Zaher Fallahi, Tax Attorney, CPA; 2016 Year-End Tax Planning
Welcome you to the Website of Zaher Fallahi, Tax Attorney, CPA. The tax materials contained herein below are for general informational purposes only, and are not to be considered as tax or legal advice. These are selective items only and do not include all important 2016 tax law. For specific advice suitable to your particular situation, consult appropriate advice from tax advisors.
Most small businesses utilize cash basis of accounting for their taxes, may defer their 2016 billing and collection efforts to 2017, if they believe to have less income or predict the tax rates will be lower next year, and their conduct doesn’t violate any laws. Conversely, if they believe they will have more income next year or they will be in higher tax bracket next year, they may accelerate their billing and increase their current year income.
Tax Tip: If you believe the incoming Trump Administration will cut the tax rates, you may defer your income to 2017. For employees and executives, this means deferring 2016 bonuses to 2017.
Taxpayers who believe they will be in a higher tax bracket next year, they may defer current deductions into 2017. Conversely, they may accelerate their business deductions, medical expenses, 4th quarter State estimated taxes, property taxes, etc., after consulting their advisor to avoid any AMT trap, and their conduct is not illegal.
Tax Tip: If you believe the incoming Trump Administration will cut the tax rates, you may accelerate 2016 expenses.
0.9% Medicare Tax Hospital Insurance Tax
The employee’s share of the Federal Insurance Contributions Act (FICA) withholding from wages has increased from 1.45% to 2.35% on wages in excess of $250,000 for joint filers and $200,000 for married taxpayers filing separately. The extra tax is imposed on the combined salaries of the spouses for joint filers, including the self-employed individuals as well. No matching by employer.
Tax Tip: It may be tax-advantageous to accelerate other income such as year-end bonuses if you will have more income in 2017, or delay it if you will have less income in 2017. Any tax-advantageous reclassification of income must be analyzed thoroughly to ensure its legality.
Net Investment Income Tax (NIIT)
Starting in 2013 a 3.8% Medicare tax is imposed on certain net investment income (NII) of individuals, estates, and trusts by the 26 USC § 1411 on the lesser of:
1- Taxpayer’s net investment income is the investment income reduced by applicable associated cost; interest, dividends, rents, annuities, royalties, and net capital gains from disposition of property not used in a trade or business, or
2- Modified Adjusted Gross Income (MAGI; adjusted for foreign earnings) that exceeds the threshold of $250,000 for married filing joint taxpayers or $200,000 for single taxpayers.
In general, investment income includes, but is not limited to: interest, dividends, capital gains, rental and royalty income, non-qualified annuities, income from businesses involved in trading of financial instruments or commodities, and businesses that are passive activities to the taxpayer. The NII is reduced by certain expenses properly allocable to the income.
Kinds of gains are included in Net Investment Income
To the extent that gains are not otherwise offset by capital losses, the following gains are common examples of items taken into account in computing the NII:
a) Gains from the sale of stocks, bonds, and mutual funds.b) Capital gain distributions from mutual funds.c) Gains from the sale of investment real estate, including gain from the sale of a second home.
d) Gains from the sale of interests in partnerships and S corporations to the extent you were a passive owner.
What are some common types of income that are not NII?
Wages, unemployment compensation, operating income from a non-passive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, gain on the sale of a personal residence, and distributions from certain Qualified Plans.
Tax Tips: Eliminating or minimizing the 3.8% tax may be done by deferring the NII or reducing the MAGI, or both. Disposition of commercial rental properties with prior suspended losses may release those losses and reduce your tax burden. This is an unchartered territory and requires sophisticated professional advice.
Capital Gains Tax
Capital Gains and Dividends tax rates increased from 15% to 20% for taxpayers with taxable income in excess of the thresholds mentioned above ($400,000 for single filing status, etc). Net capital gains from selling collectibles such as coins or art are taxed at a maximum 28% rate. The rate will remain 15% for the middle class and the taxpayers in the 10% and 15% bracket still pay zero taxes on their Capital Gains.
Wash sale rule
Under the “wash sale” rule that applies to the disposition of an asset when a loss is
recognized, the IRS doesn’t permit taxpayers deduct the loss if they repurchase the same or identical investment during the 30-day period before or after the sale date.
Tax Tip: Consider selling worthless stocks or losing stocks and repurchasing them 31 days later to avoid wash sale, if advisable. See the §§ 1202 and 1244 stocks explained below.
Section 1202, Qualified Small Business Stock (QSBS)
Under 26 US §1202, taxpayer excludes 75% of the gain recognized from the sale or exchange of QSBS that is held more than five years on a qualified stock acquired on or before September 27, 2010 and after February 17, 2009 and 100% on qualifying stock acquired after September 27, 2010, and before Jan. 1, 2014.
Tax Tip: The stock must be issued by domestic C corporation, originally issued after August 10, 1993, with total gross assets of $50 million or less, at least 80% of the value of the corporation’s assets was used in the active conduct of qualified businesses, held by non-corporate taxpayer, held more than five years, etc. Application of this law may be complicated and need tax professional advice.
Section 1244 (small business) stock
The loss from the sale of a qualified corporation may be used against ordinary income similar to net operation loss up to $50,000 for single filers and $100,000 for married filing jointly.
Tax Tip: To qualify as section 1244, stock must be issued by a domestic corporation, issued for money or other property. The total amount of money and other property received by the corporation for its stock as a contribution to capital and paid-in surplus generally may not exceed $1 million, etc. This loss is claimed on Form 4797, not Schedule D.
Cancellation of Debt (forgiveness)
The Mortgage Debt Relief Act of 2007 generally allows taxpayers to exclude up to $2 million of forgiven debt ($1 million if married filing separately) from the discharge of debt on their principal residence through foreclosure, restructuring, or short sale, thorough December 31, 2016.
Tax Tip: If you are in such an unfortunate event, try to get the process expedited and completed before the end of December 2016 to take advantage of this law, because of future uncertainty. Canceled debt on rental and other properties may be excluded on the basis of on bankruptcy, insolvency, etc.
Itemized State & Local Taxes, Medicare and Miscellaneous Deductions
Beginning Jan. 1, 2013, you can claim deductions for medical expenses not covered by your health insurance that exceed 10 percent of your adjusted gross income. There is a temporary exemption from Jan. 1, 2013 to Dec. 31, 2016 for individuals age 65 and older and their spouses. If you or your spouses are 65 years or older or turned 65 during the tax year, you are allowed to deduct unreimbursed medical care expenses that exceed 7.5% of your adjusted gross income. The threshold remains at 7.5% of AGI for those taxpayers until Dec. 31, 2016.
Tax Tip: If tax advantageous, the amount of medical expense, state & local taxes and miscellaneous deductions, you may expedite or defer them to 2017. Do not fall into the Alternative Minimum Tax (AMT) trap, because some of these are AMT preference and adjustment items. Note: The incoming Trump administration has avowed to repeal AMT
Individual Retirement Account (IRA)
Traditional tax deductible IRA contribution for 2016 is $5,500, and $6,500 for taxpayers 50 years or older. Contribution for a taxpayer married to one who is covered by a retirement plan at work, is phased out between Adjusted Gross Income (AGI) of $184,000 and $194,000.
Tax Tip: Contribution must be made on or before April 18, 2017.
Roth IRA Contribution
Non-tax deductible Roth contribution is $5,500 and $6,500 for taxpayers 50 years or older, for married filing jointly with AGI less than $184,000. More than $193,000 AGI, no contribution allowed.
Roth IRA Conversion
If advantageous to your particular situation, and you are eligible, you may convert your
traditional IRA into a ROTH IRA. This may be more appropriate when the traditional IRA has declined in value and costs you less in taxes.
If you converted your traditional IRA during the year and the assets in the ROTH declined further in value, re-characterize the conversion by transferring the asset back to the traditional IRA to minimize your current taxes. You will need assistance from your tax professional in this respect to be sure.
Tax Tip: Contribution must be made on or before April 18, 2017. Distribution from Roth would be tax free.
Direct Charitable Distribution From IRAs
Taxpayers over 70 ½ years old can now make $100,000 per year direct tax-free distributions from their IRAs to their choice of qualified charitable organizations, regardless of their Adjusted Gross Income (AGI). These transfers are neither included in gross income nor deducted on Schedule A. Furthermore, these distributions are not included in gross income for the phase-out purposes of deductions, exclusions, tax credits, etc.
Tax Tip: Transfer up to $100,000 per year directly from your IRAs to your favorite charities while alive and save on taxes.
Simplified Employee Pension Plan (SEP-IRA)
IRC § § 402(h) and 415 limit the amount of contributions made to an employee’s SEP-IRA to the lesser of $53,000 or 25% of the eligible employee’s compensation.
Tax Tip: Contribution may be made until the filing of the tax returns, including extensions through October 16, 2017.
The 2016 maximum employee contribution is $18,000.
Tax Tip: Maximize your contribution and benefit from most employers’ matching policy.
Foreign Account Tax compliance Act (FATCA), IRS Form 8938
Under the requirements of Sections 1471 through 1474 of the IRC, commonly known as Foreign Account Tax compliance Act (FATCA), certain U.S. taxpayers holding specified foreign financial assets with an aggregate value exceeding $50,000 must report information about those assets on new Form 8938, which must be attached to the taxpayer’s annual income tax return.
Tax Tip: Include earnings from FATCA accounts in your 2016 estimated taxes to avoid potential penalties. If you have never reported these accounts to the US Treasury, consult a tax attorney with expertise in handling international and foreign bank accounts such as FBAR and Offshore Voluntary Disclosure Program (OVDP).
Report of Bank & Financial Accounts (FBAR), Financial Crimes Enforcement Network (FinCen Form 114) must be e-filed
If you have a financial interest in, or signature authority or other authority over a foreign financial account, including a bank account, brokerage account, mutual fund, trust, or other type of foreign financial account with aggregate value exceeding $10,000, the Bank Secrecy Act (BSA) requires you e-file the FBAR report with the US Treasury Financial Crimes Enforcement Network (FinCen) form 114 (formerly TD F 90-22.1) by no later than April 15, 2017. The new deadline is under the Surface Transportation and Veterans Health Care Choice Improvement Act of 2015 and there will be a 6-month extension available for the first time.
Tax Tip: Include earnings from FBAR accounts in your 2016 estimated taxes. If you have never reported these accounts to the US Treasury, consult a tax attorney with special skill in handling international and foreign bank accounts such as FBAR and OVDP.
Foreign Earned Income Exclusion, IRS Form 2555
If you are subject to the US taxes (U.S. citizen or a US resident alien) and live overseas, you are taxed on your worldwide income (the US and Eritrea are the only two countries with such tax law). However, if you qualify, you may exclude from income up to $101,300 under tax code Section 911(b) (2) (D) (i) for the year 2016. In addition, you can exclude or deduct certain foreign housing amounts.
Tax Tips: Only earned income qualifies for exclusion. Other income such as interest, dividends, capital gains, etc. do not qualify. Generally, you may not live more than 35 days a year in the US during the year, and must file timely tax returns to claim the exclusion. Consult a tax attorney for filing delinquent 2555.
Documentation of charitable contribution
The substantiation requirements for monetary donations of less than $250 remain fairly informal under Sec. 170(f) (17): The donor should maintain a bank record of the contribution or written communication from the donee stating the name of the donee organization, as well as the date and dollar amount of the donation. For donations of $250 or more, Sec. 170(f)(8) requires that the donor must obtain a contemporaneous written acknowledgment, stating the amount of the contribution, whether the donee provided goods or services in consideration for the donation, in whole or in part, and a good-faith estimate of the value of any goods or services the organization provided. If goods or services received consist solely of intangible religious benefits, the contemporaneous documentation must contain a statement to that effect.
Tax Tip: Obtain supporting documents at the time of making the contribution.
Residential Energy Efficient Property Credit (Section 25D)
A credit of 30 percent of the expenditures made by a taxpayer during the taxable year for:
1) qualified solar electric systems;
2) qualified solar water heaters;
3) qualified fuel cell property;
4) qualified small wind energy property; and
5) qualified geothermal heat pumps.
The credit for expenditures made for qualified fuel cell property is limited to $500 for each 1/2 (one-half) kilowatt of capacity of the property; the amounts of the other qualified expenditures eligible for the credit are not limited. Furthermore, this credit may be carried over if it exceeds the limitation imposed by section 26(a). The credit is available for property placed in service through December 31, 2016. The credit for solar electric property and solar water heating property is extended for property placed in service through December 31, 2021, as described in the statute.
Tax Tip: Obtain documents proving eligibility from the manufacturer of these items to ensure eligibility.
Alternative Minimum Tax (AMT)
The 2016 AMT exemption increases to $83,800 for married filing jointly (MFJ), $53,800 for single filers, $41,900 for married filing separately, and $24,100 for trusts.
Tax Tip: Consult a tax advisor to avoid AMT trap.
Recognition of Same-Sex Marriage
In United States v. Windsor, (2013) (Docket No. 12-307), the Supreme Court held that section 3 of the Defense of Marriage Act (DOMA) is unconstitutional because it violates the principles of equal protection of the Fourteenth Amendment to the US Constitution. It concluded that this section “undermines both the public and private significance of state-sanctioned same-sex marriages” and found that “no legitimate purpose” overcomes section 3’s “purpose and effect to disparage and to injure those whom the State, by its marriage laws, sought to protect” (Windsor, 133 S. Ct. at 2694-95). This ruling provides guidance on the effect of the Windsor decision on the Internal Revenue Service’s interpretation of the sections of the Code that refer to taxpayers’ marital status.
Tax Tip: Because of the Windsor holding, all of the tax laws discussed herein are applicable to the Same-Sex couples as well.
Litigation attorneys beware; some settlement awards may be taxable
Some plaintiffs or their lawyers may assume that settlements or awards are tax free. Not so, says Uncle Sam. Internal Revenue Code (IRC) § 61 states all income from whatever source, including lawsuit awards, derived is taxable, unless specifically excluded by another Code section. IRC § 104 is the exclusion from taxable income with respect to lawsuit settlements and awards.
The 1996 amendment added to IRC § 104(a) (2) the word “physical” to the clause “on account of “personal physical injuries or physical sickness”. Therefore, in order for damages to be excludible from income, the judgment or settlement must be derived from personal physical injuries or physical sickness. Prior to the 1996 amendment, IRC § 104(a) (2) was extensively litigated with respect to what was personal injuries.
The litigators are advised to discuss the tax consequences of their potential awards or their settlements structure with a tax attorney before the case is settled, to ensure that their clients will get a tax advantageous settlement, if qualify. A complaint may be filed on the basis of a particular cause of action, if possible. The plaintiffs need to do their own tax planning and be aware of taxability of their awards and settlements to avoid unnecessary taxes and unexpected AMT trap due to deducing their legal fees on Schedule A subject to 2% limitation. The losing parties should study possible tax deductibility of the settlement or judgment and their legal fees.
Tax Tip: If your trial attorney tells you that your settlements/awards are tax free, thank her or him for it, and ask to see the following in the documents:
i) Internal Revenue Code 104(a) (2) or other;ii) Cause of action contained in the complaint; and,
iii) Relevant sections of the settlement agreement or court decree referring to non-taxability and the amount.
Foreign Investment in Real Property Tax Act (FIRPTA)
The Foreign Investment in Real Property Tax Act (FIRPTA) requires a tax of 15% of the amount realized on the disposition of all US real property. A buyer of U.S. real property interest from a foreign investor is considered the withholding agent of the IRS and is obligated to find out if the seller is a foreign person. If the transferor is a foreign person and the transferee fails to withhold, the buyer may be held liable for the tax. The seller must report the sale of the real property interests by filing a U.S. Federal Tax Form 1040-NR or Form 1120-F. The withholding agent must remit the withholding of tax to the IRS by the 20th day of the date of the transfer.
The transferor may be eligible for a lesser withholding in the following circumstances:
The disposition of the US real property interest takes place under one of the non-recognition provisions of the Internal Revenue Code.
a) When the transferor’s maximum tax liability on the disposition is less than the amount otherwise required to be withheld.
b) The transferor or transferee wants to come under certain installment sale rules.
c) The transferor or transferee enters into an agreement with the IRS by posting a type of security (letter of credit, bond, etc.).
d) The transferor or transferee may enter into a 12- month agreement with the IRS to obtain a “blanket withholding certificate” for multiple properties.
e) A non-standard application may be submitted for unique situations that do not fit into the above categories.
Note: Acquisition of the US Real Property by Foreign Persons from countries under the US Economic Sanctions are subject to specific licensing requirements of the US Treasury Office of Foreign Assets Control (OFAC). In a addition, purchase of these properties from the foreign persons from citizens of those countries may be subject to the same laws. These countries include but are not limited to Syria, North Korea, Iran, etc.
Tax Tip: The transferee; ascertain the nationality of the transferor and withhold the required taxes. When representing a client with connection to sanctioned countries, seek advice from OFAC attorneys.
Reasonable Compensation for Shareholders who work for the Corporation
When a stockholder works for her/his own corporation, she or must be on the company payroll and paid a reasonable amount of salary for the services performed. The Government Accountability Office has reported many employment tax abuses with respect to S corporation shareholders who worked for the corporation, alleging unreasonably low compensation paid to these shareholders. The IRS has ascertained corporate income tax abuses by unreasonably excessive compensation of C corporation shareholders who worked in their corporations.
Tax Tip: Pay the working shareholder reasonable salary before January 1, 2017 and incorporate any estimated taxes into W-2 form. Alternatively, if you discover this situation after January 1, 2017, convert some of the distribution into executive management fee and show as Schedule C income to have a good-faith defense in case of an audit.
S Corporation or Limited Liability Company (LLC) losses
The amount of losses from an S corporation or an LLC you can deduct is limited to your basis (your capital adjusted for earnings, drawls, etc.) in each entity.
Tax Tip: The above-mentioned losses are temporarily suspended and not deductible.
First Year Bonus Depreciation
The bonus depreciation expense for property acquired and placed in service during 2016 has been extended through 2019. The amount of deprecation is 50 percent for cost of property placed in service during the year, in addition to regular deprecation.
Tax Tip: You may purchase any necessary business equipment before January 1, 2017 deduct 50% of the cost as deprecation expenses, plus regular depreciation based on life-expectancy of the qualifying equipment.
Section 179 Depreciation
Under IRC Section 179, now permanent and indexed for inflation, taxpayers other than an estates, or trusts, or certain non-corporate lessors, may elect to deduct as an expense up to $500,000, rather than to depreciate over life- expectancy of assets specified by the IRS, with $2,000,000 total assets limitation, and the maximum annual expense is reduced dollar-for-dollar in excess of $2,000,000. Therefore, taxpayers with assets purchase of $2,500,000 cannot use Section 179 anymore. After December 31, 2015, both the $500,000 and $2,000,000 are indexed for annual inflation; Code Sec. 179(b) (6). are
Tax Tip: You may purchase any necessary business equipment before January 1, 2017 and use up to $500,000 for the year 2016. The deduction is limited to $25,000 for California. at real property
Credit Card Charges
All charges made to your credit cards before January 1, 2017 to pay business expenses may be deducted as 2016 expenses, although the payments may be made in 2017. In addition, all checks written and dated in 2016, but cashed in 2017 regarding 2016 tax related item can be deducted as 2016 tax year expenses.
Tax Tip: You may consider taking advantage of this option in consultation with your tax adviser.
In most cases, you must pay estimated taxes for 2016 if both of the following apply.
a) You expect to owe at least $1,000 in tax for 2016, after subtracting your withholding and refundable credits.
b) You expect your withholding and refundable credits to be less than the smaller of:
90% of the tax to be shown on your 2016 tax return, or 100% of the tax shown on your 2013 tax returns;
Note. The above percentages may be different if you are a farmer, fisherman or higher income taxpayer.
Tax Tip. The purpose of making estimated tax payments is to avoid underpayment and late payment penalties and interest. The 2016 estimates taxes must take into consideration the following factors:
a) New 4.6% tax for the high earners;
b) New 0.9% Medicare tax; and,
c) New 3.8% NIIT explained above.
In addition, preparation of quarterly financial statements for business would be instrumental in calculating accurate estimated taxes.
The life-time gift exclusion is $5, 450,000. Any amount in excess of this threshold is taxed at 40%. The annual gift exclusion remains $14,000 per person per year.
Tax Tip: The annual gift, including funding an Irrevocable Life Insurance Trust (ILIT) must be paid before January 1, 2017. Do not forget the “Crummey Powers”.
Inheritance Tax/Estate Tax and Planning
The life-time estate exclusion is $5,450,000. Any amount in excess of this threshold is taxed at 40 %. The estate portability, by which the surviving spouse may use the Deceased Spouse’s Unused Exclusion amount, is now permanent and available through an election made in a timely filed estate tax return for the decedent spouse.
Tax Tip: Consult a estate planning attorney whether an A-B or QTIP trust is still suitable to you particular situation.
Foreign Gifts and Inheritances, IRS Form 3520
In you received gifts or inheritances in excess of $100,000 during 2016; make sure to report it on the form 3520 “Annual Return To Report Transactions With Foreign Trusts and Receipt of Certain Foreign Gifts” to the IRS. This is due at the same time as your personal income tax returns but is mailed to a separate address.
a) Failure to file this form timely, may subject you up to 25% to 35% (distribution from a foreign trust) penalty on the whole amount of gift or inheritance.
b) Any delinquent filing of the form 3520 should be based “reasonable cause” and in consultation with a tax counsel.
c) Actual or constructive receipt of gift cash or equivalent overseas, may subject you to FBAR filing.
Zaher Fallahi, Tax Attorney, CPA, assists taxpayers, Americans living abroad and non-resident aliens, in resolving their tax problems, including the Report of Foreign Bank and Financial Accounts (FBAR) and Offshore Voluntary Disclosure Program (OVDP). Telephones: (310) 719-1040 (Los Angeles), (714) 546-4272 (Orange County), e-mail [email protected]