What Are The New Individual Income Taxes?

Congress has given us a new tax bill – the American Taxpayer Relief Act of 2012. It was passed by the Senate at approximately 2 a.m. on January 1 and ….. Actually, that fact alone tells you about the quality of this tax bill.

Let’s take a look at some individual tax measures.

(1)   The 2% social security tax reduction is gone. Everybody with a paycheck will immediately see their take-home pay go down.

(2)   The previous tax rates of 10/15/25/28/33/35 percent still exist, but ….

a.      There is a new 39.6% tax rate.

NOTE: The new rate starts at $400,000 for singles and $450,000 for marrieds.

(3)   The qualified dividends and capital gains rates do not change UNLESS…

a.      … you make more than $400,000 for singles and $450,000 for marrieds.

b.      If this is you, your NEW qualified dividends and capital gains tax rate will be 20%.

OBSERVATION:  Let’s be fair: 20% is not a bad tax rate.

You may have noticed that the above three changes pivot on $400,000/$450,000.

QUESTION: Can we rely on this throughout the new law?  

ANSWER: Silly you. Of course not.

(4)   Phaseout of your personal exemptions

Tax pros call this the “PEP,” and it is the brilliant idea to reduce (if not eliminate) your exemptions for yourself, your spouse, your kids and anyone else – once you go past a certain income.

QUESTION: What is that income level?

ANSWER: $250,000 for singles and $300,000 for marrieds.

(5)   Phaseout of your itemized deductions

You have the same reasoning as (4), but this time we are talking about reducing your itemized deductions. These are your mortgage, real estate taxes, contributions and so on.

QUESTION: What is that income level?

ANSWER:  $250,000 for singles and $300,000 for marrieds.

(6)   Alternative Minimum tax

Congress reset the exemption amounts to $50,600 for singles and $78,750 for marrieds – about in line with 2011.

This is good news because – if Congress did nothing – the exemption amounts were scheduled to decrease drastically. This would have pulled millions more people into the AMT, even with the same income as 2011 and would have made for some stressful client conversations.

Congress has also linked the AMT exemption and phaseout levels to an inflation factor. Finally and thank goodness.

Frankly, in my opinion the AMT may be the most important thing Congress did with individual taxes in this legislation.

(7)   Coverdell IRAs

a.      Remain at $2,000 rather than reverting to $500

b.      As an FYI, these are the “education” IRAs

(8)   Employer provided education

a.      The exclusion from income is renewed at $5,250.

NOTE: This will make a Tax Guy’s wife happy as she returns for her Master’s.

(9)   Student loan interest

a.      Remains deductible up to $2,500

(10)  The American Opportunity tax credit     

a.      Is renewed up to $2,500

NOTE: Good news for a Tax Guy with a daughter in college

(11)    The $250 supplies deduction for elementary and secondary school teachers

a.      Is renewed

(12)    Mortgage debt exclusion from income

a.      Up to $2 million is renewed but for 2013 ONLY

(13)    The sales tax deduction in lieu of income tax deduction

a.      Is renewed

b.      Good news if you live in Florida, which does not have an income tax

(14)    Above-the-line deduction for higher education

a.      Up to $4,000 – if you can meet the income limits

(15)    Child credit

a.      Stays at $1,000 per child rather than dropping to $500

Let’s go back a moment to the 39.6% tax rate (income of $400,000/450,000) and the PEP/Pease (income of $250,000/300,000).  In addition to this spaghetti, there are two NEW taxes in 2013. They are NOT in this bill because they already existed and were waiting to hatch, like something in the movie Aliens. They are ADDITIONAL taxes on top of the above. They are:

(1)   If your income goes above $200,000 for singles and $250,000 for marrieds, there will be a new 3.8% tax rate on your interest, dividends, capital gains and investment income of that type. This was courtesy of ObamaCare.

(2)   If your income goes above $200,000 for singles and $250,000 for marrieds, there will be a new 0.9% tax on your salary for additional Medicare. This too is courtesy of ObamaCare.

Did you see what Congress did here? Look at the income thresholds on some of these taxes:

               $200,000/$250,000

               $250,000/$300,000

               $400,000/$450,000

Try remembering all that and doing the math in your head whenever you get a client phone call.

Notice what the “true” top federal tax rate is: 39.6% plus 3.8% plus 0.9% plus 1.2% (approximate PEP/Pease effect) equaling 45.5%. This is Congress' thing now: sneaking taxes on you through the back door.

We will go over the business tax provisions with another blog.

CPAs Blow Their Own Tax Planning

Here is one of my favorite tax quotes thus far in 2012:

                That an accounting firm should so screw up its taxes is the most remarkable feature of the case.”

You can be sure that language isn’t going to make it to the firm’s brochure.

What happened? It started with compensation. There is a CPA firm in Illinois with three senior partners. These partners were making pretty good jack, enough so that they did not want the other partners to know the actual amounts. Considering that they are – you know, a CPA firm – that could be a tall order. So the three senior partners in turn started three other companies.

EXAMPLE: Let’s say you, me, and the guy in the elevator form three companies to hide our good fortunes from our partners. Let’s say company 1 paints and wallpapers CPA offices, company 2 shreds CPA firm files and company 3 provides door-to-door transportation to CPAs during busy season.  We will have our firm “pay” these companies for services and then we will split it up – behind the scenes, of course. Brilliant! What could go wrong?

The firm and tax case is Mulcahy, Pauritsch, Salvador & Co. They had approximately 40 employees and revenues between $5 and $7 million during the years at issue. The firm was organized as a C corporation. This technically made the partners “shareholders,” and the existence of a C corporation allowed for the possibility of dividends. The three shareholders had the following ownership:

                Edward Mulcahy                              26%

                Michael Pauritsch                            26%

                Philip Salvador                                  26%

For the years at issue they received W-2s as follows:

                                               

                                                              2001                       2002                       2003

                Mulcahy                           106,175                 103,156                 102,662                    

                Pauritsch                            99,074                  96,376                   95,048                         

                Salvador                           117,824                 106,376                 112,086

The firm paid consulting fees to the three companies of:

                2001                                   911,570                

                2002                                   866,143

                2003                                   994,028

The three companies then paid the three shareholders according to the hours each worked during the year.

The IRS comes in and asks the obvious question: what consulting services were provided?

Back to our example:

               

                IRS:  Steve, how many paints and wallpapers did you do?

                Me:  Er, none.              

                IRS:  How many files did you shred?

                You: None.

                IRS:  How many transportation clients did you drive?

                Elevator guy: None.

Truly folks, it does not require graduate school and years of study and practice in taxation to guess the IRS’ reaction. They disallowed the deduction and said that it was a disguised dividend to the three shareholders.

MPS is upset. If it is not consulting, they argue, then it is compensation.

The IRS says: please show us the W-2, the 1099, anything which indicates that this is compensation. MPS argues that it is “like” compensation. Heck, at the end-of-the-day the three companies paid the shareholders based on their hours worked. Doesn’t that sound like compensation? “Sounds like” is a childhood game, says the IRS, and is not recognized as sound tax planning. Surely MPS would know this, being a CPA firm and all.

MPS goes to Tax Court. MPS argues that its intent was to compensate, therefore the tax consequence should follow its intent. It brought in experts to prove that the shareholders were undercompensated, malnourished and in need of more sunshine. The Court listened to the argument, gave it weight and said the following:

               

There is no evidence that the ‘consulting fees’ were compensation for the founding shareholders’ accounting and consulting services. If they had been that—rather than appropriations of corporate income—why the need to conceal them?”

There is an important point here. There is a long-standing tax doctrine that you may select any form and structure you wish for a transaction, but once you do you are bound by that form and structure. The CPA firm was a C corporation and was transacting with its shareholders. A C corporation transacts in one of two ways with its shareholders: as compensation or as dividends/distributions. If the compensation was disallowed, you have the possibility of a dividend.

The Court did try to work with MPS. It noted that two tests for compensation are that (1) it must be reasonable and (2) it must be for services performed. This brought in the “independent investor test” of Exacto Spring, which precedent the Tax Court had used in the past. The idea is easy: what return would you need on your investment to pay someone a certain amount of compensation?

EXAMPLE: A hedge fund manager receives 20% of the fund’s capital gains. This is referred to as the “carry.” Why would an investor agree to this? What if the manager was returning 20% to 30% to you annually – even after deducting his/her 20%? Would you agree to this? Uh, yes.

So the Court looks at MPS’ taxable income for the years at issue:

                2001                                    11,249

                2002                                   (53,271)

                2003                                      -0-

The Court observed that the firm had money invested in its offices, technology, furniture, etc. It noted that – according to normal market expectations – that invested capital required a rate of return. It did not think that taxable income of zero was a reasonable rate of return. The Court was aware that the firm was zeroing-out its taxable income by paying consulting fees. This indicated to the Court that the firm was not concerned with a reasonable return on invested capital. MPS could not meet the Exacto standard. Without meeting that standard, the Court could not weave “compensation” out of “consulting fees” whole cloth. This was an unfortunate result because the firm received no deduction for dividends but the shareholders had to pay taxes on them. That is the double taxation trap of a C corporation. It is also a significant reason why many planners – including me – do not often use C corporations.

Let’s go tax nerd for a moment. I believe that MPS would have substantially prevailed had it deducted the payments as compensation (and included on the W-2) and the IRS in turn argued unreasonable compensation. Why? Because I believe the Court might have disallowed some of the compensation but permitted the rest. MPS instead came from the other direction: it had to argue that the payments were compensation rather than something else. This changed the dynamic, and it now became an all-or-nothing argument. MPS lost the argument and got nothing.

MPS appealed the case but with the same result. It is here that the Seventh Circuit Court of Appeals gave us the quote:

                That an accounting firm should so screw up its taxes is the most remarkable feature of the case.”

The taxes were almost $980,000. Remember, the personal service corporation lost its deduction (and paid taxes) and the shareholders received dividends (and paid taxes). The penalties alone exceeded $190,000.

MY TAKE: This tax strategy borders on the unforgivable. There were so many ways to sidestep this result.  One way would have been working with disregarded entities, also known as single-member LLCs. The three shareholders performed services for and received W-2s from the accounting firm. The Court however did not agree that their three companies performed services for the accounting firm. A disregarded entity would have avoided that result by having the member’s activities attributed to the SMLLC.

How could the firm pay entities that provided no services? Was nobody in that tax department paying attention? I presume they were steamrolled by the three senior shareholders.

I was brought up with the technique of draining professional service corporation profit to zero by using year-end bonuses. That technique has frayed over recent years as new doctrines – such as Exacto Spring– have appeared. It is as though these MPS guys were stuck in a time warp.

Another way, and the obvious, would be to have just paid the founding partners more compensation. Yes, that would have given away the amount of actual compensation to the senior partners. Then again, this case has also given away that information.

Taxation and Renouncing Citizenship: Part II

Let’s say that you were born in Brazil. Your family was wealthy. Due to safety concerns (such as the risk of kidnapping), they moved you to the United States when you were young. You grew up in a southern and international city – perhaps Miami. You went to Harvard. While there you met and bankrolled a cantankerous near-friendless computer genius who came up with the next great social media idea. He tried to boot you out of the fledging company, but after a lawsuit and hard feelings, you kept about 4% or so of the shares. Much to your delight, the company went recently went public and made you a multibillionaire. Prior to that, you met with high-powered attorneys and tax advisors. You renounced your U.S. citizenship and are now living in Singapore. Where is Singapore? Think Vietnam, and then turn south. It is a former British colony, and you like pasties and room-temperature beer. Seems a fit.

Why would you do this?

Let’s go over several tax reasons. We need numbers in this conversation. Let’s use the following:

            Proceeds from IPO                          $ 4.0 billion

            Expected annual salary                     $ 7.5 million

            Expected annual dividends               $ 40 million

            Expected capital gains                      $ 25 million

What are your U.S. 2013 taxes if you remain a U.S. citizen?

(1)   Your salary may be taxed as high as 39.6% next year. Let’s say that it will be. The federal tax would be $7,500,000 times 39.6% equals $2,970,000.

(2)   If your dividends are “qualified” dividends, you would pay a 15% tax rate this year. The President’s proposed 2013 budget would increase this to 39.6%. In previous budgets, however, he has proposed 20%. What rate should we use? Let’s use 20%.  Your tax would be $ 40,000,000 times 20% equals $8,000,000.

(3)   The capital gains are a wild card. Let’s say that you will be selling stock periodically to fund your lifestyle. What amount? Let’s say $25 million annually. Let’s also say that your basis is so low that any sale is virtually all gain. The long-term capital gains rate is currently 15%, but everyone expects this rate to go up. Unless Congress acts, the rate will increase to 20% in 2013. Let’s use 20%. Your tax would be $5,000,000.

(4)   Starting in 2013, there is a new surtax on investment income if your income exceeds either $200,000 or $250,000, depending on filing status. You have clearly blown past that speed bump like Steven Tyler’s new Hennessey Venom GT Spyder. That new tax is 2.9% and will cost you $1,885,000.

(5)   Starting in 2013, there is a Medicare surcharge for persons earning more than $200,000. The surcharge is 0.9% and will cost you $67,500.

What are your 2013 taxes in Singapore?

(1) The top tax rate in Singapore is 20%. Taxes on your salary will be $1,500,000.

(2) Taxes on your dividends will be $8,000,000.

(3) There are no taxes on your capital gains.

OK, let’s look at the scorecard. A quick back-of-the-envelope calculation shows:

            United States              $ 17,922,500   

            Singapore                   $  9,500,000

Is there more? Well, yes.

(1) Let’s say that you invested in mutual funds to obtain those dividends. Chances are these funds will be considered PFIC’s (“pea-fics”) and carry some heavy U.S. tax disapproval.

The best you can do with a PFIC is make a QEF election and pay taxes every year on your share of income, whether distributed to you or not. This requires the PFIC manager to want to go to the trouble of assembling this information for you, as the PFIC tax is an American concept. A fund manager in Hong Kong, for example, might be less than interested in IRS mandates. In any event, the U.S. wants to accelerate your tax without regard to whether you received any cash.

If the fund manager is unwilling, you go to an ugly place in U.S. taxation. Without belaboring this, it may require you to go back and recalculate your prior year taxes on an “as if” basis. You will then write a real check to the IRS for that “as if” calculation. You also have to pay the IRS interest for not having paid taxes in the earlier “as if” tax year.

(2) Don’t forget your FBAR filing every June 30.

You have financial accounts overseas, so you will have an FBAR filing.

Penalties for failure to file an FBAR border can be severe. Penalties begin at $10,000 for each non-willful violation. If willful, the penalty goes to the greater of $100,000 or 50% of the account for each violation. Oh, each year is considered a separate violation. And the IRS gets to decide what is willful.

You got it: if the IRS considers your violation to be willful for two years, you have wiped-out the account.

(3)   You have to file the new Form 8938 disclosing foreign financial assets.

This is the FATCA and its reason for existing reads like a bad dream. In essence, the IRS felt that it was not getting enough information from the FBAR, and it really wanted more information. Think about this. The FBAR is mailed to the U.S. Treasury, and technically the IRS is part of the U.S. Treasury. One would think that the IRS and Treasury would speak, perhaps weekly for breakfast. Treasury did not upgrade the FBAR, nor did it replace the FBAR with the IRS Form 8938. No sir, the IRS created a new form and they kept both filing requirements. Well, it is one more opportunity to confuse the populace and maximize those penalty dollars. Brilliant!

Penalties can be rough: $10,000 for each failure to file. If you both fail to file the 8938 and fail to pay tax on the foreign income, there is a super-penalty of 40% on the tax underpayment. Don’t do that.

(4)   Should you leave family behind, gifting to them will certainly be a problem. These transfers will be picked up under the expatriation rules of Section 877 and trigger tax at the maximum gift tax rate. That rate is currently 35% but is expected to increase to 55% next year.

You read that right: Uncle Sam is your biggest beneficiary. More so than your mom, son or daughter. 

You may want to take them with you.  Singapore has no gift tax.

(5)   Should you remain a U.S. citizen, consider hiring an experienced tax attorney and/or CPA to navigate all this. It is another expense, but least you can write-off the professional fees on your taxes. Oh, wait. No you can’t. Chances are the fees will not exceed 2% of your income. If you are in the AMT, they will not be deductible in any event.

There are reasons other than taxation to renounce. There are many expatriates overseas who have no intention of returning to the U.S. They have lives, spouses, children, jobs and friends there. Perhaps they will return, but it will be at some unknown and distant date.

It is unfortunate to renounce citizenship over tax reasons. The U.S. does press your hand by taxing you on your worldwide income, irrespective of where you live, work or maintain family. The U.S. is virtually alone in the world with this type of taxation. If this ever made sense, does it still make sense? Leaving the U.S. doesn’t mean that you leave its mandates. You have to renounce.

What would you do?