Tax Impact - September October 2012

 

tax 

IMPACT

Multistate taxation

Give your business a nexus checkup Rules of the house: The tax ins and outs of refinancing GST tax requires special planning Sharing wealth with grandchildren and beyond

Tax Tips Supreme Court ruling on health care law, deducting local lodging expenses and more

September/October 2012

 

Multistate taxation

Give your business a nexus checkup The Internet and other technological developments have made it easy for companies to do business across state lines. Unfortunately, along with these new business opportunities comes a new set of tax headaches. Whether your business is subject to another state’s income, franchise, sales and use, or other taxes depends on whether you have a substantial connection — or “nexus” — with that state. But the rules regarding nexus vary from tax to tax, state to state and even locality to locality, so understanding and complying with multistate tax obligations can be a challenge. To avoid unexpected tax liabilities, consider conducting periodic nexus checkups.

A matter of presence Traditionally, having a nexus with a state required a physic  physical  al  presence  presence in that state, such as retail stores, offices, manufacturing facilities or employees. But cash-strapped state and local governments have been stretching the boundaries of nexus in an attempt to bring in additional tax revenues.

In situations that don’t fall within the rules, a mere economic  presence may suffice.

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The U.S. Supreme Court has held that a physical presence is still required for a state to impose sales tax collection obligations on out-of-state businesses. And a federal law bars states from imposing their taxes on businesses whose activities in limited to the solicitation theincome state are

of orders for tangible personal property that are approved and filled outside the state. But many states have reduced to a bare minimum the contact necessary to establish physical presence. In some states, for example, brief trips by out-of-state sales reps are enough to create nexus. And several states now impose sales tax collection liability on out-of-state sellers without a physical presence if those sellers are affiliated with an in-state business or if sales are generated through referrals from an in-state business’s website (so-called “click-through nexus” laws). The enforceability of these laws is uncertain, though. At least one state’s click-through nexus law has been struck down by the courts as unconstitutional. In situations that don’t fall within the above rules, such as franchise taxes or income taxes on businesses that sell services or intangible property, a mere economic presence (such as substantial sales to a state’s residents) may suffice.

Legislative solutions Inconsistent state and local tax rulesand make it difficult for businesses to anticipate control

 

their tax obligations. There have been some efforts to improve consistency among state tax laws, such as the Streamlined Sales and Use Tax Agreement (SSUTA), which has been adopted by many states, and the activities of the Multistate Tax Commission. But many experts believe that a federal legislative solution is required.

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In recent years, lawmakers have introduced several bills in Congress that would make multistate tax compliance easier. Proposed solutions include:

Don’t wait

  Allowing

employees to work across state lines for a limited period of time (such as 30 or fewer days) without triggering the other state’s income tax withholding and payment obligations,

  Establishing

a bright-line bright-line physical presence presence standard for nexus and a consistent definition of physical presence for income and other business activity taxes, and

Allowing states that adopt sales tax simplification measures, such as SSUTA, to impose sales tax collection obligations on out-of-state sellers.

Consult with your tax advisor periodically to find out whether any or all of these measures are actually enacted.

Businesses will need to comply with confusing and often inconsistent state and local tax obligations until Congress simplifies multistate tax compliance. And this may not happen anytime soon. So don’t wait. Work with your tax advisor now to give your business a nexus checkup by taking inventory of your activities in and connections with various states, ensuring compliance with all applicable tax laws and regulations, and identifying potential strategies for minimizing your tax burden. 

Rules of the house: The tax ins and outs of refinancing Many homeowners have come face to face with the issue of refinancing their mortgages in recent years. What they may not have realized, when starting the process, is that they also have to deal with certain tax issues related to the refinancing, such as the impact of a straight replacement loan vs. cash-out refinancing. If you’re considering refinancing a home, make sure you understand the tax rules.

Defining “home” The mortgage interest deduction is available for interest on loans secured by your principal home or a second home. The definition of “home” can range from a house, condo or co-op to a mobile

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home or even a trailer or boat that’s equipped with sleeping, cooking and toilet facilities. The Internal Revenue Code allows you to deduct interest on up to $1 million in what’s known as “acquisition indebtedness” — that is, debt used to buy, build or substantially renovate a home — plus interest on up to $100,000 in home equity debt used for any purpose. These limits apply to the combined principal of every loan that’s secured by your principal and second homes. If your tax status is married filing separately, the limits are cut in half to $500,000 and $50,000, respectively. Homeowners who have more than $1 million in acquisition indebtedness may deduct interest on the excess as home equity debt, subject to the $100,000 limit, of course.

When you buy a home, “points” are deductible immediately. When you refinance, however, such prepaid interest is amortized and deducted ratably over the life of the loan. Let’s say you refinance a $500,000 mortgage with a new, 30-year loan,

Replacement vs. cash-out financing

paying points ($10,000). Evendeduct thoughthem you pay thetwo points up front, you must over 30 years at a rate of $333 per year. (Firstand last-year deductions, however, will be less.)

When you refinance a mortgage, the tax treatment of interest on the new loan depends on whether you do a straight replacement loan or a cash-out refinancing. With a replacement loan, you borrow an amount equal to the outstanding balance on the old mortgage. Interest on the new mortgage is fully deductible, provided your total acquisition indebtedness is no more than $1 million.

The definition of “home” can range from a house, condo or co-op to a mobile home or even a trailer or boat.

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Making a point about points

With a cash-out refinancing, in which you borrow more than you need to cover your outstanding mortgage balance, the tax treatment depends on how you use the excess cash. If you use it for home improvements, for instance, it’s considered to be acquisition indebtedness, and the interest is deductible (subject to the $1 million limit). If you use the excess cash for another purpose, such as buying a car or paying tuition, it’s considered home equity debt subject to the $100,000 limit.

If you’re already amortizing points — from a previous refinancing, for example — and you refinance with a new lender, you can deduct the unamortized balance in the year you refinance. But if you refinance with the same lender, you must add the unamortized points from the old loan to any points you pay on the new loan and deduct the total over the life of the new loan. There’s an exception for certain cash-out refinancing, however. You can immediately deduct points attributable to the portion of the new loan used to improve your principal residence. Going back to the previous example, if you use $100,000 of the $500,000 loan for home improvements, you can deduct one-fifth of the points, or $2,000, up front.

Maximize your tax benefits The tax consequences of refinancing can be difficult to grasp. But you need not go through the hassle alone. Contact your tax advisor. He or she understands the tax ins and outs of refinancing and can help you through the process. 

 

GST tax requires special planning Sharing wealth with grandchildren and beyond 

Designed to ensure that assets are taxed at each generational level, the generation-skipping transfer (GST) tax generally applies — in addition to gift or estate taxes — to transfers that skip a generation. It’s imposed at a flat rate equal to the highest federal estate tax rate at the time the transfer is made. If you want to share some of your wealth with your grandchildr grandchildren, en, great-grandchildren great-grandchildren or even more remote generations, special planning is required to keep taxes to a minimum.

There’s an exception if your child predeceases his or her own children during your lifetime. Under those circumstances, the grandchildren aren’t considered skip persons.

A limited-time offer?

2. A taxable termination. This occurs when assets in a trust you establish for a non-skip person, such as your child, pass to a skip person, such as your grandchild, on the death of the non-skip person.

The GST tax exemption, like the gift and estate tax exemptions, currently stands at a record-high $5.12 million ($10.24 million for married couples). But, also like the gift and estate tax exemptions, as of this writing it’s scheduled to drop back to just $1 million after 2012 (though, unlike the other two exemptions, the GST tax exemption will be adjusted for inflation). In addition, the top tax rate for all three taxes is scheduled to increase from 35% to 55% next year. While it’s possible that Congress will act to extend current exemption amounts and tax rates beyond 2012 or make other changes, there are no guarantees. Affluent families should consider making gifts this year to minimize gift, estate and GST taxes. Keep in mind that, for the transfer to be completely tax-free, you must also apply your gift tax exemption.

GST tax applies to three types of transfers: 1. A direct skip. This involves a gift or bequest to a grandchild or other skip person (including a trust that’s considered a skip person).

3. A taxable distribution. This is a distribution of trust income or principal to a skip person.

The tax doesn’t apply to gifts that are shielded by the annual gift tax exclusion (currently, $13,000 per recipient; $26,000 for gifts split by married couples).

3 types of GSTs A GST is a transfer to a “skip person,” such as a grandchild or other family member who’s more than one generation below you. It also includes non-family members who are more than 37.5 years younger than you. A trust is considered a skip person if all of its beneficiaries are skip persons.

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Leveraging your exemption Often, the best strategy is to establish a GST or “dynasty” trust designed to benefit your grandchildren, great-grandchildren and future generations. If the trust is structured properly, it will allow you to leverage your exemption.

The automatic allocation pitfall Unlike the gift and estate tax exemptions, which apply to taxable gifts and bequests without the need for any action on the taxpayer’s part, the GST tax exemption is a “use it or lose it” proposition. In other words, to take advantage of the exemption, you must allocate it to GSTs. However, to prevent you from inadvertently losing the GST tax exemption’s benefits, the tax code automatically allocates it to certain transfers unless you “opt out.”

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In other words, if your exemption covers the value of your gifts to the trust, it will also shield future appreciation from GST taxes — as well as gift and estate taxes. If your exemption covers only a portion of your gifts, however, only a portion of the appreciation will be sheltered from tax. If you have an existing trust that’s partially protected by your GST tax exemption, there may be advantages to splitting it into two separate trusts. (See “Should you split your trust in two?” below.)

Review your plan If you plan to make gifts to your grandchildren or later generations, consider doing so before year end to take advantage of the current GST tax exemption. If your estate plan includes trusts that will (or may) benefit skip persons, talk with your advisors about strategies that can minimize your GST tax exposure. 

Automatic allocation works well if your net worth is less than $5.12 million ($10.24 million if you’re married). It ensures that your GST tax exemption protects any gifts or bequests you make directly to a grandchild or other skip person or to a trust that will potentially benefit skip persons down the road. If your net worth is significantly higher Should you split your trust in two? than the exemption amount, however, It’s not unusual for people to have “blended trusts” — that automatic allocation can lead to undeis, trusts that are only partially protected by the generationsirable tax consequences. skipping transfer (GST) tax exemption. This might happen if you make additional gifts to a trust after you’ve used up your Suppose you set up a trust designed exemption. If such a trust benefits both non-skip and skip primarily to benefit your children. If persons, there may be tax advantages to splitting the trust in there’s a possibility that the trust will two (if permitted under applicable federal and state law). result in a taxable termination or distribution to your grandchildren in the Suppose, for example, that you contribute $2 million to a future, your exemption may automatidiscretionary trust that benefits your children and grandcally be allocated to the trust. If the children, allocating $1 million of your GST tax exemption. possibility that the trust’s assets will go The trust has an “inclusion ratio” of 0.5, which means that to your grandchildren is remote, how50% of any distributions to your grandchildren will be ever, your exemption might be wasted. subject to the GST tax. If, however, you split the trust in In such situations, generally, it’s best to two — with inclusion ratios of 1 and 0, respectively — the opt out and allocate your exemption to trustee can use the latter for distributions to your granddirect skips or to trusts that are more children free of GST taxes. likely to trigger GST taxes.

 

Supreme Court’s health care law decision impacts tax planning The U.S. Supreme Court’s June decision upholding the 2010 health care law could affect your year end tax planning. The ruling means that several new tax provisions will go into effect in 2013 — unless Congress repeals them.

tax  TIPS

If you’re a high-income taxpayer, the most significant change is likely that, starting in 2013, you’ll pay an additional 0.9% Medicare tax on earned income exceeding certain limits. In addition, you may owe a new, 3.8% Medicare tax on a portion of your unearned  income.  income. So, to the extent possible, you may want to accelerate income into 2012, such as by selling long-term appreciated securities. Taxpayers who itemize deductions may be affected by an increase in the medical expense deduction floor. Starting in 2013, the threshold for deducting such expenses increases from 7.5% to 10% of adjusted gross income. So, if you’ll exceed the floor this year but might not exceed the higher floor next year, consider incurring controllable expenses in 2012 rather than 2013. 

Basis overstatement not a “substantial omission” Generally, the IRS has three years to challenge a tax return after it’s filed, but it has six years if the taxpayer makes a “substantial omission” of income, defined as 25% or more of the gross income reported in the return. The U.S. Supreme Court recently held that an overstatement of basis is not  a   a substantial omission. The taxpayer in that case sold its business and properly reported the gross proceeds, but used a questionable strategy to inflate its basis, thereby reducing its capital gains. The Court said that “omission” is limited to an understatement of amounts realized. 

Deducting local lodging expenses Generally, lodging expenses aren’t deductible unless you’re traveling away from home on business. But the IRS recently issued proposed regulations that permit you to deduct certain local lodging expenses incurred for your employer’s business purposes. The regs include a safe harbor, which allows a deduction for local lodging expenses if:   The

lodging is necessary for an employee to participate fully in or be available for a bona fide business meeting, conference, training activity or other business function,

  The

lodging doesn’t exceed five calendar days or occur more than one time per calendar quarter,

  The

employer requires requires the employee to remain at the function overnight, and

  The

lodging isn’t lavish lavish or extravagant and doesn’t provide a significant element of personal pleasure.

7 You may rely on the proposed regulations now. Also, you might be able to amend previous years’ tax returns to deduct local lodging expenses. 

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