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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.

How to Borrow Money from a 401(k)

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401k loanOne benefit of being a participant in a qualified retirement plan (e.g., 401(k) or profit sharing plan, but not a SIMPLE or SEP) is the ability to borrow money from the qualified plan.  The loan process is usually quick, the funds can be borrowed for any reason, it won’t affect the participant’s credit rating, and can cost less than a bank loan.  Additionally, the interest the participant pays on the loan is essentially paid back into the participant’s plan account (i.e., the participant is paying interest to herself).

It is important that the loan follow certain rules or the amount loaned will be treated as a taxable distribution and be subject to the 10% early withdrawal penalty.

The Maximum Loan Amount Requirement

The loan amount cannot exceed the lesser of:

  • $50,000 or
  • One-half of the present value of the participant’s nonforfeitable accrued benefit under the plan

If the plan meets certain requirements, a loan of up to $10,000 is allowed even if $10,000 is greater than ½ of the participant’s nonforfeitable accrued benefit.

A participant can have more than one outstanding loan at a time.  However, any new loan, when added to the outstanding balance of all of the participant’s plan loans, cannot exceed the plan maximum amount.

The Term Requirement

The loan must generally be repaid within five years with substantially level amortization, with payments made not less frequently than quarterly, over the term of the loan.  The five-year term requirement does not apply when the plan loan is used to buy a principal residence for the participant.

The level amortization is not required if the participant is on a leave of absence not lasting more than one year (longer, if for military service) and either (1) is not receiving pay or (2) is receiving pay at a lower rate than the required installments under the plan loan.  Even though the level amortization requirement is avoided, the loan must still be repaid within the five years.

Documentation Requirement

The loan must be evidenced by a legally enforceable written agreement with terms that demonstrate compliance with the requirements for non-distribution treatment, specifying the amount and date of the loan, and the repayment schedule.

Is the Interest Deductible?

Probably not.  There are three situations where interest is definitely not deductible.  The first is where the loan is made to a key employee (a 5% owner of the company or an officer making more than $170,000 for 2016).  The second situation is where the loan is secured by amounts attributable to the employee’s contribution amounts to the plan.  The final situation is where the loan is used for education.  Even if none of these three rules bar the interest deduction, the plan loan must meet specific statutory rules to be deductible (e.g., business loans, loans secured by a residence, etc.)

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.

Here’s My Article About Prince and the Estate Tax

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prince estate tax

The estate tax is still around, but it is as good as dead for the vast majority of people.  When I began practicing in tax in 1996, anyone who had a gross estate over $600,000 had to be concerned about the estate tax. This $600,000 amount was the estate tax exemption amount for that year.  The gross estate for U.S. citizens and permanent residents includes assets held throughout the world, the face amount of life insurance, and various other items that may surprise taxpayers.

I Would Die 4 U and File a 706 Return

While the estate tax is applied to asset transfers upon his or her death, the gift tax applies to transfers made during life.  This prevents people from gifting all their assets shortly before death to avoid the estate tax.

The estate tax exemption amount for 2016 is $5.45 million, and is indexed for inflation.  Anyone with a gross estate under $5.45 million will not have to file an estate tax return or pay the estate tax.  While anyone with a gross estate over $5.45 million will have to file an estate tax return, there may not be a tax due because the gross assets are reduced by liabilities, estate tax deductions, and the exemption amount.  These items may reduce the taxable estate to nothing.  The estate tax rate is currently 40%.  Besides the estate tax exemption, another significant deduction is the marital deduction.  Basically, the first spouse to die could transfer his or her assets to the surviving spouse after death and receive a deduction from estate tax.  The problem with this strategy is that It wasted the first deceased spouse’s exemption amount.

Example:  John and Joan are married.  For this example, the estate tax exemption amount is $1 million.  Each of them has $1 million in assets.  If all of John’s assets are transferred to Joan upon his death, he would owe no estate tax because his $1 million gross estate is reduced to $0 by the marital deduction.  The problem is that Joan now has $2 million in assets.  When she dies, her gross estate is $2 million.  The $2 million gross estate is reduced by her $1 million estate tax exemption leaving her with a $1 million taxable estate.  If the estate tax rate is 40%, her estate tax would be $400,000. 

Nothing Compares to Portability

Portability refers to the new ability of one spouse to transfer her unused estate tax exemption to her surviving spouse.  Before portability, each spouse had an exemption amount and the exemption amount could not be transferred to the surviving spouse.  A common tax planning technique was to create two trusts upon the death of the first spouse.  The first trust would basically be funded with an amount equal to the exemption amount.  This is the family trust which could be used to support the surviving spouse and the other family members.  The amount used to fund the family trust would be sheltered by the estate tax exemption amount.  The remainder of the assets would either be transferred directly to the surviving spouse or to a marital trust which would only support the surviving spouse.  The amount used to fund the marital transfer would be sheltered by the marital deduction.

Example: Ricky and Lucy each have assets of $1.5 million and the estate tax exemption amount is still $1 million.  Upon Lucy’s death, she transfers $1 million of assets to a family trust that can provide support to Ricky and other family members.  Lucy is thus able to utilize her estate tax exemption amount.  The remaining $500,000 of her assets will be transferred directly to Ricky.  Lucy’s $1.5 million estate is thus reduced to $0 by her $1 million exemption amount (the amount transferred to the family trust) and by the $500,000 marital deduction for the transfer to her spouse.  Ricky’s gross assets are $2 million (his own $1.5 million plus the $500,000 he inherited, but not the $1 million in the family trust).  Ricky can now employ additional estate tax reduction techniques to get his taxable estate.  Without this strategy, Ricky would have $3 million of gross assets (his and Lucy’s $1.5 million in assets) and would have to do more extensive planning to reduce his taxable estate by an additional $1 million.   

Let’s Pretend We’re Married/Elect Portability

Under portability, the use of the family trust is no longer needed solely to utilize the estate tax exemption amount.  The first spouse to die can transfer his unused estate tax exemption amount to the surviving spouse.  This is done by electing portability on a timely filed estate tax return.  If the only reason for filing the estate tax return is to elect portability, a simplified return can be filed.

Example:  Fred and Wilma each have assets of $5.45 million.  The 2016 estate tax exemption amount is $5.45 million.  Fred dies and leaves all of his assets to Wilma.  Fred’s executor files an estate tax return and claims a $5.45 million marital deduction for the transfer to Wilma.  Fred’s executor also makes a portability election to transfer Fred’s unused $5.45 million estate tax exemption to Wilma.  Wilma now has $10.9 million in assets.  If Wilma dies shortly after, her gross estate of $10.9 million is reduced by her own $5.45 million estate tax exemption and her spouse’s unused estate tax exemption of $5.45 million.

Needless to say, the examples in this post were over-simplified but the purpose was to show the basic mechanics of the estate tax system.  While the need for estate tax planning has been diminished, the need for estate planning for succession, asset protection, business continuity and many other issues is still very, very important.

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 Long Should Tax Records be Kept?

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tax recordsBusinesses must maintain tax records to substantiate amounts reported on their tax returns.  Because of the hustle and bustle of business ownership, many business owners consider record keeping a low priority.

Bad Things Happen When Records Are Not Kept

However, if the IRS audits a business and the business owner has failed to maintain adequate records, the result can be catastrophic.  Imagine spending $20,000 on marketing and failing to keep records of this expense.  If the IRS disallows the deduction, and the taxpayer is in the 25% tax bracket, the IRS will send a bill for $5,000 plus significant penalties and interest.  Imagine if the business owner had $200,000 in expenses and didn’t keep adequate records.

The IRS Requires Records to be Kept

Every taxpayer is required by IRC Section 6001 to maintain adequate tax records and to make those records available to the IRS upon request.  When determining how long to keep tax records, we typically look at the relevant statute of limitations periods—the period of time a taxpayer can amend a tax return to claim a credit or refund or for the IRS to assess additional tax.  The statute of limitations begins running from the tax return’s original due date (generally April 15th), or the date filed, if later.

The statute of limitations is generally 3 years.  However, the limitations period is 6 years if the tax return understates gross income by more than 25%.  There is no statute of limitations if a tax return was never filed or a fraudulent return was filed. There are special statutes of limitations for certain types of deductions (e.g., a 7 year statute of limitations applies to bad debts and worthless securities).

How Long Should Records be Kept?

A good rule of thumb is to add one year to the statute of limitations period.  You often hear tax records should be kept for 7 years.  This is based on the 6 year statute of limitations for returns that have a greater than 25% understatement of income, plus one year.

Certain tax records, however, should be kept much longer than described above and, in some cases, indefinitely.  Records substantiating the purchase price of property that could eventually be sold, such as investment property and business assets, should be retained based on the record retention period for the year the property is sold.

Keep in mind that there may be nontax reasons to hold on to records beyond the time needed for tax purposes.  This might include documents such as insurance policies, leases, real estate closing statements, employment records, and other legal documents.

The 7 year retention policy for tax purposes is a good rule of thumb (unless a special statute of limitations applies).  The State of Michigan has a 4 year statute of limitations, in general.  The 7 year retention policy will thus work well in the State of Michigan.

Records Can be Scanned into Computer Files

It’s also important to know that the IRS allows taxpayers to store certain tax documents electronically.  The rules permit taxpayers to convert paper documents to electronic files (e.g., pdf or image files) and maintain only the electronic files.  Then, the paper documents can be destroyed.  Certain requirements must be met to take advantage of the electronic filing system, so contact us if you have any questions.

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.

When are Work Clothes Deductible?

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Personal Expenses Generally Not Deductibleclothing deduction

Personal expenses are not deductible.  However, the Internal Revenue Code allows a deduction for all ordinary and necessary expenses incurred while carrying on a trade or business.  A trade or business includes the trade or business of being an employee—meaning unreimbursed expenses of an employee are deductible as an itemized deduction subject to the extent they exceed 2% of adjusted gross income.

Expenses for purchasing and maintaining clothing are generally nondeductible personal expenses even though the clothing may be worn by a taxpayer in connection with his or her trade or business.

But…

Clothing expenses may be deductible if:

  • The clothing is required or essential in the taxpayer’s employment or business
  • The clothing is not suitable for general or personal wear
  • The clothing is not actually worn outside the taxpayer’s trade or business

All three requirements must be met for the clothing to be deductible.  Whether the clothing is suitable for general or personal wear is an objective test—meaning a reasonable person would not wear the clothing outside of her trade or business (the taxpayer’s personal belief about whether the clothing is suitable for personal wear is irrelevant.)

The third requirement basically means that even if the clothing is not suitable for general wear, if the employee actually wears the clothing in his personal life, the clothing expenses are not deductible.

Examples

Example:  In a recent Tax Court case, a sales person for Ralph Lauren was required to wear Ralph Lauren clothing in his job.  The sales person attempted to deduct the cost of this designer clothing, but the deduction was disallowed.  Even though he was required to wear the Ralph Lauren clothing, the clothing was suitable for general/personal wear, so the deduction was disallowed.

Example:  John is an attorney who purchases expensive suits to impress potential clients.  Again, because the expensive suits are suitable for personal wear, the suits are not deductible.

Example:  Terry is a flight attendant.  Since his flight attendant uniform is not suitable for general wear, the cost of his uniform is deductible.

Example: Tina works at a fast food shop and is required to buy her uniforms.  Again, since these uniforms are not suitable for personal wear, the uniforms are deductible.

Example:  Same as example 3 except that Tina actually wears her uniform to social functions.  Since she wears the uniform personally, the uniforms are no longer deductible.

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.

Keep An Eye Out for Obamacare Tax Forms

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Form 1095Tax season 2016 is well under way.  This tax season is the second year that the Affordable Care Act has an effect.  Last year was the first year the Form 1095-A was distributed to taxpayers who purchased health insurance from the exchange.  This form was used to (1) prove that individuals had qualifying health insurance coverage to avoid the Shared Responsibility Penalty and (2) calculate the Premium Subsidy available to qualifying individuals to help them afford their health insurance premiums.

This year, two more forms will be issued to taxpayers so they can prove that they had qualifying health insurance throughout 2015.  Form 1095-C will be issued to employees who work for Applicable Large Employers (ALEs).  ALEs are employers that employ 50 or more full time equivalents and are required to provide their employees with health insurance under the Affordable Care Act.

Form 1095-B will be issued by all other providers of health insurance (e.g., small employers, Medicaid, etc.)

The deadline for the Marketplace to provide Form 1095-A is February 1, 2016.  The deadline for coverage providers to provide Forms 1095-B and employers to provide Form 1095-C has recently been extended to March 31, 2016.

Yes, Forms 1095-B and 1095-C don’t have to be issued until March 31, 2016 while the deadline to file tax returns this year is April 18 (Emancipation Day is being recognized on April 15 so the filing deadline is April 18).  Many taxpayers therefore won’t receive Forms 1095-B or 1095-C by the time they file their tax returns.  It is not necessary to wait to receive these two forms in order to file.  Taxpayers may instead rely on other information about their health coverage and employer coverage to prepare their returns.  Taxpayers should retain health insurance statements and other proof that they had coverage during 2015.

Taxpayers who will receive Form 1095-A must wait until they receive this form to file their tax returns.  The form has important information required to calculate the Premium Subsidy.

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 Is On Lookout for Falsely Padded Deductions

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taxes-1060125_1280Each year the IRS publishes a list of its Dirty Dozen tax scams list. The list usually includes scams such as abusive trusts, improperly inflating refundable credits such as the earned income tax credit, and hiding income or assets offshore.

A new entrant for 2016 is falsely padding deductions on tax returns. Recently, the IRS warned taxpayers to avoid the temptation of falsely inflating deductions or expenses on their tax returns to under pay what they owe or to increase their refunds.

The audit rate for personal tax returns is under 1% so many people feel they can inflate their deductions and there is little chance the IRS will find out. However, if the IRS does audit a return with inflated deductions, the taxpayer is in for a nightmare experience.

Civil Penalties

Significant civil penalties may apply for taxpayers who file incorrect tax returns, including:
• 20% of the disallowed for filing an erroneous claim for refund or credit
• $5,000 if the IRS determines a taxpayer has filed a “frivolous tax return.” A frivolous tax return is one that does not include enough information to figure the correct tax or that contains information clearly showing that the tax reported is substantially incorrect
• In addition to the full amount of tax owed, a taxpayer could be assessed a penalty of 75% of the amount owed if the underpayment on the return resulted from tax fraud

Criminal Penalties

Criminal penalties may also be imposed for actions such as:
• Tax evasion
• Willful failure to file a return, supply information, or pay any tax due
• Fraud and false statements
• Preparing and filing a fraudulent tax return
• Committing identity theft

The actual punishment for criminal actions include substantial monetary penalties and jail time.

Most tax return preparers will prepare returns honestly. However a cottage industry for tax scam artists exists. These preparers manufacture tax returns that grossly overstate deductions and create tax returns that qualify for substantial refundable credits such as the earned income tax credit.

The IRS published guidance to taxpayers on properly selecting a tax return preparer.

 

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

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Avoid Paying Tax When Student Loans are Discharged

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student loan forgivenessThe nation’s student loan debt amounts to $1.3 trillion. Unfortunately, many students finish college with crushing debt without the gainful employment needed to pay off the debt. In some cases, student loans may be discharged or paid off by another party.

When debt is forgiven, the amount forgiven is generally taxable income to the borrower.
Fortunately, there are a few special provisions that help students avoid paying tax on discharged student loans.

Excluding Debt Forgiveness in General

There are two primary provisions that allow taxpayers to exclude debt forgiveness from taxable income:
• When the taxpayer is insolvent (i.e., the taxpayer’s total liabilities exceed her total assets), debt discharge income is excludable to the extent of the taxpayer’s insolvency (see example below)
• When the taxpayer’s debt is discharged through bankruptcy, debt discharge income is fully excluded from taxable income

Example: Joan has $100,000 in student loan debt and is unable to find a job in her profession. The student loan is her total debt and the value of all her assets is $25,000. To determine insolvency, Joan’s total assets ($25,000) are subtracted from her total liabilities ($100,000) and Joan’s insolvency is $75,000. Therefore, Joan can exclude $75,000 from taxable income. She must pay tax on the remaining $25,000 of debt forgiveness.

Example 2: Same facts as above except that Joan’s student loan is forgiven through bankruptcy (incredibly difficult to do). Since the student loan was discharged in bankruptcy, the full $100,000 discharged is not taxable.

Special Provisions for Student Loan Forgiveness

Tax Exclusion if Student Loan is Forgiven When Student Works in Certain Professions
Congress enacted a special rule that excludes student loan debt forgiveness from taxable income if the student works for a certain period of time in certain professions and for any of a broad class of employers. Congress enacted this special rule for certain student loans to encourage students to go into such occupations as medicine, nursing, and teaching in rural and low-income areas.

Department of Education Student Loan Discharges
The Education Department can use at least a couple procedures to discharge federal student loans.

Under the Closed School discharge process, the department can discharge a student loan when the student was attending a school at the time it closed or if the student withdrew within a certain period before the closing date. Student loans discharged under this program are excludable from taxable income.

Under the Defense to Repayment discharge process, the Education Department is required to discharge a federal Direct Loan if a student establishes, as a defense to repayment, that the school’s actions would give rise to a cause of action (lawsuit) against the school under state law. Student loans forgiven under this program are taxable unless the student qualifies under the insolvency or bankruptcy exceptions described above.

In 2015, the IRS ruled that students who took out student loans to finance attendance at a school owned by Corinthian Colleges, Inc. (eg, Everest, Everest University Online, Everest College Phoenix, Heald College, WyoTech) are able to exclude student loan debt forgiveness if the student loan was discharged under either the Closed School discharge process or the Defense to Repayment discharge process. This relief helps students whose student loans were discharged under the Defense to Repayment provision by not requiring them to prove insolvency or file for bankruptcy.

When Student Loans are Paid by an Employer

When an employer pays a student loan for an employee, it is taxable compensation to the employee. Simple enough.

 

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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