Following are some of the more common oddities of the tax law that effect more taxpayers than you might think.
The Marriage Penalty – "Oxymoron" or "Truism"?
It would seem inexplicable that the entering into the institution of marriage should bring about a tax penalty. However, the way the tax brackets are arranged for different categories of filers, it is very possible for two unmarried individuals to pay less tax on a combined basis than if they were married.
For example, two unmarried individuals filing as single, earning $183,250 each, would pay tax at a marginal tax rate of 28% for a total of $89,206 ($44,603 each). However, if those same individuals were married and filed a joint return, their combined income would yield a tax liability of $97,257. This translates into a marginal tax rate of 33% and a tax increase of $8,051. "Huh?" A marriage penalty indeed!
Incentive Stock Options – "Carrot" or "Stick"?
Congratulations! The company for which you worked for the past three years just went public at $100 per share and the incentive stock options ("ISOs") you were granted in year one are worth a fortune. You know that the primary benefit of an ISO is that long-term capital gains rates can be utilized if certain holding period requirements are met. The stock needs to be held for at least one year after exercise and at least two years from the option grant date. The 100,000 options you were granted have a $0.10 exercise price and are now worth $10 million.
While jumping for joy, you call up the company and inform them that you want to immediately exercise all of your options. You pay the company $10,000 (100,000 options * $0.10 exercise price) and the company puts 100,000 shares into your brokerage account. On your way to the IPO party, you call your accountant to tell her about your newfound wealth. However, she proceeds to inform you that you now owe about $2.8 million in federal taxes even though you did not sell a single share. "Huh?"
What you did not know is that ISOs, although when exercised, are not subject to regular tax, are subject to Alternative Minimum Tax ("AMT"), at a rate of 28%, on the difference between the exercise price and the fair market value at the time of exercise. Of course, you could sell enough shares to pay the tax. However, then the taxable income on the shares sold will be taxed at ordinary instead of capital gains rates. Now let's add some more salt to the wound.
The next morning you wake up to headlines stating that your company is being investigated for fraud. The stock drops to $0.01. This is a disaster! You still owe $2.8 million in taxes from the option exercise and even if it was possible to sell stock, you would not generate sufficient cash to pay the tax bill. Further, with the expiration of the refundable alternative minimum tax credit in 2012, any tax benefit attributable to the AMT taxes paid can only be applied to prospectively generated income. This means that unless you have significant income in the future, you may never recoup all of the taxes paid for the now worthless stock.
The moral of the story is never exercise ISOs without discussing it with a qualified tax professional.
Statutory Residency – When is a "Pied-à-Terre" a huge pain?
Most people consider themselves a resident of only one state but this is not necessarily the state they are employed in. If your home is located a distance from your place of employment, it would not be uncommon for you to purchase or rent an apartment that is closer to your employment but not in the state in which you reside. You now exist in a twilight zone because it is very possible that you could be considered a statutory resident of the state you are employed in as well as the state you call home. (See "Home is Where The Heart Is").
New York State (NYS) and New York City (NYC) would consider your "Pied-à-Terre" a "permanent place of abode" for statutory residency purposes. If you spend more than 183 days in NYC (any portion of a day, not necessarily a work day), you would be deemed a NYS and NYC statutory resident subject to tax on ALL of your income (including interest, dividends, capital gains, etc.) not just the portion you earned in NY. The issue here is that your home state will also tax all of your income but they will only allow you a credit for taxes paid to NY that relate to your NY earned income. No credit would be allowed for your unearned investment income (e.g., interest, dividend, etc.) and this would be subject to a hefty double tax.
Of course, you might wonder how NY would even know that you have an apartment in NY. The answer is very simple. If you file a NY Non Resident return to report your NY earnings there is a question on page 1 of the return that you must answer. It asks, "Did you or your spouse maintain living quarters in NY?" Once you check this box "Yes" your chances of being audited by NY jump significantly. Once under audit, the burden is on you to prove where you were on every single day including holidays and weekends. If you cannot prove where you were on a specific day, NY will count this as an NY day. "Huh?"
Maintaining detailed documentation of your whereabouts is critical. If you choose to take on this mission "almost" impossible, consult with a tax advisor who is experienced with residency issues.
Expatriation – "You can leave but it will cost you!"
The United States taxes its citizens and long-term green card holders on their world-wide income regardless of where they live. The only way out of the U.S. tax regime is to move abroad and give up your citizenship/green card. However, before you get all happy, you should know that the U.S. will charge an exit tax on your assets' unrealized gain at the time of expatriation. "Huh?"
This exit tax is effectively a mark-to-market regime that takes all of your assets and deems them as being sold on the day you leave the country. Of course, expatriating is not as simple as this. Therefore, before you pack your bags, consult a qualified tax advisor.
Conclusion
The U.S. as well as the States' tax law is full of items that will make you say "huh?" The items listed above are just a small sampling illustrating the importance of having a qualified tax advisor as part of your professional advisory team.
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