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Coping with the New 3.8% Medicare Surtax

Tax strategies to use in 2012

Beginning in 2013, a new 3.8% Medicare surtax will apply to investment income received by certain high-income taxpayers. The tax law provision authorizing this surtax was included in the Patient Protection and Affordable Care Act of 2010 recently upheld by the U.S. Supreme Court.

Here’s how it works: Based on a tax return calculation, a 3.8% surtax applies to the lesser of (1) your net investment income or (2) the amount by which modified adjusted gross income (MAGI) exceeds an annual threshold of $200,000 for single filers and $250,000 for couples filing jointly. The surtax is also imposed on trusts and estates with income above the threshold based on the dollar amount of the highest tax bracket.

For this purpose, “net investment income” includes interest and dividends; distributions from annuities (other than tax-deferred distributions); rent and royalties; gains from investments in passive activities; trades of financial instruments and commodities; and net capital gain from the sale of property (other than property held in an active trade or business). Significantly, it does not include salary or wages; distributions from IRAs and qualified retirement plans; taxable Social Security income; active trade or business income; self-employment income; gain on the sale of active interests in a partnership, S corporation or limited liability company; income from tax-exempt municipal bonds; and tax-deferred income from nonqualified annuities.

For instance, suppose that a couple filing a joint return realizes net investment income of $100,000 and has a MAGI of $300,000 in 2013. Because the $50,000 excess above the MAGI level is lower than the $100,000 of net investment income, the couple owes a surtax of $1,900  (3.8% of $50,000), on top of their regular income tax liability. However, for a couple with the same net investment income of $100,000 and a MAGI of $500,000, the surtax is $3,800 (3.8% of $100,000).

The 3.8% Medicare surtax in 2013 creates an added tax incentive to realize certain income before the end of this year. Here are several potential year-end strategies for investors to consider:

Final words: These are only a few of the ideas that may be considered in view of your personal circumstances. The tax law is ever-changing, so obtain professional assistance with respect to year-end planning.

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Glad Tidings for Year-end Gifts

Tax breaks available under current law

Due to recent tax law changes, you may want to give generous gifts to family members this holiday season. The gifts can reduce the size of your taxable estate. Here is a brief overview of the basic tax rules.

Annual gift-tax exclusion: Under the annual gift-tax exclusion, you can give away a specified amount each year to a recipient without paying any federal gift tax. The exclusion, which is indexed for inflation, is $13,000 for 2012. (It is being increased to $14,000 for 2013.) For example, you might give up to $13,000 to each of your two children and three grandchildren—a total of $65,000 in gifts—without triggering any gift tax.

Furthermore, the annual gift-tax exclusion is doubled to $26,000 if your spouse joins in the gifts. In other words, you might give away $26,000 to each of the five family members, free of gift tax. That totals $130,000 in tax-free gifts. By giving the same amount for five years in a row, you can reduce your taxable estate by $650,000.

Cumulative gifts: The amount of any gifts made above the annual gift-tax exclusion may be sheltered by the lifetime gift-tax exemption (although this reduces the available tax shelter for your estate). Prior to the 2010 Tax Relief Act, the estate- and gift-tax systems were severed, with the lifetime gift-tax exemption remaining locked at $1 million. But a 2010 act reunified the two systems, with a maximum exclusion amount of $5 million per person for 2011 and 2012 (indexed to $5.12 million for 2012).

Educational and medical gifts: You can pay qualified expenses directly to a medical provider or educational institution on behalf of others without incurring any gift-tax liability. For instance, if your child or grandchild attends college, pay the youngster’s tuition directly to the school. These gifts do not count against the amounts sheltered from gift tax by the annual gift-tax exclusion.

Note that your family may also save income tax when you give gifts to other family members. Typically, the income subsequently earned from the gifts is taxed to a family member in a lower tax bracket than you are. For instance, you might decide to transfer income-producing property to a minor child. However, don’t overlook the impact of the “kiddie tax.” If a child younger than 19 or a full-time student younger than 24 receives more than $1,900 in unearned income in 2012, the excess is generally taxed at the income tax rate of the child’s parents—regardless of the source of the gifts.

With the end of the year fast approaching, you can set up a gift-giving program to maximize the tax benefits. Reminder: The estate-tax laws are scheduled to “sunset” after 2012, so be sure that your plan can accommodate changes.

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Can the Corporate Veil Be Pierced?

Protection from liability is not absolute

There are several possible reasons why you might incorporate a business. One of the main advantages unrelated to taxes is the protection of the “corporate veil” (also known as the “corporate shield”). Under this basic principle of law, a business owner cannot be held personally liable for the debts and obligations of the corporation. Nevertheless, be aware that the corporate shield is far from invincible.

Background: A corporation is separate and distinct from its individual shareholders. This includes limited liability companies (LLCs), whose owners are “members,” but not partnerships or self-employed operations. As a result, corporate shareholders (or LLC members) are not legally required to “make good” on the corporation’s debts when creditors come calling.

However, in certain situations, a court may still hold officers, directors and shareholders (or members) personally liable for debts. This is often referred to as “piercing the corporate veil.” It happens more often to owners of small, closely held businesses than it does to officers of Fortune 500 companies.

When the corporate veil is pierced, creditors can pursue your personal assets—such as your home, bank accounts and investments—to satisfy the corporate debt. But courts will impose personal liability on individuals only in limited circumstances.

For example, the appropriate court may consider the following factors in determining whether or not to pierce the corporate veil:

Based on those factors, owners of closely held companies are more vulnerable to losing protection than are shareholders of large, publicly traded corporations. For instance, a small company may not observe all the corporate formalities, such as recording minutes for significant business decisions. To be on the safe side, small corporations (and LLCs) should hold annual meetings of directors and shareholders or members; keep accurate and detailed minutes of important decisions at meetings; adopt company bylaws; and make sure that officers and agents abide by those bylaws.

A small-business owner is also more likely to be guilty of commingling assets. For example, an owner might divert corporate assets for his or her own personal use by writing a check from the company account to pay the mortgage on a home or depositing a check made out to the corporation into a personal bank account.

Better approach: The corporation should maintain its own bank account, and the owner should not use the company account personally in any way, shape or form.

When a business owner handles things on the straight and narrow, a corporation can provide a formidable shield from personal liability should dire financial situations occur. But blurring the lines between your business and your personal affairs is only asking for trouble. If you have any questions about the distinctions, consult your professional advisers.

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Tax Whistleblower Reaps a Windfall

The rewards for turning in tax cheaters to the IRS can be ample.

Under a revised program, “whistleblower” awards can range between 15% and 30% of the total collected. But the awards are limited to cases involving a tax liability of $2 million or more.

In a highly publicized new case, banker Bradley Birkenfeld helped identify foreign accounts held by U.S. taxpayers at UBS. His award was $104 million. Birkenfeld’s disclosures enabled the IRS to collect more than $5 billion in unpaid taxes.

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Avoid These Seven E-mail Mistakes

Common errors in the business world

E-mail has been around for awhile now, so you probably feel you have the hang of it. Nevertheless, business people continue to make the same mistakes over and over again. Not only can this make you look foolish but it could irreparably harm a business relationship. Here are seven common errors to avoid.

1. You don’t use your business e-mail address. Typically, you might reference your personal e-mail accounts at work, keeping them open on your desktop. Then you accidently fire off a business e-mail from one of your personal accounts. Besides being inappropriate, the message could be directed to the recipient’s spam folder. Check first before you click “Send.”

2. You exclude e-mail recipients. This is easy enough to do but just as easy to forget. If you want to keep several people in the loop, remember to hit “Reply to All” before sending out a response. Again, check before you click.

3. You send a stand-alone response. When you correspond with dozens of business contacts during the day, you can easily forget the details of a prior conversation or even that it occurred. It is helpful to you and others to be able to skim the back-and-forth you have already had. Do everyone a favor by including the entire thread of past communications when you respond.

4. You don’t reply at all. Sometimes you may forget to respond to an e-mail or simply ignore the communication. When you do not respond, it’s almost like saying, “I am more important than you.” Show your business contacts  courtesy by answering them.

5. You don’t “blind carbon copy” others. The blind carbon copy (Bcc) function has several benefits. It can help inform recipients who do not need to be part of the conversation. The Bcc function can also protect the person’s e-mail address from other recipients. And it is a good way to copy someone on a message without the other recipients knowing about it.

6. You “carbon copy” too many people. The flip side of not using the Bcc function is overusing the carbon copy (Cc) option. Although it is often helpful to reply to all (see Mistake #2), it is not always sensible to copy everyone under the sun. Ask yourself if this person is a worthwhile recipient or if it is simply bothersome to him or her. Use the Cc with discretion.

7. You ramble on or you are unprofessional. E-mails should be concise and to the point. If you can’t say what you want in just a few sentences, you are probably better off just picking up the phone (unless you’re stating something that should be documented). Even though the message is short, keep it professional. Also, most business messages should avoid slang and reflect proper grammar.

Is that all? Not really, because other mistakes in the form of commissions and omissions are often made in e-mails. However, if you fix these seven common errors, it will give you a good head start.

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Facts and Figures

Timely points of particular interest

IRS Investigations—If taxpayers don’t turn over records, the IRS may issue a summons compelling them to do so. Increasingly, the IRS is becoming aggressive in its use of this administrative tool, resulting in more legal challenges. According to the Taxpayer Advocate Service, the number of lawsuits brought against the IRS for this reason totaled 132 in 2011, a threefold increase since 2005.

Financial Forecasts—How can you forecast business revenue and expenses for a start-up? It’s more of an art than a science. Entrepreneurs often complain that creating a reasonably accurate forecast takes up valuable time that is better spent on other matters. But it is difficult to attract investors without meaningful figures. Rely on your professional advisers to assist with the process.

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