Vernoia, Enterline + Brewer, CPA LLC

Archive for October, 2012

FAQ: What happens to IRS’s deadline to audit a return with an extended filing date?

The Tax Code provides that the IRS generally may not select an individual, partnership, or corporate tax return for audit after a period of three years has expired, dating from the tax return’s filing date or due date, whichever is later. For example, if a taxpayer filed his 2011 Form 1040 on February 10, 2012, and the due date for the filing of returns that year was April 17, 2012, then the statute of limitations period ends on April 17, 2015, and not February 10, 2015. On the other hand, if the taxpayer filed his tax return late, on November 10, 2012, and had not obtained an extension of time to file, the statute of limitations period would run from November 10, 2012.

If a taxpayer receives an extension of time to file the return (for example, an automatic six-month extension until October 15), however, the return is considered filed on the actual date of filing rather than the extension date.  On the other hand, filing an amended tax return, such as a Form 1040X, however, would generally have no effect on the three-year period if it does not increase tax liability. For example, if the taxpayer filed his tax return on April 17, 2012, subsequently discovered a missing item of deduction, and filed an amended return on May 15, 2012 that did not increase his tax liability, the three-year state of limitations period will still run from April 17, 2012 to April 17, 2015.

For more information on the statute of limitations on tax assessments and any exceptions, please contact our office at (908) 425-4414.

How do I? Deduct employee compensation given as year-end bonuses

Whether or not the IRS will allow a deduction for year-end bonuses for services performed during that year depends not only on the timing of the payment, but also the events surrounding the payment. If your business is planning to provide year-end bonuses to employees, you may find the following tax tips useful in your planning.

The “All Events” test

Code Sec. 461(a) provides that the amount of any deduction for employee bonuses must be taken for the proper tax year as determined under the method of accounting the taxpayer uses to compute taxable income. (The two most common methods are the cash method and the accrual method, the latter of which allows taxpayers to include income items when earned and claim deductions when expenses are incurred.)

Under the accrual method of accounting, the three-prong “All events” test is used to determine the tax year in which a liability-in this case the year-end employee bonuses—is incurred. The prongs are:

  • Have all the events have occurred that establish the fact of the liability?
  • Can the amount of the liability be determined with reasonable accuracy?
  • Has economic performance occurred for the liability?

Approval and retention provisions

Some year-end bonus plans are structured with certain conditions attached to payment. For example, some bonus plans provide that payment cannot occur until formally approved. In such cases, the fact of the liability may not be established, and the employer may need to wait a year before being able to deduct the bonus amount.

Other plans specify that bonus payments cannot be made if an employee has left employment at year-end. In this case as well, questions arise as to whether liability for the bonuses has been fixed at the end of the year in which the employee’s services were performed.

Deferred compensation

Generally, Code Sec. 404 states that, an employer may not deduct deferred compensation paid to an employee until the employee includes it in income. However, a bonus received within a 2 1/2-month period after the end of the tax year in which the employee has rendered its services is not considered deferred compensation. The employer should be able to claim a tax deduction for the bonus in the tax year during which the services were rendered provided that the liability meets the all events test. If the employee receives the deferred amount more than 2 1/2 months after the close of the employer’s taxable year, the payment is presumed to have been made under a deferred compensation plan.

If you think you might be interested in structuring a year-end bonus plan specific to your business, please feel free to contact this office at (908) 725-4414 for an appointment.

2013 inflation-adjusted taxes; increases benefitting taxpayers

Taxpayers recovering from the current economic downturn will get at least some relief in 2013 by way of the mandatory upward inflation-adjustments called for under the tax code, according to CCH, a Wolters Kluwer business. CCH has released estimated income ranges for each 2013 tax bracket as well as a growing number of other inflation-sensitive tax figures, such as the personal exemption and the standard deduction.

Projections this year, however, are clouded by the uncertainty of expiring provisions in the tax code. If Congress allows the so-called Bush-era tax cuts to expire at the end of 2012, many taxpayers could lose more ground than they will otherwise gain. These tax cuts, first enacted within Economic Growth Tax Recovery and Reconciliation Act of 2001 (EGTRRA) with a ten-year life, were last extended by the 2010 Tax Relief Act, but only for two years through 2012.

When there is inflation, indexing of brackets lowers tax bills by including more of taxpayers’ incomes in lower brackets – in the existing 15-percent rather than the existing 25-percent bracket, for example. The formula used in indexing showed an average amount of inflation this year of about 2.5 percent – the highest in several years. Most 2013 figures therefore have moved higher.

Tax Rates

The current 10, 15, 25, 33 and 35-percent rates are now officially scheduled to sunset to the pre-EGTRRA rate structure of 15, 28, 31, 36 and 39.6-percent. While no one in Washington is calling for a full sunset of all the current tax rates, congressional gridlock might produce a cliffhanger on what will happen until after the November elections, and perhaps not even before January when the new, 113th Congress convenes. In the meantime, there are three possible alternative scenarios being debated by lawmakers:

  • Extend the current tax bracket structure in its entirety;
  • As proposed by President Obama, keep the current rate structure except revive the 36 and 39.6-percent rates, starting at a higher-income bracket level of $200,000 for single filers, $250,000 for joint filers, $225,000 for head-of-households and $125,000 for married taxpayers filing separately, also indexed for inflation since initially proposed in 2009 but keyed to adjusted gross income (AGI) rather than taxable income (indexed 2013 projections for those AGI levels, based on the Administration’s FY 2013 Budget, are $213,200 / $266,500 / $239,850 / and $133,250, respectively); or
  • As proposed by certain Senate Democrats, raise the top tax rate only for individuals making more than $1 million.

Tax Brackets

Here is a sample of how inflation will raise rate brackets in 2013, assuming a full extension of tax rates:

  • Joint returns. For married taxpayers filing jointly and surviving spouses, the maximum taxable income subject to the 10-percent bracket will rise from $17,400 in 2012, to $17,850 in 2013; the top of the 15-percent tax bracket will increase from $70,700 to $72,500. The bracket amounts for the remaining tax rates will show similarly proportionate increases: $146,400 as the maximum for the 25-percent bracket (up $3,700 from 2012); $223,050 for the 28-percent bracket (up $5,600 from 2012); and $398,350 for the 33-percent bracket (up $10,000 from 2012). Amounts above the $398,350 level will be taxed at the 35-percent rate.
  • Single filers. For single taxpayers, the maximum taxable income for the 10-percent bracket will increase to $8,925 for 2012 (up from $8,700 in 2012). The remainder of the rate brackets show inflation increases of: $900 for the top of the 15-percent bracket (to $36,250); $2,200 for the 25-percent bracket (to $87,850); $4,600 for the 28-percent bracket (to $183,250); and $10,000 for the top of the 33-percent bracket (to $398,350).

Standard Deductions

The 2013 standard deduction will increase for all taxpayers. The standard deduction amounts for 2013 is projected to be $6,100 for single taxpayers; $8,950 for heads of households; $12,200 for married taxpayers filing jointly and surviving spouses; and $6,100 for married taxpayers filing separately. The standard deduction for dependents rises $50 to $1,000 (or earned income plus $350). The additional standard deduction for those have reached 65 or are blind will rise to $1,200 for married taxpayers; $1,500 for unmarried individuals.

Personal Exemptions

The amount of personal and dependency exemptions for 2013 will increase to $3,900 from the 2012 level of $3,800.

Gift Tax Exclusion

The gift tax annual exclusion, which rose from a base of $10,000 to $11,000 in 2002; $12,000 in 2006, and $13,000 in 2009, once again will rise in 2013 to $14,000. Pursuant to the IRC, the exemption can rise only when the inflation adjustment produces an increase of $1,000 or more.

Year-end; 3.8 % Medicare tax looms for 2013

In 2013, a new and unique tax will take effect—a 3.8 percent “unearned income Medicare contribution” tax as part of the structure in place to pay for health care reform. The tax will be imposed on the “net investment income” (NII) of individuals, estates, and trusts that exceeds specified thresholds. The tax will generally fall on passive income, but will also apply generally to capital gains from the disposition of property.

Specified thresholds

For an individual, the tax will apply to the lesser of the taxpayer’s NII, or the amount of “modified” adjusted gross income (AGI with foreign income added back) above a specified threshold, which is:

  • $250,000 for married taxpayers filing jointly and a surviving spouse;
  • $125,000 for married taxpayers filing separately;
  • $200,000 for single and head of household taxpayers.

Examples. A single taxpayer has modified AGI of $220,000, including NII of $30,000. The tax applies to the lesser of $30,000 or ($220,000 minus $200,000), the specified threshold for single taxpayers. Thus, the tax applies to $20,000.

A single taxpayer has modified AGI of $150,000, including $60,000 of NII. Because the taxpayer’s income is below the $200,000 threshold, the taxpayer does not owe the tax, despite having substantial NII.

For an estate or trust, the tax applies to the lesser of undistributed net income, or the excess of AGI over the dollar amount for the highest tax rate bracket for estates and trusts ($11,950 for 2013). Thus, the tax applies to a much lower amount for trusts and estates.

Application of tax

The tax applies to interest, dividends, annuities, royalties, and rents, and capital gains, unless derived from a trade or business. The tax also applies to income and gains from a passive trade or business.

Other items are excluded from NII and from the tax:  distributions from IRAs, pensions, 401(k) plans, tax-sheltered annuities, and eligible 457 plans, for example. Items that are totally excluded from gross income, such as  distributions from a Roth IRA and interest on tax-exempt bonds, are excluded both from NII and from modified AGI.

The tax does not apply to nonresident aliens, charitable trusts, or corporations.

Tax planning techniques

Taxpayers are concerned about having to pay the tax. One technique for avoiding the tax is to sell off capital gain property in 2012, before the tax applies. This can be particularly useful if the taxpayer is facing a large capital gain from the sale of a principal residence (after taking the $250,000/$500,000 exclusion from income). Older taxpayers who do not want to sell their property may want to consider holding on to appreciated property until death, when the property gets a fair market value basis without being subject to income tax.

The technique of “gain harvesting” may be even more attractive if tax rates increase on dividends, capital gains, and AGI in 2013, with the potential expiration of the Bush-era tax cuts. However, the status of these tax rates will not be determined until after the election, potentially in a lame-duck Congressional session. It is also possible that Congress will simply extend existing tax rates for another year and “punt” the decision until 2013, as tax reform discussions heat up.

Taxpayers may also want to change the source of their income. Investing in tax-exempt bonds will be more attractive, since the interest income does not enter into AGI or NII. Converting a 401(k) account or traditional IRA to a Roth IRA will accomplish the same purpose. Income from a Roth conversion is not net investment income, although the income will increase modified AGI, which may put other income in danger of being subject to the 3.8 percent tax. Increasing deductible or pre-tax contributions to existing retirement plans can also lower income and help the taxpayer stay below the applicable threshold.

Trusts and estates should make a point of distributing their income to their beneficiaries. A trust’s NII will be taxed at a low threshold (less than $12,000), while the income received by a beneficiary is taxed only if the much higher $200,000/$250,000 thresholds are exceeded.

Uncertainty

There was some uncertainty about the tax taking effect because of litigation challenging the health care law providing the tax, but a June 2012 Supreme Court decision upheld the law. The application of the tax is also uncertain because the Republican leadership has vowed to pursue repeal of the health care law if the Republicans win the presidency and take control of both houses of Congress in the November 2012 elections. But this is speculative. In the meantime, the Supreme Court decision guarantees that the tax will take effect on January 1, 2013.

These can be difficult decisions. While economic considerations for managing assets and income are important, it also makes sense for a taxpayer to look at the tax impact if the certain asset sales or shifts in investment portfolios are otherwise being considered.

Congress leaves tax law up in the air

Lawmakers have departed Washington to campaign before the November 6 elections and left undone is a long list of unfinished tax business.  In many ways, the last quarter of 2012 is similar to 2010, when Congress and the White House waited until the eleventh hour to extend expiring tax cuts. Like 2010, a host of individual and business tax incentives are scheduled to expire.  Unlike 2010, lawmakers are confronted with massive across-the-board spending cuts scheduled to take effect in 2013.

Unfinished business

Since the start of 2012, the list of tax measures waiting for Congressional action has remained unchanged. Among the individual tax provisions scheduled to expire after 2012 are:

  • Reduced individual income tax rates
  • Reduced capital gains and dividend tax rates
  • Temporary repeal of the limitation on itemized deductions and the personal exemption phaseout for higher income taxpayers
  • Reduced estate, gift and generation-skipping transfer tax rates
  • Enhancements to many education tax incentives, such as the American Opportunity Tax Credit, Coverdell education savings accounts, and more.

Also scheduled to expire at the end of 2012 is the payroll tax holiday.  The employee share of Social Security taxes is 4.2 percent rather than 6.2 percent, up to the Social Security earnings cap of $110,100 for 2012.  Self-employed individuals benefit from a similar reduction.

Additionally, many so-called tax extenders for individuals expired after 2011.  They include the state and local sales tax deduction, the teachers’ classroom expense deduction, and more.  The most recent alternative minimum tax (AMT) “patch” expired after 2011.

The list of expiring or expired tax incentives for businesses is just as long.  They include:

  • Enhanced Code Sec. 179 expensing (after 2012)
  • 100 percent bonus depreciation (generally after 2011)
  • 50 percent bonus depreciation (generally after 2012)
  • Research tax credit (after 2011)
  • Production tax credit for wind energy (after 2012)
  • Enhanced Work Opportunity Tax Credit (WOTC) for veterans (after 2012)
  • Regular WOTC (after 2011)
  • A lengthy laundry list of business tax extenders, such as special expensing rules for television and film productions, the Indian employment credit, and more (after 2011).

Along with all of the expiring provisions are even more pending proposals. They include proposals by the White House to enact tax incentives to encourage employers to hire long-term unemployed individuals, impose a minimum tax on overseas profits and more. The likelihood of any of these proposals being enacted before year-end is slim, but they could be revisited in 2013 depending on the outcome of the November elections. Comprehensive tax reform, including any reduction in the individual tax rates below their 2012 levels and a reduction in the corporate tax rate, is also expected to wait until 2013 or beyond.

Behind the scenes talks

The lame-duck Congress, which will meet after the November elections, may tackle some or all of the expiring tax incentives, or it could do nothing and punt them to the next Congress.  Behind the scenes, some Democrats and Republicans in Congress are reportedly talking about a short-term extension of the expiring/expired provisions, for six months or one year, which would give lawmakers and the White House more time to reach an overall agreement.  However, the dynamic could and likely will change if the GOP takes the White House and wins control of the Senate.

In the Senate, Sen. Kent Conrad, D-ND, has told reporters that he and several other senators from both parties have been discussing whether or not to extend the expiring tax cuts. Conrad, who is retiring at the end of 2012, has acknowledged that Democrats and Republicans are far apart on revenue raisers and spending cuts.  Reports of informal talks among the members of the House Ways and Means Committee have also circulated but no concrete proposals have so far been revealed.

Sequestration

The imminent spending cuts (called sequestration) are the result of the Budget Control Act of 2011.  The 2011 Act imposes approximately $110 billion in spending cuts, impacting defense and non-defense spending, for 2013.  Almost every area of federal spending, including tax enforcement, will be affected.

In recent months, some lawmakers have proposed to mitigate the spending cuts by raising revenues elsewhere.  One area targeted for tax increases is the oil and gas industry.  However, several attempts to repeal tax preferences for the oil and gas industry failed in Congress in 2012.

Any extension of the expiring tax breaks will have to take into account the looming across-the-board spending cuts. Tax reform and debt reduction will go hand-in-hand.  However, it is unclear if debt reduction will drive tax reform or vice-versa.  Our office will keep you posted of developments.

Please contact our office at (908) 725-4414, if you have any questions about pending federal tax legislation.