Vernoia, Enterline + Brewer, CPA LLC

Archive for March, 2013

FAQ: Pros & cons of LLCs?

When starting a business or changing an existing one there are several types of business entities to choose from, each of which offers its own advantages and disadvantages. Depending on the size of your business, one form may be more suitable than another. For example, a software firm consisting of one principal founder and several part time contractors and employees would be more suited to a sole proprietorship than a corporate or partnership form. But where there are multiple business members, the decision can become more complicated. One form of business that has become increasingly popular is called a limited liability company, or LLC.

The LLC combines several favorable characteristics of a traditional partnership, in which all members are entitled to participate in the management and operation of the business, with those of a corporation, in which the owners, directors, and shareholders are generally shielded from liability for the corporation’s debts. The means that in an LLC, just as in a corporation, the personal assets of the business owners’ would generally be protected if the business failed, lost a lawsuit, or faced some other catastrophe. Members are only liable to the extent of their capital contribution to the business. In addition, members can fully participate in the management of the business without endangering their limited liability status.

When filing season begins, the profits (or losses) from the LLC pass through to its members, who pay tax on any income when filing their individual returns. In other words, income from the LLC is taxed at the individual tax rates. Income from corporations, on the other hand is taxed twice, once at the corporate entity level and again when distributed to shareholders. Because of this, more tax savings often results if a business formed as an LLC rather than a corporation.

Taxpayers should note, however, that Congress recently increased the top marginal individual income tax rate to 39.6 percent, has placed a .09 percent additional Medicare tax on wages over $200,000 (single taxpayers), and has imposed a 3.8 percent net investment income tax on higher-income taxpayers. At the same time, there is strong talk among members of both political parties of lowering the corporate rate from the current 35 percent to something around 28 or 25 percent to make the United States more competitive with foreign nations. If this happens, many highly profitable LLC businesses may need to rethink their situation and consider switching to a corporate form.

Forming an LLC involves many requirements, but the benefits can be substantial. Please call our office at (908) 725-4414 if you have any questions.

How do I….calculate Pease itemized deductions limitation under ATRA?

The limitation on itemized deductions (also known as the Pease limitation after the member of Congress who sponsored the original legislation) is reinstated by the American Taxpayer Relief Act (ATRA) for tax years beginning after December 31, 2012. The reinstated Pease limitation is intended to reduce or eliminate the itemized deductions of higher income taxpayers to raise revenue.

Background

The Pease limitation dates to 1990. At that time, Congress was looking to raise revenue without increasing the income tax rates and lawmakers created the Pease limitation. The Pease limitation effectively limits the benefit of itemized deductions claimed by higher income individuals. Itemized deductions that would otherwise be allowed are reduced by the lesser of three percent of adjusted gross income (AGI) that exceeds a threshold amount or 80 percent of the total amount of otherwise allowable itemized deductions.

In 2001, Congress passed the Economic Growth and Tax Relief Reconciliation Act (EGTRRA). The 2001 law gradually eliminated the Pease limitation for the years 2006 through 2010. In 2010, Congress extended repeal of the Pease limitation through 2012. Last year, repeal was again up for a vote in Congress. Many lawmakers wanted to extend repeal of the Pease limitation for one or two more years (or make repeal permanent) but ATRA instead reinstated the Pease limitation for 2013 and subsequent years.

Reinstated Pease limitation

ATRA provides that the amount of a taxpayer’s otherwise allowable itemized deductions is reduced or eliminated if the taxpayer’s AGI exceeds “applicable threshold amounts.” The applicable threshold amounts for application of the Pease limitation in 2013 are $300,000 in the case of married couples filing a joint return or surviving spouse; $275,000 in the case of head of household; $250,000 in the case of an unmarried individual who is not a surviving spouse or head of household; and $150,000 in the case of a married couple filing separately. After 2013, the applicable threshold amounts are adjusted for inflation.

Congress selected these applicable threshold amounts to limit application of the Pease limitation to higher income taxpayers. A taxpayer’s AGI must exceed the applicable threshold amount for the Pease limitation to apply.

Certain other rules apply. For purposes of the 80 percent limitation, itemized deductions do not include certain deductions: the deductions for qualified medical expenses, interest expenses, casualty or theft losses, and allowable wagering losses. Additionally, limitations on itemized deductions are applied first and then the otherwise allowable total amount of itemized deductions is reduced. These include the two percent floor for miscellaneous itemized deductions.

Let’s take a look at an example:

Inez, age 30, and Tyler, age 31, are married, have no children and file a joint federal income tax return for 2013. Their AGI for 2013 is $350,000. Inez and Tyler have the following amounts to report as itemized deductions on their 2013 return:

 

Contributions to charitable organizations:

$4,000.00

State and local real property taxes:

$11,000.00

Medical expenses (in excess of the 10 percent AGI floor for 2013):

$2,000.00

Because their AGI exceeds the applicable threshold of $300,000 for a married couple filing a joint return, the amount of their otherwise allowable itemized deductions ($17,000) must be reduced. The first possible reduction is three percent of the excess of their AGI over the applicable threshold amount (($350,000 − $300,000) x 0.03) which is $1,500. The second possible reduction is 80 percent of the amount of itemized deductions (excluding medical expenses) ($15,000 x 0.80) which is $12,000. The lesser of these two amounts is $1,500. Inez and Tyler must reduce their otherwise allowable deductions to $15,500 ($17,000 − $1,500).

If you have any questions about the reinstated Pease limitation, please contact our office at (908) 725-4414

Tax penalties: sometimes good intentions are not enough

One morning you reach into your mailbox or bin to find the dreaded letter from the IRS announcing that you owe unpaid taxes. As if that wasn’t enough to induce panic, you may discover there are add-on charges for interest and penalties. Penalties for what, you may ask?

If you violate the Tax Code, the IRS may impose civil and/or criminal penalties, depending on the type of infraction committed. Civil penalties are commonly imposed for a failure to pay taxes when due, failure to report the correct amount of tax owed, a failure to deposit federal tax deposits, filing late, or even failing to pay because of a bounced check. There are more than 100 kinds of civil penalties in the Tax Code, ranging in severity. For example, a penalty for failure to file (separate and apart from a failure to pay) carries a minimum $100 fine, while a penalty for valuation overstatement can result in a 30 percent penalty on the amount of tax owed as a result. Criminal penalties can be even more severe, and may include terms of imprisonment as well as fines.

Taxpayers, return preparers, and third parties with some connection to the tax return in question may all become subject to penalties. Common civil penalties include failure to file tax returns, failure to pay taxes due, underpaying tax due to negligence, and valuation misstatements that result in inaccurate reporting of income (and therefore an incorrect amount of tax owed).

Criminal penalties are imposed for violations of federal Tax Code and Criminal Code, which include the willful (or intentional) attempt to evade or defeat any federal tax, the failure to collect or truthfully account for and pay any federal tax as required, or the failure to keep required records, supply required information or make required returns. Generally the IRS Criminal Investigations Division will conduct investigations into allegations of criminal tax violations, and if it recommends that the government prosecuted, the case could be referred to the IRS Office of Chief Counsel, the Department of Justice, the U.S. Attorney’s Office, or some combination of the three.

Hopefully you will never receive a letter from the IRS about either civil or criminal penalties. But if you do, please call our offices with any questions at (908) 725-4414.

What does ATRA do for estate planning?

The American Taxpayer Relief Act of 2012 (ATRA) has provided much needed certainty for estate tax planners and for taxpayers who want to arrange their financial affairs. For the first time in 10 years, beginning January 1, 2013, the maximum estate tax rate, the inflation-adjusted exclusion, and other estate tax features have been made permanent.

The top tax rate is 40 percent, the maximum exclusion for both estate and gift taxes is a unified amount of $5 million (indexed at $5.12 million for 2012 and $5.25 million for 2013), the tax basis of property acquired from a decedent is stepped up, and the portability of a deceased spouse’s unused exclusion (DSUE) amount is preserved. The generation-skipping transfer (GST) tax exemption, which is tied to the estate tax rate, is also set at $5 million, adjusted for inflation. However, taxpayers should realize that inheritance taxes imposed by a state may apply to a lower amount, so some estate tax planning for state taxes may be appropriate.

If Congress had not acted on the sunsetting provisions, the maximum estate tax rate would have been 55 percent effective January 1, 2013, and the maximum exclusion would have been only $1 million. However, even though these changes are permanent and do not have an expiration date, one never knows whether Congress may change the law in the future.

Stepped-up basis

Stepped-up basis is preserved for assets passing through the estate. This is particularly important for people whose estates are not large enough to owe estate taxes (under $5 million, as indexed for inflation). In 2010, when there was no estate tax, the Tax Code applied a modified carryover basis regime with $1.3 million worth of assets subject to a basis step-up (plus $3 million for property passing to the spouse). All other properties would have a carryover basis and thus could have significant built-in gains when acquired by the estate tax beneficiary.

Now, all properties passing through the estate for tax purposes are entitled to a step-up in basis, whether or not they are subject to estate tax. This will have a significant impact on income taxes for taxpayers receiving assets from the estate, insulating built-in gains from taxes, and allowing taxpayers to sell assets and invest them in other arrangements.

Unified estate and gift tax

Even though the lifetime exemption under the unified estate and gift tax ($5 million, adjusted for inflation) may never be used up, filing gift tax returns for annual gifts above the exclusion is still necessary. The annual gift tax exclusions ($13,000 for 2012; $14,000 for 2013) are much lower than the lifetime exclusion. However, thanks to the lifetime exclusion, taxpayers often will not owe any gift taxes on a gift, even one that exceeds the annual exclusion.

Portability

The portability of the DSUE amount was enacted in 2010 and originally applied where the first decedent in a married couple died in 2011 or 2012. In ATRA, Congress made portability permanent.

In the absence of portability, the first spouse to die could transfer property to the surviving spouse tax-free, by claiming the marital deduction. But the second spouse, as sole owner of the assets, was in danger of exceeding the applicable estate tax exclusion and owing more estate tax.

For example, a husband owns $7 million in property and the wife owns $5 million in property. Upon A’s death, the husband’s estate passes $2 million of property to his children, and $5 million in property to his wife, using the marital deduction. When the wife dies, she has $10 million in property (assuming that the wife’s earnings and expenses offset each other), but only has an exclusion of $5 million. Thus, $5 million of assets are taxable.

Portability eliminates or substantially lessens this problem. If the husband passes $2 million to his children, and $5 million to his wife, he has a DSUE amount of $3 million. The wife, when she dies with an estate of $10 million, has an estate tax exclusion of $8 million ($3 million from the husband, plus her own $5 million exclusion), and will owe estate tax on $2 million, instead of $5 million. At a 40 percent maximum rate, this is a potential savings of $1.2 million to the wife (and to the husband and wife collectively). Portability lessens the need for complex estate planning when the husband and wife together have assets in the $10 million range (more or less).

Other tax provisions

ATRA provides additional certainty for other estate, gift, and generation-skipping transfer (GST) tax provisions. More liberal rules for using installment payments for estate taxes will continue to apply. The five percent surtax on estates and gifts between $10 million and $17,184,000, which is designed to offset the benefits of graduated rates, will no long apply.

Modifications to the exclusion for qualified conservation easements are permanently extended, again facilitating planning in this area. The repeal of certain distance requirements is permanently extended; accordingly, the exclusion is available to any qualified real property, located in the U.S. or a U.S. possession, that was owned during the three-year period ending on the date of the decedent’s death.

ATRA also extended a number of GST tax provisions set to expire at the end of 2012. These included the GST deemed allocation and retroactive allocation provisions; clarification of valuation rules for determining the inclusion ratio; provisions allowing the qualified severance of a trust; and relief from late GST allocations and elections.

Finally, ATRA extended the IRA charitable deduction for two years, through 2013. Taxpayers age 70 ½ and older can make a maximum distribution of $100,000 directly from their IRA (traditional or Roth) to a charity, without including any of the distribution in income.

Not all of ATRA’s provisions are beneficial to taxpayers. ATRA permanently extended the deduction for estate taxes imposed by a state, rather than a tax credit. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) first repealed the state death tax credit for decedents dying after 2004 and replaced the credit with a deduction. ATRA also extended repeal of the deduction for qualified family-owned business interests, a provision that has been in effect since 2004.

If you would like more specific information on how the American Taxpayer Relief Act affects your estate plans, please contact this office at (908) 725-4414.

Legislation delays to end soon

The IRS expects to process more than 140 million individual returns this filing season and for many taxpayers the process has been moving along without any significant problems. A large number of taxpayers, however, have experienced delays in filing their returns because of late tax legislation. The IRS has predicted that all remaining delays should end by early March. One wrinkle may be mandatory across-the-board spending cuts, scheduled, at this time, to take effect after February 28, which could slow the processing of returns. At the same time, the IRS is redoubling its efforts to crackdown on fraudulent refunds and identity theft.

Late legislation

Whenever Congress passes tax legislation late in the year, the IRS has to scramble to reprogram its processing systems to reflect changes to the tax laws. This year was no different. Congress passed the American Taxpayer Relief Act of 2012 on January 1, 2013 and President Obama signed it into law on January 2, 2013. ATRA made changes to numerous portions of the Tax Code.

Fortunately, the IRS had anticipated some of the changes, such as a permanent extension of the alternative minimum tax (AMT) relief and an extension of the $1,000 child tax credit, so the agency left its core processing systems unchanged for these provisions. As a result, the IRS reported that 80 percent of individuals were able to file when the 2013 filing season officially opened on January 30. However, that left 20 percent of individuals unable to file on January 30 because the IRS needed more time to reprogram its processing systems for many ATRA-affected forms.

For business taxpayers, the filing season generally opened on February 4. The February 4 opening covered non-1040 series business returns for calendar year 2012, including Form 1120 filed by corporations, Form 1120S filed by S corporations, Form 1065 filed by partnerships, Form 990 filed by exempt organizations and most users of Form 720, Quarterly Excise Tax Return. Business taxpayers filing many ATRA-affected forms have experienced delays similar to individual taxpayers.

Delayed forms

Since January 30, the IRS has been making progress in reprogramming its processing systems for the remaining ATRA-affected forms. In mid-February, the IRS began accepting returns from taxpayers filing Form 8863, Education Credits, (including the popular American Opportunity Tax Credit and Lifetime Learning credit) and taxpayers filing Form 4562, Depreciation and Amortization. Taxpayers claiming the student loan interest deduction or the higher education tuition deduction did not experience a delay.

The IRS anticipates that it will begin accepting the remaining forms in early March. Included in this group are taxpayers filing Forms 3800, General Business Credits: Form 5695, Residential Energy Credit; and Form 5884, Work Opportunity Tax Credit. If there is any further delay, our office will alert you.

Penalty relief

The IRS gave special penalty relief to farmers and fishermen because of late legislation. The IRS will waive the estimated tax penalty for farmers and fishermen who did not meet the March 1 deadline for filing and paying taxes. Some tax professional associations have asked the IRS to consider penalty relief for other groups of taxpayers because of the delay in filing the ATRA-affected forms. The IRS has not announced any additional penalty relief but it could. Our office will keep you posted of developments.

Refunds

The IRS’s popular online Where’s My Refund? tool has been overwhelmed by a large number of requests, the agency reported. To avoid service disruptions, the IRS asked taxpayers to only check on the status of their refunds once a day, preferably weekday evenings or on weekends. The IRS is currently predicting that nine out of 10 taxpayers who file their returns electronically and who opt for direct deposit should receive their refunds within 21 days. That timeframe could change depending on the IRS’s workload and the possible impact of across-the-board budget cuts scheduled to take effect after February 28.

Sequestration

Sequestration is the official term for mandatory budget cuts to most federal government operations, including the IRS. Very generally, the spending reductions are to be made equally from defense spending and from all other federal spending (with some programs, such as Medicare excluded). The reductions required in each of these categories are then divided proportionally between discretionary spending and mandatory spending.

ATRA delayed the start of sequestration until March 1. President Obama and Senate Democrats have proposed a package of spending cuts and revenue raisers. The House GOP has rejected previous proposals for revenue raisers, insisting that deficit reduction be accomplished through spending cuts. At press time, negotiations continue.

The IRS will remain open after February 28. However, some of its operations could be impacted if a deal is not reached. The IRS is expected to concentrate its resources on tax administration, including the processing of returns, and tax enforcement. The IRS has released very few details about its plans for sequestration. Our office will keep you posted.

Identity theft

Along with processing returns, the IRS is combating the growing problem of identity theft. Criminals use stolen identities to file fraudulent returns and claim refunds. Typically, this occurs early in the filing season. An unsuspecting taxpayer is often unaware that his or her identity had been stolen until he or she files a legitimate return and it is rejected. In fiscal year (FY) 2012, the IRS reported that it prevented the issuance of more than $20 billion in fraudulent refunds.

The IRS has designed new identity theft filters to flag false returns before they are processed. The IRS has also issued more than 700,000 identity protection personal identification numbers (IP PINs) to taxpayers who have been victims of identity theft. In January, the IRS launched a nationwide crackdown on identity theft suspects. The IRS reported that the coast-to-coast effort against 389 identity theft suspects led to 734 enforcement actions, including indictments, informations, complaints and arrests.

If you have any questions about the 2013 filing season, please contact our office at (908) 725-4414.