Retirement and Charitable Remainder Trusts

I got a call from a potential client yesterday. Looking towards retirement he said "tax optimization" is his goal and he seems to believe that setting up a charitable remainder trust (CRT) is the way to achieve that. Unfortunately, he caught me off guard with some terminology from some online stuff he had been reading so I probably won't be gaining him as a client.

Also unfortunately, for him, based on his readings on the Internet he strongly believes that the distributions a donor receives from a charitable remainder trust are tax free. There are exceptions but having them apply is rare. In general, distributions from a CRT are taxable to the recipient. Technically, the nature of the income earned by the trust determines the taxability of the distribution. First, all the ordinary income (taxable at ordinary rates) is deemed to comprise the distribution, then any capital gains and finally any tax exempt income.

Example 1: Suppose a CRT starts with $100,000 of assets and earns a total of $9,000 during the year composed of $4,000 of ordinary income, $3,000 of long term capital gains and $2,000 of tax exempt interest. Let's assume the distributions are $5,000 per year. The ordinary income is deemed to be distributed first, then the long term capital gains, then the exempt interest. So our donor/taxpayer has $4,000 of ordinary income, $1,000 of long term capital gains and $0 of tax exempt interest.

Example 2: The CRT starts with $100,000 of assets and somehow manages to earn $5,000 of tax exempt interest. Now the $5,000 distribution is tax exempt to the recipient.

A problem is, in today's economy, it's somewhere between difficult and impossible to earn 5% or more on an investment in state and local bonds (the securities that generate tax exempt interest income) without taking extraordinary risks. On top of that, the trustee will be attempting to maximize the remainder interest (for the benefit of the charity) which is not conducive to investments in low interest bonds. Remember, the CRT isn't paying income taxes so the trustee has zero incentive to make investments that generate tax exempt income.

I regret not making a better impression on my caller for two reasons. First, I'm almost certainly not getting him as a client. Second, he's liable to make an irreversible decision based on his misinformation, something that would be avoided if he had me as his CPA.

Takeaway for me: Be ready for anything, particularly jargon created for use in sales pitches.

Takeaway for you: Don't believe everything you read on the Internet, especially about finances and taxes.

Caveat: The rules regarding charitable remainder trusts are way more complex and arcane than covered in this post. Don't even think about creating one for your favorite charitable organization until you've consulted with a tax professional, ONE WHO DOESN"T CARE WHETHER YOU CREATE A CRT OR NOT.

If you have questions about charitable remainder trusts or retirement planning or anything else related to income taxes, email me at bill@hollandbrowncpa.com. I promise I know more about this stuff than yesterday's caller probably believes.

Myths Regarding the Flat Tax

A flat tax on income would tax all individual income at the same rate. At a 15% rate, a person making $10,000 would pay $1,500 in taxes and a person making $100,000 would pay $15,000. Current proposals would eliminate income taxes on capital gains and dividends (so it isn't really the same tax rate on ALL income).

It is more fair than the current system - only if you agree that tax burden should be shifted from the wealthiest 10% or so of taxpayers to everyone else. Of the taxpayers who paid tax in 2012, those with AGI under $50,000 (90,812,022 returns) had 1.8% of total net taxable gains while those with AGI of a $1,000,000 or more (392,850 returns) had 73.5% of those gains. The flat tax would have eliminated taxes on almost $455 billion of capital gains realized by the very wealthy (about $1,158 per tax return and on $11.4 billion of capital gains on the under $50,000 taxpayers (about 12 cents per return). The division of taxable dividends is not quite as extreme: About 7.8% were received by taxpayers with AGI between $1 and $50,000 while 52.0% were received by taxpayers with AGI of a $1,000,000 or more.

Here are some other comparisons. 28.9% of the educator expense deductions were taken on tax returns with AGI of under $50,000 while almost none were taken by those with AGI of $1,000,000 or more. 58.2% of the total student loan interest deductions were taken by taxpayers with AGI under $50,000 while those over $1,000,000 deducted nothing (due to the AGI related phase out).

It is simpler than the current system - because it eliminates tax breaks such as home mortgage interest and real estate tax deductions, charitable contribution deduction, education credits and deductions, dependent care and child credits, and more. I've seen no suggestion that businesses would lose all their deductions and credits therefore that part of the tax code, with all its complexities, would remain.

The overwhelming majority of the complexity affecting individual tax returns provide tax savings; because of phase outs based on AGI, much of that savings is enjoyed by taxpayers with AGI under $100,000 or so.

Anyone who thinks a flat tax would remain simple needs a reality check. Just look at what Congress has done with the current income tax law during the last 2 or 3 decades. A flat tax might not even begin very simple because of the lobbying efforts of those negatively affected by elimination of home mortgage interest and real estate tax deductions, charitable contribution deduction, education credits and deductions, dependent care and child credits, and more.

The IRS would be eliminated - not true. It might be renamed but a tax collection agency would continue to exist. Those parts of the IRS needed to enforce business related parts of the Internal Revenue Code would remain unchanged.

It would reduce fraud - Ha! Crooks are crooks. Crooks will still cheat on their taxes. Most of the dollar cost of income tax fraud today comes from failing to report taxable income. Phony deductions and credits pale in comparison.

A flat tax would stimulate the economy here like it did in Eastern Europe - Some former members of the Soviet Union, primarily Baltic countries, did adopt a flat tax and did enjoy initial economic growth. Whether that growth was a result of a flat tax regime or because of suddenly having a free more capitalistic economy is open to debate. In any event, those countries’ economies are now no better, perhaps worse, than other countries.

In short, the benefits claimed for a flat tax are unlikely to occur, certainly for no significant length of time. The costs include the significant economic dislocation (job migration and price fluctuations are two examples) that would accompany any significant change in a tax regime. All the costs of having a flat income tax easily outweigh the mostly non-existent benefits.

Income tax information came from the IRS at http://www.irs.gov/uac/SOI-Tax-Stats-Individual-Income-Tax-Return-Form-1040-Statistics.

Costs and Benefits - the IRS Budget

I know I'm frustrated with long wait times when calling the IRS on behalf of a client. I'm confident that my colleagues in the tax preparation industry are as well. John Koskinen, Commissioner of the Internal Revenue Service has a suggestion for us and anyone else who has waited on hold for 2 or 3 or more hours to get a question answered or an issue resolved. Accounting Today says that advice is "to call their member of Congress."

As noted by the Commish, a 1% decline in tax compliance costs $30 billion in revenue. The IRS budget is $11 billion. Congress continually piles on the IRS work load (not just the ACA but every new complexity to the tax law) while cutting the IRS budget. Koskinen was also quoted in the Washington Post stating that every additional $1 budgeted for tax enforcement yields $4 of additional revenue.

Poorer service and decreased tax revenues causes the phrase "penny wise and pound foolish" to come to mind.

I agree with Commissioner Koskinen's advice. If you don't like incredibly long telephone wait times or if you don't like tax cheats getting away with their lawlessness, then call or write your Representative in Congress.

Tax Implications of Bitcoins

Back on March 25 the IRS issued IR-2014-36 entitled “IRS Virtual Currency Guidance : Virtual Currency Is Treated as Property for U.S. Federal Tax Purposes; General Rules for Property Transactions Apply.”  
The title pretty much says it all. Virtual currency, of which Bitcoins are a well-known example, is treated like regular currency although not legal tender in the U.S.
“General tax principles that apply to property transactions apply to transactions using virtual currency.  Among other things, this means that:

• Wages paid to employees using virtual currency are taxable to the employee, must be reported by an employer on a Form W-2, and are subject to federal income tax withholding and payroll taxes.
• Payments using virtual currency made to independent contractors and other service providers are taxable and self-employment tax rules generally apply.  Normally, payers must issue Form 1099.
• The character of gain or loss from the sale or exchange of virtual currency depends on whether the virtual currency is a capital asset in the hands of the taxpayer.
• A payment made using virtual currency is subject to information reporting to the same extent as any other payment made in property.”

Payments described in the first two bullet items are reported at the fair market value of the virtual currency on the date of the payment. Reporting requirements mentioned in the last bullet item also use fair market value on the transaction date to determine whether the need for a report is triggered.
If you invest in a virtual currency, like Bitcoins, when you sell that investment you will have a capital gain or loss.
The full text of Notice 2014-36 is available as a PDF file here.
If you have questions about this or any other tax issue, give me a call (804-745-7157) or send me an email (bill@hollandbrowncpa.com).

Travel & Entertainment: Maximizing Tax Benefits

Tax law allows you to deduct two types of travel expenses related to your business, local and what the IRS calls "away from home."

1. First, local travel expenses. You can deduct local transportation expenses incurred for business purposes such as the cost of getting from one location to another via public transportation, rental car, or your own automobile. Meals and incidentals are not deductible as travel expenses, but you can deduct meals as an entertainment expense as long as certain conditions are met (see below).
2. Second, you can deduct away from home travel expenses-including meals and incidentals, but if your employer reimburses your travel expenses your deductions are limited.

Local Transportation Costs

The cost of local business transportation includes rail fare and bus fare, as well as costs associated with use and maintenance of an automobile used for business purposes. If your main place of business is your personal residence, then business trips from your home office and back are considered deductible transportation and not non-deductible commuting.

You generally cannot deduct lodging and meals unless you stay away from home overnight. Meals may be partially deductible as an entertainment expense.

Away From-Home Travel Expenses

You can deduct one-half of the cost of meals (50 percent) and all of the expenses of lodging incurred while traveling away from home. The IRS also allows you to deduct 100 percent of your transportation expenses--as long as business is the primary reason for your trip.

Here's a list of some deductible away-from-home travel expenses:

• Meals (limited to 50 percent) and lodging while traveling or once you get to your away-from-home business destination.
• The cost of having your clothes cleaned and pressed away from home.
• Costs for telephone, fax or modem usage.
• Costs for secretarial services away-from-home.
• The costs of transportation between job sites or to and from hotels and terminals.
• Airfare, bus fare, rail fare, and charges related to shipping baggage or taking it with you.
• The cost of bringing or sending samples or displays, and of renting sample display rooms.
• The costs of keeping and operating a car, including garaging costs.
• The cost of keeping and operating an airplane, including hangar costs.
• Transportation costs between "temporary" job sites and hotels and restaurants.
• Incidentals, including computer rentals, stenographers' fees.
• Tips related to the above.

Entertainment Expenses

There are limits and restrictions on deducting meal and entertainment expenses. Most are deductible at 50 percent, but there are a few exceptions. Meals and entertainment must be "ordinary and necessary" and not "lavish or extravagant" and directly related to or associated with your business. They must also be substantiated (see below).

Your home is considered a place conducive to business. As such, entertaining at home may be deductible providing there was business intent and business was discussed. The amount of time that business was discussed does not matter.

Reasonable costs for food and refreshments for year-end parties for employees, as well as sales seminars and presentations held at your home are 100 percent deductible.

If you rent a skybox or other private luxury box for more than one event, say for the season, at the same sports arena, you generally cannot deduct more than the price of a non-luxury box seat ticket. Count each game or other performance as one event. Deduction for those seats is then subject to the 50 percent entertainment expense limit.

If expenses for food and beverages are separately stated, you can deduct these expenses in addition to the amounts allowable for the skybox, subject to the requirements and limits that apply. The amounts separately stated for food and beverages must be reasonable.

Deductions are disallowed for depreciation and upkeep of "entertainment facilities" such as yachts, hunting lodges, fishing camps, swimming pools, and tennis courts. Costs of entertainment provided at such facilities are deductible, subject to entertainment expense limitations.

Dues paid to country clubs or to social or golf and athletic clubs however, are not deductible. Dues that you pay to professional and civic organizations are deductible as long as your membership has a business purpose. Such organizations include business leagues, trade associations, chambers of commerce, boards of trade, and real estate boards.

Tip: To avoid problems qualifying for a deduction for dues paid to professional or civic organizations, document the business reasons for the membership, the contacts you make and any income generated from the membership.

Entertainment costs, taxes, tips, cover charges, room rentals, maids and waiters are all subject to the 50 percent limit on entertainment deductions.

How Do You Prove Expenses Are Directly Related?

Expenses are directly related if you can show:

• There was more than a general expectation of gaining some business benefit other than goodwill.
• You conducted business during the entertainment.
• Active conduct of business was your main purpose.

Record-keeping and Substantiation Requirements

Tax law requires you to keep records that will prove the business purpose and amounts of your business travel, entertainment, and local transportation costs. For example, each expense for lodging away from home that is $75 or more must be supported by receipts. The receipt must show the amount, date, place, and type of the expense.

The most frequent reason that the IRS disallows travel and entertainment expenses is failure to show the place and business purpose of an item. Therefore, pay special attention to these aspects of your record-keeping.

Keeping a diary or log book--and recording your business-related activities at or close to the time the expense is incurred--is one of the best ways to document your business expenses.

If you need help documenting business travel and entertainment expenses, don't hesitate to call us. We'll help you set up a system that works for you--and satisfies IRS record-keeping requirements.

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For more useful tax information, please read our monthly newsletter.

Email: bill@hollandbrowncpa.com

Web page: http://www.hollandbrowncpa.com

Individual Tax Provisions of the American Taxpayer Relief Act of 2012

Here are some of the tax provisions of the ATR which affect individuals.

Permanent Provisions

Alternative Minimum Tax fix - The higher exclusion amount that has been effect for several years was restored for tax year 2012 and made permanent. Starting in 2013, the exclusion amount will increase as the Consumer Price Index (CPI) increases.

Bush era tax brackets (limited) - For married couples with income* of $450,000 or less, the maximum tax bracket continues to be 35%. For married couples making more in 2013, the top bracket is now 39.6%. After 2013, the threshold amount is indexed to changes in the CPI. (For heads of household, single taxpayers and married taxpayers filing separate tax returns, the threshold amounts are $425,000, $400,000 and $225,000 respectively.)

Phase out of personal exemptions and itemized deductions eliminated - For married couples with income of $300,000 or less, reduction in personal exemptions and itemized deductions is permanently eliminated. Again, the threshold amount is indexed to changes in the CPI. (For heads of household, single taxpayers and married taxpayers filing separate tax returns, the threshold amounts are $275000, $250,000 and $150,000 respectively.)

Estate Tax modified - The maximum estate tax rate is set at 40%. The exclusion amount for an estate is $5,000,000 in 2012 and indexed to the CPI beginning in 2013.

15% maximum tax rate on long term capital gains and qualified dividends (limited) - The maximum tax rate for these income items goes to 20% for taxpayers to the extent they have income in the 39.6% bracket.

"Marriage Penalty" Relief - The provisions providing relief for married couples with similar amounts of income, including standard deductions and tax brackets are made permanent. Note that about one third of married couples enjoyed a "marriage bonus" even without these provisions and another third had no significant penalty or bonus.

Expanded Coverdell Education Savings Accounts - Maximum annual contribution of $2,000 made permanent. Use of distributions to pay K-12 costs made permanent.

Employer-provided Educational Assistance - This provision, which allows employers to reimburse  up to $5,250 per year of an employee's qualified education costs with the employer getting a tax deduction and the employee having no increase in taxable income, is made permanent.

2001 Modifications of Child Tax Credit - The $1,000 credit amount is made permanent. Expansion of refundability is made permanent.

Extenders

2003 Modifications of Child Tax Credit - Even greater expansion of refundability of this credit is extended five years through December 31, 2017.

American Opportunity Tax Credit - This education credit is extended five years to December 31, 2017.

Deduction of qualified tuition expenses - The above-the-line deduction for tuition is extended to December 31, 2013. This benefit phases out for higher income levels. It provides a deduction whether the taxpayer itemizes or not.

Deduction for certain expenses of elementary and secondary school teachers - The provision allowing classroom teachers to deduct above-the-line up to $250 of out of pocket costs for classroom supplies is extended to December 31, 2013. ("Above-the-line" means teachers get the deduction whether they itemize or not.)

Mortgage debt forgiveness - The provision allowing up to $2,000,000 of mortgage debt forgiveness to be excluded from taxation is extended to December 31, 2013.

Mortgage insurance deduction - The deductibility of mortgage insurance premiums as if they were mortgage interest is extended to December 31, 2013.

Option to deduct state/local sales taxes instead of income taxes - Of benefit mainly to taxpayers living in state with no individual income tax, the provisions has been extended to December 31, 2013.

Tax-free distributions from individual retirement plans for charitable purposes - This provision is of benefit to taxpayers who would otherwise not itemize their deductions and to taxpayers would otherwise be subject to phase-out of other tax benefits due to higher adjusted gross income. It has been extended to December 31, 2013.
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There are other less commonly useful individual provisions and a many business tax provisions in the bill.