Whether they realize it or not, taxes ended up going up for most taxpayers last year, despite the extension of the Bush tax cuts at the beginning of last year.
Greg Rosica, a tax service partner at Ernst & Young and contributing author to the EY Tax Guide 2014, pointed to the combined impact of the fiscal cliff deal, which was enacted as the American Taxpayer Relief Act, or ATRA, and the expiration of the payroll tax cuts.
“I think really almost every taxpayer is facing higher taxes for 2013, whether they see it or they don’t see it,” he said in an interview last week. “The obvious part is the higher rates that came through from ATRA that really at different income levels phase in with different items. At $200,000 there’s an impact, at $300,000 of income there’s an impact, and at $400,000 there’s yet another impact. But also anyone who works and earns wages, from $1 to $115,000, had this Social Security payroll tax holiday that went away. It was 4.2 percent and went back to 6.2 percent, so that 2 percent went away. That’s not so visible because it came out of every paycheck and people didn’t see it. But I think the reality is that everyone, from the wage earner up through the higher-income level people, is seeing the impacts of the tax law changes and provisions that sunset.”
The hot topic these days for EY’s clients is the Net Investment Income Tax, which was mandated as part of the Affordable Care Act. The IRS only recently finalized the forms and instructions for that tax, even though it took effect at the beginning of last year (see IRS Finalizes Instructions for Net Investment Income Tax Form).
“One is understanding it, and two is understanding how it applies, and three is getting it on the forms correctly, as all of those things are new,” said Rosica. “They’re being evaluated and we’re trying to understand the implications. Understanding straightforward items like interest, dividends and capital gains from publicly traded securities and those kinds of things, you’re either at an income threshold level where those things apply or you’re not, and there’s not a whole lot to deal with. But in the area of trades or businesses, particularly partnerships or S corporations where there’s flow-through income that comes through to taxpayers, it takes a lot more analysis to determine whether the owners of those interests are involved in the business or not, and whether in fact that income is subject to it or is not subject to it. It’s not something that you get from the K-1 that tells you that answer, so you have to be able to evaluate your situation and look at it from the perspective of what that trade or business is. There may not be just one [business], even though it comes through on one K-1, and then whether you’re able to take that and combine or group it with other types of activities that you have to either make it so it’s not subject to that tax, or if it is subject to that tax to be able to apply that to it.”
Rosica also needs to look at the tax from a planning perspective, particularly when the entities are owned by trusts. “In the trust context, if they’re receiving K-1’s of these S corporations or partnerships, that may or may not be subject to the Net Investment Income Tax, it’s more a function of whether the trustee—the fiduciary in that case—participates in that activity, whether they’re active or passive in that particular activity,” he said.
ATRA also changed the deduction phase-outs that used to be known as the PEP and Pease limitations.
“You’re losing some of the exemptions and itemized deductions based on your income level,” said Rosica. “It enters into a planning discussion as to how we can best plan through those types of items. As we look at a multiyear tax projection that we would typically do with our clients, we’re looking at how we can minimize the impact of that by maybe trying to bunch up some deductions every other year or so. It’s harder to do in certain states and easier in others. If you’re earning a wage in a state like New York that has a state income tax, you’re going to have state income taxes withheld. There’s not a whole lot of navigating around that, so that’s something that’s going to be driving your itemized deductions and perhaps even putting you into AMT. But to the extent those are controllable, maybe you make estimated tax payments or you live in a state without income taxes and you’re able to time when you make your real estate tax payments, when you make your charitable contributions, not so much necessarily on mortgage interest if you have that, but you may very well be in a situation where you can bunch those into an every-other-year pattern and be able to take the standard deduction on the off years and therefore the phase-out, because it’s based on your income level, not your itemized deductions. It’s a set hurdle, and then once you’re over there, you get 100 percent of the benefit of all of those deductions. Trying to plan one’s affairs to be able to maximize that is how we deal with the phase-out of the itemized deductions.”
With talk of Congress soon turning its attention to the renewal of at least some of the tax extenders, there are prospects for several of the more popular ones getting extended again.
“One that comes to mind is the provision around mortgage cancellation of debt that happened,” said Rosica. “When people were having short sales, that was a help that came into play at the height of the mortgage crisis when people were having mortgage forgiveness and here they were in dire straits, having their house potentially foreclosed on, or short sales on these kinds of things. Not only are they dealing with that, but now they find out they potentially had income to the extent of the mortgage forgiveness. There were always provisions in the tax law that allowed for people that were considered insolvent to not include that in income, but that wasn’t necessarily always the case for people that were in that situation. That was extended through 2013, but it’s not there for 2014.”
He hopes to see Congress look into extending that provision, as some clients are still asking about it, even though the mortgage crisis is not as severe as it was a few years ago.
Another good prospect for extension is the $250 above-the-line deduction for teachers who purchase school supplies on their own. That was extended through 2013, but is not in place right now. “That’s a nice thing to have,” said Rosica. “I’m not sure it costs that much to have it. I think we’ll see some of those things being addressed as well.”