2014 Tax Considerations
Date posted: December 26, 2014
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The followings are articles regarding tax law changes and are categorized in:
- Individual Income Tax Provisions
- Trust, Estate and Decedent Income Tax
- Estate, Gift and Generation-Skipping Transfer Taxes
- Pension and IRA Provisions
- Business Provisions
- Things to Consider Before The End of 2014
- 2014 Tax Rate Schedule
- 2015 Tax Rate Schedule
Individual Income Tax Provisions
0% and 15% Capital Gain Rates are Made Permanent; 20% Rate is Added for High-Income Taxpayers After 2012
The 2012 Taxpayer Relief Act added a new 20% capital gain tax rate for high-income taxpayers. The 20% rate applies to the adjusted net capital gain (or, if less, taxable income) that exceeds the amount that is taxed at the 0% or 15% rates.
For tax years beginning after 2012, the 2012 Taxpayer Relief Act raises the top rate for capital gains and dividends to 20% (up from 15%) for taxpayers with incomes exceeding $400,000 ($450,000 for married taxpayers). After accounting for Code Sec. 1411’s 3.8% surtax on investment-type income and gains for tax years beginning after 2012, the overall rate for higher-income taxpayers will be 23.8%. (Under the EGTRRA/JGTRRA sunset provisions, long-term capital gain was to be taxed at a maximum rate of 20%, with an 18% rate for assets held more than five years, and dividends paid to individuals were to be taxed at the same rates that apply to ordinary income.)
For taxpayers whose ordinary income is generally taxed at a rate below 25%, capital gains and dividends will permanently be subject to a 0% rate. (Under the EGTRRA/JGTRRA sunset provisions, long-term capital gain of lower-income taxpayers was to be taxed at a maximum rate of 10%, with an 8% rate for assets held more than five years, and dividends were to be subject to ordinary income rates.) Taxpayers who are subject to a 25%-or-greater rate on ordinary income, but whose income levels fall below the $400,000/$450,000 thresholds, will continue to be subject to a 15% rate on capital gains and dividends. The rate will be 18.8% for those subject to the 3.8% surtax (i.e. those with modified adjusted gross income (MAGI) over $250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 in any other case).
Under the 2012 Taxpayer Relief Act, the 15% rate applies to the lesser of:
- the portion of the adjusted net capital gain (or, if less, taxable income) that exceeds the amount that is taxed at a 0% rate, or
- the excess of: (i) the amount of taxable income that would otherwise be taxed at a rate below 39.6%, over (ii) the sum of the amounts that are taxed at ordinary income rates or the 0% capital gain rate.
The 39.6% income tax rate applies to taxable income above $450,000 for joint filers and surviving spouses, $425,000 for heads of household, $400,000 for single filers, and $225,000 for married taxpayers filing separately, adjusted for inflation after 2013. Thus, the 20% capital gain rate applies to taxpayers whose income exceeds these thresholds.
Because the 3.8% net investment income tax (NIIT) applies to most capital gains starting in 2013 the overall capital gain rate for some high-income taxpayers will be 23.8% (20% + 3.8%). The NIIT applies to taxpayers whose modified adjusted gross income (MAGI) exceeds $250,000 for joint returns and surviving spouses, $125,000 for separate returns, and $200,000 in all other cases.
Taxpayers who are subject to a 25%-or-greater rate on ordinary income, but whose income is below the 39.6% rate threshold, will continue to be subject to a 15% capital gain rate. For taxpayers whose ordinary income is taxed at a rate below 25%, capital gains will permanently be subject to a 0% rate.
Qualified Dividends are Taxed at 0%, 15%, and 20% Rates after 2012
“Qualified dividend income” – generally, dividends received from domestic corporations and “qualified foreign corporations,” subject to holding period requirements and specified exceptions – is effectively treated as, and is taxed at the same rates that apply to, adjusted net capital gain.
For dividends on stock to qualify as qualified dividend income, the taxpayer must hold the stock for at least 61 days during the 121-day period beginning 60 days before the ex-dividend date.
Unrecaptured Section 1250 Gain
The amount of a taxpayer’s “unrecaptured section 1250 gain” – that portion of a noncorporate taxpayer’s long-term capital gain that is attributable to real estate depreciation – that is eligible to be taxed at a maximum 25% rate is limited to the taxpayer’s net capital gain determined without regard to the taxpayer’s qualified dividend income.
The treatment of qualified dividend income as adjusted net capital gain, taxable at the same rates that apply to adjusted net capital gain, is made permanent.
Under the 2012 Taxpayer Relief Act, capital gain is taxed at 0%, 15%, and 20% rates after 2012. The 20% rate applies to taxpayers whose income exceeds $450,000 for joint filers and surviving spouses, $425,000 for heads of household, $400,000 for single filers, and $225,000 for married taxpayers filing separately. Qualified dividends will be taxed at the same 0%, 15%, and 20% rates that apply to capital gain.
Because the 3.8% net investment income tax (NIIT) applies to dividends starting in 2013, the overall tax rate on qualified dividends for some high-income taxpayers will be 23.8% (20% + 3.8%). The NIIT applies to taxpayers whose modified adjusted gross income (MAGI) exceeds $250,000 for joint returns and surviving spouses, $125,000 for separate returns, and $200,000 in all other cases.
Taxpayers who are subjected to a 25%-or-greater rate on ordinary income, but whose income is below the 39.6% rate thresholds, will continue to be subject to a 15% rate on qualified dividends. For taxpayers whose ordinary income is taxed at a rate below 25%, qualified dividends will permanently be subject to a 0% rate.
With the removal of the JGTRRA sunset, the following rules related to qualified dividends, discussed above, have also been made permanent:
- The holding period rule for determining when dividends on stock qualify as qualified dividend income.
- The exclusion of qualified dividend income from net capital gain for purposes of computing the limitation on the amount of unrecaptured section 1250 gain that is eligible to be taxed at a maximum 25% rate.
The effect of the provision is to remove the sunset that would have been effective for tax years beginning after December 31, 2012.
Election to Include Qualified Dividends in Investment Income for Purposes of Investment Interest Deduction is Made Permanent
A noncorporate taxpayer’s deduction for investment interest expense is limited to the amount of the taxpayer’s net investment income, i.e., the excess of investment income over investment expenses for the year. Any investment interest that is disallowed because it exceeds this limit is carried over to the next tax year and treated as investment interest paid or accrued in that year.
Qualified dividend income (dividends taxed at capital gain rates) is included in “investment income” for this purpose only to the extent the taxpayer elects to include it. Any amount that the taxpayer elects to treat as investment income is not treated as qualified dividend income and is not eligible to be taxed at capital gain rates.
A taxpayer whose investment interest deduction is limited because the interest exceeds the amount of his net investment income can increase the deduction by electing to include all or part of qualified dividend income in investment income. The cost of making the election is that the dividends will be taxed as ordinary income rather than capital gain.
Exclusion of 100% of Gain on Certain Small Business Stock Extended
A taxpayer may exclude all of the gain on the disposition of qualified small business stock acquired after September 27, 2010 and before January 1, 2014. None of the excluded gain is subject to the alternative minimum tax.
Under pre-Act law, the exclusion was to be limited to 50% of gain for stock acquired after December 31, 2013, and 7% of the excluded gain was to be an alternative minimum tax preference.
The Act extends the 100% exclusion and the exception from minimum tax preference treatment for one year (i.e., for stock acquired before January 1, 2015).
Personal Exemption Phaseout (PEP) Applies When AGI Exceeds $300,000 (Joint Returns) and $250,000 (Single Filers) for Tax Years Beginning After December 31, 2012
Taxpayers are allowed two types of personal exemptions: the exemption for the taxpayer and the taxpayer’s spouse, also referred to as the “personal exemptions,” and the exemption for dependents. An individual is entitled to a deduction of a $3,800 for 2012 (as adjusted for inflation) for a personal exemption.
Under the personal exemption phaseout (PEP) rules in effect before the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), the exemption amount of a taxpayer whose adjusted gross income (AGI) for the tax year exceeded a specified threshold amount was reduced by an applicable percentage. The applicable percentage was two percentage points for every $2,500 (or fraction of $2,500) by which the taxpayer’s AGI for the tax year exceeded the threshold amount. The threshold amount varied, depending on the taxpayer’s filing status. The indexed threshold amounts for tax years beginning in 2009 were, for joint filers: $250,200, with complete phaseout occurring at $372,700; and for singles: $166,800, with complete phaseout occurring at $289,300.
New Law Effective for Tax Years Beginning after December 31, 2012
Under the 2012 Taxpayer Relief Act (the “Act”) the PEP is restored, but the amounts of AGI at which the PEP applies are higher than under pre-Act law. Under the Act, a taxpayer’s exemption amount is reduced by the applicable percentage when his AGI for the tax year exceeds the “applicable amount” that is in effect.
The “applicable amounts” for purposes of the overall limitation on itemized deductions are: for joint filers or surviving spouses, $300,000; for heads of household, $275,000; for singles, $250,000; and for married filing separately, half of the joint filer amount. After 2013, the applicable amounts are adjusted for inflation.
Overall Limitation on Itemized Deductions is Restored. Applies when AGI Exceeds $300,000 (Joint Returns) and $250,000 (Single Filers)
Individuals who do not elect to itemize their deductions are allowed, instead, to deduct from their adjusted gross income (AGI) an inflation-adjusted basic standard deduction to determine their taxable income.
Under an overall limitation on itemized deductions in effect before the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), if an individual’s adjusted gross income (AGI) exceeded the “applicable amount,” the amount of the itemized deductions otherwise allowed for the tax year was reduced by the lesser of: (i) 3% of the excess of AGI over the applicable amount, or (ii) 80% of the amount of itemized deductions otherwise allowable for the tax year. The inflation-adjusted applicable amounts for any tax year beginning in a calendar year equaled the statutory applicable amount ($100,000 or $50,000, whichever applied), multiplied by the percentage (if any) by which the consumer price index (CPI) for the calendar year preceding the calendar year in which the tax year began exceeded the CPI for calendar year 1990. For 2009, an individual’s AGI exceeded the statutory $100,000 “applicable amount,” as adjusted for inflation, if it exceeded $166,800. For 2009 for marrieds filing separately, an individual’s AGI exceeded the statutory $50,000 “applicable amount,” as adjusted for inflation, if it exceeded $83,400.
The above-described reduction in total itemized deductions is referred to as the “overall limitation on itemized deductions,” the “3%/80% rule,” or the “Pease limitation.”
New Law Effective for Tax Years Beginning after December 31, 2012
Under the 2012 Taxpayer Relief Act (Act) the overall limitation on itemized deductions is restored, but the Act has increased the inflation-adjusted “applicable amounts.” Under the Act, the “applicable amounts” are:
- $300,000, for a joint return or surviving spouse (as defined in Code Sec. 2(a)); (Code Sec. 68(b)(1)(A) as amended by 2012 Taxpayer Relief Act § 101 (b)(2)(A)(i));
- $275,000, for a head of household (as defined in Code Sec. 2(b)) (Code Sec. 68(b)(1)(B) as amended by 2012 Taxpayer Relief Act § 101 (b)(2)(A)(i));
- $250,000, for an individual who is not married and is not a surviving spouse or head of household (Code Sec. 68(b)(1)(C) as amended by 2012 Taxpayer Relief Act § 101 (b)(2)(A)(i)); and
- One-half the amount in (1) (after adjustment for inflation), for a married individual filing separately (Code Sec. 68(b)(1)(D) as amended by 2012 Taxpayer Relief Act § 101 (b)(2)(A)(i)).
The Act also amends the inflation adjustment rules. The inflation adjustment, which applies to tax years beginning in calendar years after 2013, is arrived at by multiplying the applicable amounts above by the percentage (if any) by which the consumer price index (CPI) for the calendar year before the calendar year in which the tax year begins exceeds the CPI for calendar year 2012.
Summary of Individual Extenders in the 2014 Tax Increase Prevention Act
The new law extends the following items for the period indicated beyond their prior termination date as shown in the listing:
- The $250 deduction for certain expenses of elementary and secondary school teachers, which expired at the end of 2013 and which is now revived for 2014;
- The exclusion for discharge of qualified principal residence indebtedness, (up to $2,million limit) which applied for discharges before January 1, 2014 and which is now continued to apply for discharges before January 1, 2015;
- Parity for the exclusions for employer-provided mass transit and parking benefits, which applied before 2014 and which is now revived for 2014;
- The treatment of mortgage insurance premiums as qualified residence interest, which expired at the end of 2013 and which is now revived for 2014;
- The option to deduct State and local general sales taxes, which expired at the end of 2013 and which is now revived for 2014;
- The special rule for contributions of capital gain real property made for conservation purposes, which expired at the end of 2013 and which is now revived for 2014;
- The above-the-line deduction for qualified tuition and related expenses, which expired at the end of 2013 and which is now revived for 2014; and
- Tax-free distributions from individual retirement plans for charitable purposes, which expired at the end of 2013 and which is now revived for 2014.
Exclusion for Debt Discharge Income from Home Mortgage Forgiveness is Extended for One Year Until the End of 2014
The rule that a discharge of indebtedness gives rise to income includible in gross income- “cancellation of debt (COD) income” or “debt discharge income” is subject to certain exceptions, including exceptions for discharges in Title 11 bankruptcy cases or when the taxpayer is insolvent (the “insolvency exclusion”). For these exceptions, taxpayers generally reduce certain tax attributes, including basis in property, by the amount of the debt discharged.
An exception for home mortgages – the “mortgage forgiveness exclusion” – applies to discharges after December 31, 2006. Any debt discharge income resulting from a discharge (in whole or in part) of “qualified principal residence indebtedness” is excluded from gross income. “Qualified principal residence indebtedness” is acquisition indebtedness (as defined by Code Sec. 163(h)(3)(B) except that the dollar limitation is $2 million) with respect to the taxpayer’s principal residence; – i.e., the debt must have been used to acquire, construct, or substantially improve the taxpayer’s principal residence, or to refinance the debt (but only up to the amount refinanced), and must have been secured by the residence. This exclusion applies where taxpayers restructure their acquisition debt on a principal residence or lose their principal residence in a foreclosure.
The basis of the residence is reduced by the amount excluded under the above-described mortgage forgiveness exclusion, but not below zero.
“Principal residence” has the same meaning for this purpose as under the Code Sec. 121 homesale exclusion rules–i.e., the home where the taxpayer ordinarily lives most of the time. The exclusion does not apply to debt forgiven on second homes, business property, or rental property.
If only part of the discharged loan is qualified principal residence indebtedness, the mortgage forgiveness exclusion applies only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before the discharge) that is not qualified principal residence indebtedness.
The mortgage forgiveness exclusion does not apply if the discharge is on account of services performed for the lender or any other factor not directly related to a decline in the residence’s value or to the taxpayer’s financial condition.
The mortgage forgiveness exclusion also does not apply to a taxpayer in a Title 11 bankruptcy case; instead, the general exclusion rules apply. Where an insolvent taxpayer (other than the one in a Title 11 bankruptcy) qualifies for the mortgage forgiveness exclusion, the mortgage forgiveness exclusion applies unless the taxpayer elects to apply the insolvency exclusion.
The 2014 Tax Increase Prevention Act extends the mortgage forgiveness exclusion for one year, so that it applies to indebtedness discharged before January 1, 2015.
As described above, an insolvent taxpayer (not in a Title 11 bankruptcy case) whose debt is discharged (in whole or in part) uses the mortgage forgiveness exclusion rules, including the basis reduction requirement for the residence, for any portion of the discharged debt that is “qualified real property indebtedness.” That is, if the taxpayer wants to use the insolvency exclusion rules, including the tax attribute reduction requirements, he must elect “out” of the mortgage forgiveness exclusion. By extending the mortgage forgiveness exclusion for one year, the Act also extends for one year the period for which an insolvent taxpayer must affirmatively elect to use the insolvency exclusion.
Taxpayers usually will not benefit from electing the insolvency exclusion here. The insolvency exclusion requires the taxpayer to make the same basis and tax attribute reductions as are required in a Title 11 bankruptcy case. The mortgage forgiveness exclusion requires the taxpayer to reduce his basis in the residence. In addition, the amount of debt discharge income that is excluded from income under the insolvency exclusion is limited to the amount by which the taxpayer is insolvent. This limitation does not apply in the case of the mortgage forgiveness exclusion.
The Adoption Assistance Exclusion is Made Permanent
Employees can exclude from gross income the qualified adoption expenses paid or reimbursed by an employer under an employer-provided adoption assistance program. The exclusion is subject to both (i) a dollar limit (under which the total amount of excludible adoption expenses cannot exceed a maximum amount), and (ii) an income limit (under which the exclusion is ratably phased out over a certain income range, based on modified adjusted gross income (AGI)).
The 2001 Economic Growth and Tax Relief Reconciliation Act made modifications to the adoption assistance exclusion, as described below.
EGTRRA modified the exclusion by:
- increasing the maximum exclusion from $5,000 ($6,000 for special needs adoptions) to $10,000 (for all adoptions);
- allowing the maximum exclusion amount for special needs adoptions, without regard to the amount of adoption expenses actually incurred;
- increasing the income phaseout range from a range of $75,000 to $115,000, to a range of $150,000 to $190,000;
- providing that the dollar limit and the income limit are to be adjusted for inflation; and
- making the exclusion “permanent” (instead of being set to expire after December 31, 2001, as provided under pre-EGTRRA law), but still subject to EGTRRA’s sunset provision which provided that all changes made by EGTRRA (including the changes to the adoption assistance exclusion described above) were not to apply to tax years beginning after December 31, 2010.
The 2010 Tax Relief Act extended the adoption assistance exclusion as expanded by EGTRRA for one year (through 2012). The 2010 Act accomplished this by amending the EGTRRA sunset provision by replacing the December 31, 2010 sunset date with a December 31, 2012 sunset date. Thus, under the 2010 Tax Relief Act, the changes made to the exclusion by EGTRRA (items listed above) were extended through 2012.
For tax years beginning in 2012:
- the maximum exclusion was $12,170, as adjusted for inflation; and
- the phaseout range was $182,520 to $222,520, as adjusted for inflation.
For tax years beginning after December 31, 2012, the adoption assistance exclusion was going to revert to pre-EGTRRA law, which provided that the exclusion was to expire for amounts paid, or expenses incurred, after December 31, 2001. Thus, for tax years beginning after 2012, the exclusion was not going to be available.
The 2012 Taxpayer Relief Act permanently extends the adoption assistance exclusion.
For Tax years beginning in 2013 (and years thereafter), it is anticipated that IRS will issue inflation-adjusted amounts for the maximum exclusion and the phaseout range.
For tax years beginning in 2015:
- the maximum exclusion is $13,400, as adjusted for inflation; and
- the phaseout range is $201,010 to $241,010, as adjusted for inflation.
Additional 0.9% Medicare Tax Will be Imposed After 2012 on Wages and Self-Employment Income over Threshold Amounts
The Federal Insurance Contributions Act (FICA) imposes two taxes on employees on wages received with respect to employment. Similar taxes are imposed on wages paid by employers.
The Old Age, Survivors and Disability Insurance (OASDI) tax is imposed at a 6.2% rate, on wages up to an annually-adjusted “wage base” ($106,800 for 2010).
Under pre-2010 Health Care Act law, the Medicare Hospital Insurance (HI) tax was imposed at a 1.45% rate on all wages, regardless of amount.
Employers must collect the employee FICA tax by withholding it from the employee’s wages when paid.
The 2010 Health Care Act increases the employee portion of the HI tax after 2012 by an additional tax of 0.9% on wages received in excess of the applicable threshold amount (see below). Unlike the general 1.45% HI tax on wages, the additional tax on a joint return is on the combined wages of the employee and the employee’s spouse.
The same additional HI tax applies to the HI portion of SECA tax on self-employment income. Thus, an additional tax of 0.9% is imposed on every self-employed individual on self-employment income in excess of the applicable threshold amount. The threshold amount is reduced (but not below zero) by the amount of wages taken into account in determining the taxpayer’s FICA tax.
For tax years beginning after December 31, 2012, an additional 0.9% HI tax will be imposed on taxpayers (other than corporations, estates, or trusts) on wages received with respect to employment in excess of:
- $250,000 for joint returns (Code Sec. 3101(b)(2)(A)),
- $125,000 for married taxpayers filing a separate return, and
- $200,000 in all other cases.
These threshold amounts are not indexed for inflation. Thus, as time goes on, more taxpayers will become subject to these taxes.
This tax will be in addition to the regular HI rate of 1.45% of wages received by employees with respect to employment.
Thus, the HI tax rate will be:
- 1.45% on the first $200,000 of wages ($125,000 on a separate return, $250,000 of combined wages on a joint return); and
- 2.35% (1.45% + 0.9%) on wages in excess of $200,000 ($125,000 on a separate return, $250,000 of combined wages on a joint return).
This change does not affect the HI tax imposed on employers.
A single taxpayer earns wages of $500,000 for 2013. Taxpayer pays HI tax of $2,900 on the first $200,000 of wages ($200,000 x 1.45%) and $7,050 on the excess of his wages over $200,000 ($300,000 x 2.35%), for a total HI tax of $9,950.
For 2013, H and W file a joint return. H earns wages of $125,000 and W earns wages of $175,000. H and W pay HI tax of $3,625 ($250,000 x 1.45%) on their first $250,000 of wages and $1,175 on the excess of their combined wages over $250,000 ($50,000 x 2.35%), for a total HI tax of $4,800.
Employer’s Obligation to Withhold
The employer is required to withhold the additional 0.9% HI tax on wages. The employer is liable for the tax that it fails to withhold from wages or to collect from the employee (where the employer fails to withhold).
However, an employer’s obligation to withhold the additional 0.9% HI tax applies only to wages in excess of $200,000 that the employee receives from the employer. The employer may disregard the amount of wages received by the employee’s spouse. The Committee Report adds that the employer must disregard the spouse’s wages.
Thus, the employer is only required to withhold the additional 0.9% HI tax on wages in excess of $200,000 for the year, even though the tax may apply to a portion of the employee’s wages at or below $200.000, if the employee’s spouse also has wages for the year, they are filing a joint return, and their total combined wages for the year exceed $250,000.
For 2013, H has wages of $250,000, and W has wages of $100,000. H’s employer must withhold the additional 0.9% HI tax on the $50,000 of H’s wages in excess of $200,000. W’s employer is not required to withhold any portion of the additional 0.9% HI tax, even though H and W’s combined wages are over the $250,000 threshold.
Couples in this situation may have to make estimated tax payments to cover the additional 0.9% HI tax, because the amounts withheld by their employers will not be sufficient.
The employer will not be liable for any additional 0.9% HI tax that it fails to withhold and that the employee later pays, but will be liable for any penalties resulting from its failure to withhold.
The employee will be liable for the additional 0.9% HI tax to the extent it is not deducted by the employer. In contrast, employees generally have no direct liability for the employee portion of the general 1.45% HI tax.
The amount of the additional 0.9% HI tax not withheld by an employer must be taken into account in determining a taxpayer’s estimated tax liability.
The above is effective for tax years beginning after December 31, 2012.
New 3.8% Medicare Contribution Tax Will be Imposed after 2012 on Net Investment Income of Individuals, Estates, and Trusts
The 2010 Reconciliation Act imposes an unearned income Medicare contribution tax on individuals, estates, and trusts.
The tax is generally levied on income from interest, dividends, annuities, royalties, rents, and capital gains.
For individuals, the tax is 3.8% of the lesser of (a) net investment income or (b) the excess of modified adjusted gross income (MAGI) over the applicable threshold amount.
Net investment income is investment income reduced by the deductions properly allocable to such income.
MAGI is adjusted gross income (AGI) increased by the amount excluded from income as foreign earned income, net of the deductions and exclusions disallowed with respect to the foreign earned income.
The threshold amount is $250,000 for joint returns or surviving spouses, $125,000 for separate returns, and $200,000 in other cases.
Only individuals with MAGI above the applicable threshold amount will be subject to the tax.
- For 2013, a single taxpayer has net investment income of $50,000 and MAGI of $180,000. The taxpayer will not be liable for the Medicare contribution tax, because his MAGI ($180,000) does not exceed his threshold amount ($200,000).
- For 2013, a single taxpayer has net investment income of $100,000 and MAGI of $220,000. The taxpayer would pay a Medicare contribution tax only on the $20,000 amount by which his MAGI exceed his threshold amount of $200,000, because that is less than his net investment income of $100,000. Thus, taxpayer’s Medicare contribution tax would be $760 ($20,000 x 3.8%).
An individual will pay the 3.8% tax on the full amount of his net investment income if his MAGI exceeds his threshold amount by at least the amount of the net investment income.
- Assume that the taxpayer in illustration (2) had MAGI of $300,000. Because taxpayer’s MAGI exceeds his threshold amount by $100,000, he would pay a Medicare contribution tax on his full $100,000 of net investment income. Thus, taxpayer’s Medicare contribution tax would be $3,800 ($100,000 x 3.8%).
The Medicare contribution tax is in addition to the 0.9% HI tax on wages and on self-employment income in excess of threshold amounts. Taxpayers who have both high wages or self-employment income and high investment income may be hit with both taxes.
- For 2013, a single taxpayer has net investment income of $100,000, Wages of $300,000, and MAGI of $375,000. In addition to paying a Medicare contribution tax of $3,800, as explained in illustration (3), the taxpayer would also pay an additional HI (Medicare) tax of $900 ($100,000 x 0.9%) on his wages in excess of $200,000.
For estates and trusts, the tax is 3.8% of the lesser of (a) undistributed net investment income or (b) the excess of AGI over the dollar amount at which the highest estate and trust income tax bracket begins.
“Net Investment Income” Defined
For purposes of the Medicare contribution tax, “net investment income” means the excess, if any, of:
- The sum of:
- gross income from interest, dividends, annuities, royalties, and rents, unless those items are derived in the ordinary course of a trade or business to which the Medicare contribution tax does not apply (see below),
- other gross income derived from a trade or business to which the Medicare contribution tax applies (see below),
- net gain (to the extent taken into account in computing taxable income) attributable to the disposition of property other than property held in a trade or business to which the Medicare contribution tax does not apply, over
- The allowable deductions that are properly allocable to that gross income or net gain.
Gross income does not include items, such as tax-exempt bond interest, veterans’ benefits, and excluded gain from the sale of a principal residence, that are excluded from gross income for income tax purposes.
Trades and Businesses to Which Tax Applies
The Medicare contribution tax applies to a trade or business if it is:
- a passive activity of the taxpayer, within the meaning of Code Sec. 469, or
- a trade or business of trading in financial instruments or commodities as defined in Code Sec.475(e)(2).
The Medicare contribution tax does not apply to other trades or businesses conducted by a sole proprietor, partnership, or S corporation.
Thus, for a taxpayer that does not engage in a passive activity or a financial instrument or commodities trading business, “net investment income” will include non-business income from interest, dividends, annuities, royalties, rents, and capital gains, minus the allocable deductions. Business income will not be included.
For a taxpayer that does engage in a passive activity or a financial instrument or commodities trading business, “net investment income” will include the above items, plus the gross income (minus allocable deductions) from the passive activity or trading business.
Income on Investment of Working Capital Subject to Tax
For purposes of the definition of “net investment income,” a rule applies that is similar to the rule of Code Sec. 469(e)(1)(B), which treats income, gain, or loss attributable to an investment of working capital as not derived in the ordinary course of a trade or business.
Thus, income, gain, or loss on working capital is not treated as derived from a trade or business.
As a result, those items will be subject to the Medicare contribution tax.
Exception for Certain Active Interests in Partnerships and S Corporations
Gain from a disposition of an interest in a partnership or S corporation is taken into account as net investment income only to the extent of the net gain that the transferor would take into account if the partnership or S corporation had sold all its property for fair market value immediately before the disposition.
A similar rule applies to a loss from a disposition of an interest in a partnership or S corporation.
Thus, only net gain or loss attributable to property held by the entity that is not properly attributable to an active trade or business is taken into account. For this purpose, a business of trading financial instruments or commodities is not treated as an active trade or business.
Qualified Plan Distributions
Qualified retirement plan distributions are not included in investment income. Specifically, net investment income does not include any distribution from a plan or arrangement described in: (Code Sec. 1411 (c)(5))
- Code Sec. 401(a) (qualified pension, profit-sharing, and stock bonus plans);
- Code Sec. 403(a) (qualified annuity plans);
- Code Sec. 403(b) (annuities for employees of tax-exempt organizations or public schools);
- Code Sec. 408 (individual retirement accounts-IRAs);
- Code Sec. 408A (Roth IRAs);
- Code Sec. 457(b) (deferred compensation plans of state and local governments and tax exempt organizations).
Investment income does not include amounts subject to SECA taxes. Specifically, net investment income does not include any item taken into account in determining self-employment income for the tax year, if that item is subject to the HI portion of SECA taxes under Code Sec. 1401(b).
Estates and trusts are subject to a Medicare contribution tax for each tax year equal to 3.8% of the lesser of:
- The estate’s or trust’s undistributed net investment income for the tax year, or
- The excess (if any) of:
- the estate’s or trust’s AGI for the tax year, over
- the dollar amount at which the highest tax bracket in Code Sec. 1(e) begins for the tax year.
For 2010, the highest estate and trust income tax bracket begins at $11,200. These brackets are indexed for inflation. Presumably, by the time the Medicare contribution tax takes effect in 2013, the dollar amount will be higher.
The Medicare contribution tax does not apply to a trust all of the unexpired interests in which are devoted to one or more of the charitable purposes described in Code Sec. 170(c)(2)(B).
The tax also does not apply to a trust that is tax-exempt under Code Sec. 501 or a charitable remainder trust exempt from tax under Code Sec. 664.
In addition, the Medicare contribution tax probably will not apply to simple trusts and grantor trusts. A simple trust is a trust that makes no distribution other than of current income and whose terms require all of its income to be distributed currently and do not provide for charitable contributions. Thus, it would not have any undistributed net investment income that would be subject to the Medicare contribution tax.
Under the grantor trust rules, a grantor or other person, such as a beneficiary, may be treated as “owner” of all or part of the trust and taxed directly, to that extent, on the trust income. To the extent that the grantor trust rules apply, the regular rules for taxing trusts and their beneficiaries do not apply.
The Medicare contribution tax is subject to the individual estimated tax provisions. The Medicare contribution tax is treated as “tax” for purposes of computing the penalty for underpayment of estimated tax.
Items of income that are excluded from income reduce both MAGI and net investment income. This provides higher-income taxpayers potentially subject to the UIMCT additional incentive to structure transactions that result in either tax-exempt or tax-deferred income. Higher-income taxpayers can minimize the UIMCT by including non-dividend paying growth stocks, which do not increase MAGI or create investment income until sold, in their investment portfolio. Tax-deferred annuities and related investments will also minimize liability for the UIMCT, and may become more popular.
Because tax-exempt income is not included in either MAGI or investment income, higher-income taxpayers will have increased incentive to invest in state and local obligations exempt from tax.
Investment income includes net gain (to the extent taken into account in computing taxable income) from the disposition of property. Tax planning strategies that reduce or defer capital gain income will also reduce or defer net investment income for purposes of the UIMCT. Using the installment method of accounting to report gain on the sale of property sold on an installment basis, for example, will minimize the impact of the UIMCT because it avoids a large increase in both MAGI and investment income in the year of sale. Taxpayers selling property on an installment basis in 2012, on the other hand, should consider electing out of the installment method and recognizing the entire amount of the gain before the 3.8% UIMCT goes into effect.
Because gain on the disposition of property is included in investment income only to the extent it is taken into account in computing taxable income, taxpayers should analyze their portfolios at the end of the year to determine whether they can reduce their MAGI and investment income. For example, selling stock that has decreased in value and using the loss to offset capital gain that would otherwise be included in income will reduce both MAGI and investment income.
Because distributions from qualified retirement plans are not included in net investment income, the UIMCT provides taxpayers with additional incentive to maximize retirement plan contributions.
Taxpayers should consider the UIMCT in planning for passive activities. Passive income is investment income for purposes of the UIMCT. Classifying income as passive is generally advantageous for taxpayers with sufficient passive losses to offset the passive income. For taxpayers with net passive income, however, the UIMCT increases the tax rate on passive income. The UIMCT gives taxpayers with passive activities, including passive rental activities, and additional factor to consider in passive activity planning.
The UIMCT provides higher-income taxpayers with another incentive to consider the use of family limited partnerships and related estate planning techniques. Investment income transferred from parents with significant MAGI and investment income to children with MAGI below the applicable threshold amount through the use of family limited partnerships will not be subject to the UIMCT on what otherwise would be the parent’s investment income. Although investment income transferred to children through a family limited partnership may be taxed at their parent’s rate under the “kiddie tax” rules, the children will be subject to the UIMCT only if their income (including income from a family limited partnership) exceeds the applicable threshold. Children subject to the kiddie tax are taxed at their parent’s rate for purposes of the regular tax. Children will not be subject to the UIMCT merely because their parents are.
Estates and trusts with undistributed net investment income will be subject to the UIMCT whenever their adjusted gross income exceeds the dollar amount at which the top marginal tax rate begins. Because the top marginal rate for estates and trusts begins at a relatively small amount of income ($11,650 in 2012), the UIMCT is of particular concern to estates and trusts and should be considered in both distribution and investment decisions.
Estates and trusts are subject to the UIMCT only if they have undistributed net investment income. Estates and trusts can reduce undistributed net investment income and thereby minimize or eliminate the UIMCT by distributing income to beneficiaries. Any distribution will increase the beneficiary’s net investment income and potential liability for the UIMCT. However, the threshold amount for individuals is much higher than that for estates and trusts, and the UIMCT can be eliminated if the beneficiary’s MAGI remains below the threshold amount.
Estates and trusts should also consider the UIMCT in making investment decisions. Because estates and trusts are subject to the UIMCT at a relatively low level of adjusted gross income, the previously discussed strategies for reducing adjusted gross income and net investment income are particularly important for estates and trusts. The UIMCT increases the already existing incentives estates and trusts have to invest in tax-exempt and tax-deferred investments.
The new 0.9% tax on earned income and 3.8% tax on net investment income will increase the tax burden of higher-income taxpayers beginning in 2013. Taxpayers should begin planning now in order to minimize the impact of these taxes in 2013 and beyond.
Limits on Deductions for Investment and Personal Interest
The deductibility of investment and personal interest is limited.
Investment interest, generally defined as interest used to buy or carry investment property, is deductible by noncorporate taxpayers only to the extent of net investment income. Investment income includes income such as dividends, interest and certain gain on the sale of investment property but, for purposes of the investment interest deduction, generally does not include net capital gain from disposing of investment property (including capital gain distributions from mutual funds) or qualified dividend income. Net capital gain is the excess of net long-term capital gain for the year over the net short-term capital loss for the year. Qualified dividend income is income from dividends that qualify to be taxed at the net capital gain tax rates. However, the taxpayer can choose to include part or all of net capital gain and qualified dividend income in investment income. (Investment interest not allowed as a deduction for a tax year because of the investment interest limit is treated as interest paid or accrued in the following year and may eventually become deductible, either in the following tax year or in some later year).
Election to Include Net Capital Gain and Qualified Dividend Income in Investment Income
A taxpayer may elect to include all or part of his net capital gain and qualified dividend income in investment income. However, any amount that the taxpayer elects to include in investment income does not qualify for the favorable maximum tax rates that apply to net capital gain and qualified dividend income. Net capital gain and qualified dividend income is reduced (but not below zero) by the amount the taxpayer elects to take into account as investment income to permit investment interest deductions. (In deciding whether to make the special election, taxpayers whose marginal rate is 25% or higher should compare the relative tax benefits of:
- postponing the interest deduction to a later year, or
- giving up the benefit of the maximum capital gain and qualified dividend income rate ceilings.
Their calculations should take into account the time value of money, the length of the deferral and the taxpayer’s top tax brackets for 2010 and for the year that the investment interest is likely to be deducted).
Personal interest is not deductible. This includes all interest except:
- interest connected with a trade or business (but not interest paid on a tax deficiency arising from an unincorporated business),
- investment interest,
- passive activity interest,
- qualified residence interest,
- interest on qualifying higher-education loans, and
- otherwise deductible interest on deferred estate tax payments.
Passive Activity Loss Rules
Interest may also be subject to passive activity loss rules. The passive activity loss and investment interest rules dovetail in such a way that any interest, other than personal interest, qualified residence interest, estate tax interest, or interest relating to a trade or business in which the taxpayer materially participates, is subject to one of the two rules. The application of the investment interest limitation is described above. Interest that relates to a passive activity is subject to the passive activity rules.
Qualified Residence Interest
One kind of interest that remains deductible is qualified residence interest. This term includes interest on debt secured by the taxpayer’s principal residence and one other qualified residence (including a trailer or houseboat). If the taxpayer has a principal residence and two or more other residences, he can choose each year which of the other homes qualifies as his second residence.
Qualified residence interest includes acquisition debt and home equity debt with respect to a taxpayer’s qualified residence. The maximum amount of acquisition debt is $1 million. Home equity debt cannot exceed $100,000 (or, if less, taxpayer’s equity in the home). Under a grandfather provision, pre-October 14, 1987 mortgage debt (regardless of amount) is treated as acquisition debt.
Acquisition debt is debt that is incurred in acquiring, constructing or substantially improving the principal or second qualified residence of the taxpayer and which is secured by the residence. If the debt to acquire, construct or substantially improve a principal and second residence exceeds $1 million, then only the interest on a total principal amount of $1 million is deductible as interest on acquisition debt.
You cannot deduct the interest for acquisition debt greater than $1 million ($500,000 for married individuals filing separately). So, for example, if you were to buy a $2 million house with a $1.5 million mortgage, only the interest that you pay on the first $1 million in debt will be deductible. The rest will be considered personal interest and not deductible.
Note also that the $1 million ceiling on deductible home mortgage debt includes both your primary residence and your second home combined.
Acquisition indebtedness is defined by code section 163(h)(3) as any indebtedness which is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence. In other words if you borrowed $500,000 from the bank and secured this loan with your primary residence and further used the $500,000 to acquire a vacation home in Wisconsin, a literal reading of the code would conclude that the interest expense on this $500,000 loan would be non-deductible personal interest and this is because the Wisconsin residence does not secure such debt. The interest on this same loan would be fully deductible simply by securing the loan by the Wisconsin residence.
We have seen many clients borrowing on their principal residence in order to acquire a second home in the last few years. In order to be able to deduct this interest expense you must make sure that the debt is secured by the second home. While this may seem unnecessary, we have reached our conclusions after receiving second opinions on this issue from a law firm as well as directly from the IRS.
A residence under construction may be treated as a qualified residence for a period of up to 24 months, but only if it becomes a qualified residence as of the time it is ready for occupancy. The 24-month period referred to above may begin on or after the date construction began.
X owns a residential lot. On April 20 of year 1, X obtains a mortgage loan secured by the lot and any property to be constructed on the lot. He uses the proceeds of the loan to finance the construction of a vacation home on the lot. Construction commences on August 9 of year 1. The vacation home is ready for occupancy on November 9 of year 3, and qualified as X’s second residence at that time. Under these circumstances, X may treat the vacation home as a second residence for any 24-month period during which it was under construction. This 24-month period may commence on or after the date construction began (August 9 of year 1). If X chooses to begin this 24-month on August 9 of year 1, the period ends on August 8 of year 3. Whether the vacation home is a qualified residence for the period August 9 – November 8 of year 3 is determined without regard to the “under construction” rules.
If you are planning to refinance your mortgage, special rules apply. If the old mortgage that you are refinancing is home acquisition debt, your new mortgage will also be home acquisition debt, up to the principal balance of the old mortgage just before it was refinanced. The interest on this portion of the new mortgage will be deductible. Any debt in excess of this limit will not be home acquisition debt. In other words, a taxpayer who refinances cannot take down additional cash and have it count as acquisition indebtedness. Acquisition indebtedness may be refinanced to take advantage of lower rates or more favorable terms. As long as there is no additional amount of indebtedness the new debt is also treated as acquisition indebtedness. In general, points that you pay to refinance your home are not fully deductible in the year that you paid them. Instead, you can deduct a portion of these points each year over the life of the loan.
Home Equity Debt
Home equity debt is debt (other than acquisition debt) secured by the taxpayer’s principal or second residence. Interest on home equity debt is deductible even if the proceeds are used for personal purposes.
Tracing of Interest
Temporary regs on allocating interest expense for purposes of the limitations on passive activity losses, investment and personal interest employ a system of tracing disbursements of debt proceeds to specific expenditures. This generally means that the allocation of interest depends on how the debt proceeds are used. An exception to this rule applies to qualified residence interest, the allocation of which is governed by the security (i.e., the residence) given for the debt. Taxpayers can take advantage of these rules by using loan proceeds for deductible purposes, or by using home equity debt as the source of personal expenditures.
Health Savings Accounts
The rising cost of health care coverage has caused many individuals and employers to switch from traditional health insurance coverage to high-deductible health plans. Individuals or employees who were covered by a high-deductible health plan at any time during 2012 have a savings opportunity. They can contribute an amount equal to all or a part of their annual deductible to a Health Savings Account (HSA). Contributions by an individual to an HSA are deductible above-the-line in computing Adjusted Gross Income (AGI).
Any “eligible individual” can set up an HSA. An eligible individual is a person who:
- is covered under a high-deductible health plan (HDHP) on the first day of the month,
- is not covered by any other health plan that is not a HDHP (with certain exceptions for plans providing limited types of coverage),
- is not entitled to Medicare benefits (generally, has not yet reached age 65), and
- may not be claimed as a dependent on another person’s tax return.
For example, an individual may acquire high-deductible health coverage from an insurer and set up an HSA through the insurer or with a bank. Similarly, an employee who has qualifying high-deductible coverage through his employer can independently establish and fund an HSA.
For 2013, a high deductible health plan may be either an insured plan or an employer-sponsored self-insured medical reimbursement plan. In the case of individual self-only coverage, a plan must have an annual deductible of at least $1,250 and an annual cap on out-of-pocket expenses (counting deductibles, copayments, and other amounts, but not premiums) of no more than $6,250. For family coverage, the annual deductible must be at least $2,500 and the annual out-of-pocket expense cap cannot exceed $12,500. The plan must provide that no payments will be made until the family as a whole has incurred annual covered expenses in excess of the annual deductible.
The amount that can be contributed to an HSA depends on the type of coverage (i.e., self-only or family), the annual deductible, and the period of coverage during the year. The maximum annual contribution is the sum of limits determined separately for each month.
For 2015, the maximum monthly contribution for an individual with self-only coverage is 1/12 of the lesser of the annual deductible (minimum $1,300) or $3,350. For family coverage, the maximum annual contribution is 1/12 of the lesser of the annual deductible (minimum $2,600) or $6,650.
Individuals age 55 and older can make catch-up contributions in addition to their regular contributions for the year. For 2015, the catch-up contribution limit is $1,000. As with regular contributions, catch-up contributions are computed on a monthly basis.
Contributions, including catch-up contributions cannot be made to an individual’s HSA after age 65.
Although the contribution limits are determined monthly, annual HSA contributions can be made in one or more payments at any time before the contribution deadline. The contribution deadline is the due date (without extensions) for filing the individual’s return for the year of the contribution. Thus, for calendar year taxpayers, the deadline for making 2014 HSA contributions is April 15, 2015.
Distributions from an HSA are tax-free to the extent they are used to pay for qualified out-of-pocket medical expenses of the HSA account holder or the account holder’s spouse or dependents. However, distributions qualify for tax-free treatment only if they are used to pay qualified medical expenses that were incurred after the HSA was established. Consequently, taxpayers who have not yet established an HSA will not be able to use their 2014 contributions to cover medical expenses incurred earlier in the year.
HSA funds that are not needed for medical expenses can serve as a tax-deferred savings for retirement. A distribution that is not used to pay qualified medical expenses is includible in the gross income of the account holder. In addition, such a distribution generally is subject to an additional 10% tax. However, the 10% penalty tax does not apply to distributions made on account of death or disability or after the account holder reaches age 65.
Reduced Home Sale Exclusion for Some Sellers
Most homeowners are aware of the home sale exclusion, a provision of the tax laws which provides that homeowners who sell their principal residence typically do not need to pay taxes on as much as $500,000 of their gain if they meet certain conditions. (The $500,000 exemption is the maximum exclusion for a married couple filing jointly; taxpayers filing individually get an exemption of up to $250,000.) To be eligible for the full exclusion, a taxpayer must have owned the home – and lived in it as his or her principal residence – for at least two of the five years prior to the sale. Because of the “principal residence” requirement, vacation or second homes normally do not qualify for the exclusion. However, in what some saw as a loophole, the law permitted taxpayers to convert their second home to their principal residence, live in it for two years, sell it, and take the full $250,000/$500,000 exclusion available for principal residences, even though portions of their gains were attributable to periods when the property was used as a vacation or second home, not a principal residence.
The new law closes that “loophole” by requiring homeowners to pay taxes on gains made from the sale of a second home to reflect the portion of time the home was not used as a principal residence (e.g., vacation or rental property). The amount taxed will be based on the portion of the time during which the taxpayer owned the home that the house was used as a vacation home or rented out. The rest of the gain remains eligible for the up-to-$500,000 exclusion, as long as the two-out-of-five year usage and ownership tests are met. The new law in effect reduces the exclusion based on the ratio of years of use as a principal residence to the total time of ownership. For example, if a taxpayer owned a vacation home for ten years, but lived in it as a principal residence only for the final two years prior to sale, the maximum available exclusion would be reduced by four-fifths. Accordingly, a $400,000 gain on the sale that would be eligible for the full exclusion under pre-Act law would be reduced by four-fifths, to $80,000.
The good news for current owners of second homes is that the new law is not retroactive. The tightening applies only to sales after 2008. Plus, any periods of personal or rental use before 2009 are ignored for purposes of the provision. Also, the new law does not change the rule that allows homeowners to take advantage of the home sale exclusion every two years. Taxpayers can still “home hop” with full tax exclusion if they only own one home at a time. Moreover, the taxpayer still qualifies for capital gain treatment on the amount of gain that cannot be excluded.
For purposes of the allocation of gain to periods of nonqualified use, a “period of nonqualified use” is any period (other than the portion of any period preceding January 1, 2009) during which the property is not used as the principal residence of the taxpayer or the taxpayer’s spouse or former spouse.
Since the definition of a period of nonqualified use doesn’t include any period preceding January 1, 2009, a taxpayer can avoid the application of Code Sec. 121 (b)(4) if he moves into his vacation home (or any other residence owned by the taxpayer) and makes it his principal residence before January 1, 2009.
Exceptions to the Definition of a Period of Nonqualified Use
A period of nonqualified use will not include any portion of the five-year testing period which is after the last date that the property is used as the principal residence of the taxpayer or the taxpayer’s spouse. Thus, any period after the last date the property was used as the principal residence of the taxpayer or his spouse (regardless of use during that period) is not taken into account in determining periods of nonqualified use.
Z, an individual, buys a principal residence on January 1, Year 9 (a year beginning after December 31, 2008), for $400,000, and moves out on January 1, Year 19. On December 1, Year 21 (more than two years after it was last used as Z’s principal residence), Z sells the property for $600,000. The entire $200,000 gain will be excluded from gross income, as under pre-2008 Housing Act law.
Since the period that Z did not use the residence as a principal residence occurred after the last date that Z had used the property as a principal residence during the five-year testing period, that period will not be considered to be a period of nonqualified use under the exception. Thus, even if Z had rented the residence (his former principal residence) during Years 19 and 20, that period will not be considered to be a period of nonqualified use.
Since the exception provided above will only apply to any portion of the five-year testing period which is after the last date that the property is used as the principal residence of the taxpayer or the taxpayer’s spouse, the exception will not apply to periods of nonqualified use that occurred before the five-year testing period. If a taxpayer uses the property as his principal residence in more than one period of time during the ownership period, the exception will only apply to the period after the last date that the property was used a principal residence by the taxpayer or his spouse. Any other periods that he did not use the property as his principal residence presumably will be considered to be periods of nonqualified use. Unless one of the other exceptions (such as the temporary absence exception or the exception for taxpayers serving on qualified official extended duty, both described below) apply, those periods of nonqualified use will be included in the numerator of the ratio (used to determine the amount of gain allocated to nonqualified use as part of the aggregate periods of nonqualified use during the period the taxpayer owned the property.
C, an individual, buys a principal residence on January 1, Year 1 (a year beginning after December 31, 2008), for $400,000, and lives in it as his principal residence for five years (i.e., until December 31, Year 5). Due to a change in his employment, C moves away and does not use the property as his principal residence for the next five years (January 1, Year 6 to December 31, Year 10). On January 1, Year 11, C moves back in the house and uses it as his principal residence. On December 31, Year 20, C sells the property for $800,000 and realizes a gain of $400,000.
The five-year period from January 1, Year 6 to December 31, Year 10 will not qualify for the exception and thus, is a period of nonqualified use. That period of nonqualified use was not a portion of the five-year testing period which was after the last date that the property was used as a principal residence.
Thus, 25% of the gain [5 years (the aggregate period of nonqualified use during the taxpayer’s ownership of the property) ¸ 20 years (the period of the taxpayer’s ownership of the property)] will be gain allocated to periods of nonqualified use and the Code Sec. 121 exclusion will not apply to $100,000 (25% of $400,000). Of the remaining $300,000 of gain, the maximum amount of gain that qualifies for the Code Sec. 121 exclusion will be $250,000.
In Summary, C’s taxable gain from the sale will include: $100,000 of gain allocated to periods of nonqualified use, and $50,000 of gain in excess of C’s Code Sec. 121 exclusion ($300,000 – $250,000).
C’s absence from the residence (January 1, Year 6 to December 31, Year 10) will not qualify for the temporary absence exception to the definition of a period of nonqualified use because the absence exceeded an aggregate period of two years.
Temporary Absence – Exception to the Definition of a Period of Nonqualified Use
A period of nonqualified use will not include any other period of temporary absence (not to exceed an aggregate period of two years) due to change of employment, health conditions, or any other unforeseen circumstances as may be specified by IRS.
Taxpayers Serving on Qualified Official Extended Duty – Exception to the Definition of a Period of Nonqualified Use
A period of nonqualified use will not include any period (not to exceed an aggregate period of ten years) during which the taxpayer or the taxpayer’s spouse is serving on qualified official extended duty as a member of the uniformed services , a member of the Foreign Service, or an employee of the intelligence community.
The suspension election for members of the uniformed services, members of the Foreign Service, and employees of the intelligence community is the same as it was under pre-2008 Housing Act law.
If any gain was attributable to post May 6, 1997 depreciation, the exclusion will not apply to that amount of gain as under pre-2008 Housing Act law.
The above is effective for sales and exchanges after December 31, 2008.
Converting a Residence to Rental Property
A taxpayer may decide to permanently convert a personal residence to rental property. This decision is often made as a result of the taxpayer’s inability to sell the property at a gain, or a desire to retain the property for future personal use.
The decision whether to convert a personal residence to rental property may be based on several non-tax factors. If selling a personal residence would result in a nondeductible loss, the taxpayer should consider converting the residence to rental property since any loss realized while the home is a personal residence is never deductible. While tax savings opportunities are generally limited for residential rental conversions primarily because of the passive activity loss rules, converting a personal residence into rental property may allow the taxpayer to eventually recognize a loss on the property’s subsequent sale if it continues to decline in value.
When a principal residence is converted to business use (or for use in the production of income), its starting point for basis for depreciation is the lower of (1) the adjusted basis on the date of conversion, or (2) the property’s fair market value at the time of conversion.
Taxpayer purchased a home in Chicago in 2004 for $250,000, of which $50,000 represented the cost of the land. Taxpayer lived in the home until 2008, when he moved to New York. Rather than sell the house, he converted it to a rental property. The property’s FMV, excluding the land, on its conversion to rental property was $185,000. Taxpayer’s basis for depreciation is $185,000, the FMV at the time of conversion, since it was less than the adjusted basis. (Adjusted basis is generally the cost of the property plus amounts paid for capital improvements less any depreciation claimed for tax purposes).
Property converted from residential to rental use must be depreciated using the method and recovery period in effect in the year of conversion.
If the taxpayer intends to incur major renovation or remodeling costs, the costs should be incurred after the property has been placed into service (offered for rent). This may allow for a higher depreciable basis of the property and turn repairs into deductions.
Taxpayers may need the equity in cash from their current residence for a down payment on a new residence. Yet, for non-economic reasons they may want to retain the old residence. In this situation, they should consider selling the home to a newly formed controlled entity (for example, a wholly owned S Corporation) at fair market value for a mortgage note. The residence can then be rented inside the S Corporation and depreciated at the stepped-up FMV basis. The residence is effectively retained with no current tax cost because the gain on the sale is excluded under Sec. 121 (provided the requirements of Sec. 121 are met).
The IRS has ruled that the sale of a residence to a taxpayer’s wholly owned corporation qualified for the former Sec. 1034 Gain Deferral. In that ruling, the IRS stated that there was no prohibition in the Sec. 1034 rules against selling the residence to a related party and excluding the gain. Many tax practitioners believe this same rationale can apply to the Sec. 121 Gain Exclusion rules.
Taxpayers own a house that they have lived in for 20 years. The house has a tax basis of $75,000 and a FMV of $275,000. They have decided to relocate in order to live closer to their family. They need the value in cash from their old residence for a down payment on their new residence. However, because they hope to move back in a few years, they would prefer not to sell the old residence. They like the idea of renting the old house in order to retain it and still provide some tax benefits and possibly some cash flow.
Taxpayers can form a wholly owned S Corporation and have the S Corporation buy the residence for its value ($275,000) on a third-party mortgage note. Taxpayers would receive cash of $275,000, and the $200,000 gain ($275,000-$75,000) is excluded under Sec. 121. Therefore, this is accomplished at no current tax cost.
The S Corporation can begin to rent the house and take depreciation deductions on the portion of the $275,000 cost allocated to the building. The rental activity inside the S Corporation will generate either passive activity gains or losses.
If gain from the sale of the residence to the controlled entity exceeds the maximum Sec. 121 exclusion, the excess is taxable as ordinary income (rather than capital gain) because the controlled entity (related-party) purchaser will depreciate the property (Sec. 1239 (a)).
If the S Corporation ultimately sells the residence, any gain would be taxed at capital gains rates (currently 15%), subject to a 25% rate for unrecaptured Sec. 1250 gain (i.e. gain attributable to depreciation allowed on the residence for periods after May 6, 1997).
If a residence converted to rental property is later sold at a gain, the basis in the converted property is the original cost or other basis plus amounts paid for capital improvements, less any depreciation taken. If the sale results in a loss, however, the starting point for basis is the lower of the property’s adjusted cost basis or FMV when it was converted from personal to rental property. This rule is designed to ensure that any decline in value occurring while the property was held as a personal residence does not later become deductible on the sale of the rental property.
Taxpayer converted their personal residence to income-producing property in 2000. The house had a $50,000 original cost, and the property’s FMV was $45,000 when it was converted to rental use. Over the eight year rental period, a total of $8,000 in depreciation was taken. In 2008, taxpayer sold the property for $40,000.
- Original Cost $50,000
- Conversion Value $45,000
- Depreciation Taken $8,000
- Adjusted Basis for Determining Gain (1– 3) $42,000
- Adjusted Basis for Determining Loss Lesser of (1) or (2 – 3) $37,000
- Sales Price $40,000
- Recognize Gain (6 – 4) but not less than 0 $ – 0 –
- Recognize Loss(6 – 5) but not more than 0 $ – 0 –
No reportable gain or loss occurs because (1) no gain results when the original cost is used in the gain computation, and (2) no loss results when using the lower of cost or market basis for determining loss.
The fact that a residence is rented at the time of a sale does not automatically preclude gain attributable to such use from being excluded under Sec. 121. The taxpayer must still meet the ownership and use and the one-sale-in-two-years tests of Sec. 121 and gain cannot be excluded to the extent of depreciation adjustments to periods after May 6, 1997.
Safe Harbor for Exchanges of Vacation Homes
Until recently, taxpayers who own vacation and second homes have been in a quandary as to whether Section 1031 (Like-Kind Exchange) could apply to exchanges of those types of properties. In order to qualify for nonrecognition treatment under Section 1031 both the property relinquished and the property received must be deemed held for use in the taxpayer’s trade or business or for investment.
One consequence of the held for requirement is that homes used purely for personal use do not qualify for exchange treatment. Nevertheless, taxpayers often purchase and own second homes with the duel intention of personal use and future appreciation. These taxpayers have wondered whether this type of ownership could be considered as “held for investment” so as to qualify the property for exchange treatment on sale.
In 2007, the tax court for the first time considered the application of Section 1031 to vacation homes. In Moore, TCM 2007 – 134, the court denied Section 1031 treatment on an exchange of vacation properties, which it deemed were not held primarily for trade or business or for investment by the taxpayers. The facts in Moore illustrate a fairly common scenario associated with recreational vacation properties. In 1988 the Moore’s purchased two contiguous parcels of lakefront real property, along with a mobile home located on one of those parcels (the Clark Hill property). The Moore’s and their children used the Clark Hill property two or three weekends a month during the summers. They also made various improvements to the property. They never advertised the Clark Hill property for sale and never rented or attempted to rent the property to others. They did not claim deductions for investment interest or for maintenance and repair costs. Several years later, the Moore’s moved their principal residence and decided to sell the Clark Hill property and purchase another piece of improved lakefront property closer to their new residence (the Lake Lanier property). In 1999 they bought a 75% interest in the Lake Lanier property and an escrow agent bought a 25% interest, which the Moore’s later acquired after the sold the Clark Hill property, treating the 25% Investment in the Lake Lanier property as replacement property in a Section 1031 exchange for the Clark Hill property. They and their children used the Lake Lanier property similarly to the Clark Hill property. They never rented or attempted to rent the Lake Lanier property. The Moore’s asserted that one of their principal reasons for holding both the Clark Hill property and the Lake Lanier property was the investment potential of these assets. The tax court dismissed this rationale, holding that in order to qualify for Section 1031 treatment on the exchange the Moore’s had to prove that they held both properties primarily for investment. This conclusion is the critical holding in the case.
The court specifically held that it was not sufficient to show that expectation of appreciation in value was one of the motives for holding the property, but that investment must be the principal or primary intent. It further relied on a line of cases that rejected taxpayer attempts to convert primary residences to investment property be moving out prior to placing the property on the market for sale. The court concluded, based on the Moore’s use of the homes, the lack of rental activity, and their failure to hold the homes primarily for sale at a profit, that they did not hold the homes primarily for investment. Accordingly, Section 1031 treatment was denied.
A government report stated that there is a lack of IRS guidance as to whether vacation and second homes qualify under Section 1031. The report urged the IRS to issue clear guidance in this area.
In March 2008, the IRS issued Rev. Proc. 2008-16. The procedure provides a safe harbor under which the service will not challenge whether a dwelling unit qualifies as property held for productive use in a trade or business or for investment under Section 1031. The safe harbor is effective for exchanges occurring after March 9, 2008.
Under Rev. Proc. 2008-16, a dwelling unit passes the held for test with respect to its personal use as relinquished property in a like-kind exchange if it is owned by the taxpayer for at least 24 months immediately before the exchange and in each of the two 12-month periods immediately preceding the start of the exchange:
- The taxpayer rents the property to another person at a fair rental for 14 days or more, and
- The taxpayer’s personal property does not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the property is rented at a fair rental.
Similarly, a dwelling unit passes the held for test with respect to its personal use as replacement property in an exchange if it is owned by the taxpayer for at least 24 months immediately after the exchange and in each of the two 12-month periods immediately after the exchange:
- The taxpayer rents the property to another person at a fair rental for 14 days or more, and
- The taxpayer’s personal use of the property does not exceed the greater of 14 days or 10% of the number of days during the 12-month period that the dwelling unit is rented at a fair rental.
Steve has a summer cottage in Fort Wayne that he purchased in 2006. Steve lives full time in Indianapolis. For the first several years of ownership, Steve used the cottage himself during the summer. Steve did not attempt to rent the cottage to third parties. In 2007 and 2008, Steve rented the cottage to a family at fair rental value for 175 days during the summer and fall. In each of those two years, Steve used the cottage himself for 16 days during the spring. In December 2008, Steve exchanges the cottage for a larger house in Pompano Beach, Florida. Steve rents that house to third-party tenants a total of 200 days during 2009 and just 14 days during 2010. Steve uses the home himself for 19 days during 2009 and for no days during 2010.
Steve meets the safe harbor described by Rev. Proc. 2008-16. As such, he may properly report his exchange of the Fort Wayne cottage for the Pompano Beach house as a valid Section 1031 exchange on his 2008 federal income tax return, provided that all other requirements of Section 1031 are met.
The post-exchange replacement property use requirements applicable to Steve extends well beyond the time he is required to file his tax return for the year of the exchange. What if planned rental usage does not materialize or a taxpayer’s personal use of the property exceeds the allowable limits? Rev. Proc. 2008-16 provides for this by stating that if a taxpayer reports a transaction as an exchange on the taxpayer’s federal return expecting that the replacement property will meet the Revenue Procedure’s qualifying use standards but this does not occur, the taxpayer, if necessary, should file an amended return and not report the transaction as an exchange.
Accordingly, if Steve ends up using the Pompano House primarily for his own personal use and does not rent it out for the two 12-month periods following its exchange, he may be required to amend his 2008 return and report a taxable sale of the Fort Wayne cottage unless he can establish that the personal use was not his primary purpose for ownership of the cottage.
Rev. Proc. 2008-16 offers a fairly clear, albeit limited, set of parameters for determining whether vacation property held for personal use as well as future appreciation qualifies under Section 1031. It is important to remember, however, that as a safe harbor it neither establishes substantive law nor affects any requirement of Section 1031 other than the question of whether personal use of a residence prevents it from being deemed to be held primarily for use in a trade or business or for investment.
To qualify for the safe harbor for property being sold, a taxpayer must rent out the property for the two years prior to an exchange, and during that period engage in limited personal use. To avoid potential IRS challenge on the held for issue with respect to vacation property being acquired in an exchange, the taxpayer must rent out that property and also limit personal use for the two years following the exchange. There is clearly no requirement that both sides of an exchange satisfy these requirements; because all real estate is generally considered like-kind, a taxpayer can exchange a vacation property for an office, commercial, or other type of rental property or vice versa.
While it clearly does not resolve the issue of when vacation homes may be the subject of like-kind exchanges, Rev. Proc. 2008-16 provides welcome guidance to taxpayers seeking to exchange vacation properties and second homes. The safe harbor will allow taxpayers that buy and hold such properties with true investment intent to structure valid Section 1031 exchanges despite limited amounts of personal use. It also should reduce the time to audit and review such transactions. Nevertheless, Rev. Proc. 2008-16 is just a safe harbor. Taxpayers can and should be able to structure exchanges of homes that fall outside its guidance.
New Tax-Advantaged Achieving a Better Life Experience (ABLE) Accounts
For tax years beginning after December 31, 2014, Tax Increase Prevention Act of 2014 allows states to establish tax-exempt “Achieving a Better Life Experience” (ABLE) accounts to assist persons with disabilities in building an account to pay for qualified disability expenses. A tax exemption would be allowed for an ABLE program; amounts in an ABLE account would accumulate on a tax-exempt (or, in some cases, tax-deferred) basis.
A qualified ABLE account is generally exempt from income tax but is subject to the tax imposed by Code Sec. 511 on the unrelated business income of tax-exempt organizations. A “qualified ABLE program” is subject to the excise tax on non-plan tax-exempt entities that are parties to prohibited tax shelter transactions and subsequently listed transactions. Any person may make contributions to an ABLE account. Contributions to an ABLE account are not deductible for income tax purposes.
A qualified ABLE program is a program established and maintained by a state or state agency or instrumentality that:
- provides that non-cash contributions and contributions that exceed the annual contribution limit will not be accepted. (Non-cash contributions will not violate this rule if they are returned before the return due date). Except in the case of a rollover contribution from another account, an ABLE program must limit the aggregate contributions from all contributors for a tax year to the amount of the annual Code Sec. 2503(b) gift tax exclusion for that tax year ($14,000 for 2015, adjusted annually for inflation). A 6% excise tax is imposed on excess contributions to an ABLE account;
- provides separate accounting for each designated beneficiary;
- limits the designated beneficiary’s investment direction to no more than two times in a calendar year;
- prohibits the use of any interest or any portion of an interest in the program as security for a loan; and
- provides adequate safeguards to prevent excess aggregate contributions.
The program must limit a designated beneficiary to one ABLE account. If an ABLE account is established for a designated beneficiary, no account later established for that beneficiary is treated as an ABLE account.
The program must allow an ABLE account to be established only for a beneficiary who is a resident of either the state that maintains the program (a “program state”) or of a contracting state that has not established an ABLE program but has entered into a contract with a program state to provide the contracting state’s residents with access to the program state’s ABLE program.
The designated beneficiary of an ABLE account is an eligible individual who established the account and is its owner. An individual is an eligible individual for a tax year if, during that tax year:
- The individual is entitled to benefits based on blindness or disability under the Social Security disability insurance program (title II of the Social Security Act) or the SSI program (title XVI of the Social Security Act), and that blindness or disability occurred before the date on which the individual reached age 26, or
- A disability certification for the individual has been filed with IRS for the tax year. A disability certification is one made by the eligible individual or his parent or guardian, that certifies that:
- The individual has a medically determinable physical or mental impairment, which results in marked and severe functional limitations, and that can be expected to result in death or that has lasted or can be expected to last for a continuous period of not less than 12 months, or is blind, and
- That blindness or disability occurred before the date on which the individual attained age 26.
The certification must include a copy of the individual’s diagnosis relating to the individual’s relevant impairment(s), signed by a licensed physician.
No amount of a distribution from an ABLE account is includible in gross income if distributions from the account do not exceed the designated beneficiary’s qualified disability expenses. “Qualified disability expenses” are any expenses related to the eligible individual’s blindness or disability that are made for the benefit of an eligible individual who is the designated beneficiary. They include:
- Employment training and support,
- Assistive technology and personal support services,
- Health, prevention, and wellness,
- Financial management and administrative services,
- Legal fees,
- Expenses for oversight and monitoring,
- Funeral and burial expenses, and
- Other expenses that are approved under IRS regs and consistent with Code Sec. 529A’s purposes.
If the distributions exceed the qualified disability expenses, then the amount otherwise includible in gross income is reduced by an amount that bears the same ratio to the distributed amount as the qualified disability expenses bear to that amount.
Distributions from a qualified ABLE program are includible in the distributee’s gross income under the Code Sec. 72 annuity rules to the extent not excluded from gross income under any other income tax provision.
A taxpayer who receives a distribution from a qualified ABLE program that is includible in gross income is subject to an additional 10% tax on the includible part. An exception to this rule applies to the distribution of certain contributions made during the tax year on the designated beneficiary’s behalf.
A payment or distribution from an ABLE account is not taxable to the extent that the amount received is paid, no later than the 60th day after the date of the payment or distribution, into another ABLE account for the benefit of the designated beneficiary or an eligible individual who is a family member of the designated beneficiary.
A change in the designated beneficiary of an interest in a qualified ABLE program during a tax year is not treated as a taxable distribution if the new beneficiary is both an eligible individual for the tax year and a member of the family of the former beneficiary.
Upon the death of an eligible individual, any amounts remaining in the account (after Medicaid reimbursements) would go to the deceased’s estate or to a designated beneficiary and would be subject to income tax on investment earnings, but not to the 10% penalty.
Amounts in an individual’s qualified ABLE account (including earnings), contributions to the individual’s account, and distributions to pay qualified disability expenses are disregarded for purposes of determining an individual’s eligibility for, or the amount of any assistance or benefit authorized by any federal means-tested program. This rule overrides any other federal law that requires those amounts to be taken into account.
However, in the case of the SSI program, distributions from an ABLE account for housing expenses are considered income; and amounts (including earnings) in an ABLE account in excess of $100,000 are considered a resource of the designated beneficiary. The SSI benefits of an individual who has excess resources because the individual’s ABLE account balance exceeds $100,000 are not terminated. Instead, the benefits are suspended until the individual’s balance falls below $100,000. The suspension of SSI benefits does not apply for purposes of Medicaid eligibility.
For purposes of determining SSI eligibility, states must submit to the Commissioner of Social Security, in the manner specified by the Commissioner, monthly electronic statements on relevant distributions and account balances from all ABLE accounts. This requirement is effective for tax years beginning after December 31, 2014.
Property of a bankruptcy estate does not include funds placed in an ABLE account no later than 365 days before the filing date of the bankruptcy petition. But only if the designated beneficiary of the account was the debtor’s child, stepchild, grandchild, or step-grandchild for the tax year for which funds were placed in the account.
And, the exclusion is limited to $6,225 for funds placed in all ABLE accounts having the same designated beneficiary no earlier than 720 days nor later than 365 days before the filing date.
Extension of the American Opportunity Credit in the 2012 American Taxpayer Relief Act
The recently enacted 2012 Taxpayer Relief Act includes a five-year extension (through 2017) of the American Opportunity tax credit for college costs. Added to the tax code in 2009 as a temporary replacement of the previous Hope tax credit, the American Opportunity credit both increased the tax relief available for students from middle-income families and also extended relief for the first time to students from lower-income families. Now that the American Opportunity tax credit has been extended for five years, it might be a good time to review the tax benefits available under that credit, with an eye to how it compares with the Hope credit, which would have been in effect over the next two years had the American Opportunity credit not been extended.
- Families with a family member in college can benefit from a tax credit for tuition and fees. From a taxpayer’s point of view, a credit is almost always preferable to a deduction, because a credit reduces taxes owed, while a deduction only reduces taxable income. The maximum amount of the American Opportunity tax credit is $2,500 (up from a maximum credit of $1,800 under the Hope credit). The credit is 100% of the first $2,000 of qualifying expenses and 25% of the next $2,000, so the maximum credit of $2,500 is reached when a student has qualifying expenses of $4,000 or more.
- While the Hope credit was only available for the first two years of undergraduate education, the American Opportunity tax credit is available for up to four years.
- Under the Hope credit, qualifying expenses were narrowly defined to include just tuition and fees required for the student’s enrollment. Textbooks were excluded, despite their escalating cost in recent years. The American Opportunity tax credit expands the list of qualifying expenses to include textbooks.
- The Hope credit was nonrefundable, i.e., it could reduce your regular tax bill to zero but could not result in a refund. This meant that if a family did not owe any taxes it could not benefit from the credit, which prompted critics to argue that the credit was thus denied to the very families most in need of help affording college. The American Opportunity tax credit addresses this criticism to a degree by providing that 40% of the credit is refundable. This means that someone who has at least $4,000 in qualified expenses and who would thus qualify for the maximum credit of $2,500, but who has no tax liability to offset that credit against, would qualify for a $1,000 (40% of $2,500) refund from the government.
- The Hope credit was not available to someone with higher than moderate income. Under the credit’s “phaseout” provision, taxpayers with adjusted gross income (AGI) over $50,000 (for 2009) saw their credits reduced, and the credit was completely eliminated for AGIs over $60,000 (twice those amounts for joint filers). Under the American Opportunity tax credit, taxpayers with somewhat higher incomes can qualify, as the phaseout of the credit begins at AGI in excess of $80,000 ($160,000 for joint filers).
Lifetime Learning Credit
The lifetime learning credit helps parents and students pay for post-secondary education.
For the tax year, you may be able to claim a lifetime learning credit of up to $2,000 for qualified education expenses paid for all students enrolled in eligible educational institutions. There is no limit on the number of years the lifetime learning credit can be claimed for each student. However, a taxpayer cannot claim both the American opportunity credit and lifetime learning credits for the same student in one year. Thus, the lifetime learning credit may be particularly helpful to graduate students, students who are only taking one course and those who are not pursuing a degree.
Generally, you can claim the lifetime learning credit if all three of the following requirements are met:
- You pay qualified education expenses of higher education.
- You pay the education expenses for an eligible student.
- The eligible student is either yourself, your spouse or a dependent for whom you claim an exemption on your tax return.
If you’re eligible to claim the lifetime learning credit and are also eligible to claim the American opportunity credit for the same student in the same year, you can choose to claim either credit, but not both.
If you pay qualified education expenses for more than one student in the same year, you can choose to take credits on a per-student, per-year basis. This means that, for example, you can claim the American opportunity credit for one student and the lifetime learning credit for another student in the same year. The 2015 income phaseout begins at $55,000 (For 2014 at $54,000) for a single person and at $110,000 (For 2014 at $109,000) for married filing jointly.
Qualified Tuition Deduction is Retroactively Extended Through 2014
An individual is allowed an above-the-line deduction for “qualified tuition and related (QT&R) expenses” for higher education paid by the individual during the tax year. These expenses include tuition and fees for the enrollment or attendance of the taxpayer, the taxpayer’s spouse, or any dependent for whom the taxpayer can claim a personal exemption, at an eligible institution of higher education for courses of instruction at the institution. These expenses must be in connection with enrollment at an institution of higher education during the tax year, or with an academic term beginning during the tax year or during the first three months of the next tax year. The amount of these expenses must be reduced by tax-free educational assistance and certain exclusions from income under the rules for savings bond interest, Coverdell education savings accounts (ESAs), and qualified tuition programs (QTPs or 529 plans).
The maximum deduction is:
- $4,000 for an individual whose adjusted gross income (AGI), with certain modifications, does not exceed $65,000 ($130,000 for a joint return),
- $2,000 for an individual whose modified AGI exceeds $65,000 ($130,000 for a joint return), but does not exceed $80,000 ($160,000 for a joint return), or
- zero for other taxpayers.
The Act extends the qualified tuition deduction for two years so that it is generally available for tax years beginning before January 1, 2015.
EGTRRA Changes to Student Loan Deduction Rules are Made Permanent
Individuals can deduct a maximum of $2,500 annually for interest paid on qualified higher education loans. The deduction is claimed as an adjustment to gross income to arrive at adjusted gross income (AGI). The deduction phases out ratably for taxpayers with modified AGI between $60,000 and $75,000 ($125,000 and $155,000 for joint returns). The phaseout amounts and ranges are indexed for inflation.
The Economic Growth and Tax Relief Reconciliation Act amended the rules for deducting interest on student loans, effective generally for tax years beginning after 2001, by:
- eliminating the 60-month limit on the deduction for interest paid on a qualified education loan and
- increasing the pre-2001 EGTRRA AGI phaseout ranges ($40,000 to $55,000 for taxpayers other than joint filers; $60,000 to $75,000 for a married couple filing jointly) applicable to the student loan interest deduction. The phaseout ranges, as amended by 2001 EGTRRA, were indexed for inflation.
Increased $2,000 Contribution Limit and Other EGTRRA Enhancements to Coverdell ESAs are Made Permanent
An individual can make a nondeductible cash contribution to a Coverdell education savings account (“Coverdell ESA”, or “CESA”, formerly called an “education IRA”) for qualified education expenses of a beneficiary under the age of 18. A specified aggregate amount can be contributed each year by all contributors for one beneficiary. The amount an individual contributor can contribute is phased out as the contributor’s modified adjusted gross income (MAGI) exceeds specified levels. A 6% excise tax applies to excess contributions.
Earnings on the contributions made to a CESA are subject to tax when withdrawn. But distributions from a CESA are excludible from the distributee’s (i.e., the student’s) gross income to the extent the distributions do not exceed the qualified education expenses incurred by the beneficiary during the tax year the distributions are made. The earnings portion of a CESA distribution not used to pay qualified education expense is includible in a distributee’s income, and that amount is subject to a 10% tax that applies in addition to the regular tax.
Tax-free (including free of the 10% tax described above) transfers or rollovers of CESA account balances from a CESA benefiting one beneficiary to a CESA benefitting another beneficiary (and redesignations of named beneficiaries) are permitted if the new beneficiary is a family member of the previous beneficiary and is under age 30. Generally, a balance remaining in a CESA is deemed to be distributed within 30 days after the beneficiary turns 30.
Under the Economic Growth and Tax Relief Reconciliation Act of 2001, the CESA rules were modified to:
- increase the limit on CESA aggregate annual contributions (from $500) to $2,000 per beneficiary;
- permit corporations and other entities (in addition to individuals) to make contributions to a CESA, regardless of the corporation’s or entity’s income;
- increase the MAGI phaseout range for joint filers (from $150,000 – $160,000) to $190,000 – $220,000 to equal twice the range for single filers (i.e., $95,000 – $110,000), and so eliminate any “marriage penalty;”
- permit contributions to a CESA for a tax year to be made until April 15th of the following year;
- modify the definition of excess contribution to a CESA for purposes of the 6% excise tax on excess contributions to reflect various other EGTRRA changes;
- extend the time (to before June 1st of the following tax year) for taxpayers to withdraw excess contributions (and the earnings on them) to avoid imposition of the 6% excise tax;
- expand the definition of education expenses that can be paid by CESAs to include elementary and secondary school expenses (in addition to qualified higher education expenses);
- provide for coordination of the Hope and Lifetime Learning credits with the CESA rules to permit a Hope or Lifetime Learning credit to be taken in the same year as a tax-free distribution is taken from a CESA for a designated beneficiary (but for different expenses);
- provide rules coordinating distributions from both a qualified tuition program (QTP, or “529 plan”) and a CESA for the same beneficiary for the same tax year (but for different expenses);
- eliminate the age limitations described above for acceptance of CESA contributions, deemed balance distributions, tax-free rollovers to other family-member-beneficiaries, and tax-free change of beneficiaries, for “special needs beneficiaries;”
- provide that the 10% additional tax on taxable distributions from a CESA does not apply to distributions of contributions to a CESA made by June 1st of the tax year following the tax year in which the contribution was made.
Specifically, as a result of the above extension, the following rules apply on a permanent basis:
- the limit on CESA aggregate annual contributions is $2,000 per beneficiary (and is not decreased to $500 per beneficiary);
- corporations and other entities (not just individuals) can make contributions to a CESA, and the corporations and other entities can do so regardless of their income;
- the MAGI phaseout range for joint filers is $190,000 – $220,000 (and does not decrease to $150,000 – $160,000);
- CESA contributions for a tax year can be made until April 15th of the following year;
- the definition of CESA excess contribution reflects the various other EGTRRA changes to the CESA rules;
- taxpayers have until June 1st of the following tax year to withdraw excess contributions (and the earnings on them) to avoid imposition of the 6% excise tax;
- education expenses that can be paid by CESAs include elementary and secondary school expenses and qualified higher education expenses (rather than only qualified higher education expenses);
- a Hope or Lifetime Learning credit can be taken in the same year as a tax-free distribution is taken from a CESA for a designated beneficiary (but for different expenses);
- the rule coordinating distributions being made from both a QTP and a CESA for the same beneficiary for the same tax year (but for different expenses) applies;
- special needs beneficiaries are exempted from the age limitations for a CESA’s acceptance of contributions, deemed balance distributions, tax-free rollovers to other family-member-beneficiaries, and tax-free change of beneficiaries; and
- the 10% additional tax on taxable distributions from a CESA is inapplicable to distributions of contributions to a CESA made by June 1st of the tax year following the tax year in which the contribution was made.
Exclusion for Employer-Provided Educational Assistance, and Restoration of the Exclusion for Graduate-Level Courses, Made Permanent
Under Code Sec. 127, an employee’s gross income does not include amounts paid or expenses incurred (up to $5,250 annually) by the employer in providing educational assistance to employees under an educational assistance program. An educational assistance program is a separate written plan of the employer for the exclusive benefit of its employees, having the purpose of providing the employees with educational assistance. The courses taken need not be related to the employee’s job for the exclusion to apply. To be qualified, the program must not discriminate in favor of highly compensated employees, nor may more than 5% of the amounts paid or incurred by the employer for educational assistance during the year be provided for individuals (and their spouses and dependents) owning more than 5% of the employer. Further, the program cannot provide employees with a choice between educational assistance and other remuneration that would be includible in their gross income. Finally, reasonable notification of the program’s availability and terms must be provided to employees.
Before the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), Congress had periodically waited until the educational assistance exclusion was set to expire before renewing it, and had sometimes allowed it to expire, and then extended it retroactively. The exclusion was set to expire for courses beginning after December 31, 2001. Under EGTRRA, the exclusion was extended “permanently” subject to the EGTRRA sunset.
Also, EGTRRA restored the exclusion for graduate level courses, which had earlier been eliminated. This was also subject to the EGTRRA sunset.
Income Exclusion for Awards Under the National Health Service Corps and Armed Forces Health Professions Programs Made Permanent
Gross income does not include (i) any amount received as a “qualified scholarship” by an individual who is a candidate for a degree at a primary, secondary, or post-secondary educational institution, or (ii) qualified tuition reductions for certain education provided to employees (and their spouses and dependents) of those educational institutions. But these exclusions do not apply to any amount that a student receives that represents payment for teaching, research, or other services provided by the student, required as a condition for receiving the scholarship or tuition reduction.
Thus, before enactment of the Economic Growth and Tax Relief Reconciliation Act of 2001, there was no exclusion from gross income for health profession scholarship programs which required scholarship recipients to provide medical services as a condition for their awards.
EGTRRA provided that education awards received under specified health scholarship programs may be tax-free qualified scholarships, without regard to any service obligation on the part of the recipient. Specifically, the rule that the exclusions for qualified scholarships and qualified tuition do not apply to amounts received which represent compensation does not apply to any amount received by an individual under the following programs:
- the National Health Service Corps Scholarship Program (the “NHSC Scholarship Program,” under Sec. 338A(g)(1)(A) of the Public Health Services Act), and
- the F. Edward Hebert Armed Forces Health Professions Scholarship and Financial Assistance program (the “Armed Forces Scholarship Program,” under Subchapter 1 of Chapter 105 of Title 10 of the United States Code).
Interest Exclusion for Higher Education
The interest on U.S. Savings Bonds redeemed to pay qualified higher education expenses may be tax-free. The exclusion is phased out at certain income levels, which are adjusted annually for cost-of-living increases. The phaseout for 2014 will begin at modified adjusted gross income above $76,000 ($113,950 on a joint return). For 2013, the corresponding figures are $74,700 and $112,050.
Scholarships and Fellowships
A scholarship is generally an amount paid or allowed to, or for the benefit of, a student at an educational institution to aid in the pursuit of studies. The student may be either an undergraduate or a graduate. A fellowship is generally an amount paid for the benefit of an individual to aid in the pursuit of study or research. Generally, whether the amount is tax free or taxable depends on the expense paid with the amount and whether you are a degree candidate.
A scholarship or fellowship is tax free only if you meet the following conditions:
- You are a candidate for a degree at an eligible educational institution.
- You use the scholarship or fellowship to pay qualified education expenses.
Qualified Education Expenses
For purpose of tax-free scholarships and fellowships, these are expenses for:
- Tuition and fees required to enroll at or attend an eligible educational institution.
- Course-related expenses, such as fees, books, supplies, and equipment that are required for the courses at the eligible educational institution. These items must be required of all students in your course of instruction.
However, in order for these to be qualified education expenses, the terms of the scholarship or fellowship cannot require that it be used for other purposes, such as room and board, or specify that it cannot be used for tuition or course-related expenses.
Expenses that Don’t Qualify
Qualified education expenses do not include the cost of:
- Room and board.
- Clerical help.
- Equipment and other expenses that are not required for enrollment in or attendance at an eligible educational institution.
This is true even if the fee must be paid to the institution as a condition of enrollment or attendance. Scholarship or fellowship amounts used to pay these costs are taxable.
Illinois “Bright Start” College Savings Plan
The Illinois “Bright Start” college savings plan is being offered under provisions of Section 529 of the Internal Revenue code. Bright Start works by investing in mutual funds. Illinois has contracted with Oppenheimer Funds to manage the investment trust. Portfolios are managed by OFI Private Investments, Inc., a subsidiary of Oppenheimer Funds, Inc. and Illinois Investments managed by Oppenheimer Funds, Inc. and its affiliates, as well as the Vanguard Group and American Century Investments.
Illinois also has “College Illinois” which has been around for a few years. Prepaid tuition through the college Illinois plan is a less aggressive investment, a defined benefit plan that acts as a hedge against tuition inflation by allowing parents and grandparents to lock in current tuition rates for state schools.
Section 529 college savings plans offer contribution advantages over another option called Coverdell Education Savings Accounts with their low annual deposit limits of $2,000.
Contributions of up to $14,000 a year and $350,000 over the life of the account are permitted in Bright Start.
Provisions for lump sum contributions as large as $70,000 ($140,000 for married couples) without gift tax penalties are also included in the tax code, in case grandma and grandpa want some of their nest egg to go toward educating their grandchildren.
Private institutions may be sponsors of prepaid tuition programs. The definition of a “Qualified Tuition Program” will include certain prepaid tuition programs established and maintained by eligible educational institutions (including private institutions) that satisfy the requirements under code section 529.
Exclusion for qualifying payouts. Distributions will be excluded from gross income to the extent they are used to pay for qualified higher education expenses. The exclusion will apply to payouts from qualified state tuition programs, and to payouts from qualified tuition programs established and maintained by entities other than a state.
Qualified higher education expenses will include special needs services for special needs beneficiaries.
For the exclusion for distributions from qualified tuition plans to pay for qualified higher educational expenses, including room and board, the maximum room and board allowance will be the actual amount charged by the educational institution for room and board.
During the same tax year, taxpayers will be able to claim the American Opportunity Credit or Lifetime Learning Credit and exclude amounts distributed from a qualified tuition program for the same student as long as the distribution is not used for the same expenses as which a credit will be claimed.
The definition of a family member for purposes of beneficiary changes and rollovers will include first cousins of the original beneficiary.
Coverdell ESAs and Qualified Tuition Programs offer essentially the same income tax benefit, namely tax-free earnings if payouts are made for qualified educational purposes. However, each offers a unique combination of benefits and limitations. For example, a Coverdell ESA can be used for elementary and secondary school expenses or college costs, but annual contributions are limited $2,000 per beneficiary and an individual’s contributions are subject to AGI phase outs. The qualified tuition program, on the other hand, does not restrict contributions, but must be used for higher education. The best savings vehicle ultimately will depend on the needs of the donor and the beneficiary who will receive the education.
Unlike custodial mutual funds in his name that become his property at age 18, college savings plans like Bright Start remain in the name of the adult who opened the account. The beneficiary may be changed to another family member, including adults who may want to pursue an advanced degree.
The account is also not included as part of the owner’s taxable estate.
However, withdrawals for nonqualified education expenses incur a federally mandated 10% penalty on top of the income being taxed at the owner’s higher rate.
Most Section 529 savings plans offered by other states are open to out-of-state residents.
Bright Start applications and other information are available at 877-43-BRIGHT or online at www.brightstartsavings.com.
Trust, Estate and Decedent Income Tax
25%, 28%, and 33% Trust and Estate Income Tax Rates are Permanently Extended, Top Rate Increases to 39.6% Beginning in 2013
The 2012 Taxpayer Relief Act provides the following tax brackets beginning after 2012, for trusts’ and estates’ income tax at 15%, 25%, 28%, 33%, and 39.6% marginal tax rates.
2014 Rate Schedule for Trusts and Estates:
|If taxable income is:||The tax would be:|
|Not over $2,500||15% of taxable income|
|Over $2,500 but not over $5,800||$375 plus 25% of the excess over $2,500|
|Over $5,800 but not over $8,900||$1,200 plus 28% of the excess over $5,800|
|Over $8,900 but not over $12,150||$2,068 plus 33% of the excess over $8.900|
|Over $12,150||$3,140 plus 39.6% of the excess over $12,150|
2015 Rate Schedule for Trusts and Estates:
|If taxable income is:||The tax would be:|
|Not over $2,500||15% of taxable income|
|Over $2,500 but not over $5,900||$375 plus 25% of the excess over $2,500|
|Over $5,900 but not over $9,050||$1,225 plus 28% of the excess over $5,900|
|Over $9,050 but not over $12,300||$2,107 plus 33% of the excess over $9,050|
|Over $12,300||$3,180 plus 39.6% of the excess over $12,300|
Estate, Gift, and Generation-Skipping Transfer Taxes
Current Estate Tax Rules Made Permanent, but Top Rate Increases from 35% to 40%
Under the 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA), the estate tax was scheduled to be repealed in 2010, and then to return in 2011 with an exemption of $1 million and graduated rates reaching a top rate of 55% on transfers over $3 million. The 2010 Tax Relief Act reinstated the estate tax retroactively to the beginning of 2010, except where the executor of the estate of a decedent dying in 2010 made an election to opt out of the estate tax and be subject to the modified carryover basis rules instead.
For estates of decedents dying after 2009, the 2010 Tax Relief Act provided an estate tax exemption of $5 million (indexed for inflation after 2011). The exemption amount was $5,120,000 for 2012, and based on inflation data, RIA has calculated the exemption amount to be $5,430,000 for 2015. Also, under the 2010 Tax Relief Act, the tax was imposed at a top rate of 35% on all transfers exceeding the exemption amount.
For estates of decedents dying after 2010, the 2010 Tax Relief Act made the estate tax exclusion (but not the GST exemption) portable between spouses, by allowing the estate of a surviving spouse to use any unused portion of the deceased spouse’s exclusion, in addition to the surviving spouse’s own exclusion.
Under pre-2010 Tax Relief Act law, the generation-skipping transfer (GST) tax was scheduled to be repealed in 2010. The 2010 Tax Relief Act reinstates the GST tax retroactively to the beginning of 2010. For transfers in 2010 only, the tax rate for GST tax purposes was zero. The amount of the GST exemption is the same as the estate tax exemption ($5 million in 2010 and 2011, indexed for inflation after 2011, see above). The GST exemption may have been allocated to a trust created or funded in 2010.
The gift tax was never scheduled to be repealed. For gifts made after 2010, the 2010 Tax Relief Act reunified the gift tax exemption with the estate tax exemption ($5 million, as indexed for inflation, see above). For gifts made after 2010, the 2010 Tax Relief Act reunified the gift and estate tax rate schedule, which imposed tax at a top rate of 35% on all transfers exceeding the exemption amount.
Thus, except for the changes to the estate and gift tax rates (see below), all of the estate, gift and GST tax rules applicable during the years 2010 to 2012 are made permanent starting in 2013. This includes the increased and indexed estate, gift and GST tax exemption of $5 million ($5,430,000 in 2015, as indexed for inflation), and the portability rules.
Top Tax Rate Increased to 40%
The Act also provides that the estate and gift tax rates for amounts over $500,000 are as follows:
- For amounts over $500,000 but not over $750,000, the tax is $155,800, plus 37% of the excess over $500,000;
- For amounts over $750,000 but not over $1 million, the tax is $248,300, plus 39% of the excess over $750,000; and
- For amounts over $1 million, the tax is $345,800, plus 40% of the excess over $1 million.
Thus, under the Act, the top estate and gift tax rate is increased from 35% to 40%.
Estate Tax Exclusion is Made Portable Between Spouses for Decedents Dying after 2010, but GST Exemption is not Portable
A credit (the “unified credit”) is allowed against the estate tax imposed on U.S. citizens and residents. The credit is equal to the tentative tax on the “applicable exclusion amount,” determined under the estate tax rate schedule.
Pre-2010 Tax Relief Act law did not allow for any unused portion of a decedent’s applicable exclusion amount to be used by the estate of the decedent’s surviving spouse.
Every individual is allowed an exemption from the generation-skipping transfer (GST) tax. Under pre-2010 Tax Relief Act law, the GST exemption amount was equal to the applicable exclusion amount for estate tax purposes.
Under the 2010 Tax Relief Act, any applicable exclusion amount that remains unused as of the death of a spouse who dies after December 31, 2010 (the “deceased spousal unused exclusion amount”) generally is available for use by the surviving spouse, as an addition to the surviving spouse’s applicable exclusion amount.
Specifically, the 2010 Tax Relief Act provides that the “applicable exclusion amount” is the sum of (1) the “basic exclusion amount” ($5 million, subject to an adjustment for inflation for estates of decedents dying after 2011), and (2) the “deceased spousal unused exclusion amount.”
For the surviving spouse of a deceased spouse dying after December 31, 2010, the term “deceased spousal unused exclusion amount” means the lesser of:
- the basic exclusion amount ($5 million, subject to an adjustment for inflation for estates of decedents dying after 2011), or
- the excess of:
- the basic exclusion amount of the last deceased spouse dying after December 31, 2010, of the surviving spouse, over
- the amount of the tentative tax on the estate of the deceased spouse, determined under the estate tax rate schedule.
A surviving spouse may use the deceased spousal unused exclusion amount in addition to the surviving spouse’s own $5 million exclusion for taxable transfers made during life or at death.
Assume that Husband 1 dies in 2014, having made taxable transfers of $3 million and having no taxable estate. An election (see below) is made on Husband 1’s estate tax return to permit Wife to use Husband 1’s deceased spousal unused exclusion amount. As of Husband 1’s death, Wife has made no taxable gifts. Thereafter, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1), which she may use for lifetime gifts or for transfers at death.
If a surviving spouse is predeceased by more than one spouse, the amount of unused exclusion that is available for use by the surviving spouse is limited to the lesser of $5 million or the unused exclusion of the last deceased spouse. This so-called “last deceased spouse” limitation applies whether or not the last deceased spouse has any unused exclusion, and whether or not his estate makes a timely election to allow the surviving spouse to use the deceased spousal unused exclusion amount.
Assume the same facts as above, except the Wife later marries Husband 2. Husband 2 also predeceases Wife (thus becoming the “last deceased spouse”), having made $4 million in taxable transfers and having no taxable estate. An election is made on Husband 2’s estate tax return to permit Wife to use Husband 2’s deceased spousal unused exclusion amount. Although the combined amount of unused exclusion of Husband 1 and Husband 2 is $3 million ($2 million for Husband 1 and $1 million for Husband 2), only Husband 2’s $1 million unused exclusion is available for use by Wife, because the deceased spousal unused exclusion amount is limited to the lesser of the basic exclusion amount ($5 million) or the unused exclusion of the last deceased spouse (Husband 2) of the surviving spouse (Wife). Thus, Wife can only use Husband 2’s $1 million unused exclusion. Thereafter, Wife’s applicable exclusion amount is $6 million (her $5 million basic exclusion amount plus $1 million deceased spousal unused exclusion amount from Husband 2), which she may use for lifetime gifts or for transfers at death.
The Committee Report also provides the following example of how the deceased spousal unused exclusion amount works when the surviving spouse remarries, and then predeceases her second spouse.
Assume the same facts as above, except that Wife predeceases Husband 2. Following Husband 1’s death, Wife’s applicable exclusion amount is $7 million (her $5 million basic exclusion amount plus $2 million deceased spousal unused exclusion amount from Husband 1). Wife made no taxable transfers and has a taxable estate of $3 million. An election is made on Wife’s estate tax return to permit Husband 2 to use Wife’s deceased spousal unused exclusion amount, which is $4 million (Wife’s $7 million applicable exclusion amount less her $3 million taxable estate). Under the provision, Husband 2’s applicable exclusion amount is increased by $4 million, i.e., the amount of Wife’s deceased spousal unused exclusion amount.
Election by deceased spouse’s estate to allow surviving spouse’s estate to use deceased spousal unused exclusion amount.
A deceased spousal unused exclusion amount may not be taken into account by a surviving spouse unless the executor of the estate of the deceased spouse files an estate tax return on which the amount is computed, and makes an election on the return that the amount may be taken into account by the surviving spouse. The election, once made, is irrevocable. No election may be made if the estate tax return of the deceased spouse is filed after the due date (including extensions) for filing the return.
The election must be made on an estate tax return of the deceased spouse, regardless of whether the estate of the deceased spouse is otherwise required to file an estate tax return.
GST Exemption is not Portable
The 2010 Tax Relief Act re-defines the amount of the generation-skipping transfer (GST) tax exemption from the “applicable exclusion amount” to the “basic exclusion amount” ($5 million, indexed for inflation after 2011). Thus, the 2010 Tax Relief Act provision allowing portability of the estate tax applicable exclusion amount does not allow a surviving spouse to use the unused GST exemption of a predeceased spouse.
Estate Tax Return Filing Threshold is Tied to Basic Exclusion Amount ($5 Million)
The Tax Relief Act provides that the estate of a U. S. citizen or resident must file an estate tax return if the gross estate exceeds the “basic exclusion amount” (i.e., $5 million, subject to an adjustment for inflation after 2011).
Thus, the estate of a U. S. citizen or resident dying after December 31, 2010, must file an estate tax return if the gross estate exceeds $5 million (as indexed for inflation after 2011), even if the decedent’s applicable exclusion amount is greater than $5 million as a result of the deceased spousal unused exclusion amount.
Portability permits the entire unused exemption of the first spouse to die to be preserved, even if that spouse’s estate was too small to use the entire exemption. A first-deceased spouse’s estate that is valued at zero may still leave to the surviving spouse a deceased spousal unused exclusion (DSUE) amount equal to the entire unused applicable exclusion amount, if a timely estate tax return is filed and an election is made.
Another advantage of portability is that the surviving spouse receives a second automatic basis adjustment when he or she dies with respect to the assets received from the first-deceased spouse which are then included in the surviving spouse’s estate.
A third advantage of portability may be that it is available when the assets of the first-deceased spouse pass outside of the will or revocable trust, and are therefore unavailable to fund the nonmarital share. This could occur if much of the decedent’s assets are held jointly with the surviving spouse with a right of survivorship, or are contractual benefits, such as life insurance. Portability is still available in such circumstances.
A fourth advantage of portability is that it may be an effective estate planning device where the first-deceased spouse’s assets are largely items of income in respect of a decedent, such as retirement benefits (e.g., an IRA) and deferred annuities. Such assets are poor choices to fund nonmarital share, because they will be reduced by income taxes when they are received. Leaving $5.25 million of retirement benefits to a nonmarital deduction trust actually funds the trust with only about $3,412,500 (after, for example, combined federal and state income tax). Leaving the surviving spouse the DSUE amount passes a full $5.25 million exemption to the surviving spouse.
Portability, however, also has several limitations. First, the unused GST exemption of the spouse dying first is not portable and will be lost to the extent not used. A client who wants to leave assets in trust for the benefit of future generations more remote than the first generation below that of the client will want to use a trust to take full advantage of the GST exemption.
Second, assets passing outright to the surviving spouse likely will be subject to the claims of creditors of the survivor, including any subsequent spouse in a divorce. Property placed in trust usually is protected from such claims.
Third, a trust provides independent management of the assets, protecting them from the unwise decisions of the beneficiaries. Even clients who believe that their spouse and children are competent managers may want to consider this benefit, because it avoids the potential adverse influence of unwise friends and in-laws.
Fourth, as indicated above, to secure portability an estate tax return must be filed even if one otherwise would not be due, and that may increase the costs of administering the estate of the first deceased spouse. If an express credit-shelter trust is used, and the estate is below the indexed shelter at death, then no estate tax return would be due except to elect portability for any unused shelter.
Fifth, the DSUE amount is not indexed for inflation. Property that is placed into a credit-shelter trust may appreciate at a rate equal to or greater than inflation and that entire amount should pass free of estate tax when the surviving spouse dies.
Pension and IRA Provisions
Plan Benefit and Contribution Limits Increased
Defined Benefit Plans
The maximum annual benefit payable at retirement under a defined benefit plan is generally the lesser of 100% of average compensation or a statutory amount, $210,000 for 2015.
Defined Contribution Plans
The qualification rules for defined contribution plans limits the annual additions for each plan participant to the lesser of 25% of compensation or a statutory amount ($53,000 for 2015 and $52,000 for 2014).
The annual compensation of each participant that can be taken into account for purposes of determining contributions and benefits under a plan is limited to a statutory amount, $265,000 for 2015.
Elective Deferral Limitations
The limit on the deductible amount of elective deferrals to 401(k) plans and 403(b) annuities may not exceed the “applicable dollar amount.” The applicable dollar amount for these plans will be $18,000 for 2015 and $17,500 for 2014.
The deductible amount of elective deferrals to SIMPLE plans will be limited to another “applicable dollar amount.” The applicable dollar amount for SIMPLE plans will be $12,500 for 2015 and $12,000 for 2014.
Section 457 Plans
The limit on the deductible amount of elective deferrals to a Section 457 plan is also an applicable dollar amount. The maximum annual deferral will be $18,000 for 2015 and $17,500 for 2014.
Under the special catch‑up rule, the limit is twice the otherwise applicable dollar amount in the three years before retirement.
For Individuals Over Age 50, Additional Elective Deferrals in Excess of Otherwise Applicable Limits
The otherwise applicable dollar limit on elective deferrals under a Section 401(k) plan, Section 403(b) annuity, Simplified Employee Pension (SEP), or SIMPLE, or deferrals under a government Section 457 plan is increased for individuals who have attained age 50 by the end of the year. The additional amount of contributions that may be made is the lesser of (1) a specified dollar amount or (2) the participant’s compensation for the year reduced by his or her other elective deferrals for the year. The dollar amount under a Section 401(k) plan, Section 403(b) annuity, SEP, or Section 457 plan is $6,000 for 2015 and $5,500 for 2014.
The dollar amount under a SIMPLE plan is $3,000 for 2015 and $2,500 for 2014.
Higher IRA Contribution Limits
An individual may make annual deductible contributions to a traditional IRA if neither the individual nor his spouse is an active participant in an employer‑sponsored retirement plan. For a married couple, deductible IRA contributions can be made for each spouse (including, for example, a homemaker who does not work outside the home) if the combined compensation of both spouses is at least equal to the contributed amount. If the individual is an active participant in an employer‑sponsored retirement plan, the deduction limit is phased – out if Adjusted Gross Income exceeds certain levels for the tax year. For example, for 2015, the IRA deduction for single taxpayers phased out over $61,000 to $71,000 of Adjusted Gross Income ($98,000 to $118,000 for married taxpayers filing jointly). For a nonactive participant who had an active‑participant spouse, the IRA deduction phaseout begins at $183,000 of Adjusted Gross Income.
Contributions to Roth IRAs are subject to income limits. The maximum yearly contribution that can be made to a Roth IRA is phased out for a single individual with an Adjusted Gross Income between $116,000 and $131,000 and for joint filers with Adjusted Gross Income between $183,000 and $193,000 in 2015.
The maximum annual dollar contribution limit for IRA contributions will increase to the following levels:
|Tax Years Beginning in||Maximum Deductible IRA Amount|
|2013 through 2015||$5,500|
Individuals who attain age 50 before the close of the tax year will be able to make additional catch‑up IRA contributions. The otherwise allowable maximum contribution limit (before applying the Adjusted Gross Income phaseout limits) for these individuals will be $1,000 for 2006 and later years.
401(k) and 403(b) Plans May Treat Post-2005 Elective Deferrals as After-Tax Roth IRA Type Contributions
For tax years beginning after 2005, a 401(k) plan or 403(b) annuity will be allowed to include a “qualified Roth contribution program” that allows participants to elect to have all or part of their elective deferrals treated as Roth contributions. These deferrals will not be excludable from gross income. The annual dollar limit on a participant’s Roth contribution will be the then‑applicable Code Section 402(g) limitation on elective deferrals (e.g., $18,000 in 2015). This new option for elective deferrals will allow taxpayers to make larger annual Roth IRA contributions than they can make with regular Roth IRAs.
Tax Credit to Help Lower‑Income Taxpayers Save for Retirement
Eligible lower‑income taxpayers can claim a nonrefundable tax credit for contributions to certain qualified plans. The maximum annual contribution eligible for the credit is $2,000.
The credit will be in addition to any deduction or exclusion that would otherwise apply for a contribution. Only an individual who is 18 or over (other than a full‑time student or an individual allowed as a dependent on another taxpayer’s return) will be eligible for the credit.
The credit will be available for elective contributions to 401(k) plans, 403(b) annuities, Section 457 plans, SIMPLE or SEP plans, traditional or Roth IRAs, and voluntary after‑tax employee contributions to a qualified retirement plan. The amount of any credit‑eligible contribution will be reduced by taxable distributions received by the taxpayer.
The credit rate (50%, 20%, or 10%) depends on the taxpayer’s filing status and modified Adjusted Gross Income. For 2015, the rates are as follows:
|Modified Adjusted Gross Income||ApplicablePercentage|
|Joint Return||Head of Household||All Other Cases|
|Over||Not Over||Over||Not Over||Over||Not Over|
|$ – 0 –||$36,500||$ – 0 –||$27,375||$ – 0 –||$18,250||50%|
The maximum credit allowed to an individual will be $1,000 ($2,000 x 50%) on joint returns with modified Adjusted Gross Income not over $36,500.
Minimum Distribution Regulations
On April 16, 2002, the IRS released final minimum distribution regulations for profit sharing, stock bonus, 401(k), and other defined contribution plans and IRAs. The regulations are effective beginning January 1, 2003 but may be used in determining minimum distributions for 2002.
The required distribution beginning date has not changed. Minimum distributions are first required for the year the plan participant reaches age 70½ but may be deferred until April 1st of the following year. If the employee is not a 5% owner of a company that maintains a qualified plan, the first year a distribution from the qualified plan is required is the year in which the employee retires, if this is later than the year he or she reaches 70½.
The amount to be taken as a minimum distribution is the balance on December 31st of the prior year divided by a divisor, which generally appears in a uniform lifetime table. The table is based on the joint life expectancy of the IRA owner and a hypothetical person ten years younger.
The tables in the final regulations recognize improvements in mortality and allow distributions over a longer period of time than under tables previously used.
Distributions are required after an owner’s death when an individual other than the spouse is beneficiary. When an individual who is not the owner’s spouse is beneficiary, distributions must begin by December 31st of the year following the owner’s death. If the owner dies before the required beginning date of his or her distributions, the amount to be distributed is determined by dividing the account balance at the beginning of the year following death by the beneficiary’s remaining life expectancy. If the owner dies after the required beginning date of his or her distributions, the divisor is the longer of the owner’s or beneficiary’s remaining life expectancy.
|Uniform Table for Lifetime Distributions|
|Age||Applicable Divisor||Age||Applicable Divisor||Age||Applicable Divisor|
Roth IRA Conversion
The Tax Increase Prevention and Reconciliation Act of 2005 included the following:
- The $100,000 modified Adjusted Gross Income limit on conversions of traditional IRA’s to Roth IRA’s will be eliminated for tax years beginning after December 31, 2009. For conversions occurring in 2010, unless a taxpayer elected otherwise the amount includible in gross income as a result of the conversion will be included ratably in 2011 and 2012.
This year, for the first time ever, all taxpayers, regardless of their modified adjusted gross income (AGI), may convert amounts in a traditional IRA to amounts in a Roth IRA. Marrieds filing separately also are eligible. Before 2010, only taxpayers with modified AGI of $100,000 or less could make such conversion, and marrieds filing separately were not eligible regardless of modified AGI.
Amounts from a SEP-IRA or a SIMPLE IRA also may be converted to a Roth IRA, but a conversion from a SIMPLE IRA may be made only after the 2-year period beginning on the date on which the taxpayer first participated in any SIMPLE IRA maintained by the taxpayer’s employer.
A conversion from a regular IRA to a Roth IRA generally is subject to tax as if it were distributed from the traditional IRA and not recontributed to another IRA, but isn’t subject to the 10% premature distribution tax.
Roth IRAs have two major advantages over regular IRAs:
- Distributions from regular IRAs are taxed as ordinary income (except to the extent they represent nondeductible contributions). By contrast, Roth IRA distributions are tax-free if they are “qualified distributions,” that is, if they are made after the 5-tax-year period that begins with the first tax year for which the taxpayer made a contribution to a Roth IRA, and when the account owner is 59 ½ years of age or older, or on account of death, disability, or the purchase of a home by a qualified first-time homebuyer (limited to $10,000).
- Regular IRAs are subject to the lifetime required minimum distribution (RMD) rules that generally require minimum annual distributions to be made commencing in the year following the year in which the IRA owner attains age 70 ½. By contrast, Roth IRAs aren’t subject to the lifetime RMD rules that apply to regular IRAs (as well as individual account qualified plans).
The consensus view is that the conversion route should be considered by taxpayers who:
- Have a number of years to go before retirement (and are therefore able to recoup the dollars that are lost to taxes on account of the conversion),
- Anticipate being taxed in a higher bracket in the future than they are now, and
- Can pay the tax on the conversion from non-retirement-account assets (otherwise, there will be a smaller buildup of tax-free earnings in the depleted retirement account.
A unique income inclusion rule applies for IRA-to-Roth-IRA conversions occurring in 2010. Unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012. Taxpayers who elect to include all of the 2010 rollover income on their 2010 return cannot change the election after the due date of that return.
Roth IRA Contributions
Individuals may make nondeductible contributions to a Roth IRA, subject to the overall limit on IRA contributions. The maximum annual contribution that can be made to a Roth IRA is phased out for taxpayers with MAGI over certain levels for the tax year. For taxpayers filing joint returns, the otherwise allowable contributions to a Roth IRA will be phased out ratably in 2015 for MAGI between $183,000 and $193,000 (up from between $181,000 and $191,000 in 2014). For single taxpayers and heads of household it will be phased out ratably for MAGI between $116,000 and $131,000 (up from $114,000 and $129,000 for 2014). For married taxpayers filing separate returns, the otherwise allowable contribution will continue to be phased out ratably for MAGI between $0 and $10,000 (same as for 2014).
Distributions From Elective Deferral Plans May be Rolled Over to Designated Roth Accounts
The new law allows 401(k), 403(b), and governmental 457(b) plans to permit participants to roll over their pre-tax account balances into a designated Roth account. The amount of the rollover will be includible in taxable income except to the extent it is the return of after-tax contributions. If the rollover is made in 2010, the participant can elect to pay the tax in 2011 and 2012. Plans will be able to allow these rollovers immediately upon the Act’s enactment.
To be eligible for rollover to a designated Roth account, a distribution must be (i) an eligible rollover distribution, (ii) otherwise allowed under the plan, and (iii) allowable in the amount and form elected. For example, an amount in a 401(k) plan account that is subject to distribution restrictions (e.g., because the participant has not reached age 59 ½) cannot be rolled over to a designated Roth account under the new rollover rules. However, an employer may expand its distribution options beyond those currently allowed by the plan (e.g., by adding in-service distributions before normal retirement age) in order to allow employees to make rollover contributions to a designated Roth account through a direct rollover to the designated Roth account within that plan.
If a plan allows rollover contributions to a designated Roth account, the plan must be amended to reflect this plan feature.
Although there are many similarities between the treatment of Roth IRAs and designated Roth accounts, one difference is that, in determining the taxation of Roth IRA distributions that are not qualified distributions, after-tax contributions are considered recovered before income. This basis-first recovery rule for Roth IRAs does not apply to distributions from designated Roth accounts. Another difference is that a first-time homebuyer expense can be a qualified distribution from a Roth IRA (even without the occurrence of another event, such as the individual reaching age 59 ½), but cannot by itself be qualified distribution from a designated Roth account.
A taxpayer who can rollover an amount from an applicable employer plan to either a Roth IRA or a designated Roth account, might consider whether taking withdrawals from the Roth account or Roth IRA within the five-tax-year holding period for qualified distributions would result in additional tax on a distribution from a designated Roth account (because for the unavailability of the basis-first recovery rule). Also, a taxpayer who is contemplating a withdrawal from the Roth account or Roth IRA to purchase a home as a first-time homebuyer, but who has not yet reached age 59 ½, should consider that such a withdrawal can be qualified distribution from a Roth IRA, but not from a designated Roth account, if the taxpayer has not reached age 59 ½.
Under the 2010 Small Business Act, the tax-free treatment of rollovers that ordinarily applies (under Code Sec. 402(c) for qualified plans, under Code Sec. 403(b)(8) for 403(b) annuities and under Code Sec. 457(e)(16) for governmental section 457 plans) does not apply for distributions rolled over from an applicable retirement plan to a designated Roth account (as described above). Rather, the amount that an individual receives in a distribution from an applicable retirement plan that would be includible in gross income if it were not part of qualified rollover distribution, must be included in his gross income.
If a direct rollover is made by a transfer of property to a designated Roth account, then the amount of the distribution is the fair market value of the property on the date of the transfer.
Any amount that is includible in a taxpayer’s gross income for any tax year beginning in 2010 by reason of a distribution from an applicable retirement plan that is rolled over to a designated Roth account (as described above) is included in gross income ratably over the two-year period beginning in the first tax year beginning in 2011. However, the taxpayer may elect to not have this two-year deferral apply (and thus, to include the taxable portion in gross income in the 2010 tax year). Any such election for any distributions made during a tax year may not be changed “after the due date for such taxable year.”
Presumably, the “due date for such taxable year” refers to the due date for 2010, i.e., for most individuals, April 15, 2011. Neither the Act nor the Committee Reports indicate that the “due date” includes extensions.
Multiemployer Pension Reform
The consolidated and further appropriations Act of 2015 contains a significant 160 page amendment on multiemployer pension reform. This legislation is designed to give multiemployer pension plans the tools they need to remain viable. One of the new provisions allow trustees of severely underfunded plans to adjust vested benefits without violating the Code Sec. 411(d)(6) anti-cutback rule, which may enable deeply troubled plans to survive without a federal bailout.
Code Section 179
Subject to certain limitations, taxpayers can elect to treat the cost of any section 179 property placed in service during the tax year as an expense which is not chargeable to capital account, and, thus, allowed as a deduction for the tax year in which the section 179 property is placed in service.
Under pre-2014 Tax Increase Prevention Act, the deductible Code Sec. 179 expense could not exceed $500,000, not adjusted for inflation (dollar limitation). The maximum deductible expense had to be reduced (i.e., phased out, but not below zero) by the amount by which the cost of section 179 property placed in service during a tax year beginning in 2013 exceeded $2 million not adjusted for inflation (beginning-of-phaseout amount).
Under pre-2014 Tax Increase Prevention Act, subject to a dollar limitation and a carryover limitation, “Section 179 property” included up to $250,000 of the cost of “qualified real property.”
Under pre-2014 Tax Increase Prevention Act, for tax years beginning after 2013, the dollar limitation (discussed above) was to be $25,000 and the phaseout amount (discussed above) was to be $200,000.
The $25,000 and $200,000 amounts were not to be adjusted for inflation.
The 2014 Tax Increase Prevention Act extends for one year the increased $500,000 maximum expensing amount under Code Sec.179 and the increased $2 million investment-based phaseout amount. The increased amounts will apply for qualified property placed in service before January 1, 2015. For tax years beginning after 2014, the maximum expensing amount is again scheduled to drop to $25,000 and the investment-based phaseout amount is scheduled to drop to $200,000. For tax year 2014 up to $250,000 of qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property is eligible for expensing under Code Sec. 179.
Increase in First-Year Depreciation Cap for Cars that are “Qualified Property” is Extended Through December 31, 2014
Code Sec. 280F(a) imposes dollar limits on the depreciation deductions (including deductions under the Code Sec. 179 expensing election) that can be claimed with respect to “passenger automobiles.” The dollar limits are adjusted annually from a base amount to reflect changes in the automobile component of the Consumer Price Index (CPI). Generally, for passenger automobiles placed in service in 2014, the adjusted first-year limit is $3,160. For passenger automobiles built on a truck chassis (“qualifying trucks and vans”) a different CPI component is used, and for 2014 the adjusted first-year limit is $3,460.
For any passenger automobile that is “qualified property” and which is not subject to a taxpayer election to decline the bonus depreciation and AMT depreciation relief otherwise available for “qualified property” under Code Sec. 168(k), the above rules apply, except that the applicable first-year depreciation limit is increased by $8,000 (not indexed for inflation).
The 2014 Tax Increase Prevention Act provides that the placed-in-service deadline for “qualified property” is December 31, 2014.
Thus, for a passenger automobile that satisfies the other requirements (see below) for qualified property (and is not subject to the election to decline bonus depreciation and AMT depreciation relief), the 2014 Tax Increase Prevention Act extends the placed-in-service deadline for the $8,000 increase in the first-year depreciation limit from December 31, 2013 to December 31, 2014.
Bonus Depreciation and AMT Depreciation Relief are Extended for Most Qualified Property Placed in Service Through December 31, 2014
Under code Sec. 168(k), a taxpayer that owns “qualified property” (see below) is, generally, allowed 50% depreciation (bonus depreciation) in the year that the property is placed in service (with corresponding reductions in basis and, thus, reductions of the regular depreciation deductions otherwise allowed in the placed-in-service year and in later years).
Additionally, qualified property is exempt from the alternative minimum tax (AMT) depreciation adjustment, which is the adjustment that requires that certain property depreciated on the 200% declining balance method for regular income tax purposes must be depreciated on the 150% declining balance method for AMT purposes.
Also, qualified property is allowed an $8,000 increase in the otherwise-applicable dollar limit on first-year depreciation for passenger cars.
The rules discussed above for qualified property do not apply to classes of property for which, under Code Sec. 168(k)(2)(D)(iii), the taxpayer elects to not apply Code Sec. 168(k) (an “election-out”).
The following are the requirements for qualified property under Code Sec. 168(k)(2):
- the property must be of a qualifying type; i.e., generally, most machinery, equipment or other tangible personal property; most computer software; and certain leasehold improvements;
- the property must not be property that must be depreciated under the alternative depreciation system;
- the property must not be the subject of certain disqualifying transactions involving users other than the taxpayer or persons related to the taxpayer or the other users;
- the property’s original use generally must begin with the taxpayer after December 31, 2013;
- the property must meet a timely-placed-in-service requirement (see below); and
- the property must meet a timely acquisition requirement (see below).
New Law Effective for Property Placed in Service after December 31, 2013 in Tax Years Ending after December 31, 2013 and Before January 1, 2015
The 2014 Tax Increase Prevention Act extends the availability of 50% bonus depreciation.
The 2014 Tax Increase Prevention Act changes the timely-placed-in-service requirement (above) to provide that qualified property has to be placed in service by the taxpayer before January 1, 2015, except that the aircraft and long-production-period property discussed above have to be placed in service before January 1, 2016.
In addition to extending the eligibility period for bonus depreciation, the extension of the placed-in-service deadline for qualified property also extends the eligibility period for obtaining the exemption, discussed above, from the AMT depreciation adjustment.
Disregard of Certain Bonus Depreciation in Applying the Percentage of Completion Method is Extended for an Additional Time Period
Under the percentage of completion method of accounting (PCM) for a long term contract, the taxpayer includes in income the percentage of the total estimated revenue from the contract that corresponds to the “completion percentage.” The completion percentage is determined by comparing costs allocated to the contract and incurred before the close of the tax year with the estimated total contract costs. The completion percentage is then multiplied by the total estimated revenue to obtain the cumulative gross receipts. The gross receipts for the current year are then determined by subtracting the cumulative gross receipts for the immediately preceding tax year. Thus, as the taxpayer incurs allocable contract costs, it includes the contract price in gross income.
Costs are allocated to a contract under a regular PCM method or under an alternative simplified method. Under both methods, depreciation, amortization and cost recovery allowances on equipment and facilities used to perform the contract are taken into account as costs under the contract.
Thus, an increased depreciation deduction for a tax year will increase the percentage of completion for that year and the amount of gross receipts for the year.
Under Code Sec. 168(k), a taxpayer that owns “qualified property,” is, generally, allowed a 50% depreciation deduction (bonus depreciation) in the year that the property is placed in service (with corresponding reductions in basis and, thus, reductions of the regular depreciation deductions otherwise allowed in the placed-in-service year and in later years).
For purposes of determining the completion percentage (see above), bonus depreciation, with respect to certain qualified property, is not taken into account. The qualified property to which the exclusion applies is property that (i) has an MACRS recovery period of seven years or less (the recovery period requirement) and (ii) is placed in service during a required period (the timing requirement).
New Law Effective for Property placed in service after December 31, 2013 in tax years ending after December 31, 2013 and before January 1, 2015
The 2014 Tax Increase Prevention Act adds an additional period of time (i.e., during the calendar year 2014, and during 2014 and 2015 for long-production period property) during which qualified property satisfies the timing requirement discussed above. The additional period is the period after December 31, 2013 and before January 1, 2015.
15-Year MACRS Depreciation for Certain Building Improvements and Restaurants is Extended to Apply to Property Placed in Service Before January 1, 2015
The rules that in most situations assign a recovery period (i.e., depreciation period) to the various types of MACRS property are known as the General Depreciation System (GDS).
Assets that are nonresidential real property-generally, nonresidential buildings and their structural components – are depreciated on the straight-line method, over a thirty-nine-year GDS recovery period.
However, under 2014 Tax Increase Prevention Act, a building improvement that is “qualified leasehold improvement property” placed in service before January 1, 2015 is depreciated on the straight-line method, over a fifteen-year GDS recovery period.
Similarly, a building improvement that is “qualified retail improvement property” placed in service before January 1, 2015 is depreciated on the straight-line method, over a fifteen-year GDS recovery period.
Also, a building or a building improvement that is “qualified restaurant property” placed in service before January 1, 2015 is depreciated on the straight-line method, over a fifteen-year GDS recovery period.
New Law Effective for Property Placed in Service after December 31, 2013 and Before January 1, 2015
The 2014 Tax Increase Prevention Act extends the rules discussed above for qualified leasehold improvement property, qualified retail improvement property, and qualified restaurant property for one year by providing that the three types of property must be placed in service by January 1, 2015.
Thus, the 2014 Tax Increase Prevention Act retroactively restores and extends for one year the period in which qualifying property can be placed in service to be eligible for the accelerated depreciation rules discussed above.
The fifteen-year GDS recovery period continue in effect for qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property placed in service before January 1, 2015, but a thirty-nine-year GDS recovery period will apply to qualified leasehold improvement property, qualified retail improvement property and qualified restaurant property placed in service after December 31, 2014.
Business Extenders in the 2014 Tax Increase Prevention Act
Business Tax Breaks Extended
The following business credits and special rules are extended:
- The research credit is modified and retroactively extended for one year through 2014.
- The temporary minimum low-income tax credit rate for nonfederally subsidized new building is extended to apply to housing credit dollar amount allocations made before January 1, 2015.
- The Indian employment tax credit is retroactively extended for one year through 2014.
- The new markets tax credit is retroactively extended for one year through 2014.
- The railroad track maintenance credit is retroactively extended for two years through 2014.
- The mine rescue team training credit is retroactively extended for two years through 2014.
- The employer wage credit for employees who are active duty members of the uniformed services is retroactively extended for one year through 2014.
- The work opportunity tax credit is retroactively extended for one year through 2014.
- Qualified zone academy bonds are retroactively extended for one year through 2014.
- The enhanced charitable deduction for contributions of food inventory is retroactively extended for one year through 2014.
- Allowance of the domestic production activities deduction for activities in Puerto Rico applies for the first eight tax years of the taxpayer beginning after December 31, 2005, and before January 1, 2015.
- Exclusion from a tax-exempt organization’s unrelated business taxable income (UBTI) of interest, rent, royalties, and annuities paid to it from a controlled entity is extended through December 31, 2014.
- Treatment of certain dividends of regulated investment companies (RICs) as “interest-related dividends” is extended through December 31, 2014.
- Inclusion of RICs in the definition of a “qualified investment entity” is extended through December 31, 2014.
- The exception under subpart F for active financing income (i.e., certain income from the active conduct of a banking, financing, insurance or similar business) for tax years of a foreign corporation beginning after December 31, 1998 and before January 1, 2015, for tax years of foreign corporations beginning after December 31, 2005, and before January 1, 2015.
- Look-through treatment for payments between related controlled foreign corporations (CFCs) under the foreign personal holding company rules is extended through January 1, 2015.
- Exclusion of 100% of gain on certain small business stock acquired before January 1, 2015.
- Basis adjustment to stock of S corporations making charitable contributions of property in tax years beginning before December 31, 2014.
- The reduction in S corporation recognition period for built-in gains tax is extended through 2014, with a five-year period instead of a ten-year period.
- Various empowerment zone tax incentive, including the designation of an empowerment zone and of additional empowerment zones (extended through December 31, 2014) and the period for which the percentage exclusion for qualified small business stock (of a corporation which is a qualified business entity) is 60% (extended through December 31, 2018).
- Tax-exempt financing for New York Liberty Zone is extended for bonds issued before January 1, 2015.
- Temporary increase in limit on cover over rum excise taxes to Puerto Rico and the Virgin Islands is extended for spirits brought into the United States before January 1, 2015.
- American Samoa economic development credit, as modified, is extended through January 1, 2015.
Energy-Related Tax Breaks Extended in the 2014 Tax Increase Prevention Act
The recently enacted 2014 Tax Increase Prevention Act extends a host of important energy-related tax breaks for individuals and businesses.
The various energy credits extended include:
- The nonbusiness energy property credit for energy-efficient existing homes is retroactively extended for one year through 2014. A taxpayer can claim a 10% credit on the cost of: (i) qualified energy efficiency improvements, and (ii) residential energy property expenditures, with a lifetime credit limit of $500 ($200 for windows and skylights).
- The cellulosic biofuel producer credit is modified and extended one year through 2014.
- The credit for biodiesel and renewable diesel is retroactively extended for one year through 2014.
- The production credit for Indian coal facilities placed in service before 2009 is extended one year. The credit applied to coal produced by the taxpayer at an Indian coal production facility during the nine-year period beginning on January 1, 2006 through December 31, 2014, and sold by the taxpayer to an unrelated person during such nine-year period and the tax year.
- The credits with respect to facilities producing energy from certain renewable resources is modified and extended one year. A facility using wind to produce electricity will be a qualified facility if it is placed in service before 2015.
- The credit for energy-efficient new homes is retroactively extended for one year through 2014.
- The additional depreciation deduction allowance for cellulosic biofuel plant property is modified and extended one year through December 31, 2014.
- The special rule for sale or disposition to implement federal energy regulatory commission (FERC) or State electric restructuring policy for qualified electric utilities is retroactively extended for one year through 2014.
- The alternative fuels excise tax credits for sale or use of alternative fuels or alternative fuel mixtures is retroactively extended for one year through 2014.
Shortened S Corp Built-in Gains Holding Period Extended for 2012, 2013, and 2014 and Application of Built-in Gains Tax Clarified
An S corporation is generally not subject to tax, but passes through its items to its shareholders, who pay tax on their pro-rata shares of the S corporation’s income. Where a corporation that was formed as a C corporation elected to become an S corporation (or where an S corporation received property from a C corporation in a nontaxable carryover basis transfer), the S corporation was taxed at the highest corporate rate (currently 35%) on all gains that were built-in at the time of the election if the gains were recognized during the recognition period, i.e., the first ten S corporation years (or during the ten-period after the transfer). The 2009 Recovery Act provided that, for S corporation tax years beginning in 2009 and 2010, no tax was imposed on the net unrecognized built-in gain of an S corporation if the seventh tax year in the recognition period preceded the 2009 and 2010 tax years. This rule applied separately for property acquired from C corporations in carryover basis transactions. The 2010 Small Business Act added that for S corporation tax years beginning in 2011, no tax was imposed on the net unrecognized built-in gain of an S corporation if the fifth year in the recognition period preceded the 2011 tax year.
Where the net recognized built-in gains (i.e., the amount by which recognized built-in gains exceeded the recognized built-in losses) for any tax year exceeded the taxable income of the S corporation (as determined for purposes of the built-in gains tax), the built-in gains tax was not imposed. However, the excess net recognized built-in gain was carried forward to the next year to be treated as a recognized built-in gain in that next tax year.
The 2012 Taxpayer Relief Act provides that for S corporation tax years beginning in 2012 and 2013, the recognition period is limited to five years. The 2014 Tax Increase Prevention Act extends this through 2014.
Thus, a five year period applies for the 2011, 2012, 2013, and 2014 tax years. Since the ten-year period will apply after the 2014 tax year (unless extended by Congress), sellers should complete the sales in the 2014 tax year.
When an asset is sold in an installment sale under Code Sec. 453, the treatment of the payments is determined by the tax year in which the sale is made.
Thus, if an asset is sold within the recognition period, the gain will be subject to the built-in gains tax, even if the gain is recognized after the recognition period under the installment sale rules.
The rules regarding carryovers of net recognized built-in gain are such that net recognized built-in gain is only carried over to years that are within the recognition period.
Thus, if built-in gain is not taxed during the recognition period because of the taxable income limitation, the built-in gain will not be taxed in a later year.
Safe Harbor Provides Simplified Option for Claiming Home Office Deduction
Rev Proc 2013-13, 2013-6 IRB, IR 2013-5
In a revenue Procedure, IRS has provided an optional safe harbor method that individuals can use to determine the amount of their deductible home office expenses, effective for tax years beginning on or after January 1, 2013. The safe harbor – $5 x square feet of qualified use (up to three-hundred square feet) provides an alternative to the calculation, allocation, and substantiation of actual expenses required under Code Sec. 280A.
The general rule under Code Sec. 280A(a) is that no deduction is allowed for the business use of a dwelling unit that is also used by the taxpayer as a residence during the tax year. But under exceptions, if strict requirements are met, deductions are allowed for direct expenses and the business-use part of the indirect expenses relating to business use of a residence:
- Home office expenses are deductible if part of the home is used regularly and exclusively as (i) a principal place of business, or (ii) as a place to meet or deal with customers or clients in the ordinary course of business. Taxpayers who are employees must meet an additional test – their use of the home office must be for the convenience of the employer. (Code Sec. 280A(c)(1))
- Expenses that are allocable to space within the dwelling unit used on a regular basis for the storage of inventory or product samples held for use in the taxpayer’s trade or business of selling products at retail or wholesale are deductible if the dwelling unit is the sole fixed location of the trade or business. (Code Sec. 280A(c)(2))
- Expenses that are attributable to the rental of the dwelling unit or a part of the unit are deductible. (Code Sec. 280A(c)(3))
- Expenses that are allocable to the part of the dwelling unit used on a regular basis in the taxpayer’s trade or business of providing day care for children, for individuals who have attained age sixty-five, or for individuals who are physically or mentally incapable of caring for themselves are deductible. (Code Sec. 280A(c)(4))
These deductions are limited to the activity’s gross income reduced by all other deductible expenses that are allowable regardless of qualified use (e.g., mortgage interest, real estate taxes, and casualty losses) and by the business deductions that are not allocable to the use of the home itself (e.g., expenses of advertising, wages, and supplies). Expenses disallowed solely because they exceed business income can be carried forward, subject to the gross income limitation in the later year. (Code Sec. 280A(c)(5))
New Safe Harbor
To reduce the administrative, recordkeeping, and compliance burdens of determining the allowable deduction for the qualified business use of a residence under Code Sec. 280A, Rev Proc 2013-13 provides a safe harbor method under which an individual determines his allowable deduction for the qualified business use of a home by multiplying a prescribed rate ($5) by the square footage of the part of this residence that is used for business purposes, not to exceed three-hundred square feet. “Qualified business use” for this purpose is a business use that satisfies the requirements of Code Sec. 280A(c)(1) through Code Sec. 280A(c)(4) – that is, uses for which a deduction under Code Sec. 280A would otherwise be allowed. The $5 rate may be updated from time to time, as warranted. Adjustments are provided for determining the allowable square footage for a taxpayer with a qualified business use of a home for only a part of a year. (Rev Proc 2013-13, Sec. 3, Rev Proc 2013-13, Sec. 4)
Thus, the maximum deduction under the safe harbor is limited to $1,500 ($5 rate x three-hundred square feet).
For purposes of the safe harbor, “home” means a dwelling unit used by the taxpayer during the tax year as a residence (as defined in Code Sec. 280A(d) and Code Sec.(f)(1)), including a dwelling unit leased by a taxpayer. However, only a dwelling unit that is Code Sec. 1250 property (generally depreciable real property) and MACRS property (generally defined in Reg § 1.168(b)-1(a)(2) as tangible, depreciable property subject to Code Sec. 168 that is placed in service after Dec. 31, ’86) qualifies as a home. (Rev Proc 2013-13, Sec. 3.03)
The safe harbor method does not apply to an employee with a home if he receives advances, allowances, or reimbursements for expenses related to the qualified business use of the employee’s home under a reimbursement or other expense allowance arrangement with his employer. (Rev Proc 2013-13, Sec. 4.01(4))
The safe harbor is an alternative to deducting actual expenses. Accordingly, a taxpayer electing the safe harbor method for a tax year generally cannot deduct any actual expenses related to the qualified business use of that home for that tax year, with the following exceptions:
- Otherwise Allowable Home-Related Deductions.
A taxpayer who itemizes deductions and uses the safe harbor may deduct any allowable expenses related to the home that are deductible without regard to whether there was a qualified business use of the home for that tax year (e.g., deductions for qualified residence interest, property taxes, and casualty losses). Taxpayers using the safe harbor method deduct these expenses as itemized deductions on Form 1040, Schedule A, and cannot deduct any part of these expenses from the gross income derived from the qualified business use of the home – either for purposes of determining the net income derived from the business or for purposes of determining the net income derived from the business or for purposes of determining the gross income limitation under Rev Proc 2013-13, Sec. 4.08(2) (which parallels the gross income limitation under Code Sec. 280A(c)(5)). Taxpayers with a qualified business use of a home who also have a rental use of the same home under Code Sec. 280A(c)(3) must allocate a portion of these expenses to the rental use to the extent required under Code Sec. 280A and its regs. (Rev Proc 2013-13, Sec. 4.04)
- Business Deductions Unrelated to Qualified Home Use.
A taxpayer using the safe harbor method for a tax year may deduct any allowable trade or business expenses unrelated to the qualified business use of the home for that tax year (e.g., expenses for advertising, wages, and supplies). (Rev Proc 2013-13, Sec. 4.05)
A taxpayer using the safe harbor for a tax year cannot deduct any depreciation (including first-year bonus depreciation) or Code Sec. 179 expensing for the part of his home that is used in qualified business use for that tax year. (Rev Proc 2013-13, Sec. 4.06) If he calculates and substantiates actual Code Sec. 280A expenses for a later year, he must calculate the depreciation deduction by using the appropriate optional depreciation table applicable for the property in the manner described in Rev Proc 2013-13, Sec. 4.07(2), regardless of whether he used an optional depreciation table for the property in its placed-in-service year. (Rev Proc 2013-13, Sec. 4.07)
A taxpayer using the safe harbor method for a tax year cannot deduct any disallowed amount under Code Sec. 280A(c)(5) carried over from a prior tax year during which the taxpayer calculated and substantiated actual Code Sec. 280A expenses. He can deduct the carried-over amount in the next succeeding tax year in which he calculates and substantiates actual Code Sec. 280A expenses. (Rev Proc 2013-13, Sec. 4.08(3))
Electing the Safe Harbor
A taxpayer may elect from tax year to tax year whether to use the safe harbor method or calculate and substantiate actual expenses under Code Sec. 280A. A taxpayer elects the safe harbor by using the method to compute the deduction for the qualified business use of a home on his timely filed, original federal income tax return for the tax year. Once made, an election for the tax year is irrevocable. A change from using the safe harbor method in one year to actual expenses in a succeeding tax year (or vice-versa) is not a change in accounting methods. (Rev Proc 2013-13, Sec. 4.03)
One-Year Rule for Prepaid Expenses
The final regulations under Sec. 263(a) issued in January 2004 included a 12-month rule (Regs. Sec. 1.263(a)-4(f)), whereby taxpayers are not required to capitalize an expense if it is paid or incurred (see Regs. Sec. 1.263(a)-4(j)) to create a right or benefit that does not extend beyond the earlier of (1) 12 months after the first date of the right or benefit or (2) the end of the tax year following the tax year in which the expense was paid or incurred.
Regs. Sec. 1.263(a)-4(f)(6) makes it clear that, for an accrual-method taxpayer, the 12-month rule does not eliminate the other requirements for deduction – all the events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred with respect to the liability.
Corporation X, an accrual-method taxpayer with a calendar tax year, made two prepayments in June 2005. One payment was for a fire and casualty insurance policy; the other was for equipment rental. Both payments covered the period July 1, 2005 to June 30, 2006. X is not required to capitalize the portion of the insurance payment attributable to 2006 because of the 12-month rule, and the portion can be deducted in 2005 because the all-events test is met, the amount is determinable with reasonable accuracy, and economic performance was satisfied on payment. The portion of the rental payment attributable to 2006 does not have to be capitalized because of the 12-month rule and, with the all-events and determinable-with-reasonable-accuracy requirements met, it can be deducted in 2005 if the payment satisfies the requirements for the economic performance recurring-item exception under Regs. Sec. 1.461-5.
The Sec. 263(a) regulations provided that for the first tax year ending on or after December 31, 2003, taxpayers wishing to change their accounting method to a method consistent with the regulations can make the change using the automatic consent procedure described in Rev. Proc. 2002-9. Accordingly, for example, a calendar-year taxpayer could make a change to apply the 12-month rule beginning with its tax year ended December 31, 2003, by filing Form 3115, Application for Change in Accounting Method, by the due date (including extensions) of its 2003 return.
Rev. Proc. 2004-23 was issued later. It provided additional guidance for completing Form 3115 under the automatic consent procedure to change to an accounting method to conform to the Sec. 263(a) regulations for the first tax year ending on or after December 31, 2003. Taxpayers could also use the procedure to correspondingly change their accounting methods to use the economic performance 3½-month rule or recurring-item exception in conjunction with the items changed under the 12-month rule, by including this information on the same Form 3115. The availability of the automatic consent procedure to change to the 12-month rule and to use the 3½-month rule or recurring-item exception was later extended by Rev. Proc. 2005-9 for taxpayers’ second tax year ending on or after December 31, 2003.
Rev. Proc. 2006-12 was issued on December 21, 2005. It allows taxpayers to change, under the automatic consent procedure, to an accounting method provided under the Sec. 263(a) regulations beginning with tax years ending on or after December 31, 2005. However, a major departure form Rev. Proc. 2004-23 and 2005-9 was made. Rev. Proc. 2006-12 only applies to taxpayers changing to an accounting method provided under the Sec. 263(a) regulations; it does not apply to taxpayers changing their method using the economic performance 3½-month rule or recurring-item exception. Rev. Proc. 2006-12 states:
Thus, for a change in method of accounting utilizing the 3½-month rule or the recurring-item exception in conjunction with a change to a method provided by the final regulations, a taxpayer must file two separate applications for a change in method of accounting – an application for a change in method of accounting under this revenue procedure to change to the method of accounting provided in the final regulations, and a separate application for a change in method of accounting under Rev. Proc. 97-27 for a change in method of accounting utilizing the 3½-month rule or the recurring-item exception.
Accordingly, in the example above, to change to an accounting method under which X could deduct in 2005 the insurance premium and equipment rental payments attributable to 2006, X would have to file two Forms 3115 – one under the automatic consent procedure by the due date of the 2005 return to change to the 12-month rule for both payments, and the other under the advance consent procedure, which would have to be filed by December 31, 2005 to permit X to use the recurring-item exception to deduct its equipment rental payment.
It appears the IRS made this significant change due to its findings that change to the use of the 3½-month rule or recurring-item exception when it is necessary to comply with the economic performance requirement in conjunction with a change to the 12-month rule was often not being made, and when made the exception may not have been applied correctly. It also appears that the IRS is proposing to modify Rev. Proc. 2006-12 to allow taxpayers in this situation to file one Form 3115 for both changes (instead of two) under the advance consent procedure. Rev. Proc. 2006-12 was modified by Rev. Proc. 2006-37 to allow taxpayers to file one Form 3115 for both changes.
Deduction for Manufacturing/Production Activities
For tax years beginning after 2004, the Act provides a deduction that is equal to a percentage of the income earned from manufacturing (and certain other production activities) undertaken in the U.S. The deduction equals the lesser of:
- A percentage of the lesser of the qualified production activities income of the taxpayer for the tax year or taxable income without regard to this deduction, for the tax year. The percentage is 3% for tax years beginning in 2005 and 2006, 6% for tax years beginning in 2007-2009, and 9% thereafter.
- 50% of the sum of wages paid by the taxpayer and the elective deferrals, that are made by the taxpayer during the calendar year that ends in the tax year. (W-2 wages only include amounts that are properly allocable to domestic production gross receipts).
Qualified production activities income is equal to domestic production gross receipts reduced by the sum of:
- the costs of goods sold that are allocable to such receipts, other deductions, expenses, or losses that are directly allocable to such receipts, and
- a ratable portion of other deductions, expenses, and losses that are not directly allocable to such receipts or to another class of income.
Domestic production gross receipts are gross receipts of a taxpayer that are derived from:
- any sale, exchange or other disposition, or any lease, rental or license, of qualifying production property that was manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the U.S.,
- any sale, exchange or other disposition, or any lease, rental or license, of qualified films produced by the taxpayer,
- any sale, exchange or other disposition of electricity, natural gas, or potable water produced by the taxpayer in the U.S.,
- construction activities performed in the U.S., or
- engineering or architectural services performed in the U.S. for construction projects located in the U.S.
Domestic production gross receipts do not include any gross receipts derived from the sale of food or beverages prepared by the taxpayer at a retail establishment, or the transmission or distribution of electricity, natural gas, or potable water.
Qualifying production property includes any tangible personal property, computer software and sound recordings. In order to be a qualified film, 50% of the total compensation relating to the production of the film must be for services performed in the U.S. by actors, production personnel, directors and producers.
The deduction is available to C corporations, S corporations, partnerships, sole proprietorships, co-operatives, and estates and trusts, and subject to an adjustment, is allowed for AMT purposes.
Who Must Use Accrual Method
C corporations, partnerships having a C corporation as a partner and tax shelters cannot use the cash method and must instead use the accrual method. However, this rule does not apply to a corporation or partnership (assuming it is not a tax shelter) if a not-more-than-$5 million average annual gross receipts test is met. “Tax shelter” means, among other things, a partnership or S corporation, interests in which are sold through an offering registered with a state or federal agency, or more than 35% of whose losses are allocable to limited partners and certain other non-active participants.
Small Business Exceptions to Required Accrual Accounting
The accrual method generally is also mandatory for purchases and sales where inventories must be used. However, qualifying small businesses with 3-year average annual gross receipts of more than $1 million but not more than $10 million that are not prohibited from using the cash method under Code Sec. 448 (such as tax shelters, and C corporations with more than $5 million average gross receipts, as discussed above) and otherwise would have to keep inventories and use accrual accounting may, instead, use the cash method for an eligible trade or business. Under this IRS relief, the following types of qualifying small businesses may use the cash method for all of their trades and businesses:
- One whose principal business activity for its immediately preceding tax year is other than mining, manufacturing, wholesale trade, retail trade, or information industries.
- Service providers, including those providing property incident to those services.
- Fabricators or modifiers of tangible personal property upon demand in accordance with customer design or specifications.
Qualifying small businesses that come within any of these categories may use the cash method even for parts of their businesses, such as retailing or wholesaling, which otherwise would not qualify for the cash method.
IRS also allows taxpayers with average annual gross receipts of $1 million or less to use the cash method, with fewer restrictions than under the $10 million exception discussed above. For instance, retailers and wholesalers with gross receipts up to $1 million may use the cash method, but those with gross receipts between $1 million and $10 million generally may not.
Businesses that use the cash method under the exceptions generally include amounts in income attributable to open accounts receivable (i.e., receivables due in 120 days or less) as amounts are actually or constructively received. Businesses permitted to use the cash method under these exceptions that do not want to account for inventories must treat all inventoriable items (e.g., items purchased for resale and raw materials purchased for use in producing finished goods) in the same manner as nonincidental materials and supplies under Reg § 1.162-3 (i.e., deductible only in the year in which they are actually consumed and used in the taxpayer’s business).
Qualifying small business taxpayers that want to use the cash method and/or not account for inventories as described above must follow the automatic-change-in-accounting-method provisions of Rev. Proc. 2008-36, 2008-33 IRB 340, as modified by Rev. Proc. 2009-39, 2009-38 IRB, with certain modifications.
“S” Corporation Shareholder Compensation
The IRS is on the lookout for S Corporations that fail to pay reasonable salaries to shareholders who perform services for the corporation. The failure to pay adequate salaries to shareholder-employees is a red flag for an audit.
The IRS can reclassify as salaries any distributions to the shareholders. Determining what a reasonable salary is may be more art than science, but the attempt must be made.
Because the IRS’s goal is to collect FICA tax on the salaries, one solution is to pay the maximum amount of wages subject to FICA tax, assuming, of course this is a reasonable salary, based on the shareholder-employee’s services actually rendered. A smaller salary may be justified for an executive in a startup or a relatively small corporation. The salary should also consider the shareholder-employee’s experience and skill, the geographical region, customer base, number of employees, and time committed to the corporation. What is a reasonable salary depends on the facts of each case. No test is conclusive. It often becomes a judgment call by the IRS. Comparable salaries from industry data are usually appropriate.
The tax court in several instances allowed statistical data from an industry and region to be used as guidance for reasonable compensation. There is no IRS rule that insolates the S Corporation from an audit on this issue. A reasonable salary depends on all the facts and circumstances in each individual case. If the S Corporation is a personal service corporation with one employee, the shareholder-employee, then a case can be made that the entire net earnings of the corporation should be salary. At the other extreme, if the S Corporation is a construction company with large amounts of capital equipment, then a good deal of the corporate earnings are a return on this capital and a reasonable salary may be just a small percentage of corporate earnings.
The reclassification of a distribution to salary results in increased taxes to you in the form of payroll taxes.
The lost revenue is of great concern to the IRS. In May, 2005, the office of the Treasury Inspector General for the administration reported that in 2000 alone, more than 36,000 single-shareholder S Corporations with profits excess $100,000 paid no salaries or payroll taxes. Another 40,000 with profits between $50,000 and $100,000 did not pay any salaries.
We have seen an extreme increase in audits related to this issue. The IRS compares the officer compensation line item on the S Corporation return to the profit of the S Corporation and will typically audit those returns that show little if any officer compensation.
Shareholder Loans to “S” Corporations
On October 17, 2008 the IRS finalized regulations on the treatment of open account debt between S Corporations and their shareholders. If a shareholder’s basis in S Corporation shareholder debt has been reduced by his or her share of the S Corporation losses and the S Corporation makes a distribution or pays off the debt with an amount in excess of the remaining basis, gain must be recognized.
A capital gain will result if the debt is evidenced by a written note. If the S Corporation repays the debt and the shareholder lends more money later in the year for purposes of avoiding the gain, each payment is treated as an individual transaction, and the two payments are not netted for purposes of determining basis in debt at the end of the year. When the debt of the S Corporation to the shareholder is paid off in installments, each installment is allocated between return of capital and gain based on the proportion of the shareholder’s basis in the debt to its face amount. Under the final regulations, open account debt would be defined as shareholder advances not evidenced by separate written instruments for which the principal amount of the aggregate advances does not exceed $25,000 at the close of any day during the S Corporation’s tax year. If the running balance exceeds $25,000, the entire principal amount of that debt would no longer be open account debt. The principal amount would be treated as debt evidenced by a written instrument.
Regulation 1.1367-2(a) states that generally, if shareholder advances are not evidenced be separate written instruments for which the principal amount of the aggregate advances does not exceed $25,000 and repayments on the advances, the debt is called open account debt and treated as a single debt. However, ordinary income results on the S Corporation’s repayment of the open account debt.
Although ordinary income is a disadvantage of not evidencing loans, an advantage is that multiple loans and repayments made throughout the year are considered open account debt and are netted at the end of the year rather than gain occurring on repayment of each individual debt. The final regulations generally are proposed to apply to shareholder advances to S Corporations made on or after October 20, 2008.
If the indebtedness is evidenced by a note, the repayment is treated as a sale or exchange. Accordingly, if the note is a capital asset in the shareholder’s hands the excess of the amount repaid over basis is taxed as capital gain. (Rev. Rul. 64-162, 1964-1 C.B. 304).
However, if the debt is not evidenced by a note, there is no sale or exchange when the debt is paid. Thus, a payment by an S Corporation of a debt to a shareholder that is carried on an open account, will be ordinary income to the extent of the amount paid over the applied basis (Rev. Rul. 68-537, 1968-2 C.B. 372).
If a shareholder’s advances are not evidenced by a separate written instrument, net of repayments, exceed an aggregate outstanding principal amount of $25,000 at the close of the S Corporation’s tax year, for any later tax year, the aggregate principal amount is treated as indebtedness evidenced by a separate written instrument, with the result that the indebtedness is not open account debt and is subject to all basis adjustment rules applicable to basis of indebtedness of an S Corporation to a shareholder. However, in this case the gain would be ordinary as there is no written note it is merely deemed a written note for purposes of the timing of taxability. Should you find yourself in this situation, you should draw up actual notes so that the gain would be capital gain.
Economic Substance Doctrine Clarified
Under pre-2010 Reconciliation Act law, courts denied claimed tax benefits under two closely related nonstatutory doctrines that evolved in judicial decisions. Under the “economic substance” doctrine, courts generally denied claimed tax benefits if the transaction that gave rise to those benefits lacked economic substance independent of tax considerations – even though the purported activity actually occurred. A common law doctrine that often was considered together with the economic substance doctrine was the business purpose doctrine. The business purpose doctrine involved a subjective inquiry into the taxpayer’s motives, i.e., whether the taxpayer intended the transaction to serve some useful non-tax purpose.
There was a lack of uniformity as to the proper application of the economic substance doctrine. Some courts applied a conjunctive test that required a taxpayer to establish the presence of both economic substance (i.e. the objective component) and business purpose (i.e. the subjective component) for the transaction to be given effect. Under a narrower approach used by some courts either a business purpose or economic substance was sufficient to have the transaction respected. Under a third approach economic substance and business purpose were viewed as simply more precise factors to consider in determining if a transaction had any practical economic effects other than the creation of tax benefits. In 2006, the Federal Circuit Court stated that while the economic substance doctrine could well apply if the taxpayer’s sole subjective motivation was tax avoidance, even if the transaction had economic substance, a lack of economic substance was sufficient to disqualify the transaction without proof that the taxpayer’s sole motive was tax avoidance. In 2009, the 5th Circuit also adopted the view that a lack of economic substance alone was sufficient to disqualify the transaction without regard to the taxpayer’s motive.
The 2010 Reconciliation Act provides statutory rules for applying the economic substance doctrine.
The 2010 Reconciliation Act also defines the economic substance doctrine as the common law doctrine under which the Federal income tax benefits of a transaction are not allowable if the transaction does not have economic substance or lacks a business purpose.
Testing a Transaction Under the Codified Economic Substance Doctrine
Under the 2010 Reconciliation Act, a transaction to which the economic substance doctrine is relevant (see below) has economic substance only if:
- The transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and
- The taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction. (This list is referred to as the economic substance test list.)
The determination of whether the economic substance doctrine is relevant to a transaction is made as if this provision was never enacted. Thus, the provision does not change current law standards in determining when to utilize an economic substance analysis.
Things to Consider before the End of 2014
- Use up expiring loss and credit carryovers.
- Increase basis in Partnership or S-corporation to make possible 2014 loss deduction.
- Buy equipment by December 31st to get bonus depreciation deductions in 2014.
- Apply bunching strategy to “miscellaneous” itemized deductions, medical expenses, and other itemized deductions in order to increase deductible amounts.
- Increase withholding to eliminate estimated tax penalty.
- Set up self-employed retirement plan.
- Make gifts taking advantage of $14,000 gift tax exclusion.
- Avoid personal-holding company tax by making dividend payments.
- Minimize income tax on social security benefits.
- Dispose of passive activity in order to free-up suspended losses.
- Make IRA contributions as early as possible.
- Delay late year mutual fund investments until after the fund’s dividend date.
- Maximize your contribution to a tax‑deferred retirement plan.
2014 Tax Rate Schedule
|Married IndividualsFiling Joint Returns andSurviving Spouses||Not over $18,150||10% of taxable income|
|Over $18,150 but not over $73,800||$1,815 plus 15% of the excess over $18,150|
|Over $73,800 but not over $148,850||$10,163 plus 25% of the excess over $73,800|
|Over $148,850 but not over $226,850||$28,925 plus 28% of the excess over $148,850|
|Over $226,850 but not over $405,100||$50,765 plus 33% of the excess over $226,850|
|Over $405,100 but not over $457,600||$109,588 plus 35% of the excess over $405,100|
|Over $457,600||$127,963 plus 39.6% of the excess over $457,600|
|Heads of Household||Not over $12,950||10% of taxable income|
|Over $12,950 but not over $49,400||$1,295 plus 15% of the excess over $12,950|
|Over $49,400 but not over $127,550||$6,763 plus 25% of the excess over $49,400|
|Over $127,550 but not over $206,600||$26,300 plus 28% of the excess over $127,550|
|Over $206,600 but not over $405,100||$48,434 plus 33% of the excess over $206,600|
|Over $405,100 but not over $432,200||$113,939 plus 35% of the excess over $405,100|
|Over $432,200||$123,424 plus 39.6% of the excess over $432,200|
|Unmarried Individuals(Other ThanSurviving Spouses andHeads of Household)||Not over $9,075||10% of taxable income|
|Over $9,075 but not over $36,900||$908 plus 15% of the excess over $9,075|
|Over $36,900 but not over $89,350||$5,081 plus 25% of the excess over $36,900|
|Over $89,350 but not over $186,350||$18,194 plus 28% of the excess over $89,350|
|Over $186,350 but not over $405,100||$45,354 plus 33% of the excess over $186,350|
|Over $405,100 but not over $406,750||$117,541 plus 35% of the excess over $405,100|
|Over $406,750||$118,119 plus 39.6% of the excess over $406,750|
|Married IndividualsFiling SeparateReturns||Not over $9,075||10% of taxable income|
|Over $9,075 but not over $36,900||$908 plus 15% of the excess over $9,075|
|Over $36,900 but not over $74,425||$5,081 plus 25% of the excess over $36,900|
|Over $74,425 but not over $113,425||$14,463 plus 28% of the excess over $74,425|
|Over $113,425 but not over $202,550||$25,383 plus 33% of the excess over $113,425|
|Over $202,550 but not over $228,800||$54,794 plus 35% of the excess over $202,550|
|Over $228,800||$63,981 plus 39.6% of the excess over $228,800|
2015 Tax Rate Schedule
|Married IndividualsFiling Joint Returns andSurviving Spouses||Not over $18,450||10% of taxable income|
|Over $18,450 but not over $74,900||$1,845 plus 15% of the excess over $18,450|
|Over $74,900 but not over $151,200||$10,313 plus 25% of the excess over $74,900|
|Over $151,200 but not over $230,450||$29,387 plus 28% of the excess over $151,200|
|Over $230,450 but not over $411,500||$51,577 plus 33% of the excess over $230,450|
|Over $411,500 but not over $464,850||$111,324 plus 35% of the excess over $411,500|
|Over $464,850||$129,996 plus 39.6% of the excess over $464,850|
|Heads of Household||Not over $13,150||10% of taxable income|
|Over $13,150 but not over $50,200||$1,315 plus 15% of the excess over $13,150|
|Over $50,200 but not over $129,600||$6,872 plus 25% of the excess over $50,200|
|Over $129,600 but not over $209,850||$26,722 plus 28% of the excess over $129,600|
|Over $209,850 but not over $411,500||$49,192 plus 33% of the excess over $209,850|
|Over $411,500 but not over $439,000||$115,737 plus 35% of the excess over $411,500|
|Over $439,000||$125,362 plus 39.6% of the excess over $439,000|
|Unmarried Individuals(Other ThanSurviving Spouses andHeads of Household)||Not over $9,225||10% of taxable income|
|Over $9,225 but not over $37,450||$922 plus 15% of the excess over $9,225|
|Over $37,450 but not over $90,750||$5,156 plus 25% of the excess over $37,450|
|Over $90,750 but not over $189,300||$18,481 plus 28% of the excess over $90,750|
|Over $189,300 but not over $411,500||$46,075 plus 33% of the excess over $189,300|
|Over $411,500 but not over $413,200||$119,401 plus 35% of the excess over $411,500|
|Over $413,200||$119,996 plus 39.6% of the excess over $413,200|
|Married IndividualsFiling SeparateReturns||Not over $9,225||10% of taxable income|
|Over $9,225 but not over $37,450||$922 plus 15% of the excess over $9,225|
|Over $37,450 but not over $75,600||$5,156 plus 25% of the excess over $37,450|
|Over $75,600 but not over $115,225||$14,693 plus 28% of the excess over $75,600|
|Over $115,225 but not over $205,750||$25,788 plus 33% of the excess over $115,225|
|Over $205,750 but not over $232,425||$55,662 plus 35% of the excess over $205,750|
|Over $232,425||$64,998 plus 39.6% of the excess over $232,425|