President Obama recently said that he wants a tax reform/deficit reduction package by August and lawmakers have many proposals to consider. The President has introduced a $3.77 trillion budget for fiscal year (FY) 2014 with a host of tax reform proposals, the House and Senate Budget Committees have approved competing deficit reduction and tax reform blueprints, other committees are exploring ideas for tax reform, and private groups, most notably authors of the Simpson-Bowles Plan, are also making proposals. Whatever proposals are adopted, the outcome is sure to impact your tax strategy and planning.

President Obama recently said that he wants a tax reform/deficit reduction package by August and lawmakers have many proposals to consider. The President has introduced a $3.77 trillion budget for fiscal year (FY) 2014 with a host of tax reform proposals, the House and Senate Budget Committees have approved competing deficit reduction and tax reform blueprints, other committees are exploring ideas for tax reform, and private groups, most notably authors of the Simpson-Bowles Plan, are also making proposals. Whatever proposals are adopted, the outcome is sure to impact your tax strategy and planning.

All of the proposals have one common goal: reduce the federal government's approximate $16 trillion federal budget deficit. To reduce the budget deficit, many of the plans propose to cut spending and raise revenues. Lawmakers and the White House also want to replace sequestration (across-the-board spending cuts for many federal agencies) for FY 2014 and beyond. Replacing sequestration will require spending cuts, new revenue or a combination of both. Let's take a look at how some of the tax proposals would affect individuals, businesses and others.

Individuals

The American Taxpayer Relief Act of 2012 (ATRA), signed into law on January 2, 2013, set the individual tax rates at 10, 15, 25, 28, 33, 35 and 39.6 percent for 2013 and beyond. The House GOP budget blueprint would consolidate the current seven individual income tax rate brackets into two rates. The lower rate would be 10 percent with the goal of a top rate of 25 percent. The Simpson-Bowles plan also calls for lower rates but does not specify the amounts; however, lower rates would be contingent on eliminating certain tax credits and deductions, possibly some popular ones such as the home mortgage interest deduction. President Obama has not proposed any changes to the current individual income tax rates.

President Obama has, however, proposed a minimum 30 percent tax on individuals with incomes over $1 million (full phase in at $2 million).  This was known as the "Buffett Rule" (now called the Fair Share Tax).  President Obama would also limit the tax rate at which higher income individuals can reduce their tax liability to a maximum of 28 percent. This limit would apply to all itemized deductions; foreign excluded income; tax-exempt interest; employer sponsored health insurance; retirement contributions; and selected above-the-line deductions. Another proposal would limit contributions and accruals on tax-favored retirement accounts, including IRAs, qualified plans, tax-sheltered annuities, and deferred compensation plans.

The budget blueprint put forward by Senate Democrats makes similar proposals. The Senate plan would impose across-the-board limits on itemized deductions claimed by the top two percent of income earners, by capping the rate at which itemized deductions and other tax preferences reduce tax liability, a percentage of income cap, or a specific dollar cap.  The Senate plan also proposes to change, without giving details, unspecified itemized deductions into tax credits.

Not surprisingly, the House plan, written by the GOP, does not include these proposals.  Along with consolidating the individual tax rates, the House blueprint would repeal the 3.8 percent net investment income (NII) surtax and the 0.9 percent Additional Medicare Tax, both of which took effect in 2013. The House plan also calls for repealing the alternative minimum tax (AMT). The House plan also calls for tax simplification but does not give details.

Another proposal endorsed by the President but which will be a difficult sale in Congress is to increase the federal estate tax. ATRA "permanently" extended the estate tax at a maximum rate of 35 percent with a $5 million exclusion (indexed for inflation).  President Obama wants to raise the maximum rate to 45 percent with a $3.5 million exclusion (not indexed for inflation) after 2017. 

Businesses

Reducing the U.S. corporate tax rate is a common goal of many of the tax reform proposals but they take different approaches. President Obama has said he would support lowering the corporate tax rate in exchange for businesses giving up unspecified tax preferences. These could include tax incentives for fossil fuels, the Code Sec. 199 deduction and more. The House blueprint would reduce the top corporate tax rate to 25 percent, paid for by tax savings elsewhere. The Simpson-Bowles plan also calls for a reduction in the corporate tax rate, contingent on businesses relinquishing unspecific tax preferences.

President Obama and the House and Senate budgets also propose a number of incentives to encourage business spending and job creation. These include:

• Enhanced small business expensing (Obama and House but at different amounts);
• Permanent research tax credit (Obama, House and Senate);
• Temporary tax credit for increasing payrolls (Obama); and
• Special incentives for manufacturing in the U.S. (Obama).

Another key difference among the competing proposals: the House budget plan would repeal the Patient Protection and Affordable Care Act, including all of its business tax-related provisions, such as employer-shared responsibility provisions, the medical device excise tax, and more.  The Senate approved a non-binding resolution to repeal the medical device tax but is not expected to go along with repeal of the entire Affordable Care Act.

Internet sales tax

In May, the Senate is expected to approve the Marketplace Fairness Act (H.R. 743). The bill gives states the authority to compel online merchants, no matter where they are located, to collect sales tax at the time of a transaction.  However, states would be able to compel collection of sales tax only after they have simplified their sales tax laws, such as by adopting the Streamlined Sales and Use Tax Agreement.  The bill has the support of President Obama. However, the bill may not pass in the House, where many lawmakers view it as a tax increase.

Discussion drafts

The two Congressional tax writing committees – House Ways and Means and Senate Finance – are engaged in discussions among their members over tax reform.  Ways and Means has produced three detailed discussion drafts exploring possible approaches to reforming the taxation of financial products, the taxation of small businesses and moving the U.S. to a territorial system of taxation. Ways and Means Chair Dave Camp, R-Mich., has promised to introduce tax reform legislation this year. Senate Finance has also produced four discussion drafts, less detailed than the House drafts, on simplifying the Tax Code, business taxation and education, and infrastructure, energy and natural resources. Senate Finance Committee Chair Max Baucus, D-Mont., has pledged his commitment to seeing tax reform through before his retirement, which he announced would start at the end of 2014.

Looking ahead

Tax reform coupled with deficit reduction is starting to gain momentum. Whether this will lead to legislation this summer or before year-end is unclear. As long as the key players continue their discussions, there is the chance of tax reform.

Our office will keep you posted of developments. Please contact our office if you have any questions about the tax reform proposals we have reviewed.

Did you owe tax on your 2012 tax return? Did you receive a sizeable refund? Or, conversely, did you receive a smaller refund than you expected? If so, take another look at your tax return from this past year. It is quite possible that by making a few changes, you could put more money in your pocket in the short term. And by examining your investments as they are reported on your tax return, you may be able to strategize for the long-term future. Trying to implement this type of plan may seem difficult at first. However, just by looking at your tax return, you can start the critical planning that can lead you to broader goals of financial independence and a comfortable retirement.

Did you owe tax on your 2012 tax return? Did you receive a sizeable refund? Or, conversely, did you receive a smaller refund than you expected? If so, take another look at your tax return from this past year. It is quite possible that by making a few changes, you could put more money in your pocket in the short term. And by examining your investments as they are reported on your tax return, you may be able to strategize for the long-term future. Trying to implement this type of plan may seem difficult at first. However, just by looking at your tax return, you can start the critical planning that can lead you to broader goals of financial independence and a comfortable retirement.

Federal withholding

If you received a large tax refund, it might be time for you to adjust the amount of tax the federal government withholds from your paycheck. Although next year your refund check may not be as large, you will have the advantage of seeing a larger sum deposited directly into your pocket every month. To adjust your withholding, fill out and sign a Form W-4, and submit it to your employer. You would want to do this in cases where your adjustments to income, exemptions, and deductions remain relatively steady from year-to-year, and where the government consistently is required to give you a large refund.

If you do not change your withholding allowances, the government essentially is holding your money for a year without paying any interest on it. You may lose some potential investment opportunity or, at the very least, the ability to increase your monthly discretionary income. On the other hand, many taxpayers prefer to receive the large refund check after tax filing season because it is a no-hassle way to ensure large savings at the end of the year.

Conversely, many taxpayers may want to change their withholding allowances because they owe the government a significant amount of money at the end of the year. Taxpayers who expect to owe at least $1,000 in tax for the 2013 tax year, after subtracting withholding and any refundable credits, and who also expect their 2013 withholding and credits to be significantly less than the projected tax owed for 2013, may need to file estimated taxes. Failure to do so could result in penalties. Alternatively, taxpayers should consider making quarterly estimated tax payments, especially if they anticipate a significant amount of investment gains for the year or other income unrelated to wage compensation.

State withholding

Some people are entirely exempt from state tax, but it is withheld from their paychecks nevertheless. At the end of each year, they may include the amount of their state taxes in their itemized deductions, but then receive a refund which they have to declare as income in the next year. This problem particularly applies to active duty military families, many of whom are posted in states other than their state of residency. Military families can check with their state income tax authority to see if there is an appropriate form that can be completed and filed, which would exempt them from withholding. A higher adjusted gross income (AGI), even if it is subsequently reduced by itemized deductions, can erode other adjustments to income, such as a deduction for student loans, IRA contributions, higher education expenses, and more because of certain AGI caps on these benefits.

Tax rates and adjusted gross income

As you may have heard, Congress allowed the Bush-era tax cuts to expire for higher-income earners. That means joint filers with more than $450,000 of adjusted gross income ($400,000 for single individuals) are now in the 39.6-percent tax bracket. Taxpayers at this level of income or above are also subject to a higher long-term capital gains tax rate: 20 percent, up from 15 percent paid by other taxpayers.

In addition, for tax years beginning in 2013, the 33-percent tax bracket for individual taxpayers ends at $398,350 for married individuals filing joint returns, heads of households, and single individuals. If you were hovering near the bottom of the 35-percent bracket for the 2012 tax year, then you might want to see if you can readjust your income so that you fall within the 33-percent category.

Higher-income taxpayers also have two new taxes to worry about for 2013 and beyond. Joint-filing taxpayers with modified adjusted gross income of $250,000 ($200,000 for single filers) are also subject to the 3.8-percent surtax on net investment income and a .9-percent Additional Medicare Tax. Look at your adjusted gross income for last year. Does it approach these figures? Is it on the edge of the income brackets? Will stock market increases this year put you over the top of those income thresholds? If so, it may be time to find ways to reduce your income for 2013.

Investments

At some point in your efforts over the years to accumulate a savings nest egg, you will need to consider diversification, the process of putting your money in the right kind of investment vehicles to satisfy your personal risk strategy and achieve your goals. Looking at your tax return will help you decide whether the investments you now have are the right ones for you. For example, if you are in a high tax bracket and need to diversify away from common stocks, investing in tax-exempt bonds might help, especially if you have state income taxes to worry about, too.

Reviewing the Schedule D and Form 8949, which cover Capital Gains and Losses from last year's return and from the past three or four years, can be an eye-opener for many. Did you hold stocks long enough to be entitled to the long-term capital gains rate? Did you try to balance short-term gains with short-term losses? Are you bouncing from one investment trend to another without a long-term investment plan that achieves long-term needs? Are your mutual funds "tax smart"? Become familiar with different types of banking institutions and their products. Find out about CDs, money-market funds, government securities, mutual funds, index funds, and sector funds and how they interrelate with the determination of your tax liability each year. You may want to put that knowledge to work in your investment strategy.

Medical costs

Should you be taking advantage of the medical expense deduction? Many people assume that with the 10 percent adjusted gross income floor on medical expenses now imposed for tax years starting in 2013 (7.5 percent for seniors) that it doesn't pay for them to keep track of expenses to test whether they are entitled to itemize. But with the premiums for certain long-term care insurance contracts now counted as a medical expense, some individuals are discovering that along with other health insurance premiums, deductibles and timing of elective treatments, the medical tax deduction may be theirs for the taking.

Retirement planning

Don't forget to protect for eventualities. Are you maximizing the amount that Uncle Sam allows you to save tax-free for retirement? A look at your W-2 for the year, and at the retirement contribution deductions allowed in determining adjusted gross income should tell you a lot. Should your spouse set up his or her own retirement fund, too? Are you over-invested in tax-deferred retirement plans? If so, you may lose a significant amount of your nest egg to tax after retirement.  

When you are reviewing last year's tax return, it may help to review some of what you've learned from it. This could foster an important conversation with your tax advisor about how to establish or modify your plan for your financial future. If you would like to review last year's completed tax return with future planning in mind, please feel free to give us a call and set up a time when we can meet and discuss this matter.

Questions over the operation of the new 3.8 percent Medicare tax on net investment income (the NII Tax) continue to be placed on the IRS's doorstep as it tries to better explain the operation of the new tax.  Proposed "reliance regulations" issued at the end in 2012 (NPRM REG-130507-11) "are insufficient in many respects," tax experts complain, as the IRS struggles to turn its earlier guidance into final rules.

Questions over the operation of the new 3.8 percent Medicare tax on net investment income (the NII Tax) continue to be placed on the IRS's doorstep as it tries to better explain the operation of the new tax.  Proposed "reliance regulations" issued at the end in 2012 (NPRM REG-130507-11) "are insufficient in many respects," tax experts complain, as the IRS struggles to turn its earlier guidance into final rules.

A public hearing on the existing regulations, held at IRS headquarters in Washington, D.C., in early April 2013, only confirmed how the application of the NII Tax to certain categories of income—particularly income arising from "passive activities"—is challenging even the experts. Nevertheless, taxpayers are not getting a reprieve from the immediate application of this new tax.  The 3.8 percent Medicare surtax on net investment income (NII) became effective January 1, 2013. Current confusion over exactly how the 3.8 percent operates can impact on tax strategies that should be put into motion in 2013. Any misinterpretation can also bear on 2013 estimated tax that may be due to cover any 3.8 percent NII Tax liability.

NII Tax Thresholds

For tax years beginning after December 31, 2012, the NII surtax on individuals equals 3.8 percent of the lesser of: net investment income for the tax year, or the excess, if any, of:

• the individual's modified adjusted gross income (MAGI) for the tax year, over
• the threshold amount.

The threshold amount in turn is equal to:

• $250,000 in the case of a taxpayer making a joint return or a surviving spouse,
• $125,000 in the case of a married taxpayer filing a separate return, and
• $200,000 in any other case.

Trusts and estates are also subject to the NII surtax, to the extent of the lesser of: (i) undistributed net investment income, or (ii) the excess of adjusted gross income over the dollar amount at which the highest tax bracket begins (which, for 2013, is $11,950).

Net Investment Income

The primary confusion over application of the 3.8 percent NII Tax revolves around finding a precise definition of "net investment income" as enacted by Congress. To appreciate the complexity of the task, just look at the applicable Internal Revenue Code provision. Code Sec. 1411(c)(1) defines net investment income as the sum of:

• Category (i) income: Gross income from interest, dividends, annuities, royalties, and rents, other than such income which is derived in the ordinary course of a trade or business not described in Code Sec. 1411(c)(2);
• Category (ii) income: Other gross income derived from a trade or business described in Code Sec. 1411(c)(2); and
• Category (iii) income: Net gain attributable to the disposition of property, other than property held in a trade or business not described in Code Sec. 1411(c)(2); over

Deductions properly allocable to such gross income or net gain.

A Code Sec. 1411(c)(2) trade or business includes a passive activity under Code Sec. 469 with respect to the taxpayer or trading in financial instruments or commodities.

Comment.  Code Sec 1411 effectively creates a new tax and a new tax base, on top of the income tax, alternative minimum tax, self-employment tax and payroll taxes. Nevertheless the Preamble to the proposed regs states that, except as otherwise provided, the income tax rules should apply to Code Sec. 1411 unless good cause otherwise exists. Practitioners have asked the IRS that the final regulations give greater reassurance of this general rule.

Complexity

The IRS has stated that the principal purpose of Code Sec. 1411 is "to impose a tax on unearned income or investments of certain individuals, estates, and trusts." Unfortunately, Code Sec. 1411 is not so direct and simple, with its three categories of income (that is, (i), (ii) and (iii), above), complicating matters, albeit in an effort to close every door to those who try to "game the system."

Application of the 3.8 percent NII Tax to capital gains and dividends from a personal stock portfolio is clear under this rule of thumb. But clarity breaks down when a "trade or business" is thrown into the mix and the concept of "passive activity" is added to it.

If gain or other income is the result of an active business activity, it generally escapes NII Tax. However, when the "active" business is a passive activity (for example, a rental business), it may be deemed to generate income that is subject to the NII Tax. Furthermore, when a passive activity is not merely incidental to a business however otherwise active that business should be, the NII Tax also becomes an issue. 

Passive Activity

Any revised or additional rules from the IRS on the application of the NII Tax on passive activities should be made more user friendly to the broad middle range of taxpayers and their advisors, one expert at the hearing recommended.  The IRS should err on the side of explaining things clearly and simply, even at the expense of not covering every possible nuance of interpretation.

At the same time, however, other experts are asking for more detail, at least in the way of clarification. For example, the IRS has stated that passive activity for NII Tax purposes should be applied within a narrower scope than the passive activity loss rules under Code 469.  Those Code Sec. 469 rules restrict "passive losses" from reducing income that is not "passive income."  Experts want the IRS to explain exactly what they mean by a "narrower scope."

Self-Rental Activities/Grouping

The self-rental recharacterization rule under Code Sec. 469 affects taxpayers who rent property to a trade or business in which they materially participate. Concern has been expressed over the possibility of interpreting net investment income under Code Sec. 1411 to include rental income from a self-rental activity grouped with a trade or business activity in which the taxpayer materially participates.

The material participation and trade or business requirements should be tested on the grouped activity as a whole rather than on a component basis, one expert in particular stressed at the hearing. If that test is passed, he argued, the trade or business income and rental income from the grouped activity should be excluded from the reach of the NII Tax. For example, the owners of self-rental properties should not have that rent considered as separate from their overall business activity and subject to the net investment tax simply because properties are held in a separate LLC to avoid tort liability.

Regrouping deadline

The proposed regulations permit businesses subject to the NII Tax to elect to regroup their activities for passive-loss purposes in 2013 or 2014. This regrouping election allows taxpayers with a fresh start to accommodate the new NII surtax. Without permitting regroupings, taxpayers would be bound by their original grouping decisions, some of which may have been made as many as 20 years ago, only for purpose of Code Sec. 469 passive loss rules and not the NII Tax. Some small business representatives are also concerned that, because of the complexity of the rules, the final regulations should extend the deadline for a regrouping election through 2015.

Application of the net investment income tax is particularly difficult to get a handle on in a variety of situations.  Unfortunately, however, at 3.8 percent, it is costly enough not to be ignored. 

If you have any questions about how the NII Tax may apply to your business, rental operations, or overall investment strategy, please do not hesitate to call our office.

Under the Patient Protection and Affordable Care Act (PPACA), small employers can claim a credit for providing health insurance for employees and their families. Health insurance includes not only basic medical and hospital care, but dental or vision, long-term care, and coverage for specific diseases or illness. Self-funded plans do not qualify; the insurance must be provided through a third party.

Under the Patient Protection and Affordable Care Act (PPACA), small employers can claim a credit for providing health insurance for employees and their families. Health insurance includes not only basic medical and hospital care, but dental or vision, long-term care, and coverage for specific diseases or illness. Self-funded plans do not qualify; the insurance must be provided through a third party.

For 2010-2013, for-profit employers can claim a credit of 35 percent of the employer's nonelective contributions, increasing to 50 percent for 2014 and 2015. Nonprofit employers can claim a credit of 25 percent through 2013, and 35 percent for the two succeeding years. Beginning in 2012, the credit for nonprofit employers is limited to the payroll taxes paid by the employer.

Small employers

Employers can claim the full credit if their full-time equivalent (FTE) employees are 10 or less, and their average annual wages per employee are $25,000 or less. FTEs are determined by figuring total hours of service for all employees and dividing the total by 2,080.

The credit is phased out for employers with 11 to 25 employees or with average wages between $25,000 and $50,000. The credit percentage is reduced 6.67 percent per "excess" employee (over 10) and four percent for each $1,000 of average wages in excess of $25,000.

To determine the amount of the credit, employers must add up the total premiums they paid on behalf of their employees during the year, subject to the state average premium limit. This total is then multiplied by the applicable percentage (25 or 35 percent for 2013, minus any phase-out). The credit is then reduced for FTEs in excess of 10, and for average annual wages (in units of $1,000) over $25,000. The result is the total credit that the employer can claim.

Other requirements

Under current law, employers must pay at least 50 percent of the insurance costs and must pay a uniform percentage for all employees. The credit is reduced if the employer premiums exceed the state's average premium for small group markets.

In its proposed fiscal year 2014 budget, the Obama administration would modify or eliminate some of these requirements. The credit phase-out would apply to employers with 21-50 employees, rather than 11-25. The phase-out rate would also be more gradual. Furthermore, the administration would eliminate the requirement that employers make a uniform contribution for each employee, and would eliminate the limit for state average premiums.

Reports indicate that the small business health insurance credit is being underutilized, with many businesses leaving this tax money on the table without claiming it or arranging their affairs to do so.

If you have any questions about how you might be able to position your business to claim this credit or claim a larger credit, do not hesitate to call this office for an update.

A business that manufactures products to be sold, or purchases products for resale, must value its product inventory at the beginning and the end of each tax year to determine the cost of goods sold (COGS) during the year. The business determines its gross profits by deducting COGS from its gross receipts for the year. The business then deducts its other business expenses from gross profits, to determine its net (taxable) income for the year.

A business that manufactures products to be sold, or purchases products for resale, must value its product inventory at the beginning and the end of each tax year to determine the cost of goods sold (COGS) during the year. The business determines its gross profits by deducting COGS from its gross receipts for the year. The business then deducts its other business expenses from gross profits, to determine its net (taxable) income for the year.

Certain expenses are included in COGS. Expenses that are included in COGS cannot be deducted again as a business expense. COGS expenses include:

• The cost of products or raw materials, including freight or shipping charges;
• The cost of storing products the business sells;
• Direct labor costs for workers who produce the products; and
• Factory overhead expenses.

Purchased inventory

If the business purchases its inventory for resale, its inventory costs are the invoice price plus transportation and other necessary expenses, less discounts.  Discounts that must be deducted from the costs of purchased inventory include trade discounts, manufacturer's rebates, and cash discounts.

Trade discounts are a reduction in the price of goods that a manufacturer or wholesaler provides to a retailer.  It includes a discount that is always allowed, regardless of the time of payment. A manufacturer's rebate is based on the dealer's purchases during the year. A cash discount is a reduction in the invoice price that the seller provides if the dealer pays immediately or within a specified time. The cash discount may reduce COGS, or it may be treated separately as gross income. Certain excise tax reimbursements may reduce the value of ending inventory and therefore reduce COGS.   

Methods of accounting

It is usually impractical to associate items of intermingled or fungible inventory with specific invoices and costs. Instead, taxpayers use certain assumptions or methods of accounting to identify the goods on hand and their costs. The traditional assumptions include FIFO (first-in, first-out) and LIFO (last-in, first-out). In some cases, specific identification is used. The courts have approved the average cost method, although the IRS disagrees with its use. The IRS will permit taxpayers to use other inventory cost assumptions, such as the rolling-average method, if they are reasonable for the taxpayer's trade or business and clearly reflect income.

Under the FIFO, the taxpayer is presumed to sell the oldest goods in inventory and to retain the most-recently produced or purchased items. If production (inventory) costs are rising, the use of FIFO reduces COGS and increases the taxpayer's income. Under LIFO, the taxpayer is presumed to sell the most recently obtained goods and to retain the oldest goods in inventory. Assuming that inventory costs are rising, the LIFO method will increase COGS and decrease the taxpayer's income. Under the average cost method, all units purchased during the year are averaged with the cost of beginning inventory, to determine an average cost.

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of May 2013.

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of May 2013.

May 1
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates April 24-26.

May 3
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates April 27-30.

May 8
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 1-3.

May 10
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 4-7.

Employees who work for tips. Employees who received $20 or more in tips during April must report them to their employer using Form 4070.

May 15
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 8-10.

May 17
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 11-14.

May 22
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 15-17.

May 24
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 18-21.

May 30
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 22-24.

May 31
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 25-28.

June 5
Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 29-31.

Individuals who have been "involuntarily terminated" from employment may be eligible for a temporary subsidy to help pay for COBRA continuation coverage. The temporary assistance is part of the American Recovery and Reinvestment Act of 2009 (2009 Recovery Act), and is aimed at helping individuals who have lost their jobs in our troubled economy. However, not every individual who has lost his or her job qualifies for the COBRA subsidy. This article discusses what qualifies as "involuntary termination" for purposes of the temporary COBRA subsidy.

Background

The 2009 Recovery Act temporarily allows individuals involuntarily terminated from their employment between September 1, 2008 and December 31, 2009 to elect to pay 35 percent of their COBRA coverage and be treated as having paid the full amount. In most cases, the former employer pays the remaining 65 percent of the premium and is reimbursed by claiming a payroll tax credit.

Some individuals who are "qualified beneficiaries" may also be eligible for the COBRA subsidy. They include spouses and dependent children. However, domestic partners generally do not qualify for the COBRA subsidy.

Income limits

The COBRA subsidy is excludable from gross income. However, individuals with modified adjusted gross incomes (MAGI) between $125,000 and $145,000 ($250,000 and $290,000 for married couples filing jointly) must repay part of the subsidy. For individuals with MAGI exceeding $145,000 and married couples with MAGI exceeding $290,000, the full amount of the subsidy must be repaid as additional tax.

Coverage period

The COBRA subsidy applies as of the first period of coverage starting on or after February 17, 2009 (the effective date of the 2009 Recovery Act). For most plans this was March 1, 2009. The subsidy is available for nine months. However, the nine-month subsidy period may end earlier if the individual becomes eligible for Medicare or another group health plan (such as one sponsored by a new employer).

Involuntary termination

One of the most important questions for purposes of the COBRA subsidy is what is involuntary termination? The IRS has explained that involuntary termination is severance from employment due to an employer's unilateral authority to terminate the employment. However, the IRS stresses that whether an involuntary termination has occurred depends on all the facts and circumstances.

Involuntary termination can also occur when an employer:

• Declines to renew an employee's contract;
• Furloughs an employee;
• Reduces an employee's time to zero hours;
• Tells an employee to "resign or be fired;"
• Relocates its office or plant and an employee declines to relocate; or
• Locks out its employees.

Extended election

Moreover, individuals involuntarily terminated between September 1, 2008 and February 18, 2009, but who declined COBRA coverage, have a second chance under the 2009 Recovery Act. They may be eligible to re-elect COBRA coverage and receive the subsidy.

Small businesses

COBRA continuation coverage and the subsidy are generally unavailable to employees of small businesses (businesses with 20 or fewer employees). However, some states have mini-COBRA laws that extend COBRA continuation coverage and the subsidy to workers at small businesses. COBRA continuation coverage and the subsidy are also unavailable if the employer terminates its health plan.

If you would like to know more about the COBRA premium subsidy, please contact out offices. We can help determine your eligibility for this assistance.

Many businesses are foregoing salary increases this year because of the economic downturn. How does a business find and retain employees, as well as keep up morale, in the face of this reality? The combined use of fringe benefits and the tax law can help. Some attractive fringe benefits may be provided tax-free to employees and at little cost to employers.

De minimis fringe benefits

A de minimis fringe benefit is any property or service whose value is so small or minimal that accounting for it would be administratively impracticable. Such benefits are excluded from an employee's gross income. Examples of de minimis fringe benefits include:

Occasional overtime meals and meal money. To qualify as a tax-free de minimis fringe benefit, the meal or meal money must be provided to your employees so that they can extend their normal workday, thereby enabling them to work overtime. Such meals and meal money can only be provided occasionally. This means that they generally cannot be provided routinely, when overtime work is a common occurrence or are contractually mandated for overtime work. Occasional snacks may also qualify as a de minimis fringe benefit but if the snacks are provided daily, they would not qualify.

Occasional transportation. Transportation costs can also qualify as de minimis fringe benefits. Taxi-fare for an employee to return home after working late, for example, may be a de minimis fringe benefit. The transportation must be occasional.

Holiday gifts. Traditional holiday gifts, such as a Thanksgiving turkey, with a low fair market value can generally qualify as a de minimis fringe benefit. However, cash or a cash equivalent such as a gift certificate in lieu of the property, do not qualify. In fact, cash and cash equivalent fringe benefits, no matter how little, are never excludable as a de minimis fringe benefit, except for occasional meal money or transportation fare.

E-filing. Electronically filing an employee's tax return, but not paying for someone to prepare the return, may qualify as a de minimus fringe benefit.

Telephone calls. An employer may treat the cost of local telephone calls made by employees as a de minimis fringe benefit.

Working condition fringe benefits

A working condition fringe benefit is any type of property or service provided to your employees to the extent that the cost of such property or services would have been deductible by the employee as a trade or business expense, depreciation expenses, or as if the employee paid for the property/services himself or herself. Working condition fringe benefits have special tax rules for employers and employees.

Vehicles. If an employer-provided vehicle is used 100 percent for business and the use is substantiated, use of the vehicle is considered a working condition fringe benefit. The value of use of the vehicle is not included in the employee's wages. However, when an employer-provided vehicle is used by the employee for both personal and business purposes, an allocation between the two types must be made. The portion allocable to the employee's personal use is generally taxable to the employee as a fringe benefit. The portion allocable to business use is generally considered a working condition fringe benefit and is excludable from the employee's income. 

No additional cost services

If an employer-provided service does not cause the employer to incur any substantial additional costs, it may qualify as a "no additional cost service" and be excludible from the employee's income. The service must be offered to customers in the employer's ordinary course of business. Some of the most common examples are airline, rail and bus tickets and hotel and motel rooms provided at a reduced rate or at no cost to employees. This benefit can be offered to retired employees as well as active employees. There are special rules for highly-compensated employees.

If you are considering alternatives to salary compensation, and would like to know what your options are, please contact our office. We can discuss the tax benefits and drawbacks of providing your employees with various types of fringe benefits.

Many taxpayers are looking for additional sources of cash during these tough economic times. For many individuals, their Individual Retirement Account (IRA) is one source of cash. You can withdraw ("borrow") money from your IRA, tax and penalty free, for up to 60 days. However, the ability to take a short-term "loan" from your IRA should only be taken in dire financial situations in light of the serious tax consequences that can result from an improper withdrawal or untimely rollover of the funds back into an IRA.

The funds must be returned, or rolled back into, an IRA within 60 days from the day after the date of the withdrawal, or income and penalty taxes are imposed on the amount withdrawn and not returned. These tax consequences can be serious. Therefore, it is imperative that you return the withdrawn funds back into an IRA within 60 days.

Tax and interest imposed

If the funds are not returned within 60 days, the withdrawal will not only be treated as a taxable distribution for individuals who are under the age of 59 1/2, but you will also face an additional 10 percent penalty tax, as well as possible state income tax.

Example

You withdraw $10,000 from your IRA on March 2. The 60-day period begins on March 3. To avoid income taxes as a result of early withdrawal treatment and an additional 10 percent penalty tax, the amounts must be returned to an IRA on May 2. Although May 2 falls on a Saturday, there is no extension as a result of weekends (or holidays).

Income tax reporting

If you decide to take the short-term, 60 day "loan" from an IRA you must report the entire amount of the withdrawal. The withdrawal is reported on line 15a of your Form 1040 for the tax year in which you took the withdrawal. If you have returned the withdrawn funds within the 60 day period, you will enter "zero" as the taxable amount of line 15b of Form 1040.

One-year rule

You can only take a "60 day loan" from a specific IRA account and return the funds to that IRA or a different account once during a one-year period. If you make a withdrawal from the same IRA more than once during a one-year period, the second withdrawal is treated by the IRS as a taxable IRA distribution, again generally subject to income taxes and a 10-percent early withdrawal penalty tax.

Moreover, if you redeposit funds back into a particular IRA account and withdraw money from that same account within the one-year period, again the withdrawn funds are again treated as a premature withdrawal subject to income taxes and the 10-percent penalty tax.

For those struggling in these economic times and looking for additional sources of cash, there are other options in addition to a 60-day loan from your IRA. Our office can discuss your options and the potential tax consequences of each. 

You have carefully considered the multitude of complex tax and financial factors, run the numbers, meet the eligibility requirements, and are ready to convert your traditional IRA to a Roth IRA. The question now remains, however, how do you convert your IRA?

Conversion basics

A conversion is a penalty-free taxable transfer of amounts from a traditional IRA to a Roth IRA. You can convert part or all of the money in your regular IRA to a Roth. When you convert your traditional IRA to a Roth, you will have to pay income tax on the amount converted. However, a traditional IRA may be converted (or rolled over) penalty-free to a Roth IRA as long as you meet the requirements for conversion, including adjusted gross income (AGI) limits in effect until 2010. You should have funds outside the IRA to pay the income tax due on the conversion, rather than taking a withdrawal from your traditional IRA to pay for it - those withdrawals are subject to an early withdrawal penalty and they cannot be put back at a later time to continue to accumulate in the tax-free environment of an IRA.

Big news for 2010 and beyond

Beginning in 2010, you can convert from a traditional to a Roth IRA with no income level or filing status restrictions. For 2008, Roth IRAs are available for individuals with a maximum adjusted gross income of $116,000 ($169,000 for joint filers and heads of household). These income limits have prevented many individuals from establishing or converting to a Roth IRA. Not only is the income limitation eliminated after 2009, taxpayers who convert to a Roth IRA in 2010 can recognize the conversion amount in adjusted gross income (AGI) ratably over two years, in 2011 and 2012.

Example. You have $14,000 in a traditional IRA, which consists of deductible contributions and earnings. In 2010, you convert the entire amount to a Roth IRA. You do not take any distributions in 2010. As a result of the conversion, you have $14,000 in gross income. Unless you elect otherwise, $7,000 of the income is included in income in 2011 and $7,000 is included in income in 2012.

Conversion methods

There are three ways to convert your traditional IRA to a Roth. Generally, the conversion is treated as a rollover, regardless of the conversion method used. Any converted amount is treated as a distribution from the traditional IRA and a qualified rollover contribution to the Roth IRA, even if the conversion is accomplished by means of a trustee-to-trustee transfer or a transfer between IRAs of the same trustee.

1. Rollover conversion. Amounts distributed from a traditional IRA may be contributed (i.e. rolled over) to a Roth IRA within 60 days after the distribution.

2. Trustee-to-trustee transfer. Amounts in a traditional IRA may be transferred in a trustee-to-trustee transfer from the trustee of the traditional IRA to the trustee of the Roth IRA. The financial institution holding your traditional IRA assets will provide directions on how to transfer those assets to a Roth IRA that is maintained with another financial institution.

3. Internal conversions. Amounts in a traditional IRA may be transferred to a Roth IRA maintained by the same trustee. Conversions made with the same trustee can be made by redesignating the traditional IRA as a Roth IRA, in lieu of opening a new account or issuing a new contract. As with the trustee-to-trustee transfer, the financial institution holding the traditional IRA assets will provide instructions on how to transfer those assets to a Roth IRA. The transaction may be simpler in this instance because the transfer occurs within the same financial institution.

Failed conversions

A failed conversion has significant negative tax consequences, and generally occurs when you do not meet the Roth IRA eligibility or statutory requirements; for example, your AGI exceeds the limit in the year of conversion or you are married filing separately (note: as mentioned, the AGI limit for Roth IRAs will no longer be applicable beginning in 2010).

A failed conversion is treated as a distribution from your traditional IRA and an improper contribution to a Roth IRA. Not only will the amount of the distribution be subject to ordinary income tax in the year of the failed conversion, it will also be subject to the 10 percent early withdrawal penalty for individuals under age 59 1/2, (unless an exception applies). Moreover, the Tax Code imposes an additional 6 percent excise tax each year on the excess contribution amount made to a Roth IRA until the excess is withdrawn.

Caution - financial institutions make mistakes

The brokerage firm, bank, or other financial institution that will process your IRA to Roth IRA conversion can make mistakes, and their administrative errors will generally cost you. It is imperative that you understand the process, the paperwork, and what is required of you and your financial institution to ensure the conversion of your IRA properly and timely. Our office can apprise you of what to look out for and what to require of the financial institutions you will deal with during the process.

Determining whether to convert your traditional IRA to a Roth IRA can be a complicated decision to make, as it raises a host of tax and financial questions. Our office can help you determine not only whether conversion is right for you, but what method is best for you, too.

To ease the pain of the ever-escalating costs of healthcare, many employers provide certain tax-driven health benefits and plans to their employees. To help employers understand the differences and similarities among three popular medical savings vehicles - health savings accounts (HSAs), flexible spending accounts (FSAs) and health reimbursement arrangements (HRAs) - here's an overview.

Health Savings Accounts (HSAs)

HSAs are relatively new. An HSA is a tax-exempt trust or custodial account that is established exclusively to pay for (or reimburse) the qualified medical expenses of the account holder (typically an employee), a spouse or dependents such as children. Individuals get to take an above-the-line deduction for HSA contributions, while employer contributions to an employee's HSA are neither included in the employee's gross income nor subject to employment taxes. HSA earnings grow tax-free and distributions to pay for qualified medical expenses are also tax-free.

For 2008, a deduction may be taken up to $2,900 by individuals with self-only coverage and $5,800 by individuals with family coverage. And, individuals age 55 or older may make additional "catch-up" contributions to an HSA.

HSA contributions in an account carry over from year to year until the employee uses them. HSAs are also portable, meaning that an employee can take their funds when they leave or change jobs.

To be eligible for an HSA, an individual must generally:

• Have a high deductible health plan (HDHP);
• Have no other health coverage except for certain types of permitted coverage (for example, coverage for accidents, disability, dental and vision care, and long-term care);
• Not be enrolled in Medicare; and
• Not be able to be claimed as a dependent on another person's tax return.

HDHPs feature higher annual deductibles than other traditional health plans. For 2008, the minimum HDHP deductible is $1,100 for self-only coverage, and $2,200 for family coverage. HSA annual contributions, however, are not limited to the annual deductible under an HDHP.

Flexible Spending Arrangements (FSAs)

An FSA is an employer-provided benefit program that reimburses employees for specified expenses as they are incurred. Employees must first incur and substantiate the expense before it is reimbursed by the employer. FSAs are also known as "cafeteria plans" or "Section 125 plans" because they are allowed under Code Sec. 125 of the Internal Revenue Code. An FSA allows employees to contribute before-tax dollars to the account to be used to reimburse health care costs. Employers can also contribute to an employee's FSA. Generally, distributions may only be made to reimburse an employee for qualified medical expenses. They generally cannot be carried forward from year to year; specific "use-it-or-lose-it" rules apply.

Funds set aside in an FSA, typically through a voluntary salary reduction agreement, are not included in an employee's gross income or subject to employment taxes (with an exception for employer contributions used to pay for long-term care insurance). Withdrawals from an FSA are tax-free if used for qualified medical expenses. Employees can also withdraw funds from their account to pay for qualified medical expenses even if they have not yet placed the funds in the FSA.

Health Reimbursement Arrangements (HRAs)

An HRA is a type of FSA in which an employer sets aside funds to reimburse employees for qualified medical expenses up to a maximum dollar amount. Employer HRA contributions are not included in employees' gross income or subject to employment taxes. Additionally, employers get to deduct amounts contributed to employees' HRAs. HRAs can only be established and funded by an employer, and can be offered together with other employer-provided health benefits. Self-employed individuals are not eligible for HRAs.

Generally, there is no limit on the amount an employer can contribute to an employee's HRA, and any unused amounts in an HRA can be carried forward to later years. HRAs, however, are not portable and therefore do not follow employees if they change employment.

Distributions from HRAs can only be used to pay for qualified medical expenses that an employee has incurred on or after the date he or she enrolled in the HRA. If a distribution is made to pay for non-qualified medical expenses, those amounts are included in the employee's gross income. Moreover, distributions made to someone other than the employee, their spouse or dependents are taxable income.

If you need further analysis of which of these health-benefit plans may be right for you, and your employees if applicable, please call us.

The IRS allows taxpayers with a charitable inclination to take a deduction for a wide range of donated items. However, the IRS does provide specific guidelines for those taxpayers contributing non-cash items, from the type of charity you can donate to in order to take a deduction to the quality of the goods you contribute and how to value them for deduction purposes. If your summer cleaning has led, or may lead, you to set aside clothes and other items for charity, and you would like to know how to value these items for tax purposes, read on.

Household items that can be donated to charitable, and for which a deduction is allowed, include:

• Furniture;
• Furnishings;
• Electronics;
• Appliances;
• Linens; and
• Similar items.

The following are not considered household items for charitable deduction purposes:

• Food;
• Paintings, antiques, and other art objects;
• Jewelry; and
• Collections.

Valuing clothing and household items

Many people give clothing, household goods and other items they no longer need to charity. If you contribute property to a qualified organization, the amount of your charitable contribution is generally the fair market value (FMV) of the property at the time of the contribution. However, if the property has increased in value since you purchased it, you may have to make some adjustments to the amount of your deduction.

You can not deduct donations of used clothing and used household goods unless you can prove the items are in "good," or better, condition; and in the case of equipment, working. However, the IRS has not specifically set out what qualifies as "good" condition.

Fair market value is the amount that the item could be sold for now; what you originally paid for the clothing or household item is completely irrelevant. For example, if you paid $500 for a sofa that would only get you $50 at a yard sale, your deduction for charitable donation purposes is $50 (the sofa's current FMV). You cannot claim a deduction for the difference in the price you paid for the item and its current FMV.

To determine the FMV of used clothing, you should generally claim as the value the price that a buyer of used clothes would pay at a thrift shop or consignment store.

Comment. In the rare event that the household item (or items) you are donating to charity has actually increased in value, you will need to make adjustments to the value of the item in order to calculate the correct deductible amount. You may have to reduce the FMV of the item by the amount of appreciation (increase in value) when calculating your deduction.

Good faith estimate

All non-cash donations require a receipt from the charitable organization to which they are donated, and it is your responsibility as the taxpayer, not the charity's, to make a good faith estimate of the item's (or items') FMV at the time of donation. The emphasis on valuation should be on "good faith." The IRS recognizes some abuse in this area, yet needs to balance its public ire with its duty to encourage legitimate donations. While the audit rate on charitable deductions is not high, it also is not non-existent. You must be prepared with reasonable estimates for used clothing and household goods, high enough so as not to shortchange yourself, yet low enough to prevent an IRS auditor from threatening a penalty.

In any event, if the FMV of any item is more than $5,000, you will need to obtain an appraisal by a qualified appraiser to accompany your tax form (which is Form 8283, Noncash Charitable Contributions). When dealing with valuables, an appraisal helps protect you as well as the IRS.

If you have questions about the types of items that you can donate to charity, limits on deductibility, or other general inquiries about charitable donations and deductions, please contact out office.

On December 18, 2007, Congress passed the Mortgage Forgiveness Debt Relief Act of 2007 (Mortgage Debt Relief Act), providing some major assistance to certain homeowners struggling to make their mortgage payments. The centerpiece of the new law is a three-year exception to the long-standing rule under the Tax Code that mortgage debt forgiven by a lender constitutes taxable income to the borrower. However, the new law does not alleviate all the pain of all troubled homeowners but, in conjunction with a mortgage relief plan recently announced by the Treasury Department, the Act provides assistance to many subprime borrowers.

Cancellation of debt income

When a lender forecloses on property, sells the home for less than the borrower's outstanding mortgage debt and forgives all, or part, of the unpaid debt, the Tax Code generally treats the forgiven portion of the mortgage debt as taxable income to the homeowner. This is regarded as "cancellation of debt income" (reported on a Form 1099) and taxed to the borrower at ordinary income tax rates.

Example. Mary's principal residence is subject to a $250,000 mortgage debt. Her lender forecloses on the property in 2008. Her home is sold for $200,000 due to declining real estate values. The lender forgives the $50,000 difference leaving Mary with $50,000 in discharge of indebtedness income. Without the new exclusion in the Mortgage Debt Relief Act, Mary would have to pay income taxes on the $50,000 cancelled debt income.

The Mortgage Debt Relief Act

The Mortgage Debt Relief Act excludes from taxation discharges of up to $2 million of indebtedness that is secured by a principal residence and was incurred to acquire, build or make substantial improvements to the taxpayer's principal residence. While the determination of a taxpayer's principal residence is to be based on consideration of "all the facts and circumstances," it is generally the one in which the taxpayer lives most of the time. Therefore, vacation homes and second homes are generally excluded.

Moreover, the debt must be secured by, and used for, the principal residence. Home equity indebtedness is not covered by the new law unless it was used to make improvements to the home. "Cash out" refinancing, popular during the recent real estate boom, in which the funds were not put back into the home but were instead used to pay off credit card debt, tuition, medical expenses, or make other expenditures, is not covered by the new law. Such debt is fully taxable income unless other exceptions apply, such as bankruptcy or insolvency. Additionally, "acquisition indebtedness" includes refinancing debt to the extent the amount of the refinancing does not exceed the amount of the refinanced debt.

The Mortgage Debt Relief Act is effective for debt that has been discharged on or after January 1, 2007, and before January 1, 2010.

Mortgage workouts

In addition to foreclosure situations, some taxpayers renegotiating the terms of their mortgage with their lender are also covered by the new law. A typical foreclosure nets a lender only about 60 cents on the dollar. When the lender determines that foreclosure is not in its best interests, it may offer a mortgage workout. Generally, in a mortgage workout the terms of the mortgage are modified to result in a lower monthly payment and thus make the loan more affordable.

More help

Recently, Treasury Department officials brokered a plan that brings together private sector mortgage lenders, banks, and the Bush Administration to help homeowners. The plan is called HOPE NOW.

Here's how it works: The HOPE NOW plan is aimed at helping borrowers who were able to afford the introductory "teaser" rates on their adjustable rate mortgage (ARM), but will not be able to afford the loan once the rate resets between 2008 and 2010 (approximately 1.3 million ARMs are expected to reset during this period). The plan will "freeze" these borrowers' interest rates for a period of five years. The plan, however, has some limitations that exclude many borrowers. Only borrowers who are current on their mortgage payments will benefit. Borrowers already in default or who have not remained current on their mortgage payments are excluded.

Under the HOPE NOW plan, borrowers may be able t

- Refinance to a new mortgage;

- Switch to a loan insured by the Federal Housing Authority (FHA);

- Freeze their "teaser" introductory rate for five years.

Without the Mortgage Debt Relief Act, a homeowner who modifies the terms of their mortgage loan, or has their interest rate frozen for a period of time, could be subject to debt forgiveness income under the Tax Code. This is why the provision of the Mortgage Debt Relief Act excluding debt forgiveness income from a borrower's income is a critical component necessary to make the HOPE NOW plan effective.

If you would like to know more about relief under the Mortgage Forgiveness Debt Relief Act of 2007 and the Treasury Department's plan, please call our office. We are happy to help you navigate these complicated issues.

If you own a vacation home, you may be considering whether renting the property for some of the time could come with big tax breaks. More and more vacation homeowners are renting their property. But while renting your vacation home can help defray costs and provide certain tax benefits, it also may raise some complex tax issues.

Determining whether to use your vacation home as a rental property, maintain it for your own personal use, or both means different tax consequences. How often will you rent your home? How often will you and your family use it? How long will it sit empty? Depending on your situation, renting your vacation home may not be the most lucrative approach for you.

Generally, the tax benefits of renting your vacation home depend on how often you and your family use the home and how often you rent it. Essentially, there are three vacation home ownership situations for tax purposes. We will go over each, and their tax implications.

Tax-free rental income

If you rent your vacation home for fewer than 15 days during the year, the rental income you receive is tax-free; you don't even have to report it on your income tax return. You can also claim basic deductions for property taxes and mortgage interest just as you would with your primary residence.

You won't, however, be able to deduct any rental-related expenses (such as property management or maintenance fees). And, if your rental-related expenses exceed the income you receive from renting your vacation home for that brief time, you can't take a loss. Nevertheless, this is an incredibly lucrative tax break, especially if your vacation home is located in a popular destination spot or near a major event and you don't want, or need, to rent it out for a longer period. If you fit in this category of vacation homeowners and would like more information on this significant tax benefit, call our office.

Pure rental property

Do you plan on renting your vacation home for more than 14 days a year? If so, the tax rules can become complicated. If you and your family don't use the property for more than 14 days a year, or 10% of the total number of days it is rented (whichever is greater), your vacation home will qualify as rental property, not as a personal residence.

If you rent your vacation home for more than 14 days, you must report all rental income you receive. However, now you can deduct certain rental-related expenses, including depreciation, condominium association fees, property management fees, utilities, repairs, and portions of your homeowner's insurance. How much you can deduct will depend on how often you and your family use the property. But, as the owner of investment property, you can take a loss on the ultimate sale of your rental homes, which second-homeowners can't do.

Income and deductions generated by rental property are treated as passive in nature and subject to passive activity loss rules. As passive activity losses, rental property losses can't be used to offset income or gains from non-passive activities (such as wages, salaries, interest, dividends, and gains from the sale of stocks and bonds). They can only be used to offset income or gains from other passive type activities. Passive activity losses that you can't use one year, however, can be carried forward to future years.

However, an owner of rental property who "actively participates" in managing the rental activities of his or her vacation home, and has an adjusted gross income that doesn't exceed $100,000, can deduct up to $25,000 in rental losses against other non-passive income, such as wages, salaries, and dividends. It's not all that difficult to meet the "active participation" test if you try.

Personal use for more than 14 days

If you plan on using your vacation home a lot, as well as renting it often, your vacation home will be treated as a personal residence. Specifically, if you rent your home for more than 14 days a year, but you and your family also use the home for more than 14 days, or 10% of the rental days (whichever is greater), your vacation home will qualify as a personal residence, not a rental property, and complex tax issues arise.

All expenses must be apportioned between rental and personal use, based on the total number of days the home is used. For example, you must allocate interest and property taxes between rental and personal use so that a portion of your mortgage interest payments and property taxes will be reported as itemized deductions on Schedule A (the standard form for itemized deductions) and a portion as deductions against rental income on Schedule E (the form for rental income and expenses.) You will only be able to deduct your rental expense up to the total amount of rental income.  Excess losses can be carried forward to future years though.

Proper planning

With proper planning and professional advice, you can maximize tax benefits of your vacation home. Please call our office if you have, or are planning to buy, a vacation home and would like to discuss the tax consequences of renting your property.

Fringe benefits have not only become an important component of employee compensation, they also have a large financial impact on an employer's business. Fringe benefits are non-compensation benefits provided by an employer to employees. Unless they fall within one of the specific categories of tax-exempt fringe benefits, however, are taxable to employees.

Qualified employee discounts are among several categories of fringe benefits that are non-taxable to the employee under Code Sec. 132 and also deductible by the employer as an ordinary and necessary business expense. If you want to give employee discounts, this is the type you should consider first.

Qualified employee discounts

For an employee discount to be excludable from an employee's income and deductible by the employer, it must constitute a qualified employee discount. A qualified employee discount is an employee discount provided on qualified property or services. If the benefits are not qualified, they are taxable to the employee.

Qualified employee discounts are those that are provided on products or services sold in the ordinary course of the employer's line of business. For instance, employee discounts on items sold only at an employee store are not excludable from gross income because they are not offered for sale to non-employee customers in the ordinary course of the employer's line of business.

An employer may exclude the value of an employee discount provided to an employee from his or her wages, up to the following limits:

• For a discount on services, 20% of the price the employer charges non-employee customers for the service.

• For a discount on merchandise or other property, the employer's gross profit percentage times the price the employer charges non-employee customers for the property.

For example, if an employer's business sells a product for $100 and its cost is $75, the gross profit margin is $25. Therefore, to be tax-free to the employee, the discount cannot exceed $25. If an employer charges customers $100 for a certain service, the employee's tax-free discount for the same service cannot exceed $20 (i.e. 20 percent of the value of the service). Any excess discount will be treated as taxable income to the employee.

Qualified employee discounts can be provided through a direct reduction in the price of property or services as well through a cash rebate system. However, the discounts cannot be provided on real estate or investment property, such as stocks and bonds.

Non-discrimination

Qualified employee discounts must be available to employees on a nondiscriminatory basis, which requires that the benefits be available on substantially the same terms to all employees or to each member of a reasonable classification of employees that does not discriminate in favor of highly compensation employees. An employer engaged in more than one line of business must treat each line of business separately in applying the discrimination test. If an employer's plan fails the test, only your employees who are not highly compensated may exclude the value of the benefit from income.

Business expense deduction

An employer can deduct the actual cost of providing fringe benefits to employees as an ordinary and necessary business expense, whether or not the benefits are taxable to the employees. Employers can deduct the cost of providing qualified employee discounts as either compensation for services rendered or as a tax deductible business expense under Code Sec. 162.

As with other business expenses incurred by an employer for which tax deductions are sought, expenses paid or incurred in carrying on a trade or business are deductible only if they are ordinary and necessary. Ordinary and necessary expenses must be reasonable in amount to be deductible.

Because a qualified employee discount is a type of fringe benefit (albeit tax exempt), and fringe benefits are a form of employee compensation under Code Sec. 61, a qualified employee discount will meet the business expense requirements of Code Sec. 162, providing for deduction by an employer. Thus, employers can deduct the cost of qualified employee discounts and not pay any employment taxes on them.

In order to be tax deductible, compensation must be a reasonable payment for services. Smaller companies, whose employees frequently hold significant ownership interests, are particularly vulnerable to IRS attack on their compensation deductions.

Reasonable compensation is generally defined as the amount that would ordinarily be paid for like services by like enterprises under like circumstances. This broad definition is supplemented, for purposes of determining whether compensation is deductible as an ordinary and necessary expense, by a number of more specific factors expressed in varying forms by the IRS, the Tax Court and the Circuit Courts of Appeal, and generally relating to the type and extent of services provided, the financial concerns of the company, and the nature of the relationship between the employee and the employer.

Why IRS Is Interested

A chief concern behind the IRS's keen interest in what a company calls "compensation" is the possibility that what is being labeled compensation is in fact a constructive dividend. If employees with ownership interests are being paid excessive amounts by the company, the IRS may challenge compensation deductions on the grounds that what is being called deductible compensation is, in fact, a nondeductible dividend.

Another area of concern for the IRS is the payment of personal expenses of an employee that are disguised as businesses expenses. There, the business is trying to obtain a business expense deduction without the offsetting tax paid by the employee in recognizing income. In such cases, a business and its owners can end up with a triple loss after an IRS audit: taxable income to the individual, no deduction to the business and a tax penalty due from both parties.

Factors Examined

The factors most often examined by the IRS in deciding whether payments are reasonable compensation for services or are, instead, disguised dividend payments, include:

1. The salary history of the individual employee
2. Compensation paid by comparable employers to comparable employees
3. The salary history of other employees of the company
4. Special employee expertise or efforts
5. Year-end payments
6. Independent inactive investor analysis
7. Deferred compensation plan contributions
8. Independence of the board of directors
9. Viewpoint of a hypothetical investor contemplating purchase of the company as to whether such potential investor would be willing to pay the compensation.

Failure to pass the reasonable compensation test will result in the company's loss of all or part of its deduction. Analysis and examination of a company's compensation deductions in light of the relevant listed factors can provide the company with the assurance that the compensation it pays will be treated as reasonable -- and may in the process prevent the loss of its deductions.

Note: In the case of publicly held corporations, a separate $1 million dollar per person cap is also placed on deductible compensation paid to the CEO and each of the four other highest-paid officers identified for SEC purposes. (Certain types of compensation, including performance-based compensation approved by outside directors, are not included in the $1 million limitation.)

The S Corp Enigma

The opposite side of the reasonable compensation coin is present in the case of some S corporations. By characterizing compensation payments as dividends, the owners of these corporations seek to reduce employment taxes due on amounts paid to them by their companies. In these cases, the IRS attempts to recharacterize dividends as salary if the amounts were, in fact, paid to the shareholders for services rendered to the corporation.

Caution. In the course of performing the compensation-dividend analysis, watch out for contingent compensation arrangements and for compensation that is proportional to stock ownership. While not always indicators that payments are distributions of dividends instead of compensation for services, their presence does suggest the possibility. Compensation plans should not be keyed to ownership interests. Contingent and incentive arrangements are also scrutinized by the IRS. The courts have frequently ruled that a shareholder has a built-in interest in seeing that the company is successful and rewarding him for increasing the value of his own property is inappropriate. Similar to the reasonable compensation test, however, this rule is not hard and fast. Accordingly, the rules followed in each jurisdiction will control there.

Conclusions

Determining whether a shareholder-employee's compensation is reasonable depends upon many variables, such as the contributions that employee makes to your business, the compensation levels within your industry, and whether an independent investor in your company would accept the employee's compensation as reasonable.

Please call our office for a more customized analysis of how your particular compensation package fits into the various rules and guidelines. Further examination of your practices not only may help your business better sustain its compensation deductions; it may also help you take advantage of other compensation arrangements and opportunities.

Non-cash incentive awards, such as merchandise from a local retailer given to its employees or vacation trips offered to the employee team member who contributes the most to a special project, are a form of supplemental wages and are subject to most of the reporting and withholding requirements of other forms of compensation that employees receive. There are, however, special rules for calculating and timing withholding, as well as exceptions for de minimis awards and "length of service" awards.  

Withholding, depositing, and reporting

Similar to regular pay, employers must withhold income, Social Security, Medicare, and federal unemployment taxes from non-cash incentive awards based on their fair market value. Employers must deposit the tax withheld, along with matching payments of Social Security and Medicare taxes, during the period the incentive award is deemed to be paid. Employers must also report incentive awards on Form W-2, Wage and Tax Statement.  

Calculating withholding rules  

However, since non-cash incentive awards are considered supplemental wages, employers have several different options in calculating withholding. For incentives paid along with regular pay not separately specified on the pay stub, employers may withhold payroll taxes at the normal rate as if the employee simply received a larger paycheck.

For incentive awards paid separately from regular pay, employers have a choice of combining the two and withholding the normal rate or withholding the normal percent from the regular pay and a flat 25 percent from the incentive award.  

But, for those fortunate employees who receive incentive awards in excess of $1 million, the employer is required to withhold at a flat rate equal to the highest income tax rate (currently 35%).  

Timing

Special timing rules apply to withholding for non-cash incentive awards. Employee compensation is ordinarily treated as a "pay-as-you-go" tax, meaning that employers are required to withhold payroll taxes periodically throughout the year, rather than all at once at the end of the year. Employers are allowed to withhold taxes on incentive awards, on the other hand, by the pay period, by the quarter, or on any other consistent basis as long as it is paid at least once a year.  

Timing requirements become stricter, however, for personal investment property and real property given to employees as incentive awards. For these categories, the date the property was actually transferred must be used to determine when the employee was "paid."

Withholding exceptions

Noncash incentive awards given to employees that have a de minimis value are excluded from wages and therefore not subject to withholding. Taking into account how frequently similar benefits are given to employees, the award must have little value and cannot be in the form of cash.

Finally, length-of-service or safety achievement awards equal to or less than $1,600 made under a qualified plan, or $400 otherwise, are excluded from wages and therefore not subject to withholding as well.  The only exception is that a sole proprietor can't give such a tax-free award to him or herself.

If someone told you that you could exchange an apartment house for a store building without recognizing a taxable gain or loss, you might not believe him or her. You might already know about a very valuable business planning and tax tool: a like-kind exchange. In some cases, if you trade business property for other business property of the same asset class, you do not need to recognize a taxable gain or loss.

Not a sale

An exchange is a transfer that is not a sale. Essentially, it is a trade of like property.

In an exchange, property is relinquished and property is received. If the transaction includes money or property that is not of a like kind (referred to as "boot"), the transaction does not automatically become a sale. Any gain realized in the transaction, however, is recognized in that tax year to the extent of boot received.

In a like-kind exchange, the basis in the property received is the same as the basis in the property relinquished, with some adjustments. Any unrecognized gain or loss on the relinquished property is carried over to the replacement property. At a future time, the gain or loss will be recognized. If there is boot in the exchange and the gain is recognized, basis is increased by the amount of recognized gain.

The like-kind rules also require that property must be business or investment property. The taxpayer must hold both the property traded and the property received for productive use in its trade or business or for investment. Additionally, most stocks, bonds and other securities are not eligible.

Example

Jesse owns an office supply company and wants to expand his business. Carmen owns a restaurant and also wants to expand her business. Both individuals own parcels of land for investment that would benefit their respective expansion plans. The adjusted basis of both properties is $250,000. The fair market value of both properties is $400,000. Jesse and Carmen engage in a like-kind exchange. Neither Jesse nor Carmen would report any gain or loss.

More than two properties

Like-kind exchanges can involve more than two properties. While the rules are complicated, the basic approach is to combine properties into groups consisting of the same kind or class. If you are interested in a like-kind exchange involving more than two properties, we can help you.

Timing

The exchange does not have to take place at a given moment. If property is relinquished, the replacement property can be identified and received anytime within a specific period. Replacement property must be identified within 45 days after property is relinquished. The replacement property has to be received within 180 days after the transfer but sooner if the tax return is due before the 180 days are over (although the due date takes into account any extension that is permitted).

Reporting

A like-kind exchange must be reported to the IRS. The report must be made even if no gain is recognized in the transaction.  Again, our office can help you make sure that everything that needs to be reported to the IRS is reported.