The Advisor Spring 2012


Estate Planning:

Take this Important Step NOW

With the federal estate tax exemption at $5 million for 2011 ($5.12 million for 2012), the topic of estate planning may have fallen completely off your radar. After all, you may think there's no way your estate would lose money if you happen to die between now and 2013, so there's no need to do anything.

Wrong! There is an important estate planning action you should take right now. Check the beneficiary designations for your bank accounts, brokerage firm accounts, tax-favored retirement accounts, company benefit plans, life insurance policies, annuities, and 529 college accounts.

Events that take place in your life could change how you choose assets you hold to be disposed of in the event of your death. If you have not yet turned in the forms to officially designate beneficiaries because you just haven't gotten around to it, after such events, please turn them in. If your forms are out of date, turn in new ones.

Let's say you die and your ex-spouse, who is not intended to get nothing further after your divorce, was allowed to collect your company pension benefits and the proceeds from your company-provided life insurance because you forgot to change the beneficiary designations. Without the updated beneficiaries being listed, the money would go to your ex-spouse.

Similar issues exist if you become disenchanted with, or estranged from, one of your adult children. Or personal decision to leave more of your life insurance benefits to an adult child who just had twins and a less to your childless offspring. There is a variety of considerations that occur in one’s life that could alter the impact of beneficiary designations.

By making specific designations you control where the benefits go directly to the named beneficiaries.

In contrast, if you name your estate or fail to designate your beneficiaries and depend on your will to direct the money to your loved ones, the estate must go through the potentially time-consuming and expensive process of court-supervised probate before the money is allowed to arrive at the intended destinations.

Do not depend on your will to override outdated beneficiary designations. As a general rule, whoever is named on the most-recent beneficiary form (which may not be recent) will get the money automatically if you die -- regardless of what your will might say.

Jointly held assets will go to the survivors.   Community property states could require you to obtain separate consent for certain changes. So, if you intend assets to be allocated to beneficiaries the designation forms must indicate this, or in some cases they place assets in trust, or separate assets so they can be specifically designated for that asset.

Conclusion: It is also a good idea to keep lists of assets and their designations.  It is also a good idea to review your designations at least once a year or whenever significant life events occur.


IRS Issues New Proposed Regulations on Passive Activity Losses

The passive activity loss (PAL) rules can limit your ability to claim current federal tax deductions for losses thrown off by passive activities. This is because you can generally deduct passive losses only to the extent you have passive income from other sources. If you have little or no passive income, your passive losses are suspended until you have sufficient passive income -- or until you dispose of the loss-producing activities.

However if you materially participate in an activity for the tax year, you are exempt from the PAL limitations for the activity for that year. Therefore, you can deduct the loss from that activity unless another tax rule prevents it.

Question: What about losses incurred by limited partners?  The PAL rules often make it difficult for limited partners to meet the material participation standard, while general partners usually have an easier time. So it's better to be classified as a general partner for PAL purposes than a limited partner.

Next Question: Since LLC members have limited liability, must they be classified as limited partners for PAL purposes, which would be unfavorable, when an LLC is treated as a partnership or a sole proprietorship for federal income tax purposes?  So far, the IRS has always said yes. However, the courts have repeatedly disagreed with the IRS. In apparent reaction to the losing streak, the IRS recently released taxpayer-friendly proposed regulations. But the rules in the proposed regulations will not take effect until they are issued in final form.

Before addressing the court decisions and the new proposed regulations, we'll first cover some background information on how the rules work.

Material Participation Tests in a Nutshell

IRS regulations prescribe seven tests to determine if a taxpayer can meet the material participation standard with respect to a particular business activity:

  • 1. More-Than-500-Hours Test - You pass this test if you participate in the activity for more than 500 hours during the year.

  • 2. Substantially-All Test - You pass if your participation in the activity during the year constitutes substantially all the participation by all individuals (including those who are not owners of interests in the activity) during that year.
  • 3. More-Than-100-Hours Test - You pass if you participate in the activity for more than 100 hours during the year, and no other individual participates more than you during that year.

  • 4. Significant Participation Activity (SPA) Test - You pass if the activity is a SPA (a term defined by IRS regulations) in which you participate for more than 100 hours during the year, and your total participation in all SPAs during the year exceeds 500 hours.

  • 5. Prior-Year Material Participation Test - You pass if you materially participated in the activity for any five of the 10 immediately preceding years.

  • 6. Personal Service Activity Test - You pass if the activity is a personal service activity, and you materially participated in the activity for any three preceding years.

  • 7. Facts and Circumstances Test - You pass if consideration of relevant facts and circumstances dictate that you materially participate in the activity on a regular, continuous, and substantial basis.

If you can pass one or more of these tests for the tax year in question, you meet the material participation standard for that activity for that year, which means the unfavorable PAL rules are inapplicable to that activity for that year. General partners can take all seven tests in attempting to meet the material participation standard.

Limited Partners Can Only Use Three Tests

When your interest in an activity is owned through a limited partnership interest, the seven material participation tests summarized in the right-hand box are unavailable. Instead, a limited partner can only use the first, fifth, and sixth tests in attempting to meet the material participation standard (the more-than-500-hours test, the prior-year material participation test, and the personal service activity test). These three tests are often much more difficult to pass than the other four.


Court: IRS Can Reclassify S Corp Distributions as Wages

If you run your business as an S corporation, you are probably both a shareholder and an employee. As such, the corporation pays you a salary that reflects the work you do for the business. The first $110,100 of any employee's 2012 salary (including yours) is subject to a 13.3 percent federal employment tax rate. Of that, 10.4 percent is for the Social Security tax and 2.9 percent is for the Medicare tax. The 10.4 percent Social Security tax cuts out above the $110,100 wage ceiling, but the 2.9 percent Medicare tax continues to hit an unlimited amount of wages.

Note: For 2012 wages, the Social Security tax rate is reduced from the normal 12.4 percent to 10.4 percent (same as for 2011). However, the Social Security tax rate will return to the standard 12.4 percent in 2013 and beyond unless Congress takes further action.

A portion of the Social Security and Medicare taxes are withheld from your paychecks and the remainder is paid directly to the government by the S corporation in its role as your employer. (You must, of course, pay income tax at your personal level on salary received from the corporation.)

On its annual federal income tax return (Form 1120S), the corporation deducts your salary and the employer's share of Social Security and Medicare taxes. These corporate-level write-offs reduce the taxable income passed through to you on the Schedule K-1 you receive from the corporation. Whatever amount of corporate-level taxable income is left after deducting your salary and related employment taxes can then be paid out to you as a cash distribution without any Social Security or Medicare taxes due.

S Corp Status Can Reduce Employment Taxes

As the following example illustrates, the federal employment tax rules leave an opening that can potentially save you major amounts of taxes over the years.

Example with a Modest S Corp Salary: Let's say you're trying to decide if you should establish a single-member LLC (SMLLC) or an S corporation for your solely-owned small business. Assume that for 2012, you expect the business to earn about $100,000 after paying all expenses but before paying any Social Security or Medicare taxes. Also assume that if you choose the S corporation option, a $40,000 salary would be reasonable for your work in the business, albeit on the low side of reasonable.

  • With an SMLLC, you would have to pay the 10.4 percent Social Security tax plus the 2.9 percent Medicare tax on all of your net self-employment income. The employment tax hit would be about $12,300.

  • With an S corporation, you would only have to pay Social Security and Medicare taxes on the $40,000 amount taken out as salary. The employment tax hit would only be about $5,300.

You can expect to reap comparable federal employment tax savings year after year, assuming your business continues to generate about $100,000 of income adjusted for inflation.

Note: Setting a relatively low salary can also mean reduced deductible contributions to your tax-deferred retirement plan account. So if you place a premium on maximizing deductible retirement plan contributions, the modest salary approach illustrated in this example might not be right for you.

The IRS Knows the Game

The IRS is aware of the strategy of using modest S corporation salaries to reduce federal employment taxes for shareholder-employees. The tax-saving advantage is lost if the government successfully asserts that S corporation cash distributions are actually disguised salary payments. Then, the corporation can be hit with back employment taxes, interest, and penalties.

Back in 2002, a Treasury Inspector General for Tax Administration report said IRS auditors should be devoting substantial attention to the issue of understated compensation for S corporation shareholder-employees. Therefore, be prepared to defend stated shareholder-employee salary amounts as being reasonable for the work performed.


What Parents (and Grandparents) Need to Know About Custodial Accounts

Custodial accounts for children can be established for various reasons. However, many folks who establish custodial accounts fail to recognize that they have significant legal and tax implications.

Here are five important facts parents (and grandparents) need to understand.

1. The Money Now Belongs to the Child. Once funds are transferred into a minor child's custodial account at a financial institution or brokerage firm, the funds then irrevocably belong to the child. While the parent can, and usually does, function as the custodian (manager) of the account, the money can legally be used only for expenditures that benefit that child. In other words, parents are legally forbidden from using custodial account money for expenditures that benefit themselves (like a new car). And they cannot take money from one child's custodial account and use it to open up or supplement an account for another child.

2. The Child Will Gain Control at a Relatively Young Age. A minor child's custodial account must be established under the applicable state Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA). Most states have UTMA regimes these days. In any case, under applicable state law, the child will gain full legal control over the account once he or she ceases to be a minor. This will happen somewhere between age 18 and 21 (in most states the magic age is 21). Parents should consider the possibility of future "UGMA or UTMA regret" before taking the irrevocable step of putting a substantial sum into a child's custodial account.  Once the money is committed and control is lost when the child is no longer deemed a minor.

3. The Child May Have to File Tax Returns and Pay Taxes. Any income from a child's custodial account belongs to the child. If that income exceeds $950 for 2012 (unchanged from 2011), a separate federal income tax return generally must be filed for the child using Form 1040, 1040A, or 1040EZ. The child will probably owe some tax, and the Kiddie Tax rules may make it higher (see below). A state income tax return may be required too.

Exception: If all of the child's income consists of interest, dividends, and mutual fund capital gain distributions, the parent may be eligible to simply include the income on the parent's Form 1040 and pay the resulting extra tax with that return. Details about this option are explained on IRS Form 8814 (Parents' Election to Report Child's Interest and Dividends).

4. The Kiddie Tax Might Apply. Congress created the so- called Kiddie Tax to prevent income shifting to lower brackets of related taxpayers. Under the Kiddie Tax rules, a minor child's investment income above $1,900, some or all of which may come from assets in a custodial account, may be taxed at the parent's higher rates. This is true even if all the money to fund the custodial account came from a grandparent or someone else other than a parent. Therefore, if the parent is a high-income individual, the federal income tax rate on a child's interest income could be as high as 35 percent, and long-term gains and dividends could be taxed at 15 percent. (The $1,900 investment income threshold for the Kiddie Tax applies for both 2011 and 2012; in later years, it could be higher due to inflation adjustments.)

The Kiddie Tax is calculated on Form 8615 (Tax for Certain Children Who Have Investment Income of More Than $1,900) or on the aforementioned Form 8814 (when allowed).

5. There Could Be Gift Tax Consequences. For 2011 and 2012, each parent or grandparent can take advantage of the annual federal gift tax exclusion to move up to $13,000 per child.

However if parent or grandparent transfers more than $13,000, will cause a gift tax return to be filed.

Conclusion: Direct gifts to children through custodial accounts are only one way to accomplish decisions to assist children or reduce estates.  There are other alternatives such as trust and 529 plans.

 

IRS Clarifies W-2Reporting of Healthcare Costs to Employees

Under the Patient Protection and Affordable Care Act passed in 2010, many employers will soon be required to report to employees the cost of their group health plan coverage. As the deadline gets closer, many employers are having trouble figuring out how they are supposed to calculate the reportable cost.

The IRS has recently provided some guidance, but first, here is some background information.

As part of the sweeping healthcare law, reporting of the aggregate cost of employer-sponsored healthcare benefits is to be made on annual Form W-2s. It was originally supposed to start with the 2011 calendar year, but reporting for last year was made optional after the IRS provided relief (IRS Notice 2010).

The IRS recently issued guidance (IRS Notice 2012-9) to help employers with the mandatory reporting that is scheduled to begin with 2012 W-2 forms. Employers are generally required to give 2012 W-2 forms to employees by January 31, 2013, and then file them with the Social Security Administration.

Important: The reporting requirement is informational only as is the health care only where premiums are paid or charged. It does not affect whether coverage is excludable from gross income under the tax code and does not affect the amount includable in income or the amount reported in any other box on Form W-2.

"The purpose of the reporting is to provide useful and comparable consumer information to employees" on the cost of their coverage, according to the IRS.

Fortunately, there is relief from the reporting requirements for some employers. Here are some highlights of the latest IRS guidance:

  • If an employer issues W-2 forms for less than 250 employees in the preceding year, it is exempt from the W-2 reporting requirement.

  • Tribally chartered corporations, which are wholly owned by federally recognized Indian tribal governments, are also exempt.

  • The aggregate reportable cost generally includes the portion of the cost paid by the employer and the portion of the cost paid by the employee, regardless of whether the employee paid for it through pre-tax or after-tax contributions.

  • Employers who are subject to the reporting requirements include federal, state, and local government entities, churches and other religious organizations, as well as employers that are not subject to the COBRA continuation coverage requirements under the tax code, to the extent such employers provide applicable employer-sponsored coverage under a group health plan.

  • The aggregate reportable cost will be reported on Form W-2 in box 12, using code DD.

  • What are the requirements if a staff member terminates employment during the year? An employer may "apply any reasonable method of reporting the cost of coverage provided under a group health plan" for the employee, provided that the method is used consistently for all employees receiving coverage under that plan who leave their jobs during the plan year and continue or otherwise receive coverage after the termination of employment. However, an employer is not required to report any amount in box 12 using Code DD for a departing employee who has requested to receive a Form W-2 before the end of the calendar year.

  • An employer also does not have to issue a W-2 reporting the healthcare cost to retirees, who are not otherwise required to receive a W-2.

  • An employer is not required to include the cost of coverage under a dental or vision plan if it satisfies the requirements for being accepted benefits under the Health Insurance Portability and Accountability Act (HIPAA). Generally, to be excepted benefits for this purpose, the dental or vision benefits must either:
    • Be offered under a separate policy, certificate, or contract of insurance.

    • Participants must have the right not to elect the dental or vision benefits and, there must pay an additional premium or contribution for that coverage.

  • The employer funding of a healthcare flexible spending account is not required to be included in the reportable costs.

  • Reporting requirements also do not apply to amounts contributed to an Archer Medical Savings Account or to any health savings account of an employee or an employee's spouse.

  • Coverage of employee assistance programs (EAPs), wellness programs or outside medical clinics.

These are only some of the rules associated with the new healthcare reporting requirements. For more information, consult with your tax or employee benefits adviser.


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