Roth IRA Contributions
Individual Retirement Accounts have been available since 1974, and have proven useful for people who do not have retirement plans through their employers, or for people who do have other retirement plans but have relatively low income. All taxpayers can contribute an amount equal to their earnings, up to $5,000 ($6,000 if over 50 years of age) to an IRA; if they have no other retirement plan, they can deduct that contribution from their taxable income, and earnings in the account are free of tax until withdrawn.
Persons with income under $120,000 (single) or $176,000 (married) can deduct their contributions to a traditional IRA even if they are covered by another retirement plan. Taxpayers covered by retirement plans whose income is above the limits for deducting contributions have for years been allowed to make their $5,000 or $6,000 contributions to an IRA, but can’t deduct the contributions. The non-deductible contribution comes out tax-free when withdrawn. While the earnings from the IRA are taxed when withdrawn, there would still be the advantage that income earned in the IRA compounds free of tax until withdrawn.
IRAs are generally subject to minimum distribution requirements once the owner reaches age 70-1/2. The minimum distribution requires people to withdraw funds from IRAs, creating a taxable event, making taxpayers pay income tax on the deferred contribution and on the earnings in the account.
Roth IRAs are a new breed of IRAs that were created in 1997. Roth IRAs have tax advantages for many people. Roth IRAs are created with after-tax funds. There is no deduction in the year contributions are made. When withdrawals are made the withdrawals are totally tax-free—not only the amount contributed, but the income earned in the account as well.
Roth IRAs are a good tool for transferring wealth to the next generation. Since withdrawal from a Roth does not create a taxable event, there is no minimum distribution requirement forcing a taxpayer withdraw his Roth IRA. The taxpayer leave his Roth IRA intact, and withdrawals from the Roth IRA will not be taxable income to whomever would inherit it. Beneficiaries are required to withdraw the Roth over their life expectancies (hopefully a long time), but the funds withdrawn are tax-free.
Congress enacted an income limit for Roth IRAs—you cannot contribute to a Roth IRA if your income exceeds $100,000.
The advantages of Roth IRAs are so great that Congress created a way for taxpayers to convert their traditional IRAs into Roth IRAs, by paying tax on the amount converted in the year of conversion. And the advantages are so great that many taxpayers are willing to pay the tax before they would otherwise be required to, in order to qualify for the Roth rules.
Prior to 2010, only taxpayers with incomes of under $100,000 could convert traditional IRAs into Roth IRAs. Effective in 2010 and thereafter, however, taxpayers making any amount are allowed to convert their traditional IRAs into Roth IRAs.
The ability to convert non-deductible IRAs into Roth IRAs gives higher income taxpayers an unanticipated advantage. Taxpayers can contribute up to the maximum contribution to IRAs ($5,000 if younger than 50, $6,000 if 50 or over) even if they are covered by a retirement plan, regardless of their income level, although they can only deduct the contribution if they are not covered by a retirement plan, or, if they are covered and their income is below the levels of $120,000 or $176,000. By contributing to a non-deductible IRA, and then converting that IRA into a Roth, taxpayers can avoid the income limitation on contributing a Roth.
There are some technicalities with which to comply in completing the two-step transaction of (1) investing in a non-deductible IRA so that (2) you can then convert that IRA into a Roth. The biggest issue to watch for is a complication if you already have other IRAs. For purposes of computing the basis of an IRA withdrawal, all IRAs are treated as a single entity. If you already have a traditional after-tax $20,000 IRA, if you contribute $5,000 to a non-deductible IRA, the rules say that if you then make a withdrawal (to transfer to a Roth or to spend), one-fifth ($5,000/$25,000) of your withdrawal comes from the latest contribution, the balance from the earlier contributions. Failure to anticipate this rule might result in having taxable income of $9,000 when you combine the $5,000 non-deductible IRA contribution with the taxable four-fifths of the $5,000 transfer to the Roth.
If you have no previous IRAs, or if you are willing to convert all of your IRAs into Roths at once, with a little work you can contribute indirectly to a Roth IRA regardless of your income.
Federal Income Tax–Cancellation of Debt Income
General Rule
In 2009 financial institutions wrote-off $200 Billion in consumer mortgages, and wrote-off $33 Billion in other consumer debt. Cancellation of Debt normally produces taxable income for the debtor. (See Section 61(a)(12) of the Internal Revenue Code). If you have had debt forgiven, you may have to pay tax on part of those write-offs.
In order to provide some relief to taxpayers benefitting from Cancellation of Debt (likely people who have suffered financial harm), Congress has created some exclusions to the general rule. If you fit into one of these exclusions, you are generally required to adjust your “tax attributes”–tax benefits, carryovers or future write-offs that you must give up to take advantage of the exclusions.
Most of the following materials are available in IRS Publication 4681, Cancelled Debts, Forclosures, Repossessions, and Abandonments. The Publication is very technically written, This article will hopefully make that publication more understandable. Also note that the current edition of Publication 4681 is dated for the 2008 tax year. When reading its examples remember that the date January 1, 2009 is meant to refer to the year after the Cancellation of Debt.
If you have property that is repossessed or foreclosed in partial satisfaction of your debt, you are treated as if you sold the property, and must compute a gain or loss. If the property is repossessed or foreclosed in full satisfaction of your debt, you may have two transactions to report, first, the income from the cancellation of the debt, and second, the gain or loss on the disposition of the property.
Forms 1099A and 1099C
If an institution cancelled debt which your client owed, or if your client abandoned property to his lender, he will normally receive Form 1099A, Acquisition or Abandonment of Secured Property, or Form 1099C, Cancellation of Debt. Since these transactions normally produce taxable income, Internal Revenue Service will be looking for the amounts shown on these Forms to be reported on his income tax return.
Discounts and Loan Modifications
A discount or loan reduction received from a lender results in Cancellation of Debt income to the extent of the discount or reduction. The income will be taxable, unless it is covered by an exception. Note that a reduction in the interest rate on an outstanding loan, while it may be as much of a concession as a discount, does not produce Cancellation of Debt income.
Business Tax Deferral on Cancellation of Debt Income
Businesses were granted an elective tax deferral applicable to tax years 2009 and 2010. The deferral allows electing businesses to pay tax on Cancellation of Debt income received in 2009 or 2010 to be reported over a five year period beginning in 2014. Businesses that take advantage of this election are not allowed to take advantage of any exclusion otherwise available.
Foreclosures or Repossessions
If you have property that is repossessed or foreclosed in partial satisfaction of your debt, you are treated as if you sold the property, and must compute a gain or loss.
Recourse Debt: If you owned property subject to a recourse debt (a debt on which you are personally liable for repayment) in excess of the property’s Fair Market Value, foreclosure or repossession of the property will result in Cancellation of Debt income if the lender either cannot, or does not seek payment of the deficiency from you. The Cancellation of Debt income is equal to the excess of the amount owed on the property foreclosed or repossessed over the Fair Market Value of the property. The difference between the Fair Market Value which you have given to the lender, and your “basis” in the property (generally your cost, reduced by depreciation you have claimed on your tax returns) is taxed as a sale or disposition. An excess of the Fair Market Value over your basis produces a taxable gain (which may be ordinary or capital gain). If your basis exceeds the Fair Market Value of the property, you have a loss, which will be deductible if the property was a business asset, but not if it was used personally.
Non-Recourse Debt: If you owned property which was subject to a non-recourse debt (a debt on which you are not personally liable for repayment) in excess of the property’s Fair Market Value, foreclosure or repossession of the property does not result in Cancellation of Debt income. The entire non-recourse debt is treated as the amount realized on the disposition of the property, which is compared to your basis to determine gain or loss.
Abandoned Property: If you abandon property which secures a debt on which you are personally liable and the debt is cancelled, you will realize cancelled debt income equal to the entire debt. You may also have a loss on the abandonment, comparing the amount realized on the disposition (zero) with your adjusted basis.
EXCEPTIONS TO THE CANCELLATION OF DEBT RULES
There are several Exceptions to transactions that might at first appear to be taxable Cancellations of Debt.
Exception 1—Gifts
Cancellation of Debt intended as a gift is not Cancellation of Debt income. Mom and dad can forgive their child’s note without income tax effect.
Exception 2—Student Loans
Student loans forgiven in exchange for work in certain professions for specified periods of time are not considered taxable Cancellation of Debt income. The loan must be given by a government or a qualified educational institution. The Cancellation of Debt which is not taxable has no effect on other tax attributes.
Exception 3—Reduction in Deductible Debt
Forgiveness of debt that would be deductible if paid is not considered Cancellation of Debt income. An example would be the forgiveness by a utility of a bill that would be deductible by the business if it were paid. The cancelled debt is not taxable, and the unpaid debt is not deductible.
Exception 4—Price Reduced After Purchase
If a debt incurred in buying property is reduced by the seller, the reduction is not treated as Cancellation of Debt income, but rather as a reduction of the purchase price. The basis or depreciable basis of the property must be reduced.
EXCLUSIONS REQUIRING TAX ATTRIBUTE REDUCTION
Congress created several Exclusions from the general rule that Cancellation of Debt results in the recognition of income. These Exclusions require that certain tax benefits or “attributes” that the taxpayer might otherwise have must be given up or “reduced” to the extent that Cancelled Debt is excluded from tax. The specific rules relating to which tax attributes are given up vary, depending on which Exclusion is being used. This list of attributes which must be reduced relates to Cancellation of Debt income that is not taxed because it was cancelled in bankruptcy. Attributes are reduced in the following order:
- Any Net Operating Loss incurred in or carried to the year of the Cancellation of Debt;
- General Business Credit incurred in or carried to the year of the Cancellation of Debt (credits are reduced at the rate of $1.00 for each $3.00 of cancelled debt);
- Minimum Tax Credit incurred in the year of the Cancellation of Debt, or earlier (again reducing the credit at the rate of $1.00 for each $3.00 of cancelled debt);
- Any Capital Loss from the year of the Cancellation of Debt, or earlier;
- Basis of property owned, first business property and then non-business property;
- Passive Activity Losses that the taxpayer has carried forward;
- Foreign Tax Credit incurred in the year of the Cancellation of Debt, or earlier (again reducing the credit at the rate of $1.00 for each $3.00 of cancelled debt).
The specific tax attributes affected by each Exclusion from the general rule that Cancellation of Debt income results in the recognition of income vary in each Exclusion.
There are two interesting aspects to the Reduction of Tax Attributes. First, if you don’t have sufficient Tax Attributes to absorb the entire cancelled debt on which income tax is forgiven, you are still entitled to use most Exclusions (other than the Qualified Farm Indebtedness Exclusion). Second, all of the Tax Attribute Reductions are made as of January 1 of the YEAR AFTER the Cancellation of Debt. Delaying the reduction of tax attributes until the year after the Cancellation of Debt appears to be a way Congress is trying to reduce the pain of taxpayers’ financial distress. You are allowed to use your tax benefits for the one final year in which you had Cancellation of Debt income.
Exclusion 1—Bankruptcy
There were 1.4 million personal bankruptcies in the United States in 2009.
Debt forgiven or cancelled in bankruptcy, whether Chapter 7, Chapter 13, or any other provision of the Bankruptcy Code, is excluded from being taxed. Publication 4681 uses the unfortunate term “Title 11 Bankruptcy” which might imply that there is some other type of bankruptcy. Title 11 is the entire Bankruptcy Code, so all forms of bankruptcy are included.
When using the Bankruptcy Exclusion, the taxpayer’s tax attributes, as listed above, must be adjusted in the order listed. The taxpayer may, at his option take the entire reduction in tax attributes from his depreciable business property, first from depreciable real property, and then from depreciable personal property. If he has additional untaxed debt, he must then reduce his other tax attributes, if any.
Exclusion 2—Insolvency
Debt forgiven or cancelled is excluded from taxation to the extent that the debtor is insolvent before the cancellation. The Insolvency referred to here is not the inability to pay current debts as they come due, it is the “bankruptcy definition” of insolvency—debts exceeding assets. Thus if a $10,000 debt is cancelled for a person whose debts exceed his assets by $7,000, the Cancellation of Debt income is not taxed to the extent of $7,000. The remaining $3,000 is subject to tax. The assets that are included in the formula for determining the taxpayer’s solvency include his retirement funds.
When using the Insolvency Exclusion, the taxpayer’s tax attributes must be reduced, the same attributes and in the same order as under the Bankruptcy Exclusion.
Exclusion 3—Qualified Farm Indebtedness
Debt forgiven or cancelled is not taxed to the extent that it is Qualified Farm Indebtedness. Qualified Farm Indebtedness is indebtedness incurred directly in connection with the business of farming, by a farmer (over half of whose gross receipts for the three years prior to the cancellation were from farming), which cancellation is by an organization whose business is lending money. It can’t be the farmer’s family, the seller of the farm property, or a person who receives a commission from the farmer’s investment in the property. The farmer cannot exclude more than the adjustments to his “tax attributes”.
If the debt cancelled qualifies for the bankruptcy exclusion, that must be applied first. If the debt qualifies for the insolvency exclusion, that must be applied before the Qualified Farm Indebtedness Exclusion.
The farmer’s tax attributes are the same as those for the Bankruptcy Exception and Insolvency Exception except that in adjusting the basis of the taxpayer’s property, only farm property is adjusted.
Exclusion 4—Qualified Real Property Business Indebtedness
Debt forgiven or cancelled is not taxed to the extent that it is Qualified Real Property Business Indebtedness. Qualified Real Property Business Indebtedness is (1) debt incurred or assumed to acquire, construct, or improve property in connection with real property used in a trade or business, (2) debt secured by the property acquired, and (3) debt to which you elect to apply this exclusion. It also includes debt incurred to refinance Qualified Real Property Business Indebtedness, up to the amount being refinanced. (Note: You elect to apply this exclusion by claiming it on a timely filed tax return—if you file late, you lose the exclusion.)
If the debt cancelled qualifies for the bankruptcy exclusion, that must be applied first. If the debt qualifies for the insolvency exclusion, that must be applied before the Qualified Real Property Business Exclusion.
The amount that can be excluded under the Qualified Real Property Business Exclusion is limited to the excess of the outstanding principal of the Qualified Real property Business Debt (immediately before the cancellation) over the Fair Market Value of the business real property securing such debt (reduced by any other Qualified Real Estate Business Debt secured by the property, but not more than the adjusted bases of depreciable property held by the taxpayer immediately before the cancellation).
If you elect this exclusion, you must reduce the basis of your depreciable property (but not below zero) by the amount of cancelled Qualified Real Property Business Indebtedness. The basis reduction, like the other tax attribute adjustments, is made as of the first day of the tax year after the debt was cancelled.
Exclusion 5—Qualified Personal Residence Indebtedness
Cancelled Debt can be excluded from income if it is Qualified Personal Residence Indebtedness.
Monroe County, Michigan, reports that residential values in the County fell by 15% in 2009.
Qualified Personal Residence Indebtedness is debt incurred in acquiring, constructing, or substantially improving the taxpayer’s residence. Qualified Personal Residence Indebtedness also includes the refinancing of Qualified Personal Residence Indebtedness to the extent that the replacement debt does not exceed the amount of the debt replaced. The maximum that you may treat as Qualified Personal Residence Indebtedness is $1,000,000, on a single return, $2,000,000 on a joint return. Amounts in excess of this limit may be excludible under another exception.
The Exclusion for Cancellation of Qualified Personal Residence Indebtedness was added as a temporary measure effective January 1, 2007, and is scheduled to expire on December 31, 2012.
The only Tax Attribute that you need to reduce if you qualify for the Cancellation of Qualified Personal Residence Indebtedness Exception is the basis of the house itself.
Reporting Cancelled Debt
Cancelled Debt excluded from income is reported on Form 982. The Form requires the reporting of the type and amount of excluded debt cancellation, and the Type and amounts of Tax Attributes reduced.
Summary
There are several ways to avoid tax on the Cancellation of Debt. There are four Exclusions from the definition of Cancelled Debt: (1) Debt reductions as gifts, (2) Debt reductions of student loans under government or college programs, (3) Debt reduction for items that would be deductible if paid, and (4) Reduction in the contract balance by the Seller. In addition, there are five Exceptions to the rule that Cancelled Debt is taxable: (1) Bankruptcy (all types), (2) Insolvency (to the extent of insolvency), (3) Qualified Farm Indebtedness (Debt directly connected with farming), (4) Qualified Real property Business Indebtedness (real estate purchase or improvement), and (5) Qualified personal Residence Indebtedness (Purchase or improvement of the residence).
Each of the Exceptions requires the adjustment of Tax Attributes.
Resources:
Internal Revenue Code:
Section 108—Income from discharge of Indebtedness.
Section 1017—Discharge of Indebtedness.
Treasury Department Regulations:
1.108-4—Election to reduce basis of depreciable property under section 108(b)(5) of the Internal Revenue Code.
1.108-5—Time and manner of making the election under the Omnibus Budget Reconciliation Act of 1993.
1.108-6—Limitations on the exclusion of income from the discharge of qualified real property business indebtedness.
1.108-7—Reduction of attributes.
1017-1—Basis reductions following discharge of indebtedness.
Internal Revenue Service Publications:
4681—Cancelled Debts, Foreclosures, Repossessions and Abandonments (for Individuals)
Internal Revenue Service Forms:
Form 982—Reduction of Tax Attributes due to Discharge of Indebtedness.<–>
Federal Income Tax – Conversion of IRAs to Roth IRAs
Conventional Individual Retirement Accounts have been with us since 1974. IRAs can be funded up to certain limits annually. The limits currently are $5,000 per year for people under age 50, and $6,000 per year for people over that age (up to the amount of the taxpayer’s earned income). If the taxpayer either doesn’t have another retirement plan, or his income is under certain limits, the contributions to the IRA can be deducted from taxable income. (The limits are $65,000 for a single person covered by a retirement plan, $109,000 for a married couple both covered by retirement plans, and $176,000 for married person whose spouse is covered by a retirement plan.) If the taxpayer is not eligible to make a deductible contribution, he may still make a non-deductible contribution—if he wants to keep track of the “basis” of the IRA on which tax has been paid for the rest of his life.
Roth IRAs have been around since 1997. Roth IRAs can be funded up to the same annual limits as conventional IRAs. Roth IRA contributions are not deductible from income, but qualifying withdrawals from Roth IRAs are totally tax free.
Taxpayers have been allowed to “convert” conventional IRAs into Roth IRAs since Roths have existed, by paying income tax on the amount converted. For many years only taxpayers with Adjusted Gross Income of less than $100,000 (excluding the conversion) were allowed to convert their IRAs into Roths.
Beginning in 2010 there is no longer an income limit on converting a conventional IRA (or some other defined contribution retirement accounts) into a Roth IRA. Many more people will qualify, and many will find it advantageous.
The reasons to convert to a Roth IRA are:
- Convert to avoid future tax rate increases.
- Convert to use your tax-sheltering attributes.
- Convert to make your taxable savings tax-free.
- Convert to maximize funds passed to your heirs.
1. CONVERT TO AVOID FUTURE TAX RATE INCREASES
Do you expect that tax rates will increase over the rest of your life? We seem to be asking government to do more and more for us, which eventually will increase our tax bills.
If you expect tax rates to go up, you can “lock in” present tax rates on your IRA by converting to a Roth. If you convert this year, you can pay this year’s rates. Future income on your retirement account, and future withdrawals are tax free.
Locking in the present tax rates may turn out to be a wise move if rates increase, even for people who plan to use their Roth IRA to fund their retirement. Roth distributions are not listed on your tax return, so disadvantages that are based on Adjusted Gross Income are reduced: less of your Social Security benefits are taxed, or less are taxed at the higher rates. Property tax credits to low income taxpayers are increased. Reductions of itemized deductions or exemptions might be avoided. Alternative Minimum Tax rules might be avoided by having less taxable income.
2. CONVERT TO USE YOUR TAX-SHELTERING ATTRIBUTES
Do you have tax attributes that make your tax rate this year exceptionally low? A Net Operating Loss or a Disaster Loss? Early retirement with little taxable income? Charitable contribution carryovers? Exceptionally large itemized deductions?
If you have any tax attributes that wipe out your income, consider taking advantage of them by filling the tax-free hole with otherwise taxable retirement funds. Be more aggressive, and withdraw enough to use the entire 10% and 15% tax brackets. It’s unlikely you will regret it. You may be able to make a series of withdrawals to convert your retirement into a Roth at little or no cost—and have the Roth advantages described below.
3. CONVERT TO MAKE YOUR TAXABLE SAVINGS TAX-FREE
Roth conversions work best when the tax on the conversion can be paid with funds that would otherwise produce taxable income. The funds are paid to IRS, and no longer produce taxable income. Your annual tax bill is reduced. Other taxes, costs, and lost deductions, such as the portion of Social Security subject to tax, or property tax relief based on having low Gross Income, will also be moved in your favor.
Equivalent funds within the Roth which would someday have been paid as taxes from a conventional IRA are growing TAX-FREE. That’s tax-free now, and tax-free in the future. Totally tax-free.
4. CONVERT TO MAXIMIZE FUNDS PASSED TO YOUR HEIRS
Retirement plans receive special tax treatment, including tax deduction on their creation, and tax-free growth, in order to provide funds for seniors to live on in retirement. To encourage the notion of providing funds for retirement the Tax Code provides that participants must take mandatory distributions after age 70-1/2. These Required Minimum Distributions create taxable income for the participant, and tax for the United States Treasury. Once the Required Minimum Distributions start, the participant is not allowed to make further contributions to the IRA. (Otherwise participants might simply trade dollars, taking their Required Minimum Distributions, but making an equivalent contribution to the IRA.) Required Distributions encourage the use of the funds during retirement, rather than using the retirement accounts as a vehicle to transfer wealth to the next generation.
Roth IRAs have no Required Minimum Distributions. Since the funds are not taxable on withdrawal, Congress did not provide for mandatory withdrawals during the participant’s life. Roth IRAs can be left entirely alone for the participant’s whole life, if he has other funds to live on. The original Roth, and all of its growth, can be used to pass wealth to the next generation.
Along with the right to maintain the Roth IRA without mandatory distributions, there is no age at which a person having earned income can no longer contribute to a Roth. People who continue to work after age 70-1/2 can continue to add to their Roths.
If you can avoid distributions from your retirement fund, you can continue its tax-free growth.
The people who inherit the Roth (that is, your heirs) are required to withdraw it over their life expectancies, but the period of tax-free growth can be substantial. What other property can you pass on to your heirs where their income will be tax-free, part of it for the heir’s whole life expectancy.
FEATURES OF A ROTH IRA
Roth IRAs are designed to be created with after-tax money, and are totally tax-free. They can only be created by two methods: using the normal contribution rules for IRAs, or by converting a retirement account into a Roth IRA. Originally only IRAs could be converted into Roth IRAs. Under the current rules, other retirement accounts as well as IRAs can be converted into Roth IRAs upon paying the tax.
Annual contributions can be withdrawn from the Roth IRA at any time after their contribution tax free (after all, the contributions were made with after tax money). IRA conversions to Roths are also tax free, but are subject to an early withdrawal penalty if they are withdrawn within the first five years. After 5 years there is no early withdrawal penalty, and after five years an the participant’s age 59-1/2, all withdrawals are totally free of tax.
If you are the participant considering conversion to a Roth IRA, you are thinking of the advantages of many years ‘ of tax-free growth. But remember, this is YOUR money for all of your life, and if you need it, you can withdraw it.
When there was an income limit on Roth conversions, it was possible for people to convert their IRA into a Roth IRA, and later find that their Adjusted Gross Income was over $100,000, so the conversion was not allowed. To help these people out, the law provided for a “Recharacterization” of the withdrawal: If you wished, any time before your tax return was due, with extensions(that is, up until October 15 of the year following the year of conversion), you could “recharacterize” the Roth IRA as a traditional IRA, meaning that you had simply made a “rollover” of a conventional IRA, and you owed no tax.
With the new rules in 2010 there is no maximum Adjusted Gross Income limitation on the conversion, so there is no reason for allowing a “recharacterization”. Nevertheless, Congress left the provisions in the Code, so it is still available for use. Presumably people will find it useful if the value of their IRA decreases before the final day of making the “recharacteriaztion” election, converting the previous year’s conversions back into a conventional IRA (no tax due on that simple rollover), and converting the now less valuable IRA to a Roth the next year at a lower tax cost.
In fact, you might convert your conventional IRA into two or three Roth IRAs, each invested in different securities. When the final election day came (which could be over 21 months from the initial conversions) the accounts that lost money could be “recharacterized” back to conventional IRAs, for last year’s tax return, and converted again into a Roth in order to lower the tax cost of their conversion. The accounts that had increased in value would be left as completed conversions.
Conversion of retirement funds into Roth IRAs involves projecting likely results several years into the future. It must be done carefully, and should generally be done with professional help. This article is only meant to suggest some of the situations in which a conversion can be beneficial.
References:
Internal Revenue Code:
Section 408A Roth IRAs
Treasury Regulations:
Section 1.408A-0 Roth IRAs; table of contents
Section 1.408A-1 Roth IRAs in general
Section 408A-2 Establishing Roth IRAs
Section 408A-3 Contributions to Roth IRAs
Section 408A-4 Converting amounts to Roth IRAs
Section 1.408A-5 Recaracterized contributions
Section 1.408A-6 Distributions
Section 1.408A-7 Reporting
Section 1.408A-8 Definitions
Section 1.408A-9 Effective Date
Federal Income Tax – Taxes and Divorce
Divorcing people find themselves very interested in several sections of the Internal Revenue Code. Where one spouse has substantial retirement benefits, the parties should examine the rules for a Qualified Domestic Relations Order, or QDRO, which can divide the retirement benefits between the parties. If one party will be making payments to the other, the parties are allowed to determine which of them will be taxable on the payments through the Alimony rules of Section 71 of the Code.
In property settlements between divorcing parties, no gain or loss is recognized. The parties should realize, however, that the “basis” (cost) of whatever property they receive will carry over from when the couple acquired it. This can make a large difference when a party later sells the property. They should make an effort to divide both the property and the basis fairly. There is a $500,000 exclusion of gain on selling a marital residence. The excludable gain is only half as much for a single person. Couples with a large gain on their residence must be careful to sell at the proper time, and under the right conditions to maximize the exclusion.
The custodial parent normally gets the dependency exemption for dependent children. Only if the custodial parent signs off on claiming the exemption is the non-custodial parent allowed to claim the child or children.
Legal fees incurred in getting a divorce are not deductible. Legal fees incurred in getting tax advice, or in obtaining or collecting taxable alimony, are deductible.
QUALIFIED DOMESTIC RELATIONS ORDERS
The legal instrument for dividing retirement plans between the divorcing parties is the Qualified Domestic Relations Order (QDRO).
Retirement Plans come in two flavors: (1) Defined Contribution Plans, where the current value can be determined at any time, but the retirement benefits are not determinable, and (2) Defined Benefit Plans, where the retirement benefit is pre-defined, but the value at an earlier date can only be determined by an actuary.
Most retirement plans are subject to the Employee Retirement Income Security Act (ERISA). Plans that are subject to ERISA must provide for Qualified Domestic Relations Orders (QDROs) to divide retirement benefits between the plan participant and his or her spouse or other dependents.
Before QDROs, retirement plans were taken into account in divorce settlements, but the non-participant spouse was often given additional property to “offset” the retirement plan value retained by the participant spouse. The offset method is still often used for simplicity where the value of the retirement assets is small. The offset method won’t work in all cases because parties often don’t have enough assets outside of the plan to offset the value of the plan.
QDROs allow plans to be divided by the “Deferred Division Method” or the “Shared Benefit Method”. “Deferred Division” implies that both spouses will use the plan assets for retirement, but they are not required to. Many QDRO divisions are immediately rolled over into an IRA, or simply cashed out. The early withdrawal penalty does not apply when cashing out a QDRO. There are rumors that people have divorced in order to receive QDRO funds which are usually not available under retirement plans, and to avoid the early withdrawal penalty.
The “Shared Benefit Method” assures that both spouses will use the retirement fund for their retirement. Shared benefit assigns a portion of each benefit payment to each spouse. The shared benefit method avoids the necessity of valuing the plan at the time of divorce. The shared benefit method is often used where withdrawals from the plan have already begun before the divorce.
Plan administrators are often available to assist with forms or wording of QDROs. A QDRO can’t increase a plan’s obligations; it can only divide existing obligations between the plan participant and his or her spouse or dependents. Plans can have a variety of benefits besides a normal retirement annuity—survivor benefits, augmented early retirement benefits. These benefits should be addressed in the QDRO. Both parties and their attorneys should read at least the Summary Plan Description to know what benefits are available to be divided.
QDROs can divide retirement plans in favor of children or other dependents as well as spouses.
QUALIFIED ALIMONY/SECTION 71 PAYMENTS: DEDUCTIBLE BY PAYOR, TAXABLE TO PAYEE
Qualified Alimony is defined in Section 71 of the Internal Revenue Code. The definition in Section 71 does not correspond to other definitions of alimony in the legal or real world. In Section 71, there is no requirement that Alimony be for support, or that it be paid in periodic payments. Section 71 Alimony that is taxable to the payee is deductible by the payor.
Section 71 requires that deductible alimony be paid in cash. Property or the use of property doesn’t count as alimony. Payments can be to a third party “on behalf of” the payee. Deductible alimony must be paid under a Court Order or Written Separation Agreement. The Court Orders mentioned in Section 71are: a decree of divorce; a decree of separate maintenance; a written instrument incident to a decree. The parties may write their own Written Separation Agreement calling for payments that will qualify as alimony under Section 71.
To qualify as deductible alimony the payments must not be designated as non-deductible/non-taxable in the governing instrument. The parties cannot be members of the same household at the time the payments are made.
To qualify as deductible payments, there must be no liability to make payments for any period after the payee’s death, and no liability to make any substitute payments. The lack of liability for continuing payments may (and should) be stated in the governing instrument (Decree or Separation Agreement), or it can be a feature of local law. In Michigan, “Alimony” does not survive the payee’s death. Note that “Qualified Alimony” does not necessarily correspond to alimony as defined in Michigan divorce law. There does not need to be any support element or Periodic Payments in “Qualified Alimony.”
If the alimony payee is concerned to receive a certain amount in from the dissolution of the marriage even if he or she should die, this would be an ideal place to use life insurance. The alimony payee can insure his or her death, but the alimony payor should not provide that insurance directly.
If you wish to describe “Qualified Alimony” be sure to state that the payments end in the event of the death of the payee, regardless of how unlikely that death is before the payment of the alimony—even if the payment is being made on the same day the agreement is signed.
Qualified Alimony payments cannot be treated as child support in the document, either directly, or by adjusting the “Alimony” payments as the children reach certain ages.
Excessive “front loading” of alimony payments in the first three years will cause a portion of payments to be recaptured in the third year. Front loading is the most complex requirement Qualified Alimony must meet, but it only tests the first three years, so the math is manageable. Front loading is only concerned with decreasing payments. If the payments stay level or increase, there is no front loading issue.
Excessive “front loading” is calculated as follows:
- Begin with the third year’s payment(s).
- Second year payments will not be excessively front loaded if they do not exceed third year payments plus $15,000.
- First year payments will not be excessively front loaded if they do not exceed the average of the second and third years’ payments plus $15,000.
It might be easier to apply two rules of thumb which avoid going through the calculations: You can have one $15,000 “step down” in the first three years, or you can have two $10,000 “steps down” in the first three years without excessive front loading. Note that years one, two and three are calendar years. If the first payment is near the end of year one, year two’s payment may be paid shortly thereafter.
Qualified Alimony need not be paid for support. It can be used to pay attorney fees, to equalize property settlements, to buy out a business interest, to divide a small or non-qualified pension plan, to make the “interest” portion of a property settlement deductible to the payor, or for any other reason the parties may have, so long as the requirements are met.
PROPERTY SETTLEMENT: NO GAIN OR LOSS IS RECOGNIZED ON TRANSFERS BETWEEN THE SPOUSES OR INCIDENT TO A DIVORCE
A transfer is “incident to a divorce” if it occurs within one year of the divorce, or if it is related to the cessation of the marriage. A right of first refusal granted in a property settlement was found to be “related to the cessation of the marriage” years after the divorce.
The transferee spouse takes the property as if received by gift from the transferor spouse—cost basis and date basis carry over. Divorcing parties (or their attorneys) should compare not only the current values of the property being divided, but also the basis of the property, so that one spouse is not burdened with excessive low-basis assets which will generate taxable gains in the event of sale. Cost basis can be adjusted in some cases by borrowing against the property before its transfer.
How should the parties take potential tax liability into account? Subtracting a calculated tax from the current value sort of assumes an immediate sale. Ignoring the potential tax sort of assumes the property is never sold. It seems appropriate to compromise somewhere in the middle. Michigan courts have seldom reduced property values for potential tax liability, generally finding that assuming a taxable sale of the property was speculative.
If property is to be disposed of in a divorce, it is important to transfer the property between the spouses (tax-free) before the sale to locate the tax liability where it is appropriate. The tax liability is determined by the ownership of the property when it is sold. If property is sold by husband and wife as joint owners in Michigan, it is reported one-half on each spouse’s tax return. If property becomes co-tenancy property under the divorce decree, it will be an equal co-tenancy unless the court specifies otherwise. The parties are free to divide property or the proceeds of sale of the property in another proportion; make their ownership interests proportionate to their sale proceeds, or someone will pay too much tax. If the property is to be sold and Husband is to receive ¼ of the proceeds, make him a co-owner of ¼, or he will be paying tax on1/2 of the sale proceeds, including part that goes to his EX.
While the parties can divide their property between themselves to control their tax consequences, they can’t “assign” taxable income earned by one to the other. An attorney who assigns half of an expected fee to his spouse will be taxable on the whole fee. Most adjustments of taxable income between the spouses can be solved using Section 71 payments.
A common problem of divorcing couples is buying out a business interest of a soon-to-be ex-spouse in a tax efficient manner. One way it is done is to “hire” the ex-spouse to pay her with deductible corporate dollars. A second way is to pretend to hire the ex-spouse, paying her for no services with deductible corporate dollars. If this sham is discovered by IRS, the result is no deduction to the corporation, and the taxation of a dividend to the owner. A solution is to pay the dollars to the continuing owner, who transfers them to the ex-spouse using Section 71 Qualified Alimony.
Another way to handle the buyout of the ex-spouse would be by the redemption of stock. Assume W owns 100% of Company X. W transfer 50% of Company X to H. H’s shares are redeemed by Company X over time. Company X’s obligation to H is guaranteed by W. This is all a perfectly acceptable way to have the business buy out the ex-spouse (with after tax funds), provided W has no “primary and unconditional obligation” to make the payments due H. If she does have a primary obligation, then the corporation is paying her obligation, which will be treated as a dividend taxable to her.
The parties might also arrange for the use of Qualified Retirement Plan funds to buy out the ex-spouse. A QDRO pays the ex-spouse (or soon-to-be ex-spouse) the buy-out value. This provides security to the spouse receiving the funds, it preserves the business owner’s cash flow, and the retirement fund might be replenished for the business owner over time.
MARITAL RESIDENCE GAIN EXCLUSION
Internal Revenue Code Section 121 provides for the exclusion of $250,000 of the gain on the sale of a residence for a single person, and an exclusion of $500,000 of gain for a married couple. Requirements are (1) that the home be owned and used as the parties’ primary residence for two years out of the last five years before sale, (2) that the parties have not used the exclusion in the last two years, and (3) that the couple file a joint return. Both parties must satisfy the two year use requirement, but only one needs to satisfy the two year ownership requirement. The two year ownership and use requirements are pro-rated if an early sale is caused by unforeseen circumstances—loss of job, health problems, or divorce.
Unmarried co-habitants—A & B, unmarried, have owned their home jointly and have lived in it for over two years. They are about to sell it for a gain of $256,000. By virtue of their joint ownership, the gain is attributed ½ to each of them. Each has an exemption of $250,000 available, so each of their gains are excluded. If only one had owned the home, there would be only one $250,000 exclusion.
Newly married—A & B marry and buy a new home. They each sell their previous homes, A’s for a gain of $300,000, and B’s for a gain of $200,000. Each had owned and occupied their respective homes for more than two years. A is allowed an exclusion of $250,000, and B is allowed an exclusion of $200,000.
If a single homeowner marries the spouse must reside in the home (and not sell another home) for two years before the couple qualifies for a $500,000 exclusion.
The date basis for purchase of the home transfers from one spouse to the other if the property is transferred in a divorce. Use by a spouse or former spouse which is specifically provided in the divorce decree or written separation agreement is attributed to the non-occupant spouse. Arrangements for the custodial parent to use a co-owned home while children are minors, then house to be sold, will qualify for the $250,000 exclusion for each co-owner, even though the non-custodial parent has not lived in the home for years.
HOME DEDUCTIONS
In joint ownership each party can deduct the interest and taxes that he or she paid.
In co-ownership each party can deduct the interest and taxes he or she paid only up to that party’s proportional interest in the property.
Tenancy by the entireties (marital joint ownership) converts into equal co-tenancy upon divorce, unless the divorce decree specifies otherwise.
The marital home can be a qualifying first or second home for the non-custodial parent (for the purposes of deducting mortgage interest) if his or her children live there.
With some planning, the parties can use the Alimony definition of Section 71 to assign the home deductions to whomever benefits from them.
CHILDREN’S DEPENDENCY EXEMPTIONS
The general rule is that the custodial parent gets a child’s dependency exemption UNLESS he or she agrees not to take the exemption on Form 8332. This general rule applies whenever the parents together provide more than half of the support for the child, and have custody of the child for more than one-half of the year.
Any substitute for Form 8332 must have all of the information contained on Form 8332. A letter of intent or a letter of agreement between attorneys or parties won’t serve as a substitute for Form 8332. The Form can be signed once to cover one year or many years into the future. Probably the best practice is for the custodial parent sign Form 8332 each year after all support payments are made. Assignment of the dependency exemption to the non-custodial parent in the divorce decree is not effective BUT Michigan courts can require the custodial parent to sign Form 8332 if that is equitable or conforms to a divorce judgment.
Either parent may deduct medical expenses paid for their dependent child.
LEGAL FEES
Legal fees that either spouse pays in a divorceare considered personal and non-deductible. Fees that either party pays for tax advice are deductible under Section 212(3) of the Internal Revenue Code which provides that all fees paid to plan or calculate taxes are deductible.
Legal fees related to the production or collection of taxable alimony are deductible. Fees for fighting against the award of alimony are not deductible.
FILING STATUS
If the parties are married on December 31, they are treated as married for tax purposes. They may file a tax return as “Joint”, or as Married Filing Separately. Joint return filing rates are the lowest of any filing method. Married Filing Separately rates are the highest.
There is an exception for a parent who has been separated from the other parent for the last six months of the year, and provides a home for one or more dependent children. The separated parent can file as “Head of Household”, with rates lower than Married Filing Separately, and even lower than Single filing. The other parent, unless he or she also provides a home for another child or children, must file as Married Filing Separately.
When the divorce is final, the custodial parent providing a home for the dependent children can file as Head of Household. The non-custodial parent can file as Single.
Resources:
Internal Revenue Code:
Section 71, Alimony and Separate Maintenance Payments
Section 121, Exclusion of Gain from Sale of Principal Residence
Section 152, Dependents Defined
Section 163, [Deduction of] Interest
Section 164, [Deduction of] Taxes
Section 212, [Deduction of] Expenses for the Production of Income
Section 215, [Deduction of] Alimony, etc., Payments
Section 414(p) Qualified Domestic Relations Order Defined
Section 1041 Transfers of Property Between Spouses or Incident to Divorce
Treasury Regulation:
Section 1.121-3, Reduced Maximum Exclusion for Taxpayers Failing to Meet Certain Requirements
Internal Revenue Forms:
Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents
Federal Income Tax – Appeal Your Audit
If you don’t agree with the results of a tax audit, appeal! The Appeals Division is the only place to appeal audit results within the Internal Revenue Service. The Appeals Division’s job is to reduce the number of unagreed cases. Move to Appeals, and you will get several chances to improve or correct the findings of the audit.
Appeals wants to settle cases. That is its reason for existence. Section 8.1.1.1-2 C of the Internal Revenue Manual states:
“Appeals accomplishes this mission by considering protested cases, holding conferences, and negotiating settlements in a manner which ensures the following:
As many non-docketed cases as possible are closed while in non-docketed status, and as many docketed cases as possible are closed without trial.”
Non-docketed cases are cases that have not yet been filed in Court. Appeals measures its success by how many cases it can settle without court filings.
Prepare, Prepare, Prepare
While you are appealing, you can further prepare your case. You prepared for the tax audit. Now you have just gone through the audit. You have been told which items the auditor accepts, and which he rejects and why. At the appeals level, you will be allowed to present ANY arguments or facts you have that will improve your position, even if you did not present them previously. (This is different from the court system, where you present your best case first, or you lose the opportunity.)
If you can get a letter from your employer to support your position, do it. If the connection between your expense and your business is questioned, work on that connection. If more supporting documents are needed, try to obtain them. Use your imagination. If detailed mileage logs are not available for all of your mileage, try to support your mileage for one month and convince the Appeals Officer to accept it as “typical.” Use your appointment book to show your travel. Concentrate on the areas the auditor did not accept.
Again, if you remember or find issues that are in your favor, you are allowed to raise them. If you forgot to deduct some business expenses, tell the Appeals Officer. The Appeals Officer is directed not to raise new issues on behalf of the government, but to accept any new information in the taxpayer’s favor. Inernal Revenue Manual Section 8.6.1.6.4-1 states:
“Appeals gives full, fair and impartial consideration to the merits of each new issue raised by a taxpayer. If such an issue is based upon important evidence, such evidence is ordinarily referred to IRS Compliance for verification.”
Opening an Appeal
The normal income tax examination involving less than $25,000 in tax can be appealed with a simple letter stating what issues you don’t agree with, and why, and requesting Appeals consideration.
If your tax controversy exceeds $25,000, or involves issues other than the normal income tax examination (retirement plan issues, partnerships, S Corporations, appeals of liens, levies, seizures, or installment agreements) you will need to file a formal “Protest” of Internal Revenue Service’s decision or action. A formal Protest is simply a letter identifying you, a statement that you want to appeal IRS’s findings to the Appeals Office, a copy of the notice of the IRS findings, the time periods involved, a list of the changes you don’t agree with, a statement of the facts that support your position, and a statement of the law that supports your position. The protest must be signed under penalties of perjury.
Mission Statement
Internal Revenue Service states the mission of the Appeals Office as follows:
“The Appeals Mission is to resolve tax controversies, without litigation, on a basis which is fair and impartial to both the Government and the taxpayer and in a manner that will enhance voluntary compliance and public confidence in the integrity and efficiency of the Service.”
Resolution of tax controversies, “on a basis which is fair and impartial” claims to be a place where you can receive “justice” in the tax system. You would assume that, in a “fair and impartial” system, if you had a better argument than IRS on a tax issue, IRS would back down and concede the issue. It doesn’t work out that way. The Appeals Officer, rather, is working for Internal Revenue Service. The Appeals Officer has the authority to compromise issues with taxpayers. The way in which the Appeals Officer evaluates issues is to calculate the government’s chance of winning each issue, and then offering a settlement to the taxpayer based on that chance of winning.
Hazards of Litigation
If the Appeals Office feels that you have a 60% chance of winning an issue in court, it will not concede the issue. Appeals Officers have the authority to split the issue. They may settle such an issue with the Taxpayer by having the taxpayer pay 40% of the tax IRS billed (in this example) in the examination process. This process is called taking into account the “hazards of litigation.” Examination level employees are supposed to raise all issues on which Internal Revenue Service has any chance of winning in court, and Appeals Officers are authorized to consider how strong the government’s case is.
As explained in Regulation 601.106 (f):
| “(2) RULE II. Appeals will ordinarily give serious consideration to an |
| offer to settle a tax controversy on a basis which fairly reflects the |
| relative merits of the opposing views in light of the hazards which would |
| exist if the case were litigated. However, no settlement will be made |
| based upon nuisance value of the case to either party. If the taxpayer |
| makes an unacceptable proposal of settlement under circumstances |
| indicating a good faith attempt to reach an agred disposition of the case |
| on a basis fair both to the Government and the taxpayer, the Appeals |
| official generally should give an evaluation of the case in such a manner |
| as to enable the taxpayer to ascertain the kind of settlement that would |
| be recommended for acceptance.” |
Taking the hazards of litigation into account should leave the taxpayer in a better position than if he accepted the examiner’s conclusions, where the examiner raised all issues on which Internal Revenue Service had any chance of winning. But from the taxpayer’s perspective, wouldn’t it be fairer if all cases where the taxpayer has probably interpreted the law correctly were dropped?
Correspondence Appeal?
As part of its efficiency drive, Internal Revenue Service would like to settle as many cases as possible with as little taxpayer contact as possible. Appeals are handled by correspondence, telephone or in person. If you can manage it at all, arrange an in-person conference. You will be more than a number to the Appeals Officer after you have conferred for an hour about your tax situation. You will have a better chance to explain your position, and especially to answer the Appeals Officer’s questions. You will be able to see where your arguments are not getting through, and be able to expand them.
Internal Revenue Service makes a big point of stating that interest and penalties continue while you are appealing their decisions. In point of fact, the tax audit usually doesn’t happen until all penalties have reached their maximum. Interest continues, but is calculated at a rate related to the Treasury borrowing rate, so is not severe.
The Appeals level can be skipped. If you don’t request to go to Appeals, you will receive a letter that states that you have 90 days to appeal the results of the audit to the Tax Court. Remember the examiner is supposed to raise all questions on which the government might win. The bill you get after the examination will be the highest you can possibly get in the system. Go to Appeals if you have any strong arguments, and you may get a better result.
Appeals Officers settle about 9 out of 10 cases they handle, so your chance of getting a result you can live with is pretty good.
If you skip Appeals, or if you don’t resolve your case in Appeals, you will receive a “90 day letter” which advises you that you have 90 days to appeal your case to the Tax Court. Pay attention to the due date for your filing with the Tax Court. If you miss the date, the Tax Court is deprived of jurisdiction, so you have lost your best chance to resolve your case in your favor in court.
When your case is “docketed” in Tax Court, the case is assigned to an attorney to prepare it for trial. The attorney’s job is to plan and gather evidence to present the case to the Tax Court. The attorney will gladly confer with the taxpayer, in an attempt to “narrow the issues” that the Court will have to address. The taxpayer can use this as another opportunity to resolve the case, short of going to Court, although the attorney will be working with the Appeals Officer that originally considered the case.
References:
Internal Revenue Code:
Section 7123, Appeals Dispute Resolution Procedure
Treasury Regulations:
Section 601.105, Examination of Returns and Claims for Refund, Credit or Abatement
Section 601.106, Appeals Functions
Internal Revenue Manual:
Part 4, Examining Process
Part 8, Appeals
Internal Revenue Publications:
No. 556, Examination of Returns, Appeal Rights and Claims for Refund
Federal Income Tax – Income Tax Audit
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Your tax return was selected for an income tax audit? IRS audits one tax return out of every hundred it receives. How could you be so lucky? Selection of returns for examination
Selection of Tax Returns for Audit The Internal Revenue Manual states, at 4.1.1.1-5.“The primary objective in selecting returns for examination is to promote the highest degree of voluntary compliance on the part of taxpayers.” How would returns be selected to “promote the highest degree of voluntary compliance on the part of taxpayers”? Wouldn’t a random chance have the greatest effect of keeping people honest? That is not the way returns are selected for audit. With so few returns being audited, IRS attempts to make every audit count. It wants to bring in as much revenue as possible from its audits. The most common source of tax returns selected for audit is the comparison of income shown on the return with the reports the payers have sent to IRS. Since IRS knows what it believes to be your error, it computes the increase in tax before you are even notified. These audits are usually handled by correspondence. You will not receive a letter that says “You have reported more income than we think you actually received,” as IRS’s computers are programmed to find underreporting on tax returns. (The computers couldn’t be programmed otherwise, unless all payers filed reports on all payments.) IRS records can be mistaken, and the information submitted to IRS can be erroneous. If you are notified that your tax return does not agree with records submitted to IRS, take the notice seriously, and check all the income IRS thinks you received. A second common way in which tax returns are selected for audit is by computer scores calculated for the return based on the information shown on the return. IRS has a program called the Discriminant Inventory Function System (DIF) which assigns a numerical score to every tax return based on the items shown on return and on previous returns for the same taxpayer. The DIF score is calculated to select returns where there might be errors or underreporting resulting in relatively large recoveries of tax. A self-employed person in a business that handles a lot of cash transactions, whose business does not show the sales IRS would expect, based on the expenses shown on the return, would make a good audit candidate. If the person consistently earns a small amount, but lives in an exclusive neighborhood, that might add to the DIF score. IRS does not disclose either how DIF scores are calculated, or the DIF scores of returns selected for audit. IRS also selects returns for audit based on information it collects from public records, newspapers and tips from individuals. Big Brother is watching; don’t brag about your tax exploits. IRS selects some returns for audit randomly, hoping to keep all of us honest. With a total of only 1% of tax returns audited, and large numbers accounted for by discrepancies with information submitted by third parties, and by DIF scores, there is room for very few random audits. How to avoid an audit Avoid an audit by fitting into the pack. If you have unusually large amounts of itemized deductions your chances of an audit are increased. Averages are published by IRS. Complex transactions, especially transactions that are designed to take advantage of tax loopholes increase your chances of being called in.. A self-employed person in a business that takes in a large amount of cash is more likely to be audited than a wage earner. Do you claim a large amount of charitable contributions? Have you bragged to others about a “clever” tax strategy? Claim all your legitimate deductions, but be aware that some deductions make an audit more likely. You are entitled to bring someone with you to assist you at a tax audit. The people you may bring are the persons authorized to represent taxpayers before the Internal Revenue Service—attorneys, Certified Public Accountants, enrolled agents (usually former IRS employees who have passed an exam), and the person who prepared your return. The Internal Revenue Code specifies that discussions between taxpayers and their professional advisors, attorneys, accountants or enrolled agents, are “confidential”. Confidentiality of conversations with attorneys is a tradition of long-standing, but confidentiality of communications with accountants is a new concept. How confidential are your communications with your accountant? The Internal Revenue Code provides that communications with your attorney, accountant or enrolled agent are protected as long as IRS is working on civil matters (How much tax is due?), but may have to be disclosed in criminal investigations. Why are you Nervous? What are the chances that you are going to end up owing IRS after your audit is complete? Look at the sources of how your return was selected for audit. Nearly all of the sources indicate that IRS has already determined that it is likely that you owe money: Comparison of your return with reports from payers of income; a DIF score that indicates that your return would likely yield additional tax; tips from individuals or public records that seem to contradict your declared income. A few returns are added at random, but generally you can expect that IRS has selected you because it sees some issues or feels it will find some issues that it would have a pretty good chance of winning, if they argued against you in court. You are likely to pay some money before this is over. Another reason you should be nervous is that the IRS employee you are dealing with has been told to challenge you on every issue that the government might win on, if the issue were taken to court. Examination level employees are not permitted to view your audit as a judge; their job is to spot the issues for higher-ups to settle or to argue in court. Examination level employees are the District Attorneys of the tax system. Their job is to raise the issues—someone else will decide them. The fact that examination level employees raise all issues on which the IRS has a chance of winning is not a bad thing, it is just a fact of life. If you want “justice”, you will have to appeal the audit up to a level where employees can take into account the chances of IRS winning an issue, and settling with you on that basis. The unfortunate part of raising all issues that favor the government is that, after the auditor has raised every issue the government might win, including strong issues, where IRS’s chance might be 80 or 90%, and including weak issues where IRS’s chances might be 25 or 30%, the auditor is instructed to try to get your agreement to his one-sided report. Is the auditor a judge, trying to dispense impartial justice? Absolutely not, but he tells you that he is just applying the law. Prepare, Prepare, Prepare If your return is selected for audit, prepare for the audit. It’s very easy to treat the letter from IRS as simply a notice of an appointment. Don’t do it. IRS tells you in its initial contact with you the areas it wishes to question. Take some time to try to reconstruct the figures shown in those areas. It has been months or possibly a couple of years since you completed work on the tax return being questioned. You’ve put your papers away, and it will take some time to recall the various sources of figures on the return. Put in the work. Your efforts will be justified. When you explain an item to the auditor, you will be much more convincing if you clearly recall how you arrived at the figure originally. If you have been audited on the same issues in the past two years with no changes, IRS will generally waive your audit. The audit itself is conducted informally. If it is a correspondence audit, you can gather and send any supporting documents you think would be helpful—receipts, invoices, letters you ask others to write to support your position. Send as complete an explanation as possible along with the documents. If your audit is in person, prepare the same kinds of things to bring to the audit, and you will have the added benefit of being able to talk to the auditor and explain the relevance of the documentation. If IRS disbelieves one or more deductions on the return, it is likely to disallow the deduction. If it disbelieves income figures on the return, it may contact third parties to get information to reconstruct your income. Before IRS contacts third parties about your tax return, it is supposed to notify you of its plans to do so. You are allowed to raise issues in your favor at the audit. If you forgot to deduct sales tax on a new car, bring it up. If you missed aa contribution to the Haiti earthquake victims, bring your proof. The auditor is directed to accept any new issues from the taxpayer whenever you bring them up. Conclusion of the Audit At the conclusion of the audit, the result will be either a “No Change” determination by the auditor, or suggested changes by the auditor. The suggested changes are usually in the government’s favor, for the reasons stated above: first, your return was selected because of the likelihood that there were errors in your favor, which the auditor has now uncovered, and second, the auditor is instructed to work for the government, raising its issues, not yours. The changes are reported to the taxpayer on a Statutory Notice of Deficiency (a 30 day letter). You can either agree with the auditor’s changes, or you can disagree. If you agree, you can sign your agreement on the Notice of Deficiency, and make arrangements to pay the additional tax. If you don’t agree with the results of the tax audit, there are several steps that you can take to try to get a more favorable result. First, you can ask for a conference with the auditor’s manager. The manager’s job, like the auditor’s, is to raise every issue on which Internal Revenue Service might win at trial. Neither the auditor nor the supervisor is supposed to be “fair” with the taxpayer; they are not supposed to be impartial judges. Examiners are to be the “prosecuting attorneys.” The manager is working under the same rules the auditor works under, but you do get a second look by a more experienced auditor. The manager may have more pressures to settle cases, and may offer to drop an issue if you can accept the remainder of the audit. This “Manager’s Conference” is easier to arrange and more productive after an in-person audit than after a correspondence audit. After an in-person audit you can usually arrange a face to face meeting with the auditor’s manager. After a correspondence audit you can generally only talk to the manager on the phone, a much less satisfying arrangement. Regardless of how the Manager’s Conference will be conducted, prepare for it. Prepare for the individual issues that the auditor has raised. Get additional documentation. Dig out more records. Get letters confirming your position from your employer or your doctor. This is your second chance to win arguments at the audit level—take advantage of it. The auditor’s job and his supervisor’s, is to raise every issue on which Internal Revenue Service might win at trial. Neither the auditor nor the supervisor is supposed to be “fair” with the taxpayer; they are not supposed to be impartial judges. Examiners are to be the “prosecuting attorneys.” But, of course, both the auditor and the supervisor wish to close as many cases as possible, making as few waves as possible. They will try to concede a little in order to resolve a minor issue, or occasionally they will trade issues, withdrawing one where IRS’s case is weak if the taxpayer agrees to accept an issue where IRS’s argument is stronger. You may resolve one or more issues in the Manager’s Conference, but still have more issues which were not resolved. Don’t despair. Even after the Supervisor’s Conference about 19 out of 20 cases are resolved before reaching any court. Beyond the Manager’s Conference, you can appeal the auditor’s findings to the only audit level within the IRS, the Appeals Division. See the topic “Appeal Your Tax Audit”. The Appeals Division’s job is to reduce the number of unagreed cases. Move to Appeals, and you will get several chances to improve the findings of the audit. |
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| References:
Internal Revenue Code: Section 7123, Appeals dispute resolution procedure Treasury Regulations: Section 601.105, Examination of Returns and Claims for Refund, Credit or Abatement Internal Revenue Manual: Part 4, Examining Process Internal Revenue Publications: No. 556, Examination of Returns, Appeal Rights and Claims for Refund |
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Medicare Part B Premiums – Fairness?
A separate article discusses increases in Medicare Part B Premiums due to the income levels of insureds Medicare Part B Premiums–High Income Individuals.
An interesting wrinkle in the Social Security Act protects beneficiaries from having their net monthly benefits reduced by increases in Medicare Part B premiums. This provision keeps the Medicare Part B premium assessed to Social Security recipients from being raised in years, like 2009, when there is no Cost of Living Adjustment to Social Security benefits. A second wrinkle specifies that estimated costs for 25% of Medicare Part B will be assessed against insureds, to limit the government’s contribution to 75% of costs.
About 73% of insureds are receiving Social Security benefits; these are the folks who can’t be assessed any increase in costs under the first “wrinkle” above.
Total medical costs for 2010 are expected to rise about 4% from 2009.
Under the second wrinkle above, the total increase in cost for 2010 is charged against the 27%of insureds who do not receive Social Security benefits; to cover the required costs, the premium increase for this 27% of insureds was 15%. The premiums for 25% of this 27% are paid by state welfare agencies, transferring most of the cost increase from the federal government to the state governments.
The final 2% of insureds have to pay four times the actual increase in Medicare costs to protect the other recipients from a reduction in their net benefit. This discrepancy will get worse annually as long as there is no COLA adjustment to Social Security benefits, which may be for years. How will the adjustment be made when COLA does return—will premiums be equalized, or will the medical cost increase be applied ratably to both the low and higher premiums?
Medicare insureds who do not collect Social Security benefits in 2010 are being treated unfairly, and will continue to be treated unfairly for life.
Federal Income Tax – Making Work Pay Credit
In 2009 Congress passed the “Making Work Pay Tax Credit”. This is a credit available in tax years 2009 and 2010 to taxpayers with earned income (income from jobs or from self-employment). The credit is calculated at the rate of 6.2% of earned income, until the credit reaches $400 for single taxpayers, or $800 for joint returns. The credit phases out for single taxpayers having adjusted gross income above $75,000, and joint filers with incomes above $150,000. The credit is not available to persons claimed as dependents on someone else’s income tax return, nor to non-resident aliens. The taxpayer must submit a Social Security number (not a taxpayer identification number) to claim the credit.
The 6.2% tax credit rate is exactly the rate of the employee’s portion of Social Security Tax. The $400 credit for an individual is equivalent to the employee’s share of Social Security tax on earned income of $6,450; the $800 credit allowed on joint returns is equivalent to the employee’s share of Social Security tax on $12,900. The modest amount of the credit and the relatively low “phase out” indicate that Congress was addressing the burden payroll taxes impose on low wage taxpayers.
The Making Work Pay Tax Credit was part of the American Recovery and Reinvestment Act of 2009, a part of the early 2009 stimulus package.
To get immediate buying power into the hands of consumers, Congress provided a $250 Economic Recovery Payment in early 2009 to every Social Security beneficiary (and other retirees on federal pensions) and reduced withholding from wages by amounts that hopefully approximated the tax credit. Congress was so anxious to get buying power into the hands of consumers that it reduced the withholding tax rate on pensions, even though pensions don’t qualify for the credit.
The final reckoning comparing the credit (and other tax computations) with the withheld tax occurs on the 2009 federal income tax return. Taxpayers who received the $250 Economic Recovery Payment must reduce their Making Work Pay Tax Credit by that amount.
References:
Internal Revenue Code:
Section 36A, Making Work Pay Credit
IRS Publication:
No. 4787, Catch a Break – Individual
Medicare Part B Premiums – High Income Individuals
Medicare is the government program to provide medical services generally to seniors. Medicare Part B is the part of Medicare that pays doctors and other medical service providers. Part A pays hospitals and other medical facilities. Part A is provided for everyone who has worked enough to be fully covered by Medicare. No premium payment is required from insureds. About 25% of the cost of Medicare Part B is paid by the people insured, with the government paying balance.
Seniors are not required to have coverage under Medicare Part B. If they choose not to be covered, and later wish coverage, they will have to wait for an open enrollment period, and will have to pay a premium penalty (10% of the premium for each year they were eligible but not enrolled).
For people collecting Social Security benefits, Medicare Part B premiums are deducted from the insured’s Social Security benefits. Part B premiums are generally the same for all covered persons, with the exception of those felt to be “exceptionally high income individuals.” For “exceptionally high income individuals” premiums are raised. (Technically, for exceptionally high income individuals the government subsidy is reduced.) Medicare claims that only 5% of insureds fall into this category.
Federal income tax returns are used to establish income levels for the “exceptionally high income individuals”. Adjusted Gross Income is taken from peoples tax returns with a single modification, adding tax exempt interest, yielding a figure called Modified Adjusted Gross Income. Modified Adjusted Gross Income affects the premiums for Medicare Part B as follows:
| Modified Adjusted Gross Income Table | |||
| 2010 | Single | Joint | |
| “Subsidy | Individual | Tax | Tax |
| Reduction” | Premium | Return | Return |
| 0% | 110.50 | Less than 85,000 | Less than 170,000 |
| 35% | 154.70 | 85,001–107,000 | 170,001–214,000 |
| 50% | 221.00 | 107,001–160,000 | 214,001–320,000 |
| 65% | 287.30 | 160,001–214,000 | 320,001–428,000 |
| 80% | 353.60 | 214,001 & greater | 428,000 & greater |
People who have “exceptionally high income” year after year present no problem in applying the formula to raise the premium rates—whatever year is chosen as a base year will be typical. People whose income varies, however, present a problem. If tax records are to be used, the Social Security Administration would have trouble using the Current Year’s income as the basis for adjusting monthly premium: there would be sizeable amounts due from people whose income had been higher than anticipated, especially if their income had decreased again before the amount they owed the government was calculated. Also, because of the delay in compiling income records and passing them around the government, using the income from the immediately prior year presents similar problems. For these reasons, the Social Security Administration uses income from two years previous to the current year to set its premiums. Thus the Medicare Part B premiums paid in 2010 are based on the insured’s income in the year 2008. When income records for two years previous are not available, SSA uses the third year previous to the current year.
With the two-year lag between the measurement of income and the change in Medicare Part B premiums, some situations can develop that don’t seem fair. A person who is single in the base year, but married by the current year would be an appropriate candidate for having an adjustment to the formula. Indeed, SSA does apply a different formula, using the first year previous to the current year to determine the premium when the insured has had a “life changing event.” Recognized “life changing events” are marriage, divorce, death of spouse, loss (or reduction) of employment, decreased income from income-producing property (if caused by a disaster or other event beyond your control), or reduction of benefits from a government insured pension plan. If you have a life changing event, you may ask that the first year prior to the current year (one year back) be used for calculation of your Medicare Part B premium.
If you do not have a “life changing event”, you are not entitled to request that another year be used to determine your premium regardless of the “fairness” of the situation. Even if you had a one-time event two years ago—sale of property, conversion of IRA into a Roth, bonus, taxable inheritance or other one-time source of income—your Modified Adjusted Gross Income from that year will determine your premium for the current year.
The Social Security Administration calculates Medicare Part B premiums based on income reported to it by the Internal Revenue Service. It makes no effort (and probably could not determine) whether the two year or one year (based on the “life changing event”) Modified Adjusted Gross Income should be applied. All initial premium determinations are mechanically based on the income reported two years previous to the current year. This appears to mean that all retirees’ Part B premiums will be initially set using their last working year’s income. All requests that the SSA consider using one-year-old data instead of two-year-old data are “Appeals” from initial determinations. Every senior whose working income was above the threshold for “subsidy reduction” will be required to file an appeal of an initial determination by SSA.
Seniors considering decisions which will increase their Adjusted Gross Income will wish to consider the effect of such decisions on their Medicare Part B premiums. Some of these decisions would be sale of appreciated property, including one’s home, if the gain were not sheltered, conversions of IRAs or retirement plans into Roth IRAs or other large retirement plan withdrawals.
Resources:
United States Code:
Title 42 Section 1395r
Social Security Administration Publications:
The Official U. S. Government Site for People with Medicare: WWW.Questions.medicare.gov
2010 Medicare and You Handbook, Centers for Medicare and Medicaid Services
Michigan Business Tax – Basics
The Michigan Business Tax is actually four taxes. Normal taxpayers pay both a Business Income Tax and a Modified Gross Receipts Tax. Two additional specific taxes apply to insurance companies and financial institutions. The tax on Gross Receipts is meant to reduce the cyclicality of the State’s revenue by taxing a base that does not fluctuate as much as business income. In an effort to make Michigan’s tax environment more business friendly, the Single Business Tax was repealed as part of the package to enact the Michigan Business Tax. In addition, substantial changes were made in the taxation of business real property, and the Michigan Business Tax provides substantial credits for personal property tax and many other tax credits.
The Michigan Business Tax is complex. To simplify let’s first look at a single business entity located in Michigan. We can then add complications such as combined entities and foreign businesses.
Unless our business is an insurance company or a financial institution, it will, if it is located in Michigan, be subject to the Michigan Business Tax once its receipts reach $350,000. And once subject to the tax, it will be subject to both branches of the tax, the Business Income Tax and the Modified Gross Receipts Tax.
I. Business Income Tax
The Business Income Tax is one component of the Michigan Business Tax. It is a tax on all Michigan businesses (other than insurance companies and financial institutions) of any form (proprietors, partnerships, corporations, trusts or associations).
The starting point for calculating the Business Income Tax base is Federal Taxable Income. Several adjustments are made to Federal Taxable Income, first the usual adjustments for converting federal taxable income to state taxable income—Subtract From Income: U. S. interest which is not taxable in Michigan, Add To Income: federally tax exempt interest paid by states other than Michigan, Add To Income: state taxes measured by income, Add To Income: the Michigan Business Tax, Add To Income: any Net Operating Loss deducted in calculating Federal Taxable Income, Subtract From Income: carryover losses to the extent allowed in the Michigan Business Tax (Business Tax losses can be carried over for ten years).
The Michigan Business Tax then has some more unusual adjustments. Subtract From Income: any self-employment income included in Federal Taxable Income (to equalize the tax base between corporations for whom all compensation is deductible and partnerships and proprietorships having non-deductible self-employment income), Subtract From Income: dividends and royalties received from persons other than United States persons, Add to Income: any deduction for a royalty, interest or other expense paid to a related person for use of any intangible asset, Subtract From Income: any income attributable to another entity whose business activities are subject to the separate provisions of the Michigan Business Tax that would otherwise be included with the unitary income of the taxpayer (related insurance companies and financial companies which are subject to separately calculated Michigan Business Tax). The Business Income Tax rate (before surcharge) is 4.95% of the tax base.
II. Modified Gross Receipts Tax
The starting point for calculating the Modified Gross Receipts tax base is Gross Receipts, which is total sales plus all other receipts of the company in the year in question—interest income, dividend income, sales of business assets, freight charges, miscellaneous income, service income and any other receipts. (Personal investments of a natural person are excluded, including interest, dividends and capital gains.) The major modification of Gross Receipts to reach Modified Gross Receipts is the deduction of purchases from other firms. Deductible Purchases include purchases of inventory (including shipping and delivery), purchases of depreciable assets, purchases of materials and supplies including repair parts and fuel, for a staffing company the compensation of personnel supplied to customers, and for most construction contractors, payments to subcontractors.
The Modified Gross Receipts Tax is imposed on the Modified Gross Receipts Tax base at the rate of 0.8% before the surcharge.
The Michigan Business Tax is the sum of the Business Income Tax and the Modified Gross Receipts Tax.
III. Surcharge
Michigan’s legislature had no sooner finished drafting the Michigan Business Tax than the State determined that it was going to be short an additional $750,000,000 in the 2008 fiscal year. The first attempted solution was to extend the sales tax, which applies to the sale of tangible personal property, to services. This solution did not sit well with voters, and the legislature repealed the sales tax extension on the very day it was to go into effect. To replace the needed revenue, the legislature determined to extend the just drafted Michigan Business Tax. A surcharge was added to each component of the Michigan Business Tax.
The legislature determined to apply a surcharge of 21.99% to both components of the Michigan Business Tax, raising the effective rate of the Business Income Tax to 6.0385%, and the effective rate of the Modified Gross Receipts Tax to 0.976%. The maximum surcharge was set at $6,000,000. Taxpayers qualifying for the Small Business Alternative Credit (Gross Receipts of less than $20,000,000, and no officer or shareholder earnings in excess of $180,000) are exempt from the surcharge. Some credits that are provided against the Michigan Business Tax are not allowed to offset the tax surcharge.
IV. Returns
The annual Michigan Business Tax return is filed on Form 4567—MBT Annual Return, or on Form 4583—MBT Simplified Return. Annual returns are due at the end of the fourth month following the end of the taxpayer’s fiscal year. Estimated tax returns are due on Form 4548—Michigan Business Tax Quarterly Return, due 15 days after the end of each quarter, or on Form 160—Combined Return for Michigan Taxes, due 20 days after the end of each month, if the taxpayer is also liable to pay either sales and use tax or withheld Michigan income tax. The Michigan Department of Treasury requires that all Michigan Business Tax returns prepared on commercial software be filed electronically.
V. Segue
The above is an introduction to the Michigan Business Tax. There are many other important elements to the tax. Any companies related to each other must be familiar with the Unitary filing requirement. Anyone based outside of Michigan must be familiar with the requirements for what sort of connection to Michigan one must have to be subject to the tax (Nexus). There are many credits under the Michigan Business Tax, some to reduce other business taxes to make Michigan more business friendly, some to ease the burden for some types of businesses, and some to encourage certain investments or contributions.
References:
Michigan Compiled Laws:
Section 208.1101 et. seq.—Michigan Business Tax Act
Michigan Business Tax Forms:
Form 4600—Michigan Department of Treasury, Michigan Business Tax Instruction Booklet for Standard Taxpayers