Archive for January, 2012

OK, perhaps I was a bit harsh yesterday when I compared life as a CPA to serving hard time. For fear that I may have dissuaded any impressionable readers from pursuing a potentially rewarding career in the field, allow me to highlight some of the advantages to becoming an accountant, starting with the undeniable fact that  — much like midget wrestlers and left-handed relief pitchers — accountants will always be in demand.    

If you don’t believe me, check out this list of the 6 Jobs to Watch in 2012,  on which accounting is firmly entrenched at #1. Take that, computer systems analysts!

Accountants are in especially high demand in April. But throughout the year, large firms require the assistance of public accountants to prepare, analyze, and verify financial documents. The Labor Department projects that more than 279,000 accounting positions will become available between 2008 and 2018.

As gratifying as that ranking may be, the accounting industry still has a bit of a “public perception” problem to overcome before it will ever be embraced for reasons other than its consistent demand. CPAs, it has long been my contention, are subject to more scorn and ridicule than any other profession in America, save for perhaps male nurses. We’re seen as Bob Cratchitt-types; complete with pale skin, thick glasses, and a healthy fear of our own shadow, conventional and tedious to the core, with the only thing less impressive than our sense of humor our aerobic capacity. While some may argue that this stereotype is too firmly entrenched in the collective conscience of the American public to ever be undone, I’d beg to differ.

As with most stereotypes, the one of the “geeky accountant” can be shattered simply through closer inspection. Throughout history, CPAs have run the gamut of the coolness meter. Consider these examples:

Clearly, being an accountant is not mutually exclusive with being a badass, regardless of popular opinion. There’s no reason you can’t crunch numbers, train for an Ironman, interpret the tax code, and lay down some hot licks on your guitar all in the same day. And while that race car driver gig you’ve always day-dreamed about might play better with the ladies, good luck finding a race car driver with a solid 401(k).

Of course, you could always just be a race car driver AND a CPA, like WS+B’s very own Rebecca Machinga:

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Last night, I parked myself on the couch just in time for President Obama’s State of the Union Address. As a tax geek, I was excited to hear his proposals for comprehensive change to the Internal Revenue Code. I was excited to hear if he had solidified plans for the much-discussed “Buffet Rule.” I was, perhaps, most excited to hear if he would fan the flames of the perceived inequities in this country by highlighting the 13.9% effective tax rate paid by his chief opposition, leading Republican candidate Mitt Romney. This would be an address, I believed, that could change both the future of our country, and from a selfish perspective, my career.

But then I noticed Teen Wolf was on AMC, so I bagged the address and watched that instead. Hey, I’m only human.

I kid, I kid. I managed to watch the entire address — no small feat when you have a two-year old boy — and while the President left Romney’s hot-button tax rate out of his address, he did cap the night by urging Congress to require taxpayers with income exceeding $1,000,000 to pay a minimum effective rate of 30% as part of his State of the Union Address.

This is nothing new from the President, who originally floated the idea of a “Buffet Rule” that would require the nation’s wealthiest taxpayers to pay a minimum effective rate back in September, though at that time it was purely a concept with no framework for application.

This “Buffet Rule’ began to take shape on Tuesday night. While some details remain unclear, it appears this 30% rate on high-earners would be achieved not by substantially increasing the preferential rates currently in place on qualified dividends and long-term capital gains, but rather by eliminating certain deductions such as mortgage interest, tax-free health care, retirement savings and child-care benefits for those with adjusted gross income in excess of $1,000,000. The President made it clear that charitable contributions will not be impacted or further limited by the potential changes.

As we saw back in September, President Obama reiterated his commitment to taxpayers on the other end of the income spectrum, requiring that taxes not increase on those with incomes under $250,000.

Noticeably absent from the President’s address was a proposal discussed in September that taxpayers with income in excess of $250,000 but less than $1,000,000 would see a return to the top tax rates of 39.6% as of January 1, 2013, as well as a 28% cap on certain itemized deductions. I don’t know if this means the President has abandoned this proposed reform on these mid-range earners, or if it was purely omitted from the address. Time will tell.

From a corporate perspective, President Obama was adamant that comprehensive corporate tax reform is necessary to entice U.S. corporations to bring jobs back home. The President recommended a three-prong approach designed to eliminate current incentives that make it more attractive to ship jobs overseas:

  1. Eliminate tax deductions for outsourcing jobs; replace it with new tax credit to cover moving expenses for companies that close production overseas and bring jobs back to the U.S.
  2. Remove incentive to locate corporations overseas through an international minimum tax on overseas profits. If all corporations are required to pay a minimum tax on international income, other countries will not be able to entice American business through unusually low tax rates.
  3. Increase tax breaks for U.S. manufacturers by reducing rates and doubling the tax deduction for high-tech manufacturers.

All in all, there were no great surprises in the address. And let’s be honest, given the current congressional gridlock, the odds of any of these changes being enacted in the  near future are extremely slim, reducing last night’s address to one hour of spirited rhetoric.

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Yesterday was the unofficial start of “busy season” in the accounting world, which is every bit as depressing as it sounds. For the next few months we’ll be confined to our cubicles and deprived of sunlight and sound nutrition for days at a time; surviving only by adopting a singular focus on doing whatever it takes to make it until April 17th arrives to return our freedom. If busy season sounds a lot like a prison sentence, it’s because it is, only without all the free weights and shower shivvings.   

But if we’re gonna’ do it, we may as well do it right. To that end, throughout the next few months I’ll  touch on some commonly encountered tax compliance issues that are often misunderstood or misapplied. Today’s lesson: determining the deductible amount of mortgage interest when a taxpayer has total mortgage debt that exceeds the statutory limitations.

First, a primer on the limitations:

Since 1986, I.R.C. § 163(h)(3) has allowed a deduction for qualified residence interest for up to $1,000,000 of acquisition indebtedness and $100,000 of home equity indebtedness. Prior to amendment, the Code generally permitted a deduction for qualified residence interest on debt that did not exceed the basis of the residence and the cost of improvements.

Questions have surrounded the continued relevancy of temporary regulations that were issued prior to the 1986 amendments. The IRS recently answered these questions  — albeit 25 years late — in Chief Counsel Memo 201201017. The memo holds the following:

  • A taxpayer may use any reasonable method, including the exact method and simplified method provided for in the temporary regulations, to determine the amount deductible as qualified residence interest when total debt exceeds the statutory limitations.
  • Regardless of which method is used, a taxpayer may allocate any interest in excess of the limited amounts in accordance with the use of the proceeds under the interest tracing rules. Thus, if the excess proceeds are traced to use in a rental activity, the interest can be deducted on Schedule E; if they were used to purchase investments, the interest may be deductible on Sch. A as investment interest, and so on…

If those bullets make perfect sense to you, lovely. If not, read on, as a detailed explanation and illustration follows.

The Temporary Regulations

The outdated temporary regulations[i] provided two methods for determining a taxpayer’s qualified residence interest when debt exceeded the applicable limitation: the simplified method and the exact method. Citing the legislative history of I.R.C. § 163, the IRS held in CCM 201201017 that a taxpayer can also use any reasonable method to allocate debt in excess of the $1,100,000 limitation. An example of any reasonable method would be the method used in the worksheet found in Publication 936.

Simplified Method

Under the simplified method, interest on all debts is multiplied by the following fraction to determine the maximum deductible amount  :  $1,100,000/ the sum of the average balances of all secured debts.[ii]

To illustrate, assume you owned a home secured by the following debts: First mortgage: $900,000; Home equity line: $300,000; Second mortgage: $150,000.

Assume the home equity line was used for personal expenses and the second mortgage was used entirely in your rental real estate business. If the total interest expense on all three mortgages for 2011 was $80,000, using the simplified method the maximum amount of interest deductible on Schedule A as qualified residence interest would be: $80,000 * $1,100,000/$1,350,000 = $65,185.

Under the temporary regulations, if you used the simplified method you were required to treat interest on all excess debt as nondeductible personal interest. Thus, you would not be permitted to deduct any of the remaining interest in excess of the $65,185 computed above, even though the proceeds of the second mortgage were used in a rental activity. In perhaps the most important piece of CCM 20120107, however, the IRS ruled that a taxpayer using the simplified method can, in fact, apply the interest tracing rules to any interest expense in excess of the limited amount.

Exact Method

Under the exact method, the amount of qualified residence interest is determined on a debt-by-debt basis by comparing the applicable debt limit for the debt to the average balance of each debt. The applicable debt limit is an amount that is equal to the $1,000,000 limit on qualified residence debt reduced by the average balance of each debt that was previously secured by the qualified residence.

If the average balance of the debt does not exceed the limitation for that debt, all the interest on that debt is qualified residence interest. If the average balance of the debt exceeds the limitation, the amount of qualified residence interest is determined by multiplying the interest with respect to the debt by a fraction, the numerator of which is the applicable debt limit for that debt and the denominator of which is the average balance of the debt.

Applying the same facts as above, the applicable debt limit for the $900,000 first mortgage would be $1,000,000, and the entire interest expense related to the debt would be deductible. The applicable debt limit for the $250,000 debt would be $100,000 ($1,000,000 – $900,000), and 10/25 of the interest expense would be deductible as qualified residence interest. The interest on an additional $100,000 of the $250,000 debt would be deductible as home equity interest. Lastly, the applicable debt limit for the second mortgage of $150,000 would be $0, as the entire $1,000,000 limitation has been used.

Under the exact method, a taxpayer is also permitted to treat interest on debt that exceeds the limitations according to the use of the debt proceeds under the interest tracing rule. Thus, though the interest on the remaining home equity line of $50,000 would not be deductible — as it was used for personal expenses — the interest on the $150,000 second mortgage would be deductible as trade or business interest under the interest tracing rules.

[i] Treas. Reg. § Section 1.163-10T

[ii] Prior to the amendment, this numerator was the adjusted purchase price of the residence.

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While Mitt Romney’s 13.7% effective tax rate finds itself squarely in the crosshairs of both the Republican and Democratic parties, Janet Novack over at Forbes correctly points out that Newt Gingrich used some savvy tax planning of his own to minimize his overall tax liability. Gingrich owns two S corporations, and he leveraged a fifty-year old Revenue Ruling to his advantage by taking “only” $450,000 of compensation from the corporations, while allowing the net profits of $2.4 million to flow through to his individual tax return free from payroll taxes.

In this article published in the Tax Adviser, a certain Aspen-based author takes a thorough look at the issue of S corporation reasonable compensation and explains in detail the mechanism by which Gingrich — and many wealthy business owners like him — are able to save on payroll taxes by minimizing salary in favor of distributions. The article also examines the substantial case history surrounding S corporation compensation, and offers guidance on how to minimize the risk of a successful IRS attack. Fortunately for all, the Tax Adviser article is devoid of the low-brow humor, grammatical errors, and misspellings that have come to define the author’s mildly popular blog:

This S corporation flow-through income has long enjoyed an employment tax advantage over that of sole proprietorships, partnerships and LLCs. This advantage finds its genesis in Revenue Ruling 59-221,[i] which held that a shareholder’s undistributed share of S corporation income is not treated as self-employment income. In contrast, earnings attributed to a sole proprietor, general partner or many LLC members are subject to self-employment taxes.[ii]

As these employment tax obligations have climbed, the advantage of operating as an S corporation has become magnified. Since S corporation income is not subject to self-employment tax, there is tremendous motivation for shareholder-employees to minimize their salary in favor of distributions, which are also not subject to payroll or self-employment tax. Consider the following example:

Example 1: A owns 100% of the stock of S Co., an S corporation. A is also S Co.’s president and only employee. S Co. generates $100,000 of taxable income in 2011, before considering A’s compensation. If A draws a $100,000 salary, S Co.’s taxable income will be reduced to zero. A will report $100,000 of wage income on his individual income tax return, and S Co. and A will be liable for the necessary payroll taxes. S Co. will be required to pay $7,650 (7.65% of $100,000) as its share of payroll tax, and S Co. will withhold $5,650 (5.65% of $100,000) from A’s salary towards A’s payroll obligation, resulting in a total payroll tax bill of $13,300.  

Example 2: Alternatively, A may choose to withdraw $100,000 from S Co. as a distribution rather than a salary. S Co.’s taxable income will remain at $100,000 and will be passed through to A and reported on his individual income tax return, where it is not subject to self-employment tax. The $100,000 distribution is also not taxable to A, as it represents a return of basis.[iii]  By choosing to take a $100,000 distribution rather than a $100,000 salary, S Co. and A have saved a combined $13,300 in payroll taxes.

Now, let it be said, while some may paint Gingrich’s $450,000 salary as unreasonably low — particularly in light of the fact that majority of the earnings of the S corporations appear to be attributable solely to services provided by Gingrich and his wife — there is no precedent in which the courts have held a salary of this magnitude to be unreasonable low.* To the contrary, the majority of IRS challenges have come when shareholders pay themselves less than the social security wage base, thereby avoiding the 12.4% (10.4% in 2011) social security tax on wages below $106,800 in addition to the 2.9% Medicare tax on all foregone wages.

Once a shareholder has paid himself  — at minimum — the social security wage base as compensation, the avoided payroll tax becomes limited to the 2.9% Medicare piece, and the risk of an IRS challenge appears to become significantly reduced. In Gingrich’s case, taking a salary of $450,000 allowed him to avoid only the 2.9% Medicare tax on the additional profits of $2.4 million; and while $70,000 is not a paltry sum by any means, it will certainly not go down among the great tax avoidance strategies of all time.

 Hat Tip: Tax Prof

[i] Rev. Rul. 59-221, 1959-1 C.B. 225.

[ii] Sec. 1402(a).

[iii] Sec. 1368.

* Also note, Novack’s article does not quantify how much of the $2.4M earnings of the S corporations was distributed to Gingrich or his wife as distributions. There appears to be no significant exposure to an S corporation shareholder who foregoes significant compensation provided they also forego taking distributions; the risk begins when a shareholder draws distributions but not a reasonable amount of salary.

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Ed note: If you received an email earlier today, please disregard. I had a case of premature publication. It’s embarassing, but it happens, and I’m not ashamed to admit it.

In response to increased scrutiny regarding the effective tax rate paid on his substantial income, Republican Presidential candidate Mitt Romney released his tax returns late last night. Yours truly was given an opportunity to review the returns immediately upon their release for Bloomberg and provide comment. You can read that article here, but in the interest of keeping this blog self-contained, the most revealing items included in Romney’s 2010 individual tax return are discussed below:

  •  His real name is Willard? I’d go with Mitt, too.
  • Romney paid $3,000,000 of federal tax on $21,600,000 of gross income, for an effective rate of 13.9%. While this is sure to draw ire from the 99-percenters, it is 100% legal, and is largely attributable to two things:
  1. Romney’s $18,000,000 of alternative minimum taxable income (he paid a small amount of AMT)  consisted of $15,500,000 of income eligible for the preferential tax rate of 15%. In specific, $3.3M of Romney’s $4.7M of dividend income was eligible to be taxed at this lower rate, a break that was added to the Code with the Bush tax cuts. In the absence of the Bush legislation, Romney’s entire $4.7M of dividends would have been taxed at the maximum ordinary income rate, currently 35%. In addition, Romney’s also recognized $12.2M of long-term capital gains, which similarly benefitted from the Bush cuts. The gains are currently taxed at 15% rather than the 25 or 28 percent rates that existed previously.
  2. As expected, Romney benefits greatly from the current treatment of “carried interest” as provided for under administrative rulings issued by the IRS. In short, a carried interest is a partnership interest granted to a partner — typically a money manager in a private equity firm — in only the future profits of the partnership in exchange for managing the money of the private equity firm, choosing its investments, divestitures, etc… Under Rev. Procs. 93-27 and 2001-43, the granting of a pure profits interest is not a taxable event; thus, when Romney receives a profits interest in a private equity firm, it is not taxed as compensation (or capital gain), and the future income of the private equity partnership that is allocated to him — typically long-term capital gains — is eligible for the preferential 15% rates.

The reason carried interests have come under attack — particularly from the Obama administration — is obvious. On the surface, the amounts allocated to the managing partner certainly appear to be compensation for services; thus, according to critics, they should be taxed at ordinary income rates rather than capital gain. While this law may change in the future, it is important to note that Romney is completely correct in treating the amount of income allocated to him from his carried interests — $7,000,000 of the total $12,200,000 of capital gain according to his campaign — as LTCG rather than compensation.

  • Of Romney’s $3,000,000 of charitable contributions, half were made in cash to the Church of Latter Day Saints (which would appear to be part of Romney’s tithing requirement), and half made in stock to Romney’s private foundation, the Tyler Foundation.
  • How bad were things in 2009 if even Mitt Romney had a $4,000,000 capital loss carryforward to 2010?

All in all, there as nothing shocking about Romney’s tax returns. Yes he paid only 13.7% of his income to the IRS in federal tax, but such is life under the current tax regime when the overwhelming majority of your income is earned in the form of long-term capital gains and qualified dividends. Critics, however, are sure to focus on four things:

  1. The effective rate. Again, for right or wrong, Romney paid only 13.7% of his income in tax, but he did so legally and in total compliance with the current rules.
  2. The pure size of the numbers. Even for a Presidential candidate, $20M of AGI is a lof to income, which may not be particularly well received in this time of the Occupy Wall Street movement, cries of economic inequality, and other opening salvos of class warfare.
  3. Romney received a $1.6M tax refund in 2010. Now you and I know that tax refunds are purely a function of your tax liability compared to the estimated payments you’ve made, but the public is likely to find it hard to swallow that someone with $20M of income received a refund exponentially larger than most people’s income for the year. Again, it’s not the right reaction, but it’s likely to occur.
  4. Prior to the release of his returns, Romney admitted to a 15% effective rate, stating that he did generate some ordinary income from speaking fees, but “not much.” It turns out “not much” was in excess of $500,000, a sum most would be more than happy to accept for a few hours of speaking. This could position Romney as “out of touch” with the average American, an angle many of his critics and opponents may embrace.

Additional coverage:

The Washington Post

The NY Times

CBS News

Wall Street Journal

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As a young CPA, I had tremendous difficulty grasping the difference between a taxpayer’s “effective” tax rate and his “marginal” tax rate. Of course, I also have tremendous difficulty grasping how Twitter works, so perhaps I’m not the best barometer for this sort of thing.

But if you find yourself similarly challenged, this piece from the USA Today may help end the confusion. The impetus for the article is the recent hubbub surrounding Republican Presidential candidate Mitt Romney’s admission that he paid a tax rate of approximately 15% on his millions of taxable income. As the author points out:

Under the United States’ progressive tax system, income is taxed at graduated rates. An individual’s tax bracket, sometimes referred to as the marginal tax rate, refers to the percentage of income that’s taxed at the top tax rate — not the rate for the entire amount. (Ed note: this marginal rate is often referred to as the tax rate imposed on the last dollar of taxable income earned.) The effective tax rate, meanwhile, is the amount a taxpayer pays in taxes as a percentage of total income.

Thus, assume Romney earned $500,000 in speaking fees and $5,000,000 in long-term capital gains from his role as a retired partner in Bain Capital. While Romney’s marginal tax rate would be 35%, as his income level reaches the highest tax bracket, the fact that the overwhelming majority of his taxable income qualifies for the preferential tax rate on capital gain means his effective tax rate would approximate 15%.

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A few things you may have missed while watching Lee Evans and Kyle Williams let the Super Bowl slip between their fingers.

Some key numbers to have handy during individual filing season.  The most important one?  It’s only 85 days until April 17th.

Despite the fact that the federal deficit is growing faster than Kobe’s divorce settlement, the IRS is cutting agents. Did you know that based on a 2,080-hour work year, cutting one senior corporate auditor would cost the U.S. $19 million in lost revenue.  If I were a senior corporate auditor, I’d totally use that factoid to pick up chicks.

Obama would like to see the U.S. corporate tax rate lowered, but its reach extended.  He should make sure to leave a reminder on a  Post-it note for the new guy. HI-YO!

Speaking of unpopular Presidents, the Bush tax cuts apparently made the rich richer and the poor poorer. Odd. I would have thought the lower and middle classes — what with their expansive stock portfolios — would have stood to benefit the most from reduced capital gains rates.

If you’re over 70 1/2, pull yourself away from that Murder She Wrote  marathon on AMC long enough to check out this article, reminding you that your ability to make a contribution from your IRA directly to a charity without generating taxable income is gone. For now.

Lastly:    Wooderson + Butch Walker = Awesomeness. That’s just science.

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