New Obama Budget Proposal Includes Old Tax Increases and Some Surprises

Pres. Obama released his fiscal year 2015 budget proposal on March 4, 2014.  Most commentators view the proposal as a political document designed for the elections this fall.  Nevertheless, some tax proposals have a way of finding themselves law in the future and so it is important to be aware of the proposals.

The following tax increases are proposed:

·       Increase IRS funding by 6.3% to increase the number of tax audits.

·       Reduce the tax rate benefit of itemized deductions to 28% (which impacts taxpayers paying tax at the higher 33%, 35%, and 39.6% rates).

·       Implement the so-called “Buffett Rule” to require millionaires to pay no less than a flat 30% tax on income after the deduction of charitable contributions.

·       Prevent individuals from saving additional money in tax-preferred retirement accounts once their accumulated balances exceed roughly $3.2 million per person.

·       Require non-spouse beneficiaries of IRAs and qualified plans and annuities to fully distribute the inherited account by the end of the fifth year.
·       Require Roth IRAs to make lifetime minimum required distributions when the account owner turns age 70 1/2 (currently only Roth 401(k) accounts are required to make lifetime MRDs).

·       Increase the estate, gift, and generation skipping tax (GST) rate from 40% to 45%.

·       Lower the estate tax and GST exemptions from $5.34 million to $3.5 million.

·       Lower the gift tax exemption from $5.34 million to $1.0 million.

·       Require grantor-retained annuity trusts (GRATs) to have a minimum 10-year term and to have a remainder value greater than zero.

·       Eliminate the benefits of sales to “defective” grantor trusts by coordinating the income tax rules with the transfer tax rules.

·       Limit the duration of the exemption from GST tax to 90 years for “dynasty” trusts created after the date of enactment.

·       Eliminate the unlimited number of permitted annual gift tax exclusions for gifts of present interests of $14,000 in favor of a flat $50,000 per donor for all gifts.

·       Require professional service business profits to be subject to Social Security and Medicare taxes regardless of whether the business is conducted through an S corporation, an LLC, or a limited partnership.

·       Repeal the last-in, first-out (LIFO) method of inventory tax accounting.

·       Limit the amount of real estate like-kind exchange gain that can be deferred to $1 million per taxpayer per year after 2014.

·       Tax “carried interests” (partnership or LLC profits interests) as ordinary income instead of long-term capital gain.

·       Eliminate the specific identification method and require the average cost method for identifying the cost basis of stocks purchased after 2014.

Several new tax-cut proposals are proposed:

·       Permanently increase the Section 179 equipment expensing limit from $25,000 to $500,000.

·       Permanently extend the research and experimentation tax credit (expired after 2013).

·       Permanently increase the exclusion for qualified small business stock to 100%, and extend the time for tax free reinvestment from 60 days to 6 months for stock held for more than 3 years.

·       Make the expanded American Opportunity Tax Credit for college costs permanent.  It is currently scheduled to revert to the lower credit amount after 2017.

·       Allow non-spouse beneficiaries of IRAs and qualified plans to rollover the inherited balances within 60 days (presently only spouse beneficiaries can do so).

·       Eliminate required minimum distributions for those who attain age 70 ½ if the IRA balance is $100,000 or less.

·       Establish the MyRA savings bond announced in the state of the union address.

New One-Year Delay of the Health Insurance Mandate for Midsized Employers

On February 10, 2014, the IRS announced that employers with 50 to 99 full-time employees (counting “equivalents”) may wait until January 1, 2016 to comply with the requirement for “large” employers to offer affordable, minimum essential health insurance coverage to their full-time employees.  The start of the employer mandate was previously delayed from January 1, 2014 to January 1, 2015.  With this announcement, there are three categories of employers: 

1.     Small employers with less than 50 FTEQs, not subject to the mandate,

2.     Midsize employers with 50 but less than 100 FTEQs, subject to the mandate beginning January 1, 2016, and

3.     Large employers with 100 or more FTEQs, subject to the mandate beginning January 1, 2015.

To qualify for the delay, the IRS says that employers must not reduce their workforce or hours of service in order to qualify and they must maintain their previously offered health insurance.

For large employers, new regulations phase-in the percentage of full-time employees that must be offered affordable, minimum essential health insurance.  For 2015, at least 70% must be offered insurance.  The percentage rises to 95% in 2016 and beyond.

Distributions from a Grandparent or 3rd Party Owned College Savings 529 Plan May Negatively Impact Student College Aid Eligibility

With rising tuition costs, 529 plans have become a popular way for family members to help fund a student’s college education.  However, distributions from such plans may actually decrease a student’s eligibility for federal financial aid.

When a student applies for federal aid, he or she must fill out the Free Application for Federal Student Aid (FAFSA). Eligibility is determined based on the assets and income of a student and their parents, with income being more heavily weighted.  Although, 529 plans owned by grandparents or other third parties, such as aunts or uncles, are not included as assets for FAFSA purposes, any qualified distributions to the student is counted as untaxed income received by the student, thereby decreasing the student’s federal aid eligibility.

Below is a reproduction of a chart created by Mark Kantrowitz (see his article here) that shows the treatment of 529 plan funds for FAFSA purposes:

529 Plan Owner	Treatment of Asset	Treatment of Qualified Distributions	Treatment of Non-Qualified Distributions
Dependent Student	Parent Asset	Ignored	Taxable Income to Beneficiary
Parent of Dependent Student	Parent Asset	Ignored	Taxable Income to Beneficiary
Independent Student	Student Asset	Ignored	Taxable Income to Beneficiary
Grandparent, Noncustodial Parent or other third party	Ignored	Untaxed Income to Beneficiary	Taxable Income to Beneficiary

Strategies

Funds from plans owned by the student’s parents should be used first, and funds from the grandparent owned 529 should be reserved until the student’s final year of college when the student will no longer be applying for future aid.  Since eligibility is based on the previous year’s income and assets, funds used for a student’s final year of college will not negatively impact a student’s eligibility for aid.  Those funds can also be used after graduation to pay off student loans.  Delaying distributions from the grandparent’s 529 plan will not only avoid requiring the student to report additional income, but using the parent’s 529 plan first will result in lower assets being reported in subsequent years, which may increase federal aid for a student’s sophomore or junior year of college.

Some states allow 529 plan funds to be transferred from one plan to another.  If grandparents or other relatives have 529 plans, they can transfer those funds to a plan owned by the parent. The assets of the plan would still be counted in the financial aid calculation, but distributions from the 529 plan would not be counted as income to the student.  The state of Utah allows a transfer between plans, however, such transfers may not be eligible for state income tax benefits and any tax credits or deductions previously claimed must be recaptured. 

Unpleasant Surprises are in Store for Many 2013 Tax Return Filers

Taxpayers are currently obtaining their 2013 tax information and organizing their financial data this month.  Many taxpayers are vaguely aware of the major tax increases that took effect a year ago.  But for higher income taxpayers, the reality of writing larger checks to the U.S. Treasury won’t hit until their tax returns are completed over the next two months.  Listed below are the various ways your taxes will increase for 2013 and for future tax years.  These increases underscore the need for year-round tax planning.

·       The top ordinary income tax rate is now 39.6% instead of 35.0%.  The new tax rate bracket begins when taxable income exceeds $450,000 for joint; $400,000 for single; $425,000 for head of household; and $225,000 for married filing separately statuses.  These thresholds are indexed for future inflation.

·       The top long-term capital gain tax rate is now 20% instead of 15%.  The new tax rate begins when taxable income exceeds $450,000 for joint; $400,000 for single; $425,000 for head of household; and $225,000 for married filing separately statuses.  These thresholds are indexed for future inflation.

·       A brand new income tax of 3.8% is imposed upon net investment income.  This complicated new tax was enacted as part of the Affordable Care Act (Obamacare).  Investment income is defined broadly for this purpose and includes the business income of pass-through entity owners who do not materially participate in the business.  The tax applies to individuals having modified adjusted gross income over $250,000 for joint; $200,000 for single; $200,000 for head of household; and $125,000 for married filing separately statuses.  These thresholds are NOT indexed for future inflation.
In addition, this new tax applies to income tax returns of estates and trusts when adjusted gross income exceeds the start of the top income tax bracket for estates and trusts, which is only $11,950 in 2013.  Unlike for individuals, this threshold is indexed for future inflation.

·       Itemized deductions are reduced by a percentage of AGI.  The amount of the reduction is 3% of the excess of adjusted gross income over $300,000 for joint; $250,000 for single; $275,000 for head of household; and $150,000 for married filing separately statuses.  These thresholds are indexed for future inflation.  The effect of the loss of itemized deductions is equivalent to an increased income tax rate of 1.2%.

·       Personal exemptions are reduced by a percentage of AGI.  The total amount of personal exemptions are reduced by 2% for each $2,500 (or portion thereof) by which adjusted gross income exceeds $300,000 for joint; $250,000 for single; $275,000 for head of household; and $150,000 for married filing separately statuses.  Personal exemptions are totally phased out once AGI exceeds these thresholds by $122,501.  These thresholds are indexed for future inflation.  During the phase-out range, the effective marginal tax rate increase is roughly one percentage point per exemption.

·       Medicare tax rate increases 0.9 percentage points.  Taxpayers having wages and self-employment income above certain thresholds will be assessed an additional Medicare tax on their income tax returns.  Employers are only required to withhold the extra tax when compensation exceeds $200,000.  Because the extra tax applies on a combined basis for joint return filers, insufficient tax will have been withheld on dual income couples.  The threshold amounts are 250,000 for joint; $200,000 for single; $200,000 for head of household; and $125,000 for married filing separately statuses.  These thresholds are NOT indexed for future inflation.

Extension for Small Estates to Elect Portability

The IRS just released Revenue Procedure 2014-18 outlining a procedure for certain eligible small estates of persons who died before 2014, and who had a surviving spouse, to obtain an automatic extension of time to elect “portability.”  Portability was added to the law for deaths after 2010.  Portability allows the surviving spouse to elect to add the deceased spouse’s unused estate tax exclusion (DSUE) amount to his or her own estate and gift tax exemption amounts.  The election is made by filing Form 706, the estate tax return.  In some cases, administrators of small estates have had a difficult decision to make, whether to incur the costs of filing an estate tax return when it wasn’t otherwise necessary, simply to make the portability election.  This new procedure gives administrators a fresh start and the ability to examine the issue again, as long as the estate return is filed by the end of 2014.

For example, assume husband died in 2011 having a gross estate of $2 million and that the assets were left to a credit shelter trust under his estate plan.  His DSUE is $3 million.  Assume the surviving spouse also had a gross estate of $2 million.  Since the surviving spouse’s estate is way under the $5 million exemption, and the exemption is indexed for inflation going forward, does it make sense to incur the costs (which could start at $5,000 at the low end) of filing an estate tax return to make the portability election?  On the other hand, if the husband’s assets were all left to the surviving spouse, then the gross estate of the surviving spouse would be $4 million and the husband’s DSUE would be $5 million.  In this case, it would be reasonable to assume that the surviving spouse’s estate could grow and exceed the future estate tax exemption amount, and so the portability election would be desirable.  Note, that there are many other factors that must be considered before deciding whether or not to make the portability election.  These factors are not discussed in this article.

A small estate is one where the value of the gross estate (plus adjusted taxable gifts) is less than the Form 706 filing threshold amount.  The portability election is made by filing the Form 706 estate tax return.  Form 706 is due nine months following the date of death.  A six-month extension can be obtained if the extension request is filed by the original due date.

Before this revenue procedure, the estate administrator had to apply to the IRS under Treas. Reg. §301.9100-3 to obtain late filing relief in order to file a late estate tax return to make the portability election.  The application had to establish to IRS's satisfaction that the estate acted reasonably and in good faith and that granting relief would not prejudice the interests of the government.

This revenue procedure now grants an automatic extension for a late estate tax return filed to make the portability election if all of the following criteria are met:

1.     The decedent: (a) had a surviving spouse, (b) died after 2010 but before 2014, and (c) was a citizen or resident of the United States on the date of death.

2.     The estate wasn’t required to file an estate tax return because the gross estate (plus adjusted taxable gifts) was under the filing threshold.  The relevant filing thresholds were as follows:

Deaths in 2011:  $5,000,000
Deaths in 2012:  $5,120,000
Deaths in 2013:  $5,250,000

3.     The estate did not file Form 706 by the due date; and

4.     The estate files a complete and properly-prepared Form 706 on or before December 31, 2014.

If these criteria are not met, estates may continue to request an extension of time to make the portability election under Treas. Reg. §301.9100-3 by filing a private letter ruling request with the IRS.

Selected New Tax Laws Starting in 2014

While the start of 2014 doesn’t bring with it the enormous tax changes that the start of 2013 brought, there are still many important changes that will impact your taxes.  Here is an overview of some of those changes.  I do not address the dozens of tax laws that expired at the end of 2013.

Personal Taxes

·       Individuals must pay a tax penalty if they do not maintain minimum essential health insurance coverage for each month during 2014.  There is an exception for one short-term gap in coverage of three months or less.  Also, the Federal government apparently gave a hardship waiver from the penalty to all individuals who received a notice saying that their current health insurance plan was being cancelled.  To receive the waiver, it appears that the affected individuals must buy a “catastrophic” health insurance policy.

·       Certain low- or moderate-income families buying health insurance through a government exchange may qualify for a refundable tax credit.  Most people eligible for the credit will use it during the year to help pay the cost of monthly premiums.  Since the credit is based upon estimated 2014 household income, a reconciliation of the credit will be part of the 2014 tax return.

·       The provision for direct charitable gifting of up to $100,000 of IRA assets for those age 70 ½ or older expired at the end of 2013.  This important tax break enabled taxpayers to meet their required minimum distributions (RMD) and exclude the charitable IRA distribution from adjusted gross income.  Congress has historically retroactively reinstated this provision several times in the past.  You may wish to wait towards the end of 2014 before taking your RMD to see whether this provision may be reinstated for 2014.

Business Taxes

·       Recently published final regulations concerning the acquisition, production, and improvement of tangible property go into effect for tax years beginning on or after January 1, 2014.  Some of the provisions may require a change in tax accounting methods including the required filing of Form 3115 to report the change.

·       The amount that taxpayers can expense under Section 179 drops to $25,000 from $500,000 for tax years that began in 2013.  The expensing limit is reduced dollar for dollar as total eligible Section 179 property purchases during the year exceeds $200,000 (down from $2 million in 2013).  A trap exists for fiscal year pass-through entities whose tax years begin in 2013 and end in 2014.  If the entity claims an expensing amount above $25,000 per owner, the excess will be permanently lost because the owners receiving the expensing allocation must follow the 2014 limits.  They can’t deduct more than $25,000 and any excess allocation  is permanently lost.

·       Corporations that issue or are included in audited financial statements, that have total assets of $10 million or more (down from $50 million in 2013), and that have made a contingency reserve for possible additional taxes (or did not record a reserve because they intend to litigate the issue if challenged), must include Schedule UTP with their 2014 income tax returns.  UTP means “uncertain tax positions.”  The government is requiring these corporations to self-report their uncertain tax positions, giving the IRS notice of issues that can be audited.

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%