The Law Firm of Bucknam & Black PC

Payroll Taxes and Health Care Surtaxes

By John H.W. Cole, Esq.

In my previous tax planning article I discussed how graduated tax rates worked and how to save on income taxes by deferring taxable income to later years. The saving results from the fact that (1) a portion of income isn’t taxed at all, due to exemptions and deductions, and (2) income is taxed in segments, at graduated rates. Even the wealthiest individual only pays 10% on his first $16,750 of taxable income. This article discusses payroll taxes and the new income surtaxes that will apply in 2013.

Once upon a time only a small portion of wages and self employment earning were subject to payroll taxes. In the last forty years payroll taxes have increased more than income taxes, by increasing the portion of earnings to which they apply. OASDI (Social Security) payroll taxes are 12.4% (employer and employee share combined) of compensation up to $106,800 (the 2011 taxable wage base), and an HI (health insurance) tax of 2.9% (combined) applies to all compensation. The taxable wage base is indexed for inflation, and increases almost every year. For 2011 only, a 2% tax holiday for employees was enacted as an economic stimulus.

Payroll taxes are imposed on gross wages or self employment income, unreduced by adjustments to gross income, exemptions or deductions. Income taxes, on the other hand, are imposed upon taxable income, after adjustments to gross income, exemptions, and deductions (standard or itemized). For example, if a married taxpayer has a salary of $26,000, $14,600 of personal exemptions, and the standard deduction of $11,400, he will pay no income taxes. However, he and his business will pay a combined $3,978 in payroll taxes.

If in the same example his income is increased to $94,400, his income taxes will be $9,363. His payroll taxes will be an astonishing $14,443. His greatest tax liability does not come from income taxes; it’s from payroll taxes. Payroll taxes can’t be totally avoided, but they certainly can be reduced.

The most obvious way to avoid unnecessary payroll taxes is to avoid having to pay payroll taxes on employee benefits. Take health insurance, for example. My annual premium is $12,000. If the $12,000 is paid by my corporation it’s a tax free benefit to me, deducted by my corporation on its tax return. The same payment if I was a self employed individual would be subject to payroll taxes, and would be deducted on my Form 1040 as an adjustment to gross income. If my self employment income were below the taxable wage base, my health insurance would cost me $1,836 in unnecessary payroll taxes.

The same result occurs with retirement plan funding. If $20,000 is funded into a profit sharing plan for me by my corporation, there are no payroll taxes on this plan funding and the corporation deducts the $20,000. If I were self employed the $20,000 of plan funding would be considered self employment income subject to payroll taxes. It could not be deducted as a business expense but would be deducted, instead, on my Form 1040. If my self employment income were below the wage base, the payroll tax on my $20,000 of plan funding would be $3,060. Between health insurance and plan funding that’s $4,896 down the drain.

I have $100,000 invested in my business between furniture, fixtures, and equipment. I am certainly entitled to at least a 10% ($10,000) return on my investment. If my business is incorporated as an S corporation I am entitled to receive that return as pass through income – not subject to payroll taxes. If I were self employed and my income was under the taxable wage base, that’s another $1,530 down the drain, for a total of $6,526 of unnecessary taxes.

The pain is not limited to those with self employment income under the taxable wage base. Assume that I am self employed, that my earnings are well in excess of the taxable wage base and that I am funding my plan to the maximum ($49,000). The sum of my plan funding, health insurance and return on investment is $71,000. The HI tax on this amount is $2,059 (2.9% x $71,000).

Taxpayers have a civic duty to pay their taxes, but certainly not to overpay them because Congress taxes different business structures differently. The additional accounting costs of doing business as an S corporation, instead of as a sole proprietor, LLC, or partnership are very small. Just ask your accountant. Instead of a complex, personal return you report the same information on a corporate return and have a simple personal return (and a lower tax profile). Your accounting fees will increase by less than $1,000 while your tax savings will be much greater. If you are doing business with others as a partnership or an LLC there is no increased reporting expense for changing to an S corporation because you are already filing a separate return. The bottom line is that most small businesses could avoid paying unnecessary payroll taxes by doing business as an S corporation.

But Wait, There’s More

Additional ways of avoiding payroll taxes involve how you structure the ownership of your office building, who owns office equipment, and who pays for leasehold improvements. The most advantageous structure will vary from state to state, but the goal is to make certain that the return on your investment in your business is not subject to payroll taxes.

The .9% Medicare Surtax

The Patient Protection and Affordable Care Act of 2010 (PPACA) added a .9% Medicare tax on wages and self-employment income in excess of $200,000 ($250,000 if married). This new tax is effective in 2013 and is imposed on the employee only (no employer share). Assume that my self employment earnings are well in excess of the $250,000 and that I am funding my profit sharing plan to the maximum ($49,000). The sum of my plan funding, health insurance and my $10,000 return on investment is $71,000. The HI and Medicare Surtax on this amount will be $2,698 (.038% x $71,000) down the drain.

The 3.8% Medicare Tax on Unearned Income

PPACA also added a Medicare tax on the lesser of net investment income or the excess of adjusted gross income over the threshold amount, effective for 2013. The threshold amount is $250,000 for a married taxpayer and $200,000 for a single taxpayer. Basically, it means that if your adjusted gross income is over $250,000, you are going to pay an additional tax on your investment income.

There are two exceptions to what is considered unearned income. (1) income from a qualified retirement plan is not unearned income; and (2) pass through earnings from S corporations in an active trade or business are not unearned income. There are three ways to avoid this tax. (1) Fund your retirement plan to the maximum so that your earnings on investments will not be subject to the surtax (when withdrawn); (2) shift income to family members; and (3) when investing in an active business make certain that it is operated through an S corporation.

Did Anyone Say C Corp?

Although I have focused above on the difference between conducting business in an unincorporated structure versus conducting business as an S Corporation, I personally do business as a C corporation. The reason for this is that I have $10,000 of medical expenses (including dental, eye care, and items not covered by insurance) which are paid for by my corporation’s medical reimbursement plan. This saves me $1,530 in payroll taxes, $2,500 in federal income taxes, and $900 in Vermont State Income Tax, for a total tax savings of $4,930. It also allows me to lower the premium on my high deductible health insurance policy by more than my out-of-pocket cost for items otherwise covered. In my situation it’s a no brainer.

Conclusion

Businessmen can avoid paying unnecessary payroll taxes, and in 2013 avoid paying unnecessary Medicare surtaxes, by tailoring the structure of their business and investments to their specific situation, and by maximizing their retirement plan funding. The time to look at their structure is as soon in a calendar year as possible, and whenever contemplating a significant capital expenditure related to their business or investments.

For further information, comments, or questions, contact me at jcole@erisajd.com

In My Next Article: The Magic of Tax Free Compounding








Tax Planning For Graduated Rates

Tax Planning for Graduated Rates

By John H.W. Cole, Esq.

This article and several that will follow explore the elements of tax planning.  Because a tax plan can be overwhelming when it is all put together my memos will develop the components one at a time.  The first component is taking advantage of graduated tax rates.

Federal Income Taxes are imposed upon Taxable IncomeTaxable Income is Gross Income less allowable deductions and exemptions.  Gross Income is your income from all sources, most commonly wages and investment income.

Example:  Ken and Barbie had a combined Gross Income of $212,700 in 2010.  They had two dependent children which translates into $14,600 of personal exemptions.  They file a joint return, and claim the standard deduction of $11,400.

Their Taxable Income for 2010 was $186,700 ($212,700 of Gross Income reduced by the standard deduction of $11,400 and personal exemptions of $14,600).

For 2010, the tax rates were as follows for married taxpayers filing jointly.

Taxable Income

  •                                                                                                                            of the
  •     But Not                                                      Base                   % on              amount
  •      Over                        Over                          Tax                Excess                over—
  • $         0                    $   16,750                           $0                     10%                    $0
  •   16,750                         68,000                 1,675.00                     15%             16,750
  •   68,000                       137,300                 9,362.50                      25%            68,000
  • 137,300                       209,250               26,687.50                      28%          137,300
  • 209,250                       373,650               46,833.50                      33%          209,250

Ken and Barbie’s 2010 taxes were determined as follows:

  •                             Income                 Tax                        Rate                                                            
  • On their first   $   26,400                      0                           0% (offset by exemptions & deductions)
  • On their next       16,750                1,675                         10%
  • On their next       51,250                7,688                         15%
  • On their next       69,300              17,325                         25%
  • On their next       49,000              13,720                         28%
  • Totals:           $  212,700           $ 40,408

Suppose that Ken had set up a qualified plan and deferred $49,000 into it.  Ken and Barbie’s federal taxes would now be determined as follows:

  •                            Income                  Tax                         Rate                                                          
  • On their first   $  26,400                       0                           0% (offset by exemptions & deductions)
  • On their next      16,750                1,675                         10%
  • On their next      51,250                7,688                         15%
  • On their next      69,300              17,325                         25%
  • Totals:           $ 163,700           $ 26,688

By deferring $49,000 into a qualified plan, Ken and Barbie would avoid paying $13,720 in federal income taxes.   If they lived in a state with a state income tax, like Vermont (9%), they could save another $4,410 in state income taxes.  By avoiding paying payroll taxes on the $49,000 they would save another $1,421.  Their total tax savings would be a combined $19,551.

Flash forward to 2011 when Ken and Barbie retire.  Assume the same exemptions and the use of the standard deduction.  They withdraw the $49,000 from the plan.  Their taxes are determined as follows:

  •                                           Income                           Tax                Rate                                                           
  • On their first              $       26,400                               0                   0% (offset by exemptions & deductions)
  • On their next                      16,750                        1,675                 10%
  • On the remaining                5,850                            878                 15%
  • Total                          $      49,000                     $  2,553

The $49,000 of retirement plan income would not be subject to payroll taxes.  In Vermont it would not be subject to state income taxes because it is below the state income tax threshold. Accordingly the tax savings from delaying a year would be $16,998.  In Virginia, which imposes a state income tax on this amount of income, the tax savings would be slightly less, at $15,698.

Of course, Ken and Barbie may have other sources of income when they retire. However, the above example assumed retirement the following year, so a similar amount of outside income would have been present in both 2010 and 2011.  An additional $40,000 of investment income would change their top bracket to 33% in 2010, while in 2011 an additional $40,000 would still be taxed at only 15%.

Furthermore, the example does not take into account the fact that tax brackets are indexed and that any increase in tax rates would only take place at very high income levels.  In 1993 the 28% bracket for joint filers was $36,900 of taxable income.  Today the 28% bracket starts at $137,650 of taxable income.

Let’s go back to the beginning and assume that Ken and Barbie did not defer the $49,000.  Instead they paid their payroll taxes, and state and federal income taxes, and invested the money for 20 years, and enjoyed a 6% return.  At the end of 10 years they would have accumulated $66,496, after taxes.

Sheltered in a qualified plan, the same $49,000 would have become $112,596, almost double.

Assume they took the entire $112,596 out at once, as their only income for the year, and that brackets never went up (although in fact they do).  Their taxes would be determined as follows:

  •                            Income                             Tax                         Rate                                                           
  • On their first   $   26,400                                 0                           0% (offset by exemptions & deductions)
  • On their next       16,750                          1,675                         10%
  • On their next       51,250                          7,688                         15%
  • On their next       18,196                          4,549                         25%
  • Totals:            $ 112,596                     $ 13,912

They would have $98,685 in after tax dollars to live on for the year, compared with $66,496 from investing on the outside.

The first lesson of this example is that some of your income isn’t taxed at all.  Secondly, that which is subject to tax is taxed progressively starting with low tax rates.  Third, significant taxes can be saved by shifting income from high tax rate years to lower tax rate years.  The tax planning objective is to move income out of the 25%-33% federal bracket and 9% state bracket into the 15% federal bracket and 0-4% state income tax bracket.

The final lesson is that because of reduced income, rising brackets, or both, the low tax bracket years for most of us lie further down the road, when we retire, or at least slow down.  The way to retire with the greatest amount of income is to take advantage of tax deferral vehicles, such as IRAs, SEPS, and qualified retirement plans.

For further information, comments, or questions, contact me at jcole@erisajd.com

In my next Article:  Payroll taxes and the new Medicare Surtaxes








Tax Time: a word of caution for divorced parents and family lawyers

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Its tax time again, and divorced parents and family law practitioners should be aware of the IRS rule that went into effect in 2009.  Prior to that, a non-custodial parent could claim exemptions for their children if it was part of a divorce decree or child support order.  The parent need only file a copy of the order with his or her tax return.  For any decree filed after 2009, the IRS requires  Form 8332  to be filed with the return.  Form 8332 provides for the custodial parent to sign a release for his or her claim of exemption.  There is a provision on the form for exemptions in future years;  but there is also a provision to revoke release of  the exemption.  Therefore, a post 2008 court order providing that a non-custodial parent can claim the exemption is not effective for a non-custodial parent to claim the exemption.  A non-custodial parent will have to rely on the custodial parent’s good faith to continue to release the exemption.  In the past, an agreement for the non-custodial parent to claim the tax exemption was often part of negotiations concerning child support.  Now it  may be difficult to use that as a bargaining tool, because of the custodial parent’s ability to revoke his or her release of claim for exemption by simply filing an 8332 form.








Tax Issues for divorcing and separating couples, by Bob Brazil

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One of the most frequent questions we get this time of year from clients in the middle of a divorce is “what do I do about my taxes?” For couples without children the answer may be as simple as working out a filing status. For couples with children, the answer can be more complicated. Custody and child support orders/agreements may have an impact on the each parent’s tax circumstances. Specific individual circumstances should be reviewed by an accountant or tax attorney, but some general information can help take the guess work out of what is usually already a stressful situation.

Filing Status

Your filing status depends in large part on your marital status on the last day of the tax year. Basically the two options are “married” or “unmarried.” It seems like common sense, but how the question of marital status is answered will play a role in determining what exemptions and credits you may be eligible for. IRS rules determine which category you fit into.

“Married persons” have the option of filing either as “married, filing jointly” or “married, filing separately.” For federal tax purposes, “marriage” means only a legal union between a man and woman as husband and wife. If on the last day of the tax year you are married, then you qualify as “married persons.” Generally, if you are separated on the last day of the tax year but have not obtained a final divorce or separation decree, the IRS considers you to be still married.

Typically a couple filing “married filing jointly” receives a higher level of exemptions, deductions and credits. It may be worthwhile, however, for each spouse to calculate their tax obligation individually as well as jointly before deciding which status to choose. To file jointly at least one spouse must be a U.S. citizen or resident alien on the last day of the tax year. A joint return can be filed even if only one spouse had income during the year. To be a valid “joint return” both spouses must sign the return. While the potential increase in exemptions, deductions and credits may make filing jointly attractive, it is important to keep in mind that both you and your spouse may be held “jointly and individually” responsible for any tax, interest and/or penalty that is owed. This means that you could be responsible for all of the tax obligation, even if all income was earned by your spouse. There are exceptions to “joint liability” but you must meet certain requirements before the IRS will relieve you of your obligation. It is also important to keep in mind that any overpayment shown on your joint return could be applied to your spouse’s past-due tax debt. Again, there are exceptions to this rule but you must meet certain requirements before the IRS will exempt you from liability.

For some couples in the midst of separation or divorce, the risks associated with filing jointly may outweigh the potential for a higher tax usually occurring when filing as “married filing separately.” No joint liability is present, and each party is responsible for only for the accuracy and resulting obligation of their respective filing. Typically, however, filing separately will result in a higher combined federal tax than if you file jointly. Unless you can establish “head of household status, filing separately also keeps you from claiming certain credits and deductions, including credit for child and dependent care expenses (in most cases) and the earned income credit. As mentioned

earlier, it is important that you speak with an accountant or tax attorney before deciding which filing status you, as a divorcing or separated spouse, should use.

“Head of Household”

Filing as head of household as advantages, particularly if you are filing as “married filing separately.” You can claim many of the credits and deductions not typically allowed when filing separately. “Head of household” status has three requirements: 1) you are unmarried or “considered unmarried” on the last day of the tax year; 2) you paid for more than half the cost of keeping up a home for the year; and 3) a qualifying person lived with you in the home for more than a year.

Status as “considered unmarried” requires that your spouse did not live in the home during the last six months of the tax year and that your home was the main home your child, stepchild or foster child for lived in for more than half the year. You must also be able to claim an exemption for the child. (It is possible, in some circumstances, to claim the child as an exemption if when the noncustodial parent is claiming the same exemption. The IRS will apply the “tie breaker” rule when both parents claim the same child.)

Paying for more than half the costs of keeping up the home for the year applies only to costs related to the home: rent, mortgage interest, real estate taxes, insurance, repairs, utilities and, interestingly, food eaten at home. Costs related to clothing, education, medical treatment, life insurance and transportation are not in included in the calculation.

You and your child (“qualifying person”) can be considered to live together even if one or both of you are temporarily absent from the home because of illness, education, business, or military service. The assumption is that in such circumstances you or your child will return home after the temporary absence. You must, however, keep up the home during the absence in order to qualify as head of household.

Exemptions for Dependents

The term “dependent” means other a “qualifying” child or relative, but for purposes of this article the focus is on claiming a child as a dependent. One exemption is allowed for each child you can claim as a dependent. IRS rules about claiming a child as dependent when the parents are divorcing are fairly detailed. New rules were put into place in 2009. The rules for divorced or separated parents also apply to parents who were never married.

To be a “qualifying child” the child must be your son, daughter, stepchild, foster child. The child must be under age 19 at the end of the year, under the age of 24 and a full time student, or any age if permanently and totally disabled. The child must live with you for more than half the year, and the child must not have provided more than half of his/her own support for the year.

Even if the child meets the test for “qualifying” as dependent, you must still be the parent entitled to claim the child for exemption as a dependent. Typically, the residency requirement (living with the parent more than half the year) means the “custodial” parent

has the right to claim the exemption. Under certain circumstances, however, the noncustodial parent can claim the qualifying child as a “dependent.” For a noncustodial parent to claim the exemption, the parents must be legally divorced or legally separated, separated under a written separation agreement or have lived apart at all times during the last 6 months of the year. The child must receive over half of his/her support from the parents and be in the custody of one or both parents for more than half the year. Lastly, the custodial parent must sign a written declaration (“Form 8332”) that he/she will not claim the child as a dependent for the year. The noncustodial parent must attach the declaration to his/her own return. Only when these requirements are met ca a noncustodial parent claim the qualifying child as a dependent.

If you are the custodial parent who is considering allowing the other to claim the qualifying child, keep in mind that whoever gets to claim the child will take all benefits (assuming eligibility is met for each) based on the qualifying child, including the child exemption, child tax credit, head of household filing status, the credit for child and dependent care expenses, the exclusion from income for dependent care benefits and the earned income credit. These benefits cannot be split up, with one parent taking some and the other taking the remainder-it’s an all or nothing proposition. It cannot be said enough- speak with an accountant or tax attorney before making any agreement.

It happens sometimes that divorcing or separated parents will both claim the qualifying child as a dependent. In that case the “tie breaking” rule applies. Where only one of the couple is the parent of the child, the parent wins. In cases of two parents not filing a joint return, the parent with whom the child lived for the longer period during the tax year will have the right to claim the child. Where the parents file separately and the child lives with both parents equally during the year, the parent with the higher adjusted gross income will have the right to claim the child.

Conclusion

The information provided here is intended only as a general overview. The consequences of not understanding your options can have serious consequences- both in terms of penalties and in lost benefits. Plenty of information is available from the IRS, but federal tax rules can be complicated, particularly when you are in the midst of a divorce or separation. Application of any one particular rule will often depend on individual circumstances, and qualifying for a particular benefit will often require satisfying multiple requirements. Consult with a qualified accountant or tax attorney before making any decisions. For more information regarding tax issues for divorced or separated couples, click here.








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