Business Tax Changes in the 2010 Tax Relief Act

Several generous business tax cuts were contained in the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (TRA), enacted on December 17, 2010.  Those of particular note are:

• Bonus Depreciation.  Under the Small Business Jobs Act of 2010 (SBJA), the old 50% bonus depreciation that had expired after 2009 was extended to qualifying property placed in service through 2010.  The TRA increases the percentage to 100% of the cost of qualifying assets placed in service from September 9, 2010 through December 31, 2011.  The TRA also extends the 50% bonus depreciation to assets placed in service during 2012.  No bonus depreciation applies after 2012 (except for certain long-term production-period property).  Unlike the Section 179 expensing election, bonus depreciation applies to all sizes of businesses and can create a net operating loss that can be carried back to refund taxes paid in prior tax years.  However, bonus depreciation only applies to "new" property, whose original use starts with the taxpayer.  As an additional benefit, property for which bonus depreciation is claimed is not subject to the alternative minimum tax depreciation adjustment.  Qualifying property typically consists of machinery, equipment, other tangible personal property, most computer software, and certain leasehold improvements.  A taxpayer may elect not to claim bonus depreciation in those cases where it might not prove beneficial.  Note that bonus depreciation is determined upon the placed in service date whereas Section 179 expensing is determined upon taxable years.
• Section 179 Expensing.  Under the SBJA, the amount of qualifying property that could be expensed was raised to $500,000 for assets placed in service during tax years beginning in 2010 and 2011.  The $500,000 is reduced dollar for dollar as the amount of total qualifying property exceeds $2 million in the taxable year.  Qualifying property typically consists of new or used personal property and software; but for tax years beginning in 2010 and 2011, a special rule permits certain purchases of qualified real property to be included, up to $250,000 of the $500,000 limit.  The TRA retains these amounts for tax years beginning in 2010 and 2011 and changes (with inflation adjustments) the expensing limit to $125,000 and the start of the phase-out to $500,000 for tax years beginning in 2012.  However, the TRA did not extend the special qualified real property expensing provision past 2011.  For tax years beginning after the 2012, the limitations will be $25,000 and $200,000 respectively.  With 100% bonus depreciation available for assets placed in service through 2011, Section 179 expensing will not prove as useful except for "used" property for which bonus depreciation is not available.
• Research and Experimental Tax Credit.  The TRA retroactively extends the research tax credit that had expired at the end of 2009 until the end of 2011 for amounts paid or accrued.  For eligible small businesses, important changes were made by the SBJA such that, for tax years beginning in 2010, the research tax credit is not limited to the excess of regular tax over AMT and any unused 2010 research credit may be carried back five tax years instead of one.  An eligible small business is (1) a corporation the stock of which is not publicly traded, (2) a partnership, or (3) a sole proprietorship, if the average annual gross receipts of the business for the three-tax-year period preceding the 2010 tax year does not exceed $50 million.
• 15-Year Depreciation of Qualifying Leasehold Improvements.  The special 15-year (instead of 39-year), straightline depreciation method available for qualifying leasehold improvements, qualified restaurant property, and qualified retail improvements, was extended to such property placed in service through 2011.  In addition, this property may also be eligible for the special Section 179 expensing provisions for qualified real property (discussed above).

Estate Tax Provisions, 2010 through 2012

The 2010 Tax Relief bill enacted on December 17, 2010, contained dramatic estate, gift, and generation skipping transfer tax (GST) changes for the years 2010 through 2012, decreasing such taxes by $68 billion.  The so-called "Bush tax cuts" of 2001 increased the exemption from estate tax and lowered the tax rate over the years to 2009, and then provided for no estate or GST tax in 2010 (although gift tax continued to apply).  With the scheduled "sunset" of the tax cuts, the former higher estate tax rules would return in 2011.  Given the dramatic whip-saw effect of the changes, observers were shocked to see that Congress did not act to reform the estate tax prior to 2010.

The new tax law retroactively reinstates the estate tax to January 1, 2010 and provides an enhanced exemption of $5 million and a lowered tax rate of 35% through 2012.  The so-called "step-up in basis rule," which permits the income tax basis of non-income-with-respect-to-a-decedent property to be adjusted to fair market value as of the date of death, is also retroactively reinstated and the modified carryover basis regime repealed.  However, for deaths occurring in 2010, the executor of the estate may elect out of these new rules and instead apply the zero estate tax rate and modified carryover basis rules that previously applied.  For 2010 estates smaller than $5 million, the retroactive extension of the estate tax should be beneficial because of the full step-up in tax basis provision.  For very large 2010 estates, electing out of the estate tax and becoming subject to the modified carryover basis regime is probably best.  Careful analysis is necessary to decide which rules to follow for 2010 estates greater than $5 million and less than perhaps $40 million.

The lifetime gift tax exemption remains at $1 million for 2010 but is then re-unified with the estate tax exemption of $5 million beginning in 2011.  The GST exemption amount for 2010 through 2012 is increased to $5 million but the tax rate remains at 0% for 2010, increasing to 35% in 2011 and 2012.

A 2010 estate tax return (Form 706) is now required for gross estates above $5 million.  The normal due date of 9 months following the date of death has been extended to be no earlier than 9 months following the date of enactment, for deaths occurring January 1, 2010 through December 17, 2010.  If the executor elects out of the estate tax for 2010, then the modified carryover basis disclosure (Form 8939) must be filed by that date.

A major change in the new law is the so-called "portability" of the estate tax (and gift tax by reason of "unification") exemption between spouses, for deaths occurring in 2011 and 2012.  However, the GST exemption is not portable.  The deceased spouse's estate must file an estate tax return to claim the portability benefit.  Portability helps to solve the vexing problem of wasting a portion of the estate tax exemption if one spouse does not separately own property worth at least as much as the estate exemption.  Any unused estate exemption of the first spouse to die may be carried over to the surviving spouse.  In the case of multiple spouses, only the unused exemption of the last spouse to die may be used.  A person cannot accumulate unused exemptions from multiple spouses who die!  Does portability eliminate the need for credit-shelter or family trusts?  Such trusts might not be needed for federal estate tax in 2011 and 2012, but with multiple marriages and litigation in today's society, these trusts will still prove to be very useful even if not needed for federal estate tax planning.  Also, this portability provision is only temporary and ends after 2012.  The uncertainty surrounding the estate tax has not been solved by this new law, and you must still consider what the law might be after 2012 in your planning!

With the "reunification" of the gift and estate tax exemptions, taxpayers who have previously used up their $1 million lifetime gift tax exemption will be able to make significant new gifts in 2011 and 2012.

Estate tax planning provisions in your existing wills and trusts that rely on formula provisions to fund the credit shelter or family trust should be reviewed.  The provisions were written when the exemption from estate tax was much smaller.  For example, in 1999 the exemption was only $650,000; now it is $5 million through 2012.  The increase in the federal exemption changes how the estate property will be inherited among your beneficiaries and may not reflect your intentions.  Credit shelter trusts often put restrictions on how much the surviving spouse may benefit from the trust, and in some cases, may totally exclude the surviving spouse.  The temporary change in law does not mean credit shelter trusts are no longer necessary, it means that you may wish to consider limiting how much goes into the credit shelter trust and/or to add provisions enabling your surviving spouse to more easily benefit from the trust.

Certain proposed adverse changes to estate planning techniques were not included in the new law.  The proposal to require GRATs to have a 10-year minimum term (among other requirements) and the proposal to eliminate some valuation discount opportunities were not included.

Last minute 2010 transfer tax planning primarily concerns GST planning.  Consider implementing before 2011 the following:

• Make direct-skip gifts to grandchildren or to a GST-trust for the exclusive benefit of grandchildren and further descendants.  Be careful to avoid making gifts above the amount of your unused $1 million lifetime gift tax exclusion or else a gift tax of 35% will be incurred even though the GST tax rate is 0% in 2010.
• Make distributions to grandchildren from trusts that are not exempt from GST (zero-inclusion ratio).

The following table summarizes the transfer tax exemptions and rates for 2009 through 2013.

Year	2009	2010	2011	2012	2013
Estate exemption	$3.5M	$5.0M	$5.0M	$5.0M*	$1.0M
Estate tax rate	45%	35%	35%	35%	55%
Gift exemption	$1.0M	$1.0M	$5.0M	$5.0M*	$1.0M
Gift tax rate	45%	35%	35%	35%	55%
Gift annual exclusion	$13K	$13K	$13K	$13K*	$13K*
GST exemption	$3.5M	$5.0M	$5.0M	$5.0M*	$1.0M*
GST tax rate	45%	0%	35%	35%	55%

* As indexed for inflation

Major Tax Changes for 2011 and 2012

Pres. Obama signed the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 on December 17, 2010.  Over 10 years the Act cuts taxes by $801 billion, with a $917 billion reduction during 2011-2013 followed by $116 billion of offsetting tax increases during the latter years.  Another $56 billion is spent on an extension of unemployment insurance benefits.  Working on the federal budget deficit was evidently a problem for another day!  The Act essentially extends the so-called "Bush tax cuts" for two more years, pushing off the problem of increasing tax rates until the end of 2012, a presidential election year!  In addition to income tax cuts, the Act makes major cuts to the estate tax in 2011 and 2012 ($68 billion) and to Social Security taxes on employees in 2011 ($111 billion).  Significant business tax cuts were also enacted as well as an extension of so-called "tax extenders."  The tax extender provisions had expired at the end of 2009, and so the two-year extension only takes these provisions through 2011 instead of 2012.  This article will focus on individual tax cut extensions and other articles will address business and estate tax provisions.

Significant ordinary income and capital gain tax rate cuts were enacted in 2001 and 2003 along with enhanced tax deductions and credits.  Due to Senate budgetary rules, the cuts were designed to expire ("sunset") at the end of 2010.  Most observers believed at the time that the problem of expiring tax cuts would be addressed before the end of 2010.  Now the problem has been procrastinated to the end of 2012.  In 2013 the former higher tax rates return and, in addition, the tax increases of ObamaCare begin.  In short:

1. The ordinary tax rates of individuals remain at 10%, 15%, 25%, 33%, and 35% in 2011 and 2012 for all taxpayers, not just those earning less than $250,000 ($200,000 for single taxpayers) as originally proposed by the President.
2. The ordinary tax rates of trusts and estates remain at 15%, 25%, 28%, 33%, and 35% in 2011 and 2012.  The 10% rate has never applied to trusts and estates.
3. The long-term capital gain and qualifying dividend tax rates remain at 0% for taxpayers in the 10% and 15% ordinary income rate brackets, and 15% for those in higher ordinary rate brackets, in 2011 and 2012.  The current 28% and 25% capital gain rates for collectibles and unrecaptured real estate depreciation remain unchanged.
4. The elimination of the reduction to itemized deductions and personal exemptions based upon AGI levels, reached for the first time in 2010, continues in 2011 and 2012.
5. The enhanced American Opportunity Tax Credit (formerly the HOPE credit) for college costs continues for 2011 and 2012, permitting a credit of up to $2,500 (with income-based limitations) for four years of college education.
6. The exemption from alternative minimum tax is increased to $72,450 and $47,450 for joint and single filers in 2010.  The exemption increases to $74,450 and $48,450 respectively in 2011.  For 2012, Congress will again need to "patch" the AMT exemption amount to prevent over 20 million more taxpayers from becoming subject to the AMT.  The cost of patching the AMT is becoming very expensive because the AMT is essentially an upper-middle class tax.  This provision alone cuts taxes by $137 billion.
7. The employee 6.2% Social Security tax rate will be reduced to 4.2% in 2011 only.  The employer's share of the tax will remain at 6.2%.  The additional 1.45% Medicare portion of the FICA tax will remain the same and continues to be assessed on all compensation.  This provision replaces the Making Work Pay Credit that applied only to lower income earners.  The 2% rate reduction also applies to self-employment tax.  Changes are made to the calculation of the deductible percentage of self-employment tax in order for the full cost of the "employer match portion" of the self-employment tax to be deductible in 2011.
8. The election to deduct state and local sales tax in lieu of state income tax is extended to 2010 and 2011.
9. The ability to make direct, tax-free traditional IRA distributions to public charities is extended to 2010 and 2011.  The extension will qualify any 2010 charitable transfers made before enactment of the Act.  Direct charitable transfers count towards fulfilling the annual minimum required distribution.  While the transfer reduces adjusted gross income, there is no charitable itemized deduction (which would otherwise be a double benefit).  This provision continues to be limited to taxpayers age 70 1/2 or older and may not exceed $100,000 in a tax year.  Because this provision was extended so late in the year, a special election permits a charitable distribution made during January 2011 to be treated as if it had been made on December 31, 2010 for purposes of the annual $100,000 limitation and for purposes of meeting the 2010 minimum required distribution.
10. The residential energy tax credit is extended through 2011.  However, the extension uses the old pre-2009 rules of a $500 lifetime limit and a credit percentage of 10% of costs instead of the $1,500 lifetime limit and percentage of 30% of costs that applied during 2009 and 2010.  If you have already claimed credits of $500 or more in the past, no further credit is available.

Charitable IRA Transfer Proposal

Prior law permitted taxpayers age 70 1/2 or older to make tax-free distributions from their IRA (limited to $100,000 each year) directly to public charities.  This transfer counted as part of the taxpayer's required minimum distributions.  As a result, the taxpayer's adjusted gross income (AGI) was lowered by the direct transfer to charity.  A lower AGI can reduce the portion of Social Security benefits subject to income tax, and also permit additional medical expenses to become deductible.  The trade-off was the loss of the itemized charitable deduction for the direct transfer, but with lower AGI, the charitable deduction was in effect transferred to an "above-the-line" deduction.

Current tax law proposals will extend the charitable IRA transfer provision retroactively to the beginning of 2010 and through 2011.  An interesting feature of the proposal is that taxpayers may elect to treat transfers made in January 2011 as if made in 2010 for purposes of the annual $100,000 limit, and importantly, as part of their 2010 required minimum distribution amount.  The January 2011 feature is necessary because Congress is waiting until the last days of 2010 to extend the tax law, and taxpayers are unsure of what to do.

An alternative to waiting is to make the direct charitable IRA transfer now.  If the law is extended retroactively, it will include the transfer made before enactment of the extension.  If the law is not extended, then the charitable distribution is taxable, but it will be offset by the charitable itemized deduction.  I do not advise making charitable IRA transfers in excess of the required 2010 minimum distribution amount until an extension of the provision is actually enacted.

Deficit Commission Final Report Released

The National Commission on Fiscal Responsibility and Reform, appointed by Pres. Obama, adjourned on December 3, 2010, with only 11 of 18 members voting to recommend the final report. Fourteen votes were necessary to send the report to Congress for legislative action.  While the report was ominously titled, "The Moment of Truth," it will sit on the shelf gathering dust.  Parts of the report may be used or referred to in future presidential budget recommendations and in future legislative squabbles.

A few items to observe from the final report that are in addition to my November 12th blog include:

• Capital gains would be taxed at ordinary rates
• State and municipal bond interest would be taxable
• All retirement accounts would be consolidated and tax-preferred contributions capped at the lower of $20,000 or 20% of income.

Interesting 2010 Tax Return Due Dates

While we wait for our elected national leaders to do something responsible with our 2010 and 2011 tax laws, let's look ahead to some interesting 2010 tax return due dates.

Even though April 15, 2011 falls on Friday, the due date for filing 2010 federal individual income tax returns is Monday, April 18, 2011.  So I will lose another weekend to tax season!  The due date is delayed because Friday, April 15^th is Emancipation Day, a legal holiday in Washington, DC.  The various states will have their own due dates.  Utah’s due date will follow the federal due date.  The April 18^th due date is also effective for filing Form 4868 for an automatic six-month extension.  The extended due date is October 17, 2011, because October 15^th falls on Saturday.

New for 2010 Utah partnership tax returns, the six-month extension period has been shortened to five months.  So the extended Utah partnership due date is now September 15, 2011 instead of October 17, 2011.  This change conforms the Utah partnership extension due date to the federal due date, which was previously shortened to five months for 2009 partnership tax returns.

Note that even though the federal trust tax return extension period was shortened to five months beginning with 2009 trust tax returns, Utah’s trust tax return extension period remains at six months for 2010 trust tax returns.  Also, no changes have been made to federal or Utah corporation tax return due dates.

Deficit Commission Draft Proposal Released

The co-chairmen of the National Commission on Fiscal Responsibility and Reform released their draft proposal on November 10, 2010.  The Commission was established by Pres. Obama on February 18, 2010 and is to provide recommendations for reducing the national budget deficit by December 1, 2010.  The draft proposal has brought fierce reactions from politicians and others seeking to protect their personal interests in government benefits.  In my opinion, if our politicians are unwilling to responsibly lead, and if the public is unwilling to make sacrifices, the country's financial mess will produce consequences that will be more severe than the steps needed to fix the mess.

The draft proposal suggests a variety of spending cuts and tax increases, organized into three options.  Some of the proposals are:

OPTION 1:  THE ZERO PLAN

• Eliminate income tax deductions worth $1.1 trillion of tax savings.  The Commission terms this as eliminating "tax expenditures," which is political-speak for deductions.  Only a politician can think that legitimate tax deductions are a form of government spending.
• Lower the top individual income tax rate to 23% and the corporate tax rate to 26% once deductions have been eliminated.  This is called "broadening the base."  Then, as certain deductions are deemed desirable, correspondingly increase the tax rates.  We saw this before under Pres. Reagan as part of the Tax Reform Act of 1986.  Deductions were eliminated and the tax rates lowered.  Of course, once more income became taxable, Congress later increased the tax rates.
• Eliminate the alternative minimum tax.

OPTION 2:  WYDEN-GREGG STYLE REFORM (named after proposed legislation)

• Repeal the alternative minimum tax.
• Triple the standard deduction to $30,000 ($15,000 for individuals).
• Repeal the deduction for state income taxes, cafeteria plans, and miscellaneous itemized deductions.
• Disallow mortgage interest deductions for mortgages over $500,000.
• Allow charitable deductions only to the extent the amount exceeds 2% of adjusted gross income.
• Establish three individual tax rates of 15%, 25%, and 35%.
• Eliminate depreciation, LIFO, and oil and gas industry incentives for corporations and lower the tax rate to 26%.
• Permanently extend the research credit.

OPTION 3:  TAX REFORM TRIGGER

• Call upon Congress to enact tax reform by 2012.
• If tax reform is not enacted by 2012, then starting in 2013, all deductions and credits would be reduced across the board by 15% to achieve certain deficit reduction goals.
• Increase the percentage haircut over time until tax reform is enacted.  The Commission thinks Congress will be forced to reform taxes by inflicting more pain on the public.

OTHER ITEMS

• Increase the gasoline excise tax by 15 cents per gallon over time.
• Eliminate or limit the income tax exclusion for employer-sponsored health care coverage.
• Gradually increase the Social Security retirement age to 68 by 2050 and to 69 by 2075.  Increase the amount of wages subject to Social Security tax.  The unfortunate fact about Social Security is that the past decades of surplus taxes, which were supposed to constitute a "trust fund," have been spent and have masked the size of previous budget deficits.  Now that the program needs to tap into the "trust fund," nothing is there.  Excess Social Security benefits now have to be funded with additional budget deficits, higher taxes, reduced benefits, or a combination of all three.
• Reduce "discretionary spending" in the budget, including defense and farm subsidies.

Selected 2011 Inflation-Adjusted Tax Figures

Each year new tax rate bracket amounts, deduction limitations, exemptions and other items are adjusted to reflect inflationary increases.  The Tax Code now requires over 50 inflation-driven computations to determine deduction, exemption and exclusion amounts.  In addition, many items have built-in statutory changes enacted under previous tax legislation.  Due to nominal inflation during the 12-month measuring period, most of the amounts have not changed from 2010.  Some of the more important 2011 tax figures announced by the Federal Government or estimated by the Research Institute of America (RIA) are the following.

• The Social Security wage base is $106,800 (the same as 2010)
• The personal exemption is $3,700 (up from $3,650 in 2010)
• The IRA contribution limit is $5,000 with a $1,000 "catch-up" for those age 50 or older (the same as 2010)
• The Roth IRA contribution phases out for modified adjusted gross income between $169,000 and $179,000 (up from $167,000 to $177,000 in 2010) for joint tax returns, and between $107,000 and $122,000 (up from $105,000 and $120,000) for single and head of household filers
• Note that the Roth IRA conversion income limit does not apply any more after 2009
• The 401(k) plan deferral limit is $16,500 with a $5,500 "catch-up" for those age 50 or older (the same as 2010)
• The annual limit on additions to defined contribution plan accounts is $49,000 (the same as 2010)
• The annual gift tax exclusion is $13,000 (same as 2010)

Information regarding 2011 tax figures for the following items remain uncertain.  These are items that could change depending upon whether or what portions of the Bush tax cuts of 2001 and 2003 that expire on 12/31/2010 are extended into 2011 and/or what portions of the Obama budget proposals are adopted.

• Income tax rate brackets
• Overall limitation on itemized deductions
• Phase-out limitation on personal exemptions
• Estate tax exemption amount and tax rate
• Alternative minimum tax exemption amount

Preparing for a Disaster

Planning ahead to prevent the loss of important financial information is critical to reducing the cost and time needed to recover from a disaster.  A disaster can be large or small and can be natural or man-made.  Examples include an earthquake, fire, flood, computer hacking, accidental deletion, and identity theft.  In addition to planning for your business, be sure to also include your personal finances and digital libraries.  Good practices and safeguards I recommend include:

• Offsite computer file back-up.  For home computer backup, consider an online service such as Mozy.com that automatically backs up your data several times a day.
• Computer firewall, anti-virus, and anti-spyware programs that are kept current with at least weekly scans.
• Email spam and phishing filters.  Also, be sure never to click on suspicious file attachments, even if the email is sent by someone you know.  I will occasionally receive dangerous email attachments from friends who have had their email address book hacked.
• Use a login password to access your computer with a screen-saver that will re-lock your computer after a period of inaction, such as 10 minutes.
• Do not let the internet browser save your usernames and passwords associated with your financial accounts.  Keep your usernames and passwords private.  Use the "InPrivate Browsing" feature when using public-access computers, and then be sure to completely logout of the site and clear the browsing history.
• Use paperless statements and automatic bill paying services.  This eliminates private information from sitting in your mail box and paper statements from being accessible at home.  Shred old records and scan those that you wish to keep.
• Don't give out personal or financial information over the phone or email unless you initiated the contact or know who you dealing with.  Remember the IRS and your financial institutions won't contact you for such information.  They already have it!
• Make a video recording of your home, your valuables and business equipment for insurance purposes.
• Plan for how you will contact your customers, employees and family members, and where you will meet.
• Have available 72-hour emergency kits with some food, water, lighting, shelter, and medical supplies.
• Learn how to perform CPR and to handle minor medical emergencies.

Several good resources are available with information to help you take action to prepare for disasters.

• Federal Trade Commission Identity Theft Site:  http://www.ftc.gov/bcp/edu/microsites/idtheft//
• Utah Government Identity Theft Reporting Information System (IRIS):  http://www.idtheft.utah.gov/
• Internal Revenue Service:  http://www.irs.gov/businesses/small/article/0,,id=180547,00.html
• Be Ready Utah:  http://bereadyutah.gov/
• U.S. Homeland Security:  http://www.dhs.gov/index.shtm
• American Red Cross:  http://www.redcross.org/
• Small Business Administration:  http://www.sba.gov/services/disasterassistance/disasterpreparedness/index.html

Consider Paying Corporate Dividends Before 2011

Dividends paid by C corporations are taxable to shareholders and are not deductible to corporations.  This is the classic "double tax" treatment of C corporation profits.  For this reason most privately-owned C corporations do not pay dividends.  Dividends are ordinary taxable income, but since the Bush tax cuts of 2003, the maximum qualified dividend tax rate has been 15%, equal to that of long-term capital gains.  The Bush tax cuts expire at the end of 2010.  If Congressional action is not taken, the maximum dividend tax rate would increase to 39.6% for dividends received after 2010.  Pres. Obama has proposed that the maximum dividend tax rate not exceed 20%.  The post-2010 tax rate is hard to predict given the dysfunction of our national leaders.  Furthermore, the so-called health care reform law will add an additional 3.8% Medicare tax to dividend income beginning in 2013, for individuals having modified adjusted gross income of $200,000 or more ($250,000 for joint filers).  Given the higher, possibly dramatically higher, dividend tax rates in the near future, should your corporation pay dividends before 2011?

There are several specific circumstances where paying a dividend could make sense.  Additional financial and tax analysis is necessary to determine whether the ideas below are proper for your circumstances.

1. The C corporation has accumulated excess funds that are not needed for business purposes.  An accumulated earnings penalty tax of could be imposed by the IRS on the corporation.  The penalty tax rate is equal to the maximum dividend tax rate.  Paying a dividend of the excess accumulation avoids the risk of the penalty tax.
2. The C corporation has sold assets and has retained the after-tax sale proceeds to invest.  If the investments produce interest, dividends, royalties, rents, and annuity income, and such income equals 60% or more of the adjusted ordinary gross income of the corporation, then the corporation must pay the personal holding company penalty tax.  The penalty tax rate is equal to the maximum dividend tax rate.  Distributing the investments in liquidation of the corporation eliminates the annual problem of the personal holding company tax.  Note, however, that the corporation could recognize a taxable gain on the dividend distribution if the investments have appreciated in value.
3. The S corporation was previously a C corporation having accumulated earnings and profits.  If the S corporation earns passive investment income in excess of 25% of gross receipts, then a penalty tax applies.  Furthermore, the S election is lost after three consecutive years of excess passive income.  Passive investment income includes interest, dividends, royalties, rents, and annuity income.  The penalty tax is equal to the maximum C corporation tax rate, currently 35%.  A special election is available to distribute the accumulated C corporation earnings as profits as a taxable dividend.  The election and distribution will purge the S corporation of the problem of accumulated C corporation earnings and profits and enable the S corporation to avoid the penalty tax and potential loss of the S election.
4. The C corporation has strong cash flow, low debt, and currently pays dividends.  A special dividend that is financed with debt could be paid in 2010 in order to capture the lower tax rates.  The special dividend is in essence a prepayment of future dividends.

Overview of the Small Business Jobs Act of 2010

The Small Business Jobs Act of 2010 (the "Act") was signed by Pres. Obama on September 27, 2010.  The name of the Act is somewhat of a misnomer in that there are tax provisions that apply to large companies and also tax provisions that apply to individuals.  The Act provides $12 billion of tax incentives that are paid with $12 billion of accelerated tax collections and penalty increases.  Some of the important tax provisions are generally described below.  As always, the devil is in the details.

1. The 50% bonus depreciation for the purchase of new business equipment that expired at the end of 2009 is retroactively extended until the end of 2010
2. The Section 179 expensing election for the purchase of new or used business equipment is modified for tax years beginning in 2010 and 2011:
   >  The maximum deduction is increased from $250,000 in 2010 and from $25,000 in 2011 to $500,000
   >  The beginning of the phase-out of the deduction is increased from $800,000 in 2010 and from $200,000 in 2011 to $2,000,000
   >  Computer software remains eligible for Section 179 expensing through 2011
   >  New for the first time, eligible Section 179 property will now include up to $250,000 of certain qualifying real estate improvements made during 2010 and 2011
   >  After 2011 the Section 179 limits will drop down to $25,000 and $200,000
3. The tax on so-called "built-in gains" of S corporations that were formerly C corporations does not apply to gains recognized in 2011 if the fifth year since the S election ends before 2011
4. Eligible small businesses can carry back unused tax credits generated in tax years beginning in 2010 five taxable years instead of the usual one year
5. Up to 100% of the gain on the sale of certain small business stock acquired after September 27, 2010 and before 2011 may be excluded if the stock was held for at least five years
6. The business start-up expense deduction limits have been modified for one year, for tax years beginning in 2010, as follows:
   >  The maximum immediate deduction is increased from $5,000 to $10,000
   >  The beginning of the phase-out of the deduction is increased from $50,000 to $60,000
7. The computation of net earnings subject to the self-employment tax can now include a deduction for health insurance costs, but only for the tax year beginning in 2010
8. Companies that maintain a Roth 401(k) account may now amend their plans to permit participants to rollover all or a portion of their pre-tax 401(k) account balances to the Roth 401(k) account.  This is similar in concept to the conversion of a traditional IRA to a Roth IRA.  The rollover is taxable, but rollovers accomplished in 2010 are taxable one-half each in 2011 and 2012, unless an election is made to include the rollover income in the 2010 tax return.  After 2010 rollovers are fully taxable in the year of rollover.  The rollover isn't subject to the 10% pre-age 59 1/2 penalty.
9. Owners of rental real estate must begin issuing Forms 1099 for rental expenses of $600 or more paid to service providers (e.g. a plumber or painter, etc.) after 2010.
10. Penalties for the non-filing or late-filing of Form 1099 information tax returns are dramatically increased for returns due after 2010.  Taxpayers having average gross receipts of no more than $5 million would suffer a smaller annual maximum penalty as disclosed in [brackets].
    >  Not more than 30-days late, increased from $15 to $30 per day for each form, the annual penalty limit increasing from $75,000 to $250,000 [from $25,000 to $75,000]
    >  More than 30-days late but filed on or before August 1st, increased from $30 to $60 per day for each form, the annual penalty limit increasing from $150,000 to $500,000 [from $50,000 to $200,000]
    >  Filed after August 1st, increased from $50 to $100 per day for each form, the annual penalty limit increasing from $250,000 to $1,500,000 [from $100,000 to $500,000]
    >  Intentionally failing to file information tax returns will increase from $100 to $250 per day
    >  The penalty amounts will be indexed for inflation after 2012
11. The above penalty is for not filing information returns with the IRS.  A DUPLICATE PENALTY applies if the information return wasn't also provided to the companies to which payments were made.  So, in most situations, if an information return is missed, two penalties apply and the amounts shown above are effectively doubled!  The government's practice of enacting new burdensome tax requirements and then imposing draconian financial penalties in order to "pay" for certain tax breaks is very concerning because it can financially destroy businesses and families who inadvertently fail to comply with constantly changing and increasing tax filing requirements.

Small Tax Exempt Charities at Risk of Losing Tax Exempt Status

Small charities must file annual information tax returns.  For charities with annual gross receipts of $25,000 or less (increasing to $50,000 in 2010), only a so-called electronic postcard, Form 990-N is required.  For charities with annual gross receipts of more than $25,000 but less than $500,000 and whose total assets are less than $1,250,000 (dropping to $200,000 of gross receipts and $500,000 of total assets in 2010); the short-form 990-EZ is required.  The tax returns are due on the 15th day of the fifth month following the charity's year end.  Small charities that haven't filed tax returns for 2007, 2008, and 2009 will lose their tax exemption on October 15, 2010 unless they file the past three years under the IRS special one-time relief program.  The IRS estimates some 300,000 charities could be affected.  The IRS has published a list by state of the charities that will lose their exemption at: http://www.irs.gov/charities/article/0,,id=225889,00.html  Check the list for your charity!

For those charities eligible to use Form 990-N, an automatic extension is granted until October 15, 2010 to file the past-due tax returns.  For those charities eligible to file From 990-EZ, their past-due returns must also be filed by October 15, 2010 but they must also pay a small compliance fee of from $100 to $500, depending on the amount of their gross receipts. See http://www.irs.gov/charities/article/0,,id=225705,00.html for more information.  

The IRS filing relief program does not apply to larger charities that must file the full form 990, nor does it apply to private foundations.  Private foundations must file the full form 990-PF.  Private foundations cannot file an e-postcard, and there isn't a short form.  Surprisingly, unfunded private foundations, those with no prior contributions or assets still must file Form 990-PF to avoid losing their exemption.  This could be a sleeper issue for some individuals who may have already formed a private foundation in connection with their estate planning documents but haven't funded it yet.  There is no exemption from filing Form 990-PF based upon the size or the funding of the foundation.

Volcker Report on Tax Reform Released

The President's Economic Recovery Advisory Board, chaired by former Federal Reserve Chairman Paul Volcker, released their report on August 27, 2010 on options for changes in the current tax system.  The Board was tasked with generating options to simplify the tax system, to improve taxpayer compliance with tax law, and to reform the corporate tax system.  The Board was created in February 2009 and consisted of 17 members drawn from industry, academia, and economics.  The Board was instructed by the president to exclude options that "would raise taxes for families with incomes less than $250,000 a year."  Furthermore, the Board did not consider major overarching tax reform, such as the introduction of a value-added tax.  The report doesn't endorse specific recommendations, but the findings could be referenced in future tax legislative proposals.  This report could also be overshadowed by the Alan Simpson and Erskine Bowles committee which will report (after the November elections) on ways to cut the federal budget deficit.

Some of the interesting options listed in the report include the following:

• Eliminating some of the penalty-free early withdrawal provisions from IRAs, such as for withdrawals for education, first-time home buyer expenses, and medical expenses.
• Eliminating minimum required distribution requirements where total retirement accounts are less than $50,000.
• Replace the numerous different long-term capital gain tax rates with a 50% exclusion.
• Limit or repeal Section 1031 like-kind exchanges.
• Have the IRS send taxpayers who don't itemize deductions a pre-filled tax return that they could simply sign or make simple updates to.
• Dedicate more resources to the IRS for enforcement actions, increase the statute of limitation period for audits, and examine multiple tax years at once.
• Increase information reporting and institute income tax withholding on "large payments" to independent contractors.
• Reduce the top C corporation tax rate from 35% (the second highest rate among developed nations) while expanding the tax base by preventing businesses possessing certain "corporate" characteristics from being classified as a pass-through entities (thereby avoiding C corporation taxes) such as a partnerships, LLCs, or S corporations.
• Reduce the amount of interest expense that can be deducted by C corporations by 10% of the amount of interest in excess of $5 million.
• Eliminate the domestic production deduction.
• Eliminate or reduce accelerated depreciation.
• Eliminate the exemption of credit unions from income tax.

New Education and Medicaid Spending Bill Enacted

On August 10, 2010, Pres. Obama signed into law $26 billion of new spending for education and Medicaid assistance to the States, H.R. 1586.  According to the New York Times, the US Senate was in such a hurry to get to their summer vacation when they passed the bill on August 5th that the Senate failed to even put a name to the bill.  The US House was already on vacation and came back for one day on August 10th to pass this nameless bill.  The cost of the bill was "paid for" by enacting $9.0 billion of tax increases "reforming" international taxation (details beyond the scope of this blog), saving $1.1 billion by ending the advance earned income credit used by low-income individuals (which appears to be a one-time accounting gimmick), by cutting food stamp money by $11.9 billion beginning on March 31,2014 (which cuts may never really happen), and by making cuts in "budgetary authority" to programs that cannot spend their allocated funds fast enough before the programs expire.

Congress has left for another day the very important work in considering the following tax matters:

• The estate tax whipsaw in 2010 and 2011,
• Extending income tax provisions that expired at the end of 2009, such as the research and experimental credit, sales tax deduction, etc.
• Dealing with the Bush-era tax cuts that expire on December 31, 2010 resulting in large income tax increases beginning January 1, 2011, and
• Patching the alternative minimum tax exemption amount for 2010 so that 22 million more middle-class taxpayers don't fall into the AMT trap.

I expect that a lot of tax law changes will occur this Fall.  But again, with this Congress, maybe not.

Financial Reform Act Signed into Law

Pres. Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act into law on July 21, 2010.  The Act is the most sweeping overhaul of the financial system since the Great Depression.  At over 2,300 pages, many of the provisions won't be understood for years, as various commissioned studies and regulations are completed.  We can be sure that the "law of unintended consequences" will apply to something so vast and unrefined.  For example, the limits to be imposed upon debit card swipe fees charged by banks and other fee limitations could lead to the loss to consumers of no-fee checking accounts and the reduction of benefits associated with the use of credit cards, such as cash back and travel point programs.

The Act is proclaimed to be able to prevent future financial meltdowns for which the American taxpayer will be on the hook, and to protect consumers with the creation of a Bureau of Consumer Financial Protection to be housed in the Federal Reserve.  Nevertheless, regulation of the Fannie Mae and Freddie Mac mortgage companies, which represent the largest exposure for taxpayer bailouts, was left out of this bill, as was the regulation of financing departments of auto dealers which touch the lives of most consumers.

The Act instructs the SEC to conduct a 6-month study of whether to apply a fiduciary standard of care to registered broker-dealers when providing investment advice to consumers.  Presently the fiduciary standard applies to investment advisors but not to broker-dealers.  Broker-dealers only have to recommend investments that are considered "suitable" for their customers.  If the fiduciary standard is extended to brokers, then they will be required to recommend investments that are "in the best interest" of their customers.

The Act also permanently raises the FDIC deposit insurance limit to $250,000 retroactively to January 1, 2008.  Previously the insurance limit was scheduled to drop to $100,000 after 2013.

CBO Report on Social Security

The Congressional Budget Office just released the report, "Social Security Policy Options."  Social Security outlays will exceed annual tax revenues in 2010, which is the first time since the 1983 reform.  The CBO states that if the economy recovers soon, Social Security taxes will again be sufficient to pay current expenses, but only for a few years.  By 2016, annual spending will regularly exceed tax revenues.

The CBO references the so-called Social Security "trust fund," where previous excess taxes were accumulated.  The trust fund is projected to be exhausted in 2039.  The problem, of course, is that there isn't really a trust fund.  Prior excess Social Security taxes went to pay for other government spending by purchasing U.S. Treasury debt obligations.  There is not a cash balance to draw upon as the trust fund misnomer would indicate.  To pay for program benefits in excess of Social Security taxes, the government will need to issue more debt obligations, thus increasing the national debt, or raise taxes in order to fund the redemption of Treasury securities purchased with previous Social Security surpluses.  That is one reason why this issue must be addressed now.  The other major reason is the aging of the American population who will claim benefits.  The options to address the funding shortfall can be basically categorized as lowering Social Security benefits or raising Social Security taxes, or some combination, because there isn't really 29 years worth of money on deposit in a "trust fund."

The CBO report analyzes 30 options.  The CBO proceeds under the assumption that people currently older than 55 will not be affected by any changes.  This cut-off makes it uncomfortable for people like me that are slightly younger than this age!  While the CBO did not make recommendations, options analyzed include the following:

• Increase the payroll tax rate from one to three percentage points
• Remove the upper cap on compensation subject to the payroll tax but do not increase benefits
• Lower benefits for the top 50% or 70% of earners
• Raise the full retirement age to 70
• Reduce the cost-of-living adjustments for benefits

Americans must be prepared to fund more of their retirement needs in the future.  While the Social Security program will continue to be a part of our future, the combination of benefit reductions and higher taxes will increase the need for the public to take more responsibility for their retirement income needs.  Future retirees will need to save more of their earnings for retirement during their working years while being subjected to higher taxes on those earnings.

IRS to Require Small Businesses to Pay Taxes Electronically in 2011

Prior to 2011, businesses with less than $200,000 of aggregate federal income tax, employment tax, excise tax, and etc. could pay their taxes to the government by depositing a check with a commercial bank using the Federal Tax Deposit paper coupon, Form 8109.  Beginning in 2011, all businesses (except those with less than $2,500 of quarterly tax deposits) must pay their taxes using the Electronic Federal Tax Payment System (EFTPS).  Registration with the EFTPS is required, and can take several weeks to complete.  Businesses that are currently using the paper deposit method should register at www.eftps.gov before the end of 2010 so that there is no delay in making tax deposits and incurring substantial penalties.  Failure to use EFTPS when required results in a "failure-to-deposit" penalty of up to 15% of the amount required to be electronically deposited, even if the taxes are timely paid by paper.  Payments made using the EFTPS must be scheduled by 8:00 p.m. ET at least one calendar day prior to the tax due date.  The payment is made by debiting the business' bank account registered with EFTPS.  I have found the EFTPS to be convenient and that its use helps reduce errors on the part of the government when processing tax payments.  If you are not already using EFTPS, you should consider using it for the balance of 2010.

June 30, 2010 New Home Purchase Credit Deadline Extended to September 30, 2010

Original Post
The first-time homebuyer or long-term-owner tax credits of up to $8,000 or $6,500 respectively expired generally on April 30, 2010.  The actual amount of the credit depends on several factors, including a phase-out based upon modified adjusted gross income.  However, a transition rule allows the credit to those who had a written binding contract to purchase or construct a new principal residence by April 30, 2010, and who close on the purchase or receive their certificate of occupancy by June 30, 2010.  Immediate steps should be taken to ensure that the closing or issuance of the certificate of occupancy happens on time.  The credit is claimed on Form 5405 and certain documentation such as a copy of the binding contract, the settlement statement or certificate of occupancy, and other information must be attached to the form.  The credit may be claimed on either your 2009 or 2010 tax return.  Planning may be necessary to determine the best tax year in which to claim the credit.


July 1, 2010 Update
The ending date of the transition rule has been extended from June 30, 2010 to September 30, 2010.  This will give an estimated 180,000 homebuyers who would miss the earlier date more time to complete their purchase or finish constructing their new principal residence.  Congress enacted the extension on June 30th (H.R.5623) and Pres. Obama is expected to sign the legislation shortly.

Foreign Bank Account Reports (FBAR) Due June 30th

The Treasury Department requires every U.S. citizen or resident, including all forms of organizations, having a financial interest in, or signature or other authority over a financial account in a foreign country to file a Foreign Bank Account Report (FBAR). The report is made for each calendar year using form TD F 90-22.1 and must be received by the government no later than June 30th of the next year. No extension of time to file the report is permitted. The report is a separate filing and is not included with your income tax return, although certain questions in your income tax return about foreign bank accounts must be answered. The report is required if the aggregate value of all foreign accounts exceed $10,000 at any time during the calendar year. Some foreign financial accounts may not be readily apparent.  For example, one local bank offered local companies a sweep account that paid a higher rate of interest that was actually located in the Cayman Islands!  Civil penalties for not filing on time can range from a minimum of $10,000 to the greater of $100,000 or 50% of the account value.  Criminal penalties can range from a fine of up to $500,000 plus 10 years in jail.  Clearly the US government is serious about forcing FBAR compliance.  The government assumes noncompliance is indicative of tax fraud.

The 2010 HIRE Act added new disclosure requirements for those with more than $50,000 of "specified foreign financial assets" for tax years beginning on or after March 19, 2010.  In this situation, disclosure in the income tax return is required, but this does not relieve the FBAR requirement.  The penalty for failing to disclose this information in the income tax return is $10,000 and increases $10,000 every 30 days thereafter, not to exceed $50,000.

Health Care Reform, Part 4: Mandated Health Insurance Begins in 2014

Starting in 2014 individuals will be required to purchase "minimum essential" health insurance coverage for each month or else pay a penalty.  Individuals covered by Medicare or Medicaid (and certain other exceptions) are exempt from the mandate.  The amount of the penalty is computed using a formula that takes into account the person's household income and a flat dollar amount.  In 2014 the monthly penalty is 1/12 of the greater of $95 or 1% of income for the year.  In 2015 the penalty increases to the greater of $325 or 2% of income.  In 2016 the penalty increases to the greater of $695 or 2.5% of income.  The penalty is computed upon each household member age 18 or older.  The penalty for those under age 18 is one-half the adult amount.  An upper cap on the penalty limits the total amount of penalty assessed upon a household to a flat dollar cap of $285 in 2014, $975 in 2015, and $2,085 in 2016.  In addition, the household penalty may not exceed the national average annual premium for the "bronze" level of coverage through the coming insurance exchange.  The calculation of the penalty is so complex that it is to be administered by the IRS and collected on the individual's income tax return!  Even though assessment and collection of the penalty is through the income tax system, non-payment of the penalty does not result in additional interest or penalty.  The IRS is also prohibited from filing liens and levies against property, and may not criminally prosecute those who do not pay the penalty.

Also starting in 2014, employers with an average of 50 full-time employees (FTEs) not offering "minimum essential" health insurance coverage to its FTEs must pay a penalty.  The penalty is an "excise tax" equal to the number of FTEs over a 30-FTE threshold during any month, times 1/12 of $2,000 (adjusted for inflation).  In addition, if the employer offers health insurance and an employee whose household income falls below certain thresholds instead enrolls in a health insurance exchange for which the employee receives a premium tax credit or cost-sharing reduction, then the employer must pay a penalty equal to $3,000 times 1/12 for each month the employee is so enrolled.  An upper-cap to the penalty applies.  This second penalty does not apply if the employer provides such employee a "free choice voucher."  The voucher obligates the employer to pay to the insurance exchange an amount that the employer would have paid in providing coverage to the employee under the plan offered by the employer.

These are complicated provisions for which the IRS will need to issue guidance as to implementation.  Individuals and employers are in this together.  Indeed, the health care law calls these penalties "shared responsibility" penalties.

Health Care Reform, Part 3: 2013 Tax Changes

The largest tax impact from health care reform for individuals occurs in 2013.  Four significant changes are as follows:

Increased Medicare Tax on Employees and the Self-Employed.  The Medicare tax is currently 2.90% of wages.  The employee and the employer each pay one-half, or 1.45%.  Self-employed individuals pay both halves, or 2.90%, and may deduct one-half of that amount from income taxes for the deemed employer's share.  For earnings after 2012, the Medicare tax rate on the employee one-half rises to 2.35% on wages exceeding $250,000; $200,000; or $125,000 for joint, single, or separate return filers respectively.  The employer's tax rate remains at 1.45%.  Although the employer isn't subject to the tax rate increase, the employer must withhold the additional 0.90% tax once wages exceed $200,000 regardless of the employee's marital status.  Any shortfall or overage in this additional Medicare withholding tax is the responsibility of the employee and is reported on the income tax return.  The Medicare tax rate for the self-employed rises to 3.80% at the $250,000/$200,000/$125,000 income levels, but there is no increase to the income tax deduction because the rate increase is for the deemed employee's share.  This increased tax on wages has the effect of increasing the cost of the so-called "marriage penalty" where two-earner spouses do not receive the same tax treatment as two-earner, non-married couples.

Medicare Surtax on Unearned Income.  Beginning in 2013, individuals, trusts, and estates are subject to a new, additional Medicare tax of 3.80% on the lesser of:  1) net investment income, or 2) the excess of (modified) adjusted gross income over certain thresholds.  The thresholds are $250,000; $200,000; or $125,000 for joint, single, or separate return filers respectively.  The threshold for trusts and estates is the top income tax bracket amount which is currently only $11,200.  Net investment income includes interest, dividends, capital gains, annuities, rents, royalties, and passive activity income less related investment expenses.  Investment income does not include active trade or business income and gains from disposing of interests in active businesses in which the taxpayer materially participates, distributions from IRAs and qualified retirement plans, tax-exempt interest, gain excluded under from the sale of a principal residence, and any self-employment income.  This is a significant tax increase.  Coupled with the sunset of the Bush tax cuts in 2011, the top federal tax rate in 2013 on ordinary investment income would be 43.4% and on long-term capital gains 23.8%.  A future article will review planning ideas to reduce the impact of this new tax.

Reduction in Itemized Medical Deductions.  Currently unreimbursed medical expenses must exceed 7.5% of AGI to net an itemized tax deduction.  Beginning in 2013 the threshold increases to 10.0% for taxpayers under age 65.  For those age 65 and older, the 10.0% threshold starts in 2017.

Reduction in Health FSA Contributions.  Beginning in 2013, the maximum contribution amount permitted to a flexible spending account for medical expenses is $2,500.  There is no upper limit under current law, except for that imposed under the employer's cafeteria plan.

Health Care Reform, Part 2: 2011 & 2012 Tax Changes

The most significant tax changes occurring in 2011 pertain to the sunset of the 2001 tax cuts enacted by Pres. Bush.  Those changes will be discussed in a later blog post as this article focuses on tax changes enacted by the health care reform act.

• A new type of employee benefit plan, the Simple Cafeteria Plan, will be available beginning in 2011.  The rules will ease traditional restrictions on participation by company owners so that more small business can provide tax-free benefits to their employees.  A small business is defined as one with 100 employees or less.  A "cafeteria plan" is established by an employer to offer a "menu" of certain nontaxable benefits from which participating employees may select.  Examples of benefits include medical spending accounts and dependent care assistance.
• Over-the-counter medicines will no longer be eligible for tax-free reimbursement from Flexible Spending Accounts, Health Reimbursement Accounts, Archer Medical Savings Accounts, and Health Savings Accounts beginning in 2011.  The penalty on nonqualified distributions from Health Savings Accounts will increase from 10% to 20% and on Archer Medical Savings Accounts from 15% to 20%.
• Employers are required to report the total cost of providing employer-sponsored health insurance coverage to each employee on his or her Form W-2, starting with the 2011 plan year.  This is for information reporting only and does not make such benefits taxable.  UPDATE:  On October 12, 2010, the IRS released Notice 2010-69 wherein this W-2 reporting will not be mandatory for W-2s issued for 2011 in order to provide employers with additional time to make the changes to their systems to comply with the reporting requirement.  UPDATE #2:  The IRS subsequently released Notice 2011-28 that further delays the requirement of W-2 disclosure until W-2s are issued for 2012 compensation for small employers filing less than 250 W-2s.
• Beginning in 2012, all businesses must report payments of $600 or more on Forms 1099 for all persons and entities providing services or property to the business.  Currently, Form 1099 is not required to be prepared for payments to corporations or for the receipt of property.  Businesses that do not complete the required Forms 1099 are subject to penalties.  UPDATE:  New legislation enacted on April 14, 2011 repeals the expansion of Form 1099 reporting.

Health Care Reform Act, Part I: 2010 Tax Changes

Now that the April 15th tax day has come and gone, it is time to look ahead at some of the tax law changes that have been enacted as part of the Health Care Reform Act.  Since there are so many changes, we'll examine them over a series of postings.

After a long and contentious process, Pres. Obama and the Democrats in Congress forced through a series of laws that resulted in a reform of the health care system.  The final piece, the Health Care and Education Reconciliation Act of 2010 was signed on March 30, 2010.  An estimated $437 billion in new taxes, fees, and penalties were enacted to partially pay for the nearly $1 trillion in costs, as estimated over the next 10 years.  The balance is supposed to be paid for by Medicare cost savings and other assumptions.  Several tax changes take effect in 2010.

First, a small employer tax credit is available to help offset the cost of employer-provided health insurance where the employer pays at least half of the premium cost.  A small employer is defined as one with no more than 25 employees whose average annual wages do not exceed $50,000.  In 2010 through 2013 a tax credit of up to 35% of the cost of the premium paid by the small employer is available.  After 2013, a 50% credit is available for two years if the insurance is purchased through an "insurance exchange."  The full tax credit is only available to small employers with 10 or fewer employees with average annual wages not exceeding $25,000.  The tax credit phases out as the number of employees or the average annual wages increases to 25 and $50,0000 respectively.  Very detailed rules apply to qualify for and compute the credit.

Second, the adoption tax credit for qualified adoption expenses is increased to $13,170 and becomes a refundable credit for 2010 and 2011.  The credit phases out for those with modified adjusted gross income from $182,520 to $222,520.

Third, a 10% excise tax is imposed on individuals paying for indoor tanning services provided on or after July 1, 2010.

Fourth, the so-called "economic substance doctrine" has been enacted into law effective for transactions entered into on or after March 30, 2010.  A transaction is treated as having economic substance only if it changes the taxpayer's economic position in a meaningful way (apart from federal tax effects) and the taxpayer has a substantial, non-tax purpose for entering into the transaction.  Failure to meet this standard will result in the loss of expected tax benefits and the imposition of a 20% or 40% penalty.  There are no exceptions to this penalty for disclosure or for reasonable cause.  This provision is not intended to affect normal business transactions or prevent the realization of tax benefits consistent with Congressional purpose.

Congress Passes the 2010 Hiring Incentives to Restore Employment (HIRE) Act

On March 17, 2010, Congress passed a new "jobs bill" that Pres. Obama is expected to quickly sign.  The HIRE Act provides a "tax holiday" for employers who hire "qualified individuals."  The 6.2% employer portion of the Social Security tax is waived on wages paid after the date of enactment through the end of 2010 to qualifying new hires.  No waiver is available for the employer's 1.45% share of the Medicare tax.  A qualified individual must start work after February 3, 2010 and before January 1, 2011.  Such individual must certify that he or she has not been employed for more than 40 hours during the 60-day period ending on the date of hire.  Many special rules apply, such as the new hire cannot displace a current employee unless the current employee leaves voluntarily or is fired for cause.  In addition to the payroll tax savings, the employer will receive up to $1,000 of tax credits for each qualifying new hire who is employed for at least 52 consecutive weeks.  Again, special rules apply.

The HIRE Act extends the 2009 enhanced levels of business equipment expensing under Code Section 179.  The expensing limit is $250,000, reduced for purchases over $800,000, for purchases made in tax years beginning in 2010.  Previously, those limits would have been $125,000 and $500,000.  Note that the expensing limit is based upon purchases made during "tax years" and not simply calendar year 2010.  The HIRE Act did not extend the 50% bonus depreciation for new equipment purchases that expired on December 31, 2009.

Income from the Cancellation of Indebtedness

Recent tough economic times have led some lenders and borrowers to work out debt modifications, including the cancellation or forgiveness of some or all of the debt.  The amount of the cancelled debt generally must be reported as income on your tax return.  If a financial institution forgives the debt, it is required to issue Form 1099-C, reporting the amount of the forgiveness to the IRS.  There are many specific provisions that excuse the debtor from having to pay tax on the forgiven debt.  These include the following:

• Discharge of a private debt from a relative or friend that is intended as a gift,
• Discharge of student loans of doctors, nurses and teachers who agree to serve in rural or low income areas and meet certain conditions,
• Discharge of debt that, if paid, would have resulted in a tax deduction (e.g. accrued mortgage interest expense),
• Reduction in price for the purchase of property,
• Discharge of debt through bankruptcy,
• Discharge of debt of an insolvent taxpayer,
• Discharge of qualified farm debt,
• Discharge of qualified real property business debt, and
• Discharge of qualified principal residence debt.

There are many complicated rules and time limits associated with these exceptions.  Most of these exceptions must be reported to the IRS on Form 982 and result in the reduction of certain tax attributes, such as the tax basis of property or the carryover of tax losses.

Is a Roth IRA Conversion a Good Idea?

This article assumes that you are familiar with the features of a Roth IRA and the opportunity to convert your traditional IRA to a Roth IRA. Refer to my November 11, 2009 post for some background information. This post reviews a few “rules of thumb” to determine whether you might be a good candidate for a conversion. There is no mathematical benefit to a conversion if your income tax rate in retirement is the same as the tax rate for the year of conversion and you pay the conversion tax with IRA funds. Some other factor is needed for the conversion to be favorable, such as:

• You have non-IRA funds that can be used to pay the conversion tax.
• Your average tax rate will be higher in the future (when you retire and draw upon IRA funds) than your marginal tax rate at conversion.
• You have a net operating loss carryover (but not a capital loss carryover) or an unused charitable contribution that could offset some of the conversion income.

In addition, if you have one of the following characteristics, you may find the Roth conversion useful:

• You don’t need the IRA to fund retirement expenses and can leave it to your heirs.
• Your proportion of nondeductible IRA tax basis to the total value of all your IRAs is over 50%.
• Your IRA assets are temporarily depressed in value or are expected to greatly increase in value in the future.

However, a Roth IRA conversion is not a good idea for most middle- and upper-middle-income people. Such people need to rely on their IRA to fund retirement. The marginal tax paid when converting the traditional IRA will almost always be higher than the average tax paid in retirement when taking IRA distributions. Even if tax rates increase in the future, those increases will mostly affect the upper tax brackets applicable to very high income earners. Not many taxpayers in the 28% marginal bracket today will be pay an average 28% rate in retirement because the income tax brackets are indexed for inflation, and the average of lower brackets will always be less than the highest rate bracket to which you are subject. Therefore, be very careful of making a Roth IRA conversions if:

• You are not consistently in the top income tax bracket, and if not,
• You will pay conversion tax at a marginal tax rate above 15%.

Update on 2010 Charitable Contributions

Congress has passed the Haiti Charitable Deduction Bill (H.R. 4462) that permits taxpayers to make an election to deduct cash charitable contributions on their 2009 income tax return for Haiti relief donations made after January 11, 2010 and before March 1, 2010.  Normally cash donations are deductible in the tax year made.  Be sure to let your tax preparer know if you made a donation and would like to make the election.  You will need to keep track of these donations so that if the election is made, the deduction is not again claimed on your 2010 income tax return.  The election can make sense if your marginal 2009 income tax rate will be equal to or greater than your expected 2010 marginal income tax bracket.

Many taxpayers used the provision allowing individuals aged 70 1/2 and older to donate up to $100,000 from their individual retirement accounts (IRAs) and Roth IRAs to public charities without having to count the distributions as taxable income.  This provision expired on December 31, 2009.  The U.S. House passed a tax extenders bill on December 9, 2009 to extend this provision through 2010.  However, the U.S. Senate has not yet taken up a tax extenders bill.  Therefore, this popular provision is not currently available, but may be restored if the Senate acts upon it later this year.

Required Minimum Distributions Restart in 2010

Employer-sponsored defined contribution retirement plans (profit sharing plans, 401(k)s, etc.) and IRAs are subject to so-called, required minimum distribution rules.  The rules generally apply upon attainment of age 70 1/2 or after the death of the retirement account owner.  A 50% penalty of the RMD amount applies to failures to distribute the required amount.  The rules and penalty are designed to force out retirement savings so that they will be subject to income tax during the owner's retirement years and to prevent the use of retirement accounts solely as an inheritance vehicle.  The government enacted a one-year waiver of these rules for the year 2009 in response to the 2008 stock market crash.

Now that the waiver is over, what are the general implications for 2010?

• Those who attained age 70 1/2 prior to 2009:  use the account value as of December 31, 2009, the Uniform Lifetime Table factor for their attained age in 2010, and make the distribution no later than December 31, 2010.
• Those who attained age 70 1/2 in the year 2009:  use the account value as of December 31, 2009, the Uniform Lifetime Table factor for their attained age in 2010, and make the distribution no later than December 31, 2010.  The special rule that allows a deferral of the first RMD to April 1st of the calendar year following the year age 70 1/2 is reached does not apply.
• Those who attain age 70 1/2 in 2010:  regular RMD rules apply (including deferral of the first RMD to April 1, 2011) as the waiver has no effect.
• Beneficiaries using the five-year payout method:  the year 2009 is not counted as one of the five years.
• Beneficiaries using the lifetime payout method:  use the account value as of December 31, 2009 and apply the life expectancy factor from Single Life Table using the normal rules.

RMD rules can be quite complicated to apply and the one-year waiver for 2009 introduces some uncertainty into the process of restarting the RMDs in 2010.