Curcuru & Associates CPA, PLC | 248-538-5331

Deducting Investment Interest

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investment interest expenseInvestors are allowed to deduct interest expense they pay on debt incurred to purchase or carry property held for investment.  Property held for investment includes any property producing interest, dividends, annuities, royalties, and gain-generating property other than that used in a business.

How the Investment Interest Expense Deduction Works

Investment interest is deductible as an itemized deduction.  It is limited to net investment income.  Net investment income is defined as investment income that exceeds investment expenses.  Investment income includes interest and includes gains that are not subject to the reduced capital gains tax rate (e.g., short term capital gain taxed at ordinary rate is qualifying investment income while long term capital gain taxed at 15% is not qualifying investment income).  Also excluded from qualifying investment income are qualified dividends subject to the lower capital gains tax rates.  An election exists whereby a taxpayer can treat qualifying dividends and capital gains as ordinary income and treat such income as qualifying investment income in order to deduct investment interest expense, but this election generally won’t be beneficial.

Watch Out for Tax Exempt Securities

Investment interest does not include interest expense incurred to purchase tax-exempt securities, so such interest expense is not deductible.  This rule also applies to mutual funds so if a fund invests in both taxable and tax-exempt securities, the interest expense must be allocated proportionally based on the income in the fund.

Because expenses allocated to tax-exempt securities are not deductible, the allocation of expenses to tax-exempt income should be minimized.  While it is common to allocate investment expenses to taxable and non-taxable income based on the amount of income in each category, allocating the interest expense in a different manner (such as the number of transactions or the amount of time spent on each class of income) may provide larger allocations to taxable income and therefore increase the amount of deductible investment interest expense.

Example:  Danny manages his own investments.  He trades very frequently, but hasn’t been successful this year.  His taxable investment income is $5,000 and his tax-exempt investment income is also $5,000.  If he allocated investment interest expense based on the relative amount of income from each class, only half of his investment interest expense would be deductible.  However, if 90% of his time in his investment activities is managing his taxable investments and 10% of his time is spent managing his tax-exempt investments, then he has a strong case that 90% of his investment interest should be deductible.

Taxpayers who receive tax exempt income must submit with their returns an itemized statement showing the amount of each class of exempt income and the expenses allocated to each class.  If an item is allocated between tax-exempt and taxable income, the basis of the allocation must be shown on the statement.

To see how this applies to you, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Tax Scammers Sending Affordable Care Act Penalty Notices

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aca-scamTax scammers are at it again.  The IRS has just issued an alert to taxpayers to be on guard against fake emails containing a fraudulent IRS tax bill related to the Affordable Care Act.  The fraudulent tax bill uses the same formatting and very similar language to the actual IRS Form CP2000.

The Real Form 2000CP

The IRS sends Form 2000CP when income reported from third-party sources (such as an employer) does not match the income reported by the taxpayer on his return.  The form provides instructions to taxpayers about what to do if they agree or disagree with the proposed additional tax.  If the taxpayer will send payment, the form instructs that payment be made out to “United States Treasury.”  The Form 2000CP is mailed to taxpayers—it is never emailed.

The Fake Form 2000CP

The IRS has received numerous reports of a fake Form 2000CP being emailed to taxpayers around the country.  The fake forms have the following characteristics:

  • An email that contains the fake CP2000 as an attachment
  • The notice appears to be issued from Austin, Texas
  • The underreported issue is related to the Affordable Care Act requesting information regarding 2014 coverage
  • The payment voucher lists the letter number as 105C
  • The notice includes a payment request that taxpayers mail a check made out to “I.R.S.” to the “Austin Processing Center” at a PO Box. This is in addition to a payment link within the email itself.

The American Institute of Tax Problem Solvers (of which we are members) obtained a copy of the fake tax notice.  It can be viewed here.

What to Do if You Receive a Fake Notice

Taxpayers who receive this scam email should not open the attachment, but forward it to phishing@irs.gov and then delete it from their email account.  Taxpayers should be wary of any unsolicited email purported to be from the IRS.  They should never open an attachment or click on a link within an email sent by an unknown source.

 

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

 

Tax Credits for Energy-Efficient Homes

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energy-tax-creditOver the past several years, Congress has provided taxpayers with a nonrefundable tax credit for energy efficient home improvements.  These tax credits were scheduled to expire in the past, but Congress continues to extend them.  Once again, these credits have been extended through 2016.  This post is a summary of the current rules regarding these credits.

The Credit for Nonbusiness Energy Property

Individuals can claim a nonrefundable tax credit for certain expenditures during 2016 to increase the energy efficiency of their primary residences (not for vacation or second homes) in the United States.

The credit equals the sum of:

  • 10% of certain costs for property installed during the year to improve the energy efficiency of existing homes (these costs are referred to as building envelope components)
  • amounts paid for residential qualified energy property expenditures

Building envelope components are:

  • insulation systems that reduce heat gain/loss
  • exterior windows (including skylights)
  • exterior doors
  • certain metal and asphalt roofs designed to reduce heat gain

For building envelope components, the credit is allowed only for amounts paid to purchase the components.  The credit is not available for amounts paid for onsite preparation, assembly, or original installation of the component.  The component must meet or exceed certain energy efficiency criteria (the manufacturer will certify whether a component meets the criteria).

Qualified energy property is property that meets certain energy efficiency criteria (once again, the manufacturer will certify whether a product meets the criteria).  The credit equals 100% of the cost of the property (up to the limits below).  Qualified energy property includes:

  • electric heat pump water heaters (up to $300)
  • electric heat pumps (up to $300)
  • biomass fuel stoves (up to $300)
  • high-efficiency central air conditioners (up to $300)
  • natural gas, propane, or oil water heaters (up to $300)
  • natural gas, propane, or oil furnaces or hot water boilers (up to $150)
  • advanced circulating air fans (credit limited to $50)

For qualified energy property, the credit is available for amounts paid to purchase the property as well as for costs for onsite preparation, assembly, or original installation.

For building envelope components and qualified energy property, there is a taxpayer lifetime tax credit limit of $500 ($200 for exterior windows and skylights), taking into account all such credits allowed to the taxpayer after 2005.

The Credit for Residential Energy Efficiency Property

This is an entirely separate tax credit and is generally available for installation of alternative energy equipment through at least 2016.  Taxpayers can claim a tax credit for 30% of the cost of eligible solar water heaters, solar electricity property, fuel cell property, small wind energy property, and geothermal heat pump property.  The 2016 Consolidated Appropriations Act extends the Residential Energy Efficient Property credit for five years so it applies to property placed in service through 2021, but ONLY for qualified solar electric property expenditures and qualified solar water heating property expenditures.  The credit will decrease to 26% for 2020 and 22% for 2021 (down from the current 30%).

Expenditures for labor costs for onsite preparation, preparation, assembly, or original installation of qualified property and for piping or wiring to interconnect such property to the dwelling unit also qualify for the credit.

The principal residence requirement does not exist for qualified solar water heating, solar electric, small wind energy, or geothermal heat pump expenditures.

To see how this applies to you, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

The High Tax Cost of Renouncing U.S. Citizenship

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tax-exitWith the upcoming election there is increased talk about leaving the country if that person wins.  While these statements are generally made in jest, there has been an increase in the number of Americans contemplating expatriation because of high U.S. taxation or administrative burdens.

Expatriation comes at a high tax cost for certain people who are covered expatriates.  Covered expatriates are basically treated as if they sold all of their assets at current market value and recognize any gain in excess of an exclusion amount.  If someone renouncing their U.S. citizen is a covered expatriate, he may face a very steep tax cost for expatriation.

Who is a Covered Expatriate?

A covered expatriate is a person who meets any ONE of the following tests:

  • for 2016, the individual’s average annual net income tax liability for the give preceding five years exceeds $161,000
  • the individual has a net worth of $2 million or more
  • the individual fails to certify under penalties of perjury that he has complied with all U.S. federal tax obligations for the preceding five years (this question is often posed to those seeking expatriation)

The following individuals are NOT covered expatriates (as long as compliant with all tax obligations for the past 5 years):

  • an individual born a citizen of the U.S. and another country if she continues to be a citizen and resident of the other country and has not resided in the U.S. for more than 10 out of the last 15 years
  • An individual who gives up U.S. citizenship before reaching age 18 and a half if not a resident in the U.S. for more than 10 years before relinquishment

The Income Tax Cost of Expatriation

The exit tax treats the expatriate as having sold all of her assets for fair market value on the day before expatriation.  Keep in mind that the expatriate is not required to actually sell his assets, he just has to pay tax as if he did.  Gain realized from the deemed sale must be taken into account without regard to other provisions of the Code.  This means that gains that would otherwise be tax-free are subject to tax (e.g., gain on the sale of a principal residence would be taxable when it would otherwise be tax free).  For 2016, net gain on the deemed sale is included in taxable income to the extent it exceeds $693,000.

Example:  Johnny renounces his U.S. citizens.  His net worth is $3 million so he is a covered expatriate.  The tax basis of his assets equals $1 million, so he has a net gain of $2 million.  He has taxable income to the extent his $2 million net gain exceeds the exclusion amount of $693,000.  His taxable income is therefore $1,307,000.  Depending on the type of assets he owns, some of the gain will be capital gain and some will be ordinary income.  Basically, Johnny will owe a tax of several hundred thousands of dollars for renouncing his U.S. citizenship.

The Estate & Gift Tax Cost of Expatriation

Normally, the gift and estate tax is paid by the person giving away the property.  In the case of a covered expatriate gifting or bequeathing property, the tax is paid by the recipient if the recipient is a U.S. citizen or resident.  The tax is the highest gift or estate tax rate in effect on the date of transfer (currently a 40% tax rate).  The value of the gift or bequest is reduced by the $14,000 annual gift tax exclusion and by any gift/estate tax paid to a foreign country.  The gift/bequest is NOT reduced by the lifetime exclusion amount (currently $5.45 million).

The following items are exempt from this tax:

  • a gift by a covered expatriate shown on a timely-filed gift tax return
  • a bequest by a covered expatriate shown on a timely-filed estate tax return
  • a gift or bequest that would be eligible for an estate or gift tax charitable or marital deduction if the transferor were a U.S. citizen

As you can see, the tax cost of someone renouncing her U.S. citizenship is very high.  This is not a decision to be taken lightly.

 To see how this applies to you, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

New Relief for Missing 60 Day Rollover Deadline

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60 day waiverDistributions from IRAs or qualified plans are not taxable and not subject to penalty if they are transferred to an eligible retirement plan no later than the 60th day following the day of receipt.  A similar rule applies to 403(a) annuity plans, 403(b) tax sheltered annuities, and 457 government plans.

If the rollover is not made within 60 days of receipt, the amount distributed will be subject to income tax and will be subject to a 10% early withdrawal penalty.  Unfortunately, mistakes happen and taxpayers sometimes miss the 60 day deadline to complete the rollover.

Relief Available for Missing the 60 Day Rollover Deadline

The IRS may waive the 60 day requirement where the failure to waive the 60 day requirement would be against equity or good conscience, including casualty, disaster, or other events beyond the reasonable control of the taxpayer.

New guidance from the IRS provides relief for taxpayers who have a good reason for missing the 60 day deadline.  The guidance allows the taxpayer to make a written certification to a plan administrator or IRA custodian that the taxpayer meets the requirements for the IRS to waive the 60 day rule.  The IRA custodian or plan administrator may rely on the written certification and treat the rollover as if it was made within the 60 day period.  However, the certification is subject to audit by the IRS.

The requirements of the self certification are:

  1. the IRS must not have denied a previous waiver request with respect to a rollover of all or part of the distribution to which the contribution relates
  2. the taxpayer must have missed the 60 day deadline because of the taxpayer’s inability to complete a rollover due to one or more of the following reasons:
  • an error was committed by the financial institution receiving the contribution or making the distribution to which the contribution relates
  • the distribution, having been made in the form of a check, was misplaced and never cashed
  • the distribution was deposited into and remained in an account that the taxpayer mistakenly thought was an eligible retirement plan
  • the taxpayer’s principal residence was severely damaged
  • a member of the taxpayer’s family died
  • the taxpayer or a member of the taxpayer’s family was seriously ill
  • the taxpayer was incarcerated
  • restrictions were imposed by a foreign country
  • a postal error occurred
  • the distribution was made on account of an IRS levy and the proceeds of the levy were returned to the taxpayer
  • the party making the distribution delayed providing information that the receiving plan or IRA required to complete the rollover despite the taxpayer’s reasonable efforts to obtain the information

The contribution must be made to the plan or IRA as soon as practicable after the reason(s) listed in the preceding paragraph no longer prevent the taxpayer from making the contribution.  This requirement is automatically satisfied if the contribution is made within 30 days after the reason(s) no longer prevent the taxpayer from making the contribution.

The Self-Certification is Subject to IRS Audit

The IRS may, in audit, consider whether a taxpayer’s contribution meets the requirements for a waiver.  For example, the IRS may determine that the requirements for a waiver were not met because of a misstatement in the self-certification, the reason(s) claimed for missing the 60 day deadline did not prevent the taxpayer from completing the rollover within 60 days, or the taxpayer failed to make the contribution as soon as practicable after the reason(s) no longer prevented the taxpayer from making the contribution.  If the IRS disallows the waiver, the taxpayer will be subject to tax and penalty on the distribution.

To see how this applies to you, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

IRS Impersonators Now Targeting Students & Parents

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More and more people are receiving phone calls from IRS impersonators.  The latest scam involves telephone scammers targeting students and parents during the back-to-school season and demanding payment for non-existent taxes, such as the “Federal Student Tax.”

During these calls, if the student or parent does not cooperate with the scammer, the scammer will become aggressive and threaten to report the student to the police to be arrested.  As schools and universities are preparing for the new school season, it is important for taxpayers to be aware of this latest scam.

IRS impersonators are constantly identifying new ways to carry out their crimes in new and unsuspecting ways.  Some of the latest scams include:

  • Altering the caller ID on incoming phone calls in a spoofing attempt to make it seem like the IRS, the local police, or another government agency is calling
  • Imitating tax software providers to trick tax professionals
  • Demanding fake tax payments using iTunes gift cards
  • Contacting human resource professionals to solicit W-2 information of employees
  • “Verifying” tax return information over the phone
  • Pretending to be from the tax preparation industry

These scammers often threaten to do things that the IRS would never do.  It is the telltale sign of a scam if the impersonator attempts extraordinary IRS measures.  The IRS will never:

  • Call to demand immediate payment using a specific payment method such as a prepaid debit card, gift card, or wire transfer. The IRS will first mail you a bill before doing anything else.
  • Threaten to immediately bring in local police or other law-enforcement groups to have you arrested for not paying
  • Demand that you pay taxes without giving you the opportunity to question or appeal the amount they say you owe
  • Ask for credit or debit card numbers over the phone

If you get a call from an IRS impersonator, here’s what you should do:

  • Do not give out any information. Hang up immediately
  • Search the web for telephone numbers scammers leave in your voicemail asking you to call back. Some of the phone numbers may be published online and linked to criminal activity
  • Contact the U.S. Treasury Inspector General for Tax Administration (TIGTA) at 800-366-4484 or at their website to report the call.
  • Report the call to the Federal Trade Commission at the FTC Complaint Assistant site website.
  • If you may owe additional taxes, contact a tax professional

 

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

New Deadline for Form 1099-MISC–Avoid Late Penalties!

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Form 1099MISC deadlineForm 1099-MISC has to be filed when payments are made in the course of a trade or business.  Personal payments do not have to be reported on a Form 1099-MISC.  The IRS requires businesses to issue Form 1099-MISC to the payee and submit a copy to the IRS.  This is done to ensure that the payee reports and pays income tax on the payment.

NEW FILING DEADLINE FOR FORM 1099-MISC

Starting with 2016 Form 1099-MISCs, the IRS copy of the form must be filed with the IRS by January 31 if you are reporting payments in box 7 (non-employee compensation).  The prior due date was February 28 (and March 31 if filing electronically).  The form filing deadline for payments outside of box 7 (e.g., rent or royalty) have not changed (i.e., due February 28 or, if filed electronically, March 31).  The payee copy, regardless of the type of payment, is still due on January 31.

Penalties for Late Filing/Non-Filing

If the Form 1099 is filed within 30 days after the deadline, the penalty is $50 per 1099.  If the Form 1099 is filed between 30 days after the deadline and by August 1, the penalty is $100 per 1099.  If the Form 1099 is filed after August 1 (or not filed at all), the penalty is $260 per 1099.  If there is intentional disregard of the filing requirement, the penalty is $530 per 1099.

The above penalties apply if the form is not filed with either the IRS or the payee.  If the Form 1099 is not filed with either the IRS or the payee, the above penalty is essentially doubled.

What Type of Payments Have to Be Reported on Form 1099-MISC?

Payments that require the filing of a Form 1099-MISC include:

  • $10 or more in royalty payments
  • At least $600 in:
    • Rents
    • Services provided to you by someone who is not your employee (e.g., independent contractor)
    • Prizes and awards
    • Other income payments
    • Crop insurance proceeds
    • Cash payments for fish (or other aquatic life) you purchase from anyone engaged in the trade or business of catching fish
    • Cash paid from a notional principal contract to an individual, partnership, or estate
    • Payments to an attorney
    • Any fishing boat proceeds

In addition, Form 1099-MISC is used to report that you made direct sales of at least $5,000 of consumer products to a buyer for resale anywhere other than a permanent retail establishment.

What Payments Do NOT Have to Be Reported on Form 1099-MISC?

Certain payments do not have to be reported on Form 1099-MISC, although they may still be taxable to the payee.  Common payments that do not have to be reported on a Form 1099-MISC include:

  • Payments to a corporation (see exceptions below)
  • Payments to an LLC that elects to be treated as a corporation (again, see exceptions below)
  • Payments for merchandise
  • Wages paid to employees
  • Payments of rent to real estate agents (but the real estate agent must use Form 1099-MISC to report the rent paid over to the property owner)
  • Payments made by credit cards (the credit card company will issue a 1099-K to the recipient)

When Payments to Corporations Must Be Reported on Form 1099-MISC

Form 1099-MISC is required for payments to corporations for:

  • Medical and health care payments
  • Fish purchases
  • Attorney fees
  • Gross payments to attorneys (generally by insurance companies)
  • Substitute payments in lieu of dividends

When Backup Withholding is Required

You must withhold 28% of the payment you make to certain recipients.  This withholding is referred to as backup withholding and is paid to the IRS.  Backup withholding is required when:

  • The payee fails to furnish a SSN or TIN (it is recommended to get the payee’s SSN or TIN prior to the payee performing any services for you)
  • IRS notifies payer to impose backup withholding

To see how this applies to you, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Crowdfunding & Taxes

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crowdfunding taxSome start-up businesses looking to raise capital have turned to crowdfunding as an alternative to venture capital.  Crowdfunding is a way for businesses and entrepreneurs to solicit online contributions from multiple parties.  This is typically done through a crowdfunding platform such as Kickstarter (www.kickstarter.com) or AngelList (www.angel.co).

Crowdfunding has increased in popularity since the enactment of Title III of the Jumpstart our Business Startups (JOBS) Act in 2012.  This act created a federal exemption under the securities law to permit companies to offer and sell securities through crowdfunding.  Since that time, this practice has generated billions in capital for startups and small businesses.

While this is becoming a more popular method of raising funds, little is known about how such fund-raising models are taxed.

As a general rule, crowdfunding contributions are includable in the startup’s taxable income.  However, depending on how the contribution is structured, the contribution may qualify as a tax-free loan, gift, or capital contribution.

Tax-Free Loan

Crowdfunding contributions structured as loans are tax-free.  However, the arrangement must have sufficient debt-like characteristics.  Debt-like characteristics include an unconditional promise to repay, a fixed interest rate, and a specified maturity date.  If the interest rate depends on the profitability or cash-flow of the business, then it may be considered an equity contribution (which may also qualify as tax-free).  Funds transferred without a bona fide repayment obligation will be taxable even if the parties characterize the deal as a loan.

Tax-Free Gift

If the contribution is a gift, then it is not taxable to the business.  To qualify as a gift, the contribution must be out of a detached and disinterested generosity.  Basically, the donor does not expect any repayment or return on the contribution—it is done out of generosity.  If the donor receives anything of benefit from the contribution, the contribution will be taxable to the business.

Some crowdfunding platforms offer rewards in exchange for contributions.  These rewards may negate a contributor’s donative intent unless the reward is clearly inconsequential.  There is no direct guidance on how to determine if a reward is inconsequential, but the IRS’ guidance on quid pro quo charitable contributions may provide some help.

If the contribution qualifies as a gift, the contributor may have a gift tax issue if the contribution exceeds $14,000.

Tax-Free Equity Contribution

If the crowdfunding contribution qualifies as a contribution to equity and the contributor becomes an owner, it will generally be tax-free to the business and the contributor.

Where We Stand

So far, there are no statutes, regulations, court cases, or IRS rulings that directly address the taxability of crowdfunding contributions.  For now, it is safe to assume that crowdfunding contributions will be taxable income unless it qualifies as a loan, gift, or capital contribution.

To see how this applies to you, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

Increases Expected to Social Security Tax Base

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FICA tax baseAnyone who has received a paycheck knows that FICA takes a chunk out of their gross pay every payday, but many people don’t understand what FICA is (or what it stands for).  FICA is the Federal Insurance Contributions Act and it imposes two taxes on employers, employees, and self-employed people.  The first tax is Old Age, Survivors, and Disability Insurance (OASDI; commonly known as Social Security).  The second tax is Hospital Insurance (HI; commonly known as Medicare).

How Much is the FICA Tax?

The total FICA rate for both taxes is 7.65%–6.2% for Social Security and 1.45% for Medicare.

For 2016, an employee will pay:

  • 2% Social Security tax on the first $118,500 of wages (maximum tax is therefore $7,347 [6.2% of $118,500]) plus
  • 45% Medicare tax on the first $200,000 of wages ($250,000 for joint returns; $125,000 for married taxpayers filing separately), plus
  • 35% Medicare tax (regular 1.45% Medicare tax plus 0.9% additional Medicare tax) on all wages in excess of $200,000 (($250,000 for joint returns; $125,000 for married taxpayers filing separately)

The employer will match the employee’s 6.2% Social Security tax and the 1.45% Medicare tax (but not the 0.9% additional Medicare tax—this tax is just on the employee).

For 2016, a self-employed person will pay:

  • 4% Social Security tax on the first $118,500 of self-employment income (maximum tax is therefore $14,694 [12.4% of $118,500]) plus
  • 9% Medicare tax on the first $200,000 of self-employment income ($250,000 for joint returns; $125,000 for married taxpayers filing separately), plus
  • 8% Medicare tax (regular 2.9% Medicare tax plus 0.9% additional Medicare tax) on all self-employment income in excess of $200,000 (($250,000 for joint returns; $125,000 for married taxpayers filing separately)

There is a maximum amount of income subject to Social Security tax, but there is no maximum amount for Medicare.

Projected Increases in Social Security Tax Base

The Social Security’s Office of the Chief Actuary (OCA) is projecting that the Social Security trust fund will become insolvent in 2034, and that the Disability Insurance trust fund will become insolvent in 2023.  To shore up the programs’ solvency, it is expected that the Social Security taxable base will be increased.  The OCA has provided the following estimated projection of the increase in the Social Security taxable base over the next few years:

  • 2016 $118,500
  • 2017 $126,000
  • 2018 $129,900
  • 2019 $135,900
  • 2020 $142,500

These are just estimates—the actual increases to the taxable base are announced in October of the preceding year and are based on then-current economic conditions.

Basically, someone with at least $126,000 in wages will owe an additional $465 in taxes in 2017 because of the taxable base increase ($126,000 less $118,500 times 6.2%).  A self-employed person with equal income will owe an additional $930 in self-employment tax.

To see how this applies to you, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

How Terminations or Sales of Life Insurance Policies are Taxed

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life insurance taxationLife insurance proceeds on the death of an insured are generally income-tax free.  Other forms of distributions from life insurance policies may or may not be taxable.

How a Termination/Surrender is Taxed

When a life insurance policy is terminated and the policyholder receives cash, the cash receipt will be taxable to the extent it exceeds the investment in the contract.  The investment in the contract is the total amount of premiums or other consideration paid for the contract, less the aggregate amount of non-taxable proceeds received under the contract (e.g., as a loan or nontaxable dividend).

Example:  Joan has paid $24,000 in premiums for a whole life policy.  The current cash value is $30,000.  Joan has not received any distributions from the policy.  If Joan cancels her policy and receives the $30,000 cash value (assume no surrender fees), she has taxable income equal to the proceeds ($30,000) less her investment in the contract ($24,000).  Thus, her taxable income is $6,000.

The next question is whether the $6,000 is taxed as capital gain (subject to a maximum 20% tax rate) or as ordinary income (subject to a maximum 39.6% tax rate).  Unfortunately, when a life insurance policy is terminated, any income will be taxed as ordinary income.

How a Sale of a Policy is Taxed

In contrast to a termination or surrender of a life insurance policy, when a policy holder sells a life insurance policy, a portion of the income may qualify for capital gain treatment.  The portion of the sales proceeds that exceeds the cash value can qualify for capital gain treatment.

Example 2:  Same facts as above except that Joan finds a viatical settlement company to purchase her policy for $35,000.  Joan’s total income is $11,000–the $35,000 sales proceeds less her $24,000 investment in the contract.  The portion of her income that can be taxed as capital gain is $5,000 (the excess of the sales proceeds over the cash value).  The remaining $6,000 of income is taxed at her ordinary income rate.

Tax-Free Sales if Policyholder is Terminally or Chronically Ill

An important exception to the taxability of a sale of a life insurance policy is when the policy is sold to a qualified viatical settlement provider and the policyholder is terminally or chronically ill.  In this situation, the proceeds are tax free if the policyholder is terminally ill.  If the policyholder is chronically ill, the proceeds are tax-free subject to certain limits.

Loans Can Cause a Problem

If there is an outstanding loan on the policy when the policy is terminated, the outstanding amount of the loan will be treated as cash proceeds (i.e., it will be taxable if it exceeds the investment in the contract).

Example:  Jim has paid $24,000 in premiums.  He has taken out a $20,000 policy loan.  The cash value of the policy is $10,000.  If Jim terminates the policy, his cash proceeds will be equal to his actual cash distribution ($10,000) plus his outstanding loan ($20,000).  His total cash proceeds are $30,000.  His taxable income will be his $30,000 proceeds less his $24,000 investment in the contract.  He will have $6,000 of income taxed at his ordinary tax rate.

Exchanging Life Insurance Policies Can Be Tax-Free

When a policyholder needs a different level of coverage and/or wants to work with a different life insurance company, an exchange of life insurance policies can be tax-free if strict requirements are met.  This is done under Section 1035, which is a provision of the U.S. tax code that gives a policyholder the ability to transfer funds from a life insurance, endowment or annuity to a policy of a similar type.

 

To see how this applies to you, give us a call at 248-538-5331.

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Buzzkill Disclaimer:  This post contains general tax information that may or may not apply in your specific tax situation. Please consult a tax professional before relying on any information contained in this post.

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