Optimal numbers in tax planning

Nicholas Paleveda MBA J.D. LL.M for ProducersWeb.com  writes: Taxes are about numbers, where a percentage of net earnings is sent to the federal or state government based on perceived success. The theory is, the more success one has in the economic game, the more they should contribute to the common good in the form of taxation. Theoretical models have been built by academics as to tax structures; see Brito, Hamilton, Slutsky, Stiglitz, Pareto Efficient Tax Structures1990 SSRN working paper 3288. However, like most academic papers, it is based on models that do not comport with reality and current tax planning. 

Most individuals wish to optimize the highest amount of earnings for themselves and the least amount of taxation sent to the government. The code actually provides optimal numbers for tax planning; however, very little research takes place in this area. This article is an attempt to open up the discussion for using optimal formula clauses, adjustment clauses and compensation in various areas of tax planning. Hence, it will be useful for tax practitioners as well as academics who devote more time to the research and development of tax planning. 

Optimal numbers in retirement planning 

I first came across optimal numbers working with enrolled actuaries who specialize in ERISA. The world of enrolled actuaries is quite small. According to Google, there are about 4,700 enrolled actuaries in the U.S. Enrolled actuaries are the only profession that is allowed to sign schedule SB or MB, the valuation schedules for defined benefit pension plans. Tax attorneys, CPAs and other tax professionals are not allowed to sign this schedule. The exams are extremely difficult, allowing a pass rate of about 17 percent per exam for individuals who are used to scoring 800 on the math section of the SAT or GRE. The test follows the lines of MEGA and TITAN, found on the MEGA SOCIETY website. Demographically, this is a unique group of individuals. 

Optimal number for retirement plans 

The optimal number for compensation in 2012 was $200,000 for individuals who can and have the ability to set their own salary. The reason is that this is the maximum considered compensation under ERISA for benefits purposes. If you take any salary data above this number, your benefits and tax deductible contributions to a qualified plan will not increase. If you take salary data below this, your benefits and tax deductible contributions will decrease. For example, person A, age 55, makes a gross amount of $517,888 a year. Person A comes to you and asks how much he should take out in salary and how much should or could be deferred into qualified plans. After a quick review of the internal revenue code, the following observation is made: 

Person A should take a salary of $200,000 a year, assuming there is no Watson issue. Person A then could fund X amount until age 65, which will provide him a lifetime income of $200,000 for the rest of his life. If A decreases his salary to $190,000, he can only fund an amount X, which will provide him a $190,000 salary for the rest of his life at age 65; hence a lower amount will be funded on a tax deductible basis into his plan. If A increases his salary to $250,000, he will be able to fund X amount that will provide him an income of $200,000 for the rest of his life. Hence, $200,000 is an optimal salary number for him. 

In terms of X, the tax deductible funding amount into a pension plan, this number is calculated on either using actuarial assumptions or guaranteed interest rates from pension annuities and annuity conversion rates, or annuity purchase rates (APR). An annuity purchase rate is the amount Person A would pay to an insurance company to provide a guaranteed income for the rest of his life.
For example, assume the APR is 0.00513. This is the amount per thousand/per month an insurance company will pay for benefits at age 65. To provide a monthly income of $16,666 (which translates to $200,000 a year), the employee in a pension plan would need to accumulate $3,248,733 as a lump sum (LS). In order to accumulate $3,248,733 in a plan in 10 years, the participant would need to contribute $283,388.70 each year for 10 years (assuming a 3 percent interest rate guarantee). Hence, Person A would take home $200,000 in salary and defer $283,388.70 in the pension plan, consuming $483,388.70 of A’s $517,888 gross income and leaving $34,550, which could be placed into another qualified plan. 

The Pension Protection Act of 2006 allows the taxpayer to maintain a profit sharing plan along with the defined benefit plan. The profit sharing plan is limited to 6 percent of pay, if the defined benefit plan is not covered by the Pension Benefit Guarantee Corporation (PBGC) or 25 percent of pay to a maximum of $50,000, if the defined benefit plan is covered by the PBGC. Person A could set up a profit sharing plan, place $12,000 into the plan (6 percent x 200,000 = $12,000), set up a 401(k) profit sharing plan and deduct/defer $22,500 into the 401(k), wiping out $34,500 of gross income, leaving additional tax on $50.00. 

Optimal numbers in tax planning have simple math but complex laws. For example, if Taxpayer A is 56 years old (as opposed to 55 years old), the benefit formula must be reduced 10 percent each year the taxpayer does not fund for 10 years, meaning the maximum benefit is $180,000 as opposed to $200,000, and the optimal salary is now $180,000. Another complication is that the maximum considered compensation under ERISA for testing purposes, including profit sharing contributions, is not $200,000, but $250,000. Taxpayer A would be able to contribute $15,000 to the profit sharing plan, as opposed to $12,000 if A increases his or her salary to $250,000. In addition, if A has a common law employee, the percentage of pay on which a formula can be drafted for testing purposes is $250,000, as opposed to $200,000, which would reduce plan contributions to an employee 0.796 percent. 

So an argument can be made that the optimal compensation for a self-employed individual is $200,000 if he or she has no employees, or $250,000 if he or she has employees. 

Optimal numbers for estate planning 

In 2013, the American Tax payer Relief Act of 2012 came into effect. In 2012, $5,120,000 was exempt from the federal estate tax (indexed). But what do you do with an amount over $5,120,000? Case law suggests an adjustment clause could be used where the excess goes to a spouse or to a charity. 

Adjustment clause 

Adjustment clauses, or formula clauses, are given to us on a silver platter in the Wandry case. For example, I gift and bequeath 900,000 limited partnership shares with a value of $5,400,000. If the IRS does not agree with the value, the share value will be adjusted to reflect such valuation, as stated in Wandry. 

I hereby assign and transfer as gifts, effective as of January 1, 2004, a sufficient number of my units as a member of Norseman Capital, LLC, a Colorado limited liability company, so that the fair market value of such units for federal gift tax purposes shall be as follows: 

Name — gift amount 

Kenneth D. Wandry — $261,000

Cynthia A. Wandry — 261,000

Jason K. Wandry — 261,000

Jared S. Wandry — 261,000

Grandchild A — 11,000

Grandchild B — 11,000

Grandchild — C 11,000

Grandchild — D 11,000

Grandchild E — 11,000

Total: 1,099,000

Although the number of units gifted is fixed on the date of the gift, that number is based on the fair market value of the gifted units, which cannot be known on the date of the gift but must be determined after such date based on all relevant information as of that date.
Furthermore, the value determined is subject to challenge by the Internal Revenue Service (IRS). I intend to have a good-faith determination of such value made by an independent third-party professional experienced in such matters and appropriately qualified to make such a determination. Nevertheless, if, after the number of gifted units is determined based on such valuation, the IRS challenges such valuation and a final determination of a different value is made by the IRS or a court of law, the number of gifted units shall be adjusted accordingly so that the value of the number of units gifted to each person equals the amount set forth above, in the same manner as a federal estate tax formula marital deduction amount would be adjusted for a valuation re-determination by the IRS and/or a court of law. 

The adjustment clause (or formula clause) has also been upheld inEstate of Petter v. Commissioner, T.C. Memo. 2009-280: 

Section 1.1 of Terry's transfer document reads: “Transferor assigns to the trust as a gift the number of units... that equals one-half the minimum dollar amount that can pass free of federal gift tax by reason of Transferor's applicable exclusion amount allowed by Code Section 2010(c). Transferor currently understands her unused applicable exclusion amount to be $907,820, so that the amount of this gift should be $453,910; and Transferor assigns to [the charitable foundation] as a gift to the [charitable foundation] the difference between the total number of unites [940 units] and the number of units... assigned to the trust.” 

Under the terms of the transfer documents, the foundations were always entitled to receive a predefined number of units, which the documents essentially expressed as a mathematical formula. This formula had one unknown: the value of a LLC unit at the time the transfer documents were executed. But though unknown, that value stood as a constant, which means that both before and after the IRS audit the foundations were entitled to receive the same number of units. Absent the audit, the foundations may never have received all the units they were entitled to, but that does not mean that part of the taxpayer’s transfer was dependent upon an IRS audit. Rather, the audit merely ensured the foundations would receive those units they were always entitled to receive. 

Conclusion 

Even though the bulk of advanced estate planning will center on the use of family limited partnerships, other aspects will be reviewed, such as trusts beyond the revocable living trusts, irrevocable life insurance trusts, like IRA conduit trusts, retirement plan distributions, special use valuation under 2032A, the alternate valuation date, contingent private foundations and finally, Section 6166.

Can I Deduct a Live-In Girlfriend or Boyfriend on My Taxes?

Jane Bryant Quinn for Mainstreet.com writes:  Ask Jane: Can I Deduct a Live-In Girlfriend or Boyfriend on My Taxes? Maybe, if he or she wasn’t working last year or didn’t earn very much. A qualifying partner gives you an extra personal exemption, worth $3,800. This works for same-sex couples, too.

You can claim a live-in friend as a tax dependent if he or she had a gross income of less than $3,800 last year. Your friend had to live with you all year (except for temporary absences, which could include a short spat). You also have to have paid more than half or his or her support.

If your friend wasn’t working, those should be easy conditions to meet. If you paid for his or her education expenses, you get a deduction or tax credit for that, too.

If your friend has children who live with you, you might be able to claim personal exemptions for them as well, H&R Block reports. You get the write-off if your friend (earning less than $3,800) isn’t required to file a tax return or filed it only to get a refund.

The children have to live with you full time, except for temporary absences.

”Temporary” might be weekend visits to their dad but not a co-custody arrangement that takes them away for months. You also have to pay more than half of the children’s support.

You don’t get the tax credit for children. Nor do you get the tax-saving head-of-household filing status, which is reserved for relatives.

But the extra personal exemption adds to the pleasure of living with someone you love.

The Income Tax Rescission Doctrine - The Code’s "Etch-A-Sketch" Tax Planning Tool

Thomas Gallagher for Cozen O'Conner writes: Neither the tax code nor the regulations to the tax code answer the question whether a transaction purporting to unwind or rescind an earlier transaction will be given effect so that neither transaction will be treated as having occurred for federal income tax purposes. This area of the income tax law has been the subject of dispute for a long period of time with only limited government guidance. Recently, the IRS announced it was studying the issue and planned to release guidance concerning the scope and application of the doctrine. Because an effective rescission can be a powerful tool for taxpayers to undo transactions that present adverse or unanticipated economic or tax consequences, understanding the requirements for successful rescission relief is important for taxpayers.

Where the rescission doctrine applies, taxpayers can unwind or substantially modify an already closed and completed transaction for both non-tax and tax-related reasons without tax consequences. Typical non-tax motivations include mistakes as to the underlying transaction, the occurrence of unanticipated events, or even the unwinding of a sale of property that was alleged to be voidable under state law. Tax-motivated reasons can also prompt a rescission including, for example, the failure to properly anticipate the taxpayerâ€"s tax circumstances prior to carrying out the transaction.

Under its current view, the IRS permits the rescission of an earlier transaction even though the principal, and maybe sole, motivation is tax-based. There is no particular form or document needed to accomplish a rescission. It is not even clear whether a rescission transaction need be identified as such by the taxpayer. In practice, however, taxpayers usually document the unwinding by entering into a document that somewhere contains the statement the transaction is a rescission of an earlier transaction. Under the case law and IRS rulings, if a rescission occurs within the same tax year as the year of the transaction being unwound, e.g., a sale of property, the subsequent reconveyance of the property is effective on a retroactive basis so that it is as if the initial transaction never occurred. On the other hand, where the year of sale has already closed, a subsequent rescission transaction, even where the buyer and seller are placed in exactly the same position as the status quo ante, is treated as a separate taxable event with its own separate tax consequences to the parties. This is true even where the right to rescind is provided explicitly in the initial agreement.

IRS GUIDANCE

The existing IRS published authority provides very limited guidance for what will constitute a successful rescission. In Rev. Rul. 80-58, the IRS determined whether a rescission transaction involving the sale of land and its reconveyance by the seller to the buyer under the terms of the contract of sale constituted a successful rescission for federal income tax purposes. Relying on Penn v. Robertson, 115 F.2d 167 (4th Cir. 1940), the IRS concluded, where the rescission placed the seller and buyer at the end of the taxable year of sale in the same positions as they were prior to the sale, the original sale would be disregarded "because the rescission extinguished any taxable income for that year with regard to the transaction." Where the rescission occurred in the following year, however, the IRS concluded both the original sale transaction in the first year, and the later reconveyance, were given independent effect for income tax purposes. In reaching these conclusions, the IRS relied on the annual accounting period principle that "requires the determination of income at the close of the taxable year without regard to subsequent events." On its face, Rev. Rul. 80-58 has two simple conditions. The parties to the transaction must be returned to the status quo ante, and the restoration must be accomplished within the same taxable year as the original transaction.

"Importantly, these rulings clarified that hindsight as to the tax consequences of the original transaction is not a bar to successful rescission relief."

The IRS has applied Rev. Rul. 80-58 in a series of private letter rulings. Importantly, these rulings clarified that hindsight as to the tax consequences of the original transaction is not a bar to successful rescission relief. For example, where the S election of a corporation was terminated by the issuance of a class of convertible prefer red stock to three separate partnerships and, within the same taxable period, the preferred stock was cancelled and the parties returned to the status quo ante, the IRS ruled the corporation's Selection was unaffected. In another case, where a parent corporation acquired stock in a subsidiary corporation (Old Sub) for cash and liquidated that corporation, it realized (belatedly) the liquidation may have been imprudent for tax purposes. Within the same taxable year, it formed a new subsidiary (New Sub) and transferred all of the assets and liabilities of Old Sub to New Sub. The IRS ruled that the liquidation and reincorporation of Old Sub and New Sub should be disregarded as a successful rescission of the initial transaction.

These rulings provide helpful, but hardly expansive, guidance concerning the parameters of the rescission doctrine. For example, a taxpayer was required to recognize gain from the unauthorized sale of a portion of the stock held in his brokerage account by his broker. The taxpayer purchased replacement shares of stock within the same taxable year as the fi rst sale, paying a substantially higher price than paid for the shares sold. In the subsequent taxable year, the stockholder and his broker entered into a rescission and settlement agreement and the broker paid damages. The IRS refused to treat the later acquisition of shares as a valid rescission because the taxpayer was unable to unilaterally return to the status quo ante. Further, the later rescission agreement was not effective within the same taxable year as the original sale.

The willingness of the IRS to grant rescission relief in the income tax context stands in contrast to its approach to attempted rescissions in the gift tax context. Generally, a successful rescission for gift tax purposes requires that there have been a mistake of fact at the time that the purported gift was made. Where the taxpayer was mistaken as to the application of the gift tax law, the attempted rescission was unsuccessful.

INTERPRETING THE STATUS QUO ANTE REQUIREMENT

In Rev. Rul. 80-58, the taxpayer was able to satisfy the status quo ante requirement by re-conveying the land following the failure to achieve zoning approval within the same taxable year as the first transaction. How the status quo ante requirement applies where, for example, the item originally transferred was an operating business and, prior to the rescission, the operating business remained an ongoing, income-producing business activity, is unclear and creates uncertainty when planning a successful rescission.

In its private letter rulings, the IRS treats this requirement as satisfied where the parties are returned to the positions they would have occupied if the first transaction had not occurred. This condition assumes, without stating so, that: (i) the original parties to the transaction are the parties that participate in the rescission transaction and (ii) no consideration is paid in order to induce one or the other of the parties to assent to the rescission transaction. As noted above, where the legal existence of one of the entities was terminated, the IRS has permitted the "resurrection" of that entity by the formation of a new entity under state law.

A more troublesome issue is the IRS's view, expressed in its letter ruling policy, that no consideration can be paid in connection with the unwinding transaction in order to induce the cooperation of the parties. To the extent that one of the parties to the transaction involving parties acting at arms length cannot be provided with an inducement to rescind an otherwise closed transaction, the availability of the rescission doctrine would be limited to transactions solely among parties that are members of the same economic unit. In that case, the reach and utility of the rescission doctrine would be greatly limited.

CONCLUSION

The rescission doctrine is a powerful, taxpayer-friendly doctrine that permits the parties to a transaction to unwind bilateral transactions after the fact where the circumstances warrant. The precise mechanics for the unwinding in the case of operating businesses are unclear, however, and resort to the doctrine requires careful attention to the economic underpinnings of the original transaction and the positions of the parties. Practitioners remain hopeful the IRS follows through on its plan to issue more robust guidance in this area.

Tax Aspects Of Paul Ryan's Fiscal Year 2014 Republican Budget Proposal

Tony Nitti for Forbes writes: Earlier today, House Republican and budget chief Paul Ryan (Wisconsin) issued his fiscal year 2014 Budget Resolution, which, if enacted, promises to eliminate the federal deficit – expected to be around $850 billion in 2013 – by 2023.

Drawing much of the attention upon the budget’s release has been Ryan’s cuts to governmental spending. Ryan’s latest proposal would grow spending at 3.4% as opposed to the 5% rate currently scheduled, and as result, would decrease total spending over the next decade by $4.6 trillion, from the currently budgeted $46 trillion to $41 trillion.

To achieve the reduced spending, Ryan takes aim at many of the same programs targeted in his FY 2013 budget. Medicare and Medicaid spending is cut by $885 billion over the next decade. Adherence to and extension of the recent sequester saves another $1.2 trillion. And in what likely amounts to little more than a pipe dream, Ryan would save $1.8 trillion by repealing the President’s signature Obamacare legislation.

But analyzing spending isn’t my thing; I want to know what Ryan has to say about tax policy. And upon further review, it’s clear that Ryan’s current tax proposal has the same strengths – and glaring shortcomings – as his previously released budgets.

For starters, what’s in the plan? Ryan’s 2014 budget would enact the following changes:

• Do away with the current seven tax rate system applied to individual taxpayers, which currently ranges from 10% to 39.6%, and replace it with only two rates: 10% and 25%. While the budget doesn’t clarify this, in the past Ryan has stated that the 10% rate would apply to taxable income less than $100,000, with the 25% rate applying to all income in excess of that threshold.
• Repeal the alternative minimum tax as well as any and all taxes imposed by Obamacare, including the 3.8% tax on a taxpayer’s net investment income.
• Reduce the maximum corporate rate from 35% to 25%.
• Transition the international tax regime from the current “deferral” approach to a full territorial system.

That’s it; that’s all the budget says about tax reform.

So let’s start with the good.

The AMT has to go. As anyone who read my post from last night can attest, it reads as clear as Chinese arithmetic. This parallel tax has long since strayed from its original intention of ensuring that the nation’s wealthiest taxpayers pay some level of federal income tax and has evolved into the bane of the middle class. Even worse, it requires an amount of time and expertise to appropriately navigate that is unrealistic to expect from the average taxpayer.

I’m also in favor of Ryan’s proposed international reform. I discuss the merits of both territorial systems and worldwide systems, which President Obama favors, here, but in general, I believe a territorial system is the way of the modern international market, and would greatly reduce both the complexity and exploitations that plague the current system.

Now, let’s move on to Ryan’s proposal for individual reform. As a guy who makes his living in the nether regions of the Internal Revenue Code, I, like many Americans, crave simplicity from the tax law. And while both parties often speak longingly of simplifying the Code, recent legislation, from Obamacare to the fiscal cliff deal, has done anything but. The Code has only grown more convoluted and complex, and history has shown that when a law becomes overly complicated, it raises the cost of compliance, in both man hours and dollars, and invites abuse.

Any significant plan for tax reform would have to contain two of the premises embodied by Ryan’s proposal: lower rates and fewer deductions. Clearly, a two-rate system of 10% and 25% would be a radical departure from the seven-tier system we find ourselves stuck in today, and a major step towards a system where every American can quickly estimate their federal tax liability.

While the text in the current budget fails to shed light on the nuances of Ryan’s plan, much can be gleaned from the summary tables included with the budget.  Interestingly, Ryan’s proposal will raise the exact same amount of tax revenue over the next decade as would be raised under President Obama’s current policy. In other words, much like the proposal Mitt Romney’s embraced during his election campaign, Ryan’s plan would be revenue neutral: it would not add a single dollar to the deficit.

But obviously, a maximum rate of 25% would generate significantly less gross tax revenue than the current system, which contains a top rate of 39.6% (actually, over 44% when factoring in Obamacare and the repeal of the PEASE limitation on itemized deductions). So how can Ryan’s plan be revenue neutral?

Because accompanying the reduction in tax rates would be the much-discussed and rarely clarified “base broadening,” whereby the countless deductions and preferences contained in the current version of the Code would be limited or eliminated. The theory being, if you cut enough deductions, the same level of net tax revenue can be maintained despite a nearly 20% drop in the top rate.

And that is what I don’t like about Ryan’s plan.

For starters, eliminating anything from the Code has become an exercise in futility in light of the army of special interest groups and professional lobbyists who fight on behalf of even the most narrow, industry-specific provisions contained in the law. It is exceedingly hard to believe that House Representatives and Senators would be willing to look past their own self-interests (read: reelection) and willingly alienate even a small portion of their constituents by permitting, for example, the mortgage interest or charitable contribution deduction to be removed from the law.

But let’s ignore the implausibility of sweeping tax reform for a moment. Experts have shown that there are simply not enough deductions to remove from the Code to make up for the revenue lost by dropping the top rate to 25%. Or at least, not enough to recover that lost revenue from those who will benefit the most from such a reduction: the wealthy.

When Ryan introduced his FY 2013 budget, it contained an identical vision for tax reform. And in response, the Tax Policy Center crunched the numbers and determined that reducing the rates to 10% and 25%, as Ryan proposes, would cost the government $4.5 trillion in tax revenue over a 10 year period. Keep in mind, this was when the maximum rate was 35%; now that the top rate has climbed to 39.6%, the forgone revenue would be greater.

Keeping things simple, in order for Ryan’s plan to remain revenue neutral as promised, it must raise at least $4.5 trillion in additional tax revenue through the elimination of deductions and preferences. And as the TPC proved with Mitt Romney’s plan, it is simply a mathematic impossibility to accomplish this without heavily shifting the burden from the wealthy to the middle class.

To illustrate, under Ryan’s proposal — but before considering the effect of any base broadening –taxpayers earning in excess of $1,000,000 would enjoy an average tax cut of $265,000, those earning between $500,000 and $1,000,000 would experience an average $47,000 reduction in their tax bills, and those and those earning between $200,000 and $500,000 would see their average tax bill decrease by $120,000. To the contrary, taxpayers earning between $40,000 and $100,000 would enjoy an average cut of approximately $1,000.

And here’s the rub: as was proven with the Romney plan, there are simply not enough deductions to limit or eliminate to offset the tax cuts experienced by those earning more than $200,000. The benefit from the reduction in their top rate from 39.6% or even 35% or 33% to 25% far outweighs any damage that can be done by eliminating deductions. So if you believe in basic math, if those earning in excess of $200,000 are going to walk away with a net tax cut, and the plan is to be revenue neutral, then…Voila!… there must be an offsetting increase in the tax liability of those earning less than $200,000.

Now, there is one way you could drop the top rate to 25% (or perhaps 28%) and maintain progressivity, but it requires a step Ryan appears to have no appetite for: taxing long-term capital gains and qualified dividends as ordinary income. Start taxing the Warrant Buffetts of the world at 25% on every dollar of investment income they earn over $100,000, and suddenly the landscape changes, and Ryan’s proposal would represent more than merely a windfall for those who need it least.

Navigating through a sea of college tax breaks

Amy Feldman for Reuters writes:  If you have kids in college, you already know that higher education isn't getting any cheaper - some private schools will now set you back more than $60,000 a year.  You may need a high-priced education just to figure out how to write it off. The federal government offers a variety of tax breaks to lessen your burden. But they are complicated, limited and overlapping, and it is not always easy to figure out how to maximize them.  And if you've already saved money in a tax-favored 529 college savings plan, that adds another layer of complexity to your tax calculations.

Here's a brief guide for the perplexed.

THREE BIG BREAKS

There are three main educational tax breaks to consider at tax time. First, the American Opportunity Tax Credit, which offers a $2,500 tax credit per student. It is the best of the bunch.

Second, the Lifetime Learning Credit, a less-valuable credit, allows you to reduce your taxes by up to $2,000 per return.

Finally, the tuition and fees deduction lets you deduct up to $4,000 from your taxable income. Remember that a deduction, which reduces the income subject to taxes, is worth less than a credit, which lowers your tax bill dollar for dollar.

Of course, there is a catch: You have to choose which credit or deduction to take, and there's no double-dipping.

If you have one child in college, you must pick one. A family with two kids in college may be able to mix and match but can take only one credit per student. In the case of the Lifetime Learning credit, the maximum credit is $2,000 per return, regardless of how many students your family may have in school.

Making matters more complicated, all three tax breaks have different income limits and eligibility requirements on the kinds of educational costs they will cover. (For all the nitty-gritty details, see the Internal Revenue Service's publication 970, Tax Benefits for Education.)

FORMULATING A PLAN OF ATTACK

Since you cannot take more than one of these tax breaks per student, you need to prioritize. If you qualify for all of them, take them in this order: First, the American Opportunity credit; then the Lifetime Learning credit; and finally the tuition and fees deduction.

In the 28 percent tax bracket, for example, both the $2,000 and $2,500 credits will trump the $4,000 deduction, which would lower your federal tax bill by just $1,120.

The American Opportunity credit has advantages for both upper-income taxpayers and lower-income ones. It has the highest income cap of the three, partially phasing out at $160,000 in income for married couples filing jointly and disappearing completely above $180,000.

At the low end, the credit is especially valuable because it is partially "refundable," as it's known in tax lingo, meaning you can claim a piece of it even if you don't owe any tax. That's unusual; most credits can only be used to lower the tax you owe.

The caveat is that the American Opportunity credit is for undergraduate education only, and you can claim it only four years per student.

The Lifetime Learning credit, on the other hand, can be used for all post-secondary education, including courses you take to improve your job performance. A student in graduate school, for example, would qualify for the Lifetime Learning credit but not the American Opportunity credit; so, too, would someone taking a few college courses but not pursuing a degree. Since you can take it for an unlimited number of years, you also could claim it for a student who's already maxed out the American Opportunity credit.

For tax purposes, those paying for higher education will receive a Form 1098-T from the college or university. Check it over closely; some recipients have found errors on their forms that can bring unwanted attention from the IRS.

WHO TAKES THE CREDIT?

Because of the income limitations, many upper-income parents may not qualify for the education credits, though their children might. That can be a great strategy.

"I just finished somebody's return, and it saved them $800 to take the education credit on the child's return," says Bill Fleming, managing director in PwC's personal financial services division. "The kid had made money in the summertime, so was going to pay some income taxes."

The general rule is that if the parents claim their kids as dependents, only they can claim a college credit. For the student to claim the credit, he or she cannot be claimed as a dependent on the parents' tax return. That can be worthwhile if, as in Fleming's clients' case, the parents make so much that they would lose tax breaks for their kids anyway under alternative minimum tax rules.

It's a case-by-case determination, Fleming says, and you need to run the numbers. Then you need to remember from year to year which children are on the parents' tax returns.

"We are constantly doing these back-and-forth calculations," he says.

WEAVING IN THE 529 PLAN

If you've saved in a 529 college savings plan or a Coverdell education savings account, congratulations - the funds you withdraw for tuition and fees won't be taxed. But that will add another layer of complexity to your tax return.

You can't get double tax breaks for the same educational expense, so if any part of it was already covered by tax-free scholarships, Pell grants or these tax credits, using money from a 529 plan to cover the same expenses may trigger a tax on that withdrawal.

Let's say you have one child in college and incur qualified educational expenses of $21,000. If you got $12,000 in tax-free assistance (from scholarships, fellowships or Pell grants), you'd have $9,000 in remaining educational expenses. You could then claim the American opportunity credit. It works on a formula in which you get to claim 100 percent of the first $2,000 in expenses, but only 25 percent of the next $2,000, for a total of $2,500 in credits for $4,000 in expenses.

How much could you withdraw tax-free from your 529 plan? Subtract the eligible expenses from that $9,000 to get the answer: $5,000. If you go above that amount, you'd owe tax on theearnings, but not the principal, of that withdrawal.

So plan your withdrawals accordingly, and then give yourself a back pat: If you can work your way through all that financing, you deserve some sort of honorary degree, at least.

Marginal vs. Average Tax Rates: They Both Matter

Jonathan Clements for Citibank writes: Do  you know your federal tax rate? If you answered something like 25%, 28%, or 39.6%, you’re correct—up to a point. That may be your marginal tax rate, which is the rate you pay on the last $1 that you earn. But if you want to know where you stand tax-wise, you also need to know your average rate. As you finish up your federal tax return, you might take a moment to do the calculation. Your average, or effective, tax rate is simply your total federal income tax bill divided by your total income. Let’s say you’re married filing jointly and you’ll earn $100,000 in 2013, all of it earned income. If you claim the standard deduction, that will lower your taxable income by $12,200. Each spouse also gets a personal exemption of $3,900, for an additional reduction of $7,800. Add those up and your taxable income would be $80,000. That’s enough to put you in the 25% marginal tax bracket.

But the federal income taxes owed on your $100,000 would be $11,857.50, equal to 12% of your total income and 15% of your taxable income. The total tax bite on your income would be somewhat larger once you figure in state and local income taxes, and also Social Security and Medicare payroll taxes. In addition, you may be contending with other taxes, such as property and sales taxes.

So when should you pay attention to your marginal rate—and when should you consider your average rate? Your average rate can be useful when thinking about budget-related issues, such as how much monthly disposable income you’ll have and how big an emergency fund you need. Let’s say you wanted enough set aside to cover your expenses if you were out of work for six months. Without any earned income, you wouldn’t have to pay nearly so much in taxes, but the best indication of the tax savings would likely be your average tax rate, not your marginal rate.

Meanwhile, your marginal rate can help you figure out the tax savings from, say, making tax-deductible contributions to an IRA or having tax-deductible mortgage interest. Your marginal rate can also help you weigh whether to buy taxable or tax-free bonds. The reason: These financial steps can add to, or subtract from, your regular income—and the impact can usually be gauged by looking at your marginal tax rate.

Tax Tip: Can You Deduct Gym Membership?

Robert D Flach for MainStreet.com writes: An actor emailed me to ask if he could deduct his gym membership as a business expense, since staying in shape leads to more roles. The same question could have been asked by one of my police or firefighter clients. Unfortunately, my answer was “no.” General toning and fitness workouts are considered personal expenses by the IRS. You may be able to deduct your health club or gym membership as a medical expense, though.

IRS Publication 502 (Medical and Dental Expense) tells us “You cannot include in medical expenses health club dues paid to improve one’s general health or to relieve physical or mental discomfort not related to a particular medical condition.” Yet several IRS rulings over the years tell us that if a doctor diagnoses you with a specific medical condition such as obesity or hypertension, or a specific physical or mental defect or illness, and prescribes workouts at a health club or participation in a weight loss program to treat or mitigate the condition, defect or illness, the membership dues may be deductible.

To deduct health club or gym dues:

• A doctor must diagnose you with a specific medical condition or a specific physical or mental defect or illness, and you must have written documentation of this diagnosis.
• You must use the health club facilities to treat the specific condition, defect or illness as recommended by your doctor.
• You must not have belonged to the health club or gym before the diagnosis and would not have joined if you were not diagnosed with the specific condition, defect or illness.

Automatic Stay: Rolling The Dice With A Tax Deed

Vicki Harding for Pepper Hamilton writes: Can the IRS issue a tax deed for real property after a bankruptcy has been filed where the tax sale took place prior to bankruptcy, or is that a violation of the automatic stay? In reaching its decision theRugroden court evaluated (i) the nature of the debtor's property interest after the IRS sale, (ii) the effect of the automatic stay on the debtor's right of redemption, and (iii) whether issuance of the tax deed deprived the estate of any property interest in violation of the automatic stay.

Rugroden involved an IRS levy on two parcels of real estate to pay income taxes. Under the Internal Revenue Code, real and personal property are treated differently. When there is a sale of real estate, the winning bidder obtains a certificate of sale as opposed to the property itself. The taxpayer has a right to redeem the property within 180 days after the sale by paying the tax sale purchaser the amount it paid plus 20% interest. If the property is not redeemed, the IRS issues a deed that serves to convey "all the right, title, and interest the party delinquent had in and to the real property thus sold at the time the lien of the United States attached thereto."

Under Section 541 of the Bankruptcy Code, the bankruptcy estate consists of all of the debtor's property, including all legal or equitable interests as of the commencement of the case. Although the tax sales took place prior to bankruptcy, the redemption periods did not expire until after the bankruptcy was filed. Since the debtor still held title to the real estate and still possessed a statutory right of redemption at the commencement of the case, it had an interest in the real estate under Section 541.

The next question was the impact of the bankruptcy on the redemption period. The debtor argued that the automatic stay under Section 362 of the Bankruptcy Code served to extend the redemption period indefinitely. However, under Section 108(b) of the Bankruptcy Code, when non-bankruptcy law fixes a period for a debtor to do something, the deadline is extended to the later of (i) the end of the period under non-bankruptcy law and (ii) 60 days after the case commences. The court concluded that the more specific Section 108 provisions controlled over the more general Section 362 provisions so that the redemption periods expired at the end of the 60 days.

Since this was a chapter 13 case (which involves a payment plan by an individual debtor), the court also addressed a debtor's right to cure defaults under Section 1322(c)(1) prior to a foreclosure sale. The court concluded that there was no such right in this case since the right to cure the failure to pay income taxes expired once the real estate was sold at a tax sale. After that, the debtor had only a right of redemption, not a right to cure.

The IRS issued tax deeds to the tax sale purchaser a couple of days after the redemption period (as extended under Section 108) expired. Although the debtor argued that this was a violation of the automatic stay, the court found that the debtor had no further interest in the real estate once its redemption rights expired. Further, execution of the deeds by the IRS was purely ministerial.  According to the court, the automatic stay does not bar a purely ministerial act, which Black's Law Dictionarydefines as an act which "involves obedience to instructions or laws instead of discretion, judgment, or skill."

Consequently, the court denied the debtor's motion for sanctions for willfully violating the automatic stay, and also denied the IRS request for nunc pro tunc relief from the automatic stay since it was not necessary.

Bankruptcy courts take the automatic stay very seriously. Here the court noted that "[t]he majority view is that the issuance or recording of a deed after expiration of a redemption period is ministerial." However, that leaves a minority view that issuance or recording of a deed may not be a ministerial act and may require relief from the stay. You take action that is potentially in violation of the stay at your peril.

10 Important Facts from the IRS about Mortgage Debt Forgiveness

If your lender cancelled or forgave your mortgage debt, you generally have to pay tax on that amount. But there are exceptions to this rule for some homeowners who had mortgage debt forgiven in 2012.

Here are 10 key facts from the IRS about mortgage debt forgiveness:

1. Cancelled debt normally results in taxable income. However, you may be able to exclude the cancelled debt from your income if the debt was a mortgage on your main home.

2. To qualify, you must have used the debt to buy, build or substantially improve your principal residence. The residence must also secure the mortgage.

3. The maximum qualified debt that you can exclude under this exception is $2 million. The limit is $1 million for a married person who files a separate tax return.

4. You may be able to exclude from income the amount of mortgage debt reduced through mortgage restructuring. You may also be able to exclude mortgage debt cancelled in a foreclosure.

5. You may also qualify for the exclusion on a refinanced mortgage. This applies only if you used proceeds from the refinancing to buy, build or substantially improve your main home. The exclusion is limited to the amount of the old mortgage principal just before the refinancing.

6. Proceeds of refinanced mortgage debt used for other purposes do not qualify for the exclusion. For example, debt used to pay off credit card debt does not qualify. 

7. If you qualify, report the excluded debt on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. Submit the completed form with your federal income tax return.

8. Other types of cancelled debt do not qualify for this special exclusion. This includes debt cancelled on second homes, rental and business property, credit cards or car loans. In some cases, other tax relief provisions may apply, such as debts discharged in certain bankruptcy proceedings. Form 982 provides more details about these provisions.

9. If your lender reduced or cancelled at least $600 of your mortgage debt, they normally send you a statement in January of the next year. Form 1099-C, Cancellation of Debt, shows the amount of cancelled debt and the fair market value of any foreclosed property.

10. Check your Form 1099-C for the cancelled debt amount shown in Box 2, and the value of your home shown in Box 7. Notify the lender immediately of any incorrect information so they can correct the form.

Use the Interactive Tax Assistant tool on IRS.gov to check if your cancelled debt is taxable. Also, see Publication 4681, Canceled Debts, Foreclosures, Repossessions and Abandonments. IRS forms and publications are available online at IRS.gov or by calling 800-TAX-FORM (800-829-3676).

IRS Seeks Volunteers for Taxpayer Advocacy Panel

The Internal Revenue Service seeks civic-minded volunteers to serve on the Taxpayer Advocacy Panel (TAP), which is a federal advisory committee that listens to taxpayers, identifies key issues, and makes recommendations for improving IRS services.

The TAP provides a forum for taxpayers to raise concerns about IRS service and offer suggestions for improvement.  The TAP reports annually to the Secretary of the Treasury, the IRS Commissioner and the National Taxpayer Advocate. The Office of the Taxpayer Advocate is an independent organization within the IRS and provides oversight of the TAP.

“In trying to comply with an increasingly complex tax system, taxpayers may find they need different services than the IRS is currently providing,” said Nina E. Olson, National Taxpayer Advocate. “The TAP is vital because it provides the IRS with the taxpayers’ perspective as well as recommendations for improvement. This helps the IRS deliver the best possible service to assist taxpayers in meeting their tax obligations.” 

The TAP includes members from all 50 states, the District of Columbia and Puerto Rico.  Each member is appointed to represent the interests of taxpayers in their geographic location as well as taxpayers as a whole.

New to the TAP

For the first time, the TAP this year is seeking to include at least one additional member to represent international taxpayers.  For these purposes, “international taxpayers” are broadly defined to include U.S. citizens working, living, or doing business abroad or in a U.S. territory. The new international member will not be required to attend any face-to-face meetings and cannot be reimbursed for such expenditures if he or she chooses to attend.

To be a member of the TAP you must be a U.S. citizen, be current with your federal tax obligations, be able to commit 200 to 300 hours during the year, and pass an FBI criminal background check.  New TAP members will serve a three-year term starting in December 2013.  Applicants chosen as alternate members will be considered to fill any vacancies that open in their areas during the next three years.

The TAP is seeking members in the following locations: California, Colorado, Illinois, Indiana, Iowa, Louisiana, Michigan, Mississippi, Missouri, Nebraska, North Carolina, Ohio, Pennsylvania, Rhode Island, South Dakota, Texas, Washington, Puerto Rico and any other U.S. territory or location abroad.  The panel needs alternates for the District of Columbia, Kansas, Kentucky, New Hampshire, New Jersey, South Carolina and Tennessee.

Applications for the TAP will be accepted through April 1, 2013. Applications are available online at www.improveirs.org.  For additional information about the TAP or the application process, please call 1-888-912-1227 (a toll-free call) and select prompt number five. Callers who are outside of the U.S. and U.S. territories should call 954-423-7973 (not a toll-free call).  You may also contact the TAP staff at taxpayeradvocacypanel@irs.gov for assistance.

Tax Tip: Deducting Student Loan Interest

Robert D Flach for MainStreet.com writes: You can claim up to $2,500 in interest paid on qualified student loans used to pay for post-secondary education — college or vocational school — for yourself, your spouse or your dependent as an “above the line” deduction on your 2012 Form 1040. To claim a deduction you must be legally obligated to repay the loan and you must actually make the payments. In many cases the student, if a dependent, and the parents are both legally obligated to repay the loan. In such a case the deduction is allowable to whoever makes the payments. If you are claimed as a dependent on the tax return or your parents or anyone else, you cannot deduct student loan interest on your return.  The amount you can deduct is phased out as your “modified” Adjusted Gross Income goes from $60,000 to $75,000 if you are single or from $125,000 to $155,000 on a joint return.You cannot claim the deduction if you are married filing separately.  Student loan interest paid is reported on Form 1098-E.  I recently had a situation where the Form 1098-E was issued in the name and Social Security number of the student. But the parents were also named on the loan and had a legal obligation to repay it, and they made all the loan payments for the year. The student could not deduct the interest on her return. But I did claim a deduction for the interest paid, subject to the $2,500 limitation (which was further reduced by the MAGI phaseout), on the parents’ Form 1040. Interest on a loan from a related party or from a qualified employer plan, such as a 401(k), are not deductible.