Annual Inflation Adjustments for 2013: Overview

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On January 11, 2013, the IRS announced annual inflation adjustments for the tax year 2013, including the tax rate schedules, and other tax changes from the recently passed American Taxpayer Relief Act of 2012.

Changes in Tax Brackets; Adjustment to Standard Deduction and Personal Exemption

Starting tax year 2013, a new tax rate of 39.6 percent has been added for individuals whose income exceeds $400,000 ($450,000 for married taxpayers filing a joint return). The other marginal rates — 10, 15, 25, 28, 33 and 35 percent — remain the same as in prior years, though the taxable income thresholds for each of the marginal rate have changed (see this article).

For the tax year 2013, the standard deduction increased to $6,100 for individuals and $12,200 for married couples filing jointly. This is up from the 2012 numbers of $5,950 for individuals and $11,900 for married couples filing jointly.

Note that the American Taxpayer Relief Act of 2012 added a limitation for itemized deductions claimed on 2013 returns of individuals with incomes of $250,000 or more ($300,000 for married couples filing jointly).

For the tax 2013, the personal exemption rose to $3,900, up from the 2012 exemption of $3,800. However beginning in 2013, the exemption is subject to a phase-out that begins with adjusted gross incomes of $250,000 ($300,000 for married couples filing jointly). It phases out completely at $372,500 ($422,500 for married couples filing jointly.)

Alternative Minimum Tax Changes

The Alternative Minimum Tax (“AMT”) exemption amount for tax year 2013 is $51,900 ($80,800 for married couples filing jointly as set by the American Taxpayer Relief Act of 2012. The 2012 exemption amount was $50,600 ($78,750 for married couples filing jointly).

One of the most important changes introduced by the American Taxpayer Relief Act of 2012 was the permanent “fix” of the AMT by indexing future exemption amounts for inflation.

Earned Income Tax Credit

For the year 2013, the maximum Earned Income Credit amount is $6,044 for taxpayers filing jointly with 3 or more qualifying children, up from a total of $5,891 for tax year 2012.

Other Inflation Adjustments

There are a number of other inflation adjustments published by the IRS. This essay merely attempts to clarify those which are most common. More details are contained in IRS Revenue Ruling 2013-15.

Overview of the New Investment Tax

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The enactment of the Health Care and Education Reconciliation Act of 2010 (the “Act”) has profound implications for U.S. investors. The Act imposes a new tax on investment income of certain individuals, estates and trusts. The focus of this article is on the new tax on individuals and how it operates.

IRC Section 1411: Imposition of 3.8% Tax

Section 1402(a) of the Act added section 1411 to a new chapter 2A of subtitle A (Income Taxes) of the Internal Revenue Code effective for taxable years beginning after December 31, 2012. IRC Section 1411 imposes a 3.8 percent tax on the investment income of certain individuals, estates, and to some trusts.

It is important to note that the new tax is not deductible against any other income taxes.

Who is Affected by the New 3.8% Tax?

As mentioned above, the tax applies to certain individuals, annuities, estates, and to some trusts.
It is widely expected that the 3.8% tax applies only to those who are considered to be high-wage earners (at least, at the time the new tax was enacted, because the American Taxpayer Relief Act of 2012 seems to re-define who the high-wage earners are) who earn above certain thresholds and have investment income.

The tax does not apply to a nonresident alien and some other types of trusts (this is a complex subject that may be addressed in another article). If an nonresident alien is married to a U.S. citizen or resident and has made, or is planning to make, an election under IRC section 6013(g) to be treated as a resident alien for purposes of filing as Married Filing Jointly, the proposed regulations provide these couples with special rules and a corresponding IRC section 6013(g) election for the NIIT.

How Does the 3.8% Tax Work?

The application of the new tax can be quite complex, especially where the issues of subpart F and PFIC (Passive Foreign Investment Company) income are involved in the calculation of required thresholds. Generally, however, section 1411(a)(1) imposes a tax on the lesser of (A) the individual’s net investment income for such taxable year, or (B) the excess (if any) of (i) the individual’s modified adjusted gross income for such taxable year, over (ii) the threshold amount).

The threshold amounts are provided in Section 1411(b) and depend on the individual’s filing status (all amounts refer to modified adjusted gross income (“MAGI”)):

Single: $200,000
Married Filing Jointly: $250,000
Married Filing Separately: $125,00
Head of Household: $200,000
Qualifying Widow(er) with dependent child $250,000

Basically, this provision of Section 1411(a)(1) means that, in order for a taxpayer to be subject to the 3.8% tax, he has to have net investment income and MAGI above the thresholds listed above. The tax will be imposed either on the excess of income above MAGI or net investment income, whichever is less.

What Type of Income is Subject to the new 3.8% Tax?

Generally, any net investment income is potentially subject to the 3.8% tax. This includes net income from: interest, dividends, capital gains, rental and royalty income, non-qualified annuities and other income NOT derived in the ordinary course of trade or business (as specified in Section 1411(c)(2)). In order to arrive at the net income, the taxpayer may subtract from the gross investment income any allowable allocable deductions.

Also certain capital gains (that are not otherwise offset by capital losses),are taken into account in computing net investment income. Here is the list of common example: gains from the sale of stocks, bonds, mutual funds, capital gain distributions from mutual funds, gains from the sale of investment real estate (including gain from the sale of a second home that is not a primary residence). Even gains from the sale of interests in partnerships and S corporations (to the extent that the taxpayer was a passive owner) are potentially included.

It is important to note that income from businesses involved in trading of financial instruments or commodities and businesses that are passive activities to the taxpayer are considered investment income.

On the other hand, certain income is excluded from the definition of investment income. Here is the list of most common exclusions: wages, unemployment compensation; operating income from a nonpassive business, Social Security Benefits, alimony, tax-exempt interest, self-employment income, Alaska Permanent Fund Dividends and distributions from certain Qualified Plans

The rules regarding determining whether your income is subject to the investment tax are complex, especially when it comes to businesses. You should contact a tax attorney to determine if your income should be subject to the 3.8% tax.

Where Should the 3.8% Be Reported by Individual Taxpayers?

The new tax should be reported on Form 1040 and paid with the rest of the tax when Form 1040 is filed.

It is also important to note that the new tax should be included in the estimated tax payments. Failure to do so may result in underpayment penalties.

Contact Sherayzen Law Office for Help with the New Investment Tax

If you are not sure whether you are facing the new investment tax or whether you wish to know if there is any tax planning available for dealing with the new investment tax in your particular situation, contact Sherayzen Law Office. Our experienced tax firm will thoroughly review your situation, determine whether the new investment tax applies to you and analyze alternative tax structures that would minimize the impact of the new tax in your particular situation.

Tax Withholding Update: Social Security and Medicare Tax for 2013

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Following the passage of the American Taxpayer Relief Act of 2012, the IRS issued Notice 1036 with respect to withholding tables for the year 2013, which includes the 2013 Percentage Method Tables for Income Tax Withholding.

Under the notice, the IRS requires the employers to implement the 2013 withholding tables as soon as possible, but not later than February 15, 2013. However, the use the 2012 withholding tables is permitted until employers implement the 2013 withholding tables; in such case, the employers should make an adjustment in a subsequent pay period to correct any under-withholding of social security tax by March 31, 2013.

One of the biggest news, of course, is the increase of the employee tax rate for social security to 6.2%. Previously, the employee tax rate for social security was 4.2%. The employer’s tax rate for social security remains unchanged at 6.2%. The social security wage base limit increases to $113,700. The Medicare tax rate is 1.45% each for the employee and employer, unchanged from 2012. There is no wage base limit for Medicare tax.

The second big news is that the withholding taxes will go up with Additional Medicare Tax for certain high-income wage earners. As described in an earlier article, starting January 1, 2013, Additional Hospital Insurance Tax (Additional Medicare Tax) of 0.9% will be imposed on employees who earn wages above certain thresholds. For the withholding purposes, the IRS requests that an additional 0.9% tax is withheld on wages paid to an employee in excess of $200,000 in a calendar year. The employer is required to begin withholding Additional Medicare Tax in the pay period in which he pays wages in excess of $200,000 to an employee and he should continue to withhold the Additional Medicare Tax each pay period until the end of the calendar year.

Note that Additional Medicare Tax is only imposed on the employee; there is no employer share of Additional Medicare Tax.

IRS Plans January 30, 2013 as Tax Season Opening Date For 1040 Filers

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Following the January tax law changes made by Congress under the American Taxpayer Relief Act (ATRA), the IRS announced on January 9, 2013, that it plans to open the 2013 filing season and begin processing individual income tax returns on January 30, 2013.

The IRS will begin accepting tax returns on that date after updating forms and completing programming and testing of its processing systems. This will reflect the bulk of the late tax law changes enacted on January 2, 2013. This should cover the great majority of the filers.

The IRS estimates that remaining households will be able to start filing in late February or into March because of the need for more extensive form and processing systems changes. This group includes people claiming residential energy credits, depreciation of property or general business credits. Most of those in this group file more complex tax returns and typically file closer to the April 15 deadline or obtain an extension.

“We have worked hard to open tax season as soon as possible,” IRS Acting Commissioner Steven T. Miller said. “This date ensures we have the time we need to update and test our processing systems.”

The IRS will not process paper tax returns before the anticipated Jan. 30 opening date. There is no advantage to filing on paper before the opening date, and taxpayers will receive their tax refunds much faster by using e-file with direct deposit.

Indirect Ownership of Foreign Entities for Form 5471 Purposes

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Every now and then, I encounter foreign business structures built on the incorrect belief that only direct ownership matters for U.S. tax reporting purposes in general and Form 5471 purposes in particular. In this essay, I broadly address the question of Form 5471 reporting with respect to indirect ownership of a foreign company (I am not discussing the major issue of “constructive ownership” in this essay).

Form 5471 Reporting Requirements

In an earlier article I already discussed the purpose of Form 5471 and the general reporting requirements this form entails, but I will briefly address these issues here.

Form 5471 is used by certain categories of U.S. taxpayers to report their ownership of foreign corporations. Generally, the form is designed to address the reporting requirements of IRC (Internal Revenue Code) Sections 6038 and 6046.

Under these IRC provisions, four general categories of U.S. taxpayers must file Form 5471 together with their U.S. tax returns: (1) U.S. taxpayers considered as U.S. shareholders (generally, U.S. taxpayers who own 10% or more of a foreign corporation) (these are category 3 filers), (2) U.S. persons who are directors and/or officers of a foreign corporation in which there are U.S. shareholders which meet the requirements of Form 5471 (these are category 2 filers), (3) U.S. persons who had control of a foreign corporation for an uninterrupted period of 30 days (these are category 4 filers); and (4) U.S. shareholders who owned a stock in a foreign corporation that is considered to be a Controlled Foreign Corporation for an uninterrupted period of 30 days and who owned that stock on the last day of the year (these are category 5 filers). Note, that Category 1 was repealed by Congress in section 413(c)(26) of the American Jobs Creation Act of 2004.

What truly adds to the complexity of the application of these four categories are the specific definitions of virtually every word in the description of these four categories which may differ from category to category. For example, “US taxpayer”, “US person”, “control”, “owned” – these are some of the words that are separately defined in the IRS regulations with respect to each category above.

Therefore, for a non-attorney, it is extremely dangerous to rely on these general definitions. Rather, the determination of whether Form 5471 requirement applies to you should be made by an international tax attorney.

Ownership Has Broad Definition for Form 5471 Purposes

As mentioned above, word “owned” has a number of diverse and special meanings for Form 5471 purposes. Generally, it includes not only the direct ownership of a stock, but also indirect ownership and constructive ownership. The concepts of “indirect ownership” and “constructive ownership” are described in separate complex IRS regulations.

The upshot of this discussion is that “ownership” is defined very broadly under the IRS regulations related to Form 5471, and one should not rely on direct ownership in determining whether Form 5471 needs to be filed.

Indirect Ownership for Form 5471 Purposes: IRC Section 958

We now came to the main purpose of this article – discussion of “indirect ownership” for Form 5471 purposes. Form 5471 Instructions as well as IRS regulations generally refer to IRC Section 958 for the definition of indirect ownership.

This provision sets forth the rules for determining stock ownership, including direct, indirect and constructive ownership of a stock. For the purposes of our discussion, we concentrate on Section 958(a)(2) which describes the rules for stock ownership through foreign entities. It states as follows:

“(2) Stock ownership through foreign entities: For purposes of subparagraph (B) of paragraph (1), stock owned, directly or indirectly, by or for a foreign corporation, foreign partnership, or foreign trust or foreign estate (within the meaning of section 7701(a)(31)) shall be considered as being owned proportionately by its shareholders, partners, or beneficiaries. Stock considered to be owned by a person by reason of the application of the preceding sentence shall, for purposes of applying such sentence, be treated as actually owned by such person.”

Thus, it becomes clear that, generally, a U.S. shareholder of a foreign company is likely to be considered a shareholder of other foreign companies owned by this foreign company. For example, where foreign corporation A owns 25% of foreign corporation B, a 45% shareholder of Company A is likely to be deemed as a 11.25% owner of company B. Obviously, this is a very general example and there are various facts and circumstances that may change this simplified calculation. Again, you should retain an international tax attorney to determine your ownership of foreign companies under IRC Section 958.

Implications for Form 5471 Reporting and Tax Planning Strategies

The most obvious result of IRC Section 958 are additional Forms 5471 that need to be timely filed with the U.S. shareholder’s US tax return. It is now easy to see why I would encounter in my practice a situation where a client would comply with Form 5471 requirements for the purposes of some of his companies and fail to do so with respect to the others because either he or his accountant simply did not understand the implications of Section 958 indirect ownership rules.

Section 958 also has a major influence on a U.S. person’s tax plan. Where such person and his tax advisor ignore the relevant implications of IRC Section 958, they are engaging in a potentially disastrous course of action. Beyond the penalties associated with the failure to file Form 5471 timely (as well as other potential penalties stemming from other U.S. international tax forms that may need to be filed), the effect of the entire tax structure could be nullified and potentially expose U.S. taxpayer to additional US taxes.

Contact Sherayzen Law Office for Help With Form 5471 and Tax Planning

If you or your business own companies overseas, contact Sherayzen Law Office for help with U.S. tax compliance, including Form 5471, as well as creating a comprehensible tax plan that would allow you to avoid over-payment of U.S. taxes while remaining in compliance with the Internal Revenue Code.