Tax Return That Surprised An Accountant

Let’s do something a little different this time.

I want you to see numbers the way a tax CPA does.

Let’s say that you are semi-retired and you bring me your following tax information:

                    W-2                                         24,000

                    Interest income                            600

                    Qualified dividend income      40,000

                    Long-term capital gains          10,000

                    IRA                                         24,000

Looks to me like you have income of $98,600.

How about deductions?

                    Real estate taxes                    10,000

                    Mortgage interest                      5,000

                    Donations                                26,000

I am seeing $41,000, not including your exemptions.

You did some quick calculations and figure that your federal taxes will be about $6,500. You want to do some tax planning anyway, so you set up an appointment. What can you do to reduce your tax? 

What do I see here?

I’ll give you a hint.

Long-term capital gains have a neat tax trick: the capital gains tax rate is 0% as long as your ordinary income tax rate is 15% or lower. This does not mean that you cannot have a tax, mind you. To the extent that you have taxable income in excess of those capital gains, you will have tax.

Let’s walk though this word salad.

Income $98,600 – deductions $41,000 – exemptions $8,100 = $49,500 taxable income.

You have capital gains of $10,000.

Question: will you have to pay tax on the difference – the $39,500?

Answer: qualified dividends also have a neat tax trick: for this purpose, they are taxed similarly to long-term capital gains.

NOTE: Think of qualified dividends as dividends from a U.S. company or a foreign company that trades on an U.S. exchange and you are on the right path.

You have capital gains and qualified dividends totaling $50,000.

Your taxable income is $49,500.

All of your taxable income is qualified dividends and capital gains, and you never left the 15% tax bracket.

What is your tax?

Zero.

How is that for tax planning, huh?

From a tax perspective, you hit a home run.

Let me change two of the numbers so we can better understand this qualified dividend/capital gain/taxable income/15% tax bracket thing.

                    W-2                                         36,000

                    Qualified dividends                 28,000

As you probably can guess, I left your taxable income untouched at $49,500, but I changed its composition.

You now have capital gains and qualified dividends of $38,000. Your taxable income is $49,500, meaning that you have “other” income in there. You are going to have to pay tax on that “other” income, as it does not have that qualified dividend/capital gain trick.

The tax will be $1,153.

You still did great. It is just that no tax beats some tax any day of the week.

It is something to consider when you think about retirement planning. We are used to thinking about 401(k)s, deductible IRAs, Roth IRAs, social security and so on, but let’s not leave out qualified dividends and capital gains. Granted, capital gains are unpredictable and not a good fit for reliable income, but dividend-paying stocks might work for you. When was the last time Proctor & Gamble missed a dividend payment, for example?

OK, I admit: if you leave the 15% tax bracket the above technique fizzles. That however would take approximately $76,000 taxable income for marrieds filing jointly. Congrats if that is you.

BTW I saw scenario one during tax season (I tweaked the numbers somewhat for discussion, of course). The accountant was perplexed and asked me to look at the return with him. The zero tax threw him.

Now he knows the dividend/capital gain thing, and so do you.

No Soup For You!

“No soup for you!”

The reference of course is to the soup Nazi in the Seinfield television series. His name is Al Yegeneh. You can still buy his soup should you find yourself in New York or New Jersey.

However, it is not Al who we are interested in.

We instead are interested in Robert Bertrand, the CEO of Soupman, Inc, a company that licenses Al’s likeness and recipes. Think franchise and you are on the right track.

Bertrand however has drawn the ire of the IRS. He has been charged with disbursing approximately $3 million of unreported payroll, in the form of cash and stock.

The IRS says that $3 million of payroll is about $600,000 of unpaid federal payroll taxes.    

Payroll taxes – as we have discussed before – have some of the nastiest penalties going.

And that is just for paying the taxes late.

Do not pay the taxes – as Bertrand is charged – and the problem only escalates. He faces up to five years in prison. His daughter co-signed a $50,000 bond so he could get out of jail.

BTW the judge also ordered him to hire an attorney.

COMMENT: I don’t get it either. One of the first things I would have done was to hire a tax attorney.

I have not been able to discover which flavor of stock-as-compensation Soupman, Inc used, although I have a guess.

My guess is that Soupman Inc used nonqualified stock options.

COMMENT: There are multiple ways to incorporate stock into a compensation package. Nonqualified options (“nonquals” or “NSO’s”) are one, but qualified stock options (“ISO’s”) or restricted stock awards (“RSA’s”) are also available. Today we are talking only about nonquals.

Using nonquals, Soupman Inc would not grant stock immediately. The options would have a delay – such as requiring one to work there for a certain number of years before being able to exercise the option. Then there is the matter of price: will the option exercise for stock value at the time (not much of an incentive, if you ask me) or at some reduced price (zero, for example, would be a great incentive).

Let’s use some numbers to understand how nonquals work.

• Let’s start with a great key employee that we are very interested in retaining. We will call him Steve.
• Let’s grant Steve nonqualified options for 50,000 shares. Steve can buy stock at $10/share. As the stock is presently selling at $20/share, this is a good deal for Steve.
• But Steve cannot buy the stock right now. No, no, he has to wait at least 4 years, then he has six years after that to exercise. He can exercise once a year, after which he has to wait until next year. He can exercise as much of the stock as he likes, up to the 50,000-share maximum.
• There is a serious tax trap in here that we need to avoid, and it has to do with Steve having unfettered discretion over the option. For example, we cannot allow Steve to borrow against the option or allow him to sell the option to another person. The IRS could then argue that Steve is so close to actually having cash that he is taxable – right now. That would be bad.

Let’s fast forward six years and Steve exercises the option in full. The stock is worth $110 per share.

Steve has federal income tax withholding.

Steve has FICA withholding.

Steve has state tax withholding.

Where is the cash coming from for all this withholding?

The easiest solution is if Steve is still getting a regular paycheck. The employer would dip into that paycheck to take out all the withholdings on the option exercise.

OBSERVATION: Another way would be for Steve to sell enough stock to cover his withholdings. The nerd term for this is “cashless.”

It may be that the withholdings are so large they would swamp Steve’s regular paycheck. Maybe Steve writes a check to cover the withholdings.

COMMENT: If I know Steve, he is retiring when the checks clear.

Steve has income. It will show up on his W-2. He will include that option exercise (via his W-2) on his tax return for the year. The government got its vig.

How about the employer?

Steve’s employer has a tax deduction equal to the income included on Steve’s W-2.

The employer also has employer payroll taxes, such as:

·      Employer FICA

·      Federal unemployment

·      State unemployment

Let’s be honest, the employer payroll taxes are a drop in the bucket compared to Steve’s income from exercising the option.

Why would Steve’s employer do this?

There are two reasons. One is obvious; the second perhaps not as much.

One reason is that the employer wants to hold onto Steve. The stock option serves as a handcuff. There is enough there to entice Steve to stay, at least for a few years.

The second is that the employer manufactured a tax deduction almost out of thin air.

Huh?

How many shares did Steve exercise?

50,000.

What was the bargain element in the option exercise?

$110 - $10 = $100. Times 50,000 shares is $5,000,000 to Steve.

How much cash did the employer part with to pay Steve?

Whatever the employer FICA, federal and state unemployment taxes are – undoubtedly a lot less than $5,000,000.

Tax loophole! How Congress allow this? Unfair! Canadian football!

I disagree.

Why?

To my way of thinking, Steve is paying taxes on $5,000,000, so it is only fair that his employer gets to deduct the same $5,000,000. To argue otherwise is to wander into the-sound-of-one-hand-clapping territory.    

But, but … the employer did not actually pay $5,000,000.
   

COMMENT: Sometimes the numbers go exponential. Mark Zuckerberg, for example, had options to purchase 120 million shares for just 6 cents per share when Facebook went public at $38 per share. The “but, but …” crowd would want to see a $4,550,000,000 check.

I admit: so would I. I would frame the check. After I cashed it. It would also be my Christmas card every year.

You are starting to understand why Silicon Valley start-up companies like nonqualified stock options. Their cost right now is nada, but it can be a very nice tax deduction down the road when the company hits it big.

I suspect that Soupman, Inc did something like the above.

They just forgot to send in Steve’s withholdings.

The Qualified Small Business Stock Exemption

Let’s say that you are going to start your own company. You talk to me about different ways to organize:

(1) Sole proprietor – you wake up in the morning, get in your car and go out there and shake hands. There is no paperwork to file, unless you want to get a separate tax ID number. You and your proprietorship are alter-egos. If it gets sued, you get sued.

(2) Limited liability company – you stick that proprietorship in a single-member LLC, writing a check to your attorney and secretary of state for the privilege. You gain little to nothing tax-wise, but you may have helped your attorney (and yourself) if you ever get sued.

(3) Form a corporation - a corporation is the old-fashioned way to limit your liability. Once again there is a check to your attorney and secretary of state. Corporations have been out there long before LLCs walked the land.

You then have to make a decision as to the tax flavor of your corporation: 

a.    The “C” corporation – think Krogers, Proctor & Gamble and Macy’s. The C is a default for the big boys – and many non-bigs. There are some goodies here if you are into tax-free reorganizations, spin-offs and fancy whatnot.

Problem is that the C pays its own tax. You as the shareholder then pay tax a second time when you take money out (think a dividend) from the C.  This is not an issue when there are a million shareholders. It may be an issue when it is just you.

b.    The “S” corporation – geared more to the closely-held crowd. The S (normally) does not pay tax. Its income is instead included on your personal tax return. Own 65% of an S and you will pay tax on 65% of its income, along with your own W-2, interest, dividends and other income.

This makes your personal return somewhat a motley, as it will combine personal, investment and business income into one. Don’t be surprised if you are considered big-bucks by the business-illiterate crowd.

The S has been the go-to corporate choice for family-owned corporations since I have been in practice. A key reason is avoiding that double-tax.

But you can avoid the double tax by taking out all profits through salaries, right?

There is a nerdy issue here, but let’s say you are right.

Who cares then?

You will. When you sell your company.

Think about it. You spend years building a business. You are now age 65. You sell it for crazy money. The corporation pays tax. It distributes whatever cash it has left-over to you.

You pay taxes again.

And you vividly see the tax viciousness of the C corporation.

How many times are you going to flog this horse? Apple is a multinational corporation with a quarter of a trillion dollars in the bank. Your corporate office is your dining room.

The C stinks on the way out.

Except ….

Let’s talk Section 1202, which serves as a relief valve for many C corporation shareholders when they sell.

You are hosed on the first round of tax. That tax is on the corporation and Section 1202 will not touch it.

But it will touch the second round, which is the tax on you personally.

The idea is that a percentage of the gain will be excluded if you meet all the requirements.

What is the percentage?

Nowadays it is 100%. It has bounced around in prior years, however.

That 100% exclusion gets you back to S corporation territory. Sort of.

So what are the requirements?

There are several:

(1) You have to be a noncorporate shareholder. Apple is not invited to this soiree.

(2) You have owned the stock from day one … that is, when stock was issued (with minimal exceptions, such as a gift).

(3) The company can be only so big. Since big is described as $50 million, you can squeeze a good-sized business in there. BTW, this limit applies when you receive the stock, not when you sell it.

(4) The corporation and you consent to have Section 1202 apply.

(5) You have owned the stock for at least 5 years.

(6) Only certain active trades or businesses qualify.

Here are trades or businesses that will not qualify under requirement (5):

(1) A hotel, motel, restaurant or similar company.

(2) A farm.

(3) A bank, financing, leasing or similar company.

(4) Anything where depletion is involved.

(5) A service business, such as health, law, actuarial science or accounting.

A CPA firm cannot qualify as a Section 1202, for example.

Then there is a limit on the excludable gain. The maximum exclusion is the greater of:

(1) $10 million or

(2) 10 times your basis in the stock

Frankly, I do not see a lot of C’s – except maybe legacy C’s – anymore, so it appears that Section 1202 has been insufficient to sway many advisors, at least those outside Silicon Valley.

To be fair, however, this Code section has a manic history. It appears and disappears, its percentages change on a whim, and its neck-snapping interaction with the alternative minimum tax have soured many practitioners.  I am one of them.

I can give you a list of reasons why. Here are two:

(1) You and I start the company.

(2) I buy your stock when you retire.

(3) I sell the company.

I get Section 1202 treatment on my original stock but not on the stock I purchased from you.

Here is a second:

(1) You and I start the company.

(2) You and I sell the company for $30 million.

We can exclude $20 million, meaning we are back to ye-old-double-tax with the remaining $10 million.

Heck with that. Make it an S corporation and we get a break on all our stock.

What could make me change my mind?

Lower the C corporation tax rate from 35%.

Trump has mentioned 15%, although that sounds a bit low.

But it would mean that the corporate rate would be meaningfully lower than the individual rate. Remember that an S pays tax at an individual rate. That fact alone would make me consider a C over an S.

Section 1202 would then get my attention.

Suboptimal Tax Laws Are Still Valid Tax Laws

I have a family member who has accepted in position in, and will be moving to, Chicago. You can bet that we have discussed the compensation package, and I am to review the deferred compensation package when provided. His is a “C suite” position, so deferred compensation means more than just the 401(k) with which you and I are familiar.

I find myself reviewing a Federal Court of Claims decision on an airline pilot that got on the wrong side of FICA taxation of deferred compensation.

His name is Louis Balestra, and he was a pilot with United Airlines from 1979 until his retirement in 2004. There may have been no tax case, except that United Airlines filed for bankruptcy in 2002.

Let’s talk about the “general timing rule” for FICA taxation. It is easy: you pay FICA when you are paid. No pay, no tax. No fair to not cash your paycheck!

We also have deferred compensation, more specifically “nonqualified” deferred compensation, which means a retirement plan which deviates, either a little or a lot, from somewhat rigid IRS requirements in order to be “qualified.” There is then a ‘special timing rule” (I am not making this up, I swear), the purpose of which is to speed-up when the income is taxed for FICA. The Code section is 3121(v)(2):

   3121(v)(2) TREATMENT OF CERTAIN NONQUALIFIED DEFERRED COMPENSATION PLANS.—

3121(v)(2)(A) IN GENERAL.— Any amount deferred under a nonqualified deferred compensation plan shall be taken into account for purposes of this chapter as of the later of—

3121(v)(2)(A)(i)   when the services are performed, or

3121(v)(2)(A)(ii)   when there is no substantial risk of forfeiture of the rights to such amount.

We have a new shiny: “substantial risk of forfeiture.” If the company funds your benefit, for example, chances are that your FICA tax will be accelerated, perhaps many years before you actually receive any money.

Let’s work through this with an extremely simplified example. The company agrees to pay you $100,000 five years from now. Let’s also posit that you clear the second requirement of “no substantial risk of forfeiture.” Congratulations, you have FICA tax. Right now.

Being a tax accountant by training if not by temperament, I have to ask the question: how do I calculate the income to be taxed? Is it $100,000? That doesn’t make sense, as you will receive the money five years from now. A hundred grand then is not the same as a hundred grand now, if for no other reason than you could put it n a CD (if you received it now) and have more than a hundred grand five years hence. Is it the present value of the $100,000, discounted at some interest rate and for five years? That makes more sense, and that is the guidance provided by the Regulations.

Remember what I said about United Airlines filing for bankruptcy in 2002, two years before Balestra retired? Shouldn’t we take into consideration that United Airlines might not pay everything to which Balestra is entitled?

Makes sense to me. For example, Balestra paid FICA on approximately $289,000 of deferred compensation. United actually paid him approximately $63,000. He had paid FICA on that entire $289,000, and he wanted some of it back.

CLARIFICATION: It would be more correct to say that he paid the Medicare portion of FICA, as the social security side only applies up to an income limit.  Let’s continue. We are on a roll.

Balestra sued.  

And the Court was looking at the Shakespearean prose of Reg 31.3121(v)(2)-1(c):

(ii) Present value defined.— For purposes of this section, present value means the value as of a specified date of an amount or series of amounts due thereafter, where each amount is multiplied by the probability that the condition or conditions on which payment of the amount is contingent will be satisfied, and is discounted according to an assumed rate of interest to reflect the time value of money. For purposes of this section, the present value must be determined as of the date the amount deferred is required to be taken into account as wages under paragraph (e) of this section using actuarial assumptions and methods that are reasonable as of that date. For this purpose, a discount for the probability that an employee will die before commencement of benefit payments is permitted, but only to the extent that benefits will be forfeited upon death. In addition, the present value cannot be discounted for the probability that payments will not be made (or will be reduced) because of the unfunded status of the plan, the risk associated with any deemed or actual investment of amounts deferred under the plan, the risk that the employer, the trustee, or another party will be unwilling or unable to pay, the possibility of future plan amendments, the possibility of a future change in the law, or similar risks or contingencies.

Balestra tried, but he could not overcome the fact that the Regulations did not include “employer bankruptcy” as a possible reason to discount the amount of income accelerated for FICA tax – or, at least, to allow some of the FICA to be refunded once the actual payments are known.

Balestra lost his case.

The Court did realize the unfairness of the law, however.

It might have been wiser to have selected as a trigger something other than there being ‘no substantial risk of forfeiture’ … and instead considered the financial solvency of the employer – or to have deferred taxation while an employer is in bankruptcy, rather than until promised benefits are ‘reasonable ascertainable.”

You think?

But these are matters for law makers, not judges – suboptimal laws are still valid tax laws.”

I know. I would be more optimistic if I had any regard for the suboptimals in Congress.

Tile 26 of the United States Code would be a good deal shorter if the unwise tax laws could be purged by the judiciary.”

You must admit, it is easy to like this Court.

The Clintons And Their Residence Trusts

I am looking at a Bloomberg article titled” Wealthy Clintons Use Trusts to Limit Estate Tax They Back.”

I get the hypocrisy. There truly cannot be any surprises left with this pair, but I get it.

I also have no problem with the tax strategy. I would use it unapologetically, if I were within its wheelhouse.

This trust is known as a Qualified Personal Residence Trust (QPRT), pronounced “cue-pert.” I use to see more of them years ago, as this trust works better in a high interest rate environment. We haven’t had high interest rates for a while, so the trust is presently out of its natural element.

You can pretty much deduce that this trust is funded with a house. It can be funded with a main residence or a second home. I have seen it done with (very nice) vacation homes. There are income tax and gift tax consequences to a QPRT. 

Let’s go through an example to help understand the hows and whys of this thing.

Let’s say that we have a modestly successful, low-mileage, middle-aged tax CPA. We shall call him Steve. Steve owns a very nice second home in Hailey, Idaho. Word is he bought it from Bruce Willis. Steve and Mrs. Steve are meeting with their tax advisor, and they are discussing making gifts to their children. The advisor mentions gifting the Hailey residence, using a QPRT.

Mrs. Steve: How does that work?

Advisor:      The house is going to go the kids eventually, someday. We are just putting it in motion. We set up a trust. We put the house in the trust. We have the trust last a minimum number of years – in your case, maybe 15 years. At the end of the trust, the house belongs to the kids. Maybe it belongs to a trust set up for the kids. You can decide that.

Mrs. Steve: What’s the point? In any event the kids will wind up with house anyway.

Advisor:      The point is to save on estate and gift taxes. Someday this house will pass to the kids. If it happens while you are alive, we have to discuss gift taxes. If it happens at your or Steve’s death…

Steve:         I am right here, people.

Advisor:      Just explaining the process. If it happens at death, we have to discuss estate taxes.

Mrs. Steve: So, either way …

Advisor:      … you are hammered.

Mrs. Steve: How do I save money?

Advisor:      You continue to live in the house for a while, say fifteen years. The house is eventually going to the kids, so there is a gift. However the house is not going to the kids for fifteen years, so the value of the gift is the house fifteen years out.

Mrs. Steve: Wait. The house will be worth more fifteen years out. How is this possibly helping me?

Advisor:      I said it wrong. The IRS considers the gift to be made today for something to be delivered fifteen years out. That long wait reduces the value of the gift, which is what drives the gift tax planning with a QPRT.

Mrs. Steve: Should I just invite the IRS to an audit?

Advisor:      Not at all. We can find out what the house is worth today. The IRS has given us tables and interest rates to calculate the fifteen years wait. Since we are using their tables and their rates, it is fairly safe mathematics. There isn’t much to audit.

Steve:         I am stepping out to stretch my legs.

Mrs. Steve: Give me an example.

Steve:         Is there fresh coffee in the break room?

Advisor:      We have seen cases where someone has transferred a house worth $2 million in a ten-year QPRT and the IRS says the gift was only around $550 thousand.

Mrs. Steve: Which does what?             

Advisor:      You get to hold on to your lifetime gift tax exemption as long as possible. You can make more, or larger, gifts and not owe any gift tax as long as you have some lifetime exemption amount remaining.

Mrs. Steve: Who pays for the house; you know, the utilities, the maintenance, taxes and all that?

Advisor:      You do. And Steve, of course.

Steve:         (from outside the room) Did I hear my name?

Mrs. Steve: No! Go find your coffee.  

Mrs. Steve: Who gets to deduct the real estate taxes – the trust?

Advisor:      The trust is “invisible” for tax purposes. It is a “grantor” trust, which means that – to the IRS – there is no trust and it is just you and Steve. You get to deduct the real estate taxes.

Mrs. Steve: Wait a minute. If there is no trust, how can there be a gift?

Advisor:      This part gets confusing. For income tax purposes, the IRS says that there is no trust. For gift tax …

Steve:         (from outside the room) Where’s the cream?

Advisor:      For gift tax purposes, the IRS says there is a trust. Because there is a trust, you can make a gift.

Mrs. Steve: You are kidding.

Advisor:      No. Tax law can be crazy like that.

Mrs. Steve: What happens if after fifteen years I still want to live there? Does the trust boot me out?

Advisor:      Nope. You can rent the house, but you will have to pay fair market value, of course.

Mrs. Steve: Because I no longer own it.

Advisor:      Right. Also, since you do not own it, technically the kids could act against you and sell the house, even if against your will. That is a reason for keeping the house in some kind of trust, even after the QPRT term, as it allows for an independent trustee.

Mrs. Steve: What is the downside to this QPRT thing?

Steve:         (walking back into room, with coffee) We done yet?

Advisor:      You have to outlive the trust.

Steve:         I intend to. What are you talking about?

Advisor:      If the QPRT is for fifteen years, then you have to live at least fifteen years and a day for this thing to work.

Steve:         And if I don’t?

Advisor:      It will be as though no trust, no gift, no anything had ever happened. The house would be pulled back into your estate at its value when you die.

Steve:         Why do I keep dying with you two?

Mrs. Steve: OK. Steve dies before fifteen years. What can I do to minimize the risk to me of him dying….

Steve:         Risk to you?

Mrs. Steve:  … of him dying before his time?

Advisor:      Several things. You and Steve own the house jointly, right?

Mrs. Steve: Of course.

Steve:         (under his breath) As though there was a choice.

Mrs. Steve: What was that, dear?

Steve:         Just blowing on the coffee to cool it down, dear.

Advisor:      We set up two trusts. One for Steve and one for you. It helps with the odds.

Mrs. Steve: I like that.

Advisor:      We can even “supercharge” that by putting fractional interests in the trusts. Say you put a 1/3 fractional interest each. You and Steve would be able to fund six different trusts. We could vary the term of the trusts – say from ten to twenty years – again improving your odds.

Steve:         Are we still talking about me?

Mrs. Steve: It’s not about you, dear.

Believe it or not, this is pretty straightforward and well-marked tax planning for folks who know they will be subject to the estate tax. Few planners would describe QPRTs as aggressive. There are some twists and turns in there – say if the trust sells the house during the trust term, for example – but that can be a blog for another day.

How and why would the Clintons be pursuing this strategy? Remember that they own two houses: one in Washington (worth approximately $2 million) and another in Chappaqua, New York (worth approximately $5 million). They have quite a bit of money tied-up there. They are almost certain to face an estate tax some day, bringing them well within the wheelhouse of a QPRT.

Not bad for dead broke.