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Optional Safe Harbor Method for Claiming Home Office Deduction for 2013

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On January 15, 2013, the IRS today announced a simplified option for claiming home office deduction (i.e. deduction for the business use of a home). The new optional deduction, capped at $1,500 per year based on $5 a square foot for up to 300 square feet, will reduce the paperwork and recordkeeping burden on small businesses by an estimated 1.6 million hours annually.

Background Information

Internal Revenue Code (IRC) Section 280A generally deals with the tax treatment of home office expenses. Generally, IRC Section 280A(a) disallows any deduction for expenses related to a dwelling unit that is used as a residence by the taxpayer during the taxable year. However, Provisions 280A(c)(1) through (4) allow a deduction for expenses related to certain business or rental use of a dwelling unit, subject to the deduction limitation in § 280A(c)(5).

Section 280A(c)(1) permits a taxpayer to deduct expenses that are allocable to a portion of the dwelling unit that is exclusively used on a regular basis (A) as the taxpayer’s principal place of business for any trade or business, (B) as a place to meet with the taxpayer’s patients, clients, or customers in the normal course of the taxpayer’s trade or business, or (C) in the case of a separate structure that is not attached to the dwelling unit, in connection with the taxpayer’s trade or business.

Section 280A(c)(2) permits a taxpayer to deduct expenses that are allocable to space within the dwelling unit used on a regular basis for the storage of inventory or product samples held for use in the taxpayer’s trade or business of selling products at retail or wholesale, if the dwelling unit is the sole fixed location of the trade or business.

Section 280A(c)(3) permits a taxpayer to deduct expenses that are attributable to the rental of the dwelling unit or a portion of the dwelling unit.

Section 280A(c)(4) permits a taxpayer to deduct expenses that are allocable to the portion of the dwelling unit used on a regular basis in the taxpayer’s trade or business of providing day care for children, for individuals who have attained age 65, or for individuals who are physically or mentally incapable of caring for themselves.

Optional Safe Harbor Method

After recognizing that Section 280A(c)(1) imposes a substantial compliance burden on taxpayers (and, perhaps, with the desire to cut its own enforcement costs), the IRS decided to provide for the very first time a new method of calculating home office deductions – the optional safe harbor method.

Under this safe harbor method, taxpayers determine their allowable deduction for business use of a residence by multiplying a prescribed rate (currently set at $5 per square foot) by the square footage of the portion of the taxpayer’s residence that is used for business purposes (“allowable square footage”). The allowable square footage is the portion of a home used in a “qualified business use” of the home, but not to exceed 300 square feet.

“Qualified Business Use” is a term of art. Under the Rev. Proc. 2013-13, this term means (1) business use that satisfies the requirements of § 280A(c)(1), (2) business storage use that satisfies the requirements of § 280A(c)(2), or (3) day care services use that satisfies the requirements of § 280A(c)(4) (see above).

The safe harbor method provided by this revenue procedure does not apply to an employee with a home office if the employee receives advances, allowances, or reimbursements for expenses related to the qualified business use of the employee’s home under a reimbursement or other expense allowance arrangement (as defined in § 1.62-2) with his or her employer.

Note that the current restrictions on the home office deduction, such as the requirement that a home office must be used regularly and exclusively for business and the limit tied to the income derived from the particular business, still apply under the new option.

Advantages and Disadvantages of the New Optional Safe Harbor Method

The new option provides eligible taxpayers an easier path to claiming the home office deduction. Currently, they are generally required to fill out a 43-line form (Form 8829) often with complex calculations of allocated expenses, depreciation and carryovers of unused deductions. Taxpayers claiming the optional deduction will complete a significantly simplified form.

The new option does not affect business expenses unrelated to the home (such as advertising, supplies and wages paid to employees). Such expenses are still fully deductible.

The down side of the new option is that the homeowners cannot depreciate the portion of their home used in a trade or business. However, they can still claim allowable mortgage interest, real estate taxes and casualty losses on the home as itemized deductions on Schedule A. These deductions need not be allocated between personal and business use, as is required under the regular method.

A taxpayer using the safe harbor method for a taxable year cannot deduct any depreciation (including any additional first-year depreciation) or § 179 expense for the portion of the home that is used in a qualified business use of the home for that taxable year. The depreciation deduction allowable for that portion of the home for that taxable year is deemed to be zero.

Switching the Methods

The election of whether to use safe harbor method is made on a annual basis. Therefore, in one year, a taxpayer may use the safe harbor method, while the next year he can choose to calculate and substantiate actual expenses for purposes of § 280A. A change from using the safe harbor method in one year to actual expenses in a succeeding taxable year, or vice-versa, is not a change in method of accounting and does not require the IRS consent.

It is important to remember that an election for any taxable year, once made, is irrevocable

More complications arise if the taxpayer depreciates his home subsequent (or even prior to) electing to use the safe harbor method.

Safe Harbor Method Available in 2013

The new simplified option is available starting the tax year 2013.

Itemized Deductions Limitation in 2013

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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).

In reality this is not a new law; this is basically a re-birth of the famous “Pease limitation” that was the part of the Omnibus Budget Reconciliation Act of 1990. This limitation was later phased out during the era of Bush tax cuts and completely eliminated for the year 2010. Subsequently, additional legislation extended the elimination of the Pease limitation from 2010 through 2012. Now, as part of the New Year’s compromise, the American Taxpayer Relief Act of 2012 reinstated the provision with an upgrade; the provision is codified as 26 USC §68.

In order to understand how the provision works, it is important to emphasize that the idea is to limit the impact of certain itemized deductions, but not to completely eliminate the tax advantages of such deductions.

Types of Itemized Deductions Affected by the Limitation

Armed with this understanding, let’s look at the details of the Pease limitation. First, the provision mostly applies to the following types of itemized deductions: charitable contributions, mortgage interest, state/local/property taxes and miscellaneous itemized deductions. However, the statute expressly excludes medical expense deductions, the investment interest deduction, casualty, theft, or gambling loss deductions (see 26 USC §68(c)).

Limitation and Thresholds

For the tax year 2013, 26 USC §68 starts to limit the itemized deductions once the AGI exceeds $250,000 for individuals and $300,000 for joint filers (these are the items indexed for inflation). The limitation will consist of the less of (a) 3% of the adjusted gross income above the threshold amount, or (b) 80% of the amount of the itemized deductions otherwise allowable for the taxable year.

For example, in a hypothetical where a an individual earns $300,000 in 2013 and his itemized deductions consist of mortgage interest and property tax deductions of $50,000, the individual’s itemized deductions will be reduced by $ 1,500.

Based on the information in our hypothetical (and disregarding any other facts and factors), here are the calculations:

(a) $300,000 AGI – $250,000 (threshold for 2013) = $50,000; 3% x $50,000 = $1,500;
(b) 80% x $50,000 of itemized deductions = $40,000.

Since $1,500 is less than $40,000, this is the amount that should be used to reduce the taxpayer’s itemized deductions.

Contact Sherayzen Law Office for Tax Planning Help Regarding Pease Limitation

If you are potentially facing the limitation of your itemized deductions, it is possible that you are overlooking tax alternatives that may mitigate the impact of Pease Limitation. If you wish to explore such alternatives as part of your overall tax plan, contact the experienced tax firm of Sherayzen Law Office.

FBAR Criminal Prosecution and Smaller Banks: The Case of Wegelin

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On January 3, 2013, Wegelin & Co., the oldest Swiss private bank announced that it will close down following its guilty plea to criminal charges of conspiracy to help wealthy U.S. taxpayers evade taxes through secret financial accounts. The guilty plea and the closure of one of the most prestigious European banks that served its clients since the year 1741 constitute big victories for the U.S. authorities. It surely will inspire additional movement of non-compliant U.S. taxpayers into the 2012 OVDP (Offshore Voluntary Disclosure Program) as well as ensure more widespread compliance with the FBAR, Form 8938 and other numerous international tax forms required by the IRS.

However, in addition to its significance to U.S. tax compliance, the Wegelin case also has other interesting features that may point to future trends in the IRS international tax enforcement. In this article, I will outline these trends and explore their potential implications for U.S. tax enforcement.

Jurisdiction to Prosecute Foreign Banks: Minimal Contact Will Suffice

In order to criminally charge a foreign bank, U.S. tax authorities need to establish some connection between the United States and the foreign bank. It appears that after the Wegelin case, proving U.S. exposure will not a be a significant problem for the IRS.

The main reason for Wegelin’s bold defiant behavior (Wegelin specifically advertised itself as a safe, tax-free alternative to U.S. taxpayers who were fleeing UBS after criminal prosecution charges were filed against UBS in 2008) was its deep belief that it cannot be criminally prosecuted in the United States because U.S. tax authorities have no jurisdiction over it. Unlike UBS, Wegelin had virtually no physical presence in the United States, no operating divisions and no branch offices in the United States.

However, Wegelin miscalculated. The IRS discovered that Wegelin did have presence in the United States because it “directly accessed” the U.S. banking system through a correspondent account that it held at UBS AG (“UBS”) in Stamford, Connecticut. The Justice Department successfully argued that this one correspondent account was sufficient to give the United States government the jurisdiction to criminally charge Wegelin.

Hence, one of the biggest consequences of the Wegelin case is that it will not be difficult for the U.S. tax authorities to establish jurisdiction to criminally charge foreign banks even with very insignificant presence in the United States.

Size Matters: Increased Risk for Smaller Banks

The other important lesson of the Wegelin case is that it appears that the IRS is more likely to aggressively pursue smaller banks than the bigger banks the demise of which can cause systemic instability in the world economy.

The collapse of Wegelin stands in stark contrast to the survival of its bigger Swiss rival, UBS. UBS offered pretty much the same services to U.S. taxpayers as Wegelin involving vastly larger number of U.S. persons and amounts of money (at the very least, 20 billion dollars versus Wegelin’s 1.2 billion dollars). The IRS did file criminal charges against UBS, but UBS entered into a deferred prosecution agreement and charges were dropped eighteen months later.

It could be that some of the aggressiveness of the U.S. government came precisely from Wegelin’s defiant stance. In order to reinforce its recent victory in the UBS case, the IRS had to adopt a more assertive stand. However, it did not necessarily have to end in Wegelin’s demise.

Some commentators argued that Wegelin was already a shadow of its former self at the time of its closure, because it aggressively sold-off all of its non-US related assets. Therefore, it may be argued that it is premature to draw general conclusions from the Wegelin’s case about the risks facing small foreign banks who find themselves indicted by the U.S. government. On the other hand, the very fact that Wegelin decided that it would be better for the bank to sell off its assets rather than fight the IRS and the fact that the U.S. government was not concerned about this decision do point to a conclusion that the Wegelin case may be demonstrative of the general vulnerability of smaller banks in such situations.

Unresolved Issues: Client Information and Sold-Off Practice

One of the most important issues, however, is still unresolved in the Wegelin case and makes it worthwhile to observe to its end. The issue is: will the bank disclose the names of its U.S. clients to the IRS?

Typically, disclosure of the names of U.S. taxpayers constitutes a key request by the IRS in such major investigations. Therefore, it does not seem likely that the IRS will simply leave this issue without at least attempting to obtain the names of non-compliant U.S. taxpayers as part of the final deal.

The other unresolved issue is whether a strategy similar to Wegelin’s sale of its non-US accounts to the Austrian Bank Raiffeisen just before the indictment is going to challenged by the IRS if the sale does involve U.S. clients and maybe even if it does not (especially where the bank is left without any assets). It is not known if we are going to get an answer at this time, but it is likely that this issue will show up again in a future case.

Contact Sherayzen Law Office for Help With Voluntary Disclosure of Foreign Financial Accounts

If you have undisclosed offshore accounts (whether in the hard-hit Switzerland or any other country) ,contact Sherayzen Law Office to explore the voluntary disclosure options available in your case. Our experienced voluntary disclosure firm will thoroughly review your case, explore available options, propose a definite plan for moving forward, prepare all of the necessary legal documents and tax forms, and guide you though the entire case while rigorously representing your interests in your negotiations with the IRS.

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.