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The Buffett Rule

On Monday President Obama unveiled his deficit reduction plan.  In addition to reducing the deficit, he outlined his ideas to pay for the American Jobs Act he proposed two weeks ago.   No surprise his plan includes tax increases on more wealthy Americans.  Phrases such as “shared sacrifice” and people paying “their fair share” make for good sound bites.  However with Washington, the challenge is often deciphering what their pithy sayings mean.

He referenced the “Buffett Rule” as one of his proposals.  It’s named after Billionaire Warren Buffett who has been rather outspoken about the need to raise taxes on the super-wealthy.  Cueing off of a New York Times op-ed piece written by Mr. Buffett a few weeks ago, the Buffett Rule is supposed to make sure people who make over $1 million a year will pay a higher percentage of their income in taxes than someone who makes less than the $1 million threshold.

You may agree or disagree with the concept of the Buffett Rule.  Regardless if you think it’s a good idea, I have three primary issues with the proposed Buffett Rule.

  1. Additional Complexity.  As a tax professional, I can attest that the tax code is exceptionally complex and at times unwieldy.  With the myriad of deductions, exemptions and exceptions, it will be virtually impossible to make sure some making over $1 million will pay taxes at a higher rate than someone making less.  Everyone’s tax situation is unique, so it’s near impossible to offer such a guarantee.  It may sound simple, but it’s going to be very difficult to achieve.
  2. Increased Tax Avoidance.  While it may be good for those of us in the tax business, I can assure you that there will be a host of tax professionals looking for ways to minimize the tax liabilities of their clients under whatever new rules are enacted.  It’s simple economics.  The higher the tax rate, the more cost-effective it is to pay someone to find strategies which minimize your taxes.   You may have your opinions about what’s fair and right, but there is nothing illegal or immoral about structuring your affairs to pay less tax.  Tax evasion is illegal, but tax avoidance is not.  As I recently wrote, if you personally feel like you aren’t paying your fair share, then I would encourage you to make a voluntary contribution to the U.S. Treasury.  Trust me… they’ll take your money.  Political discourse and debate are fine, but it’s wrong to castigate someone who is abiding by the law because you don’t think the result is fair.
  3. Unintended Consequences.  Congress has a lousy track record of using the tax code to target certain persons.  The Law of Unintended Consequences often kicks in, and the negative ramifications are often much more detrimental than anyone anticipated.  Two great examples come to mind; one recent and one from decades ago.  The 1099 reporting provision included in the health care reform is the most recent Congressional bumbling.  As soon as it was passed, it became clear the administrative nightmare would far exceed any benefits obtained.  Fortunately, Congress repealed it before it became effective.  The Alternative Minimum Tax (AMT) is the classic example of unintended consequences.  The AMT was enacted in 1969 to tax 155 wealthy families who were viewed as not paying their fair share.  By 2008, 3.9 million taxpayers were subject to AMT, and 27% of them made less than $200,000. This probably isn’t what the 91st Congress had in mind.

The Buffett Rule may cause some wealthy people to pay more in taxes, but if history is a predictor of the future, the long-term results will be much different than expected.  Such targeted tax policy generally hasn’t yielded the desired results.  I’m not sure why they think the Buffett Rule will be any different.

Raising Taxes on the Super-Rich

Billionaire Warren Buffett made headlines last week with an opinion article he wrote for the New York Times.  His statement “My friends and I have been coddled enough by a billionaire-friendly Congress” attracted a lot of media attention and discussion.

In writing, “It’s time for our government to get serious about shared sacrifice” you can deduce his apparent attempt to sway public opinion and encourage Congress to increase the tax burden upon the wealthiest individuals in the country.  He generally described the targets for the additional sacrifice as those making over $1 million each year, but he didn’t offer specific proposals or suggestions of what additional sacrifice they should be required to make.

In the article, Mr. Buffett disclosed his 2010 tax liability of $6,938,744, which he said was 17.4% of his 2010 income.  It’s a hefty sum; not surprising for one of the world’s richest men.  Most of us would be happy to earn $6,938,744 in our lifetime, let alone pay that much in taxes in one year.

I have no qualms with Mr. Buffett sharing his opinion and participating in the debate over U.S. tax policy.  It’s part of his First Amendment rights to free speech.  Hypothetically, I would ask Mr. Buffett one question… if you believe your taxes are too low, what’s stopping you from paying more?

If Mr. Buffett thought $6,938,744 was insufficient or not his fair share, what prevented him from paying more?  I contend the only thing preventing him from paying a greater sum was himself.   If he chose, Mr. Buffett could have voluntarily added to his 2010 tax liability whatever additional amount he thought was fair.  The U.S. Treasury would have gladly accepted his additional contribution.

His tax liability of $6,938,744 is a rather exact number.  While not explicitly stated, it’s implied this was the statutory amount he was required to pay.  Thus, he paid the minimum amount he was legally obligated to pay, which is what everyone does, irrespective of their socio-economic status.

I may be cynical, but I know many wealthy people who advocate for government spending and programs, yet are constantly trying to minimize their personal tax liabilities.  There is nothing wrong with minimizing your tax liability.  It is part of what I do for people on a daily basis.  However, I see a tinge of hypocrisy when you think others should pay more tax, yet look for “loopholes” for yourself.

I think Mr. Buffett’s credibility in advocating for higher personal income taxes would be bolstered if he chose to make a voluntary contribution above and beyond the minimum required tax liability. His convictions would be demonstrated by his actions and not just his words.

That’s my opinion. What’s yours?

Tax Tip: Charitable Contributions

Americans are some of the most generous and charitable people in the world.  According to a report by the Giving USA Foundation, Americans gave over $300 billion in 2008.  Your primary motivation for giving to a charity should not be saving taxes, but if you are going to give, you might as well reap whatever tax benefits are available.

Like many areas of tax law, a seemingly simple subject can become complex rather quickly.  There is not enough room to cover all of the rules regarding charitable contributions in this short article, but I’ll hit some of the highlights you should be aware of when it comes to claiming a charitable deduction.

The first requirement is to make sure that the recipient is a qualified charity.  You can give money to any person, group or organization you want, but it may not qualify as a tax deduction.  Click here to search the IRS list of officially recognized charities.  Gifts to individuals are not charitable contributions.  You may want to help someone recover from a natural disaster or medical condition, but your gift isn’t tax deductible.  You can’t circumvent this rule by giving money to a charity that is specifically designated to an individual.

Be advised that there are limitations on the amount of charitable deductions you can claim in any one tax year.  The limitations are 20%, 30% and 50% of your adjusted gross income.  The percentage limitation is determined based upon the property you are giving and the nature of the charity.  Any unused contributions can be carried forward for 5 years.

You can receive a deduction for cash or property donated.  Although your services may be invaluable, they aren’t tax deductible.  One of the biggest issues of donating property is determining the fair market value.  You may be able to get away with your best guesstimate when donating clothes to the Salvation Army or Goodwill, but it gets much more complicated for more valuable items that may not be easily valued.

You can receive a charitable deduction for out-of-pocket expenses you pay on behalf of a charity.  It may be preferable for you to give cash and have the charity reimburse you, but this may not always be feasible.   In any event, you must be able to demonstrate that the expenses were incurred for a charitable purpose and not your personal benefit.  Travel expenses can qualify, but it can’t be a clever way for you to deduct your vacation expenses.

While you may be an honest and trustworthy person, the IRS can require you to substantiate your charitable contributions.  Your word may be good, but it won’t work for cash donations.  You either need to have a receipt from the charity or a copy of a canceled check.  Most public charities will provide you with a statement no matter how much you give, and they are required to provide you with a receipt if you give over $250 in any one gift.  The charity must also indicate if you received any substantial benefits for your gift.  You may give $1,000 to your alma mater, but if you receive sporting event tickets worth $200, you can only deduct $800.

These are just a few of the requirements for deducting charitable contributions.  Consult a tax advisor if you have questions about your particular situation.  Savings taxes will probably not motivate you to make a contribution, but it can make it less expensive or allow you to give more.  Either way, don’t overlook the tax savings that can be derived from a properly documented charitable contribution.

Tax Tip: Credits v. Deductions

Credits and deductions will reduce your tax liability, but credits provide a bigger bang for the buck.  Tax credits provide a dollar-for-dollar reduction in your tax liability, whereas deductions reduce your taxable income.  Thus, the economic benefit of a particular deduction is determined by your tax rate. 

The following is a simple illustration.  In 2010, each individual is granted a $3,650 personal exemption.  A personal exemption can only be claimed by one taxpayer and requires a valid Social Security Number.  Assuming that your marginal tax rate is 25%, you save $912.50 in taxes as a result of your personal exemption. Thus, your tax rate determines your tax savings.  Contrast this with the $400 making work pay credit, which will reduce your tax liability by $400.  Thus, all else being equal, a credit is more valuable than a deduction.

Although credits are more valuable than deductions, you usually don’t have a choice of which benefit you will take.  With few exceptions, the rules define if you get a credit or a deduction.  One exception relates to higher education expenses.  You may choose to take an education credit or a tuition deduction.  Depending upon your situation, you may find the deduction generates a greater benefit.

How can this be?  Well… in the world of tax credits, not all credits are created equal.  There is a distinction between refundable credits and nonrefundable credit.  A refundable credit (e.g., the earned income credit) can actually pay you money, even if you owe (or paid) no taxes.  A nonrefundable credit (e.g., child and dependent care credit) can only reduce your tax liability to a certain threshold (even zero).  Thus, a nonrefundable credit will only refund money that you previously paid, but a refundable credit can actually put dollars in your pocket that you didn’t pay.  You probably aren’t surprised that most credits are nonrefundable.

To make matters worse, many credits are limited to the dreaded alternative minimum tax (AMT).  When utilizing these credits, you can’t reduce your tax liability below the alternative minimum tax (e.g., education credits).  As a result, you may qualify for an education tax credit, but not be able to realize the full benefit of it, because of your AMT liability.

As you can imagine, there are more potential deductions than credits, and more nonrefundable credits than refundable ones.  It may seem rather obvious, but it’s helpful to understand the distinction.  You might be disappointed if you equate a deduction with a nonrefundable credit that is subject to AMT.   It can be confusing, so if you have questions or are unsure, consult a tax professional for further guidance.

Tax Tip: Deducting Sales Taxes

Sales taxes are generally not deductible, unless paid in connection with a qualified business expense.  Even in a business context, sales taxes paid for the purchase of a capital asset must be added to the cost of the asset and are recaptured through depreciation.

In the 2010 Tax Relief Act, Congress extended a provision that allows individual taxpayers to claim a sales tax deduction in lieu of deducting state income taxes.  This provision is allowable for tax years 2010 and 2011.  Frequently, it is only beneficial to taxpayers who reside in those states that do not have a state income tax. 

The deduction amount is determined by either (1) accumulating actual receipts showing general sales tax paid or (2) using IRS tables.  The tables are published in the instructions to Schedule A (Itemized Deductions).  You can also click here and go to an IRS link that will calculate the deduction for you.  The deduction tables are based upon your state, the number of exemptions claimed on your tax return, and your income.  Carefully review the instructions for calculating your income.  Income for this purpose is your adjusted gross income, plus certain nontaxable income such as tax-exempt interest, nontaxable Social Security benefits, worker’s compensation, etc.

Taxpayers who use the IRS tables can also add the sales taxes paid for certain large purchases, such as vehicles, boats, motorcycles, RV’s, etc.   If you made a substantial purchase of one of these items in 2010, you may receive a larger benefit from claiming the sales tax deduction in lieu of state income taxes, especially if your state income tax liability is not that large. 

You must personally pay the expenses in order for the tax to be deductible. This provision may eliminate a potentially large benefit to taxpayers who engaged in a substantial construction project.  The sales taxes on construction materials are often paid by the contractor, which would prevent you from claiming the deduction.

Some of what Congress gives, they also take away.  Keep in mind that no taxes are deductible for the alternative minimum tax.  Thus, your benefit may be reduced or eliminated as a result of the alternative minimum tax.

Sales taxes paid on personal purchases have generally not been deductible since 1986.  Congress added a benefit in 2005, which was primarily targeted towards those individuals living in states without a state income tax.  Although set to expire in 2009, the provision was extended through 2011. 

No matter where you live, if you made large purchases in 2010 and can document the sales taxes paid, you may benefit from the sales tax deduction.

Tax Tip: Mortgage Interest Deduction

If you have a mortgage on your personal residence, you’re probably well aware of the mortgage interest deduction, but like many tax provisions, a simple rule can be complex.  There are many factors involving the deductibility of mortgage interest. 

Generally, you are able to deduct the interest associated with $1 million of acquisition indebtedness and $100,000 of home equity debt.  The interest can relate to your principal residence (as defined) and one other residence you select. 

Some of the requirements for deducting the interest associated with acquisition indebtedness are as follows.

  • Acquisition debt is associated with acquiring, constructing or substantially improving a qualified residence.
  • The debt must be secured by the residence.  Not a problem if you borrowed money from a financial institution, since they will definitely secure their mortgage.  However, if you borrowed money from a family member, your loan document may not state that the loan is secured by the property.
  • You must own the property on the debt you are paying and must personally make the payments. For example, if parents pay the mortgage for their children, the interest isn’t deductible by either of them.

The following are some of the rules related to deducting interest on a home equity loan.

  • The home equity loan can’t exceed the equity in your house.  You generally can’t borrow more than the value of your home, but this could be problematic given the recent decline in real estate prices.
  • The proceeds from a home equity can be used for any purpose, except to purchase tax-exempt securities. 
  • Interest associated with proceeds used for purposes other than for a residence may be subject to the alternative minimum tax.

Mortgage points are generally deductible when paid for an initial loan to purchase a property.  Points paid upon the refinance of a mortgage must be amortized over the life of the new loan.

The IRS is very strict in apply the $1 million acquisition and $100,000 home equity debt limits.  However, the Service issued a ruling in 2009 in which they stated that acquisition indebtedness in excess of $1 million to acquire, construct or substantially improve a residence could be considered home equity interest.  Thus, taxpayers could deduct interest on $1.1 million of acquisition indebtedness without having to take out a separate home equity loan.

As you can see, a simple deduction has rather complex requirements.  If you have an unusual situation or are unclear about the tax rules, you should consult a tax professional.  A mortgage interest deduction can drastically reduce your tax bill, but it can also be quite costly if your deduction is disallowed.

Tax Tip: Self-Employed Health Insurance

While the debate over health care and health insurance continues in the U.S., there is one thing we call agree on… health insurance is expensive.  If you are paying for health insurance, any tax benefits you receive will help reduce the effective cost of your coverage.

A majority of people in the U.S. receive their health insurance coverage as a tax-free employee fringe benefit.  You may contribute to the expense, but the portion your employer pays is typically tax-free to you.  In order to attain parity between an employer and someone who is self-employed, self-employed taxpayers are allowed to deduct 100% of their premiums in calculating their adjusted gross income.  While it may seem logical and fair, it was not always this way.

In order to take the deduction, you must have self-employment income equal to or greater than your health insurance premiums.  Your salary, wages, interest, dividends, pension and other income are not considered self-employment income.  Thus, the portion of insurance you are contributing to your employee benefits and premiums you are paying while unemployed do not count.  The premiums may be deductible as an itemized deduction, but they do not qualify for the self-employed health insurance deduction.

There are a couple of changes that can affect your 2010 tax liability.

  • Your health insurance premiums are treated as a deduction for calculating your net self-employment income, which will reduce the self-employment taxes you pay.  This benefit is only applicable for 2010, unless otherwise extended by Congress.
  • The IRS has determined that Medicare Part B premiums can be treated as self-employed health insurance premiums.  Thus, if you are over 65 and are having Medicare Part B premiums deducted from your Social Security check, you can deduct the premiums if you have net self-employment income greater than or equal to your Medicare Part B premiums.
  • After March 30, 2010, any premiums paid for a child who is under age 27 will qualify for the deduction.
  • After March 30, 2010, the deduction is not allowed for anyone who is eligible to participate in any subsidized health insurance plan for themselves, their spouse or dependent (i.e., you can’t deduct your portion of the premiums paid as part of a subsidized employer health plan).

If you are self-employed or have self-employed income, the self-employed health insurance deduction may help reduce the cost of maintaining health insurance coverage.  The tax savings may not make get you over the affordability hump, but if you are paying, you might as well take advantage of whatever tax breaks you can.

Tax Tip: Self-Employment Taxes

Self-Employment taxes are Social Security and Medicare taxes.  If you are an employee, half of the taxes are withheld from your paychecks and the other half is paid by your employer.  If you are self-employed, you get to pay all of the taxes yourself.   Lucky you.

Self-employment taxes are assessed upon your net self-employment income over $400.  Without delving into all of the various types of self-employment income, it basically means being paid for your hard work and efforts.  It does not include interest income, dividends, capital gains, pensions or other investment income.  Some of the common forms of self-employed income include:

  • Net earnings from a trade or business
  • Consulting and director fees
  • Tips
  • Payments for any services you provide to another person (e.g., maintenance, repairs, cleaning)
  • Pass through income from a partnership or limited liability company

A portion of your self-employed income may be reported to you on a 1099-MISC or a partnership Schedule K-1, but it’s highly likely that some self-employed income won’t be reported to you.  The income is taxable to you even if you don’t receive a 1099, Schedule K-1 or other tax reporting statement, and getting paid in cash doesn’t mean you don’t have to report the income.

Just like an employee, the tax is divided between Social Security and Medicare.  The Social Security tax portion is assessed at 12.4% on the first $106,800 of income for 2010 and 2011.  Since there is no cap on Medicare earnings, you’ll pay 2.9% on all of your self-employed income, no matter how high it goes.  The good news is that you get to deduct half of the self-employment tax in computing your adjusted gross income.  The bad news is that if you’re married, you and your spouse are subject to the tax separately.

There is one taxpayer favorable provision that you want to take advantage of in 2010.  For this year only, you can deduct your self-employed health insurance premiums in determining your net self-employed income.  It’s a one-year benefit, unless Congress decides to extend it.

Special rules can apply to farmers, real estate professionals, ministers, and investors.  It can get complex rather quickly, and the myriad of potential issues are beyond the scope of this article.  If you have questions or wonder if certain income is subject to self-employment taxes or exempt, you should consult a tax professional. 

With an effective tax rate that can be over 15%, self-employment taxes add up quickly.  Better to get it right, than be surprised with an unexpected tax bill later.

Burdensome 1099 Tax Reporting

The tax gap is the deficiency between the amount of tax that should have been paid and the amount that is voluntarily reported and paid by taxpayers.  The IRS estimates the tax gap to be $350 billion annually.

Underreporting of income is a primary contributor to the tax gap.  Form 1099 reporting is one of the mechanisms the IRS uses to ensure that taxpayers report income they receive.  A 1099 is issued by the payer to the payee.  The IRS will match the income reported on the taxpayer’s return with the 1099, and a discrepancy will generate a notice. 

A Form 1099-MISC must be filed to report the payment of more than $600 for compensation for services.  This would typically involve people who perform independent and subcontract services (e.g., contractors, lawyers, consultants).  Payments to corporations for these services were exempt from 1099 reporting.

For years the IRS has advocated for an expansion of the reporting requirement to include corporations.  Not only did Congress act upon the suggestion last year, they expanded it. Included in the Patient Protection and Affordable Care Act (aka Obamacare) was a requirement for any business to issue a 1099-MISC to any person or entity for the purchase of more than $600 of goods or services during a calendar year, starting in 2012.

Under the old rules, a taxpayer had to track payments made for services rendered by nonemployees.  The new requirement will force businesses to track the purchase of goods and services.  For instance, if you purchase more than $600 of office supplies, lumber or gas from one retailer throughout the year, you must issue a 1099-MISC.  Imagine the paperwork and administrative nightmare this creates for any business to comply with these rules.

Not surprisingly, this expanded requirement has generated a tremendous firestorm of criticism, especially amongst small business owners.  This provision is supposed to generate $17 billion of revenue over ten years, but I doubt anyone quantified the cost of compliance, both for the IRS and for taxpayers. 

Personally, I think the net revenue generated from this provision is greatly overstated.  It might generate $17 billion in new revenue, but the IRS could easily spend more than that amount just to process the mountain of forms that will be filed.  

It’s been rather humorous to watch the politicians handle this issue.  Congress included this provision in the healthcare bill and President Obama signed it, yet over the past six months, there has been a parade of politicians, including the President, who have talked about how bad this requirement is for business and the need to get it reversed.  It’s funny; the same people who created the requirement are now championing its repeal.  Only in Washington is this considered normal.

Despite months of clamoring, Congress still hasn’t repealed this reporting requirement.  Last week, the Senate added it to a bill dealing with modernization and safety issues of the Federal Aviation Administration.  Most commentators and professionals expect it to be repealed; it’s just a matter of when.  I think Congress knows they will eliminate it too, which is why they aren’t rushing to pass the repeal.

To me, it’s just another example of the dysfunction that is prevalent in our nation’s Capitol.  They know it’s bad, and they know they’ll eliminate it.  Rather than having a simple vote to repeal the rule and move on to other business, it gets dragged out for months and wrapped into some political deal.  I ask… what does 1099 reporting have to do with a safety bill for the FAA?

The expansion of the 1099 reporting was a poorly conceived idea with little consideration of the real world compliance implications.  It never should have been enacted, and I expect it will be repealed this year.  If you’re a business owner, you can be thankful that this is one tax reporting requirement you’ll never have to comply with, but the sooner you know for sure, the better.

Tax Tips – Make an IRA Contribution

With the start of a new year, there is little that you can do to change your tax liability for last year.  It’s history now.  About all that is left is preparing your tax return correctly and making sure you don’t miss any deductions that you may be allowed. Like most tax rules, there are a few exceptions. 

One exception is making a contribution to an Individual Retirement Account (IRA).  You have until April 18, 2011 to make a 2010 IRA contribution. 

Be advised that there are many different rules regarding the amount you can contribute and deduct as an IRA contribution. 

The maximum contribution to an IRA for 2010 and 2011 is $5,000.  If you are at least age 50 by the end of the year, you can contribute an additional $1,000.

There are several rules regarding the deductibility of your IRA contribution.

  • Your deduction is limited to the lesser of the contribution limit ($5,000 or 6,000) or the amount of taxable compensation included in your gross income.
  • You can deduct the full amount if you are not an active participant in an employer-sponsored retirement plan (there is a box on your W-2 that will be checked if you are an active participant).
  • If you participate in an employer-sponsored pension plan, your contribution is fully deductible if your Adjusted Gross Income (AGI) is less than $109,000 if you’re a joint filer or $56,000 if you file as a single or head of household.  Your contribution will be limited if your AGI is above these amounts.
  • No deduction is allowed for a tax year in which the taxpayer turns 70½, or in subsequent years.
  • If your spouse doesn’t participate in an employer-sponsored pension plan, you can make a contribution on behalf of your spouse, provided that you have sufficient taxable compensation.

If you participate in an employer-sponsored pension plan, you can still make a nondeductible contribution.  The contribution will not be deductible, but the earnings of the IRA will continue to be tax-deferred, which means the earnings of the IRA will not be taxable until you withdraw the funds.

If you have not yet made a 2010 contribution to an IRA, it’s not too late.  You have until April 18th to make the contribution.  It is one thing that you can do in 2011 to reduce your 2010 tax liability.