... 75 Gain Recognized ....................................................................................................... 75 When is an exchange not advisable? ........................................................................ 76 The Basic Exchange .................................................................................................. 76 A More Complicated Exchange ................................................................................ 77

ALTERNATIVE MINIMUM TAX ....................................................................................... 81 The Basic Calculation ............................................................................................... 81 Which Do You Pay? .................................................................................................. 81 So Now the AMT is Fixed, Isn’t It? ........................................................................... 81 What Did it Cost to Index the AMT? ......................................................................... 82 Percentage of Taxpayers on AMT by State 2012 ...................................................... 82 Repeal? Not Without Complete Tax Reform ............................................................ 83

THE TOP 10 AMT KICKERS ........................................................................................... 83 Prepay State Income Taxes and Reduce the AMT .................................................... 86 Capital Gains and Dividends .................................................................................... 87 2014 Top of 15% Marginal Rate Bracket ................................................................. 87

KIDDIE TAX ................................................................................................................... 88 EDUCATION CREDITS ..................................................................................................... 89

American Opportunity Tax Credit And Lifetime Learning Credits §25a ................. 89

TAX RATES .................................................................................................................... 92

ELECTIONS ................................................................................................................... 92

DEDUCTIBLE IRAS ......................................................................................................... 92 NONDEDUCTIBLE IRAS HAVE NEW LIFE AFTER TIPRA ’05 ......................................... 93

Individuals of Any Income May Convert Traditional IRAs to Roth IRAs in 2010 .... 93


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© 2015 Karen Brosi, EA, CFP® Individual Tax Planning iv

CAPITALIZE CARRYING CHARGES .................................................................................. 95 INVESTMENT INTEREST .................................................................................................. 96

TAX PLANNING CHECKLIST ................................................................................... 97


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Together with the related lecture this handout is designed to provide accurate and authoritative information about complex areas of tax law. But, the information contained in this manual may change as a result of new tax legislation, Treasury Department regulations, Internal Revenue Service or Franchise Tax Board interpretations, or judicial and state agency interpretations of existing tax law. This manual is not intended to provide legal, accounting, or other professional services and is provided with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional services. This manual and related lecture should not be used as a substitute for professional advice. If legal advice or other expert assistance is required, the services of a competent tax advisor should be sought. From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a committee of Publishers and Associations.

©2015 Karen Brosi, EA, CFP®


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© 2015 Karen Brosi, EA, CFP® Individual Tax Planning 1

What is Tax Planning? Tax planning could and should be a year-round process. At its most basic, tax planning involves examining alternatives related to personal and business transactions and determining the tax impact of those choices. Because decisions made in one year can impact taxes in future years, careful tax planning should always encompass multiple years.

Where to Look for Planning Opportunities Throughout the year, our clients experience changes in their personal, business and financial lives. Staying in touch, and knowing what to look for, can provide us with opportunities to help reduce taxes.

Change in Marital Status

Marriage Divorce Unmarried Life Partners Death of Spouse

Change in Family Structure

Birth of child Adoption Loss of dependency exemption Birth of a grandchild

Change in Earned Income

New employment/return to work Loss of job Change from employee to

independent contractor (and vice versa)

Bonus/stock options Deferred compensation

Qualified plan contributions Control timing of income collection

and expenses Retirement

Change in Assets

Acquisition of personal residence Sale of personal residence Extraordinary capital losses Extraordinary capital gains Sale of business activity Sale of passive activity Inheritance Gifts made

Change in Health

Disability Long-term care Funding extraordinary medical

expenses


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The Structure of the Tax Planning Engagement Tax planning is an estimate of the tax impact of certain transactions on the individual’s tax situation. It is important that your clients recognize the approximate nature of the planning process and that they understand that, no matter how complex, projections are meant to be estimates demonstrating the relative tax consequences of planning assumptions. Nevertheless, it is equally important that we, as tax professionals, provide sound planning techniques with strict attention to the intricacies of the tax code and regulations.

Caution! Pencil to paper tax estimates are a sure-fire way to test the efficacy of your E&O insurance.

Limitations on itemized deductions, phase-outs of personal exemptions, five different capital gains rates, passive loss limitations, and the Alternative Minimum Tax are just a few of the factors that make it impossible to produce effectively a manual tax calculation. Moreover, rarely can we isolate the tax on any single item of income or expense without examining it within the context of the client’s entire tax picture.

Example. Sharon and Vern are contemplating selling some appreciated stock with a long-term capital gain of $100,000. They are California residents (marginal tax rate = 9.3%), and in 2014 they had Adjusted Gross Income of $200,000 consisting of $195,000 wages and $5,000 interest. They paid $7,000 property taxes and $30,000 mortgage interest. Assuming other income and expenses will be the same as last year, they want you to tell them how much they should set aside for taxes from the stock sale.

Is your answer $24,300?

Answer: Let’s hope not! Vern and Sharon will actually owe an additional $28,100 from the $100,000 long-term capital gains. Here’s how: Without Capital Gain

2015 With Capital Gain

2015 Income: Wages 195,000 195,000Interest and Dividends 5,000 5,000Capital Gains & Losses 100,000Adjusted Gross Income 200,000 300,000Itemized Deductions: Taxes 16,961 16,961Interest Expense 30,000 30,000 Total Itemized 46,961 46,961Personal Exemptions 8,000 8,000Total Deductions from AGI 54,961 54,961Taxable Income 145,039 245,039


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Without Capital Gain 2015

With Capital Gain 2015

Regular Tax: Schedule or Table Tax 27,847 56,392Alternative Capital Gain Tax 0 42,847Appropriate Regular Tax 27,847 42,847Net Alternative Minimum Tax 0 1,891Medicare Investment Income Tax 0 1,900Total Federal Taxes 27,847 46,638CA State Tax 9,961 19,261Total Taxes 37,808 65,899

A Word About Software

Most of the major tax preparation software makers now also provide some form of planning software. These can be very convenient in that they allow you to transfer prior year data into the projection year and then make changes as appropriate. As an alternative, you can purchase a variety of stand-alone planning software that ranges in price as well as complexity. Some of these allow you to import data from your preparation software, some do not. Like preparation software, the choice of planning and projection software is an individual one and should be driven by the amount of planning work you perform and the nature and complexity of the work. A few popular stand-alone packages:

BNA Income Tax Planner with 50 States www.bnasoftware.com

CFS Tax Tools www.taxtools.com

Back to Basics www.btb-tax.com


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Gathering the Data

The first step in any planning engagement is to gather as much data as necessary to produce a realistic estimate of tax liability. In most cases, you will not have the kind of detailed forensic information you normally gather to produce a tax return. Remember, planning is a process of estimating, making assumptions, and comparing alternatives. Prior Years’ Returns. If this is a new client, always collect the last two years’ tax returns. These will provide you with carry over amounts, as well as a benchmark for safe harbors. Current Year Income Sources. Year-to-date pay stubs are an absolute must for any planning engagement. In addition, don’t forget to ask about any bonuses or other extraordinary pay that may not be reflected on the pay stubs or may be payable later in the year. For business income, obtain a year-to-date profit and loss report and an estimate of projected revenues and expenses for the remainder of the year. Don’t forget to include depreciation and any other non-cash expenses in your projection. Investment income (i.e., interest, dividends and capital gains distributions) can be obtained from current bank statements and broker reports. Unless there has been a significant change (large investment or withdrawal) you may simply determine that this income is SALY (same as last year!). Realized capital gains and loss reports are often included with the client’s monthly statements from brokers and investment advisors. Online traders will need to provide an estimate of year-to-date gains and losses. Stock option holders can obtain reports from their companies of options exercised, ESPP shares purchased, and options available for exercise. Determine if passive activities, partnership and S-Corporation income, and retirement plan distributions are the same or altered for the current year. Social Security recipients are sent a notice of the amount of their annual benefits at the beginning of each year. Current Year Deductions. Unless the taxpayer has refinanced or bought or sold a home, mortgage interest expenses will drop slightly and property taxes will rise slightly for the current year. In the case of a purchase, sale, or refinance, obtain the escrow closing statement. Determine if medical and charitable expenses will remain the same or if the taxpayer made extraordinary payments in the prior year or anticipates doing so in the current year. Find out the amount of state income taxes paid for the previous year in the current year and any state estimate paid in January for the prior year.

Projecting for the Year

Depending upon when in the tax year you are providing planning services, you may need to project out certain items of income and expense. Because we always want our clients to remember that a projection is not a tax return, we often round off certain projected amounts.


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Filing Status The definition of marriage is changing across the country. Generally, whether a taxpayer is married for Federal income tax purposes is determined by reference to the laws of the State of the taxpayer’s marital domicile. There have been several cases on this point:

Sullivan v. Commissioner, 256 F.2d 664 (4th Cir. 1958), affg. 29 T.C. 71 (1957); Dunn v. Commissioner, 70 T.C. 361, 366 (1978), affd. without published opinion

601 F.2d 599 (3d Cir. 1979); Lee v. Commissioner, 64 T.C. 552, 556-559 (1975), affd. 550 F.2d 1201 (9th Cir.

1977)

But recent years have shown that while the courts continue to rely on state law for determining marriage in common-law states, states’ rights do not prevail when the state recognizes same-sex marriages. The result can be a different filing status for federal tax purposes and for state purposes.

Common Law Marriage Status Texan Hatem Elsayed originally filed his 2004 return as a single, unmarried man. Later, on audit, he changed his story claiming he and his sweety pie Irma Angelica Cueto were married by common law at the end of 2004 (though he actually married her in separate civil and religious ceremonies in March of 2005). IRS balked at his newfound assertion, declining his plea for joint filing status. The Tax Court, looking to state (Texas) law, also choose not to recognize his assertion of common law marriage (Hatem Elsayed v. Comm., TCS 2009-81). Texas law acknowledges common law marriage if three conditions are met: (1) the parties must agree to marry; (2) they must live together in Texas; and (3) they must represent to others that a marriage exists. The court ruled that Hatem and Angelica handily met the first two tests, but failed the third because: (a) Hatem purchased a house in 2004 utilized as their personal residence in his name only; (b) he did not add her to the utility bills or his bank account until 2005; (c) she did not change her driver’s license to her married name until 2005; (d) they did not register their marriage at the county courthouse, as was available under Texas law; (e) he filed his Form 1040 under single filing status in 2004; and (f) he only raised the issue of common law marriage after his return was audited.

Planning. According to www.findlaw.com, twelve states currently recognize common law marriage established within their state boundaries, and another four states recognize certain prior established, “grandfathered in” common law marriages.


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Common Law Marriage Jurisdictions

Jurisdictions Where Common Law Marriage May Be Established Currently

Alabama

Must agree to be husband and wife, have the mental capacity to enter into and understand such an agreement and consummate the marital relationship

Colorado Proven cohabitation and reputation for being married

District of Columbia

Explicit intent to be married and cohabitation

Iowa Intent and agreement to be married, continuous cohabitation and the couples’ public declarations they are husband and wife

Kansas Mental capacity to marry, agreement to be married at the present time and represent to the public they are married

New Hampshire Must have the mental capacity to marry, agreement to be married at the present time and represent to public they are married

Montana Capacity to consent to marriage, agreement to be married, cohabitation and have a reputation of being married

Oklahoma Must be competent, agree to enter into a marriage relationship and cohabitate

Rhode Island A man and woman have a serious intent to be married and engage in conduct that leads to a reasonable belief in the community they are married

South Carolina If a man and woman intend for others to believe they are married, a common law marriage may be established

Texas Agree to be married, cohabitate and represent to others (including sign a form provided by the county clerk) that they are married

Utah Sign a form provided by the county clerk, agree to be married, cohabitate, represent to others that they are married and sign a form provided by the county clerk

Jurisdictions Recognizing Prior Established, “Grandfathered In“ Common Law Marriages

Georgia Recognizes common law marriages entered into before January 1, 1997

Idaho Recognizes common law marriages entered into before January 1, 1996

Ohio Recognizes common law marriages entered into prior to October 10, 1991

Pennsylvania Recognizes common law marriages entered into prior to January 1, 2005


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Planning. An important question to ask is whether a state that does not itself recognize common law marriage (e.g., Louisiana) will recognize the common law marriage recognized by another state (e.g., Texas). The answer to this question will, of course, vary by state. Some states, even though they do not themselves have statutes providing for common law marriages, will recognize a common law marriage if it is established and valid in a state recognizing common law marriage.

Same-Sex Marriages On June 26, 2013, the US Supreme Court ruled Section 3 of the 1996 Defense of Marriage Act (DOMA) unconstitutional. In rendering its decision, the Court changed the way same-sex married couples will be treated under federal tax law.

Planning. While the IRS now acknowledges same-sex unions for federal tax purposes, state tax planning in non-recognition states has become more complex.

Same-Sex Marriage States in the US

Massachusetts Connecticut California Iowa Vermont New Hampshire District of Columbia New York Maine Washington Maryland Rhode Island Delaware Minnesota Hawaii Illinois New Jersey New Mexico Oregon

Pennsylvania Indiana Oklahoma Utah Virginia Wisconsin Colorado Nevada West Virginia North Carolina Idaho Alaska Arizona Wyoming Kansas Montana South Carolina Alabama * Florida

* On Mar. 3, 2015, the Alabama Supreme Court ordered the state’s 68 probate judges to stop issuing marriage licenses to same-sex couples, despite an earlier federal court ruling that struck down the state’s gay marriage ban, and the US Supreme Court’s decision to allow same-sex marriages to proceed in the state. The state Supreme Court gave probate judges five days to respond if they do not feel they have to follow the order.

The Defense of Marriage Act (DOMA) The Defense of Marriage Act is a United States federal law signed into law by President Bill Clinton on September 21, 1996, whereby the federal government defines marriage as


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a legal union between one man and one woman. Under the law, also known as DOMA, no state (or other political subdivision within the United States) may be required to recognize as a marriage a same-sex relationship considered a marriage in another state. The law passed both houses of Congress by large majorities. Section 3, which prevents the federal government from recognizing the validity of same-sex marriages, has been found unconstitutional in eight federal courts, including the First and Second Circuit Courts of Appeals.

Supreme Court Hears Arguments on the Constitutionality of DOMA On March 27, 2013, the US Supreme Court heard oral arguments in Windsor v. United States. In 1963 Edie Windsor met her late spouse, Thea Spyer, in New York City. Shortly thereafter, Windsor and Spyer entered into a committed relationship and lived together in New York. In 1993, Windsor and Spyer registered as domestic partners in New York City, as soon as that option became available. In 2007, as Spyer’s health began to deteriorate due to her multiple sclerosis and heart condition, Windsor and Spyer decided to get married in Canada where gays and lesbians are permitted to marry. Spyer died in February 2009. According to her last will and testament, Spyer’s estate passed for Windsor’s benefit. Because of the operation of DOMA, Windsor did not qualify for the unlimited marital deduction under §2056(a) and was required to pay $363,053 in federal estate tax on Spyer’s estate, which Windsor paid in her capacity as executor of the estate. On November 9, 2010, Windsor commenced suit, seeking a refund of the federal estate tax levied on Spyer’s estate and a declaration that section 3 of DOMA violates the Equal Protection Clause of the Fifth Amendment of the US Constitution. The Bipartisan Legal Advisory Group of the U.S. House of Representatives (BLAG) moved to intervene to defend the constitutionality of the statute. BLAG’s motion was granted on June 2, 2011. In rendering its decision on June 6, 2012, the US District Court Southern District of New York held in favor of Ms. Windsor that section 3 of DOMA is unconstitutional as applied to her and awarded judgment in the amount of the full amount of estate tax paid, plus interest. On October 18, 2012, the Second Circuit Court of Appeals upheld the lower court’s ruling and on December 7, 2012 the Supreme Court agreed to hear the case. The Court is expected to rule in June, 2013. On March 27, 2013, the US Supreme Court heard oral arguments in Windsor v. United States and on June 26, 2013 ruled Section 3 of DOMA is unconstitutional. In the 5-4 decision Justice Anthony Kennedy, writing for the majority, explained “that the principal purpose and the necessary effect of this law are to demean those persons who are in a lawful same-sex marriage. This requires the Court to hold, as it now does, that DOMA is unconstitutional as a deprivation of the liberty of the person protected by the Fifth Amendment of the Constitution.”


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The 2015 Supreme Court Cases

Since June 2013, there have been 65 rulings in favor of marriage for same-sex couples. In spring 2015, the question of whether same-sex couples everywhere can marry had its day before the nation’s highest court. In January 2015, the Court granted review of cases from four states - Kentucky, Michigan, Ohio and Tennessee – and an oral argument was held on April 28. A decision should be announced by the end of June 2015. This followed an earlier decision in October 2014 when the Court denied petitions in five marriage cases, thereby allowing court-mandated marriages to take effect in 11 states. Nearly 72 percent of Americans live in a state that grants marriage to same-sex couples. There are now just 13 states without same-sex marriage recognition.

Community/Separate Property

Community property is the total of the following property acquired and earnings received:

By a registered domestic partner (RDP) during a registered domestic partnership while domiciled in a community property state.

By an RDP that is not separate property. Each RDP owns one-half of all community property.

Separate property is:

All property owned separately by an RDP before entering into a registered domestic partnership.

All property acquired separately after entering into a registered domestic partnership, such as gifts, inheritances, and property purchased with separate funds.

Money earned while domiciled in a separate property state. All property declared separate property in a valid agreement entered into before or

after registration of the domestic partnership. Community income is all income from community property, wages, salaries, and other compensation for personal services of either RDP while in a registered domestic partnership. Community income is divided equally between RDPs . Under California law community status ends in any of the following situations:

Upon the death of either RDP. When the decree of dissolution or termination of registered domestic partnership

becomes final. When RDPs separate with no immediate intention of reconciliation.


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Income from separate property is income of the RDP who owns the property. When filing separate returns, the domicile of the RDP who earns the income determines the division of income between the RDPs. For income tax purposes, the income of RDPs domiciled in a community property state may be community income or separate income. When RDPs file separate returns, each RDP reports the following:

One-half of the community income All of his or her separate income.

IRS Reverses Decision Regarding Community Property

As mentioned above, federal tax law does not recognize civil unions or RDPs for purposes of filing status. While RDPs must use a married filing status (MFJ or MFS) for their state tax returns, these taxpayers must continue to use whatever single status (Single or Head of Household) is appropriate for federal income tax purposes. IRC §61(a)(1) provides that gross income means all income from whatever source derived including compensation for services such as fees, commissions, fringe benefits, and similar items. Federal tax law generally respects state property law characterizations and definitions (U.S. v. Mitchell, 403 U.S. 190 (1971), Burnet v. Harmel, 287 U.S. 103 (1932)). In Poe v. Seaborn, 282 U.S. 101 (1930), the Supreme Court held that for federal income tax purposes a wife owned an undivided one-half interest in the income earned by her husband in Washington, a community property state, and was liable for federal income tax on that one-half interest. Accordingly, the Court concluded that husband and wife must each report one-half of the community income on his or her separate return regardless of which spouse earned the income. United States v. Malcolm, 282 U.S. 792 (1931), applied the rule of Poe v. Seaborn to California's community property law. Community property laws developed in the context of marriage and originally applied only to the property rights and obligations of spouses. The laws operated to give each spouse an equal interest in each community asset, regardless of which spouse is the holder of record (d'Elia v. d'Elia, 58 Cal. App. 4 th 415 (1997)). By 2007, California had extended full community property treatment to registered domestic partners. Washington extended this coverage in 2009 as did Nevada and Wisconsin. On May 5, 2010, the Office of Chief Counsel issued CCA 201021050 regarding the treatment of community property for RDPs on their federal income tax returns. Applying the principle that federal law respects state law property characterizations, the federal tax treatment of community property should apply to RDPs. Consequently, for tax years beginning after December 31, 2006, a California registered domestic partner must report one-half of the community income, whether received in the form of


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compensation for personal services or income from property, on his or her federal income tax return. The CCA went on to stipulate, however, that for tax years beginning before June 1, 2010, registered domestic partners may, but are not required to, amend their returns to report income in accordance with this CCA. Further, in CCA 201021048 the IRS stipulated that one-half of the credit for income tax withholding should be allocated to each RDP. Reg. §1.31-1(a) provides that the recipient of the income is the person subject to the tax imposed under the income tax provisions upon the wages from which the tax was withheld. In an example, the regulation states that if a husband and wife domiciled in a community property state file separate returns, each reporting for income tax purposes one half of the wages received by the husband, each spouse is entitled to one half of the credit allowable for the tax withheld at source with respect to such wages. Because an RDP is the recipient of half of the community property income, he/she is entitled to half of the amount withheld as a credit against the income tax imposed on the income. The requirement under state law to treat a taxpayer’s earnings as community property, and thus half of a taxpayer’s earnings as vested in his/her partner, does not result in a transfer of property by the taxpayer to his/her partner for federal gift tax purposes under IRC §2501.

Confusion Reigns

Even with IRS’s updates to Publication 555 Community Property and the new Form 8958, practitioners and taxpayers alike have questions about what is and isn’t community property.

Dependents With two exceptions, if a child may be claimed as a qualifying child by 2 or more taxpayers for a taxable year, such individual shall be treated as the qualifying child of the taxpayer who is a parent of the individual, or if not a parent, the taxpayer with the highest adjusted gross income for such taxable year (§152(c)(4)(A)(i) & (ii)). Exception #1. When both parents claim a qualifying child, the child shall be treated as the qualifying child of the parent with whom the child resided for the longest period of time during the taxable year, or if the child resides with both parents for the same amount of time during such taxable year, the parent with the highest adjusted gross income.(§152(c)(4)(B)(i) & (ii)).


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Example. Although never married, Matt and Sara live together with their one biological child, Jack. Therefore, Jack is the qualifying child for both. As Sara’s AGI is higher than Matt’s AGI, starting in 2009, Matt cannot claim Jack as a qualifying child on his return, unless they mutually decide, between themselves, who will claim Jack and, thereby, avoid the tie-breaking rules. Planning. This change may reduce the opportunity to claim an EIC by requiring that the qualified child be claimed on the return of the highest paid (unmarried) parent. Exception #2. Starting in 2009, if the parents of an individual may claim such individual as a qualifying child but no parent claims the individual, such individual may be claimed as the qualifying child of another taxpayer but only if the adjusted gross income of such taxpayer is higher than the highest adjusted gross income of any parent of the individual (§152(c)(4)(C)). Planning. If the child or individual fails to meet the five requirements to be considered a qualifying child, the individual may still be claimed as a “qualifying relative” if he or she meets those requirements.

Gross Income

Wages IRS Asks Workers to Identify Employers Who Misclassify (IR-2007-203).

Employee or Independent Contractor?

Want to cut worker/independent-contractor’s SE tax in half? IRS blesses a new option! Instead of reporting compensation on the employee/worker’s W-2, some businesses treat the worker as an independent contractor to save on payroll taxes (i.e., 7.65% FICA tax) and report the compensation on Form 1099-MISC. The worker then reports this amount on Schedule C, resulting in the worker paying self-employment (SE) taxes at a 15.3% rate on the net earnings. Some workers complain they should have been treated as employees instead of an independent contractors and therefore should only be required to contribute 7.65% FICA instead of the 15.3% SE tax (5.65% vs. 13.3% for 2012). Starting with the 2007 tax year, the IRS allows the worker to file Form 8919, Uncollected Social Security and Medicare Tax on Wages, instead of filing Schedule SE (Form 1040), Self-Employment Tax, if they meet at least one of seven criteria (e.g., reason codes) as enumerated below. Previously, misclassified workers were required to file Form 4137, Social Security and Medicare Tax on Unreported Tip Income, for this purpose, a form that will still be used by certain tipped employees to report social security and Medicare taxes on allocated tips and tips not reported to their employers.


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Example. The 2014 FICA wage base is $117,000. The self-employed’s maximum SE tax for OASDI is $14,500 whereas the employee’s maximum OASDI FICA tax is half that, $7,250, resulting in an annual $7,250 savings! This option can create a substantial tax savings for the qualified worker. Planning. By filing Form 8919, the worker’s social security and Medicare taxes will be credited to the worker’s social security record. In other words, the worker will get the same credit as if filing as self-employed – at half the cost. Four requirements to file Form 8919. The worker may file Form 8919 if all of the following apply:

The worker performed services for a firm; The firm did not withhold the worker’s share of social security and Medicare

taxes from the worker’s pay; The worker’s pay from the firm was not for services as an independent contractor;

and One or more of the reasons listed below under reason codes apply to the worker.

Reason codes. When treated by the employer as an independent contractor, the worker should indicate on Form 8919 one of six reasons why he/she determines he/she should have been treated as an employee. If none of the first six reason codes apply, but the worker still believes he/she should have been treated as an employee, the worker should enter reason code G, and file Form SS-8 on or before filing the worker’s tax return.

A. Worker filed Form SS-8 and received a determination letter stating that the worker was an employee of the firm.

B. The worker was designated as a “section 530 employee” by the employer or by the IRS prior to January 1, 1997.

C. The worker received other correspondence from the IRS stating the worker was an employee.

D. The worker was previously treated as an employee by the firm and was performing services in a substantially similar capacity and under substantially similar direction and control. (The worker must also enter reason code G.)

E. Any co-workers, performing substantially similar services under substantially similar direction and control, were treated as employees. (The worker must also enter reason code G.)

F. Any co-workers, performing substantially similar services under substantially similar direction and control, filed Form SS-8 for the firm and received a determination that they were employees. (The worker must also enter reason code G.)

G. The worker filed Form SS-8 with the IRS and has not received a reply.


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Planning. Risk of filing Form 8919 may result in job loss! Along with the reason code, the worker must list the firm’s name and the firm’s federal identification number. If the worker enters reason codes D, E, F, or G, the worker or the firm that paid the worker may be contacted by the IRS for additional information. Additionally, the use of these reason codes is not a guarantee that the IRS will agree with the worker’s status determination. If the IRS does not agree that the worker is an employee, the worker will probably be billed for the additional tax, penalties, and interest resulting from the change to this worker status.

Maximizing Deferrals

In the tax planner’s bag of tricks, this is about the only idea for reducing tax that doesn’t involve giving someone else the money. Today most people don’t have a traditional pension, so saving for retirement is everyone’s responsibility. And using a 401(k) deferral makes saving tax deferred. Here are a few planning tips for wage earners looking to maximize their deferral program:

1. Strive to defer the maximum. For 2014 that’s $17,500 for everyone. Individuals age 50 and older can defer an additional $5,500.

2. Take full advantage of company match. If an individual can’t defer the maximum dollar amount for the year, at least contribute enough to receive the full amount the company will match. And try to stay until fully vested in the company’s match.

3. Consider Roth 401(k). Although this alternative gives up current deduction for salary deferred, it plans for a bigger payoff later when distributions are entirely tax free. Presumably, the taxpayer may be in a higher tax bracket later.

4. Don’t take the money out. Even if the individual changes jobs, and most will do so several times over the course of their careers, keep 401(k) funds tax deferred. Choices often include, leaving the plan with the former employer, rolling into and IRA or transferring to a new company’s plan.

5. Manage the investments within the plan. Retirement plan assets should be as carefully managed as outside investments, even though they may have a longer investment time profile.

Interest and Dividends

Tax-Exempt Interest

Interest on a bond used to finance government operations generally is not taxable if the bond is issued by a state, the District of Columbia, a U.S. possession, or any of their political subdivisions (§103). Political subdivisions include:

Port authorities,

Toll road commissions,


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Utility services authorities,

Community redevelopment agencies, and

Qualified volunteer fire departments (for certain obligations issued after 1980).

There are other requirements for tax-exempt bonds. See IRC §§141-150 and the related regulations. Obligations That Are Not Bonds Interest on a state or local government obligation may be tax exempt even if the obligation is not a bond. For example, interest on a debt evidenced only by an ordinary written agreement of purchase and sale may be tax exempt. Also, interest paid by an insurer on default by the state or political subdivision may be tax exempt.

Registration Requirement

A bond issued after June 30, 1983, generally must be in registered form for the interest to be tax exempt (§149(a)).

Indian Tribal Government

Bonds issued after 1982 by an Indian tribal government are treated as issued by a state. Interest on these bonds is generally tax exempt if the bonds are part of an issue of which substantially all of the proceeds are to be used in the exercise of any essential government function. However, interest on private activity bonds (other than certain bonds for tribal manufacturing facilities) is taxable (§7871(a)(4)).

Tax-Exempt Bonds Purchased at Original Issue Discount

Original issue discount (OID) on tax-exempt state or local government bonds is treated as tax-exempt interest (§1272(a)(2)(A)).

Tax-Exempt Bonds Purchased at Market Discount

Market discount on a tax-exempt bond is not tax-exempt (§1276(a)(1)). If a taxpayer bought the bond after April 30, 1993, you can choose to accrue the market discount over the period he/she owns the bond and include it in income currently, as taxable interest. If you do not make that choice, or if the taxpayer bought the bond before May 1, 1993, any gain from market discount is taxable when he/she disposes of the bond.

Planning with Tax-Exempts

Investing in tax-exempt bonds and/or mutual funds can produce tax advantages for the right investors. Caution! Remember that tax-exempt income is not included in AGI for purposes of determining the limitation on itemized deductions or the phase-out of personal exemptions. In addition, tax-exempt income is not part of net investment income or AGI


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for the 3.8% Medicare surtax. For taxpayers with AGI in excess of the thresholds, the rate of return on a taxable investment will need to be higher.

Example. Rob and Denise have adjusted gross income in 2014 of $250,000. They receive $3,500 in tax-exempt interest income from a $100,000 investment earning 3.5%. Their taxable income of $187,600 places them in the 28% marginal rate bracket. Under a basic calculation, it would appear that if they invested in a taxable fund returning 4.86%, they would net the same after-tax cash flow. However, because of the limitations, their actual results are:

Federal income tax with $4,860 taxable income $41,735 Federal income tax with $3,500 tax-exempt income 39,982 Tax savings 1,753

After-tax yield on taxable investment ($4,860 - $1,753 tax) $3,107

Dividends Ordinary (taxable) dividends are the most common type of distribution from a corporation. They are paid out of the earnings and profits of a corporation and are ordinary income to the taxpayer (§316(a); Reg. §1.316-1).

Dividends & JGTRRA 2003

Dividends received by an individual shareholder from domestic corporations are taxed at the same rates that apply to net capital gains originally through 2008, extended to 2010 by TIPRA 2005, extended through 2012 by TRA 2010 and made permanent by ATRA 2012. This treatment applies for purposes of both the regular tax and the Alternative Minimum Tax. Thus, under these provisions, dividends are taxed at rates of 0% and 15% through 2012, and at rates of 0%, 15% and 20% beginning in 2013. Although dividends are taxed at capital gain rates and the calculation of that tax is done on the federal Schedule D, dividends may not be offset by capital losses.

Tax Rates on Qualifying Dividends 10% & 15% Bracket 25% - 35% Bracket 39.6% Bracket 2003 – 2007 5% 15% N/A 2008 – 2012 0% 15% N/A 2013 and later 0% 15% 20% Mutual Funds Mutual funds can cause tax headaches because investors have no control over when and how much their funds realize in gains. Fund managers buy and sell securities for fund investors, often without taking tax considerations into account. Mutual funds must pass along to their shareholders any realized capital gains that are not offset by realized losses


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by the end of their accounting year. That is particularly painful if you have just purchased the fund, because you are paying taxes for gains you didn't get.

Example. Sharon invested $250 in Fund D on Monday. The fund’s Net Asset

Value (NAV) was $25, so she was able to buy 10 shares. If the fund made a $5-per-share distribution on Tuesday (which means Sharon was handed a $50 distribution) and she reinvested, her investment is still worth the same $250 because the fund’s NAV would have decreased with the distribution:

Monday 10.0 shares @ $25 = $250

Tuesday 12.5 shares @ $20 = $250

The trouble is, Sharon now owes taxes on that $50 distribution. We’ll assume that the distribution is made up entirely of long-term gains and is therefore taxed at 15%. That would translate into a $7.50 tax bill for Sharon.

If Sharon immediately sold the fund, the whole thing would be a wash, as the capital gains would be offset by a capital loss. But we’re guessing that if Sharon just invested in the fund, she wasn't planning to turn around and sell it right away.

Funds occasionally can add insult to injury by paying out a large capital-gains distribution in a year in which the fund lost money. In other words, investors can lose money in a fund and still have to pay taxes. In 2000, for example, many specialty-technology funds made big capital gains distributions, even though almost all of them were in the red for the year. Although the funds lost money during the year, they sold some stocks bought at lower prices and had to pay out capital gains as a result. Technology fund investors lost money to both the market and Uncle Sam that year.

Tax-Efficient Funds

How do you find tax-wise funds? According to John Waggoner, a personal finance columnist for USA Today, the simplest way is to look for funds sold as “tax-managed” funds. The top performers for the past five years are comprised of many international or small-company funds. That's because both categories have fared well since 2001. But you don't have to restrict yourself to the subset of self-described tax-managed funds. You can find funds that are tax-efficient without bragging about it. The best indicator of a tax-efficient fund is one that has been tax-efficient in the past, says Jim Peterson, vice president at Charles Schwab, the discount brokerage. Morningstar's tax-cost ratio is one measure of that. Lower is better. A ratio of 1 means that the fund gave up an average of 1 percentage point to taxes over time. You can find a fund's tax-cost ratio at www.morningstar.com.


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Index funds, particularly large-company index funds, also tend to be tax-efficient. The funds simply track a stock index, such as the Standard & Poor's 500-stock index. These funds tend to trade infrequently. Funds that are most likely to hit you with a big tax bill have a few things in common:

New manager. If the fund manager left, it's likely that the new manager will rearrange the portfolio. That can result in an above-average gains distribution.

New management. If the fund is merged into another fund, the old fund's

holdings could be liquidated — which might also produce a big payout.

Capital Gains The traditional method of capital gains planning involved offsetting gains by “harvesting” losses before year end. Although 2008 and 2009 market performance resulted in extraordinary capital losses for many clients, more recent results brings us back to this traditional process.

Harvesting Losses

Offset capital gains by selling other capital assets at a loss. Look for assets inherited in 1998 through 2000 when market values may have been substantially higher. Other sources of capital losses: Worthless stock. Stocks, stock rights and bonds that became worthless during the tax

year are treated as though they were sold on the last day of the tax year (§165(g)). Use this date in determining the holding period for worthless securities. Report as either long-term or short-term on Schedule D and print “worthless” in the column for sale price.

Example. Joe bought 100 shares of Schwartz, Inc on May 1, 2000, for a total price of $1,000. On April 1, 2015 Schwartz ceased doing business, and the company was liquidated. Shareholders of Schwartz received no consideration for their shares. Joe reports a long-term capital loss on his 2015 return for $1,000. To prove total worthlessness, investors need to prove that the securities truly have zero value. For instance, a company declared bankruptcy, stopped doing business and is insolvent. If the company's shares are still trading - even at pennies per share - they're not considered worthless, and no deduction will be granted. Nor can you claim a deduction for a partially worthless corporate bond. Selling shares that are traded on the so-called pink sheets can be tricky business for individual investors you'll likely have to turn to a full-service brokerage to execute that trade. If that seems too costly or unwieldy, you might be tempted to hang on to those


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shares until they do become worthless. If that’s the case, look for news that can bolster your claim of worthlessness. Taxpayers may file a claim for a credit or refund due (Form 1040X, Amended U.S. Individual Income Tax Return) to amend a return for the year a security became worthless. Amended returns may be filed within 7 years from the date the original return for that year had to be filed, or 2 years from the date the tax was paid, whichever is later. Repositioning Portfolio. For clients using modern portfolio theory models for their

asset allocations, selling off securities with accumulated losses may be an opportunity to reposition their portfolios and reduce taxable capital gains.

The 2015 Planning Opportunity – Harvesting Gains

For many clients, the bad news bear markets of 2008 and 2009 can provide an opportunity to sell assets that they have been reticent to dispose of because of large built-in gains. As tax professionals, each of us probably has at least one client with capital losses that could exceed his or her lifetime. Remember that 35 year old taxpayer with a $135,000 capital loss carryover will have to live to be 80 to use up that loss in $3,000 annual increments. Where do we help them find the gains – and perhaps – tax-free income? Sell gifted assets with very low cost basis Sell appreciated second home/vacation homes Sell collectibles – These can also avoid 28% capital gains rate if losses offset Take taxable boot in an exchange Sell negative basis limited partnership interests to generate phantom income –

make sure it will be capital gain and not ordinary income! Accelerate installment sale collections Sell personal residence that has gain in excess of the Section 121 exclusion

Playing the Spread

The spread between ordinary income tax rates and the long-term capital gains tax for all taxpayers has increased for sales after May 5, 2003 through December 31, 2012. The previous spread between the highest income tax brackets was 18.6 percent (38.6% less 20%). Even though marginal rates were lowered under the 2003 law, the spread increased to 20 percent (35% less 15%). As a result, keeping an eye on holding period is extremely important from a tax planning perspective. Of course, other financial considerations, including risk and market volatility, must be weighed in the balance. Nevertheless, some value may be lost while netting an after-tax gain for waiting-out the holding period.


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Example. Vern is holding 1,000 shares of Tax Inc. currently valued at $50 per share. Vern originally purchased the shares June 10, 2014, at $10 per share. If Vern sells the shares today, May 19, 2015, he’ll recognize a short-term capital gain of $40,000. Vern is in the highest tax marginal bracket, and he’ll pay roughly $14,000 tax on the gain. Vern nets $36,000 ($50,000 proceeds less $14,000 tax) after-tax on the sale.

If Vern decides to wait until June 11, 2015, to sell the shares, he risks a downturn in the value of the stock. But suppose the stock drops 10% in value during the month. Vern sells the shares for $45,000 and pays long-term capital gains at the rate of 15%, or approximately $5,250. In this case, Vern nets $39,750 after-tax on the sale.

Planning for Gains in 2015 and Beyond

For a higher-income taxpayer, it’s tough to plan to have a very low income year for just one year, but on January 1, 2013, Congress extended and made permanent the lower capital gains rates enacted in 2003. This may give more taxpayers the chance to receive some capital gains “tax-free.”

In order to take advantage of this opportunity, the amount of ordinary income in a taxpayer’s total taxable income must be less than the upper threshold for the 15% marginal tax bracket for his or her filing status. Then, the amount of taxable income within the limit that is made up of qualified dividends and/or long-term capital gains will be taxed at 0%.

Example. Karen, a single taxpayer, has taxable income in 2015 of $100,000. Of this amount, $25,000 is ordinary and $75,000 is long-term capital gains. Using the top of the 15% marginal rate bracket for 2015, $12,450 ($37,450 – 25,000) of Karen’s capital gains will be taxed at 0%. The remaining $62,550 will be taxed at 15%.

Strategies for reducing taxable income include: Defer receipt of income where taxpayer can control payment sources Take a sabbatical or unpaid leave Invest in tax-free income producing assets Invest for appreciation rather than current income Bunch deductible expenses Prepay deductible expenses to the extent allowable Perform deferred maintenance and repairs on rental properties generating taxable

income Maximize Section 179 expensing for new business assets acquired If possible under RMD guidelines, reduce distributions from retirement plans


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Installment Sales

When a taxpayer sells property and some or all of the payments for sale are to be paid in the future, the transaction generally is called an installment sale. When installment reporting of the gain is available, it is an important financing and tax planning option for both the seller and the buyer.

Why use the installment method? To spread the taxable gain over multiple years. A taxpayer who sells property on the installment plan is allowed to have a pro-rata portion of the total gain taxed as each installment is actually received. Thus, the seller, instead of paying the whole tax in the year of the sale, may spread the tax on the gain over the period during which the installments are received. Benefits of an Installment Sale: Taking payments over time may facilitate the sale and improve the price.

Deferring long-term capital gain may provide the opportunity to offset it with a loss realized in the future.

Pushing gain into a future year when the current year has a NOL may allow more loss to be carried back against a previous year’s ordinary income.

Deferring gain may place the income into a lower tax-bracket year.

Example. Ralph and Cay, residents of California, sold appreciated property in 2014 with an adjusted basis of $50,000 at a sale price of $150,000. They received $75,000 on the close of the sale, and will receive the remaining $75,000 one year from the date of the close. They surrendered title on the closing date and received a note, payable with interest, for the remaining $75,000.

Without

Installment Sale

With Installment Sale 2014 2015 2014 2015 Other Ordinary Income 50,000 50,000 50,000 50,000 Interest 5,000 5,000 5,000 5,000 Capital Gains 100,000 0 50,000 50,000 Adjusted Gross Income 155,000 55,000 105,000 105,000 Itemized Deductions

Taxes 8,474 775 3,886 3,886

Standard Deduction 12,400 12,600 12,400 12,600 Personal Exemptions 7,900 8,000 7,900 8,000 Taxable Income 134,700 34,400 84,700 84,400 Federal Regular Tax 13,436 4,238 5,936 5,663 State Regular Tax 8,474 775 3,886 3,886

2-Year Total Taxes

26,923

19,371


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3.8% Medicare Tax Imposed on Net Investment Income - Starting 2013

Starting in 2013, a 3.8% Medicare tax is imposed on the lesser of:

an individual's net investment income for the tax year or modified AGI in excess of a floor: $250,000 for joint filers and surviving

spouses, $125,000 for a married taxpayer filing separately and $200,000 in any other case (§1411(a)(1) & (b)).

Planning Point. There is no 3.8% Medicare tax if the taxpayer’s MAGI is equal to or less than the threshold amount. And, of course, there is no 3.8% Medicare tax for those taxpayers with high salaries and no investment income.

Example. AGI under threshold. In 2013, Ron, a single taxpayer, has $199,000 of modified adjusted gross income. $25,000 being from interest, dividends and includible capital gains. Because zero is the “lesser of'” $25,000 (net investment income) OR zero ($199,000 minus $200,000 is negative), Ron is not subject to the 3.8% Medicare tax.

Example. AGI over threshold but AGI difference smaller than investment income. In 2014, Ron’s MAGI increases to $220,000. His 3.8% Medicare tax is limited to $760 as the tax applies to the lesser of $25,000 (net investment income) or $20,000 ($220,000 MAGI minus $200,000 threshold for a single).

Example. AGI over threshold but investment income smaller than AGI difference. In 2015, Ron’s MAGI increases to $250,000. His $25,000 of unearned income is subject to a 3.8% Medicare tax of $950, as the tax applies to the lesser of $25,000 (net investment income) or $50,000 ($250,000 MAGI minus $200,000 threshold for a single).

Example. Combined AGI over MFJ threshold. In 2013, Carol and Eric each earn $130,000, report $40,000 of unearned income and file jointly. As their combined income of $300,000 is $50,000 over the $250,000 MFJ threshold, their 3.8% Medicare tax is limited to $1,520 as the tax applies to the lesser of $40,000 (net investment income) or $50,000 ($300,000 MAGI minus $250,000 MFJ threshold).

Example. Combined AGI over MFJ threshold. In 2013, Jill and Bill, married filing jointly, have $400,000 of salaries and $50,000 of net investment income. As their combined income is $150,000 over the $250,000 MFJ threshold, their 3.8% Medicare tax is limited only to their net investment income ($50,000 x 3.8% = $1,900.)


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Planning point. In January 2013, the highest marginal rate increased from 35% to 39.6%. In January 2013, this 3.8% tax increases the highest marginal rate to 43.4%.

Investment income is the sum of:

1. Gross income from a. interest, b. dividends, c. royalties, d. annuities, and e. rents (unless such income is derived in the ordinary course of any trade or

business other than from (2) or (3) below); 2. Gross income from a §469 passive activity; 3. A trade or business of trading in financial instruments or commodities (as defined

in §475(e)(2)); and 4. Net gain (to the extent included in computing taxable income) attributable to the

disposition of property other than property held in any trade or business not described in (2) or (3) above (§1411(c)(1) and (2)). The tax does not apply to other trades or businesses conducted by a sole proprietor, partnership, or S corporation.

Net investment income is the above-mentioned investment income less any allowable deductions properly allocable to such income or gain (§1411 (c)(1)(B)). Net investment income also includes any income, gain, or loss that is attributable to an investment of working capital (§1411(c)(3)). Net investment income does not include:

1. Active income in family partnerships and S corporations, which will become more popular in attempting to avoid the 3.8% unearned income Medicare contribution tax.

2. Any item taken into account in determining self-employment income if HI or Medicare tax is imposed (§1411(c)(6)),

3. Any distribution from qualified employee benefit plans or arrangements (§1411(c)(5)),

4. Interest on tax-exempt and tax-deferred vehicles such as a. municipal bonds, b. tax deferred non-qualified annuities, c. life insurance, d. veterans' benefits,

5. Excluded gain from the sale of a principal residence, and 6. Other such items which are otherwise excluded from gross income.


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What Investment Expenses Are Deductible in Computing Net Investment Income (NII)? (§1.1411-4)

In order to arrive at Net Investment Income, Gross Investment Income is reduced by deductions that are properly allocable to items of Gross Investment Income. Examples of properly allocable deductions include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items included in Net Investment Income.

Example - Investment interest expense (Example 5). In 2013, Amanda, an unmarried individual, pays interest of $4,000 on debt incurred to purchase stock. Under §1.163-8T, this interest is allocable to the stock and is investment interest within the meaning of §163(d)(3). Amanda has no investment income in 2013. Under §163(d)(1) Amanda may not deduct the $4,000 investment interest in 2013. The $4,000 investment interest is carried forward and is treated as investment interest paid by Amanda in 2014. In 2014, Amanda has $5,000 of §163(d)(4) net investment income. For both income tax purposes and for determining §1411 net investment income, Amanda's $4,000 carryforward of interest expense disallowed in 2013 may be deducted in 2014.

Example - Limitations on itemized deductions (Example 6). Facts. Barry, an unmarried individual, has adjusted gross income in 2013 as follows: Wages $1,600,000 Interest income 400,000 Adjusted gross income $2,000,000 In addition, Barry, has the following items of expense qualifying as itemized deductions: Investment expenses $70,000 Job-related expenses 30,000 Investment interest expense 80,000 State income taxes 120,000 Barry's investment expenses and job-related expenses are miscellaneous itemized deductions. In addition, Barry's investment interest expense and investment expenses are properly allocable to net investment income (within the meaning of this section). Barry's job-related expenses are not properly allocable to net investment income. Of the state income tax expense, $20,000 is properly allocable to net investment income and $100,000 is not properly allocable to net investment income. First, calculate the investment expenses after the 2% AGI limit on miscellaneous itemized deductions. Barry's 2% floor under §67 is $40,000 (2% of $2,000,000). Barry's


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total miscellaneous itemized deductions allowable before the application of the 2% limit is $100,000 ($70,000 in investment expenses plus $30,000 in job-related expenses), and the total miscellaneous deductions allowed after the application of the 2% limit is $60,000 ($100,000 minus $40,000). The amount of the deduction allowed for investment expenses after the application of the 2% limit is computed as follows: $70,000 X $60,000/ $100,000 = $42,000. The amount of the deduction allowed for job-related expenses after the application of the 2% limit is computed as follows: $30,000 X $60,000/ $100,000 = $18,000. Next calculate allocable investment expenses after the 3% itemized deduction phaseout. For 2013, the 3% itemized deduction phaseout under §68 starts at adjusted gross income of $250,000 ($300,000 MFJ). The itemized deduction phaseout disallows $52,500 of Barry's itemized deductions that are subject to the itemized deduction phaseout (3% of the excess of $2,000,000 adjusted gross income over the $250,000 limitation threshold). Barry’s itemized deductions subject to the itemized deduction phaseout and allowed after the application of the 2% miscellaneous itemized deduction limit, are the following: Investment expenses $ 42,000 Job-related expenses 18,000 State income tax 120,000 Deductions subject to $180,000 itemized deduction phaseout Of Barry’s itemized deductions that are subject to the AGI phaseout, the amount allowed is $127,500 ($180,000 minus the $52,500). The amount of the investment expense deduction allowed after AGI phaseout is determined as follows: $42,000 X $127,500/ $180,000 = $29,750. The amount of the state income tax deduction allowed after the AGI phaseout and properly allocable to net investment income is determined as follows: $20,000 X $127,500 / $180,000 = $14,167

Calculation of net investment income after 2% miscellaneous itemized deduction limit and 3% itemized deduction phaseout (§1.1411-4 (f)(ii))

Allocable gross amount

After 2% misc itemized

deduction floor

After 3% AGI phaseout of

itemized deductions

Investment income $400,000

Investment interest expense $80,000

($80,000)

Investment expense $70,000 $42,000 $29,750 ($29,750)

State income tax $20,000 $14,167 ($14,167)


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Calculation of net investment income after 2% miscellaneous itemized deduction limit and 3% itemized deduction phaseout (§1.1411-4 (f)(ii))

Net investment income

$276,083

Medicare tax @3.8%

$10,491

Note. The $80,000 deduction for the investment interest expense is not subject to the 3% itemized deduction phaseout.

Is a Real Estate Professional’s Income Subject to the New 3.8% Medicare Tax? (§1411(C)(2)(a))

Can Rental Real Estate Income Be Derived in the Ordinary Course of a Trade or Business?

Interestingly, the Preamble to the Final Regulations admits that, in certain circumstances, the rental of a single property may require “regular, continuous and substantial” involvement, resulting in the rental activity being a §162 trade or business. This admission acknowledged the holdings in Fackler v. Comm., 45 BTA 708 (1941), aff'd, 133 F.2d 509 (6th Cir. 1943); Hazard v. Comm., 7 T.C. 372 (1946); and Lagreide v. Comm., 23 T.C. 508 (1954), that the activities of a single property can rise to the level of a trade or business (TD 9644; Preamble, 5,B,ii,a). Rental of single property unlikely to be an active trade or business. At the same time, the Preamble further noted that the rental of a single piece of property would normally not rise to the level of a trade or business in every case as a matter of law (TD 9644; Preamble, 5,B,ii,a). For example, §1.212-1(h) provides that the rental of real property is an example of a for-profit investment activity under §212, not a §162 trade or business (TD 9644, Preamble, 5,B,ii,a). Example. Rental activity. Adam rents a commercial building to Windstorm, Inc. for $50,000. Adam is not involved in the rental activity on a regular, continuous and substantial basis. Adam’s rental activity does not rise to the level of a trade or business, and it is a passive activity. Because the $50,000 rental income is not derived from a trade or business, Adam must treat it as gross income from rents subject to NII (per §1.1411-4(a)(1)(I)) [§1.1411-5(b)(3), Exp 1]. Key factual elements that may be relevant when determining when a rental activity rises to the level of a trade or business, include, but are not limited to:

the type of property (commercial or residential real property, personal property, etc.),

the number of properties rented,


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the day-to-day involvement of the owner or its agent, the type of rental, a net lease versus a traditional lease, and short-term versus long-term lease (TD 9644, Preamble, 5,B,ii).

The final regulations state that bright-line definitions would be impractical and imprecise due to the large number of factual combinations that exist in determining whether a rental activity rises to the level of a §162 trade or business (TD 9644, Preamble, 5,B,ii).

Preparer note: Trades or businesses issue Form 1099-MISC, landlords don’t. The IRS will closely scrutinize situations where taxpayers are inconsistent in their treatment of an activity as a trade or business. For example, if a taxpayer takes the position that a certain rental activity is a trade or business for purposes of §1411, the IRS will take into account whether the taxpayer complied with any Form 1099 trade or business information reporting requirements to help determine if the activity was a trade or business (§6041; TD 9644, Preamble, 5,B,ii,a)).

A Real Estate Professional’s Rental Income May Not Be NII

If a taxpayer meets the “50%/750 hours in the real property trades or businesses” requirements to be a real estate professional, the taxpayer’s interest in rental real estate is no longer considered a “per se” passive rental activity; instead the rental is treated as if a “trade or business,” and the “non-rental” rental real estate activity will not be a passive activity if the taxpayer materially participates in each activity. Relief provision for real estate professional’s rental real estate. Once an individual establishes real estate professional status (e.g., contractors, real estate agents, landlords, property managers, etc.), that status only allows the taxpayer to treat rental real estate activities as nonpassive if the taxpayer satisfies at least one of the seven material participation tests (see §1.469-5T(a)). The Preamble in the Final Regulations notes that not all of the material participation tests provide conclusive evidence that a taxpayer is regularly, continuously, and substantially involved in a rental trade or business, especially when the taxpayer claims material participation by performing substantially all of the work and the total time spent on the activity is under 500 hours in the year (TD 9644, Preamble, 5,E,iii). Example. Mark is a contractor who works full time in his contracting business. He also owns a single family residence that is rented month to month. Mark is a real estate professional because he works more than 750 hours per year and more than 50% of his time in his contracting business. Additionally, Mark is the only person that provides services for his residential rental, but he rarely spends more than 20 hours in any given year. While Mark satisfies the material participation test, it is unlikely that his rental real estate rises to the level of a trade or business. Any profit he realizes would likely be included in NII.


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Real estate professional safe harbor rules. The final regulations provide a safe harbor test for real estate professionals. If a real estate professional participates in rental real estate activities:

for more than 500 hours per year, OR for more than 500 hours per year in five of the last ten taxable years (one or more

of which may be taxable years prior to 2013), the rental income, and the net gain on sale associated with that activity, will be deemed to be derived in the ordinary course of a trade or business exempt from the NII tax (§1.1411-4(g)(7)(i)(A) & (B); §1411(c)(1)(A)(iii); TD 9644, Preamble, 5,E,iii). Example. Sharon owns a shopping center. She spends 1,000 hours a year managing the property. Because Sharon spends more than 750 hours a year and spends more than 50% of her personal service hours in a qualified real estate activity, she is a real estate professional (§469(c)(7)). In addition, as she spends more than 500 hours materially participating in her rental activity, any income Sharon receives from the shopping center, including any gain realized upon its eventual sale, is not NII (per §1.1411-4(g)(7)). Real estate professionals unable to meet the 500 hour safe harbor may still avoid NII tax. Real estate professionals with substantial rental activities may derive such rental income in the ordinary course of a trade or business, even though they fail to satisfy the safe harbor 500 hour requirement. All facts and circumstances must be analyzed to determine if a real estate rental activity rises to the level of a trade or business (§1.1411-4(g)(7)(iii); T. D. 9644, Preamble, 5,E,iii).

Planning point. The election to treat all rental real estate as a single activity is permitted for NII purposes (under §1.469-9(g)). However, any rental real estate grouped with a trade or business (under §1.469-4(d)(1)(i)(A) or (d)(1)(i)(c)) is treated as a trade or business, not a rental real estate activity (§1.1411-4(g)(7)(ii)(B)).

Planning for MAGI May Involve the Installment Sales Provision in the Future

Since the Medicare tax is triggered when AGI exceeds $200,000/$250,000, using an installment sale to spread income over several years can reduce the impact of this additional tax.


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Example. No installment sale. In 2013, Paul and Susie report $200,000 as wages and $225,000 as gains from the sale of their rental building. Their modified AGI is $425,000. Paul and Susie will pay a 3.8% unearned income Medicare contribution tax on the lesser of their: (1) $225,000 of net investment income or (2) $175,000 of modified AGI, the amount in excess of the $250,000 threshold for MFJ taxpayers. Their unearned income Medicare contribution tax in 2013 will be $6,650 ($175,000 x 3.8%).

Example. Installment sale. In 2013, Paul and Suzie sell the previously mentioned rental building on a 10-year installment contract. They collect the note over ten years and will report $22,500 of taxable gain each year. Because their AGI stays below $250,000 threshold by using an installment sale, they pay no Medicare tax on investment income. These investments will become more attractive when compared to the above-listed investment income vehicles.

Ideas for Keeping MAGI below the Threshold Modified AGI may be reduced below $250,000/$200,000/$125,000 threshold amount by using: Installment sales Deferred annuities Municipal bonds Pension contributions Deferred compensation Charitable remainder trusts Charitable lead trusts


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Sole Proprietors Individual tax returns with self-employment activities continue to draw the most IRS scrutiny. On average, returns with Schedule C or Schedule F are audited a third more than all other individual returns. The audit statistics for 2011 Schedule C/F filers were (see 2012 IRS Data Book):

Sch. C Gross receipts

# of returns

filed

# of returns audited

2013 As a %

Field Audits

Correspondence audits

<$25,000 10,473,171 105,312 1.0% 44,534 60,778

>$25k, <$100k 3,091,195 57,832 1.9% 28,111 29,721

>$100k, <$200k 865,666 20,999 2.4% 15,796 5,203

>$200,000 666,991 13,961 2.1% 12,789 1,172

All Sch. F 1,287,565 6,072 0.5% 3,332 2,740

Totals 16,384,588 204,176 1.25% 104,562 99,614

Bonus Depreciation Expired in 2014

Congress allowed businesses, beginning January 1, 2008 through December 31, 2009, to take an additional “bonus” depreciation deduction allowance equal to 50% of the cost of new business depreciable personal property placed in service in those years. Under the Small Business Jobs Act of 2010, this bonus depreciation deduction allowance was extended through December 31, 2010. The 2010 Tax Relief Act modified the acquisition date and temporarily increased the bonus depreciation percentage for investments in new business equipment. For investments placed in service after September 8, 2010 and through December 31, 2011, the bill provided for 100% bonus depreciation. For investments placed in service after December 31, 2011 and through December 31, 2012, TRA 2010 reduced the bonus depreciation to 50%. It also allowed corporate taxpayers to elect to accelerate some AMT credits in lieu of bonus depreciation for taxable years 2011 and 2012. The American Taxpayer Relief Act of 2012 extended the TRA 2010 bonus depreciation rules through 2013 and the Tax Increase Prevention Act of 2014 extended them again through 2014.


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Bonus Depreciation Chart

Effective Date Deduction Amount

Jan. 1, 2008 to Sep. 8, 2010 50%

Sep. 9, 2010 to Dec. 31, 2011 100%

Jan. 1, 2012 to Dec. 31, 2014 50%

Jan. 1, 2015 and after 0%

Planning point. Bonus depreciation continues to be limited to $8,000 for a new luxury auto. Thus, the maximum depreciation for a new luxury auto purchased in 2010 is $11,060 ($8,000 + $3,060). Planning point. Section 179 is limited to $25,000 for the purchase of an SUV weighing more than 6,000 pounds (GVW). There is no similar limit to bonus depreciation. So the purchase of a new SUV will qualify the taxpayer for a 50% write off (times the business percentage.)

Maximum Amount and Phase-out Threshold under §179

A taxpayer may elect to deduct the cost of certain qualified business property placed in service for the year rather than depreciate those costs over time. The 2003 tax cuts temporarily increased the maximum dollar amount that may be deducted from $25,000 to $100,000. These amounts have been further increased and extended several times on a temporary basis, including most recently as part of the Small Business Jobs Act which increased the thresholds to $500,000 and $2,000,000 for the taxable years beginning in 2010 and 2011. The 2010 Tax Relief Act extended the maximum amount and phase-out thresholds for taxable years beginning in 2012, at $125,000 and $500,000 respectively, indexed for inflation. Then, the American Taxpayer Relief Act of 2012 retroactively increased the thresholds back to $500,000 and $2,000,000 for 2012 through 2013. And, the Tax Increase Prevention Act of 2014 extended the thresholds through 2014.

§179 Chart 2008-2009 2010-2014 2015

Maximum §179 Deduction $250,000 $500,000 $25,000

Maximum Annual Qualifying Property Before Phase-out

$800,000 $2,000,000 $250,000

Planning point. The taxable income of the business limits the usefulness of large §179 deductions for some businesses.


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Taxable Income Limitation

The §179 deduction is limited to the taxpayer's taxable income computed without taking into account any deduction for self-employment taxes, net operating loss carryback or carryover, §179 expensing, or deductions suspended under any provision (§179(b)(3); §1.179-2(c)(1)). Any amount limited by this provision may be carried forward and deducted in subsequent tax years, subject to the maximum dollar and investment limitations, or, if lower, the taxable income limitation in effect for the carryover year (§179(b)(3)(B)).

Planning point. Therefore, any 2014 §179 carryover, plus any 2015 expensing, will be limited to $25,000 in 2015.

Comparing §179 and Bonus Depreciation

§179 §168(k)

New or used property Both new or used New, original use only

Placed in service Taxable years beginning in Calendar year 2008 - 2014

Limited to taxable income Yes No

Eligible property Generally, only personal property, but in 2010 - 2014 some real

property improvements qualify

MACRS life of 20 years or less

Types of activities Active trade or business only All activities (rentals)

Election can be modified Yes, on amended return No, binding w/o IRS permission

Deduction amount limited $500,000 ($25,000 in 2015) No

Like-kind exchange basis New boot only 100% of basis

Purchase amount limited Yes, phaseout starts @ $2,000,000 ($250,000 in 2015)

No, unlimited purchases

Planning point. A 100% deduction in the year of purchase (§179) or 50% deduction (bonus depreciation) for equipment that is paid for over several years will create extra deductions above cash requirements in year one. When the loan payments are made in subsequent years, profits will be used to make non deductible payments. “Phantom” income will result.

Section 179 is Recaptured as Ordinary Income at Sale

Any §179 expense deduction that is later recaptured on sale of real property will be taxed as ordinary income (§1245(a)(2)).


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Should the client take the §179 anyway and give up the lower capital gains rates at sale? Here are a few considerations:

1. A deduction today and a pay back several years from now still gives the client a measurable present value calculation.

2. The tenant who pays for, or shares in the payment of, his leasehold improvements will have no gain when he abandons his lease. He didn’t sell anything.

3. The landlord who pays for tenant improvements may tear them out when her tenant vacates to make the property more rentable. She has no gain on sale; she didn’t sell.

4. The landlord who pays for tenant improvements and later sells the property would have recapture at ordinary rates if he actually paid taxes at the sale. But, don’t many property owners exchange their properties onto others? The recapture just may be deferred forever if the client continues to exchange.

§179 Cannot Create or Increase a Loss

The expensing election is limited to the amount of taxable income from all of the taxpayer’s active trades or businesses. Taxable income is computed without the §179 deduction, without any net operating loss carrybacks or carryforwards, and without deducting one-half of self-employment (§1.179-2(c)(1)). The net income, and losses, from all actively conducted businesses of the taxpayer (i.e., all Schedules C’s, F’s and K-1's) are aggregated for purposes of this income limitation (§1.179-2(c)(1)). The "net income definition" includes a partner's share of income from a partnership (or shareholder's share of income from an S corporation) as long as the partner/shareholder is active (§1.179-2(c)(2); -2(c)(6)(ii)). Also aggregated are §1231 gains (or losses) from the sale of business assets and interest income from working capital (§1.179-2(c)(1)). §179 deductions that are disallowed because of the income limitation may be carried forward indefinitely, subject to the annual limitations for total §179 expense and for maximum assets purchases (§1.179-3(a)). The taxpayer may choose the properties for which the cost will be carried forward, as well as the portion of each property's cost to be carried forward.

PlanningPoint. A taxpayer can include wages and salaries of the taxpayer (and spouse), even if the earned wages are not from the business deducting the §179 property (§1.179-2(c)(6)(iv)).

Planning Point. Vehicles for which a §179 deduction has been claimed must maintain business use >50% or be subject to §179 recapture. Such recapture is reported on Form 4797 in the year that business use drops to 50% or below. The recapture amount is reported as other income on the schedule where the depreciation was originally taken (i.e., Sch. C). An amended return is not required (see Michael Birdsill v. Comr., TCS 2008-55).


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Business Related Health Benefits

What health benefits apply to owners?

Sch C Sch F 1065 1120S 1120

SE health insurance deduction

X X X X

Reduces SE tax/FICA No No No Yes N/A

Tax free health insurance X

Medical expense reimbursement

X

HSAs X X X X X

Deducting Health Insurance for the Self-employed Health insurance, and medical expenses not covered by health insurance, paid by sole proprietors are generally §262(a) personal expenses, deductible “below-the-line” on Schedule A, subject to the 7.5% AGI “haircut” §213(a) limitations. Congressional solution: allow the self-employed to deduct health insurance “above the line.” §162(l) permits 100% of the health insurance premiums to be deductible “above-the-line” (before AGI) with the following limitations:

Deduction is limited to that business’s earned income. The income from two businesses cannot be aggregated for income limits although each business could pay different specific health insurance plans (CCA 200524001).

Planning. Earned income for an S corporation shareholder includes only form W-2 wages. S corporation flow through income from the K-1 is not “earned income” for these purposes (§162(l)(5)).

Deduction is limited when taxpayer is eligible to participate in a subsidized health

plan maintained by his or her employer or the spouse’s employer (§162(l)(2)(A) & (B)).

Deduction isn’t available for self-employment tax purposes (§162(l)(4)). Policy in own name still policy of the business. A sole proprietor who purchases health insurance in his or her individual name is still considered to have established a plan providing medical care coverage with respect to his or her trade or business and therefore may deduct the medical care insurance costs for himself, his spouse and dependents as if it qualified for the §162(l) 100% self-employed health insurance deduction “above-the-line.” (Notice 2008-1; LTR 200623001; CCA 200552401)


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IRS Changes Its Mind on Medicare Premiums as Self-Employed Health Insurance

Chief Counsel Advice says all Medicare premiums qualify for SE health insurance deduction; amended returns permitted (CCA 201228037; Pub 535). Maybe it is not news but now it is official. Medicare insurance premiums are insurance for purposes of the self-employed health insurance deduction. A small change in Publication 535 stated that “Medicare B premiums can be used to figure the (self-employed health insurance) deduction.” A Chief Counsel Advice clarifies what’s included:

1. All Medicare Parts (B and D) for the self-employed individual and spouse are insurance that constitutes medical care under §162(l).

2. A partner in a partnership may pay the premiums directly and be reimbursed by the partnership, or the premiums may be paid by the partnership. In either case, the premiums must be reported to the partner as guaranteed payments, and the partner must report the guaranteed payments as gross income on his or her Form 1040. A 2% shareholder-employee in an S corporation may pay the premiums directly and be reimbursed by the S corporation or the premiums may be paid by the S corporation. In either case, the premiums must be reported to the 2% shareholder-employee as wages on Form W-2, and the 2% shareholder-employee must report this amount as gross income on his or her Form 1040. A sole proprietor must pay the Medicare premiums directly.

3. If all the requirements of §162(l) are satisfied, Medicare premiums may be deducted under §162(l) for coverage of the self-employed individual's spouse, dependent or a child (as defined in §152(f)(1) who as of the end of the taxable year has not attained age 27).

4. Self-employed individuals who failed to deduct Medicare premiums for prior (open) years may file an amended return to claim the deduction.

Example. Mary, a self-employed architect, pays $1,200 of Medicare B premiums in 2013. Tom, Mary’s husband, is retired and also pays $1,200 of Medicare B premiums. Mary may deduct $2,400 as self-employed health insurance in 2013, and she may also amend any open years to add the Medicare premiums paid on her and Tom’s behalf to her self employed health insurance deduction.

Potential tax-saving scheme: Hire spouse and deduct 100% of employer-provided health coverage with no W-2 income to spouse! If the sole proprietor hires his or her spouse as an employee, 100% of the cost of the spouse’s accident and health coverage, including medical expense reimbursements, are deductible as a §162(a) business expense if the employee-spouse is determined to be a bona fide employee of the business under the common law rules or otherwise provides services to the business for which the accident and health coverage is reasonable compensation. Additionally, the cost of the coverage and medical reimbursements is excludable from the employee spouse’s income


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under §105(b) and §106, (i.e., the amount paid to provide employee accident and health is excluded from the W-2 as a tax-free fringe benefit). Do we need to adopt a written agreement and plan document? Not for the payment of the §106 health insurance premium. But if the §105(b) self-insured medical expense reimbursement plan is also adopted, the IRS states that the business should be able to show that the employee-spouse is eligible to participate. “For example, very often a specific service requirement applies to current employees as well as new employees. This waiting period may not have been applied to the employee-spouse but may have been used to exclude other employees. Thus, if it is not documented that the employee-spouse has met the service requirement, the employee-spouse may not participate and medical expense reimbursements would not be excludable under §105(b) because they would not be received under an accident and health plan” (ISP, 3/29/00).

Planning. The IRS states that an employee-spouse cannot receive tax-free reimbursements under a self-insured medical expense reimbursement plan for expenses incurred before the plan is adopted! The IRS cites as its authority for this position American Family Mutual Insurance Company, 93-1 USTC ¶50025 and Rev. Rul. 71-403.

If spouse is covered, do all other employees also have to be covered? If the service requirement has not been consistently applied to all employees, the medical expense reimbursement plan is discriminatory under §105(h). The health insurance discrimination rules in §106 are more liberal. Bona fide employee requirement. Whether the “employee-spouse” is a bona fide employee is determined on a case-by-case basis, using the common law rules (see Rev. Rul 87-41 and IRS’s training manual 3320-102 (Revised 10-96), “Independent Contractor or Employee?”). The extent and nature of the spouse’s involvement in the business operations is critical. A part-time worker may still qualify as a bona fide employee, although the performance of nominal or insignificant services that have no economic substance or independent significance may be challenged. Merely calling a spouse an “employee” is not sufficient to qualify a non-working spouse as an employee. Be careful, the spouse must be an employee - not an owner! The IRS brings up a most interesting, and potentially confusing, argument by stating that the spouse may actually be a self-employed individual engaged in the trade or business as a joint owner, co-owner, or partner. “For example, a significant investment of the spouse’s separate funds in (or significant co-ownership or joint ownership of) the business assets may support a finding that the spouse is self-employed in the business rather than an employee.” Reasonable compensation requirement. The total salary (if any) plus the value of the tax-free medical fringe benefit must be deemed “reasonable compensation,” i.e., would the business pay this benefit to an outside unrelated employee? The following factors are considered in determining the reasonableness of compensation:


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1. Employee’s role in the company, 2. External comparison with other companies, 3. Character and condition of the company, 4. Internal consistency in compensation, and 5. Potential conflicts of interest/hypothetical independent investor (Elliotts, Inc. v.

Commissioner (83-2 USTC ¶9610 ), 716 F.2d 1241 (9th Cir. 1983)). Example. Jake owns an unincorporated insurance business. He hires his wife, Linda, to work 5 hours a week to answer the telephone, paying her $9 an hour and providing health insurance for her and her family and a medical reimbursement plan that reimburses uninsured medical expenses. During 2014, Linda’s W-2 wages are $2,250. In addition, Jake’s business paid $7,200 ($600 per month) in Blue Cross health insurance premiums and $2,800 in medical reimbursements. The tax problem is: would Jake pay an outside party $12,250 per year to simply answer the telephone? Would the IRS find this “unreasonable?” Checklist for Family Employee Benefit Programs As previously discussed, business owners employing and providing benefits to family members will receive a great deal of scrutiny in the event of an audit. Of greatest concern is the legitimacy of the employer-employee relationship. Below is a checklist of factors that should be considered. While no one (or group of) item(s) is controlling, these are the types of factors that the IRS will investigate.

Factor to Consider Yes No

Is the compensation paid to the family member:

1. Reasonable, e.g., valued at fair market?

2. Evidenced by a written check, e.g., properly documented?

3. For medical expenses deducted in the year reimbursed by the business?

4. Redeposited into the business checking account?

Is there documentation of the benefit plan, such as:

1. Written employee benefit plan?

2. Employee time records?

3. Employment contract? Job description?

4. Filed employment tax returns (941s, W-2s, etc)?


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Factor to Consider Yes No

5. Having the medical insurance plan in the name of (and are premiums paid by) the business or employee (not the proprietor/owner)?

6. Adherence to nondiscrimination rules for non-family employees?

Other items:

1. Is money paid by employee spouse for medical expenses?

2. Is money paid to employee spouse as a reimbursement or does business pay expenses directly?

3. Is insurance in employee spouse’s name?

Office-in-home Rules

To deduct expenses related to the business use of part of the home, the taxpayer must meet specific requirements. Even then, the deduction may be limited. For home office expenses to qualify for a deduction, the portion of the home that is used for business must:

1. be used exclusively, (however, exceptions exist, see: James A. & Joan H. Soholt v. Comm., TCS 2007-49, few personal papers in the home office didn’t disqualify home office deduction )

2. on a regular basis, 3. in connection with a trade or business, AND

in one of the following ways:

4. as the principal place of business for any of the taxpayer’s trade or business; or 5. as a place of business for meeting or dealing with patients, clients or customers in

the ordinary course of business, or 6. in connection with the taxpayer’s trade or business if the taxpayer is using a

separate structure that is not attached to the dwelling (§280A(c)(1)). The meaning of home. The term home includes a house, apartment, condominium, mobile home, or boat. It also includes structures on the property, such as an unattached garage, studio, barn, or greenhouse. However, it does not include any part of the property used exclusively as a hotel or inn (§1.280A-1(c)(2)).

Home Office Definition of “Principal Place of Business”

Applying the principal place of business test when the taxpayer engages in business at multiple locations. To reverse the Solomon decision, Congress created a simple, two-step


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test to determine if the home office is the taxpayer’s principal place of business. Starting in 1999, a home office qualifies as the taxpayer’s “principal place of business” if:

1. The inside test. The home office is used by the taxpayer for the administrative or management activities of any trade or business of the taxpayer, and

2. The outside test. There is no other fixed location of the trade or business where

the taxpayer conducts substantial administrative or management activities of the trade or business (new §280A(c)(1) flush language and effective for tax years after December 31, 1998).

Planning. This liberal expansion restores the office deduction to the vast majority of the estimated 34 million business persons who work out of their home, such as:

home-based employees who telecommunicate to the main office; doctors who perform their duties in hospitals but need to do their billings from

their home office; outside salespeople who call at the customers place of business; professional speakers who prepare at home but deliver the presentation at hotels

and convention centers; and plumbers and other tradespeople who perform their duties at job sites away from

the shop.

Simplified Option for Claiming Home Office Deduction Starting with 2013 Returns

In Rev. Proc 2013-13 IRS announced a new, simplified method for the home office deduction. The new optional deduction is capped at $1,500 per year based on $5 a square foot for up to 300 square feet. Taxpayers claiming the optional deduction will complete a simplified form, rather than the Form 8829 now required. Depreciation expense not allowed. Homeowners using the new option cannot depreciate the portion of their home used in a trade or business. Interest and taxes claimed on schedule A. Taxpayers will claim allowable mortgage interest, real estate taxes and casualty losses on the home as itemized deductions on Schedule A. These deductions cannot not be allocated between personal and business use, as is required under the regular method. The simplified method saves time but does it save tax dollars? In tax year 2010, nearly 3.4 million taxpayers claimed the home office deduction. IRS estimates that their new simplified method of claiming home office deduction will save taxpayers 1.6 million recordkeeping hours annually.


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Example. Sharon uses a 180 square foot bedroom in her 2,200 square foot home

(8%) for a home office. She otherwise qualifies for the home office deduction.

Home office expense Simplified method @ $5 per sq ft plus Schedule A interest and taxes

Regular method @ 8% allocation

180 sq ft @ $5 $900

$12,000 interest deduction $960 $960

$4,000 property tax $320 $320

$ 900 insurance $72

$1,800 utilities $144

$7,600 depreciation $608

home office income tax deduction

$2,180 $2,104

home office self employment tax deduction

$900 $2,104

Planning point. During tax season, look at each 2012 home office deduction and see if this simplified method really works. It will be an easy comparison to the amount actually deducted in 2012 versus a deduction based on $5 per square foot. Seems that this “standard deduction” for the home office deduction may not work out for our clients.

Limitations regarding carryovers. The amount of the deduction computed using the safe harbor method provided cannot exceed the gross income derived from the qualified business use of the home for the taxable year reduced by the business deductions (the same as the Form 8829 method). But, any amount in excess of this gross income limitation is disallowed and may not be carried over and claimed as a deduction in any other taxable year. In addition, a taxpayer who uses the safe harbor method for a taxable year may not deduct in that taxable year any disallowed amount carried over from a prior taxable year during which the taxpayer calculated and substantiated actual expenses for purposes of §280A. A taxpayer who calculated and substantiated actual expenses for purposes of §280A in a prior taxable year and whose deduction was limited by the gross income limitation in §280A(c)(5) may deduct the disallowed amount, subject to all other applicable restrictions, in the next succeeding taxable year in which the taxpayer calculates and substantiates actual expenses for purposes of §280A.


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All other home office rules still apply. Current restrictions on the home office deduction, such as the requirement that a home office must be used regularly and exclusively for business and the limit tied to the income derived from the particular business, still apply under the new option.

Passive Activities

Releasing Passive Losses

Losses from passive trade or business activities, to the extent they exceed income from all such passive activities generally, may not be deducted against other income, such as salaries and wages, or interest and dividends. The one major exception is the ability of middle-income taxpayers to deduct up to $25,000 of rental losses from “actively managed” real estate (IRC §469(a)). So what happens to these disallowed losses? Are they lost forever? No. They are suspended and carried forward; they become deductible only against passive activity income in future years (IRC §469(b)). Additionally, they are “triggered” at time of sale. If the disallowed losses are not fully utilized when taxpayers dispose of their entire interest in the activity in a fully taxable transaction, the remaining losses are allowed in full, even against active income (IRS §469(g)(1)).

Example. Vern and Karen own a single family rental property that they actively manage. They originally purchased it 10 years ago for a total price of $100,000. With depreciation allowed, the property has produced a net loss of ($3,000) every year, including this year. Vern and Karen’s other income, from wages and investments, has consistently been too high to allow them to deduct losses in any year. Coming into 2015, they had suspended Passive Activity Losses in the amounts of $30,000 for regular tax and $20,910 for AMT. The property is currently worth $150,000.


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For 2015, if Vern and Karen continue to own the property, their tax situation would look like this: 2015 Income:

Wages

150,000 Interest and Dividends 5,000 Rental Real Estate 0 Adjusted Gross Income 155,000 Standard Deduction 12,600 Personal Exemptions 8,000 Total Deductions from AGI 20,600 Taxable Income 134,400 Total Federal Taxes 25,188 If Vern and Karen sell the rental property, their gain on sale would look like this: Sale Proceeds 150,000 Original Basis 100,000 Less Accumulated Depr. -29,091 Adjusted Basis -70,909 Realized Gain 79,091 Of the realized gain, $50,000 comes from appreciation, subject to 15% long-term capital gains rates, and $29,091 comes from depreciation subject to unrecaptured Section 1250 rates of 25%. So, Vern and Karen will owe (50,000 x 15% + 29,091 x 25%) $14,773 federal tax on the sale of the property, right? Wrong. Vern and Karen have $33,000 suspended losses (including this year’s loss) that will be “triggered” from the sale. Their 2015 tax liability, including the sale would be: 2015 Income:

Wages

150,000 Interest and Dividends 5,000 Rental Real Estate -33,000 Capital Gains & Losses 79,091 Adjusted Gross Income 201,091 Standard Deduction 12,600 Personal Exemptions 8,000 Total Deductions from AGI 20,600 Taxable Income 180,491 Total Federal Taxes 31,711 Vern and Karen pay an extra $6,523 federal taxes – an effective rate of 8.25 percent!


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Self-Charged Interest

Section 469(a)(1)(A) provides that if aggregate losses from passive activities exceed aggregate income from passive activities for the taxable year, the excess losses are not allowable for that taxable year. Under §469(e)(1), passive activity income does not include income from interest, dividends, annuities, and royalties (a.k.a. portfolio income) not derived in the ordinary course of a trade or business. Final regulations, issued in 2002 and effective for tax years beginning after December 31, 1986, provide self-charged treatment for items of interest income and interest expense in lending transactions between a taxpayer and a pass-through entity in which the taxpayer holds a direct or qualifying indirect interest.

Example. Sharon, Vern and Ron are equal partners in the Santana Road Shopping Center Partnership. The partnership needs a new roof and must borrow $200,000 to pay for it. If the partnership borrows from a commercial lender, charging 7% interest, Sharon, Vern and Ron will each receive a K-1 from the partnership showing ordinary losses of $35,000.

Sharon has $200,000 in a Treasury Note, earning 5%. Sharon must declare the $10,000 interest income on her Schedule B, but because her AGI exceeds $150,000, the passive activity rules suspend the losses from the partnership.

If Sharon loans the partnership the $200,000 for the roof, and the partnership pays

her 7%, she will report the $14,000 interest income on her Schedule B, but the self-charged interest rules allow Sharon to deduct without regard to the passive activity limits the amount of interest expense paid to her and included in her K-1 loss. Since Sharon is a 1/3 owner, her loss comes in part from 1/3 of $14,000 interest paid on her loan. Sharon can deduct $4,667 of partnership losses.

Sharon’s net taxable income is reduced by $667, but her actual interest income has gone up by $4,000!


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Social Security The questions abound from our clients nearing retirement. When should I begin to draw benefits? How much will my benefit be? How much of my benefit will be taxable? And the list goes on. In reality, probably the best source for these and other answers is the Social Security Administration’s web site:

www.socialsecurity.gov Once you have the basic answers for your client, you can proceed to tax plan.

When Should I Retire?

Choosing when to retire is one of the most important decisions a person will make in his or her lifetime. And choosing when to get Social Security retirement benefits offers several options.

Retire at full retirement age and get full retirement benefits. Retire early, before reaching full retirement age and receive "reduced" benefits. Retire late, working beyond full retirement age.

Individuals who choose to work beyond full retirement age have two more options.

Work and get full retirement benefits no matter how much they earn.

Work and choose to delay getting retirement benefits until age 70, earning credits that increase their benefit amounts.

Full Retirement Age

Beginning with the year 2000 (workers and spouses born 1938 or later, widow(er)s born 1940 or later), the retirement age increases gradually from age 65 until it reaches age 67 in the year 2022. The following chart contains the full retirement age for workers and spouses born after 1937:

Full Retirement Age If your birth date is... Then your full retirement age is...

1/2/38-1/1/39 65 years and 2 months 1/2/39-1/1/40 65 years and 4 months 1/2/40-1/1/41 65 years and 6 months 1/2/41-1/1/42 65 years and 8 months


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Full Retirement Age 1/2/42-1/1/43 65 years and 10 months 1/2/43-1/1/55 66 years 1/2/55-1/1/56 66 years and 2 months 1/2/56-1/1/57 66 years and 4 months 1/2/57-1/1/58 66 years and 6 months 1/2/58-1/1/59 66 years and 8 months 1/2/59-1/1/60 66 years and 10 months 1/2/60 and later 67 years If your client decides to wait until he or she reaches full retirement age, advise the client still to file for Medicare three months before his or her 65th birthday. There is a penalty for applying late for Medicare benefits.

Early Retirement

Any individual can begin receiving retirement distributions as early as age 62. In addition, one can also retire at any time between age 62 and full retirement age. However, benefits are reduced a fraction of a percent for each month before full retirement age. As a general rule, early retirement will pay about the same total Social Security benefits over one’s lifetime, but in smaller amounts to take into account the longer period of distribution.

Social Security Full Retirement and Reductions * by Age No matter what your full retirement age is, you may start receiving benefits as early as age 62

Year of Birth

Note: Persons born on January 1 of any year should refer to the

previous year.

Full Retirement Age

Age 62

ReductionMonths

Monthly % Reduction

Total %

Reduction

1937 or earlier 65 36 .555 20.00 1938 65 and 2 months 38 .548 20.83 1939 65 and 4 months 40 .541 21.67 1940 65 and 6 months 42 .535 22.50 1941 65 and 8 months 44 .530 23.33 1942 65 and 10 months 46 .525 24.17 1943--1954 66 48 .520 25.00 1955 66 and 2 months 50 .516 25.84 1956 66 and 4 months 52 .512 26.66 1957 66 and 6 months 54 .509 27.50 1958 66 and 8 months 56 .505 28.33 1959 66 and 10 months 58 .502 29.17 1960 and later 67 60 .500 30.00 * Percentage monthly and total reductions are approximate due to rounding. The actual reductions are .555 or 5/9 of 1% per month for the first 36 months and .416 or 5/12 of 1% for subsequent months .


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Here's An Important Point: There are disadvantages and advantages to taking benefits before full retirement age. One advantage is that the individual collects benefits for a longer period of time. One disadvantage is that the benefit is permanently reduced. Factors To Consider. Deciding to take Social Security retirement benefits early is one of the most difficult choices for our clients. Part of the problem is the number of variables to be considered:

Life Expectancy and Health. The amount of the reduced benefit is based upon statistical life expectancy tables. If the individual outlives the statistical norm, he or she will receive more total benefits by waiting until full retirement age.

Cash Needs. Some individuals may need the additional cash flow provided by

receiving benefits sooner than normal retirement age.

Other Retirement Assets. Early distributions of Social Security benefits may allow an individual to continue to defer pensions and other tax-deferred savings.

Time Value of Money. Factoring in the investment rate of return on long-term

investments that may be allowed to continue to compound because of early Social Security benefits increases the total value of those distributions.

Spouse’s Survivor Needs. Survivor benefits will be tied to the individual’s

reduced benefit regardless of the deceased or surviving spouse’s age at death. If the surviving spouse is much younger or has little or no Social Security benefits of his or her own, early distributions will result in lower cash flow for the survivor.

Continuing to Work. This factor is a wild card in itself. Earned income can

cause a forfeiture of benefits for an individual under full retirement age. But additional years of wages/self-employment income could result in an increase in retirement benefits. See the complete discussion under How Work Affects Benefits below.

Late Retirement Some people continue to work full time beyond their full retirement age—and they don't sign up for Social Security until later. This delay in retirement can increase Social Security benefits in two ways:

Extra income usually will increase “average” earnings, and the higher the average earnings, the higher the Social Security benefit will be.

In addition, a special credit is given to people who delay retirement beyond their

full retirement age. This credit, which is a percentage added to one’s Social Security benefit, varies depending on date of birth. For people reaching full


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retirement age in 2007, the rate was 7.5 percent per year. That rate reached 8 percent per year for people reaching full retirement age in 2008 or later. This delayed retirement credit is no longer earned after age 70.

Chart of Delayed Retirement Credit Rates.

If you reached full retirement age... Then your monthly % is...and Your yearly % is...

Prior to 1982 1/12 of 1% 1% 1982-1989 1/4 of 1% 3% 1990-1991 7/24 of 1% 3.5% 1992-1993 1/3 of 1% 4% 1994-1995 3/8 of 1% 4.5% 1996-1997 5/12 of 1% 5% 1998-1999 11/24 of 1% 5.5% 2000-2001 1/2 of 1% 6% 2002-2003 13/24 of 1% 6.5% 2004-2005 7/12 of 1% 7% 2006-2007 5/8 of 1% 7.5% 2008 or later 2/3 of 1% 8%

How Work Affects Benefits

Individuals can receive Social Security retirement or survivors benefits and work at the same time. However, depending on age, benefits could be reduced if earnings exceed certain amounts. Note: A different set of rules applies to people receiving Social Security disability benefits or Supplemental Security Income (SSI) payments. They should report all earnings to Social Security. Also, a different set of rules applies to most work performed outside the United States. Under the foreign work test, monthly benefits are withheld for each calendar month that an individual (or a person entitled to benefits on that individual’s record) works:

Outside the U.S.; In work for pay not covered by Social Security; and For more than 45 hours.

What Are The Year 2015 Earnings Limits?

A law that went into effect January 1, 2000, changed the way Social Security determines how benefits are affected when an individual works while receiving retirement or survivors benefits. When working, a benefit amount will now be reduced only until the individual reaches full retirement age (age 66 in 2015), not up to age 70 as the previous law required.


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This formula determines how much the benefit must be reduced:

If under full retirement age when he or she begins receiving Social Security benefits, $1 in benefits will be deducted for each $2 earned above the annual limit. For 2015, that limit is $15,720.

In the year he or she reaches full retirement age, $1 in benefits will be deducted

for each $3 earned above a different limit, but only for the months before the month he or she reaches the full retirement age. For 2015, this limit is $41,880. Starting with the month full retirement age is reached, an individual can receive full benefits with no limit on earnings.

Planning Tip! If the taxpayer is under full retirement age, and his or her earned income for the year will exceed the sum of the following:

The annual earnings limit, plus 2 times taxpayer’s social security benefit for the year

the taxpayer will forfeit all benefits for the year.

Example. Sharon begins receiving Social Security benefits at age 62 in January 2015, and she’s entitled to $600 a month ($7,200 for the year). During the year, Sharon works and earns $20,000 ($4,270 over the $15,720 limit). $2,135 of Sharon’s Social Security benefits ($1 for every $2 over the limit) will be withheld, but she would still receive $5,065 in benefits. Or, let's say Sharon was age 65 at the beginning of the year, but reached full retirement age (66) in October 2015. She earned $43,080 in the nine months from January through September. During this period, the amount of benefits withheld would be $400 ($1 for every $3 earned above the $41,880 limit). Sharon would still receive $5,000 of her Social Security benefits through September. And, starting in October (when she reaches 66), Sharon would be entitled to keep her full benefits, no matter how much she earns.

Excess earnings are charged against and deducted from benefits. The deductions begin with the first chargeable month of the taxable year and continue each month until all excess earnings have been charged.

Work Can Increase Benefits Too

Any individual’s benefit amount may be recomputed (and increased) one or more times after the first computation. The first computation is made at the time he or she become entitled to retirement or disability insurance benefits. There is no need for a beneficiary to take any special action to have the benefit recomputed.


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The automatic recomputation gives an individual credit for any substantial additional covered earnings in the year he or she first became entitled to benefits or in a later year. A recomputation to include a particular year's earnings is effective in January following the year in which the earnings were paid. For example, a benefit increase resulting from an automatic recomputation to include 2014 earnings will first be paid for January 2015. The automatic recomputation also credits any earnings in the year that a retirement or disability insurance beneficiary dies. It is the same as above, except that it is effective with the month of death. Therefore, any resulting increase in the Primary Insurance Amount (PIA) is reflected in the amount of all monthly survivors' benefits, beginning with the first month of entitlement to survivors' benefits. A recomputation never decreases the PIA or benefits. However, an automatic recomputation can increase the PIA or benefits if earnings in the additional base year considered are higher than earnings in the lowest computation year used in the individual’s last computation or recomputation.

Social Security Changes Rule Revising Withdrawal Policy

On December 8, 2010, the Social Security Administration published final rules, effective immediately, that limit the time period for beneficiaries to withdraw an application for retirement benefits to within 12 months of the first month of entitlement and to one withdrawal per lifetime. In addition, beneficiaries entitled to retirement benefits may voluntarily suspend benefits only for the months beginning after the month in which the request is made. The agency is changing its withdrawal policy because recent media articles have promoted the use of the current policy as a means for retired beneficiaries to acquire an “interest-free loan.” However, this "free loan" costs the Social Security Trust Fund the use of money during the period the beneficiary is receiving benefits with the intent of later withdrawing the application and the interest earned on these funds. The processing of these withdrawal applications is also a poor use of the agency’s limited administrative resources in a time of fiscal austerity – resources that could be better used to serve the millions of Americans who need Social Security’s services.

Taxing Social Security Benefits

The rules for the taxation of Social Security benefits includes retirement benefits, survivor and auxiliary benefits, disability benefits and tier 1 railroad retirement benefits. They do not include supplemental security income (SSI) payments which are not taxable. According to IRC §86, in order to determine whether any benefits are taxable, compare the base amount (explained later) for the individual’s filing status with the total of:

One-half of the benefits, plus Modified Adjusted Gross Income.


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When making this comparison, modified adjusted gross income is AGI:

increased by the amount of interest received or accrued by the taxpayer during the taxable year which is exempt from tax (IRC §83(b)(2)(A))

and determined without regard to any exclusions for:

Interest from qualified U.S. savings bonds (§135), Employer-provided adoption benefits (§137), Interest paid on education loans (§221), Qualified tuition and expenses (§222), Foreign earned income or foreign housing (§911), or Income earned in Guam, American Samoa, the Northern Marianas (§931) or

Puerto Rico (§933) by bona fide residents.

Base Amount IRC §86(c)(1) defines the base amount as:

$25,000 for single, head of household, or qualifying widow(er), $25,000 for married filing separately and lived apart from spouse for all of the tax

year, $32,000 for married filing jointly, or $-0- for married filing separately and lived with spouse at any time during the tax

year. Generally, up to 50% of benefits are taxable. However, in the case of taxpayers whose modified adjusted gross income plus one-half benefits exceeds the following adjusted base amount, up to 85% of benefits may be taxable. Adjusted Base Amount IRC §86(c)(2) defines the adjusted base amount as: $34,000 for single, head of household, or qualifying widow(er), $34,000 for married filing separately and lived apart from spouse for all of the tax

year, $44,000 for married filing jointly, or $-0- for married filing separately and lived with spouse at any time during the tax

year. Who Is Taxed The person who has the legal right to receive the benefits must determine whether the benefits are taxable. For example, if a taxpayer and his or her child receive benefits, but the check for the child is made out in the name of the taxpayer, use only the taxpayer’s part of the benefits to see whether any benefits are taxable to him or her. One-half of the


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part that belongs to the child must be added to that child's other income to see whether any of those benefits are taxable to the child. Watch Out for the Thresholds The rules surrounding the thresholds for the taxation of Social Security benefits can surprise even experienced tax planners. Don’t overlook the affects certain life changes may have on your client’s social security. Required Minimum Distributions from Retirement Plans Reaching age 70-1/2 means clients must begin taking minimum amounts from their qualified plans, including IRAs. This change in income could be the catalyst for taxation (or increased taxation) of social security benefits.

Example. Sandra is a single taxpayer. In 2012 her income was the following: Taxable interest income $10,000 Non-taxable interest income 3,000 Social Security benefits 20,000 For 2012, none of her Social Security benefits were taxable. Her taxable income, after the standard deduction and personal exemption, -$1,200 – she has no filing requirement. Sandra turned 70-1/2 in 2013. She has been told she can wait to make the required minimum distribution from her IRA until April 1, 2014. She hasn’t been told that if she waits, she will have to take the equivalent of two minimum distributions in 2014. The fair market value of Sandra’s IRA was $50,000 on December 31, 2012. Her RMD for 2013 is $1,825. If the fair market value remains unchanged at December 31, 2013, her RMD for 2014 will be $1,887. Clearly, Sandra is in the lowest, 10% federal tax bracket. If she waits to take both distributions in 2014, she’ll still be in the 10% federal bracket. So why not wait? If Sandra waits to take both distributions in 2014, she will pay $235 more in federal tax, an effective rate of nearly 12.9% on her first RMD. Taking her distributions singly in each year would leave her modified adjusted gross income below the $25,000 threshold every year. Grouping two distributions together into 2014 raises her modified AGI to $26,712 causing $856 of her Social Security benefits to be taxable that year.


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Surviving Spouses Surviving spouses can run into surprises at tax time if their professionals have failed to plan for the year after death.

Example. Adam’s wife Eve died in 2012. For that tax year, Adam and Eve had the following income: Interest 3,000 Adam’s retirement plans 20,000 Adam’s Social Security benefit 12,000 Eve’s Social Security benefit 6,000 None of Adam and Eve’s social security income was taxable for 2012, and with a standard deduction and personal exemptions, their taxable income was $1,200 and their federal tax liability $121. However, for 2013 with all other income the same, Adam’s provisional income (modified AGI) makes $2,000 of his Social Security includible in gross income. Further, with only one personal exemption and the standard deduction, Adam’s taxable income for 2013 is $13,500 and his total federal tax liability $1,579.

Why Roth is Good What’s the difference between a distribution from a traditional IRA and a Roth? Modified Adjusted Gross Income – or, more importantly – taxation of Social Security benefits. Here’s a chance to help minimize or reduce taxation of benefits for your clients.

Example. Ron and Cindy want to discuss Ron’s retirement. He is currently 60 and plans to retire at age 65, in five years. In 2013, Ron will earn $85,000 wages and he and Cindy will have about $5,000 in interest income.

Ron and Cindy’s AGI for 2013 $90,000

When Ron retires in 2018, he will receive $20,000 per year in Social Security benefits, and Cindy’s annual benefit will be $10,000. They expect they will continue to earn $5,000 interest income, and Ron will receive a fixed monthly pension of $12,000 per year. With that total of $47,000, Ron and Cindy think they will need to withdraw an additional $12,000 per year from Ron’s IRA, the balance of which is currently $150,000. We recommend Ron and Cindy convert the IRA to a Roth this year. Because they pay tax on the total now, they will not include the distributions in income in 2018. As a result, modified AGI will be $32,000 ($15,000 + $12,000 + $5,000), and none of their social security benefits will be taxable.


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Medicare Part B Premiums

Upper-income seniors began paying considerably higher Medicare Part B premiums beginning in 2007. For 2015, taxpayers with a modified 2013 AGI exceeding $85,000 for single, or $170,000 for married filing joint, pay an income-related monthly adjustment for their Medicare Part B premiums.

Modified AGI for this purpose is 2013 federal AGI plus:

Tax-exempt interest;

Excluded savings bond interest used to pay for educational expenses;

Excluded foreign-earned income;

Income derived from sources within Guam, American Samoa, or the Northern Mariana Islands; and

Income from sources in Puerto Rico (20 CFR Part 418, §418.1010).

Taxpayers who file as head of household or qualifying widow or widower will be treated as single for purposes of the Medicare premium surcharge.

A taxpayer who files an amended tax return that reduces federal AGI may request a re-determination from SSA of the surcharge amount. Also, the law provides for re-determination based on a major life-changing event.

2015 If Your 2013 Income was

Single Married Couple

$104.90 $85,000 or less $170,000 or less

$146.90 $85,001-$107,000 $170,001-$214,000

$209.80 $107,001-$160,000 $214,001-$320,000

$272.70 $160,001-$214,000 $320,001-$428,000

$335.70 Above $214,000 Above $428,000

You Pay If You Are Married but You File a Separate Tax Return From Your Spouse and Your 2013 Income was

$104.90 Under $85,000 or less

$272.70 $85,001-$129,000

$335.70 Above $129,000


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Here are some additional key points:

The additional premium is due even if the beneficiary did not sign up for prescription drug coverage.

The provision that limits Medicare premium increases to the amount of Social Security (or Tier 1 railroad retirement) cost-of-living adjustments does not apply.

The IRS will provide information to the Social Security Administration (SSA) for purposes of determining the surcharge (IRC §6103(1)(10)).

Married couples

Because the surcharge applies to each premium, a married couple will actually pay double the surcharge if both are Medicare beneficiaries.

Example. Sharon and Vern are married and both have Medicare. Their 2013 income is as follows:

Pension $100,000 Social Security $22,000 Tax-exempt interest $30,000 Rental income $40,000 Their federal AGI is $158,700. However, their modified AGI for purposes of the Medicare surcharge is $188,700. Their surcharge is 160.00%, which is applied to each of their premiums. So, in effect, their additional cost will be $335.60 × 12 months, or $4,027.20 per year based on 2015 Medicare premiums. The SSA will determine which beneficiaries are subject to the increased premiums based on information provided by the beneficiary and the IRS. Affected beneficiaries will receive a letter notifying them of the adjustment at the end of each year. The letter will explain the additional amount of their Medicare Part B premium and any related changes in the amount of their monthly Social Security benefits (or railroad retirement or civil service annuity payments). If a beneficiary disagrees with the SSA’s determination or would like to request a re-determination based on a later year because of changed circumstances (death of spouse, retirement, divorce, etc.), he or she will have 60 days after the receipt of the notice to appeal the initial determination. Use Form SSA-44 Medicare Part B Income-Related Premium - Life-Changing Event to request a redetermination.

Planning around Medicare Part B Premiums

Tax planning will affect the Medicare premium. The rate of return of tax-exempt income will decrease for higher-income taxpayers. Tax-exempt interest already increases AGI for


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purposes of Social Security taxability, and now tax-exempt interest can also push a client into a higher Medicare premium. In an extreme example, a single taxpayer with $100 of tax-exempt interest could be pushed up a Medicare surcharge bracket, which will wipe out that income.

Example. Brad has federal AGI of $213,950 in 2013. He also had $100 in tax-exempt interest on a bond he purchased late in the year. His Medicare premium was $104.90 per month in 2014. Because his modified AGI for purposes of the Medicare surcharge is $214,050 his premium surcharge is $230.80 per month, or $2,769.60 per year. His net return on the bond is $100.00! Without the bond income, his surcharge would only be $167.80 per month, or $2,013.60 per year. So, the bond is creating a $756.00 annual surcharge increase. The cliff thresholds make tax planning to those levels an important part of the plan. While it is difficult to hit an exact income figure in tax planning, hitting the target is more important now than ever. Some planning pointers:

Remember to reduce tax-exempt income by amortized premiums paid on purchases

Restructure portfolio to invest in tax-deferred growth Consider installment sales to reduce AGI Roth IRAs become more valuable in retirement because distributions are not

included in Modified AGI Make contributions to qualified charities directly from IRAs for individuals age

70 1/2 or more

Adjustments to Income

Qualified State Tuition Programs §529

The estate and gift tax rules applying to educational IRAs also apply to contributions to qualified tuition programs. Contributions to a qualified tuition program will be treated as a completed gift of a present interest from the contributor to the beneficiary at the time of the contribution. Annual contributions are eligible for the present law gift tax exclusion provided by §2503(b) and also are excludable for purposes of the generation skipping transfer tax (provided that the contribution, when combined with any other contributions made by the donor to that same beneficiary, does not exceed the annual gift tax exclusion limit of $14,000, or $28,000 in the case of a married couple for 2015. For more information, see: www.collegesavings.org and www.savingforcollege.com


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Special rule for contributions exceeding $14,000/$28,000 limit ($70,000/$140,000 for 5-year gift). If a contribution in excess of $14,000 ($28,000 in the case of a married couple) is made in one year, the contributor may elect to have the contribution treated as if made ratably over five years beginning in the year the contribution is made. Example. A $30,000 contribution to a qualified tuition program would be treated as five annual contributions of $6,000. The donor could therefore make up to $8,000 in other transfers to the beneficiary each year without payment of gift tax. Under this rule, a donor may contribute up to $70,000 every five years ($140,000 in the case of a married couple) with no gift tax consequences, assuming no other gifts are made from the donor to the beneficiary in the five-year period. A gift tax return must be filed with respect to any contribution in excess of the annual gift-tax exclusion limit, and the election for five-year averaging must be made on the contributor's gift tax return. If a donor making an over $14,000 contribution dies during the five-year averaging period, the portion of the contribution that has not been allocated to the years prior to death is includable in the donor's estate. Example. If a donor makes a $40,000 contribution, elects to treat the transfer as being made over a five-year period, and dies the following year, $8,000 would be allocated to the year of contribution, another $8,000 would be allocated to the year of death, and the remaining $24,000 would be includable in the estate. Losses in the §529 plan account. The §529 plan was enacted to allow a parent, grandparent or other donor to open a college savings account for a beneficiary. Income from the account is currently deferred and becomes tax free if the funds are used for the beneficiary’s college expenses. But §529 accounts have suffered the same losses as other stock accounts. The question is whether losses are deductible if the §529 account balance has dropped below the donor’s contributions? While the IRS has not provided an answer to this question, you can find some guidance at www.savingforcollege.com. It seems that if the donor closes the §529 plan for the beneficiary, losses can be deducted, but they are Schedule A miscellaneous itemized deduction subject to 2% of AGI limitations and, of course, the AMT preference impact. Computer Technology and Equipment Added to Qualified Higher Education Expense for §529 Plan. For §529 purposes, ARRA 2009 expanded the definition of qualified higher education expenses for expenses paid or incurred in 2009 and 2010 to include expenses for certain computer technology and equipment to be used by the designated beneficiary while enrolled at an eligible educational institution.


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In addition to computer equipment, qualified higher education expenses include tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a designated beneficiary at an eligible educational institution, and expenses for special needs services in the case of a special needs beneficiary that are incurred in connection with such enrollment or attendance. Qualified higher education expenses generally also include room and board for students who are enrolled at least half-time (§529(e)(3)(A)(iii)).

Coverdell Educational Savings Accounts §530

Annual contribution limit is $2,000. Aggregate contributions that may be made by all contributors to one (or more) Coverdell Educational Savings Accounts established on behalf of any particular beneficiary is limited to $2,000 for each year. Phase-out of contribution limit – marriage penalty eliminated. The phase-out range for married taxpayers filing a joint return is $190,000 to $220,000 of modified adjusted gross income, twice the range for single taxpayers.

Phaseout Single $95,000- $110,000 Married filing joint $190,000- $220,000


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Deduction Planning

Bunching Strategies Bunching has to do with certain expenses that are only deductible once they exceed a floor. For example, medical expenses are deductible to the extent they are greater than 7-1/2 percent of Adjusted Gross Income. Miscellaneous itemized deductions become deductible when they exceed 2 percent of AGI. If significant expenses in these areas have already been incurred this year such that the floor has been met, or very nearly met, then additional expenses that your client may be delaying until next year should be accelerated into the current year. Clients who wait may not exceed the floor for either year, thus losing any deductibility. Moreover, if your client is experiencing an especially high-income year that will not repeat next year, delaying some expenses and “bunching” them into the subsequent year may allow him/her to deduct them then.

Example. Sal, a single taxpayer, expects his Adjusted Gross Income to be about $50,000 this year. At his regularly scheduled dentist’s appointment in November, he was told he needs major dental work which will take about three months to complete. The total estimated cost will be $5,100 and his dentist has very helpfully suggested that he can pay that in three easy installments beginning in December. But you, as Sal’s tax advisor, suggest the following alternatives: Sal pays in full in December for the dental work Sal pays in three easy installments, but begins the work in January

Bunching strategies also involve accelerating certain deductible expenses into a high income year. Examples are real estate property taxes, state income taxes and charitable contributions. We’ll examine each of these more completely in other sections.

Tax Payments The most conventional of all tax planning strategies involves pre-paying state income taxes, and in some cases, real estate property taxes. Even the beginning tax planner knows that the danger of these strategies is the dreaded Alternative Minimum Tax. But for many tax payers, failing to prepay state income taxes could mean an AMT hit the following year. And even if it doesn’t, failing to prepay state income taxes in a high income year could move the deduction into a lower marginal tax rate year, making it less beneficial overall.


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Example. Midge is the executive vice president of Schmidt, Inc. and is responsible for sales and marketing. For 2015 Schmidt had a remarkably good year in sales, and Midge will receive a special, one-time-only bonus of $50,000. This is in addition to her regular salary of $95,000 from which Midge withholds $16,800 federal and $5,980 California taxes. Midge’s only other itemized deduction is charitable contributions of $1,500, and her regular withholding covers her federal and state tax liability each year. The extra income in 2015 is almost fully taxed at 28% because Midge’s taxable income without the bonus is typically just at the top of the 25% bracket. If Midge fails to prepay her extra California taxes of $4,650 in 2015, she will lose the benefit of deducting them at 28%, and receive only a 25% tax benefit when they are paid in 2016.

Mortgage Interest Generally home mortgage interest is any interest paid on a loan secured by a taxpayer’s home (main home or a second home). The loan may be a mortgage to buy the home, a second mortgage, a line of credit, or a home equity loan. Deduct home mortgage interest only if the taxpayer meets all the following conditions.

Files Form 1040 and itemizes deductions on Schedule A (Form 1040).

Taxpayer must be legally liable for the loan. Do not deduct payments made for someone else if the taxpayer is not legally liable to make them. Both the taxpayer and the lender must intend that the loan be repaid. In addition, there must be a true debtor-creditor relationship between the taxpayer and the lender.

The mortgage must be a secured debt on a qualified home. “Secured debt” and

“qualified home” are explained later.

Secured Debt

Deduct home mortgage interest only if the mortgage is a secured debt. A secured debt is one in which there exists a signed instrument (such as a mortgage, deed of trust, or land contract) that:

1) Makes the taxpayer’s ownership in a qualified home security for payment of the debt,

2) Provides, in case of default, that the home could satisfy the debt, and

3) Is recorded or is otherwise perfected under any state or local law that applies.

(Reg. §1.163-10T(o)(1)) In other words, a mortgage is a secured debt if the taxpayer put his/her home up as


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collateral to protect the interests of the lender. If he or she cannot pay the debt, the home can then serve as payment to the lender to satisfy (pay) the debt.

A debt will not be considered to be secured by a qualified residence if it is secured solely by virtue of a lien upon the general assets of the taxpayer or by a security interest, such as a mechanic’s lien or judgment lien, that attaches to the property without the consent of the debtor.

For our purposes here, mortgage will refer to secured debt.

Collateral Must Be Correct

The specific security requirement compels the correct property be pledged as collateral against the loan. Peter and Mary Boehme were not entitled to deduct interest payments paid in connection with a loan secured by their right to twelve annual lottery payments because the interest was personal in nature. Boehmes’ argument that the interest was qualified residence interest was rejected although the proceeds from the loan were used for improvements to the couple’s home, the residence was not used as collateral for the loan as required under §163(h)(3)(B)(i)(II) (Boehme vs. Commissioner, T.C. Memo. 2003-81). Then there’s the case, as reported by the Wall Street Journal in 2002, of former presidential chief of staff John Sununu who purchased a home in Georgetown by borrowing $400,000 secured by his New Hampshire home. Is this common? Of course. Taxpayers buy vacation homes with loans secured by their primary residences. They borrow out of rental properties to buy second homes. Or, in the case of the Boehmes above, they use other collateral to borrow proceeds to improve their principal residence. All bad planning! All result in zero deduction!

Choice to Treat the Debt as Not Secured by Home

A taxpayer may choose to treat any debt secured by a qualified home as not secured by the home. This treatment begins with the tax year for which the choice is made and continues for all later tax years. The election may be revoked only with the consent of the Internal Revenue Service. Why do this? Consider treating a debt as not secured by the taxpayer’s home if the interest on that debt is fully deductible (for example, as a business expense) whether or not it qualifies as home mortgage interest. This may allow, if other home mortgage limits apply, more of a deduction for interest on other debts that are deductible only as home mortgage interest (Reg. §1.163-10T(o)(5)).


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Example. Joe owns a principal residence with a fair market value of $375,000

and an adjusted purchase price of $240,000. In 2003, debt A, the proceeds of which were used to purchase the residence, has an average balance of $215,000. The proceeds of debt B, which is secured by a second mortgage on the property, are allocable to Joe’s trade or business under §1.163-8T and has an average balance of $95,000.

In 2004, Joe incurs debt C, which is also secured by Joe’s principal residence and

which has an average balance of $50,000. In the absence of an election to treat debt B as unsecured, Joe’s total mortgages would exceed his acquisition debt ($215,000) plus the allowable $100,000 equity loan. In that case $45,000 of the new debt C would be not deductible.

The “10-T” Election

The election to treat debt as not secured by the taxpayer’s qualified home should be made in writing.

Sample Election Statement Under Reg. Sec. 1.163-10T(o)(5)

Taxpayer Name: Joe Client Social Security Number: 999-99-9999 Form: 1040 Tax Year Ending: 12/31/08 The taxpayer elects to treat $95,000 of home equity debt, the proceeds of which were used to purchase equipment and supplies for his business, as trade or business debt. The interest on this debt for the tax year was $6,175 and is reported on Line 16b of Schedule C. What if I Failed to Attach the Election in Writing? Michael D. and Christine R. Alexander incurred credit card debt to purchase equipment for their tree farm. The credit card debt was allocable to a trade or business expenditure (§1.163-8T(b)(7) and (c)(1)). Subsequently, the Alexanders took out a home equity loan, secured by their main home, and used the proceeds to pay off the credit card debt. The temporary regulations provide that to the extent proceeds of any debt (the “replacement debt”) are used to repay any portion of a previously existing debt, the replacement debt is allocated to the expenditures to which the repaid debt was allocated (§1.163-8T(e)(1)). Mr. Alexander credibly testified that he used the proceeds from the home equity loan to repay the credit card debt. The home equity loan was ruled by the tax court to be “replacement debt” and the interest accruing thereon was properly


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allocable to a trade or business expenditure even though the Alexanders did not attach a written election to their returns (Alexander v. Commissioner, T.C. Summary Opinion 2006-127). New Chief Counsel Advice Changes Way Election to Trace Home Equity Borrowing Works (CCA 201201017) The Chief Counsel Advice clarifies that if an election is made, the entire proceeds of the refinance must be traced to and treated as business, rental or other deductible interest rather than qualified residence interest. If an election is not made, the proceeds are first considered equity borrowing and only the amounts over the $100,000 debt equity limit can be traced.

News. In the past, we thought that if an election was not made, the interest above the $100,000 equity borrowing amount would be considered personal interest. The CCA clarifies that the interest is directly traced according to the general interest tracing rules in §1.163-8(T). But the CCA also contains a potential trap with the use of the wording “entire proceeds” as illustrated in the third example.

Example. Sharon borrows $150,000 from her home’s equity and deposits the proceeds into her business account to pay business bills. She does not include an election under §1.163-10T(o)(5) with her Form 1040. Sharon must allocate interest to Schedule A as home equity borrowing to the extent of $100,000 (assuming she has not already borrowed from her house). The balance of interest can be traced to her Schedule C and deducted as a business interest expense.

Example. Sharon borrows $150,000 from her home’s equity and deposits the proceeds into her business account to pay business bills. She includes an election under §1.163-10T(o)(5) with her Form 1040. Sharon can deduct interest on the entire $150,000 loan as business interest expense.

Example. Sharon borrows $50,000 from her home’s equity and deposits $30,000 into her business account to pay business bills and uses the remaining $20,000 to pay personal credit card debt. She includes an election under §1.163-10T(o)(5) with her Form 1040. The interest on 3/5's of the loan are deductible as business interest expense. But, the interest on 2/5's of the loan is no longer deductible, not even as home equity debt because the §1.163-10T(o)(5) election out applies to the entire proceeds. Interest on debt used personally is not deductible at all. And the election is an all or nothing election. It would have been much smarter for her to have taken out two separate loans.


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Planning point. Failing to make an election may be to the taxpayer’s advantage if the proceeds are used to buy a rental (and if the client is not in AMT). Since passive rules can often suspend any rental loss, Schedule A interest deduction may result in lower current tax.

Collateral Chart

Collateral Proceeds Used to: Deductible? Main Home 1. Buy, build or improve main home up to $1 million

2. Any other purpose up to $100,000 3. Buy, build, or improve 2nd home1 4. Buy, build, improve or expenses of rental property 5. In trade or business 6. Make taxable investment2

1. Yes. Sch A Mortgage 2. Yes. Sch A Equity 3. Maybe. Sch A Equity 4. Yes. Sch E w/ 10-T 5. Yes. Sch C w/ 10-T 6. Yes. Sch A w/ 10-T

Second Home 1. Buy, build or improve main home up to $1 million 2. Any other purpose up to $100,000 3. Buy, build or improve 2nd home1 4. Buy, build, improve or expenses of rental property 5. In trade or business 6. Make taxable investment2

1. Maybe. Sch A Equity 2. Yes. Sch A Equity 3. Yes. Sch A Mortgage 4. Yes. Sch E w/ 10-T 5. Yes. Sch C w/ 10-T 6. Yes. Sch A w/ 10-T

Rental House 1. Buy, build or improve main home up to $1 million 2. Any other purpose up to $100,000 3. Buy, build or improve 2nd home1 4. Buy, build, improve or expenses of rental property 5. In trade or business 6. Make taxable investment2

1. No. 2. No. 3. No. 4. Yes. Sch E 5. Yes. Sch C tracing 6. Yes. Sch A tracing

Any other 1. Buy, build or improve main home up to $1 million 2. Any other purpose up to $100,000 3. Buy, build or improve 2nd home1 4. Buy, build, improve or expenses of rental property 5. In trade or business 6. Make taxable investment2

1. No. 2. No. 3. No. 4. Yes. Sch E 5. Yes. Sch C tracing 6. Yes. Sch A tracing

Is Acquisition Debt Allocated Per Person or Per Property?

IRS says $1 million limit applies per property, not per taxpayer (Rev. Rul. 2010-25; PLR 200911007). Although the IRS ruling never addresses whether the mortgage is actually acquisition indebtedness, it does state that under §163(h)(3)(B)(i), acquisition indebtedness is defined, in relevant part, as indebtedness incurred in acquiring a qualified residence of the taxpayer – not as indebtedness incurred in acquiring taxpayer’s portion of a qualified residence. The entire amount of indebtedness incurred in acquiring the qualified residence constituted “acquisition indebtedness” under §163(h)(3)(A)(i). In this case, the amount of indebtedness incurred in acquiring the property exceeded $1,000,000. However, under §163(h)(3)(B)(ii), the amount treated as acquisition indebtedness for purposes of the

1 Not over $1 million combined main and second home. 2 Subject to investment interest expense limitations.


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qualified residence interest deduction was limited to $1,000,000 of total, “aggregate” acquisition indebtedness. The IRS believes this was evident from the parenthetical in §163(h)(3)(B)(ii) which limits the aggregate treated as acquisition indebtedness to $500,000 for a married taxpayer filing a separate return. Co-owners Limited to Interest Paid on $1.1 Million Acquisition & Equity Debt. Home mortgage limits apply on a per residence basis not per taxpayer. Charles Sophy and Bruce Voss purchased a home together in Beverly Hills. The qualified home acquisition indebtedness was $2,000,000. Additionally, they had a $300,000 home equity line of credit on a Beverly Hills home and owned a second home in Rancho Mirage with a mortgage of $500,000. In 2006, the outstanding balances of their mortgages was $2,703,568. Filing as two single taxpayers, Sophy and Voss each deducted the interest paid on mortgages of $1.1 million. The IRS argued that the home mortgage interest deduction on both returns could not exceed the interest paid on $1.1 million of acquisition and home equity debt. The excess amount was not deductible. The Court ruled that the $1,000,000 acquisition indebtedness and the $100,000 home equity borrowing limitations in §163(h)(3)(B)(ii) and (c)(ii) are applied on a per residence, not a per taxpayer, basis and limited the interest deductions for Sophy and Voss to the interest paid on the first $1.1 million (Charles J. Sophy v. Comm., Bruce H. Voss v. Comm., 138 TC No. 8, Mar. 5, 2012). Comment. The Tax Court first applied the $1,100,000 debt limit and then divided it between the co-owners based on each co-owner’s actual payment schedule (see Rev. Rul. 71-269, Powell v. Comm. TCM 1967-32). The interest would generally be divided based on each owner’s ownership percentage if paid out of community property funds or from another jointly-owned account.

Example. On January 1, 2012, Nancy and David, an unmarried couple, paid $400,000 for a principal residence as co-owners. The interest paid by each would be fully deductible (no limit) as qualified residence acquisition debt because the total was below the limit.

Note. The mortgage interest limits are cut in half for those filing married filing separate regardless of whether or not the other spouse is claiming any mortgage interest deduction (see: Faina Bronstein v. Comm., 138 TC No. 21, Dkt 24168-10, May 17, 2012)

Example. Paula, who is married to Larry, obtained as $1 million mortgage to purchase her residence. Paula filed a married filing separate return. Even though Larry does not deduct any mortgage interest on his married filing separate return, Paula may only include $500,000 or mortgage debt to calculate her mortgage interest deduction. Whether the mortgage interest is claimed by the other spouse has no impact on the limitations that result when a married filing separate return is filed.


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Charitable Contribution Planning Whether you make a charitable contribution in the form of cash or in the form of property can change the amount of the deduction to which you are entitled. In the case of cash, you may deduct the amount of cash you donated less any benefit you received for the contribution. For example, if you paid $100 for a ticket to a charity dinner and the value of the dinner was $25, you may deduct $75 as your charitable donation. The amount you may deduct for a charitable contribution of appreciated property depends on whether it is ordinary income property or capital gain property, or a combination of both. For ordinary income property, your deduction is limited to basis. This includes inventory property, artworks and manuscripts created by you and capital assets held less than the long-term capital gains holding period. For appreciated capital gain property held for the long-term holding period, you may generally deduct the fair market value of the property on the date of the gift. For publicly trade stock, determine the fair market value by finding the mean between the high and low trading prices of the stock on the date of contribution. Gifts of appreciated property donated to certain private foundations are limited to a deduction for basis only.

Required Documentation for Charitable Deductions Chart (Summertime Tax Tip 2009-21)

Amount Required records

C

A S H

Single cash contribution of less than $250 Cancelled check, bank record, credit card statement or written acknowledgment from the charity. §170(f)(17) ; IR-2006-192

Single cash contribution of $250 or more Written acknowledgment from the charity.§170(e)(8)

Payroll Deduction Pledge card and W-2, paystub, etc. §1.170A-13(c); Notice 2008-16

N O N C A S H

Non-cash contributions less than $250 Written acknowledgment from the charity or other reliable record. §1.170A-13(b)(1)

Non-cash contribution of $250 but not more than $500

Written acknowledgment from the charity. §1.170A-13(b)(3)

Non-cash contribution over $500 but not more than $5,000 §170(e)(12)

Written acknowledgment from the charity and form 8283, part A. §1.170A-13(b)(3)

Non-cash contribution of over $5,000 of similar items

Written acknowledgment from the charity, appraisal and form 8283, part B. §170(f)(11)(c)

Non-cash contribution of more than $500,000

Written acknowledgment from the charity, appraisal and form 8283, part B. Attach appraisal to the return. §170(f)(11)(D)


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Required Documentation for Charitable Deductions Chart (Summertime Tax Tip 2009-21)

Amount Required records

O T H E R G I F T

Non-cash contribution of auto, boat or airplane with a value of more than $500

Written acknowledgment from the charity. Attach form 1098-C and form 8283 to return. §170(e)(11)(c); IR-2006-172

Non-cash contribution of publicly traded stock

Written acknowledgment from the charity and form 8283, part A. §1.170A-13 (c)(7)(xi)(B)

Non-cash contribution of privately traded stock of more than $5,000

Written acknowledgment from the charity, and form 8283 part B. If the privately traded stock is valued at $10,000 or more, attach an appraisal to the return. §1.170A-13 (c)(2)(ii)(B)(1)

Non-cash contribution of art valued at more than $20,000

Written acknowledgment from the charity, appraisal, form 8283, part B. Appraisal and a photo of the art must be attached to the return. Rev. Proc. 96-15.

The written acknowledgment must be received from the charity before the due date of the return (including extensions), and it must include a statement regarding goods and services received in exchange for the contribution.

Donor Advised Funds

Certain taxpayers may benefit from larger contributions in years of higher income. However, these same taxpayers may not be able to identify a charity or charities they want to receive such a large sum, or taxpayer may want the charity to receive smaller gifts over time. For these clients examine the Donor Advised Funds operated by most brokerage houses, mutual funds and Community Foundations.

With these funds, the taxpayer receives a charitable deduction for the year in which he or she contributes to the fund. Subsequently, gifts are made out of the fund on the timing and in the amounts specified by the donor. Donations made from the fund are not deductible in the year in which they are made, rather the donor will have already deducted his/her donation.

Example. Bill received a large severance payment from terminating his employment this year. As a result, he expects to be in the highest 35% tax bracket for this year only. Prior and subsequent years should return him to his usual 28% bracket. Bill receives solicitations several times a year from his alma mater, State University, and he would like to make a gift to the school. However, Bill knows that if he gives the college $50,000 this year, they will expect and request a similar amount next year. Instead, Bill funds a Charitable Gift Fund through his discount broker in the amount of $50,000. He can now deduct the full amount this year but have the fund make annual distributions to State U in smaller increments of $5,000 each year.


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Furthermore, if Bill in the above example had funded his gift fund with appreciated assets, such as stock, he would have avoided paying tax on the gain on the assets as well as achieving a charitable deduction for the year of transfer.

Charitable Remainder Trusts

In the case of an individual who is charitably-minded but may have cash flow problems associated with large holdings in highly appreciated, non-income producing assets, the answer might by a Charitable Remainder Trust. A CRT can provide a guaranteed income stream to the grantor as well as a charitable contribution deduction and avoidance of capital gains recognition. Charitable remainder trusts come in two types: the annuity trust and the unitrust. Both of these are irrevocable. The basic rules for CRTs stipulate that a fixed percentage (not less than 5% and not more than 50%) of the net fair market value of the trust’s assets must be paid annually to one or more named beneficiaries for a term of years (no more than 20) or for life. No other payments can be made to any person other than a qualifying charity, and the remainder interest must be transferred to a qualifying charity at the end of the income payment period. Upon establishing a charitable remainder trust, the grantor may claim a charitable contribution deduction for the fair market value of the remainder interest in the property transferred into the trust.

Example. Mary and John Jones had property with a cost basis for tax purposes of $40,000. The property has increased in value such that it is worth $200,000 today. If Mary and John sell the property, they will incur a capital gain of $160,000. If they donate the property to a charity which establishes a Charitable Remainder Annuity Trust for their benefit, Mary and John create an income tax deduction of $98,885 based on federal tax tables that consider their ages and the amount of the gift.

Mary and John choose a 6% rate of return, which means a $12,000 annual income for the rest of their lives. The Trust will be revalued annually, and they will receive this fixed rate of income as long as there are sufficient assets in the trust. At their deaths, the remainder of the trust assets go to the charity they chose. Their estimated income will be $188,400 over 15.7 years for an effective rate of return of 7.09%. If the trust earns 8% on the assets and pays the 6% fixed rate to Mary and John, the assets will increase. After both Mary and John have died, the trust passes without probate to the charity, and the estimated total gift amount based on our assumptions will be $296,860.


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Charitably Minded IRA Owners Waiting for Extender for 2015

Through 2014, an IRA owner, age 70 ½ or over, can directly transfer tax-free, up to $100,000 per year to an eligible charitable organization. This provides an exclusion from gross income for otherwise taxable IRA distributions from a traditional or a Roth IRA in the case of qualified charitable distributions. This option became available in tax year 2006 and has been extended several times by Congress. Eligible IRA owners can take advantage of this provision, regardless of whether they itemize their deductions. Distributions from employer-sponsored retirement plans, including SIMPLE IRAs and simplified employee pension (SEP) plans are not eligible. To qualify, the funds must be contributed directly by the IRA trustee to the eligible charity. Amounts so transferred are not taxable, and no deduction is available for the amount given to the charity. Not all charities are eligible under this provision. For example, donor-advised funds and supporting organizations are not eligible recipients. Transferred amounts are counted in determining whether the owner has met the IRA’s required minimum distribution rules. Where individuals have made nondeductible contributions to their traditional IRAs, a special rule treats transferred amounts as coming first from taxable funds, instead of proportionately from taxable and nontaxable funds, as would be the case with regular distributions. Substantiation Rules Apply This exclusion applies only if a charitable contribution deduction for the entire distribution otherwise would be allowable (under present law), determined without regard to the generally applicable percentage limitations. Thus, for example, if the deductible amount is reduced because of a benefit received in exchange, or if a deduction is not allowable because the donor did not obtain sufficient substantiation, the exclusion is not available with respect to any part of the IRA distribution. IRA that Contains Non-Deductible Contributions If the IRA owner has any IRA that includes nondeductible contributions, a special rule applies in determining the portion of a distribution that is includible in gross income (but for the provision) and thus is eligible for qualified charitable distribution treatment. Under the special rule, the distribution is treated as consisting of income first, up to the aggregate amount that would be includible in gross income (but for the provision) if the aggregate balance of all IRAs having the same owner were distributed during the same year. In determining the amount of subsequent IRA distributions includible in income, proper adjustments are to be made to reflect the amount treated as a qualified charitable distribution under the special rule.


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IRA Distributions Are Not Part of Tax Return Contributions Distributions that are excluded from gross income by reason of the provision are not taken into account in determining the deduction for charitable contributions under §170. Thus the taxpayer avoids the AGI percentage limits.

Example 1. Sharon, who is age 71 (although she looks 39), has a traditional IRA

with a balance of $100,000, consisting solely of deductible contributions and earnings. Sharon has no other IRAs. The entire IRA balance is distributed to the YMCA building fund. Under present law, the entire distribution of $100,000 would be includible in Sharon's income. Under the law, the entire distribution of $100,000 is a qualified charitable distribution. As a result, no amount is included in Sharon's income as a result of the distribution and the distribution is not taken into account in determining the amount of Sharon's charitable deduction for the year.

Example 2. Vern, who is 80 (although he looks 85), has an IRA consisting solely of deductible contributions and earnings. He contributes $5,000 each year to his church. But, because he and his wife take the standard deduction, he gets no tax benefit. Vern's required minimum distribution is $5,000. Assuming he is in the 28% tax bracket, if he takes the $5,000 out of his IRA and writes a check to his church, he will pay $1,400 tax ($5,000 times 28%) but will have no charitable deduction. By requesting the IRA trustee to send a check directly from his IRA to his church, he saves $1,400.

Planning Contributions from IRAs

Non-itemizers get full benefit for the contribution and the full benefit of the standard deduction!

Since the IRA distribution made to a charity is not included in the taxpayer’s taxable income, the many AGI related phaseouts are minimized. For example, the client does not experience

o a phaseout of itemized deductions, o a 50% charitable contribution base limitation, or o an increase in the amount of social security benefits taxable as he or she

would under prior law if the IRA distribution is included in AGI and then the amount paid over to the charity is deducted on his or her schedule A.

Taxpayers will have to rethink the source of large charitable contributions during their lifetime. Perhaps the gift from an IRA will be a better choice than the gift of appreciated stock. Since the IRA produces income in respect of a decedent at the death of the account owner, leaving stock rather than the IRA may result in less tax to the beneficiary.

Distributions to donor advised funds, private foundations, charitable remainder trusts, and gift annuities do not qualify for this provision.

Distributions from a retirement plan do not qualify for this provision.


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Since the IRA distribution made to a charity is not included in the taxpayer’s AGI, the medicare B premium surcharge may be reduced if an IRA transfer is made directly to the charity. Note! Will this provision be extended beyond 2014?

Gambling Losses Income derived from wagering transactions is includible in gross income under the provisions of section 61 of the Internal Revenue Code of 1954. Losses from wagering transactions are allowable only to the extent of gains from such transactions, under section 165(d) of the Code, and may be claimed only as an itemized deduction.

Recordkeeping Regarding Wagering Winnings and Losses (Rev. Proc. 77-29)

General recordkeeping rules. Rev. Proc. 77-29 provides guidelines regarding the responsibility for maintaining adequate records to support wagering winnings and losses. These recordkeeping suggestions are intended as general guidelines to assist taxpayers in establishing their reportable gambling gains and deductible gambling losses. While following these will enable most taxpayers to meet their obligations under the Internal Revenue Code, these guidelines cannot be all inclusive, and the tax liability of each depends on the facts and circumstances of particular situations (Rev. Proc. 77-29, Sec. 4). An accurate diary or similar record regularly maintained by the taxpayer, supplemented by verifiable documentation will usually be acceptable evidence for substantiation of wagering winnings and losses. In general, the diary should contain at least the following information: 1. Date and type of specific wager or wagering activity; 2. Name of gambling establishment; 3. Address or location of gambling establishment; 4. Name(s) of other person(s) (if any) present with taxpayer at gambling

establishment; and 5. Amount(s) won or lost (Rev. Proc. 77-29, Sec. 3). Verifiable documentation for gambling transactions includes but is not limited to Forms W-2G; Forms 5754, Statement by Person Receiving Gambling Winnings, wagering tickets, canceled checks, credit records, bank withdrawals, and statements of actual winnings or payment slips provided to the taxpayer by the gambling establishment. Where possible, the diary and available documentation generated with the placement and settlement of a wager should be further supported by other documentation of the taxpayer's wagering activity or visit to a gambling establishment. Such documentation includes, but is not limited to, hotel bills, airline tickets, gasoline credit cards, canceled checks, credit records, bank deposits, and bank withdrawals. Additional supporting evidence could also include affidavits or testimony from responsible gambling officials regarding wagering activity.


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Requirements to Become a Professional Gambler

Professionals deduct losses “above the line” whereas nonprofessionals get stuck with “below-the-line.” If a taxpayer is engaged in a trade or business of gambling, wagering losses, to the extent deductible under §165(d), are deducted in computing adjusted gross income (see §62). On the other hand, if the taxpayer is not in a trade or business of gambling, wagering losses, to the extent deductible under §165(d), are deductible as an itemized deduction in the computation of taxable income. So what must a gambler do to reach the level of being a professional? For gambling to reach the level of a trade or business activity it must be "pursued full time, in good faith, and with regularity, for the production of income for a livelihood, and * * * not a mere hobby" (Comm. v. Groetzinger, 480 U.S. 23, 35 (1987)). The Supreme Court, in Groetzinger, held that a taxpayer who spent between 60 and 80 hours per week at dog races qualified as a professional gambler even though the taxpayer received income during the year from interest, dividends, capital gains and salary earned before his job was terminated. Likewise, a taxpayer who spent 35 hours a week at a horse track after losing his job as a salesman and who was seeking a new sales job (where, at the track?) qualified as a professional gambler for purposes of §162 (Rusnak v. Comm., TCM 1987-249). A truck driver who averaged 40 hours per week betting on horse races at Yonkers Raceway and who prepared his own detailed “speed figures” also qualified as a professional gambler (James Castagnetta v. Comm., TCS 2006-24). Most gamblers are not professional. In most cases, though, the taxpayer is unsuccessful in convincing the court the taxpayer has a bona fide intent of making a profit (e.g., Jose Calvao v. Comm., TCM 2007-57, slot machine player with $132,000 of W-2G’s failed to convince court he wasn’t gambling for recreational and entertainment purposes; Pansy V. Panages v. Comm., TCS 2005-3, a full-time florist who spent evenings playing the slot machines failed to convince the court that she desired to make a profit gambling; Thomas L. Pias v. Comm., TCS 2005-138, a retired accountant going to casino 2 to 3 times a week as he “was in what I thought was a lucky streak” not considered a professional gambler as the court was not satisfied that he looked to the gambling activity as a source of production of income for his livelihood; Michael Merkin v. Comr., TCM 2008-146, player club points don’t help Park Avenue psychiatrist convert gambling activity into trade or business.)

Professional Horse Racing Gambler Permitted to Deduct Business Expenses That Create a Loss

Note. The Chief Counsel announced agreement with the court's analyses in Ronald Mayo (136 TC 81, Dec. 58,524). §165(d) limits the deduction for the wagering losses of persons engaged in the trade or business of gambling. However, §165(d) does not limit deductions for expenses incurred to engage in the trade or business of gambling. Those business expenses are deductible under §162.


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Ronald Mayo reported his gambling activity on his 2001 Schedule C. He tried to deduct the entire $22,265 loss against his other income. The IRS denied the $22,265 loss on the grounds that §165(d) doesn’t allow gambling losses to be used against non-gambling income. The issue was does the §165(d) loss limitation apply only to direct gambling winnings or does it also apply to other gambling expenses?

Taxpayer IRS Court

Gross receipts $120,463

Wagers 131,760

Net from losses gambling ($ 11,297)

Total business expenses (travel, tote sheets, etc.) ($10,968)

Schedule C gambling losses ($22,265) ($22,265) ($22,265)

§165(d) gambling loss limitation -0- $22,265 $11,297

Schedule C losses deductible against other income

$10,968

Taxpayer was professional gambler. The IRS conceded Ronald was in the trade or business of gambling on horse races. And the court emphasized that §165(d), which limits wagering losses to the amount of wagering gains, trumps the general language of §162(a), which allows deductions for ordinary and necessary business expenses. Therefore, the court held that Ronald’s wagering expenses of $131,760 constituted losses from wagering transactions that were limited by §165(d) to the gains he reported from wagering ($120,463), notwithstanding Ronald's engagement in the trade or business of gambling. The IRS’s disallowance of $11,297 of Ronald’s claimed loss was correct. Wagering expenses allowed. Next, the court had to decide whether the §165(d) limitation on “Losses from wagering transactions” extended to Ronald's $10,968 of wagering expenses. The IRS, relying on Offutt v. Comm., (16 TC 1214 (1951)) and Estate of Todisco v. Comm., (757 F.2d 1(1st Cir. 1985)), argued that “Losses from wagering transactions” covers both, so that Ronald could not deduct either the $11,297 excess of his wagering expenses over gambling gross receipts or the $10,968 in business expenses he claimed in connection with carrying on his gambling business. Offutt and Estate of Todisco held that §165(d) limits amounts expended on wagers as well as other expenses incurred in carrying on the trade or business of gambling, such as a bookmaker's mailing, printing, and stenographic expenses (Offutt), or his State taxes on wagering (Estate of Todisco). This court, pointing out that Offutt offered no reasoning to support its conclusion, held that reconsideration of Offutt's interpretation of “losses from wagering transactions” was warranted. Then it concluded that Offutt should no longer be followed. The court stated that “Generally, it is not sufficient that the gain arise merely in connection with the conduct of wagering activities; the gain must be the direct result of a wager entered by the taxpayer.” Thereafter, the court held that Ronald was entitled to


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deduct under §162(a) the $10,968 in business expenses claimed in connection with carrying on his gambling business (Ronald Andrew Mayo and Leslie Archer Mayo v. Comm., 136 TC No. 4, Jan. 25, 2011; IRS acquiesces (AOD-2011-06, IRB 2012-23, Dec, 21, 2011).


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Special Income and Deduction Topics

Parents Need Children’s Help Thousands of baby boomers across the nation are in the middle of what pop-psychologists are calling "The Sandwich Generation." The sandwich "middles" are comprised of those individuals who must manage the care of both their young children and their aging parents. According to a 1990 Newsweek story, the average woman spends 17 years raising children and 18 years helping aging parents. The life expectancy of parents, however, is higher than ever before. Members of the sandwich generation are like slices of baloney expected to give taste and meaning to the "bread" of their own children on one hand and their parents on the other.

Example. Norm and Gail are your forty-something clients who have two teenaged children. Their household income annually is about $75,000 and they’ve owned their own home for about 10 years. Last year they refinanced their $200,000 mortgage at a fixed rate of 4% for 30 years. They have saved well for college for the kids, and for their own retirements. They come to you, however, with a problem for Norm’s mother. Norm’s mother is 70, a widow, and living on a fixed income. Aside from social security and a small pension benefit from Norm’s father, her other income is derived from interest on bank CDs. She has about $250,000 in CDs, and is currently earning 1.0%. While mom’s needs are not great, with interest rates so low she falls short about $500 each month. Norm and Gail would like to help her and have asked about any tax consequences of giving mom the extra $500 per month. You advise them not to make any gifts to mom at all and to refinance their mortgage instead! Here’s how: Norm and Gail will refinance their existing 4% mortgage by having mom become the secured lender. The terms to mom will be the same as their current loan. Thus, Norm and Gail do not change their own cash flow by even one dollar, but mom trades in 1.0% interest for a 4% rate of return, increasing her monthly cash flow by $600.

Tax-Deferred Exchanges There were 108,100 exchanges reported on 1999 individual tax returns, deferring about $38 billion of gain on property valued at almost $54 billion. The total number of exchanges reported on all types of tax returns in 1999 was 193,200 according to IRS data. Real estate exchanges are more popular than ever!


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Basic Exchange Rules IRC §1031 and the related regulations lay out the following rules related to exchanges: No gain or loss shall be recognized on the exchange of property held for productive

use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment (§1031(a)(1)),

To the extent of cash or other “boot” (not like kind property) received, gain is recognized (§1031(b)),

Net relief of the transferor taxpayer’s mortgage debt is considered boot received (§1.1031(b)-1),

The amount of boot received is decreased by the taxpayer’s exchange expenses (§1.1031-(d)-2, Ex.(2)).

Gain Recognized Gain to be recognized on an exchange is the sum of: Money or Other Boot Received __________ Plus Net Mortgage Relief __________ Reduced by Exchange Expenses __________ Gain Recognized __________ Note. Money or other boot given can offset mortgage relief. However, an increase in mortgage does not offset cash or other boot received, §1031 Is Mandatory An exchange must be reported as an exchange. Section 1031 is not subject to election or waiver, and if all the exchange elements are present, the taxpayer must report the transaction as an exchange. But §1031 and its associated nonrecognition of gain or loss can be intentionally avoided by evading one of the six exchange elements: Property. There must be property transferred and property received Exchange. There must be an “exchange” of properties Qualified Use. Both the property transferred and the property received must be held

for “productive use in a trade or business or for investment” Not Excluded Property. The tax-free benefits of §1031 are not available to the

transfers of stock in trade (e.g., inventory), stocks, bonds, notes, other securities or evidences of indebtedness or interest, interests in a partnership, certificates of trust or beneficial interests, or choses in action; and therefore exchanges of any of the enumerated properties are taxable transfers

Like Kind. The business or investment properties transferred must also be of a “like kind”

No Boot. For the transaction to be entirely tax-free, the property received must be exchanged solely for qualified like-kind property


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When is an exchange not advisable? Generally, real estate investors wish to avoid an exchange transaction in the following situations: When property could be sold for a loss. Loss on an exchange is not currently

deductible, and the loss on a sale may be fully currently deductible as a §1231 ordinary business loss

When a taxable gain can be offset with other currently deductible losses that result in minimal tax due. Exchanges generally cost more money to complete than sales transactions and, thus, current losses are normally more valuable than deferred losses.

When liquidity is required. This usually occurs at the time of retirement or for medical or other emergencies

When investors do not want any other property. Some individuals wish to discontinue managing real estate or become tired of being landlords.

The Basic Exchange Most tax professionals consider the like-kind exchange computation to be very difficult. And looking at Form 8824 and the myriad of worksheets available in courses on the subject may confirm this misconception. Don’t let the forms scare you. It’s easy to calculate the gain that is tax-free! There are really two steps involved in reporting a like-kind exchange: Calculate the recognized gain (if any) Compute the adjusted basis of the property received

Example. Donna owns an apartment house in Atlanta, which she purchased for $100,000 on November 1, 2000. The property has a fair market value of $225,000 on December 1, 2013. She has taken 27.5-year straight-line depreciation since her purchase 13 years ago ($47,273 accumulated depreciation). She wants to sell it and buy an apartment house in Missoula, Montana that has a fair market value of $225,000. Her taxable gain when she sells the Atlanta property would be $172,273 calculated as follows: Sale price $225,000 Less Adjusted Basis Original Cost $100,000 Minus Depreciation - 47,273 Adjusted Basis - 52,727 Long-term capital gain $172,273


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Donna’s tax, assuming she is in the 25% tax bracket, would be: Depreciation recapture $ 47,273 x 25% $ 11,818 Long-term capital gain 125,000 x 15% 18,750 Total gain $172,273 $ 30,568 Instead of selling, Donna trades her $225,000 Atlanta apartment house for the $225,000 Missoula apartment. None of the $172,273 gain is recognized on Donna’s tax return, she would file a Form 8824 and report a §1031 tax-free exchange, thereby currently saving $30,568 in federal taxes.

Planning. The basic rule in exchanges is to be the party who trades equal or up – both in fair market value and in debt – and don’t receive any boot! But for planning purposes, there can be good reasons to take boot, thus making an exchange partially taxable.

A More Complicated Exchange The following example is from IRS Reg. §1.1031(d)-2, Example 2.

Example. Sid owns an apartment with an adjusted basis of $100,000 and a fair market value of $220,000, but subject to a mortgage of $80,000. Joe wants to trade to Sid his apartment, which has an adjusted basis of $175,000 and a fair market value of $250,000, but is subject to a mortgage of $150,000. To even equity, Joe agrees to pay Sid $40,000 in cash. Closing is January 1, 2010. As Sid’s tax preparer, you know that Sid originally purchased the property for $158,065 on January 1, 1997, with $25,000 allocated to land and has accumulated $58,065 of depreciation during his twelve-year ownership. The exchange expenses are $5,000. This is all the information we need in order to calculate the tax ramifications of Sid’s exchange!


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Step 1. Realized Gain Fair Market Value of Qualifying Property Received $250,000 Cash and other non-like-kind property received 40,000 Less exchange expenses - 5,000 Total Sid Received $285,000 Less Adjusted Basis Original Cost $150,000 Plus purchase expenses 8,065 Cost of property given 158,065 Less accumulated depreciation - 58,065 Adjusted basis of property given -100,000 Realized Gain $185,000 Step 2. Recognized Gain Cash and other non-like-kind property received $ 40,000 Less exchange expenses - 5,000 Total consideration received 35,000 Mortgage on property given $ 80,000 Mortgage on property received -150,000 Net mortgage relief (if less than zero, use zero) - 0 Gain recognized (cannot exceed realized gain) 35,000


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The Delayed Exchange (Starker Exchange) Suppose your client wants to sell property for cash with a plan to reinvest it in the future but does not want to pay the capital gains tax associated with the sale? No problem! Just so long as the strict guidelines issued after the settlement of the Starker cases in 1979 are followed. Once the old property is conveyed (sold), the period for identifying the replacement property ends exactly 45 days later, and the period for receiving the new property ends exactly 180 days later – no extensions are available. If, as part of the same deferred exchange, the exchanger transfers more than one relinquished property and the relinquished properties are transferred on different dates, the identification period and the exchange period are determined by reference to the earliest date on which any of such properties are transferred, and ends exactly 45/180 days (or the filing date of the taxpayer’s tax return, with extensions)later, even if the beginning or ending date is a Saturday, Sunday or legal holiday. How to identify property within the 45 days. The identification must be in a written document, signed and delivered. Property must be designated as replacement property in writing, signed and delivered (either by hand, mailed, faxed or otherwise sent) to the person obligated to transfer the replacement property or to any other person involved in the exchange such as any of the other parties to the exchange, an accommodator, an escrow agent or a title company. A document signed by all parties prior to the end of the 45 days is also sufficient. The property description must be unambiguous: Describing real property: exchanger may use legal description, street address or

distinguishable name (e.g., Trump Tower). Describing personal property: description must be specific (e.g., truck must designate

make, model and year). Property that is to be produced or constructed in the future also qualifies but must follow special rules. Limitations on how many replacement properties may be designated (the alternate and multiple property rules) Regardless of the number of relinquished properties in the same deferred exchange, the maximum number of replacement properties the taxpayer may designate is three; if more than three properties are identified, then property value may not exceed twice the aggregate fair market value of the property given up; and if both more than three properties and twice fair market value are identified, then the exchanger must purchase 95 percent of all the properties identified.


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Example. Lonnie transfers a $100,000 fair market value property to Rich in a delayed exchange on May 17, 2010. On June 28, 2010, Lonnie hand-delivers to Rich written, signed instructions identifying real properties J, K and L as potential replacement properties (fair market values of $75,000, $100,000 and $125,000 respectively). On August 1, 2010, Lonnie informs Rich which of the three properties he wishes.

Violation of all three tests (3-property, 200% rule, and 95% purchase) makes the exchange fully taxable. But, if all the property to be acquired is received within 45 days, the identification rule is waived. How to properly receive property within the required time frame. The regulations provide that replacement property is received before the end of the exchange period (i.e., the filing date or 180 days after transfer) if the replacement property received is “substantially the same” property as was identified. If the taxpayer identifies more than one replacement property, the receipt rules apply separately to each.

Example. On May 1, 2010, Karen enters into an agreement to sell (not exchange) to Sharon a $100,000 rental building on May 17, 2010. Prior to closing, on May 16, Karen retains Acme Accommodators to facilitate a deferred exchange by entering into a deferred exchange agreement. Acme is a qualified accommodator and is not a disqualified person. Under the terms of the deferred exchange agreement, on May 17, 2010, Karen will transfer the rental property to Acme subject to Sharon’s right to purchase it for $100,000 on that date. Karen has to identify the replacement property by July 1, 2003, and Acme must purchase that identified property by November 13, 2010, and transfer it to Karen. Karen’s rights are limited by substantial limitations, and she is not related to Acme. Karen pays $1,000 to Acme for facilitating this transaction. On May 17, 2010, Acme acquires the rental property from Karen and simultaneously transfers it to Sharon in exchange for $100,000 cash. For reasons unrelated to the federal income tax, the rental property’s legal title is transferred directly from Karen to Sharon (permitted by §1.1031(k)-1(g)(4)(iv) and Rev. Rul. 90-34). On June 1, 2010, Karen identifies an office building as replacement property. On August 9, 2010, Acme purchases the office building for $100,000 and transfers it to Karen. The transfer of the rental property by Karen is a qualified §1031 exchange. Even though Acme acquires the rental property subject to Sharon’s right to purchase the property on prearranged terms and conditions and similarly acquires the office building, they both are deemed legitimate acquisitions. Karen is deemed not to be in constructive receipt of the money before he receives the office building.


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Alternative Minimum Tax

The Basic Calculation

Regular Tax Alternative Minimum Tax Items of Gross Income

Taxable Income (plus exemptions)

(Adjustments) . Adjustments/(Adjustments) Adjusted Gross Income Preferences/(Preferences) (Deductions) NOL Adjustment (Exemptions) . (Itemized Deductions Limitation) . Taxable Income Alternative Minimum Taxable Income (Exemption) . Taxable AMTI Apply graduated rates to taxable income = 26% of $185,400 plus 28% of remainder = Regular Tax Tentative Minimum Tax

Which Do You Pay?

Compare Regular Income Tax to Tentative Minimum Tax, and you pay whichever is higher. Therefore, shouldn’t this be called The Mandatory Maximum Tax?

Example. Vern and Sharon have adjusted gross income in 2014 of $200,000 and owe regular tax in the amount of $33,346. They have AMT preferences and adjustments totaling $35,360, resulting in a tentative minimum tax of $33,482. Vern and Sharon will owe a total tax of $33,482 – the regular tax plus $136 AMT. Vern hates the AMT. He asks you to run a projection for 2015. All income and deductions are the same. Result? Regular tax of $33,123. Tentative minimum tax of $32,988. Why did their tax go down by almost $500? The AMT exemption amount and the phase-out threshold for the exemption have been automatically inflation adjusted.

So Now the AMT is Fixed, Isn’t It?

According to Tax Policy Center, fewer than 2 million taxpayers paid AMT in any year before 2002. Because the 2001-2003 tax cuts were not matched by equivalent reductions in the AMT, the number of taxpayers subject to the alternative levy rose to 5 million in 2005. Subsequent increases in the AMT exemption reduced that number slightly before ATRA permanently indexed the exemption and other parameters starting in 2012. The number of taxpayers who owe AMT will stabilize at about 4.6 million by the end of the decade.


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VT 3.3NH 3.4MA 6.5RI 4.0CT 8.1NJ 8.8DE 3.3MD 6.5DC 7.9

US 4.4

1.7 Percent on AMT

7.1 to 8.8 (4) 5.5 to 7.0 (3) 3.4 to 5.4 (14) 1.5 to 3.3 (30)

6.9

2.8

5.2 2.43.7

2.9

2.9

4.5

2.9

3.4

2.2

2.9

3.5

2.7

4.0

2.7 1.9

3.3

3.7

2.9

2.0

2.8 2.7

2.6

2.9

3.5

3.02.8

7.7

3.9

2.0

3.0

5.2 2.0

3.2

2.8

3.82.2

But certain taxpayers are more at risk of falling subject to the AMT than others. Taxpayers at the very top of the income scale are less likely to pay AMT than those just below them because they pay regular tax rates higher than the top AMT rate. Under current law, 6.3% of taxpayers with three or more children will have paid AMT for 2012, compared with 2.3% of childless taxpayers because the AMT denies exemptions for dependents that the regular tax system allows. And over 4% of residents of high-tax states will owe AMT for 2012, compared with less than 2% of residents of low-tax states because the AMT does not allow a deduction for state and local taxes paid.

What Did it Cost to Index the AMT?

The increase in the AMT exemption in 2012 from $45,000 to $78,750 for married couples filing jointly and from $33,750 to $50,600 for other taxpayers cut revenues by $86 billion for the calendar year 2012. For 2012 it also reduced the number of AMT taxpayers by almost 88% from over 32 million to 4.0 million. Permanently extending and indexing the exemption will reduce revenue by an estimated $814 billion over the 2012-2022 period, relative to pre-ATRA law3.

Percentage of Taxpayers on AMT by State 2012

3 Source: Urban-Brookings Tax Policy Center Microsimulation Model.


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The map above shows the proportion of taxpayers in AMT in each state in 2012. In two-thirds of the states, less than 3% of taxpayers were subject to the AMT. But in New Jersey, 8.8% paid AMT. In New York, Connecticut and the District of Columbia over 7% of taxpayers paid AMT, followed closely by California at 6.9%.

Repeal? Not Without Complete Tax Reform

In March 2013 Senate Finance Committee released what it calls “the first in a series of papers compiling tax reform options that Finance Committee members may wish to consider as they work towards reforming our nation’s tax system.” Among the recommendations for simplifying the tax code, the paper calls for a repeal of the alternative minimum tax. However, President Obama’s 2014 budget proposal does not call for AMT repeal. Instead, it would create additional limitations on certain itemized deductions such as home mortgage interest and charitable contributions for certain taxpayers, and invoke the so-called “Buffet Rule” which would impose a minimum tax on income over $1 million. Some critics have called this a second AMT.

The Top 10 AMT Kickers4 1. High State Taxes and Substantial Property Taxes (66% total AMT preferences) Many taxpayers get a double-whammy from payment of high state taxes and also large property tax payments on rising real estate values. Careful tax professionals should always project two years tax liability to minimize the effect of state taxes owed for one year and paid the next. 2. Big Families - Personal Exemptions (22%) Although we don’t really consider children to be a tax shelter, a large deduction for personal exemptions from many children can push some taxpayers into the AMT. In D.R. Klaassen (76 TCM 20, Dec. 52,775(M), TC Memo. 1998-241), the taxpayers had 10 children. Their AGI was reduced to about $34,000 taxable income by itemized deductions which included both medical expenses and state taxes. Their AMT was approximately $1,000 above their regular tax liability. Klaassen argued that Congress never intended to apply the AMT to adversely affect large families. He lost. 3. Large Miscellaneous Itemized Deductions (10%) Employees with large unreimbursed expenses should consider asking their employers to develop a reportable plan. Or, demonstrate the lack of economic benefit to your taxpayer for paying these expenses, and develop a reasonable budget. 4. Net Operating Losses (3%) Differences in calculating the NOL for regular and minimum tax often result in AMT in an NOL year. Moreover, years into which a NOL is carried back often generate AMT.

4 Percentages total more than 100% because some adjustments, not in the top 10, are negative. Source: Office of Tax Analysis, Department of the Treasury.


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5. Standard Deduction (1%) Remember to consider forcing itemized deductions, even if less than the standard deduction. 6. Passive Activity Losses (1%) Differences in accumulated suspended passive losses for regular tax and AMT can also result in AMT. 7. Incentive Stock Options (1%) Taxpayers who exercise and hold incentive stock options often find themselves in AMT. Under IRC §422, the exercise of an incentive stock option does not result in ordinary income to the taxpayer if the shares are held for the qualifying period (one year from date of exercise and two years from date of grant). The bargain element on date of exercise is a deferral adjustment for AMT purposes. Include the bargain element on the date of exercise for incentive stock options exercised during the year and held at year-end in the calculation of AMTI (IRC §56(b)(3)). Adjust the basis of the stock for AMT purposes.

Example: On August 1, 2013, Karen exercised 1,000 shares of Tax Inc. under a qualified incentive stock option plan. The option was granted January 1, 2011, at an exercise price of $0.20 per share. On the date of exercise, the fair market value of Tax Inc. was $10 per share. Karen intends to hold the stock until November 1, 2014.

1. No income tax in 2011 for granting of option.

2. No regular income tax in 2013 for exercising option.

3. Alternative Minimum Tax income adjustment in 2013 for the difference between the fair market value on the date of exercise and the amount paid for the stock (exercise price). Report $9,800 on Form 6251 line 14 for 2013.

4. Assume Karen holds the shares until November 1, 2014. She sells the stock for $15 per share.

5. Karen will have long-term capital gains in 2014 for the difference between the sale price and the exercise price. Report $14,800 long-term capital gain on Form 8949 and Schedule D for 2014.

6. Karen will also have an Alternative Minimum Tax gain or loss adjustment in 2014 for the different AMT vs. regular tax basis in the stock. Report $5,000 long-term capital gain on AMT Schedule D and ($9,800) on Form 6251 line 17 for 2014.


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Equalizing Regular Tax and AMT For a taxpayer who is AMT-averse, exercise ISOs to the point that the preference raises AMT to an amount just below regular tax. This strategy allows for the exercise of options without triggering the prepayment of tax.

Example. Carolyn and Eric, who file married jointly, have combined wages of $200,000, mortgage interest expense of $60,000 and property taxes of $9,000. Eric also has Incentive Stock Options in VAM, Inc. to purchase 2,000 shares at an exercise price of $1 per share. The fair market value of VAM shares today is $15.

2014 Eric and Carolyn’s Federal Income Tax without options exercise $20,714 Tentative Minimum Tax without options exercise $15,054 If Eric exercises options up to a $20,500 preference, they will have the following result: Eric and Carolyn’s Federal Income Tax with options exercise $20,714 Tentative Minimum Tax with options exercise $20,644 Eric can exercise 1,464 shares ($15 FMV - $1 Exercise Price x 1,464 shares = $20,496). Note. Because of limitations and exclusions, it is very complicated to try to calculate this amount for high-income taxpayers. Several of my engineer clients have tried to develop a formula and failed. For my purposes, I use tax projection software that allows me to change the preference amount while viewing the regular and alternative minimum tax. 8. Beneficiaries of Estates (1%) Almost all of these top-10 preferences and adjustments can pass through to the beneficiaries of an estate or trust. In particular, miscellaneous itemized deductions, depreciation adjustments from the sale of rental properties and private activity bond interest can create AMT for a beneficiary who otherwise would never encounter it. 9. Medical Deductions (0.5%) The deduction for medical and dental expenses is limited to 10% of Adjusted Gross Income for purposes of the AMT (IRC §56(b)(1)(B)). Add the lesser of 2.5% of AGI or the total allowable medical and dental deduction from Schedule A. 10. Private Activity Bond Interest 1%) Taxpayers should more closely monitor, examine tax-exempt bond funds before investing. New Law! The 2008 Housing and Economic Recovery Act of 2008 provides that tax-exempt interest on (i) exempt facility bonds issued as part of an issue 95% or more of the net proceeds of which are used to provide qualified residential rental projects (as defined


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in section 142(d)), (ii) qualified mortgage bonds (as defined in section 143(a)), and (iii) qualified veterans’ mortgage bonds (as defined in section 143(b)) is not an item of tax preference for purposes of the alternative minimum tax. This provision applies to interest on bonds issued after July 30, 2008. More New Law! The American Recovery and Reinvestment Act of 2009 added IRC §57(a)(5)(C)(vi) specifying that tax-exempt interest on private activity bonds issued in 2009 and 2010 will not be treated as a tax preference. Refunding bonds issued in 2009 or 2010 will be treated as issued on the original bond’s issue date. However, any refunding bond issued in 2009 or 2010 to refund a private activity bond issued after December 31, 2003 and before January 1, 2009 will not receive this treatment, and will be AMT exempt.

Prepay State Income Taxes and Reduce the AMT

It’s just not right. Conventional wisdom has always held that taxpayers receive no tax benefit from prepaying state income taxes in a year when they are subject to the AMT. But changes brought about by the Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) 2003 have thrown even that most basic tenet out. Now, careful tax planners need to look at the kind of income contributing to the AMT before deciding their clients’ best course of action.

Example. Eric and Carolyn are residents who want to retire and move out of high-priced California and spend their days playing cards in Florida. They sold their Palo Alto home in 2014 and recognized a long-term capital gain, after the allowance of their $500,000 §121 exclusion, of $500,000. Before the sale, their situation looked like this:

Wages $ 120,000 Interest 5,000 Capital Gains 0 Total AGI 125,000

Charitable Contributions 1,500 Property Taxes 6,000 State Income Taxes 3,600 Mortgage Interest 25,000 Limitation on Itemized Deductions - 0 Total Itemized Deductions 36,100

Personal Exemptions 7,900 Taxable Income 81,000


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We’ve long seen the phenomenon that with large capital gains, taxpayers are suddenly subject to the AMT. So, after realizing the $500,000 long-term capital gain, they shouldn’t prepay any of the $49,200 extra CA tax, should they?

Prepay State Tax

Don’t Prepay State Tax

Adjusted Gross Income 625,000 625,000 Itemized Deductions 75,700 26,500 Personal Exemptions 0 0 Taxable Income 549,300 598,500

Appropriate Regular Tax 82,400 98,400

Tentative Minimum Tax 101,500 107,650

What happened??!! Although in either case Eric and Carolyn were subject to the AMT in 2014, they ended up paying almost $6,000 less in federal taxes by prepaying their state tax!

Capital Gains and Dividends

Income from capital gains that is taxed at the 0%, 15%, 20%, 25% and 28% capital gains tax rates is taxed the same for regular tax and the AMT (IRC §53(b)(3)). To the extent that the taxpayer has unused 15% bracket for regular tax purposes, adjusted capital gains are taxed at 0% for both regular tax and AMT purposes. Dividends taxed at 0%, 15% or 20% capital gains tax rates are also taxed the same for regular tax and the AMT (IRC §53(b)(3)).

Regular Tax Alternative Minimum Tax Taxable Income

Alternative Minimum Taxable Income

(Long-term capital gains & qualified divs) . (Long-term capital gains & qualified divs) . Taxable Excess Taxable Excess AMTI Apply graduated rates to taxable excess + Apply 26% & 28% to taxable excess + Capital gains rates on LTCG & Qual. Divs. Capital gains rates on LTCG & Qual. Divs. Regular Tax Tentative Minimum Tax

2014 Top of 15% Marginal Rate Bracket

Filing Status Top of 15% Marginal Rate Single $36,900 Married Filing Joint $73,800 Head of Household $49,400


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The quirk here is that we are not accustomed to thinking of a taxpayer with AGI over $125,000 as being in the 15% tax bracket. Because so much of these taxpayers’ income is derived from “adjusted net capital gain” income, their remaining taxable income for regular tax purposes is less than the $73,800 bracket threshold. As a result, the more deductions they have against regular taxable income, the more “adjusted net capital gain” income will be taxed at 0% - free. For the AMT calculation, the amount of “adjusted net capital gain” taxed at the 0% rate is determined using taxable income for regular tax purposes. Thus, prepaying state income taxes, although not a deduction for AMT purposes, reduces the total tax calculation for both regular and alternative minimum tax. A change in the calculation contained in the Working Families Tax Act of 2004 improved this result even more for certain taxpayers whose regular taxable income (including adjusted net capital gain) falls below the top of the 15% marginal bracket for their filing status. The correction is retroactive to the enactment of the Taxpayer Relief Act of 1997 – May 7,1997.

Kiddie Tax Generally, the kiddie tax applies to a child if: (1) the child has not reached the age of 19 or is a full-time student over age 18 but under age 24 by the close of the taxable year, (2) either of the child's parents is alive at such time, and (3) the child's unearned income exceeds $1,900 (2012, $2,000 in 2013 & 2014), and (4) the child does not file a joint return.

Note. Disabled children are not excepted from the age test for kiddie tax purposes. Under these rules, the net unearned income of a child (generally unearned income over $2,000 for 2013 and later) is taxed at the parents' tax rates if the parents' tax rates are higher than the tax rates of the child. The remainder of a child's taxable income (i.e., earned income, plus unearned income up to $2,000, less the child's standard deduction is taxed at the child's rates, regardless of whether the kiddie tax applies to the child. For these purposes, unearned income is income other than wages, salaries, professional fees, other amounts received as compensation for personal services actually rendered, and distributions from qualified disability trusts. In general, a child is eligible to use the preferential tax rates for qualified dividends and capital gains. Kiddie tax doesn’t apply for child who provides own support. The expanded provision applies only to children whose earned income does not exceed one-half of the amount of their support. Scholarships are not counted in the support test. The exemption from the kiddie tax for 2013 and later is $2,000. A parent is able to elect to include a child’s income on the parent’s return if the child’s income is more than $1,000 and less than $10,000 [2009: Rev. Proc. 2008-66, Sec. 3.02; 2008: Rev. Proc. 2007-66; §1(g)(4)]


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Planning Pointers for the 2015 Kiddie Tax

Delay collections of all unearned income until the child turns 19 or 24 if the child is a full time student.

Borrow college funds from subsidized loan programs (where interest doesn’t accrue until graduation) rather than sell stock where gains are subject to the kiddie tax.

Invest in growth stock rather than stock paying dividends including use of “tax efficient” mutual funds.

Invest in tax-exempt bonds.

Invest in US savings bonds and delay cashing in the bonds until the child is out of the kiddie tax trap.

Move custodial bank accounts (CUTMA balances) into a §529 plan for the child.

Warning. Parents’ tax rate will include 3.8% Medicare tax starting but the child’s may not.

Education Credits

American Opportunity Tax Credit And Lifetime Learning Credits §25a

The Hope Scholarship Credit Is Now the “American Opportunity Tax Credit” (ARRA 2009; Rev. Proc. 2008-66, sec. 3.05; amended by Rev. Proc. 2009-21) Maximum credit increased to $2,500. The allowable modified credit is up to $2,500 (was $1,800) per eligible student per year for qualified tuition and related expenses paid for each of the first four years of the student's post-secondary education in a degree or certificate program. The modified credit rate is 100% on the first $2,000 of qualified tuition and related expenses, and 25% on the next $2,000 of qualified tuition and related expenses. For purposes of the modified credit, the definition of qualified tuition and related expenses is expanded to include course materials. First four years. The modified credit is available with respect to an individual student for four years, provided that the student has not completed the first four years of post-secondary education before the beginning of the fourth taxable year. Thus, the modified credit, in addition to other modifications, extends the application of the Hope credit to two more years of post-secondary education. MAGI phaseout starts at $80,000/$160,000. The modified credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified adjusted gross income between $80,000 and $90,000 ($160,000 and $180,000 for married taxpayers filing a joint return).


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AMT phaseout starts at $80,000/$160,000. The modified credit may be claimed against a taxpayer's alternative minimum tax liability. Part of credit is refundable. Forty percent of a taxpayer's otherwise allowable modified credit is refundable. However, no portion of the modified credit is refundable if the taxpayer claiming the credit is a child to whom kiddie tax rules apply for such taxable year (generally, any child under age 18 or any child under age 24 who is a student providing less than one-half of his or her own support, who has at least one living parent and does not file a joint return).


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Major Features of the American Opportunity Tax Credit (Hope Credit) and the Lifetime Learning Credit

Feature American Opportunity (Hope) Tax Credit

Lifetime Learning Tax Credit

Higher Education Tax Deduction

Type of benefit 40% of the credit is refundable except if a child subject to kiddie tax claims the credit.

Nonrefundable tax credit (cannot exceed tax liability).

Above the line tax deduction (filers do not need to itemize).

Dates applicable 2009 through 2017 Indefinite 2014

Maximum benefit

$2,500 (100% of first $2,000 in qualified expenses, 25% of second $2,000) per student.

$2,000 (20% of first $10,000 in qualified expenses) per return.

$4,000 deduction for 2009 per return (but only $2,000 maximum deduction available for higher income taxpayers).

Income limit For 2009, credit begins to phase out at $80,000 modified AGI and is fully phased out at $90,000 ($160,000 and $180,000 thresholds for joint returns).

For 2009, credit begins to phase out at $50,000 modified AGI and is fully phased out at $60,000 ($100,000 and $120,000 thresholds for joint returns).

Deduction available to taxpayers with up to $65,000 in modified AGI ($130,000 for joint returns); taxpayers with modified AGI or more than $65,000 but less than $80,000 can claim smaller maximum deduction ($130,000 and $160,000 thresholds for joint returns)

Postsecondary education expenses qualifying for benefit

Tuition, fees and course materials required for enrollment.

Tuition and fees required for enrollment.

Tuition and fees required for enrollment.

Type of postsecondary education

First 4 years of undergraduate education when enrolled on at least a half-time basis in a program leading to a degree, credential, or certificate.

For any year of undergraduate or graduate enrollment with no limit on the intensity of enrollment or the type of program.

For any year of undergraduate or graduate enrollment with no limit on the intensity of enrollment or the type of program.


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Tax Rates The American Taxpayer Relief Act of 2012 made permanent the Bush-era marginal tax rates while adding a new top rate of 39.6%. For 2015, the individual tax brackets are:

Rate Single Filers Married Joint Filers Head of Household

Filers

10% $0 to $9,225 $0 to $18,450 $0 to $13,150

15% $9,225 to $37,450 $18,450 to $74,900 $13,150 to $50,200

25% $37,450 to $90,750 $74,900 to $151,200 $50,200 to $129,600

28% $90,750 to $189,300 $151,200 to $230,450 $129,600 to $209,850

33% $189,300 to $411,500 $230,450 to $411,500 $209,850 to $411,500

35% $411,500 to $413,200 $411,500 to $464,850 $411,500 to $439,000

39.6% $413,20 and up $464,850 and up $439,000 and up

Elections There are more than one hundred different kinds of elections to be found in the Internal Revenue Code. Careful planners select among these choices to make wise planning decision for their clients. We have already examined some elections throughout this material. Let’s look at a few more.

Deductible IRAs For certain low-income taxpayers, electing to make a nondeductible IRA will give the taxpayer basis in the IRA. Here are some situations where a taxpayer may want to make an otherwise deductible IRA contribution nondeductible: Taxpayer has a Net Operating Loss Taxpayer has no taxable income

Example. In 2006, Rhonda World (age 52) spent 11 months working in Peru. Her income is $120,000, and she takes the $80,000 foreign income exclusion. She also had other losses and allowable itemized deductions that dropped her federal taxable income to zero. If Rhonda contributes to an IRA, she may elect to make it a nondeductible IRA, thus creating basis in the IRA.


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Nondeductible IRAs Have New Life After TIPRA ’05

While the debate goes on about whether the traditional or the Roth IRA is better for clients of various ages and income levels, the nondeductible IRA has been lost in the shuffle. While the nondeductible IRA does not provide an immediate tax deduction like the traditional IRA and does not provide completely tax-free distributions like the Roth IRA, it does have one distinct advantage over its more famous siblings: Anyone with earned income can contribute even if he or she already participates in a tax-deferred retirement plan. Like both the traditional and the Roth IRAs, the nondeductible IRA provides tax-deferred growth. For individuals who have not forgotten their nondeductible IRAs, very often the basis within many of them has been forgotten. While all distribution amounts from traditional IRAs are taxable and all distribution amounts from Roth IRAs are tax-free, nondeductible IRAs are taxable only to the extent that the distribution exceeds pro rata basis under the principles of IRC §72(t). To make matters even a little more complicated, nondeductible IRA contributions can be deposited into traditional IRA accounts (but not Roth accounts). Keep in mind, too, that trustees are not responsible for distinguishing nondeductible from traditional contributions and are not responsible for computing the taxable amount of any distribution. It is the taxpayer’s responsibility, which means it is the tax professional’s responsibility.

Individuals of Any Income May Convert Traditional IRAs to Roth IRAs in 2010

TIPRA ’05 eliminates the income limitation that currently prevents high-income taxpayers from converting traditional IRAs to Roth IRAs in taxable years beginning after December 31, 2009. High-income taxpayers who don’t qualify to contribute to either deductible IRAs or Roth IRAs may want to start making nondeductible IRA contributions and plan to convert them to a Roth in 2010. Making the conversion Beginning in 2010 the income limits on Roth conversions disappear. This means that the amounts that a high-income individual contributed to a nondeductible IRA can be converted to a Roth in 2010 and receive tax-free growth thereafter. As with all conversions, the amount of the conversion, less basis must be recognized as income. For nondeductible contributions, this means that the only income recognized is the amount of growth in the account. In addition, there’s a bonus in the law regarding income recognition. The wording of the law is a bit odd: “… shall be so included ratably over the two-taxable-year period beginning with the first taxable year beginning in 2011.” (Act §512(b)(1)) What this means is that if a taxpayer makes the conversion in 2010, he or she recognizes half the income in 2011 and half in 2012. If he/she makes a conversion in a later year,


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he/she recognizes half in the year of conversion and half the following year (so a 2011 conversion will also be recognized in 2011 and 2012). The taxpayer may elect to recognize all of the income in the year of conversion. Another planning trick Beginning in 2010, this new law not only terminates the income limitations on Roth conversions, it also effectively terminates the income limitations on Roth contributions. Why? Because a taxpayer whose income disqualifies him or her for a Roth will be able to make a nondeductible contribution and immediately convert it to a Roth. By doing so immediately, the taxpayer will avoid any growth in the account and, as such, avoid any taxable income on the conversion. Cautions! The strategy can be used by anyone with earned income but is most useful for high-income individuals. However, there are certain hurdles that must be taken into account. Distribution ordering rules: Under the distribution rules, all of the taxpayer’s IRAs are combined (IRC §408(d)(2). This can lead to undesirable results for a high-income taxpayer who may have made deductible contributions in earlier years.

The five-year rule: Distributions from a Roth that are not qualified may be subject to income tax and an additional 10% early distribution penalty may apply (IRC §72(t); Treas. Reg. §671.408A-6). To be qualified, the distributions must meet a five-year test. The five-year test for tax purposes begins on the first day of the taxable year for which the first Roth contribution is made (IRC §408A(d)(2)(B). For penalty purposes, each conversion must take into account a new five-year test. Form 8606: The taxpayer must file Form 8606 for each year of nondeductible contributions and for the year of conversion. Example. Betty has a traditional IRA with a value of $100,000 consisting of deductible contributions and earnings. Betty does not have a Roth IRA. She converts the traditional IRA to a Roth IRA in 2010, and, as a result of the conversion, $100,000 is includible in gross income. Unless Betty elects otherwise, $50,000 of the income resulting from the conversion is included in income in 2011 and $50,000 in 2012.


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Later in 2010, Betty takes a $20,000 distribution, which is not a qualified distribution and all of which, under the ordering rules, is attributable to amounts includible in gross income as a result of the conversion. Under the accelerated inclusion rule, $20,000 is included in income in 2010. The amount included in income in 2011 is the lesser of (1) $50,000 (half of the income resulting from the conversion) or (2) $80,000 (the remaining income from the conversion). The amount included in income in 2012 is the lesser of (1) $50,000 (half of the income resulting from the conversion) or (2) $30,000 (the remaining income from the conversion, i.e., $100,000 - $70,000 ($20,000 included in income in 2010 and $50,000 included in income in 2011)), or $30,000.

Capitalize Carrying Charges Generally, IRC §266 allows a taxpayer to elect to capitalize “carrying charges” on real or personal property if those carrying charges are otherwise deductible. There is an important limitation in IRC §266 and an equally important exception. The limitation is that once a taxpayer makes an election it remains in effect until the property is placed in service. The exception applies to unimproved and unproductive real estate where the election is made on an annual basis. A taxpayer can deduct in one year and capitalize in another. A taxpayer can also elect with respect to specific types of expenses and not with others. However, having elected to capitalize a type of expense, a taxpayer must capitalize all items of expense within that type (Reg. §1.266-1(c)(2)). Generally, there are three types of expenses associated with raw land: Mortgage interest Property taxes Other carrying charges that are miscellaneous itemized deductions (e.g., weed-

clearing costs) Consider making the election to capitalize when the taxpayer: Has more deductions than income Has AMT and cannot use the tax or miscellaneous itemized deductions Cannot use miscellaneous itemized deductions because of 2 percent AGI limitation. Make the election by attaching a statement to the taxpayer’s return that: States that the taxpayer elects under Reg. §1.266-1 to capitalize carrying charges; Describes the asset or project being capitalized; and Separately itemizes each type of expense and the total amount of each expense.


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Investment Interest Federal law requires that a taxpayer who includes long-term capital gain income as part of net investment income may not use the more beneficial federal capital gain rate. Investment interest expense is deductible in the current year to the extent it does not exceed net investment income. Taxpayers may elect to include a part or all of long-term capital gains in investment income, but they forego the more favorable tax rate on those gains In addition, under Reg. §1.163(d)-1, finalized March, 2005, taxpayers may also elect to include qualified dividends in investment income, foregoing favorable tax rates, but allowing deduction for investment interest expense.


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Tax Planning Checklist Postpone/Accelerate Sales of Appreciated Assets

This can be a tricky strategy if economic and market conditions are volatile.

Use Installment Sales Use this technique to spread a portion or all of the gain on sale into subsequent tax years.

Section 1031 Exchange Defer the recognition of gain on the sale of property by acquiring replacement property within the specified parameters. If suspended passive losses, take “boot” to release losses.

Combine Section 121 and Section 1031 Under the guidelines of Rev. Proc. 2005-14 for mixed use property, combine up to $500,000 exclusion on gain from personal residence sale with deferral of additional gain under Section 1031.

Contributions of Appreciated Property to Qualified Charities Avoid capital gain recognition and receive tax deduction for the fair market value in most cases.

Gifts of Appreciated Property to Family Members Transferring capital gains property to junior family members in a lower tax bracket to take advantage of the 5 percent (or 0% in the case of assets sold in 2008) capital gains rate.

Gifts to College Savings Plans Transferring money to Coverdell education savings accounts or Section 529 plans removes assets from estate and eliminates the earnings from current taxable income.

Transfer CUTMAs to Section 529 Plans Removing current income from taxation and converting to tax-free income when funds are used to pay college costs.

Maximize Contributions to Qualified Retirement Plans Tax deductible contributions and tax-deferred savings are the first choice of tax planners. And don’t forget the catch-up provisions.

IRA and Roth IRA Contributions Even if contributions are not deductible (in the case of IRAs), remove earnings from current taxable income.


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Postpone Salary or Bonuses

In cases where postponement is allowed, but advise clients carefully regarding the constructive receipt rules.

Delay Billing Clients or Customers or Completion of Sales or Contracts Avoid constructive receipt problems here by following the rules for billing and collection.

Flexible Benefit Arrangements Reduce taxable income by using pre-tax dollars to fund child care, medical expenses and more.

Employ Family Members Employ your spouse in the business for reasonable compensation and provide spouse with tax-deductible employee benefits.

Buy CDs, Treasury Bills Maturing Next Year For cash-basis taxpayers, these investments pay interest (and are thus taxed) at maturity.

Invest in Tax-Exempt Instruments Convert taxable income into tax-free income.

Invest in Tax-Managed Mutual Funds These funds are managed to avoid taxable events for investors such as substantial capital gains dividends.

Harvest Capital Losses to Offset Gains (and vice versa) Sell loss investments in order to reduce taxable gains, or sell capital gain assets in order to reduce losses to the $3,000 limit.

Bunch Expenses Group expenses subject to AGI floors into the same tax year in order to exceed the limits.

Buy Business Equipment Reduce net profits at year-end with the acquisition of new equipment

Prepay Taxes For taxpayers not subject to the AMT, reduce federal taxes by prepaying state, local and property taxes.


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Donor Advised Funds Take larger charitable deduction in year of contribution and distribute gifts over time.

Convert Personal Interest to Deductible Interest Pay off personal loans with up to $100,000 equity loan and deduct mortgage interest.


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Benefi ts of Membership

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Learn more and join at calcpa.org/fss

For more information, contact:Marty Laffer, Forensic Services Section Chair [email protected] Ku, Forensic Services Section Manager [email protected]

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MaySchool Districts ConferenceMay 8: Sacramento | Webcast

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