Checklist of Various Tax Matters to Consider Before Year-End 2014

As the end of 2014 approaches, there are many tax matters to consider, including the following (non-exhaustive) list:

1.     Small estates should consider whether to elect portability of the deceased spouse’s unused exemption amount by the December 31, 2014 special extended deadline.  See my January 28, 2014 post here.

2.     Project your 2014 and 2015 income tax rates to see whether it is beneficial to accelerate deductions into 2014 and defer income to 2015, or to do just the opposite.

3.     Determine whether prepaying state income taxes by December 31^st is beneficial.  If the alternative minimum tax applies, prepaying is generally not beneficial.

4.     Be careful of buying mutual funds before their December ex-dividend dates to avoid inadvertently increasing your taxable income simply from your purchase!

5.     Be sure to receive the required minimum distribution (RMD) from an inherited IRA (traditional or Roth) or an inherited qualified retirement plan by December 31^st to avoid a 50% penalty!

6.     If you are over age 70 ½ in 2014, you must also receive the RMD from your traditional IRA or qualified plan by December 31^st to avoid the 50% penalty.

a.      If you make contributions to public charities, consider waiting until further into December to see if Congress and the President will extend the charitable IRA rollover provision that can count as part of your RMD and save you taxes.  See my January 12, 2013 post here for a discussion of this technique.  If you aren’t sure whether the provision will be extended and the end of the year is approaching, make the charitable IRA rollover anyway in case the provision is retroactively extended.

b.     If you turned age 70 ½ in 2014, then your RMDs must begin.  For the first year that you are subject to the RMD, you can choose whether to receive the RMD by December 31, 2014 or by April 1, 2015.  If you choose April 1, 2015, then two RMDs will occur in 2015 as the 2015 RMD must be received by December 31, 2015.  The choice depends upon your income tax rates and the impact upon adjusted gross income (AGI) based deductions and taxes between the two years.

7.     For those employing a program of making annual exclusion gifts of $14,000 each year as part of their estate planning, be sure the checks are cashed early enough in December so that the funds are removed from your bank account by December 31^st, or else use cashier checks.

 8.    Businesses should be sure that their written capitalization policy for 2015 is in place by December 31, 2014.

2015 Health Insurance Marketplace (Exchange) Open Enrollment

On November 15, 2014, the 2015 open enrollment period begins for the Federal Health Insurance Marketplace or Exchange.  This is the second year of the Exchange that infamously had many problems a year ago.  More than seven million people are estimated to have obtained coverage in the first year and that number is expected to grow to 13 million in the coming year.  Utah residents use the Federal Exchange as the state did not build its own, although Utah does have its own small business exchange (SHOP) known as Avenue H.

Open enrollment for 2015 insurance coverage ends February 15, 2015.  This three-month period is only half as long as the 2014 open enrollment period.  You must enroll by December 15, 2014 to have coverage effective January 1, 2015.  If you enroll during December 16-31, coverage won’t begin until February 1, 2015 and you will have a gap in coverage!  So it is important not to delay if you purchase health insurance on the Exchange.  On December 31, 2014, coverage ends for 2014 plans, but you will automatically be re-enrolled in that plan on December 15, 2014 if you take no action.

During the open enrollment period you may change to a different insurance plan or keep your existing plan.  You shouldn’t just blindly accept re-enrollment in your existing plan as premiums and features will have changed from 2014.  So you should shop the Exchange to be sure that you have the most appropriate plan for your circumstances.   Be sure that your doctors and medications will be covered if you change plans.  During the open enrollment period you also apply for premium support subsidies based upon your estimate of your 2015 household income.

Undo a 2013 Roth IRA Conversion by October 15th

In some instances it makes tax and financial sense to convert a traditional IRA to a Roth IRA.  A traditional IRA generally permits tax deductible contributions (but not for certain higher income taxpayers who actively participate in an employer retirement plan), and distributions are taxable income.  A Roth IRA does not permit deductions for contributions, but future qualifying distributions are excluded from taxable income.  In 2014, the ability to contribute to a Roth IRA is restricted once adjusted gross income exceeds $181,000 for joint filers and $114,000 for single filers.  However, there is no income restriction on the ability to “convert” a traditional IRA to a Roth IRA.  A conversion is best handled by means of a direct trustee-to-trustee transfer of funds from the traditional IRA to a Roth IRA.

The amount converted to a Roth IRA is treated as a taxable distribution.  If you converted to a Roth IRA in 2013, and the value of the Roth IRA account has dropped such that the taxable amount on the conversion exceeds the current value of the account, you should consider “recharacterizing” the Roth conversion by October 15, 2014.  To recharacterize means to unwind the conversion so that the balance in the Roth conversion account is transferred back to a traditional IRA by means of a direct trustee-to-trustee transfer.  Recharacterizing eliminates the taxable income from the conversion.  For example, if you originally converted $100,000 to a Roth IRA, but the investments have declined to $70,000; you would pay tax on $30,000 too much income and should consider recharacterizing to avoid paying unnecessary taxes.

You are eligible to make a recharacterization by October 15, 2014 if either:  1) you filed your 2013 income tax return on time by the April 15, 2014 due date, or 2) you timely filed an extension to file your 2013 tax return.  A tax return extension isn’t a requirement for purposes of the October 15^th Roth recharacterization deadline as long as you filed your 2013 tax return by April 15^th.  An amended tax return is necessary if you have already filed your tax return.

Once the amount has been recharacterized back to the traditional IRA, you may “reconvert” once more to a Roth IRA.  However, the reconversion cannot be done before the later of:  1) 30 days from the date of recharacterization or 2) the beginning of the tax year following the year of the initial conversion.  For example, if you originally converted your traditional IRA to a Roth IRA on December 15, 2013, and you recharacterized the conversion on October 15, 2014, then you may not reconvert until November 14, 2014.  On the other hand, if you converted on January 8, 2014 and recharacterized on November 17, 2014, you may not reconvert until January 1, 2015.  Reconversion gives you an opportunity to convert the IRA funds to a Roth IRA at a lower tax cost, assuming that the account value doesn’t increase during the waiting period and assuming no change in the effective income tax rate from the tax year of the original conversion.

IRS Eases Rules for Converting Non-Roth, After-Tax Qualified Plan Savings to a Roth IRA

IRS Notice 2014-54 opens up new Roth IRA planning opportunities for taxpayers who have made after-tax contributions to their employer’s retirement plan.  This issue does not involve 401(k) deferrals, either pre-tax or designated Roth 401(k) contributions, but rather additional after-tax savings that some qualified plans permit.  Taxpayers having after-tax savings in qualified plans have long sought a means of directly rolling over (“trustee to trustee”) the taxable portion of a qualified plan distribution to a traditional IRA and the nontaxable portion (or “basis”) to a Roth IRA.  Previously the IRS announced in Notice 2009-68 that it was not possible to isolate the basis as a separate distribution amount, but that each rollover consisted of a proportionate amount of basis.  Thus, if a taxpayer had $100,000 in his or her 401(k) account to be directly rolled over, and $30,000 of that amount consisted of after-tax (non-Roth) savings, it was not possible to direct only the $30,000 basis tax-free to a Roth IRA.  Instead, $21,000 of the $30,000 rolled over to the Roth IRA would be taxable ($30,000 X $70,000/$100,000).  Taxpayers devised means around this restriction, but it was uncertain whether the strategies would be respected by the IRS, and the strategies were complicated.  The IRS has now responded to taxpayer feedback and has issued this favorable notice.  The notice requires that the taxpayer inform the qualified plan administrator of how to allocate the basis to the rollover IRAs.  The plan administrator is then required to prepare the Form 1099-R’s accordingly.  The new notice is effective beginning in 2015, but it indicates that it is reasonable to rely upon it for distributions made on or after September 18, 2014.  Under Notice 2014-54, the taxpayer in our example would not have any taxable income upon directing the $100,000 rollover distribution as $30,000 of basis to a Roth IRA and as $70,000 of pre-tax amounts to a traditional IRA.

The notice opens up a new tax planning opportunity for individuals who already contribute the maximum permitted to their 401(k).  If the employer retirement plan permits after-tax voluntary employee contributions, then the individual may save additional money in the plan up to the maximum contribution limit of $52,000 for 2014, after taking into account the 401(k) deferrals, employer matching, and other contributions and forfeitures.  Note that so-called “catch-up” contributions (limited to $5,500 in 2014) for those age 50 or older do not count towards the contribution limit.  These additional after-tax contributions are then positioned for a Roth IRA rollover when the employee leaves employment.  This planning opportunity can be viewed as a “back-door” means of contributing to a Roth IRA in the future, and the amounts saved may go well beyond the normal Roth IRA contribution limits.  If your employer 401(k) plan does not permit voluntary employee after-tax contributions, the plan must first be amended.  Depending upon your position in the company and upon the type of qualified plan, there could be non-discrimination testing restrictions on how much can be saved.

Notice 2014-54 does not deal with isolating basis of non-deductible IRA contributions.  Making a Roth IRA conversion of a traditional IRA having tax basis will still be taxable according to the proportionate basis allocation rule.  Therefore, saving after-tax money in a 401(k) plan is a better choice than saving money as a non-deductible IRA contribution when looking forward to a future Roth IRA conversion.

S Corporation Shareholder Loans and Tax Basis

For income tax purposes, the definition of the word “basis” generally means the amount of after-tax investment in an asset.  Basis is a dollar amount that is used in various ways in the tax law, including the following examples:

1.     Basis is subtracted from the selling price of an asset to determine gain or loss.

2.     Basis is the amount that can be depreciated or amortized.

3.     Basis is the tax-free portion of retirement account or annuity distributions.

4.     Basis is the limitation on the amount of tax losses that can be deducted by a partner of a partnership, a member of a limited liability company, or a shareholder of a Subchapter S corporation.  These entities are called “pass-through” entities, meaning that the owner’s allocable share of the entity’s taxable income or loss (as shown on Schedule K-1) is reported on the owner’s income tax return.

Basis generally starts out as the after-tax cost of an asset or investment.  Then adjustments are made to basis depending upon the tax rules that apply.  For example, depreciation deductions reduce the original basis so that a double tax benefit isn’t received when the asset is sold:  once for the depreciation deduction and again in calculating gain or loss if basis isn’t reduced for the depreciation deduction.  When the asset is sold, “adjusted basis” is used in calculating the gain or loss.

For an S corporation shareholder, the original basis in the shares acquired is adjusted upward for allocated income and is adjusted downward for allocated losses and deductions and for distributions.  In addition, a special rule permits a shareholder to increase basis for the amount of loans made by the shareholder to the S corporation.  Unlike for a partnership or an LLC, third-party debt incurred by the S corporation does not increase basis for the shareholder.  Only bona fide shareholder loans to the S corporation create basis.  Loan basis permits the deduction of losses in excess of the shareholder’s basis in the S corporation’s stock.  Loan basis has been a source of controversy between the IRS and taxpayers over the years.  The IRS recently released final regulations governing shareholder loan basis.

The regulations permit loan basis only for bona fide, direct shareholder loans to the S corporation.  Personal guarantees of loans to the corporation made by third parties do not create basis, except when and only to the extent the shareholder actually makes payments under the guarantee.  Taxpayers run into trouble establishing basis when attempting to get around the third party debt limitation on basis if they engage in “circular loans” with a related party or if they do not properly structure “back-to-back” loans with an unrelated third party.  Generally a back-to-back loan will create basis if an independent third party loans money to the shareholder and the shareholder loans that amount to the S corporation in exchange for a promissory note secured with corporate assets.  This promissory note plus collateral of the shareholder is assigned to the third-party lender as security on the loan to the shareholder.  It is critical that the shareholder be directly liable on the third-party loan and not the corporation in order for the back-to-back loan structure to create basis.

How the Health Insurance Premium Assistance Tax Credit Impacts the Self-Employed Health Insurance Income Tax Deduction

Starting in 2014, taxpayers having household income below 400% of the Federal poverty line will receive a premium assistance tax credit if they purchase health insurance on a government health insurance exchange or marketplace.  Currently there is a legal challenge as to whether this credit is permitted if the purchase is made on the Federal exchange instead of on a State exchange (see my previous blog article for a brief description of the challenge).

Generally, self-employed individuals may deduct the cost of health insurance premiums as an adjustment for Adjusted Gross Income.  How is this deduction calculated if a premium assistance tax credit is received?  Surprisingly, the calculation is extremely complicated!  The deduction is limited to the lesser of:  1) the amount of the premiums paid less the premium credit claimed on the tax return, or 2) the sum of the premiums paid as reduced by an advance of the premium credit plus any required repayment of excess premium credits advanced once the income tax return is completed.  Many people ask for the premium assistance tax credit to be advanced in order to reduce their monthly premium cash expense.  Since the amount of the premium credit is based upon an estimate of AGI, a portion of the advance may be required to be repaid on the income tax return if the estimate of household income was too low.  Because household income is based upon modified AGI, and because AGI is reduced by the amount of the self-employed health insurance deduction, the amount of the premium tax credit changes based upon the amount of the deduction, and the deduction changes based upon the amount of the credit!  This is a circular calculation.

In Revenue Procedure 2014-41, the Internal Revenue Service provides instructions on how to compute the self-employed health insurance deduction as impacted by the premium tax credit.  The revenue procedure provides an iterative and an alternative calculation method in an attempt to resolve the circular computation.  Either method may be used.  Based upon the examples provided in the revenue procedure, the amount of the deduction and the amount of the premium credit may both be larger in many cases if the more complex iterative calculation method is used.  These complex calculations will require the use of a computer!  Thus, self-employed taxpayers who qualify for both the deduction and the premium tax credit will need good tax software and/or the services of a tax advisor in order to calculate the deduction and the credit.

Some Updates Regarding the Affordable Care Act

Several interesting developments regarding Obamacare occurred during July 2014.

Premium Tax Credit for Federal Exchanges

One of the primary features of the ACA is the establishment of so-called health insurance exchanges, now termed “marketplaces.”  The law contemplated that the marketplaces would be established by most of the States with a Federal backup for those States that did not establish their own marketplaces.  The reality is that 36 States chose not to establish their own exchanges requiring their citizens to purchase needed health insurance through the Federal exchange.  The ACA provides for substantial premium assistance tax credits to help make health insurance premiums affordable to lower income and middle class individuals and families.  These credits apply to taxpayers “enrolled through an Exchange established by the State” according to the statutory language.  The IRS interpreted this language to include Federal exchanges.  This interpretation was challenged in court and could affect an estimated 5 million people who are receiving the premium tax credit on the Federal exchange.

Two Federal Appeals Courts ruled on this challenge on July 22, 2014.  A three-judge panel of the District of Columbia Circuit Court ruled the IRS interpretation invalid with the consequence that the credits should not be available to those who enrolled through the Federal exchange.  The Fourth Circuit held that the IRS interpretation was consistent with congressional intent.  The conflicting opinions will need to be resolved by the U.S. Supreme Court.  The credit will remain in place for the Federal exchange until final resolution.  On August 1^st, the U.S. Justice Department asked the full District of Columbia Circuit Court to reconsider its opinion, which if it does, could delay the time that this matter will be heard by the U.S. Supreme Court.

Update:  the District of Columbia Circuit Court agreed on September 3, 2014, to rehear the case before the full court and vacated the earlier decision that would deny credits for those enrolling through a Federal exchange.

Second Update:  the U.S. Supreme Court agreed on November 7, 2014, to hear this matter.  If it rules that credits are not permitted for Federal exchanges, the decision could be the death knell for the ACA as health insurance would no longer be affordable by millions of people relying on the credits.

Draft Information Reporting Forms Released

On July 24, 2014, the IRS released drafts of the following information forms to report health insurance coverage:

·       Form 1095-B:  used by health insurance providers (including self-insured employers) to report monthly coverage of individuals.

·       Form 1095-C:  used by employers subject to the mandate to report the offering of health insurance to employees and to list the covered individuals.

·       Form 1094-B:  the transmittal form for submitting Forms 1095-B to the IRS.

·       Form 1094-C:  the transmittal form for submitting Forms 1095-C to the IRS; but this form also requires additional information pertaining to the aggregation of related employers and for indicating whether transition relief for 2015 applies (mid-sized employers having 50 to 99 full-time employee equivalents).

In addition, the IRS released a draft of Form 8965 that is to be used by individuals to report a marketplace-granted coverage exemption (e.g. premiums exceed 8% of household income) or a coverage exemption (e.g. a religious objection) from the individual mandate.  This form informs the IRS why the individual claims exemption from the penalty for not having minimum essential coverage health insurance.

2014 National Bronze-Level Premium Set for Individual Mandate Penalty

Unless an exemption applies, individuals and members of the individual’s tax household must be covered by minimum essential health insurance each month during 2014 or else pay a tax penalty for each month of non-coverage.  An exception is granted once each year for short periods of non-coverage that does not exceed three months.  The penalty is the greater of a flat dollar amount or a percentage of household income, not to exceed the national bronze-level premium amount.  Revenue Procedure 2014-46 sets the bronze-level national premium amount for 2014.  The annual penalty amount is calculated as follows.  Note, the amounts shown below are annual amounts; they should be converted to monthly amounts for purposes of computing the monthly penalty.

·       Flat dollar amount per adult age 18 and older: $95.00.  Flat dollar amount per child under age 18: $47.50.

o   The total flat dollar amount can’t exceed three times the per-adult penalty, so for 2014 the upper limit on the flat dollar amount is $285.

·       The percentage of household income (assessed on the amount in excess of the income tax return filing threshold amount) is 1%.

·       The national bronze coverage premium for each individual to be covered is $2,448 with the premium capped at $12,240 for a family with five or more members.