Vito Curcuru
IRS Is On Lookout for Falsely Padded Deductions
Each 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.
How to Deduct Travel Expenses
Travel expenses include transportation, lodging, meals, and related incidentals. Business travel expenses are fully deductible (except for meal expenses, which are 50% deductible). The travel expenses must be properly substantiated.
There are different rules for domestic and foreign travel. There are also different rules depending on whether the travel is exclusively for business, primarily for business, or primarily for personal reasons.
Domestic Travel
Exclusively for Business: If a taxpayer’s trip is solely for business reasons, all reasonable and necessary travel expenses (travel fares, lodging, transportation, meals, and incidentals) are fully deductible (except that meals are 50% deductible).
Primarily for Business: the deductible travel expenses include the costs of getting to and from the business destination and any business related expenses while at the business destination. Personal expenses incurred while at the destination are not deductible.
Primarily for Personal Reasons: the costs of getting to and from the destination are not deductible because they are considered personal expenses. However, any business costs the taxpayer pays at the destination will be deductible.
Whether the trip is primarily for business or personal reasons depends on the facts and circumstances of the travel. The IRS tends to focus on the amount of time spent on business and personal activities. The primary purpose of the trip is determined based on which purpose (business or personal) exceeds 50% of the time spent on the trip.
Example 1: Joan has a business in Detroit. She travels to L.A. for meetings that span four days. Joan arrives in L.A., spends four days in meetings, and immediately returns home to Detroit. She spent $500 in airfare, $800 in lodging, and $500 in food. Since, Joan’s trip is exclusively for business, Joan can claim travel expenses of $1,550 ($500 airfare, $800 lodging, and 50% of $500 food).
Example 2: Same facts as above except Joan spends three days site seeing throughout California. She spends $600 in lodging, $250 in meals, and $150 in auto expenses while site seeing. Since the primary purpose of her trip was business (based on 4 days of business versus 3 days personal), she may still deduct the $1,550 travel expenses from Example 1. However, the expenses for lodging ($600), meals ($250), and auto expenses ($150) she spent while site seeing are nondeductible personal expenses.
Example: Same facts as example 2 except Joan spends 6 days site seeing. Since the purpose of her trip is now considered personal (based on 4 days of business versus 6 days personal), the costs of getting to and from the destination are nondeductible. Thus, the $500 airfare to L.A. is no longer deductible. Her site seeing expenses are also not deductible. However, Joan may still deduct her business expenses while in L.A. ($800 in lodging and 50% of her $500 food expenses from example 1).
Foreign Travel
Exclusively for Business: If a taxpayer’s trip is solely for business reasons, all reasonable and necessary travel expenses (travel fares, lodging, transportation, meals, and incidentals) are fully deductible (except that meals are 50% deductible).
Majority of Time on Business: ALL travel expenses are allocated between deductible business expenses and nondeductible personal expenses. The expenses should be allocated to deductible and nondeductible categories using a day-to-day allocation method based on business days and personal days. There are two things to take note of:
- This differs from the domestic travel rules where the costs of getting to and from and destination are fully deductible if the trip is primarily for business. For foreign travel, the costs of getting to and from the destination must be allocated if the trip is not exclusively for business, even though the majority of time is spent on business
- ALL travel expenses (not just getting to and from the destination) must be allocated
Majority of Time for Personal Reasons: ALL travel expenses (costs of getting to and from the destination, lodging, meals, etc.) are not deductible because they are considered personal expenses. However, any expenses that the taxpayer pays at the destination will be deductible if they are directly related to business.
While the foreign travel rules require an allocation of expenses if business travel is combined with personal travel, there is a safe harbor. If the primary purpose of the trip was business AND any of the following exceptions is met, allocation of travel expenses is not required–the trip is treated as being exclusively for business (and 100% of the travel costs are deductible):
- No more than seven consecutive days are spent outside the U.S.
- Less than 25% of the total time on the trip is devoted to nonbusiness activities
- The taxpayer has no substantial control over arranging the trip—a self employed taxpayer is generally considered to have substantial control over his travel and won’t qualify under this exception. Employees may qualify under this exception.
- The taxpayer establishes through a facts and circumstances analysis that personal vacation was not a major consideration.
Comments or questions about this post? Please let us know through the comment area below!
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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.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230
The Right Way and The Wrong Way to Reimburse Employees
When a business reimburses an employee for incurring business expenses, there is a right way and a wrong way to do so. The right way is through what is known as an accountable plan. The wrong way is through…wait for it…a nonaccountable plan.
The Wrong Way
If the employer has a nonaccountable plan, when the employer reimburses an employee for business expenses the employer takes a deduction in the amount of the reimbursements. The deduction is treated as a compensation deduction and the reimbursement is included in the employee’s income. Payroll taxes on this amount are due. If the employee has substantiation for the expenses, she can deduct them as an itemized deduction on her personal tax return. These expenses are reported on Form 2106, and are subject to the 2% of AGI floor. Additionally, if the employee had meal expenses, she can only deduct 50% of them.
Example: JoJo Corp employs John and JoJo Corp does not have an accountable plan. John incurs business expenses of $1,000 for travel and supplies and $500 for meals. JoJo Corp reimburses $1,500 of John’s expenses. JoJo Corp takes a $1,500 deduction (JoJo Corp’s deduction for meals is not reduced by 50%). JoJo Corp pays FICA, FUTA, and state unemployment tax on this $1,500 compensation deduction. John’s W-2 is increased by the $1,500 reimbursement. John will also pay his share of FICA tax. John can take an itemized deduction for $1,000 of the travel and supplies expenses and an itemized deduction of $250 for the deductible 50% of meal expenses. However, these expenses are reduced by 2% of Jon’s AGI. If John has AGI of $100,000, the $1,250 deduction is reduced by $2,000 (2% of $100,000 AGI). Since the deductions are less than 2% of AGI, John cannot take a deduction.
The Right Way
If the employer has an accountable plan, expense reimbursements are deductible by the employer as business expenses rather than as compensation. The 50% meal limitation now applies to the employer. The reimbursements are excluded from the employee’s income and are exempt from payroll tax.
Example: Same facts as above, except JoJo Corp has an accountable plan. JoJo Corp will have a business deduction of $1,250 ($1,000 for travel and supplies plus 50% of the $500 meal expense). John will not have to report the amount of the reimbursement as income. Neither JoJo Corp nor John will owe any payroll taxes on the reimbursement. Since JoJo Corp takes the deduction for the business expenses, the 2% of AGI floor is irrelevant.
There are three requirements of an accountable plan:
PROVING A BUSINESS CONNECTION
The plan pays reimbursement and allowances only for otherwise deductible business expenses (such as travel, lodging, or meal expenses)
MAINTAINING ADEQUATE SUBSTANTIATION
The employee accounts for the business expenses by submitting to the company a detailed written record substantiating the expense’s time, place, amount, and business purpose.
REQUIRING EMPLOYEES TO RETURN EXCESS ADVANCES
This mainly applies when an employer advances funds to the employee to pay business expenses. Advances in excess of business expenses must be returned to the employer.
A few years back, the IRS had an audit initiative focused on executive compensation, fringe benefits, and employee reimbursement plans. IRS found a great deal of noncompliance and, in future audits will spend more time auditing these items. It is very important to properly comply with the three requirements of accountable plans if you want to take advantage of the benefits they offer.
Comments or questions about this post? Please let us know through the comment area below!
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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.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230
Getting Schooled—Providing Employee Educational Assistance
There are two primary methods for business owners to provide tax-free educational assistance to themselves and to their employees. The methods are:
- Working Condition Fringe Benefit
- Section 127 Plan
Working Condition Fringe Benefit
Educational expenses paid under this method are deductible by the employer and are tax free to the employee. The educational expenses are also excluded from payroll taxes such as FICA and FUTA. There is no limit on the amount of educational expenses that qualify; however, the educational expenses must be ordinary and necessary business expenses.
To qualify as a working condition fringe benefit, the educational program must relate to maintaining or improving the skills required by the employee’s job. The education itself must NOT lead to the student qualifying for a new trade or business. Education required to meet the minimum skill level required for the job does NOT qualify. Job related education may be furnished directly by the employer or through a third party such as an educational institution or seminar organization. The educational expenses of the business owner also qualify.
Example: ABC Corp employees Joan as an engineer. Joan is climbing the corporate ladder and believes an MBA will help her develop management skills to help her advance her career. ABC Corp pays for her MBA. Since the MBA will improve her skills, the educational expenses paid by ABC Corp will not be taxable to her. In addition, ABC Corp can take a deduction for the educational expenses.
Example 2: John is a law student working in a law firm as a legal assistant. The law firm offers to pay John’s law school tuition. These expenses will NOT qualify as a working condition fringe benefit because the law degree is required for John to meet the minimum requirements for his job as an attorney. However, the tuition may qualify for exclusion as a Section 127 plan.
Section 127 Plan
A Section 127 plan is a qualified education assistance program. The first $5,250 of qualified educational assistance provided during the year is exempt from tax, including FICA and FUTA.
To qualify under Section 127, a plan is required. The plan must:
- Be in writing
- Provide educational assistance exclusively to employees (possibly including owners)
- Not provide employees with a choice of education assistance and taxable compensation
- Provide reasonable notice of the availability and terms of the program
- Not discriminate in favor of highly compensated employees or their dependents
- Not pay more than 5% of the benefits to more-than-5% owners or their spouses or dependents
Children of owners can participate in a Section 127 plan if they are at least 21 years of age, are legitimate employees, are not more than 5% owners, and are not dependents of the owner. Children under age 21 can still participate in Section 127 plans, but their educational expenses are subject to the nondiscrimination rules (which could disqualify the plan).
Example: ABC Corp is owned by John. ABC Corp has three employees—Adam (John’s son) and two unrelated employees. All employees are 22 years old. John does not claim Adam as a dependent. ABC Corp pays $5,000 towards each employee’s tuition. Since Adam is at least 21 years old, is a legitimate employee, is not a dependent, and is not a more-than-5% owner, the tuition paid on his behalf is not counted as being for a highly compensated employee or a more than 5% owner. All employees may exclude the $5,000 tuition payment from their incomes.
Example 2: Same facts as above except that Adam (John’s son) is 20 years old. Since Adam is under age 21, he is attributed ownership from his father (i.e., Adam is considered a 100% owner). Since 33% of the benefits ($5,000 tuition for Adam divided by $15,000 total tuition paid) are paid for a more-than-5% owner, EACH employee must report the $5,000 tuition payment as income.
Key Difference between a Working Condition Fringe Benefit and Section 127 Plans:
- A $5,250 cap applies to Section 127 Plans, but not working condition fringe benefits
- If over $5,250 is spent on educational expenses under a Section 127 plan, the excess may qualify as a working condition fringe benefit
- The cost of travel, meals, and lodging may qualify as a working condition fringe benefit but not under a Section 127 plan
- The working condition fringe benefit is not subject to nondiscrimination rules
- The limitation on expenses that qualify a student for a new job or to meet minimum eligibility requirements will not qualify as a working condition fringe benefit, but may qualify under a Section 127 plan.
These rules are fairly complex. If you need help navigating through these rules, give us a call and we’ll be happy to help.
If you found this article informative, subscribe to our Tax Newsletter.
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.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230
IRS Provides Relief for Credit Card Sales Reported on 1099-K
Beginning in 2011, credit card companies were required to report business’ credit card sales to the IRS via Form 1099-K. This form reported a business’ total credit card sales for the year, and the form broke that sales figure down into monthly totals.
A substantial problem with this form was that the credit card sales reported on the 1099-K included sales tax and employee tips.
Example: JoJo’s Restaurant has credit card sales (excluding sales tax) of $600,000 for 2011. At the end of the year, JoJo’s Restaurant received Form 1099-K showing credit card sales of $731,400. The reason the sales on the 1099-K is much larger than the actual credit card sales is because it includes sales tax of $36,000 plus tips of $95,400 (assuming a 15% tip rate).
Since the sales reported on Form 1099-K will almost certainly exceed actual sales, businesses were required to reconcile the sales reported on Form 1099-K with their actual sales. The above example was a fairly simple one—imagine if those sales included carry-out sales on which tips are not paid. A point of sale system should be able to capture this information, but for restaurants using cash registers, it will be very, very difficult to gather this information.
Recognizing the hardship this would cause on businesses (plus the hardship on the IRS to actually audit this information), the IRS waived the reconciliation requirement for 2011 tax returns. Based on a recent letter from the IRS deputy commissioner for services and enforcement, Steven Miller (not the singer), to the National Federation of Independent Businesses, the IRS is extending indefinitely the waiver of the reconciliation requirement. Mr. Miller stated, “There will be no reconciliation on the 2012 form, nor do we intend to require reconciliation in future years. (emphasis added)”
Good news! However, credit card companies will continue to issue Form 1099-K. If the sales amount on these forms differ substantially from sales reported on tax returns, you may still want to conduct an informal reconciliation (not included on any tax filings) in case of an audit.
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.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230
Special Tax Credit for Restaurants
There is a tax credit available to restaurants that have tipped employees. The credit is based on the FICA taxes paid by the restaurant on reported tips. Although this credit has been available to restaurants for years, many tax professionals fail to inform their clients that the credit is available. If you’re a restaurant owner, keep reading.
Background
Restaurants must pay FICA taxes on any tips reported by tipped employees. This requirement has been criticized by the restaurant industry since 1987 because reported tips in excess of the minimum wage are not counted as wages under the Fair Labor Standards Act (FLSA). Since tips in excess of minimum wage are not counted as wages under the FLSA, it is argued that it is not appropriate to require restaurants to pay FICA taxes on these tips.
As a result of lobbying by the restaurant industry, Congress created a tax credit in 1993 to offset some of the FICA taxes paid by restaurants on excess tips (tips that get the employee over minimum wage). The credit is named the Credit for Portion of Employer Social Security Paid with Respect to Employee Cash Tips. They tried, but couldn’t come up with a longer name.
How it Works
The credit is calculated as 7.65% of tips in excess of the federal minimum wage. For purposes of this tax credit, the federal minimum wage is capped at $5.15, and not at the normal $7.25 federal minimum wage. Michigan’s minimum wage of $7.40 is not relevant to this credit; however, under Michigan law the employee’s base wage plus tips must be at least $7.40.
Example: JoJo’s Restaurant has a tipped employee who earns $2.65 per hour. The employee worked 1,500 hours during 2012 and had tips of $8,000.
The tip tax credit is calculated as follows:
Hourly Tip Rate: $5.33 ($8,000 tips divided by 1,500 hours)
Tips Deemed Wages: $2.50 ($5.15 federal minimum wage less $2.65 wage)
Excess Tips per Hour: $2.83 ($5.33 total tips less $2.50 tips treated as wages)
Total Excess Tips: $4,245 ($2.83 excess tips per hour times 1,500 hours worked)
Tip Tax Credit $325 ($4,245 times 7.65% FICA rate)
The tip tax credit for this single employee is $325.
The tip tax credit is calculated for each individual employee. Modern payroll software makes it much easier to determine how much of each employee’s tips are deemed wages and how much are excess tips.
There has been some confusion as to whether restaurant owners could claim the credit on unreported tips discovered during an IRS audit. The answer is yes—restaurant owners can claim the tip tax credit on unreported tips discovered during an audit (good news if you’re looking for a silver lining during an audit.)
Find this article informative? Subscribe to our Tax Newsletter.
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.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230
Tax Credit for Hiring Veterans
Congress, in order to encourage employers to hire members of targeted groups, provided a tax credit to employers who hire members of these groups. This tax credit is the Work Opportunity Credit. The credit expired for most targeted groups in 2011. However, the VOW to Hire Heroes Act of 2011 extended the Work Opportunity Credit to qualified veterans who begin work before January 1, 2013.
The credit is 40% of qualified first year wages for certified veterans who work at least 400 hours, and 25% for certified veterans who work at least 120 hours but less than 400 hours. Qualified wages are limited to $12,000; however, qualified wages for veterans who were unemployed for at least six months in the prior year are limited to $14,000.If the veteran has a service connected disability and was unemployed for at least six months in the prior year, qualified wages are limited to $24,000.
The veteran must be certified. This is done by the employer filing Form 8850, Pre-Screening Notice & Certification Request for the Work Opportunity Credit, with the employer’s state workforce agency within 28 days after the eligible employee begins work.
Employers claim this credit as a general business credit against their income tax. For tax-exempt employers, the Work Opportunity Credit is claimed against the employer portion of Social Security taxes.
Example 1: John is an Iraq War veteran. ABC Corp hires John during 2012. During 2012, John works 1,500 hours at $20 per hour ($30,000 gross pay for 2012). Since John worked more than 400 hours, the Work Opportunity Credit equals 40% of his wages (up to the limit of $12,000). ABC Corp claims a credit of $4,800.
Example 2: Same as above, except John was unemployed for 7 months during 2011. Since John was unemployed for more than six months in the prior year, the ceiling on qualifying wages is increased to $14,000. The credit is now $5,600.
Example 3: Same as Example 2, except John was injured in Iraq. Since John has a service related injury and was unemployed for at least six months in the prior year, the ceiling on qualifying wages is increased to $24,000. The credit is now $9,600. $9,600 is the maximum Work Opportunity Credit possible.
Example 2: Same as above, except John only works 200 hours ($4,000). Since John worked between 120 and 400 hours, his credit equals 25% of his wages of $4,000. ABC Corp claims a credit of $1,000.
The Work Opportunity Credit targeted more groups in the past, but in 2012 it only applies to qualified veterans. It is possible Congress will extend the credit for these other groups. Groups that qualified for the credit in the past included:
- Qualified IV-A recipients
- Ex-felons
- Long term family assistance recipients
- Vocational rehabilitation referrals
- Summer youth employees
- Nutrition assistance recipients
- Social security income recipients
- Designated community residents
- Disconnected youths
These groups may qualify in the future. We’ll keep our eyes open.
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.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230
You’re Still Getting a Bonus (Depreciation) in 2012
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Normally, when you buy long lived property, you can’t deduct the full cost of the property in the year you purchase it. The purchase price is deducted over the expected life of the property. In late 2010 through 2011, business owners were allowed to immediately deduct 100% of the cost of certain assets. This was known as 100% bonus depreciation. 100% bonus depreciation ended on December 31, 2011. Bonus depreciation is alive and well in 2012; however, it has been reduced to 50% from 100%. 50% bonus depreciation lasts through December 31, 2012. It is extended to December 31, 2013 for property having a longer production period (discussed later).
What is Eligible Property?
To be eligible for bonus depreciation, the property must meet three criteria:
1. The asset must be qualified property
- The asset must have a recovery period of 20 years or less. This includes most tangible personal property. It excludes almost all real estate.
- General purpose buildings used in agriculture, such as machine sheds and shops, are 20 year property and are eligible for bonus depreciation
- Off the shelf software qualifies
- Qualified leasehold improvement property qualifies
2. The ORIGINAL use must commence after December 31, 2007
- The asset must generally be NEW. Used property doesn’t qualify.
- New property initially used by a taxpayer for personal use and subsequently converted to business use meets the original use requirement
- Expenditures to recondition or rebuild assets satisfies the original use requirement, but purchases of reconditioned or rebuilt assets do not qualify. However, an asset that contains used parts will not be considered used if the cost of the used parts is 20% or less of the total cost.
3. The asset must be acquired and placed in service on or before December 31, 2012
- The placed in service requirement is extended to December 31, 2013 for property that has a longer production period and has an expected life of at least 10 years OR is commercial transportation property or certain aircraft.
- A longer production period is defined as exceeding two years OR an estimated production period exceeding one year and a cost exceeding $1 million.
- Only costs attributable to production before January 1, 2013 will qualify for this exception.
Qualified leasehold improvement property also qualifies for 50% bonus depreciation. Qualified leasehold improvement property meets the following tests:
- The improvement is to an interior of a building
- The building is nonresidential
- The improvement is made pursuant to a lease by either the lessee, sublessee, or by the lessor to property to be occupied by the lessee or sublessee
- The improvement is placed in service more than three years after the date the building was first placed in service by any person
- Leases between related parties do not qualify
Call us if you would like to discuss how this applies in your business.
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.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230
The New Medicare Tax on Investment Income
Under the 2010 Health Care Act, Medicare taxes will be going up for certain people on January 1, 2013. There are two separate Medicare tax increases. One will be a 3.8% Medicare tax on unearned income. The other is a 0.9% Medicare tax on wages and self-employment income. This post describes the 3.8% Medicare Contribution Tax on unearned income.
The Medicare Contribution Tax (3.8%) on Unearned Income
This tax is levied on unearned income such as interest, dividends, annuities, royalties, rents, and capital gains. It also includes flow through income from an LLC or S corporation in which the owners are not active (e.g., investors ).
The tax is 3.8% of the lesser of:
- Net investment income OR
- The excess of modified adjusted gross income over the applicable threshold amount
Some definitions:
Net Investment Income is investment income reduced by investment expenses (e.g., research expenses, advisory fees, etc.)
Modified Adjusted Gross Income is adjusted gross income increased by excluded foreign earned income (there is an exemption from U.S. tax for certain income earned overseas-but this is a topic for a separate blog post).
The Applicable Threshold Amount is $250,000 for joint filers or surviving spouses, $200,000 for single filers, and $125,000 for married filing separate filers.
Net Investment Income Does NOT Include:
- Distributions from regular or Roth IRAs
- Distributions from 401(k) or other qualified plans
- Social Security Income
- Life insurance proceeds
- Municipal bond interest
- Veterans’ benefits
- Gain from the sale of a personal residence if the gain doesn’t exceed the exclusion amounts of $500,000 for a joint return and $250,000 for a single filer
- Income from businesses where the owners materially participate
Example: John files a joint return and has $150,000 in wages, $30,000 in interest income, $70,000 in rental income, and a $30,000 gain on the sale of a rental property. John’s modified adjusted gross income is $280,000. John’s net investment income is $130,000 (the $30,000 in interest, $70,000 in rental income, and $30,000 gain from the rental property). John’s Medicare Contribution tax equals 3.8% times the lesser of:
- Net investment income of $130,000 OR
- The excess of modified adjusted gross income over the applicable threshold amount. This amount is $30,000 ($280,000 modified adjusted gross income less $250,000 threshold amount).
John’s Medicare Contribution tax is therefore $1,140 (3.8% times $30,000).
Example 2: Jill has $200,000 in wages. She is a passive investor in an S corporation, ABC Corp (i.e., outside of her investment in ABC Corp, she has no involvement in the business). She has $100,000 in flow through income from ABC Corp. She also sold some of her ABC Corp stock for a $50,000 gain. Jill’s modified adjusted gross income is $350,000. Since Jill is not active in ABC Corp, her flow through profit of $100,000 and her gain on sale of stock of ABC Corp of $50,000 are considered investment income. Jill’s Medicare Contribution tax is calculated as 3.8% times the lesser of:
- Net investment income of $150,000 OR
- The excess of modified adjusted gross income over the applicable threshold amount. This amount is $100,000 ($350,000 modified adjusted gross income less $250,000 threshold amount).
Jill’s Medicare Contribution tax is $3,800.
Example 3: Joan works full time in her S corporation, ABC Corp. She has $200,000 in wages and $100,000 in flow-through profit from ABC Corp. She also sold some of her ABC Corp stock for a $50,000 gain. Based on Joan’s full time employment in ABC Corp, she materially participates in the business. Since she materially participates, her flow through profit of $100,000 and gain on sale of stock of ABC Corp of $50,000 are NOT included in net investment income. Therefore, Joan is not subject to the 3.8% Medicare Contribution tax.
Some tips on avoiding the Medicare Contribution Tax:
- Try to accelerate income into 2012 so that modified adjusted gross income in 2013 will be under the threshold
- People owning rental property should try to qualify as a real estate professional
- This requires more than 50% of time spent in real estate activity and 750 hours per year in real estate activity
- Consider investing in municipal bonds
- Municipal bond interest is not subject to the 3.8% tax
- It also does not increase modified adjusted gross income so it may reduce the tax on other investment income
- Business owners should try to qualify as active owners in their businesses so that flow through income and gain on sale of ownership interests are not subject to the tax.
For more information on how this applies in your situation, please give us a call.
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.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230
The Small Business Health Care Credit
Beginning in 2010, small businesses are eligible for a tax credit by providing qualified health care coverage for their employees. The credit starts off smaller during 2010 to 2013, but fully kicks in starting 2014. Despite the hype, very few businesses have qualified for this credit due to its limitations on the number of employees and average wage of employees.
How Much is the Credit?
During 2010 to 2013, the maximum credit is 35% of the employer’s premium expenses. Starting in 2014, the maximum credit is increased to 50% of the employer’s premium expenses.
Who Qualifies for the Credit?
Small businesses must meet three requirements to qualify for the credit:
- employers must have fewer than 25 full time equivalent (FTE) employees
- the average annual wages must be less than $50,000 per FTE
- the employer must pay the premiums under a qualifying arrangement.
Determining Number of FTEs
Employers calculate the number of FTEs by dividing the total number of employee hours worked (by both full time and part time employees) during a year by 2,080. If the result is not a whole number, the result is rounded down.
Example: ABC Corp reviews its payroll reports and determines that all of its employees (full and part time) worked 10,000 hours during the year. ABC Corp divides the 10,000 total hours worked by 2,080 to calculate its FTEs (10,000 hours divided by 2,080 equals 4.81 rounded down to 4 FTEs).
Determining Average Annual Wages
To calculate average annual wages, the employer divides its total wages for the year by the number of its FTEs.
Example: ABC Corp has $80,000 total payroll for the year. To determine if its average annual wages are under $50,000 it divides its total payroll ($80,000) by the number of its FTEs (4). Its average annual wages for the year is $20,000.
In calculating average annual wages, wages for seasonal employees and owners and their families are excluded from the calculation.
What, Pray Tell, is a Qualifying Arrangement?
Under a qualifying arrangement, the employer pays premiums for each employee enrolled in health care coverage offered by the employer in an amount equal to a uniform percentage (not less than 50%) of the premium cost of coverage. The credit only applies to the employer paid portion.
Example: ABC Corp pays 80% of the premiums for each of its employees. Since it pays more than 50% of each employee’s premium, it qualifies for the credit (but only on the 80% that the employer pays, not on the 20% paid by employees).
Example 2: ABC Corp pays 40% of the premiums for each of its employees. Since it pays less than 50% of each employee’s premium, it does not qualify for the credit.
Example 3: ABC Corp pays 60% of the premiums for some employees, and 30% of the premiums for other employees. ABC Corp does not qualify for the credit because it does not pay a uniform percentage of each employee’s health premium.
There is an upper limit on the amount of premiums that qualify for the credit. If the average premium for a small group market in a State is less than the premiums paid by the employer, the amount of the average premium for a small group market in the state will be used instead of the actual premiums paid by the employer.
Calculating the Credit Phaseout
The full credit is allowed if the employer has up to 10 employees and up to $25,000 average annual wages. If the employer has more than 10 employees OR average annual wages exceeding $25,000 the credit begins to phase out.
The credit reduction for the FTE phaseout is calculated as:
Number of FTE over 10 divided by 15
ABC Corp has $80,000 of insurance premiums, and its maximum credit for 2010 is $28,000 ($80,000 times the 35% credit).
If ABC Corp has 18 employees, the credit reduction is calculated as follows:
(18 minus 10) divided by 15 = 53%
The FTE phaseout reduces the $28,000 credit from above by 53%. The credit must be reduced by $14,840.
The credit reduction for the average wage phaseout is calculated as:
Amount of Average Wages over $25,000 divided by $25,000.
If ABC Corp has average annual wages of $30,000, the phaseout is calculated as:
($30,000 minus $25,000) divided by $25,000 = 20%.
The average annual wage phaseout reduces the $28,000 credit from above by 20%. The credit must be reduced by $5,600.
When the employer has more than 10 FTEs and more than $25,000 in average annual wages, the FTE credit reduction and the wage credit reduction are added together. Thus, ABC Corp’’s total reductions are 20,440 ($14,840 FTE reduction plus $5,600 wage phaseout). So, ABC Corp’s credit is $7,560 (total credit of $28,000 reduced by total credit reductions of $20,440).
At this point you’re probably sick of reading this post, so I’ll leave you with a few quick bullet points:
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The credit is claimed on the employer’s annual income tax return
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it is NOT a refundable credit
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It is a general business credit that can be carried back 1 year and forward 20 years
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However, since 2010 is the first year, it cannot be carried back for 2010.
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Tax exempt organizations qualify for the credit under slightly different rules (check back for upcoming blog posts).
There you have it, a brief 3 page overview of the new small business health care credit. I’ll be posting more frequently (possibly twice a week) over the next few months to keep you up to date on the constant tax law changes. The tax laws are a-changin’.
If you have any questions on how this applies to your business, please feel free to give us a call.
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.
Any tax advice contained in the body of this post was not intended or written to be used, and cannot be used, by the recipient for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions. Any information contained in this post does not fall under the guidelines of IRS Circular 230
