Are You Ready for Tax Armageddon?

Armageddon appears once in the Bible and relates to the final conclusive battle between the forces of good and evil.  The word, Armageddon, has also become a general term that denotes any disastrous "end of the world" event.  With the looming tax law changes, the popular press has coined a new phrase, "Tax Armageddon" or "Taxmageddon" for short.  Assuming that the world survives the end of the Mayan calendar on December 21, 2012, then we face the largest tax increase in history on January 1, 2013!  The tax increase is estimated to be $500 billion for 2013 alone.  However, even this historic tax increase won't pay for half of the projected Fiscal 2012 budget deficit of $1.3 trillion!  To pile on, the federal debt ceiling will likely be reached around this same time.  To pile even higher, the failure of the "super committee" last fall requires $1 trillion in spending cuts over 10 years, beginning January 1, 2013, divided half between military and social spending.  This nation truly has severe budgetary problems, and failure to solve these problems is the true Armageddon that must be avoided.

Just what taxes are increasing and what can you do about them?  This post outlines the major categories of tax increases.  Future articles will explore the increases in more detail and outline available planning opportunities.  We expect that Congress may act to prevent some of these increases, but what can we really count on from Congress?

1. The so-called Bush tax cuts of 2001 and 2003, originally set to expire at the end of 2010 are now set to expire at the end of 2012.  Significant cuts included the lowering of all of the ordinary tax rates, including the top rate from 39.6% to 35.0%.  The top long-term capital gain rate was cut from 20% to 15% and the qualified dividend rate cut from 39.6% to 15.0%.  In addition, a host of other cuts were made including eliminating the loss of itemized deductions and personal exemptions based upon income levels, increasing a variety of personal and education tax credits, and reducing the so-called marriage tax penalty.
2. The exemption from estate and gift tax in 2012 is $5.12 million.  The exemption declines to $1.0 million in 2013.  In addition, the top estate and gift tax rate increases from 35% to 55%.
3. The alternative minimum tax exemption amount declined from $74,450 and $48,450 for joint and single filers in 2011 to $45,000 and $33,750 in 2012.  This decline will increase taxes on 30 million taxpayers unless the exemption is once again "patched" with a new temporary increase.
4. The employee portion of the Social Security tax was reduced from 6.2% to 4.2% for 2012.  The rate will revert to 6.2% in 2013.
5. Business 100% bonus depreciation on the purchase of new equipment in 2011 declined to 50% in 2012 and then is eliminated in 2013.
6. New Medicare taxes are imposed on compensation and investment earnings in 2013 as part of the so-called Obamacare tax provisions.  Compensation above certain thresholds will suffer an extra 0.9% tax.  Investment income of taxpayers having modified adjusted gross income above certain thresholds will, for the first time, be subject to Medicare tax, at a rate of 3.8%.  The U.S. Supreme Court is expected to issue its ruling on the constitutionality of the Affordable Care Act by the end of June 2012.  Whether this ruling will impact the Medicare tax increase remains to be seen.

Understanding Tax Issues of Employee Expense Reimbursement Plans

Employers will generally reimburse or provide advances to cover ordinary and necessary business expenses incurred by their employees for travel, meals, and entertainment.  Specific tax rules, including time limits, must be observed to avoid income tax pitfalls.  There are two tax categories of expense reimbursement plans:  accountable (tax favorable) and nonaccountable (tax unfavorable).

For an accountable plan, the employee must timely document the expenses to the employer and also timely return any excess reimbursement or advance to the employer.  The time requirements are as follows:

1. The employer may not provide an advance more than 30 days before the time the employee will incur the expense.
2. The employee must provide adequate documentation of expenses within 60 days after the expense was paid or incurred.
3. The employee must return any excess reimbursement within 120 days after the expense was paid or incurred.
4. If the employer gives periodic statements (at least quarterly) to the employee asking for an accounting of the expenses and a return of any excess reimbursement, then employee must comply within 120 days of the date of the statement.

The tax benefit of an accountable plan is that the expense reimbursement is not treated as taxable wages.

In lieu of actual expenses, per diem amounts for lodging and meals and incidental expenses, and mileage rates for driving a personal car for business may be used.  As long as the amounts do not exceed the rates published by the IRS, and the employee otherwise provides documentation, the employee is deemed to have met the accountable plan rules and any excess does not need to be returned to the employer.  See IRS Publication 1542 for per diems rates.  The business mileage rate for 2012 is 55.5 cents per mile.

A nonaccountable plan is an arrangement that does not meet the rules for an accountable plan.  Also, if the employee does not comply with the time requirements, then the expense reimbursements are treated as though paid under a nonaccountable plan.  The amounts paid under a nonaccountable plan are treated as regular taxable wages, subject to income and payroll tax withholdings, and are reported on Form W-2.  The employee may then deduct the business expenses, but they are miscellaneous itemized deductions.  Miscellaneous itemized deductions only provide tax savings to the extent the total exceeds 2% of adjusted gross income, if the employee has itemized deductions in excess of the standard deduction, and if the employee is not subject to the alternative minimum tax!  There are a lot of hurdles for an employee to clear to receive a tax deduction for business deductions under a nonaccountable plan, so it is advisable for the employee to comply with the accountable plan rules to avoid very negative tax results.

Observations from Tax Season

"Tax season" ended last week for 2011 income tax returns.  This season seemed particularly painful given the expanded reported requirements for sales of investments and the delay in receiving Forms 1099 from financial institutions.  Some of the tax returns also held surprises for some taxpayers.  Here are a few observations that may be of benefit to you.

1. A windfall of additional income does not belong 100% to you.  The government is your partner in every dollar you earn.  You cannot spend the extra income without first providing for income taxes or you may find that the money left over not sufficient to pay your partner!  If you are in the top Federal and Utah brackets, for 2012 the government will be at least a 40.0% to 42.9% partner.  In 2013, the government demands an even larger share, 48.4%.
2. Your choice of investments can greatly complicate your income tax return.  Although income taxes should not be the primary factor in choosing suitable investments, you should be aware of the tax reporting implications of those choices, which can add to the costs of preparation and delay the timing of when the tax return can be completed.
   
   For example, with the sharp decline in interest rates over the past several years, purchasing Treasury notes and CD's on the market rather than at original issue will result in the payment of premiums and accrued interest.  The financial institution's Form 1099 will report to the IRS the amount interest income earned according to the stated coupon rate, which greatly overstates the actual economic interest earned.  Tax elections and complicated calculations for premium amortizations and accrued interest adjustments are necessary to avoid overpaying tax.
   
   Another example relates to investments that are bought and sold by investment advisors as if the investment were shares of stock, but the investment is actually a tax partnership.  As an owner of a partnership you will receive a Schedule K-1 rather than a Form 1099 for the investment income or loss.  Tax partnerships are complicated!  Many times the K-1s are not even provided until September, requiring a six-month extension of your tax return.  Some of the partnerships invest in foreign entities that require expanded disclosures in your tax return.  Others hold property in a variety of other states that may require you to file tax returns in those states.  All of these consequences bring delays and added costs.  Therefore, an investment structured as a tax partnership should be a conscious choice because of its unique investment opportunities not otherwise available.
3. Tax planning beyond 2012 is difficult because of tax law uncertainty.  We know what most of the rules are for 2012.  We know what the tax laws are scheduled to be in 2013.  But we don't know what the outcome of the national elections will be this fall, and we certainly don't know what our elected politicians will do about the dramatic fiscal, debt, and tax problems this country is facing.  In the face of uncertainty, it is wise to be conservative and to use the tax benefits currently available.  Three of the most important benefits that are scheduled to disappear after 2012 are:  (1) the 15% Federal long-term capital gain tax rate, (2) the 35% top ordinary tax rate, and (3) the $5.12 million gift tax exemption amount.  You should plan to use these benefits where they fit into your overall financial and estate plan.  Consultations with your tax advisor this summer and again after the elections may prove particularly valuable this year.

Utah Business Personal Property Tax

Counties in the State of Utah impose a tax on tangible personal property used in a business.  "Personal property" means everything that is not treated as "real property" as opposed to personal-use property.  Examples of personal property include equipment, furniture, supplies, etc. and examples of real property include land and building.  The tax is imposed as of January 1st of each year based upon the location and status of property on that date.  The tax return is generally due in March of each year.  Many counties offer online filing of personal property tax returns.  For example, the Salt Lake County online filing site is located at www.assessor.slco.org/ppfile/.

Personal property tax is assessed against values that are based upon a combination of the acquisition cost and the "percent good" factor found in a published table.  The percent good factor is developed from IRS economic life estimates assuming straight-line depreciation to a residual value.  Depreciation of value is different from financial or tax depreciation.  Property that is fully depreciated for accounting or tax purposes but still used in the business is taxable and must be reported.  Leased personal property is generally assessed to the lessor, except for conditional sales agreements that are taxed to the lessee.  Personally owned items used in the business are taxable.

All tangible personal property used in the business is taxable unless exempted.  The following are exempt from personal property tax:

1. Personal property with a total aggregate fair market value of $4,000 in 2013 ($3,900 in 2012) or less per taxpayer within a single county.
2. An item of expensed personal property having an acquisition cost of $1,000 or less and having a percent good of 15% or less.
3. Inventory held for resale in the normal course of business.
4. Farm equipment and machinery used primarily for agricultural production.
5. Livestock.
6. Household furnishing.
7. Intangible personal property.
8. Personal property used for irrigation purposes.

Complex Regulations on Deducting or Capitalizing Repairs Now in Effect

As if constantly changing tax laws weren't complex enough, the IRS has also been issuing new forms, rulings, and regulations.  On December 23, 2011, temporary regulations were issued changing the tax rules (effective for tax years beginning on or after January 1, 2012) regarding whether costs incurred for tangible property must be capitalized as an asset or may be expensed as a repair.  Since all businesses own or lease tangible property, all businesses are affected by these regulations.  In some cases, businesses will need to change their method of tax accounting to comply with the new regulations.  Changing a tax accounting method is complex and often involves a cumulative adjustment to taxable income to change from the effects of the prior method.

The length and complexity of the regulations prohibit a full analysis.  Some of the highlights are:

1. New rules are set forth for deducting or capitalizing materials and supplies.
2. Several methods of accounting are provided for rotable and temporary spare parts.
3. Rules are provided for moving and reinstalling property.
4. To determine whether a cost incurred for property is an "improvement" requiring capitalization, it is necessary to refer to what is called a "unit of property."  A "unit of property" is somewhat subjective as demonstrated by numerous examples in the regulations.  Generally, the larger the unit of property the more likely the cost can be deducted as a repair.
5. For buildings, the IRS has identified eight component systems as "units of property" making improvements to these components (e.g., HVAC, plumbing, electricity, elevators, etc.) more likely to be capital expenditures (requiring lengthy depreciation) rather than repairs (permitting current deductions).
6. Leasehold improvements are a separate unit of property.
7. For machinery and equipment, a unit of property is one that performs a discrete and major function or operation.
8. While a "unit of property" is considered in accounting for repairs or improvements, the concept is not used for purposes of determining the property's depreciation period.
9. Improvements are required to be capitalized.  An improvement means that a unit of property has been bettered.  For example, a material defect prior to acquisition has been fixed, a material addition has been added, capacity has been increased, the unit of property has been restored, or the unit of property has been adapted to a new or different use.
10. Routine maintenance such as cleaning, testing, and reasonable replacement of parts is not considered an improvement and may be deducted as a repair.
11. The retirement of a structural component of a building may now be treated as a disposition separate from the overall building and a loss claimed for the adjusted tax basis.

The complexity and cost of complying with these regulations just to determine whether an expenditure is a repair or is a capital asset certainly won't make American business any more competitive in the global marketplace.  Taxpayers have been making these decisions for decades, and now the IRS comes along with new rules changing long-held accounting practices.  The increased intrusion of government regulators into normal business accounting practices drives up the cost of business.  These rules are currently in effect and must be dealt with in your accounting systems.

Proposal Would Dramatically Change Rules for Inherited IRAs

On February 7th, Max Baucus, the Senate Finance Committee Chairman, proposed dramatic changes to the distribution rules for beneficiaries of inherited IRAs, 401(k)'s, and other qualified plan accounts (all termed "IRAs" in this post), for deaths after 2012.  The proposal raises $4.6 billion over 10 years and is part of a highway funding bill.  The change would require beneficiaries to completely distribute the inherited accounts within five years.  Exceptions would be provided for certain beneficiaries:  disabled or chronically ill individuals, surviving spouses, children who had not attained the age of majority, and beneficiaries who are not more than 10 years younger than the deceased account owner.  Once these beneficiaries die, the five-year rule applies to their beneficiaries.  Furthermore, when a beneficiary-child reaches the age of majority, the five-year rule commences.  Senator Baucus justifies his proposal by stating that IRAs are intended for retirement, but some taxpayers are using them to give tax-free benefits to second, third, and maybe fourth generations.  He further stated that if this proposal doesn't pass now, perhaps it will as part of tax reform.

Current rules permit beneficiaries to stretch-out distributions from inherited IRAs over their life expectancies.  The younger the beneficiary, the longer the stretch-out period.  In the early years, the IRA can continue to grow in value as the required distribution amounts will generally be less than the IRA earnings.  Distributions from traditional IRAs are subject to income tax.  A 50% penalty applies to any shortfall in the required minimum distribution amount.  Accelerating the required distribution amounts eliminates the financial benefits of compounding IRA earnings on a tax-deferred basis.  The proposed change will have a major detrimental financial impact upon families that have used retirement accounts to save for the future.  Larger required distributions will likely cause the beneficiary to pay income tax on the benefits at a higher tax rate, and will tempt beneficiaries to spend their inheritances instead of preserving the IRA benefits for their own retirements.  Furthermore, once the assets are outside of the IRA, the beneficiary loses whatever asset protection benefits were afforded by the IRA.

The proposed change goes even further and can apply to IRA accounts of owners who have died or will die before 2013.  Once the primary IRA beneficiary (who may use the current stretch-out rules) dies, those who succeed to the primary beneficiary's benefits will be subject to the new five-year payout rule!

Many commentators do not believe this proposal will become law at this time.  If it does become law, proactive planning will be necessary to reduce the resulting financial loss on families.  This proposal will upend the financial planning of many families, and seems to be a short-sighted grab for tax revenue to fund one-time government expenditures.

Voluntary Offshore Disclosure Program, Round Three

The IRS has had a major focus on finding and penalizing taxpayers who have foreign financial accounts and who have not made proper disclosure of those accounts and have not paid U.S. income tax on earnings in those accounts.  Two temporary, voluntary disclosure programs in 2009 and 2011 were established to encourage delinquent taxpayers to come forward and clear up the matter.  About 33,000 disclosures were made and $4.4 billion was collected.  The new program started in January 2012 and has no end date.  However, the IRS cautions that it could end or modify the program at any time, and so taxpayers should come forward expeditiously.  The IRS also warns of severe civil (criminal penalties are also a possibility) penalties if they find a taxpayer with delinquent foreign accounts before such taxpayer makes a voluntary disclosure.  The IRS also states that "quiet disclosures," whereby taxpayers amend past tax returns to disclose foreign financial accounts and pay back taxes, will not avoid the full extent of penalties that the IRS will assert if the quiet disclosure is discovered.  Taxpayers must come under the new voluntary disclosure program to reduce penalties.

The new program is not inexpensive.  The program requires up to eight years of corrected back tax returns, with added taxes, interest, and the addition of the accuracy-related and/or delinquency penalty.  In addition, the taxpayer must pay a penalty of 27.5% of the highest aggregate balance in foreign financial accounts during the eight full years prior to the date of disclosure.  This is an increase from the 25% penalty under the 2011 program.  The penalty might be reduced to 12.5% if foreign accounts and assets total $75,000 or less.  There is also a penalty reduction to 5% for certain restrictive situations.

Taxpayers who have yet to make full disclosure of their foreign accounts and to pay U.S. income tax on foreign earnings should use this program to come clean.  The risks of coming clean with quiet disclosure in order to avoid the settlement penalties are too high.  More information about the program can be found on the IRS website at http://www.irs.gov/newsroom/article/0,,id=252162,00.html.