Understanding the Wash Sale Rule and Capital Loss Harvesting

Typical year-end tax planning involves the “harvesting” of tax losses.  The word “harvesting” means selling investments with unrealized losses in order to trigger tax deductions.  Taxpayers who allocate their investments across different asset classes will nearly always have some investments that lose money.  That is the nature of diversification.  Selling securities with losses will produce capital losses for income tax purposes.  These losses can offset capital gains and up to $3,000 of ordinary income.  Capital gain taxes can be surprisingly high given the layers of taxes imposed.  See the tax rates shown in the table below.

Prudent investors will want to repurchase securities to maintain their asset allocation percentages.  The “wash sale” rule is a tax rule that disallows the deduction of realized capital losses in certain circumstances.  The rule applies if the repurchased security is substantially identical to the security that was sold, and the repurchase occurs during the 61-day period starting 30 days before the date of sale and ending 30 days after the date of sale.  In other words, in order to deduct the capital loss, the government wants you out of the investment for at least 31 days before repurchasing the same security.  The date to be used is the “trade” date rather than the “settlement” date.  The loss disallowed under the wash sale rule is added to the cost of the replacement security.  So the loss isn’t permanently disallowed, it is just deferred until the replacement security is sold.

In order to trigger the tax loss but remain invested in the asset class, the replacement security needs to be a different security.  For example, you could purchase stock in another company in the same industry, or purchase a mutual fund from another fund family.

The wash sale rule also applies to related accounts and spouses.  The rule will apply if you use your IRA to purchase a substantially identical security to the one sold in your taxable account.  A husband cannot purchase the same security sold by a wife within the 61-day period and avoid the wash sale rule.

Capital Losses Can Save Taxes at These Rates	Top Federal Rate	Obamacare Rate	Itemized Deduct Phaseout	Utah Rate	Total  Tax Rate
Short-term capital gain	39.6%	3.8%	1.2%	5.0%	49.6%
Long-term capital gain	20.0%	3.8%	1.2%	5.0%	30.0%
Real estate recapture CG	25.0%	3.8%	1.2%	5.0%	35.0%
Collectibles capital gain	28.0%	3.8%	1.2%	5.0%	38.0%

Last Minute 2013 Personal Tax Planning

Consider implementing the following strategies by December 31^st to save income taxes.  The income tax laws are now so complex that it is difficult to know whether any of these general recommendations will actually save you tax without undertaking a computerized tax projection.  You should consult your tax advisor before implementing these ideas.

1.      Harvest capital losses as necessary to reduce capital gains tax, and to lower the Obamacare tax on net investment income.  Be sure to avoid the “wash sale” rule that applies if you purchase substantially identical replacement securities within 30 days before or 30 days after the date of sale.

2.      Be sure that any year-end charitable donations are either delivered or mailed and postmarked by the 31^st.

3.      For those at least age 70 ½, consider using your traditional IRA to make a direct charitable donation.  This can satisfy your 2013 minimum required distribution and lower your overall income tax.

4.      Consider donating any long-term appreciated securities to charity.  You can claim a tax deduction equal to the fair market value without triggering tax on the capital gain.

5.      For those at least age 70 ½, and for those who have inherited an IRA, don’t forget to take your minimum required distribution by the 31^st in order to avoid a 50% penalty.

6.      Prepay state income tax unless you are subject to the alternative minimum tax (AMT) because taxes are not deductible for the AMT.

7.      Consider accelerating ordinary income into 2013 if you are subject to the AMT and may not be in 2014.

8.      Consider making a Roth IRA conversion if you are in a lower tax bracket this year.

9.      For purposes of gift and estate tax planning, don’t forget to use the $14,000 annual exclusion.  Giving cashier checks is advisable when cash gifts are made at year end to be sure that the gift is completed in the 2013 calendar year.

10.  Many upper-income individuals will suffer dramatic 2013 tax increases from the combination of income tax rate hikes and the start of Obamacare taxes.  Such taxpayers should consider estimating these tax increases in order to avoid surprises at April 15^th and to be sure sufficient cash is on hand to pay the additional tax on time, in order to avoid late payment penalties and interest.

Last Minute 2013 Business Tax Planning

Although, the IRS has delayed the start of tax filing season to January 31, 2014, taxpayers have less than two weeks until December 31, 2013, to implement any “last minute” income tax planning strategies.  Here is a checklist of several strategies applicable to businesses:

1.      Purchase and “place in service” any necessary equipment or furnishings by December 31^st to take advantage of  the 50% bonus depreciation that goes away after 2013 and to utilize the higher Section 179 business expensing limit of up to $500,000 that drops to only $25,000 for tax years beginning in 2014.

2.      Adopt a qualified retirement plan, such as a profit sharing plan, a 401(k) plan, or a defined benefit plan.  Unlike a qualified plan, a simplified employee pension (SEP) plan does not need to be adopted by December 31^st.

3.      Purchase stock directly from a qualified small business C corporation to be eligible for a potential 100% gain exclusion upon a future qualifying sale of the stock.  The exclusion drops to 50% for stock purchased after 2013.

4.      Cash basis taxpayers should pay and mail all outstanding bills and payroll by December 31^st.

5.      Accrual basis corporations may declare and accrue bonuses by December 31^st as long as actual payment occurs no later than March 15, 2014.  Special rules exist for shareholders owning directly or indirectly more than 50% of the corporation’s stock.  Bonuses to such shareholder-employees must be paid by December 31^st to be deductible.

6.      Estimate the business’ marginal income tax rate for 2013 and 2014 and shift income and deductions as appropriate to allow more income to be taxed at lower tax rates, or to allow more deductions to be claimed at higher tax rates.

7.      If you own an interest in a partnership or an S corporation, you may need to increase your tax basis in the entity so you can deduct a loss from it for this year.

 

Written Capitalization Policy Statement Required by December 31, 2013!

The Federal government recently published final regulations concerning the acquisition, production, and improvement of tangible property.  The regulations are effective for tax years beginning on or after January 1, 2014.  These regulations have been in the works for about 10 years and will change how businesses have historically accounted for repairs, maintenance, and asset purchases.  One of the provisions requires prompt action by all businesses.  This blog post is limited to this provision.  Future posts will cover other aspects of the final regulations.

The regulations provide for an annual "de minimis" safe harbor election for expensing the cost of tangible property equal to or less than a certain threshold amount.  The threshold amount is $5,000 for businesses that file financial statements with the SEC or with a state or local government, or that have a certified audited financial statement (reviewed or complied statements don't qualify).  These financial statements are termed, "applicable financial statements." The threshold is only $500 for businesses without applicable financial statements.  The safe harbor expensing election also applies to tangible property having an economic useful life of 12 months or less.  Note that this de minimis safe harbor election is different from, and is in addition to, bonus depreciation, and expensing under Section 179.

The safe harbor election requires that the business have a written capitalization policy for their financial accounting records BEFORE the start of the tax year for which the expensing will be taken.  Be sure that you have a written policy in place by December 31, 2013 if your tax year starts January 1, 2014.  Without a timely written policy, you can't elect the safe harbor, and asset purchases you choose to expense will be subject to challenge by the IRS, even if under the threshold amount.  The capitalization policy should refer to the dollar threshold amount, and also state whether property having an economic useful life of 12 months or less is also required to be expensed.

In brief, the requirements of the safe harbor election are as follows:

• A written capitalization policy statement is in place before the start of the tax year,
• The purchased items are actually expensed in the financial statements,
• The invoice total, or the cost of each asset purchased as itemized on the invoice, is equal to or less than $5,000 or $500 as applicable, and
• An election statement is made on a timely filed, original income tax return for each tax year.

The expensing ceiling is an all or nothing approach.  For example, if an item cost $5,001 (or $501 if no applicable financial statement), none of its cost can be expensed.

Social Security Benefits Increase for 2014

The Social Security Administration (SSA) announced a benefit increase of 1.5% for 2014.  Social Security benefits are indexed for inflation.  Average retirement benefits will increase by $19 a month to $1,294.  Fortunately, given the small increase, Medicare Part B premiums do not increase in 2014 and consume the increased benefit.

The inflation standard used by the SSA is CPI-W, the Consumer Price Index for Urban Wage Earners and Clerical Workers.  Notice that these are wage earners and there are no retirees in this index.  Retired persons spend more on health care, and those costs have been rising faster than overall inflation.  So over time, retirees who depend on Social Security benefits will suffer a lower standard of living because of the mismatch between the CPI-W and the cost of actual goods and services consumed by retired persons.  Furthermore, discussions for scaling back the cost of the Social Security program have considered replacing CPI-W with so-called “chained CPI.”  Chained CPI grows at a slower pace than CPI-W because it presumes that when prices increase, people will purchase less expensive items by substituting items of lesser quality.  If adopted, chained CPI will further erode retirees’ standard of living.  Therefore, it is imperative for people who wish for a comfortable retirement to save and invest for their future, rather than relying upon Social Security benefits to be the primary source of their retirement income.

Separately, the Social Security wage base, upon which the Social Security tax of 6.2% is imposed, rises from $113,700 in 2013 to $117,000 in 2014.  This is an increase of 2.9%.  The inflation increase for the taxable wage base uses a different index than CPI-W.  The 2014 increase is based upon the national average wage index for 2012 ($44,321.67) as related to the index for 1992 ($22,935.42), then multiplied by the 1994 Social Security wage base of $60,600.00.  The computation is as follows:  $44,321.67 / $22,935.42 X $60,600.00 = $117,106.78; rounded to the nearest multiple of $300.00 or $117,000.00.  See http://www.ssa.gov/oact/cola/cbbdet.html.

Medicare Open Enrollment Period Ends December 7, 2013

With the current confusion regarding health insurance marketplace exchanges, it is important for Americans turning age 65 to remember to enroll in Medicare.  Medicare is not purchased through the Affordable Care Act's individual exchanges, but rather with the Federal government at www.medicare.gov.

Your initial Medicare enrollment period begins three months before the month you turn age 65 and ends three months after the month you turn age 65.  If you are still working for an employer with 20 or more employees, and are covered by health insurance, you may delay enrollment until you stop working.  If you do not enroll on time, your Medicare premiums will be higher by 10% times the number of years you are late in signing up.

If you are already enrolled in Medicare, you do not need to re-enroll, nor do you have to worry about the ACA's health insurance exchanges.  However, during Medicare's annual open enrollment period, you can make changes your Medicare plans.  Medicare's open enrollment began on October 15, 2013 and ends on December 7, 2013.

Medicare is federal health insurance for those age 65 and older.  If you apply for Social Security benefits early, at age 62, it does not make Medicare available to you any earlier than age 65.  Medicare is a self-only policy and does not include family members.  There is no pre-existing condition exclusion.  Medicare insurance consists of several parts, and it is important to enroll in all of the parts for which you desire coverage.
 

·       Part A:  coverage for hospital stays, home health services, and hospice care.

·       Part B:  coverage for doctor services, outpatient care, and medical equipment.

·       Part C:  known as Medicare Advantage, are policies from insurance companies rather than from the Federal government, that provide Part A and B coverage, and often Part D.

·       Part D:  prescription drug coverage, offered through private stand-alone drug plans or by Medicare Advantage plans.

·       Medigap:  private supplemental insurance that covers many of traditional Medicare's (Parts A & B) out-of-pocket expenses.  Medigap is inappropriate for Medicare Advantage plans.

You are not charged premiums for Part A if you or your spouse are eligible for Social Security benefits, otherwise the premiums will be $426.00 per month in 2014.

Premiums are charged for Parts B and D.  The amount of the 2014 premiums vary and are based upon the amount of your adjusted gross income reported on your Federal income tax return for 2012, according to the following table.

If your yearly income in 2012 was			You pay Part B premiums in 2014 of	You pay Part D premiums in 2014 of
File individual tax return	File joint tax return	File married & separate tax return
$85,000 or less	$170,000 or less	$85,000 or less	$104.90	Your plan premium
above $85,000 up to $107,000	above $170,000 up to $214,000	Not applicable	$146.90	$12.10 + your plan premium
above $107,000 up to $160,000	above $214,000 up to $320,000	Not applicable	$209.80	$31.10 + your plan premium
above $160,000 up to $214,000	above $320,000 up to $428,000	above $85,000 and up to $129,000	$272.70	$50.20 + your plan premium
above $214,000	above $428,000	above $129,000	$335.70	$69.30 + your plan premium

Deducting HSA Contributions Made by Someone Else

A Health Savings Account (HSA) is a special financial account to which deductible contributions can be made.  The deduction is an adjustment to arrive at adjusted gross income (AGI), meaning that the account owner does not have to itemize deductions to claim the benefit.  HSA distributions used to pay medical expenses, or to reimburse medical expenses paid by the account owner, are not subject to income tax.  HSA payments of non-medical expenses are subject to income tax plus a 20% penalty.  If the account owner is 65 or older, the penalty disappears but non-qualifying payments remain taxable.

An HSA is only permitted when established in connection with high-deductible health insurance plans (HDHP).  An HDHP, which covers you but not your family, is a plan which has an annual deductible of at least $1,250 in 2013 or 2014, and limits total out-of-pocket expenses to $6,250 in 2013 and $6,350 in 2014.  In the case of family coverage, the plan must have an annual deductible of at least $2,500 in 2013 or 2014 and limit total out-of-pocket expenses to $12,500 in 2013 and $12,700 for 2014.

Contributions for a tax year may be made as late as April 15^th of the subsequent year.  Contributions may not exceed the following amounts: 

	2013	2014
Individual Plan	$3,250	$3,300
Family Plan	$6,450	$6,550
Age 55 catch-up	$1,000	$1,000

An interesting planning idea is that contributions to the account owner’s HSA can be made by anyone.  If a contribution is made by the employer, the contribution is excluded from wages.  If the contribution is made by a parent, the contribution is a gift to the child and the contribution is deductible by the child.  See IRS Publication 969, pages 2 & 4.  In the case of where parents might want to financially assist their children by paying modest amounts of out-of-pocket medical expenses, the parent should consider making a contribution to their child’s HSA instead of directly paying the medical expense.  The child can then use the HSA money to pay the expense.  This enables the child to receive an income tax deduction that would otherwise go to waste if the parent paid the medical expense directly to the service provider.  Reducing the child’s AGI could also open up other tax benefits that are limited by the amount of AGI.

 

This planning idea applies to the following fact pattern:  the child has an HSA in connection with a HDHP, the child is not a tax dependent of the parent, the amount of medical expense to be paid is modest and fits within the parent’s gift tax annual exclusion amount (whereas the direct payment of medical expenses is not counted as a gift for gift tax purposes), and the gift to the HSA, when aggregated with all other contributions, does not exceed the HSA maximum for the year.

Looming Change to Section 179 Expensing Amounts

Under current tax law, certain purchases of new or used property may be “expensed” for income tax purposes under Section 179 of the tax code, in the year of purchase, instead of being depreciated over a number of years.  The amount that taxpayers can expense is currently $500,000 for tax years beginning in 2013.  After 2013 the amount drops to $25,000.  The expensing limit is reduced dollar for dollar as total eligible Section 179 property purchases during the year exceed $2 million.  After 2014 the beginning of the phase-out starts at only $200,000. 

In addition to changes in these limits, the provisions permitting Section 179 to apply to the cost of qualified leasehold improvements, qualified restaurant improvements, new restaurant buildings, qualified retail improvements, and to off-the-shelf computer software will no longer apply in years beginning after 2013. 

While considering year-end business tax planning, you should take note of these changes.  There is a chance that Congress will restore the higher limits for years after 2013, but nothing is certain about what Congress will do. 

Fiscal-year partnerships, limited liability companies, and S corporations (known as “pass-through entities” because their owners pay the tax on company profits) should be careful of a potential trap that could waste part of their Section 179 expensing election.  For fiscal years beginning in 2013, the full amount of the expensing limits is available.  However, since Section 179 deductions of pass-through entities are allocated to owners in the calendar year in which the fiscal year ends (by Schedule K-1), the owners must contend with 2014 limitations.  For example, assume an S corporation whose fiscal year starts November 1, 2013, elects to expense $200,000 of equipment under Section 179.  Assume further that the S corporation is owned by two 50% owners.  The tax result is that only $50,000 of the $200,000 expense is deductible ($25,000 for each owner).  The excess $150,000 is lost!  In this case, the S corporation should wait to make the Section 179 election on its tax return until it learns of any potential tax law extensions.  If the law isn’t extended, then the S corporation should elect to expense only $50,000 and depreciate the balance of the cost to avoid wasting any deductions.

Same-Gender Married Couples in Utah May Now File Joint Income Tax Returns

This is an update to my original blog post on this subject.
A U.S. federal district judge ruled on December 20, 2013, that Utah's constitutional ban on same-sex marriage violates the U.S. constitution.  About 1,400 gay couples rushed to get married in Utah before the U.S. Supreme Court issued a stay on the district judge's ruling on January 6, 2014, pending an appeal.  The Utah governor announced that the state would not recognize the gay marriages performed during this brief time period, pending an appeal.  The Obama administration announced that the federal government would recognize these marriages.  To address the confusion of whether 2013 Utah income tax returns could be filed using a joint status, the Utah State Tax Commission issued an announcement on January 15, 2014 that reverses its earlier guidance referenced below.

Same-sex couples who are eligible to file a joint federal income tax return and who elect to file jointly, may also file a joint 2013 Utah individual income tax return.  Note that this announcement applies more broadly than to just those marrying in Utah in late December 2013.  It also appears to apply to couples legally married in other states.  Eligible married couples may file a joint return if they are married as of December 31, 2013.  The notice is expressly limited to the 2013 tax year.  It also mentions the possibility that taxpayers may be required to amend their 2013 tax return depending upon future court rulings.

Previously it was announced:
On October 9, 2013, the Utah State Tax Commission released a notice stating that same-sex couples in Utah must file a Utah income tax return with a filing status of single or head of household.  This guidance comes in light of an IRS ruling (Rev. Rul. 2013-17) that same-sex couples may file a joint Federal income tax return, no matter where they live, if their marriage is legally recognized in the state in which the marriage ceremony was performed.  Utah does not recognize same-sex marriages.  Those who are impacted by this notice must provide the same Federal income tax information on the Utah tax return that the taxpayer would have provided prior to the IRS ruling.  This means that another Federal income tax return must be prepared only for Utah tax purposes, using either a single (not married filing separately) or a head of household status.

Utah Health Insurance Marketplace Exchange

In Utah, the health insurance marketplace exchange is bifurcated in two.  The Federal government runs the individual exchange and the State government runs the small business exchange.  The Individual and Family Exchange is accessed at www.HealthCare.gov.  Select “Get Insurance” and then “Individuals & Families.”  Next choose Utah from the drop-down box.  The website won’t become active until October 1, 2013, but you can gather some general information at this point.  The individual mandate to have health insurance coverage or else pay a penalty begins January 1, 2014.

Because of the complexity in figuring out how to purchase health insurance on the exchange, and in determining whether financial subsidies apply for purchasing insurance, the Affordable Care Act created the concept of “navigators” to help with the application process.  Such assistance is particularly needed by those who haven’t had health insurance in the past.  The term “navigators” appears to have recently been changed to “marketplace assisters.”  Find help from navigators at https://localhelp.healthcare.gov/.  

The Utah small business exchange is called Avenue H and is accessed at www.avenueh.com.  The website is currently active.  A small business is one with 2 to 50 employees.  Avenue H provides a unique way for an employer to provide health insurance to its employees.  Rather than the employer purchasing a group plan for the employees, Avenue H is a “defined contribution” type of plan.  The employer provides a set amount of money that the employee controls and uses to purchase their choice of health insurance.  Employees can compare plans and premiums from different providers and apply for coverage online.  See the website for more details. 

The next several weeks and months will bring many changes into the health insurance marketplace.  In addition to the websites listed above, the IRS has a web page devoted to the Affordable Care Act at www.irs.gov/uac/Affordable-Care-Act-Tax-Provisions-Home.

Employer Notice Required by October 1, 2013, Regarding Health Insurance Marketplaces (Exchanges)

One of the key provisions of the Affordable Care Act (Obamacare) is the establishment of health insurance marketplace exchanges.  As originally contemplated, the States would each establish their own exchange.  But, the U.S. Supreme Court ruled that the Federal government couldn’t punish States that chose not to establish exchanges by withholding Federal Medicaid cost sharing payments.  Following the ruling, many States chose not to set up state-run exchanges.  The Federal government will establish and run exchanges in those States.  The government has recently been using the term “health insurance marketplaces” in place of the original term, “exchanges.”  The marketplaces are supposed to be up and running October 1, 2013 with policies beginning coverage as early as January 1, 2014. 

The ACA requires employers to give notice to all of their employees about the existence of marketplaces in their states.  All employees must be given the written notice regardless of health insurance plan enrollment status (if applicable) or of part‐time or full-time employment status.  The notice must be given to new employees within 14 days of starting work.  The notice is required even though an employer might not be a “large” employer subject to the employer health insurance mandate now postponed to 2015.  The notice requirement applies to employers subject to the Fair Labor Standards Act. 

If employees are not offered affordable, “bronze-level” health insurance benefits, they may go to the marketplaces to purchase health insurance.  Employees with household income of up to 400% of the Federal poverty level may receive tax subsidies to offset the cost of premiums.  The government is requiring employers to educate their employees about the marketplaces. 

The government has provided two model notices at www.dol.gov/ebsa/healthreform/.  You must select the proper notice.  The proper notice depends upon whether or not you, as the employer, currently offer health insurance to your employees.  The model notice is provided in “Word document” format so that you can complete it for your business. 

There is no financial penalty if you fail to provide the required notice in a timely manner.  Quoting from the DOL website at http://www.dol.gov/ebsa/faqs/faq-noticeofcoverageoptions.html,   “Q: Can an employer be fined for failing to provide employees with notice about the Affordable Care Act's new Health Insurance Marketplace?  A: No. If your company is covered by the Fair Labor Standards Act, it should provide a written notice to its employees about the Health Insurance Marketplace by October 1, 2013, but there is no fine or penalty under the law for failing to provide the notice.”

Avoiding Tax Problems with Shareholder—Corporation Loans

Owners of closely-held corporations will often either borrow money from the corporation or lend money to it.  Many times these arrangements are informal and not carefully documented.  In such cases it can appear as though the corporation’s bank account is functioning as if it were another personal account of the shareholder or vice versa.  These loose arrangements are problematic from an income tax point of view because the corporation and the shareholder are treated as distinct persons for tax purposes.

Poorly documented amounts borrowed from a corporation may be deemed instead by the IRS as a distribution.  For a C corporation, a deemed distribution is a dividend taxable to the shareholder and not deductible to the corporation.  For an S corporation, a deemed distribution may give rise to a potential second class of stock problem that could invalidate the S election, or perhaps the IRS might treat the deemed distribution as compensation subject to payroll taxes normally avoided by true S corporation distributions.

On the other hand, poorly documented amounts loaned to the corporation may be deemed instead by the IRS as a contribution to shareholder capital.  A contribution of capital cannot be repaid to the shareholder like a loan can be.  Instead repayments are treated as distributions to the shareholder with the applicable treatment depending upon the classification of the corporation.

In order to avoid these kinds of problems with shareholder—corporation loans, be sure to observe the following factors that have been considered by the courts when ruling on disputes between taxpayers and the IRS.  The main factor in determining whether the transaction is a loan for tax purposes is whether the parties intend for the money to be repaid.  Such intention should be contemporaneously evidenced as follows.

1.       Is there a promissory note or other written obligation promising repayment?

2.       Is adequate interest being charged?

3.       Has a fixed schedule for repayment and maturity date been established?

4.       Has collateral been given to secure repayment?

5.       Have repayments actually been made?

6.       Is there a reasonable prospect that the borrower can repay the loan?

Another factor to consider is this:  if the shareholder does not respect the separate existence and legal form of the corporation, will the corporate “veil” of limited liability be pierced if there is a third-party lawsuit, putting the shareholder’s personal assets at risk?