If you contribute to a 401(k), SEP, SIMPLE, IRA or Roth and have modest income, there may be a federal tax credit for you. It is the “credit for qualified retirement savings,” shortened to the savers credit in practice. The credit can be as much as $1,000 per person and phases out as your income rises.
If you are single, the credit phases-out at $27,750. For head-of-household it is $41,625 and for marrieds it is $55,500.
You claim the credit on Form 8880. There are some restrictions, such as you cannot be a full-time student or be claimed as a dependent.
By the way, you may overlook this credit if you file a 1040-EZ, as the form does not have a line for it.
Tuesday, June 21, 2011
An ESOP Too Far
Every now and then I read a tax case or summary that takes my breath away. I came across one recently. It has to do with an employee stock ownership plan (ESOP). ESOPs are specialized retirement plans. They are funded with company stock rather than with cash. As a participant in such a plan, your account would represent company shares. There is a way to turbocharge an ESOP by having the plan borrow money to buy the stock. The company sponsoring the plan then pays dividends, and the plan would use the dividends to repay the bank loan. I’ve seen a couple of ESOPs since I’ve been in Cincinnati. In my experience they have served primarily as a way to cash-out existing shareholders.
Back to our story. There is a dentist in Iowa. We’ll call him Michael C. Hollen. He incorporated his dental practice (Hollen PSC). The PSC began sponsoring an ESOP on 11/1/86. The plan chose a fiscal year-end of October, so its first and initial plan year was 10/31/87.
In 10/89, the plan borrowed approximately $415,000 and used those funds to purchase stock of Hollen PSC. Hollen PSC in turn contributed approximately $200,000 to the ESOP, which the plan put to good use by paying down its debt.
Problem One:
The plan allocated over $150,000 of the $200,000 to Dr. Hollen’s account. There are rules and regulations here. For this year, the “annual addition” limit was $30,000 or 25% of a participant’s compensation. Dr Hollen thought he got around this problem by calling the $200,000 a “dividend.” Generally, the annual addition would not include a dividend, but the IRS reserves the right to recharacterize a transaction if required to combat abuse. The court took pains to explain that it could not glance askance from a $200,000 “dividend,” especially where $150,000 went to Dr Hollen on a tax-deductible basis. This is a way of saying “abuse.”
The PSC hired Stephen Thielking, a CPA, as the plan’s accountant. Thielking appraised the stock held by the ESOP in 2001, 2002, and 2003. ESOPs have to appraise the stock.
Problem Two:
The IRS has procedures for one to be a “qualified” appraiser and eligible to do appraisals for an ESOP. Mr. Thielking could not be bothered with such trifling matters as following the procedures to be considered a qualified appraiser.
The Small Business Jobs Act of 1996 and the IRS Restructuring and Reform Act of 1998 amended any number of Code plan provisions. When this happens, plans are permitted a certain amount of time to review their documents and procedures and bring them into compliance.
Problem Three:
This was not done. More correctly, some of this was done but not all.
Qualified plans have to vest contributions in the participants. Vesting means that the employee has rights to an amount and can take it with him/her upon leaving the company.
Problem Four:
The plan did not keep its books on the same vesting schedule as its plan documents required. For reasons beyond my ken, the plan declined the IRS’ offer to participate in a closing agreement program (CAP), which would allow for retroactive compliance on this issue.
It appears clear to me that the court did not sympathize with Dr Hollen at all. The court twice disapprovingly mentioned Hollen’s failure to correct plan defects through the IRS-provided CAP program. In one footnote it sniffed that Dr Hollen had made assertions that “the record does not substantiate…” The court also swiped that Dr Hollen “offers no explanation why the vesting schedules … did not follow that schedule.”
So what happened? The Court disqualified the plan from inception – all the way back to 1987. The consequences are mind-boggling. The corporation took deductions to which it was not entitled. The plan contributions would represent taxable income to the participants, as there is no qualified plan to receive the contributions. A plan has to be qualified to defer tax recognition. Corporate returns have to be amended. Individual returns have to be amended. The penalties alone would be staggering.
Back to our story. There is a dentist in Iowa. We’ll call him Michael C. Hollen. He incorporated his dental practice (Hollen PSC). The PSC began sponsoring an ESOP on 11/1/86. The plan chose a fiscal year-end of October, so its first and initial plan year was 10/31/87.
In 10/89, the plan borrowed approximately $415,000 and used those funds to purchase stock of Hollen PSC. Hollen PSC in turn contributed approximately $200,000 to the ESOP, which the plan put to good use by paying down its debt.
Problem One:
The plan allocated over $150,000 of the $200,000 to Dr. Hollen’s account. There are rules and regulations here. For this year, the “annual addition” limit was $30,000 or 25% of a participant’s compensation. Dr Hollen thought he got around this problem by calling the $200,000 a “dividend.” Generally, the annual addition would not include a dividend, but the IRS reserves the right to recharacterize a transaction if required to combat abuse. The court took pains to explain that it could not glance askance from a $200,000 “dividend,” especially where $150,000 went to Dr Hollen on a tax-deductible basis. This is a way of saying “abuse.”
The PSC hired Stephen Thielking, a CPA, as the plan’s accountant. Thielking appraised the stock held by the ESOP in 2001, 2002, and 2003. ESOPs have to appraise the stock.
Problem Two:
The IRS has procedures for one to be a “qualified” appraiser and eligible to do appraisals for an ESOP. Mr. Thielking could not be bothered with such trifling matters as following the procedures to be considered a qualified appraiser.
The Small Business Jobs Act of 1996 and the IRS Restructuring and Reform Act of 1998 amended any number of Code plan provisions. When this happens, plans are permitted a certain amount of time to review their documents and procedures and bring them into compliance.
Problem Three:
This was not done. More correctly, some of this was done but not all.
Qualified plans have to vest contributions in the participants. Vesting means that the employee has rights to an amount and can take it with him/her upon leaving the company.
Problem Four:
The plan did not keep its books on the same vesting schedule as its plan documents required. For reasons beyond my ken, the plan declined the IRS’ offer to participate in a closing agreement program (CAP), which would allow for retroactive compliance on this issue.
It appears clear to me that the court did not sympathize with Dr Hollen at all. The court twice disapprovingly mentioned Hollen’s failure to correct plan defects through the IRS-provided CAP program. In one footnote it sniffed that Dr Hollen had made assertions that “the record does not substantiate…” The court also swiped that Dr Hollen “offers no explanation why the vesting schedules … did not follow that schedule.”
So what happened? The Court disqualified the plan from inception – all the way back to 1987. The consequences are mind-boggling. The corporation took deductions to which it was not entitled. The plan contributions would represent taxable income to the participants, as there is no qualified plan to receive the contributions. A plan has to be qualified to defer tax recognition. Corporate returns have to be amended. Individual returns have to be amended. The penalties alone would be staggering.
Payroll Deduction IRA
This is a not a new topic but the question has come up:
Can an employer setup an IRA for their employees, withhold from their paychecks and remit the monies directly to the financial institution?
You bet.
In Publication 4587, Payroll Deduction IRAs for Small Businesses, the IRS clarifies that an employer can do what we described above. The key point is to keep the employer involvement to a minimum, as the program will not be treated as a retirement plan, with its attendant rules, requirements and filings. With this arrangement there is no minimum number of employees who have to participate, nor is there a discrimination issue. The employee unfortunately has to pay the annual cost for the IRA, if there is one.
Notice what the above does NOT do: the employer cannot make an employer contribution to the plan. All the monies described are the employees’ monies.
Can an employer setup an IRA for their employees, withhold from their paychecks and remit the monies directly to the financial institution?
You bet.
In Publication 4587, Payroll Deduction IRAs for Small Businesses, the IRS clarifies that an employer can do what we described above. The key point is to keep the employer involvement to a minimum, as the program will not be treated as a retirement plan, with its attendant rules, requirements and filings. With this arrangement there is no minimum number of employees who have to participate, nor is there a discrimination issue. The employee unfortunately has to pay the annual cost for the IRA, if there is one.
Notice what the above does NOT do: the employer cannot make an employer contribution to the plan. All the monies described are the employees’ monies.
The 2011 Home Energy Tax Credit
The 2010 Tax Relief Act extended the (IRC Sec. 25C) nonbusiness energy property tax credit through December 31, 2011 – one more year. However, stricter rules apply for 2011 than for 2010.
A taxpayer can claim a 10% credit for “qualified energy property” placed in service in 2011 up to a $500 lifetime limit. Oh yes, you have to reduce the $500 by any credits you claimed previously.
The credit for residential energy property expenditures are limited to:
(i) $50 for an advanced main circulating fan;
(ii) $150 for any qualified natural gas, propane, or hot water boiler;
(iii) $300 for any item of energy-efficient property (with no more than $200 from windows and skylights)
My take: Are you kidding?
A taxpayer can claim a 10% credit for “qualified energy property” placed in service in 2011 up to a $500 lifetime limit. Oh yes, you have to reduce the $500 by any credits you claimed previously.
The credit for residential energy property expenditures are limited to:
(i) $50 for an advanced main circulating fan;
(ii) $150 for any qualified natural gas, propane, or hot water boiler;
(iii) $300 for any item of energy-efficient property (with no more than $200 from windows and skylights)
My take: Are you kidding?
Avoiding Capital Gains Tax - Part II
Let’s return to our article of December 7, 2010 on preserving a gain position in a stock. In that article we talked about buying a put on P&G stock.
P&G closed yesterday at $64.50. Let’s say I am looking at selling a call on P&G for January, 2012, with a strike price at $60. This means that – in January, 2012, someone can require me to sell P&G for $60 a share. For this they will pay me a premium of $3.55. Remembering that options trade in lots of 100, that means that I will receive $355 (before commissions) by selling this call.
Let’s back up. A call means that the buyer of the option can buy the seller’s stock. The buyer pays the seller a premium. In our example, the premium of $355 gives the buyer the right to buy my stock for $60 share. The total price to me is $63.55 a share. Yesterday it traded at $64.50. I am preserving all but a dollar a share of my gain through all of 2011.
The downside? If the stock runs up in price, then I will be leaving profit on the table. The buyer of the call will almost surely exercise the option and keep the profit for himself/herself. That is the reason for buying a call, after all. As a seller, I am making a contrary bet – the price will not run up.
But I may have other reasons. I may be locking in my profit. If I am happy with my profit at $63.55, and happy to receive another year’s worth of dividends, then I may sell the call to lock-in that profit. Perhaps I am guaranteeing my cash flow, such as for a child beginning college in 2012. Perhaps I am minimizing my taxes, if 2011 will be a banner year but I do not expect 2012 to repeat.
The premium of $355 is not taxable to me right away. If I wind up selling the stock, then the premium will be reported as an increase to my selling price for the stock ($60 plus $3.55). If the option lapses, I will have $355 of short-term capital gain in 2012. If I close the position – say by buying a January, 2012 call – then the difference between $355 and what I paid for the new call will be short-term capital gain or loss to me.
P&G closed yesterday at $64.50. Let’s say I am looking at selling a call on P&G for January, 2012, with a strike price at $60. This means that – in January, 2012, someone can require me to sell P&G for $60 a share. For this they will pay me a premium of $3.55. Remembering that options trade in lots of 100, that means that I will receive $355 (before commissions) by selling this call.
Let’s back up. A call means that the buyer of the option can buy the seller’s stock. The buyer pays the seller a premium. In our example, the premium of $355 gives the buyer the right to buy my stock for $60 share. The total price to me is $63.55 a share. Yesterday it traded at $64.50. I am preserving all but a dollar a share of my gain through all of 2011.
The downside? If the stock runs up in price, then I will be leaving profit on the table. The buyer of the call will almost surely exercise the option and keep the profit for himself/herself. That is the reason for buying a call, after all. As a seller, I am making a contrary bet – the price will not run up.
But I may have other reasons. I may be locking in my profit. If I am happy with my profit at $63.55, and happy to receive another year’s worth of dividends, then I may sell the call to lock-in that profit. Perhaps I am guaranteeing my cash flow, such as for a child beginning college in 2012. Perhaps I am minimizing my taxes, if 2011 will be a banner year but I do not expect 2012 to repeat.
The premium of $355 is not taxable to me right away. If I wind up selling the stock, then the premium will be reported as an increase to my selling price for the stock ($60 plus $3.55). If the option lapses, I will have $355 of short-term capital gain in 2012. If I close the position – say by buying a January, 2012 call – then the difference between $355 and what I paid for the new call will be short-term capital gain or loss to me.
Avoiding Capital Gains Tax - Part 1
As part of year-end tax planning, it is common to review a client’s investment portfolio. If there are capital gains (and yes, this year there are), we go looking for capital losses to offset those gains. What is the point of sitting on capital losses when the alternative is to send Uncle Sam a check for taxes on capital gains? This process is called “loss harvesting,” which term I find to be both humorous and macabre.
Let’s go the other way. What if the client has capital gains but is concerned that the gains may evaporate. Sell the stock, we would say. No, says the client; the stock is a winner. The client however is concerned about market swings before getting to the long-term. What if he or she needs the money and the swing is down? Given market behavior since 2007, this is not an unreasonable fear. What if he/she is just wrong about the stock?
There are a few things you can consider to protect that gain. Today I want to talk about one. We will come back and talk about other techniques, but let’s do it another day.
The technique today uses protective puts. Yep, we are talking options.
You may remember that there are two basic types of options: calls and puts. If a sell a call to you, you have the right to buy my stock. If I sell a put to you, you have the right to sell me your stock. The direction I want here is to buy a put. That means I can require you to buy stock that I own. Since I am buying, this is going to cost me money.
An example is the way to go.
P&G closed today at around $62. Let’s say I believe that P&G is a good long-term hold (which I do, by the way), but I want to hedge my bets. I bought P&G at a great price, say $42. Nice unrealized gains here. Let’s say I have been reading articles by Nouriel Roubini and am terrified of imminent economic collapse. What if P&G goes to $20 before it goes to $100?
I will buy a $60 put for January 2012. That means that – until January, 2012 – I can require you to buy my P&G at $60 a share. You are not going to do this from the goodness of your heart. I am going to pay you approximately $5 for the right. This $5, by the way, is called the “premium.” You can look it up on stock market websites. You do not believe that P&G is going to crash. You believe that it will trade within a range or maybe even go up. You know that I would never sell you the stock if it stays above $60. Even if I do, I paid you $5, so your net cost is $55 ($60 - $5) for the stock.
If the stock goes up or moves sideways, I will likely allow the put to expire. I am not going to sell you stock at $60 when I can call Fidelity and sell at a higher price. I wasted $5 on the premium.
Say the stock goes to $40. Different answer. I exercise the put and require you to buy the stock. I sell at $60. I paid $5. I cleared $55, and I can turn around and buy the stock at $40. There is no wash sale, because I sold at a profit. The wash only applies when one sells at a loss.
There is a non-intuitive tax result in here, by the way. Let’s say that I let the put expire. My first response is that I have a $5 capital loss, which is the premium I paid for the put. I am partially right. I do have a $5 loss, but the IRS will not let me deduct it. Since I still own the stock, the IRS requires me to increase my basis in P&G by that $5. I will get it back someday – when I sell the stock. The technical reason is that the protective put creates a tax “straddle,” and the result I described is the general result for tax straddles.
Let’s go the other way. What if the client has capital gains but is concerned that the gains may evaporate. Sell the stock, we would say. No, says the client; the stock is a winner. The client however is concerned about market swings before getting to the long-term. What if he or she needs the money and the swing is down? Given market behavior since 2007, this is not an unreasonable fear. What if he/she is just wrong about the stock?
There are a few things you can consider to protect that gain. Today I want to talk about one. We will come back and talk about other techniques, but let’s do it another day.
The technique today uses protective puts. Yep, we are talking options.
You may remember that there are two basic types of options: calls and puts. If a sell a call to you, you have the right to buy my stock. If I sell a put to you, you have the right to sell me your stock. The direction I want here is to buy a put. That means I can require you to buy stock that I own. Since I am buying, this is going to cost me money.
An example is the way to go.
P&G closed today at around $62. Let’s say I believe that P&G is a good long-term hold (which I do, by the way), but I want to hedge my bets. I bought P&G at a great price, say $42. Nice unrealized gains here. Let’s say I have been reading articles by Nouriel Roubini and am terrified of imminent economic collapse. What if P&G goes to $20 before it goes to $100?
I will buy a $60 put for January 2012. That means that – until January, 2012 – I can require you to buy my P&G at $60 a share. You are not going to do this from the goodness of your heart. I am going to pay you approximately $5 for the right. This $5, by the way, is called the “premium.” You can look it up on stock market websites. You do not believe that P&G is going to crash. You believe that it will trade within a range or maybe even go up. You know that I would never sell you the stock if it stays above $60. Even if I do, I paid you $5, so your net cost is $55 ($60 - $5) for the stock.
If the stock goes up or moves sideways, I will likely allow the put to expire. I am not going to sell you stock at $60 when I can call Fidelity and sell at a higher price. I wasted $5 on the premium.
Say the stock goes to $40. Different answer. I exercise the put and require you to buy the stock. I sell at $60. I paid $5. I cleared $55, and I can turn around and buy the stock at $40. There is no wash sale, because I sold at a profit. The wash only applies when one sells at a loss.
There is a non-intuitive tax result in here, by the way. Let’s say that I let the put expire. My first response is that I have a $5 capital loss, which is the premium I paid for the put. I am partially right. I do have a $5 loss, but the IRS will not let me deduct it. Since I still own the stock, the IRS requires me to increase my basis in P&G by that $5. I will get it back someday – when I sell the stock. The technical reason is that the protective put creates a tax “straddle,” and the result I described is the general result for tax straddles.
The Old and New IRA Charitable Distribution
You may remember that taxpayers were allowed to distribute $100,000 directly from their IRAs to charity. No deduction was allowed for the contribution, but then the IRA distribution was not included in income. When you also remember that contributions are limited to 50% of income, this rule was very favorable indeed for someone making very generous contributions relative to that year’s income.
This deduction expired in 2010 as Congress played Russian Tax Roulette.
The new tax bill brought it back.
Taxpayers 70 1/2 or older can again make tax-free distributions to a charity from an IRA up to $100,000. These distributions aren't subject to the charitable contribution percentage limits nor are they included in gross income. These rules are good for one year more - through 2011.
Here’s the unexpected part:
In addition, a taxpayer can elect a distribution made in January, 2011 to be treated AS IF it were made on December 31, 2010. Therefore a distribution made in January, 2011 may be (1) treated as made in the taxpayer's 2010 tax year and counted against the 2010 $100,000 limitation, and (2) treated as made in the 2010 calendar year and used to satisfy the taxpayer's minimum distribution requirement for 2010.
The problem here is that prudent tax planning would have required an age 70 ½ taxpayer to have taken his/her2010 required minimum distribution by December 31, 2010. This taxpayer would therefore not need another 2010 distribution, unless he/she simply wanted to maximize charitable contributions. The question has been raised whether a taxpayer who did take a 2010 RMD because of tax law uncertainty can put the monies back in – to “recontribute” the monies. The IRS has just clarified that this cannot be done, as the tax bill did not include this option.
This deduction expired in 2010 as Congress played Russian Tax Roulette.
The new tax bill brought it back.
Taxpayers 70 1/2 or older can again make tax-free distributions to a charity from an IRA up to $100,000. These distributions aren't subject to the charitable contribution percentage limits nor are they included in gross income. These rules are good for one year more - through 2011.
Here’s the unexpected part:
In addition, a taxpayer can elect a distribution made in January, 2011 to be treated AS IF it were made on December 31, 2010. Therefore a distribution made in January, 2011 may be (1) treated as made in the taxpayer's 2010 tax year and counted against the 2010 $100,000 limitation, and (2) treated as made in the 2010 calendar year and used to satisfy the taxpayer's minimum distribution requirement for 2010.
The problem here is that prudent tax planning would have required an age 70 ½ taxpayer to have taken his/her2010 required minimum distribution by December 31, 2010. This taxpayer would therefore not need another 2010 distribution, unless he/she simply wanted to maximize charitable contributions. The question has been raised whether a taxpayer who did take a 2010 RMD because of tax law uncertainty can put the monies back in – to “recontribute” the monies. The IRS has just clarified that this cannot be done, as the tax bill did not include this option.
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