How to make our tax system less painful / Commentary: At age 100, time is right for federal tax code overhaul

J.J. Zhang for MarketWatch / Wall St.Journal writes: The 2012 tax filing year has ended — for those who did not file for an extension — and as always paying taxes was a thoroughly unenjoyable experience. It’s become an annual rite of passage for working adults and now an ingrained part of our yearly life. But little noticed was the fact that 2013 marks the 100th anniversary of the modern U.S. federal income tax. So how well has our centenarian aged over the years?

Historically, governments in the distant past focused on property and excise tax as the primary income source, not labor. The first U.S. federal income tax was not levied at the founding of the country; instead it occurred almost 70 years later in 1861 to pay for the Civil War. The tax bracket for the Civil War income tax was 3% on income over $600 and 5% on income over $10,000.

After the war, the income-tax law expired in 1873 and labor was again tax free. For the next 40 years, various attempts at income tax were tried but ruled unconstitutional until the passage of the Sixteenth Amendment giving Congress the power to tax in 1909. Shortly after final State approval in February of 1913, the first 1040 form appeared with a 1% tax on income over $3,000 ($70,000 today) and 7% on income over $500,000 ($11.8 million today).

The first forms were relatively simple, three pages of calculations: one on net income, one on gross income and one on deductions with less than two dozen total questions. The modern 1040 numbers nearly 80 questions not including additional attachments, schedules and forms. Why is it called the 1040? The number was next in the government forms control numbering system.

The true costs of tax complexity

The tax code has similarly aged and grown a bit fat. According to CCH, a tax-information business, relevant federal tax law filled up 400 pages in 1913 but now sits at over 73,000 pages. For those keeping score, the original Gutenberg Bible was 1,272 pages. Folks with insomnia can read the U.S. tax code here.

In accordance with the complexity, a whole (highly profitable) industry (estimated at $6+ billion annually) has popped up to deal with it. There is an estimated 900,000 to 1.2 million tax preparers in the country, almost double the number of law-enforcement personnel and quadruple the number of firefighters. They make up one out of every 200 adults living in the country. That number is almost one-third of the entire U.S. population during the revolutionary war.

Compliance is time consuming and expensive. The Government Accountability Office in a 2005 report estimates a lower range cost of $100 billion to $150 billion for individual and corporate tax compliance cost. Other reports estimated compliance costs of 2-5% of GDP, a figure that if accurate would represent up to $750 billion today.

This is money that could have been spent on food or housing, or invested in capital and starting new businesses. On top of that cost, taxpayers also pony up almost $12 billion per year to keep the IRS going.

Beyond just the dollar cost, there is also the time and headache associated with filing our taxes. The IRS estimated compliance times for filling out the 1040 at over 13.5 hours in 2004, not insignificant when multiplied by the number of people filing.

A new tax system?

While I dislike taxes as much as everyone else, I do recognize the important services that our tax money pays for and the ultimate necessity — well some of it at least. However, with the high time and money cost associated with our current system, there must to be better ways to go about it.

So what can be done to simplify not just the tax system but also the tax collection part? One small but visible and useful proposal is through implementing some form of a return-free filing system.

Internationally, there are several alternatives to the current U.S. withholding and filing system. Many countries such as the U.K. and Japan employ a system where tax liabilities are automatically determined and adjusted so that many do not file returns.

Several proposals have been made in the U.S. for return free filing or a “simple return.”A “simple return” system, as advocated by the Brookings Institute, can potentially and dramatically reduce the complexity associated with tax compliance for most people.

These proposals take advantage of the fact that most Americans have relatively simple situations and that the IRS already has the relevant information on their income and tax liability. Using that information, the IRS can provide you with precalculated and precompleted documents, either mailed or via the Internet, for you to review and confirm or contest the result.

Imagine if filing your tax return is as simple as going to the IRS website, entering your login information, double checking your income and deductions and clicking done.

For taxpayers with more complex situations, such as investors with interest, dividend and capital gains, significant changes to the tax code and reporting structure would have to be made to simplify their returns to the same degree. However some of these changes are already being implemented, thanks to the bailout bill of 2008, which instituted mandatory cost-basis reporting to the IRS.

Given that many of these proposals can be implemented today, the question is why hasn’t anything happened? It has been piloted in some limited cases, such as California’s ReadyReturn program.

With tax reform starting to be discussed in Washington again, the time is right to call for simplification of both the tax code and the filing process. 

Are IRS-Prepared Tax Returns The Solution To Our Tax Woes?

Forbes & Investopedia write: Would you like the IRS to prepare your tax return for you? Under a proposed system, the Internal Revenue Service would pre-fill taxpayers’ returns with the data employers and financial institutions already report to it. What would such a system mean for federal taxpayers, tax preparers and federal revenue?

How IRS-Prepared Returns Could Affect Taxpayers
Under what’s known as a “return-free” system, taxpayers would accept or correct their IRS-prepared returns before paying any tax due or requesting a refund. This system could mean significant cost savings for taxpayers, who would no longer have to purchase tax software, hire an accountant or spend hours preparing a return.

“For many filers with simple situations and little tax planning flexibility, a formulaic government tax prep system could – in theory – work well, since the math is very simple,” says Jeff Camarda, chairman and CIO of Camarda Wealth Advisory Group in Fleming Island, Fla.

A number of problems, however, could prevent such a system from functioning well.

“The IRS is already quite error prone,” Camarda says, and correcting errors is difficult enough with a taxpayer advocate on the job. The IRS might not detect or actively correct its own errors.

Furthermore, the IRS would not be aware of unreported items, such as business expenses, that influence taxpayers’ filing decisions, Camarda says. The tax code’s complexity “makes such a simplistic system very problematic,” he adds.

An IRS-prepared return program would be perfect for someone with a simple W-2 who takes the standard deduction and has no asset transactions, but it would never work for people with complex returns, or even those with transactions as simple as stock sales, says Vincenzo Villamena, managing partner of Online Taxman and a licensed CPA in New York.

Accuracy and Fairness of IRS-Prepared Returns
Critics of return-free programs are concerned about the program’s accuracy and fairness, according to a March 26 ProPublica article by Liz Day.

The IRS already has a system for filing returns on behalf of taxpayers. It employs this system, called a substitute for return (SFR), when a taxpayer hasn’t filed a return or responded to IRS requests to do so. The SFR system uses data reported to the IRS plus internal IRS data to compute how much a taxpayer owes and send him or her a bill. This system has a major shortcoming, however.

“When the IRS files an SFR for you, they do not include any allowable exemptions or deductions,” says Evan Wolf, a tax attorney in Franklin, Michigan. “If you fall into this category, you will owe significantly more than you would if you filed yourself.”

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If a system of voluntary IRS-prepared returns were similar to the SFR system, it could overcharge taxpayers who accepted their pre-filled returns instead of adjusting them to account for the exemptions, deductions and credits they qualify for that the IRS has no way to know about.

IRS-Prepared Returns Would Impact Major Tax-Prep Firms
In theory, a return-free system means taxpayers wouldn’t need to buy tax software or hire tax professionals to prepare their tax returns. Both H&R Block HRB -0.75% and Intuit INTU -2.18%, the company behind TurboTax, have lobbied against such a system, according to Day’s article.

“Honestly, they would probably lose a lot of business,” says Villamena. “These companies go for lower-hanging fruit – the easy returns by people that either don’t want to deal with their taxes or don’t know how.” These are the same clients that would be the target market for automation, he says.

Taxpayers with an annual income of $57,000 or less in 2012 are already eligible for free tax software through the Free File Alliance, and anyone can use the IRS’s free fillable forms, which do the tax math for you. The latter option is only useful, however, if you can make sense of those forms and don’t need software or a professional to walk you through them.

Wolf thinks that under a return-free system, companies like H&R Block and Turbo Tax “would lose a lot of money, but would still have plenty of business from everyone that is married, has kids or claims any other expenses or deductions.”

Would IRS-Prepared Returns Cause Taxes to Rise?
A return-free system does not require any change in tax rates or tax brackets. There are a few reasons, however, why taxpayers might find themselves paying more in taxes if the IRS prepared their returns.

The Tax Policy Center states that such a system would be easier to manage if most taxpayers had the same marginal tax rate, if all tax returns were filed individually rather than some being filed by couples, and if there were limited deductions. Such changes would affect everyone’s tax rates and cause some taxpayers to pay more and others to pay less than they do now.

The Tax Policy Center emphasizes that taxpayers could continue to file returns as they do now -the return-free system would be optional. Taxpayers wouldn’t have to accept IRS calculations or pay more than they truly owe. But Villamena adds that people might just take the standard deduction and not deduct valid expenses related to work, charitable donations and moving.

Furthermore, less-educated taxpayers might not understand that they have the option to calculate their own tax bills. If the IRS calculation doesn’t factor in every exemption, deduction or credit a taxpayer is entitled to, those taxpayers could pay more.

In addition, the IRS might need additional resources – that is, tax dollars – to pay its staff to prepare returns. The government might need to raise taxes to cover this expense.

The Bottom Line
If the IRS prepared taxpayers’ returns for them using the data it already collects from employers and financial institutions, taxpayers with simple tax situations could save time and money on tax preparation. To make the most of such a system, taxpayers would need to be educated about whether they have a more complex situation in which they would save money by rejecting the IRS’ pre-filled return. Those taxpayers would still need to hire a tax professional or purchase software to add the data to their returns that would qualify them for the exemptions, deductions and credits that would lower their tax bills.

Backdoor Roth IRA conversion: Tax-free? / When you make a nondeductible contribution to a traditional IRA and you immediately convert it to a Roth IRA, 100% of the conversion is nontaxable, right? Not necessarily.

Robert Klein for MarketWatch writes: You may be asking yourself, how it could be taxable since you didn't get a tax deduction for the contribution to your IRA. What about the backdoor Roth IRA conversion strategy?  Before I get too far ahead of myself, let me back up and review some basics about taxation of deductible versus nondeductible IRA contributions and taxation of Roth IRA conversions that is relevant to this discussion.

Deductible vs. nondeductible IRA contributions

In 2013, the maximum you can contribute to all of your traditional and Roth IRAs is the lesser of (a) $5,500 or (b) your taxable compensation for the year. If you're 50 or older, the limit is $6,500. You can make contributions to a traditional IRA until age 70-1/2.

Without getting into details, the ability to take a deduction for part or all of a contribution to a traditional IRA is dependent upon three things:

• Whether you're covered by a retirement plan at work
• Tax filing status
• Amount of modified adjusted gross income ("MAGI")

If you're single and not covered by a retirement plan or if you're married and neither one of you is a participant in a retirement plan, then 100% of your contribution up to the limit is deductible. If this isn't the case, then the amount of your IRA deduction is dependent upon your MAGI and tax filing status.

Taxation of IRA distributions that include nondeductible IRA contributions

What happens when you eventually take distributions from your traditional IRA account that includes nondeductible IRA contributions? The good news is that your nondeductible contributions won't be taxed. All of your earnings, on the other hand will be included in ordinary income. This could be a significant amount assuming that you make nondeductible contributions over many years.

The calculation of the taxable portion of distributions from a traditional IRA account that includes deductible and nondeductible contributions isn't simple. It takes into consideration the cumulative amount of previously-unused nondeductible contributions, or "basis," as a percentage of the previous end-of-the-year value of all of your traditional IRA accounts to determine the taxable amount of distributions in a particular year.

Roth IRA conversion

Getting back to the fact that all earnings on deductible and nondeductible traditional IRA contributions will eventually be taxable, is there a way to minimize the damage? The answer is yes, through a Roth IRA conversion. You can transfer, or convert, part, or all of your traditional IRA to one or more Roth IRA accounts. This will eliminate taxation of distributions from your Roth IRA accounts down the road, including all earnings from the date of conversion, provided you comply with certain rules.

The trade off for obtaining this favorable result is taxation of the value of the transfer amount from your traditional to Roth IRA on the date of conversion. The conversion is treated as a withdrawal from your traditional IRA, except that the 10% early withdrawal penalty doesn't apply if you're under age 59-1/2.

The simple backdoor Roth IRA conversion strategy

The plot thickens. What if you made nondeductible contributions to the traditional IRA account that you're converting to a Roth IRA? Aren't the nondeductible contributions nontaxable? The answer is "yes," however, only in a limited situation.

Let's suppose that you're 30 years old, you don't have any traditional IRA accounts, you make a maximum contribution of $5,500 to a traditional IRA, you're covered by a retirement plan at work, and your MAGI exceeds the level for receiving a deduction for your contribution. After your nondeductible traditional IRA contribution has been credited to your account, you can immediately do a Roth IRA conversion. Since there are no earnings, 100% of your conversion will be nontaxable. This is referred to as a backdoor Roth IRA conversion.

See “Two Steps to a Nontaxable IRA for High Income Individuals” for an example of the potential power of using this strategy over an extended period.

Don't forget about other traditional IRA accounts

Let's assume in our previous example that you have another traditional IRA account that was rolled over from a 401(k) plan with a value of $100,000. Would 100% of your backdoor Roth IRA conversion still be nontaxable?

The nontaxable amount of your Roth IRA conversion would be equal to your conversion of $5,500 multiplied by a fraction equal to your nondeductible contribution of $5,500 divided by the total value of all of your traditional IRA accounts of $105,500, or 5,500 x $5,500/$105,500, or $287. This results in a taxable amount of $5,213 ($5,500 - $287), or 95% of your conversion amount. Quite a different result compared with the situation where you had no other traditional IRA accounts.

The backdoor Roth IRA conversion is a great strategy for transferring a nondeductible tax-deferred IRA contribution into a tax-free situation provided that (a) you have no other traditional IRA funds, or (b) the value of your other IRA's is less than or equal to the basis in your IRA accounts.

Innovative Accounting: A Generational Shift

Kevin Gilroy for Accounting Today writes:  Can you do analysis on business results in real-time during the monthly close process, or from smartphone? How about helping clients identify fraud while they are sleeping or whipping through approving invoices while stuck in traffic? Technology can now offer a myriad of tools to automate accounting activities such as these. 

But the game changing evolution is about using the data created by daily business transactions. By using this data correctly, finance professionals will increase their efficiency when analyzing it, spot more accurate trends, and ultimately make better decisions based on predictive modeling of business results.

This combination of rapidly evolving technology and an emerging generation of users who embrace innovation are combining to create powerful change. The Millennial Generation, commonly known as digital natives, was born with an insatiable thirst for new and powerful technology. The native knowledge of technology that the younger generation possesses signifies a generational shift in business execution and places an emphasis on upgrading financial systems with innovative technologies. As these Millennials have entered the workforce, many have found themselves at the helm of leadership positions at small and large enterprises. Small businesses in particular see this younger generation using technological innovations in order to keep pace with larger companies that boast greater resources.

Engrained in technology usage out of the gates, this generation of leaders would prefer to tackle accounting challenges right from the start. Therefore, businesses see greater numbers of Millennials who make a stronger push for early investment and adoption of unified accounting systems. These solutions and interest in technology can be combined with the know-how and best practices of today’s accountants to create a faster, more proactive company that truly takes advantage of the data at its fingertips.

In the next decade, the volume of available financial data for any size customer will continue to grow very quickly. Financial experts need to ask themselves how they will appropriately organize the data, sift through it all and use it effectively. With the power of analytics, businesses can streamline this process. Business analytics can help an organization understand its sources of revenue and cost drives for better resource allocation and prudent investment decisions. Small businesses that need to maximize every penny in their business and large enterprises that must answer to investors can use analytics to proactively plan against changing business variables through “what-if” analysis.

We’re all familiar with the idea that implementing an integrated accounting solution enables business to accelerate financial closes, increase the accuracy of financial reporting, and maintain superior cash management. Businesses will no longer expect their finance team to simply provide an accurate balance sheet; instead, they will look to them to act as leaders and proactively tackle challenges to spur growth.  So how do we make this a reality?  What technologies exist to accomplish this and how can they help these financial experts adopt a seamless IT system to reduce accounting backlog?

No longer will financial experts have to carry around hard copies of reports and financial statements.  Cloud technology has enabled the accounting department to access its records from anywhere and with the sophistication of previously unaffordable solutions, particularly for those small businesses that so carefully need to effectively monitor their finances. For large enterprises, the cloud is impacting how the access to financial data and analytics tools can be rolled out across the enterprise. Data can now be made available at a low per-seat cost via the cloud. What was once seen by only 15 expert users can now be made available to 150 in real time. This helps ensure that all the appropriate people in the business can work off the same data at the same time.

Mobile accounting solutions allow businesses to achieve valuable financial insights anytime and anywhere. This is particularly important for small businesses that may be on the move more frequently and need access to their finances on short notice. For all companies, however, the infusion of mobile applications in the financial realm helps increase operational efficiency and financial productivity by accelerating key process cycle times and eliminating approval bottlenecks. The accounting department can help their business step on the gas simply by freeing up cash more quickly where it is needed most. Companies now have better control of key performance indicators, including revenue and margins, while reducing financial risk by allowing teams to respond in real time.

It is no surprise that as more Millennials enter the financial workforce in both small and large enterprises, there is an uptick in the interest of technology solutions that benefit the accounting profession as a whole. Today, more than ever, there is a real opportunity for the finance and accounting teams to supercharge their companies. This generational shift that we see on a day-to-day basis has helped companies move away from more antiquated methods of managing finances and move towards solutions such as the cloud, mobility and analytics. The know-how and best practices of today’s accountants combined with this surge in technology by Millennials places the teams controlling the books in the driver’s seat of deep and insightful conversations. Whether it’s a multi-billion dollar company or a start-up with five employees, those who recognize the need for early adoption of a comprehensive financial system will thrive.

IRS Widens Its Hunt of Offshore Accounts / Tax Authorities Seek Bank Records Related to Canadian Imperial Bank's Barbados Unit

Brent Kendall & Laura Saunders for the Wall St Journal write: The Internal Revenue Service is seeking bank records for U.S. taxpayers suspected of hiding accounts at a Caribbean lender, opening up a new front in efforts to combat offshore tax evasion.

The IRS said it is investigating whether taxpayers stashed money at Canadian Imperial Bank of Commerce's CM.T +1.55% FirstCaribbean International Bank. Instead of pursuing foreign bank records directly, the IRS got court authorization to serve a "John Doe" summons on Wells Fargo WFC +0.26% & Co., where Barbados-based FirstCaribbean International Bank, or FCIB, maintained a U.S. account.

FCIB could use the Wells account, known as a correspondent account, to wire funds to other accounts in the U.S. and overseas, an IRS agent said in a court declaration. The agent said the Wells bank records will contain information needed to identify U.S. taxpayers with undisclosed accounts. The IRS is seeking account records from 2004 to 2012.

Observers said the move is a tactic tax authorities can use to track down taxpayers who use foreign banks like FCIB that may not be under U.S. jurisdiction.

"The IRS can do this time and time again without the need to build a criminal case against an institution," said Daniel Reeves, a retired senior IRS official. Mr. Reeves led the agency's civil offshore investigation into Swiss bank UBS AG, UBS +6.02% which in 2009 agreed to turn over thousands of U.S. client account records to the IRS.

The IRS effort, made with help from the Justice Department, is the latest sign that U.S. tax enforcers are targeting hidden offshore accounts in countries other than Switzerland, which has been a focal point of attention to date.

"Our work here shows our resolve to pursue these cases in all parts of the world," IRS acting Commissioner Steven T. Miller said in a statement.

A Wells Fargo spokesman said the bank "will review the summons and respond as legally required."

FCIB said it was working with Wells on the matter. "It is our intention to cooperate with authorities in accordance with the respective laws of all jurisdictions involved," the bank said.

Court filings indicated some information on FCIB's alleged activities came from an IRS program allowing taxpayers to voluntarily confess about secret accounts.

Individuals accepted in the program, which levies stiff penalties but protects participants from criminal prosecution, have to provide detailed account information for IRS use in investigations.

The IRS said taxpayers making voluntary disclosures have reported the use of hidden accounts at hundreds of banks around the world.

Scott Michel, a lawyer with Caplin & Drysdale in Washington, said he expects the IRS would seek to serve more summonses in coming months, "aimed at a variety of banks around the world and their U.S. customers."

Women CPAs to Host Virtual Accounting Conference in May

The Second Annual Ultimate Accounting vCon will be held on May 16-17, 2013, in the comfort of participants' own offices. The all-virtual, Cloud-based Ultimate Accounting vCon (which is short for virtual conference) is the brainchild of Michelle Long and Sandi Smith Leyva, two popular accounting industry speakers. 

Michelle Long, CPA and owner of Long for Success, runs the 25,000-plus member LinkedIn group called Successful QuickBooks Consultants. Long is a popular speaker and trainer and the author of two books, including Successful QuickBooks Consulting. 

Sandi Smith Leyva, CPA and owner of Sandra L. Leyva, Inc., runs the popular practice-growth program, Accountant's Accelerator, where she is known for her teachings on value pricing and "On Millionaire Time" management techniques. 

Conference topics include:

• Escaping the hourly pricing trap.
• Handling sticky client communications.
• Assessing and monetizing client's accounting needs.
• Learning value-add services above and beyond compliance.
• Gaining estimating and pricing skills.

All sessions are filled with hands-on demos, case studies, and checklists. Top-tier sponsors include Xero, Personable, and Bill.com.

The First Annual Ultimate Accounting vCon, held in November 2012, was an overwhelming success, with 85 percent of participants saying they would "highly recommend" the conference. Over 350 attendees and thirteen exhibitors, including Intuit, Intacct, Bill.com, Xero, ScanWriter, Cloud9 RealTime, Avalara, and more, enjoyed the conference webinars, prizes, chat room, CPE, and exhibits – without spending money on hotel, airfare, meals, transportation, and even dry cleaning. 

Attendees participated, often from multiple monitors, PCs, tablets, and smartphones, in the twelve webinar sessions, chat room conversations, exhibit hall displays, and much more in the fully virtual event. A few accountants commented they liked this format better because their shyness did not work against them as in a regular brick-and-mortar conference. They can be the fly on the wall, listening in to every conversation and absorbing the knowledge of the participants, speakers, and vendors. Other appreciated the transcripts, which made the vCon accessible for hearing-impaired accountants.

The price for participants is $199, with discounts for early bird registration. Participants can earn up to twelve hours of CPE. For more information, visit the Ultimate Accounting vCon website.

The New 0.9% Medicare Surtax and 3.8% Tax on Net Investment

The U.S. Treasury and the IRS recently released guidance in the form of proposed regulations and frequently asked questions on the new 0.9% Medicare surtax and the new 3.8% tax on net investment income. These two provisions were included in the Affordable Care Act (the “ACA”), which was enacted in 2010, but didn’t receive much attention until recently because: 1) the constitutionality of the ACA was challenged in the Supreme Court, and 2) these provisions don’t take effect until 2013. Since the U.S. Supreme Court upheld the constitutionality of the ACA and 2013 is now upon us, taxpayers must be aware of the impact of these new taxes. Both new taxes are designated as Medicare taxes, but none of the funds generated by these provisions are earmarked for Medicare or health care purposes.

While the income subject to tax under these new provisions is different, there is an overlap in the definition of taxpayers subject to these new taxes. The 3.8% tax on net investment income applies to unincorporated taxpayers (basically individuals, estates, and certain trusts) who have modified adjusted gross income (“MAGI”) in excess of certain threshold amounts: $250,000 in the case of married taxpayers filing a joint return or a surviving spouse; $125,000 in the case of a married taxpayer filing separately; and $200,000 for everyone else except estates and trusts, where the threshold is equal to the highest amount at which the maximum tax rate begins (projected to be $11,950 in 2013). The 0.9% Additional Medicare Tax applies to individuals at the same threshold amounts, but does not apply to estates or trusts. Neither of these new taxes applies to individuals who are treated as non-resident aliens for U.S. income tax purposes. Let’s look at each of these new taxes separately.

3.8% Tax on Net Investment Income

Perhaps no area has generated more activity from a year-end tax planning standpoint than the new tax on net investment income. This tax will apply to net investment income of taxpayers to the extent their net investment income and their MAGI, including their net investment income, is in excess of the threshold amounts discussed above. Proposed regulations take 159 pages to define “net investment income;” however, the term basically includes most dividends, interest, annuities, royalties, rents and the taxable portion of gains from the sale of property. Gains or losses from the disposition of partnership or S Corp interests are generally not subject to this tax, except to the extent the pass-thru entity would have generated gain or loss if it had sold all of its assets immediately before the sale of the pass-thru interest (the deemed sale rule). To the extent that rents and other income are treated as passive investment income under Code Sec. 469, they are not treated as net investment income subject to the 3.8% surtax. Qualified plan distributions and any income items subject to self-employment tax are not treated as net investment income subject to this surtax.

Most planning relating to this tax focuses on: 1) harvesting gains and other income subject to the tax before the tax takes effect next year, 2) deferring losses and deductions to next year so that the income subject to the surtax is minimized or the taxpayer will be under the threshold, 3) changing investment portfolios so that income generated will not be subject to tax (e.g., tax exempt bond interest, growth stocks instead of dividend paying stocks, annuities which will defer income until later years when the taxpayer will in a lower tax bracket), 4) maximizing deductions (e.g., depreciation, investment expenses, and other properly allocable deductions) that will reduce income otherwise subject to the tax, and/or 5) reorganizing or regrouping rental activities.

Additional 0.9% Medicare Tax

The additional 0.9% Medicare tax on wages and self-employment income is applicable only to income in excess of the threshold amounts discussed above, starting next year. The threshold and the amount of income subject to tax is based on the combined income of a husband and wife on a joint return. Thus, even if each is under the threshold amount individually, the couple will be subject to the tax to the extent their combined incomes exceed the threshold. In addition, in the case of wages paid to an employee, the surtax applies only to the employee’s share of the employment tax. Therefore, a single taxpayer with a salary of $300,000 would pay Medicare tax at a rate of 1.45% on the first $200,000 of salary received, but 2.35% on the $100,000 of salary received in excess of the $200,000.

Employers are required to withhold additional Medicare tax on wages in excess of $200,000 in a calendar year, without regard to the employee’s filing status or income from other sources. If an employer withholds the Additional Medicare Tax and no Additional Medicare Tax is due – for example, in the case of a married taxpayer who is under the $250,000 married filing jointly threshold but has wages in excess of $200,000 – the employer must withhold the tax and the employee will claim a credit for the withheld taxes on his or her income tax return for the year. If no tax is withheld – for example, if a husband and wife are each paid under $200,000 for the year, but their combined income exceeds the threshold amount – they should either request additional withholding or cover their additional liability for this tax by paying estimated tax.

A self-employed person will pay self-employment tax at a rate of 2.9% on self-employment income up to the threshold amount and 3.8% on income in excess of the threshold. These amounts are reduced, but not below zero, by the amount of FICA wages taken into account in determining the Additional Medicare Tax.

Self-employed individuals, as well as salaried employees, need to take both of these new taxes into account when determining estimated tax for 2013.

It should be evident that the rules applicable to these new taxes are extremely complex. We encourage you to meet with your CB&H tax advisor to explore ways that the impact of these new taxes, as well as the other tax law changes taking effect next year, can be mitigated. 

Seven Tips for Taxpayers with Foreign Income

The IRS reminds U.S. citizens and residents who lived or worked abroad in 2012 that they may need to file a federal income tax return. If you are living or working outside the United States, you generally must file and pay your tax in the same way as people living in the U.S. This includes people with dual citizenship.

Here are seven tips taxpayers with foreign income should know:

1. Report Worldwide Income.  The law requires U.S. citizens and resident aliens to report any worldwide income. This includes income from foreign trusts, and foreign bank and securities accounts.
2. File Required Tax Forms.  In most cases, affected taxpayers need to file Schedule B, Interest and Ordinary Dividends, with their tax returns. Some taxpayers may need to file additional forms. For example, some may need to file Form 8938, Statement of Specified Foreign Financial Assets, while others may need to file Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts, with the Treasury Department. See Publication 4261, Do You Have a Foreign Financial Account?, for more information.
3. Consider the Automatic Extension.  U.S. citizens and resident aliens living abroad on April 15, 2013, may qualify for an automatic two-month extension to file their 2012 federal income tax returns. The extension of time to file until June 17, 2013, also applies to those serving in the military outside the U.S. Taxpayers must attach a statement to their returns explaining why they qualify for the extension.
4. Review the Foreign Earned Income Exclusion.  Many Americans who live and work abroad qualify for the foreign earned income exclusion. This means taxpayers who qualify will not pay taxes on up to $95,100 of their wages and other foreign earned income they received in 2012. See Forms 2555, Foreign Earned Income, or 2555-EZ, Foreign Earned Income Exclusion, for more information.
5. Don’t Overlook Credits and Deductions. Taxpayers may be able to take either a credit or a deduction for income taxes paid to a foreign country. This benefit reduces the taxes these taxpayers pay in situations where both the U.S. and another country tax the same income.
6. Use IRS Free File.  Taxpayers who live abroad can prepare and e-file their federal tax return for free by using IRS Free File. People who make $57,000 or less can use Free File’s brand-name software. People who earn more can use Free File Fillable Forms, an electronic version of IRS paper forms. Free File is available exclusively through the IRS.gov website.
7. Get Tax Help Outside the U.S.  Taxpayers living abroad can get IRS help in four U.S. embassies and consulates. IRS staff at these offices can help with tax filing issues and answer questions about IRS notices and tax bills. The offices also have tax forms and publications. To find the nearest foreign IRS office, visit the IRS.gov website. At the bottom of the home page click on the link labeled ‘Contact Your Local IRS Office.’ Then click on ‘International.’

More information is available in Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad. IRS forms and publications are available at IRS.gov or by calling 1-800-829-3676.

Additional IRS Resources:

• IRS Free File
• Publication 54, Tax Guide for U.S. Citizens and Resident Aliens Abroad
• Report of Foreign Bank and Financial Accounts (FBAR)
• Publication 4261, Do You Have a Foreign Financial Account?
• Form 8938, Statement of Specified Foreign Financial Assets
• Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts
• Form 2555, Foreign Earned Income
• Form 2555-EZ, Foreign Earned Income Exclusion
• International IRS offices

What Happens When You Sell An MLP? (Master Limited Partnership) / Make sure you understand the tax consequences of MLPs before you invest.

The Chestnut for Seeking Alpha writes: Understanding the tax consequences of the sale of an MLP interest is crucial. A basic understanding of the tax consequences helps to inform tax planning, leading to higher after-tax returns. It can also help guide the investor's MLP-related investment decisions in the first place. This Article provides a brief primer of a fairly complex subject: the sale of a partnership interest. It also makes a few tax planning suggestions, based on these consequences.

Sale of an MLP Interest: Tax Consequences The sale of partnership interest can be broken down into two steps. First, the gain or loss must be calculated. Second, the gain or loss must be characterized. This assumes, of course, that the gain or loss is both realized and recognized.

Step 1: Calculating Gain/Loss

Calculating the gain or loss is fairly easy. Akin to other investments, you will realize a gain or loss equal to your Amount Realized minus your Adjusted Basis. At its simplest, your Amount Realized is simply the cash received on the sale (including any liabilities shed). The Adjusted Basis is your cost basis, which has been adjusted throughout the year to reflect distributions and your share of the MLP's income and liabilities. You can calculate your Adjusted Basis by simply adding the amount in your tax capital account to your share of liabilities (both of these values are found on the K-1).

Step 2: Characterizing Gain/Loss

Characterizing the gain or loss is more complex. Sadly, many investors wrongly assume that all of the gain/loss will be capital. This is far from true. Rather, I.R.C. 751 states that gain or loss is capital, "except as provided in section 751." As a result of section 751, a large portion of the gain/loss triggered on sale may be ordinary in character. The goal of 751 was to prevent people from stuffing ordinary income-producing assets into partnerships, merely to convert ordinary income into capital gains (i.e. absent 751, they could just sell the partnership interest and realize a capital gain, even if the partnership consisted predominantly of ordinary income-producing assets). In light of section 751, the character of the gain/loss is bifurcated as follows:

First, the sale of section 751 items trigger ordinary income upon sale (I.R.C. 751). The scope of 751 items is expansive and may result in a substantial amount of the gain/loss being treated as ordinary. Section 751 items include unrealized receivables, which are not yet included in income (I.R.C. 751(c)). Think of these as the right to payments for goods or services delivered (or to be delivered), which the partnership has not yet included in income. For example, it might include payments from customers, which have not yet been collected, if the partnership is a cash basis taxpayer.

Unrealized receivables also include amounts that would be subject to recapture at ordinary income rates (I.R.C. 751(c)). This includes, for example, depreciable personal property under section 1245 and depreciable real property under section 1250. Section 751 items also include inventory that the partnership holds (I.R.C. 751(d)). Inventory includes classic inventory, which is property held for sale to customers (I.R.C. 1221(1)). Section 751 inventory also encompasses all unrealized receivables as well, which are included in the partnership's income (see 751(d)). This is not an exhaustive list. Other items, not mentioned here, also fall within the scope of 751(c) and 751(d). The partner's share of the gain/loss from section 751 property, if all assets were sold at fair market value before the partner sold his interest, is characterized as ordinary (Treas. Reg. 1.751-1(a)).

Second, the 'excess'--the remaining part of the gain/loss, which isn't attributable to 751 items--is characterized as capital (I.R.C. 741). Notice that not all of this capital gain will receive the lowest, preferential rate. Rather, Treas. Reg. 1-(h)(1) contains a look-through rule. Basically, capital gains attributable to collectibles or Section 1250 property (such as depreciable buildings) will be taxed at rates higher than the lowest capital gains rate.

In sum, the sale of an MLP interest can result in an investor realizing a fair amount of ordinary income. It might also result in the taxpayer recognizing capital gain income, which is taxed at rates higher than the lowest capital gains rate. Tax planning, then, is important for any investor who wishes to minimize the effect of the ensuing taxes and maximize his real returns.

Tax Planning

With these tax consequences in mind, here are a few planning tips:

Be intentional about when you choose to sell your interest in the MLP.Under Section 706, the partnership's taxable year closes vis-a-vis the seller when he sells his interest. Notice that this affects the timing ofwhen the seller will include gains, losses, deductions, and other items in his basis. Put simply, the sooner you sell, the sooner you need to include these items in your basis (because the partnership's taxable year 'ends' sooner). Depending on (1) your inherent gain/loss in the MLP, (2) the outlook for the partnership for the remainder of the taxable year, and (3) the presence of any potentially offsetting losses, you may want wait before selling your MLP interest.

Consider holding MLPs in tax-deferred account(s). I write this grudgingly. While it allows you to avoid realizing ordinary income upon sale of the MLP, it leaves you vulnerable to UBTI. This is a well-trod subject, which I will not rehash here. Spreading MLPs across multiple tax-deferred accounts is one way to minimize (but not eliminate) the UBTI threat. Notice, however, that for those MLPs that generate losses, holding MLPs in a tax-deferred account is less than ideal. Part of the losses will presumably be ordinary, and yet you cannot enjoy these ordinary losses when the MLP is held in the IRA (or other tax deferred account).

Conclusion

It is somewhat frightening how much wrong information surrounds the tax treatment of MLPs. Make sure you understand the tax consequences of MLPs before you invest. Do your own research and/or consult a tax professional or a financial advisor. Not only will this help you understand your real returns (and maximize them through tax planning), but it will also help you make better investment decisions in the first place.

Disclaimer: This communication is for informational purposes only. As of this writing, the author is not an attorney or a certified financial planner or advisor. Any U.S. Federal Tax advice contained in this communication is not intended or written to be used, and cannot be used, for avoiding penalties under the internal revenue code or promoting, marketing or recommending to another party any tax-related matters addressed herein. This post is not intended as a solicitation or endorsement for legal services, and all data and all information is not warranted as to completeness and are subject to change without notice and without the knowledge of the author.

Who Claims the Mortgage-Interest Tax Deduction?

Neil Shah for the Wall St. Journal writes: One lesson we learned from the housing-market collapse is if you encourage Americans to borrow — by making home-mortgage interest tax deductible — people will borrow more, maybe too much for their own good. But who exactly tends to take advantage of this tax benefit?

In a report released Tuesday, the Pew Charitable Trusts finds the popularity of the tax deduction for mortgage interest — one of the biggest so-called tax expenditures in the U.S. tax code — varies greatly both across and within states. In a nutshell, it’s much more popular in areas with relatively high incomes and property values, especially along the East Coast and in parts of the West. Areas in the South, by contrast, tended to abstain. Beneficiaries also tended to cluster around major metro areas rather than less-populous areas.

Look at the map below. Roughly 25% of U.S. tax filers claimed the mortgage interest deduction in tax year 2010. But that masks considerable variation: In Maryland and Connecticut, for example, around 35% of tax filers claimed this benefit, while in Mississippi and Louisiana, only about 17% did. (The Internal Revenue Service has now released state data for 2011, but Pew says the geographical distribution of claim-rates remains largely the same.)

Inherited IRA Rules: What You Need To Know

Deborah L Jacobs for Forbes writes: Many people who inherit IRAs are unfamiliar with the rules that apply to them. My article for Forbes magazine, “Five Rules For Inherited IRAs,” gives a broad overview of the subject. In this post I answer questions from two readers with concerns that affect other people, too.

Michael Twersky, a 26-year-old consultant in New York, asks:

I inherited a $15,000 traditional IRA from my father. As a child beneficiary, will I avoid income tax upon withdrawal if I wait until I’m 60? If not, would it be better to withdraw now while I’m still in a pretty low tax bracket?

You don’t have the option of waiting until you are 60 to take withdrawals. Generally, non-spousal IRA heirs must withdraw a minimum amount each year, starting by Dec. 31 of the year after the IRA owner died. Note: This is true whether it’s a traditional IRA or a Roth (a common misconception).

To calculate this distribution, you take the balance on Dec. 31 of the previous year and divide it by the inheritor’s life expectancy, as listed in the IRS’ “Single Life Expectancy” table. (You can find the table in IRS Publication 590, “Individual Retirement Arrangements (IRAs),” which downloads here as a PDF.) Unless the account is a Roth, there is income tax on this required payout.

Don’t make the mistake, as some people do, of using the number from the table to figure a percentage. In subsequent years, you simply take the number you used in the first year and reduce it by one before doing the division.

If they choose to, IRA inheritors can draw out these minimum required distributions over their own expected life spans, as explained here. This is known as the stretch-out – a financial strategy to extend the tax advantages of an IRA. Stretching out the IRA gives the funds extra years and potentially decades of income-tax deferred growth in a traditional IRA or tax-free growth in a Roth IRA. This is a wonderful investment opportunity.

A financial advisor in Overland Park, KS, asks:

My father-in-law, who lived in Missouri and died in October 2012, named my husband as the sole beneficiary of a $100,000 IRA. Sounds nice, but my mother-in law, 63, really needs the money. (She isn’t able to work and doesn’t have a lot of savings.) If my husband disclaims the IRA, does it automatically go to his mother? There are no contingent beneficiaries on the account and my father-in-law didn’t have a will. 

Disclaiming (turning down) an inheritance in a case like this one is a wonderful strategy, but your father-in-law’s failure to take basic estate planning steps might prevent your husband from disclaiming the whole thing.

People making disclaimers, known as disclaimants, are generally treated as if they had died before the person from whom they are inheriting. So the first question is: Who would be next in line to inherit?

Money in individual retirement accounts (or employer sponsored retirement plans, such as 401(k)s and 403(b)s) will not normally be covered by a will. Instead, an IRA inheritance is given out according to beneficiary designation forms that you fill out when you open the accounts or later amend. These forms notify the bank or financial institution (the custodian) about who will inherit your account. This is the beneficiary.

Since your father-in-law did not name an alternate beneficiary, it’s not clear from the form who is next in line to inherit. If your husband were to disclaim, it would be as if your father-in-law had not named a beneficiary at all.

When there is no beneficiary for an IRA, a default policy, spelled out in the custodial agreement, applies. And you’re at their mercy. Most default to the estate but some let it to go first to the spouse. So first find out what is the custodian’s policy. If it defaults to the spouse, your husband should be able to disclaim and have the assets to go to his mother.

If, on the other hand, it defaults to the estate, there is another complication since your father-in-law died without a will. While it’s true that retirement assets generally don’t pass according to the terms of the will, when there is no beneficiary designation form, the custodian might take the position that the IRA should go to the people named in the will.

If you die without a will or living trust (“intestate,” in legalese), state law will determine how most of your belongings are distributed. These laws establish a ranking of inheritors. Some newer laws say everything will go first to the spouse, then to children, parents and siblings. (See my post, “‘I Don’t Have An Estate. Why Do I Need An Estate Plan?’“) Missouri law is different, however. It says that if you die without a will, but leave behind a spouse and children, the spouse only gets 60%.

You can see this for yourself by going to the wonderful, free, interactive website, mystatewill.com. On the map of the United States at the top of the homepage, click on the abbreviation for your state–it includes all states (plus the District of Columbia) except Louisiana. Without asking for your name or any other identifying information, it steps you through a series of questions. Then it tells you what would happen if someone dies without a will.

But let’s hope you can work this out with the IRA custodian. Get past the person who answers the 800 phone number and ask to speak to the individual who oversees inherited IRAs. Then make the case for an equitable result as convincingly as you have above.