by George G. Jones and Mark A. Luscombe
The unpleasant reality of rising unemployment in recent months has given many practitioners the occasion to brush up on tax strategies that are applicable to a growing number of clients who may be “between jobs.”
While many of the tax principles applicable to those clients have remained fairly static over the past few years, some new developments - both in the tax law and in its application to changing compensation practices - call for a revision of certain strategies. There are myriad factors to consider when tax planning for the unemployed client. Here are some concepts and ideas that may help.
Compensation strategies
Severance pay. Severance payments are generally considered taxable wages. Union severance or strike payments are presumed to be taxable also, since the union dues that cover them were generally deductible in the first place.
Tort payments. Under section 104(a)(2), gross income does not include the amount of any damages received on account of personal injuries or sickness. The Small Business Job Protection Act of 1996 amended section 104(a)(2) to limit the exclusion to amounts received for personal physical injuries or physical sickness, applicable to amounts received after Aug. 21, 1996.
Emotional distress, including related physical symptoms, such as insomnia, headaches and stomach disorders, by itself is not a physical sickness or injury for purposes of the exclusion. Unless a termination settlement is the result, at least in part, of a physical injury that happened on the job, payments must be included in income.
Employers often require employees to release any personal injury claims against the employer in exchange for a termination payment. However, typical boilerplate release language covering unidentified, undisclosed or potential personal injury claims against the employer will not render any part of a severance package excludable as damages for personal injury.
Unemployment compensation. Unemployment insurance payments are taxable as income. FICA taxes, however, are not applicable. Payments to laid-off employees from company-financed supplemental unemployment benefit plans (referred to as “guaranteed annual wage” plans) also constitute taxable income to the employees in the year received.
Year-end payments. Unemployment benefits are not taxed at a flat rate. Someone earning a high salary who is let go late in the year will pay tax on unemployment compensation that is received for the rest of the year at rates that start with income he has already earned or realized for the year.
This income also may impact the ability of the taxpayer to deduct medical insurance premiums paid under COBRA, or initial job-search expenses, since itemized medical deductions have a 7.5 percent adjusted gross income floor threshold and job-hunting expenses come under a 2 percent AGI floor applicable to all miscellaneous itemized deductions.
Remember, also, that although severance may be paid to cover a certain period (say, six months’ salary), it is taxed when paid. If paid in a lump sum, it is taxed at that time. Ironically, many taxpayers who are terminated toward the end of the year who receive a substantial severance package will find themselves in a higher tax bracket than had they continued working. Providing for installment payments within a severance package may be worthwhile from both the employer’s and the former employee’s perspectives.
In addition, while income must be included in income as soon as it is able to come under the control of the taxpayer, termination near year’s end may create an opportunity for an employer to delay making a payment due to “normal administrative procedures” until after year’s end, when the taxpayer will be in a lower tax bracket.
Deferred comp. Deferred compensation payments are often triggered by termination of employment. As soon as the deferred compensation is pay-able, it is taxed to the former employee.
Incentive stock options. Incentive stock options are not taxed as income at the time the stock option is granted to an employee, nor are they taxed as regular income at the time the employee exercises the option and buys the stock. Instead, tax is generally deferred until the employee sells the stock, at which time (and after a two-year holding period) the lower capital gains tax rates apply. Status as a current employee, however, is not required to benefit from these rules, so a former employee who is terminated should try to stick to a long-term plan that will yield the capital gain benefit.
Wage withholding. If an employee terminates employment before the end of the payroll period, the tax is determined on the wages paid during the short period but the withholding exemptions and the tax itself are computed on the basis of the regular payroll period.
This method of computation is more advantageous to the employee because he gets the benefit of the full withholding exemption. In circumstances where a spouse is working and a joint return is filed, that spouse might want to apply for lower withholding as soon as is practicable.
Job placement services. To the extent that a severance package includes job placement counseling, a resume service, office space, or the like, the IRS has ruled that it generally will be considered a tax-free fringe benefit offered for a business reason. Equal treatment to all terminated employees is not required for this treatment to apply. However, if the employer offers cash to the employee as an alternative, the services are taxed to the extent of the additional cash that is offered.
Tapping into retirement savings
Most employees who are terminated anticipate a cash flow problem or, at least, want to take steps to avoid one. Tempting sources of cash are qualified retirement plans, 401(k)s and IRA assets. Cashing out, however, should be undertaken only as a last resort. Some factors to consider include:
● Once funds are withdrawn from an IRA, they cannot be replaced after 60 days - future tax-deferred accumulation is therefore sacrificed if funds are withdrawn.
● Qualified retirement funds often can be withdrawn penalty-free for “financial hardship,” depending upon the plan terms. Financial hardship, however, is not necessarily the same as unemployment.
● Once 401(k) contributions are made for the year, they are irrevocable. Once IRA contributions are made for any year, they may be re-characterized and taken back by the taxpayer up until the time that the return for that year is filed.
● Employees with a balance in their 401(k) plans of at least $5,000 can generally leave it there. Especially if the plan allows for loans to all participants, this option would allow an employee to borrow funds without withdrawal penalties - an option unavailable to roll-over IRAs.
● Unemployment compensation does not count when determining compensation for contributing to an IRA.
Job-hunting expenses
Deductions by an employee for job-seeking expenses are classified as miscellaneous itemized deductions, and may be taken only to the extent that all miscellaneous itemized deductions for the year exceed 2 percent of adjusted gross income. Until 2006, these deductions are also subject to the overall limitation on itemized deductions that applies to taxpayers whose AGI exceeds a threshold amount.
Same trade or business. To be entitled to deduct job-hunting expenses, an employee must seek employment in the same trade or business as the one in which he is engaged. Such expenses include the preparation and mailing of resumes, as well as travel expenses. Job-hunting expenses are not deductible, however, if an individual is seeking employment in a new trade or business.
Just what constitutes a “new field” is not necessarily intuitive. The IRS has held that different types of jobs in the same employment sector are, nevertheless, jobs in different fields. In making this determination, focus is generally on the nature of the employment rather than the status of the taxpayer as employee or self-employed (for example, a CPA or an attorney).
Temporary jobs taken while searching for permanent employment will not affect the deductibility of job-search expenses. On the other hand, part-time employment presumably can qualify a taxpayer to search either for full or part-time employment in the same field and fully deduct job-search expenses, restricted only by the limitation that they be reasonable for the position sought. Someone working part-time who wishes to go back to work full-time, presumably, can deduct his job search expenses.
An additional requirement for deducting job-hunting expenses is that there must be no substantial lack of continuity between the preceding employment and the search for new employment. Generally, a month or two is acceptable; so is keeping within Department of Labor statistics on average length of time to find a position within specified categories.
Taking temporary work in another line of business while continuing a rigorous search in the taxpayer’s former line of business will not preclude the job-hunting deduction.
Networking expenses. Ironically, perhaps, expenses incurred in doing what most experts believe is the best way to land another job - networking - are generally not deductible. Establishing friendships and professional contacts for networking purposes for the inevitable time when a job search is resumed in earnest are generally not sufficiently direct to warrant a miscellaneous itemized deduction.
However, attending professional meetings and events during a period of unemployment to generate job leads should qualify, if detailed records of who was contacted, etc., are kept (and the charges are reasonable). “Networking evenings” sponsored for graduate-school alumni should fall into this category. Similar to the rules governing when business meals are deductible, however, any preliminary contact work in which a job search is not mentioned would likely fail IRS scrutiny.
Lifetime learning credit. Brushing up classes to make a taxpayer more marketable, or even to prepare for changing careers, may be covered by the lifetime learning credit. Eligible expenses include expenses for undergraduate or graduate-level and professional degree courses, as well as expenses with respect to any course of instruction at an eligible educational institution to acquire or improve job skills.
As of 2003, the credit is equal to 20 percent of up to $10,000 of the qualified tuition and related expenses. The credit is subject to an AGI phaseout, starting at $41,000 for singles and $82,000 for joint filers in 2003, making the timing for taking such classes during any tax year relevant to some. These classes, however, must be academic in nature, so that payment of courses on resume writing or job hunting cannot be transformed into an expense eligible for a credit, rather than a miscellaneous itemized deduction.
Starting a separate business. Although job-hunting expenses are deductible only if in the same trade or business, starting a new business to replace lost income may in fact yield higher tax deductions. The expenses of starting a business may be deducted on Schedule C, without the limitation of a 2-percent floor. The hobby loss rules and the rule requiring the capitalization of certain startup costs must be navigated, but the reward is an overall above-the-line loss deduction for these expenses.
Home office deduction? An interesting consideration applicable to job hunting arises as the result of the change in the law in 1998 on when a home office deduction is allowed. In reaction to the Supreme Court’s Soliman decision, Congress provided that a taxpayer’s home office will be considered his principal place of business if it is used by the taxpayer to conduct administrative or management activities of any trade or business of the taxpayer.
The question now arises whether a taxpayer’s continuing in the same trade or business in the capacity of job hunting may itself qualify the tax-payer’s home office as a principal place of business while job hunting.
No IRS guidance has been issued on the subject, and it likely would reject an interpretation of the rule that would allow such a home-office deduction on the grounds that job hunting, per se, is not a taxpayer’s trade or business. Again, being an independent contractor or sole proprietor with a home office avoids the issue entirely, since efforts to find work during any hiatus in business is simply “a part of the business.”
Conclusion
Due to a more fluid employment environment, losing a job does not carry the stigma it once did. Many people anticipate having five, six or more jobs over the course of their professional careers. Practitioners should be ready to help clients move from one career to another and minimize the often harsh tax consequences. Advance planning is especially important, particularly when clients have deferred compensation or other arrangements.
Helping a client attack the tax aspects of his unemployed status can pay significant dividends, not only in tax savings but also in generating goodwill after the client is re-employed.
