Is That Inheritance Taxable?

Article Highlights: 

  • Estate Tax 
  • Estate Tax Exemption 
  • Fair Market Value at Date of Death 
  • Step up in Basis 
  • Community Property 
  • Deferred Untaxed Income 

Are inheritances taxable? This is a frequently misunderstood taxation issue, and the answer can be complicated. When someone passes away, all of their assets (their estate) will be subject to estate taxation, and whatever is left after paying the estate tax passes to the decedent’s beneficiaries. 

Sound bleak? Don’t worry, very few decedents’ estates ever pay any estate tax, primarily because the tax code exempts a liberal amount of the estate’s value from taxation; thus, only extensive estates are subject to estate tax. In fact, with the passage of the Tax Cuts & Jobs Act (tax reform), the estate tax exemption has been increased to $11,580,000* for 2020 and will be inflation-adjusted in future years. That generally means that estates valued at $11,580,000* or less will not pay any federal estate taxes, and those over the exemption amount only pay estate tax on the excess amount. Of interest, there are less than 10,000 deaths each year. The decedent’s estate exceeds the exemption amount, so there will be no estate tax for most estates, and the beneficiaries will generally inherit the entire estate. 

* Note that, as with anything tax-related, the exemption is not always a fixed amount. Prior gifts must reduce it above the annual gift exemption, and it can be increased for a surviving spouse by the decedent’s unused exemption amount. 

Of course, once a beneficiary (also referred to as an heir) receives the inherited asset, any income generated by that property—be it interest from cash, rent from real estate, dividends from stocks, etc.—will be taxable to the beneficiary, just as if the property had always been the beneficiaries. 

Because the value of an estate is based upon the fair market value (FMV) of the assets owned by the decedent on the date of their death (or in some cases, an alternative valuation date six months after the decedent’s date of death, which is rarely used), the beneficiaries will generally receive the inherited assets with a basis equal to the same FMV determined for the estate. What this means to a beneficiary is that if they sell an inherited asset, they will measure their gain or loss from the inherited basis (FMV at date of death). 

Example #1: Joe inherits shares of XYZ Corporation from his father. Because XYZ Corporation is a publically traded stock, the FMV can be determined by what it is trading for on the stock market. Thus, if the inherited basis was $40 per share and the shares are later sold for $50 a share, Joe will have a taxable gain of $10 ($50 – $40) per share. The increase will also be a long-term capital gain since all inherited assets are treated as being held long-term by the beneficiary. On the flip side, if the shares are sold for $35 a share, Joe would have a tax loss of $5 per share. 

Example #2: Joe inherits his father’s home. Like other inherited property, Joe’s basis is the FMV of the house on the date of his father’s death. However, unlike the stock, the FMV, which could be determined from the trading value, the home needs to be appraised to determine its FMV. It is highly recommended that a certified appraiser perform the appraisal and be done reasonably close in time to the decedent’s death date. This is frequently overlooked and can cause problems if the IRS challenges the amount used for the basis. 

This FMV valuation of inherited assets is frequently referred to as a step-up in basis, which is a misnomer because the FMV can, under some circumstances, also be a step down in basis. 

If the decedent was married at the time of death and resided in a community property state, and if the couple held the property as community property, the beneficiary spouse will generally receive a basis equal to 100% of the FMV of the property, even though the spouse will have only inherited the deceased spouse’s share. 

Not all inherited assets received by the beneficiary fall under the FMV regime. If the decedent held assets that included deferred untaxed income, they would be treated differently by the beneficiary. Examples of those include inherited: 

Traditional IRA Accounts – These are taxable to the beneficiaries. Still, special rules generally allow a spouse beneficiary to spread the income over the surviving spouse’s lifetime, while the distribution period is capped at ten years for most non-spouse beneficiaries if the decedent died after 2019. Previously, the rules allowed most non-spouse beneficiaries of decedents who died before 2020 to use a lifetime distribution method. 

Roth IRAs – Qualified distributions are not taxable to the beneficiary. 

Compensation – Amounts received after the decedent’s death as compensation for their services. 

Pension Payments – These are generally taxable to the beneficiary. 

Installment Sales – Sometimes taxpayers will structure sales, usually of real property, so that the buyer pays the seller for the purchase with interest over several years. This is referred to as an installment sale. Whoever receives an installment obligation due to the seller’s death is taxed on the installment payments the same as the seller would have been had the seller lived to receive the payments.

This is just an overview of issues related to being the beneficiary of an inheritance. If you have questions about the tax ramifications of a potential or actual estate, please contact us.

Renting Your Home or Vacation Home for Short Periods

Article Highlights: 

  • Airbnb, VRBO, and HomeAway 
  • Rented for Fewer than 15 Days During the Year 
  • The 7-day and 30-day Rules 
  • Exceptions to the 30-Day Rule 
  • Schedule C Reporting 

Many taxpayers rent out their first or second homes without considering tax consequences. Some of these rules can be beneficial, while others can be very detrimental. If you rent your home to others, you should be aware of some special tax rules that apply to you. 

Even if you rent out your property using rental agents or online rental services that match property owners with prospective renters (such as Airbnb, VRBO, or HomeAway), it is still your responsibility to properly report the rental income and expenses on your tax return. 

Special (and sometimes complicated) taxation rules can make the rents that you charge tax-free. However, other situations may force your rental income and expenses to be treated as a business reported on Schedule C, as opposed to a rental activity reported on Schedule E. 

The following is a synopsis of the rules governing short-term rentals. 

Rented for Fewer than 15 Days During the Year – When a property is rented for fewer than 15 days during the tax year, the rental income is not reportable. The expenses associated with that rental are not deductible. Interest and property taxes are not prorated. The full amounts of the qualified mortgage interest and property taxes are reported as itemized deductions (as usual) on the taxpayer’s Schedule A. 

The 7-Day and 30-Day Rules – Rentals are generally passive activities, which means that losses from these activities are usually the only deductible up to the number of gains from other passive activities. However, an activity is not treated as a rental if either of these statements applies: 

A. The average customer use of the property is for seven days or fewer—or 30 days or fewer if the owner (or someone on the owner’s behalf) provides significant personal services. 

B. The owner (or someone on the owner’s behalf) provides extraordinary personal services without regard to the property’s average period of customer use.

If the activity is not treated as a rental, it will be treated as a trade or business. The income and expenses, including prorated mortgage interest and real property taxes, will be reported on Schedule C. IRS Publication 527 states: “If you provide substantial services that are primarily for your tenant’s convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C.” Substantial services do not include the furnishing of heat and light, the cleaning of public areas, the collecting of trash, or other such general amenities. 

The exception to the 30-Day Rule – If the personal services provided are similar to those that generally are provided in connection with long-term rentals of high-grade commercial or residential real property (such as public area cleaning and trash collection). If the rental also includes maid and linen services that cost less than 10% of the rental fee, then the personal services are neither significant nor extraordinary for the 30-day Rule. 

Profits and Losses on Schedule C – Typically, if you own and operate a business that isn’t set up as a corporation, your business’s income and expenses would be reported on Schedule C as part of your income tax return. You would pay self-employment tax (Social Security and Medicare taxes), as well as income tax, on the profit. However, suppose you have a profit from a rental activity. In that case, it is not subject to self-employment tax even when reported as self-employment income unless you are a real estate dealer. Suppose you have a loss from this type of activity. In that case, it is still treated as a passive activity loss unless you meet a material participation test—generally by providing 500 or more hours of personal services during the year related to the rental or qualifying as a real estate professional. Losses from passive activities are deductible only up to the passive income amount, but unused losses can be carried forward to future years. A special allowance for real estate rental activities with active participation permits a loss against nonpassive income of up to $25,000. This phases out when modified adjusted gross income is between $100K and $150K. However, this allowance does not apply when the activity is reported on Schedule C.

These rules can be complicated; please contact us to determine how they apply to your particular circumstances and what actions you can take to minimize tax liability and maximize tax benefits from your rental activities.

Preparing for 2021: Tax Planning Strategies for Small Business Owners

If you are a small business owner, every penny of your income counts. This means that you want to optimize your revenue and minimize your expenses and your tax liability. Unfortunately, far too many entrepreneurs are not well-versed in the tricks and tools available to them and end up paying far more than they need to. You don’t need an accounting degree to take advantage of tax-cutting tips. Here are a few of our favorites. 

Think About Changing to a Different Type of Tax Structure 

When you started your business, one of the first decisions you needed to make was whether you wanted to operate as a sole proprietor, partnership, LLC, S corporation, or C corporation. But as more time goes by, the initial reasons for structuring your business the way that you did may no longer be applicable or in your best interest from a tax perspective. There is no requirement that you stick with the business structure you initially chose. 

Ever since the Tax Cuts and Jobs Act of 2017 (TCJA) changed the highest corporate income tax rate from 35% to 21%, sole proprietorships, LLCs, partnerships, and S corporations can realize significant tax savings by electing to be taxed as a C corporation. This simple change can make sense if these pass-through businesses’ owner is taxed at a high tax bracket. If so, all you need to do is fill out and file Form 8832. Before doing so, make sure that the tax savings you can realize are a reasonable tradeoff for the other reasons that you may have initially selected the structure you are currently in. 

Pass-Through Businesses Can Get a 20% 

One of the most impactful changes that the TCJA made for pass-through businesses whose income is passed-through for taxation as their owners’ income is a valuable tax break known as the qualified business income (QBI) deduction. For eligible recipients, this deduction is worth a maximum 20% tax break on the income they receive from the business – but determining whether or not you qualify can be a challenge. 

There are several restrictions on taking advantage of the deduction, particularly regarding specified service trade or businesses (SSTBs) whose owners either earn too much income or rely specifically on their employees’ or owners’ reputation or skill. Though architecture and engineering firms escape this limitation, other business models – including medical practices, law firms, professional athletes and performing artists, financial advisors, investment managers, consulting firms, and accountants – fall into the category that loses out of their income is too high. In 2019 single business owners of SSTBs began phasing out at $160,700 and are excluded once their income exceeds $210,700, while those who are married filing a joint return phase out at $321,400 and are excluded at $421,400. To calculate the deduction, use Part II of Form 8995-A

Businesses that are not SSTBs are eligible to take the deduction even when they pass the upper limits of the thresholds, but only for either half of the business owners’ share of the W-2 wages paid by the business or a quarter of those wages plus 2.5% of their share of qualified property. 

These limitations and specifications for what type of business is and is not eligible are head-spinning. Though it is tempting to take the deduction simply, it’s a good idea to confirm whether you qualify and how to claim it with our office before moving forward. 

Know How You’re Going to Pay Your Taxes

It is gratifying to live the dream of owning your own small business, but the hard work required to generate revenue makes paying taxes extra painful. This is especially true because of the “pay as you go” tax system that the United States uses, asking business owners to make estimated quarterly payments. While employees pay their taxes ahead via payroll deductions withheld by their employers, no such automatic system is set up for small business owners. That leaves many with the temptation of delaying making payments to maintain liquidity. 

Unfortunately, failing to pay taxes quarterly can put you in the uncomfortable position of still having to pay at one point, with the additional burden of penalties and interest resulting from your delay. Though setting aside the money to pay taxes requires discipline, doing so will save you from the penalties charged by the IRS. These are calculated based on the amount you should have paid each quarter multiplied by your shortfall and the effective interest rate during the specific quarter (established as 3 percent over the federal short-term rate – C corporations pay a different rate). Even if you don’t calculate your quarterly estimated rates correctly, the safe harbor rule allows small businesses to pay the lower amount, which is either 90% of the tax due on your current year return or 100% of the tax shown on your last filed tax return. For those whose AGI was over $150,000 in the previous tax year, the safe harbor percentage is 110% of the previous year’s taxes. 

It is always a good idea to increase the amount you send in if you have a higher-income year. By doing a simple calculation of your safe harbor number and dividing it by four, you have a reasonable quarterly payment that you can safely send in on the due dates (April 15th, June 15th, September 15th, and January 15th of the following year). By setting aside the appropriate percentage that you will owe from each payment you receive, you can easily set aside the money you will need to pay and entirely avoid concerns about penalties or interest. Payment is most easily submitted using the online link for IRS Direct Pay, though many people opt for sending in the paper vouchers for IRS Form 1040-ES, along with a check. There is also an EFTPS system available for C Corporations’ use. 

Choose Your Accounting Method Carefully

Each small business owner calculates their income and revenue differently, with many using a method of accounting that is based on when money is received rather than when an order is placed and counts expenses when they are paid rather than the item or service ordered. This is known as the cash method of accounting. 

Whatever method of accounting you use, smart business owners can strategically adjust their approach—reporting their annual income based on cash receipts to reduce their end-of-year revenues, especially if there is reason to believe that next year’s income will be lower or they anticipate being in a lower tax bracket. 

An example of how this approach would be helpful can be seen in a business that expects to add new employees in the new year. Between that expense and other improvements planned, it makes sense to anticipate that net income will be down. The tax bracket for the business will be lower, so any work is done or orders placed towards the end of the current tax year should be accounted for when payments arrive so that the income can be taxed at a lower rate. The contrast to this is if you anticipate your business revenue to increase and be forced into a higher tax bracket in the new year. In that case, it makes sense to try to collect monies for work done in the current year early so that you can take advantage of your current, lower tax rate. This can be done for business expenses such as office supplies and equipment, which can be deferred and accelerated in the same way so that you can take advantage of tax deductions in the most advantageous way. 

Establish and Make Deposits Into a 401(k) or SEP 

One of the smartest ways to lower your taxable income is to contribute to a retirement account. Not only does doing so reduce your business’ tax liability, but it also ensures a more secure future. As a small business owner, either a 401(K) plan or a Simplified Employee Pension (SEP) plan will do the trick while benefiting both you and those who work for you in the future. 

While a 401(k) that is established before year-end will let you deduct any contributions you make (with contributions limited to the lower of $57,000 or the employee’s total compensation), business owners who fail to set up this type of plan by December 31st can still turn to the SEP as an alternative. Though SEP contributions are restricted to 25% of the business owner’s net profit, less the SEP contribution itself (technically 20%), a SEP can be established, and contributions made up until the extended due date of your return. Suppose you obtain an extension for filing your tax return. In that case, you have until the end of that extension period to deposit the contribution, regardless of when you file the return.

If You Took Out a PPP Loan, Plan on it Being Forgiven 

Many small businesses took advantage of the PPP loans that were offered by the government in the face of the COVID-19 crisis. While these loans were attractive because they are forgivable and gave businesses a chance to survive the dire circumstances, in April of 2020, the IRS issued Notice 2020-32, which indicated that even though the forgivable loans can be excluded from gross income, the expenses associated with the money received cannot be deducted. This effectively erases the tax benefit initially offered because losing the employee and expense deduction increases the business’ income and profitability. 

There is some chance that this issue will be resolved by Congress, as it contradicts the original intent of the tax benefit that accompanied the PPP funds, but that action has not yet been taken. It’s a good idea to talk to our office about this as soon as possible. Having to pay taxes on expenses incurred may be particularly challenging in the face of the difficulties the pandemic has imposed. Being financially prepared to pay more taxes than you originally intended may be a bitter pill to swallow. However, it will still be better than paying penalties and interest if you fail to pay what the government says that you owe. 

Though all of these strategies can be helpful, they may not all be appropriate for your situation. Keep them in mind as you go into the end of the year, and be prepared to ask questions to determine which apply to you when you speak with our office. Contact us to discuss tax planning for your business today.

What Happens if You Missed the October 15th Tax Extension Deadline?

We’ve all been there. Life is super busy. We have to take care of our families and friends, work obligations, and other everyday responsibilities. With all of the hustle and bustle, you realize that the October 15th tax extension deadline has passed, and unfortunately, you still haven’t filed. What should you do now? 

This article provides guidance when you miss the tax extension deadline and the next steps you should take. 

Will I Be Penalized for Filing After the Deadline? 

Yes, if you missed the October 15th filing deadline, you can be penalized. The IRS allowed you an additional six-month extension of time to file your taxes (from April 15th to October 15th). That was not an extension to pay taxes, only an extension to complete your return. In addition to any interest and penalties that you may owe as a result of failing to file (and pay) your tax on time, you will now be subject to a late filing fee on any unpaid taxes. The penalty, which includes interest, is generally 5% per month of any outstanding balance for up to 5 months. This penalty can increase to up to 25% of the remaining balance owed. To make matters worse, the interest continues to accrue until any liability is finally paid. 

If you file your taxes more than 60 days late, you may receive an additional penalty of $435. That is the minimum late filing penalty, which is the lesser of what you owe in taxes or the $435. It’s crucial to go ahead and file even if you can’t pay the outstanding balance in full and work with the IRS to create a payment arrangement. Even if you are missing some information you need to file, you can file now and amend later when the information becomes available. 

What Happens if the IRS Owes Me a Refund? 

For taxpayers who believe they are owed a refund from the Internal Revenue Service, you have three years from the original due date of the return to file and claim your refund. However, if you wait too long, you will forfeit any refund you might be entitled to. 

If you are filing your tax return after the October 15th deadline and do not owe any tax, there will be no late filing penalties or interest. 

What Happens If I Don’t File My Return? 

Suppose you don’t file your tax return with the IRS. In that case, they will likely create a substitute return on your behalf based on income data such as W-2s, 1099s, and other documentation provided to them by your employer and other financial institutions. 

It’s important to understand that this substitute return will not include any calculations for credits and deductions that you may be qualified for. Consequently, the substitute return will likely result in a higher balance owed and penalties than if you prepared your return. 

What Happens If I Can’t Pay the Tax Balance Owed? 

If you can’t pay your tax obligations with the IRS, it is crucial to go ahead and get the tax return filed and then work with the Internal Revenue Service to set up a payment plan. 

The IRS’ Fresh Start Program allows taxpayers with balances of less than $25,000 to set up a monthly installment plan, allowing you to make payments on your balance over several years. 

There is an “Offer In Compromise” option that allows you to settle your tax debt for less than the amount owed for those experiencing more financial difficulty. 

The interest and penalties for filing your tax return after the final tax deadline can be severe. It is important to get your return filed, even if you need to make arrangements to pay the balance owed to the IRS. 

If you have any questions about the steps you should take if the October 15th tax extension deadline has passed you by, or for more information about our tax planning and preparation services, please contact us.

Don’t Miss Out on Year-End Tax-Planning Opportunities

Article Highlights: 

  • October 15 extended due date for filing federal individual tax returns for 2019. 
  • Late-filing penalty. 
  • Interest on tax due. 
  • Other October 15 deadlines. 

Because of the COVID-19 pandemic emergency, the IRS postponed the original due date for filing 2019 returns to July 15, 2020. If you could not complete your 2019 tax return by July 15 and filed a request for additional time to file, that extension expires on October 15, 2020. Failing to file before the extension period runs out may cost you late-filing penalties. 

There are no additional extensions available (except in designated disaster areas), so if you do not or will not have all of the information needed to complete your return by October 15, please contact this office. We can explore your options for meeting your extended filing deadline. 

If you are waiting for a K-1 from a partnership, S-corporation, or fiduciary return, the extended deadline for those returns is September 15 (September 30 for fiduciary returns); so you should probably make inquiries if you have not received that information yet. 

Late-filed individual federal returns are subject to a penalty of 5% of the tax due for each month (or part of a month) if a return is not filed, up to a maximum of 25% of the tax due. If you are required to file a state return and do not do so, the state will also charge a late-file penalty. The filing extension deadline for individual returns is also October 15 for most states. 

 Interest continues to accrue on any balance due, currently at the rate of 3% per year, and this rate is subject to quarterly adjustment. 

If this office is waiting for some missing information to complete your return, we will need that information at least a week before the October 15 due date. Please contact this office immediately if you anticipate complications related to providing the required information so that we can determine a course of action to avoid the potential penalties. 

Additional October 15, 2020 Deadlines – In addition to being the final deadline to file 2019 individual returns on an extension, October 15 is also the deadline for the following actions: 

  • FBAR Filings – Taxpayers with foreign financial accounts exceeding an aggregate value of $10,000 at any time during 2019 must file a Financial Crimes Enforcement Network (FinCEN) Form 114, Report of Foreign Bank and Financial Accounts (FBAR) electronically with the Treasury Department. The original due date for the 2019 report was April 15, but individuals have been granted an automatic extension to file until October 15, 2020. 
  • SEP-IRAs – October 15, 2020, is the deadline for a self-employed individual to set up and contribute to a SEP-IRA for 2019. The deadline for contributions to traditional and Roth IRAs for 2019 was July 15, 2020, instead of the usual April 15 contribution due date because of the COVID-19 emergency, but no further extension is available. 
  • Special Note: Disaster Victims – If you reside in a presidentially declared disaster area, the IRS and most states provide additional time to file various returns and make payments. 

Please contact us for information on extended due dates of other types of filings and payments as well as extended filing dates in disaster areas.

How to File Taxes After Moving to a New State

Moving to a new state can be an incredible new adventure. No matter what takes you to your new residence, you can’t forget about taxes. Here’s what you need to know about filing taxes in your new state as you settle into your new routine. 

Establish Residency in Your New State

Even if you haven’t sold your home or severed all ties with your previous hometown, you will need to make as many connections with your new residence as possible.

  • Change your mailing address 
  • Get your driver’s license and voter registration in your new state 
  • Register children for school (if applicable) in your new state 
  • Move your personal belongings and family pets to your new home 

This will help prove that you have fully moved from the original state and are no longer subject to taxes there as a resident. 

Cut Ties with Your Previous Jurisdiction 

If you have a second home in another state or you are still working or doing business in your previous state, you may still qualify as a resident in that state for tax purposes. 

If you still have ties in your previous state, make sure you understand the residency qualifications so that you can avoid any surprises at tax time. 

Determine What Kind of Tax Return Is Required 

Unless you moved on January 1st of the calendar year, you are likely – at a minimum – a part-year resident of each state. 

Typically, this means that you will allocate your income, deductions, credits, and other tax items based on the number of days you lived in each state. You would file a part-year tax return in each state unless the state that you are moving from or moving to does not have a state income tax requirement. 

Check Your Eligibility for Tax Credits, and Other Tax Benefits That You May Be Eligible for in Your New State 

The forms that each taxpayer may use are consistent when completing your federal tax return. However, no two states are exactly alike when it comes to filing a tax return. Credits and other benefits that you may be eligible for in one state may not apply in another state. 

You may find that you now qualify for extra credits or other incentives not previously available to you. 

Get Help from a Tax Professional 

When it comes to your taxes, it’s best to contact a tax professional if you’re unsure of the steps to take when completing your tax forms. 

We can assist with tax planning and identifying tax credits and deductions. Your Tarlow advisor can help you avoid mistakes when completing your tax return that can result in costly interest and penalties. Please contact us for more information.

Don’t Throw Away IRS Notice 1444

Article Highlights:

  • IRS Notice 1444
  • You May Qualify for Additional Credit on the 2020 Return
  • Tax Records

The IRS is mailing all recipients of Economic Impact Payments a Notice 1444 that provides information about the amount of their payment, how the payment was made, and how to report any payment that wasn’t received. If you’ve already received your economic impact payment, you’ve probably already received this document too. This notice was issued from The White House and looked more like a letter than a traditional IRS notice, but the notice number is in the upper right-hand corner of the heading, just below the date.

For security reasons, the IRS mails this notice to each recipient’s last known address within 15 days after the payment is sent. Don’t discard this notice, as you may need it when you prepare your 2020 tax return. The economic impact payment is an advance payment of a refundable tax credit based upon your 2020 tax return. In order to get the money into people’s hands during the time of the greatest need, these payments generally were made based upon each individual’s 2019 return, or in some cases, their 2018 return.

However, your filing status, income, and dependents may be different in 2020. If the advance payment was less than what you are entitled to based upon the 2020 return, you would qualify for the difference as a refundable credit on your 2020 return.

Example: Don and Shirley, whose AGI is less than $150,000, are newlyweds with no children and filed a joint return in 2019. They receive an advance economic impact payment of $2,400. In 2020, they have a baby, and when their credit is determined on the 2020 return, it is $2,900 ($1,200 + $1,200 + $500). Since they only received $2,400 as an advance payment, they will be entitled to a $500 refundable credit on their 2020 return. The credit will first be used to reduce their tax, and then any excess credit will be refunded.

As you can see, you need to keep IRS Notice 1444 – Your Economic Impact Payment, with your tax records since it documents the payment you received. You should keep this notice filed with all your other important tax records, including W-2s from employers, 1099s from banks and other payers, other income documents, and records to support tax deductions.

If you have any questions regarding your economic impact payment, please contact us.

Tax Changes For 2019

As the end of the year approaches, it is a good time to review the various changes that impact 2019 tax returns. Some of the changes are likely to apply to your tax situation. In addition, be aware that various tax-related bills currently in Congress may or may not pass this year. If any of them do pass, we will quickly get the details to you. 

Medical Threshold – Medical expenses are deductible as itemized deductions only if the total medical expenses for the tax year exceed a specified percentage of a taxpayer’s income. After dropping to 7.5% for 2017 and 2018, this threshold reverts to 10% for 2019. As a result, any medical expenses from 2019 are deductible only to the extent that they exceed 10% of a taxpayer’s adjusted gross income for the year. 

Electric Vehicle Credit Phaseout – As an incentive to get taxpayers to move away from conventional-fuel (gasoline or diesel) vehicles, Congress has provided tax credits of up to $7,500 for the purchase of plug-in electric vehicles. However, Congress’s rules limit the full credit to the first 200,000 vehicles sold by a given manufacturer. Once a company sells 200,000 qualifying vehicles, the credit begins to phase out for that company. Tesla, Chevrolet, and Cadillac have all reached the phaseout point. The table below shows the credits available depending upon the quarter when the vehicle is purchased. 

Vehicles Beginning Phaseout out 2019
Date Acquired

>>>

Vehicle

Before 2019 Jan – Mar 2019 Apr – June 2019 July – Sept 2019 Oct – Dec 2019 Jan – Mar 2020 After Mar 2020
Tesla* $7,500 $3,750 $3,750 $1,875 $1,875 $0 $0
Chevrolet* $7,500 $7,500 $3,750 $3,750 $1,875 $1,875 $0
Cadillac* $7,500 $7,500 $3,750 $3,750 $1,875 $1,875 $0

*All qualifying models

If a qualifying vehicle is used partiality for business, the credit is proportionally allocated between personal and business tax credits. The personal portion can only offset the individual’s current-year tax liability; any excess is lost. The business portion can be carried back for one year and then forward up to 20 years until it is used up; any credit remaining after the 20th year is lost. As a tip, please note that the credit limit is per vehicle, not per taxpayer, so individuals who make multiple purchases can receive multiple credits. 

Alimony – One delayed effect of the 2017 tax reform is that the treatment of alimony changes for some individuals starting in 2019. 

For divorces or separations entered into before 2019, alimony payments continue to be deductible for the payer and taxable for the recipient. These payments also still qualify as earned income for purposes of the recipient’s qualification for an IRA deduction. For divorces or separations that occurred after December 31, 2018, alimony payments are no longer deductible for the payer. Also, for the recipient, they are no longer taxable income and do not count as earned income IRA deduction. 

Divorces or separations entered into before 2019 continue to follow the pre-2019 rules unless they have been modified after December 31, 2018. In that case, the alimony payments are subject to the post-2018 rules if the modification expressly provides for this. 

Finalization of State- and Local-Tax Deduction Limitation – The 2017 tax reform limited the itemized deduction for state and local taxes (SALT) to $10,000 (or $5,000 for married individuals filing separately). This has adversely impacted taxpayers in high-tax states such as California, Connecticut, New Jersey, and New York. Elected officials in several states have attempted to work around this restriction by establishing (or proposing to establish) state charities. The idea is that taxpayers would make deductible contributions that, in return, would give them tax credits against their SALT equal to most of the value of the charitable contributions. Unfortunately, these officials have overlooked the 1986 U.S. Supreme Court ruling that, if a taxpayer receives something in return for a donation (i.e., a quid pro quo), the contribution is not deductible.

The final regulations generally reduce the charitable contribution deduction by the amount of any SALT credit received. However, as an exception, if the credit does not exceed 15% of the contribution, the entire contribution is deductible.

Penalty for Not Being Insured – The Tax Cuts and Jobs Act (tax reform) that was enacted at the end of 2017 eliminated the Obamacare shared-responsibility payment, effective starting in 2019. Congress didn’t actually repeal this penalty; instead, it effectively abolished it by setting zero values for both the percentage of household income used in the calculation and the flat dollar amount of the penalty. As a result, the amount of the penalty is always zero. However, keep in mind that the penalty could be restored in the future if the direction of the political winds changes. In addition, beginning in 2020, some states may pick up where the federal government left off and charge a penalty to residents without qualified health insurance coverage.

Qualified Opportunity Funds – Taxpayers who receive capital gains on the sale or exchange of property (if the other party is unrelated) may elect to defer – and, potentially, partially exclude – those gains from their gross income if they are reinvested in a qualified opportunity fund (QOF) within 180 days of the sale or exchange. The amount of the gain (not the amount of the proceeds, as in Sec. 1031 deferrals) needs to be reinvested to defer the gain. The deferral period ends when the QOF investment ends or on December 31, 2026 – whichever is sooner. At that time, taxes must be paid on the deferred gain.

However, 10% of the deferred gains are forgiven QOF investments that have been held for at least five years, and 15% of the gains are forgiven when those investments have been held for at least seven years. Note that, with the deferral end date of December 31, 2026, qualifying for the 15% forgiveness requires a QOF investment on or before December 31, 2019.

Seniors Get a Special Tax Form – Lawmakers have long sought to provide taxpayers who are age 65 and older with a simplified tax form in place of the Form 1040. In the 2018 budget bill, Congress finally included a requirement that the IRS create such a form. As a result, the IRS will introduce Form 1040-SR, which will look a lot like the old form before the 2018 tax reform instituted its division of the Form 1040 into multiple postcard-size schedules. It is unclear how much simpler the Form 1040-SR will be, but it will be available for 2019 returns. Note: Form 1040-SR will be optional.

Family and Medical Leave Credit – The employer credit for family and medical leave, which was created in the 2017 tax reform, ends after 2019. This two-year program provides employers with a tax credit equal to 12.5% of the wages they paid to qualifying employees during any period when those employees were on family and medical leave, provided that the rate of the leave payments are at least 50% of the employees’ regular wages. The credit can be claimed for a maximum of 12 weeks of leave for any employee during the tax year. For each percentage point for which the leave payments exceed 50% of regular wages, this credit increases by 0.25 percentage points (up to a maximum of 25%). Participation in this credit program is optional.

Inflation Adjustments – Just about every tax-related value is adjusted for inflation. Some values are adjusted for any level of change, but others are adjusted only if the change reaches a specific dollar amount (so these values may not change every year). The table below includes the actual 2019 inflation adjustments and the projected 2020 adjustments for some of the most frequently encountered values.

 

Year 2018 2019 2020
Standard Deduction
Single or Married Filing Separately 12,000 12,200 12,400
Head of Household 18,000 18,350 18,650
Married Filing Jointly 24,000 24,400 24,800
Additional Standard Deduction (Age 65+ or Blind)
Unmarried 1,600 1,650 1,650
Married 1,300 1,300 1,300
Other Values
Annual Gift-Tax Exclusion 15,000 15,000 15,000
Foreign Earned-Income Exclusion 103,900 105,900 107,600
IRA Contribution Limit 5,500 6,000 6,000
IRA Contribution Limit (Age 50+) 6,500 7,000 7,000
401(k) Contribution Limit 18,500 19,000 *
401(k) Contribution Limit (Age 50+) 24,500 25,000 *

All values are in U.S. dollars. 

* Value not available as of publication

Form W-4 Revision – During the previous tax season, many people received a smaller federal tax refund than normal, or actually owed taxes despite usually getting a refund. In most cases, this was due to the last-minute passage of the tax-reform law at the end of 2017, which did not give the IRS sufficient time to adjust the W-4 form and related computation tables for the 2018 tax year so as to account for all of the new law’s changes. The planned major revision to the W-4 for the 2019 tax year has since been delayed until 2020, so all taxpayers should make sure that their 2019 withholding is adequate. 

If you are conversant with tax terminology, you can use the IRS’s newly updated withholding estimator. This tool helps taxpayers to determine whether their employers are withholding the right amount of tax from their paychecks. However, please note that the results are only as good as the information that is put into the estimator. Users need to properly estimate their other income for the year from various sources. 

If you have questions related to any of the subjects discussed in this article, please contact us.

Defer Gains with Qualified Opportunity Funds

If you have a large capital gain from the sale of a stock, asset, or business and would like to defer that gain with the possibility of excluding some of it from taxation, you may want to check out the new investment vehicle created by tax reform, called a qualified opportunity fund (QOF).

Congress, as a means of helping communities that have not recovered from the past decade’s economic downturn, included a provision in the Tax Cuts and Jobs Act intended to promote investments in certain economically distressed communities through QOFs. Investments in QOFs provide unique tax incentives that lawmakers designed to encourage taxpayers to participate in these funds.

Reinvesting Gains – Taxpayers who have a capital gain from selling or exchanging any non-QOF property to an unrelated party may elect to defer that gain if it is reinvested in a QOF within 180 days of the sale or exchange. Only one election may be made with respect to a given sale or exchange. If the taxpayer reinvests less than the full amount of the gain in the QOF, the remainder is taxable in the sale year, as usual. Only the gain need be reinvested in a QOF, not the entire proceeds from the sale. This is in sharp contrast to a 1031 exchange where the entire proceeds must be reinvested to defer the gain.

The gain income is deferred until the date when the QOF investment is sold or December 31, 2026, whichever is earlier. At that time, the taxpayer includes the lesser of the following amounts as taxable income:

a. The deferred gain or
b. The fair market value of the investment, as determined at the end of the deferral period, reduced by the taxpayer’s basis in the property. (Basis is explained below.)

A taxpayer who holds a QOF investment for 10 years or more before selling it can elect to permanently exclude the gain from the sale that is in excess of the originally deferred gain (i.e., the appreciation).

Qualified Opportunity Fund Basis – The basis of a QOF that is purchased with a deferred gain is $0 unless either of the following increases apply:

(a) If the investment is held for 5 years, the QOF’s basis increases from $0 to 10% of the deferred gain.

(b) If the investment is held for 7 years, the QOF’s basis increases from $0 to 15% of the deferred gain.

If, on December 31, 2026, a taxpayer holds a QOF that was purchased with deferred gains, the original deferred gain, or if less, the difference between the fair market value of the QOF reduced by the basis, must be included as gross income on that taxpayer’s 2026 return; the basis of the investment will then be increased by the amount of this included gain.

If the QOF investment is held for at least 10 years before being sold, the taxpayer can elect to increase the basis to the property’s fair market value. This adjustment means that the QOF’s appreciation is not taxable when it is sold.

Example 1: On June 30, 2018, Phil sold a rental apartment building for $3 million, resulting in a gain of $1 million. Within the statutory 180-day window, he invested that $1 million into a QOF and elected to defer the gain from the building’s sale. On July 1, 2026, he then sold the QOF for $1.5 million. Because Phil held the investment for over 7 years, its basis is enhanced by $150,000 (15% of $1 million). Because the investment’s fair market value is greater than the original deferred gain, he must include a taxable gain of $1.35 million ($1.5 million – $150,000) in his 2026 gross income. 

Example 2: The facts here are the same as in Example 1, except Phil waited to sell the QOF until 2030, meaning that he held it for nearly 12 years. On December 31, 2026, the fair market value of the QOF was $1 million. Because he had the investment on December 31, 2026, he was required to include $850,000 ($1 million – $150,000) of deferred gain on his 2026 return, the lesser of the $1 million gain he deferred or the FMV less his basis. He then increases his basis in the QOF from $0 to $850,000. After selling the QOF for $1.5 million in 2030, Phil elected to permanently exclude the gain by increasing his basis to $1.5 million (the fair market value on the date of the sale). Thus, he has no gain ($1.5 million – $1.5 million) in 2030.

Mixed Investments – If a taxpayer’s investment in a QOF consists of both deferred gains and additional investment funds, it is treated as two investments; this provides the tax benefits of both types: the temporary gain deferral and the permanent gain exclusion (which applies only to the deferred gain).

Qualified Opportunity Funds – To defer capital gains-related taxes through the recently enacted opportunity-zone program, taxpayers must invest in a QOF – an investment vehicle that is organized as a corporation or a partnership for the purpose of investing in properties within qualified opportunity zones. These investments cannot be in another QOF, and the properties must have been acquired after December 31, 2017. The fund must hold at least 90% of its assets in the qualified-opportunity-zone property, as determined by averaging the percentage held in the fund on the last days of the two 6-month periods of the fund’s tax year. Taxpayers may not invest directly in qualified opportunity zone property.

Partnerships – Because a QOF that is purchased with deferred capital gains has a basis of zero, taxpayers who invest in QOFs that are organized as partnerships may be limited to deducting the losses that these partnerships generate.

Qualified Opportunity Zones – A low-income census tract can be specifically designated as a qualified opportunity zone after a nomination from the governor of that community’s state or territory. Once the qualified opportunity zone nomination is received in writing, the U.S. Treasury Secretary can certify the community as a qualified opportunity zone. Once certified, zones retain this designation for 10 years.

If you have a capital gain or potential gain and would like to explore the tax ramifications for your particular situation of deferring the gain into a QOF, please call us.

Start Off on the Right Foot for the 2019 Tax Year

Individuals and small businesses should consider various ways of starting off on the right foot for the 2019 tax year.

W-4 Updates – If you are employed, then your employer takes the information from your Internal Revenue Service (IRS) Form W-4 and applies it to the IRS’s withholding tables to determine the amount of income tax to withhold from your wages in each payroll period. This process did not work all that well in 2018 because, in the wake of the tax reform, the IRS did not have time to properly redesign Form W-4 and adjust its withholding tables. In fact, the IRS has announced that this task will not be completed until it issues the 2020 versions of Form W-4 and the withholding tables.

Thus, the problem from 2018 continues into 2019; if your 2018 refund or balance due was not the desired amount, then please consider adjusting your withholding based on your projected tax for 2019. If you need assistance, please call this office.

W-9 Collection – If you are operating a business, then you are required to issue a Form 1099-MISC to each service provider to which you have paid at least $600 during a given year. It is a good practice to collect a completed W-9 form from every service provider (even if you are paying less than $600), as you may use that provider again later in the year and may have difficulty getting a W-9 after the fact—especially from providers that do not plan to report all of their income for the year.

Estimated Tax Payments – If you are self-employed, then you prepay each year’s taxes in quarterly estimated payments by sending 1040-ES payment vouchers or making electronic payments. For the 2019 tax year, the first three payments are due on April 15, June 17, and September 16, 2019, and the final payment is due on January 15, 2020. Generally, these payments are based on the prior year’s taxable income; if you expect any significant changes in either income or deductions relative to the previous year, please contact this office for help in adjusting your payments accordingly.

Charitable Contributions – If you marginally itemize your deductions, then you can employ the bunching strategy, which involves taking the standard deduction one year but itemizing your deductions in the next. However, you must make this decision early in the year so that you can make two years’ worth of charitable contributions in the bunching year.

Required Minimum Distributions – Each year, if you are 70.5 or older, you must take a required minimum distribution from each of your retirement accounts or face a substantial penalty. By taking this distribution early in the year, you can ensure that you do not forget and accidentally subject yourself to penalties.

Gifting – If you are looking to reduce your estate-tax exposure or if you just want to give some money to family members, know that, each year, you can gift up to $15,000 to each of an unlimited number of beneficiaries without affecting the lifetime estate-tax exclusion amount or paying a gift tax.

Retirement-Plan Contributions – Review your retirement-plan contributions to determine whether you can afford to increase your contribution amounts and to make sure that you are taking full advantage of your employer’s contributions to the plan.

Beneficiaries – Marriages, divorces, births, deaths, and even family clashes all affect whom you include as a beneficiary. It is good practice to periodically review not just your will or trust but also your retirement plans, insurance policies, property holdings, and other investments to be sure that your beneficiary designations are up to date.

Reasonable Compensation – With the advent of the 20% pass-through deduction, which is available to most businesses other than C-corporations, the issue of reasonable compensation takes on a whole new meaning, particularly for S-corporations’ shareholders. This has been a contentious issue in the past, as it has allowed shareholders who are not just investors but who are actually working in the business to take a minimum salary (or no salary at all) so that all their income passes through the K-1 as investment income. This strategy allows such shareholders to avoid payroll taxes on income that should be treated as W-2 compensation. A number of issues factor into a discussion of reasonable compensation, including comparisons to others in similar businesses and to employees within the same business, as well as the cost of living in the business’s locale. This is a subjective amount, and it generally must be determined by a firm that specializes in making such determinations.

Business-Vehicle Mileage – Generally, vehicles with business use also have some amount of nondeductible personal use in a given year. It is always a good practice to record a vehicle’s mileage at the beginning and at the end of each year so as to determine its total mileage for that year. The total mileage figure is then used when prorating the personal- and business-use expenses related to that vehicle.

College-Tuition Plans – Contribute to your child’s Section 529 plan as soon as possible; the funds begin accumulating earnings as soon as they are in the account, which is important because the student will likely begin using that money at age 18 or 19.

Only a few of the tax-related actions that you take during a year will benefit yourself or others. The most important of these actions is keeping timely and accurate tax records; for businesses in particular, this is of the utmost importance. Those who have well-documented income and expense records generally come out on top when the IRS challenges them.

Please call us if you have any questions related to your taxes or if would like an appointment for tax projections or tax planning.