Tuesday, October 25, 2011
Let’s talk about PFICs.
It is pronounced “Pea Fick,” and it is shorthand for a passive foreign investment company. We are continuing our “foreign” theme of late.
A PFIC is a foreign mutual fund. Think about your funds at Fidelity or Vanguard and relocate them to Bonn or London. That is all you have done, but with that act you have entered a twilight world of odd tax reporting.
Why? Treasury does not like foreign mutual funds. Why? That question has several possible answers, but I believe that a large part is because Treasury cannot control the taxation. A mutual fund in the United States is a “regulated investment company.” One of the requirements is that it has to pass along its taxable income to its investors in order to preserve its tax standing. Shift that fund to Bonn, and the German fund manager may not have the same level of concern in maintaining that “regulated investment company” status. The German fund manager may do something unconscionable, such as not declare dividends or distribute income to investors. That would allow the German fund to delay tax consequence to its U.S investors, possibly for many years. Why, the U.S. investor may eventually report the income as capital gain rather than ordinary dividend income. This is clearly an unacceptable scenario.
It didn’t use to be this way. The law for PFICs changed in 1986.
You are going to be specially taxed. You however can choose one of three methods of taxation:
(1) The Excess Distribution Method
This is the default method and is found in Section 1291 of the Internal Revenue Code.
At first glance it sounds good. You pay no tax until you either sell or receive an “excess distribution.” When you do, the IRS presumes that the income was earned ratably over the years you owned the fund. You have to pay tax at the highest marginal tax rate. It does not matter what your actual tax rate was. What if the fund lost money for 8 years, had one great year that made up for all losses and then you sold at a profit. ? Doesn’t matter. The IRS presumes that your profit was earned pro rata over 9 years. Now you are late on your taxes (remember, you did not include the profit in your prior year returns because there WAS NO PROFIT). You now have to pay tax using the highest-marginal tax rates. For 9 years. And then there is interest on the late taxes.
Oh, you may not be allowed to claim the loss if you sell the PFIC at a loss.
You really do not want to use this method.
(2) The Mark to Market Method
This option was added to the Code in 1997.
You mark your PFIC to market every year-end. In other words, you pay taxes on the difference between the share price on January 1st and December 31st. Every year.
You forfeit capital gains and losses. Whatever income or loss you report is ordinary. Sorry.
The big requirement here is that the PFIC has to have published fund prices. If the prices are not published, you simply cannot use the mark to market method.
(3) The Qualified Electing Fund
This is the method I have normally seen. The problem is that the fund has to provide certain information annually. As that information has meaning only to a U.S. taxpayer, the fund may decide that it is not worth the time and cost and refuse to provide it. In practice, I have seen these funds go through investment houses such as Goldman Sachs. Goldman can pool enough U.S. investors to make it worthwhile to the foreign fund manager, so the fund agrees going in that it will provide this additional information annually.
A QEF is basically like a partnership. It passes-though its income to the U.S. investor – whether distributed or not – and the U.S. investor pays taxes on it. Ordinary income is taxed at ordinary rates, and capital gains at capital gains rates. What changes is that Treasury does not wait for a distribution.
A QEF should be elected in the first year you own the QEF. If so, you avoid the “excess distribution” regime altogether. If you make the election in a later year, then there is a procedure to “purge” the earlier PFIC treatment.
The QEF election is made fund by fund.
Yes, there is a special form to use with PFICs. It is Form 8621 “Information Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing Fund.” It can be an intimidating three pages of tax-speak.
I saw PFICs a few years back, as we had several well-heeled clients. What I generally saw was a K-1, perhaps from a hedge fund. That fund in turn invested, and some of its investments were PFICs. The fund K-1 would arrive with its booklet of information, explanation and disclosures. The PFICs inside would further swell the page count. I remember these K-1s going on for 30 or 40 pages. These K-1s are not for young tax accountants.
As I said, Treasury really does not like foreign mutual funds.
Thursday, October 20, 2011
My brother-in-law is married to an English citizen. My other brother-in-law lives near Saffron Walden, north of London. Perhaps it is because of my wife’s family, but I have paid attention to the tax issues of expatriates for a long time.
Let’s reverse the direction, however, for today’s discussion. Let’s say that you are a U.S. citizen or green card holder. You live in the United States. It is the family that lives abroad. You receive a gift or bequest from the family. To simplify the discussion, let’s stipulate that the family has no ties to the U.S., other than having you in the family. Maybe you are the in-law.
What does your tax radar tell you?
Generally there is no U.S. gift tax on a gift from overseas – with some exceptions. There are always exceptions. The gift could be subject to U.S. gift tax if it is “U.S. situs” property. In general, tangible property located in the U.S. is “U.S. situs” property. Examples would include:
· Vacation property
Did I say cash? Yep. The IRS considers cash to be tangible property. The IRS could, for example, consider a check given to you in the U.S. to be a gift of personal property subject to the gift tax. I personally would visit the family overseas, receive the check and sidestep this issue altogether. I have never understood why cash is singled out. I like to remember tax law by understanding what the law is attempting to reach, but this rule has never made sense to me.
Generally intangible property is not considered “U.S. situs” property. Intangibles would include stocks and bonds, for example. There is a different rule with respect to U.S. stocks and bonds and the estate tax, but we are discussing only gift tax today.
Short of transferring a house to you, it is unlikely that your in-laws will have a U.S. gift tax return. You however may have to file Form 3520, “Annual Return to Report Transaction With Foreign Trusts and Receipt of Certain Foreign Gifts,” depending on the amount of the gift. The good news is that there is no tax with Form 3520. It is a reporting form. You are required to file Form 3520 only if gifts from individuals exceed $100,000 for the year. There is a lower threshold for gifts from a foreign corporation or partnership - $14,375. I have never seen a gift from a foreign corporation or partnership, however.
But remember to file the 3520, because if you don’t file the penalties will be 5% of the gift amount for each month you don’t file.
I suspect you figured out where the IRS gets its money on foreign gifts.
Monday, October 17, 2011
It was one of the last individual tax returns I saw this year going into October 15, so the topic is on my mind.
The topic is bankruptcy. It seems that I have seen or discussed bankruptcy more in the last three years than in the balance of my career years combined. There are peculiar tax rules to bankruptcy. Today I want to talk about chapter 7, also known as liquidation, as that is the type of bankruptcy that I have been seeing the most.
Chapter 7 is the classic bankruptcy. Your assets and liabilities pass to the bankruptcy trustee. The trustee sells what he/she can and pays what is possible to the creditors. When done the judge discharges the bankruptcy and one is free of all debts. Depending on the state you may retain certain types of assets. The example I am familiar with is the primary residence in Florida. Some debts may follow you out of bankruptcy. An example is the loan on your car. You reaffirm the debt because you want, or need, to keep the car. If you want the car you have to keep the debt.
Upon filing a Chapter 7, your assets and liabilities past to the bankruptcy estate, which is normally represented by a trustee. It may be that some assets do not pass, but let’s not include that issue in our discussion. The estate also succeeds to one’s tax attributes. Think of attributes as tax benefits waiting to happen: a net operating loss or a general business tax credit, for example. When they finally kick-in, there is a benefit – meaning a reduction in tax – to you.
Why is this important? Because the estate is a separate taxpaying entity. When calculating its tax, the trustee can use your tax attributes to offset the estate’s tax. So, if you have an NOL, the trustee can use it to offset the estate’s taxable income. When you remember that the NOL can only be used once, this has meaning to you. If the trustee uses it, then you cannot.
There is another important tax consideration to bankruptcy. You may already know that debt discharged in bankruptcy is not taxable to you. Did you know, however, that you have to reduce your tax attributes to the extent that you have discharged debt? If you have $56,000 of debt discharged and have a $61,000 NOL carryforward, you have to reduce that NOL carryforward to $5,000 ($61,000 – 56,000).
What is the estate taxed on? Remember that one’s assets move to the estate upon filing Chapter 7. If the income can be traced to the asset, then the income is taxable to the estate as long as the asset is inside the estate. Examples include:
· Dividends on stocks
· Interest on bonds
· Royalties on mineral rights or patents
· Rental income on rental real estate
· Capital gains or losses from selling stocks and bonds
What is not taxable to the estate? The classic example is your paycheck. It cannot be traced to an asset inside the estate, so it is not taxable to the estate. It is however taxed to you.
So the estate files a tax return for interest and dividends. You file a tax return for your wages. You now have two tax returns where there used to be just one.
And that is how the estate uses up your tax attributes. When the estate is discharged, it should tell you what is left on the tax attributes, because now you can use what is left. There may be nothing left.
This works well if the estate is large enough to have its own tax return. Frankly, what I have seen in recent years (at least the last 5 years) are small bankruptcy estates. These estates generally do not file a separate estate return, although technically they are supposed to. Rather all the estate numbers (think dividends and the sale of the stock that generated them) are combined with the taxpayer’s other non-bankruptcy numbers (think W-2) and reported on taxpayer’s individual income tax return. Now it becomes important for the CPA to remember the tax attribute rule, because there is no separate estate return to remind him/her.
This past weekend I met with a client who had $79,901 discharged in Chapter 7. There was no separate bankruptcy estate tax return. We did not make an election to end the client’s tax year upon the date of the Chapter 7 filing. She did have tax attributes to reduce. The client’s tax consequence went as follows:
Debt discharged 79,901
Net operating loss carryover ( 43,268)
Capital loss carryover ( 11,045)
Note receivable ( 25,588)
The client lost the NOL and capital loss carryovers to the debt discharge. The amount left over reduced the client’s basis in a note receivable from a partnership. Think about this for a moment. What happens when our client is repaid the note in the future? Our client would receive more money than the client has basis in the note. Is this a taxable event? You bet. Why did we select the note? Because the note is in a partnership that is unlikely to ever repay our client in full. We considered the risk of the “phantom income” to be slight.
The IRS does not intend for bankruptcy to be “free.” From a tax perspective, what the IRS wants is for the bankruptcy to be tax-neutral over a period of time. In the above example, our client was not taxed on the $79,901, but the IRS has immediately eliminated $54,313 of tax benefits. The IRS further hopes that our client is repaid the note in full, because that will trigger $25,588 of phantom income. At that point $54,313 + 25,588 equals $79,901, which was the discharged income the IRS did not tax. To the IRS this would constitute a “push,” as it was out only the time value of the tax but not the tax itself.
Is there an order how the tax attributes are to be used up? Of course. The order is as follows:
· Net operating loss carryover
· General business credit carryover
· Minimum tax credit carryover
· Capital loss carryover
· Basis of property
· Passive activity loss and credit carryovers
· Foreign tax credit carryover
There are other types of bankruptcy than Chapter 7. There is Chapter 13, which is a reorganization of debt for an individual. Chapter 12 is for farmers and Chapter 11 is for businesses. Perhaps we will talk about them – on another day.
Friday, October 7, 2011
The Senate Democrats have offered yet another tax to pay for yet another $447 billion stimulus package. They now want to impose a 5.6% surtax on income over $1 million per couple.
Let’s add-up the increases that are being discussed or have already been passed into legislation:
· The expiration of the Bush tax cuts 39.6%
· The phase-out of itemized deductions (Pease) 1.19%
· The phase-out of personal exemptions (PEP) 1.15%
· The Medicare surtax on investment income 3.8%
· The Medicare surtax on earned income 0.9%
· This week’s Senate Democrat proposal 5.6%
I doubt this list is complete as the above is just off the top of my head.
You get the idea.
Wednesday, October 5, 2011
We’ve been looking again at the small business health care tax credit. Truthfully, I have been less than impressed with this credit, at least for our clients. It seems quite heavily engineered to accomplish so little.
There are three key steps to this credit:
(1) How many employees do you have?
(2) How much do you pay them?
(3) Do you have a “qualifying” insurance arrangement?
Let’s go through them.
HOW MANY EMPLOYEES DO YOU HAVE?
To be fair, the credit does not address the number of employees. It instead addresses “full time equivalents.” This makes sense, as it may require two (or three) part-time employees to have one “full-time equivalent” employee.
The first thing to do is count the number of employees. This requires a definition of “employee” (remember, this is the tax code). The term “employee” does NOT include the following:
· a sole proprietor
· a partner in a partnership
· a more-than-2% shareholder in an S corporation
· a more-than-5% owner in any other business
Wait, there is more:
· a family member of the above, including spouses, lineal family (ancestor/descendent) and in-laws.
So, you start with your year-end payroll summary. You eliminate the owners and their family. That leaves you with “employees’ for purposes of this credit.
Next you add-up the hours worked for those who remain. You stop counting at 2,080 hours per employee. After you adding-up all the hours, you divide by 2,080 to arrive at the number of FTEs. If this number is less than 25, you are still in the hunt.
The magic number is 10 or less FTEs. Above that number you will start to phase-out. By 25 you have phased-out completely.
The magic number is 10 or less FTEs. Above that number you will start to phase-out. By 25 you have phased-out completely.
HOW MUCH DO YOU PAY THEM?
We are talking Medicare wages, not income-taxable wages. The key difference will be contributions to 401(k)s, as those are Medicare-taxable but not income-taxable.
Fortunately you get to exclude the wages for the people left out above: the owners, their spouses and other family.
This can get you into an odd factual situation. You can have a workforce over 25 people – all full-time – and still qualify for this credit. The reason is that you have to eliminate the owners, their spouses and family. For some of our clients, that eliminates a sizeable part, if not the majority, of the workforce.
The key number here is $25,000 per FTE. Above that amount you will start to phase-out. By $50,000 you have completely phased-out.
DO YOU HAVE A “QUALIFYING”INSURANCE ARRANGEMENT?
The insurance we are discussing is what you would anticipate: traditional insurance, HMO, PPO and hospital indemnity. It also includes specified illness (think cancer insurance) as well as some dental and vision insurance.
What it doesn’t include is an HSA.
The key requirement is that you – the employer - have to pay at least 50% of the cost of the insurance. There are some tweaks around the edges (such as if the insurance company does not charge the same premium for all employees in single coverage).
If you do not pay at least 50% of the health insurance, there is no point in even starting the calculation.
There is also a “ceiling” test: your insurance can only be so expensive for purposes of this calculation. The government will publish state-specific amounts for “small group market average premiums.” Your insurance cannot exceed that amount for your state.
AN INTERIM STEP
Add-up your cost of premiums for “qualifying” insurance for your “FTEs.”
WHAT IS THE AMOUNT OF THE CREDIT
If you are for-profit, the credit is 35% of the interim step.
ARE WE DONE?
Of course not. If you have too many employees – or the right number of employees but pay them too much – your credit gets phased-out, eventually to zero. No credit for you.
There are two phase-outs, which means that you cannot do this in your head.
(1) If you have more than 10 FTE’s you start to phase-out. The phase-out is
(FTE – 10)
So, at 25 FTE’s you are completely phased-out.
(2) If your average wage is more than $25,000, you start to phase-out.
(average annual wage - 25,000)
So, at $50,000 you are completely phased-out.
HOW ABOUT AN EXAMPLE?
Let’s say that you have 9 FTEs with an average wage of $23,000.
4 are single coverage and 5 are family coverage. You pay 50% of the single rate.
The premiums are $4,000 for singles and $10,000 for family. The state limits are $5,000 for singles and $12,000 for family.
Here is the calculation.
$2,000 times 9 equals 18,000
The credit is 35% times 18,000 or $6,300.
LET’S CHANGE AN ASSUMPTION
What if the employer pays 50% whether of single or family coverage?
Here is the calculation:
$2,000 times 4 equals 8,000
$5,000 times 5 equals 25,000
The credit is 35% times 33,000 or $11,550.
HOW ABOUT ANOTHER EXAMPLE?
Let’s say you have 40 part-time employees. They total 20 FTEs. The average wage is $25,000. To keep this easy, let’s say that your cost of the health insurance is $240,000
(1) First phase-out
20 FTE - 10 equals 66.6% phase-out
(2) Second phase-out
$25,000 - $25,000 equals 0% phase-out (that’s good!)
The credit is (35% times $240,000) times (100% minus 66.6%) times (100% minus 0%) - or $28,000.
The credit is part of the general business credit, which means that you get to carry it over if you cannot use it in a given tax year. In addition, the credit is allowed for AMT, which is good. You do have to reduce your deductible insurance by the amount of the credit.
As I said, we have been less than impressed. It is, however, a great way for Congress to increase someone’s tax preparation fees.