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Marital Dissolution Planning Post TCJA

  • Written by Sidney Kess, CPA, J.D., LL.M.

mug sid kessThe IRS reports that nearly 600,000 taxpayers claimed an alimony deduction on their 2015 returns (the most recent year for statistics) (https://www.irs.gov/pub/irs-soi/soi-a-inpd-id1703.pdf). The Tax Cuts and Jobs Act of 2017 (TCJA) (P.L. 115-97) made important changes in the tax rules for alimony. These changes have a ripple effect throughout the tax law, impacting a number of other provisions. Here are the basic rules for alimony and their impact on other tax provisions in light of TCJA.

Alimony

Currently, payments that meet the definition of “alimony” under Code Sec. 71 are deductible by the payer and includible in gross income by the recipient. There are no dollar limits on these amounts. These rules continue to apply to payments under divorce or separation agreements executed before January 1, 2019.

However, alimony will not be deductible, or includible in the recipient’s gross income, for any divorce or separation instrument executed after December 31, 2018, as well as those executed earlier but modified after 2018 expressly providing that the repeal of qualified alimony and separate maintenance rules apply. In effect, those with post-2018 divorces will see alimony treated the same as child support (i.e., nondeductible by the payer and nontaxable to the recipient).

Clearly, this tax law change will impact negotiations for alimony payments for new marital dissolutions. Those considering modifications of existing arrangements have leeway in their course of action. They can continue to apply the old rules unless they agree to have the new rules apply by expressly referencing the TCJA deduction repeal. Reasons to consider opting for TCJA treatment include changes in the income levels of the payer and/or recipient. For example, the payer may be in a lower bracket and won’t benefit greatly from a deduction, or the recipient may be in a higher bracket and prefer tax-free income.

Any modifications should take the “recapture rule” into account. This rule requires the payer to recapture (i.e., report as income) some amounts previously deducted. The rule is triggered when alimony paid in the third year of the first three-year period is more than $15,000 less than in the second year or if the alimony paid in the second and third years decreases significantly from the amount paid in the first year. This rule has not been changed by the TCJA.

It should also be noted that post-2018 decrees and agreements do not have to conform to the definition of alimony. Whereas deductible alimony payments under pre-2019 decrees and agreements must be in cash, payments to a spouse or former spouse under post-2018 decrees and agreements need not be in cash. It would seem, for example, that a transfer from a qualified retirement plan pursuant to a qualified domestic relations order (QDRO) may be used to make a lump-sum alimony payment by the payer. In the same vein, perhaps stock or realty could be used to satisfy a lump-sum alimony payment. And it would not matter whether payments end on the death of the recipient.

Child Support

The tax treatment of child support has not been changed by the TCJA. Payments are not deductible by the payer or taxable to the recipient (Code Sec. 71(c)).

Dependency exemptions. The dependency exemption applies for 2017 returns. The custodial parent can waive the dependency exemption to allow the noncustodial parent—often the person providing the child support—to claim the exemption. This waiver is made on Form 8332, Release/Revocation of Release of Claim to Exemption for Child By Custodial Parent.

The TCJA suspends the dependency exemptions for 2018 through 2025. Despite this suspension, the concept of a dependent remains viable through these years for various tax provisions (e.g., child tax credit) and should not be overlooked.

Existing divorce agreements likely have factored in the tax benefit for dependency exemptions, as well as the tax rates that the payer is subject to. In other words, one parent may have agreed to pay a certain amount with the understanding that he/she could claim an exemption for the child. For example, in 2017, the $4,050 exemption amount saves a parent in the top tax bracket more than $1,600 in taxes. If the parties renegotiate agreements after 2018 to make changes in child support, it is important to note the impact of the language on alimony (i.e., whether the parties opt for pre-2019 treatment for alimony).

Child tax credit. For purposes of the child tax credit (Code Sec. 24), which was greatly expanded, a taxpayer can claim a credit for a:

Qualifying child. The child (the taxpayer’s child, sibling, or descendant) must be under age 17 by the end of the year and not provide more than half of his/her support. Usually the child must live with the taxpayer for more than half the year but there is an exception in the case of divorce. The credit is up to $2,000; up to $1,400 can be refundable.

Qualifying dependent. This can be a qualifying relative of any age as long as he/she would qualify as a dependent under the old dependency rules (Code Sec. 152(b)) (e.g., a taxpayer’s child who is over age 17). The nonrefundable credit is up to $500.

Education. Another change by the TCJA is the ability to use up to $10,000 annually from a 529 plan to pay for elementary and secondary school. Those with agreements requiring a parent to pay out of pocket for these costs may need to be revisited.

IRAs

IRAs continue to be an asset that can be addressed in a marital dissolution. The rules have not been changed by the TCJA. Courts may direct the account owner to transfer some or all of the funds to the spouse or former spouse. The transfer is not taxable to the account owner if it’s made pursuant to a court order and done by directly transferring a fixed dollar amount or percentage of the account to the spouse’s IRA or by setting up a new IRA to which these funds are transferred. If there’s a court order but the account owner transfers funds to his/her checking account and then writes a check to the spouse, the account owner is taxable (see Kirkpatrick, TC Memo 2018-20).

A recipient of taxable alimony can count it as income for purposes of making an IRA contribution. Thus, a nonworking individual receiving alimony in 2018 can base an IRA contribution on alimony payments. In 2019, those receiving alimony under a divorce or agreement finalized before 2019 can continue to treat the taxable alimony as compensation for purposes of IRA contributions.

However, for those who receive nontaxable alimony starting in 2019, the opportunity to make IRA contributions based on alimony payments no longer exists.

Conclusion

It will be busy for matrimonial attorneys with clients who want to finalize agreements before 2019 as well as for those who may want to delay the process. There is much to consider for these individuals and their families…and taxes should be an important factor is reaching a marital dissolution.


Executive Editor Sidney Kess is CPA-attorney, speaker and author of hundreds of tax books. The AICPA established the Sidney Kess Award for Excellence in Continuing Education in his honor, best-known for lecturing to over 700,000 practitioners on tax. Kess is senior consultant for Citrin Cooperman, consulting editor to CCH and Of Counsel to Kostelanetz & Fink.

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QBI Deduction Issues for Professionals

  • Written by Sidney Kess, CPA, J.D., LL.M.

mug sid kessMost attorneys, accountants, and other professionals operate as unincorporated sole practitioners, or through partnerships and limited liability partnerships (LLPs), making them owners of pass-through entities. Such professionals may be able to cut the effective tax rate on the income from their practices through the use of the qualified business income (QBI) deduction (Code Sec. 199A). This deduction, which was created by the Tax Cuts and Jobs Act of 2017, is up to 20% of QBI, but limitations and other rules can limit or prevent any write-off. Here are some key issues related to the QBI deduction for professionals in light of recently proposed regulations (REG-107892-18, released on 8/8/18 and published in the Federal Register on 8/16/18).

Overview

The deduction under Code Sec. 199A (QBI deduction) is a personal deduction claimed on an individual’s federal income tax return. It is neither a deduction in computing an individual’s adjusted gross income, nor is it an itemized deduction. The deduction does not reduce business income. Rules on the treatment of the QBI deduction for state income tax purposes depends on each state’s tax conformity with federal income tax rules and special state-level rules. It appears that in New York and New York City, the QBI deduction is not allowed because income taxes here starts with federal adjusted gross income (which does not include the QBI deduction). However, future guidance from the New York Department of Taxation and Finance could allow the deduction to be treated as an itemized amount for state and city income tax purposes.

The QBI deduction is 20% of qualified business income for a professional with taxable income up to $315,000 on a joint return or $157,500 on any other type of return. For example, a sole practitioner who is single and has taxable income of $125,000 can claim the full 20% of QBI deduction.

When the professional’s taxable income exceeds this threshold, then two limitations come into play:

General limitation. The deduction is the lesser of (1) 20% of QBI, or (2) the greater of (a) 50% of W-2 wages (“W-2 wages”), or (b) 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of qualified property.

Limitation for specified service trades or businesses (SSTBs) (defined below). The limitation under (b) for all types of businesses applies for married filing taxpayers filing joint returns whose taxable income is over $315,000, and other taxpayers whose taxable income is over $157,500. But for SSTBs, the amount of QBI that can be taken into account phases out over the next $100,000 for joint filers or $50,000 for other filers. In effect, a practitioner (and any other individual in an SSTB) with taxable income over $415,000 on a joint return or $207,500 on another type of return cannot take any QBI deduction; all of the QBI has been phased out.

For example, the partnership’s taxable income is less than the threshold amount, but each of the partnership’s individual partners have income that exceeds the threshold amount plus $50,000 ($100,000 in the case of a joint return). As a result, none of the partners may claim a QBI deduction with respect to any income from the partnership’s SSTB.

Guaranteed payments

Qualified business income means the net amount of items of income, gain, deduction and loss attributable to the practice. Not taken into account are capital gains and losses (including Section 1231 gains), dividends, and interest income on working capital, reserves, and similar accounts (i.e., investment-type interest). However, interest income on accounts or notes receivable received is part of QBI.

QBI does not include guaranteed payments received for services performed for the practice (Code Sec. 707(c)). However, the partnership’s related expenses for making the guaranteed payments may nonetheless reduce QBI.

While guaranteed payments are not part of QBI, they do factor into the partners’ taxable income. Because taxable income limits or bars the QBI deduction, the impact of guaranteed payments needs to be taken into account.

Specified service trades or businesses

A specified service trade or business (SSTB) includes any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees; engineering and architecture are not included. Proposed regulations help to clarify what constitutes an SSTB. Here are the rules for law and accounting:

Law. This includes the provision of services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals. It does not include the provision of services that do not require skills unique to the field of law; for example, the provision of services in the field of law does not include the provision of services by printers, delivery services, or stenography services.

Accounting. This includes the provision of services by accountants, enrolled agents, return preparers, financial auditors, and similar professionals in their capacity as such. The provision of services in the field of accounting is not limited to services requiring state licensure as a certified public accountant (CPA). The field of accounting does not include payment processing and billing analysis.

Multiple activities

If professionals derive income from rentals of property to their partnerships, proposed regulations help to clarify when the income is or is not treated as an SSTB. In general, an SSBT includes any trade or business that provides 80% or more of its property or services to an SSBT if there is 50% or more common ownership (determined under Code Secs. 267(b) and 707(b)). If less than 80% is provided but there is that 50% common ownership, then that portion of the trade or business providing property or services to the commonly-owned SSTB is treated as part of the SSTB.

For example, a law firm that’s a partnership providing services to clients owns its own office building and employs administrative staff. The firm divides into three partnerships: Partnership 1 performs legal services to clients, Partnership 2 owns the building and rents it to the firm, and Partnership 3 employees the administrative staff through a contract with Partnership 1. All three partnerships are owned by the same individuals (the original firm partners). Because the common ownership test is met, all three partnerships are treated as one SSBT.

Figuring the QBI deduction

Again, the QBI deduction is applied at the professional’s level; it does not impact the practice’s income that is passed through to the owners. Thus, as stated earlier, it is the professional’s taxable income that determines the amount of the deduction. However, Schedule K-1 must report items needed by professionals to compute their deduction. More specifically, on Schedule K-1 of Form 1065, “other information” must include:

• Section 199A income (code Z)
• Section 199A W-2 wages (code AA)
• Section 199A unadjusted basis (code AB)
• Section 199A REIT dividends (code AC)
• Section 199A PTP income (code AD)

Special basis adjustments

Partnerships may make special basis adjustments under Code Sections 734(b) or 743(b). Proposed regulations provide that partnership special basis adjustments are not treated as separate qualified property (Reg. Sec. 1.199A-2(c)(1)(iii)). If the IRS had allowed the special basis adjustments to be treated as separate qualified property, then it could result in a duplication of UBIA if, for example, the fair market value of the property has not increased and its depreciable period has not ended.

Impact on self-employment tax

The QBI deduction does not reduce net earnings from self-employment for purposes of figuring self-employment tax. In effect, self-employment tax is figured as though there were no QBI deduction.

Conclusion

Some of the guidance from the proposed regulations may be changed when final regulations are released. Comments to the proposed regulations are being accepted no later than October 1, 2018. In the meantime, FAQs posted by the IRS (https://www.irs.gov/newsroom/tax-cuts-and-jobs-act-provision-11011-section-199a-deduction-for-qualified-business-income-faqs) help to clarify some of the rules for this important tax deduction.


Executive Editor Sidney Kess is CPA-attorney, speaker and author of hundreds of tax books. The AICPA established the Sidney Kess Award for Excellence in Continuing Education in his honor, best-known for lecturing to over 700,000 practitioners on tax. Kess is senior consultant for Citrin Cooperman, consulting editor to CCH and Of Counsel to Kostelanetz & Fink.

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Charitable Contributions for High-Income Taxpayers

  • Written by Sidney Kess, CPA, J.D., LL.M.

mug sid kessThe government views those with income of $200,000 or more as “high-income taxpayers,” and charitable contributions are a popular write-off for this group of individuals. For 2015 (the most recent year for which statistics are available), the average charitable contribution deduction for those with adjusted gross income (AGI) of $200,000 to under $250,000 was $11,370. For those with AGI of $250,000 or more, the average deduction was $16,580. In this period of tax uncertainty resulting from Congressional goals of tax reform, what can high-income taxpayers do to maximize their tax-advantaged giving opportunities?

Tax Rules for Charitable Contributions

High-income taxpayers should understand the basic charitable contribution rules for federal income tax purposes, which are fairly straightforward (Code Sec. 170):

• A taxpayer must itemize deductions. No above-the-line deduction for non-itemizers is allowed.

• Donations must go to an IRS-recognized charity, which can be found in Publication 78 online (https://www.irs.gov/charities-non-profits/organizations-eligible-to-receive-tax-deductible-charitable-contributions).

• A taxpayer must follow substantiation rules, with may include obtaining written acknowledgments from the charity and qualified appraisals from outside appraisers.

• Cash donations are limited to 50% of adjusted gross income. Donations of appreciated property usually are limited to 30% of AGI (with the exception of donations of conservation easements explained later). Deductions in excess of these limits can be carried forward for up to five years.

• The deduction for charitable contributions is subject to the phase-out of itemized deductions for high-income taxpayers. This means that the tax write-off for contributions can be reduced by as much as 80%.

Conservation Easements

Conservation easements are a type of special arrangement to let taxpayers have their cake and eat it too. Property owners can give away interests, take a tax deduction, and continue to enjoy the property.

To be deductible, the donation must be a contribution of a qualified real property interest (i.e., a restriction granted in perpetuity on the use which may be made of the real property) to a qualified organization exclusively for conservation purposes (Code Sec. 170(h) and Reg. §1.170A-14). The types of conservation contributions include:

• Preservation of land areas for outdoor recreation by, or the education of, the general public.

• Protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem.

• Preservation of open space (including farmland and forest land).

• Preservation of a historically important land area or a certified historic structure (such as a building façade).

Donations of conservation easements are limited to 50%of AGI minus the deduction for other charitable contributions. Any excess amount can be carried forward for up to 15 years. For donations by farmers and ranchers, the AGI limit is 100%, rather than the usual 50%, with the same 15-year carryover.

However, the IRS has made syndicated conservation easements a reportable transaction that must be disclosed on a taxpayer’s return and may invite IRS scrutiny (Notice 2017-10, IRB 2017-4, 544). For more details about conservation easements in general, see the IRS’s Conservation Easement Audit Technique Guide (https://www.irs.gov/pub/irs-utl/conservation_easement.pdf).

Qualified Charitable Distributions

An IRA owner who is at least age 70½ has an additional way to give to charity. They can make a qualified charitable distribution (QCD) of up to $100,000 annually from the IRA (Code Sec. 408(d)(8)). The distribution is not taxed, and can be counted toward a required minimum distribution (RMD). But no charitable contribution deduction can be taken; no double tax break is allowed.

QCDs are restricted to regular IRAs. They cannot be made from IRA-type accounts, such as SEP-IRAs or SIMPLE-IRAs.

Donor-Advised Funds

A donor-­advised fund is a fund or account in which a donor can advise but not dictate how to distribute or invest amounts held in the fund (Code Sec. 170(f)(18)). Usually, a taxpayer giving cash or property to a donor-advised fund can take an immediate tax deduction even though the funds have not yet been disbursed to a charity.

Donor-advised funds from some major brokerage firms and mutual funds have minimum contribution amounts and fees.

Business Donations

High-income taxpayers may own businesses that can make donations.

• For C corporations, donations are limited to 10% of taxable income.

• For owners of pass-through entities, their share of the businesses’ donations is reported on their personal returns.

Usually, donations of inventory are deductible to the extent of the lesser of the fair market value on the date of the contribution or its basis (typically cost). If the cost of donated inventory is not included in your opening inventory, the inventory's basis is zero so no deduction can be claimed. However, businesses that donate inventory for the care of the ill, the needy, or infants, an enhanced deduction is allowed (Code Sec. 170(e)(3)).

Leave-based donation programs. Companies may have programs that enable employees to donate their unused personal, sick, or vacation days, with this time used by other employees in medical emergencies or disasters. Donated leave time is taxable compensation to the donors, subject to payroll taxes. Employees cannot take any charitable contribution for their donations.

A special rule applies for donations to benefit victims of Hurricane Harvey. The IRS has guidance (https://www.irs.gov/pub/irs-drop/n-17-48.pdf) on the tax treatment of these leave-based donation programs. Employees are not taxed on their donations for this purpose, and no employment taxes are owed on employee contributions for this purpose. Employer can then donate the amount of these donations to a charity providing relief to victims of Hurricane Harvey and claim a tax deduction for this action. Employer donations to tax-exempt organizations must be made before January 1, 2019.

Other Rules

There are many variations on charitable giving, each with special tax ramifications. Some examples:

• Donations of appreciated property held more than one year are deductible at the property’s fair market value on the date of the contribution. Potential capital gain is never recognized.

• Donations can be arranged through special trusts, such as charitable remainder trusts. The donor (and spouse) can enjoy the property for life (or a term of years), with the remainder passed to a named charity. The donor can take a current deduction for the present value of the remainder interest. Another trust option is the charitable lead trust.

• Wealthy individuals can set up their own private foundations to further their philanthropic goals. Special tax rules apply to these foundations.

Year-End Tax Planning

At present, it is uncertain whether there will be any changes in the rules for charitable contributions and, if so, when they will become effective. Likely, the charitable contribution rules for 2017 will be unchanged. However, a decline in tax rates would mean that tax value of donations would be reduced. For example, a $1,000 donation for someone in the 39.6% tax bracket saves nearly $400 in federal income taxes. If the rate for the same taxpayer declines to 25%, the savings would be only $250.

Conclusion

While high-income taxpayers may continue to be generous donors, regardless of tax breaks for giving, thought should be given now to making donations before the end of the year. Review charitable giving to year-to-date and project the tax savings for additional gifts that can be made by December 31, 2017. Allow sufficient time when making donations that require qualified appraisals and legal documentation.

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Tax Cuts and Jobs Act of 2017: Impact on Individuals

  • Written by Sidney Kess, CPA, J.D., LL.M.

kess sidneyOn December 19, 2017, Congress passed a major tax package (H.R. 1) designed to cut taxes on individuals and businesses, and to stimulate the economy and create jobs. The tax cuts are projected to be nearly $1.5 trillion. The long-term impact on the deficit is unclear; the measure adds to the deficit in the short term but could reduce it in the long term if predictions of economic growth come true. The following is a roundup of the key provisions impacting individuals. Those impacting businesses are in a subsequent column. All of the following provisions apply starting in 2018 unless otherwise noted. Most of the provisions for individuals are temporary; they expire after 2025 unless Congress takes further action.

Tax Rate Reduction

The linchpin to this tax legislation is a reduction in individual tax rates. While the current number of tax brackets has been retained, each one has been reduced slightly.

Tax Brackets
The brackets for individuals are cut to 10%, 12%, 22%, 24%, 32%, 35%, and 37% (Code Sec 1). The top tax rate applies to joint filers with taxable income over $600,000 (single filers over $500,000).

Tax Rates for Owners of Pass-Through Entities
There is no special tax rate or cap for taxes on pass-through income. There is, however, a new 20% deduction for business income, although many restrictions apply that prevent this break from being claimed by most attorneys, accountants, and number of other professionals (new Code Sec. 199A).

Capital Gains and Dividends
The 15% and 20% tax rates on long-term capital gains and qualified dividends have been retained. Those in the 10% or 12% tax bracket pay zero tax on these gains and dividends. Also, there had been proposals to require the use of first-in, first-out (FIFO) in determining basis on the sale of stock and mutual fund shares rather than allowing investors to designate which shares are being sold when shares were acquired at different times. This measure was not included in the final package.

AMT
The tax rates for the alternative minimum tax (AMT) are retained, but the exemption amounts are increased (Code Secs. 53, and 55-59). More specifically, the exemption amounts increase to $109,400 for joint filers, $54,700 for married filing separately, and $70,300 for other filers. The phase-out threshold for the exemption increases to $1 million for joint filers and $500,000 for other filers; phase-out amounts are indexed for inflation after 2018. Also, the current 10%-of-AGI threshold for medical expenses deductible for AMT purposes is decreased to the 7.5%-of-adjusted-gross-income (AGI) threshold for 2017 and 2018.

Deductions

The personal and dependency exemptions are repealed, while the deduction for student interest that had been slated for repeal has been retained. Other changes to deductions include:

Above-the-Line Deductions
The alimony deduction is eliminated, but this repeal only applies for payments under agreements entered into or substantially changed after 2018 (Code Sec. 71). This means that recipients of alimony under agreements entered into or substantially changed after 2018 will not be taxed on the payments they receive. The deduction for moving expenses is also repealed, except for members of the military (Code Sec. 217). A deduction for legal fees and court costs in whistleblower cases can be deducted from gross income.

Standard Deduction
The standard deduction increases to $24,000 for joint filers, $18,000 for heads of households, and $12,000 for other filers. These amounts are indexed for inflation after 2018. The additional standard deduction amounts for age and blindness have been retained. Currently, about two-thirds of individuals claim the standard deduction. The number of taxpayers who do not itemize their personal deductions is expected to increase when the higher standard deduction amounts are implemented.

Itemized Deductions
Many of the itemized deduction rules have changed:

• The medical deduction is retained, with the 7.5%-of-AGI floor retained for all taxpayers for 2017 and 2018 (Code Sec. 213). After 2018, the threshold returns to 10%-of-AGI.
• The cap for deducting mortgage interest for buying or building a home is reduced from the current $1 million cap to $750,000; no interest is deductible for home equity debt (Code Sec. 163(h)).
• The deduction for state and local income, property, and sales taxes is capped at $10,000 (Code Sec. 164). This so-called SALT deduction, which stands for state and local taxes, is a substantial reduction from the former rule allowing all property taxes, plus all state and local income or sales taxes, to be claimed as an itemized deduction. Prepaying 2018 state and local income taxes in 2017 does not help; no deduction in 2017 is allowed for such prepayment.
• The percentage of AGI for charitable contributions is increased from 50% to 60% for cash donations, but no deduction is allowed for donations in exchange for college athletic event seating rights (Code Sec. 170). The cents-per-mile rate for driving for charitable purposes has not been changed; it remains at 14 cents per mile.
• The casualty loss deduction is repealed, except for losses in federally-declared disasters (Code Sec. 165). Miscellaneous itemized deductions subject to the 2%-of-AGI floor, such as unreimbursed employee business expenses and tax preparation fees, are repealed (Code Secs. 61, 67, and 212)).
• The phase-out of itemized deductions for high-income taxpayers is also repealed.

Credits

Despite various proposals in the House bill, the final measure retained most current tax credits, including the child and dependent care credit, the credit for the elderly and permanently disabled, and the credit for plug-in electric drive motor vehicles. However, some credit changes were made:

Child Tax Credit
The amount of the credit increases to $2,000 per qualifying child (up from $1,000) (Code Sec. 24). The refundable portion of the credit increases to $1,400. There is a nonrefundable $500 credit for a qualifying dependent other than a qualifying child that applies through 2025. The AGI phase-out for the child tax credit increases substantially, but is not indexed for inflation.

Other Credits
There are some modifications to the earned income tax credit (Code Sec. 32). The credit for nonbusiness energy property for installing insulation, storm windows, etc., which expired at the end of 2016, has not been extended.

Other Provisions

The new law contains various other tax rules of note, including:

Individual Mandate
The shared responsibility payment for individual mandate, which is a penalty for not having required minimum essential health coverage and no exemption from the mandate, is repealed (Code Sec. 5000A). However, this change does not take effect until 2019. Thus, it continues to apply for 2017 and 2018. No changes have been made in the premium tax credit for those who choose to buy health coverage from a government Marketplace.

Roth IRA Conversions
The ability to unwind a Roth IRA conversion by recharacterizing it as an IRA by October 15th can no longer be done (Code Sec. 408A). This means that conversions are permanent.

529 Plans
The use of these plans is expanded in two ways:

• Tax-free distributions up to $10,000 can be made for tuition at elementary and secondary schools, whether public, private, or religious (Code Sec. 529).
• Rollovers of funds from 529 plans to ABLE accounts—special savings accounts for the benefit of a qualified disabled individual—can be made on a tax-free basis (Code Secs 529 and 529A).

Home Sales
There had been proposals to change the rules for excluding gain on the sale of a principal residence (Code Sec. 121). The proposals were not included in the final measure.

Estate and Gift Taxes
These transfer taxes are retained but the exemption amount is increased substantially. The $5 million exemption doubles to $10 million (Code Secs. 2001 and 2010). The $10 million amount is indexed for inflation after 2011, making it more than $11 million for 2018. For a couple, this means estates can be transferred tax free up to $22 million.

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Death of an Employee: Tax Ramifications

  • Written by Sidney Kess, CPA, J.D., LL.M.

mug sid kessWhen an employee dies, family members, co-workers and others may experience profound loss. For the family and the company, there are important tax considerations that arise. Here are some of the issues of note.

Retirement Benefits

If a deceased employee was a participant in a company’s qualified retirement plan, benefits are paid to the designated beneficiary. This is usually a surviving spouse if there is one. If an employee had wanted benefits to be payable to someone other than a surviving spouse, the surviving spouse would have had to consent in writing to this arrangement (Code Secs. 401(a)(11)(F) and 417(a)). The plan administrator should have a record of who was designated as the beneficiary or what happens if there is no such beneficiary (e.g., the beneficiary predeceased the employee).

The person inheriting retirement benefits is not immediately taxed on the inheritance (Code 102). However, when benefits are distributed to the beneficiary, they become taxable to the same extent that they would have been taxable to the employee.

A surviving spouse can roll over the benefits to his/her own account. This allows the surviving spouse to name his/her own beneficiary and to postpone required minimum distributions until age 70½.

A non-spouse beneficiary may direct the trustee of the plan to transfer inherited funds directly to an IRA set up for this purpose. The account should be titled: [Beneficiary’s name], a beneficiary of [employee’s name]. While the non-spouse beneficiary must take distributions over his/her life expectancy (Table I in the appendices to IRS Publication 590-B), this avoids an immediate distribution of the entire inheritance. Generally, distributions must begin by the end of the year following the year of death. However, under a five-year rule, no distributions are required until the end of the fifth year following the year of death, at which time the entire account must be withdrawn.

If the deceased employee’s estate paid federal estate tax, then a beneficiary can claim a miscellaneous itemized deduction for the portion of this tax when benefits are included in his/her income (Code Sec. 691(c)). It is not subject to the 2%-of-adjusted-gross-income floor that applies to most miscellaneous itemized deductions; it is subject to the phase-out for high-income taxpayers.

COBRA Coverage

Under federal law, if the employer has 20 or more full- and part-time employees for at least half of the business days during the previous year and has a group health plan, COBRA coverage (a continuation of the company health plan) must be offered to a surviving spouse and a dependent child (Consolidated Omnibus Budget Reconciliation Act of 1985). A number of states have “mini-COBRA,” which requires the offer of continuing coverage by smaller firms.

The employer must notify the qualifying beneficiary (spouse/dependent child) within 14 days the plan received notice of the qualifying event (the death of the covered employee) about COBRA. This notice of election must spell out what it means and how to make it. What it means is that the qualifying beneficiary can continue the same or reduced coverage for up to 36 months. This election is voluntary, so if the spouse has access to better or less costly coverage elsewhere (e.g., through the Medicare for the spouse; through the children’s health insurance program [CHIP] for the child), making the election may not be advisable. The qualifying beneficiary must pay the cost of coverage, plus an administrative fee up to 2% (unless the company voluntarily pays for some or all of this coverage).

COBRA does not apply to:

• Health savings accounts (HSAs) (discussed later), even though coverage under a company’s high-deductible health plan (HDHP) is subject to COBRA

• Disability insurance for short-term or long-term disability

• Long-term care insurance

Life Insurance

Insurance on the life of an employee is payable at death to the beneficiary of the policy. Depending on the type of coverage, this may be the surviving spouse, the company, or anyone else. As a general rule, the receipt of insurance proceeds payable on account of the death of the insured is tax-free (Code Sec. 101).

Group-term life insurance. Typically proceeds are payable to the surviving spouse or the employee’s child. If the employee has not designated a beneficiary, proceeds are payable according to state law. In order of precedence, this is usually a current spouse, but if there is none, then to children or descendants. If none, then to parents, and then to the employee’s estate.

Key person insurance. This is coverage owned by the company and is designed to provide a financial backstop needed during a replacement period for the deceased employee.

Insurance under buy-sell agreements. If the deceased employee is an owner and there is a buy-sell agreement that has been funded by life insurance, the proceeds are paid out to the company if the company owned the policy (an entity purchase buy-sell agreement), or to co-owners if they owned the policy (a cross purchase buy-sell agreement).

Workers’ Compensation

If an employee dies because of a work-related injury or illness, a death benefit is payable to eligible dependents (usually a surviving spouse and minor children, but to others if there is no spouse or minor child). The receipt of these benefits is tax-free (Code Sec. 104(a)(1)).

The amount of the benefit varies from state to state. For example, in New York the death benefit is two-thirds of the deceased spouse’s average weekly wage for the year before the accident (but not more than a maximum amount adjusted annually), or less if there is no surviving spouse, children, grandchildren, grandparents, siblings, parents, or grandparents. In addition, there may be a payment for funeral expenses.

When there is a work-related death covered by workers’ compensation, this usually becomes the sole remedy against the employer. However, an action against the employer may not be barred in some situations (e.g., death because of toxic substances, defective products, intentional actions by the employer).

FSAs

If the deceased employee had been contributing to a flexible spending account for health care or dependent care costs, contributions cease at death. The executor can continue to submit claims for reimbursement for eligible expenses incurred before death; these reimbursements are tax-free. The plan administrator can provide details about the deadline for these submissions.

Restricted Stock and Stock Options

What happens to restricted stock and stock options when an employee dies varies greatly from company to company. Unvested grants may vest upon death. For example, the terms of a stock option plan may immediately vest any unvested grant, allowing the estate of the deceased employee to exercise the options within a set period.

Nonqualified stock options become part of the deceased employee’s estate. If the executor exercises them, income is taxable to the estate (Form 1099-MISC is issued to the estate). There is no withholding required. Similarly, any restricted stock released to the estate becomes taxable to it (assuming that the employee did not make a Sec. 83(b) election); there is no withholding required.

Special Benefits

In addition to what the law requires, some companies may offer families of deceased employees special benefits. For example, Google pays 50% of a deceased employee’s salary to a surviving spouse or domestic partner for 10 years (http://money.cnn.com/2012/08/09/technology/google-death-benefits/index.html). The company also pays each dependent child a monthly amount until age 19, or 23 if a full-time student.

Conclusion

Families must present death certificates to the company in order to receive any employment-related benefits on behalf of the deceased employee. They should also work with the company to undo other entanglements, such as company credit cards and company vehicles.

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