Over-the-Counter Medication and Medical Reimbursement Plans

For many years, taxpayers have not been able to deduct as a medical expense on their tax return the cost of unprescribed over-the-counter medications. However, taxpayers with Flexible Spending Arrangements (FSA), Health Reimbursement Arrangements (HRA), Health Savings Accounts (HSA) and Archer Medical Savings Accounts (Archer MSA) could reimburse themselves for the cost of over-the-counter drugs, and, as a result, pay for the medication with tax-deductible dollars.

As part of the new Health Care legislation, that benefit will go away in 2011 and the cost of over-the-counter drugs, except for insulin, will no longer be reimbursable unless they are prescribed by a physician. This essentially puts those with the tax-favored FSA, HRA, HSA and MSA plans on an equal status with other taxpayers with respect to over-the-counter medication after 2010.

Taxpayers with these plans should, where appropriate, stock up on essential over-the counter medication before the end of 2010.

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Is Your Business Ready for 2011 Credit Card Income Reporting?

Beginning for sales made in 2011, payment settlement entities (e.g., merchant card processing companies like American Express, Visa and MasterCard merchant banks) will be required to report each business's payment transactions to the IRS.

To facilitate this reporting, the IRS has developed Form 1099-K which will report a merchant's credit and debit card income for the year and will be issued to the merchant in the early part of the subsequent year just like 1099s for interest, dividends, pensions, etc., are. Unlike other 1099 forms, the 1099-K will actually break the income down by the month. The first 1099-Ks will be issued in early 2012.

Individuals and merchants with Internet sales (e.g., eBay and their online sales) that utilize an internet payment system such as PayPal can expect to see those sales included in this new reporting requirement if their annual third-party transactions total more than $20,000 and the number of transactions is over 200.

This new reporting requirement provides the IRS with a far-reaching compliance tool. It will allow them to determine a business's gross income from credit/debit card sales and make it easier to segregate those payment card sales from cash sales.

The IRS will then be in a position to see if the credit card dollar figure reported on the merchant's tax return matches the bank's information return. This also allows them to see if a business's other sales from cash and check payments makes sense in the context of the firm's overall business.

We can probably expect the IRS to develop statistics for various types of businesses related to the ratio of cash payments to credit payments, as a means of imputing cash payments for merchants that do not report a reasonable amount of income over and above that reported by the payment processors.

How Does This Affect You?

1. You can expect your bank or other payment settlement services to be verifying your tax ID number and contact information in the next few months leading up 2011. Be sure that the information you provide them is correct and matches the information on file with the IRS.
   
2. If you fail to provide the settlement entity with the information requested or the information does not match the information on file with the IRS, the settlement entity is authorized to withhold 28% of the payment as withholding. You will receive credit for the withholding when your tax return is filed, but, if the withholding is in excess of what you owe, you will have to wait until you file your return to get the excess back.
   
3. Make sure that your business has an appropriate accounting system in place to properly record card payments so that they can be reconciled with the 1099-K.
   

Payment Cards - A payment card, as defined by the IRS regulations, includes, but is not limited to, credit cards, debit cards, and stored-value cards (e.g., gift cards or similar cards with a prepaid value). A payment card also includes the acceptance as payment of any account number or other indicia associated with a payment card. The use of a payment card to obtain a loan or cash advance does not constitute a payment card transaction. The same holds true for the withdrawal of cash from an automated teller machine—it is not considered a payment card transaction.

If you have questions related to how the new reporting requirement for credit and debit card sales will impact your business, or what steps you should take to prepare for this new requirement, please give our office a call.

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Will You Be Hit by the AMT in 2010?

AMT is the acronym for Alternative Minimum Tax. It is a different (alternative), and generally punitive, method of computing income tax when either certain types of income receive preferential tax treatment or there are excessive deductions in certain categories. Congress originally implemented it to impose a minimum tax on higher-income taxpayers who were avoiding taxes though tax shelters and other legal means. However, years of inflation without corresponding adjustment to the AMT components have, each successive year, caused an increasing number of taxpayers to be subject to the AMT.

Much as the regular income tax allows personal exemptions, the AMT calculation allows an exemption but based upon filing status. For the past several years, the IRS has on a year-to-year basis increased that exemption for inflation. However, should they fail to provide an increase for 2010, the exemption amounts would revert to the 2001-2002 levels, which would result in an approximate 30% decrease in the exemption amount. This would snare a significant number of taxpayers (estimated around 28 million) for the first time in 2010. For example, the exemption amount for joint filers was $49,000 in 2002 and was $70,950 in 2009.

Other factors that can create an AMT for the average taxpayer include the following:

Medical Deductions – Medical deductions are allowed for the AMT computation, but only to the extent that they exceed 10% of a taxpayer's income. In contrast, the regular tax computation limit is a lesser 7.5%. When a taxpayer knows that they are going to be affected by the AMT, it sometimes is possible to defer or accelerate medical expenses from one year to another, such as paying the orthodontist in installments or all at once.
If your employer offers one, consider participating in a flexible spending plan. It allows you to pay medical expenses with pre-tax dollars and avoid both the regular tax and AMT deduction limitations.

Tax Deductions – When itemizing deductions, a taxpayer is allowed to deduct a variety of taxes, including real property, personal property and state income tax. But for AMT purposes, none of the itemized taxes are deductible. For most taxpayers, this represents one of their largest tax deductions and frequently triggers the AMT. If you are affected by the AMT, conventional wisdom would dictate deferring tax payments to a subsequent year when the AMT may not apply. When deferring, care should be exercised in regards to late payment penalties and interest on underpayments for certain taxes. In addition, taxpayers can annually elect to capitalize taxes on unimproved and unproductive real estate. This means foregoing the deduction currently and adding the tax paid to the cost basis of the real property.

Home Mortgage Interest – For both the regular tax and AMT computations, interest paid on a debt to acquire or substantially improve a home or second home is deductible as long as the debt limit (generally $1.1 million) is not exceeded. This is true of refinanced debt, except that any increase in debt is treated as equity debt. For regular tax purposes, the interest on up to $100,000 of equity debt on the two homes can also be deducted. However, equity debt is not deductible against the AMT; neither is the acquisition or equity debt interest on a motor home or boat that qualifies as a second home. Therefore, taxpayers should exercise caution when incurring home equity debt. Generally, loan brokers are not aware of these limitations, and there are numerous pitfalls.

Miscellaneous Itemized Deductions – The category of miscellaneous deductions that includes employee business expenses and investment expenses is not deductible for AMT purposes. For certain taxpayers with deductible employee business expenses, this can create a significant AMT. Employees with significant employee business expenses should attempt to negotiate an "accountable" reimbursement plan with their employer. Under this type of plan, the reimbursement for qualified expenses is tax-free. Because the employee has been reimbursed, he or she no longer claims a deduction for the expenses, thus eliminating the miscellaneous deduction. Another strategy would be to defer the expenses to a year not affected by the AMT.

Personal Exemptions – Personal exemptions for dependents provide no benefit when taxed by the AMT method. Therefore, divorced or separated parents should carefully consider which party should claim the exemption for a dependent child.

Standard Deduction – For AMT purposes, there is not a standard deduction as there is with the regular tax computation. Thus, taxpayers affected by the AMT should always itemize. Granted that the benefit of some deductions will be lost, there is still a partial advantage. Even the smallest of charitable deductions will benefit at a minimum of 26% (the lowest bracket for the AMT).

The AMT is an extremely complicated area of tax law that requires careful planning to minimize its effects. Please contact our office for further assistance.

Caution: Although not frequently encountered, incentive stock options (ISO) can have a profound impact on the AMT, and clients are strongly encouraged to seek advice prior to exercising incentive stock options.

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Time is Running Out for the Home Energy Property Credit

Planning to make an "energy-saving" improvement to your home? 2010 is the final year to take advantage of the tax credit available so you will need to act quickly as there are only three months left. Whether you simply want to cut your utility bills or winterize your home, do it soon!

The name "Home Energy Property Credit" given by Congress is not as descriptive as it could have been and is easily confused with other credits. This credit is for energy-saving improvements to a taxpayer's principal residence. The credit is limited to $1,500 (30% of up to $5,000 of qualified expenditures) for improvements made in 2009 and 2010. So, if you claimed this credit in 2009, the maximum that can be claimed in 2010 is the $1,500 maximum less any amount claimed in 2009.

Qualified improvements, the use of which must originate with the taxpayer, must have a reasonable expected life of at least five years, and include:

• Energy-efficient Exterior Windows and Skylights,
  
• Energy-efficient Exterior Doors,
  
• Energy-efficient Metal Roofs with appropriate pigmented coatings,
  
• Energy-efficient Asphalt Roofing with appropriate cooling granules,
  
• Energy-efficient Heating Systems,
  
• Energy-efficient Air Conditioning Systems and
  
• Insulation Materials or Systems designed to reduce heat loss or gain.
  

Credit is not allowed for on-site preparation, assembly or the installation of the component. It is a non-refundable personal credit; thus, the credit can only be used to bring your tax (including the alternative minimum tax) down to zero. Any excess is not refundable and cannot be carried over to a subsequent year.

Each manufacturer must comply with the government's established standards for the product to be qualified as "energy-efficient." And each manufacturer who meets those standards will provide a written certification that the product meets the definition of qualified property under IRC Sec 25C. Taxpayers cannot simply rely on an Energy Star label in claiming the Sec 25C credit for exterior windows and skylights.

Reliance on the certification is allowed only if installation of the component is consistent with the certification (for example, the item must be installed in the appropriate climate zone identified in the certificate statement).

Caution - At the time this article was prepared, it was uncertain if this credit will offset the alternative minimum tax (AMT). The law allowing it to offset the AMT in prior years expired for years after 2009 and will require Congressional action to extend.

Don't confuse this credit with the "Residential Energy-Efficient Property Credit" which also provides a 30% tax credit for energy-generation installations (such as solar, fuel cells, geothermal and wind energy). That credit offsets the AMT, is available through 2016, and has no annual maximum credit.

If you have questions related to this credit, please give our office a call.

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New Penalties for Failure to File or Furnish Information Returns

Tax law requires businesses to provide information returns, such a 1099s, to each payee that the business has paid $600 or more for the year. The law also includes penalties for failure to file the same information returns with the IRS.

To ensure compliance with these requirements, there are substantial penalties, and, as part of the recently passed Small Business Jobs Act of 2010, those penalties have been doubled. The penalties are generally based upon how late the returns are filed with the IRS or provided to the recipient of the income and are broken down into three tiers:

Tier 1 – Where the returns are filed or provided late but within 30 days of the prescribed due date.

Tier 2 – Where the returns are filed or provided more than 30 days after the prescribed due date and before August 1 of the calendar year in which the filing was required.

Tier 3 – Where the returns are filed or provided after August 1 of the calendar year in which the filing was required.

In addition, the maximum penalties for the year are based on business size determined by the business's gross receipts. Businesses with gross receipts of $5 million or less are subject to the small business penalty maximums.

The following table shows the penalties for information returns required to be filed in 2010 and those imposed for returns required to be filed after 2010.

	Small Businesses		General
	Filings in 2010	Filings after 2010	Filings in 2010	Filings after 2010
Tier 1	$15 (Max $25,000)	$30 (Max $75,000)	$15 (Max $75,000)	$30 (Max $250,000)
Tier 2	$30 (Max $50,000)	$60 (Max $200,000)	$30 (Max $150,000)	$60 (Max $500,000)
Tier 3	$50 (Max $100,000)	$100 (Max $500,000)	$50 (Max $250,000)	$100 (Max $1,500,000)

In addition, the minimum penalty for each intentional failure-to-file act increases from $100 to $250.

Rental Owners Included in the Reporting Requirement Effective in 2011 – Effective for 2011 filings due in 2012, the 2010 Small Business Act provides that solely for purposes of filing information returns, a person receiving rental income from real estate will be considered to be engaged in a trade or business of renting property. Thus, recipients of rental income from real estate generally are subject to the same information reporting requirements as taxpayers engaged in a trade or business. In particular, rental income recipients making payments of $600 or more to a service provider (such as a plumber, painter, or accountant) in the course of earning rental income are required to provide an information return (typically Form 1099-MISC) to IRS and to the service provider. The new law does provide the IRS with the ability to permit exceptions to the filing requirement for hardship cases and when minimal rental income is received, but neither "hardship" nor "minimal" are yet defined.

In order to comply with these requirements and avoid these substantial penalties requires collecting the payee's name, SSN number and contact information before making payment. If you need assistance setting up a procedure for collecting the required information or filing your information returns for the year, please give our office a call.

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New Breaks for Small Businesses

The 2010 Small Business Jobs Act enacted September 27, 2010 includes an assortment of incentives and tax breaks for small businesses. The following is a brief overview of some of the key provisions included in the new law. Watch for additional details in future newsletters.

• Cell Phones No Longer Listed Property - This means that cell phones can be deducted or depreciated like other business property, without the complicated recordkeeping required for listed property. This is effective for tax years beginning after Dec 31, 2009.
  
• Business Owners' Health Insurance Deduction Reduces Self-Employment Tax - The new law allows business owners to deduct the cost of health insurance incurred in 2010 for themselves and their family members in calculating their 2010 self-employment tax.
  
• Boosted Deduction for Start-up Expenditures – For 2010, businesses can deduct up to $10,000 (was previously $5,000) in trade or business start-up expenditures. However, the $10,000 limit is reduced by the amount by which start-up expenditures exceed $60,000 (was previously $50,000).
  
• Increased Small Business Section 179 Expensing –Small business taxpayers can elect to write off the cost of certain capital expenses in the year of acquisition in lieu of recovering these costs over a period of years through depreciation.
  
  For tax years beginning in 2010 and 2011, the new law allows a taxpayer to expense up to $500,000 (up from $250,000 under prior law) of qualifying property which includes machinery, equipment and certain software placed in service during the year. For 2010 and 2011, the annual expensing limit is reduced by the cost of qualifying property that is placed into service during the year exceeding the $2 million (was $800,000) investment limit.
  
• Certain Real Property Can Be Expensed – The new law also makes certain real property eligible for Sec 179 expensing. For property placed in service in any tax year beginning in 2010 or 2011, the up-to-$500,000 deduction of property expensed can include up to $250,000 of qualified real property (qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property).
  
• 50% Bonus First-Year Depreciation Extended - Businesses normally can only deduct the cost of capital expenditures over time through depreciation—most commonly at the rate of about 14% or 20% of the cost of machinery or equipment for the first year. For 2008 and 2009, businesses were permitted to write off 50% of the cost of new machinery and equipment placed in service during those years. In the new law, Congress extends the first-year 50% write-off to qualifying property placed in service in 2010 (2011 for certain property).
  
• General Business Credits for 2010 Can Be Carried Back 5 Years – Under the new law, for the first tax year beginning in 2010 (2010 for calendar year taxpayers), eligible small businesses (ESB) (generally one with $50 million or less in average annual gross receipts for the prior three years) can carry back unused general business credits for five years. ESBs include sole proprietorships, partnerships and non-publicly traded corporations.
  
• General Business Credits of Eligible Small Businesses in 2010 Aren't Subject to AMT - Under the Alternative Minimum Tax (AMT) rules, taxpayers can generally only claim allowable general business credits against their regular tax liability, and only to the extent that their regular tax liability exceeds their AMT liability. A few credits, such as the credit for small business employee health insurance expenses, can be used to offset AMT liability. The new law allows eligible small businesses, as defined above, to use all types of general business credits to offset their AMT in tax years beginning in 2010.
  
• Other Provisions With Limited Application – Calculations of the built-in gains tax on S-Corporations converted to C-Corporations, special rules for long term contract accounting and limitation on the penalty for failure to disclose certain reportable transactions (including listed transactions) on a return.
  

If you have questions related to any of these new tax benefits or wish to schedule a tax planning appointment to see how your business might benefit, please give our office a call.

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Does the IRS Owe You Money??

If you have not filed a prior year tax return and are due a refund, you should consider filing the return to claim that refund. If you are missing a refund for a previously filed tax return, you should check the status of your refund and confirm your current address.

Unclaimed Refunds

Some people may have had taxes withheld from their wages but were not required to file a tax return because they had too little income. Others may not have had any tax withheld but would be eligible for the refundable Earned Income Tax Credit.

• To collect this money, a return must be filed with the IRS no later than three years from the due date of the return.
  
• If no return is filed to claim the refund within three years, the money becomes the property of the U.S. Treasury.
  
• There is no penalty assessed by the IRS for filing a late return qualifying for a refund.
  

Undeliverable Refunds

Were you expecting a refund check but never received it?

• Refund checks are mailed to your last known address. Checks are returned to the IRS if you move without notifying the IRS or the U.S. Postal Service.
  
• You may be able to update your address with the IRS on the "Where's My Refund?" feature available on IRS.gov. You will be prompted to provide an updated address if there is an undeliverable check outstanding within the last 12 months. If you do not have access to the Internet, please call this office for assistance.
  
• You can also ensure the IRS has your correct address by filing Form 8822, Change of Address.
  

If you need assistance in filing past due returns or tracing a refund, please call our office.

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Reminders for September 15th

Individuals:

• The third installment of 2010 individual estimated taxes is due.

Corporations:

• File a 2009 calendar year income tax return (Form 1120 or 1120-A) and pay any tax, interest, and penalties due. This due date applies only if you timely requested an automatic 6-month extension.
• Deposit the third installment of estimated income tax for 2010 for calendar year corporations.

S Corporations:

• File a 2009 calendar year income tax return (Form 1120S) and pay any tax due. This due date applies only if you requested an automatic 6-month extension.

Social Security, Medicare, and Withheld Income Tax:

• If the monthly deposit rule applies, deposit the tax for payments in August.

Nonpayroll Withholding:

• If the monthly deposit rule applies, deposit the tax for payments in August.

Partnerships:

• File a 2009 calendar year return (Form 1065). This due date applies only if you were given an additional 5-month extension. Provide each partner with a copy of K-1 or a substitute Schedule K-1.

Fiduciaries of Estates and Trusts:

• File a 2009 calendar year return (Form 1041). This due date applies only if you were given an additional 5-month extension. If applicable, provide each beneficiary with a copy of K-1 (Form 1041) or a substitute Schedule K-1.

If you have any questions about any of the above, please give our office a call.

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Tax Increases Are Coming Unless Congress Takes Action

Normally, one would think that Congress would have to take some action to increase taxes. However, it is quite the opposite for 2011. If Congress fails to take action, there will be a tax increase affecting just about everyone in every tax category. In order to skirt a Senate rule that requires 60 votes to pass a bill that increases the deficit beyond a ten-year window, Congress passed the Bush tax cuts in 2001 and 2003 with most provisions designed to sunset this year.

Despite President Obama's vow of no new taxes for individuals earning less than $200,000 and families earning less than $250,000, stopping these tax increases from taking place will require Congressional action. However, not only are we in an election year - when most of our politicians tend to steer away from tax-related discussions before voting day - Congress is looking for ways to make up some of the budget deficit, and many legislators consider extending the current laws to be too costly. So, we may not see any action on tax increases or extensions until late in November, if then.

To put this all in perspective, the following is a list of some of the automatic tax changes that have already taken place in 2010 or will take place in 2011 and subsequent years as a result of expiring or new tax laws.

Those Affecting 2010:

• Non-Itemizers Real Property Tax Deduction - The $500 ($1,000 for joint filers) property tax deduction for non-itemizers expired after 2009. This most likely will impact lower-income taxpayers, or those whose homes are mortgage-free and have no home interest expense, and who are unable to itemize their deductions. For taxpayers in the 15% tax bracket, this equates to a $75 tax increase (or $150 for joint filers).
  
• Sales Tax in Lieu of State Income Tax - The option to deduct sales tax in lieu of state income tax as an itemized deduction on a taxpayer's Schedule A expired after 2009. Although this will impact taxpayers with low state income taxes and those that purchased vehicles, boats or airplanes, it will have the greatest impact on taxpayers in states where there is no state income tax and thus no state income tax deduction to take in place of the expiring sales tax deduction.
  
• Farm Losses – For tax years beginning after 2009, the Farm Act limits the farming loss of a taxpayer, other than a C corporation, for any tax year in which any applicable subsidies are received. The losses are limited to the greater of (a) $300,000 ($150,000 for a married person filing separately), or (b) the taxpayer's total net farm income for the prior five tax years.
  
• Alternative Minimum Tax – Way back in 2001, Congress increased the AMT exemption to keep middle-class taxpayers from being caught up in this punitive tax and have been inflation adjusting and extending it on an annual basis in recent years. However, they seem reluctant to adjust it for 2010. If they do not, the exemption will return to $45,000 for joint filers (down from $70,950 in 2009) and $33,750 (down from $46,700 in 2009) for unmarried individuals. This will generally snare middle-income taxpayers, and the tax bite can range upwards to several thousand dollars.
  
• Teacher's Classroom Supplies Deduction – The $250 above-the-line deduction for teacher classroom supplies expired after 2009.
  
• Above-the-Line Education Deduction – The up-to-$4,000 above-the-line deduction for education expenses (tuition and fees) expired after 2009.
  

Those Affecting 2011:

• Tax Rates – As part of the Bush era tax cuts, the marginal tax rates (they increase with taxable income) were reduced to 10, 15, 25, 28 and 33 percent. These rates are set to return to their original levels of 15, 28, 31, 36 and 39.6 percent. The 10% and 15% brackets will be replaced with a single 15% bracket. This results in an increase for everyone. Those in the previously lowest bracket (10%) will see a tax increase of approximately 5%, while others will see increases ranging approximately from 2% to 6%. In addition, an expanded 15% bracket for a married couple filing a joint return has applied for several years as relief for the "marriage penalty." This will not apply as of 2011. Instead, the top of the 15% bracket for joint returns will be about 167% of the end point for single returns rather than the 200% it has been.
  
• Capital Gains Rates – Also, as part of the Bush era cuts, the capital gains rates were substantially reduced, but will return to their old levels of 10% for anyone in the 15% regular tax bracket and 20% for all others. That is up from 0% and 15% in 2010. This will impact investors, business owners and home owners when they sell a capital asset.
  
• Qualified Dividends – Generally, qualified dividend income is dividend income from stock held for 60 days or longer before the ex-dividend date. These dividends, for a number of years, have been taxed at capital gains rates (0% - 15%). However, the law providing these beneficial rates expires at the end of 2010 and all dividend income will be taxed at ordinary income rates (15% to 39.6%). This will generally impact investors holding income stocks and mutual funds. These individuals will see an overall tax increase greater than just the general 2% to 6% rise noted above.
  
• Earned Income Credit – This refundable credit currently has four categories of low-income working taxpayers, with the credit increasing as the number of children increase, up to three or more. In 2011, the "three or more children" category will go away, and taxpayers with three or more children will have to use the two or more category. This can reduce the credit for low-income taxpayers with three or more children by up to about $600.
  
• Child Credit – The tax law provides a tax credit for each of a taxpayer's children under the age of 17. This credit will drop to $500 (was $1,000 in 2010) per child. Since this credit phases out for higher-income taxpayers, it will generally impact lower-income taxpayers.
  
• American Opportunity Education Credit (AOEC) – This credit took the place of the Hope Education credit in 2009 and 2010. Where the Hope Credit is non-refundable (can only offset one's income tax liability), the AOEC was 40% refundable, and where the Hope Credit is for only the first two years of post-secondary education expenses, the AOEC allowed a credit for the first four years of post-secondary education expenses. In addition, prior to 2009, the Hope credit was limited to a maximum of $1,800 per student but the AOEC maximum was $2,500 per student. If the AOEC is not extended, low-income taxpayers will lose out on the refundable feature of the AOEC and those students in their third and fourth year of post-secondary education. Middle-income taxpayers will also be affected, because the point at which the credit phases out due to income limitations was 60% higher under the AOEC than under the Hope credit rules. Higher-income taxpayers are generally not affected since both credits are phased out for higher-income taxpayers.
  
• Employer Education Assistance – Employers are allowed to provide up to $5,250 of tax-free educational benefits. This provision expires and is no longer available after 2010. The net effect of this expiring benefit is based on the student's tax bracket. For example, if the student's employer provided the full $5,250 of benefits, and the student is in the 28% tax bracket, the loss of the tax-free benefit would equate to a $1,470 tax increase.
  
• Business Expense Deduction – Sec 179 of the tax code allows taxpayers to expense rather than depreciate certain tangible business assets and equipment in the year of purchase. For 2011, the amount that can be written off in a tax year will be $25,000, down from $250,000. This will generally impact mid-size businesses that are planning substantial equipment purchases in excess of $25,000 in the near future.
  
• Standard Deduction – In 2010, the standard deduction of taxpayers filing married joint status is twice the amount of someone filing under the single status. Beginning in 2011, the so-called marriage penalty is back: joint filers' standard deduction will be only 167% (instead of 200%) of the single amount. For a married couple in the 28% bracket, the result is additional tax of about $525.
  
• Phase-Out of Personal Exemptions – For years before 2006, the personal exemptions were phased out for high-income taxpayers. Then, in 2006 through 2010, that phase-out was gradually reduced to where there is no phase-out in 2010. However, the reduction will no longer apply after 2010, and, in 2011, the phase-out reverts to the rules in effect before 2006. This only impacts high-income taxpayers. Although the phase-out threshold income amounts for 2011 are not currently available, they will be approximately $250,000 for a married couple, $210,000 for head of household and $170,000 for single individuals. The loss of each exemption for a high-income taxpayer in the 36% tax bracket will result in an additional tax of approximately $1,300. Thus, a family of four would see an increase of $5,200.
  
• Phase-out of Itemized Deductions – At the same time that the exemption phase-out was being reduced (see immediately preceding item), the phase-out of itemized deductions for high-income taxpayers was also being reduced. Thus, for 2011, the high-income taxpayer's itemized deduction phase-out returns. The phase-out impacts all deductions other than medical, investment interest, casualty and gambling losses. The deductions are phased out by an amount equal to 3% of the taxpayer's AGI in excess of the AGI phase-out threshold, but not more than 80% of the deductions can be phased out. The phase-out threshold for most individuals will be approximately $170,000, which is significantly less than the exemption phase-out amount for married joint or head of household filers. The tax impact on an affected taxpayer will be 28% to 39.6% of the lost deductions.
  
• Coverdell Accounts – The contribution limit to Coverdell education savings accounts will be reduced from $2,000 per year to $500, tax-free distributions will no longer be allowed for elementary and secondary education (only post-secondary education), education credits will not be allowed in the same year as a Coverdell distribution, and contributions cannot be made to a Coverdell account and a Sec 529 plan in the same year.
  
• Home Energy Improvement Credit – The $1,500 credit for making improvements that increase the energy efficiency of a taxpayer's home expires after 2010.
  
• Hybrid & Lean Burn Credits – Most manufacturers have reached the 60,000 unit maximum after which the credit is reduced or no longer allowed. As a result, this credit will have very limited application in 2011.
  
• Health Savings Accounts – The penalty for a nonqualified distribution from an HSA has been increased from 10% to 20% and distribution for over-the-counter medication is no longer a qualified distribution.
  
• Making Work Pay Credit – Expires after 2010. This refundable credit of $800 for joint filers and $400 for unmarried individuals phases out for higher-income taxpayers so the loss of the credit impacts middle- to low-income taxpayers.
  
• Higher Education Interest Deduction – This deduction will phase-out for joint filing taxpayers beginning at an AGI of $60,000 (down from $120,000 in 2010). The phase-out for an unmarried taxpayer remains the same. In addition, the deduction is limited to interest paid on the first 60 months (was previously unlimited) in which interest payments are required. This will impact higher-income joint filers and taxpayers who have already exceeded the 60-month limitation.
  
• Estate Tax – The estate tax, which was eliminated for 2010, returns in 2011 with an exemption of $1 million dollars (down from $3.5 million in 2009), and a maximum tax rate of 55%, up from 45%.
  

On top of all these changes, there are the Health Care provisions that are taking effect in 2013, including the following: increasing the medical deduction floor to 10% for most individuals (up from 7.5%), adding a 3.8% unearned income surtax to high-income taxpayers, and tacking on an additional .9% to the current 1.45% hospitalization insurance (HI) portions of the FICA withholding (or the SE tax in case of self-employed individuals). The surtax and additional HI withholding apply to incomes in excess of $250,000 for married joint filers, $125,000 for married individuals filing separately and $200,000 for others.

It is anticipated that Congress will extend certain provisions and perhaps limit high-income taxpayers from benefiting from those extended provisions. We will advise you when changes are made.

If you have questions related to any of these issues or would like to set up a planning appointment, please give our office a call.

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“Flipping” Homes – A Reviving Trend in Real Estate

Prior to the recent economic downturn, flipping real estate was popular. With mortgage interest rates low and home prices at historical lows, flipping appears to be on the rise again. House flipping is, essentially, purchasing a house or property, improving it, and then selling it (presumably for a profit) in a short period of time. The key is to find a suitable fixer-upper that is priced under market for its location, fix it up, and resell it for more than it cost to buy, hold, fix up and resell it.

If you are contemplating trying your hand at flipping, keep in mind that you will have a silent partner, Uncle Sam, who will be waiting to take his share of any profits in taxes. (And most likely, Sam's cousin in your state capitol will also expect a share, too.) Taxes play a significant role in the overall transaction, and tax treatment can be quite different depending upon whether you are a dealer, an investor or a homeowner. The following is the tax treatment for each.

• Dealer in Real Estate – Gains received by a non-corporate taxpayer from business operations as a real estate dealer are taxed as ordinary income (15% to 39.6% in 2011), and in addition, individual sole proprietors are subject to self-employment tax as high as 15.3% of their net profit (the equivalent of the FICA taxes for a self-employed person). Thus, a dealer will generally pay significantly more tax on the profit than an investor. On the other hand, if the flip results in a loss, the dealer would be able to deduct the entire loss in the year of sale, which would generally reduce his tax at the same rates.
  
• Investor – Gains as an investor are subject to capital gains rates (maximum of 20% in 2011) if the property is held for more than a year (long-term). If held short-term, ordinary income rates (15% to 39.6% in 2011) will apply. However, an investor is not subject to the 15.3% self-employment tax. A downside for the investor who has a loss from the transaction is that, after combining all long- and short-term capital gains and losses for the year, his deductible loss is limited to $3,000, with carryover to the next year of any excess capital loss. The rules get a bit more complicated if the investor rents out the property while trying to sell it, and are beyond the scope of this article.
  
• Homeowner – If the individual occupies the property as his primary residence while it is being fixed up, he would be treated as an investor with three major differences: (1) if he owns and occupies the property for two years and has not used a homeowner gain exclusion in the two years prior to closing the sale, he can exclude gain of up to $250,000 ($500,000 for a married couple), (2) if the transaction results in a loss, he will not be able to deduct the loss or even use it to offset gains from other sales, and (3) some fix-up costs may be deemed to be repairs rather than improvements, and repairs on one's primary residence are not deductible nor includible as part of the cost basis of the home.

Being a homeowner is easily identifiable, but distinguishing between a dealer and an investor is not clearly defined by the tax code. A real estate dealer is a person who buys and sells real property with a view to the trading profits to be derived and whose operations are so extensive as to constitute a separate business.

A person acquiring property strictly for investment, though disposing of investment assets at intermittent intervals, is generally not regularly engaged in dealing in real estate.

This issue has been debated in the tax courts frequently, and both the IRS and the courts have taken the following into consideration:

• whether the individual is already a dealer in real estate, such as a real estate sales person or broker;
  
• the number and frequency of sales (flips);
  
• whether the individual is more committed to another profession as opposed to fixing and selling real estate; and
  
• how much personal time is spent making improvements to the "flips" as opposed to another profession or employment.

The distinction between a dealer and an investor is truly based on the facts and circumstances of each case. Clearly, an individual who is not already in the real estate profession and flips one house is not a dealer. But one who flips five or more houses and/or property and has substantial profits would probably be considered a dealer. Everything in between becomes various shades of grey and the facts and circumstances of each case must be considered.

If you have additional questions or need assistance with your specific situation, please give our office a call.

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Worker Misclassification Under Congressional Scrutiny

A Congressional research report titled "Tax Gap: Misclassification of Employees as Independent Contractors," focused on the tax gap created by misclassifying workers as independent contractors rather than employees and the problems associated with enforcing proper classifications.

Businesses must withhold tax and pay Social Security, Medicare and unemployment tax on wages paid to employees. On the other hand, they don't withhold or pay taxes on payments to independent contractors. An IRS study found that workers misclassified as independent contractors for whom employers did not report compensation on Form 1099-MISC reported only 29% of their compensation on their tax returns and, as a result, created a significant tax gap. The IRS study also found that 15% of employers misclassified 3.4 million workers as independent contractors, causing an estimated total tax loss of $2.7 billion, in inflation-adjusted 2006 dollars.

Congress is making an effort to reduce misclassification through yet to be passed legislation:

Taxpayer Responsibility, Accountability and Consistency Act - would repeal Section 530 and replace it with new rules that would make it more difficult for employers to avoid employment tax liability if they misclassified a worker as an independent contractor. The new rules would generally require employers to have a "reasonable basis" for classifying a worker as an independent contractor.

Misclassification Prevention Act - which was introduced this spring as H.R. 5107 and S. 3254, would take a different approach to reducing misclassification. It would amend the Fair Labor Standards Act of 1938 (FLSA) to require every person to (1) keep records of non-employees (contractors) who perform labor or services (except substitute work), including through an entity such as a trust, estate, partnership, association, company, or corporation, for remuneration; and (2) provide certain notice to each new employee and new non-employee, including their classification as an employee or non-employee and information concerning their legal rights.

The report concludes that improved classification would not only cut the federal tax gap but also reduce state and local tax gaps; possibly reduce the cost of publicly-provided assistance programs such as Medicaid (on the theory that independent contractors aren't provided with employee benefits and are more likely to rely on government programs); and provide reclassified workers with fringe benefits and protections under federal law.

Watch for further developments.

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Thinking of Making Home Improvements?

There is currently a 30% tax credit (maximum $1,500 for the combined 2009 and 2010 tax years) for certain home energy-saving improvements. That credit expires at the end of 2010. Examples of qualifying improvements include high-efficiency heating and AC systems, energy-efficient windows and skylights, energy-efficient doors, qualifying insulation and certain roofs also qualify for the credit. Call our office for details.

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Maximizing Medical Deductions Before 2013

Medical expenses are deductible if you itemize your deductions. However, there is a limit on how much of those medical expenses can be deducted based upon your income for the year. Currently, only medical costs that exceed 7.5% (10% if you are subject to the alternative minimum tax) of your adjusted gross income (AGI) can be deducted.

For example, you have wages of $50,000, interest income of $1,000, and no adjustments to your income. Your AGI is $51,000 and 7.5% of the AGI is $3,825. In this case, you would only be able to deduct your medical expenses that exceed $3,825. Thus, if your deductible medical expenses for the year were $5,000, you can only deduct $1,175.

This all changes in 2013 when, as part of the new health care provisions, the 7.5% floor is increased to 10%! So if you have been putting off discretionary medical procedures such as braces for the children, eye surgery, new dentures, or a knee replacement, you might consider having the work done and paying for it before 2013 so you can take advantage of the lower AGI threshold. Costs of cosmetic surgery (other than that necessitated by an accident or illness) aren't deductible, so don't schedule that facelift or teeth whitening as part of this strategy.

Another technique to employ is to bunch your medical expenses into one year so that you can overcome the medical threshold. So, instead of paying the orthodontist over a period of years, pay him all in one year.

Let's say your AGI is $75,000 and you are planning to pay the orthodontist $3,000 a year for a three-year period. You typically have other medical expenses each year of $2,000. 7.5% of $75,000 results in a medical expense deduction floor of $5,625.

Thus, if you pay the orthodontist in installments, your total medical expense for a year would be $5,000 ($3,000 + $2,000) and you would not be able to deduct any medical because the $5,625 medical floor exceeds the $5,000 expense. However, if you paid the entire orthodontist bill in one year, your medical expenses would be $11,000 ($9,000 + $2,000) and you would have a $5,375 medical deduction.

If you are short of cash to pay the entire medical bill at one time, it may be appropriate to borrow the money to pay the medical expense. However, you need to factor in the cost of borrowing the money when deciding if it makes sense to borrow.

Even if you are affected by the AMT, the bunching strategy may be able to get you over the 10% floor.

If you are a senior, age 65 (before close of year) or older, you will be able to use the 7.5% rate though 2016.

If this office can be of assistance with planning a medical strategy or answer any questions related to the deductibility of a medical expense, please call.

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2010 is the Last Year for the Lean Vehicle Credit

2010 is the final year during which taxpayers can purchase an advanced lean burn technology vehicle and claim a tax credit for the purchase. Unlike the hybrid credit, the lean burn credit is available to vehicles with internal combustion engines that are designed to operate primarily using more air than is necessary for complete combustion of the fuel, incorporate direct injection, and achieve at least 125% of the 2002 model year city fuel economy rating. The table below lists the vehicles currently certified by the IRS as qualifying for the advanced lean burn credit.

If a vehicle is used both for business and personal use, the credits are divided between personal and business use and can be used to offset both the regular and alternative minimum tax. The personal portion is a non-refundable credit, and can only reduce your current year tax to zero; any excess is lost. The business portion becomes part of the general business credit, and unused credits are carried back one year and forward twenty years.

The credit will be phased out starting in the quarter following the one in which the manufacturer records its 60,000th sale of hybrid and lean burn vehicles. Volkswagen Group America (includes Audi vehicles) has already reached that limit; thus, the allowable credits (as shown in the table below) are reduced by 50% for Audi and Volkswagen vehicles purchased for the balance of 2010.

2010 VEHICLES CURRENTLY CERTIFIED FOR THE LEAN BURN CREDIT
Mfg	Vehicle Description	Credit
Volkswagen	Jetta – 2.0L TDI (manual and automatic)	$	1,300
	Sportwagen – 2.0L TDI (manual and automatic)	$	1,300
	Touareg – 3.0L TDI	$	1,150
	Golf 2.0L TDI (automatic)	$	1,700
	Golf 2.0L TDI (manual)	$	1,300
	Audi A3 2.0L TDI Automatic	$	1,300
	Audi Q7 3.0L TDI	$	1,150
Mercedes-Benz	GL350 Bluetec	$	1,800
	R350 Bluetec	$	1,550
	ML350 Bluetec	$	900
BMW	335d Sedan	$	900
	X5 xDrive35d	$	1,800
	ActiveHybrid x6	$	1,550

If you are contemplating purchasing a vehicle that qualifies for the advanced lean burn technology tax credit or one that qualifies for the hybrid tax credit, it may be appropriate for you to call our office in advance to see how the credits will or won't benefit you. This is especially true if you are basing your purchase decision on receiving the credit. Keep in mind that the personal portion of the credit is not refundable and cannot be carried over to another year. Therefore, you may not benefit as much from the credit as the car salesperson might lead you to believe.

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Having a Bad Year? You May Qualify for the Earned Income Credit.

Many individuals find themselves earning less during these troubled economic times than in years past. As a result, they may qualify for a credit that they previously were not entitled to because of income limitations.

The Earned Income Tax Credit (EITC) is for people who work, but have lower incomes. If you qualify, it could be worth up to $5,666 for 2010. So, you could pay less federal tax or even be eligible for a refund. The credit is a refundable credit, meaning you can receive the benefits of the credit even if you may not owe any taxes. That's money you can use to make a difference in your life and help to carry you through hard times.

The EITC is based on the amount of your earned income and whether or not there are qualifying children in your household. If you have children, they must meet the relationship, age, and residency requirements. While taxpayers without children may qualify for the EITC, the potential amount of the credit is significantly more for eligible taxpayers who have one or more qualifying children. These taxpayers are also allowed to earn over 2½ times more income before the credit is phased out than workers without qualifying children.

If you were employed for at least part of 2010, you may be eligible for the EITC based on the general requirements included in this article.

The credit calculation is rather complicated and takes into account a taxpayer's income from working, his or her total income (AGI), number of children, and tax filing status. The best way to describe how this credit works is that it is zero if a taxpayer has no income from working (the credit is devised as an incentive for individuals to work) and increases as the income from working increases until the credit reaches the maximum allowed, at which point it becomes smaller as the income grows. The table below shows (1) maximum credit and corresponding earned income and (2) the income at which the credit totally phases out.

In addition, to qualify, a taxpayer must meet a few basic rules:

• The credit isn't available to individuals when their "disqualified income" (i.e., investment income such as interest and dividends) is more than $3,100.
• The taxpayer claiming the credit and any qualifying children must have a valid Social Security number.
• Have earned income from employment or from self-employment.
• Filing status cannot be married filing separately.
• The taxpayer must be a U.S. citizen or resident alien all year, or a nonresident alien married to a U.S. citizen or resident alien, and filing a joint return.
• The taxpayer cannot be a qualifying child of another person.
• A taxpayer without a qualifying child must:
  o Be age 25, but under 65 at the end of the year,
  o Live in the United States for more than half the year, and
  o Not be a qualifying child of another person.
• The taxpayer cannot file Form 2555 or 2555-EZ (related to foreign earned income).
• Members of the military can elect to include their nontaxable combat pay in earned income for the EITC. If the election to do so is made, all nontaxable combat pay received must be included in earned income for purposes of figuring the EITC.
  

The rules related to the EITC are rather complicated, so, if you have any questions related to how the credit might apply to you, please give this office a call.

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