Welcome to another year of Tax Beat. We thought we would be able to write that no tax legislation had been passed since the last newsletter, but the Small Business and Work Opportunity Tax Act of 2007 was attached to a war spending bill and signed into law. A couple of the “highlights” of the new law include an increase in the federal minimum wage, enhanced and extended §179 first year expensing of assets purchased for your business, and a broadening of the kiddie tax rules (see page 2). For further analysis of what is included in the new tax legislation and how it might affect you, please visit us at www.komisarbrady.com. This will probably not be the last piece of tax legislation passed this year, as multiple provisions expired at the end of 2006 or will expire in 2007.
If you missed an issue, or want to review past issues, they can be found on our website along with breaking news and other helpful information. If you would rather receive further issues via e-mail or if you have any other comments about the newsletter, please let us know at taxbeat@komisarbrady.com.
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BIG CHANGES TO KIDDIE TAX The recently passed Small Business and Work Opportunity Act of 2007 further raised the age limit of the kiddie tax. This comes on the heels of the 2006 increase in which the age threshold was raised from “under age 14” to “under age 18.” Now with the passage of the new law, the age has increased to “under age 19” or “under age 24” for full time students (full time student is defined as enrolled during part of any 5 calendar months of the year for the number of hours or courses which the school considers full time). The kiddie tax applies to children under the age limit having unearned income (interest, dividends, and capital gains) that exceeds $1,700. When the child’s unearned income exceeds $1,700, the excess is taxed to the child at the parent’s tax rate (if the parent’s rate is higher than the tax rate of the child).
Effective in 2008, you have until end of year to plan: When the age threshold was increased in 2006, it was retroactively raised as of January 1st, 2006. This time, the change was made prospectively; it is not effective until 2008. This allows you until the end of the year to adjust your tax planning, especially if your child will not be subject to kiddie tax in 2007, will be subject to it in 2008 and owns appreciated investments or can be gifted these investments (make sure you factor in any gift tax consequences). If your child falls into this situation, you may lower the tax on the investment by having income taxed at lower rates in 2007 when the child is not subject to kiddie tax rather than recognizing the income in a future year. If a student sells appreciated stock in 2007 when the student is not subject to kiddie tax, the gain on the sale would likely be taxed at 5%. If the student sells the stock when the student is subject to the kiddie tax, the gain will likely be taxed at 15%. If $10,000 of capital gain is recognized in 2007, the child would pay $1,000 less in federal tax than if the stock was sold in 2008 when the student is subject to kiddie tax.
For children owning investments in their name: For children that own investments in their own name, the change in the kiddie tax now taxes unearned income at their parent’s rates until they finish college (less the small amount of income under the kiddie tax threshold). The change in the kiddie tax is bad news for parents who were hoping to take advantage of the 0% capital gains tax rate that is in effect between 2008-2010 for those in the 15% or lower tax bracket. The 0% capital gain tax rate remains in effect, but this kiddie tax change will prevent dependants under the age of 24 from using it. A strategy to take advantage of the lower rates may be to take out student loans to pay for school and after graduation when the student is no longer subject to kiddie tax, to sell the securities to pay off the loans. One caveat to factor into this strategy is that the lower capital gain rates that have been around for the past few years are set to expire in 2010. After their expiration, the 5% capital gain rate disappears, and the 15% capital gain rate goes back to 20%.
What this further increase in the kiddie tax age does is to make §529 college savings plans the best way to save for a child’s education in most situations.
Who is not subject to kiddie tax: A few children falling under the age limit will not be subject to the kiddie tax rules. The kiddie tax does not apply to married couples filing a joint return, regardless of age or school status. Also, if a student over the age of 17 has earned income in excess of half of the student’s support (excluding scholarships); the kiddie tax will not apply. Support includes food, shelter, clothing, medical and dental care, education, and lifestyle items, so exceeding the threshold will be difficult unless the student has substantial earned income. If you need additional information on the kiddie tax or assistance in planning for the kiddie tax for 2007 and beyond, please contact our office.
LEGISLATIVE WATCH – NEW BILL PROPOSES REPEALING BIG SUV TAX BREAKS Congress is currently considering energy legislation that would dramatically reduce the first year expensing for heavy SUVs used for business after 2007. Currently heavy SUVs (those with a gross vehicle weight of more than 6,000 pounds) are exempt from the luxury auto limits for depreciation and first year expensing. In 2004, a $25,000 first year expensing limit was established, but that law change did not affect the depreciation rules. The pending legislation, titled the Renewable Energy and Energy Conservation Tax Act of 2007, would subject almost all heavy SUVs to the luxury auto depreciation and expensing limits effective for property placed into service after December 31, 2007. If this legislation passes, the total amount of depreciation and expensing that can be taken in the first year will be limited to $3,260 (assuming the amount is not indexed for inflation).
Although it is unknown whether this legislation will be signed into law, you may want to factor the effect of this proposed legislation into your business vehicle needs, and the timing of purchasing these vehicles. For further updates on this and other legislation, please check our website at www.komisarbrady.com.
IRS SETS NEW ROLLOVER RULES FROM FSA TO HSA The IRS has finalized the rules allowing employers to assist their employees in shifting unused flexible spending account (FSA) dollars into a health savings account (HSA). So, if you are currently enrolled in your company’s FSA plan, and wish to enroll in the company’s high deductible health plan (HDHP) with an HSA, you may be able to roll your FSA into your HSA and not face the “use it or lose it” rule. The new law, which passed in 2006, also permits holders of health reimbursement arrangements (HRA) to transfer HRA dollars into an HSA. HRA holders do not face this “use it or lose it” rule, but they may want to convert an HRA account to an HSA because HSA assets are portable and can be owned even if the employee changes jobs. Additionally, HSAs can invest in a wide variety of investments. The law, which passed in 2006 but was not clarified till earlier this year, allows a one time rollover of an FSA or HRA to an HSA. This rollover must be completed before January 1, 2012, and the rollover must be directly sent to the HSA custodian by the employer. The amount of the rollover is limited to the lesser of the balance in the FSA/HRA as of September 21, 2006, or the amount in the account at the time of the distribution. If an employee did not have an FSA/HRA account on September 21, 2006, they are not eligible to make this rollover.
In order to take part in this opportunity, your employer will need to amend their plan to allow these onetime rollovers, and you will need to elect to rollover your balance. Upon the rollover, you must be covered by an HDHP for the next 12 months. If not, the amount of the rollover will be treated as taxable income and will also be subject to an additional 10% penalty. You will not be required though to remove the contribution from your HSA account.
The rollover to an HSA is not included when calculating contribution limits, your rollover from an FSA/HRA to the HSA will not reduce the maximum annual contribution to the HSA during the calendar year in which the rollover occurs.
If your business is interested in offering an HDHP along with an HSA, and would like to use this rollover as an incentive to encourage your employees to sign up for the HDHP, please contact our office for further information.
PLANNING FOR INHERITED IRA by Bill Wright
Traditional IRAs have historically been a great way to accumulate wealth tax-free until retirement. Eventually you must begin to withdraw those funds, at which time tax will be paid on the withdrawals. The good news for those who do not need the money is that you are not required to begin taking distributions until April 1st of the year after you reach 70½, the required beginning date (RBD). At that time you must start taking minimum required distributions (MRDs) based on your life expectancy as determined by tables issued by the IRS. If you do not take your yearly MRD, you subject yourself to a 50% excise tax on the amount that should have been distributed. When you inherit an IRA, the distribution rules are affected by your relationship to the deceased. Spouse or non-spousal beneficiaries can typically take distributions based on their own life expectancies, as long as proper steps are taken before and after the owner's death. Let's review the rules for inherited IRAs and highlight the obstacles that can be encountered and avoided with proper planning.
Spousal Beneficiaries
When a spouse inherits an IRA (and for this purpose assume the surviving spouse is the wife), she may elect to treat the IRA as her own. This is the best option if tax deferral is more important to the beneficiary than access to funds. If this option is chosen, just as if the beneficiary accumulated the IRA funds herself, withdrawals are not required until the she reaches age 70½. To accomplish this, the spouse either can roll the owner's IRA into her own IRA, or she can have the IRA re-titled in her name. Be aware that if the beneficiary elects to treat the IRA as her own and she is under 59½, withdrawals from the IRA will be subject to the normal early withdrawal penalties because the IRS no longer considers this an inherited IRA. To avoid this problem, make sure to take a distribution of those funds prior to rolling it into a different account. You will pay tax on the distributions, but will not be subject to the 10% early withdrawal penalty.
If the spouse wishes to have immediate access to the funds, then no action is necessary except to start taking distributions. The minimum distribution must be taken each year or else the beneficiary will fall under the "5 year rule" which states that the full amount of the IRA must be withdrawn no later than 5 years after the year of the owner's date of death.
If the prior owner of the IRA had begun taking the RMD and the spouse chooses to leave the account in the original owner's name, he or she can choose to take the RMDs based on either the prior owner's calculated life expectancy, or their own, with the exception that the distribution in the year of death must be equal to or greater than the owner's RMD for the year.
Non-Spousal Beneficiaries
The rules regarding non-spousal beneficiaries depend on whether the owner had begun taking the RMD and whether a specific beneficiary was named. If the owner of the IRA dies before the RBD the designated beneficiary faces a couple of options. They can either withdraw all the funds within 5 years according to the "5 Year Rule", or they can elect to take RMDs based upon their own life expectancy. To make the election, all you need to do is start taking annual distributions, making sure to meet the minimum distribution requirements. Care needs to be taken to ensure that the account is properly titled as a beneficiary account. An example of proper titling is, "John Smith as beneficiary of Jane Young's IRA". Care must also be taken to ensure that the IRA is not rolled over into their own IRA account. That would be considered a taxable distribution and be subject to the “5 year rule”. If a specific beneficiary has not been named and the owner had reached the RBD, then distributions continue as based on the owner's life expectancy, except that you would not go back to the table each year but subtract one from the distribution period. If the owner had not reached the RBD then all funds must be distributed within 5 years.
Multiple Beneficiaries
When there are multiple beneficiaries the RMDs for everyone are based upon the oldest beneficiary. If there is a beneficiary that is not an individual, such as a charity or trust, then the “5 year rule" is in effect. These are not the best options for someone who is young and doesn't need the money, and can be avoided by having the IRA owner designate separate IRAs while still alive, or have the custodian of the IRA create separate accounts. Each beneficiary can then take distributions based on their own circumstances. You can also avoid this by having the oldest beneficiary, or any non-person beneficiary either disclaim their portion, or take a full distribution before September 30th of the year following the year of the owner's death, which is when the designated beneficiary is determined.
Pension Protection Act of 2006
Prior to 2007, if you inherited an IRA, SEP, or SIMPLE plan, you could take advantage of the different options mentioned here. On the other hand, if you inherited a 401(k) or profit-sharing plan the same choices were not available unless you were the plan participant's spouse who was able to roll the account over into his or her own IRA. If you are a non-spousal beneficiary, those plans typically force a decedent's account balance to be distributed in either a lump sum or within a five-year period, thus losing the tax deferral benefit. Depending on the size of the distribution, much of it might be taxed in a higher tax bracket.
With passage of the Pension Protection Act of 2006, it is now possible for non-spousal beneficiaries to transfer the account balances to an IRA and treat the account as an inherited IRA thus taking advantage of tax deferral options. If you are looking at this as an option there are a couple of obstacles that can cause problems if they are not overcome. The first is that the IRA receiving the distribution must include the name of the decedent and beneficiary in order to qualify, for example, "Jacob Brown as Beneficiary of Esther Adams' IRA". Because this IRA is treated as an inherited IRA it cannot accept other contributions or be rolled over into an IRA solely in the name of the beneficiary. The second is that the plan's RMD rules must apply to the inherited IRA. That normally is not a problem when the owner dies after the RBD. Then the RMDs' are generally made over the life expectancy of the beneficiary. However, if the plan participant dies before distributions begin, then the plan might not allow lifetime distributions, and instead require everything to be distributed within 5 years. Since the inherited IRA, to which you transferred the funds, must continue under the conditions of the plan, it would seem that you would be stuck, but an exception applies. The exception allows the beneficiary to effectively elect the life expectancy rules by completing the transfer of all funds from the plan to the IRA before the end of the year following the year of the participant's death. This makes
knowing the distribution requirements of the inherited plan very important. If they allow life expectancy distributions then you may roll over the balance at any time, as long as yearly minimum distributions are taken. If the 5 year rule is in effect then you must make sure to rollover the entire amount in time.
As an owner of an IRA or other retirement account, many headaches can be avoided by ensuring that you have designated a beneficiary. As a beneficiary of a retirement account, you must determine your need for funds and tax deferral before taking action. Do not get caught subjecting distributions to penalties and paying more tax than necessary. A little prior knowledge and planning can ensure that the right people get your hard earned money, not the government.
HYBRID TAX CREDIT UPDATE Is gas prices seemingly rise every day, hybrid cars are becoming more and more attractive to drivers looking to cut their gas bill. The attractiveness of hybrids received a large boost in 2005, when legislation was passed offering tax credits to purchasers of hybrid autos. The credits differed from hybrid to hybrid depending on the fuel economy rating of the vehicle. The legislation also contains a phase out of the credit after an automaker sells 60,000 vehicles. In the quarter following the limitation date, the credit is incrementally reduced until it is ultimately phased out. Toyota and Lexus met the 60,000 sales limit in June 2006, and the phase out limit kicked in. Toyota and Lexus models qualify for a reduced credit amount until September 30, 2007. Toyota and Lexus hybrids bought on or after October 1, 2007 will not be eligible for the credit.
Even though credits for Toyota and Lexus have been reduced and will be completely phased out after September 30th, a number of other automakers offer hybrid vehicles that are eligible for the full tax credit. These automakers include Honda (should hit the 60,000 limit this summer), Ford (Ford and Mercury), General Motors (GMC, Chevrolet, and Saturn), and Nissan.
When factoring in the tax credit into your purchasing decision, be aware that the credit can be limited or lost due to the alternative minimum tax (AMT). If you are subject to AMT, you are unable to take the credit, and there is no provision for a carryforward of the credit, it will be lost. If you are not subject to AMT, the credit is limited to the amount your regular income tax exceeds your AMT.
To ensure compliance with Treasury Circular 230, we are required to inform you that any advice concerning U.S. federal tax issues contained on this website is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties under the Internal Revenue Code and was not written to support the promotion or marketing of any transaction or matter discussed herein. Application of tax regulations is specific to the individual or business and we recommend that you consult a qualified Komisar Brady tax professional for how the above information may apply to you.
