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.