Senate Appropriations Subcommittee Cuts IRS Budget

The Senate Appropriations Subcommittee on Financial Services and General Government on July 22nd approved a fiscal year (FY) 2016 IRS funding measure that provides $10.475 billion, a cut of $470 million, or 4 percent, below the FY 2015 enacted level. Appropriators said the decrease in funds would require the IRS to streamline its activities and prioritize available resources, including user fees, to perform core agency duties.

The House on June 17th approved $10.1-billion to fund the IRS for FY 2016, representing a cut of approximately $838 million, compared to FY 2015. The funding level was $2.8-billion below President Obama’s budget request (TAXDAY, 2015/06/12, C.1).

The bill requires $2.247 billion be spent on taxpayer services, roughly in line with the House appropriations, reflecting an increase of $90 million, which the panel said is intended to significantly improve the handling of identity theft cases and IRS response rates to telephone calls and correspondence from taxpayers. The funding level, however, is $162 million less than the president’s request.

During the most recent filing season, the IRS answered only 37 percent of taxpayer calls routed to customer service representatives, and the hold time for taxpayers who got through averaged 23 minutes. This is a sharp drop-off in service from the 2014 filing season, when the IRS answered 71 percent of its calls and hold times averaged about 14 minutes. The number of disconnected calls skyrocketed to about 8.8 million, up from about 544,000 in 2014, reflecting an increase of more than 1,500 percent.

For IRS enforcement measures, the Senate level of $4.5 billion is $360 million less than FY 2015 and $548 million less than the administration’s request. Appropriators also cut IRS operations support, making the Senate level of $170 million less than FY 2015 and $960 million less than the administration’s request. Business systems modernization fared no better, receiving a $30-million cut from the FY 2015 level and $119 million less than the president’s request.

In addition, the Senate subcommittee added provisions that they said would “ensure accountability and transparency” at the IRS. The bill includes:

  • A prohibition on funds for bonuses or to rehire former employees unless employee conduct and tax compliance is given consideration;
  • A prohibition on funds for the IRS to target groups for regulatory scrutiny based on their ideological beliefs;
  • A prohibition on funds for the IRS to target individuals for exercising their First Amendment rights; and
  • A prohibition on funds for the production of inappropriate videos and conferences.

IRS Dealt Major Setbacks

Taxpayers are having a hard time reaching the IRS on the phone and resolving issues.

Senate Finance Committee Chairman Orrin G. Hatch, R-Utah, and ranking member Ron Wyden, D-Ore., on August 5th released the committee’s investigative report detailing the probe into the IRS’s treatment of 501(c)(4) organizations applying for tax-exempt status. The report was delayed for more than a year after the IRS informed the committee that it had not been able to recover a large number of potentially responsive documents that were lost when former Exempt Organizations Division Chief Lois Lerner’s hard drive crashed in 2011.

The report follows a detailed, 41-question letter sent by the committee on May 20, 2013, to the IRS requesting information about the alleged targeting by the IRS of certain social welfare organizations applying for tax-exempt status based on those organizations’ presumed political activities. That letter marked the beginning of a bipartisan investigation by the committee into the IRS’s activities related to the review of tax-exempt applications and related issues raised by the Treasury Inspector General for Tax Administration (TIGTA) in a May 14, 2013, report.

In June 2014, the committee learned that Lerner had experienced the hard drive failure in 2011, which raised questions about the IRS’s ability to produce all the documents necessary to complete the Senate Finance Committee investigation. Hatch and Wyden then asked TIGTA to investigate the matter.

The investigation found that IRS management “failed to provide effective control, guidance and direction” over the processing of applications for tax-exempt status between the years 2010 to 2013. In addition, it discovered that Lerner became aware of the Tea Party applications—which served as the basis for the investigation—in early 2010, but failed to inform her superiors about their existence.

The report stated that, “while under Lerner’s leadership, the Exempt Organizations Division undertook no less than seven poorly planned and badly executed initiatives aimed at bringing the growing number of applications from Tea Party and other groups to decision.”

“This bipartisan investigation shows gross mismanagement at the highest levels of the IRS and confirms an unacceptable truth: that the IRS is prone to abuse,” Hatch said in a statement. Wyden, however, said the investigation “showcases pure bureaucratic mismanagement without any evidence of political interference.”

Hatch made several recommendations following the report, including: having the IRS track the age and cycle times of applications for tax-exempt status to detect backlogs early in the process and allow management to take steps to address those backlogs; a list of overage applications should be sent to the commissioner on a quarterly basis; internal IRS guidance should require that employees reach a decision on applications no later than 270 days after the IRS receives that application; and having minimum training standards established for all managers within the EO Division to ensure that they have adequate technical ability to perform their jobs.

The Small Business Health Care Credit

What is the Credit?

The Small Business Health Care Credit is designed to help you provide health insurance coverage to your employees. For tax years 2010 through 2013, the credit can be up to 35% of your share of your employees’ health insurance premiums; or, if you’re an eligible tax-exempt employer, up to 25% of your share of premiums.

You are an eligible small employer for the tax year if you meet these three requirements.

  1. You paid premiums for employee health insurance coverage under a qualifying arrangement.
  2. You had fewer than 25 full-time equivalent employees (FTEs) for the tax year. You may be able to meet this requirement even if you had 25 or more employees.
  3. You paid average annual wages for the tax year of less than $50,000 per FTE.

For tax years 2014 and later, there are changes to the credit:

  • The credit can be up to 50% of your share of your employees’ health insurance premiums, or, if you’re an eligible tax-exempt employer, up to 35 percent of your share of premiums.
  • You must purchase insurance for your employees through the Small Business Health Options (SHOP) Marketplace.
  • The credit is only available to you for two consecutive years.

For more information contact a Templeton Tax Professional.

 

 

Benefits of a Health Savings Account

Given the ever-escalating cost of providing employee health care benefits we wanted to inform you of a more cost-effective method of providing these benefits; a health savings account (HSA). For eligible individuals, HSAs offer a tax-favorable way for employees to set aside funds (or their employer can do so) to meet future medical needs. Here are the key tax-related elements:

  • contributions employees make to an HSA are deductible, within limits,
  • contributions employers makes aren’t taxed to you,
  • earnings on the funds within the HSA are not taxed, and
  • distributions from the HSA to cover qualified medical expenses are not taxed.

Employee Requirements:

Who is eligible? To be eligible for an HSA, you must be covered by a “high deductible health plan” (discussed below). You must also not be covered by a plan which (1) is not a high deductible health plan, and (2) provides coverage for any benefit covered by your high deductible plan. (It’s okay, however, to be covered by a high deductible plan along with separate coverage, through insurance or otherwise, for accidents, disability, or dental, vision, or long-term care.)

For 2015, a “high deductible health plan” is a plan with an annual deductible of at least $1,300 for self-only coverage, or at least $2,600 for family coverage. For self-only coverage, the 2015  limit on deductible contributions is $3,350. For family coverage, the 2015 limit on deductible contributions is $6,650. Additionally, annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits cannot exceed $6,450 for self-only coverage or $12,900 for family coverage.

An individual (and the individual’s covered spouse as well) who has reached age 55 before the close of the tax year (and is an eligible HSA contributor) may make additional “catch-up” contributions for 2015 of up to $1,000.

A high deductible health plan does not include a plan if substantially all of the plan’s coverage is for accidents, disability, or dental, vision, or long-term care, insurance for a specified disease or illness, or insurance paying a fixed amount per day (or other period) of hospitalization.

HSAs may be established by, or on behalf of, any eligible individual.

Deduction limits. You can deduct contributions to an HSA for the year up to the total of your monthly limitations for the months you were eligible. For 2015, the monthly limitation on deductible contributions for a person with self-only coverage is 1/12 of $3,350. For an individual with family coverage, the monthly limitation on deductible contributions is 1/12 of $6,650. Thus, deductible contributions are not limited by the amount of the annual deductible under the high deductible health plan.

Also, taxpayers who are eligible individuals during the last month of the tax year are treated as having been eligible individuals for the entire year for purposes of computing the annual HSA contribution.

However, if an individual is enrolled in Medicare, he is no longer an eligible individual under the HSA rules, and so contributions to his HSA can no longer be made.

Contributions may be made to an HSA by or on behalf of an eligible individual even if the individual has no compensation, or if the contributions exceed the individual’s compensation. Contributions made by a family member on behalf of an eligible individual to an HSA (which are subject to the limits described above) are deductible by the eligible individual in computing adjusted gross income.

Further, on a once-only basis, taxpayers can withdraw funds from an IRA, and transfer them tax-free to an HSA. The amount transferred can be up to the maximum deductible HSA contribution for the type of coverage (individual or family) in effect at the time of the transfer. The amount so transferred is excluded from the taxpayer’s gross income, and is not subject to the 10% early withdrawal penalty.

Employer contributions. If you are an eligible individual, and your employer contributes to your HSA, the employer’s contribution is treated as employer-provided coverage for medical expenses under an accident or health plan and is excludable from your gross income up to the deduction limitation, as described above. Further, the employer contributions are not subject to withholding from wages for income tax or subject to FICA or FUTA. The eligible individual cannot deduct employer contributions on his federal income tax return as HSA contributions or as medical expense deductions.

An employer that decides to make contributions on its employees’ behalf must make comparable contributions to the HSAs of all comparable participating employees for that calendar year. If the employer does not make comparable contributions, the employer is subject to a 35% tax on the aggregate amount contributed by the employer to HSAs for that period.

Contributions are comparable if they are either: (1) the same amount; or (2) the same percentage of the annual deductible limit under the high deductible health plan covering the employees. For these purposes, comparable participating employees (1) are covered by the employer’s high deductible health plan and are eligible to establish an HSA; (2) have the same category of coverage (either self-only or family coverage); and (3) have the same category of employment (either part-time or full-time). (IRS regulations provide detailed guidelines for comparable contributions.)

An exception to the comparable contribution requirements applies for contributions made on behalf of non-highly compensated employees. Under this exception, an employer may make larger HSA contributions for non-highly compensated employees than for highly compensated employees.

Employer contributions are also excludable if made at the election of the employee under a salary reduction arrangement that is part of a cafeteria plan (i.e., a plan which allows you to elect to use part of your salary towards a variety of benefits). Although contributions to an employee’s HSA through a cafeteria plan are treated as employer contributions, the comparability rule does not apply to contributions made through a cafeteria plan.

Earnings. If the HSA is set up properly, it is generally exempt from taxation, and there is no tax on earnings. However, taxes may apply if contribution limitations are exceeded, required reports are not provided, or prohibited transactions occur.

Distributions. Distributions from the HSA to cover an eligible individual’s qualified medical expenses, or those of his spouse or dependents, are not taxed. Qualified medical expenses for these purposes generally mean those that would qualify for the medical expense itemized deduction. If funds are withdrawn from the HSA for other reasons, the withdrawal is taxable. Additionally, an extra 20% tax will apply to the withdrawal, unless it is made after reaching age 65, or in the event of death or disability.

Distributions from an HSA exclusively to pay for qualified medical expenses are excludable from the gross income of the account beneficiary even though the beneficiary is no longer an “eligible individual,” e.g., the individual is over age 65 and entitled to Medicare benefits, or no longer has a high deductible health plan.

As you can see, HSAs offer a very flexible option for providing health care coverage, but the rules are somewhat involved. Again, please call if you would like to discuss this topic further.

Property Tax Exemptions on the Radar

Tax-exempt hospitals are entitled to a multitude of federal and state tax benefits, with an estimated total annual value of $12 billion.

By Laura Kalik, JD, LLM in Tax

With numbers this large, just as the federal government has upped the requirements for 501(c) (3) hospitals in the financial assistance and community benefit areas, many jurisdictions are also calling for a return benefit in order to qualify for the property tax exemption. At a minimum, jurisdictions are asking for some kind of compensation to pay for the
benefits provided to the nonprofit. In the case of nonprofit hospitals, some states have enacted legislation that requires a certain amount of charity care or community benefit in order to justify property tax exemptions. Other jurisdictions, however, such as Boston, have entered into arrangements with nonprofits titled “payments in lieu of taxes,” or PILOTs, in which nonprofits compensate local governments for some of the foregone property tax revenue. These payments help subsidize police and fire protection, construction of public schools and other vital operations, and are provided by all types of nonprofit entities, ranging from hospitals to universities.

While common, however, PILOTs are not without controversy. A lack of transparency, the possible political nature of a favorable deal and the question of whether institutions are actually paying their “fair share” are common criticisms of the arrangements.

STATE LEGISLATION

After the Illinois Department of Revenue denied exemptions to several prominent taxexempt hospitals, arguing that they were not operating in a charitable manner, the state enacted a law in 2012 requiring tax-exempt hospitals to provide a certain level of charity care and community benefits commensurate with the value of their property tax exemption. Today, Illinois-based nonprofit hospitals can enjoy a property tax exemption only if they can prove that various factors – including, among others, charity care, preventive care, medical research and professional training – are equal to the value of the property tax exemption.

In Texas, as well, nonprofit hospitals must provide community benefits as a condition of their state tax exemption. Texas law gives a hospital four alternatives that cover combinations of charity care and governmentsponsored indigent health care in amounts equal to varying sums of net patient revenue.

For jurisdictions that do not have laws in place, critics are starting to challenge such exemptions.

A hospital that loses its tax-exempt status or its property tax exemption could face financial
disaster. Bond covenants could require that tax-exempt bonds be called in, turning longer term liabilities into current liabilities. The hospital’s financial difficulties could also ripple out toward the community it serves as, in many jurisdictions, nonprofit hospitals are major employers, and layoffs might be an unintended consequence. Thus, it is critical that communities and nonprofit hospitals come to an agreement on whether some kind of payment arrangement in lieu of taxes is appropriate and useful.

FEDERAL LEGISLATION

The Affordable Care Act introduced section 501(r) into the Internal Revenue Code, which requires a 501(c)(3) hospital to prepare a community health needs assessment (CHNA) and have an implementation strategy to address the findings of the assessment. Though the new federal tax requirements for 501(c)(3) hospitals also include financial assistance, billing and collection, and chargespolicy requirements, there is no requirement to provide a dollar amount or percentage of revenue in charity care or community benefits.

With varying policies on the state and federal level, nonprofit organizations must navigate complex waters in order to maintain their exemptions while carrying out their mission.

If you have any questions regarding property tax exemptions, contact a Templeton Advisor at info@templetonco.com.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Summer 2014). Copyright © 2014 BDO USA, LLP. All rights reserved. www.bdo.com

Do you want $1 to go to charity?

Understanding Payments to Agents of Charitable Organizations

By Rebekuh Eley, CPA, MST

Many times local retail chains or restaurants ask customers to donate to a local charity with the payment of their restaurant bill or store purchase. Are these donations considered tax deductible contributions? The donation is not going directly to a charity. The donation is going to a business entity that will pay the donation to the charity on the customer’s behalf.

Payments to these businesses, or agents, in lieu of a direct contribution to a qualified Internal Revenue Code (IRC) 501(c)(3) organization, are considered tax deductible donations when paid to an agent of the organization. A valid agent of the charity may also provide the contemporaneous written acknowledgement to the donor as required to take a charitable contribution deduction. An entity that enters into this type of arrangement should comply with guidelines so a true agency relationship exists with the charity to avoid income treatment of the donations received on behalf of the charity and, to allow a charitable contribution tax deduction to the donor. These agency arrangements can also be mutually beneficial to both the charity and the business entity.

The Internal Revenue Service (IRS) has issued guidelines for entities to follow to assist with obtaining an agency relationship. According to Revenue Ruling 2002-67, the agency arrangement between a charitable organization and a person or entity acting on behalf of the charitable organization should first be established through a written agreement that is valid under the applicable state law. Not all contractual relationships will necessarily result in an agency relationship.

It is important to confirm that the state law recognizes the relationship established in the agreement as a valid agency relationship. The IRS further analyzed the terms and facts and circumstances of a written agreement to establish an agency relationship in PLR 200230005. The IRS noted the following characteristics that supported a valid agency relationship between a charity and a for-profit company receiving car donations on behalf of the charity.

  • The written agreement between the charity and the company clearly established an agency relationship pursuant to certain state agency laws.
  • The company was to act on the charity’s behalf and was subject to the charity’s control in the general performance of certain activities such as solicitation, acceptance, processing and the sale of donated property.
  • The company could exercise some discretion but this was not in conflict with state law.
  • The charity remained the equitable owners of the donated property until an authorized sale occurred.
  • The charity bore the risk of accidental loss, damage or destruction of the donated property until the donated property was sold.
  • The charity had the requisite degree of control and supervision.
  • The company agreed to provide monthly accounting reports and weekly advertising reports to the charity.
  • The charity reserved the right to inspect the company’s property donation program financial statements.

Under the written agreement, the company would pay certain costs and expenses, such as advertising and insurance. This fact did not preclude a determination that there is a valid agency relationship. Also, the fact that a related person to the company could purchase any vehicle at fair market value did not preclude the agency relationship provided the company acted in accordance with its fiduciary responsibility.

After an entity has established an agency relationship to receive contributions on behalf of a charity, the entity needs to evaluate if it is considered a charitable or professional fundraiser under state law. Many states impose additional registration and annual filing requirements on entities that are considered charitable or professional fundraisers.

After reviewing the requirements set forth by the Internal Revenue Service and various states, an entity may question the decision to establish an agency relationship. However, the agent will achieve a sense of community and purpose in helping the good cause of a charity while providing additional goodwill for its own business endeavors.

Please contact your Templeton advisor, John Templeton, with any questions you may have regarding nonprofits, john@templetonco.com or 561-798-9988.

This article originally appeared in BDO USA, LLP’s “Nonprofit Standard” newsletter (Summer 2014). Copyright © 2014 BDO USA, LLP. All rights reserved. www.bdo.com

Tax Development Highlights

The following is a summary of the most important tax developments that have occurred in the past three months that may affect you, your family, your investments, and your livelihood. Please call us for more information about any of these developments and what steps you should implement to take advantage of favorable developments and to minimize the impact of those that are unfavorable.

Developments concerning the Affordable Care Act (ACA). 

In the lead-up to the roll out of the health insurance exchanges on Oct. 1, 2013, the IRS issued the following guidance on the ACA:

Individuals:

  • The IRS released Questions and Answers (Q&As) on the health insurance premium tax credit on its website. This credit is designed to make health insurance affordable to individuals with modest incomes (i.e., between 100% and 400% of the federal poverty level, or FPL) who are not eligible for other qualifying coverage, such as Medicare, or “affordable” employer-sponsored health insurance plans that provide “minimum value.” To qualify for the credit, individuals must purchase insurance on a health exchange. The Q&As note that individuals can choose to have the credit paid in advance to their insurance company to lower what they pay for their monthly premiums, and then reconcile the amount paid in advance with the actual credit computed when they file their tax return. Alternately, individuals can claim all of the credit when they file their tax return for the year. The Q&As explain exactly who is eligible for the credit and address other important aspects of it.
  • The IRS issued final regulations on the “shared responsibility” payment under the ACA, which is the enforcement mechanism for the ACA’s mandate that most individuals maintain health insurance coverage. Starting in 2014, the individual shared responsibility provision calls for each individual to have basic health insurance coverage (known as minimum essential coverage), qualify for an exemption, or make a shared responsibility payment when filing a federal income tax return. Individuals will not have to make a payment if coverage is unaffordable, if they spend less than three consecutive months without coverage, or if they qualify for an exemption under one of several other reasons, including hardship and religious beliefs. The final regulations address these and other aspects of the shared responsibility payment.

Small Businesses:

  • The IRS issued proposed regulations on the tax credit available to certain small employers that offer health insurance coverage to their employees. This credit is available to an employer with no more than 25 full-time equivalent employees (FTEs) employed during its tax year, and whose employees have annual full-time equivalent wages that average no more than $50,000. However, the full credit is available only to an employer with 10 or fewer FTEs and whose employees have average annual full-time equivalent wages from the employer of not more than $25,000. The proposed regulations would become effective when they are formally adopted as final regulations. However, employers may rely on the proposed regulations for tax years beginning after Dec. 31, 2013, and before Dec. 31, 2014.

Tax treatment of same-sex spouses. 

The IRS and other Federal agencies issued guidance on the treatment of same-sex spouses and couples for tax and other purposes in light of the Supreme Court’s landmark Windsor  decision striking down section 3 of the Defense of Marriage Act (DOMA), which had required same-sex spouses to be treated as unmarried for purposes of federal law. The key developments are as follows:

  • Effective as of Sept. 16, 2013, the IRS adopted a “state of celebration” rule in recognizing same-sex marriages. This means that same-sex couples who were legally married in jurisdictions that recognize their marriages (i.e., “state of celebration”) will be treated as married for federal tax purposes, regardless of whether their state of residence recognizes same-sex marriage. Spouse may retroactively apply this rule to open years.
  • Same-sex spouses who were legally married in a state that recognizes same-sex marriages must file their 2013 federal income tax return using either “married filing jointly” or “married filing separately” status, even if they now reside in a state that does not recognize same-sex marriage. Same-sex spouses who file an original 2012 tax return on or after Sept. 16, 2013 also generally must file using a married filing separately or joint filing status. Same-sex spouses may file original or amended returns choosing to be treated as married for federal tax purposes for one or more prior tax years still open under the statute of limitations on refunds.

The IRS provided optional special administrative procedures for employers to use to correct overpayments of employment taxes for 2013 and prior years for certain benefits provided and remuneration paid to same-sex spouses.

The Department of Labor’s (DOL)’s Employee Benefits Security Administration (EBSA) announced that it is following the IRS in recognizing “spouses” and “marriages” based on the validity of the marriage in the state of celebration, rather than based on the married couple’s state of domicile, for purposes of interpreting the meaning of “spouse” and “marriage” as these terms appear in the provisions of the Employee Retirement Income Security Act of 1974 (ERISA) and in Internal Revenue Code provisions that EBSA interprets.

  • In Frequently Asked Questions (FAQs) posted on the IRS’s website, the IRS made clear that same-sex and opposite-sex individuals who are in registered domestic partnerships, civil unions, or other similar formal relationships that aren’t marriages under state law aren’t considered as married or spouses for federal tax purposes.

New rules for deducting or capitalizing tangible property costs. 

The IRS issued new regulations for determining whether amounts paid to acquire, produce, or improve tangible property may be currently deducted as business expenses or must be capitalized. Among other things, they provide detailed definitions of “materials and supplies” and “rotable and temporary spare parts” and prescribe rules and elective de minimis and optional methods for handling their cost. They also have rules for differentiating between deductible repairs and capitalizable improvements, among many other items. The regulations generally are effective for tax years beginning on or after Jan. 1, 2014, but taxpayers can elect to apply them to certain pre-2014 years.

New rules for dispositions of certain depreciable property. 

The IRS issued proposed regulations that change several of the rules for dispositions of Modified Accelerated Cost Recovery System (MACRS) property. While the regulations are not final but merely proposed, taxpayers may rely on them. Included among the changes are rules that no longer treat structural components of a building as separate from the building and rules providing that partial dispositions generally are treated as dispositions.

New simplified relief for late elections pertaining to S corporations. 

The IRS provided simplified methods for taxpayers to request relief for late elections pertaining to S corporations. The relief covers the S corporation election itself, the electing small business trust (ESBT) election, the qualified Subchapter S trust (QSST) election, the qualified Subchapter S subsidiary (QSub) election, and late corporate classification elections which the taxpayer intended to take effect on the same date that the taxpayer intended that an S corporation election for the entity should take effect.

Simplified per-diem increase for post-Sept. 30, 2013 travel.

An employer may pay a per-diem amount to an employee on business-travel status instead of reimbursing actual substantiated expenses for away-from-home lodging, meal and incidental expenses (M&IE). If the rate paid doesn’t exceed IRS-approved maximums, and the employee provides simplified substantiation, the reimbursement isn’t subject to income- or payroll-tax withholding and isn’t reported on the employee’s Form W-2. In general, the IRS-approved per-diem maximum is the GSA per-diem rate paid by the federal government to its workers on travel status. This rate varies from locality to locality. Instead of using actual per-diems, employers may use a simplified “high-low” per-diem, under which there is one uniform per-diem rate for all “high-cost” areas within the continental U.S. (CONUS), and another per-diem rate for all other areas within CONUS. The IRS released the “high-low” simplified per-diem rates for post-Sept. 30, 2013 travel. The high-cost area per-diem increases $9 to $251, and the low-cost area per-diem increases $7 to $170.

Supreme Court to decide FICA tax treatment of severance pay. 

The Supreme Court agreed to review a decision of the Court of Appeals for the Sixth Circuit which held that severance payments aren’t wages for purposes of Federal Insurance Contributions Act (FICA) tax. Thus, the Supreme Court will resolve a circuit split that currently exists between the Sixth and Federal Circuit Courts on the issue.

Please don’t hesitate to contact us at info@templetonco.com or 561-798-9988 to begin discussing options specific to your tax situation.

Rental Activities and the 3.8% Surtax on Passive Activities

The health care reform legislation enacted in 2010 significantly broadens the Medicare tax base for higher-income taxpayers by enacting two new taxes. Beginning in 2013 higher-income taxpayers will be subject to an additional 0.9% tax on earned income and a new 3.8% tax on investment income.  As a result, business income from an activity that is passive is now subject to the 3.8% tax as it is now considered investment income.

I. Planning for those taxpayers that have net passive income from rental activities:

Two areas of the tax law that provide planning opportunities are as follows:

1. Self-rental regulations
2. Status as a real estate professional

1. When looking at the self-rental regulations, if one or more activities are treated as a single activity, then they can be  constitute an appropriate economic unit for the measurement of gain or loss under IRC Sec. 469 [Reg. 1.469-4(c)(1).  This provides that rental and trade or business activities can be combined and considered an appropriate economic-unit, if it meets the following two tests:

(a) one activity is insubstantial in relation to the other, or

(b) each owner of the trade or business activity has the same proportionate ownership interest in the rental activity.

Although no definition of insubstantial is provided in the regulations, under prior Temp. Reg. 1.469-4T, an 80/20 rule applied to determine if an activity was insubstantial. According to this rule, a rental activity could be combined with a trade or business activity if either the rental activity provided less than 20% of the gross income for the combined operation or vice versa.

A facts and circumstances test may also be used to identify activities constituting an appropriate economic unit for the measurement of gain or loss.  Any reasonable method may be used to apply the relevant facts and circumstances. The most important factors are [Reg. 1.469-4(c)(2)]:

a. Similarities and differences in types of business.

b. The extent of common control.

c. The extent of common ownership.

d. Geographical location.

e. Interdependencies between the activities.

2. The second concept which should be considered when planning for 2013 relate to the ability of a taxpayer to qualify as a real estate professional.  Here the taxpayer must meet two criteria:

1. Qualify as a real estate professional.
2. Materially participate in the real estate rental activity.

A taxpayer qualifies for the special relief provision for real estate professionals in any tax year if

(a)  more than 50% of personal services performed by the taxpayer in all trades or businesses during the tax year are performed in real property trades or businesses in which he or she materially participates, and

(b) the taxpayer performs more than 750 hours of service during the tax year in real property trades or businesses in which he or she materially participates. Regulations provide seven tests for determining material participation.

The material participation standard plays a role in two distinct aspects of the real estate professional rules. First, when determining whether a taxpayer qualifies as a real estate professional, only real property trades or businesses in which he or she materially participates are counted.  Second, once it is determined that a taxpayer qualifies as a real estate professional, non-passive treatment is available only for rental real estate activities in which he or she materially participates.

II. Summary and Final Thoughts:

The health care reform legislation has created some excellent planning opportunities for higher-income taxpayers.  Adequate planning with respect to the self-rental regulations and classification as a real estate professional are two instances where the taxpayer can eliminate the new 3.8% tax on passive income by converting those activities into non-passive.

Furthermore, upon the disposition of the activity, the gain would also not be subject to the additional tax.

Please don’t hesitate to contact us at info@templetonco.com or 561-798-9988 to begin discussing options specific to your tax situation.

New 3.8% Medicare Tax on “Unearned” Net Investment Income

High-income taxpayers will be hit with two big tax hikes under the recently enacted health overhaul legislation: a tax increase on wages and a new levy on investments.

To help offset the cost of providing health insurance to millions of Americans, the new law imposes an additional 0.9% Medicare tax on wages above $200,000 for individuals and $250,000 for married couples filing jointly. In addition, for higher-income households, the new law adds a 3.8% tax on unearned income, including interest, dividends, capital gains and other investment income.

It is the 3.8% surtax on “Unearned Income” that we write about today.

3.8% Tax on Unearned Income

Starting in 2013, high-income taxpayers will be subject to a new tax based on net investment income—a 3.8% Medicare contribution tax.  The Health Care and Reconciliation Act of 2010, which amends the Patient Protections and Affordable Care Act, outlines the new Medicare tax.  Here’s an overview of what the new tax will mean to you, and some methods to review to lessen the impact of this tax.

What is the Net Investment Income Tax (NIIT)?

Section 1411 of the Internal Revenue Code imposes The Net Investment Income Tax (NIIT). The NIIT is a tax of 3.8% on certain net investment income of individuals, estates and trusts that have income above certain threshold amounts.

Who is subject to the Net Investment Income Tax?

This new tax will only affect taxpayers whose modified adjusted gross income (MAGI) exceeds $250,000 for joint filers and surviving spouses, $200,000 for single taxpayers and heads of household, and $125,000 for married individuals filing separately. Estates and Trusts will be subject to the Net Investment Income Tax if they have undistributed Net Investment Income, and also have adjusted gross income over the dollar amount at which the highest tax bracket for an estate or trust begins for such taxable year (for tax year 2012, this threshold amount is $11,650).

(For individuals, your AGI is the bottom line on Page 1 of your Form 1040. It consists of your gross income minus certain adjustments to income. If you claimed the foreign earned income exclusion, you must add back the excluded income for purposes of the 3.8% tax.)

If your AGI is above the threshold that applies to you ($250,000, $200,000 or 125,000), the 3.8% tax will apply to the lesser of (1) your net investment income for the tax year or (2) the excess of your AGI for the tax year over your threshold amount. This tax will be in addition to the income tax that applies to that same income.

Example 1: Taxpayer, a single filer, has wages of $180,000 and $15,000 of dividends and capital gains. Taxpayer’s modified adjusted gross income is $195,000, which is less than the $200,000 statutory threshold. Taxpayer is not subject to the Net Investment Income Tax.

Example 2: A married couple that has AGI of $270,000 for 2013, of which $100,000 is net investment income. They would pay a Medicare contribution tax on only the $20,000 amount by which their AGI exceeds their threshold amount of $250,000. That is because the $20,000 excess is less than their net investment income of $100,000. Thus, the couple’s Medicare contribution tax would be $760 ($20,000 × 3.8%).

What is net investment income (NII)?

The net investment income that is subject to the 3.8% tax consists of interest, dividends, annuities, royalties, rents, and net gains from property sales. Income from an active trade or business isn’t included in net investment income, nor is wage income.

Passive business income (within the meaning of IRC section 469) is subject to the Medicare contribution tax. Thus, rents from an active trade or business aren’t subject to the tax, but rents from a passive activity are subject to the tax (however, deductible expenses related to rental income will reduce the amount subject to this tax). Income from a business of trading financial instruments or commodities is also included in net investment income.

Income that is exempt from income tax, such as tax-exempt bond interest, is likewise exempt from the 3.8% Medicare contribution tax. Thus, switching some of your taxable investments into tax-exempt bonds can reduce your exposure to the 3.8% tax. Of course, this should be done with regard to your income needs and investment considerations.

Home sales.

Let’s review how the 3.8% tax applies to home sales. If you sell your main home, you may be able to exclude up to $250,000 of gain, or up to $500,000 for joint filers, when figuring your income tax. This excluded gain won’t be subject to the 3.8% Medicare contribution tax.

However, gain that exceeds the limit on the exclusion will be subject to the tax. Gain from the sale of a vacation home or other second residence, which doesn’t qualify for the income tax exclusion, will also be subject to the Medicare contribution tax.

For example, a married couple has AGI of $200,000 for 2013 and in addition sold their main home for a $540,000 gain. The couple qualified for the full $500,000 exclusion of gain on the sale, leaving only $40,000 of taxable gain. As a result, the couple won’t be subject to the 3.8% tax, because their total AGI ($200,000 + $40,000) will fall below the $250,000 threshold.

Using the aforementioned example, if the gain on the home sale was $680,000, of which $180,000 was taxable, the couple would be subject to the 3.8% tax on $130,000 of the gain. That is the amount by which their total AGI of $380,000 ($200,000 + $180,000) exceeds their $250,000 threshold.

Exceptions from Net Investment Income

Distributions from qualified retirement plans, such as pension plans and IRAs, aren’t subject to the Medicare contribution tax. However, those distributions may push your AGI over the threshold that would cause other types of investment income to be subject to the tax.

This makes Roth IRAs more attractive for higher-income individuals, because qualified Roth IRA distributions are neither subject to the Medicare contribution tax nor included in AGI.

The tax also does not apply to the gain related to the sale of an interest in an S Corporation or partnership, to the extent that the gain on assets held by the entity is from an active trade or business.

What investment expenses are deductible in computing NII?

To determine NII, Gross Investment Income (items described above) is reduced by deductions that are properly allocable. Examples of allocable deductions would include investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items included in Net Investment Income.

How the Net Investment Income Tax is Reported and Paid

For individuals, the tax will be reported on, and paid with, the Form 1040. For Estates and Trusts, the tax will be reported on, and paid with, the Form 1041.

The Medicare contribution tax must be included in the calculation of estimated tax that you owe. Thus, if you will be subject to the tax, you may have to make or increase your estimated tax payments to avoid a penalty.

Planning Strategies

Fortunately, there are a number of effective strategies that can be used to reduce MAGI and or NII and reduce the base on which the surtax is paid. Strategies may include (1) Roth IRA conversions, (2) tax exempt bonds, (3) tax-deferred annuities, (4) life insurance, (5) meet the “Material Participation” requirements for your S Corp and Partnership holdings, (6) become a “Real Estate Professional” for purposes of holding rental real property (7) oil and gas investments, (8) timing estate and trust distributions, (9) charitable remainder trusts, and (10) installment sales and maximizing above-the-line deductions.

We would be happy to explain how these and other strategies might minimize your exposure to the Internal Revenue Code Section 1411  surtax. 

Please don’t hesitate to contact us at info@templetonco.com or 561-798-9988 to begin discussing options specific to your tax situation. 

What you need to know about the tax provisions in the 2012 American Taxpayer Relief Act

The 2012 American Taxpayer Relief Act, signed into law on Jan. 2, 2013 by President Obama, is a sweeping tax package that addresses the permanent extension of the Bush-era tax cuts for most taxpayers, revises the tax rates on ordinary and capital gain income for high-income individuals, modifies the estate tax, offers permanent relief from the Alternative Minimum Tax [AMT] for individual taxpayers, limits the deductions and exemptions of high-income individuals, and provides a host of retroactively resuscitated and extended tax breaks for individual and businesses. Here’s a rundown of the package:

  • Tax rates. For tax years beginning after 2012, the 10%, 15%, 25%, 28%, 33% and 35% tax brackets from the Bush tax cuts will remain in place and are made permanent. This means that, for most Americans, the tax rates will stay the same. However, there will be a new 39.6% rate, which will begin at the following thresholds: $400,000 (single), $425,000 (head of household), $450,000 (joint filers and qualifying widow(er)s), and $225,000 (married filing separately). These dollar amounts will be inflation-adjusted for tax years after 2013.
  • Estate tax. The new law prevents steep increases in estate, gift and generation-skipping transfer (GST) tax that were slated to occur for dying individuals and gifts made after 2012 by permanently keeping the exemption level at $5,000,000 (as indexed for inflation). The new law, however, permanently increases the top estate, gift, and GST rate from 35% to 40% It also continues the portability feature that allows the estate of the first spouse to die to transfer his or her unused exclusion to the surviving spouse. All changes are effective fore individuals dying and gifts made after 2012.
  • Capital gains and qualified dividends rates. The top rate for capital gains and dividends beginning in 2013 will be 23.8% if income falls in the 39.6% tax bracket. For lower income levels, the tax will be 0%, 15%, or 18.8%.
  • Personal exemption phase-out. Beginning in 2013, personal exemptions will be phased out (i.e., reduced) for adjusted gross income over $250,000 (single), $275,000 (head of household) and $300,000 (joint filers). Taxpayers claim exemptions for themselves, their spouses and their dependents. Last year, each exemption was worth $3,800.
  • Itemized deduction limitation. Beginning in 2013, itemized deductions will be limited for adjusted gross income over $250,000 (single), $275,000 (head of household) and $300,000 (joint filers).
  • AMT relief. The new law provides permanent AMT relief. Prior to the Act, the individual AMT exemption amounts for 2012 were to have been $33,750 for unmarried taxpayers, $45,000 for joint filers, and $22,500 for married persons filing separately. Retroactively effective for tax years beginning after 2011, the new law permanently increases these exemption amounts to $50,600 for unmarried taxpayers, $78,750 for joint filers and $39,375 for married persons filing separately. In addition, for tax years beginning after 2012, it indexes these exemption amounts for inflation.
  • Tax credits for low to middle wage earners. The new law extends for five years the following items that were originally enacted as part of the 2009 stimulus package and were slated to expire at the end of 2012: (1) the American Opportunity tax credit, which provides up to $2,500 in refundable tax credits for undergraduate college education; (2) eased rules for qualifying for the refundable child credit; and (3) various earned income tax credit (EITC) changes.
  • Cost recovery. The new law extends increased expensing limitations and treatment of certain real property as Code Section 179 property. It also extends and modifies the bonus depreciation provisions with respect to property placed in service after Dec. 31, 2012, in tax years ending after that date.
  • Tax break extenders. Many of the “traditional” tax extenders are extended for two years, retroactively to 2012 and through the end of 2013. Among many others, the extended provisions include the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction for state and local income taxes, the $250 above-the-line deduction for certain expenses of elementary and secondary school teachers, and the research credit.
  • Pension provision. For transfers after Dec. 31, 2012, in tax years ending after that date, plan provision in an applicable retirement plan (which includes a qualified Roth contribution program) can allow participants to elect to transfer amounts to designated Roth accounts with the transfer being treated as a taxable qualified rollover contribution.
  • Payroll tax cut is no more. The 2% payroll tax cut was allowed to expire at the end of 2012.