Year-end tax guide: FAQs

2015 Year-end tax guideHave questions? We have answers. The following are frequently asked questions that you might have as well.

Individual income taxes

Q: What’s a marginal tax rate?
Your income is subject to different rates as you climb up the tax brackets. Your marginal tax rate is typically the top rate that applies to you. It’s what you would pay on your next dollar of income.

Q: Is all income taxed the same way?
No, income is divided into many different categories and subject to different tax rules. Ordinary income is generally taxed at higher rates, while long-term capital gains and dividends enjoy special lower rates. Earned income is subject to employment taxes, while certain kinds of investment income are subject to net investment income (NII) tax.

Q: What’s included in ordinary income?
Ordinary income includes items like salary and bonuses, self-employment and business income, and retirement plan distributions. Even most types of investment income, like rents, royalties and interest, are taxed as ordinary income. Two kinds of investment income are not considered ordinary income and are subject to special lower rates: qualifying dividends and long-term capital gains from assets held at least one year.

Q: What’s included in earned income?
Earned income is generally income you earn from working and includes things like wages, bonuses, salaries, tips and self-employment income. It generally does not include investment income like rents, interest, dividends and capital gains.

Q: What’s the difference between an above-the-line deduction and an itemized deduction?
An above-the-line deduction is taken on the first page of your tax return to reduce adjusted gross income (AGI). It helps with AGI-based phaseouts and is taken whether or not you itemize deductions. Most deductions are itemized and do not reduce AGI, only taxable income. You typically itemize deductions only if they exceed the standard deduction, and many itemized deductions have limits, phaseouts or AGI floors.

Employment and investment taxes

Q: What’s the difference between employment tax and NII tax?
Employment taxes have long been imposed under the Federal Insurance Contributions Act (FICA) against earned income. They require both employee and employer shares (self-employed taxpayers must pay both) and are used to fund Social Security and Medicare. The tax on NII was created in 2010 and first took effect in 2013. The 3.8% rate is meant to be equivalent to the top combined Medicare employment tax rate, but the proceeds do not actually go into the Medicare trust fund. So while in some ways it was meant to expand Medicare taxes to cover investment income for the first time, it has a totally different tax base that does not fully complement earned income.

Q: What’s included in NII?
NII comprises rent, royalties, interest, dividends, capital gains, annuities and any income from a trade or a business that is a passive activity. There is an exception if income is derived in the ordinary course of a trade or a business in which you are not passive. Income from trading in financial instruments or commodities is always NII, regardless of whether you participate in the business. NII does not include qualified retirement plan distributions; and income that is generally excluded under other provisions of the tax code, such as tax-exempt interest, is also generally excluded from NII.

Q: Can my income be hit with both employment and NII tax?
No, income is never subject to both at the same time, but you can pay each tax on different streams of income.

Q: Is there any income that avoids both?
There may be income that is not subject to employment or NII tax. An S corporation owner who is active in the business will typically pay employment tax only on salary and will not owe self-employment tax or NII tax on the rest of the S corporation’s operating income. In some cases, a limited partner who participates in the partnership’s business may not pay either tax on the partnership’s operating income.

Q: Which tax would I rather pay?
The rules do not allow you to choose one or another, but in general, self-employment taxes are preferable for the deduction on the employer share of tax.

Alternative minimum tax (AMT)

Q: What is the AMT?
The AMT is essentially a separate tax system with its own set of rates, rules and deductions. Each year you must calculate your tax liability under the regular income tax system and the AMT, and then pay the higher amount.

Q: Who typically has to pay the AMT?
You generally have to pay the AMT if you use many tax benefits that are not allowed against the AMT. Common AMT triggers include the following:
  • State and local income and sales taxes, especially in high-tax states
  • Real estate or personal property taxes
  • Investment advisory fees
  • Employee business expenses
  • Incentive stock options
  • Interest on a home equity loan not used to build or improve your residence
  • Tax-exempt interest on certain private activity bonds
  • Accelerated depreciation adjustments and related gain or loss differences on disposition

Q: Can I plan around the AMT?
Yes, there are ways to take advantage of the lower rates offered by the AMT, or to lessen AMT triggers. Multiyear planning is the key because you may be subject to AMT in some years and not others.

State and local taxes

Q: Does sales tax typically apply to rentals and leases?
Yes, nearly all sales and use taxes have provisions that apply the tax to rentals and leases of goods that would be taxed if bought.

Q: Are pass-through businesses ever subject to entity-level state and local income tax?
In contrast to the federal income tax regime, a few states and local jurisdictions subject the apportioned income from pass-through businesses to entity-level tax.

Q: When do I have to collect sales tax on a sale?
The rules are complex and may depend on whether your business has a physical presence in the state or an association with an in-state individual or business, and how sales to customers in the state are actually made.  

Your filing and payment requirements

Q: What filing responsibilities do I have as an individual?
You must pay tax throughout the year through either withholding or estimated tax penalties. You must file an annual income tax return if your income is high enough, and you must pay your balance in full by April 15 even if you extend your return. You may have additional responsibilities if you have a foreign financial account, run a business or have household employees.

Q: When do I have to pay tax as an individual?
Although you don’t file your return until after the end of the year, you must pay tax throughout the year with quarterly estimated tax payments or withholding. To avoid penalties, you must generally pay at least 90% of your tax or 100% of last year’s tax (110% if AGI exceeds $150,000) throughout the year through withholding and estimated tax. Any further balance is due on the April 15 filing deadline, even if you extend your return. If necessary, quarterly estimated tax payments for individuals are due on April 15, June 15, Sept. 15 and Jan. 15.

Q: Should I file on paper or electronically?
Some businesses are now required to file electronically, but individuals are not. Filing electronically will typically get you a refund faster, and the IRS can often identify a problem up front that would take a long time to clear up if filed on paper.

Q: What do I do if the IRS contacts me?
Don’t panic and don’t ignore it. Some notices are sent in error and others raise issues that can be corrected easily. If you have a more serious issue, the IRS notice will give you a full accounting of your rights. Read it and contact the IRS or a professional if needed.

Executive compensation

Q: What’s the difference between restricted stock and stock options?
Stock options give you the option of buying stock at a set price and become valuable when the value of the stock exceeds the price. Restricted stock is granted and vests once certain conditions are met.

Q: Should I make a Section 83(b) election?
An election under Section 83(b) can convert future appreciation from ordinary income into capital gain. The biggest drawback is that you can’t get a refund of any taxes from the election if you forfeit the stock or the value decreases. You can make an 83(b) election for restricted stock but not for stock options.

Q: Do I have to disclose executive pay?
There are now a number of new reporting requirements and required shareholder votes on executive pay for public companies. Private companies are not subject to these rules.

Business taxes

Q: What’s the major tax difference between a pass-through and a C corporation?
Pass-through entities effectively pass taxation through to individual owners, so the business income is generally taxed only at the individual level. C corporation income is taxed first at the corporate level and again at the shareholder level when it is distributed to shareholders in the form of dividends.  

Q: If my business isn’t publicly traded, should it be a pass-through?
There are many considerations with entity choice, but some of the tax advantages of pass-throughs are compelling enough that most privately held C corporations should seriously consider an S election to become an S corporation, if eligible.

Q: What’s the difference between a partnership and an S corporation?
Both partnerships and S corporations are pass-through entities, but they are governed by different rules. Partnership rules are generally more complicated and flexible, and many types of state law entities are eligible to be classified as a partnership, including limited partnerships, general partnerships, limited liability partnerships (LLPs) and limited liability companies (LLCs). S corporations are always state law corporations (or LLCs that elect to be treated as corporations). They are governed under a simplified tax structure, but it comes with many restrictions. Among other things, they are allowed only one class of stock and no more than 100 shareholders, and there are limits on their passive income.

Q: What’s the difference between a stock sale and an asset sale?
A stock sale allows a C corporation owner to be taxed on only one layer of gain. An asset sale allows buyers to have depreciation write-offs. For a C corporation, an asset means the seller would be taxed twice — first at the corporate level when the assets are sold to the buyer, and then at the individual level when the proceeds are distributed.

Charitable deductions

Q: Can I donate clothing or household goods?
They must be in at least “good used condition” to be deductible.

Q: When do I need a receipt?
Cash donations of $250 or more must be substantiated by the charity. Under $250, a canceled check or credit card receipt is sufficient.

Q: Can I deduct the value of my services?
No, you cannot deduct the fair market value of donated services, only your out-of-pocket expenses. So if you are a doctor or a lawyer, for instance, and you volunteer your services, you cannot deduct the cost of what you would normally charge for those services.

Q: Can I get a deduction for letting a charity use my property?
No deduction is allowed because it isn’t considered a gift of your interest in the property to the charity.

Q: Can I get a deduction for driving?
You may deduct 14 cents for each charitable mile driven.

Q: Can I deduct the value of a donated car?
Unless the car is used by the charity in its tax-exempt function, you can deduct only what the charity receives when it sells the car.  

Retirement savings

Q: What happens if I withdraw from my account before age 59½?
You are generally subject to a 10% penalty, plus normal tax unless you qualify under narrow exceptions. Many 401(k) plans let you borrow against your account without tax consequences; there are also hardship waivers that can allow you to escape the 10% penalty (but not normal tax).

Q: Do I have to include my employees in my retirement plan?
Yes, the price for the tax advantages offered is that employees are generally required to be covered, and plans have nondiscrimination rules.

Q: When should I use a Roth account and when should I use a traditional one?
The difference stems from when you pay the tax. With a traditional retirement account, you get a tax break on the contributions and pay taxes only on the back end when you withdraw your money. For a Roth account, you get no tax break on the contributions up front, but you never pay tax again if distributions are made properly. A rollover into a Roth account can be attractive because you pay tax on the conversion from outside the account, effectively increasing the share of your wealth in a tax-preferred investment. Roth IRAs also have no required minimum distributions. But you may want to stick with a traditional account if you’ll be in a lower tax bracket or lower tax state when you retire, or if a conversion would generate a lot of income that would affect other items tied to AGI.

Q: What’s the best plan for small employers?
Both simplified employee pensions (SEPs) and savings incentive match plans for employees (SIMPLEs) are attractive options. With each plan, you must make contributions for employees, and employees are always 100% vested. A SEP does not allow employee contributions, but allows up to $53,000 in employer contributions. A SIMPLE allows employees to contribute up to $12,500 and requires an employer match of up to 3% of employee pay or a fixed contribution of 2% of pay. A SIMPLE is limited to businesses with 100 or fewer employees.

Q: When should I take money out of my account after I retire?
Generally, if your account is appreciating and you don’t need the money immediately, you should wait to make withdrawals until you’re required to do so. Your assets will continue to grow on a tax-deferred basis.

Estate planning

Q: What’s the difference between estate, gift and generation-skipping transfer (GST) taxes?
The estate and gift taxes make up the two parts of a unified tax regime with a combined $5.43 million lifetime exemption and a top rate of 40%. The GST tax is an additional tax that applies to transfers of assets to grandchildren or other family members that skip a generation (including nonrelatives at least 37½ years younger than the donor). It offers its own exemption of $5.43 million and also has a top rate of 40%.

Q: How are estate and gift taxes ‘unified’?
You have one combined lifetime exemption that can be used either by your estate at death or during your life by giving. Once your lifetime exemption is depleted, your wealth will generally be subject to a 40% tax, regardless of whether it’s imposed when you transfer assets while alive or when your estate transfers them when you’ve passed. You can also make taxable gifts during your life if you do not want to use the combined exemption.

Q: Should I ever make a taxable gift?
Making taxable gifts can have significant benefits. For one, the amount of gift tax paid is removed from the estate. If you give a $1 million taxable gift during your life, you will pay $400,000 in tax. If you hold onto that $1.4 million until you pass, your estate will pay $560,000 in tax ($1.4 million * 40%), and your heirs will receive only $840,000. Be careful, though. If you transfer property with a low basis, the step-up in basis received at death might be valuable to your heirs. In addition, if you die within three years of making a gift, the gift tax will be added back into your estate.

Q: Why are low interest rates so good for estate planning?
Many transfer tax strategies, such as grantor-retained annuity trusts and intentionally defective grantor trusts, hinge on the ability of assets to appreciate faster than the interest rates prescribed by the IRS. An appreciating market and historically low rates create the perfect atmosphere for estate planning.

Q: Is my same-sex spouse eligible for the marital deduction?
The IRS will treat any same-sex couple as married for federal tax purposes if the couple was legally married in any of the 50 states, the District of Columbia, a U.S. territory or a foreign country. The IRS does not recognize domestic partnerships, civil unions or other similar formal relationships as marriages for federal tax purposes.

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