Sunday, December 29, 2019
Congress took a tax calculation that was already a headache and made it worse.
I am looking at a tax change included in the year-end budget resolution.
Let’s talk again about the kiddie tax.
Years ago a relatively routine tax technique was to transfer income-producing assets to children and young adults. The technique was used mainly by high-income types (of course, as it requires income), and the idea was to redirect income that would be taxed at a parent’s or grandparent’s (presumably maximum) tax rate and tax it instead at a child/young adult’s lower tax rate.
As a parent, I immediately see issues with this technique. What if one of my kids is responsible and another is not? What if I am not willing to just transfer assets to my kids – or anyone for that matter? What if I do not wish to maximally privilege my kids before they even reach maturity? Nonetheless, the technique was there.
Congress of course saw the latent destruction of the republic.
Enter the kiddie tax in 1986.
In a classroom setting, the idea was to slice a kid’s income into three layers:
(1) The first $1,050
(2) The second $1,050
(3) The rest of the kid’s income
Having sliced the income, one next calculated the tax on the slices:
(1) The first $1,050 was tax-free.
(2) The second $1,050 was taxed at the kid’s own tax rate.
(3) The rest was taxed at the parents’ tax rate.
Let’s use an example:
(1) In 2017 the kid has $20,100 of income.
(2) The parents are at a marginal 25% tax rate.
(1) Tax on the first slice is zero (-0-).
(2) Let’s say the tax on the second slice is $105 ($1,050 times 10%).
(3) Tax on the third slice is $4,500 (($20,100 – 2,100) times 25%).
The kid’s total 2017 tax is $4,605.
Let’s take the same numbers but change the tax year to 2018.
The tax is now $5,152.
Almost 12% more.
Congress changed the tax rate for slice (3). It used to be the parent’s tax rate, but starting in 2018 one is to use trust tax rates instead.
If you have never seen trust rates before, here you go:
Have over $12,500 of taxable income and pay the maximum tax rate. I get the reasoning (presumably anyone using trusts is already at a maximum tax rate), but I still consider these rates to be extortion. Sometimes trusts are just that: one is providing security, navigating government programs or just protecting someone from their darker spirits. There is no mention of maximum tax rates in that sentence.
Let’s add gas to the fire.
The kiddie tax is paid on unearned income. The easiest type to understand is dividends and interest.
You know what else Congress considered to be unearned income?
Government benefits paid children whose parent was killed in military service. These are the “Gold Star” families you may have read about.
Guess what else?
Room and board provided college students on scholarship.
Seriously? We are taking people unlikely to be racking Thurston Howell III-level bucks and subjecting them to maximum tax rates?
Fortunately, Congress – in one of its few accomplishments for 2019 – repealed this change to the kiddie tax.
We are back to the previous law. While a pain, it was less a pain than what we got for 2018.
One more thing.
Kids who got affected by the kiddie tax changes can go back and amend their 2018 return.
I intend to review kiddie-tax returns here at Galactic Command to determine whether amending is worthwhile.
It’s a bit late for those affected, but it is something.
Sunday, December 22, 2019
On Friday December 20, 2019 the President signed two spending bills, averting a government shutdown at midnight.
The reason we are talking about it is that there were several tax provisions included in the bills. Many if not most are as dry as sand, but there are a few that affect retirement accounts and are worth talking about.
Increase the Age for Minimum Required Distributions (MRDs)
We know that we are presently required to begin distributions from our IRAs when we reach age 70 ½. The same requirement applies to a 401(k), unless one continues working and is not an owner. Interestingly, Roths have no MRDs until they are inherited.
In a favorable change, the minimum age for MRDs has been increased to 72.
Repeal the Age Limitation for IRA Contributions
Presently you can contribute to your 401(k) or Roth past the age of 70 ½. You cannot, however, contribute to your IRA past age 70 ½.
In another favorable change, you will now be allowed to contribute to your IRA past age 70 ½.
COMMENT: Remember that you generally need income on which you paid social security taxes (either employee FICA or self-employment tax) in order to contribute to a retirement account, including an IRA. In short, this change applies if you are working past 70 ½.
New Exception to 10% Early Distribution Penalty
Beginning in 2020 you will be allowed to withdraw up to $5,000 from your 401(k) or IRA within one year after the birth or adoption of a child without incurring the early distribution penalty.
BTW, the exception applies to each spouse, so a married couple could withdraw up to $10,000 without penalty.
And the “within one year” language means you can withdraw in 2020 for a child born in 2019.
Remember however that the distribution will still be subject to regular income tax. The exception applies only to the penalty.
Limit the Ability to Stretch an IRA
Stretching begins with someone dying. That someone had a retirement account, and the account was transferred to a younger beneficiary.
Take someone in their 80s who passes away with $2 million in an IRA. They have 4 grandkids, none older than age 24. The IRA is divided into four parts, each going to one of the grandkids. The required distribution on the IRAs used to be based on the life expectancy of someone in their 80s; it is now based on someone in their 20s. That is the concept of “stretching” an IRA.
Die after December 31, 2019 and the maximum stretch (with some exceptions, such as for a surviving spouse) is now 10 years.
Folks, Congress had to “pay” for the other breaks somehow. Here is the somehow.
Annuity Information and Options Expanded
When you get your 401(k) statement presently, it shows your account balance. If the statement is snazzy, you might also get performance information over a period of years.
In the future, your 401(k) statements will provide “lifetime income disclosure requirements.”
Great. What does that mean?
It means that the statement will show how much money you could get if you used all the money in the 401(k) account to buy an annuity.
The IRS is being given some time to figure out what the above means, and then employers will have an extra year before having to provide the infinitely-better 401(k) statements to employees and participants.
By the way …
You will never guess this, but the law change also makes it easier for employers to offer annuities inside their 401(k) plans.
Here is the shocked face:
Expand the Small Employer Retirement Plan Tax Credit
In case you work for a small employer who does not offer a retirement plan, you might want to mention the enhanced tax credit for establishing a retirement plan.
The old credit was a flat $500. It got almost no attention, as $500 just doesn’t move the needle.
The new credit is $250 per nonhighly-compensated employee, up to $5,000.
At $5 grand, maybe it is now worth looking at.
Sunday, December 15, 2019
You probably already know about the change in the tax law for deducting state and local taxes on your personal return.
It used to be that you could itemize and deduct your state and local income taxes, as well as the real estate taxes on your house, without limitation. Mind you, other restrictions may have kicked-in (such as the alternative minimum tax), but chances are you received some tax benefit from the deduction.
Then the Tax Cuts and Jobs Act put a $10,000 limit on the state income/local income/property tax itemized deduction.
Say for example that the taxes on your house are $5 grand and your state income taxes are $8 grand. The total is $13 grand, but the most you can deduct is $10 grand. The last $3 grand is wasted.
This is probably not problem if you live in Nevada, Texas or Florida, but it is likely a big problem if you live in California, New York, New Jersey or Connecticut.
There have been efforts in the House of Representatives to address this matter. One bill would temporarily raise the cap to $20,000 for married taxpayers before repealing the cap altogether for two years, for example.
The tax dollars involved are staggering. Even raising the top federal to 39.6% (where it was before the tax law change) to offset some of the bill’s cost still reduces federal tax receipts by over $500 billion over the next decade.
There are also political issues: The Urban-Brookings Tax Policy Center ranked the 435 Congressional districts on the percentage of households claiming the SALT (that is, state and local tax) deduction in 2016. Nineteen of the top 20 districts are controlled by Democrats. You can pretty much guess how this will split down party lines.
Then the you have the class issues: approximately two-thirds of the benefit from repealing the SALT cap would go to households with annual incomes over $200,000. Granted, these are the people who pay the taxes to begin with, but the point nonetheless makes for a tough sell.
And irrespective of what the House does, the Senate has already said they will not consider any such bill.
Let’s go over what wiggle room remains in this area. For purposes of our discussion, let’s separate state and local property taxes from state and local income taxes.
The important thing to remember about the $10,000 limitation is that it addresses your personal taxes, such as your primary residence, your vacation home, property taxes on your car and so on.
Distinguish that from business-related property taxes.
If you are self-employed, have rental real estate, a farm or so on, those property taxes are considered related to that business activity. So what? That means they attach to that activity and are included wherever that activity is reported on your tax return. Rental real estate, for example, is reported on Schedule E. The real estate taxes are reported with the rental activity on Schedule E, not as itemized deductions on Schedule A. The $10,000 cap applies only to the taxes reported as itemized deductions on your Schedule A.
Let me immediately cut off a planning “idea.” Forget having the business/rental/farm pay the taxes on your residence. This will not work. Why? Because those taxes do not belong to the business/rental/farm, and merely paying them from the business/rental/farm bank account does not make them a business/rental/farm expense.
State and Local Income Taxes
State and local income taxes do not follow the property tax rule. Let’s say you have a rental in Connecticut. You pay income taxes to Connecticut. Reasoning from the property tax rule, you anticipate that the Connecticut income taxes would be reported along with the real estate taxes when you report the rental activity on your Schedule E.
You would be wrong.
Whereas the income taxes are imposed on a Connecticut activity, they are assessed on you as an individual. Connecticut does not see that rental activity as an “tax entity” separate from you. No, it sees you. With that as context, state and local income tax on activities reported on your individual tax return are assessed on you personally. This makes them personal income taxes, and personal income taxes are deducted as itemized deductions on Schedule A.
It gets more complicated when the income is reported on a Schedule K-1 from a “passthrough” entity. The classic passthrough entities include a partnership, LLC or S corporation. The point of the passthrough is that the entity (generally) does not pay tax itself. Rather, it “passes through” its income to its owners, who include those numbers with their personal income on their individual income tax returns.
What do you think: are state and local income taxes paid by the passthrough entity personal taxes to you (meaning itemized deductions) or do they attach to the activity and reported with the activity (meaning not itemized deductions)?
Unfortunately, we are back (in most cases) to the general rule: the taxes are assessed on you, making the taxes personal and therefore deductible only as an itemized deduction.
This creates a most unfavorable difference between a corporation that pays its own tax (referred to as a “C” corporation) and one that passes through its income to its shareholders (referred to as an “S” corporation).
The C corporation will be able to deduct its state and local income taxes until the cows come home, but the S corporation will be limited to $10,000 per shareholder.
Depending on the size of the numbers, that might be sufficient grounds to revoke an S corporation election and instead file and pay taxes as a C corporation.
Is it fair? As we have noted before on this blog, what does fair have to do with it?
We ran into a comparable situation a few years ago with an S corporation client. It had three shareholders, and their individual state and local tax deduction was routinely disallowed by the alternative minimum tax. This meant that there was zero tax benefit to any state and local taxes paid, and the company varied between being routinely profitable and routinely very profitable. The SALT tax deduction was a big deal.
We contacted Georgia, as the client had sizeable jobs in Georgia, and we asked whether they could – for Georgia purposes – file as a C corporation even though they filed their federal return as an S corporation. Georgia was taken aback, as we were the first or among the first to present them with this issue.
Why did we do this?
Because a C corporation pays its own tax, meaning that the Georgia taxes could be deducted on the federal S corporation return. We could sidestep that nasty itemized deduction issue, at least with Georgia.
Might the IRS have challenged our treatment of the Georgia taxes?
Sure, they can challenge anything. It was our professional opinion, however, that we had a very strong argument. Who knows: maybe CTG would even appear in the tax literature and seminar circuit. While flattering, this would have been a bad result for us, as the client would not have appreciated visible tax controversy. We would have won the battle and lost the war.
However, the technique is out there and other states are paying attention, given the new $10,000 itemized deduction limitation. Connecticut, for example, has recently allowed its passthroughs to use a variation of the technique we used with Georgia.
I suspect many more states will wind up doing the same.
Sunday, December 8, 2019
I read that Harvard estimates that a change from the Tax Cut and Jobs Act will cost approximately $38 million.
Harvard is referring to the “endowment tax” on colleges and universities.
Have you heard about this?
Let us set up the issue by discussing the taxation of private foundations.
The “best” type of charity (at least tax-wise) is the 501(c)(3). These are the March of Dimes and United Ways, and they are publicly-supported by a broad group of interested donors. In general, this means a large number of individually modest donations. Mind you, there can be an outsized donation (or several), but there are mathematical tests to restrict a limited number of donors from providing a disproportionate amount of the charity’s support.
Then we get to private foundations. In general, this means that a limited number of donors provide a disproportionate amount of support. Say that CTG comes into big bucks and sets up the CTG Family Foundation. There is little question that one donor provided a lopsided amount of donations: that donor would be me. In its classic version, I would be the only one funding the CTG Family Foundation.
There can be issues when a foundation and a person are essentially alter egos, and the Code provides serious penalties should that someone forget the difference. Foundations have enhanced information reporting requirements, and they also pay a 2% income tax on their net investment income. The 2% tax is supposedly to pay for the increased IRS attention given foundations compared to publicly-supported charities.
The Tax Cut and Jobs Act created a new tax – the 1.4% tax on endowment income – and it targets an unexpected group: colleges and universities that enroll at least 500 tuition-paying students and have endowment assets of at least $500,000 per student.
Let me think this through. I went to graduate school at the University of Missouri at Columbia. Its student body is approximately 30,000. UMC would need an endowment of at least $15 billion to come within reach of this tax.
I have two immediate thoughts:
(1) Tax practitioners commonly refer to the 2% tax on foundations as inconsequential, because … well, it is. My fee might be more than the tax; and
(2) I am having a difficult time getting worked up over somebody who has $15 billion in the bank.
The endowment tax is designed to hit a minimal number of colleges and universities – probably less than 50 in total. It is expected to provide approximately $200 million in new taxes annually, not an insignificant sum but not budget-balancing either. As a consequence, there has been speculation as to its provenance and purpose.
With this Congress has again introduced brain-numbing complexity to the tax Code. For example, the tax is supposed to exclude endowment funds used to carry-on the school’s tax-exempt purpose. Folks, it does not take 30-plus years of tax practice to argue that everything a school does furthers its tax-exempt purpose, meaning there is nothing left to tax. Clearly that is not the intent of the law, and tax practitioners are breathlessly awaiting the IRS to provide near-Torahic definitions of terms in this area.
The criticism of the tax has already begun. Here is Harvard referring to its $40 billion endowment:
“We remain opposed to this damaging and unprecedented tax that will not only reduce resources available to colleges and universities to promote excellence in teaching and to sustain innovative research…”
Breathe deeply there, Winchester. Explain again why any school with $40 billion in investments even charges tuition.
Which brings us to Berea College in central Kentucky, south of Lexington. The school has an endowment of approximately $700,000 per student, so it meets the first requirement of the tax. The initial draft of the tax bill would have pulled Berea into its dragnet, but there was bipartisan agreement that the second requirement refer to “tuition-paying” students.
Berea College does not charge tuition.
Tuesday, November 26, 2019
Say that I retire. Perhaps my wife wins the lottery or marries well.
I get bored. Perhaps I would like a little running-around money. Maybe I flat-out need extra money.
I find a website that connects experienced tax practitioners to people needing tax services. There might be specializations available: as a practitioner I might accept corporate or passthrough work, for example, but not individual tax returns. I could work as much or as little as I want. I might work Friday and Saturday afternoons, for example, but not accept work on weekdays. I could turn down or fire clients. I could take time off without fear of dismissal.
There would have to be rules, of course. Life is a collection of rules. I might have to provide my state license to substantiate my credentials. I might have to post an E&O policy. It seems reasonable to expect the website to impose standards, such as for professional conduct, client communications, timeliness of service and so on
How would I get paid?
I am thinking that I would bill through the website. An advantage is that the website can devote more resources than I care to provide, making the arrangement a win-win-win for all parties involved. The website would collect from the client and then electronically deposit to my bank account.
Here is my question: is the website my employer?
Don’t scoff. We are talking the gig economy.
The issue has gained notoriety as states – New Jersey and California come to mind – have gone after companies like Uber and Lyft. From these states’ perspective, the issue is simple: if there is more than a de minimis interdependence between the service recipient and provider, then there must be an employment relationship between the two. Employment of course means FICA withholding, income tax withholding, unemployment insurance, disability insurance (in some cases), workers compensation and so on.
Let us be honest: employment status is Christmas day for some states. They would deem your garden statue an employee if they could wring a dollar out of you by doing so.
New Jersey recently hit Uber with a tax bill for $650 million, for example.
The employee-independent contractor issue is a BIG deal.
What in the world is the difference between an employee and an independent contractor?
People have been working on this question for a long time. The IRS has posited that employment means control – of the employer over the employee – and also that control travels on a spectrum. As one moves to the one end of the spectrum, it becomes increasingly likely that an employer-employee relationship exists.
The IRS looks at three broad categories:
(1) Behavioral control
(2) Financial control
(3) Relationship of the parties
The IRS then looks at factors (sometimes called the 20 factors) through the lens of the above categories.
· Can the service recipient tell you what, where, when and how to do something?
· Is the service recipient the only recipient of the provider’s services?
· Is the service relationship continuing?
Answer yes to those three factors and you sound a lot like an employee.
Problem is the easy issues exist only in a classroom or at seminar. In the real world, it is much more likely that you will find a mix of yes and no. In that event, how may “yes” answers will mean employee status? How many “no” answers will indicate contractor status?
Answer: no one knows.
Some states have taken a different approach, using what is called an “ABC” test. There was a significant case (Dynamex) in California. It interpreted the ABC test as follows:
(1) The service provider is free from the direction and control of the service recipient in connection with the performance of the work.
(2) The service provider performs work outside the usual course of the service recipient’s business.
(3) The service provider is customarily engaged in the independent performance of the services provided.
I get the first one, but I point out that it is rarely all or nothing. If we here at CTG Command bring on a contractor CPA – say for the busy season or to collaborate on a tax area near the periphery of our experience – we would still have expectations. For example,
· our office hours are XXX
· reviewer turnaround times to tax preparers are XXX
· responses to client calls are to occur with XXX hours or less
· responses to me are to occur within X hours or less
· drop-dead due dates are XXX
How many of these can we have before we fail the A in the ABC test?
Let’s look at B.
We are a CPA firm. Odds are we are interested in experienced CPAs. It is quite unlikely that we will have need of a master plumber or stonemason.
Have we automatically failed the B in the ABC test?
And what does C even mean?
I am a 30+ year tax CPA. I am a specialist and have been for many years. I would say that I am “customarily engaged” in tax practice. Do I have “independent performance,” however?
If I interpret this test to mean that I have more than one client, it somewhat makes sense, although there are still issues. For example, upon semi-retirement, I would like to be “of counsel” to a CPA firm. I have no intention of working every day, or of being there endless hours during the busy season. No, what I am thinking is that the firm would call me for specialized work – more complex tax issues, perhaps some tax representation. It would provide a mental challenge but not become a burden to me.
Would I do this for more than one firm?
Doubt it. I point to that “burden” thing.
Have I failed the C test?
I am still thinking through the issues involved in this area.
Including non-tax issues.
If I take an Uber and the driver gets into an accident – injuring me – do I have legal recourse to Uber? Seems to me that I should. Is this question affected by the employee-contractor issue? If it is, should it be?
This prompts me to think that the law is inadequate for a gig economy.
There is, for example, always some degree of control between the parties, if for no other reason than expectation is a variant of control. Not wanting to lose the gig is – at least to me – an incident of control to the service recipient. Talk to a CPA firm partner with an outsized client about expectation and control.
Why cannot CTG Command gig an experienced tax professional – say for a specific engagement or issue - without the presumption that we hired an employee? I can reasonably assure you that I will not be an employee when I go “of counsel.” You can forget my attending those Monday morning staff meetings.
Am I “independently performing” if I have but one client? What if it is a really good client? What if I don’t want a second client?
Problem is, we know there are toxic players out there who will abuse any wiggle room you give them. Still, that is no excuse for bad tax law. Not every person who works – let’s face it – is an employee. The gig economy has simply amplified that fact.
Sunday, November 17, 2019
On November 7, 2019 the IRS issued Proposed Regulations revising life expectancy tables used to calculate minimum required distributions from retirement plans, such as IRAs.
That strikes me as a good thing. The tables have not been revised since 2002.
There are three tables that one might use, depending upon one’s situation. Let’s go over them:
The Uniform Lifetime Table
This is the old reliable and the one most of us are likely to use.
Joint Life and Last Survivor Expectancy Table
This is more specialized. This table is for a married couple where the age difference between the spouses is greater than 10 years.
The Single Life Expectancy Table
Do not be confused: this table has nothing to do with someone being single. This is the table for inherited retirement accounts.
Let’s take a look at a five-year period for the Uniform Lifetime Table:
If you had a million dollars in the account, the difference in your required minimum distribution at age 71 would be $2,275.
It is not overwhelming, but let’s remember that the difference is for every remaining year of one’s life.
As an aside, I recently came across an interesting statistic. Did you know that 4 out of 5 Americans receiving retirement distributions are taking more than the minimum amount? For those – the vast majority of recipients – this revision to the life expectancy tables will have no impact.
Let’s spend a moment talking about the third table - the Single Life Expectancy Table. You may know this topic as a “stretch” IRA.
A stretch IRA is not a unique or different kind of IRA. All it means is that the owner died, and the account has passed to a beneficiary. Since minimum distributions are based on life expectancy, this raises an interesting question: whose life expectancy?
COMMENT: There is a difference on whether a spouse or a non-spouse inherits. It also matters whether the decedent reached age 70 ½ or not. It is a thicket of rules and exceptions. For the following discussion, let us presume a non-spouse inherits and the decedent was over age 70 ½.
An easy way to solve this issue would be to continue the same life expectancy table as the original owner of the account. The problem here is that – if the beneficiary is young enough – one would run out of table.
So let’s reset the table. We will use the beneficiary’s life expectancy.
And there you have the Single Life Expectancy Table.
As well as the opportunity for a stretch. How? By using someone much younger than the deceased. Grandkids, for example.
Say that a 35-year old inherits an account. What is the difference between the old and new life expectancy tables?
Hey, it’s better than nothing and – again – it repeats every year.
There is an odd thing about using this table, if you have ever worked with a stretch IRA. For a regular IRA – e.g., you taking distributions from your own IRA – you look at the table to get a factor for your age in the distribution year. You then divide that factor into the December 31 IRA balance for the year preceding the distribution year to arrive at the required minimum amount.
Point is: you look at the table every year.
The stretch does not do that.
You look at the table one time. Say you inherit at age 34. Your required minimum distribution begins the following year (I am making an assumption here, but let’s roll with it), when you are age 35. The factor is 48.5. When you are age 36, you subtract one from the factor (48.5 – 1.0 = 47.5) and use that new number for purposes of the calculation. The following year you again subtract one (47.5 – 1.0 = 46.5), and so on.
Under the Proposed Regulation you are to refer to the (new) Single Life Expectancy Table for that first year, take the new factor and then subtract as many “ones” as necessary to get to the beneficiary’s current age. It is confusing, methinks.
There are public comment procedures for Proposed Regulations, so there is a possibility the IRS will change something before the Regulations go final. Final will be year 2021.
So for 2020 we will use the existing tables, and for 2021 we will be using the new tables.