IMPACT. Taxpayer implications of an Economic Downturn TAX IMPLICATIONS

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1 TAX IMPLICATIONS IMPACT Taxpayer implications of an Economic Downturn By Joseph LiPari, CPA, M.B.A. As the United States continues to be mired in its worst recession in 80 years, we are all well aware of the overwhelming personal and financial burdens that have impacted so many people. This dramatic economic downturn has affected how people live on a daily basis, whether it be related to a job loss, business liquidation, decline in real estate values, inability to pay a mortgage or loss of a home due to foreclosure, inability to pay consumer-related debts like credit cards and auto loans, inability to pay tax obligations as they become due, insolvency and bankruptcy; the list goes on and on. For each economic hardship created by this recession, there are of course related income tax ramifications and implications. This article will examine these tax related implications so that we as tax professionals become fully aware of the majority of these possible scenarios, which will enable us to offer sound advice and guidance to our clients who are adversely affected by this far reaching economic slump. 14 NATP TAXPRO Journal Fall

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3 Tax Impact of Job/Business Loss There are a number of tax related issues to consider when an employee loses a job or a self-employed individual liquidates a business, issues such as what income might be taxable upon separation, what expenses might be deductible, the taxability of pension plan withdrawals, tax treatment of moving costs, etc. When an employee separates from service, he or she may be eligible to receive payment for unused accumulated sick pay, vacation pay, a severance package, or even severance pay for an extended period. All of the above will be treated as wages and subject to normal federal and state taxes, and reportable on the employee s annual Form W-2. In the event of a displaced employee receiving a lump-sum payment for any or all of the above forms of compensation, advice should be given to ensure adequate withholding; or in the absence of proper income tax withholding, estimated tax payments should be recommended. If a laid-off employee is eligible to receive unemployment benefits, he or she should be advised that unemployment compensation is taxable and, depending on their other income, withholding or estimated tax payments may be required. The recipient of these benefits may choose to have 10 percent of their benefit withheld for federal taxes by completing Form W-4V. The temporary exclusion of up to $2,400 of unemployment benefits available in tax year 2009 has not been extended to 2010 as of this writing. Also not extended as of this date is the COBRA Health Insurance Premium Subsidy. If a worker was involuntarily separated from service between September 1, 2008, and December 31, 2009, they were eligible to qualify for a nontaxable 65-percent subsidy for themselves and family members for up to 9 months. Clients should also be advised to keep their year-to-date pay stubs in the event their employer went out For each economic hardship created by this recession, there are related tax ramifications. of business or filed for bankruptcy. If the employee does not receive a Form W-2 by January 31, they should contact the employer or representative, where possible. If their attempts are unsuccessful, a substitute Form W-2 can be prepared. Also note that Form 1040 cannot be filed earlier than year-end to request a refund. Individual tax returns are based on a calendar year and cannot be filed and processed until January 1 of the next calendar year. When an individual separates from service or goes out of business, if self employed, quite often he or she has accumulated retirement plan contributions and vested benefits, and/or investments in Individual Retirement Accounts. This is an area where a tax professional s advice is often sought regarding the taxability of withdrawals/rollovers, etc. In general, if a taxpayer withdraws retirement funds before the eligible age (generally 59½), and does not roll over the proceeds into another qualified retirement plan or a traditional IRA within 60 days, (discussed later), that amount will be subject to regular income tax in the year withdrawn and the taxpayer may be subject to a 10-percent penalty. It should be noted that in the case of Individual Retirement Account contributions made during the current tax year, those contributions can be withdrawn without penalty if done so by the due date of the return. The taxpayer must take not only the contribution but also any interest or dividends it may have earned during this brief period. Therefore, this would be a tax-free event, provided a deduction for AGI was not taken for the contribution and any income earned was withdrawn and included in income. To discourage the use of pension funds for purposes other than normal retirement, the Code imposes additional taxes on early distributions. Many taxpayers who are recently separated from service often rely on these funds to try to maintain their lifestyle while unemployed and searching for work. It is imperative that we as tax professionals warn them of the inherent negative financial and tax impact these early distributions can create. Sound advice would dictate that the client obtain needed funds from other sources whenever feasible, such as from family members, home equity loans and lines of credit, etc. The negative tax impact is overwhelming when one considers the regular income tax liability, the additional 10-percent penalty, and perhaps an estimated tax penalty that would all be due upon filing the tax return for the year of the withdrawal. Of course, if a taxpayer withdraws cash or other assets from a qualified retirement plan, good advice would be to roll over the distri- 16 NATP TAXPRO Journal Fall

4 bution proceeds to another qualified retirement plan or to a traditional IRA. This would obviously circumvent any additional taxes and penalties. In this type of situation, you should advise your client to choose the direct rollover option as opposed to a payment made directly to the taxpayer. With a direct rollover to the new retirement plan trustee, there is no withholding required, none of the distribution is subject to the 10-percent penalty, and all income continues to be deferred. If the taxpayer receives the payment directly, they must roll over the distribution within 60 days; the payer must withhold 20 percent of the taxable portion. If under 59½, a 10-percent additional tax may apply to the taxable part (including an amount equal to the tax withheld) that is not rolled over, and any taxable part (including the taxable part of any amount withheld) not rolled over is income to the taxpayer in the year paid. When searching for new employment, certain expenses can be deducted as Miscellaneous Itemized Deductions subject to 2 percent of AGI on Schedule A. Expenses such as employment agency fees, amounts paid for typing, printing, and mailing résumés to potential employers, travel costs associated with looking for work in a different geographical area, and transportation costs are deductible, but only if these expenses are related to prospective employment opportunities in the taxpayer s current profession or occupation. Self-employed individuals who go out of business would also be able to deduct these types of expenses if they search for a similar type of business. These expenses would be considered ordinary and necessary and deductible on Schedule C. Other expenses that may be deductible are moving costs, if the time and distance tests are met, health insurance premiums, and even education expenses for courses taken to become more marketable or employable. Many laid-off workers seek advice on the possibility of opening their own business. This is an area where tax professionals can be especially helpful in advising clients as to the best form of business organization for their needs and potential liability, applying for Federal Identification Numbers, registering the business with the State, computing estimated tax liabilities, etc. Tax Implications of Debt Forgiveness Canceled debt or debt forgiveness usually results in taxable income to the debtor, and the lender is obligated to report the amount of canceled debt to the taxpayer and the IRS on Form 1099-C, Cancellation of Debt. There are a number of exceptions, however, and certain types of debt forgiveness do not result in taxable events. The most prominent type of relief was provided with the enactment of the Mortgage Debt Relief Act of 2007, which allows taxpayers to exclude income from the discharge of debt on their principal residence. The debt must be secured by the home. Debt reduced through mortgage restructuring, as well as mortgage debt forgiven in connection with a foreclosure, qualifies for the relief. This provision applies to debt forgiven in calendar years 2007 through Up to $2 million of forgiven debt is eligible for this exclusion ($1 million if married filing separately). To be applicable, the forgiveness must be directly related to a decline in the home s value or the taxpayer s financial condition. Debt used to refinance the home qualifies for the exclusion, but only to the extent that the principal balance of the old mortgage immediately before the refinancing would have qualified. The amount of debt forgiven must be reported on Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness, and this form must be attached to the tax return. In the event the taxpayer sells his or her principal residence at a loss, and the remaining mortgage balance is forgiven, the lender must generally report this canceled debt on Form 1099-C, Cancellation of Debt. However, the taxpayer may be able to exclude all or part of this income if the debt was qualified principal residence debt NATP TAXPRO Journal Fall

5 as discussed above, if the taxpayer was insolvent immediately before the discharge, or if the debt was canceled in a Title 11 bankruptcy case. Additionally, the loss on the sale of a principal residence is not deductible. With regard to the forgiveness of consumer-related debt, such as credit card debt and auto loans, these canceled debts generally result in taxable income to the debtor. There are, however, exceptions to this general rule also. Debts discharged through bankruptcy are not considered taxable income. Also, if the taxpayer is insolvent (total debts exceed the market value of all assets) when the debt is canceled, some or all of the canceled debt may not be taxable. There is also relief for certain farm debts. If the debt was directly incurred in the operation of a farm, more than half of the taxpayer s income was from farming during the prior three years, and the loan was owed to a lender regularly engaged in lending, the canceled debt is generally not considered taxable income. The final exception relates to nonrecourse loans. These are loans where the lender s only remedy in case of default is to repossess the property being financed or used as collateral (i.e., the lender cannot pursue the taxpayer personally in the event of default). Forgiveness of a non-recourse loan resulting from a foreclosure does not result in cancellation of debt income. Inability to Pay Tax Obligations Taxpayers who are unable to pay their tax obligation when it is due, should be advised to file their return by the due date and pay as much as possible to avoid penalties and interest. The IRS should also be contacted to discuss payment options. Relief might be granted via a short-term extension to pay, an installment agreement, or an offer in compromise. In some cases, the agency may waive penalties that have been assessed; however, interest charges that have accrued on unpaid taxes are never removed. If unpaid taxes result in the IRS placing a lien on the taxpayer s home, the taxpayer must satisfy the lien before he or she can sell or refinance the home. Usually, the tax lien is paid out of the sale proceeds at the closing if there is enough equity in the property. If the home is being sold for less than the lien amount, the taxpayer can request that the IRS discharge the lien to allow for the completion of the sale. Taxpayers or lenders can also ask that a federal tax lien take a second position to the lending institution s lien to allow for the refinancing or restructuring of a mortgage. If the IRS has placed a levy on the taxpayer s wages and the levy is creating an immediate economic hardship, the levy may be released. This release does not mean the balance will be forgiven, but the IRS will work with the taxpayer to establish a payment plan. If a taxpayer cannot resolve a tax problem with the IRS, he or she should be directed to the Taxpayer Advocate Service (TAS). TAS is an independent organization within the IRS whose employees assist taxpayers who are experiencing economic hardship, who are seeking help in resolving tax problems, or who believe that an IRS procedure is not working as it should. If a taxpayer needs legal representation in tax related matters but cannot afford it, assistance can be provided through the Low Income Taxpayer Clinics (LITC) program. The purpose of this program is to represent low income taxpayers before the IRS, assist taxpayers in audits, appeals and collection disputes, and can help taxpayers respond to IRS notices and to correct account problems. The LITCs are generally operated by nonprofit organizations or academic institutions; there is at least one LITC in each of the 50 states, the District of Columbia, and Puerto Rico. Each LITC independently decides if the taxpayer meets the income guidelines and other criteria before it agrees to represent them. Summary There are a myriad of tax implications created by a poor economy. As clients lose their jobs, lose their businesses, experience reductions in their income, reductions in the equity of their homes and investment properties, shrinking of their retirement plan assets, etc., there are tax implications associated with each type of event. Some of the negative consequences created by this economic downturn are tempered by some form of tax relief while other negative consequences offer no form of tax relief at all. As tax professionals, it is imperative that we be fully aware of these various tax ramifications so that we can best serve our clients who might be experiencing the effects of these difficult financial times. Joseph LiPari, CPA, M.B.A. is a professor at Montclair State University, Montclair, New Jersey, in the Department of Accounting, Law, and Taxation. 18 NATP TAXPRO Journal Fall