Archive for 'Taxes'

Jun 21

I’ve got a possible twist on a Roth conversion for you.

You may remember that you can convert your regular IRA to a Roth during 2010 and have a choice on how to pay your taxes: all at one time or spread over the upcoming two years. Therefore you can write a check in April, 2011 or you can write two checks in April, 2012 and 2013.

Let’s move on to the next level of detail. Let’s say that you have $200,000 in your IRAs. You convert $100,000 of it. How much income do you have to report on your taxes? Easy – $100,000.

Let me change the facts. You have $200,000, but $160,000 of it is in a regular IRA and $40,000 is in a nondeductible IRA. Yes, a nondeductible IRA. Those are for people with incomes too high to fund a regular IRA or a Roth.  You would think that $60,000 would be taxable ($100,000 – $40,000), but you would be wrong. The IRS has stated that all your IRAs must be aggregated to arrive at the nontaxable percentage. The IRS calculation would be as follows:

                $40,000/ (40,000 + 160,000) = 20 percent

                $100,000 times 20% equals $20,000 nontaxable

                $100,000 minus 20,000 equals $80,000 taxable

You are not surprised that the IRS calculation results in more taxable income, are you?

Here is the twist: say you have a 401((k) at work. Or say that you are self-employed and have established a solo 401(k). Say further that the 401(k) allows transfers from your IRA into the plan. You transfer $100,000 from your regular IRA into your 401(k). That leaves $100,000 of IRA money, $60,000 regular and $40,000 nondeductible.

How much is taxable now?

                $40,000/ (40,000 + 60,000) = 40 percent

                $100,000 times 40% equals $40,000 nontaxable

                $100,000 minus 40,000 equals $60,000 taxable

A little bit of inconvenience and paperwork to save taxes on $20,000? What do you think?

Jun 17

It appears that Congress may change the rules for one of my favorite wealth-transfer techniques: the grantor retained annuity trust (GRAT).

If you haven’t run into this term before, it involves a donor funding a trust for a family member. Normally, the amount transferred to the trust would be a gift (and subject to gift tax), but in this case the grantor takes back a series of payments (the annuity) from the trust. The annuity reduces his gift and likewise reduces his gift tax. If the tax planner can reach that nirvana where there is zero gift and zero gift tax, it is referred as a “zeroed-out” GRAT.

There is another important component to the math: the IRS requires you to include earnings – call it interest if you wish – in the trust. If you think about it, this makes sense. If you kept the assets, you would also have kept the earnings. You transferred the assets so you also transferred the earnings.

The IRS uses an interest rate to approximate the effect of these earnings. The rate is referred to as the Section 7520 rate (guess what Internal Revenue Code section it is under), and the rate is published monthly. The current rate is 3.2 percent. Think about this for a second. The IRS is assuming that the trust will have earnings of 3.2 percent over its term, whether that term is 2 years, 5 years or 10 years. What if you transfer assets to the trust that are almost guaranteed to earn more than 3.2 percent? Well, you now have a technique using IRS mathematics that reduces the tax cost of your gifts. How? Because you transfer assets earning more than 3.2 percent, but the math is calculated using 3.2 percent. Say the assets earn 9 percent. That is a difference of 5.8 percent – every year for the term of the trust. You are leaving money on the table, but since you are making a gift leaving money is a good thing.

By the way, what asset would pay 9 percent? Well, what if you own a company with steady earnings and a reliable dividend history? Oh, it has never paid a dividend? Maybe it could, at least for a while. You wouldn’t have to go far to find an asset to fund the GRAT, would you? Or you could establish a “skip” trust to transfer the shares to the grandchildren. The skip may require a bit more work, as you will likely want the assets to go to another trust upon leaving the GRAT.

There are variations on the GRAT. The donor can segregate his/her stocks or assets into different classes before funding the trusts. These “multiple GRATs” can be used to segregate losses on one class from gains on another class. The donor may then let the loss GRAT blow up, returning those assets to his/her estate, while diligently maintaining the gain GRAT. 

Sometimes GRATs are set up sequentially. I worked on a client several years ago who used 2-year GRATs for his sons, funding a GRAT each year for a period of years.   In year 1, for example, he funded a GRAT. He also funded in years 2, 3 and 4. The year-1 GRAT would expire at the end of year 2, but in year 2 he funded the year-2 GRAT. In year 3, he therefore had 2 GRATs (year-2 and year-3) and likewise for year 4 and so on. These are called “rolling GRATs.” It doesn’t necessarily move a lot of money at one shot, but it does over a period of time and gives the donor great flexibility.

Low interest rates power this tax technique. And we have low interest rates in the 2010 economy.

Then Congress wrecks it.

The House voted on June 15 to approve a package of tax incentives. To pay for it, the House would require GRATs to have a minimum term of 10 years. In addition, the House bill would disallow zeroed-out GRATs and also require that the annuity could not decrease over the first 10 years.

This is not a death knell for GRATs, but it certainly makes them less attractive.  Often it is an elderly taxpayer who funds the GRAT, and a minimum term of 10 years may dissuade him or her. If the taxpayer does not survive the GRAT term, then GRAT assets are returned to his/her estate. Considering that the goal is to remove assets from the estate, this result is undesirable. The zeroed-out GRATs are sometimes used for grandkids, as it is a great way to minimize the generation skipping tax. That too would be less attractive under the House bill.

Jun 15

David Watson is a CPA. After 10 years with a national firm, he joined with three other accountants and formed an accounting firm.  In 1996 each partner formed professional corporations (PCs) and substituted their PCs for their individual ownership in the firm. Watson’s PC (DEWPC) elected S corporation status.

In 2002 and 2003 DEWPC paid Watson $24,000. He did no research to establish this salary level, such as a review of average salaries in the profession.  DEWPC also distributed approximately $118,000 and $221,000 as dividends for 2002 and 2003, respectively.

The key point here is that S corporation distributions are not subject to social security. Watson was therefore tax planning by shielding the majority of his income from social security.  What could possibly go wrong?

You guessed it. In 2007 the IRS recharacterized the majority of the distributions as payroll and assessed Watson almost $50,000 in employment taxes, penalties and interest. Watson disputed this amount and paid approximately $4,000. He immediately filed a claim for refund requesting his $4,000. The IRS disagreed.  Watson went to district court and requested summary judgment against the IRS – and his $4,000 back.

Watson’s argument was fairly straightforward. His PC intended to, and did, pay him $24,000 per year. Watson argued that the IRS did not have the right to tell him what his compensation should be.

The IRS argued that Watson’s position was self-serving, and that the correct standard was whether the payments were intended as remuneration for services rendered. The IRS argued that there existed sufficient evidence that Watson misstated the portion intended as remuneration.

The court agreed with the IRS. The evidence could be interpreted differently, and therefore the court did not declare summary judgment for Mr. Watson. He might have another day in court but it won’t be for summary judgment.

Is this a case of pigs and hogs? It sure sounds like it. Dividends are normally considered a return on capital invested. The return can of course vary, and there is no prohibition against lucrative returns. However, how much capital would an average accounting firm require? An accounting firm does not carry inventory, nor does it generally have extensive investment in machinery, equipment or capital-intensive assets.  How much capital did Mr. Watson have invested that dividend distributions of over a third of a million dollars over two years would not raise eyebrows at the IRS?

Congress is wise to the ways of the Messers Watsons out there. This tax technique may be null and void if the tax extenders package passed by the House on May 28, 2010 winds up in a final tax bill. The House would require the income of an S corporation whose principal asset is the reputation and skill of 3 or fewer shareholders to be fully subject to social security. As a one-man shop, there would be no opportunity for Mr. Watson to minimize his social security if that tax provision becomes law.

Jun 10

Mercer is an employee benefit consulting firm. It has over 19,000 employees and clients over 40 countries. It recently released a survey (2009 National Survey of Employer-Sponsored Health Plans) of nearly 3,000 employers over provisions of the new health care law.

There is a provision in the law that employers must offer health benefits or pay penalties, beginning in 2014.

There is another provision that assesses employer penalties if the insurance premiums are deemed unaffordable, and unaffordable is defined is more than 9.5% of household income. If the insurance is unaffordable, then the employee may qualify for a federal subsidy to buy insurance in the to-be-created exchanges. An employee applying for coverage must provide income information to the exchange. The exchange in turn will notify employers of employees which qualify for subsidies.

The penalty is $3,000 per year for each full-time employee who gets a government subsidy. The maximum penalty is $2,000 times the total number of full-time employees in excess of 30. As an example, a company with 55 employees with 30 qualifying for the subsidy will be penalized the lower of

  • $3,000 times 30 equals $90,000, or
  • $2,000 times 25 equals $50,000

Note that employers with less than 50 employees are generally exempt from the penalties.

Mercer estimated that 38% of all employers have at least some employees for whom coverage would be considered unaffordable. Not surprisingly, Mercer found that reform may have the biggest impact on employers with large part-time populations that don’t provide coverage to part-time employees or require them to work more than 30 hours per week for coverage.

Jun 04

I saw the following in the Wall Street Journal today. There is an interesting tax story here.

It concerns Roy Halladay, who is a pitcher (and a very good one) for the Philadelphia Phillies. Now, Roy used to pitch for the Toronto Blue Jays.

Here is the tax part: Canada has a combined federal/provincial tax rate of about 40%, which is higher than the tax rate in the U.S. Remember, a U.S. citizen or green card resident has to report all income, irrespective of where earned, to the U.S. Since his Canada tax rate was higher than his U.S. rate, Halladay accumulated “excess” foreign tax credits from his Blue Jays days. He can carry these credits forward to offset “foreign income.” Trick here is that it has to be earned income, as the income which triggered the credit way back when was earned income. To a tax person, this is referred to as “general limitation income.” It is also why Roy cannot buy a portfolio of Canadian dividend-paying stocks and use up that credit. Those dividends are not “general limitation income.”

Major League Baseball moved a Phillies- Blue Jays series from Canada to Philadelphia.

Halladay earns a bit under $16 million a year. Figure that there are 162 games in a regular MLB season. According the WSJ, approximately $215,000 would have been allocated to the Blue Jays series.

You would think that the $215,000 would be reportable to Canada. If Halladay was a golfer, you would be right. However, the US and Canada apply different tax rules to an athlete who is employed by a team that participates in a league with regularly scheduled games in both countries. If that is you, Canada will not tax you if (1) you are in Canada for 183 days or less and (2) your employer is not Canada-based. The Phillies are, of course, not Canada-based.

So, Halladay would have $215,000 of salary that is considered “foreign source.” This would release those carryover foreign tax credits. How great is that! His taxes go down because he releases a credit… but he doesn’t have to pay Canada anything.

So, Bud Selig’s decision to move the series to Philadelphia cost Halladay about $75,000 ($215,000 times 35%).

Jun 02

Here is a jewel from Sec 413 from the Amendments to Senate Amendment to H.R. 4213 (the American Jobs and Closing Loopholes Act):

(a) IN GENERAL.—Section 1402 is amended by adding at the end the following new subsection:(m) SPECIAL RULES FOR PROFESSIONAL SERVICE BUSINESSES.—


(C) DISQUALIFIED S CORPORATION.—For purposes of this subsection, the term ‘disqualified S corporation’ means—

(ii) any other S corporation which is engaged in a professional service business if the principal asset of such business is the reputation and skill of 3 or fewer employees.

OK, what is Congress up to? Well, they are proposing to subject all the distributive income of a small professional services S corporation to social security tax.

Yikes. I have to question what percentage of lawyers, engineers, architects – not to mention accountants – are picked up in this net. Congress is upset about the issue of S corporation shareholders receiving small salaries and large distributions, applying social security to the salary but not to the distributions. Fair enough. We are aware of the issue, but the tax law already requires S corporation shareholder/employees to draw a “reasonable” salary. We (that is, Rick and I) do not press this issue to ridiculous limits, but we understand that there are practitioners who do. Rather than enforce the law and issue taxpayer and preparer penalties to egregious violators, Congress lobs the tax grenade of proposed Section 1402(m).

Let’s think about this. The tax won’t apply if there are four shareholders. There is a planning idea – make a fourth person a minimal shareholder. Is the IRS going to argue that the reputation and skill of the fourth shareholder is insubstantial? What if there are five shareholders but only two truly drive the firm? Do they get a pass? Say I put my office building inside my S corporation. What is my “principal asset” – me or my real estate?  Why am I being penalized if I have one or two co-shareholders but not ten, or twenty, or more?

Here is a thought: if Congress is so worried that S corporations are being exploited, why not just do away with the FICA exemption for all S corporation distributions? What is it about 3 or less S-shareholder firms that has them so concerned? This isn’t just another “revenue” grab for an an increasingly bankrupt government, is it?

 Good grief.

May 25

There is a pending IRS proposal that is causing many business tax advisers grief.

Let’s start with something called FIN 48. This is inside baseball. In June 2006 the Financial Accounting Standards Board issued Fin 48, which requires affected companies to assess and possibly disclose positions (think deductions) they took on their tax returns. Now, why would a rational person do such a thing? To an auditor it sort of makes sense.  An auditor wants to record and disclose every measurable and significant business liability. Why? Well, if for no other reason than to have a defense when the lawsuits hit the fan. If you think about it, an aggressive tax position can be considered a “contingent” liability. If your tax position is not 100% straightforward and well-trod ground, then the IRS may argue with you. Guess what, they may win. And if they do, you have to write a check to the government. That check may be sizeable. Going full circle, this may constitute a liability that the auditor wants to pin down and disclose.

It sounds so reasonable – at the beginning. Many practitioners at the time argued that this disclosure would be a bad idea because the government would use the financial statements as a road map on how to steer your tax audit. “Nonsense” said the government. They would never do such a thing.

On April 19, 2010, the IRS proposed a rule that affected companies (think $10 million and above) file a schedule with their tax return to disclose tax positions and how much money the government could wring out of them if the deductions were disallowed in full. The term of art is “uncertain” tax positions. But to the government’s credit, they are not reading your financial statements.

Take a look at this from a tax planner’s (like me, for example) perspective. Given the amount of tax law changes, there may be as many “uncertain” tax positions out there as there are “certain.” It is the nature of practice that there are more fact patterns in real life than there is space in an article or time at a seminar to discuss. It is in these “cracks” between the concrete that many a tax professional (at least the good ones) earns his or her keep. Heck, if not all you would need is TurboTax. A substantial part of what we do rises to the level of “uncertain.” It is uncertain because Congress keeps pumping this stuff out like inserts for a Sunday newspaper. It takes time for the professionals to sift through it, for articles to read and seminars to attend, for questions to be asked, for the IRS and the courts to address.

And until then you and I are expected to reveal our hands to the IRS?

May 24

There has been an agreement in the House Ways and Means Committee on a package of “tax extenders.” Extenders are tax provisions that Congress allows to lapse (sometimes annually) and then reinstates.  The vote next goes to the full House, which may happen the week of May 24th, and then to the Senate.

Deduction of general sales taxes

The bill extends (for one year) the election to claim an itemized deduction for state and local general sales taxes.

Additional standard deduction for real estate taxes 

The bill extends (for one year) the additional standard deduction (of $500, $1,000 if MFS) for state and local real estate taxes.

Deduction for qualified tuition and fees

This is the (up to) $4,000 deduction for qualified education costs. It would be extended for one year.

Deduction for teacher expenses

The bill extends (for one year) the $250 deduction for teacher expenses for books, supplies, computer equipment and supplementary materials used in the classroom

Tax-free distributions from IRAs to charity

The bill extends (for one year) tax-free distributions of up to $100,000 from IRAs directly to charity.

Paying with carried interest

This is the hedge fund provision and is a big part of how Congress will “pay” for the extenders.

The issue here is that hedge fund managers received “interests” in their hedge funds. When they received income from these “carried interests,” the income was treated as capital gains and taxed at a favorable tax rate. When you and I receive a W-2, of course, we pay the ordinary tax rate and not the capital gains rate. Hence, the controversy.

The bill would allow carried interest to be taxed at the capital gains rate if it accurately reflects an underlying investment. If not, then it is considered compensation, and 75% of the carried interest will be taxed as ordinary income. The remaining 25% will be taxed as capital gains.

May 21

The amount of health insurance paid by your employer will be reported on your W-2 next year (2011).

Hold up! This does not mean that the insurance will be included in your taxable income. It is only information reporting, at least for the time being.

May 21

I came across an interesting fact yesterday.

More than a quarter million individual tax returns claiming the homebuyer credit have been selected for correspondence audit this far in 2010.

That is about 20% of all correspondence audits.

The reason is understandable. There are paperwork requirements, such as attaching the closing statement to one’s 2009 tax return. That requirement was in response to, among other things,  a five-year old claiming the tax credit.

The good news (for practitioners like me) is that the IRS will not have those resources to do correspondence exams in other areas.