Saturday, March 11, 2017

The "Kiddie Tax"


Wondering how you can save taxes by transferring assets into your children's names?

This tax technique is called income shifting. It seeks to take income out of your higher tax bracket and place it in the lower tax brackets of your children. While some tax savings are available through this approach, the "kiddie tax" rules impose substantial limitations on it if:

1.     the child hasn't reached age 18 before the close of the tax year, or

2.     the child's earned income doesn't exceed one-half of his support and the child is age 18 or is a full-time student age 19 to 23.

The kiddie tax rules apply to your children who are under the above-described cutoff age, and who have more than a set amount of unearned (investment) income for the tax year-$2,100 for 2016 or 2015. Essentially, these rules tax the child's investment income above this amount (called "net unearned income") at the parents' (higher) tax rate. While some tax savings on up to $2,100 of income for 2016 or 2015 can still be achieved by shifting income to children under the cutoff age, the savings aren't substantial.

The following example shows how the kiddie tax rules work. Note that, under the regular tax rules, for 2016 a dependent child cannot claim a personal exemption and is limited to a standard deduction of $1,050 (unless his "earned" income, e.g., from a job, plus $350, exceeds that amount).

Example. For 2016, Mr. and Mrs. Smith are in the 25% federal income tax bracket. That is, they would pay $25 in additional tax on every $100 of additional income. The couple are the parents of a 12-year-old son, Tommy, to whom they transfer a $22,000 bond that pays 10%. Tommy therefore receives $2,200 of investment income. He has no other income.

Had the parents kept the bond, they would have paid $550 in tax on the interest ($2,200 × 25%). Tommy, instead, is taxed on $1,150 of taxable income-$2,200 of gross income reduced by his $1,050 standard deduction-as follows. His "net unearned income" is $100 (the excess of his interest income above $2,100). This part of his taxable income is taxed at 25%, for a tax of $25 ($100 × 25%). The rest of Tommy's taxable income, $1,050 ($1,150 − $100) is taxed at his 10% tax rate, for a tax of $105. Tommy's total tax is thus $130 ($25 + $105). Since the parents would have paid $525 on the interest income, the family saves $420 via the tax move.

If Tommy were 19 or older or, if a student, 24 or older, all of his taxable income would be taxed at his own 10% rate. His tax bill on his $1,150 of taxable income would be $115 ($1,150 × 10%). An additional savings of $15.

Note that, to transfer income to a child, you must actually transfer ownership of the asset producing the income: you cannot merely transfer the income itself. In the above example, the parents were careful to give the child the ownership of the bond itself and didn't merely assign the interest payments to him. Property can be transferred to minor children using custodial accounts under the state Uniform Gifts or Transfers to Minors Acts.

The portion of investment income of a child that is taxed at the parents' tax rates under the kiddie tax rules may be reduced or eliminated if the child's investments produce little or no current taxable income. Such investments include:

·         securities and mutual funds oriented toward capital growth that produce little or no current income;

·         vacant land expected to appreciate in value;

·         stock in a closely-held family business, expected to become more valuable as the family business expands, but which pays little or no cash dividends;

·         tax-exempt municipal bonds and bond funds;

·         U.S. Series EE bonds, for which recognition of income can be deferred until the bonds mature, the bonds are cashed in, or an election to recognize income annually is made.

Investments that produce no taxable income-and which are therefore not subject to the kiddie tax-also include tax-advantaged savings vehicles such as:

·         traditional and Roth individual retirement accounts (IRAs and Roth IRAs), which can be established or contributed to if the child has earned income;

·         qualified tuition programs (QTPs, also known as "529 plans"); and

·         Coverdell education savings accounts ("CESAs").

A child's earned income (as opposed to investment income) is taxed at the child's (not the parents') tax rates, regardless of amount. Therefore, to save taxes within the family, consider employing the child and paying reasonable compensation. This is particularly appropriate if you have your own business, but can be done even if you don't.

Where the kiddie tax applies, it's computed and reported on Form 8615, which is attached to the child's Form 1040.

Parents can elect to include the child's income on their own return, if certain requirements are satisfied. This avoids the need for a separate return for the child, but, generally, doesn't change the tax on the child's unearned income, which is still taxed at the parents' tax rate. However, it's important to consider that the addition of the child's income to the parent's adjusted gross income may affect the various floors and ceilings for, and therefore the amounts of, the parents' deductions and limitations.

The election to include a child's income on the parents' return is made, and the additional taxes resulting to the parents are computed and reported, on Form 8814.
 
If you have any questions on the kiddie tax or would like to discuss the tax ramifications of transferring assets into your children’s names, please contact us.

Saturday, February 11, 2017

Miscellaneous Itemized Deductions

There are types of expenses classified as a "miscellaneous itemized deductions," which may result in a tax deduction for you if you itemize your deductions, depending on your adjusted gross income (AGI) and the total of all your miscellaneous items.
 
First, you compute your total of all expenses that fall into the miscellaneous deduction categories. This amount is deductible as an itemized deduction but only if (and to the extent) it is greater than 2% of your AGI. Note that since it is an itemized deduction, it can only be claimed if you itemize your deductions and don't claim the standard deduction.
 
Example. Jerry's AGI is $75,000. His miscellaneous itemized deductions total $2,000. If he itemizes deductions, he can claim a $500 deduction for his miscellaneous items: $2,000 − $1,500 (2% of $75,000).
 
What are miscellaneous itemized deductions? The following are itemized deductions subject, in total, to the 2% rule described above:
  1. Tax return preparation costs. This category includes the fee to have your tax return prepared as well as other costs related to determining your taxes, such as appraisal costs or legal fees.
  2. Employment-related expenses of an employee other than those reimbursed under an arrangement that meets special requirements. If you incur deductible expenses in connection with your employment, they are miscellaneous deduction items. These include out-of-pocket expenses for which you aren't reimbursed by your employer. They also include expenses for which you are reimbursed or are paid an expense allowance but not under an arrangement that meets specific requirements. You will have to include the reimbursements or allowances in income and then separately deduct the expense as a miscellaneous itemized deduction.
    (If the arrangement meets the requirements, the reimbursement or allowance isn't included in income and the expense isn't deducted. To meet the requirements the arrangement must require you to give a detailed account of your expenses to your employer and to return any excess allowance amounts you received over the expenses incurred.
  3. Investment expenses, and expenses of producing or collecting taxable income. This category includes investment advisor's fees, investment publications, and the cost of a safe deposit box.
  4. Hobby expenses. Expenses related to an activity that is a mere "hobby" (i.e., not a trade or business) are only deductible up to the extent of your income from the activity. You are taxed on the income and then only separately deduct the related expenses as miscellaneous itemized deductions.
There is one final caveat. The deduction for miscellaneous itemized deductions isn't allowed for purposes of the alternative minimum tax.
 
If you have questions, please contact us.  We would be happy to assist you with your tax situation.


Tuesday, January 10, 2017

Income Averaging for Farmers and Fishermen

Look at your tax situation for the past few years.  Do you notice that your taxable income varies greatly from year to year? If so, it is likely that your applicable tax rate may be varying from 0% to as much as 39.6%. Many people are unaware that income averaging is available to farmers and fishermen. The purpose of the income averaging rules is to alleviate the problem of your paying more tax overall if a substantial portion of your income happens to be bunched in one year.
 
As a farmer (or a fisherman), you can elect to average all or part of your taxable "farming income" or "fishing income" over three years. If you make the election, your farming or fishing income subject to the election is treated as if earned in the three previous years. Thus, the elected farm or fishing income is allocated to the three previous years (base years) in equal amounts.
 
For this purpose, farming (or fishing) income includes income from the trade or business of farming or fishing; but, farming (or fishing) income does not include income, gain, or loss from the sale of development rights, grazing rights, and other similar rights. Although farming (or fishing) income does not generally include compensation received as an employee, a shareholder of an S corporation (or a partner in a partnership) engaged in a farming (or fishing) business may generally treat compensation from the S corporation (or partnership) as income from farming or fishing. It also includes income from certain crop-share arrangements, certain vessel leasing arrangements, the sale or disposition of property (other than land), regularly used for a substantial period in a farming or fishing business. Thus, investment income is not eligible for income averaging. A farming business includes operating a nursery or sod farm and raising or harvesting ornamental trees or trees bearing fruit, nuts, or other crops. A fishing business includes the conduct of commercial fishing (i.e., fishing in which all or part of the fish harvested are intended to enter commerce).
 
Here's a simple example of how averaging works. Assume that F, a single farmer, sold some of his farm machinery and more corn than usual, and all of this happened in 2015. F's 2015 taxable income is $50,000, of which $30,000 is from his farming business. F had no taxable income in 2014, $5,000 of taxable income in 2013, and $10,000 of taxable income in 2012. Since F's income is higher than in previous years, F elects to average $30,000 of his 2015 income over the three base years (2014, 2013, and 2012). F figures his 2015 tax in this manner:
  1. He subtracts the elected portion of his current year's taxable farm income ("elected farm income") from his total taxable income. Thus, in 2015, F subtracts the elected farm income ($30,000) from his taxable income of $50,000. F's remaining 2015 taxable income is $20,000.
  2. He figures the tax on the amount in (1) using the tax tables or tax rate schedules for the current year (in this case, 2015). Under the 2015 tax tables, the tax on $20,000 is $2,543.
  3. For each of the three base years (2014, 2013, and 2012), F adds one-third of the current year's (2015) elected farm income ($10,000 each year) to his taxable income for that year and figures the tax on that amount. Then, in each of the three base years (2014, 2013, and 2012), F subtracts his actual tax from the tax computed for the base year.
  4. Then, F adds the amounts computed for the three base years (2014, 2013, and 2012) to the amount of tax computed for the current year (2015) ($1,050 + $1,305 + $1,500 + $2,543) for a total tax of $6,398. If F had not elected to average his farm income, his 2015 tax (computed under the tax tables) would have been $8,300. Thus, by making the election, F saved $1,902. 
With careful year-end tax planning, we may be able to maximize the benefits of averaging for you. Generally, you will benefit from the election if the income allocated to the three previous years will be subject to a lower tax rate than it would be in the current year. For example, it could be beneficial to accelerate income this year (e.g., sell appreciated farm assets this year). This acceleration would increase this year's farming or fishing income and the increase would receive the benefits of averaging. However, we also need to keep in mind that any amounts allocated to the three previous years as additional income will continue to be allocated to those years should you elect to average your farming or fishing income in future years. Thus, the allocated amounts will increase your taxable income in those years and may reduce any benefits that you might get from an election in later years.
 
Before making an election, we will need to consider all of the tax implications of the election. For example, we would need to determine the appropriate portion of your farm or fishing income that should be subject to the election.  Also keep in mind that this election can be made on an amended return.  So even if you haven’t utilized farm income averaging in the past, a review of your last 6 years of tax returns could identify potential refunds.
 
Please contact us if you have any questions concerning income averaging or if you would like to discuss how income averaging could benefit you.

Friday, December 9, 2016

Avoiding Hobby-Loss Restrictions

Like many of us, you've probably dreamed of turning a hobby or avocation into a regular business. You won't have any unusual tax headaches if your new business is profitable. However, if the new business consistently generates losses (deductions exceed income), the IRS may step in and say it's a hobby (an activity not engaged in for profit) rather than a business.

What are the practical consequences? Under the so-called hobby loss rules, you'll be able to claim certain deductions that are available whether or not the business is engaged in for profit (such as state and local property taxes). However, your deductions for business-type expenses (such as rent or advertising) will be limited to the excess of your gross income from the hobby over those expenses that are deductible whether or not the business is engaged in for profit. Deductible hobby expenses are claimed on Schedule A of Form 1040 as miscellaneous itemized deductions subject to a 2%-of-AGI "floor."

There are two ways to avoid the hobby loss rules. The first way is to show a profit in at least three out of five consecutive years (two out of seven years for breeding, training, showing, or racing horses). The second way is to run the venture in such a way as to show that you intend to turn it into a profit-maker, rather than operate it as a mere hobby. The IRS regs themselves say that the hobby loss rules won't apply if the facts and circumstances show that you have a profit-making objective.

How can you prove that you have a profit-making objective? In general, you can do so by running the new venture in a businesslike manner. More specifically, IRS and the courts will look to the following factors:
  • how you run the activity
  • your expertise in the area (and your advisers' expertise)
  • the time and effort you expend in the enterprise
  • whether there's an expectation that the assets used in the activity will rise in value
  • your success in carrying on other similar or dissimilar activities
  • your history of income or loss in the activity
  • the amount of occasional profits (if any) that are earned
  • your financial status
  • whether the activity involves elements of personal pleasure or recreation

The classic "hobby loss" situation involves a successful businessperson or professional who starts something like a dog-breeding business, or a farm. But IRS's long arm also can reach out to more commonplace situations, such as businesspeople who start what appears to be a bona-fide sideline business.

Please contact our office to get more details on whether a venture of yours may be affected by the hobby loss rules, and what you should do right now to avoid a tax challenge.

Friday, December 2, 2016

ALERT – Deadline Change for Information Returns

A new federal law has moved up the filing date for W-2s and certain 1099 forms.  Under the new law, employers (and paid preparers) must submit copies of these forms to the IRS and SSA by January 31.  This change is effective with the 2016 information forms that will be due on January 31, 2017.  The accelerated deadline is intended to help the IRS spot errors on returns and make it easier for the IRS to verify the legitimacy of tax returns filed.

Previously, a copy of these forms was required to be provided to recipients by January 31, but employers (and paid preparers) had until the end of February (if filing on paper) or March (if filing electronically) to send copies to the Internal Revenue Service (IRS) and the Social Security Administration (SSA).

A 30-day extension is available for IRS submission.  If an extension is necessary, Form 8809 Application for Extension of Time to File Information Returns must be completed as soon as possible, but no later than January 31.

 




Wednesday, November 30, 2016

Handouts for Township Officials

On Wednesday, November 30, 2016, Curtis Root, CPA, gave a presentation on issues related to the upcoming audit cycle for local township officials.  The handouts mentioned in the presentation can be viewed and downloaded here.  Larsson, Woodyard & Henson would be pleased to answer any follow up questions.  Please contact us with any questions you have.

Wednesday, November 23, 2016

ALERT! Proposed Overtime Rule Blocked

ALERT!  The proposed overtime rules will not take effect on December 1, 2016.  A federal court has issued a preliminary injunction blocking implementation at this time.  View more about this at http://www.reuters.com/article/us-usa-employment-overtime-idUSKBN13H2JY.