What is the value of a piece of art that cannot be sold? In the case of "Canyon" by artist Robert Rauschenberg, the IRS claims it is worth $65 million. They also want to tax the heirs who now own the artwork over $29 million.
Last week I had the privilege of appearing on Fox News to discuss the dilemma that taxpayers can face when estate planning basics are overlooked. Click on the image below to watch.
All personal and business assets are subject to an estate tax based on fair market value at the date of death. In this case, deceased art owner Ileana Sonnabend knew that the Canyon artwork she held could not be sold because it prominently features a bald eagle. She had acquired a special permit to continue owning the artwork, but failed to transfer it out of her estate through a charitable donation prior to her death.
Read the New York Times Coverage
Here is an excerpt from a New York Times article on the story.
Because the work, a sculptural combine, includes a stuffed bald eagle, a bird under federal protection, the heirs would be committing a felony if they ever tried to sell it. So their appraisers have valued the work at zero.
But the Internal Revenue Service takes a different view. It has appraised "Canyon" at $65 million and is demanding that the owners pay $29.2 million in taxes.
"It’s hard for me to see how this could be valued this way because it’s illegal to sell it," said Patti S. Spencer, a lawyer who specializes in trusts and estates but has no role in the case.
The family is now challenging the judgment in tax court and its lawyers are negotiating with the I.R.S. in the hope of finding a resolution.
With the November elections approaching, there is much political talk (I could call it something else, but I am writing for a family newspaper) about the income tax. Candidates and commentators throw around revenue projections, tax rates, and statistics like so much confetti. I am not sure they know what they are talking about, but I want to make sure you do. Here are definitions of some commonly used terms.
Average Tax Rate – The rate a taxpayer would be taxed at if taxing was done at a constant rate, instead of progressively. It is calculated by dividing the total tax paid by income.
For example, the first two tax brackets for single persons in 2011 are 10% for everything up to $8,500, then 15% for everything between $8,500 and $34,500. Adjusted Gross Income (AGI) is the number at the bottom of page one and top of page two of the 1040 form. Taxable income is AGI minus deductions and exemptions. If taxable income is $20,000, then the tax is $850 (10% of the first $8,500) plus $1,875 (15% of the next $12,500) for a total of $2,750. What is the average rate? The total tax of $2,750 is divided by total taxable income of $20,000 which gives an average tax rate of 13.75%.
While this example is clear, it is not at all clear what number should be used here as "income." Is it the AGI? Is it taxable income, which would drive the Average Tax Rate up? Is it adjusted gross income plus tax-exempt interest, non-taxable social security, and other non-taxable items which would drive the Average Tax Rate down? What is total tax? Intuition dictates it is the tax due on the 1040, but some analysts add all other taxes paid (see the Debbie Bosanek example below), driving the Average Tax Rate up. When commentators and politicians throw average tax rates around, it is impossible to know if they are comparing apples to oranges because the calculation of the average rate is not made consistently. Beware.
Effective Tax Rate – This term is not used consistently. Some use it to mean exactly the same this as Average Tax Rate. Others use it to describe the amount of tax a taxpayer pays when all other government tax offsets or payments are applied, divided by total income. For example, the Congressional Budget Office refers to an effective federal tax rate on individuals which includes all benefits received including things like health care and food stamps, and all four of the major federal taxes – individual and corporate income taxes, payroll taxes (social security medicare, etc.) and excise taxes (like cigarette tax).
Marginal Tax Rate — The amount of tax paid on an additional dollar of income. The marginal tax rate for an individual will increase as income rises and higher brackets are passed into. In the above example, lets assume taxpayer made $12,000. What is his marginal rate? He has passed through the $8,500 bracket and the next $3,500 of income is taxes at 15%. If he makes another $1 of income, it will be taxed at 15%. The taxpayer’s marginal rate is 15%.
Have you heard people saying they don’t want to be in a higher tax bracket because they will pay more tax? This statement is based on a misunderstanding.
Lets look back at our example taxpayer. If he makes $20,000, his marginal rate is 15% and he is in the 15% bracket. It is important to understand that just because he is in the 15% bracket, that does not mean that all of his income is taxed at 15%. It just means that the next dollar earned will be taxed at that rate. Going in to a higher tax bracket does not raise the tax on all of the income below that bracket. Moving into a higher tax bracket is usually not a "big deal" although many folks talk about it as if it is a tax disaster. It is a complete myth that going into a higher tax bracket costs you money. A progressive tax system only imposes the highest rates of tax on the incremental dollars over the top of the last bracket.
There has been much talk about the Buffett rule. Warren Buffet pointed out that his secretary, Debbie Bosanek, pays a higher rate than he does. ABC reported Bosanek’s tax rate as 35.8% in payroll and income taxes (higher than even the top income tax rate), while Buffet’s is 17.4%. They are talking about the average rate, that is, total tax divided by total income. We don’t know the details but we can surmise that most of Buffet’s income comes from capital gains and qualified dividends, both taxed at a maximum rate of 15% while the secretary’s income is taxed at ordinary income tax rate and his numbers include her payroll taxes, both employee and employer. There are lots of other factors, too, like charitable deductions, that we really can’t quantify without seeing the actual tax returns.
Last Monday, the Senate blocked a vote on the Fair Share tax – referred to as the Buffet rule. The Fair Share tax would have required people with income offer $2 million to pay at least 30% in income tax. It didn’t pass and spawned a whole raft of articles, talk shows, and blog posts – all throwing around average, effective, and marginal rate lingo – often incorrectly.
The Bush tax cuts expire at the end of this year. You can expect to hear a lot about brackets, rates, and income from the lame-duck Congress in the seven weeks between the November 6 election and the end of the year. What will be the state of the economy and who will win control of the House, Senate and White House? No predictions here. My crystal ball is broken.
A patent is an exclusive right granted by the government to an inventor for a limited period of time in exchange for public disclosure of the invention. A patent application must include one or more claims defining the invention which must be novel and non-obvious. The exclusive right that is given with the granting of a patent is the right to prevent others from making, using, selling, or distributing the patented invention without permission or a license.Error! Hyperlink reference not valid. In general, the right to exclusivity is granted for 20 years.
The policy behind the system of granting patents is to 1) encourage inventions; 2) provide for disclosure of the invention to the public; 3) provide an incentive to invest the time, energy, and money to experiment and then to produce and market the invention; and 4) to improve upon earlier patents.
Relatively new on the scene is the tax patent. A tax patent is a business method patent that discloses and claims a system or method for reducing or deferring taxes. They are also known as "tax planning patents", "tax strategy patents", and "tax shelter patents". In 1998, the Circuit Court of Appeals held in State St. Bank & Trust v. Signature Fin. Group that tax strategies were patentable. Since 1998, 160 patents on tax strategies have been granted. Patents have been granted on charitable giving techniques, real estate transactions, retirement planning and stock options among others.
The granting of tax patents has been a controversial subject. Opponents to tax patents say that they are "government-issued barbed wire" that prevents some taxpayers from getting equal treatment under the tax law. These would be the taxpayers who can’t use certain tax strategies because the strategies have been granted exclusively to the patent holders.
The American Institute of Certified Public Accountants (AICPA) has been very critical of tax patents. Their position is that no one should have a monopoly over any part of the tax code and all Americans should be free to use any legally permissible means to comply with the law. Taxpayers should not be required to pay royalties or be subject to litigation for patent infringement just for paying their taxes.
The AICPA says that tax patents 1) limit the ability of taxpayers to fully utilize interpretations of tax law intended by Congress; 2) cause some taxpayers to pay more tax than Congress intended and may cause other taxpayers to pay more tax than others similarly situated; 3) complicate the provision of tax advice by professionals; 4) hinder compliance by taxpayers; 5) mislead taxpayers into believing that a patented strategy is valid under the tax law; and 6) preclude tax professionals from challenging the validity of tax strategy patents.
The idea of patenting tax planning techniques has caused much consternation. At a meeting of the American Bar Association, an estate planning technique using a Grantor Retained Annuity Trust (GRAT) to hold stock options was discussed. Many of the attendees received letters subsequently stating that the method under discussion had been patented – the Stock Option Grantor Retained Annuity Trust patent (“SOGRAT”) – and that taxpayers who had set up such an entity would have to pay a royalty or face suits for patent infringement.
Many of the attendees thought the technique was obvious, and many had frequently set up GRATs with various assets including stock options. With the advent of tax patents, before recommending any strategy does the lawyer have to do due diligence and search to see if the strategy was patented so as not to inadvertently violate the patent and subject himself and his client to liability for patent infringement?
In September 2011, President Barack Obama signed legislation passed by the U.S. Congress that effectively prohibits the granting of tax patents in general. The Leahy-Smith America Invents Act stops the granting of patents on tax strategies. Under the new law any “strategy for reducing, avoiding, or deferring tax liability” is deemed to be “prior art” under patent law, and, therefore not patentable. Existing tax patents were not affected by the new law and remain intact. However, tax patents in pending applications were deemed prior art under the new law and nonpatentable..
Since there are still existing tax patents, tax advisors and practitioners should know what techniques have been patented so as not to violate any patents thereby subjecting their clients and themselves to liability.
The Act specifically does not stop the granting of patents to tax preparation software and other software, and explicitly excludes the patenting of any “method, apparatus, technology, computer program product, or system, that is used solely for preparing a tax or information return or other tax filing” or that is “used solely for financial management, to the extent that it is severable from any tax strategy or does not limit the use of any tax strategy by any taxpayer or tax advisor.”
The Department of Justice, the Internal Revenue Service, and Congress have all identified "offshore tax evasion" as a primary enforcement target. The success of the enforcement effort so far has energized government efforts in these cases.
If you are an American taxpayer with an offshore account that you thought was secret, you have very little time to bring it into compliance. We are now in the second amnesty for unreported foreign income. The first amnesty was in 2009. In February 2011, the IRS announced a second amnesty for taxpayers with unreported foreign assets. It is called the 2011 Offshore Voluntary Disclosure Initiative – OVDI. The objective is to bring taxpayers who have used undisclosed foreign accounts and undisclosed foreign entities to avoid or evade tax into compliance with U. S. tax laws.
This is the last amnesty. You will not get another chance. If you have unreported foreign accounts and/or unreported foreign income, after August 31, 2011 you will no longer be able to come forward under the amnesty. There is not much time left. The disclosure and its related amended return filings and payment of taxes, interest and penalty must be completed before August 31, 2011. Once the IRS gets your name from other sources, it is too late.
Foreign banks have boots (wingtips) on the ground in the U.S. selling accounts and services. The U.S. is threatening to expel them if the foreign banks resist cooperating with the IRS. This new "cooperation" is why there will not be a third amnesty program and why the second is less generous than the first.
Taxpayers are strongly advised to bring unreported foreign income and accounts into tax compliance to avoid discovery by the IRS, higher penalties, and criminal prosecution.
If you have unreported foreign income in any amount (there are no exceptions, a small amount of unreported income is still a violation) you have three choices:
(1) Do nothing and hope you don’t get caught. I definitely do not recommend this. The government now has TIEs (Tax Information Exchange Agreements), MLATs (Mutual Legal Assistance Treaties), John Doe summonses (like those used against UBS in Switzerland and HSBC in India) and a vast collection of information from the more than 20,000 voluntary disclosures already made. The new Foreign Account Tax Compliance Act (FATCA) also creates new reporting requirements for U.S. taxpayers and foreign financial institutions. If you do nothing, keep this in mind: "He who places head in sand, will get kicked in the butt.’
(2) Make a "quiet disclosure." Some U.S. taxpayers with undeclared foreign accounts are hoping to "sneak through" by amending their returns and paying taxes on unreported income from foreign accounts. This is what is referred to as a "quiet disclosure". This is not recommended. The IRS has made it clear that these returns have a high chance of being audited. It is also well known that so-called quiet disclosures have resulted in criminal prosecutions. The IRS is targeting amended tax returns reporting increases in income. Even though tax returns are amended and taxes paid, foreign account holders will still face penalties and criminal charges.
There are other problems with a "quiet disclosure". It only addresses payment of taxes and interest, not penalties. It does not address the issue of failure to file the Report of Foreign Bank and Financial Accounts (FBAR) disclosing the foreign account. If the foreign account was in the name of a foreign trust, then an IRS Form 3520 was probably due also.
(3) The third choice, and the recommended course, is for a taxpayer with noncompliant foreign accounts to enter the Offshore Voluntary Disclosure Initiative – OVDI. In order to participate in the 2011 OVDI, taxpayers must resolve any non-compliance within an eight year period, from 2003-2010. All filings and payments must be complete by August 31, 2011.
Taxpayers have to pay: 1) income tax deficiencies during the eight year period 2003-2010; 2) interest on the deficiencies; 3) a 25% penalty on the highest aggregate balance held within foreign accounts during the eight year period. For smaller foreign holdings not exceeding $75,000, the penalty will be reduced to 12.5%. ; 4) accuracy-related penalties of 20% of the back taxes; and 5) if applicable, 25% of back taxes for failure to timely file a return or pay tax shown on a filed return.
Taxpayers who participate in the OVDI will generally avoid 1) criminal prosecution; 2) civil and criminal penalties for failure to file FBARs; and 3) any taxes, interest, and penalties prior to 2003.
While the OVDI fines and penalties are significant, they pale compared to the consequences of an IRS criminal prosecution and imposition of all penalties for non-reporting.
If you are entering the OVDI or planning a quiet disclosure it is a very serious matter with potentially life altering repercussions. Don’t rely on the internet for your advice. Make sure you get a competent tax lawyer with experience in the amnesty program.
An offer in compromise (OIC) is an agreement between a taxpayer and the Internal Revenue Service that settles the taxpayer’s tax liabilities for less than the full amount owed. Don’t get too excited – it is not that easy. Unless there are special circumstances, an offer in compromise will not be accepted if the IRS believes that the taxpayer can pay the liability in full either as a lump sum or through a payment agreement.
In most cases, the IRS will not accept an OIC unless the amount offered by the taxpayer is equal to or greater than the reasonable collection potential (RCP). The RCP is how the IRS measures the taxpayer’s ability to pay and includes the value that can be realized from the taxpayer’s assets, such as real property, automobiles, bank accounts, and other property. The RCP also includes anticipated future income, less certain amounts allowed for basic living expenses.
There are three grounds for acceptance of an OIC: 1) doubt as to collectibility, 2) doubt as to liability, and 3) effective tax administration.
Doubt as to collectibility applies when it appears unlikely that the taxpayer can pay all that is due within the statutory period for collection. Doubt as to liability exists when there is legitimate doubt about the correctness of the assessment. The examining agent may have made a mistake, or there could be an argument over interpretation, or perhaps the taxpayer has come up with new evidence. Effective tax administration exists when the taxpayer can demonstrate that the collection of the tax would create an economic hardship or would be unfair or inequitable.
Don’t think that an OIC is a way to make a deal with the IRS to split the difference. It’s not that kind of compromise. It is based on a formula to determine what the taxpayer can pay from what they owe and what they earn (the reasonable collection potential). Offers less than that amount are typically not accepted. The rules for application of the formula are very complicated. The taxpayer must present a complete financial picture to the IRS, detailing assets and liabilities, income and expenses.
An OIC is not for everyone. It actually prevents taxpayers from disputing the underlying liability at appeals or in tax court. Negotiating an installment plan that is a realistic payment plan may be a better alternative for the taxpayer. An installment plan works much like any installment loan. Those who are struggling financially catch up on their tax debt by making smaller payments over a period of time. While this may translate to paying more in total (because of interest rates and penalty charges), it’s often a workable alternative.
An OIC is a lengthy and time-consuming process. Only about 15% of applicants actually reduce their debt through the OIC program. Because the filing and process are complex, it is highly recommended that you get professional advice in preparing and negotiating the offer. You need a tax attorney, a CPA, or an Enrolled Agent. Make sure you find someone with experience in IRS collection matters. A professional can help maximize the possibility that the OIC is accepted and the tax debt is minimized.
Beware of scams where promoters claim that tax debts can be settled for "pennies on the dollar." You’ve probably seen them on late-night TV. These scammers collect high fees and then don’t deliver on the promise – because they can’t in most cases. Some preparers collect fees but then fill out and file a form but provide no backup documentation and do not negotiate with the IRS. This is a waste of time and money. If the advertising refers to a "tax settlement specialist", run the other way.
An OIC is made on Form 656. There is a $150 application fee that must accompany the form. You cannot file an OIC if you are in bankruptcy. A taxpayer filing a lump-sum offer must pay 20 percent of the offer amount with the application. A lump-sum offer means any offer of payments made in five or fewer installments. A taxpayer filing a periodic-payment offer must pay the first proposed installment payment with the application and pay additional installments while the IRS is evaluating the offer. A periodic-payment offer means any offer of payments made in six or more installments.
In February 2011, the IRS announced a second voluntary disclosure program for taxpayers with unreported foreign assets. It is called the 2011 Offshore Voluntary Disclosure Initiative – OVDI. The objective is to bring taxpayers who have used undisclosed foreign accounts and undisclosed foreign entities to avoid or evade tax into compliance with U. S. tax laws.
In announcing the 2011 OVDI, IRS Commissioner Douglas H. Shulman stated, "The situation will just get worse in the months ahead for those hiding assets and income offshore. The new disclosure program is the last, best chance for people to get back into the system. It gives people a chance to come in before we find them."
In 2009 the IRS offered a similar amnesty program for taxpayers not reporting income from foreign accounts. That program brought in 15,000 disclosures prior to its October 15, 2009 deadline.
It is not illegal to have a foreign account. What is illegal is 1) failing to disclose the accounts and 2) failing to report the income and pay income tax on income earned on the foreign assets. In addition to disclosing the existence of the accounts on your 1040 and reporting the income, Foreign Bank Account Reports ("FBARs") must be filed by any U.S. taxpayer who has signatory or other authority over a foreign account or accounts that have a combined value of more than $10,000 at any time during the calendar year.
In order to participate in the new 2011 OVDI, taxpayers must resolve any non-compliance within an eight year period, from 2003-2010. The deadline is August 31, 2011.
Taxpayers will have to pay: 1) income tax deficiencies during the eight year period; 2) interest on the deficiencies; 3) a 25% penalty on the highest aggregate balance held within foreign accounts during the eight year period; 4) accuracy-related penalties of 20% of the back taxes; and 5) if applicable, 25% of back taxes for failure to timely file a return or pay tax shown on a filed return.
For smaller holdings of not more than $75,000, the penalty will be reduced to 12.5%. The rate could be reduced to 5% if the taxpayer did not know he or she was a U.S. citizen (mostly children born in the U.S. to foreign parents and now living in the foreign jurisdiction) or if the account was inherited.
Taxpayers who participate in the OVDI will generally avoid 1) criminal prosecution; 2) civil and criminal penalties for failure to file a Report of Foreign Bank and Financial Accounts (FBARs); and 3) any taxes, interest, and penalties prior to 2003. The IRS policy on voluntary disclosures is that when a taxpayer truthfully, timely, and completely complies with all provisions of the voluntary disclosure practice, the IRS will not recommend criminal prosecution to the Department of Justice.
If the IRS has initiated an examination, regardless of whether it relates to undisclosed foreign accounts or undisclosed foreign entities, the taxpayer will not be eligible to participate in the 2011 OVDI. Taxpayers under criminal investigation are also ineligible. Disclosures involving illegal source income will not be accepted.
Some taxpayers have attempted so-called ‘quiet’ disclosures by filing amended returns and paying additional taxes and interest. The IRS is currently reviewing amended returns that show an increase in income and selecting returns for audit. Individuals who are singled out for audit are not eligible to participate in the OVDI. Individuals who have filed quietly and have not yet been audited may make an application to participate in the OVDI.
Possible criminal charges related to tax returns include tax evasion, filing a false return and failure to file an income tax return. Willfully failing to file an FBAR and willfully filing a false FBAR are both violations that are subject to criminal penalties.
A person convicted of tax evasion is subject to a prison term of up to five years and a fine of up to $250,000. Filing a false return subjects a person to a prison term of up to three years and a fine of up to $250,000. A person who fails to file a tax return is subject to a prison term of up to one year and a fine of up to $100,000. Failing to file an FBAR subjects a person to a prison term of up to ten years and criminal penalties of up to $500,000.
Warning for Tax Professionals:
It is the IRS position that it is a violation of Circular 230 to represent a taxpayer on a prospective basis if such taxpayer has noncompliance that the taxpayer elects not to resolve through a voluntary disclosure: "[a] practitioner whose client declines to make full disclosure of the existence of, or any taxable income from, a foreign financial account, may not prepare a current or future income tax return for that taxpayer without being in violation of Circular 230."
On January 31, 2010, Jackson Hewitt Tax Service filed a lawsuit against H&R Block (Jackson Hewitt Inc. v. H&R Block Tax Services LLC) to stop a new advertising campaign. The complaint is that H&R Block’s "Second Look" marketing campaign is deceiving customers and diverting business away from Jackson Hewitt. They claim that H&R Block has been disparaging Jackson Hewitt’s reputation and goodwill in the marketplace. The lawsuit also claims that H&R Block misleads customers about refund anticipation loans (RALs). The lawsuit is Jackson Hewitt Inc v. H&R Block Tax Services LLC, U.S. District Court, Southern District of New York, No. 11-00641.
H&R Block’s ad campaign claims it found errors in 2 out of 3 returns prepared by other commercial tax preparers when the returns were reviewed by Block. The reviews in question are H&R Block’s "Second Look Review" service. For $29, Block will review returns prepared by other companies, to see if anyone missed anything. Jackson Hewitt in the complaint states: "H&R Block’s 2 out of 3 claim necessarily implies the false claim that two out of three Jackson Hewitt customers who are entitled to refunds have been short-changed due to Jackson Hewitt errors or incompetence."
Interestingly, the Block TV ad campaign never mentions Jackson Hewitt in the script- it refers to "other commercial preparers." However, there is a "fine print" disclaimer on the ad which refers to Block’s review of Jackson Hewitt prepared returns. The complaint alleges that Block has run print advertisements that say, "We found errors in 2 out of 3 Jackson Hewitt Tax Returns."
H&R Block is about five times bigger than Jackson Hewitt, which is the second largest commercial tax preparer. Jackson Hewitt said it prepared 2.53 million U.S. tax returns in 2010. H&R Block prepared 20.1 million U.S. returns in its 2010 fiscal year. H&R Block is based in Kansas City, Missouri, and Jackson Hewitt in Parsippany, New Jersey.
Speculation is that the H&R Block ad campaign is in response to their being prevented from giving out RALs. This highly profitable short term loan offered by many commercial tax return preparers has been criticized by many because of high fees and interest rates.
Taxpayers who get RALs often pay charges for the application, e-filing and a range of other costs, in addition to the bank’s finance charge. This can all add up to the equivalent of an interest rate in excess of 100% and sometimes multiples of that, according to the National Consumer Law Center. The Center reported that a $3,300 RAL carries a rate of about 72% when fees and charges are added up.
In December 2010, federal banking regulators Office of the Comptroller of the Currency informed HSBC Holdings Plc., H&R Block’s principal lender, that it must stop offering RALs.
The FDIC, which governs the bank funding Jackson Hewitt’s RALs, hasn’t made the same determination. This looks like a windfall for Jackson Hewitt whose RAL program is still going strong. Despite the government’s and financial advisors’ criticism of RALs, the public apparently still likes them. Hewitt was positioned to pick up lots of business from Block since Hewitt could offer RALs and Block couldn’t.
Block, in an attempt to aggressively market its services, began a new ad campaign. The campaign focuses on the Second Look Service. Taxpayers are urged to bring in their 2007, 2008 and 2009 returns. These returns can be amended if errors are found, and Block claims 2 out of 3 reviews result in refunds.
Jackson Hewitt’s complaint says: "H&R Block’s failure to offer a program comparable to Jackson Hewitt’s RALs has proven to be a significant disappointment to H&R Block’s prospective 2011 customers, with the result that H&R Block saw itself facing significant competitive disadvantage in competing with Jackson Hewitt as the peak tax return season approached. . . H&R Block’s response was to launch a massive promotional campaign based on false and misleading statements, designed to ‘trash’ both Jackson Hewitt and its RAL service."
Since they can’t offer RALs, H&R Block has some alternative products available for this filing season, including the Emerald card – you receive your refund on a prepaid MasterCard, and a Refund Anticipation Check (RAC) – Block gets your refund, deducts its fee and possibly your tax preparation fees and gives you either a check or a direct deposit. These are not loans. Block claims you get your refund in 8 to 15 days if you use one of these products.
This year the IRS says it expects more than 70% of returns to be filed electronically. Taxpayers can expect to get refunds in 7 to 10 days after filing. Let’s see – which is better 7 to 10 days or 8 to 15 days. Be careful out there.
Jack Hough writes for SmartMoney:
"Douglas Shulman says he uses a hired tax preparer because the U.S. tax code is so complex. That’s a bad sign. He’s the I.R.S. commissioner."
"Consider the following two sentences from different sources:
1. "[A] statute which either forbids or requires the doing of an act in terms so vague that men of common intelligence must necessarily guess at its meaning and differ as to its application, violates the first essential of due process of law."
2. For purposes of paragraph (3), an organization described in paragraph (2) shall be deemed to include an organization described in section 501(c)(4), (5), or (6) which would be described in paragraph (2) if it were an organization described in section 501(c)(3).
The first sentence comes from a 1926 Supreme Court decision that helped establish the right of citizens to known what laws mean. The second comes from the tax code."
The biggest changes from the 2010 Tax Relief Act that became law on December 17, 2010 were outlined in last week’s column: extension of the Bush individual and capital gains tax cuts for two years, a one-year payroll tax cut, a top federal estate tax rate of 35% and a $5 million exemption for the estate, gift, and generation-skipping tax. But wait, there’s more:
Adoption and Childcare Provisions
Taxpayers who adopt children can receive a tax credit for qualified adoption expenses. A taxpayer may also exclude from income adoption expenses paid by an employer. The credit and the exclusion from income were both previously raised to $10,000 (both for non-special needs adoptions and special needs adoptions and subject to inflation) and would have expired in 2011, but they are now extended through 2012.
The Patient Protection and Affordable Care Act (PPACA) passed in March 2010 increased the credit and exclusion by another $1,000 to $13,170 for 2010 and 2011 and the new act made the credit refundable for 2010 and 2011.
Existing law provided employers with a credit equal to 25% of qualified expenses for acquiring, constructing, rehabilitating or expanding property which is used for a child care facility. There is an additional 10% credit for child care resource and referral services. The credit is capped at $150,000. The new law extends the credit through 2012.
Expensing Versus Depreciation under Section 179
Under prior law, a taxpayer may elect to deduct the cost of certain property placed in service for the year rather than depreciate those costs over time. The 2010 Small Business Jobs Act increased the dollar and investment limits for the maximum amount that can be deducted as an expense to $500,000 and $2 million, respectively, for 2010 and 2011. The 2010 Tax Relief Act provides for a $125,000 dollar limit and a $500,000 investment limit for 2012.
Energy-efficient new homes credit. The new law extends the credit for manufacturers of energy-efficient residential homes purchased before January 1, 2012.
Energy-efficient appliances. The new law extends through 2011 and modifies standards for the credit for US-based manufacturers of energy-efficient clothes washers, dishwashers and refrigerators.
Energy-efficient existing homes. The bill extends through 2011 the credit for energy-efficient improvements to existing homes, reinstating the credit as it existed before passage of the American Recovery and Reinvestment Act. Standards for property credit eligibility are updated to reflect improvements in energy efficiency.
Refund and tax credit disregard for means-tested programs.
The expiring law provided that the refundable components of the Earned Income Tax Credit and the Child Tax Credit do not make households ineligible for means-tested benefit programs. The new law extends these exclusions from income for purposes of means-tested programs through 2012.
Barring a technical correction, the requirement that GRATS be for a minimum term of ten years was not included. A GRAT is a special grantor trust that people use to transfer assets that are expected to increase greatly in value in a short period of time. To the extent that the appreciation outpaces inflation, leverage is gained in transferring the assets via trust at the end of a two year term. The donor gets the original funding back in an annuity plus two years of normal interest as it exists at the time of transfer, and the beneficiaries get the rest. The shorter the term of the trust, the better the leverage.
Also not included was "portability" of the Generation Skipping Transfer Tax (GSTT) exemption. Taxable transfers to beneficiaries two or more generations younger than the donor get not only the gift (or estate) tax burden, but also a second tax slice taken at the highest estate tax rate, which will be 35%. This is a heavy tax burden on such a transfer, but everyone has an exclusion amount (free pass, so to speak) of whatever is the current Estate tax exclusion amount. The Estate Tax exemption is now "portable", with the surviving spouse being eligible to use the deceased spouse’s unused exclusion amount. But, there is no such portability for the Generation Skipping Transfer Tax. If there will be a large transfer to second-generation beneficiaries in an estate plan, either directly or just in case the first generation doesn’t survive their parents, pre-death estate planning is the only way to use both parents’ full GSTT exclusion.
What Was Not in the Bill
Coverdell Accounts are tax-exempt savings accounts for paying education expenses of a beneficiary. The allowable contribution had been raised from $500 to $2,000 and elementary and secondary education expenses were included in 2001. Those changes will now be continued through 2012.
Exclusion of up to $5,250 from income and employment taxation for employer-provided education assistance is extended through 2012.
Student loan interest deduction up to $2,500 per year is allowed. The 2001 law eliminated the 60-month limit on deductions and raised the phase-out income range beginning at $55,000 AGI (the bottom number on page one of your 1040) for single filers and $110,000 for joint filers. These 2001 improvements are continued through 2012.
The American Opportunity tax credit is available for up to $2,500 of the cost of tuition and related expenses that are actually paid. All of the first $2,000 may be taken as a credit, and 25% of the next $2,000 may be taken. Phase out of the credit begins at an AGI of $80,000 for single filers, $160,000 for joint filers. This credit is now extended through 2012.
The new tax legislation passed by the House, December 15, and the Senate, December 16, (not to mention signed by the President) is referred to as a tax cut. That’s a misnomer. In fact, the legislation keeps taxes where they are. It prevents taxes from increasing. But a cut? No, not exactly.
Here are some highlights:
Estate and Gift Tax
In 2009, each person had an exclusion amount of $3.5 million they could pass on to their heirs free of federal estate tax and the tax rate on amounts over $3,500,000 was 45%. In 2010 there was no estate tax. With the new legislation, each person has a $5 million exemption, and the tax rate on amounts over $5 million is 35%. If the first spouse to die does not use all of his or her exempt amount, the unused exemption can be added on to the surviving spouse’s exempt amount. This feature is called "portability."
Before anyone starts figuring out how to chain together five or six deceased spouses’ excess exclusion amounts, know this. A surviving spouse may only use the excess exemption amount of his or her last spouse to die. Consider Herman’s Hermit’s ditty about a man named Henry marrying the widow next door who had married seven previous Henrys. If Henry VII just passed away, and the fair widow had $4 million in excess exclusion amount from Henry VI, that $4 million is gone with the death of Henry VII, to be replaced, with the excess amount, if any, from Henry VII. Also consider that if Henry VII’s Executor refuses to elect to assign the excess amount to the fair widow, she gets no excess amount from Henry VII and Henry VI’s excess exclusion amount is still eliminated.
The changes are retroactive to the beginning of 2010, and carryover basis is repealed. However, for estates of 2010 decedents; executors will have an election. They may choose to have the law apply as it was in 2010 without the change made by this legislation. In general, executors of 2010 estates larger than $ 5 million will have to decide whether to pay no estate tax and use carryover basis, or to pay estate tax and get a basis step-up. There is an extension of time to make the election, pay estate tax and file returns of 9 months after enactment. The extension also applies to ancillary planning matters such as disclaimers.
In the new law, the gift tax and the estate tax are "re-unified." The gift tax exemption is $5 million, the same as the estate tax exemption. (There is one $ 5 million exemption which can be used for making life-time gifts or for death-time transfers.) In 2010, the gift tax exemption was $1 million. The annual exclusion from the gift tax for present interest gifts remains at $13,000 per donee.
Generation-Skipping Transfer Tax
The Generation Skipping Transfer Tax (GSTT) is levied on transfers to recipients two or more generations below the donor. The exempt amount for the GSTT is the same as the Estate Tax at the time of the transfer, so for the next two years it will be $5 million. While the estate tax exemption is "portable", the GSTT exemption is not.
• The lowest bracket, 10%, is continued through 2012, rather than reverting to the 15% level. The 10% bracket applies to individuals making up to $8,500 and couples making up to $17,000.
• The 25%, 28%, 33% and 35% brackets would have increased 3%, but now they’ll remain through 2012.
• Phasing out of the personal exemption for those with higher adjusted gross income (AGI, the number at the bottom of page one of the 1040) was repealed for 2010 and now will continue to be repealed for two more years.
• Phasing out of itemized deductions for those with higher AGI was repealed for 2010 and now will continue to be repealed for two more years.
• The Alternative Minimum Tax (AMT) threshold for 2011 is $48,450 for single filers and $74,450 for joint filers.
• Long term capital gains and dividends have been taxed at 0% for those in the 15% tax bracket and at 15% for those above that bracket. This favorable treatment is extended for two more years.
• Child care credit for low income earners with children under 17 had been raised from $500 to $1,000. This increase is extended through 2012.
• The marriage penalty relief for the standard deduction, the 15% tax bracket and the Earned Income Tax Credit (EITC) has been extended through 2012.
• The dependent care credit for those with children under 13 and disabled dependents is $3,000 for one child and $6,000 for two children, and those levels have been extended through 2012.
• EITC for families with three or more children is 45% of the couple’s first $12,570 of AGI, with a phase-out that begins at a higher amount. The new law extends the three child credit and raises the phase out point somewhat through 2012. The two-child credit remains unchanged.
• Above-the-line deductions for teachers for $250 for school supplies was renewed for 2010 and 2011.
• Itemized deductions for state and local general sales taxes in lieu of itemized deductions for state and local government income taxes was renewed through 2011.
• Tax free charitable contributions directly from IRAs up to $100,000 per taxpayer per tax year was extended through 2011. Due to the late passage of the bill, such transfers made in January 2011 may be treated as made in 2010 if the taxpayer so elects.
• The unemployment insurance section provides a one-year extension of the federal unemployment insurance benefits
• Employee-paid payroll taxes are reduced. The rate for 2011 had been 6.2% of all wages earned up to $106,800 and 12.4% for self-employed individuals. The new law reduces these rates two percentage points; 4.2% for social security and 10.4% for self-employed individuals. This change is for 2011 only.
• Additional provisions of the "tax cut" will be highlighted in next week’s entry.
Unemployment Insurance and Payroll Taxes