Medical Expense Deductions

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

Although Congress continues to debate healthcare reform, current tax rules still apply. This means that taxpayers who itemize their personal deductions can claim a medical expense deduction for costs not reimbursed by insurance that exceed 7.5% of adjusted gross income. Sometimes it is not easy to determine whether an expense qualifies as a deductible medical expense. Here are some recent developments that affect medical deductions:

To be a deductible medical expense, a cost must be paid for the diagnosis, cure, mitigation, treatment or prevention of a disease; or for the purpose of affecting any structure or function of the body (Code Sec. 213(d)). In other words, two tests must be met: There must be a condition, and there must be a treatment.
Despite the 7.5% floor for deducting medical expenses and that only expenses in excess of insurance reimbursements qualify, taxpayers are claiming significant write-offs for medical expenses, according to the Spring 2009 Statistics of Income Bulletin — which details itemized deductions claimed on 2007 returns  (,,id=208577,00.html). Here are the average deductions claimed for those within an adjusted gross income range:

  • $15,000 to under $30,000: $6,849
  • $30,000 to under $50,000: $6,040
  • $50,000 to under $100,000: $6,690
  • $100,000 to under $200,000: $9,922
  • $200,000 to under $250,000: $22,810
  • $250,000 and over: $32,813

For purposes of the alternative minimum tax, only medical expenses that exceed 10% of adjusted gross income are allowed (Code Sec. 56(b)(1)(B)).

Sex Reassignment Surgery

The tax law bars deductions for cosmetic surgery unless it is incurred for treatment of a disfiguring condition that arises from a congenital abnormality, personal injury, trauma or disease — such as reconstructive surgery following the removal of a malignancy (Code Sec. 213(d)(9)). In a case of first impression, the Tax Court tackled the question of whether sex reassignment surgery meets the exception to the ban on deductible cosmetic surgery.
In the case, the taxpayer was born a genetic male but was diagnosed with gender identity disorder, or GID. This is a recognized condition in the medical field. He took female hormones and had sex reassignment surgery and breast augmentation surgery. The taxpayer, now a female, claimed a medical expense deduction for costs totaling $21,741 for the hormone therapy and sex reassignment surgery, and $19,195 for the breast augmentation surgery. None of these costs were covered by insurance.
The IRS disallowed all of these expenses. It has previously issued advice to this effect (Chief Counsel Memorandum 200603025). The IRS believed that congressional action was needed to clarify whether this type of surgery should be treated as necessary cosmetic surgery, which would be deductible; or cosmetic surgery to improve appearance, which would not be deductible. Until such time, it viewed sex reassignment surgery as a nondeductible cosmetic procedure.
The Tax Court held that all of the expenses were deductible medical costs except for those related to the breast augmentation surgery (O'Donnabhain, 134 TC No. 4 (2010)). In the court's view, both tests for a deductible medical expense are met in this case: The person suffered from a medical condition and received appropriate treatment. More specifically, it recognized that a person suffering from GID experiences persistent psychological discomfort because of gender, which is a condition. The treatment for this condition is hormone therapy, living in public as the opposite sex and ultimately, undergoing sex reassignment surgery.
The Tax Court, however, did not allow a deduction for the cost of breast augmentation. In this case, the taxpayer had normal breasts before the surgery and had the surgery to improve appearance — not to ameliorate a deformity. Previously, the Tax Court allowed an exotic dancer known as Chesty Love to take a business deduction for the cost of cosmetic surgery to become a size 56N (Hess, TC Summary Opinion 1994-79). In this case, the deduction was an ordinary and necessary business expense — her breasts became her stage props.

Cost of Baby Formula

A number of prior cases and rulings have addressed when and to what extent the cost of special foods or beverages can be deductible. More than 50 years ago, the IRS ruled that doctor-prescribed foods and beverages are deductible only if they are in addition to normal dietary needs (Rev. Rul. 1955-261, 1995-1 CB 307). On the basis of this ruling, the IRS disallowed the cost of a reduced-calorie diet prescribed by a doctor for an obese person because the food was a substitute for normal foods with nutritional requirements (Rev. Rul. 2002-19, 2002-1 CB 849).

In a recent case, a mother wanted to deduct the cost of infant formula. The mother had had a double mastectomy and was unable to breast-feed. The IRS ruled that the cost of the baby formula was not a deductible medical expense (Letter Ruling 200941003). It was used to satisfy nutritional needs of the baby — not to supplement  the baby's nutritional needs.

In Vitro Fertilization

In vitro fertilization (IV) is a process by which egg cells are fertilized by sperm outside the womb. The cost of the procedure runs about $12,000 per cycle. Although many medical insurance policies cover some fertility treatments, IV usually is not covered.
The cost of IV and other fertility treatments can be deductible by a mother who cannot become pregnant in the usual way. In this case, IV can be viewed as treating the condition of infertility. The IRS allows deductions for temporary storage of eggs or sperm as well as surgery to reverse tubal ligations and vasectomies undertaken to prevent a person from having children (see IRS Publication 502).
However, IV costs are not always deductible. Take the recent case of a healthy father who used IV with two different women to father two children. The Tax Court denied the deduction and an appellate court agreed (Magdalin, CA-1 USTC 2010-1 ¶50,150, aff'g TC Memo 2008-293).
The expenses did not meet the first criteria of a deductible medical expense because they were not incurred to treat a condition. The father was perfectly healthy. Thus, the costs were nondeductible personal expenses.

New Rules for 2010

Some numbers have changed for purposes of the medical expense deduction.

  • Health savings accounts (HSAs): A health savings account is an IRA-like account to which deductible contributions can be made (Code Sec. 223). Earnings in the account grow on a tax-deferred basis, though withdrawals to pay medical expenses can be taken tax-free. Each year, the IRS sets limits on contributions to HSAs; the limits for 2010 are higher than they were for 2009 (Rev. Proc. 2009-29, IRB 2009-22, 1050).

For 2010, the contribution limit for an individual with self-only coverage under a high-deductible health plan (defined below) is $3,050. The contribution limit for an individual with family coverage is $6,150. Anyone who is at least 55 years old by the end of the year can add another $1,000 to the deductible contribution limit.
A high-deductible health plan is defined as one with an annual deductible of not less than $1,200 for self-only coverage, or $2,400 for family coverage (Code Sec. 223(c)(2)(A)). The annual out-of-pocket expenses for deductibles, copayments and other amounts (other than premiums) cannot be more than $5,950 for self-only coverage, or $11,900 for family coverage.

  • COBRA coverage for the unemployed: The American Recovery and Reinvestment Act of 2009 (2009 Recovery Act )(P.L. 111-5) introduced a new benefit: Individuals involuntarily terminated from a job on or after Sept. 1, 2008, and before Jan. 1, 2010, and whose employers were subject to COBRA could opt for this coverage in which the federal government pays 65% of their premiums for up to nine months. The Department of Defense Appropriations Act, 2010, (P.L. 111-118) extended this benefit. More specifically, the federal government will continue to pay 65% of insurance premiums for eligible individuals for up to 15 months instead of the former nine-month period. Eligible individuals include those involuntarily terminated in January and February 2010 (instead of through the end of 2009).

Individuals using COBRA who become ineligible for coverage (e.g., they join another group plan or become eligible for Medicare) must notify the plan providing the COBRA coverage. An individual who fails to make this notification and continues to receive the COBRA premium subsidy after becoming eligible for other group health coverage or Medicare may be subject to a penalty of 110% of the subsidy (Code Sec. 6720C).
The federal subsidy is tax-free for individuals with modified adjusted gross income (MAGI) below $125,000 for singles, and $250,000 for joint filers (Act Sec. 3001(b)(1) of the 2009 Recovery Act). There is a phase-out for tax-free treatment for singles with MAGI between $125,000 and $145,000, and for joint filers with MAGI between $250,000 and $290,000. For those with MAGI over this ceiling, the subsidy is included in gross income.
The IRS provides information on the COBRA subsidy for employers as well as employees and former employees at,,id=204505,00.html.

  • Driving for medical purposes: Those who use a car to drive to a doctor, pharmacy, therapy session or for other medical purposes can deduct the cost of driving based on an IRS-set mileage rate. For 2010, the rate for medical driving is 16.5 cents per mile (Rev. Proc. 2009-54, IRB 2009-51, 930). The 2010 rate is down significantly from the 2009 rate of 24 cents per mile.

In order to claim this deduction, it is important to keep good, contemporaneous records to substantiate medical-related driving.

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.

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Roth IRA Conversions During Low-Tax Years

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

Converting traditional IRAs and qualified retirement plan accounts to Roth IRAs is a hot topic today. The reason: The Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) repealed the income limits on eligibility to make a conversion after 2009; anyone is eligible to make a conversion in 2010 and later years. Here are some key points to take into account when deciding whether to make a conversion this year and how much to convert.

Basic Rules

Starting this year, anyone, regardless of income or filing status, can opt to convert a traditional IRA or qualified retirement benefits to a Roth IRA (Code Sec. 408A(c)(3)(B) repealed). The advantage for making a conversion is the opportunity to build tax-free income for the future. Moreover, because there are no required minimum distributions from a Roth IRA during the owner's lifetime, there is also the prospect of creating a sizable legacy if the funds are not needed during retirement. The main disadvantage to making a conversion is paying income taxes on the amount converted rather than deferring taxes until such amounts are withdrawn.

Conversions in 2010 allow the taxpayer to spread the resulting income over two years—2011 and 2012. This effectively defers the tax on the conversion for some time (Code Sec. 408A(c)(3)(B)). Alternatively, a taxpayer can elect to report all of the income from the conversion in 2010 (Code Sec. 408A(e)(i)(I)). (The cases for doing this are discussed below.)

Income from conversions made after 2010 must be reported in full in the year in which the conversions are made; there is no deferral rule for conversions after 2010.

Conversion income. If the converted account has only pre-tax contributions, then it is fully includible in gross income. So, if the IRA has been funded by tax-deductible contributions, any conversion of the funds in the IRA results in full inclusion in income. If the account has been funded with both deductible and nondeductible contributions, then only a portion of the converted amount is included gross income.

For example, if a person has a single traditional IRA of $25,000 to which he/she had made a nondeductible contribution of $4,000, then 84% of the conversion, or $21,000, is taxable, while 16% represents the after-tax contributions to the traditional IRA and is not taxed. The value of amounts in all nondeductible IRAs is taken into account in determining the tax on the conversion, even if some or all of the nondeductible IRAs is not converted.

There is no 10% penalty on conversion income even though the individual is under age 59 ½, as long as the funds remain in the Roth IRA for at least five years. The fact that the traditional IRA being converted was a rollover made within 12 months does not bar the conversion of this account to a Roth IRA.

Impact of Conversion 

Making a conversion can impact other tax rules. Income from the conversion is part of adjusted gross income, an amount that limits or bars eligibility for various tax deductions and credits as well as other rules.

Those at or near retirement age should consider the timing and amount of a conversion carefully. The conversion can:

  • Impact the amount of Social Security benefits being taxed. The conversion amount can, for example, raise the amount of benefits included in income from zero to 50% or 85%.
  • Affect whether the Medicare surtax applies. Income from the 2010 conversion reported on a 2010 return could trigger or increase Medicare surtax for 2012.

State income taxes. A handful of states have no income tax, so there is no impact from a conversion on state income taxes for individuals in these states. Some states may exempt some or all of IRA distributions from their income tax, which would also mean little or no tax from the conversion. In other cases, a conversion can result not only in federal income taxes, but state income taxes as well.

Annual contributions. An individual can make a conversion and an annual contribution to a Roth IRA. For 2010, the contribution limit remains $5,000, plus an additional $1,000 for those 50 years or older by the end of the year (Code Sec. 408A(c)(2)).

However, there continues to be modified adjusted gross income (MAGI) limits on eligibility to make annual contributions to a Roth IRA. A full contribution is allowed for 2010 for singles with MAGI up to $105,000 and for joint filers with MAGI up to $167,000. A partial contribution is allowed for singles with MAGI between $105,000 and $120,000, and for joint filers with MAGI between $167,000 and $177,000.

Estimated taxes. If conversions are made in 2010 and the income will be reported in full on the 2010 return, then estimated taxes for the year should be made to cover the tax liability and avoid estimated tax penalties. Alternatively, estimated taxes for 2011 and 2012 will have to be adjusted for conversion income.

Planning Strategies

Electing not to use the 2011/2012 deferral option. It is too early to decide whether to opt to report all of the resulting income from a conversion in 2010 on a 2010 return rather than reporting half in 2011 and 2012. It depends in part of what the tax rates will be for the client in 2011 and 2012.

The president's budget proposal for fiscal year 2011 calls for a hike in the top tax rates for so-called high income taxpayers to 36% and 39.6%, up from 33% and 35%. The tax bill on the conversion could be lower for high income taxpayers if the full amount is included in income in 2010 and subject to a lower rate. Alternatively, individuals converting may now be retired and in lower tax brackets in 2011 and 2012, even if tax rates rise.

If an individual converts more than one account to a Roth IRA in 2010, the same tax treatment — full income in 2010 or deferral to 2011 and 2012 — must be used for all of the accounts. If the individual is married, each spouse can choose the tax treatment for his/her separate IRAs, so one spouse can report conversion in 2010, while the other spouse can defer the income from the conversion to 2011 and 2012.

Match cash to conversion amounts. In order to make a conversion, it is important to have sufficient cash on hand to pay the tax that results from the conversion. It is advisable to convert only as much as the cash available to pay the taxes.

Partial conversions. There is no rule requiring an individual to convert all of his or her IRAs. A portion of an account can be converted in 2010, with additional conversions made in future years.

Separate accounts. Conversions can be "undone" by recharacterizing the converted amount no later than October 15th of the year following the year of conversion (e.g., October 15, 2011, for 2010 conversions). Recharacterization removes the converted amount from income and may be advisable when the value of the account drops considerably from the time of the conversion. However, recharacterization must be made for the entire Roth IRA account; no partial recharacterizations are permitted.

It may be advisable to set up separate Roth IRAs to hold conversion amounts that are invested in different classes of assets. Then, if a particular asset class has disappointing results following a conversion, a recharacterization can be made of the separate account.

Direct conversions. Individuals can convert a 401(k) or other qualified retirement plan directly into a Roth IRA and do not have to first transfer funds into a traditional IRA and then convert. However, the ability to make a conversion from a qualified retirement plan depends on the terms of the plan. Usually the option to convert is available only when an employee leaves the company or retires, so check with the plan administrator for details.

Required minimum distributions. No conversion is allowed for the portion of the account required to be distributed for the year as a required minimum distribution (RMD); only amounts in the account after RMDs can be converted. For example, say there is a traditional IRA with $50,000 and the RMD for 2010 is $2,000. The maximum amount that can be converted in 2010 is $48,000.

Final decision. Whether to convert is a complicated decision based on an individual's current tax picture and future estimates. It may be helpful to use a calculator, such as one from CalcXML at, or for professionals, from CCH at The following tools also will help make a determination:

  • Fidelity:
  • Schwab:
  • Vanguard:

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.

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The Sid Kess Approach

  • Written by T. Steel Rose, CPA

I have had the honor of meeting and shaking the hands of several well-known people over the years. Ronald Reagan, Bill Gates, Walter Cronkite, Michael Dell, George W. Bush, and Sidney Kess all come to mind. While I remember each meeting clearly, the meeting that matters most is Sid Kess. The Sid Kess Approach: 60 Years of Best Practices in Tax, Education, Careers and Life is a new book from the AICPA in which author James Carberry chronicles the extraordinary effect of one CPA on an entire profession.

It is wonderful to acknowledge giants that have gone before us. It takes significant insight and courage to recognize the truly great ones while they are currently making huge contributions to their profession. Tennis player, Roger Federer comes to mind. He is not only, arguably the best tennis player who ever lived; he was also named the most admired person in 2011. Sid Kess is such a man. The AICPA has done every CPA a tremendous favor by compiling vignettes of Kess’ thoughts, ideas, speeches and letters from the many CPAs and others that Kess has helped and influenced.

“Sid has put into practice the values that are now institutionalized in the AICPA’s Vision Statement, contained in its, ‘The CPA Vision Project: 2011 and Beyond,’” said Carberry.

The Vision Statement says the core purpose of CPAs is, “making sense of a complex world.”  Carberry continues, “CPAs can accomplish this aim by: communicating the total picture with clarity and objectivity; translating complex information into critical knowledge; anticipating and creating opportunities; and designing pathways that transform vision into reality.”

The book uses the letters of the Sid Kess’ legion of devotees who Kess has personally helped in often extraordinary ways. These letters supplement the narrative broken into the five groups that characterize The Sid Kess Approach. They are 1) Truly Put People First, 2) Build and Maintain Core Knowledge and Expertise, 3) Be Imaginative & Act on Your Ideas, 4) Maximize Your Potential, and 5) Find and Connect With People.

In the Truly Put People First chapter, several people extol the merits of The Sid Kess Approach to treating people well, whether they are the doorman, Russian immigrants on a subway, charities, fellow CPAs or students.


“I had gained an insight into Sid’s greatness—he treats everyone he meets as if that person were the most important person he’d ever met.”

          - Houston Smith, Jr., CPA, Atlanta



“Sid Kess is a mensch! He is a dream maker for all those who are lucky to have met him.”

          - Inky Kim, Albuquerque, NM



“Mr. Kess is the Einstein of tax law.”

          - Dina Reznichenko


In the Build and Maintain Core Knowledge chapter, the Kess CPA career and CPE lecturer history is detailed in charts. His CPE expertise is summed up by Professor Paden Neely, PhD, CPA, a former VP of the AICPA, when he wrote, “Sid is, without question, the all-time number one developer, writer, and presenter in the world of CPE for CPAs, not only for the AICPA but the accounting profession as a whole.” CPA Cecil Nazareth, managing partner of IFRS Partners in New York wrote that Sid helped him re-invent himself, and told him, “if you focus on the growth area, you could be one of its leading experts, a thought leader and compete with professionals who have been in the field for 25 years.” CPA Karen Koch, who Kess helped establish as an expert in cost segregation studies, referred to Kess as a pillar in the profession. She advised, “To follow his example means we never stop learning and we never stop giving back.”

To grow a CPA practice, Kess provided several tips including scheduling year-end tax meetings with clients using checklists available from the AICPA to assist with tax reviews and planning.  Jonathan Gassman said that Sid was always ready to share practice management tips, and suggested “simple single doable things” (SSDTs) the firm could quickly implement. A table provides 36 ideas on additional services for CPA firms broken down by Advisory, Audit, Tax and Transaction services. 

CPA Clark Blackman from Kingwood, Texas said that Sid Kess is “an iconic figure in the CPA community,” and, “a veritable font of ideas and enthusiasm,” which leads into Chapter 3, Be Imaginative & Act onPut Your Ideas. Chapter 4 gives workable advice on speaking, writing and collaborating to Maximize Your Potential. The book concludes with Chapter 5, Find and Connect with People, wherein Kess describes how to be a talent hunter and how to give back by speaking, teaching and mentoring in the profession and in your community.

After 112 pages of ideas from Kess, and letters about Kess, 18 more pages are needed to list the published output of this extraordinary man and CPA. I remember a May meeting with Sid at his office in Rockefeller Center. We chatted, we had lunch. Every person in New York City we came in contact with seemed to know him. He was cordial to everyone. Sidney produced a list of ideas, along with phone numbers on who to contact on how to implement the ideas.  Before we parted, Kess mentioned a couple of people who were looking for work. The meeting seemed to encapsulate the Sid Kess Approach. Everyone should be so lucky to know this  amazing CPA. As with each terrific idea filled phone conversation, Sid parted the same way he always does. It’s part of who he is, that he never says, “Good bye; he says, “So long.”

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Inflation Adjustments for Tax Rules in 2012

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

Tax rules change annually due to legislation, court decisions, and cost-of-living adjustments (COLAs) to key tax limits and other items. There are over three dozen COLAs made annually, based on the Consumer Price Index (CPI) in August. Here is a roundup of some COLAs affecting tax rules for 2012 and some planning strategies that can be used to optimize these changes.


Personal exemptions. The personal and dependency exemption increases to $3,800 in 2012 (up from $3,700 in 2011) (Code Sec. 151). This means a family of four claims a total deduction of $15,200 ($3,800 x 4). There is no phase-out of the deduction for high-income taxpayers in either 2011 or 2012.

Tax brackets. All of the tax brackets have been adjusted for inflation. This means that a taxpayer can have more taxable income without being pushed into a higher tax bracket (Code Sec. 1). Where appropriate and possible, it can be helpful to defer income to 2012 if such income would fall into a lower tax bracket and there is no risk of loss with respect to the income.

Earned income credit. Low-income earners can claim a refundable tax credit; the credit limits and phase-out ranges have been increased for 2012 (Code Sec. 32). The amount of investment income that can be received without disqualifying the recipient for the credit is $3,200 (up from $3,150 in 2011).

Adoption credit. The credit amount decreases in 2012 because of the expiration of a law; it declines from $13,360 in 2011 to $12,650 in 2012 and the credit is not refundable (Code Sec. 23). However, the modified adjusted gross income (MAGI) limits on eligibility to claim the credit have increased. Where possible, families should try to complete adoptions this year to take advantage of the higher credit limit and refundability.


Employee benefits

            Where employers offer fringe benefits, employees should take advantage of them to the extent possible or desirable. These fringe benefits are tax free and not subject to Social Security and Medicare (FICA) taxes.

            Adoption assistance. Employers can provide tax-free payments for adoption expenses in 2012 to the same limit as the adoption credit (Code Sec. 137). The same MAGI phase-outs for the credit apply to the exclusion for adoption assistance.

            Transportation fringe benefits. Employers can pay for monthly parking that is tax free up to $240 in 2012 (up from $230 in 2011) (Code Sec. 132(f)(2)(B)). The limit on monthly transit passes and vanpooling is $125 (down from $230 in 2011 when these benefits were in parity with free parking) (Code Sec. 132(f)(2)(A)). The limit on bicycling assistance remains at $20 per month; it is not adjusted annually for inflation.

            Alternatively, employers can arrange for employees to pay for their transit passes on a pre-tax basis through cafeteria plans, an option that eligible employees should consider taking advantage of.



            The top capital gains tax rate remains at 15% (zero for taxpayers in the 10% or 15% tax bracket. The rate remains at 25% for unrecaptured depreciation and 28% for collectibles gains. However, the exclusion for qualified small business stock drops back to 50% for stock acquired in 2012; down from 100% in 2011 (Code Sec. 1202). This means that businesses should try to close on deals before the end of this year to give investors the benefit of the full exclusion. Qualified small business stock can also be given to employees in exchange for services and may be suitable for year-end bonuses in some situations.

            From a planning perspective, a family can save overall taxes by shifting appreciated property to relatives in these low tax brackets. For example, giving appreciated stock held long term to a parent in the 15% tax bracket and having the parent sell the stock means the family has no tax on the sale. However, there will be no substantial tax savings if children are subject to the kiddie tax; here the gain would likely be taxed at the same rate as the parents would have paid if they had taken the gain.

            These transfers can be made gift-tax free in using the annual gift tax exclusion. The exclusion in 2012 is $13,000 per beneficiary per year; there is no change in the exclusion amount in 2011).


Paying for higher education

            The tax law provides some key breaks for paying for college; with COLAs, so there should be increased tax savings eligible taxpayers. In 2012, these breaks have improved as follows:

            Savings bond exclusion. Interest on U.S. savings bonds used to pay higher education costs is not taxable. This interest exclusion applies only if a taxpayer’s MAGI does not exceed a set limit (Code Sec. 135). In 2012, the MAGI limit for the full interest exclusion is $72,850 for singles and $109,250 on a joint return (up from $71,100 and $106,650 respectively in 2011).

            Student loan interest deduction. Interest on a student loan is deductible up to $2,500 annually if a taxpayer’s MAGI does not exceed a set limit (Code Sec. 221). While the dollar limit on this deduction remains unchanged, the starting point of the MAGI phase-out range has been increased for joint filers to $125,000 (up from $120,000 in 2011). The starting point of the phase-out range for singles remains at $60,000.

            Education credits. The credit amount of $4,000 and phase-out range for the American opportunity credit, which can be claimed for qualified higher education costs for the first four years of college, is unchanged (Code Sec. 25A). Forty percent of the American opportunity credit is refundable.

            However, the phase-out range for the lifetime learning credit, which can be claimed for any higher education, has increased. The phase-out for 2012 starts at MAGI of $52,000 for singles and $104,000 for joint filers (up from $51,000 and $102,000, respectively, in 2011).


Saving for retirement in IRAs

            The annual limit on contributions to traditional and Roth IRAs remains at $5,000 (plus an additional $1,000 for those age 50 or older by the end of the year), but no more than compensation for the year (Code Secs. 219 and 408A). However, the phase-out ranges for eligibility to make contributions have been adjusted for inflation:

            Deductible IRAs by active participants. There is no MAGI limit on contributing to a deductible IRA if the person is not an active participant in a qualified retirement plan. However, for those who are active participants, a fully deductible contribution can be made only if MAGI in 2012 does not exceed $58,000 for singles (up from $56,000 in 2011), or $92,000 for joint filers (up from $90,000 in 2011) (Code Sec. 219). The deduction phases out with a range of MAGI; no deduction can be claimed once MAGI exceeds $58,000 for singles, or $112,000 for joint filers. The deduction for married persons filing separate returns phases out for MAGI between zero and $10,000.

            For married persons who are not active participants but their spouses are, the phase-out range for the non-active participant to make a deductible contribution is MAGI in 2012 of $173,000 to $183,000 (it had been $169,000 to $179,000 in 2011).

            Roth IRAs. While there is no income limit on eligibility to convert to a Roth IRA, income limits continue to apply in the case of annual, nondeductible contributions. For 2012, the phase-out range is $119,000 to $125,000 for singles, and $173,000 to $183,000 for joint filers. The ranges for 2011 had been $107,000 to $122,000 for singles, and $169,000 to $179,000 for joint filers. As in the case of deductible IRAs, the contribution limit for Roth IRA contributions by married persons filing separate returns phases out for MAGI between zero and $10,000.

            Retirement saver’s credit. This tax credit for low-income taxpayers who contribute to an IRA, 401(k), or similar plan will be more widely available in 2012. This is because the MAGI limits on eligibility for the credit have been increased. The credit can be claimed in addition to the tax breaks for making the contribution (e.g., a deduction for an IRA contribution and exclusion from income for a 401(k) contribution).

Tax savings for small-business owners

            Equipment purchases. The cost of computers, office furniture, machinery and other equipment can be deducted in full under 100% bonus depreciation (Code Sec. 168). This rate declines to 50% in 2012, unless Congress extends it.

            If bonus depreciation does not apply (e.g., the property is used rather than new), then equipment can be deducted using first-year expensing (Code Sec. 179). The dollar limit on this expensing deduction in 2012 declines to $139,000 (down from $500,000 in 2011), unless Congress also extends this tax break.

            The dollar limit on expensing phases out when equipment purchases exceed a fixed limit. The phase-out is one dollar for each dollar of purchases over the limit. For 2012, that limit is $560,000, so that no expensing can be claimed when equipment placed in service in 2012 exceeds $821,000 (the phase-out for 2011 started once equipment purchases topped $2 million for the year). Businesses can use expensing to upgrade needed equipment on a tax-deductible basis (even if they finance the purchase in whole or in part).

            Employing an owner’s child. In 2012, a child can earn tax-free up to $5,950 (the amount of the standard deduction for a single individual). Thus, a teenager employed in a parent’s business can gain experience and tax-free income. While the age of the kiddie tax is now under 24 for those who are full-time students who do not provide more than half of their own support, the kiddie tax does not apply to earned income.

            If the business is sole proprietorship or a limited liability company treated as a disregarded entity (i.e., a one-member LLC that files Schedule C of Form 1040), the parent does not pay Social Security and Medicare taxes (FICA) on wages to his or her child who is under age 18. The wages themselves are deductible by the parent, reducing the parent’s income taxes and self-employment tax. The child can shelter income by contributing earnings to a Roth IRA up to the annual limit; the parent can make the contribution on behalf of the child based on the child’s earnings (Code Sec. 408A).


            Now is a good time to schedule an appointment with a tax advisor to discuss the impact that COLAs will have on personal tax planning for 2011 and 2012.

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Net Investment Income Tax for Trusts and Estates

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

By: Sidney Kess, CPA, J.D., LL.M. | There is a 3.8% additional Medicare tax imposed on trusts and estates that have net investment income over a threshold amount (Code Sec. 1411). This tax is called the net investment income (NII) tax. Final regulations issued in November of 2013 and corrected last month provide some guidance for fiduciaries of estates and trusts (T.D. 9644, 11/26/13; corrections 2/24/14). The regulations generally are effective for tax years beginning after December 31, 2013. However, for 2013, the year for which the NII tax first applies, taxpayers can rely on proposed regulations issued in 2012.

Overview of the NII tax

The NII tax is imposed on the lesser of the trust or estate’s net investment income or the excess of its adjusted gross income over a threshold (Code Sec. 1411(a)(2)). The threshold is the dollar amount for the start of the highest tax bracket for trusts and estates ($11,950 for 2013; $12,150 for 2014).

Adjusted gross income for a trust or estate is generally figured in the same way as for individuals. Special rules apply to certain costs which are paid or incurred in connection with the administration of the estate or trust and which would not have been incurred if the property were not held in such trust or estate (Code Sec. 67(e)). Deductions are provided under Code Secs. 642(b) for personal exemptions (e.g., $600 for estates, $300 for simple trusts, and $100 for complex trusts). Special rules apply to the computation of distributable net income (DNI) under Code. Sec. 651, and for distributing accumulated income or corpus under Code. Sec. 661.

Exempt trusts

Certain domestic trusts are not subject to the NII tax. These include charitable remainder trusts exempt from tax under Code. Sec. 664 and qualified retirement plan trusts exempt under Code Sec. 501(a). The following are also exempt:

- Trusts where all of the unexpired interests are devoted to charitable purposes (Code Sec. 170(c)(2)(B))

- Grantor trusts (Code Secs. 671-679)

- Electing Alaska Native Settlement Funds (Code Sec. 646)

- Perpetual Care (Cemetery) Trusts (Code Sec. 642(i))

- Trusts not treated as such for federal income tax purposes, such as real estate investment trusts (REITs) and common trust funds

Net investment income

Most trusts and estates will have adjusted gross income over the threshold amount, so they likely will be subject to the NII tax. The amount of tax depends on the entity’s net investment income. Net investment income is simply investment income reduced by investment expenses.

Investment income. It includes such income items as interest, dividends, capital gains (from the sales of stocks, bonds, and mutual funds; mutual fund distributions; and gains from investment property sales), rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities.

Investment income does not include wages, unemployment compensation, operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends, and distributions from qualified retirement plans and IRAs (those described in Code Sections 401(a), 403(a), 403(b), 408, 408A, or 457(b)).

Whether business income is investment income generally follows the passive activity loss rules (Code Sec. 469). Unless there is material participation, the activity is passive and the income is investment income for purposes of the NII tax. The issue of material participation for estates and trusts is currently under study by the Treasury Department and the IRS and likely will be addressed in regulations under Code Sec. 469 for the passive activity loss rules (Preamble to T.D. 9644; Reg. Sec. 1.469-8 is reserved for this purpose). In the absence of regulations, trusts and estates have only conflicting guidance to review in determining whether material participation should be based solely on the activities of fiduciaries or can take activities of beneficiaries and employees into account.

- IRS position: The participation of a beneficiary or anyone else, other than a trustee with suitable discretion, is not taken into account for purposes of determining material participation and whether the business income is passive (investment) income. For example, one trust named a “special trustee” who happened to be the president of the S corporation owned by the trust. The IRS said that the participation of this special trustee is not taken into account because his activities as president were not in the role as fiduciary (TAM 201317010; see also TAMs 200733023 and 201029014). There are seven tests for material participation  (Reg. Sec. 1.469-5T(a).  Moreover, special rules apply for “real estate professionals” (the 750-hour test). At present, it is unclear whether the same test would apply to a fiduciary.  Instead, the fiduciary must be involved directly in the operations of the business on a “regular, continuous, and substantial” basis.

- Court position: Where a trust owned a ranch and the trustee hired a ranch manager and employees, a district court said that there was material participation for purposes of the passive activity loss rules where the trustee had ultimate decision making authority over the financial matters for the ranch (the case pre-dates the NII tax and did not consider the issue in the context of the NII tax) (Mattie K. Carter Trust, DC TX, 256 F Supp.2d 536 (2003)). The court said “[c]ommon sense dictates that the participation of Carter Trust in the ranch operations should be scrutinized by reference to the trust itself, which necessarily entails an assessment of the activities of those who labor on the ranch, or otherwise in furtherance of the ranch business, on behalf of Carter Trust.”

Note: The Tax Court may weigh in soon in the case of Frank Aragona Trust (Doc.

No. 15392-11) in which the taxpayer argued that in determining material participation with respect to rental properties the trust can perform personal services for purposes of Code Sec. 469 through the personal efforts of a non-trustee.

Investment expenses and other deductions. Investment income is reduced by deductions properly allocable to investment income, such as investment interest expense, investment advisory and brokerage fees, expenses related to rental and royalty income, and state and local income taxes properly allocable to items included in net investment income.

Carryovers allowed for regular tax purposes, such as excess net investment income and unused passive activity losses, can be used as well for the NII tax (special rules apply to net operating losses). However, tax credits that can be used only to offset the regular tax, such as the foreign tax credit and the general business tax, cannot be used to offset the NII tax. If the entity opts to treat foreign taxes as a deduction rather than as a credit, then this item reduces net investment income.

Special computational rules for certain entities

Certain trusts require special computations for the NII tax:

Qualified funeral trusts. Each beneficiary’s interest in that beneficiary’s contract is treated as a separate trust but one consolidated Form 8960 can be completed for all beneficiary contracts subject to the NII tax. Instructions to Form 8960 provide details about the computation.

Electing small business trusts (ESBTs). ESBTs in S corporations figure the NII tax in three steps:

1. The ESBT separately figures the undistributed net investment income of the S portion and non-S portion according to the general rules used for income tax purposes and then combines the undistributed net investment income of the S portion and non-S portion.

2. The ESBT determines AGI for purposes of the NII tax by adding the net income or net loss from the S portion to the AGI of the non-S portion as an income item of income or loss.

3. The ESBT compares the combined undistributed net income with the excess of its AGI over the threshold for the year (e.g., $12,150 for 2014) to determine whether the NII tax applies.

Bankruptcy estates of an individual. The estate of an individual debtor is treated as an individual for purposes of the NII tax. The applicable threshold for the NII tax is the applicable amount for a married person filing separately ($200,000), regardless of the debtor’s actual tax filing status.

Foreign trusts and estates. Distributions to a U.S. person of income from a foreign entity are included in the net investment income calculation of this person (beneficiary). However, distributions of accumulated income from a foreign trust are not taken into account.

Planning strategies

In view of the NII tax, which is a nearly 4% tax on net investment income, it may be helpful to employ certain strategies that can reduce or eliminate the tax.

Grantors with multiple beneficiaries may, in certain circumstances, prefer to set up separate trusts for each beneficiary. This will allow each trust to keep no more than the triggering amount of taxable income ($12,150 in 2014) and, thus, avoid the NII tax. On the other hand, a single trust reduces administrative costs and may enable better property management. Separate trust shares should be considered.  Thus, tax savings from using multiple trusts should be balanced against the cost and practicalities of a single trust.

An important tax savings strategy for existing trusts and estates is to distribute the income to lower-bracketed beneficiaries. This shifts the onus of the NII tax to beneficiaries who, because of their personal tax status, may not be subject to this tax. If the beneficiaries are exempt from the NII tax, there may be added pressure on fiduciaries to make income distributions in the situation where they have the discretion, under the governing instrument and state law, to do so. Fiduciaries must continue to follow state law rules and the terms in the governing instrument (a trust document or last will and testament) regarding discretionary distributions. Attention should be given to the rules under the Uniform Principal and Income Act and the applicable state law.

Fiduciaries should also maximize the use of the discretionary allocation of expense rule under Reg. Sec. 1.652(b)-3(b)). This allows the fiduciary to allocate expenses to any class of income after the required allocation of direct expenses to the associated income category and the required allocation of a share of indirect expenses to tax-exempt income. For example, if expenses for fiduciary fees, accounting fees, and legal fees can be allocated to categories of income that are investment income, the NII tax exposure is reduced. If the entity holds a business that is considered active (see the discussion of material participation above), not allocating expenses to the category of business income is beneficial because it means the expenses can be allocated to investment income categories. These rules will likely be addressed in forthcoming treasury regulations.

Be sure to factor the NII tax into estimated tax payments for trusts and estates. Estates are not required to pay estimated taxes during the first two years of their existence. Thus, it may be helpful for a revocable living trust of a deceased taxpayer to make a Sec. 645 election to be treated as a qualified revocable trust. This makes the trust part of the estate, for at least two years following the decedent’s death, exempt from aying estimated taxes. The election is made on Form 8855.


Despite lengthy regulations issued last year and extensive instructions to Form 8960 released on February 27, 2014, there are still many open questions regarding the NII tax applicable to trusts and estates, such as how to determine material participation and the deduction allocation provisions. Watch for further guidance from the IRS on this topic.

Sidney Kess, CPA, J.D., LL.M., has authored hundreds of books on tax-related topics. He probably is best-known for lecturing to more than 700,000 practitioners on tax and estate planning.

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