Financial Planning Association of Ventura County

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1 Financial Planning Association of Ventura County Tax Update 2014 New Tax Laws and Developments January 17, 2014 By Boyd D. Hudson Attorney at Law and Charles G. Stanislawski, M.B.T., C.P.A.

2 Be sure and talk with your tax attorney, CPA or tax preparer. There is so much interplay between the numerous tax planning alternatives that it is critical that you discuss it with your tax professional. This is a very complicated area. This handout is provided for informational purposes only, and should not be conveyed as specific tax or legal advice on any subject matter. You should contact your attorney or C.P.A. to obtain advice with respect to any particular issue or problem. Use of this handout does not create an attorney-client relationship, nor will any information you submit to us via be considered an attorney-client communication or otherwise be treated as confidential or privileged in the absence of a pre-existing express agreement by us to the contrary. The content of this handout contains general information and may not reflect current tax or legal developments, verdicts or negotiated settlements. The content of this handout may be considered advertising for tax and legal services under the laws and rules of professional conduct in the jurisdiction in which we practice. Prior results do not guarantee a similar outcome. If you have questions regarding the above tax rules, regulations, recommendations and advice please contact us. Contact information is located on the last page of this handout.

3 TABLE OF CONTENTS I. Highlights of 2013 and 2014 II. The American Tax Relief Act of 2012 III. Bonus Depreciation (Special Depreciation) and IRC 179 IV. IRA s - Contributions to Charities and Roth Conversions V. Estate and Gift Tax Developments VI. VII. Form 1099 Miscellaneous Income Rules Income Planning VIII. Adjustments to Income IX. Investment Planning X. Wash Sales XI. XII. Investment Interest & Expenses Mutual Fund Investments XIII. Investment Income XIV. Planning for Itemized Deductions XV. Family Strategies XVI. Retirement Strategies XVII. Year-End Planning for Business Owners XVIII. Estimated Tax Payments XIX. Other Tax Credits XX. Other Items

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5 I. Highlights for 2013 and 2014 Albert Einstein once said, The hardest thing in the world to understand is the income tax and how right he was as 2013 and 2014 are full of changes as usual with plenty of new provisions and expiring provisions alike. Below is a list of some of these changes with many being covered in more detail throughout the handout federal income tax rate brackets for individuals, estates and trusts were adjusted for inflation; however, the top federal tax rate for 2013 increased from 35% to 39.6% for single filers with taxable incomes over $400,000, $425,000 for Head of Household, $450,000 for Married Filing Joint and Surviving Spouse, and $225,000 for Married filing Separate filers. The 2014 federal tax rates are expected to remain the same with the tax brackets being adjusted for inflation. Furthermore, due to California voter approval of Proposition 30, California personal income tax rates for high income earners will be 10.3%, 11.3% and 12.3% effective for tax years 2012 through For California taxpayers with taxable income above $1 million, an additional 1% tax is assessed (referred to as the Mental Health Services Tax), making the top California tax rate 13.3%. 2. The AMT exemption patch was made permanent and is now annually adjusted for inflation beginning in 2012; phase outs apply. 3. Beginning in 2013 and continuing through 2014, long term capital gains and qualified dividends are taxed at a maximum tax rate of 20% for high income taxpayers (those subject to the 39.6% tax rate). In addition, the new 3.8% surtax on net investment income and gains will increase the maximum capital gains rate to 23.8% for higher income taxpayers with modified adjusted gross income exceeding $200,000 for single filers, $250,000 for joint filers and $125,000 for married filing separately. For taxpayers in the 25% to 35% tax bracket the capital gains rate will be 15% and an additional 3.8% surtax, if applicable, brings the maximum rate to 18.8%. The 0% capital gains tax rate will continue for taxpayers in the 10% and 15% tax brackets. 4. Beginning in % additional Medicare Tax on employee s earned income meeting income thresholds. 5. The 2013 standard mileage rate for business travel was 56.5 per mile. For 2014, the standard mileage rate for business is 56 per mile. Charitable miles remains 14 per mile for 2013 & 2014 whereas the standard mileage rate for medical and moving mileage goes from 24 per mile in 2013 down to 23.5 per mile for Beginning in 2013, personal exemptions can be phased out. The exemption amounts phase out by 2% for each $2,500 (or fraction thereof) by which the taxpayer(s) AGI exceeds the threshold amount. The 2013 AGI threshold is $250,000 [$254,200 in 2014] for a single filer, $275,000 [$279,650 in 2014] for Head of Household, $300,000 [$305,050 in 2014] for married filing joint and surviving spouse, and $150,000 [$152,525 in 2014] for married filing separate filers. The threshold amounts are inflation adjusted annually. 7. The enhanced version of the student loan interest deduction has been made permanent. The 60- month limitation has been eliminated and the maximum above the line deduction is $2,500 but, AGI limitations apply. 1

6 8. Itemized deduction phase out returns in A taxpayer s itemized deductions are reduced by 3% of the excess AGI over the threshold amount not to exceed 80% of the total itemized deductions (yes, itemized deductions can be reduced and limited to only 20% of the actual amount!). The 2013 AGI threshold is $250,000 [$254,200 in 2014] for a single filer, $275,000 [$279,650 in 2014] for Head of Household, $300,000 [$305,050 in 2014] for married filing joint and surviving spouse, and $150,000 [$152,525 in 2014] for married filing separate filers. The threshold amounts are inflation adjusted annually. 9. Beginning in 2013 The threshold for deducting medical expenses as an itemized deduction will increase from 7.5% to 10% of adjusted gross income. For tax years 2013 through 2016, the 7.5% floor continues to apply for individuals who reach age 65 before the close of the tax year. For California, the threshold will continue to be 7.5% of adjusted gross income. 10. Debt resolution fees may be allowed as an itemized deduction (subject to 2% floor). 11. $1,000 per-child tax credit has been extended permanently. Income phase out applies. 12. Dependent and child care credit is permanently extended. Income phase out applies. 13. American Opportunity Tax Credit (for education) is extended through Income phase out applies. 14. The annual gift tax exclusion was increased to $14,000 for 2013 with the exclusion remaining the same for Beginning 2013, the gift tax rate will be 40% and the gift tax exemption will be $5 million adjusted annually for inflation. 15. For decedents dying in 2013 the estate tax exclusion amount was $5,250,000 with a top estate tax rate of 40%. The annual exclusion amount is adjusted annually for inflation. The exclusion amount for 2014 will be $5,340,000 and the estate tax rate will be 40% as this amount was made permanent by the American Taxpayer Relief Act of The surviving spouse may be able to use the spousal portability election; this election was made permanent after December 31, The 30% residential energy efficient property credit (IRC25D) for installation of qualified solar, geothermal and small wind energy property applies to property placed in service through December 31, 2016 and there are NO AGI limitations. 17. Beginning in 2014, the California Franchise Tax Board (FTB) will begin accepting e-filed Form 541, California Fiduciary Income Tax Return, for the 2013 tax year (not for any pre-2013 tax years). 18. There are items, that were extended through or set to expire at the end of 2013, that as of January 10, 2014 have not been extended. There is the possibility of these and other items being retroactively extended through and possibly beyond 2014.stay tuned! (a) The election to deduct state and local general sales and use taxes, instead of state and local taxes is set to expire at the end of (b) 50% first-year bonus depreciation for original use qualified property is set to expire at the end of

7 (c) Internal Revenue Code Section 179 expensing limit of $500,000 and phase out for assets purchased in excess of $2 million is set to expire at the end of (d) 15-year accelerated recovery period allowed for qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property is set to expire at the end of 2013 and will revert back to the 39-year recovery period. (e) The $250 above the line deduction for educator expenses is set to expire at the end of (f) The above-the-line deduction for qualified tuition expense is set to expire at the end of (g) The deduction of mortgage insurance premiums (PMI) is set to expire at the end of (h) The non-business energy credits (IRC 25C) is set to expire at the end of (i) A charitable contribution from Individual Retirement Accounts is set to expire at the end of (j) The 100% exclusion on the sale of qualifying small business stock (QSBS) is set to expire at the end of For QSBS stock purchased in 2014, the exclusion amount reverts back to 50%. (k) The cancellation of debt (COD) exclusion for principal residence is set to expire at the end of (l) Enhanced amounts for certain qualified transportation benefits (vanpool and transit passes) that qualify to be excluded from wages are set to be reduced at the end of 2013 (enhanced amount of $245 monthly reduced down to $130 monthly). (m) The Health Coverage Tax Credit that provides a refundable credit of 72.5% of qualified health insurance for individuals that receive pension benefits from the Pension Benefit Guaranty Corp. or who are eligible to receive a trade adjustment allowance is set to expire at the end of II. The American Tax Relief Act of 2012 The following is a summary of the principal provisions of The American Tax Relief Act of 2012 (the Act ), approved by Congress and signed by the President several days ago. 1. Individual Tax Provisions (a) Extension of Tax Brackets- For years after 12/31/2012, the 10%, 15%, 25%, 28%, 33%, 35% rates on taxable income at or below $400,000 [$406,750 in 2014] for individual filers, $425,000 [$432,200 in 2014] for heads of households and $450,000 [$457,600 in 2014] for joint filers are extended. Income above these levels are taxed at 39.6%. All tax bracket ranges will be adjusted for inflation. 3

8 The rates are made permanent. However Congress in the future could agree to change them. (b) Capital Gains/Dividends. The Act increases the top rate for capital gains and qualified dividends to 20 percent (20%). The new top rate will apply to the extent that a taxpayer s income exceeds the threshold for the new 39.6% rate; i.e. $400,000 for single filers, $425,000 for HOH and $450,000 for joint filers. The zero percent (0%) rate on dividends and capital gains will continue to apply for those in the 15% regular tax bracket [$72,500 for MFJ and $36,250 for single filers or lower]. Everyone in between gets the benefit of the 15% rate for capital gains and qualified dividends. The 28% rate for gains on sales of collectibles and the 25% rate on Section 1250 recapture are unchanged. Payments made in 2013 and later on installment sales occurring before 2013 could be subject to the new 20% rate. Starting in 2013, under the Affordable Care Act of 2010, higher income taxpayers are subject to the 3.8% tax on net investment income (NII) including capital gains and dividends to the extent taxpayers have modified adjusted gross income exceeding $200,000 for single filers, $250,000 for joint filers and $125,000 for married filing separately. These provisions are unchanged by the new 2012 Act. Thus the rate on capital gains and dividends for taxpayers in the highest tax brackets will be 23.8% [20% + 3.8%]. (c) Alternative Minimum Tax Provisions. The Act increases the AMT exemption for 2012 with the use of the so-called patch. For years after 2012 the exemption amount is indexed for inflation. The inflation adjustment is finally permanent. The Act also provides that all nonrefundable personal credits are allowed to the full extent of a taxpayer s regular and alternative minimum tax liability for years after (d) Limit on Itemized Deductions. The Act brings back the limitation on the use of itemized deductions, the so-called Pease limitation, starting in However, the income thresholds the limitation applies are higher than what they would be without the Act. For 2013, the income [adjusted gross income] thresholds are: $300,000 for married filing jointly; $275,000 for heads of households, $250,000 for single filers; and $150,000 for married filing separately. The limitation reduces the total amount of a taxpayer s itemized deductions by three percent (3%) of the amount by which the taxpayer s AGI exceeds the threshold. The application of the limitation cannot reduce the otherwise deductible itemized deductions by more than 80%. Certain itemized deductions such as investment interest, medical expenses and casualty losses are not subject to the limitation. (e) Phase out of 2013 Personal Exemptions. The Act also brings back the rule which phases out a taxpayer s personal exemptions for higher income taxpayers. The phase out applies at the same adjusted gross income thresholds as the limitation on itemized deductions. The total amount of personal exemption that may be claimed by a taxpayer is reduced by two percent (2%) for each $2,500 or portion thereof by which AGI exceeds the threshold amount. 2. Estate Tax Provisions. The maximum estate tax rate for decedents dying between January 1, 2011 and December 31, 2012 was 35% with a $5 million exclusion for 2011 and $5.12 million for Absent the Act, the exclusion would have reverted back to $1 million along with a maximum rate of 55% for The Act permanently provides for a maximum forty percent 4

9 (40%) rate with an exclusion of $5 million. Because of inflation adjustments, the exclusion for 2013 will be approximately $5,250,000 [$5,340,000 in 2014]. For gift tax purposes, the Act provides for a 40% maximum gift tax rate and an exemption of $5 million, subject to inflation adjustments. The estate and gift tax systems are now permanently unified. The Act makes permanent the portability provisions that were effective for decedents dying between January 1, 2011 and December 31, Portability allows the unused exclusion amount of the first spouse to die to pass to the surviving spouse to use for transfers made by the surviving spouse during life or at death. III. Bonus Depreciation (Special Depreciation) and IRC Special first year bonus depreciation allowance of 50% for qualified property is allowed for Currently, the tax law does not extend bonus depreciation past December 31, To qualify for special depreciation, the asset must generally be new, rather than used. Taxpayers can elect not to claim special depreciation for any class of property. 3. If the special depreciation allowance is taken, there are no Alternative Minimum Tax (A.M.T.) adjustments for depreciation for that asset for the year placed in service or any later year. This can be extremely advantageous for taxpayer s subject to A.M.T. 4. California does not have bonus depreciation. 5. Comparison of bonus depreciation and IRC 179 for the 2013 and 2014 tax years (unless Congress acts to extend all or some of the previous limits) California Bonus Depreciation Bonus 50% 0% N/A Qualified Real Property 15 Years 39 Years N/A IRC 179 Maximum $500,000 $25,000 $25,000 Phase-out Range $2Million - $2.5 Million $200-K - $250-K $200-K - $250-K Qualified Real Property $250-K $0 N/A Computer Software Yes No No IV. IRA s - Contributions to Charities and Roth Conversions 1. IRA Contributions to Charities: This provision was extended through 2013, but is one that expired December 31, 2013 unless Congress acts some time in 2014 to retroactively reinstate this provision. Taxpayers over age 70 ½ were allowed to make tax-free transfers from an IRA directly to a charity up to $100,000. 5

10 2. Roth Conversions: From 2010 and later, taxpayers can convert funds from traditional IRAs and qualified plans to Roth IRAs regardless of their modified AGI or filing status. 3. Participants of 401(k), 403(b) and government 457(b) plans with in-plan Roth conversion features can make transfers to a Roth account at any time. V. Estate and Gift Tax Developments 1. The estate tax was repealed for decedents dying in 2010 but reinstated for decedents dying after Decedents dying in 2013 the estate tax exclusion amount was $5,250,000 (per person/decedent). For 2011 and thereafter the amount is increased by any deceased spousal unused exclusion amount (the spousal portability election). For 2014 the estate tax exclusion will be $5,340,000. The maximum estate, gift and generation skipping tax rate for 2013 and 2014 is 40%. 3. The annual gift tax exclusion amount for 2013 and 2014 is $14,000. VI. Form Miscellaneous Income Rules 1. Every person (and also all nonprofit organizations) who operates an activity for gain or profit must file Form 1099-MISC, Miscellaneous Income, for each person or business entity to whom you have paid during the year, including but not limited to: $10 or more in royalties; $600 or more for services (including parts and materials), rent, other income payments; Any fishing boat proceeds; and Gross proceeds of $600 or more paid to an attorney. (a) Exceptions. Some payments do not have to be reported on Form 1099-MISC, even though they may be taxable to the recipient, and include such items as: Generally payments to a corporation (fees paid to an attorney, law firm, or provider of legal services always receives a 1099-MISC with payments reported in box 7 or 14 depending on the nature of the payment); Payments for merchandise, telegrams, telephone, freight, storage, and similar items; and Payments of rent to real estate agents (the real estate agent would be responsible to provide the property owner with a 1099-MISC). 2. Penalties for failure to file complete and accurate information returns or for filing late with the IRS are as follows: Failures corrected within 30 days: $30 per Maximum penalty: $250,000 per year or $75,000 for a small business; 6

11 Failures corrected by August 1 st : $60 per Maximum penalty: $500,000 per year or $200,000 for a small business; and Failures corrected after August 1 st or for failure to file a return: $100 per Maximum penalty: $1,500,000 per year or $500,000 for a small business. A small business is defined as one in which average gross receipts for the 3 most recent years do not exceed $5 million. There are some exceptions to the penalty. 3. Beginning in 2011, credit card payment processors are required to make an annual information report to the merchant and the IRS stating the gross amount paid to the merchant during the year on Form 1099-K, Payment Card and Third Party Network Transactions. 4. Form 1099-B, Proceeds From Broker and Barter Exchange Transactions. Brokers must report cost or other basis of securities when sold: (1) corporate stock acquired after 2010 and (2) mutual fund shares, dividend reinvestment plan stock and ETF shares acquired after The basis in shares sold but acquired before those dates are not required to be reported on Form 1099-B. 5. California generally follows federal rules for informational return reporting. Please note, if a taxpayer is being audited by the Franchise Tax Board (FTB), the FTB can deny the deduction to a business for personal services paid if the necessary informational returns were not filed (W-2 or 1099). VII. Income Planning 1. Wages and Salaries. Wages and salaries are generally included in income in the year the services were performed. 2. Interest. An individual must include bond interest in the year of payment. U.S. Government obligation interest is taxable for Federal purposes, but not California purposes. California and local bond interest is excludable for both Federal and California purposes. Non-California municipal bonds are excludable for Federal purposes, but taxable in California. 3. Dividends. Payments an individual receives for owning stock are called dividends. Corporate distributions can also be nontaxable return of capital, which will reduce a shareholder s tax basis in the stock. If the taxpayer reinvests dividends through a stock reimbursement plan, the taxpayer still pays tax in the year the dividend was paid. (a) For tax years beginning 2013, the top tax rate increased to 39.6% and applies to individuals with taxable income of more than $400,000, to Head of Household filers with taxable income greater than $425,000, Married Filing Joint with more than $450,000, and to Married Filing Separate filers with more than $225,000. The thresholds are adjusted for inflation annually. (b) For tax years 2013 and 2014, qualified dividend and long term capital gain income will be taxed at a maximum rate of 20% (only for the 39.6% tax bracket). For taxpayers in the 10% and 15% tax brackets the rate is 0% and in the 25% to 35% tax brackets, the tax rate on qualified dividend and long term capital gain income is 15%. (c) For tax years beginning 2013, the Health Care Act imposes an additional Net Investment Income Tax (NIIT) of 3.8% on the lesser of net investment income or the excess of modified 7

12 adjusted gross income above threshold amounts (which are the same thresholds as the Medicare Hospital Insurance tax and not currently scheduled to be adjusted for inflation) for individuals, estates, and trusts. (d) The NIIT will be calculated on the new Form 8960, Net Investment Income Tax-Individuals, Estates, and Trusts. (e) For tax years beginning 2013, the Health Care Act imposes an additional.9% Medicare Hospital Insurance (HI) tax on wages and self-employment income on amounts earned over threshold amounts. The HI tax will be reconciled on the new Form 8959, Additional Medicare Tax. (f) For tax years beginning 2013, employers must begin withholding the additional HI tax when wages subject to Medicare exceed $200,000. Employer s rate of 1.45% does not change. (g) Remember that securities held in tax-deferred retirement accounts such as an IRA will not be affected by changes in the tax rates for qualified dividends and long-term capital gains as the distributions from such an account will be ordinary income when distributed. (h) Beginning January 1, 2014, taxpayers who complete a like-kind exchange of California property for property located out-of-state will be required to file an information return with the Franchise Tax Board in the year of the exchange and for each subsequent year that the gain or loss is deferred; regardless of the filing requirements of the seller/exchanger. 4. Self-Employment Income. Sole proprietorship and single member limited liability company (if treated as a disregarded entity for tax purposes), income is reported on Schedule C of Form No separate return is required (if a CA Single Member LLC, a short form filing and payment is required for CA, not fed). The owner s net income is fully subject to self-employment tax. If the owner actively participates, losses are fully deductible against the income. Net operating losses (NOL) may be carried back (generally carried back 2-years) and/or forward (generally the carry-forward period expires for unused NOL s after 20-years). (a) California All taxpayers may use NOL s again starting in 2012 and carry forward unused amounts. NOL s generated in the 2013 and 2014 tax years can be carried back 2-years in limited percentages, 50% and 75% respectively, with any unused NOL carrying forward for 20-years. NOL s incurred for and after the 2015 tax year, a 100% of the NOL can be carried back 2-years. 5. Partnerships, Limited Liability Companies (LLC) and S Corporations. A partner in a partnership, a member of an LLC or a shareholder in an S corporation must report their distributable share of income on Schedule E page 2 of Form 1040, even if the income was not paid to the partner or shareholder in cash or property. The reportable amounts will be on a Schedule K-1. (a) Income and loss from a partnership can sometimes be considered a passive investment. If the taxpayer is a material participant in the activity, i.e. the taxpayer is involved on a regular, continuous and substantial basis, it is an active investment and can deduct their share of losses against other active income. e.g., wages or self-employment income. (b) However, if the involvement is passive, then any losses can only be offset against passive income. If the taxpayer only has passive losses, the losses are suspended, and can only be 8

13 used to offset passive income in a future year or against active income when the investment is sold. (c) California A foreign (out-of-state) LLC must register if doing business in California. Doing business means actively engaging in any transaction for the purpose of financial or pecuniary gain or profit. (R&TC 17941, 23101) In addition, a foreign LLC will be considered doing business in California if one or more managing members are California residents; even if the LLC has no California source income. The LLC must prove otherwise. If a California resident member (not a managing member) performs a for profit transaction on behalf of the LLC in California, the LLC would be considered doing business in California. A California resident passive member, who does not act on behalf of the foreign LLC will not cause the foreign LLC to be doing business in California. A foreign LLC that fails to register and file in California may encounter the following: - Subject to a penalty of $2,000 per year for failing to file and register as a foreign LLC. - Annual assessment of the $800 annual tax. - 25% penalty for failure to file a return, interest, and the possibility of other penalties as well. - Lack the ability to bring suit or enforce a contract in California. 6. Taxable Distributions from an IRA. Distributions from traditional Individual Retirement Accounts (IRAs) are taxable as ordinary income. Distributions prior to age 59 and one-half (59 ½) may be subject to a 10% excise tax penalty in addition to the income tax. 7. Social Security Benefits. If a taxpayer has income over a base amount that is received in addition to Social Security benefits, a portion of the taxpayer s Social Security benefits may be taxable. If 2013 modified adjusted gross income exceeds $44,000 (for joint filers), $0 (for married filling separately) or $34,000 (for single filers or head-of-household), up to 85% (the maximum percentage) of the benefits may be taxable. (a) Individuals age 66 and older can earn an unlimited amount without losing Social Security benefits. (b) Workers receiving Social Security retirement benefits before their full retirement age (FRA), age 62 to 66 can earn up to $15,120 (2013) before benefits are reduced. For 2013 the earnings will be up to $15,480. VIII. Adjustments to Income 1. In arriving at Adjusted Gross Income (AGI), certain items are deductible: (a) Contributions to an IRA. Contributions to a traditional IRA are deductible up to $5,500 ($6,500 if age 50 and older) in 2013 and If a taxpayer or spouse is covered by an employer plan, the ability to deduct an IRA contribution may be limited. 9

14 (b) SEP, SIMPLE or Keogh Plan Contributions Elective deferral limitations. (c) 401(k), 403(b), SARSEP 457 For 2013, deductible up to $17,500 ($23,000 if age 50 and older). For 2014, up to $17,500 ($23,000 if age 50 and older). (d) SIMPLE (savings incentive match plans for employees) For 2013, deductible up to $12,000 ($14,500 if age 50 and older). For 2014, up to $12,000 ($14,500 if age 50 and older). (e) SEP (simple employee pensions) Self-employed, for 2013 up to 20% of net selfemployment (SE) income after SE tax deduction up to a maximum contribution of $51,000. If contributions made to self-employed, they must be made to eligible employees (f) SEP Eligible employee, for 2013, 25% of wages up to a maximum contribution of $51,000. (g) Alimony. Alimony payments are deducted by the payer and included in income by the recipient. (h) Self-Employment Tax. One-half of self-employment tax is deductible in determining AGI. (i) Penalty for the Early Withdrawal of Savings. (j) Student Loan Interest. For 2013 a taxpayer can deduct up to $2,500 of interest on student loans. The deduction is phased out as AGI increases. (k) Tuition and fees deduction. Extended through 2013 and income phase out applies. This deduction expired on December 31, 2013 unless Congress retroactively reinstates for (l) Self-employed Health Insurance Costs. Self-employed taxpayers, greater than 2% S- corporation shareholders, partners and LLC members can deduct 100% of the amounts paid for health insurance for themselves, their spouse and dependents. For greater than 2% S- corporation shareholders, the premium must be reported as wages on their Form W-2. For partners and LLC members, the premium must be reported as guaranteed wages on their Schedule K-1. The premiums are not subject to Social Security and Medicare taxes. (m) Educator Expenses. Extended through 2013, maximum deduction of $250. Deduction allowed to primary and secondary teachers as well as other education professionals. This deduction expired on December 31, 2013 unless Congress retroactively reinstates for (n) Health Savings Accounts (HSA) Deduction. An HSA is a savings account set up exclusively for paying qualified medical expenses of the account beneficiary or the beneficiary s spouse and dependents. To be eligible, an individual must be covered under a high deductible health plan (HDHP), not covered under any other non-hdhp, cannot be enrolled in Medicare, and cannot be claimed as a dependent on another person s tax return. Contributions are limited based on under or over 55 years of age and a self-only or family plan. Contributions to an HSA are an adjustment to your income and reported similar to an IRA contribution on your income tax return. 10

15 Withdrawals from an HSA are exempt from federal income tax if used for qualified medical expenses. Health insurance premiums generally are not qualified expenses. There are exceptions. Withdrawals not used for qualified expenses are included in gross income and are subject to a 20% penalty, except for disability, death or attaining age 65. California does not recognize HSAs. Contributions to an HSA are not tax-deductible Earnings in the HSA are not tax-deferred. Contributions and earnings create California basis in the HSA. Distributions are not taxable. Medical expenses paid with HSA proceeds are deductible on California return. (o) Certain Moving Expenses. Cost of moving household goods and personal effects, and Travel expenses (including lodging but not meals) for one trip by the taxpayer and each member of the household. Household members do not have to travel together or at the same time. (p) Certain Business Expenses of Reservists, Performing Artists, and Fee-Basis Government Officials. (q) Domestic Production Activities Deduction. IX. Investment Planning 1. Capital Gains and Losses (a) One of the most fertile areas for year-end tax planning involves the timely realization of capital gains and losses. Usually an investor has more control over the timing of these items. Therefore an understanding of the rules can result in savings. (b) Long-term capital gains were taxed at a maximum rate of 15% (0% if the taxpayer is in the 10% or 15% tax bracket) in For 2013 and thereafter, the maximum rate is 20% for higher income taxpayers. Since this rate is lower than the maximum rate on ordinary income, it makes sense to realize capital gains. Remember that long-term capital gains are those resulting from the sale of capital assets held more than one-year. Taxpayers should start counting on the day following the day of acquisition. The same date of each following month is the beginning of the new month. The day the taxpayer sells the property is part of his holding period. The holding period for inherited property is automatically long-term. 11

16 (c) Capital Losses are deductible on a dollar-for-dollar basis against net capital gains. Excess capital losses are allowed to offset up to $3,000 of ordinary income. Unused losses can be carried forward indefinitely and expire upon death. (d) Planning Techniques for Capital Gains and Losses. If a taxpayer has a capital loss carryover or realized capital losses from 2013, he or she should consider selling capital assets in 2014 that have unrealized capital gain. If the taxpayer already has realized capital gains, the taxpayer should consider selling property with capital loss potential. If the taxpayer has sufficient deductions or losses from other activities (for example a large business loss) to fully offset the capital gains, it may not be worthwhile to realize the capital losses as they may provide no current tax benefit. Short-term capital losses are first applied against short-term capital gains. Any excess short-term capital loss will be applied against net long-term capital gain. If the taxpayer has a short-term gain after applying long-term capital losses, the gain will be taxed at ordinary income rates up to 39.6% for higher income taxes. Gains from collectibles held for more than twelve (12) months are taxed at a maximum rate of 28%. Collectibles are items such as works of art, gems, stamps or antiques. Taxpayers should consider making a gift of appreciated property to a child who is in a lower tax bracket. For example, a taxpayer in the 25% bracket who sells appreciated stock (with a basis of $2,000) for $8,000 has a capital gain of $6,000 on which he will pay $900 (15% of $6,000) of tax. If the taxpayer was planning to give the proceeds to his child, who presumably is in a lower tax bracket, he could do better by gifting the stock directly to the child. The child would take the same basis as the taxpayer, i.e. $2,000. The $6,000 realized gain would be taxed at the child s rate of 0%, for a tax of $0. (e) It is important that in searching for capital gain opportunities that investors be aware of the "anti-conversion" rules that were enacted as part of the tax legislation of These rules were enacted to prevent taxpayers from reporting income at capital gains rates that should be reported as ordinary income where the investor is actually acting as a lender rather than an investor. The anti-conversion rules are directed toward transactions where all of the return is attributable to the time value of money rather than the risk of gain or loss on the property. The Code provides that certain type of arrangements is subject to the anti-conversion rules. Example: Sam buys 1,000 shares of Marvel, Inc. for $2,000 on December 1, At the same time, Sam agrees to sell the 1,000 shares to Jim on December 2, 2013 for $2,200. The anti-conversion rules apply. Sam entered into a contemporaneous agreement to sell the property when he bought it. Assuming the applicable federal rate is 6%, approximately $120 of Sam's gains will be taxable as ordinary income with approximately $80 taxable as capital gains. If Sam had no arrangement to sell the property to Jim under the same facts, the entire $200 of gain would be capital gains. 12

17 (f) The anti-conversion rules should not applicable to investors who make legitimate investments and who are willing to assume the risks that are inherently associated with the placement of investment capital. (g) Generally, securities acquired after 2010, brokers will be required to report not only the gross sales proceeds on the Form 1099-B, also the customer s adjusted basis in the security and whether any gain or loss with respect to the security is long-term or short-term. X. Wash Sales 1. Wash Sales. A wash sale allows an investor to recognize a loss on the sale of a security without giving up the security. However, in order to successfully use this technique, there are several timing rules that must be observed. (a) No deduction is allowed for a loss on the sale of a security if the taxpayer acquires substantially identical securities within a 61-day period beginning thirty (30) days before the sale and ending 30 days after the sale. (b) The obvious answer is to wait at least 31 days before repurchasing the stock. The problem with this approach is that any appreciation that occurs in the stock during the waiting period will be lost. (c) A second technique to purchase a second lot of the stock equal to the original holding, wait the requisite 31 days, and then sell the original lot at a loss. This allows for a continuing interest in the stock, but requires the taxpayer to have additional funds tied up for at least 31 days. (d) Another alternative is to sell the loss stock and buy stock of another company in the same industry that has performed the same way as the loss stock. XI. Investment Interest & Expenses 1. Investment Interest - General Rule. As a general rule investment interest expense can only be deducted against net investment income. Any excess investment interest must be carried over. 2. Net Investment Income. In the past, investors were able to utilize capital gains against investment interest expense. However, for years beginning after December 31, 1992, taxpayers can not classify their capital gains as investment income. Taxpayers can make an election to classify all or a part of their capital gains that are subject to the maximum rate of 39.6% as investment income. However, by making such an election, the amount of capital gains that are reclassified as investment income will be subject to ordinary income rates. (a) EXAMPLE. T has a net capital gain of $30,000 and investment interest expense of $12,000. T has no other investment income. T's taxable income subject to ordinary income rates is $500,000 with a maximum rate of 39.6%. If T makes the election to subject $12,000 of his capital gains to the higher 39.6% rate, he can utilize the $12,000 of investment interest expense. Thus, for an additional tax cost of $2,352 (19.6% of $12,000), T can save $4,752 (39.6% of $12,000). However, if T knew he would have at least $12,000 of regular 13

18 investment income, such as interest in 2013, and that his tax rate would be over 20%, it would be better to not make the election. 3. Whether or not to make the election requires a taxpayer to do some analysis of his or her actual tax situation. The 20% rate on capital gains should not be sacrificed without careful consideration of the total picture. 4. Investment Expenses. Investment expenses such as office rent, investment counsel fees, legal fees, safe deposit rental, subscriptions, and travel expenses offset investment income. These expenses must be related to the maintenance of investments. These investment expenses are treated as miscellaneous itemized deductions and are deductible only to the extent they exceed two percent (2%) of AGI. To receive the maximum benefits from these items, you should attempt to bunch these expenses in alternate years if possible. XII. Mutual Fund Investments 1. A mutual fund generally distributes most of its investment income to its shareholders. These distributions may be taxable to the shareholders as ordinary income, capital gains, or may be taxexempt income. 2. If the shareholder re-invests the distribution in mutual fund shares, the distribution is still taxable. The amount of the distribution does increase the taxpayer's tax basis in the investment. (a) A shareholder may want to wait to buy mutual fund shares until after the fund makes a distribution. If you buy just before a distribution, part of your investment will be returned to you as taxable income. (b) EXAMPLE. Bill purchases 400 shares of a mutual fund on February 1, 2013 for $4,000 and chooses to have all dividends re-invested in the fund. On June 1, 2013, Bill re-invests the $340 dividend from the fund to purchase 30 additional shares through the re-investment program. Bill must include the $340 as dividend income in Bill s tax basis is increased to $4,340 ($4,000 + $340). In July 2014, Bill sells all 430 shares for $5,640. In 2013, Bill must recognize long-term capital gain of $1,300. ($5,640 less $4,340). 3. Shareholders need to be careful when selling some of the mutual fund shares that they have purchased at different times. It is crucial that the shareholders keep track of their basis. Different methods are available to mutual fund shareholders to determine their basis. 4. Taxpayers should consider the turnover rate of their mutual fund investments. Mutual funds with a high turnover rate create capital gains, probably short-term capital gains. XIII. Investment Income 1. Interest Income. A Taxpayer can defer interest income into 2015 by purchasing U. S. Treasury Bills now that mature in Interest on Treasury Bills and Bank CDs having a term of oneyear or less is not includible in income until maturity. 2. Annuities. Taxpayers should consider purchasing annuities as a way to defer investment income. 14

19 3. Municipal Bond Income. Taxpayers should be aware of what they would have to earn on a taxable investment to match the yield on tax-exempt investments. This can be done be subtracting the marginal tax rate from one and dividing the result into the tax-exempt yield. Thus, if a taxpayer is in the 33% bracket, subtract.33 from one (1.0) to get.67. If the taxexempt yield is 5%, the taxpayer would need a 7.5% return on a taxable investment to get the equivalent tax-exempt yield. Taxpayers should be careful to avoid private activity bonds since interest on these bonds are subject to the AMT. 4. Other. (a) Like-Kind Exchanges. It may be possible to avoid a large gain by making a like-kind exchange of the asset. Like-kind exchanges are available for only certain types of business and investment assets. An exchange can postpone gain recognition until the exchanged asset is sold. A three-corner exchange may also be a viable alternative. (b) Installment Sales. By selling property using the installment method a taxpayer can defer the recognition of gain until the payments are received. A taxpayer can elect out of the installment method in order to accelerate the use of a capital loss from another sale. XIV. Planning for Itemized Deductions Itemized Deductions can be used to reduce taxable income. However, it is important to recognize there are limitations on the availability of certain itemized deductions. Also one must keep in mind that overall itemized deductions can be limited if the taxpayer's adjusted gross income exceeds certain amounts. 1. Deductions - General - Unless the taxpayer is an accrual basis taxpayer, the deduction is available in the year it is paid. If a taxpayer pays by check, the check should be dated on or before December 31 and be mailed by that date. The fact that the check is not cashed until after December 31 will not void the current deduction, if there is not a long delay from the date on the check and the date cashed. Payments for eligible deductions are qualified even if the money is borrowed. Taxpayers should consider a bank loan as a method of paying for eligible deductions. Taxpayers should also consider using a credit card to pay for a deduction. 2. Medical Expenses. Medical expenses are deductible only to the extent they exceed 10.0% of adjusted gross income. Medical expenses include prescription drugs, dental and insurance costs (including Part B Medicare premiums paid from Social Security benefits for taxpayers, spouses and dependents) and transportation costs for medical care. Because of this high threshold, many taxpayers who incur significant amounts of medical expenditures still do not qualify for a deduction. Planning should be to whenever possible to bunch medical expenses into one year. For example, if the taxpayer has elective surgery, he should try to bunch all treatment and surgical expenses into one year in order to get over the 10.0% of AGI limitation. Note that the 10% penalty on early distributions from an IRA plans does not apply if the distribution is used to pay medical expenses. In addition, it may be possible to avoid the 10% penalty in IRA distributions that are used to pay health insurance premiums for unemployed individuals. 3. Tax Expenses. State and local income taxes are deductible in the year paid. Real estate taxes are also deductible in the year paid. Note that if the taxpayer is in the Alternative Minimum Tax 15

20 (AMT) situation, such taxes are not deductible. With respect to income taxes, it is sometimes better to incur an Underpayment of Estimated Tax penalty for California purposes rather than pay a timely state estimated tax payment but lose the itemized deduction for taxes due to AMT liability. If AMT is not a problem, taxpayers should consider accelerating their 4th quarter 2014 California estimated tax payment (normally due January 15, 2015) and the second half of their real property tax by paying them before December 31, On the other hand, if AMT is a problem, consider postponing the second installment of the property tax payment until the usual due date (April 10, 2015). (a) State and local general sales tax deductions have been extended through 2013 if using itemized deductions and sales tax is greater than income tax paid. Based on actual sales taxes paid if receipts are maintained; Estimated sales taxes paid per IRS sales tax table. 4. Charitable Deductions. Deductions to a qualified charity are deductible to the extent of 50% of adjusted gross income. Be sure to ascertain that the charity is a qualified charity recognized by the Internal Revenue Service as a qualified Section 501(c)(3) organization. Note that pledges are not deductible. The pledge must be paid in order to qualify for a deduction. (a) Substantiation. Remember that charitable contributions of $250 or more must be substantiated by a contemporaneous written acknowledgment from the charity. A canceled check is no longer sufficient evidence of the deduction for a contribution of $250 or more. Even if contribution is less than $250.00, still necessary for taxpayer to retain such evidence as cancelled check or receipt to substantiate the deduction. (b) Gifts of Appreciated Property -- Taxpayers should consider gifts of appreciated property that they have held for more than one year. They should avoid the capital gains tax they would have to pay if they had sold the property, and they should be able to deduct the full fair market value of the property. Deductions for gifts of appreciated property are deductible to the extent of 30% of adjusted gross income. EXAMPLE. Bob and Sally donate marketable securities to the United Way worth $30,000. They purchased the securities several years ago for $10,000. Their AGI for 2012 is $110,000. They may claim a charitable deduction for the full $30,000 since that is less than 30% of their AGI of $110,000. This deduction generates a tax savings of $7,500 (25% of $30,000). They also avoid paying tax on the $20,000 gain ($30,000 less $10,000) which at a 15% capital gain rate would be $3,000. (c) "In Kind" Contributions. If the taxpayer receives something in return for his contribution, he can only deduct the portion of the payment in excess of the value of what he received from the charity. (d) Appraisal. If the taxpayer makes gifts of property other than cash to the charity, he may have to obtain a contemporaneous appraisal if the claimed deduction is more than $5,000. The appraisal should be attached to the return. (e) Charitable Remainder Trust. A Charitable Remainder Trust (CRT) can give significant tax benefits while helping a charity. A taxpayer transfers highly appreciated assets to the trust 16

21 and receives an income either for life or a term of years. At the end of the taxpayer s life or the term, the assets go to charity. The taxpayer gets a deduction for the remainder interest in the future value of the property. The trust will not pay any capital gains tax on the sale of the property. (f) Loss Property. If property has declined in value since it was acquired, taxpayers should consider selling the property first, recognizing a capital loss and then donate the cash to charity. 5. Mortgage Interest Expense. Generally, interest expense is deductible as it accrues and is paid. Therefore, absent paying the January mortgage payment before year-end, it is difficult to accelerate interest expense. Deductibility depends upon the category in which the interest paid falls: business, passive activity, investment, personal, qualified residence or home equity indebtedness. One can generally deduct mortgage interest on the first $1 million of debt incurred to acquire, construct or substantially improve a qualified residence. Interest on $100,000 of home equity debt is also deductible, regardless of how the funds are used. Generally, taxpayers cannot deduct personal interest, such as credit card or auto loans, and other interest may be limited. 6. Miscellaneous Expenses. These expenses include expenses to produce or collect investment income. Also included are expenses incurred to determine, contest or pay income tax, or to make a claim for a refund of income tax. Also included are employee business expenses, such as travel, meals, lodging, education, equipment, special clothing, or professional dues if they are not reimbursed by the employer. In order to be deductible these expenses must exceed 2% of AGI. (a) Expenses of a Statutory Employee- Statutory employees include full-time life insurance salespersons, certain agents or commission drivers, certain traveling salespersons, and certain home workers. These taxpayers can deduct their unreimbursed business expenses as a direct deduction from gross income and thus avoid the restrictions placed on miscellaneous itemized deductions. Statutory employee expenses are deducted on Schedule C. 7. Casualty Losses. (a) Given the severity of the natural disasters that occurred in California in recent years, it is important to keep in mind the rules regarding casualty losses. The following applies to personal-use property (for example your home). (b) The amount of the loss is the lesser of (1) the decrease in the fair market value of the property resulting from the casualty, or (2) the adjusted basis of the property. A taxpayer who suffers a loss must file a claim, if available, and insurance or condemnation proceeds must be deducted from the amount of the loss. (c) The deduction is further limited to that amount by which the loss (after any reimbursement) exceeds both $100 (for 2014) and 10 percent of the adjusted gross income. (d) A taxpayer who suffers a casualty loss which occurs in a federal disaster area may elect to deduct the losses if it occurred in the year immediately before the tax year of the disaster. 17

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