TAX PLANNING GUIDE
Start planning now to minimize 2017 taxes
ecause of the higher tax rates that apply to “ordinary income,” you need to be particularly careful in your planning. Ordinary income generally includes salary, income from self-employment or business activities, interest, and distributions
from tax-deferred retirement accounts. Some of it may also be subject to employment tax, or you may have to pay the AMT, under which different tax rates apply. If possi- ble, try to control to your tax advantage the timing of your ordinary income as well as your deductible expenses. When you receive income or incur an expense can affect how much tax you pay and when you have to pay it. Also keep in mind potential tax law changes. (See “What’s new! Tax law uncertainty complicates timing strategies.”)
the deductions may become more valuable because of the higher maximum regular tax rate. Finally, carefully consider the tax conse- quences of exercising ISOs.
You could be subject to the AMT next year. Consider taking the opposite approach. For instance, defer income to next year, because
The top alternative minimum tax rate is 28%, compared to the top regular ordinary-income tax rate of 39.6%. (See Chart 7 on page 24.) But the AMT rate typically applies to a higher taxable income base.
So before taking action to time income and expenses, you should determine whether you’re already likely to be subject to the AMT — or whether the actions you’re considering might trigger it. Some deductions used to calculate regular tax aren’t allowed under the AMT (see Chart 1) and thus can trigger AMT liability. Some income items also might trigger or increase AMT liability:
n Long-term capital gains and qualified dividend income, even though they’re taxed at the same rate for both regular tax and AMT purposes,
n Accelerated depreciation adjustments and related gain or loss differences when assets are sold, and
naxT-exempt interest on certain private-activity municipal bonds.
(For an exception, see the AMT Alert on page 11.)
Finally, in certain situations exercising incentive stock options (ISOs) can trigger significant AMT liability. (See the AMT Alert on page 7.)
Avoiding or reducing AMT With proper planning, you may be able to avoid the AMT, reduce its
impact or even take advantage of its lower maximum rate. To determine the right timing strategies for your situation, work with your tax advisor to assess whether:
You could be subject to the AMT this year. Consider accelerating income into this year, which may allow you
to benefit from the lower maximum AMT rate. And deferring expenses you can’t deduct for AMT purposes may allow you to preserve those deductions. If you also defer expenses you can deduct for AMT purposes,
you’ll likely pay a relatively lower AMT rate. And prepay expenses that will be deductible this year but that won’t help you next year because they’re not deductible for AMT purposes.
Also, before year end consider selling any private-activity municipal bonds whose interest could be subject to the AMT.
If you pay AMT in one year on deferral items, such as depreciation adjust- ments, passive activity adjustments or the tax preference on ISO exercises, you may be entitled to a credit in a subsequent year. In effect, this takes into account timing differences that reverse in later years.
can’t prepay property taxes that relate to next year and deduct the payment on this year’s return.
Timing income and expenses
Smart timing of income and expenses can reduce your tax liability, and poor timing can unnecessarily increase
it. When you don’t expect to be sub- ject to the AMT in the current year or the next year, deferring income
to the next year and accelerating deductible expenses into the cur- rent year may be a good idea. Why?
Because it will defer tax, which usually is beneficial.
But when you expect to be in a higher tax bracket next year — or you expect tax rates to go up — the opposite approach may be beneficial: Accelerating income will allow more income to be taxed at your current year’s lower rate. And deferring expenses will make the deductions more valuable, because deductions save more tax when you’re subject to a higher tax rate.
Warning: The impact of the income- based itemized deduction reduction (see page 4) also should be taken into account when considering timing strategies.
Whatever the reason behind your desire to time income and expenses, here are some income items whose timing you may be able to control:
n Consulting or other self-employment income,
nreUa.sSu.rTy bill income, and
n Retirement plan distributions, to the extent they won’t be subject to
early-withdrawal penalties and aren’t required. (See page 21.)
And here are some expenses with potentially controllable timing:
n State and local income taxes,
n Property taxes,
n Mortgage interest,
n Margin interest, and
n Charitable contributions.
Warning: Prepaid expenses can gen- erally be deducted only in the year to which they apply. For example, you can prepay (by Dec. 31) property taxes that relate to this year but that are due next year, and deduct the payment on your return for this year. But you generally
Miscellaneous itemized deductions
Many expenses that may qualify as miscellaneous itemized deductions are deductible for regular tax purposes only to the extent they exceed, in aggregate, 2% of your adjusted gross income (AGI). “Bunching” these expenses into a single year may allow you to exceed this “floor.”
As the year progresses, record your potential deductions to date. If they’re close to — or they already exceed — the 2% floor, consider paying accrued expenses and incurring and paying additional expenses by Dec. 31,
n Deductible investment expenses, including advisory fees, custodial fees and publications,
n Professional fees, such as tax plan- ning and preparation, accounting, and certain legal fees, and
n Unreimbursed employee business expenses, including vehicle costs, travel, and allowable meals and entertainment.
AMT ALERT! Miscellaneous itemized deductions subject to the 2% floor aren’t deductible for AMT purposes. So don’t bunch them into a year when you may be subject to the AMT.
Health-care-related breaks If your medical expenses exceed 10% of your AGI, you can deduct the excess
amount. Beginning in 2017, this floor also applies to taxpayers age 65 and older. (Previously, they could enjoy a 7.5% floor for regular tax purposes but were subject to the 10% floor for AMT purposes.) Eligible expenses may include:
n Health insurance premiums,
n Long-term care insurance premiums (limits apply),
n Medical and dental services,
n Prescription drugs, and
n Mileage (17 cents per mile driven for health care purposes in 2017).
Consider bunching nonurgent medical procedures (and any other services and purchases whose timing you can control without negatively affecting your or your family’s health) into one year to exceed the 10% floor. If one spouse has high medical expenses and a relatively lower AGI, filing separately may allow that spouse to exceed the AGI floor and deduct some medical expenses that wouldn’t be deductible if the couple filed jointly.
AMT ALERT! Because the AMT exemption for separate returns is considerably lower than the
exemption for joint returns, filing separately to exceed the floor could trigger the AMT.
Expenses that are reimbursable by insurance or paid through a tax- advantaged account such as the following aren’t deductible:
HSA. If you’re covered by a qualified high deductible health plan, you
can contribute pretax income to an employer-sponsored Health Savings Account — or make deductible contributions to an HSA you set
up yourself — up to $3,400 for self-only coverage and $6,750 for family coverage for 2017. Plus, if you’re age 55 or older, you may contribute an additional $1,000. HSAs can bear interest or be invested, growing tax-deferred similar to an IRA. Withdrawals for qualified medical expenses are tax-free, and you can carry over a balance from year to year.
FSA. You can redirect pretax income to an employer-sponsored Flexible Spending Account up to an employer- determined limit — not to exceed
$2,600 in 2017. The plan pays or reimburses you for qualified medical expenses. What you don’t use by the plan year’s end, you generally lose — though your plan might allow you to roll over up to $500 to the next year. Or it might give you a 21/2-month grace period to incur expenses to use up
the previous year’s contribution. If you have an HSA, your FSA is limited to funding certain “permitted” expenses.
Sales tax deduction
The break allows you to take an itemized deduction for state and local sales taxes in lieu of state and local income taxes. The deduction can be valuable if you reside in a state with no or low income tax or you purchase a major item, such as a car or boat.
Except for major purchases, you don’t have to keep receipts and track all the sales tax you actually pay. Your deduction can be determined using an IRS sales tax calculator that will base the deduction on your income and the sales tax rates in your locale plus the tax you actually pay on major purchases.
Limit on itemized deductions
If your AGI exceeds the applicable threshold, certain deductions are reduced by 3% of the AGI amount that exceeds the threshold (not to exceed 80% of otherwise allowable deductions). For 2017, the thresholds
are $261,500 (single), $287,650 (head of household), $313,800 (married filing jointly) and $156,900 (married filing separately).
If your AGI is close to the threshold,
AGI-reduction strategies (such as contributing to a retirement plan or HSA) may allow you to stay under it. If that’s not possible, consider the reduced tax benefit of the affected deductions before implementing strategies to accelerate or defer deductible expenses. The limitation doesn’t apply, however, to deductions for medical expenses, investment interest, or casualty, theft or wagering losses.
In addition to income tax, you must pay Social Security and Medicare taxes on earned income, such as salary and
bonuses. The 12.4% Social Security tax applies only up to the Social Security wage base of $127,200 for 2017. All earned income is subject to the 2.9% Medicare tax. Both taxes are split equally between the employee and the employer.
If you’re self-employed, you pay both the employee and employer portions of employment taxes on your self- employment income. The employer portion (6.2% for Social Security
tax and 1.45% for Medicare tax) is deductible above the line.
As a self-employed taxpayer, you may benefit from other above-the-line deduc- tions as well. You can deduct 100% of health insurance costs for yourself, your spouse and your dependents, up to your net self-employment income. You also can deduct contributions to a retirement plan and, if you’re eligible, an HSA for yourself. Above-the-line deductions are particularly valuable because they’re fully deductible and reduce your AGI and modified AGI (MAGI), which are the triggers for certain additional taxes and the phaseouts of many tax breaks.
Additional 0.9% Medicare tax Another employment tax that higher- income taxpayers must be aware
of is the additional 0.9% Medicare tax. It applies to FICA wages and net self-employment income exceeding
$200,000 per year ($250,000 if married filing jointly and $125,000 if married filing separately). Be aware that this tax could be reduced or eliminated under health care or tax reform legislation.
If your wages or self-employment income varies significantly from year to year or you’re close to the threshold for triggering the additional Medicare tax, income timing strategies may help you avoid or minimize it. For example,
if you’re an employee, perhaps you can time when you receive a bonus, or you
can defer or accelerate the exercise of stock options. If you’re self-employed, you may have flexibility on when you purchase new equipment or invoice customers. If you’re a shareholder- employee of an S corporation, you might save tax by adjusting how much you receive as salary vs. distributions. (See “Owner-employees” at right.)
Also consider the withholding rules. Employers must withhold the addi- tional tax beginning in the pay period when wages exceed $200,000 for the calendar year — without regard to an employee’s filing status or income from other sources. So your employer might withhold the tax even if you aren’t liable for it — or it might not withhold the tax even though you are liable for it.
If you don’t owe the tax but your employer is withholding it, you can claim a credit on your 2017 income tax return. If you do owe the tax but your employer isn’t withholding it, consider filing a W-4 form to request additional income tax withholding, which can be used to cover the shortfall and avoid interest and pen- alties. Or you can make estimated tax payments.
There are special considerations if you’re a business owner who also works in the business, depending on its structure:
Partnerships and limited liability companies. Generally, all trade or business income that flows through to you for income tax purposes is subject to self-employment taxes — even if the income isn’t distributed to you. But such income may not be subject to
self-employment taxes if you’re a limited partner or the LLC member equivalent. Check with your tax advisor on whether the additional 0.9% Medicare tax on earned income or the 3.8% NIIT (see page 8) will apply.
S corporations. Only income you receive as salary is subject to employ- ment taxes and, if applicable, the 0.9% Medicare tax. To reduce these taxes, you may want to keep your salary relatively — but not unreasonably — low and increase your distributions
of company income, because distri- butions generally aren’t taxed at the corporate level or subject to the 0.9% Medicare tax or 3.8% NIIT.
C corporations. Only income you receive as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. Nevertheless, you may prefer to take more income as salary (which is deductible at
the corporate level) as opposed to dividends (which aren’t deductible at the corporate level yet are still taxed at the shareholder level and could be subject to the 3.8% NIIT) if the overall tax paid by both the corporation and you would be less.
Warning: The IRS is cracking down on misclassification of corporate payments to shareholder-employees, so tread carefully. ❖
Do you know the tax consequences of your exec comp?
f you’re an executive or other key employee, you might receive stock-based compensation, such as restricted stock, restricted stock units (RSUs) or stock options (either incentive or nonqualified), or nonqualified deferred compensation (NQDC). The tax consequences of these types of compensation can be complex — subject to ordinary income, capital gains, employment and other taxes. So smart tax planning is critical. Keep in mind that proposed tax law changes such as changes to tax rates, repeal of the AMT, and reduction or repeal of the 0.9% additional Medicare tax or NIIT could affect the tax consequences — and associated planning strategies — related to
exec comp. Check with your tax advisor for the latest information.
But they do offer a limited ability to defer income taxes: Unlike restricted stock, which becomes taxable immediately upon vesting, RSUs aren’t taxable until the employee actually receives the stock. So rather than having the stock delivered immediately upon vesting,
you may be able to arrange with your employer to delay delivery.
Restricted stock is stock that’s granted subject to a substantial risk of forfeiture. Income recognition is normally deferred until the stock is no longer subject
to that risk or you sell it. When the restriction lapses, you pay taxes on the stock’s fair market value (FMV) at your ordinary-income rate. (The FMV will be considered FICA income, so it also could trigger or increase your exposure to the additional 0.9% Medicare tax. See page 5.)
But you can instead make a Section 83(b) election to recognize ordinary income when you receive the stock. This election, which you must make within 30 days after receiving the stock, can be beneficial if the income at the grant date is negligible or the stock is likely to appreciate signifi- cantly before income would otherwise be recognized. Why? Because the election allows you to convert future appreciation from ordinary income to long-term capital gains income and defer it until the stock
There are some potential disadvantages of a Sec. 83(b) election, however. First, you must prepay tax in the current
year — which also could push you
into a higher income tax bracket and trigger or increase your exposure to the additional 0.9% Medicare tax. But if your company is in the earlier stages of development, the income recognized may be relatively small.
Second, any taxes you pay because of the election can’t be refunded if you eventually forfeit the stock or you sell it at a decreased value. However, you’d have a capital loss when you forfeited or sold the stock.
Third, when you sell the shares, any gain will be included in net investment income and could trigger or increase your liability for the 3.8% NIIT. (See page 8.)
Work with your tax advisor to map out whether the Sec. 83(b) election is appro- priate for you in each particular situation.
RSUs are contractual rights to receive stock (or its cash value) after the award has vested. Unlike restricted stock, RSUs aren’t eligible for the Sec. 83(b) election. So there’s no
opportunity to convert ordinary income into capital gains.
This will defer income tax and may allow you to reduce or avoid exposure to the additional 0.9% Medicare tax (because the RSUs are treated as FICA income). However, any income deferral must satisfy the strict require- ments of Internal Revenue Code (IRC) Section 409A.
Incentive stock options
ISOs allow you to buy company stock in the future (but before a set expiration date) at a fixed price equal to or greater than the stock’s FMV at the date of the grant. Therefore, ISOs don’t provide a benefit until the stock appreciates in value. If it does, you can buy shares at a price below what they’re then trading for, as long as you’ve satisfied the applicable ISO holding periods.
ISOs receive tax-favored treatment but must comply with many rules. Here are the key tax consequences:
nouY owe no tax when ISOs are granted.
nouY owe no regular income tax when you exercise the ISOs.
n If you sell the stock after holding the shares at least one year from the exercise date and two years from the grant date, you pay tax on the sale at your long-term capital gains rate. You also may owe the NIIT. (See page 8.)
n If you sell the stock before long-term capital gains treatment applies, a “disqualifying disposition” occurs and any gain is taxed as compen- sation at ordinary-income rates. (Disqualified dispositions aren’t, however, subject to the additional 0.9% Medicare tax.)
AMT ALERT! If you don’t sell the stock in the year of exercise, a tax “preference” item is created for the difference between the stock’s FMV and the exercise price (the “bargain element”) that can trigger the AMT. A future AMT credit, however, should mitigate this AMT
hit. Consult your tax advisor because the rules are complex.
If you’ve received ISOs, plan carefully when to exercise them and whether to immediately sell shares received from an exercise or to hold them. Waiting to exercise ISOs until just before the expiration date (when the stock value may be the highest, assuming the stock is appreciating) and holding
on to the stock long enough to garner long-term capital gains treatment often is beneficial. But there’s also market risk to consider. Plus, acting earlier can be advantageous in several situations:
n Exercise early to start the holding period so you can sell and receive long- term capital gains treatment sooner.
n Exercise when the bargain element is small or when the market price is close to bottoming out to reduce or eliminate AMT liability.
n Exercise annually so you can buy only the number of shares that will achieve a breakeven point between the AMT and regular tax and thereby incur no additional tax.
n Sell in a disqualifying disposition and pay the higher ordinary-income rate to avoid the AMT on potentially disappearing appreciation.
On the negative side, exercising early accelerates the need for funds to buy the stock, exposes you to a loss if the shares’ value drops below your exercise cost, and may create a tax cost if the preference item from the exercise generates an AMT liability. See Case Study II.
The timing of ISO exercises could also positively or negatively affect your liability for the higher ordinary-income tax rates, the 20% long-term capital gains rate and the NIIT. With your tax advisor, evaluate the risks and crunch the numbers to determine the best strategy for you.
Nonqualified stock options The tax treatment of NQSOs is different from the tax treatment of ISOs: NQSOs
create compensation income (taxed at ordinary-income rates) on the bargain element when exercised (regardless of whether the stock is held or sold
immediately), but they don’t create an AMT preference item.
You may need to make estimated tax payments or increase withholding to fully cover the tax on the exercise.
Keep in mind that an exercise could trigger or increase exposure to top tax rates, the additional 0.9% Medicare tax and the NIIT.
These plans pay executives in the future for services to be currently performed. They differ from qualified plans, such as 401(k)s, in several ways. For example, unlike 401(k) plans, NQDC plans can favor highly compensated employees, but plan funding isn’t protected from the employer’s creditors. (For more on 401(k)s, see page 20.)
One important NQDC tax issue is that employment taxes (see page 4) are generally due once services have been performed and there’s no longer a substantial risk of forfeiture — even though compensation may not be paid or recognized for income tax purposes until much later. So your employer may withhold your portion of the employment taxes from your salary or
ask you to write a check for the liability. Or it may pay your portion, in which case you’ll have additional taxable income. Warning: The additional 0.9% Medicare tax could also apply.
Taxes shouldn’t be the main
driver of your investment decisions
ax treatment of your investments varies dramatically based on such factors as type of investment, type of income it produces, how long you’ve held it and whether any special limitations or breaks apply. It’s also possible that tax
law changes could affect the tax treatment of investments. Of course, taxes should never be the primary driver of your investment decisions. But tax rate uncertainty makes buying and selling securities ever more challenging.
plan contributions (see page 20) — could also help you avoid or reduce NIIT liability. Finally, keep in mind that the NIIT could be reduced or eliminated under health care or tax reform legislation.
Taxpayers with modified adjusted gross income (MAGI) over $200,000 per year ($250,000 if married filing jointly and
$125,000 if married filing separately) may owe the net investment income tax on top of whatever other tax they owe on their investment income. The NIIT equals 3.8% of the lesser of your net investment income or the amount by
which your MAGI exceeds the applicable threshold. Net investment income can include capital gains, dividends, interest
and other investment-related income (but not self-rental income from an active trade or business). The rules are somewhat complex, so consult your tax advisor for more information.
Many of the strategies that can help you save or defer income tax on your investments can also help you avoid or defer NIIT liability. And because the threshold for the NIIT is based on MAGI, strategies that reduce your MAGI — such as making retirement
Capital gains tax and timing Although time, not timing, is generally the key to long-term investment
success, timing can have a dramatic impact on the tax consequences of investment activities. Your long-term capital gains rate might be as much as 20 percentage points lower than your ordinary-income rate. The long- term gains rate applies to investments held for more than 12 months. The
applicable rate depends on your income level and the type of asset you’ve sold. (See Chart 2 on page 10.) Holding on
to an investment until you’ve owned it more than a year may help substantially cut tax on any gain.
Remember: Appreciating investments that don’t generate current income aren’t taxed until sold, deferring tax and perhaps allowing you to time the sale to your tax advantage — such as in a year when you have capital losses to absorb the capital gain. Or, if you’ve cashed in some big gains during the year and want to reduce your 2017 tax liability, before year end look for unrealized losses in your portfolio and consider selling them to offset your gains. Both long- and short-term gains and losses can offset one another.
AMT ALERT! Substantial net long-term capital gains can trigger the AMT.
And if you bought the same security at different times and prices and want to sell high-tax-basis shares
to reduce gain or increase a loss to offset other gains, be sure to specifically identify which block of shares is being sold.
Wash sale rule
If you want to achieve a tax loss with minimal change in your portfolio’s asset allocation, keep in mind the wash sale rule. It prevents you from taking a loss on a security if you buy
a substantially identical security (or an option to buy such a security) within 30 days before or after you sell the security that created the loss. You can then recognize the loss only when you sell the replacement security.
Fortunately, there are ways to avoid triggering the wash sale rule and
still achieve your goals. For example, you can:
n Sell the security and immediately buy securities of a different company in the same industry
or shares in a mutual fund that holds securities much like the ones you sold,
n Sell the security and wait 31 days to repurchase the same security, or
n Before selling the security, purchase additional shares of that security equal to the number you want to sell at a loss, and then wait 31 days to sell the original portion.
Alternatively, you can do a bond swap, where you sell a bond, take a loss and then immediately buy another bond
of similar quality and duration from a different issuer. Generally, the wash sale rule doesn’t apply because the bonds aren’t considered substantially identical. Thus, you can achieve a tax loss with virtually no change in economic position.
Warning: You can’t avoid the wash sale rule by selling stock at a loss in a taxable account and purchasing the same stock within 30 days in a tax-advantaged retirement account.
If net losses exceed net gains, you can deduct only $3,000 ($1,500 if married filing separately) of the net losses per year against other income (such as wages, self-employment and business income, dividends and interest).
You can carry forward excess losses until death. Loss carryovers can be a powerful tax-saving tool in future years if you have a large investment portfolio, real estate holdings or a closely held
business that might generate substantial future capital gains.
Finally, remember that capital gains distributions from mutual funds can also absorb capital losses.
The 0% rate applies to long-term gain that would be taxed at 10% or 15% based on the taxpayer’s ordinary-income rate. If you have adult children in one of these tax brackets, consider transferring appreciated assets to them so they can sell the assets and enjoy the 0% rate.
This strategy can be even more powerful if you’d be subject to the 3.8% NIIT and/or the 20% long-term capital gains rate if you sold the assets.
Warning: If the child will be under age 24 on Dec. 31, first make sure he or she won’t be subject to the “kiddie
tax.” (See page 19.) Also consider any gift tax consequences. (See page 22.)
Paying attention to details
If you don’t pay attention to the details, the tax consequences of a sale may
be different from what you expect. For example, the trade date, not the settlement date, of publicly traded securities determines the year in which you recognize the gain or loss.
Investing in mutual funds is an easy way to diversify your portfolio. But beware of the tax pitfalls. First, mutual funds with high turnover rates can create income that’s taxed at ordinary-income rates. Choosing
funds that provide primarily long-term gains can save you more tax dollars because of the lower long-term rates.
Second, earnings on mutual funds are typically reinvested, and unless you or your investment advisor increases your basis accordingly, you may report more gain than required when you sell the fund. Brokerage firms are required to track (and report to the IRS) your cost basis in mutual funds acquired during the tax year.
Third, buying equity mutual fund shares late in the year can be costly tax-wise. Such funds often declare a large capital gains distribution at year end, which is a taxable event. If you own the shares on the distribution’s record date, you’ll be taxed on the full distribution amount even if it includes significant gains realized by the fund before you owned the shares. And you’ll pay tax on those gains in the current year — even if you reinvest the distribution. (See Case Study III.)
Small business stock
By purchasing stock in certain small businesses, you can diversify your port- folio. You also may enjoy preferential tax treatment:
Conversion of capital loss to ordinary loss. If you sell qualifying Section 1244 small business stock at a loss, you
can treat up to $50,000 ($100,000, if married filing jointly) as an ordinary,
rather than a capital, loss — regardless of your holding period. This means you can use it to offset ordinary income, reducing your tax by as much as 39.6% of this portion of the loss. Sec. 1244 applies only if total capital invested isn’t more than $1 million.
Tax-free gain rollovers. If within 60 days of selling qualified small business (QSB) stock you buy other QSB stock with
the proceeds, you can defer the tax on your gain until you dispose of the new stock. The rolled-over gain reduces your basis in the new stock. For determining long-term capital gains treatment, the new stock’s holding period includes
the holding period of the stock you sold. To be a QSB, a business must be engaged in an active trade or business and must not have assets that exceed
$50 million, among other requirements.
Exclusion of gain. Generally, taxpayers selling QSB stock are allowed to exclude up to 50% of their gain if they’ve held the stock for more than five years. But, depending on the acquisition date, the exclusion may be greater: The exclusion is 75% for stock acquired after Feb. 17, 2009, and before Sept. 28, 2010, and 100% for stock acquired on or after Sept. 28, 2010.
The taxable portion of any QSB gain will be subject to the lesser of your ordinary-income rate or 28%, rather than the normal long-term gains rate. (See Chart 2.) Thus, if the 28% rate
and the 50% exclusion apply, the effective rate on the QSB gain will be 14% (28% × 50%).
Keep in mind that all three of these tax benefits are subject to additional requirements and limits. Consult your tax and financial advisors to be sure an investment in small business stock is right for you.
If you’ve invested in a trade or business in which you don’t materially participate, remember the passive activity rules.
Why? Passive activity income may be subject to the 3.8% NIIT, and passive activity losses generally are deduct- ible only against income from other
passive activities. You can carry forward disallowed losses to the following year, subject to the same limits.
To avoid passive activity treatment, you must “materially participate” in the activity, which typically means you must participate in the trade or business more than 500 hours during the year
or demonstrate that your involvement constitutes substantially all of the
participation in the activity. (Special rules apply to real estate; see page 13.) To help ensure your hours claim will be able to withstand IRS scrutiny, carefully track and document your time. Contem- poraneous recordkeeping is better than records that are created after-the-fact.
If you don’t pass the material participation test, consider:
Increasing your involvement. If you can exceed 500 hours, the activity no longer will be subject to passive activity rules.
Grouping activities. You may be able to group certain activities together to be treated as one activity for tax purposes and exceed the 500-hour threshold.
But the rules are complex, and there are potential downsides to consider.
Looking at other activities. If you have passive losses, one option is to limit your participation in another activity that’s generating income, so that you don’t meet the 500-hour test. Another is to invest in another income-producing trade or business that will be passive to you. Under both strategies, you’ll have passive income that can absorb some or all of your passive losses.
Disposing of the activity. This generally allows you to deduct all passive losses — including any loss on disposition (subject to basis and capital loss limitations). But, again, the rules are complex.
Income investments Qualified dividends are taxed at the favorable long-term capital gains
tax rate rather than at your higher ordinary-income tax rate.
Interest income, however, generally is taxed at ordinary-income rates. So stocks that pay qualified dividends may be more attractive tax-wise than other income investments, such as
CDs and taxable bonds. But there are exceptions.
Some dividends, for example, are sub- ject to ordinary-income rates. These include certain dividends from:
n Real estate investment trusts (REITs),
n Regulated investment companies (RICs),
n Money market mutual funds, and
n Certain foreign investments.
The tax treatment of bond income varies. For example:
n Interest on U.S. government bonds is taxable on federal returns but exempt by law on state and local returns.
n Interest on state and local government bonds is excludable on federal returns. If the bonds were issued in your home state, interest also may be excludable on your state return, depending on the state.
n Corporate bond interest is fully taxable for federal and state purposes.
n Bonds (except U.S. savings bonds) with original issue discount (OID) build up “interest” as they rise toward maturity. You’re generally considered to earn a portion of that interest annually — even though the bonds don’t pay this interest annually — and you must pay tax on it.
Keep in mind that state and municipal bonds usually pay a lower interest rate. See Case Study IV.
AMT ALERT! Tax-exempt interest from private-activity municipal bonds can trigger or increase AMT liability.
However, any income from tax-exempt bonds issued in 2009 and 2010 (along with 2009 and 2010 re-fundings of
bonds issued after Dec. 31, 2003, and before Jan. 1, 2009) is excluded from the AMT.
Investment interest expense
Investment interest — interest on debt used to buy assets held for investment, such as margin debt
used to buy securities — generally is deductible for both regular tax and AMT purposes. But special rules apply.
Your investment interest deduction is limited to your net investment income, which, for the purposes of this deduction, generally includes
taxable interest, nonqualified dividends and net short-term capital gains (but not long-term capital gains), reduced
by other investment expenses. Any disallowed interest is carried forward, and you can deduct it in a later year if you have excess net investment income.
You may elect to treat net long-term capital gains or qualified dividends as investment income in order to deduct more of your investment interest. But if you do, that portion of the long-term capital gain or dividend will be taxed at ordinary-income rates.
Payments a short seller makes to the stock lender in lieu of dividends may be deductible as an investment interest expense. But interest on debt used
to buy securities that pay tax-exempt income, such as municipal bonds, isn’t deductible.
Also keep in mind that passive interest expense — interest on debt incurred to fund passive activity expenditures — becomes part of your overall passive activity income or loss, subject to limitations.
How real estate can reduce your tax bite
here are many ways you can maximize the tax benefits associated with owning a principal residence, vacation home or rental property — or maintaining a home office. Tax planning is particularly important for higher-income individuals who
are planning to sell real estate in 2017. And keep an eye on possible tax law changes: Some real estate deductions could disappear while others might become less valuable. In addition, some tax rates could change and certain taxes could be eliminated, possibly affecting tax planning related to real estate investments.
If you’re an employee, the business use of your home office must be for your employer’s benefit and your home office expenses are a miscellaneous itemized deduction. This means you’ll enjoy a tax benefit only if these expenses plus your other miscellaneous itemized expenses exceed 2% of your AGI. (See page 3.)
Home-related deductions There are many tax benefits to home ownership — among them, various
deductions. But the income-based limit on itemized deductions (see page 4) could reduce your savings:
Property tax deduction. If you’re looking to accelerate or defer deductions, property tax is one expense you may be able to time. (See page 3.)
AMT ALERT! Property tax isn’t deductible for AMT purposes. If you’re subject to the AMT this year, a prepayment may hurt you because you’ll lose the benefit of the deduction.
Mortgage interest deduction. You generally can deduct (for both regular tax and AMT purposes) interest on up to a combined total of $1 million of mortgage debt incurred to purchase, build or improve your principal residence and a second residence.
Points paid related to your principal
residence also may be deductible.
Home equity debt interest deduction. Interest on home equity debt used for any purpose (debt limit of $100,000) may be deductible. So consider using a home equity loan or line of credit
to pay off credit cards or auto loans, for which interest isn’t deductible and rates may be higher.
AMT ALERT! If home equity debt isn’t used for home improvements, the interest isn’t deductible for AMT purposes and could trigger or increase AMT liability.
Energy-related breaks. A wide variety of breaks designed to encourage energy efficiency and conservation expired Dec. 31, 2016. Consult your tax advisor for the latest information on whether any have been extended.
Home office deduction
If your home office is your principal place of business (or used substantially and regularly to conduct business) and that’s the only use of the space, you generally can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses, and the depreciation allocable to the space. Or you may be able to use the simplified method for calculating the deduction.
Using the simplified option, you can deduct $5 per square foot for up to 300 square feet (maximum of $1,500
per year). Although you can’t depreciate the portion of your home that’s used
as an office — as you could filing Form 8829 — you can claim allowable mortgage interest, property taxes and
casualty losses in full as itemized deduc- tions on Schedule A, without needing
to apportion them between personal and business use of your home.
If you’re self-employed, however, you can deduct qualified home office expenses from your self-employment income. The 2% floor doesn’t apply.
Home rental rules
If you rent out all or a portion of your principal residence or second home for less than 15 days, you don’t have to
report the income. But expenses directly associated with the rental, such as adver- tising and cleaning, won’t be deductible.
If you rent out your principal residence or second home for 15 days or more, you’ll have to report the income. But you also may be entitled to deduct some or all of your rental expenses — such as utilities, repairs, insurance and depreciation.
Exactly what you can deduct depends on whether the home is classified as a rental property for tax purposes (based on the amount of personal vs. rental use):
Rental property. You can deduct rental expenses, including losses, subject to the real estate activity rules discussed at right. You can’t deduct any interest that’s attrib- utable to your personal use of the home, but you can take the personal portion of property tax as an itemized deduction.
Nonrental property. You can deduct rental expenses only to the extent of your rental income. Any excess can be carried forward to offset rental income in future years. You also can take an
itemized deduction for the personal portion of both mortgage interest and property taxes. In some situations, it may be beneficial to reduce personal use of a residence so it will be classified as a rental property. (See Case Study V.)
When you sell your principal residence, you can exclude up to $250,000 ($500,000 if married filing jointly) of gain if you meet certain tests. Gain
that qualifies for exclusion will also be excluded from the 3.8% NIIT. (See
page 8.) To support an accurate tax basis, maintain thorough records, including information on your original cost and subsequent improvements, reduced by any casualty losses and depreciation claimed based on business use. Warning: Gain that’s allocable to a period of “non- qualified” use generally isn’t excludable.
Losses on the sale of any personal resi- dence aren’t deductible. But if part of your home is rented out or used exclusively for your business, the loss attributable to that portion may be deductible.
Because a second home is ineligible for the gain exclusion, consider converting it to rental use before selling. It can be con- sidered a business asset, and you may be able to defer tax on any gains through
an installment sale or a Section 1031 exchange. Or you may be able to deduct a loss, but only to the extent attributable to a decline in value after the conversion.
Real estate activity rules Income and losses from investment real estate or rental property are passive by
definition — unless you’re a real estate professional. Why is this important?
Passive activity income may be subject to the 3.8% NIIT, and passive activity losses are generally deductible only against income from other passive activities, with the excess being carried forward.
To qualify as a real estate professional, you must annually perform:
n More than 50% of your personal services in real property trades or businesses in which you materially participate, and
n More than 750 hours of service in these businesses during the year.
Each year stands on its own, and there are other nuances to be aware of. If you’re concerned you’ll fail either test and be subject to the NIIT or stuck with passive losses, consider increasing your hours so you’ll meet the test. Keep in mind that special rules for spouses may help you meet
the 750-hour test. Warning: The IRS has successfully challenged claims of real estate professional status in instances where the taxpayer didn’t keep adequate records of time spent.
Depreciation-related breaks Three valuable depreciation-related breaks are available to real estate investors:
1. 50% bonus depreciation. This additional first-year depreciation allowance is available for qualified improvement property. The break has been extended through 2019, but it’s scheduled to drop to 40% for 2018 and 30% for 2019.
2. Section 179 expensing election. This allows you to deduct (rather than depreciate over a number of years) qualified leasehold-improvement, restaurant and retail-improvement property. The expensing limit for 2017 is
$510,000, subject to a phaseout if your qualified asset purchases for the year exceed $2.03 million. (These amounts are adjusted annually for inflation.)
3. Accelerated depreciation. This break allows a shortened recovery period of 15 years — rather than 39 years --
for qualified leasehold-improvement, restaurant and retail-improvement property.
It’s possible to divest yourself of appreciated investment real estate but defer the tax liability. Such strategies may even help you keep your income low enough to avoid triggering the 3.8% NIIT and the 20% long-term capital gains rate. Consider these deferral strategies:
Installment sale. An installment sale allows you to defer gains by spreading them over several years as you receive the proceeds. Warning: Ordinary gain from certain depreciation recapture is recognized in the year of sale, even if no cash is received.
Sec. 1031 exchange. Also known as a “like-kind” exchange, this technique allows you to exchange one real estate investment property for another and defer paying tax on any gain until
you sell the replacement property. Discuss the limits and risks with your tax advisor. ❖
Business owners must look out for their future when tax planning
ax planning is a juggling act for business owners. You have to keep your eye on your company’s income and expenses and applicable tax breaks (especially if you own a pass-through entity). But you also need to look out
for your own financial future. For example, you should take advantage of retirement plans that allow you to make larger nontaxable contributions than you could make as an employee. And you need to develop an exit plan so that taxes don’t trip you up when you sell your business or transfer it to the next generation.
2017 contribution needed to attain the projected future annual benefit may exceed the maximum contributions allowed by other plans, depending on your age and the desired benefit. For this reason, a business owner age 50 or older with a younger staff should consider a defined benefit plan.
If most of your money is tied up in your business, retirement can be a challenge. So if you haven’t already set up a tax-advantaged retirement plan, consider doing so this year. If you might be subject to the 3.8% NIIT (see page 8), this may be particularly
beneficial because retirement plan con- tributions can reduce your MAGI and thus help you reduce or avoid the NIIT.
Keep in mind that, if you have employees, they generally must be allowed to participate in the plan, provided they work enough hours and meet other qualification requirements. Here are a few options that may enable you to make substantial contributions:
Profit-sharing plan. This is a defined contribution plan that allows discre- tionary employer contributions and flexibility in plan design. You can make deductible 2017 contributions (see Chart 3 for limits) as late as the due date of your 2017 income tax return, including extensions — provided your plan exists on Dec. 31, 2017.
SEP. A Simplified Employee Pension is a defined contribution plan that provides benefits similar to those of a profit- sharing plan. But you can establish a SEP in 2018 and still make deductible
2017 contributions as late as the due date of your 2017 income tax return, including extensions. (See Chart 3 for contribution limits.) Another benefit is that a SEP is easier to administer than a profit-sharing plan.
Defined benefit plan. This plan sets a future pension benefit and then
actuarially calculates the contributions needed to attain that benefit. The maximum annual benefit for 2017
is generally $215,000 or 100% of average earned income for the high- est three consecutive years, if less. Because it’s actuarially driven, the
You can make deductible 2017 defined benefit plan contributions until the due date of your 2017 income tax return, including extensions — provided your plan exists on Dec. 31, 2017. Warning: Employer contributions generally are required and must be paid quarterly if there was a shortfall in funding for the prior year.
An exit strategy is a plan for passing on responsibility for running the company, transferring ownership and extracting
your money from the business. This requires planning well in advance of the transition. Here are the most common exit options:
Buy-sell agreement. When a business has more than one owner, a buy-sell agreement can be a powerful tool. The agreement controls what happens to the business when a specified event occurs, such as an owner’s retirement, disability or death. Among other bene- fits, a well-drafted agreement:
n Provides a ready market for the departing owner’s shares,
n Prescribes a method for setting a price for the shares, and
n Allows business continuity by preventing disagreements caused by new owners.
A key issue with any buy-sell agreement is providing the buyer(s) with a means of funding the purchase. Life or disability insurance often helps fulfill this need and can give rise to several tax issues and opportunities.
One of the biggest advantages of life insurance as a funding method is that proceeds generally are excluded from the beneficiary’s taxable income. There are exceptions, however, so be sure to consult your tax advisor.
Succession within the family. You can pass your business on to family members by giving them interests, selling them interests or doing some of each. Be sure to consider your income needs, the tax consequences, and how family members will feel about your choice.
Under the annual gift tax exclusion, you can gift up to $14,000 of ownership interests under your gift tax annual exclusion without using up any of your lifetime gift and estate tax exemption. Valuation discounts may further reduce the taxable
value of the gift. But a gift and
estate tax repeal has been proposed, so it’s possible that in the future
you might be able to transfer your business to the next generation free of federal tax. Check with your tax advisor for the latest information. (See page 22 for more on gift and estate planning.)
Management buyout. If family members aren’t interested in or
capable of taking over your business, one option is a management buyout. This can provide for a smooth transition because there may be little learning curve for the new owners. Plus, you avoid the time and expense of finding an outside buyer.
ESOP. If you want rank and file employees to become owners as well, an employee stock ownership plan may be the ticket. An ESOP is a qualified retirement plan created primarily to purchase your company’s stock. Whether you’re planning for liquidity, looking for a tax-favored loan or wanting to supplement an employee benefit program, an ESOP can offer many advantages.
Sale to an outsider. If you can find the right buyer, you may be able to sell the business at a premium. Putting your business into a sale-ready state can help you get the best price. This
generally means transparent operations, assets in good working condition and a healthy balance sheet.
Sale or acquisition
Whether you’re selling your business as part of an exit strategy or acquiring another company to help grow your business, the tax consequences can have a major impact on the transac- tion’s success or failure. Here are a few key tax considerations:
Asset vs. stock sale. With a corporation, sellers typically prefer a stock sale for the capital gains treatment and to avoid double taxation. (For more on capital gains tax, see page 8.) Buyers generally want an asset sale to maximize future depreciation write-offs and avoid poten- tial liabilities.
Tax-deferred transfer vs. taxable sale. A transfer of corporation ownership can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization. But the transaction must comply with strict rules.
Although it’s generally better to post- pone tax, there are some advantages to a taxable sale:
n The parties don’t have to meet the technical requirements of a tax-deferred transfer.
n The seller doesn’t have to worry about the quality of buyer stock or other business risks of a tax- deferred transfer.
n The buyer enjoys a stepped-up basis in its acquisition’s assets.
Installment sale. A taxable sale might be structured as an installment sale if the buyer lacks sufficient cash or pays a contingent amount based on the business’s performance. An installment sale also may make sense if the seller
wishes to spread the gain over a number of years — which could be especially beneficial if it would allow the seller to stay under the thresholds for triggering the 3.8% NIIT or the 20% long-term capital gains rate. But an installment sale can backfire on the seller. For example:
n Depreciation recapture must be reported as gain in the year of sale, no matter how much cash the seller receives.
n If tax rates increase, the overall tax could wind up being more.
Of course, tax consequences are only one of many important considerations when planning a sale or acquisition. ❖
Charitable giving: How to make the most of this tax planning tool
iving to charity can provide not only large tax deductions, but also the satisfaction of doing good. On top of that, it’s one of the most flexible tax planning tools because you can control the timing to best meet your needs. Well-planned gifts also can
save estate tax while allowing you to take care of your heirs in the manner you choose. But you must keep in mind various limits that could reduce the tax benefits of your donation.
Donations of long-term capital gains property are subject to tighter deduction limits, however — 30% of AGI for gifts to public charities, 20% for gifts to nonoperating private foundations.
Outright gifts of cash (which include donations made via check, credit card and payroll deduction) are the easiest. The substantiation requirements depend on the gift’s value:
n Gifts under $250 can be supported by a canceled check, credit card receipt or written communication from the charity.
n Gifts of $250 or more must be substantiated by the charity.
Deductions for cash gifts to public charities can’t exceed 50% of your adjusted gross income (AGI). The AGI limit is 30% for cash donations to nonoperating private foundations.
Contributions exceeding the applicable AGI limit can be carried forward for
up to five years.
AMT ALERT! Charitable contribution deductions are allowed for AMT purposes, but your tax savings may be less if you’re subject to the AMT. For example, if you’re in the 39.6% tax bracket for regular income tax purposes but the 28% tax bracket for AMT purposes, your deduction may be worth only 28% instead of 39.6%.
Appreciated publicly traded securities you’ve held more than one year are long-term capital gains property, which
can make one of the best charitable gifts. Why? Because you can deduct the current fair market value and avoid the capital gains tax you’d pay if you sold the property. This will be especially beneficial to taxpayers facing the 3.8% NIIT (see page 8) or the top 20% long- term capital gains rate this year.
Don’t donate stock that’s worth less than your basis. Instead, sell the stock so you can deduct the loss and then donate the cash proceeds to charity.
Taxpayers age 701/2 or older are allowed to make direct contributions from their
IRA to qualified charitable organiza- tions, up to $100,000 per tax year. A charitable deduction can’t be claimed for the contributions. But the amounts aren’t deemed taxable income and can be used to satisfy an IRA owner’s RMD. (See page 21.)
To take advantage of the exclusion from income for IRA contributions to charity on your 2017 tax return, you’ll need to arrange a direct transfer by the IRA trustee to an eligible charity by Dec. 31, 2017. Donor-advised funds and supporting organizations aren’t eligible recipients.
Making gifts over time
If you don’t know which charities you want to benefit but you’d like to start making large contributions now,
consider a private foundation. It offers you significant control over how your donations ultimately will be used.
You must comply with complex rules, however, which can make foundations expensive to run. Also, the AGI limits for deductibility of contributions to nonoperating foundations are lower.
If you’d like to influence how your donations are spent but avoid a foundation’s downsides, consider a donor-advised fund (DAF). Many larger public charities and investment firms offer them. Warning: To deduct your DAF contribution, you must obtain a written acknowledgment from the sponsoring organization that it has exclusive legal control over the assets contributed.
Charitable remainder trusts To benefit a charity while helping ensure your own financial future, consider a CRT. Here’s how it works:
n For a given term, the CRT pays an amount to you annually (some of which generally is taxable).
n At the term’s end, the CRT’s remaining assets pass to one or more charities.
n When you fund the CRT, you receive an income tax deduction for the present value of the amount that
will go to charity.
n The property is removed from your estate.
A CRT can also help diversify your port- folio if you own non-income-producing assets that would generate a large capital gain if sold. Because a CRT
is tax-exempt, it can sell the property without paying tax on the gain and then invest the proceeds in a variety of stocks and bonds.
You may owe capital gains tax when you receive the payments, but, because the payments are spread over time, much of the liability will be deferred. Plus,
a portion of each payment might be considered tax-free return of principal. This may help you reduce or avoid exposure to the 3.8% NIIT and the 20% top long-term capital gains rate.
You can name someone other than yourself as income beneficiary or fund the CRT at your death, but the tax consequences will be different.
Charitable lead trusts
To benefit charity while transferring assets to loved ones at a reduced tax cost, consider a CLT. It works as follows:
n For a given term, the CLT pays an amount to one or more charities.
n At the term’s end, the CLT’s remaining assets pass to one or more loved ones you name as remainder beneficiaries.
n When you fund the CLT, you make a taxable gift equal to the present value of the amount that will go to the remainder beneficiaries.
n The property is removed from your estate.
For gift tax purposes, the remainder interest is determined assuming that the trust assets will grow at the Section 7520 rate. The lower the Sec. 7520 rate, the smaller the remainder interest and the lower the possible gift tax — or the less
of your lifetime gift tax exemption you’ll have to use up. If the trust’s earnings outperform the Sec. 7520 rate, the excess earnings will be transferred to the remainder beneficiaries gift- and estate-tax-free.
Because the Sec. 7520 rate currently is still quite low but has been beginning to rise with other interest rates, now may be a good time to lock in a relatively low rate while still available and take the chance that your actual return will outperform it. Also keep in mind, however, that a gift and estate tax repeal has been proposed, which would reduce the benefits of a CLT. (For more on gift and estate taxes, see page 22.)
You can name yourself as the remainder beneficiary or fund the CLT at your death, but the tax consequences will
Before you donate, it’s critical to make sure the charity you’re considering
is indeed a qualified charity — that it’s eligible to receive tax-deductible contributions.
The IRS’s online search tool, Exempt Organizations (EO) Select Check, can help you more easily find out whether an organization is eligible to receive
tax-deductible charitable contributions. You can access EO Select Check at irs.gov/app/eos. Information about organizations eligible to receive deduct- ible contributions is updated monthly.
Also, don’t forget that political donations aren’t deductible. ❖
Investing in a child’s financial future
ne of the biggest goals of most parents is that their children become financially secure adults. To pave the way, it’s important to show young people the value of saving and provide them with the best education possible. By taking advantage of tax breaks available to you and your children, you can do both. If you’re a grandparent, you also may be able to take advantage of
some of these breaks — or help your grandchildren take advantage of them.
n A special break for 529 plans allows you to front-load five years’ worth of annual gift tax exclusions and make up to a $70,000 contribution (or
$140,000 if you split the gift with your spouse).
IRAs for teens
One of the best ways to get children on the right financial track is to set up IRAs for them. Their retirement may seem too far off to warrant saving now, but IRAs can be perfect for teenagers precisely because they likely will have many years to let their accounts grow tax-deferred or tax-free.
The 2017 contribution limit is the lesser of $5,500 or 100% of earned income. A teen’s traditional IRA contributions typically are deductible, but distributions will be taxed. Roth IRA contributions aren’t deductible, but qualified distributions will be
Choosing a Roth IRA is typically a no-brainer if a teen doesn’t earn income that exceeds the standard
deduction ($6,350 for 2017 for single taxpayers), because he or she will likely gain no benefit from the ability to deduct a traditional IRA contribution. Even above that amount, the teen probably is taxed at a very low rate,
so the Roth will typically still be the better answer. (For more information on Roth IRAs, see page 20.)
If your children or grandchildren don’t want to invest their hard-earned
money, consider giving them up to the amount they’re eligible to contribute. But keep the gift tax in mind. (See page 22.)
If they don’t have earned income and you own a business, consider hiring them. As the business owner, you can deduct their pay, and other tax benefits may apply. Warning: The children must be paid in line with what you’d pay nonfamily employees for the same work.
Section 529 plans provide another valuable tax-advantaged savings opportunity. You can choose a prepaid tuition plan to secure current tuition rates or a tax-advantaged savings
plan to fund college expenses beyond just tuition. Here are some of the possible benefits of such plans:
n Although contributions aren’t deductible for federal purposes, any growth is tax-deferred. (Some states do offer breaks
n The plans usually offer high contribution limits, and there are no income limits for contributing.
ns Tgheenreer’ally no beneficiary age limit for contributions or distributions.
nouY can control the account, even after the child is of legal age.
nouY can make tax-free rollovers to another qualifying family member.
Prepaid tuition vs. savings plan
With a 529 prepaid tuition plan, if
your contract is for four years of tuition, tuition is guaranteed regardless of its cost at the time the beneficiary actually attends the school. One downside is that there’s uncertainty in how benefits will be applied if the beneficiary attends a different school. Another is that the plan doesn’t cover costs other than tuition, such as room and board.
A 529 college savings plan, on the other hand, can be used to pay a student’s expenses at most post- secondary educational institutions. Distributions used to pay qualified expenses (such as tuition, manda- tory fees, books, supplies, computer equipment, software, Internet service and, generally, room and board) are income-tax-free for federal purposes and typically for state purposes as well, thus making the tax deferral
a permanent savings.
The biggest downside may be that you don’t have direct control over investment decisions; you’re limited to the options the plan offers.
Additionally, for funds already in the plan, you can make changes to your investment options only twice
during the year or when you change beneficiaries. For these reasons, some taxpayers prefer Coverdell ESAs. (See page 19.)
But each time you make a new contribution to a 529 savings plan, you can select a different option for that contribution, regardless of how many times you contribute throughout the year. And every 12 months you can make a tax-free rollover to a different 529 plan for the same child.
Coverdell Education Savings Accounts are similar to 529 savings plans in that contributions aren’t deductible for federal purposes, but plan assets can
grow tax-deferred and distributions used to pay qualified education expenses are income-tax-free.
One of the biggest ESA advantages is that tax-free distributions aren’t limited to college expenses; they also can fund elementary and secondary school costs. Another advantage is that you have more investment options.
ESAs are worth considering if you want to fund elementary or secondary education expenses or would like
to have direct control over how and where your contributions are invested. But the $2,000 contribution limit is low, and it’s phased out based on income. The limit begins to phase out at a modified adjusted gross income (MAGI) of $190,000 for married couples filing jointly and $95,000 for other filers. No contribution can be made when MAGI hits $220,000 and
Also, amounts left in an ESA when the beneficiary turns age 30 generally must be distributed within 30 days, and any earnings may be subject to tax and a 10% penalty.
Gifts and the “kiddie tax”
If you’d like to help your grandchildren (or other minors) fund their college education but you don’t want to be subject to the limitations of a 529 plan or an ESA, you can transfer cash, stocks and bonds to a Uniform Gifts (or Transfers) to Minors Act (UGMA/UTMA) account:
n Although the transfer is irrevocable, you maintain control over the assets, until the beneficiary age at which the UGMA/UTMA account terminates (age 18 or 21 in most states).
n The transfer qualifies for the annual gift tax exclusion. (See page 22.)
But UGMA/UTMA accounts are less attractive from an income tax perspective than they used to be: The income shifting that once — when the “kiddie tax” applied only to those under age 14 — provided families with significant tax savings now offers much more limited benefits. Today, the kiddie tax generally applies to children under age 19 and to full-time students under age 24 (unless the students provide more than half of their own support from earned income).
For children subject to the kiddie tax, any unearned income beyond
$2,100 (for 2017) is taxed at their parents’ marginal rate, assuming it’s higher. Keep this in mind before transferring income-generating assets to them, whether directly or via an UGMA/UTMA account.
Achieving a Better Life Experience accounts offer a tax-advantaged way to fund qualified disability expenses for a beneficiary who became blind or disabled before age 26. For federal purposes, tax treatment is similar to that of Section 529 college savings plans.
American Opportunity credit When your child enters college, you may not qualify for the American Opportunity
credit because your income is too high (phaseout range of $80,000 – $90,000;
$160,000 – $180,000 for joint filers), but your child might. The maximum credit, per student, is $2,500 per year for the first four years of postsecondary education.
And both the credit and a tax-free 529 plan or ESA distribution can be taken as long as expenses paid with the distribution aren’t used to claim the credit.
If your dependent child claims the credit, you must forgo your dependency exemp- tion for him or her (and the child can’t take the exemption). But because of the exemption phaseout, you might lose the federal benefit of your exemption anyway:
n If your exemption is fully phased out, there likely is no downside to your child taking the credit.
n If your exemption isn’t fully phased out, compare the tax savings your child would receive from the credit with the savings you’d receive from the exemption to determine which break will provide the greater overall savings for your family.
Your tax advisor can help you run the numbers. ❖
Retirement plans can minimize taxes and help maximize investment returns
t’s true that the amount high-income taxpayers are allowed to contribute to tax-advantaged retirement plans is limited. However, the exponential power of tax-deferred (or in the case of Roth accounts, tax-free) compounding makes these plans hard to pass up. And consider this: Contributions to a traditional plan reduce your AGI and, therefore, could help preserve your eligibility for certain tax breaks and avoid triggering certain taxes or higher rates. But be careful when taking retirement plan distributions — they could have the opposite effect. To fully leverage
retirement plan advantages, look ahead and watch out for tax traps.
Unlike other retirement plans, Roth IRAs don’t require you to take distributions during your lifetime, so you can let the entire balance grow tax-free over your lifetime for the benefit of your heirs.
There’s no income-based limit on who can convert to a Roth IRA. But the con- verted amount is taxable in the year of the
Retirement plan contributions Contributing the maximum you’re allowed (see Chart 5) to an employer- sponsored defined contribution
plan, such as a 401(k), is likely a smart move:
n Contributions are typically pretax, reducing your modified adjusted gross income (MAGI). This in turn can help you reduce or avoid expo- sure to the 3.8% NIIT. (See page 8.)
n Plan assets can grow tax-deferred — meaning you pay no income tax until you take distributions.
nouYr employer may match some or all of your contributions.
If you participate in a 401(k), 403(b) or 457 plan, it may allow you to designate some or all of your contributions as Roth contributions. While Roth contributions don’t reduce your current MAGI, qualified distributions will be tax-free. Roth contri- butions may be especially beneficial for higher-income earners, who are ineligible to contribute to a Roth IRA.
Roth IRA conversions
If you have a traditional IRA, consider whether you might benefit from converting some or all of it to a Roth IRA. A conver- sion can allow you to turn tax-deferred future growth into tax-free growth. It also can provide estate planning advantages.
conversion. Whether a conversion makes sense for you depends on factors such as:
n Your age,
n Whether the conversion would push you into a higher income tax bracket or trigger the 3.8% NIIT,
n Whether you can afford to pay the tax on the conversion,
nouYr tax bracket now and expected tax bracket in retirement, and
n Whether you’ll need the IRA funds in retirement.
Your tax advisor can run the numbers and help you decide if a conversion is right for you this year.
If you don’t have a traditional IRA, consider a “back door” Roth IRA: You set up a traditional account and make a nondeductible contribution to it. You then wait until the transaction clears and convert the traditional account to a Roth account. The only tax due will be on any growth in the account between the time you made the contribution and the date of conversion.
With a few exceptions, retirement plan distributions before age 591/2 are subject to a 10% penalty on top of
any income tax that ordinarily would be due on a withdrawal. This means that, if you’re in the top tax bracket of
39.6%, you can lose almost half of your withdrawal to taxes and penalties — and more than half if you’re also subject to state income taxes and/or penalties.
Additionally, you’ll lose the potential tax-deferred future growth on the with- drawn amount.
If you have a Roth account, you can withdraw up to your contribution amount without incurring taxes or penalties. But you’ll be losing the potential tax-free growth on the with- drawn amount.
So if you’re in need of cash, consider tapping your taxable investment accounts rather than dipping into your retirement plan. (See page 8 for information on the tax treatment of investments.)
Leaving a job
When you change jobs or retire, avoid taking a lump-sum distribution from your employer’s retirement plan because it generally will be taxable — and potentially subject to the 10%
early-withdrawal penalty. Here are options that will help you avoid current income tax and penalties:
Staying put. You may be able to leave your money in your old plan. But if you’ll be participating in a new employer’s plan or you already
have an IRA, this may not be the best option. Why? Because keeping track of multiple plans can make managing your retirement assets more difficult. Also consider how well the old plan’s investment options meet your needs.
A rollover to your new employer’s plan. This may be a good solution if you’re changing jobs, because it may leave you with only one retirement plan to keep track of. But also evaluate the new plan’s investment options.
A rollover to an IRA. If you participate in a new employer’s plan, this will require keeping track of two plans.
But it may be the best alternative because IRAs offer nearly unlimited investment choices.
If you choose a rollover, request a direct rollover from your old plan to
your new plan or IRA. If the funds are sent to you by check, you’ll need to make an indirect rollover (that is, deposit the funds into a new IRA) within 60 days to avoid tax and potential penalties. Warning: If you don’t do a direct rollover, the check you receive from your old plan will,
unless an exception applies, be net of 20% federal income tax withholding. If you don’t roll over the gross amount (making up for the withheld amount with other funds), you’ll be subject to income tax — and potentially the 10% penalty — on the difference.
Required minimum distributions
In the year in which you reach age 701/2, you must begin to take annual required minimum distributions from your IRAs (except Roth IRAs) and, generally, from your defined contri- bution plans. If you don’t comply, you can owe a penalty equal to 50% of the amount you should have withdrawn but didn’t. (An RMD deferral is allowed for the initial year, but you’ll have to take two RMDs the next year.) You
can avoid the RMD rule for a non-IRA Roth plan by rolling the funds into a Roth IRA.
So, should you take distributions between ages 591/2 and 701/2, or take more than the RMD after age 701/2?
Waiting to take distributions until age 701/2 generally is advantageous
because of tax-deferred compounding. But a distribution (or larger distribu- tion) in a year your tax bracket is low may save tax. Be sure, however, to consider the lost future tax-deferred growth and, if applicable, whether
the distribution could: 1) cause Social Security payments to become taxable,
2) increase income-based Medicare premiums and prescription drug charges, or 3) affect other tax breaks with income-based limits.
Warning: While retirement plan distributions aren’t subject to the additional 0.9% Medicare tax (see page 5) or 3.8% NIIT, they are included in your MAGI. That means they could trigger or increase the NIIT, because the thresholds for that tax are based on MAGI.
If you’ve inherited a retirement plan, consult your tax advisor about the distribution rules that apply to you. ❖
Estate planning: Uncertainty is in the air
s difficult as it is, accumulating wealth is only the first step to providing a financially secure future for your family. You also need to develop a compre- hensive estate plan. The earlier you begin, the more options you’ll have to
grow and transfer your wealth in a way that minimizes taxes and leaves the legacy you desire. But uncertainty is in the air this year; repeals of the estate, gift and generation-skipping transfer (GST) taxes have been proposed. If those changes are signed into law, these rules and strategies may no longer be applicable. Consult with your tax advisor for the latest information.
have — or may eventually have — large estates. With proper planning, they can use the exemption to make transfers to grandchildren and avoid any tax at their children’s generation.
A federal estate tax deduction is avail- able for state estate taxes paid. Keep
The estate tax rate remains at 40%. The estate tax exemption has increased to
$5.49 million for 2017 (see Chart 6), and it’s currently scheduled to continue to be adjusted annually for inflation.
To avoid unintended consequences, review your estate plan in light of the changing exemption. A review will allow you to make the most of available exemptions and ensure your assets will
be distributed according to your wishes.
The gift tax continues to follow the estate tax exemption and rate. (See Chart 6.) Any gift tax exemption used during life reduces the estate tax exemption available at death. Using up some of your exemption during life can be tax-smart, depending on your situation and goals.
You also can exclude certain gifts of up to $14,000 per recipient each year ($28,000 per recipient if your spouse elects to split the gift with you or you’re giving community property) without depleting any of your gift and estate tax exemption. This is the same as
the 2016 amount. (The exclusion is adjusted for inflation annually, but it increases only in $1,000 increments, so it typically goes up only every few years. It might go up again for 2018.)
Warning: You need to use your 2017
exclusion by Dec. 31. The exclusion doesn’t carry over from year to year. For example, if you don’t make an annual exclusion gift to your granddaughter this year, you can’t add $14,000 to your 2018 exclusion to make a $28,000
tax-free gift to her next year.
The GST tax generally applies to transfers (both during your lifetime and at death) made to people more than one generation below you, such as your grandchildren. This is in addition to any gift or estate tax due. The GST tax continues to follow the estate tax exemption and rate. (See Chart 6.)
The GST tax exemption can be a valuable tax-saving tool for taxpayers with large estates whose children also
in mind that some states impose estate tax at a lower threshold than the federal government does.
To avoid unexpected tax liability or other unintended consequences, it’s critical to consider state law. Consult a tax advisor familiar with the law of your particular state.
If one spouse dies and part (or all) of his or her estate tax exemption is
unused at his or her death, the estate can elect to permit the surviving spouse to use the deceased spouse’s remaining estate tax exemption.
Warning: Portability is available only for the most recently deceased spouse. It doesn’t apply to the GST tax exemption and isn’t recognized by many states.
And it must be elected on an estate tax return for the deceased spouse — even if no tax is due.
The portability election will provide flexibility if proper planning hasn’t been done before the first spouse’s death. But portability doesn’t protect future growth on assets from estate tax like applying the exemption to a credit shelter trust does. Trusts offer other benefits as well, such as creditor protection, remarriage protection, GST tax planning and state estate tax benefits.
So married couples should still consider marital and credit shelter trusts — and transferring assets to each other to the extent necessary to fully fund them at the first death. Transfers to a spouse (during life or at death) are tax-free under the marital deduction, assuming he or she is a U.S. citizen.
Giving away assets now will help reduce the size of your taxable estate. Here are some strategies for tax-smart giving:
Choose gifts wisely. Consider both estate and income tax consequences and the economic aspects of any gifts you’d like to make:
n To minimize estate tax, gift property with the greatest future appreciation potential.
n To minimize your beneficiary’s income tax, gift property that hasn’t appreciated significantly while you’ve owned it.
n To minimize your own income tax, don’t gift property that’s declined in value. Instead, consider selling the property so you can take the tax loss and then gifting the sale proceeds.
Plan gifts to grandchildren carefully. Annual exclusion gifts are generally exempt from the GST tax, so they also help you preserve your GST tax
exemption for other transfers. For gifts to a grandchild that don’t qualify for the exclusion to be tax-free, you generally must apply both your GST tax exemp- tion and your gift tax exemption.
Gift interests in your business or an FLP. If you own a business, you can leverage your gift tax exclusions and exemption by gifting ownership interests, which may be eligible for
valuation discounts. So, for example,
if the combined discount is 30%, in 2017 you can gift an ownership interest equal to as much as $20,000 tax-free because the discounted value doesn’t exceed the $14,000 annual exclusion.
Another way to potentially benefit from valuation discounts is to set up a family limited partnership. You fund the FLP with assets such as public or private stock and real estate, and then gift lim- ited partnership interests. Warning: The IRS may challenge valuation discounts; a professional, independent valuation is recommended. The IRS also scrutinizes FLPs, so be sure to properly set up and operate yours.
Pay tuition and medical expenses. You may pay these expenses without the payment being treated as a taxable gift to the student or patient, as long as the payment is made directly to
Make gifts to charity. Donations to qualified charities aren’t subject to gift tax and may provide an income tax deduction. (See page 16.)
Trusts can provide significant tax savings while preserving some control over what happens to the transferred assets. You may want to consider these:
n A credit shelter (or bypass) trust helps married couples minimize estate tax and provides additional benefits.
New new new new new new
New Tax Developments for 2017 and Beyond
With a new Republican administration and Congress ensconced in Washington, it is unclear what the tax landscape will look like by the end of 2017. So, short of hauling out a crystal ball, let’s take a look at some recent tax developments that you and your clients can plan for over the remainder of the year and beyond.
Small Employer HRAs
Tax law changes were few and far between during the lame duck session of Congress. However, one law change is noteworthy for your small business clients and their
employees. The law authorizes the creation of qualified small employer health reimbursement arrangements (QSEHRAs) to provide reimbursements for medical care for employees and their family members.
Under a longstanding IRS ruling, an employer’s payments or reimbursements for employees’ substantiated premiums for non-employer-sponsored health insurance can be excluded from employees’ incomes [IRC §106; Rev. Rul. 61-146].
However, IRS guidance makes it clear that these seemingly simple plans have one big complication. The plans are considered employer-provided group health plans subject to the full panoply of group health plan requirements, such as the prohibition on annual limits and preventive coverage requirements. What’s more, because such plans cannot meet those requirements, sponsoring employers face potential excise taxes of $100 per day per employee [Notice 2013-54].
Effective for plan years beginning after 2016, the new law creates an exception from the group health plan requirements for QSEHRAs [IRC §9831(d) as added by P.L. 114-255].
An employer is generally eligible to set up a QSEHRA if it employed fewer than 50 employees in the prior year and does not offer group health plan coverage to its employees. The plan must be funded solely by the employer and, with some exceptions, must provide benefits on the same terms and conditions to all employees.
Payments for reimbursements from a QSEHRA are generally excludable from employees’ incomes as employer-provided medical coverage. However, payments or reimbursements cannot exceed $4,950 for an individual employee or $10,000 for an employee and family members. In addition, payments or reimbursements to or for an individual are not excludable from income unless the individual has minimum essential health coverage.
An employee’s QSEHRA benefit for a year must be separately reported on the employee’s Form W-2. Code FF has been added for box 12 of the 2017 Form W-2 to report the QSEHRA benefits.
Severance Paid to Combat Veterans
Another new law change made by the Combat-Injured Veterans Tax Fairness Act (P.L. 114-292) will allow combat- injured veterans to recover income taxes that were improperly collected by the Department of Defense (DOD) on certain disability payments. The DOD is directed to identify severance payments made after Jan. 17, 1991, from which income tax was improperly withheld and to notify affected veterans. The law extends the normal three-year period for filing a refund claim to the date that is one year after the DOD provides an affected veteran with notice of the improper withholding.
Also noteworthy is what the 114th Congress didn’t do before adjourning for the last time in January. Lawmakers left without passing legislation to extend any of 35 provisions that expired at the end of 2016. For individual taxpayers, these unextended “extenders” include:
• The exclusion for discharge of indebtedness on a principal residence [IRC §108]
• Treatment of mortgage insurance premiums as deductible qualified residence interest [IRC §163]
• The above-the-line deduction for qualified tuition and related expenses [IRC §222]
• The nonbusiness energy credit for energy-efficient improvements to a principal residence [IRC §25C]
Medical Expense Deductions
For most of your clients, the deduction floor for medical expenses has been set at 10 percent of adjusted gross income (AGI) since 2013. But that hasn’t been the case for your senior clients. For tax years 2013 through 2016, if either a client or
a client’s spouse had reached age 65 before year end, the former 7.5 percent deduction floor continued to apply. For tax years beginning after Dec. 31, 2016, the floor beneath the itemized deduction for medical expenses of taxpayers who are age 65 or older increases from 7.5 percent of AGI to 10 percent of AGI [IRC § 213].
Leave Donation Programs
The IRS provided special tax treatment for leave donation programs in connection with certain natural disasters that occurred in 2016. The special tax treatment applies to donation programs for victims of severe storms and flooding in Louisiana that began on Aug. 11 and programs for victims of Hurricane Matthew, which ravaged the southeast United States from Florida to Virginia in September. Under a leave donation program, employees may donate vacation, sick
or personal leave in exchange for cash payments to tax- exempt organizations providing relief for disaster victims. In the case of the IRS-approved programs, donated leave is not includable in income of wages of employees, and the
employer may deduct the payments as business expenses or charitable contributions. To qualify, employer payments must be made before Jan. 1, 2018 [Notice 2016-55,
Missed Retirement Plan Rollover Deadlines
As a general rule, to qualify for tax-free treatment, a rollover of funds from an IRA or workplace retirement plan to another eligible plan must be completed within 60 days. Clients who miss the rollover deadline can get a waiver from the IRS if failure to meet the deadline was due to casualty, disaster or other mitigating circumstances. In the past, the only way to get a waiver was to apply for a private letter ruling from the IRS. However, under new IRS rules, taxpayers can self-certify their eligibility for a waiver under specified circumstances, including a bank error, a misplaced distribution check, damage to the taxpayer’s residence, death or illness in the family, or a postal error. (See Rev Proc 2016-47 for a complete list of circumstances in which self-certification is permitted.)
The IRS cautions that self-certification doesn’t guarantee a waiver; the IRS can later determine that a waiver is not
justified. On the other hand, the new rules permit the IRS to grant a waiver on examination even if the taxpayer did not self- certify or obtain a ruling.
ITIN Replacements Required
Any individual filing a U.S. tax return must enter a taxpayer identification number on the return. Identification numbers are also required for dependents claimed on a return. Generally, this means a Social Security number (SSN). However, in the case of individuals who are not eligible for an SSN, the IRS issues individual tax identification numbers (ITINs).
In the past, ITINs did not carry an expiration date. However, a recent law change provides that an ITIN will expire if
an individual fails to file a return or is not included as a dependent on another return for three consecutive years [IRC
§6109(i)(3)(B)]. In addition, individuals who were issued ITINs before 2013 are required to renew their ITINs on a staggered schedule between 2017 and 2020.
Under prior rules, a creditor was generally required to furnish Form 1099-C, Cancellation of Debt, if the creditor did not receive any payment on a debt for 36 months. However, those rules were confusing to taxpayers and tax professionals because receipt of a 1099-C as a result of the 36-month rule did not necessarily mean that the debt was discharged or that the taxpayer had to report taxable income from discharge
of the debt. New IRS regulations remove the 36-month rule effective for information returns required after 2016.
Installment Agreement Fees
The IRS has hiked the fees for taxpayers entering into installment agreements to pay their taxes [Reg. §§300.1; 300.2].
Effective of agreements normally entered into on or after Jan. 1, 2017, a regular installment agreement under which the taxpayer initiates periodic payment that’s set up in person, by phone or by mail will now cost $225, compared to $120 under
prior rules. A taxpayer who sets up a direct debit agreement in person, by phone or by mail will pay a reduced fee of $107, up from $52.
By contrast, a regular agreement that is set up online will cost
$149, while a direct debit online payment agreement goes for the bargain price of just $31. Prior rules did not provide reduced rates for online agreements.
Key Tax Facts for 2017
Married filing jointly/surviving spouse
HDHP deductible 1300 2600
Head of household
Maximum contribution 3400 6750
Dependent taxpayers 1050
Married/surviving spouse 1250 2500
HDHP deductible $2,250–$3,350 $4,500–$6,750
Qualified parking monthly exclusion 255
Head of household
Married filing separately
Phaseout range—single/head of household
Text Box: KIDDIE TAX
Amount taxed at child’s rate 1050
Phaseout range—joint filer/active participant spouse
Text Box: AMT exemption earned income + 7,500
Maximum credit $13,570
ROTH IRA CONTRIBUTION
Maximum contribution $5,500
Phaseout range—joint filers
American Opportunity—max. credit
Phaseout threshold—all other filers
Phaseout range—married filing separately
Phaseout threshold—joint filers
AGI limit—joint filers $0–$37,000 $37,001–$40,000 $40,001–$61,500
AGI limit—head of household $0–$27,750 $27,751–$30,000 $30,001–$46,500
AGI limit—other filers $0–$18,500 $18,501–$20,000 $20,001–$31,000
Phaseout range—all other filers
“Nanny tax” threshold
Gift tax exclusion
40 or younger 410
Older than 40 but not more than 50 770
Older than 50 but not more than 60 1530
Medical and moving allowance
Older than 60 but not more than 70
Older than 70
Foriegn earned income exclusion
Head of household
Max. salary reduction contribution
Married filing separately
Thursday, June 1
Semiweekly depositors deposit FICA and withheld income tax on wages paid on May 24-26.
Friday, June 2
Semiweekly depositors deposit FICA and withheld income tax on wages paid on May 27-30.
Wednesday, June 7
Semiweekly depositors deposit FICA and withheld income tax on wages paid on May 31-June 2.
Friday, June 9
Semiweekly depositors deposit FICA and withheld income tax on wages paid on June 3-6.
Monday, June 12
Tipped employees who received $20 or more in tips during May report them to the employer on Form 4070 (in Publication 1244, Employee’s Daily Record of Tips and Report to Employer).
Wednesday, June 14
Semiweekly depositors deposit FICA and withheld income tax on wages paid June 7-9.
Thursday, June 15
Monthly depositors deposit FICA and withheld income tax for May.
Individuals and calendar-year corporations pay second installment of 2017 estimated tax.
Individuals outside the U.S. file Form 1040 for 2016. For automatic four-month extension, file Form 4868.
Friday, June 16
Semiweekly depositors deposit FICA and withheld income tax on wages paid June 10-13.
Wednesday, June 21
Semiweekly depositors deposit FICA and withheld income tax on wages paid June 14-16.
Friday, June 23
Semiweekly depositors deposit FICA and withheld income tax on wages paid June 17-20.
Intuit is not responsible for the accuracy of the online calendar.
Wednesday, June 28
Semiweekly depositors deposit FICA and withheld income tax on wages paid June 21-23.
Friday, June 30
Semiweekly depositors deposit FICA and withheld income tax on wages paid June 24-27.
… Review tax law changes for 2017.
… Schedule much-needed R&R.
How the Tax Law Treats Residence Rentals
It’s common practice for clients to rent out their vacation homes when they are not being used for personal R&R. The rental income can cut the costs of owning and maintaining a second home. But these days, some of your clients may be cashing in on short-term rentals of their primary homes. Clients who live in or near vacation destinations or who live in the vicinity of major events can now connect with renters through advertising sites like Craigslist or rental sites like
Airbnb. For example, many Philadelphia residents jumped into the short-term rental market when Pope Francis visited that city in 2015.
Unlike typical vacation home landlords, these clients may be unfamiliar with the tax law rules on rentals of a residence.
Short-term rentals. Under a longstanding tax rule, many short- term home rentals are essentially tax-free. The IRS says that when a home is rented for less than 15 days during a year, there’s no need to report the rental income or expenses. The rental income and rental expenses are simply ignored for tax purposes. Home-related expenses, such as mortgage interest and property taxes, are deducted as usual if the client itemizes deductions.
Once rentals hit the 15-day mark, two other rules come into play depending on whether the property qualifies as a personal residence or as investment property.
Personal residence rentals. If a personal residence is rented for 15 days or more during the year, all the rental income is included in income. Expenses are allocated between personal and rental use based on the number of days the home is used for each purpose. Otherwise deductible expenses attributable to personal use (mortgage interest, property taxes) can be written off if the client itemizes deductions. All expenses attributable to rental use are deductible—but only up to the amount of gross rental income.
A home is treated as a personal residence for a tax year is it is used for personal purposes for more than the greater of (1) 14 days or (2) 10 percent of the total days it is rented at a fair rental price.
Days of personal use generally include any days the home is used by your client or a family or by anyone at less than a
fair rental price. However, days your client spends on repairs and maintenance are not personal use days, even if family members use the property for recreational purposes on the same day.
KEY POINT: This rule is not likely to come into play when a client rents out his or her primary residence on a short-term basis. But it can crop up with vacation home rentals. For example, if a client uses a vacation home for a three-week vacation each year (21 days), the home will be treated as a personal residence only if rental use is limited to a total of 30 weeks (210 days).
Investment property rentals. If a client’s property does not qualify as a personal residence, it’s considered an investment property. In that case, it is subject to the passive loss rules.
Rental deductions are not limited to the amount of rental income, but any overall loss on the rental is deductible only to the extent of income from other passive investment sources. There is, however, an important exception: If a client has adjusted gross income of $100,000 or less and is actively involved in rental of the property (for example, by making repairs, approving tenants, and the like), the client can write off up to $25,000 of the net rental loss against non-passive income, including his or her salary. The $25,000 exception
is phased out a rate of 50 cents for each dollar of income between $100,000 and $150,000.
TAX TIP: By fine-tuning personal use of the home, homeowners can pick the rule that will yield biggest tax deductions.
Example: Ben and Ann Spencer have adjusted gross income of about $95,000. The Spencers own a beach home that they use for three weeks each summer and rent for the remaining 12 weeks of the season. Their annual rental income is
$18,000. Their total annual expenses for the home, including mortgage interest, taxes, maintenance and depreciation, come to $40,000. Of that amount, $8,000--including $4,000 of mortgage interest and $800 of property taxes—is allocable to personal use. The remaining $32,000 is allocable to the rental. The Spencers' three weeks of personal use puts the vacation home in the personal residence category. Therefore, the Spencers can deduct the $4,800 of mortgage interest and taxes attributable to their personal use (the remaining expenses attributable to personal use are nondeductible). In addition, they can deduct their rental expenses—but only up to the amount of their rental income. Total deductions: $22,800.
Change of plans: The Spencers limit their annual vacation to just two weeks and rent the home for an additional week, increasing their rental income to $25,500. Based on their new mix of rental and personal use, they allocate $5,320 of
expenses, including $2,660 of mortgage interest and $532 of property taxes, to their personal use. The remaining $34,680 of expenses are allocable to the rental.
Cutting back on vacationing makes the home an investment property. The Spencers lose some deductions on the personal side; they can deduct the $532 of property taxes attributable to personal use, but not the $2,660 of mortgage interest. (Mortgage interest attributable to personal use is deductible only if the home qualifies as a personal residence.) However, they pick up substantial deductions on the rental side. They can deduct their rental expenses up to the amount of their
$25,500 of rental income. In addition, because the Spencers' adjusted gross income is below $100,000, they can deduct their $9,180 loss on the rental ($34,680–$25,500) against other income. Total deductions: $35,212.
Flip side: Assume the Spencers' adjusted gross income exceeds $150,000. In that case, they may want to do more vacationing, rather than less. Reason: Whether the home is classified as a residence or an investment property, their
rental deductions will be limited to their rental income. But by boosting their personal use, they can increase the amount of deductible mortgage interest and taxes attributable to personal use.
Deposit FUTA tax owed through June if more than $500.
File Form 941 for the second quarter of 2017 (if tax deposited in full and on time, file by Aug. 10).
File 2016 Form 5500 or 5500-EZ for calendar-year retirement and benefit plans.
Intuit is not responsible for the accuracy of the online calendar.
Alert clients to 2017 mid-year tax planning opportunities.
… Schedule Continuing Professional Education for 2017.
Tips for Homesellers: Getting Back to Basis
Summer is typically a “hot season” in the home sale market. Young families typically want to get settled in a new home before school begins in the fall, and older homesellers in northern climes want to head south before winter sets in. Your clients who are buying a new home will need to do some serious number crunching to determine what they can afford to pay—and how they will pay it. However, your clients who are homesellers will need to do some number crunching as well.
Under current tax rules, a loss on a home sale is not deductible. On the other hand, the first $250,000 of gain on a home sale is excluded from income. What’s more, for joint
filers the exclusion is generally doubled to $500,000. However, for long-time homeowners even those generous exclusions may not shelter all of their gain from tax. Therefore, they’ll need to--
Get Back to Basis
To properly determine gain (or loss) on the sale or exchange of a home, a taxpayer must know the basis of the home for tax purposes. And calculating basis will involve information that dates back to the time the home was purchased—or perhaps even earlier.
The amount of gain or loss on a sale is determined by comparing the amount realized on the sale to the adjusted basis of the home. If the amount realized is greater than the adjusted basis, the difference is a gain. If the amount realized is less than the adjusted basis, the difference is a loss [IRC Sec. 1001(a); Reg. 1.1001-1(a)].
In most cases, the starting point for determining basis is the cost of the home [IRC Sec. 1012].
If a home was purchased from the builder or from a former owner, the initial cost basis includes the purchase price and certain settlement costs. The purchase price generally
includes the down payment and any debt, such as mortgage or notes given to the seller in payment for the home [IRC Sec. 1012; Reg. 1.1012-1(a)].
Settlement fees or closing costs associated with the purchase of the home can be added to basis. However, fees associated with a mortgage on the home (e.g., appraisal fees, costs of
a credit report or mortgage insurance fees) are not added to basis. In addition, escrow amounts for payment of future
liabilities are not included in the basis of the home. Examples of settlement fees that can be added to basis include:
• Abstract of title fees
• Charges for installing utility services
• Legal fees (e.g., fees for a title search and for preparing the sales contract and deed)
• Recording fees
• Survey costs
• Title insurance
• Transfer taxes
When a home changes hands, real estate taxes for the year of the sale are apportioned between the buyer and seller based on the number of days each of them held the property during the year [IRC Sec. 164(a)(1)]. The date of the sale counts as a day the property is owned by the buyer. Real estate taxes for the year of sale may increase or decrease basis, depending on how the taxes were handled at the closing. If the buyer paid taxes owed by the seller and was not reimbursed, the taxes increase the buyer’s basis of the home. If the seller paid taxes owed by the buyer and was not reimbursed, the taxes decrease the buyer’s basis of the home [IRC Sec. 1012; Reg. 1.1012-1(b)].
In the case of a home that was constructed by or for the taxpayer, basis includes the cost of the land plus the construction costs. However, if the taxpayer did all or part of the construction personally, basis does not include the value of the taxpayer’s own labor or the value of any other
Basis Other Than Cost
Special rules apply in determining basis if a home was acquired other than by purchase or construction—for example, as a gift or inheritance or as part of a divorce settlement. In addition, a taxpayer may have a basis other than cost if a home was acquired as a replacement home in a home-sale rollover under prior law.
Adjustments to Basis
A taxpayer’s basis in a home is not static. Basis may be adjusted upward or downward to reflect expenditures made in connection with the home or payments or other benefits received [IRC Sec. 1016].
Improvements that increase basis include:
• Additions to the home, such an extra bedroom or bath, a family room, a deck or patio, or a garage.
• Landscaping and other outdoor improvements, such as a new driveway or walkway, fences and walls, a sprinkler system or a swimming pool.
• Systems improvements such as a new heating system, central air conditioning, a new furnace or ductwork, wiring upgrades, a septic system, a water heater or water filtration system, a satellite dish or a security system.
• Exterior improvements such as new storm windows or doors, roof, siding or shutters.
• Interior improvements such as built-in appliances, kitchen cabinetry, flooring, wall-to-wall carpeting and insulation.
TAX TIP: For many long-time homeowners, calculating basis will mean digging through piles of old records and receipts. And even then, the number they come up with may be a “guesstimate.” You can help clients who are new to the
housing market by giving them a list of items that are included in or will add to the basis of their new home. By tracking expenditures on an ongoing basis, they’ll be prepared when it is time to move on.
CAUTION: Improvements that are no longer part of a home are not included in the home’s basis.
Example: Joan Gordon bought her home for $200,000 in 2005. In 2006, Gordon added a deck to the home at a cost of $6,000. In 2012, Gordon remodeled the home, which involved removal of the deck and the addition of a new covered porch. The addition and porch cost $30,000. Result: After the addition of the deck in 2006, Gordon’s basis in the home increased to $206,000. However, after the deck was removed in 2012 it was no longer included in the home’s basis. Therefore, Gordon’s basis for the home following the remodeling is $230,000 ($206,000 - $6,000 + $30,000).
Examples of repairs that do not increase basis (unless they are part of an overall renovation or remodeling) include interior or exterior painting, fixing gutters, repairing leaks or plastering, and replacing broken windowpanes.
Remind clients of Sept. 15 estimated tax payment for individuals and calendar-year corporations.
… Remind calendar-year corporations with returns on extension of Sept. 15 filing deadline.
… Alert clients who are parents of first-year college students of the American Opportunity tax credit.
Tax Facts for Student Borrowers
According to the latest statistics, 60 percent of college students borrow to finance their educations. As of 2017, the average student loan debt was about $30,000, totaling more than $1.4 trillion overall.
Tax Fact #1: Education Credits for Borrowed Funds
An education credit can be claimed for the qualified tuition and related expenses paid with the proceeds of a loan.
Under current rules, there are two education credits [IRC
§25A]. The American Opportunity credit is equal to 100 percent of the first $2,000 of a student’s qualified tuition and related expenses plus 25 percent of additional expenses up to $4,000. Thus, the maximum credit is $2,500 per year. The American Opportunity credit may be claimed for any of the first four years of a student’s post-secondary education. By contrast, the Lifetime Learning credit may be claimed for an unlimited number of years with respect to an eligible student.
The Lifetime Learning Credit equals 20 percent of the first
$10,000 of qualified tuition paid by during the taxable year.
An education credit is claimed in the year payment is made with the proceeds of a loan, not in the year the debt is incurred or the year it’s repaid. Loan proceeds disbursed directly to a college are treated as “paid” on the date the college credits the proceeds to the student's account.
TAX TIP: An education credit may be claimed either by a parent or a child, but not by both. If the parent claims the child as a dependent for the taxable year, then the parent is entitled to claim the education credit, even if the qualified tuition expenses were paid with the child’s money or borrowings. If the child’s parent cannot claim the child as a dependent, or can but chooses not to, the child may claim the education credit.
Tax Fact #2: Interest Deductions for Student Loans
An eligible taxpayer can deduct interest on a qualifying student loan, up to a maximum deduction of $2,500 in a year [IRC §221]. The student loan interest deduction is an above- the-line deduction for adjusted gross income (AGI). Thus, it can be claimed by taxpayers who do not itemize deductions and claim the standard deduction. However, the deduction is subject to a phaseout based on modified AGI. For 2017, the deduction is phased out for taxpayers with modified AGI
between $65,000 and $80,000 on a single return and between
$135,000 and $165,000 on a joint return.
TAX TIP: A taxpayer is allowed a student loan interest deduction only if the taxpayer is legally obligated to make interest payments under the terms of the loan. So, for example, a parent cannot claim an interest deduction for payments made on a loan taken out by a child. On the other hand, if a parent pays interest on a child’s loan, the child can claim a student loan interest deduction for the payments.
The child is treated as having received the payments from the parent and, in turn, paid the interest.
Tax Fact #3: Tax-Free Debt Cancellation
The federal government, states and professional organizations sponsor loan forgiveness programs for college grads—most often teachers, medical professionals and lawyers—who agree to work in high-need areas or in the public service sector.
As a general rule, when a loan is forgiven, the borrower must recognize cancellation of debt (COD) income. However, COD income from cancellation of a student loan can be excluded from income if cancellation of the loan is made pursuant to
a loan provision under which all or part of the loan will be cancelled if the student works for a specified period of time, in certain professions, for any of a broad class of employers [IRC
TAX TIP: To qualify for tax-free treatment of COD income, a student loan must have been made by a qualified lender to assist the borrower in attending an eligible educational institution. Qualified lenders include: The United States or one of its instrumentalities or agencies; a state, territory or
possession of the United States, the District of Columbia, or any political subdivision; certain state, county or municipal hospitals; and certain tax-exempt educational organizations.
Tax Fact #4: Student Loan Repayment Assistance
The tax law allows a limited exclusion for student loan repayment assistance for certain health care professionals. The exclusion applies to repayments made under the National Health Service Corps (NHSC) Loan Repayment Program, a state education loan repayment program eligible for funds under the Public Health Service Act, or any other state loan repayment or loan forgiveness program that is intended to provide for the increased availability of health services in underserved or health professional shortage areas.
TAX TIP: Borrowers can’t double-dip on tax incentives. The interest paid on a student loan is not eligible for the student
loan interest deduction if the payments were made with excludable repayment assistance.
Tax Fact #5: Employer-Provided Student Loan Repayments Given the current level of student loan debt, it is not surprising that employer-provided student loan repayment assistance has emerged as an up-and-coming fringe benefit for employees.
Employers can currently offer employees up to $5,250 of annual educational assistance for current studies on a tax-free basis [IRC § 127]. However, student loan repayment assistance is not a tax-free benefit. The amount of the repayments made by an employer must be reported as wages subject to income tax withholding and payroll taxes.
TAX TIP: While employer-provided student loan repayments do not qualify for tax-free treatment, the borrower can still claim a student loan interest deduction for the repayments. Like payments made by a parent on a child’s student loan, the employer’s payments are treated as received by the employee and used to make the loan payments.
Timely Mailing is Timely Filing — If You Know the Rules
Even when their returns are on extension, some of your clients are bound to procrastinate. So at this time of the year, you and your staff may be working until the last minute to get those extended individual income tax returns filed by the Oct.16 due date.
Under the tax law rules, timely mailing is timely filing [IRC
§7502]. So, if you send those last-minute returns off before midnight on the due date, your clients will avoid late-filing penalties—but only if you know the rules. Different rules apply to different types of “mailing”—so how you send off those returns will determine whether and how the timely mailing rule applies.
The general timely mailing, timely filing rule provides that if any return or other document that is required to be filed by a particular date is delivered by United States mail after the due date, the date of the United States postmark stamped on the mailing will be treated as the date of delivery [IRC §7502(a) (1)]. The rule applies only if the postmark date is on or before the due date for the filing and the document was deposited in the mail in the United States in a properly addressed envelope with the postage prepaid. Most importantly, it applies only if the envelope was timely postmarked by the USPS.
The IRS regulations acknowledge that just dropping a document in a U.S. mailbox on the due date or even handing it to a clerk at a post office doesn’t necessarily mean it will
be postmarked on that date. The regulations provide that if a document is sent by U.S. registered mail, the date of registration of the document or payment is treated as the postmark date. If the document or payment is sent by U.S.
certified mail and the sender's receipt is postmarked by the postal employee, the date of the U.S. postmark on the receipt is treated as the postmark date. Accordingly, the risk that the document or payment will not be postmarked on the day that it is deposited in the mail may be eliminated by the use of registered or certified mail [Treas. Reg. §301.7502-1(c)(2)].
These days, many businesses use private postage meters, or may even print postage from a computer. In the case of a document with a non-USPS postmark, the timely mailing,
timely filing rule will apply only if the postmark shows a date on or before the due date and the document is delivered within a reasonable delivery time [Treas. Reg. §301.7502-
1(c)(1)(iii)(B)]. The regulations don’t say what constitutes a reasonable time, and the IRS has not provided any clear-cut guidance. In a recent case, for example, the IRS initially argued that eight days was too long—but later conceded that an eight- day delivery window might not be unreasonable.
If the document arrives late, the sender will have the nearly impossible task of proving that document was deposited in the mail before the last collection of mail from the place of deposit (e.g., a mailbox), that it was actually postmarked by the USPS before the due date, that the delay in receiving the document was due to a delay in transmission of the U.S. mail, and the cause of the delay.
Private Delivery Services
A private delivery service (PDS) may be treated like the U.S. Postal Service for the purpose of the timely mailing, timely filing rule [IRC §7502(f)(1); Treas. Reg. §301.7502-1(c)(3)]. Thus, a form posted with a PDS is timely filed if the PDS marks or records the form as given to the PDS for delivery no later than the form’s due date. However, not just any delivery service will do. The timely mailing, timely filing rule applies only to a
designated PDS. In 2016, the IRS updated its list of designated private delivery services [Notice 2016-30, 2016-18 IRB]. See the box below for the current list of designated PDSs.
CAUTION: Simply dropping a form off with a private carrier does not guarantee that the timely mailing, timely filing rule will apply. Only the specific services on the list are designated delivery services for purposes of the rule. The private carriers are not designated with respect to any type of delivery service not on the list.
A PDS must either (1) record electronically to its database or
(2) mark on the cover of an item the date the item was given to the PDS for delivery [IRC 7502(f)(2)(C)]. For purposes of the timely mailing, timely filing rule, the date recorded or
marked by the PDS is treated as the postmark date. Since each currently designated PDS electronically records the date an item is given for delivery, the recorded date is treated as the postmark date.
The postmark date for an item delivered to the IRS after the due date is presumed to be the day that precedes the delivery date by the amount of time it would normally take an item to be delivered by the specific service being used. For example, the postmark date is presumed to be two days before the actual delivery date for a two-day delivery service. A taxpayer
can overcome this presumption by showing that the date recorded in the delivery service’s electronic database is on or before the due date. For example, this may be necessary if a form given to a delivery service on the due date for next-day delivery actually takes two days to arrive. Proof of the actual date the item was given to the delivery service may include a written confirmation from the service of the date recorded in its electronic database.
CAUTION: Bear in mind that each delivery service stores the date recorded in its database for only a finite period of
time (although no less than six months). Therefore, where the timeliness of a document is critical, it may be wise to obtain confirmation of the recorded date in advance of questions from the IRS. Information concerning the recorded date for an item can be obtained by contacting the delivery service using the contact information on the company’s website.
A document filed electronically with an authorized electronic return transmitter, in the manner and time prescribed by
the IRS, is deemed to be filed on the date of the electronic postmark given by the electronic return transmitter. Thus, if the electronic postmark is timely, the document is considered filed timely although it is received after the due date [Treas. Reg. §301.7502-1(d)].
An electronic postmark is the record of the date and time (in a particular time zone) that an authorized electronic return transmitter receives the electronically filed document on
its host system. However, if the taxpayer and the electronic return transmitter are located in different time zones,
the taxpayer's time zone controls the timeliness of the electronically filed document.
Conduct year-end tax planning sessions with individual clients.
… Remind individual clients to use flexible spending account funds before year end unless plan provides post year-end grace period or carryover.
… File returns for individual clients who obtained automatic six-month extensions.
… Renew Preparer Tax Identification Number (PTIN) for 2018.
Are Your Tax Return Preparer Credentials in Order?
While the IRS abandoned its plans for full-scale registration of all tax return preparers, there are nonetheless some
credentials that all preparers will need to prepare their clients’ 2017 returns.
Virtually all individuals who prepare tax returns for compensation must have a preparer tax identification number (PTIN). This requirement generally applies to all attorneys, accountants and enrolled agents who prepare returns, as well as to other tax return preparers.
The PTIN requirement applies to any preparer who is involved in preparing a return, even if he or she is not the primary preparer who signs the return. The PTIN also applies to “supervised preparers” who do not and are not required to sign returns, but who are employed by an attorney or CPA firm and who prepare returns under supervision.
The PTIN requirement applies on an individual basis. Preparers who share an office cannot share a PTIN. Each individual who prepares or assists in preparation of returns must have his or her own PTIN.
An individual must be at least 18 to obtain a PTIN and must generally provide a Social Security number (SSN). The SSN requirement does not apply to U.S. citizens who have a conscientious objection to obtaining an SSN or to certain foreign preparers. An individual with an Individual Taxpayer Identification Number (ITIN) cannot obtain a PTIN.
Apply now. All PTINs must be renewed on a calendar-year basis using the IRS’s online application or by submitting
a paper application on Form W-12, IRS Paid Preparer Tax Identification Number (PTIN) Application. The annual fee for a PTIN is $50. Holders of valid PTINs must renew before Jan. 1 each year. Renewed PTINs are valid from Jan. 1 through Dec. 31 of the following calendar year. PTINs obtained or renewed for a calendar year expire on Dec. 31 of that year. Preparers should note that online renewal takes just minutes, while Form W-12 submissions can take four to six weeks to process.
Under current rules, the vast majority of tax return preparers must file client returns electronically. The e-file mandate generally applies to any preparer who expects to file more than 10 individual tax returns during a calendar year. Tax
preparation businesses are required to compute the total number of returns on a firm-wide basis. If the number of returns tops 10, then all members of the firm must e-file.
There are some exceptions to the e-filing requirement—for example, returns that cannot be filed electronically, returns of clients who insist on paper returns, or situations where e-filing would cause hardship for the preparer. However, preparers will generally need to e-file most, if not all, of their clients’ returns.
To file returns electronically, a preparer will need an Electronic Filing Identification Number (EFIN). Unlike PTINs, EFINs are issued on a firm-wide basis. A firm applies for an EFIN using either its Employer Identification Number (EIN) or the SSN of the sole proprietor. Applicants must pass a suitability and tax compliance check. There is currently no fee for an EFIN.
Apply now. Before applying for an EFIN, a preparer must have an IRS e-services account. E-services is a suite of web-based tools that allow tax professionals and payers to complete certain transactions online with the IRS. The tools include Registration Services, e-file Application, Transcript Delivery and TIN Matching. In the case of a firm, each principal
and responsible official must sign up for e-services. The e-services application will require identifying information
about each firm principal, including SSNs and adjusted gross income information for the prior year. When timing an e-file application, preparers should bear in mind that the e-services sign-up process can take several days.
Once the necessary e-services accounts are set up, the preparer or firm can submit an online e-file application. There are a number of e-file Provider Options; preparers who want to e-file for clients should select Electronic Return Originator (ERO). The e-file application will require additional information about the preparer or firm principals, including fingerprints, and a suitability check. Consequently, the IRS cautions that approval of an e-file application can take around 45 days.
Unlike PTINs, ETINs do not have to be renewed each year. However, application information must be updated within 30 days of any changes.
Annual Filing Season Program
The IRS offers a voluntary Annual Filing Season Program to “recognize and encourage” the efforts of unenrolled
preparers to increase and improve their competency through
continuing professional education (CPE). The program is not directed at or necessary for credentialed preparers such as attorneys, CPAs, enrolled agents, enrolled retirement plan agents or enrolled actuaries.
Preparers participating in the program must obtain 18 hours of CPE, including a six-hour federal tax law refresher course with a test. Participating preparers must also renew their PTINs for the coming year and consent to adhere to certain obligations in Treasury Department Circular 230, the “bible” for tax practice before the IRS.
Tax return preparers who complete the requirements receive an Annual Filing Season-Record of Completion. These preparers are listed in a special directory on irs.gov for taxpayers to use in searching for qualified tax return preparers. The Directory of Federal Tax Return Preparers with
Credentials and Select Qualifications lists only attorneys, CPAs, enrolled agents, enrolled retirement plan agents, enrolled actuaries—and unenrolled preparers who have received the record of completion.
File Form 941 for the third quarter of 2017 if tax for the quarter was deposited in full and on time.
Tipped employees who received $20 or more in tips during October report them to the employer on Form 4070.
Remind individual clients whose withholding status will change in 2018 to submit new W-4 forms to their employers.
… Remind individual clients who may have underpaid estimated taxes to increase withholding from salary and wages to make up for shortfall.
… Renew PTIN.
… Register online to use IRS e-services. Preparers who anticipate filing 11 or more 1040, 1040A, 1040EZ and 1041 returns during the year must file electronically.
… Set up tax preparation software and test e-filing.
Download IRS e-file logo and order IRS e-file marketing materials. See the EFTPS Tool Kit at http://www.irs.gov/pub/irs-pdf/p4320.pdf.
Get Your Clients Ready for Tax Return Season
Your office may be geared up and ready for the upcoming tax return season. However, even the most streamlined
office procedures will not guarantee a successful tax return season without the cooperation of one key element: your clients. If clients are habitually late in submitting tax return information or supply you with incomplete or disorganized information, the time spent sifting, sorting and contacting clients for missing data will throw a monkey wrench into the best-oiled machine.
Here are some tips for getting your clients ready for the upcoming tax return season.
Get Clients Organized
Now is the time to provide your clients with tax return preparation packets and tax data organizers. Send them out early, so that clients have time to complete them properly. As part of this process, explain to clients when you need to see actual source documents and when it is acceptable for them to simply provide you with lists and schedules of tax data.
Impress upon your clients that the more preparatory work they do before submitting their return for preparation, the smaller their bills will be. After all, time is money.
You may also want to consider developing a checklist for clients of the types of documentation they should be accumulating throughout the year. By giving clients this
checklist along with their completed 2017 returns, you can get a jumpstart on the next go-round. Stress to clients that it is much easier to compile tax records on an ongoing basis than to scramble to collect everything at year end—and they are much less likely to overlook something that could save them tax dollars.
Set Firm Deadlines
Establish deadlines for when you will accept client data—and clearly communicate those deadlines to your clients. Stick to your guns by putting returns on extension if documentation is submitted after the deadline. There will, of course, be extenuating circumstances in which clients deserve some leeway. However, perennial procrastinators will get the message if you set and stick to your cut-off dates.
As your deadlines approach, send out reminder notices or call those clients who have not yet submitted their 2017 tax data or who have not submitted all the information
necessary to complete their returns. Emphasize once again that a client’s return cannot be prepared by the original
return due date if tax information is not received in a timely fashion. This is a good time to get clients to commit one way or another. Explain the rules for obtaining an automatic
filing extension and advise clients that a filing extension may be appropriate if they are having difficulty gathering the necessary tax information. In fact, you may want to send this type of reminder early on to those clients whose returns have typically required an extension—for example, clients who have to apply for an extension every year because of habitually
late K-1 information from partnerships or S corporations. By identifying extended returns as soon as possible, you and your staff won’t waste limited busy season time working on returns that will not be ready by the original return due date.
Establish Procedures for Missing Information
It’s always preferable to get information from clients in writing, but it’s not always possible when the tax return deadline is
fast approaching. You may have had instances where you or a staff member obtained client information over the telephone only to have the client later dispute the accuracy of that information. To avoid such disputes, develop procedures now to ensure the accuracy of last-minute data submissions. Whenever possible, have clients submit any additional information in writing by fax or email. If you must obtain information verbally, make it a practice to follow up with a
written memo. Make sure your clients understand that you will assume the information is accurate unless you are promptly notified of any changes.
Estimate Your Bill
Most tax return preparers have had experience with clients who are outraged when they receive their bills. You can avoid this type of confrontation by providing clients with up-front estimates of their return preparation costs. Stress, however, that these figures are estimates only. Midway through the return preparation process, send an interim bill along with an explanation of any changes from your original estimate.
Cut Off Deadbeats
You may have clients who are habitually late paying their bills, who always contest—and refuse to pay—part of the bill, or who have owed you significant amounts of money for quite some time. Take a long, hard look at your outstanding accounts receivable. Now is the time to bite the bullet and decide which clients you ought to write off and refuse to serve any longer.
To avoid the risk, have your clients pay you out of their refund.
In December, employees whose withholding status will change in 2018 should submit a new Form W-4 to the employer. The new form should be submitted as early as possible to guarantee implementation of the withholding change in January.
What Your Clients Need to Know About the Nanny Tax
It seems like it happens all the time—a candidate for public office turns out to have employed a household employee “off the books.” Most recently, President Trump’s pick for Labor Secretary admitted to employing an illegal immigrant as a housekeeper. And while few, if any, of your clients are likely to undergo the same degree of scrutiny as a White House Cabinet appointee, that doesn’t mean they can safely ignore the so-called “nanny tax.”
Alert your clients who employ household workers on a regular basis that they may be required to withhold and pay employment taxes on the wages they pay those workers.
Not Just for Nannies
Although it has been dubbed the “nanny tax,” potential employment tax liability can apply to a wide variety of household workers, including housekeepers, yard workers, health aides, companions, drivers and even occasional babysitters.
The key question is whether the worker is an employee or independent contractor. As a general rule, a household worker is an employee if your client directs and controls the work to be done. For example, a babysitter/housekeeper who works in your client’s home on a daily basis must generally be treated as an employee. By contrast, an individual who operates his own landscaping business and simply cuts your client’s lawn once a week will qualify as an independent contractor.
The nanny tax rules do not apply, however, to a household employee who is under age 18 unless providing household services is the employee’s principal occupation. If the
employee is a student, household service is not considered the employee’s principal occupation even if it is the employee’s only job. The nanny tax rules also generally do not apply to payments to a client’s spouse, child under 21
CLIENT ALERT: While not technically a tax responsibility, like other employers, household employers are responsible for making sure an employee can legally work in the United States. No later than the employee’s first day of work,
your client and the employee should complete Form I-9,
Employment Eligibility Verification. Form I-9 is not required to
be filed, but should be kept with the client’s records. If your client is responsible for withholding and paying nanny taxes (see below), the client must obtain a record of the employee’s name and Social Security number (SSN) as shown on his or her Social Security card.
Nanny Tax Rules
If a client paid a household employee cash wages of $2,000 or more in 2017, the employee’s wages are subject to Social Security and Medicare tax. Your client must pay the 6.2 percent Social Security tax and the 1.45 percent Medicare tax on all cash wages paid the employee for the year. Of course, in the unlikely event the employee’s wages reached the $127,200 Social Security wage base for 2017, the Social Security tax no longer applies.
A client may also owe unemployment taxes on the employee’s wages. The federal unemployment tax (FUTA) tax is payable if your client paid cash wages of $1,000 or more to all household employees in any calendar quarter of 2017. The FUTA tax is nominally 6.0 percent of the first $7,000 of cash wages paid in 2017, but will generally be reduced by a credit of 5.4 percent
if state unemployment taxes have been paid in full and on time, reducing the net tax rate to 0.6 percent. The amount of state unemployment taxes actually payable on a household employee’s wages will depend on state law.
Your client is also responsible for withholding the employee’s share of Social Security and Medicare taxes if the employee’s cash wages will reach the $2,000 mark for the year.
KEY POINT: If a client is not sure just how much a household employee will earn during a year, the client can withhold the employee’s share of the taxes from the get-go. However, if the employee’s wages for the year do not hit $2,000, the client will have to repay the withheld amounts to the employee.
Alternatively, a client can pick up the tab for the employee’s share of the taxes. Taxes paid by your client are included in the employee’s wages for income tax purposes, but don’t count as wages for Social Security and Medicare for FUTA taxes.
Your client is not required to withhold federal income tax from wages paid to a household employee—unless the employee requests withholding and your client agrees to withhold.
Reporting the Nanny Tax
As a general rule, your client will report and pay the nanny tax on his or her 2017 federal income tax return. Nanny taxes are figured on Schedule H, Household Employment Taxes, and included as Other Taxes on Line 60a of Form 1040. A client who must report nanny taxes cannot use Form 1040A or 1040- EZ. (For individuals who are not otherwise required to file a tax return, Schedule H is filed separately.)
Nanny taxes reported on Schedule H are included in determining a client’s estimated tax liabilities for the year. Therefore, clients with household employees may need to increase withholding or up their estimated tax payments to cover the nanny taxes.
CLIENT ALERT: To report nanny taxes on Schedule H, your client will need to obtain a federal Employer Identification Number (EIN) either online or by sending Form SS-4 to the IRS.
Alternatively, a client who pays employment taxes for a business or farm can include the nanny taxes with the regular federal employment tax deposits for the business and report them on the business’ employment tax returns.
A client who is liable for nanny taxes must provide each household employee with a Form W-2, Wage and Tax Statement, and must file Form W-2 (along with a Form W-3 transmittal) with the Social Security Administration.
Child and Dependent Care Credit
If a client’s household employee is, in fact, a nanny who cares for a child or children under age 13 (or a spouse or dependent of any age who is incapable of self-care), the client may qualify for the child and dependent care credit. However, amounts paid to the employee will count for the credit only if the client reports on his or her tax return the correct name, address
and Social Security number of the employee. To obtain this information, they can have the employee fill out Form W-10, Dependent Care Provider's Identification and Certification.
Furnish copies of Form W-2 for 2017 to employees.
Employers file Copy A of all Forms W-2 issued for 2017 with the Social Security Administration (SSA). Paper Forms W-2 should be accompanied by a Form W-3.
Furnish information returns to payees for payments made in 2017.
File information returns with the IRS for nonemployee compensation paid in 2017.
Individuals file individual income tax return for 2017 in lieu of Jan. 16 estimated tax payment.
File Form 945 for 2017 to report income tax withheld on nonpayroll items.
… Send tax preparation packets and tax data organizers to individual clients.
… Alert individual clients to the option of filing the 2017 return by Jan. 31 in lieu of making final 2017 estimated tax payment.
… Remind business clients of information reporting requirements.
Tax Facts for Expatriates
For whatever reason, expatriation is on the upswing. In just five years, the number of U.S. expatriates has increased from fewer than one thousand (932) in 2012 to 2,999 in 2013, 3,415
in 2014, 4,279 in 2015 — and reached a record 5,411 in 2016.
The Tax Cost of Expatriation
Permanently departing the U.S. can have a tax cost. Under current rules, covered expatriates are subject to special expatriation tax rules [IRC §877A].
Covered expatriates include both individuals who give up their U.S. citizenship and green card holders who give up or lose their right to permanent residence in the U.S.
An expatriated individual is subject to the special tax rules if any of the following apply:
• the individual’s average annual net income tax liability for the five years before the expatriation date is more than an inflation-adjusted amount ($162,000 for 2017);
• the individual’s net worth is $2 million or more on the expatriation date; or
• the individual fails to certify on Form 8854 (see below) that he or she has complied with all U.S. federal tax obligations for the five years before the expatriation date.
A U.S. citizen will be treated as a covered expatriate as of the earlier of:
• the date the individual renounces his or her
U.S. nationality before a diplomatic or consular officer of the United States, provided the renunciation is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State;
• the date the individual furnishes the State Department with a signed statement of voluntary relinquishment of U.S. nationality, provided the voluntary relinquishment is subsequently approved by the issuance to the individual of a certificate of loss of nationality by the U.S. Department of State;
• the date the State Department issues the individual a certificate of loss of nationality; or
• the date a U.S. court cancels a naturalized citizen’s certificate of naturalization.
A green card holder ceases to be a lawful permanent resident if:
• the individual’s permanent residence status has been revoked or has been administratively or judicially determined to have been abandoned; or
• the individual (1) becomes a resident of a foreign country under the provisions of a tax treaty between the United States and the foreign country, (2) does not waive the benefits of the treaty, and (3) notifies the IRS on Form 8833, Treaty-Based Return Position Disclosure Under Section 6114 or 7701(b).
Under current rules, covered expatriates are subject to a “mark-to-market” tax. That is, the individual is treated as if his or her property had been sold for its fair market value on the day before the expatriation or residency termination. Any net gain on the deemed sale is recognized to the extent it exceeds an inflation-adjusted threshold amount ($699,000 for 2017).
The amount subsequently realized on an actual sale of the property is adjusted for gain or loss taken into account for purposes of the mark-to-market tax.
An expatriate can elect to defer payment of the mark-to- market tax until the due date for the return for the year the property is disposed of. The expatriate must post a bond in order to defer tax and interest charged for the period the tax is deferred. The election is irrevocable and is made on a property-by-property basis. The mark-to-market tax may not
be deferred beyond the due date of the return for the taxable year which includes the individual’s death.
Individuals who expatriate must file Form 8854, Initial and Annual Expatriation Information Statement. Section I of the form calls for general information, including the date of the individual’s expatriating act. Current expatriates must
complete Parts IV and V of the form to provide further information about their expatriation status, property held on the date of expatriation and certain financial information.
As a general rule, expatriates will not need to file Form 8854 in future years unless they elect to defer the mark-to-market tax or have certain deferred compensation or trust income. Special rules apply to individuals who expatriated before June 17, 2008, which may require ongoing filing of Form 8854.
CAUTION: The IRS reminds tax practitioners that anyone who has expatriated or terminated U.S. permanent residency must file Form 8854—and that a $10,000 penalty can be imposed for failure to file.
Large food and beverage establishment employers file Form 8027, Employer’s Annual Information Return of Tip Income and Allocated Tips; use Form 8027-T if reporting for more than one establishment. Electronic filers, see April 2.
File information returns (other than returns for nonemployee compensation) with the IRS for payments made in 2017. Returns for nonemployee compensation were required to be filed by Jan. 31. Electronic filers have until April 2.
… Send reminders to individual clients who have not returned tax preparation packets or scheduled appointments.
… Review pros and cons of S corporation election with eligible corporate clients.
… Remind partnerships of March 15 return filing deadline.
How to Handle W-2 Slip-Ups
Recent law changes have significantly upped the ante for employers when it comes to preparing Form W-2 wage and tax statements accurately and on time.
In the past, W-2 forms were due to employees by Jan. 31 following the close of the tax year, while the forms were not required to be filed with the Social Security Administration (SSA) until the last day of February for paper filings or March 31 for electronic filings. Under new rules, W-2s are now due to the SSA by Jan. 31—the same day they are due to employees— thus eliminating any “window of correction” for spotting and fixing errors before officially filing the forms. What’s more, another law change has significantly increased the W-2 filing penalties by providing for annual inflation adjustments. For example, by 2017, the basic penalty for failure to file Form
W-2 on time or failure to provide all the required and correct information had jumped to $260 per return.
The first step in making a W-2 correction is to determine whether the error must or can be corrected.
Social Security and Medicare Taxes
As a general rule, an employer must correct any overwithholding of Social Security or Medicare taxes and refund the overage to the employee. In the case of
underpayment, an employer must report and pay the correct amount, including both the employee and employer shares. However, the employer can recoup underwithholding from future payments to the employee. Overwithholding or underwitholding of the Additional Medicare Tax should not be corrected.
An employer cannot correct income tax withholding errors once the taxes have been deposited. The employee must make up any shortfall or obtain a refund by filing a tax return.
If an employee was underpaid or overpaid, repayment or back pay to correct the mistake is reflected on the W-2 for the year of the correction. However, if an employee repays
excess wages for the prior year, the employer must correct the amount of Social Security and Medicare wages and tax shown on the W-2 for the prior year.
An employer must correct the error if the employee’s name or Social Security number (SSN) was incorrectly reported
on Form W-2. On the other hand, if the only error on an employee’s Form W-2 is an incorrect address, no correction is required to be sent to the SSA.
Finally, the general rule is that a correction is required when an amount shown on Form W-2 is incorrect. For example, although federal income tax withholding errors cannot be corrected, a correction must be made if the amount of withholding shown on the W-2 does not match the actual amount withheld.
New de Minimis Safe Harbor
Despite the basic rules, a new de minimis safe harbor provides that an error is not required to be corrected and no penalty will be imposed if the error involves an incorrect dollar amount that’s off by no more than $100. The de minimis threshold is $25 for errors in the amount of tax withheld [IRC §§6721(c)(3), 6722(c)(3)].
The de minimis error safe harbor applies only to inadvertent errors; an employer that intentionally misreports a dollar amount will be penalized even if the amount otherwise qualifies as de minimis. In addition, the safe harbor does not apply to a failure to file for furnish Form W-2 to the employee, even if the form involves de minimis dollar amounts.
An employee who receives an incorrect form may elect not to have the safe harbor apply. If an employee makes an election, the employer may be subject to penalties even if the incorrect amount is a de minimis error.
However, an error will be treated as due to reasonable cause and not willful neglect and no penalties will apply if the employer furnishes a corrected form to the employee or payee and files a corrected form within 30 days.
KEY POINT: An employer is not prohibited from filing a corrected form for a de minimis error, even if an employee or payee does not make an election out of the safe harbor. The IRS encourages employers to correct errors on
Form W-2 even if they are de minimis. This will prevent mismatches between the employer’s employment tax returns and the amounts reported to SSA, and will ensure that employees receive proper Social Security credit for their earnings.
Is Your Client Data Secure?
Your office files and computers are chock full of sensitive personal and financial data about your clients, from Social Security numbers to banking information. Consequently, tax professionals are increasingly being targeted by identity
thieves. For example, the IRS recently warned tax pros of scam emails purporting to come from their software providers
that ask for user names and passwords to “unlock” their tax preparation software. Tax pros who provide the information are actually giving the information to cybercriminals who use the credentials to access the preparer’s account and steal client information [IR-2017-39]. Other phishing scams have involved cybercriminals posing as the IRS or other entities or even as one of your clients.
Obviously, learning to identify and to avoid these kinds of phishing expeditions is imperative to protecting your clients' data and giving you and them piece of mind (see box).
However, there are other steps you can—and should—take to protect your client data.
Secure Your Office
Make sure all physical and virtual client files are protected from unauthorized access. For example:
• Lock doors to file rooms and computer rooms.
• Permit access to client files only on an authorized need-to-know basis.
• Make sure client information, including data on computer hardware or other media, is not left unsecured inside or outside the office, such as on desks or photocopiers, in trash cans or in employees’ vehicles or homes.
• Provide for secure disposal of client information, such as by shredding unneeded documents or destroying digital media.
Secure Your Systems
While trolling in your trash is not unheard of, your computer systems are likely to be the prime target for identity theft. Here are some steps you can take to help prevent a computer data breach:
• Require separate user names and passwords for each individual with computer access— and disable and remove inactive users.
• Make sure users set up strong passwords with a combination of numbers, symbols, and upper and lowercase letters—and require your staff to make periodic password changes every 60 to 90 days.
• Lock out users after three invalid access attempts—anyone can make a typo, but three strikes and you’re out.
• Monitor computer systems for unauthorized access by reviewing system logs.
• Protect Internet-connected computers with a firewall or other barrier device.
• Maintain and update hardware and software on a regular basis.
• Ensure your tax software is secure and has secure features in it, such as masking of a client's social security number when your computer is in a resting state.
Secure Your Storage
The tax law requires you to store client data for years after their returns have been filed. But these records should be separated from your active files.
• Back up client data regularly and store it on separate secure computers or media that are not connected to the internet.
• Remove client information once the retention period expires by using software designed to securely remove the data.
• Store removable media, flash drives, recordings of meeting with clients, and any paper records in a secure location.
• Restrict access to stored data.
Secure Your Communications
Take steps to ensure the privacy of communications with clients, the IRS or other professionals.
• Encrypt all email that contains client data.
• Encrypt all client information when communicating across a network.
• Remove personal information before mailing items.
For more tips and tactics, see the IRS publication
Safeguarding Taxpayer Data, A Guide for Your Business.
How to Spot a Phishing Email
The IRS offers these tips on how to spot — and avoid — a phishing email.
It contains a link. Scammers often pose as the IRS, financial institutions, or tax companies or software providers.
They may claim that you need to update your account or change a password. The email offers links to a spoofing site that may look similar to the legitimate official website. Do not click on the link. If in doubt, go directly to the legitimate website and access your account.
It contains an attachment. Scammers often include an attachment to an email. This attachment may be infected with malware that can download malicious software onto your computer without your knowledge. If it’s spyware,
it can track your keystrokes to obtain information about passwords, Social Security numbers, or other sensitive data. Do not open attachments from unknown sources.
It appears to be from a government agency. Scammers attempt to trick people into opening email links by posing as the IRS and other government agencies. The IRS does not initiate taxpayer communications through email.
It’s an “off” email from a friend. Scammers also hack email accounts and try to leverage the stolen email addresses. You may receive an email from a “friend” that just doesn’t seem right. It may be missing a subject for the subject line or contain odd requests or language. If it seems off, avoid opening it and do not click on any links.
Individuals file 2017 returns (Form 1040, Form 1040A, or Form 1040EZ); alternatively, file for an automatic six-month extension (Form 4868).
Calendar-year C corporations file 2017 returns on Form 1120; alternatively, file for an automatic five-month extension.
Individuals and calendar-year corporations pay first installment of 2018 estimated tax.
Employers file Form 941 for the first quarter of 2018 (if tax for the quarter was deposited in full and on time, file by May 10).
Employers deposit federal unemployment tax owed through March if more than $500.
… File extensions for individual clients who will not meet April 17 filing deadline.
… Conduct reviews of clients’ prior-year returns to determine need for amended returns.
… File extensions for corporate clients that will not meet April 17 filing deadline.
What to Tell Clients About Amended Returns
At one time, a popular consumer financial magazine ran an annual feature in which accountants were asked to prepare a tax return for a hypothetical couple. And year after year, no two practitioners calculated the “correct” tax liability.
Moreover, the results they did come up with often varied by tens of thousands of dollars. True, the hypothetical returns they were asked to prepare were designed to be especially tricky. However, the fact of the matter is that mistakes can crop up even on run-of-the-mill returns.
At this time of year, tax return preparers frequently detect errors on prior years’ returns. For example, a cross-check of a client’s current return against returns for prior years may reveal unreported income or a missed deduction for an earlier year. In addition, there will inevitably be clients who show up after their returns have been filed waving a
misplaced 1099 or a stack of receipts for a deduction that was not claimed on the return.
And, of course, nobody’s perfect. There may be situations where mistakes were made in preparing a client’s return. For example, miscalculation of the holding period for an asset may have turned long-term gain into less favorably taxed short- term gain, or misapplication of a phase-out limit may have cost the client all or part of a deduction.
PRACTICE TIP: A review of returns for open years can be an enticing “value added” service for new clients. You’ll probably want to offer this service gratis in connection with preparation of the current year’s return. But, of course, you will want to charge a fee for correcting any errors you catch.
In some cases, it may be tempting to let sleeping dogs lie, especially if correcting a return error will produce a negligible difference in a client’s tax for the year. However, Treasury Circular 230, the official code of conduct for practice before the IRS, requires a preparer to “advise the client promptly” of an error. The AICPA’s Statements on Responsibilities in Tax Practice (SRTP), which interprets and expands upon Circular 230, further provides that when informing a client of an error, a practitioner should recommend the proper measures to
be taken. Moreover, the SRTP makes it clear that the duty to inform clients of a return error applies regardless of whether the preparer who caught the error actually prepared the return in question.
Some clients may be reluctant to correct a return error. In the case of underreporting, a client may want to play the odds and wait and see if the IRS picks up on the error. And even
if a correction will result in a refund, a client may believe that filing an amended return will prompt a full-scale IRS audit. In advising clients, you should point out that promptly
correcting an underreporting error will reduce the amount of interest and penalties payable on the deficiency. On the other hand, clients should be advised not to pass up legitimate
tax writeoffs out of fear of the IRS. The IRS maintains that an amended return will not automatically trigger a minute inspection of a taxpayer’s return.
In any case, the decision whether to correct a tax return error ultimately rests with the client. According to the SRTP, a practitioner has no duty to inform the IRS of a return error
and may do so only with the client’s permission “except where required by law.” On the other hand, the SRTP states that when a client refuses to correct an error that has more than
an insignificant impact on his or her tax liability, a practitioner must “consider whether to withdraw from preparing the return and whether to continue a professional relationship with the client.” If a practitioner determines that it is not necessary to sever relations with the client, the SRTP emphasizes that the practitioner must take reasonable steps to ensure that the error is not repeated on the current year’s return.
A preparer’s financial liability for a tax return error is not clear cut. From the IRS’s point of view, any unpaid tax, interest and penalties are the taxpayer’s responsibility, regardless of who made the error. However, an irate client who is advised of a mistake on his or her return may seek to hold the preparer financially responsible—and, of course, the client may object to the fee for preparing the return. To avoid disputes, many preparers use tax return engagement letters specifying the limits on the preparer’s liability for return errors.
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