Overcoming 6 tax terrors when preparing your taxes

Kay Bell for Bankrate.com writes: Admit it. You're afraid of your Form 1040 or any other tax forms. That's OK. A lot of us are. And our tax fears, sometimes irrational, sometimes warranted, cause us to do a lot of dumb things when it comes to our annual returns.
Some people put off filing, some don't file at all. Neither of those choices is a wise tax move.
But fear doesn't have to paralyze you. Here are six common tax terrors. Some are real. Some aren't nearly as terrifying as you might think. Regardless, you'll find out just how you can conquer your tax terrors, get your returns done in a timely manner and possibly save a few bucks once you've overcome your tax-filing fears.

(1)  This fear, unfortunately, is too often true, in large part because of the ever-expanding tax code. Tax law publisher CCH Inc. notes that in 1913, it took 400 pages in the company's Standard Federal Tax Reporter to discuss the legislative, administrative and judicial aspects of the tax laws. The 2013 edition covers almost 74,000 pages. With numbers like that, it's no wonder the average taxpayer feels overwhelmed. Robert Simon, CPA and managing partner at EisnerLubin llp, an accounting, tax and consulting firm in New York, notes, "It is easy to understand why people can get confused when you consider the sheer number of code sections involved."The remedy: Don't be afraid to ask for help. Most of us already do. The Internal Revenue Service says around 80 percent of us rely on tax software or tax professionals to get our tax job done. You have lots of preparer options, from a personal accountant who can fill out your return and help you plan throughout the year to franchise operations that gear up between Jan. 1 and mid-April. If your tax situation is not overly complicated, computer software might be enough to help you file with a bit more confidence. Take a look at your tax needs, then find the tax assistance that best meets them.

(2)Even folks who are brave enough to tackle their taxes on their own often face this fear. Again, it's not an unreasonable one. And once again, those folks in Washington, D.C., feed this fear.  Take, for example, the various tax laws created in response to the recent economic crisis. The first-time homebuyer credit was changed three times in less than two years. Definitions, such as who qualifies as a first-time purchaser, would make Merriam-Webster editors scream. And there are all sorts of limits and demands for various homebuying situations.

The remedy: Accept that tax filing is going to take some homework. Before you start your return, check out the countless publications -- including Bankrate's tax center. Sign up for daily or weekly (or both) tax tip newsletters. If you've been too afraid to start the process yet, check out "7 ways to get organized for the tax year." By staying on top of tax law changes and filing tips, you'll know exactly where this year's taxes might trip you up.

(3)  This is a close relative of fear No. 2. But here, the fear is not of omission, but commission.

This includes things as simple as filing the wrong tax form. It happens. In trying to get through filing as quickly as possible, some folks opt for the easy way out, in this case, the 1040EZ, and end up cheating themselves. Or they choose the incorrect filing status, such as single when they're eligible to file as the more tax-advantageous head of household. Those are just a couple of the many mistakes that tax filers make every year.

The remedy: slow down. You still have plenty of time to do it right. Read the instructions. If you're using software, don't skip steps just to finish. Answer all your tax pro's questions. If he or she says to provide more information, then provide it. A little extra work and attention to detail could cut your tax bill or get you a bigger refund.

(4)  You know you need help, but you're afraid that the person you turn to could be more of a hindrance. Unfortunately, sometimes this fear is well-founded. A few years ago, a Government Accountability Office look into commercial tax prep chains in major metropolitan areas produced the alarming finding that all the returns completed in those offices were wrong to some degree.  The Department of Justice's Tax Division regularly shuts down tax preparation offices across the United States when it finds the operators have allegedly filed bogus returns for clients. And yes, even big name, high-dollar help sometimes produces unexpected tax costs for clients.

The remedy: The IRS is hoping to reduce such mistakes with new regulations on paid preparers.

To make sure you don't end up paying for your tax preparer's mistakes, start with the hiring process. Investigate several potential preparers, and thoroughly check out each before you hand over your personal tax documents. Once you're a client, don't take every recommendation at face value. Ask questions, and make sure you understand the answers. Most of all, remember the adage, "If it sounds too good to be true, it probably is."

(5)  Everyone dreads facing a tax examiner. But audit fears tend to be much greater than audit realities. The overall risk of audit remains small. In recent years, IRS data show that its audit rate hovers around 1 percent for individuals earning less than $100,000. The agency also has admitted that it is now going after wealthier taxpayers since any filing mistakes there tend to produce a larger return on the audit effort.The remedy: Statistics don't matter if you're one of the relatively few audited. If that happens, make sure you can show an IRS examiner why you filed as you did. "If you're really doing stupid things on your tax return, expect to get audited. Deservedly so," says Eva Rosenberg, an enrolled agent based in Southern California and the Internet's TaxMama. "But if you're afraid to use a legitimate tax break because you're afraid you're going to be audited, stop it! Stand up for your rights. There's no reason to be afraid."

Keep good records. If you can prove the tax break was valid, you'll be OK. People who work for themselves and file Schedule C do tend to get scrutinized a bit more, so your business record keeping needs to be precise.

(6)  The only thing scarier than filing taxes is what could happen if you don't file. The IRS penalty for not filing is actually worse than if you file but don't pay your tax bill in full. It'll cost you 5 percent a month on any unpaid tax if you haven't sent in a Form 1040. Send in the return but no money, and you'll only be charged one-half of 1 percent of the tax owed for each month.

The remedy: File! And file on time. Then make arrangements to pay. That way you'll avoid taking that hardest tax penalty hit, which could reach a cumulative 25 percent maximum penalty.

If you can't afford to pay your full tax bill, send Uncle Sam at least a down payment. As for coming up with the rest of the tax bill, consider using a credit card; just use the card that has the lowest interest rate. The IRS also has payment plans. Though these add interest charges to your tax bill, rates right now are low. And at least you can be assured that you're meeting your filing and payment obligations.

Women and Taxes: Tax Season Gender Gap? ‘More women want to be involved on the investment side, but they still feel resistant on the tax side,’ says wealth manager Eileen O’Connor

Joyce Hanson for AdvisorOne writes: There’s no way around it: both women and men, whether married or single, will see some changes to the income tax landscape in 2013 now that President Obama and Congress’ fiscal cliff deal is a reality.

Women—whether they’re young, in mid-career or retirement age—can expect to see a few tax rules that affect them especially. Women returning to the workforce after staying home with their kids, for example, need to know about what is and isn’t deductible, while seniors may need to re-examine the tax side of their investment portfolios.

And then there’s what might be called the tax season gender gap.

Eileen O’Connor, a wealth manager with McLean Asset Management in McLean, Va., finds that while her female clients are increasingly interested in finance and investing, they tend to find taxes daunting.

“More women want to be involved on the investment side, but they still feel resistant on the tax side,” said O’Connor, who spoke last year in a TD Ameritrade Institutional webcast that asked, “What Do Wealthy Women Want?”

Women Advised to Get on Board the Tax Train

Yet with the highest federal tax rate rising to more than 40% for the highest earners, women are well-advised to get on board with tax planning, O’Connor noted. She pointed to the 2013 high-earner rates of 39.6% for income taxes compared with 35% in 2012, plus the new 3.8% Obamacare tax, plus the increase to 20% from 15% for both capital gains and dividends for the highest earners.

“If the highest bracket is 40% or more, that’s going to have a big impact on the ability to accumulate wealth,” O’Connor said.

Barbara Kogen, a financial advisor, accountant and tax lawyer, agreed. In California, where she lives and works near Los Angeles, married couples with taxable income over $450,000 and single people with taxable income over $400,000 face 2013 state and federal taxes that can total as much as 55% of earnings.

Hidden Taxes

“All these little hidden things are taxes that people weren’t really focused on,” Kogen said after totting up the combined figures of payroll tax plus the Obamacare-related surtaxes on net investment income, wages and self-employment. “You’re well into the mid-40 percentages without even thinking of state tax. In California, we’re in the mid-50s. It’s very painful.”

On the other hand, Peggy Cabaniss, a certified financial planner who served as 2005-2006 chairwoman of the National Association of Personal Financial Advisors (NAPFA), said that a surprisingly large majority of American taxpayers will see no difference to what they’ll pay in 2013 compared with 2012.

“We have so many people coming in saying, ‘we’re so worried,’ and we say, ‘why?’ and they say, ‘didn’t you hear that Obama has raised our taxes?’ But the reality is that the only tax rate increases are for taxable income over $400,000 if you’re single and $450,000 if you’re married,” Cabaniss said. “The truth of the matter that it’s only a small percentage of the population that’s really paying these higher rates. After deductions, many people will really have the same tax rates as last year.”

Peggy Cabaniss, NAPFA-registered certified financial planner and president of HC Financial Advisors Inc., Lafayette, Calif.:

With senior women, Cabaniss is seeing more and more cases where a husband who previously took care of taxes and investments is now in need of medical care, and his wife for the first time in her life is in the position of taking responsibility for their finances. At the same time, these senior couples are often getting hit with big medical expenses that can be claimed as itemized medical deductions.

Cabaniss (left) gives the example of a couple who previously took in $70,000 in income and had $10,000 in deductions, leaving them with $60,000 to live on annually. But if the husband’s medical costs total $8,000 per month, that’s a backward equation of $96,000 in deductions a year exceeding income of $70,000. The solution, according to Cabaniss, is to get rid of the tax-sheltered investments in the couple’s portfolio, including municipal bonds, and buy taxable securities such as stock and corporate bonds.

 “A lot of times older people think the most important thing are muni bonds and muni funds. You hear a lot from seniors that they want tax-free income,” Cabaniss said. “If you have high medical expenses, you will not benefit from that tax-free income. You want taxable investments. But many times women haven’t been responsible for the tax return or investments, and they say, ‘I’ve got to do what my husband did because he always did the right thing.’ But in this case, you really have to change your strategy.”

Barbara Kogen, financial advisor, CPA, tax lawyer and partner at Miller, Kaplan, Arase, North Hollywood, Calif.:

Kogen looks for what she calls “hidden tax traps” that people aren’t aware of until tax time. “It was a crazy time last year because there was so much uncertainty with the tax laws expiring in 2012 and temporary extensions. Clients would come in for advice and we would have to say, ‘This is our best advice, but we don’t know what’s going to happen.’”

As for her female clients, Kogen  said the income tax increase “impacts them greatly” because any married woman who has returned to work during the economic recovery now faces the tax burden of being part of a two-income household. Even couples without a lot of investment income—a couple that earns $300,000 with $5,000 of interest income, say—meet the $250,000 threshold for the 3.8% tax.

“From the time value of money standpoint, it’s usually better to defer income to future years and accelerate expenses to keep the current year’s income lower,” Kogen said. “But in 2012, we told our clients, ‘We think 2013 taxes will be higher, so accelerate all the income you can in 2012 because it will be cheaper than taxes in 2013. And any deductions you can defer, wait until 2013 because the tax rates will be higher.”

Eileen O’Connor, certified financial planner and managing principal of wealth management,McLean Asset Management, McLean, Va.:

Roth IRA conversions, believe it or not, have a gender bias, says O’Connor, whose firm has done a lot of Roth conversions for clients.

The reason is longevity risk, O'Connor  explained: “The combination of women living longer and a potentially high and higher tax environment in the future means that tax planning should be a priority especially for women because every extra dollar added to your portfolio is going to help. The longer you live, the more sense it makes to make Roth conversions early.”

In other words, many women should convert their savings now to Roth IRAs so they can be withdrawn tax-free in retirement—a powerful tool for women as they age, she said.

“If a woman converts now to a Roth IRA, she would take her $100,000 traditional IRA, for example, and convert it to a Roth and pay tax now on the $100,000 before she retires,” she said. “If that sum grows to $500,000, and it’s 100% tax-free in retirement and not subject to interest dividends or any earnings, it’s powerful. We’ve converted millions and millions and millions of dollars into Roths.”

Beware the costly, complicated AMT ( alternative minimum tax)

Kay Bell for Bankrate.com writes: Three letters, AMT, are striking tax fear in the hearts of more and more middle-class filers. These folks are simply trying to use the tax code, legally, to lower their annual Internal Revenue Service bills. They claim exemptions for eligible dependents, deduct the interest on their mortgage and associated equity loan, and write off the state income taxes they pay. Some of these tax breaks, however, will do them no good under the alternative minimum tax system.

Commonly referred to as the AMT, this tax has its own set of rates (26 percent and 28 percent) and requires a separate computation that could substantially boost your tax bill. Basically, it's the difference between your regular tax bill, figured using ordinary income tax rates, and your AMT bill, figured by filling out more IRS paperwork. When there's a difference, you must pay that amount, the AMT, in addition to your regular tax.
The AMT was designed in 1969 to ensure that wealthy taxpayers didn't use loopholes to escape paying their fair share of taxes. The original target was 155 filers with the then-exorbitant income of $200,000 who avoided paying any federal taxes.

Permanent AMT relief

When an AMT payment is required, affected taxpayers could end up paying thousands more in taxes.
That possibility has been a major threat since the alternative tax's creation because it was not indexed for inflation. Without that annual adjustment, a yearly raise of a few percentage points meant a taxpayer was closer to or even into the income realm that the tax law deemed almost 40 years ago as prime AMT bait.

You could owe AMT if your taxable income in 2012 was more than:

• $78,750 for a married couple filing a joint return and surviving spouses.
• $50,600 for singles and heads of household.
• $39,375 for a married person filing separately.

In past years, Congress bumped up the earnings amounts to keep more middle-income filers from paying more under the AMT system.
And on Jan. 2, 2013, with the enactment of the American Taxpayer Relief Act, the AMT was permanently indexed for inflation.

Calculation insult to tax injury

Adding insult to injury, the AMT's parallel system demands that taxpayers do more work to pay more in taxes. The effort is required in filing paperwork (the dense, two-page Form 6251, Alternative Minimum Tax -- Individuals) and maintenance of separate records for regular and alternative tax purposes.
Even filers who escape actual payment of the higher tax still must do additional work just to learn that they are off the AMT hook.
To help sort through the AMT mess, some taxpayers turn to computer software packages, most of which include AMT computation, or hire professional help. Both choices should help you stay on the IRS' good side, especially if you owe AMT, or at least put your mind at ease if you don't.
But the options also will add to the overall cost of calculating your tax bill.

Free help in figuring your AMT

For the last couple of years, the IRS has provided some free AMT calculation assistance.
AMT Assistant is an online tool to help taxpayers determine whether they owe the tax. You just answer a few questions about entries on your draft 1040 and the system does the rest. Based on your entries, the calculator will tell you that either you do not owe the AMT or that you must go further and complete more computations to find out if you owe the AMT.
The AMT Assistant is especially welcome to filers who still do their taxes by hand, because the automated program essentially replaces the tedious work sheet taxpayers are instructed to use to determine if they fall under the AMT.

With the online program, says the IRS, most people will spend only about 10 minutes to find out their AMT fates.
There are a few special instances where a filer will need to take a few extra online steps, such as claiming the foreign tax credit, dealing with disaster-related tax issues or preparing a return for a child. But most taxpayers will need just Form 1040, completed through line 44, (that's the tax you owe under the regular system), andSchedule A if itemizing.

You don't have to enter your name, Social Security number or other identifying data. The program, which guides you through a series of question-and-answer pages, only wants the numerical data from your forms.

When you're finished, it will tell you whether you now have to fill out the AMT form, but it won't tell you the actual tax damage. You'll still have to fill out Form 6251 to find out that amount.

AMT starting point

How do you know, without using tax software or the AMT Assistant, if you might be caught in the AMT net? There are some indicators, but it's not always easy to tell.
The starting point for figuring any AMT is your regular taxable income. This is the stage where the AMT Assistant (or work sheet, if you still insist on doing things by hand) kicks in.
Basically, some of the deductions you claimed to figure your regular tax bill must be added back. These are known as tax-preference items. You also might find a special exemption amount is subtracted. The resulting amount is subject to the alternative tax.
Many of the tax breaks not allowed under the AMT system do affect predominantly wealthy individuals or businesses with complicated tax circumstances. These include incentive stock options, intangible drilling costs, tax-exempt interest from certain private activity bonds, and depletion and accelerated depreciation on certain leased personal or real property.

Common tax breaks disallowed

The AMT also rejects or reduces many common tax breaks used every year by individual taxpayers to lower their IRS bills.
For example, under the AMT, you cannot deduct state and local taxes. This is a major blow to many filers, because most states collect income taxes and all jurisdictions have some type of levy that generally can be counted against a federal tax bill.
Medical costs are still allowed, but the AMT requires they exceed at least 10 percent of your adjusted gross income rather than the 7.5 percent threshold of the regular tax system for tax year 2012. In 2013, as part of health care reform the allowable medical deduction threshold amount for regular tax and AMT will be 10 percent of AGI.
Miscellaneous itemized deductions, although limited under the regular tax system, are disallowed under the AMT. Even large families can be hit. If your personal exemption total is big, look out.

Own a home? Some cherished home-related tax breaks take an AMT hit. While mortgage interest on your main and second home is still AMT-deductible, home equity loan interest is restricted. It can't be deducted unless the money is used solely to pay for home improvements. Your home's property taxes also are disallowed as deductions under the AMT.
Other commonly claimed credits also technically affect AMT calculations, such as those for dependent care and education costs. However, for the last few years the congressional AMT patch has allowed AMT taxpayers to continue to count these in their calculations.

Once you add back these AMT disallowances and run the numbers, you might be subject to a bigger IRS bill if your taxable income exceeds the annual exemption amount for your filing status.  If you find you must pay the AMT, the extra money you owe, along with the added paperwork hassle, is never welcome. But dealing with it now is better than the alternative: letting the IRS discover that you should have paid it. When Uncle Sam comes asking for back taxes, he wants interest and penalties, too.

Intuit and QuickBooks in 2020: 5 Potential Network-Based Services Offerings / (Future Accounting Transactional Connectivity)

Jason Busch for SpendMatters.com writes: We’ve been covering Intuit’s investment and partnership with supplier network/platform/e-invoicing provider Tradeshift in a series of columns. Relative to competitors in the SMB accounting and applications space (Sage/Peachtree, Microsoft, Xero, Zoho, Freshbooks), Intuit seems the most serious about finding emerging ways to enable transactional connectivity (invoice, PO, etc.) between its base and customers beyond simply emailing documents back and forth.

Yet Intuit is clearly trying to explore and flesh out strategies to target a far bigger network space opportunity. In working with Tradeshift, Intuit is deepening its knowledge in this inter-company opportunity, even dabbling in the broader connectivity and cloud apps space. And there are even broader opportunities in the coming decade. Based on this potential, the Spend Matters team came up with ten potential network-based services that Intuit or a competitor could provide (note: the ten items represent our views — not those of Intuit or any third party). These include (starting with the most logical and the “here, now or soon”):

1. E-Invoicing connectivity to larger buying organizations – Intuit should provide an on-ramp for QuickBooks users in CD and Online versions to connect directly with their customer’s systems of record. Ultimately, this cloud-based connectivity could provide for additional fields and visibility in QuickBooks, including committed payables dates. If the Tradeshift partnership works as planned, Intuit will have their solution figured out.
2. Supply chain finance/discounting – There are several discounting/supply chain finance opportunities for Intuit, but generally speaking, those of greater value (likely to be acted upon by suppliers because of reasonable APRs) will require tighter systems integration with AP portals and payment systems. The “agreement to pay on a certain date” that a supplier can access through a portal or API based on e-invoicing connectivity can provide greater assurance to lenders (banks, hedge funds, etc.) to provide funds at rates below traditional factoring options. Suppliers could “opt in” to allow this type of visibility to be seen by different competing lenders.
3. Supplier registration linked directly to supplier management tools and other networks – With the planned integration of TradeShift into QuickBooks user environments, it will be easy for TradeShift users to rapidly onboard suppliers that are already in “the network,” so to speak. But the broader opportunity for Intuit extends beyond TradeShift users to those of other eProcurement, e-invoicing, supplier management and related tools (we’re talking Oracle eBusiness Suite/Supplier Hub users). If QuickBooks users agree to share basic information with customers or prospects they’re going through registration or on-boarding processes with by using their accounting package, and they can broadcast this into all of the major P2P, ERP/MRP and supplier management tools in the market, Intuit could have a killer app for supplier on-boarding and vendor file management. This network supplier management vision is arguably more powerful coming from the QuickBooks/accounting supply side for SMBs than the buyer driven supplier management network models from the likes of Aravo, Ariba, etc. 
4. Certification/credential management (e.g., diversity, insurance certificates, regulatory compliance, material certifications, environmental/health/safety) – managing supplier certifications/credentials is a fragmented area inside companies. Fortune 500 organizations in the US often have team members dedicated to the simple maintenance of supplier diversity certifications, insurance certifications and the like (let alone broader credentials focused on regulatory compliance and related areas). If Intuit/Quickbooks enabled its users to upload and maintain this type of information via their accounting system or a linked network-based offering (which prompted users to maintain current information as certificates and related content expired) it would be a significant time saver for customers, who would happily pay a fee for yearly access to this information (and it would save suppliers from having to manually send information to their larger customers)
5. Benchmarking – The benchmarking opportunities for QuickBooks customers (and buyers working through the Intuit/Tradeshift network on the AP side) are fascinating and huge. From AR/AP cycle time, straight through processing success rates, payment terms, spend managed per FTE, etc. the individual KPIs are endless. But they could be significantly valuable for users on both side of the network equation. Moreover, those top performing SMBs might opt to “share” their KPIs with potential partners (such as banks) for access to preferred lending rates or other opportunities.    (END OF PART 1, PART 2 and 5 More Ideas Coming Soon)

Kindergarten is not mandatory in Michigan, so can I add the kindergarten tuition in figuring the Child Care Tax Credit?

Kelly Phillips Erb the Tax Girl for Forbes writes: Taxpayer asks:  Most of what I read says that kindergarten tuition cannot be used in figuring the Child Care Tax Credit. However, that said, I thought that if a person resides in a state that does not have mandatory attendance in kindergarten, the tuition can be used to figure the Child Tax Credit. Kindergarten is not mandatory in Michigan, so can I add the kindergarten tuition in figuring the Child Care Tax Credit?

Taxgirl says:

Whether kindergarten is mandatory in your state doesn’t change the answer.

Expenses for a child in nursery school, preschool, or similar programs for children below the level of kindergarten are deductible for purposes of the child care tax credit if they otherwise qualify as child care. The IRS takes the position in Pub 503(downloads as a pdf) and in the Regs that expenses to attend private or parochial kindergarten or higher grades are not deductible.

I have a slightly different take. Since it’s clear that expenses for before- or after-school care of a child in kindergarten or a higher grade at a private school can be deductible (also in the Regs), I believe that if you can clearly carve out a child care piece associated with attending the kindergarten, that portion should be deductible. However, the IRS believes that kindergarten is always educational: rebutting this presumption would be very fact dependent (and an uphill battle). Such facts would include (but are not definitive) if, during the non-educational portion:

• Attendance is not mandatory;
• Promotional materials refer to child care;
• The facility boasts a child care license;
• Grades are not assessed; and
• During the non-educational portion, a certified teacher is not present.

Again, tread carefully. Start with the general assumption that kindergarten won’t qualify and only give it a second look if your circumstances warrant. And always check with your tax professional.

Deducting The Cost Of Birth Control

Kelly Phillips Erb The Tax Girl for Forbes writes: Taxpayer asks:  My health insurance doesn’t cover the cost of my birth control. I am trying to decide between pills and an IUD. Would either or both of them be tax deductible?

taxgirl says:

You can only deduct qualifying medical expenses for federal income tax purposes. Qualifying medical expenses include the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body. These expenses visits to medical professionals as well as any medicine or drug which requires a prescription of a physician for legal use.

Under that definition, birth control pills are clearly deductible and are called out as deductible in IRS Publication 502. And while the IRS used to reference “contraceptive devices” in Publication 502, I can’t find that term anymore. Instead, the focus is on legal medical drugs and procedures for non-cosmetic purposes that would require the services of a physician. By definition, that would include an IUD, as well as Norplant and similar implantables. It also includes the costs of sterilization for women and vasectomies for men.

Not all methods of birth control will qualify for the deduction. Condoms and sponges, for example, are not deductible since they are available not by prescription but over the counter. Non-prescription items – no matter how much you think they’re necessary – are considered “personal use items” and are not deductible.

Keep in mind that medical expenses are only deductible if you itemize your deductions on a Schedule A. For 2012, you can only deduct those qualifying expenses that exceed 7.5% of your adjusted gross income (line 37 of your form 1040).

Tax Considerations For ETFs And Mutual Funds

Michael Rawson for Seeking Alpha writes: With so much uncertainty in the financial markets, there are few outcomes over which investors have much control. One area where informed decision-making can consistently pay off is tax planning. Investors in high tax brackets or with a lot of money to invest should consider which asset classes and strategies are best held in a taxable account and which are best held in a tax-deferred account. Passive strategies generally are more tax-efficient, but this is not always the case, particularly if an index fund invests in an asset class with high tax costs or tracks an index with high turnover.

Asset-Class Tax Treatment Trumps All Else
Certain asset classes offer better aftertax returns in tax-deferred accounts, such as assets that throw off a large share of their total returns in the form of interest income, which is taxed at ordinary income tax rates. For example, if an investor in the highest tax bracket were to hold iShares Core Total U.S. Bond Market ETF (AGG) in a tax-deferred account, he or she would have earned a 5.78% annualized return for the five years ended Dec. 31. That same investment held in a taxable account would have returned only 4.43% for an investor in the highest tax bracket. When choosing a fund for a taxable account, one would have been better off with the iShares S&P National AMT-Free Muni Bond ETF (MUB), which returned 5.48%. But in the tax-deferred account, the muni fund underperformed the taxable iShares Core Total U.S. Bond Market fund.

Investments that generate nonqualified dividends, such as REITs, are also better held in tax-sheltered accounts because those dividends are taxed at investors' ordinary income tax rates. For example, T. Rowe Price Real Estate's (TRREX) 10-year annualized return of 12.53% drops to 10.99% for an investor in the highest tax bracket once taxes are factored in.

Qualified dividend income, on the other hand, is somewhat tax-advantaged compared with ordinary income. For 2013, the highest ordinary income tax rate is 43.4% when including the 3.8% Medicare tax surcharge on high earners, while the highest tax rate is 23.8% on qualified dividends. Over the long term, dividend-paying stocks have performed well, so risk-tolerant investors with additional money to invest can hold dividend-focused funds in taxable accounts, despite the slight tax disadvantage compared with holding them in a tax-deferred account. Naturally, you would put dividend-paying funds in a tax-deferred account first, but those with large taxable accounts should not necessarily avoid dividend-paying stocks. It is important to remember that it is the total aftertax return that is most important, not necessarily minimizing taxes. For example, while it is true that during the past five years an investor in Vanguard Dividend Growth (VDIGX) paid more in taxes than an investor in a typical S&P 500 Index fund, VDIGX still had a much higher aftertax return.

Strategies Still Play a Role
Although the asset location decision--which asset classes to hold in which account types--is a crucial component of tax management, investors also can help improve their aftertax results by focusing on tax-efficient strategies for their taxable holdings. Exchange-traded funds are often touted as tax-efficient investments because they can gain an edge through the use of an additional tax-fighting weapon at their disposal: the creation and redemption process. Rather than selling stock to meet investor redemptions, ETFs are redeemed through an in-kind transfer with an authorized participant. The in-kind, or shares-for-shares, transfer allows for the elimination of low-cost-basis shares, thus reducing (but not eliminating) the possibility of future capital gains distributions.

But here is the rub: This in-kind creation and redemption mechanism works best for U.S.-stock funds. Once we venture outside of the U.S.-stock asset class, the tax benefits stemming from the in-kind creation and redemption process might diminish somewhat. For example, in the bond market, in-kind creations are more difficult, so cash creations and redemptions are common. During the past five years, both iShares Core Total U.S. Bond Market and iShares iBoxx $ High Yield Corporate Bond (HYG) were no more tax-efficient than comparable index mutual funds.

Investors also should remember all the commonalities between the taxation of ETFs and mutual funds. ETF investors will owe taxes on the distributions of dividends or interest income that an ETF receives and passes through to investors. They also will face capital gains taxes when selling the fund, regardless of whether the fund is an ETF or index mutual fund.

And even for U.S.-equity ETFs, most of their tax efficiency stems from the fact that they are index funds, which typically have low turnover and thus generate fewer capital gains than actively managed funds. There are plenty of ETFs (and conventional index funds, for that matter) that follow higher-turnover, so-called strategy indexes, which might be less tax-efficient than traditional, market-cap-weighted index mutual funds. For example, PowerShares Fundamental Pure Large Core ETF (PXLC) had a five-year tax-cost ratio of 0.63, high by equity ETF standards, likely because the fund has high turnover.

In addition, a handful of tax-managed mutual funds--traditional open-end funds that hew closely to market benchmarks but have active oversight--have achieved tax efficiency by following best practices, such as limiting trading, keeping track of tax lots, and appropriately timing the sale of high-cost-basis shares. In summary, tax efficiency comes from diligent implementation of a sound low-turnover strategy, not necessarily from some magical tax loophole afforded only to ETFs.

Delving Into the Details
Let's look at some specific examples to illustrate the point that ETFs can be more tax-efficient than active mutual funds but are not necessarily more tax-efficient than well-run index mutual funds.

The iShares Core S&P 500 ETF (IVV) had a 10-year pretax annualized return of 7.03% and a post-tax (but preliquidation) return of 6.71%. This results in a tax-cost ratio of 0.30. The tax-cost ratio measures the amount of return lost to taxes, so a lower number in combination with a higher after return is better. A similar ETF, SPDR S&P 500 (SPY) had a 6.99% pretax return and 6.65% post-tax return, for a tax-cost ratio of 0.32. The average tax-cost ratio for actively managed large-blend funds during the past decade has been 0.60, so these two ETFs have been much more tax-efficient.

But a number of index mutual funds and tax-managed funds have also been tax-efficient. The institutional share class of Vanguard Institutional Index (VINIX) had a pretax return of 7.11% and 6.78% post-tax, for a tax-cost ratio of 0.31. This Vanguard index mutual fund was as equally tax-efficient as the two ETFs.

In theory, an equity ETF could be even more tax-efficient than an index mutual fund, but it is hard to find the data to prove it. One reason for that is ETFs have eliminated a large chunk of their index-fund competitors. Back in the year 2000, there were more than 118 index funds in the large-blend category; today, there are 84, despite the fact that indexing has continued to grow in popularity. With the exception of Vanguard's index-fund lineup, all of the interim net new inflows into the category have gone to ETFs, while many index mutual funds have languished. Competition from ETFs has washed out more costly and less efficient competitors in the realm of traditional index funds. The end result is a leaner, less expensive, and more efficient menu for investors to choose from.

Data sourced from iShares, PowerShares, T. Rowe Price, Vanguard, and Morningstar. Tax-cost ratio data reflects five- and 10-year periods ended Dec. 31, 2012.

Tax-Weary U.S. Millionaires Embrace Cayman Islands, Hong Kong for Relief / Global advisory firm catering to wealthy expats says Texas and Florida are no longer good enough for those who’ve had it with taxes

Gil Weireich for AdvisorOne writes Much ink has been spilled on the trend of wealthier Americans fleeing fiscally dissolute, high-tax states like California and Illinois, and heading for comparative tax havens such as Texas and Florida. The golfer Phil Mickelson made headlines recently when he wondered aloud about leaving his native California over its newly enacted steeper tax rates on the rich.

And when France sought to introduce a new wealth tax, its wealthiest businessman, Bernard Arnault, sought Belgian citizenship while one of its most famous actors, Gerard Depardieu, found a financial haven in Russia.

While in the American popular imagination, tax flight is something that prompts overtaxed Europeans to come to America (think John Lennon), Facebook billionaire Eduardo Saverin’s renouncing of his U.S. citizenship and move to Singapore in 2011 to avoid a $67 million tax bill may mark the point when America came of age as a higher-tax developed nation.

That is because anecdotal evidence, as well as the increasing rate of Americans renouncing their citizenship since the IRS started tracking the phenomenon in 2008, suggests that the wealthiest Americans may no longer be content to move merely to Miami Beach or North Dallas, but are looking to overseas destinations with less onerous tax requirements.

This heightened interest in tax flight is a trend spotted by Nigel Green, CEO of the deVere Group, a global financial advisory firm catering to British expats and wealthy Americans in foreign countries, among others.

The firm, which according to its website has $90 billion in assets under management and 70,000 clients in more than 100 countries, is now making a push into the U.S., with offices in New York and Miami. AdvisorOne asked Green about the conversations occurring between his deVere's advisors and their wealthy U.S. clients.

What destinations are U.S. tax refugees looking at and why (aside from, or in addition to, tax advantages)?

In our experience, the Cayman Islands, Hong Kong, Thailand, Malaysia and the Philippines are proving to be popular destinations for America’s high-net-worth individuals who are considering moving themselves and their assets out of the U.S. to safeguard their funds.  Having said that, anywhere they’ll be taxed less than 30% might seem appealing.

Besides the tax advantages, these individuals might be drawn to a destination because it offers a more attractive quality of life, a greater potential for job promotion, lower crime rates and a safer atmosphere, a lower risk of natural hazards, and better education and health care systems, amongst other factors.

Texas Gov. Perry is flamboyantly holding open the welcome mat to California businesses. Are any international leaders involved in recruiting wealthy Americans?

To my knowledge, international leaders have not been directly involved in recruiting wealthy Americans as Gov. Perry of Texas has been doing—although perhaps they should be and will in the near future—as it might be perceived that this could potentially damage relations with Washington.

While in the American popular imagination, tax flight is something that prompts overtaxed Europeans to come to America (think John Lennon), Facebook billionaire Eduardo Saverin’s renouncing of his U.S. citizenship and move to Singapore in 2011 to avoid a $67 million tax bill may mark the point when America came of age as a higher-tax developed nation.

That is because anecdotal evidence, as well as the increasing rate of Americans renouncing their citizenship since the IRS started tracking the phenomenon in 2008, suggests that the wealthiest Americans may no longer be content to move merely to Miami Beach or North Dallas, but are looking to overseas destinations with less onerous tax requirements.

This heightened interest in tax flight is a trend spotted by Nigel Green, CEO of the deVere Group, a global financial advisory firm catering to British expats and wealthy Americans in foreign countries, among others.

The firm, which according to its website has $90 billion in assets under management and 70,000 clients in more than 100 countries, is now making a push into the U.S., with offices in New York and Miami. AdvisorOne asked Green about the conversations occurring between his deVere's advisors and their wealthy U.S. clients.

What destinations are U.S. tax refugees looking at and why (aside from, or in addition to, tax advantages)?

In our experience, the Cayman Islands, Hong Kong, Thailand, Malaysia and the Philippines are proving to be popular destinations for America’s high-net-worth individuals who are considering moving themselves and their assets out of the U.S. to safeguard their funds.  Having said that, anywhere they’ll be taxed less than 30% might seem appealing.

Besides the tax advantages, these individuals might be drawn to a destination because it offers a more attractive quality of life, a greater potential for job promotion, lower crime rates and a safer atmosphere, a lower risk of natural hazards, and better education and health care systems, amongst other factors.

Texas Gov. Perry is flamboyantly holding open the welcome mat to California businesses. Are any international leaders involved in recruiting wealthy Americans?

To my knowledge, international leaders have not been directly involved in recruiting wealthy Americans as Gov. Perry of Texas has been doing—although perhaps they should be and will in the near future—as it might be perceived that this could potentially damage relations with Washington.

What has persuaded tax migrants to give up on the U.S. rather than wait for a regime change (or be satisfied with a move to Texas or Florida)?

There’s a growing sense amongst high-net-worth Americans that the tax policy of the U.S. is heading in the wrong direction, and the majority of our clients tell us that they don’t believe a change in administration would radically alter this.

Between January and February of this year there was a 48% month-on-month rise in the number of deVere Group’s U.S. clients with assets of more than $1 million inquiring about permanently relocating outside the U.S., specifically to reduce their tax burden.

What effects do you foresee on the U.S. and their new tax havens of the migration of wealthy Americans?

Various studies over the decades have shown that capital flight hits economies hard as it represents a loss of income for the government.  We’ve seen large-scale tax migration can create higher unemployment and destabilize currency and exports, for example.

However, perhaps one of the most significant points would be the loss of all that business experience and creative flair that the country needs for sustained economic growth.

What the U.S. would lose, the lower-tax jurisdictions would surely gain.

Payroll Audits Put Small Employers on Edge Tax Crackdown Comes as Use of Contract Workers Grows; Companies Find Rules Unclear

Angus Lotun & Emily Maltby for the Wall Street Journal write: Internal Revenue Service auditors showed up with little warning at Brian Robinson's staffing firm in Atlanta a year ago, seeking to verify that a dozen outside contractors he had hired to handle his information-technology services weren't, in fact, full-time staffers.  The audit was part of a government crackdown on employers who misclassify workers as independent contractors to avoid paying payroll taxes, and other employment-related expenses.

Mr. Robinson says the auditors ultimately found that his 30-year-old family business, TRC Staffing Services Inc., with its 100 permanent employees and up to 20 temporary workers, was in the clear. But he says the audit was "nerve wracking" because tax law doesn't make it easy to distinguish between full-time staff and independent contractors doing full-time work. He says the legal distinction can be confusing even for an employer with his decades of experience in the labor market.

The appeal of using outside workers is growing as many small businesses struggle to stay lean. Some employers also are turning to contractors to avoid hitting the 50-employee threshold that would require them to pay for employees' health insurance, starting next year, under the federal health-care law, or pay a penalty.

State studies have shown that local businesses misclassify anywhere from 10% to more than 60% of their workers as independent contractors. Many business owners blame the complex tax code, which doesn't offer black-and-white standards for telling the difference. The distinction is based on the employer's degree of control over a worker, the length of the relationship and a series of other factors. But such factors are open to interpretation. Past court cases on the issue have had different outcomes, providing little guidance.

In the past three years, the IRS, working with the Labor Department and officials in more than a dozen states, set a goal of investigating 6,000 employers, like Mr. Robinson, to ensure their workers are properly classified. Since September 2011, the government has collected $9.5 million in back wages for more than 11,400 workers who were misclassified as independent contractors by their employers, the Labor Department says.

The crackdown is aimed in part at boosting tax revenue. Employers don't pay or withhold income taxes, Social Security, Medicare or unemployment taxes for independent contractors, as they do for staff workers. The U.S. Treasury estimates that forcing employers to properly classify their workers—while tightening so-called "safe harbor" rules that provide them with leeway in determining who is and isn't an employee—would yield $8.71 billion in added tax revenue over the next decade.

Despite the threat of a payroll audit, more small employers are finding that independent contractors are essential to remaining competitive. The number of small firms that rely on outside contractors, for everything from technology services and public relations to marketing and sales, has grown sharply over the past five years, according to SurePayroll, a Chicago-based payroll-management firm whose clients are small employers.

The firm says that the proportion of contractors on the 80,000 small-business payrolls it processes every month has nearly doubled over past six years, rising to 6.7% last month from 3.4% in February 2007.

"As economic situations get tougher, that's when everyone is looking to cut costs," says Lisa Petkun, partner in the tax-practice group at law firm Pepper Hamilton LLP in Philadelphia. "It's significantly cheaper to have an independent contractor."

Using independent workers gives employers flexibility to hire only when there is work to be done, and leaves them with fewer tax obligations—and thus less paperwork—than do regular full-time workers. Using contractors also can cut benefits costs: they typically aren't eligible for such benefits as health insurance and paid maternity leave.

A Michigan State University study estimates that contractors can save employers as much as 40% on labor costs. Indeed, some business owners say the IRS audits could stifle their ability to grow as demand picks up.

"I'm either going to hire someone full-time to do a job or we just won't do it," says Ciaran Dwyer, chief executive of 3t Systems Inc., a Denver-based IT company with 65 full-time workers. His firm relies on about a dozen outside contractors at any given time, depending on demand, he says.

Rather than risk an audit, and perhaps costly penalties—Mr. Robinson, the staffing-firm owner, says many of his small-business clients are rushing to convert any long-term contract workers into permanent staff.

Mike Johnson, a human-resources manager in Atlanta with over 35 years of experience with small employers, ranging from commercial insurance to telecommunications firms, says a payroll audit is a major disruption for a small business. "Apart from the legal expenses, the downtime is just not worth taking the risk," he says.

In January, the IRS extended an amnesty program designed to encourage employers to voluntarily reclassify contractors as employees by waiving some penalties. Under the program, employers pay as little as 1% of the wages paid to their reclassified workers the previous year, rather than the full amount they owe in back taxes. So far, 1,000 employers have signed on since the program was launched in 2011, the agency says.

In recent years, Congress has proposed various bills to clarify the definition of independent contractors, including as recently as December, though none of the bills has passed.

Chris Whitcomb, tax counsel for the National Federation of Independent Business, a small-business lobbying group, says that without a clear definition of who counts as an independent contractor, many employers don't know whether they are complying with tax rules "until they get audited."

Employee Stock Ownership Plan / ESOPs: Great Tax-Wise for Business Owners, but Beware the Department of Labor

Robert Bloink and William H. Byrnes for AdvisorOne write: Despite the fact that the American Taxpayer Relief Act of 2012 saved most U.S. taxpayers from a doomsday “Taxmageddon,” it remains that, all other things being equal, most high-income and small-business-owner clients will pay more in taxes in 2013 than they did in 2012.

Small business clients looking to exit the business in the near future are looking for ways to reduce—or at least defer—the taxes they will incur should they sell their business interests outright. An ESOP strategy can work well for these clients by allowing them to indefinitely defer any taxable gain on the sale of their business. Advisors must be wary, however, because Department of Labor inquiries into these transactions have recently become more frequent and detailed than ever—just when the ESOP may have become more beneficial than ever.

ESOP Basics

An employee stock ownership plan (ESOP) is a tax-preferred plan created by an employer-company that is designed to invest primarily in shares of that employer. An ESOP must meet certain employee coverage, nondiscriminatio, and vesting requirements in order to qualify for favorable tax treatment.

The primary benefit of the ESOP structure is that it allows a current business owner to sell its business interests to the ESOP and defer taxation on that sale if the owner subsequently invests the proceeds in qualified replacement property—meaning the securities of a third-party company (or companies) that does not receive more than 25% of income from passive activities—within 12 months after the sale. The ESOP must then hold the business interests for at least three years following the purchase or pay a 10% penalty tax. This type of transaction is known as a Section 1042 transaction and can allow a selling business owner to defer taxable gain on the sale indefinitely.

A small business owner who wishes to retire but does not have immediate need for the capital that the sale would generate will find this type of transaction particularly valuable in 2013, now that taxes on capital gains rates for the highest earners have increased to 23.8% (20% capital gains plus 3.8% investment income tax). By the time the owner liquidates his holdings in the qualified replacement property, he may have fallen into a much lower income tax bracket, triggering lower capital gains rates and possibly escaping the investment income tax altogether.

The Small Business ESOP Trap

If the simplicity of the tax deferral that can be realized by an ESOP strategy sounds too good to be true, that is probably because it can be. Business owners face a serious problem if they sell interests to an ESOP that is later found to be overvalued—especially in light of rampant Department of Labor (DOL) inquiries—and some very high-profile cases have put the issue in the spotlight.

The valuation problem is especially applicable to small business clients because it is unlikely that they have a ready market for their shares (because they probably are not publicly traded). The lack of trading activity makes it difficult to place a value on the interests, but other factors add to the problem.

For example, the retiring business owner who is more actively involved in the company’s affairs will impact the value of the overall business—and thus any business interests sold to an ESOP—when he leaves the company. The percentage of the business represented by the business interests sold in the small business context is likewise more important in valuation than it might be for a larger company.

Undervaluation of shares can lead to civil or even criminal prosecution following a DOL investigation. The DOL has brought lawsuits seeking over $100 million in repayments to ESOPs following findings of undervaluation in the past year.

The Appraisal Fix

In order to defend against a valuation challenge, the small business client should obtain a professional appraisal of the interests he intends to sell prior to their transfer into the ESOP. As with valuation of small business interests for estate tax purposes, the appraiser should be independent of the business.

The company’s financial history will be considered, along with the economic outlook (both generally and within the specific industry in which the business operates). A control premium—or minority discount—may be applied if the situation calls for it, and family ownership and other conflicts of interest can also be relevant.

Importantly, small business clients should note that the DOL intends to introduce a broadened fiduciary standard in the near future, and it is expected that this definition could bring independent appraisers under the fiduciary umbrella. This means that small business owners should expect even more careful scrutiny by these appraisers, who will have their own potential liability to protect against.

Conclusion

While structuring a 1042 transaction to defer taxes until your small business clients reach a lower income tax bracket at some point in retirement can provide a powerful tax-deferral incentive, it is important that these clients be advised of the new complexities that will be found in the process. Valuation has always been important, but now and in the coming months, it is more crucial than ever for clients and appraisers alike to take special care in the process or face potential DOL prosecution.

Private Equity Squeezes Out Cash Long After Its Exit / (The strategy, known as an income tax receivable agreement )

Linnley Browning for the New York Times writes When the Berry Plastics Group, a container and packaging company, went public last October, it generated up to $350 million in tax savings. But the company won’t collect the bulk of the benefits. Rather, Berry Plastics will hand over 85 percent of the savings, in cash, to its former private equity owners.

The obscure tax strategy is the latest technique that private equity firms are using to extract money from their companies, in this case long after the initial public offering.

In a typical buyout, the owners make money by sprucing up the operations and selling the business to another company or public investors. Private equity firms have also found ways to profit before the so-called exit with special one-time dividends and annual management fees.

Now, buyout specialists are increasingly collecting continuing payouts from their former portfolio companies. The strategy, known as an income tax receivable agreement, has been quietly employed in dozens of recent private equity-backed offerings, including those involving PBF Energy, Vantiv and Dynavox.

While relatively rare, the strategy, referred to as a supercharged I.P.O., has proved to be controversial. To some tax experts, the technique amounts to financial engineering, depriving the companies of cash. Berry Plastics, for example, has to make payments to its one-time private equity owners, Apollo Global Management and Graham Partners, through 2016.

“It drains money out of the company that could be used for purposes that benefit all the shareholders,” said Robert Willens, a corporate tax and accounting expert in New York who coined the term “supercharged I.P.O.”

Eva Schmitz, a spokeswoman for Berry Plastics, declined to comment, as did Charles Zehren, a spokesman for Apollo. Graham Partners did not return multiple calls for comment.

A form of the strategy, known as a tax-sharing agreement, has been around for decades. Through such deals, a parent company and its subsidiary agree to share any losses that could lower their tax bills.

Private equity firms started to take notice of the technique in 2007 after the $3.7 billion I.P.O. of the Blackstone Group. Before the offering, the private equity firm used complex partnership structures to create large deductions for good will, a type of intangible asset. Blackstone’s partners then got to keep 85 percent of the deductions, or $864 million, securities filings show.

Private equity firms are now applying the strategy to their own investments. Income tax receivable agreements account for only about one in 50 private equity-backed I.P.O.’s, according to some estimates, but industry experts say they are on the rise. “The investment banks are spending a lot of time on models for these deals,” said Eric Sloan, a principal in merger-and-acquisition services at the accounting firm Deloitte. “We are going to see more of these deals,” he said, adding that “it brings new value to the table.”

Under the typical agreement, the private equity-owned company transfers partnership interests to a newly formed entity. The transfers bolster the market value of certain items, like tax credits, operating losses, good will, amortization and property depreciation. In doing so, the related entity captures the tax savings on those items.

“It’s meant to extricate cash value from taxes,” said Warren P. Kean, a tax lawyer focused on partnerships at K&L Gates in Charlotte, N.C. “Private equity firms have realized that there’s a benefit here in unlocking the tax value associated with portfolio companies.”

Private equity firms view the deals as the “pearl in the oyster shell,” because the strategy generates valuable tax assets that did not exist or were not usable and converts them into cash.

As part of the deal, companies sign a long-term contract with the private equity owners to hand over 85 percent of their current and future tax savings. The newly public companies keep the remaining 15 percent, providing it with deductions that they otherwise would not have had.

It’s lucrative for the private equity firms. The payments, which can last as long as 15 years, create a tidy income stream, typically taxed at the lower capital gains rate. The Graham Packaging Company, a maker of plastic containers, expects to pay its former owners $200 million, according to securities filings; Emdeon, a billing company, $151 million; and National CineMedia, a cinema advertiser, more than $196 million.

But some tax experts take issue with the strategy.

“They involve millions, often billions, of dollars in cash transfers from newly public companies to a small group of pre-I.P.O. owners,” Victor Fleischer, a tax professor at the University of Colorado, and Nancy Staudt, a public policy professor at the University of Southern California, wrote in a 2013 study. The study said the primary reason for the deals was tax arbitrage.

Another potential issue is that sophisticated investors do not necessarily understand the deals, either. The agreements typically warrant just a few paragraphs in a company’s I.P.O. filings.

And the companies are generally on the hook for the cash payments, even if their profits deteriorate. Berry Plastics lost $10 million in the last quarter and already carries a costly debt load of $4.6 billion. In its I.P.O. filing, the company cautioned that the tax deal could affect its liquidity.