Who’s on the Board

The board is largely non-political. Besides Paul Volcker, the Board has as its members a former SEC chairman, a venture capitalist, a representative from AFL-CIO, corporate executives, endowment fund manager David Swensen, university professors, and Obama’s economic advisor Austan Goolsbee.

Scope of the Report

The board was asked to consider ideas that pertain to tax simplification, closing loopholes, and corporate tax reform. The board was specifically asked to exclude ideas that would raise taxes on families with income less than $250,000. So raising taxes broadly to reduce the deficit is off the table. That’s the job of a different commission, National Commission on Fiscal Responsibility and Reform, whose members are mostly elected House Representatives and Senators.

Ideas

Because the Volcker advisory board was asked not to consider any grand scheme tax reform such as flat tax or introducing a VAT, the ideas are only within the framework of the current tax system. I read the entire report (95 pages). I’m in favor of most of the ideas. I list some of the ideas on individual taxation with my comments.

1. Consolidate child related benefits (pp. 8-9)

The child tax credit, dependent exemptions, EITC, and dependent care credit are too complex. Bundling them is a good idea.

2. Consolidate education related benefits (pp. 10-15)

There are 18 education related tax benefits. Who understands them all? Give one benefit and be done with it.

3. Simplify kiddie tax (pp. 15-16)

If a child earns income from wages, I’m in favor of giving the child a larger standard deduction and not withholding taxes from wages. Investment income, however, should be taxed at the parents’ rate from the first dollar. There’s no reason to create complexity with three tiers: first $950 free, next $950 at child’s rate, anything over at parents’ rate.

4. Consolidate retirement accounts (pp. 24-28)

Yes! See previous post Retirement Plans Galore: 401(a), 401(k), 403(b), 457, SEP, SIMPLE.

5. Make everyone eligible for a deductible IRA (p. 28)

Right now whether one can take a deduction for a contribution to an IRA depends on one’s income and coverage by a retirement plan at work. The proposal makes everyone eligible for a deductible IRA but the combined limit for both IRA and employer sponsored retirement plan will stay under the $16,500 limit, meanwhile the IRA itself still has the $5,000 limit.

The proposal didn’t go far enough. It should give a combined limit to all plans and IRAs and that’s it. That’ll be simple, elegant, and it frees people from bad plans at work or not having a plan at all.

6. Consolidate non-retirement savings plans (p. 29)

Here we are talking about FSA, HSA, MSA, 529, and Coverdell. One account for health and another for college seems reasonable.

7. Simplify Social Security taxation (pp. 34-36)

The Board proposed small simplification on taxing Social Security benefits: use two tiers instead of three; not count Social Security benefits in MAGI. It’s too timid. Income is income. Just make Social Security fully taxable.

8. Indexing principal residence exclusion for capital gains (p. 41)

Bad proposal! The exclusion should be eliminated. Treat capital gains the same whether it’s from securities or real estate.

9. A pre-filled return from the IRS for taxpayers with simple returns (p. 43)

It can serve as a good starting point for many. Verify, update, and send. I won’t use it until all the tax complexities are eliminated but it’ll probably help some.

10. Limit itemized deductions and give a larger standard deduction (pp. 44-46)

The proposal only limits itemized deductions. It should eliminate them. It’s already done this way in AMT. It’s much cleaner. The majority of itemized deductions can be eliminated in exchange for a larger standard deduction.

11. Eliminate the AMT (p. 50)

When most of the itemized deductions are eliminated, we can also eliminate the AMT. Calculating taxes twice is insane.

Will these ideas be implemented? I’m not holding my breath. One can always dream, right?

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Does your state have a sales tax? According to Wikipedia, only five states don’t have a sales tax: Alaska, Delaware, Montana, New Hampshire, and Oregon. There is a sales tax everywhere else. For purchases from an out-of-state store that does not collect sales tax, the states usually have a use tax, with the same rate as the sales tax. You are supposed to report and pay the use tax for these out-of-state purchases.

Have you?

According to Wikipedia again, 22 states including New York, California, Ohio, and Virginia have a specific line for use tax on the state income tax return. If your state income tax form has a line for it, what did you put down on that line? Did you leave it empty? Did you include everything you bought online? If not, is that cheating on your taxes?

Whether the state includes a special line on the tax return or it requires you to fill out a separate form, you are still on the hook for paying the use tax. If you haven’t filed the separate use tax form, that’s still cheating on your taxes, isn’t it?

No confessions please. I don’t want to get anybody into trouble.

Most people don’t pay the use tax as required by law. And the states know it. They can’t do much about it because they don’t have any records about those out-of-state purchases. And people know it. That’s why they don’t pay that tax.

So it shows if people know the authorities don’t have any records, they cheat. People choose to disregard the law when there’s virtually no chance of being caught. You wonder where else people cheat on their taxes.

If most people don’t want to pay the use tax, and the states are not getting much revenue from it anyway, should use tax be taken off the books? I think so. The law should reflect citizens’ will, right?

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$500 or $1,000 property tax deduction for people who don’t itemize. This was originally for 2008 only. It was extended once for 2009. See previous post. Now it will be extended a second time for 2010.

Sales tax deduction. This primarily benefits people in states without an income tax on wages: Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming. Sales tax paid can be deducted on the federal tax return. The deduction was originally for only two years, 2004 and 2005. It was subsequently extended through 2009. Now it will be extended again for one more year through 2010.

College tuition deduction. A $2,000 or $4,000 tax deduction for college tuition will be extended one more year in 2010.

COBRA subsidy. The stimulus law provided a 65% COBRA premium subsidy to unemployed. The subsidy was going to expire after May 31, 2010. Now it will be extended to the end of the year.

For the small business owners who run their business through a subchapter S corporation ("S corp"), the bill will crack down on the practice of taking a small salary and taking the rest as dividends from the S corp or leaving the earnings in the S corp. Such income splitting reduces payroll tax. The rules against income splitting will affect S corps in "professional service business" defined as:

any trade or business if substantially all of the activities of such trade or business involve providing services in the fields of health, law, lobbying, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, investment advice or management, or brokerage services.

There are many more obscure provisions in the bill. Altogether the bill extends 50 different tax breaks. Please read the CCH tax briefing if interested.

As I mentioned last week, once people get used to these tax breaks, it’s very difficult to remove them, even though they were originally supposed to be only temporary.

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Currently a business is only required to issue 1099s for payments for services, not goods, purchased from individual persons, not corporations, if the total payments to that person exceed $600 a year.

I find this quite unbelievable. Small business owners buying from Costco will have to send a 1099 to Costco at the end of the year. Because chain stores are often owned by different entities under a franchise agreement, a business buying from one store versus another under the same chain will have to track the corporate entities behind each one separately. What a nightmare.

Because it’s so unbelievable, I had to look up the laws myself. It’s amazing but true. Section 9006 of Patient Protection and Affordable Care Act says (the key phrases are in bold):

SEC. 9006. EXPANSION OF INFORMATION REPORTING REQUIREMENTS.

(a) IN GENERAL.—Section 6041 of the Internal Revenue Code of 1986 is amended by adding at the end the following new subsections:
    "(h) APPLICATION TO CORPORATIONS.—Notwithstanding any regulation prescribed by the Secretary before the date of the enactment of this subsection, for purposes of this section the term ‘person’ includes any corporation that is not an organization exempt from tax under section 501(a).

… …

(b) PAYMENTS FOR PROPERTY AND OTHER GROSS PROCEEDS.— Subsection (a) of section 6041 of the Internal Revenue Code of 1986 is amended—
    (1) by inserting "amounts in consideration for property," after "wages,",
    (2) by inserting "gross proceeds," after "emoluments, or other", and
    (3) by inserting "gross proceeds," after "setting forth the amount of such".
(c) EFFECTIVE DATE.—The amendments made by this section shall apply to payments made after December 31, 2011.

After all the insertions, the amended Section 6041(a) of the Internal Revenue Code becomes (the inserted words are in bold):

(a) Payments of $600 or more

All persons engaged in a trade or business and making payment in the course of such trade or business to another person, of rent, salaries, wages, amounts in consideration for property, premiums, annuities, compensations, remunerations, emoluments, or other gross proceeds, fixed or determinable gains, profits, and income (other than payments to which section 6042(a)(1), 6044(a)(1), 6047(e), 6049(a), or 6050N(a) applies, and other than payments with respect to which a statement is required under the authority of section 6042(a)(2), 6044(a)(2), or 6045), of $600 or more in any taxable year, or, in the case of such payments made by the United States, the officers or employees of the United States having information as to such payments and required to make returns in regard thereto by the regulations hereinafter provided for, shall render a true and accurate return to the Secretary, under such regulations and in such form and manner and to such extent as may be prescribed by the Secretary, setting forth the amount of such gross proceeds, gains, profits, and income, and the name and address of the recipient of such payment.

Because I show ads on my blog and I sell my book, I’m considered as "engaged in a trade or business." Right now I don’t issue any 1099s since I don’t pay over $600 in a year for services from any individual person. All expenses are paid to corporate entities. Under the health care reform law, I will have a new 1099 reporting requirement starting in 2012.

Reference:

• A Thomson Reuters training seminar on this change: Health Care Reform Brings Several Changes to Form 1099-MISC Reporting
• The Boston Globe: Healthcare reform bill expands business tax reporting
• 2009 report from the Government Accountability Office (GAO) urging Congress to expand 1099-MISC reporting requirements: Tax Gap: IRS Could Do More to Promote Compliance by Third Parties with Miscellaneous Income Reporting Requirements

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The best way to get tax questions answered is of course asking a real CPA. I realize not everybody can afford a real CPA so they ask an amateur on the Internet. The next best way to get tax questions answered would be getting a tax book.

There are two popular tax book series. J.K. Lasser’s Your Income Tax and Ernst and Young Tax Guide. These books are updated every year. They are very inexpensive for their size (think yellow pages). They both go for $13.57 at this moment on Amazon.

My favorite tax book, however, is U.S. Master Tax Guide by CCH. Despite the name "Master" it’s not as huge as the J.K. Lasser’s book or the Ernst & Young book. It’s more expensive ($79.30 on Amazon) because it’s used by professionals. Yes, CPAs also use reference books.

The "Master" in the title is well justified because it answers more questions than the other two "consumer-grade" books. I consider CCH’s U.S. Master Tax Guide the best tax book.

I tested all three tax books with some of the questions I got from the readers recently.

"How can I carry forward unused foreign tax credit?"

"How to calculate cost basis in a stock when the company is taken over by another company in a part-stock-part-cash merger?"

"What to do with dependent care flexible spending account when a spouse doesn’t have earned income?"

Every time I found a better answer in the Master Tax Guide than in the J.K. Lasser’s or Ernst & Young books. When the questions go out of the ordinary, the J.K. Lasser’s or Ernst & Young books either don’t say anything or just send you straight to IRS publications, some of which are not easy to understand. A used copy of the Master Tax Guide sells for about $30 on Amazon, which isn’t that expensive.

The problem with tax books is that new editions keep coming out every year with tax law changes. However, it also creates an opportunity. After a new edition comes out, people sell their old editions. A used last year’s U.S. Master Tax Guide sells for as low as $1.48 plus $3.99 shipping on Amazon. That’s a bargain.

Given that if you buy a tax book it’s going to be out of date next year anyway, you might as well buy last year’s book for 90% off and keep as a reference. Tax laws change, but they don’t change that much. For example the answers to the three questions above didn’t change last year. If you can spare $30, get the current year’s book. For less than $6 shipped, last year’s book is a steal.

You can use software to help you prepare your tax return. It won’t help you understand taxes. For that, you need a tax book. You might as well get the best one.

[This post contains affiliated links to Amazon.com. Amazon will pay a commission of 4% - 6.5% to me if you make a purchase within 24 hours after you click on the link.]

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Reader Chuck asked about the 3.8% Medicare tax in the health care reform law.

"Does the 3.8% tax on unearned income kick in all at once? You could be looking at an infinity percent marginal rate if you have, say $199,999 in wage income, and $50,000 in capital gains if one extra dollar of income costs $1900 in tax, for example."

The most definitive answer has to come from the law itself. The law containing this provision is HR 4872 Health Care and Education Reconciliation Act of 2010 (full text in PDF). The Act says in Sec. 1411 (page 33 in the PDF, bold emphasis added by me):

"(a) IN GENERAL. – Except as provided in subsection (e) –
       (1) APPLICATION TO INDIVIDUALS. In the case of an individual, there is hereby imposed (in addition to any other tax imposed by this subtitle) for each taxable year a tax equal to 3.8 percent of the lesser of –
            (A) net investment income for such taxable year, or
            (B) the excess (if any) of –
                 (i) the modified adjusted gross income for such taxable year, over
                 (ii) the threshold amount."

The threshold amount in Sec. 1411(a)(1)(B)(ii) is the $200,000 single, $250,000 married filing separately number widely reported in the media.

The net investment income in Sec. 1411(a)(1)(A) includes interest, dividends, annuities, royalties, rents, and capital gains. Distributions from qualified plans or IRAs are not included. It does not make any distinction between qualified and ordinary dividends or between short-term and long-term capital gains. All dividends and capital gains are subject to the new Medicare tax equally.

Because interest from muni bonds is not part of the modified adjusted gross income, it will not be affected by this new Medicare tax.

Here are two examples for a married couple filing jointly with $260,000 in modified adjusted gross income (both earned and unearned):

Example 1: Earned income $259k, unearned $1,000. The extra 3.8% Medicare tax applies to only the $1,000 unearned income. Extra tax = $1,000 * 3.8% = $38.

Example 2: Earned income $50k, unearned $210k. The extra 3.8% Medicare tax applies to the excess of MAGI over $250k, which is $50k + $210k – $250k = $10k, because it’s less than the $210k unearned income. Extra tax = $10,000 * 3.8% = $380.

The new Medicare tax on investment income makes muni bond mutual funds more attractive than taxable bonds, CDs, and savings accounts.

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I read the excellent timeline summary from Austin and the tax summary from CCH Group. I’m not too surprised to see that the vast majority of the items have absolutely no direct benefit to me. I have health insurance from an employer, which is not a small business. I do not cover an adult child as a dependent. HIPAA has covered pre-existing conditions for nearly 15 years. I’m not on Medicare, nor its Part D.

Of the few items in the health care reform that do affect me, unfortunately all are negative. If you happen to be in a married two-earner household working in a high cost-of-living area, you have been selected as a potential revenue source for the new law. The $250,000 married-filing-jointly tax threshold is not indexed to inflation. If you haven’t crossed it yet, eventually you will, just like the AMT thresholds.

I’m not saying it’s a bad law because it doesn’t benefit me or because I have to pay more tax for it. If it does great things, I’d be glad to pay more tax and make those great things happen. Whether it will turn out great remains to be seen.

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The post Refundable Tax Credit and Non-Refundable Tax Credit is one of those posts. Let me try again with some charts.

The first chart above shows a person’s withholding and tax liability before any tax credit. Because this person didn’t withhold enough, he or she will owe some taxes at the time of filing.

This second chart shows after non-refundable tax credits (red block) are applied, the taxpayer will get a small refund instead of owing taxes. The non-refundable tax credits are capped by the tax liability. The best a person can do with non-refundable tax credits is to get all the withholding back. A non-refundable tax credit can increase your tax refund after all; it’s just the refund can’t exceed your withholding.

As you might have guessed, the refundable tax credits are not capped by one’s tax liability, as shown in this third chart. The refund can exceed the withholding.

So how did I do? Are these charts clearer than what I tried to convey before in words?

Once again, here’s the table that shows if a tax credit is refundable or not.

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Schedule L is used for claiming (a) the additional $500 or $1,000 tax deduction for property tax paid, (b) the sales tax paid on a new car purchased between Feb. 17, 2009 and December 31, 2009, and (c) a net disaster loss (together with Form 4684).

Schedule M is used for claiming the Making Work Pay tax credit. Making Work Pay tax credit is the $400/$800 tax credit added in the economic stimulus law.

While we are at it, here’s a list of the tax forms you will need for the various new tax incentives for 2009 tax year.

If you qualify for these incentives, make sure your tax return includes these forms and schedules.

Now, here’s a quiz about the $400-per-worker Making Work Pay tax credit. As you may know, the IRS changed the tax withholding tables in February 2009 to reflect this credit. In effect, people have already received this $400 credit through lower withholding and bigger paychecks. If you fill out a Schedule M and ask for the tax credit, are you double-dipping on the credit? Why and why not?

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Because the traditional IRA had mostly non-deductible contributions, I will not pay much tax for this conversion. I plan to do the same contribute-then-convert move in 2011 and beyond unless Congress changes the law.

Having a solo 401k made things easy for me. This post is a sidebar about the history of solo 401k.

Solo 401k came about in 2002 after Congress passed Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA added this small paragraph to the tax code (26 USC 404(n)):

(n) Elective deferrals not taken into account for purposes of deduction limits

Elective deferrals (as defined in section 402(g)(3)) shall not be subject to any limitation contained in paragraph (3), (7), or (9) of subsection (a) or paragraph (1)(C) of subsection (h) and such elective deferrals shall not be taken into account in applying any such limitation to any other contributions.

That one small paragraph put forward the solo 401k as the preferred retirement plan for self-employed persons.

Before EGTRRA, a self-employed person was also able to set up a 401k plan just for him- or herself. However, there wasn’t a good reason to do so, because the deduction limit for a 401k plan was the same as that for a SEP-IRA. A SEP-IRA is easier to set up and administer than a 401k plan.

The small paragraph EGTRRA added basically says the employee contributions to a 401k plan does not count toward the deduction limit. As a result, a self-employed person can contribute more money to a solo 401k than to a SEP-IRA. Because business owners are usually interested in maximizing all available tax deductions for retirement, a solo 401k plan became preferred to a SEP-IRA.

EGTRRA also affected corporate 401k plans. Before EGTRRA, employers usually limited employee contributions to no more than 15% of compensation. Together with the company match, the total contributions would stay below the deduction limit, which is 25% of payroll. After EGTRRA, employee contributions no longer count toward the 25% limit. Many companies responded by increasing the employee contribution maximum to 50% of compensation or more. This has allowed lower-income employees to contribute the maximum dollar amount allowed under the law known as the 402(g)(3) elective deferrals limit, currently $16,500 per year.

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