Is There Any Point To Middle Class Entitlements?

I was reading a Bloomberg article last week titled “Those Pointless Upper-Middle-Class Entitlements.” It is - to be fair - an opinion piece, so let’s take it with a grain of salt.

The article begins:

Let’s talk about upper-middle-class entitlements, the subsidies that flow almost entirely to those in the upper fifth or even tenth of the income distribution. You know, the home mortgage interest deduction and the tax subsidies for 401(k)s, IRAs and other retirement plans.

Then we have a spiffy graph: 

I am confused with what is considered a “tax break.”

The true “tax break” here is the earned income credit. We know that this began as encouragement to transition one from nonworking to working status, and we also know that it is the font of massive tax fraud every year. The government just sends you a check, kind of like the tooth fairy. An entire tax-storefront industry has existed for decades just to churn-out EIC returns. Too often, their owners and practitioners are not as … uhh, scrupulous … as we would want.

And this is a surprise how? Give away free money to every red-headed Zoroastrian Pacific Islander and wait to be surprised by how many red-headed Zoroastrian Pacific Islanders line up at your door. Even those who are not red-headed, Zoroastrian or Pacific Islander in any way. 

Here is more:

Of course, we wouldn’t want to take away all of those tax expenditures, would we? The earned income tax credit and the Social Security exclusion, for example, are targeted at people with pretty low incomes.

Doesn’t one need to have income before receiving an INCOME TAX expenditure?

Then we have these bright shiny categories:

·       Defined contribution retirement plans

·       Defined benefit retirement plans

·       Traditional IRAs

·       Roth IRAs

Interesting. One would think that saving for retirement would be a social good, if only to lessen the stress on social security.

We read:

Wealthy people who would save for retirement in any case respond to subsidies by shifting assets into tax-sheltered accounts; the less wealthy don’t respond much at all.

It makes some sense, but don’t you feel like you are being conned? Step right up, folks; make enough money to save for retirement and you do not need a tax break to save for retirement.

When did we all become wealthy? Did someone send out letters to inform us?

Did you know that the majority of income tax breaks are claimed by people with the majority of the income?  

Think about that one for a second, folks.

This following is a pet peeve of mine:

·       Deferral of active income of controlled foreign corporations

We have discussed this issue before. Years ago, when the U.S. was predominant, it decided that U.S. corporations would pay tax on all their earnings, whether earned in the U.S. or not.

There is a problem with that: the U.S. is almost a solo act in taxing companies on their worldwide income. Almost everyone else taxes only the profit earned in their country (the nerd term is “territoriality”).

Let’s be frank: if you were the CEO of an international company, what would you do in response to this tax policy?

You would move the company – at least the headquarters - out of the U.S., that’s what you would do. And companies have been moving: that is what "inversions" are.

So, the U.S. had no choice but to carve-out exceptions, which is how we get to “deferral of active income of controlled foreign corporations.” This is not a tax break. It is a fundamental flaw in U.S. international taxation and the reason Congress is currently considering a territorial system.

By the way, how did these tax breaks come to be, Dudley?

Why do these subsidies continue nonetheless? Mainly, it seems, because they’ve been granted to a sizable, influential population who, it is feared, will fight any effort to take them away. 

Politicians giving away money. Gasp.

But mainly it’s the millions of upper-middle-class Americans who, like me and my family, are beneficiaries of tax subsidies for home mortgages, retirement accounts and/or college savings.

To state another way: It is unfair that people with more money can do more things with money than people with less money.

Profound.

What offends about this bella siracha is:

You train for a career.

You set an alarm clock daily, dress, fight traffic and do your job.

You get paid money.

You take some of this money and save for nefarious causes such as your kids’ college and your eventual retirement.

Yet you keeping your own money is the equivalent of receiving a welfare check euphemistically described as an “earned income credit.”

No, no it is not.

And the false equivalence is offensive.

I get the issue. I really do. The theory begins with all income being taxable. When it is not, or when a deduction is allowed against income, there is – arguably - a “tax break.” The criticism I have is equating one-keeping-one’s-money (for example, a 401(k)) with flat-out welfare (the earned income credit). Another example would be equating a deeply-flawed statutory tax scheme (multinational corporations) with the state income tax deduction (where approximately 30% of this tax break goes to two states: California and New York). 

And somebody please tell me what “wealthy” means anymore. It has become one of the most abused words in the English language.

Bloomberg

Tax Break For Wealthy (Federal Government) People

Let's talk about a tax break; some may even call it a gimmick. It will never affect your or me, unless we go into the federal government.

Here is Code section 1043:

Sale of property to comply with conflict-of-interest requirements 

(a) Nonrecognition of gain

If an eligible person sells any property pursuant to a certificate of divestiture, at the election of the taxpayer, gain from such sale shall be recognized only to the extent that the amount realized on such sale exceeds the cost (to the extent not previously taken into account under this subsection) of any permitted property purchased by the taxpayer during the 60-day period beginning on the date of such sale.

(b) Definitions

For purposes of this section -

(1) Eligible person

The term "eligible person" means -

(A) an officer or employee of the executive branch, or a judicial officer, of the Federal Government, but does not mean a special Government employee as defined in section 202 of title 18, United States Code, and

(B) any spouse or minor or dependent child whose ownership of any property is attributable under statute, regulation, rule, judicial canon, or executive order referred to in paragraph (2) t a person referred to in subparagraph (A).

Let's say that you are pulling down several million dollars a year from your day job. You have the opportunity to head-up the EPA or the National Park Service. It is almost certain that your paycheck will shrink, and the Congressional committee investigating you may request you sell certain investments or other holdings to avoid conflict of interest concerns.

Folks, this is an uber-elite tax problem.

To ease your decision, the tax Code will allow you to sell your investments without paying any tax. To do so you are required to buy replacement securities within 60 days, and the non-taxed gain will reduce your basis in the new securities.

OBFUSCATION ALERT: To say it differently, your "basis" in the old securities sold will carry-over as your basis in the new securities.

By way, it is not necessary to have Congress to tell you to unload your investments. There is a more lenient "reasonably necessary" standard that might work for you. I am reasonably certain I could come up with some necessary argument so I would not pay tax.

While sweet, Section 1043 is not a complete escape clause. If you think about it, all you have done is delay the taxable gain until you sell the new securities. I suppose an escape clause is to die without selling, but I generally do not consider dying to be a viable tax strategy.

The numbers can add-up, though. It is estimated that Paul O'Neill, a former Treasury Secretary, sold approximately $100 million of Alcoa stock when he took the position. I do not know what the gain would have been (as we do not know the cost), but the tax he deferred must have been eye-opening.

By the way, you can get the same break by drawing a judicial appointment.

I do have a question: do you wonder why the politicos never mention Section 1043 whenever they rail against "tax breaks" used by wealthy people?

Nah, there is no wonder at all.

Does A Flight Attendant In Hong Kong Have Foreign Income?

I am going to put you on the spot. I will give you some facts and present a tax issue for you.

Yen-Ling is a U.S. citizen. She is an expat living in Hong Kong. She works international flights for an airline, and her flights include

• Hong Kong to/from San Francisco
• Hong Kong to/from Chicago
• Hong Kong to/from Ho Chi Minh City
• San Francisco to/from Nagoya

 What tax issues do you see?

·        Hong Kong is a red herring. As a U.S. citizen, she has to pay income taxes on her worldwide income.

·       She however does get some tax relief from the double taxation this would otherwise entail. She gets to offset her Hong Kong taxes against her otherwise payable U.S. income taxes. This is the “foreign tax credit.”

 You are doing well. Anything else?

·        I recall a “foreign income” exclusion in the tax code. I am a bit fuzzy on it, though.

Good catch. A U.S. citizen who both lives and works overseas can exclude a certain amount of his/her salary from U.S. tax. This amount is not chump-change. For 2013, for example, the maximum foreign income exclusion is $97,600.

Is all of her income foreign? She does live in Hong Kong.

·       Wait, she comes into and out of the U.S. on a regular basis. Some of her income has to be U.S. source.

You are right. How to do you propose to allocate it?

·        Hopefully the airline sent her something – maybe a breakdown of her flight and service hours.

Let’s say they do and it looks something like this:

• Hours in U.S.
• Hours in Vietnam
• Hours in Japan
• Hours in Hong Kong
• Hours in international air space

 Her total hours are 1,960 hours. How do you propose to calculate this?

 ·        I propose to divide her hours in the U.S. into 1,960 total hours.

Seems reasonable. But ...

... you would be wrong. Not surprisingly, there has been litigation on this.

The Code defines "foreign earned income” as “the amount received by such individual from sources within a foreign country.”

·        So? She did not earn it within the U.S., so how can it be anything other than “foreign?”

Take a look at the wording in the following Regulation:

• The term ‘foreign country’ when used in a geographical sense includes any territory under the sovereignty of a government other than that of the United States.”

Did you pick up on the tax hook?

 ·        You mean the word “sovereignty?”

That’s it. Under whose sovereignty is international airspace?

·        No one’s. That is why it is international.

Is her time in international airspace considered time in a “foreign country?”

·        That is ridiculous. According to this reasoning, an American on the moon would have all his/her income considered U.S. source.

You are right that this is ridiculous, but an American living (and working) on the moon would have U.S. source income. He/she would not have a foreign income exclusion, as he/she would not have foreign income.

·        Who dreamed this up?

To some extent, it is an unfortunate by-product of the U.S. worldwide tax system. It borders on the intellectually incoherent, which is why virtually all other advanced nations eschew it in favor of a territorial tax system.

·        How did it turn out for the flight attendant?

She got hosed. You can read about it at Rogers v Commissioner.

·        I could but I won’t.

Hiring Your Child

If you own a business, would it make sense to hire your child? There are different facets to this question, and the one we will discuss today are the tax consequences.

Income Taxes

You can pay your child up to $5,800 without either of you incurring an income tax liability. As long as the wages are reasonable for the work performed, the wages are deductible to your business and taxable to your child. The child’s standard deduction of $5,800 can reduce the child’s taxable income to zero, effectively sheltering the wages.

Is the “kiddie tax” a consideration? The answer is no, as the kiddie tax applies to the transfer of passive income, such as interest and dividends. The income we are discussing is earned income, and the kiddie tax does not penalize earned income.

How much can you save? Well, that depends on your tax rate. If you are in the 35% tax bracket, then you are saving $2,030 in federal income taxes alone ($5,800 times 35%). This amount may be less if there is social security or you as employer have to pay federal unemployment tax. What are the rules for those taxes?

Social Security Tax

The social security consequence will vary depending on the age of the child and whether you are self-employed.

The first requirement is that the child must be under the age of 18.

If you are self employed (which is to say, you are unincorporated and file a Schedule C), you do not have to withhold or pay FICA taxes on a child under the age of 18. If you are under the FICA limit for 2011, this may be an immediate tax savings of 14.13% (15.3% times .9235). If you are over, then the FICA savings reduce to 2.68% (2.9% times .9235).

If you are incorporated, then there are no social security savings, as a different rule applies.

What if you are a partner in a partnership (or a member in an LLC)? If the only partners (or members) are the parents, then you do not have to withhold or pay FICA. Otherwise the corporate rule applies.

Federal Unemployment Tax

The same rule as for FICA applies here, with one exception. If the child works for your unincorporated business, or in a partnership (or LLC) where you and your spouse are the only partners (or members), then the wages will not be subject to FUTA. Otherwise, FUTA will apply.

The exception is the age cutoff. For FUTA, the child must be under age 21.

Income Tax Withholding

Usually, an employee who had no income tax liability for the prior year and expects none for the current year can claim exempt status and have no federal income tax withholding. There is a different rule for children who can be claimed as dependents on their parents’ return. That child cannot claim exempt status if his/her income will exceed $950 AND include more than $300 of interest, dividends and passive income of that nature.

Mind you, it is possible that you will get back the withholding when your child files his/her individual income tax return.