Thinking on This Week's Senate Surtax

The Senate Democrats have offered yet another tax to pay for yet another $447 billion stimulus package. They now want to impose a 5.6% surtax on income over $1 million per couple.

Let’s add-up the increases that are being discussed or have already been passed into legislation:

·         The expiration of the Bush tax cuts                          39.6%

·         The phase-out of itemized deductions (Pease)        1.19%

·         The phase-out of personal exemptions (PEP)           1.15%

·         The Medicare surtax on investment income            3.8%

·         The Medicare surtax on earned income                    0.9%                   

·         This week’s Senate Democrat proposal                    5.6%

                                                                                              --------------            

                                                                                                                       52.24%                                                                          

I doubt this list is complete as the above is just off the top of my head. 

You get the idea.

Small Business Health Care Tax Credit Redux

We’ve been looking again at the small business health care tax credit. Truthfully, I have been less than impressed with this credit, at least for our clients. It seems quite heavily engineered to accomplish so little.

There are three key steps to this credit:

(1)    How many employees do you have?

(2)    How much do you pay them?

(3)    Do you have a “qualifying” insurance arrangement?

Let’s go through them.

HOW MANY EMPLOYEES DO YOU HAVE?

To be fair, the credit does not address the number of employees. It instead addresses “full time equivalents.” This makes sense, as it may require two (or three) part-time employees to have one “full-time equivalent” employee.

The first thing to do is count the number of employees. This requires a definition of “employee” (remember, this is the tax code). The term “employee” does NOT include the following:

·         a sole proprietor

·         a partner in a partnership

·         a more-than-2% shareholder in an S corporation

·         a more-than-5% owner in any other business

Wait, there is more:

·         a family member of the above, including spouses, lineal family (ancestor/descendent) and in-laws.

So, you start with your year-end payroll summary. You eliminate the owners and their family. That leaves you with “employees’ for purposes of this credit.

Next you add-up the hours worked for those who remain. You stop counting at 2,080 hours per employee. After you adding-up all the hours, you divide by 2,080 to arrive at the number of FTEs. If this number is less than 25, you are still in the hunt.

The magic number is 10 or less FTEs. Above that number you will start to phase-out. By 25 you have phased-out completely.

HOW MUCH DO YOU PAY THEM?

We are talking Medicare wages, not income-taxable wages. The key difference will be contributions to 401(k)s, as those are Medicare-taxable but not income-taxable.

Fortunately you get to exclude the wages for the people left out above: the owners, their spouses and other family.

This can get you into an odd factual situation. You can have a workforce over 25 people – all full-time – and still qualify for this credit. The reason is that you have to eliminate the owners, their spouses and family. For some of our clients, that eliminates a sizeable part, if not the majority, of the workforce.

The key number here is $25,000 per FTE.  Above that amount you will start to phase-out.  By $50,000 you have completely phased-out. 

DO YOU HAVE A “QUALIFYING”INSURANCE ARRANGEMENT?

The insurance we are discussing is what you would anticipate: traditional insurance, HMO, PPO and hospital indemnity. It also includes specified illness (think cancer insurance) as well as some dental and vision insurance.

What it doesn’t include is an HSA.

The key requirement is that you – the employer - have to pay at least 50% of the cost of the insurance. There are some tweaks around the edges (such as if the insurance company does not charge the same premium for all employees in single coverage).

If you do not pay at least 50% of the health insurance, there is no point in even starting the calculation.

There is also a “ceiling” test: your insurance can only be so expensive for purposes of this calculation. The government will publish state-specific amounts for “small group market average premiums.” Your insurance cannot exceed that amount for your state.

AN INTERIM STEP

Add-up your cost of premiums for “qualifying” insurance for your “FTEs.”

WHAT IS THE AMOUNT OF THE CREDIT

If you are for-profit, the credit is 35% of the interim step.

ARE WE DONE?

Of course not. If you have too many employees – or the right number of employees but pay them too much – your credit gets phased-out, eventually to zero. No credit for you.

There are two phase-outs, which means that you cannot do this in your head.

(1)    If you have more than 10 FTE’s you start to phase-out. The phase-out is

(FTE – 10)

15

                                So, at 25 FTE’s you are completely phased-out.

(2)    If your average wage is more than $25,000, you start to phase-out.

(average annual wage - 25,000)

25,000

                                So, at $50,000 you are completely phased-out.

HOW ABOUT AN EXAMPLE?

Let’s say that you have 9 FTEs with an average wage of $23,000.

4 are single coverage and 5 are family coverage. You pay 50% of the single rate.

The premiums are $4,000 for singles and $10,000 for family. The state limits are $5,000 for singles and $12,000 for family.

Here is the calculation.

                                $2,000 times 9 equals                     18,000

The credit is 35% times 18,000 or $6,300.                      

LET’S CHANGE AN ASSUMPTION

What if the employer pays 50% whether of single or family coverage?

Here is the calculation:

                                $2,000 times 4 equals                     8,000

                                $5,000 times 5 equals                   25,000

                                                                                           33,000

The credit is 35% times 33,000 or $11,550.                    

HOW ABOUT ANOTHER EXAMPLE?

Let’s say you have 40 part-time employees. They total 20 FTEs. The average wage is $25,000. To keep this easy, let’s say that your cost of the health insurance is $240,000

(1)    First phase-out

20 FTE - 10                           equals 66.6% phase-out

15

(2)    Second phase-out

$25,000 - $25,000              equals 0% phase-out (that’s good!)

$25,000

The credit is (35% times $240,000) times (100% minus 66.6%) times (100% minus 0%) - or $28,000.

MISCELLANEOUS

The credit is part of the general business credit, which means that you get to carry it over if you cannot use it in a given tax year. In addition, the credit is allowed for AMT, which is good. You do have to reduce your deductible insurance by the amount of the credit.

As I said, we have been less than impressed. It is, however, a great way for Congress to increase someone’s tax preparation fees.

Employee or Contractor? There Is a New IRS Program

One of my individual tax clients came in around ten days ago. He brought his 2010 tax information, including a cleaning business reported as a proprietorship (technically it is a single-member LLC). I noticed that his payroll stopped somewhere during quarter 4, 2010. This of course prompted the question: why?

I suppose I did not need to ask. I have heard it before: the payroll taxes, including workers compensation, were becoming expensive. He consequently moved everyone over to a “Form 1099,” figuring that would solve his problem.

Let’s go through the steps: (1) If you can control and direct them, they are not contractors – they are employees; [2] removing them from payroll does not make them contractors; [3] issuing a 1099 at the end of the year (which he did not do, by the way, because I would have done it) does not make them contractors; and [4] a very important person – the IRS – may disagree with your opinion that they are contractors. If they disagree, the IRS may want the payroll taxes from you anyway. You would have gained nothing except an IRS audit and my professional fee for representing you.

Yep, I got stern with my client. I do not like dumb, and what he did was dumb. Payroll tax problems can get very messy – and absurdly expensive - very fast. I told him to restart the payroll.

The reason for this story is that the IRS came out this month with a “Voluntary Classification Settlement Program.” The program allows employers a chance to reclassify independent contractors and limit their resulting federal payroll taxes. To participate one must have consistently treated the individuals as contractors (that would eliminate my client) and have filed all Forms 1099 (again eliminating my client). One cannot currently be under audit, as there is a separate program for those under audit. One also has to agree to extend the statute of limitations assessment period for each of the three years going forward.

In return, one gains a substantial tax break. Before explaining, I would like to review Section 3509 of the Internal Revenue Code:

3509(a)In General.— If any employer fails to deduct and withhold any tax  … with respect to any employee by reason of treating such employee as not being an employee for purposes of such chapter or subchapter, the amount of the employer's liability for—

3509(a)(1)Withholding taxes.— Tax … for such year with respect to such employee shall be determined as if the amount required to be deducted and withheld were equal to 1.5 percent of the wages…paid to such employee.

3509(a)(2)Employee social security tax.— Taxes … with respect to such employee shall be determined as if the taxes imposed under such subchapter were 20 percent of the amount imposed under such subchapter without regard to this subparagraph.

Let’s go over the math:

                                Employer share of FICA                             7.65%

                                Employee share of FICA                            1.53%  (i.e., 7.65% times 20%)

                                Employee federal income tax                  1.50%

                                                                                                      10.68%

So that reclassification is going to cost you an immediate 10.68%, plus penalties and interest.

The new program will allow one to

·   pay 10% of the tax otherwise due, which is 1.07% (10.68% times 10%)

·   limited to one year

·   no interest or penalties, and

·   the IRS will not conduct an employment tax audit with respect to one’s worker classification for prior years.

This is a pretty good deal.

Remember that the IRS’ new position (although they deny it) is that virtually anyone who does anything for anybody is an employee. Please remember to fork-over that social security tax, thank you. If you are “walking the line” on worker classification, please consider this program.

President’s “Plan For Economic Growth and Deficit Reduction”

I was reviewing the tax provisions of the President’s “Plan for Economic Growth and Deficit Reduction.” It is possible that the “Super Committee” may adopt some of the tax provisions, so perhaps it is worthwhile to review the proposals.

(1)  Extend through 2012 the 100% bonus first-year depreciation.

(2)  Reduce the employer portion of the social security tax from 6.2% to 3.1%.

a.       This would cap-out at $5 million in payroll.

b.      Therefore the maximum cut would be $155,000 ($5,000,000 times 3.1%).

(3)  Create a tax credit for hiring employees who have been out-of-work for more than 6 months.

(4)  Create a tax credit to offset the increase in social security tax attributable to payroll increases over the corresponding period of the preceding year.

a.       So if your payroll was $1 million last year and $1.5 million this year, you would receive a credit for the social security taxes on the $0.5 million increase.

b.      There is a cap of $50 million.

c.       The credit would be good for the last quarter of this year and all of 2012.

(5)  The pre-EGTRAA tax rates would return for those making over $200,000 and $250,000.

OBSERVATION: Senator Schumer thinks these limits should be higher for New Yorkers. He is the senator from … New York.

(6)  Limit the tax rate at which high-incomes can reduce their tax to 28% for itemized deductions, excluded foreign income, health insurance and other selected deductions.

OBSERVATION: Right… make the calculation so complicated that even tax software won’t be able to get it right. Perhaps Congress and the WH should start with eliminating the phase-outs for personal exemptions, itemized deductions, student loan interest, education credits, child credit, AMT exemption and etc that would make this a circular calculation to stress even a mathematics graduate student.

(7)  Reduce the employee social security tax from 6.2% to 3.1%.

OBSERVATION:  Read this in conjunction with (2) above.

(8)  Repeal last-in first-out accounting (LIFO).

OBSERVATION: There is no accounting reason for this, as LIFO is considered to be a generally accepted accounting principle. It forms the tax accounting backbone of virtually every vehicle dealership in the nation.

(9)  Repeal the use of lower-of-cost –or-market inventory accounting.

OBSERVATION: Again, there is no accounting reason for this.

(10)  Increase the net FUTA tax from 0.6% to 0.8%.

OBSERVATION:  FUTA was increased on a “temporary” basis from 0.6% to 0.8% in 1976, although it went back to 0.6% this year. Does that sound “temporary” to you?

(11)  Eliminate the percentage depletion and intangible drilling cost provisions for oil and gas companies.

(12)  Eliminate coal activity expensing of exploration and development costs, as well as percentage depletion for hard mineral deposits and capital gains for royalties.

(13)  Modify the transfer-for-value exception on life insurance contracts.

OBSERVATION: Seems the viatical industry has drawn attention to itself.

(14)  Require business jets to be depreciated over 7 years rather than 5.

(15)  Revise the rules on transfers of intangibles to controlled foreign corporations.

OBSERVATION:  Think Google.

(16)  Revise the rules on the deductibility of interest paid to foreign persons.

I leave it to you to deem how serious you consider these proposals.

IRS Extends Key Deadline for 2010 Estates

On September 13, 2011 the IRS announced that estates of 2010 decedents will have until next year to file certain tax forms and pay the related taxes. In addition, the IRS is also providing relief for beneficiaries of those estates.

The timing was critical, as 2010 estate tax returns for decedents dying on or before 12/16/2010 were due Monday, September 19, 2011. Estate tax returns are normally due nine months after death, but there was an exception because of last year’s tax law flux.

Remember there was no estate tax for most of 2010. On December 17, 2010, the President signed a tax bill that reinstated the estate tax retroactively to January 1, 2010. That law set a 35% estate tax rate and provided an estate tax exemption of $5 million. The advantage to this scheme is that estate assets get “stepped-up” to their fair market value at the date of death. This means that the inheritors can (generally) sell the assets right away without incurring any income tax. To complicate matters, the bill also made this scheme an option for 2010. Estates of 2010 decedents could opt out of the new tax and use a modified basis carryover regime. There would be no estate tax, but the heirs received the same basis in assets as the decedent (with a $3 million exception for the surviving spouse and a $1.3 million exception for non-spousal beneficiaries). This opt-out required the beneficiaries to know the carryover basis in the assets inherited, so the IRS created a new form (Form 8939 - Allocation of Increase in Basis for Property Acquired From a Decedent). Opting-out of the estate tax is an irrevocable election.

As I write this, the IRS has not finalized Form 8939, although a draft version is available.

The IRS is providing the following filing relief:

·    If the estate is opting out of the new estate tax regime (that is, an estate of $5 million or more) it will have until January 17, 2012, to file Form 8939. This form was previously due November 15, 2011. The new due date will apply automatically; the estate does not need to file any anything.

·    Estates between 1/1/2010 and 12/16/2010 that request an extension to file their estate tax returns and pay any estate tax due will have until March 19, 2012, to file. The IRS will not assess penalties for either late filing or late payment.  Interest will be due on any estate tax paid after the original due date.

·    Estates between 12/17/10 and 12/31/10 will be due 15 months after the date of death. The IRS will not assess penalties for either late filing or late payment.  Interest will be due on any estate tax paid after the original due date.

·    The IRS is providing penalty relief to beneficiaries who received property from a 2010 decedent and also sold the property in 2010. The taxpayer should write “IRS Notice 2011-76” on the amended return to identify the issue to the IRS.

Confused? It is easy to be.  Some thoughts:

(1)   Seems to me that an estate under $5 million would generally elect-out, especially if the appreciation in estate assets is less than $1.3 million. In that event, we don’t even need the spousal $3 million to protect all the step-up.

a.   Remember that there are assets that do not receive a step-up. These are sometimes referred to as IRD (income in respect of a decedent) assets. The most common – by far – are 401(k) s and IRAs.

(2)   Estates over $5 million are a tougher call.

a.   Even then, it depends on the mix of assets. If the majority of assets are IRD assets, the step-up may be modest, as IRD assets do not step-up. That would incline one to the carryover regime.

b.   We are now balancing the estate tax with looming income taxes when the beneficiaries sell the assets.  If there is modest appreciation, then the carryover regime would appeal. If there is substantial appreciation, then the new tax regime would appeal – maybe.

                                          i.    Why maybe? Because it depends on the tax rate. If the assets would generate capital gains, an Ohio beneficiary would face an approximate 21% income tax rate (15% federal plus 6% Ohio). Why would one pay 35% when one could pay 21%?

c.   Frankly, I am not sure how one could determine the best course of action without assembling the fair market values and basis for all estate assets and considering the intentions of the beneficiaries. If the beneficiary intends to sell the asset right away, then one could incline to a different decision than if the beneficiary intends to retain the asset forever.

d.   There is an issue in the carryover regime that concerns tax practitioners. How do you determine the basis of an asset that has been owned forever and for which cost records do not exist? This is not a small matter, as the default IRS response is to say that the asset has a basis of zero. If this fact pattern is a significant for the estate, then one would be inclined to the new tax regime as the assets would step-up to fair market value on the date of death.

Thinking About The New Medicare Taxes

You may recall that Obamacare incorporated certain tax increases, albeit delayed in some cases. I have been revisiting the payroll tax changes that will kick-in in 2013. 

The High-Earnings Medicare Tax

Beginning in 2013 the employee Medicare tax will increase if the employee is high-earning, defined as $200,000 for singles and $250,000 for marrieds. One’s tax rate will go from 1.45% to 2.35%.  Remember that there is no income limit on the Medicare tax.

Note that the employee and employer will be paying different tax rates.

There are peculiar things about this tax increase. For one thing, one’s Medicare tax rate will be affected by a spouse’s income.

EXAMPLE: Al makes $175,000 and his wife makes $100,000. In 2013 their combined income is $275,000 and subjects them to the increased 0.9% Medicare tax. The tax increase is levied on the excess earnings over $250,000, which is $25,000 ((175,000 + 100,000)-250,000).

Here is the problem: how will Al’s employer (or his wife’s) know this? They won’t. The IRS has said that an employer is required to withhold only on the employee’s wages and disregard the earnings of the spouse. Therefore, as long as a married employee is below $250,000, the employer does not have to withhold the higher tax.

Here is my problem: I am going to be as popular as bedbugs when I come in at year-end and point-out the tax due to Al and his wife.

Also, since when is one’s Medicare tax affected by a spouse’s income? This is a first, to the best of my knowledge.

The Investment Income Tax

Let’s start off with the easy part: the same $200,000 and $250,000 income limits apply.

If one’s income exceeds the limit ($200,000 or $250,000), then one will have a tax hike of 3.8% on one’s net investment income. Net investment income includes interest and dividends (the classics), but it also includes net capital gains, rents (unless it is from a trade or business), royalties and some annuities. It does not include distributions from qualified retirement plans, including distributions in the form of annuities from such plans.

Let’s go with an example.

EXAMPLE: Let’s say that Jeff and Candy have combined salaries of $235,000 and combined interest and dividends of $ 32,000. Their AGI is $267,000. They have exceeded $250,000, so they are in trouble. How much is subject to the new tax? It would be the lesser of the net investment income ($32,000) or the excess over $250,000 ($17,000). Their brand-new tax for 2013 will be $646 ($17,000 times 3.8%).

Some things about this make me uncomfortable. Say that Jeff and Candy earned $213,000 instead, with the same $32,000 in interest and dividends. Their AGI is $245,000 – below $250,000 and thus avoiding the new investment income tax. However, say that they break a 401(k) to pay family medical bills or higher education expenses. Say they break $40,000. This would put their AGI at $285,000. What just happened?

Here is what happened: we have just subjected Jeff and Candy to the new tax. They will owe tax on the lesser of (1) their net investment income ($32,000) or (2) the excess of their AGI over $250,000 ($35,000). The 401(k) break just cost them $1,216 ($32,000 times 3.8%). If Jeff and Candy are under 59 ½, remember that it also cost them the 10% penalty. And income taxes on the break itself.

Again, since when have we paid Medicare tax on unearned income?

Anyway, if you are in these income ranges, you may want to start thinking about the year after next. I can immediately see the appeal of Roths and municipal bonds under this tax regime, as they will not increase one’s AGI. On a darker side, I wonder if we will see higher-income singles less willing to marry – or alternatively higher-income marrieds more willing to divorce – for tax reasons.  Taxes encourage changes in behavior. We just don’t know yet what changes these will encourage.

Danger With Brother-Sister S Corporations

Let’s talk about the Broz case. This case involves brother-sister S corporations and claiming tax losses. It does have a fact pattern which seems to repeat in practice, so the case is worth going over.

Robert Broz (Broz) worked in the cell phone industry. He was president of Cellular Information Systems (CIS), a cellular company, during the 1980s. He decided to invest personally in the development of cell networks in rural statistical areas (RSAs) during the 1990s. The FCC began offering RSA licenses by lottery to encourage development of cellular networks in rural areas.

Broz participated in approximately 400 lotteries. He won and purchased an RSA license for Northern Michigan (the Michigan 4 license) in 1991. He organized RFB Cellular, Inc. (RFB), an S

corporation, in 1991, the year he acquired the license.

RFB entered into a purchase agreement to acquire the Michigan 2 license and related equipment in 1994. The acquisition however was stalled for two years, primarily because of a lawsuit Broz’s former employer, CIS, filed against him.

Broz wanted to expand RFB’s existing business. RFB’s lenders agreed but required that Broz form a new entity (Alpine) to isolate the liabilities. Enter the brother-sister.

CoBank was Broz’s main bank during the years at issue. Broz pledged his RFB stock as additional security but he never personally guaranteed the CoBank loan. Broz would borrow money through RFB and then ship it out to Alpine.

RFB accounted for this as “advances” to Alpine. Alpine recorded the same advances as “notes payable.” At year-end, the accountant would come in and change the entries to show Broz as borrowing the monies from RFB and in turn loaning the money to Alpine. There was enough forethought to create notes between all the parties. There was not enough forethought to charge an interest rate different from the bank or to write Alpine checks to Broz and require him to write personal checks to CoBank. RFB did not help its case by noting in its financial statements that it would not demand repayment of the loans.

The IRS challenged that Broz had basis in Alpine. There are some routine things that the IRS wanted to see. First, a shareholder must make an economic outlay for the transaction to work. An example would be Broz signing the bank loan. Second, the debt must run directly from the S to the shareholder. An example here would be Broz writing the check to Alpine that started the loan cycle. Third, Broz handed the IRS yet another argument against his cause. He had RFB borrow the money, then “lend” it to him so he could “relend” it to Alpine. This roundabout raises the stakes, because now Broz must prove RFB was acting on his behalf and that Broz was the actual lender to Alpine. Broz just handed the IRS the argument that Broz was just a conduit, and whatever transaction occurred took place at the entity-to-entity (RFB – Alpine) level.

Here comes the Tax Court, and it did not like certain facts:

(1)    Accrued interest was added to the outstanding loan and not paid.

(2)    In fact, no loan payments were ever made.

(3)    Broz signed the notes on behalf of all the companies, making it unlikely that anybody would demand payment.

(4)    Monies that RFB moved to Alpine from the CoBank loan were characterized as advances to Alpine rather than distributions to Broz (ouch!).

(5)    These were recharacterized as loans only through year-end journal entries.

So the Tax Court said this was a loan from RFB to Alpine. Broz had no basis in Alpine to claim tax losses.

I have seen any number of variations of this fact pattern over the years. It involves brother-sister S corporations and is very often bank-driven. The bank wants access to the corporate assets as collateral, and it does not want a personal loan to the shareholder. The shareholder in turn wants the loan and does not press the issue. The way we have worked with this is four-fold: (1) we never receive and disburse the loan on the same day; (2) we never use the same interest rate; (3) we never use the same maturity date; (4) we always require cash payments respecting the form of the transaction. I would still prefer to borrow personally, if at all possible. We have at times made the shareholder a co-maker of the note, although that too carries its tax risk.

Another way is to use a holding company. In this case, RFB and Alpine would be subsidiaries (Q-Subs, more specifically) of a “parent,” and the basis calculations and issues would take place at the parent level. Broz would have had to establish basis only at one level - the parent.

The morale? This is an area of tax law with more sunken ships than the Bermuda triangle. The IRS demands you respect form and procedure when establishing basis in your S corporation(s). The law wants you to invest or loan money directly. Do so.