Edward S. Karl, AICPA Tax VP
Washington (Dec.7, 2012) – Are you looking for an understandable guide to tax provisions that are at the center of the debate over the looming fiscal cliff? The American Institute of CPAs has developed a “Fiscal Cliff Series” that provides a brief, objective and non-partisan fact sheet on each of the following tax topics:
Each fact sheet describes the tax provision in question, explains what will happen if we go off the fiscal cliff, identifies who will be affected by the cliff, discusses whether the provision can be dealt with after January 1, and provides an AICPA comment and additional resources.
The fiscal cliff refers to the predicted reduction in the budget deficit and a corresponding slowdown of the economy if specific laws are allowed to automatically expire or go into effect at the beginning of 2013. The laws include tax increases due to the expiration of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 and the spending reductions (sequestrations) under the Budget Control Act of 2011.
The AICPA is a longtime advocate for sound tax policy, tax simplification and taxpayer education. In recognition of the importance of helping individuals understand their tax obligation and how it impacts their financial decisions, the Institute’s Total Tax Insights™ calculator is an easy-to-use tool that offers a clearer picture of the types of taxes individuals pay and their estimated amounts.
On its new webpage “What to Expect for Refunds in 2013,” the IRS said it issued more than nine out of 10 refunds to taxpayers in less than 21 days last year. The same results are expected in 2013. Taxpayers will be able to access the “Where’s My Refund” tool again in 2013 with some new feature: a tracker that shows progress of a specific return through three stages: return received, refund approved, and refund sent. Taxpayers will also be able to check the status of their refunds soon – within 24 hours of receipt of an e-filed return or four weeks after mailing a paper return.
IRS Improves Identity Protection PIN to Help ID Theft Victims
In mid-December 2012, the IRS sent notices to more than 600,000 taxpayers identified as victims (or potential victims) of identity theft. Notice CP01A "We've Assigned You An Identity Protection Personal Identification Number," provides the IP PIN that a victim will need to complete his or her 2012 tax return.
The IP PIN helps the IRS quickly distinguish between the genuine taxpayer and a potential identity thief and helps prevent processing delays for victims’ federal tax returns. IP PINs are valid for the current year’s federal tax return only. The IRS issues a new IP PIN each December when the taxpayer remains at risk for identity theft.
Important changes for this year:
IP PIN requirement. If a required IP PIN is missing or incorrect on an electronic return, the return will be rejected. Taxpayers can correct or include the IP PIN, request a replacement IP PIN or file a paper return. If an IP PIN is missing or incorrect on a paper return, the return will require a manual review, which will delay any refund to which the taxpayer is entitled. This review is for the protection of the taxpayer who has previously been the victim of identity theft.
Easier replacement IP PIN process. If a taxpayer misplaces the IP PIN, she can quickly get a replacement IP PIN by contacting the IRS by calling the Identity Theft Specialized Unit, or IPSU at 1-800-908-4490, ext. 245, or the IRS Help Desk at 1-800-829-1040 or by visiting a Taxpayer Assistance Center. The replacement IP PIN allows the return to be electronically "accepted" (subject to standard validation tests). However, the return will then require a manual review prior to processing, which may delay any refund to which the taxpayer is entitled.
What should tax preparers do?
• Ask the taxpayer, as part of the interview process, whether he contacted the IRS regarding identity theft or if the IRS notified them of potential identity theft. If so, ask if he received a notice from the IRS in December containing a six-digit Identity Protection PIN.
• If you cannot locate where to enter the IP PIN in commercial tax software, contact the tax software provider. Due to variances in software programs, IRS assistors cannot help with this matter.
Information for POAs
Since the Identity Protection PIN issued in 2012 is for filing the tax year 2012 income tax return, the IP PIN is considered tax year 2012 information. IRS representatives have limited ability to discuss the IP PIN or any other tax information related to the 2012 tax year unless there is a valid Power of Attorney on file that includes 2012. Disclosure laws restrict the IRS from releasing any information to a third party unless the POA is valid for the year related to that information.
Filing Options for Your Final Form 1040
Although we can’t escape death or taxes, we may be able to minimize the federal income taxes due on our final Form 1040. Filing a tax return after we die (we are then known as the “decedent”) is probably not something most of us think much about. But, a final Form 1040 generally must be filed for the year of our death and, just as in life, is typically due by April 15th of the following year. Normal tax accounting rules regarding the recognition of income and deductions generally apply for this final return. And, as is the case during life, tax planning opportunities are available both when death is imminent and after death. For instance, several decisions can affect the income or deductions reported on that final return. However, as we will discuss below, a major decision for married individuals concerns whether to file a joint return for the year of death.
When a married taxpayer dies and the surviving spouse does not remarry during the year, the spouse may file a joint return with the decedent for the year of death, but is not required to do so. The joint return will include income and deductions for the decedent prior to the date of death and the surviving spouse’s income and deductions for the entire year. If the surviving spouse remarries before the close of the tax year that includes the date of death, the spouse may not file jointly with the decedent. Instead, a separate return must be prepared for the decedent. Listed below are some of the advantages and disadvantages for joint filers to consider when filing that final return.
Advantages of Filing a Joint Return. Since the surviving spouse’s tax year does not end upon the death of the decedent, it may be possible to reduce their combined income tax liability by accelerating or postponing income or deductions to maximize use of the joint tax rates. Some other benefits include, but are not limited to: (a) use of one spouse’s excess deductions against the income of the other spouse (e.g., excess charitable contributions); (b) an increase in the IRA contribution limit (because of the spousal IRA rules); and (c) the ability of the decedent’s net operating loss (NOL), capital loss, and passive activity loss (subject to the limitation) carryovers to offset income of the surviving spouse. Note that any NOL or capital loss carryover of the decedent that is not used on the final return (whether separate or joint) will expire unused.
Disadvantages of Filing a Joint Return. Filing a joint return with the surviving spouse is not always the best option. One disadvantage of filing a joint return for the decedent’s final tax year is that the decedent’s estate and the surviving spouse are jointly and severally liable for any tax, interest, and penalties due on the joint return. In addition, when the surviving spouse is not the sole beneficiary of the estate, the decedent’s personal representative may not be willing to expose the estate to potential unknown liabilities (e.g., tax on the surviving spouse’s unreported income). Potentially, this exposure may be avoided because of the innocent spouse rules. Also, filing a joint return can negatively impact the amount of the decedent’s deductions that are subject to adjusted gross income (AGI) limitations (e.g., medical, casualty, miscellaneous itemized) since AGI is based on joint income rather than separate income. Finally, the surviving spouse must cooperate with the decedent’s personal representative by sharing the information necessary to prepare the return and by signing the return once it is prepared.
Planning for that final 1040 is something we may not think much about, but it is a good idea all the same.
Maximizing the Deduction for Start-up Expenses
Individuals starting a new business or acquiring the assets of an existing business often incur start-up expenses, which can be considerable, in the investigation and acquisition phase before actual business operations begin. Most start-up expenditures can be segregated into two broad categories: (a) investigatory expenses and (b) business preopening costs.
Taxpayers can immediately deduct up to $5,000 of start-up expenses in the year when active conduct of a business begins. However, the $5,000 instant deduction allowance is reduced dollar for dollar by cumulative start-up expens-es in excess of $50,000 for the business in question. Start-up expenses that cannot be immediately deducted in the year a business begins must be capitalized and amortized over 180 months on a straight-line basis. In many cases, start-up expenses for small businesses will be modest enough to qualify for immediate deduction under the $5,000 instant deduction allowance in the year when active conduct of business commences.
Example: Claiming the deduction for start-up expenses.
Suzie (a calendar-year taxpayer) incurs $4,200 of start-up expenses in 2012 before opening her new car wash in November of 2012. Suzie’s 2012 deduction is $4,200. Since her start-up expenses did not exceed $50,000, she can deduct the entire $4,200 in 2012.
Note: A taxpayer is not considered to be engaged in carrying on a trade or business until the business has begun to function as a going concern and has performed the activities for which it was organized.
Home Sale Gain Exclusion Restrictions for Second Homes
Many taxpayers bought a second home, such as a vacation home, with the intention of later converting the second home into their principal residence. Under pre-2008 Housing Act law, those taxpayers could have excluded up to $250,000 ($500,000 for certain joint filers) upon a later sale of that former vacation home as long as the ownership and use tests for the exclusion were satisfied. However, the Housing Act changed the method for recognizing post-2008 gain on the sale of a principal residence formerly used as a vacation or second home.
Specifically, the revised rule makes a portion of the gain from selling the residence—the nonqualified use period—ineligible for the gain exclusion privilege. A property’s nonqualified use period equals the amount of time after 2008 during which the property is not used as the taxpayer’s principal residence. However, periods of nonqualified use don’t include temporary absences that aggregate to two years or less due to changes of employment, health conditions, or certain other unforeseen circumstances; certain time periods after use as a principal residence; or certain time periods while on qualified official extended duty.
Example 1: Nonqualified use leads to additional taxes.
Floyd bought a vacation home in an exclusive area on January 1, 2005. On January 1, 2011, he converts the property into his principal residence, and he and his wife live there for all of 2011 and 2012. On January 1, 2013, he sells the home for a $450,000 gain. Floyd’s total ownership period is eight years (2005–2012). However, the two years of post-2008 use as a vacation home (2009–2010) count against him and result in a nonexcludable gain of $112,500 (2/8 x $450,000). Floyd must report the $112,500 as capital gain income on his 2013 federal tax return and pay the resulting income tax. If Floyd files jointly, he won’t owe any federal income tax on the remaining $337,500 of gain ($450,000 – $112,500) because it’s completely sheltered by the $500,000 exclusion.
Example 2: Nonqualified use has no impact.
Sandy, a single person, bought a vacation home on January 1, 2001. On January 1, 2011, she converts the property into her principal residence and lives there for all of 2011 and 2012. On January 1, 2013, she sells the home for a $360,000 gain. Sandy’s total ownership period is 12 years (2001–2012), but the two years of post-2008 use as a vacation home (2009–2010) result in a nonexcludable gain of $60,000 (2/12 x $360,000). Sandy can claim the $250,000 home sale gain exclusion against the remaining $300,000 ($360,000 – $60,000) gain, leaving a $50,000 taxable gain. The end result is that Sandy must report a total gain of $110,000 (the nonexcludable gain of $60,000, plus the $50,000 gain in excess of the home sale gain exclusion).
Even before the new nonexcludable gain rule, Sandy would have had to report taxable gain of $110,000 ($360,000 – $250,000). Since the $110,000 gain that she would have had to report anyway exceeds the $60,000 nonexcludable gain, the new nonexcludable gain rule has no impact on Sandy.
To minimize the amount of taxable gain from the sale of one of these homes, it is essential that taxpayers keep accurate records of all the money invested in home improvements (before and after it became the taxpayer’s principal residence).
Save Taxes Using a Partial Annuity Exchange
Variable annuity contract distributions generally contain two components, taxable income and nontaxable return of basis (investment). However, distributions received before the annuity starting date (nonannuity distributions) are likely to be less taxpayer-friendly. Initially, these nonannuity payments generally consist entirely of taxable income until all of the annuity contract’s earnings have been distributed. Subsequent payments are considered to be a nontaxable return of basis. Because of this issue, when an annuity owner must take a nonannuity distribution, the tax impact can be onerous.
Internal Revenue Code Section 1035 has traditionally provided a federal tax-free mechanism to exchange one annuity contract for another annuity contract. This Section 1035 exchange, without recognition of gain or loss, is limited to cases where the person who is the insured or annuitant is the same in both contracts. Recent regulatory guidance offers a way to lessen the tax impact on nonannuity distributions using the Section 1035 exchange mechanism.
A person holding a highly appreciated annuity (one containing a large amount of built-up earnings) can lessen the tax bite using a two-step process. First, he or she makes a partial withdrawal from the original annuity by completing a partial exchange into another annuity. Next, he or she surrenders either annuity contract more than 180 days later to minimize the tax impact.
Example: Partial annuity exchange.
Pat originally invested $50,000 in an annuity, which has now grown to a fair market value of $200,000. If she withdraws $100,000 from this annuity, the funds will come first from her gain and will be taxed as ordinary income. So, instead, Pat makes a Section 1035 (tax-free) exchange with half of the original annuity into a second annuity worth $100,000. Her basis in each annuity is split proportionally. Accordingly, she has a $25,000 tax cost (basis) in each $100,000 annuity after the partial Section 1035 exchange. If Pat surrenders one of the annuities in full more than 180 days after the date of the Section 1035 exchange, she receives a $100,000 distribution that is considered to be $25,000 return of basis and $75,000 of ordinary income. This is a better result than receiving $100,000 of ordinary income without the partial Section 1035 exchange.
Observation: The new annuity contract(s) received in the partial exchange typically will have a fresh surrender charge period. For this reason, Pat should surrender the old annuity first rather than the new contract subject to the penalty.
Deducting Home Mortgage Interest
The political debate on federal tax reform touches many topics, including the tax deduction for interest on home mortgage loans. At the time of publication, there was no way to determine if this deduction will continue or at what level, but we thought it would be a good time to review current federal law on deducting residential mortgage loan interest. If there is a law change, this information will help you assess its impact.
Interest paid on qualified residence debt is deductible, but limitations apply. Qualified residence debt can be either (a) home acquisition indebtedness (purchasing a home), or (b) home equity indebtedness (borrowing against the equity in your home). Qualified residence interest expense incurred on up to $1 million ($500,000 for married filing separately) of home acquisition indebtedness is fully deductible as an itemized deduction for regular tax purposes. Taxpayers generally can deduct interest on up to $100,000 ($50,000 for married filing separately) of home equity indebtedness. However, there are restrictions on the deductibility of qualified residential mortgage and home equity loan interest for alternative minimum tax (AMT) purposes.
Mortgage interest is only deductible when paid by the taxpayer who is the legal or equitable owner of the property. Thus, a taxpayer cannot deduct interest he or she pays on the mortgage of another person. This may occur, for example, if parents make mortgage payments for their adult children. Similarly, a taxpayer who holds a mortgage generally cannot deduct the interest if it is paid by another person.
A qualified residence (for determining if the underlying debt is qualified residence debt) can be the taxpayer’s principal residence and one other residence selected by the taxpayer for the tax year. In other words, if the taxpayer has several vacation homes in addition to a principal residence, the taxpayer can designate a different vacation home as the second qualified residence for different tax years. A residence, for regular tax purposes, is defined as (a) a house, (b) a condominium, (c) a mobile home, (d) a boat, (e) a house trailer, or (f) other property that under all the facts and circumstances can be considered a residence. Vacant land used for occasional camping does not qualify as a residence.
Planning Tip: Taxpayers with more than two homes should consider keeping a mortgage on their principal resi-dence, and one other residence selected as a qualified residence, and paying off debt on any house(s) for which interest will not be deductible.
Spouses who file a joint return may treat their common principal residence, as well as property that otherwise qualifies as a second residence, whether it is owned jointly or by one spouse only, as a qualified residence.
Conversely, spouses who file separate returns may each take into account only one residence as the qualified residence, regardless of how the properties are owned. However, a deduction for a second residence is available if both spouses consent in writing to one of them taking into account both the principal and the second residence.
A residence under construction can be treated as a qualified residence for up to 24 months, but only if the residence actually becomes a qualified residence when it is ready for occupancy. However, the land a home is constructed on does not qualify as a residence under this rule until construction begins. Interest on debt to acquire a lot that is incurred before construction begins is personal interest. However, that interest might be deductible if a home equity loan is used to acquire the lot.
Filing Status Implications
For married taxpayers, the implications of filing a joint or separate return extend beyond tax rates and the standard deduction. Like many aspects of income taxation, there is usually more than one approach to finding the optimal solution. We have listed some of the more common implications of filing either a joint or separate return. Although not an exhaustive list, it highlights several issues to consider.
Some of the implications of filing a joint return include (among others):
The implications of filing a separate return include (among others):
There you have it: the implications for married taxpayers filing jointly or separately. Please contact us to discuss the most advantageous filing status or any other tax compliance or planning issue.
Business Deduction for Medicare Insurance Premiums
Self-employed individuals, including qualifying sole proprietors, partners, and more-than-2% S corporation shareholder-employees, can deduct premiums paid for qualified health insurance (within limits) in computing their adjusted gross incomes (AGI).
There had been some confusion concerning whether certain Medicare premiums counted for this rule. Recent IRS guidance indicates that premiums for all parts of Medicare (A, B, C, and D) count as qualified health insurance. In addition, premiums paid for the self-employed person’s spouse and dependents can also qualify.
Retirement Contribution and Other Limitations for 2013
The IRS has announced cost-of-living adjustments affecting the dollar limitations for retirement plans, deductions, and other items. Several of the limitations are higher for 2013 because the increase in the cost-of-living index met the statutory threshold. However, some limitations did not meet that threshold and remain unchanged from 2012.
The elective deferral (contribution) limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan increased from $17,000 in 2012 to $17,500 in 2013. The catch-up contribution limit for those age 50 and over remains unchanged at $5,500.
The contribution limit for both Roth and traditional IRAs has increased $500 from 2012. You can contribute up to $5,500 ($6,500 if you are age 50 or older by year-end) to your IRA in 2013 if certain conditions are met (i.e., sufficient earned income). For married couples, the combined contribution limits are $11,000 ($5,500 each) and $13,000 ($6,500 each if both are age 50 by year-end) when a joint return is filed, provided one or both spouses had at least that much earned income.
Keep in mind that contributions to traditional IRAs may be tax-deductible, subject to specific limitations that increase for 2013. When you establish and contribute to a Roth IRA, contributions are not deductible, but withdrawals are tax-free when specific requirements are satisfied. In addition, there are no mandatory distribution rules at age 70 1/2 with a Roth IRA, and you can continue to make contributions past age 70 1/2 if you meet the earned income requirement.
The 2013 limitation for SIMPLE retirement accounts increased $500 to $12,000. However, the SIMPLE catch-up contribution for those age 50 by year-end is unchanged from 2012 at $2,500.
The 2013 contribution limit for profit-sharing, SEP, and money purchase pension plans is the lesser of (1) 25% of the employee’s compensation—limited to $255,000, an increase of $5,000 from 2012 or (2) $51,000, an increase of $1,000 from 2012.
The social security wage base, for computing the social security tax (OASDI), increases to $113,700 in 2013, up from $110,100 for 2012. The additional $3,600 for 2013 represents an increase of 3.3% in the wage base.
Finally, the annual exclusion for gifts increased by $1,000 and is $14,000 in 2013.
IRS Offers Tax Tips for “The Season of Giving”
December is traditionally a month for giving generously to charities, friends and family. But it’s also a time that can have a major impact on the tax return you’ll file in the New Year. Here are some “Season of Giving” tips from the IRS covering everything from charity donations to refund planning:
· Contribute to Qualified Charities. If you plan to take an itemized charitable deduction on your 2012 tax return, your donation must go to a qualified charity by Dec. 31. Ask the charity about its tax-exempt status. You can also visit IRS.gov and use the Exempt Organizations Select Check tool to check if your favorite charity is a qualified charity. Donations charged to a credit card by Dec. 31 are deductible for 2012, even if you pay the bill in 2013. A gift by check also counts for 2012 as long as you mail it in December. Gifts given to individuals, whether to friends, family or strangers, are not deductible.
· What You Can Deduct. You generally can deduct your cash contributions and the fair market value of most property you donate to a qualified charity. Special rules apply to several types of donated property, including clothing or household items, cars and boats.
· Keep Records of All Donations. You need to keep a record of any donations you deduct, regardless of the amount. You must have a written record of all cash contributions to claim a deduction. This may include a cancelled check, bank or credit card statement or payroll deduction record. You can also ask the charity for a written statement that shows the charity’s name, contribution date and amount.
· Gather Records in a Safe Place. As long as you’re gathering those records for your charitable contributions, it’s a good time to start rounding up documents you will need to file your tax return in 2013. This includes receipts, canceled checks and other documents that support income or deductions you will claim on your tax return. Be sure to store them in a safe place so you can easily access them later when you file your tax return.
· Plan Ahead for Major Purchases. If you are making major purchases during the holiday season, don’t base them solely on the expectation of receiving your tax refund before the bills arrive. Many factors can impact the timing of a tax refund. The IRS issues most refunds in less than 21 days after receiving a tax return. However, if your tax return requires additional review, it may take longer to receive your refund.
For more information about contributions, check out Publication 526, Charitable Contributions. The booklet is available on IRS.gov or order by mail at 800-TAX-FORM (800-829-3676).
Court cases involving business issues will soon be heard by business-savvy judges in Michigan’s largest counties, thanks to a new law that takes effect January 1, 2013. Public Act 333 (signed by Gov. Rick Snyder on October 16) mandates a “business court” in any Michigan county with at least three circuit judges. As a result, in at least 17 circuits in the Lower Peninsula every “business or commercial dispute” over $25,000 will be assigned to a specific judge who has been trained in business litigation.
As the Michigan Legislature’s lame duck session came to a close in the wee hours of the morning last Friday, the long-anticipated legislation to eliminate the personal property tax on industrial equipment was approved. A 10-year phase out is planned. The biggest sticking point was loss of revenues to local governments with a large industrial base. A portion of the state’s use tax would be allocated to offset 80 percent of the lost revenue, while the other 20 percent could be recouped through special local assessment. Voters must approve the change in the use tax through a referendum in August 2014. Read more in this article from MACPA’s lobby firm, and in this Detroit Free Press article.
Disclaimer: This article is for general information purposes only, and is not intended to provide professional tax, legal, or financial advice. To determine how this or other information in this newsletter might apply to your specific situation, contact us for more details and counsel.
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