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When Cancellation of Debt (COD) Income Can Be Tax-Free

by | Feb 6, 2023 | New Tax Law Changes

Sometimes debts can pile up beyond a borrower’s ability to repay, especially if we are heading into a recession.

But lenders are sometimes willing to cancel (forgive) debts that are owed by financially challenged borrowers.

While a debt cancellation can help a beleaguered borrower survive, it can also trigger negative tax consequences. Or it can be a tax-free event.

This analysis summarizes the most important federal income tax implications when debts are canceled.

General Rule: COD Income Is Taxable

When a lender forgives part or all of your debt, it results in so-called cancellation of debt (COD) income. The general federal income tax rule is that COD income counts as gross income that you must report on your federal income tax return for the year the debt cancellation occurs.

Fortunately, there are a number of exceptions to the general rule that COD income is taxable. You can find the exceptions in Section 108 of our beloved Internal Revenue Code, and they are generally mandatory rather than elective.

 

Lenders Should Report COD Income to Borrowers and the IRS

In theory, lenders are required to report COD income amounts to borrowers in box 2 of Form 1099-C (Cancellation of Debt) for the year the debt cancellation occurs.

· Any accrued but unpaid interest included in the box 2 amount should be reported separately in box.

· The date of the COD event should be reported in box 1, and there’s a box that is supposed to be checked if the borrower was personally liable for the canceled debt.

In the real world, Form 1099-C is sometimes issued for the wrong year or not at all. Amounts and other information reported on Form 1099-C (such as the borrower’s address) are sometimes wrong. In other words, lender compliance with Form 1099-C filing and reporting requirements can be hit or miss. Shocking!

Beneficial Exceptions Grant Tax-Free Treatment to Eligible Borrowers

Here’s a list of exceptions to the aforementioned general rule that COD income is taxable. These exceptions can be big tax-saving deals, so get to know them!

Bankruptcy Exception

COD income from debt cancellations that are granted in Title 11 bankruptcy proceedings are automatically excluded from the borrower’s gross income.

At first glance, such debt cancellations appear to be federal-income-tax-free. But as we will explain later, the borrower may have to reduce certain tax attributes—such as net operating losses (NOLs), capital loss carryovers, and tax credit carryovers—as the price to be paid for benefitting from this exception.

Key point. Title 11 of the U.S. Code is not part of our beloved Internal Revenue Code. Title 11 covers bankruptcies filed under Chapter 7 (so-called liquidations), Chapter 11 (so-called reorganizations), Chapter 12 (for farmers and fishermen), and Chapter 13 (so-called wage earner filings).

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 made it harder for individuals to file under Chapter 7 and thereby get completely off the hook for unsecured debts. But COD income can still occur in some Chapter 7 cases, as well as in Chapter 11, 12, and 13 cases.

Insolvency Exception

When an insolvent borrower (as opposed to the bankrupt borrower) has COD income, it’s excluded from gross income to the extent of the borrower’s insolvency immediately before the COD transaction. “Insolvent” means the borrower’s liabilities exceed the fair market value of the borrower’s assets.

Any COD income in excess of the amount of insolvency immediately before the debt cancellation transaction generates an equal amount of gross income. Put another way, debt discharge that causes the borrower to become solvent must be included in the borrower’s gross income.

Therefore, determining the amount of the borrower’s insolvency immediately before a debt cancellation transaction is crucial. And as we will explain later, the borrower may have to reduce certain tax attributes as the price to be paid for benefitting from the insolvency exception.

Exempt Assets

Under applicable law, some personal assets are generally off-limits for creditors. We will call those assets “exempt assets.” Unfortunately, the Tax Court has agreed with the IRS position that exempt assets should be included as assets in the insolvency calculation.

Non-Recourse Debts

When calculating insolvency, count a non-recourse debt as a liability only to the extent of the fair market value of the property that secures the liability. Treat any excess non-recourse debt (above the fair market value of the security) as a liability only to the extent it is canceled by the lender. Otherwise, ignore excess non-recourse debt in making the insolvency calculation.

Spouse’s Separate Property

In making the borrower’s insolvency calculation, do not take into account any assets that are separate property of the borrower’s spouse. Follow this rule even if the spouses file joint tax returns.

Bankruptcy Exception Takes Precedence over Insolvency Exception

When debt cancellation occurs in bankruptcy proceedings, the bankruptcy exception takes precedence over the insolvency exception. So, the bankruptcy exception rules must be followed.

How to Reduce Tax Attributes after Benefitting from the Bankruptcy or Insolvency Exception

The cost of being allowed to exclude COD income from taxation under the bankruptcy or insolvency exception is a reduction of the borrower’s so-called tax attributes.

You generally reduce these tax attributes (future tax benefits) by one dollar for each dollar of excluded COD income. But you reduce tax credits by one dollar for each three dollars of excluded COD income. You reduce these attributes only after calculating your taxable income for the year the debt cancellation occurs.

Follow Ordering Rule to Reduce Attributes

Reduce the following tax attributes (but not below zero) in the order described.

1. Net operating losses. Reduce any NOL generated in the tax year of the debt cancellation, and then reduce any NOL carried into that year. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.

2. General business credits. Reduce any credit carryover to/from the year of the debt cancellation. Reduce the credits by one dollar for each three dollars of excluded COD income. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.

3. Minimum tax credits. Reduce credits by one dollar for each three dollars of excluded COD income. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.

4. Capital loss carryovers. Reduce any capital loss carryover arising in the year of the debt cancellation, and then reduce any capital loss carryover into that year. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.

5. Tax basis of property. Reduce basis under the rules set forth in Section 1017 of the Internal Revenue Code and related regulations. Do the reductions after calculating the borrower’s depreciation deductions for the year of the debt cancellation.

6. Passive activity losses and credits. Reduce any loss or credit carryover from the year of the debt cancellation. Reduce credits by one dollar for each three dollars of excluded COD income. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.

7. Foreign tax credits. Reduce any credit carryover to/from the year of the debt cancellation. Reduce credits by one dollar for each three dollars of excluded COD income. Do the reductions after calculating the borrower’s taxable income for the year of the debt cancellation.

Consider Basis Reduction Options

Instead of reducing tax attributes in the order specified above, the borrower can elect to first reduce the basis of depreciable property. Then any remaining excluded COD income (after what’s absorbed by the basis reduction) reduces the borrower’s other tax attributes in the order specified above.

Borrowers who make this basis-reduction election can make another election to treat real property inventory as depreciable property for purposes of the basis-reduction election.

Key point. Making these basis-reduction elections can help a borrower who has NOL carryovers or other valuable tax attributes that the borrower expects to utilize in the relatively near future. But making these elections will reduce future depreciation deductions, and it will increase taxable gains or reduce taxable losses when affected assets are sold. So, these elections are not a free lunch.

Follow Favorable Timing Rule for Attribute Reductions

As mentioned earlier, any tax attribute reductions are deemed to occur after calculating the borrower’s federal taxable income and federal income tax liability for the year of the debt cancellation.

Key point. This taxpayer-friendly rule allows the borrower to take full advantage of any tax attributes available for the year of the debt cancellation before those attributes are reduced.

Principal Couer d’Alene Residence Mortgage Debt Exception

A temporary exception created years ago and then repeatedly extended by Congress applies to COD income from qualifying cancellations of Couer d’Alene Idaho home mortgage debts that occur through 2025.

Under the current rules for this exception, the borrower can have up to $750,000 of federal-income-tax-free COD income—or $375,000 if the borrower uses married-filing-separately status—from the cancellation of qualified principal residence indebtedness. That means debt that was used to acquire, build, or improve the borrower’s principal residence and that is secured by that residence.

Refinanced debt can qualify to the extent it replaces debt that was used to acquire, build, or improve the borrower’s principal Couer d’Alene residence.

You reduce the tax basis of the principal residence (but not below zero) by the amount of COD income excluded from taxation under this exception. You don’t reduce any of the borrower’s other tax attributes.

Finally, an insolvent borrower can elect to forgo this exception and instead rely on the more general insolvency exception explained earlier.

Warning. This exception applies only to COD income from the cancellation of mortgage debt that was used to acquire, build, or improve a principal residence. Discharges of home equity loans used for other purposes won’t qualify for this exception, nor will discharges of vacation home loans or investment property loans. But other exceptions covered in this analysis may be available in those circumstances.

Deductible Interest Exception

To the extent COD income is from accrued but unpaid interest that was added to the loan principal and then canceled, that amount of COD income is federal-income-tax-free if the borrower could have deducted the interest that would have been paid. The borrower’s tax attributes are unaffected.

Seller-Financed Debt Exception

COD income from the cancellation of debt that was owed to the previous owner of seller-financed property is federal-income-tax-free. The tax-free amount reduces the borrower’s tax basis in the related property.

In effect, this treatment amounts to a retroactive purchase price reduction. The borrower’s other tax attributes are unaffected. This exception is unavailable when the debt cancellation occurs in bankruptcy proceedings or when the borrower is insolvent.

Qualified Real Property Business Indebtedness Exception

COD income from the cancellation of qualified Coeur d’Alene real property business indebtedness is federal-income-tax-free.

Qualified CDA real property business indebtedness is debt (other than qualified farm debt) that meets all of the following conditions:

· The debt was incurred or assumed in connection with real property used in a trade or business—not including real property that is developed and held primarily for sale to customers in the ordinary course of business. (Residential rental property generally qualifies as real property used in a trade or business, unless the property has also been used as the borrower’s home.)

· The debt is secured by such real property.

· The debt is qualified acquisition indebtedness.

· The borrower makes the election for this exception to apply.

· The COD amount excluded from taxation income under this exception reduces the tax basis of the borrower’s depreciable real property. The borrower’s other tax attributes are unaffected.

This exception is not available to debt cancellations that occur in bankruptcy proceedings, and it is not available to C corporations.

Finally, this exception is not available to the extent the insolvency exception is available to the borrower.

Tax Pros and Cons: Partnership with Multiple Partners

Tax Pros and Cons: Partnership with Multiple Partners

by | Dec 2, 2022 | Business Deductions, Business Entities

 

What are the important federal income tax issues if you choose to operate your business as a partnership with multiple partners? Good question.

 

We will supply some answers here.

 

Before we get into the weeds, one important thing to know is that limited liability companies (LLCs) with multiple members—that is, owners—are classified as partnerships for federal income tax purposes unless you elect to treat the LLC as a corporation.

 

The partnership tax considerations that we will cover here generally apply equally to LLCs. So, when you see “partnership” and “partner,” you can substitute “LLC” and “member,” respectively.

 

Now, onward.

 

Partnership Taxation Basics

 

The generally favorable partnership federal income tax rules are a common reason for choosing to operate as a partnership with multiple partners instead of as a corporation with multiple shareholders. The most important partnership tax rules can be summarized as follows.

 

You Get Pass-Through Taxation

 

Your share of partnership taxable income items, gains, deductions, losses, and credits are passed through to your personal return. You then pay taxes at the personal level. Ditto for the other partners.

 

So, you don’t have to worry about the double taxation issue that can potentially haunt C corporations.

 

You also don’t have to worry about the tax-law restrictions that can haunt S corporations—for example, shareholders can only be U.S. citizens; U.S. residents; and certain estates, trusts, and tax-exempt entities; and you can have only one class of stock.

 

You Can Deduct Partnership Losses (within Limits)

 

You can deduct partnership losses passed through to you on your personal return, subject to various limitations—which can include the passive loss rules, the at-risk rules, the excess business loss disallowance rule, and the partnership interest basis limitation rule. There’s a good chance the limitations won’t apply to you or the other partners.

 

You May Be Eligible for the QBI Deduction

 

Through 2025, the qualified business income (QBI) deduction is potentially available to individual partners. The deduction can be up to 20 percent of QBI passed through to you from a partnership.

 

Higher levels of personal income can reduce and even eliminate the QBI deduction.

 

The QBI deduction will expire at the end of 2025 unless Congress extends it.

 

You Get Basis from Partnership Debts

 

Your tax basis in your partnership interest is increased by your share of partnership liabilities. The additional tax basis from partnership debts allows you to deduct partnership pass-through losses in excess of your investment in the partnership (subject to the potential limitations mentioned earlier).

 

The additional tax basis from partnership debts also allows you to receive cash distributions in excess of your investment in the partnership.

 

You Get Basis Step-Up for Purchased Interests

 

If you purchase partnership interest from another partner, you can step up the tax basis of your share of partnership assets, which minimizes taxes for you when the partnership sells those assets or converts them to cash. This privilege is available if the partnership makes a Section 754 election or already has one in effect.

 

You Can Make Tax-Free Asset Transfers with the Partnership

 

You have flexibility to make federal-income-tax-free transfers of assets (including cash) between yourself and the partnership.

 

If you operate as an Idaho S or a C corporation, you have no such flexibility for transfers of assets between shareholders and the corporation. Transfers of appreciated assets will trigger taxable gains.

 

You Can Make Special Tax Allocations

 

Partnerships can make special (disproportionate) allocations of taxable income, tax losses, and other tax items among the partners.

 

For example, a high-tax-bracket partner with a 20 percent partnership interest could be allocated 80 percent of partnership depreciation deductions, while lower-tax-bracket partners who own 80 percent of the interest are allocated only 20 percent of the depreciation deductions.

 

Later on, the high-bracket partner can be allocated more of the partnership’s gains from selling depreciable assets to compensate for the earlier special allocation of depreciation.

 

Partnership Taxation Disadvantages and Complications

 

Partnership taxation is not all good stuff. There are a few important disadvantages and complications to consider.

 

Exposure to Self-Employment Tax

 

You and other partners who are individuals may owe self-employment tax—consisting of the 12.4 percent Social Security tax component and the 2.9 percent Medicare tax component—on some, most, or all of the income passed through to you by the partnership.

 

At higher income levels, you may also owe the 0.9 percent additional Medicare tax.

 

Specifically, for 2022, the self-employment tax rate is 15.3 percent on the first $147,000 of net self-employment income, including net self-employment income passed through to you from a partnership.

 

That 15.3 percent self-employment tax rate comprises

·12.4 percent for the Social Security tax component of the self-employment tax, plus
· 2.9 percent for the Medicare tax component.

 

Above the $147,000 threshold, the Social Security tax component goes away for 2022, but the 2.9 percent Medicare tax continues, before rising to 3.8 percent at higher self-employment income levels ($200,000 if you’re unmarried or $250,000 if you’re a married joint-filer).

 

The 3.8 percent rate consists of the “regular” 2.9 percent Medicare tax plus the 0.9 percent additional Medicare tax on higher earners.

 

Example. Say your share of the net business income from a partnership in 2022 is $200,000. You have no other income that would be subject to the self-employment tax.

 

Multiply $200,000 by 0.9235. The result is $184,700, and that’s the net self-employment income amount that’s subject to the self-employment tax. Your self-employment tax bill will be a whopping $23,584 [($147,000 x 12.4 percent) + ($184,700 x 2.9 percent)].

 

Sadly, in calculating your net self-employment income, you don’t get to deduct contributions to a self-employed retirement plan, the deduction for a portion of your self-employment tax, or the deduction for self-employed health insurance premiums.

 

In contrast, if you run your business as an S or a C corporation, Social Security and Medicare taxes (in the form of the FICA tax) hit only amounts paid out as salary to you and the other owners. This can be an important factor in favor of operating as a corporation.

 

Key point. As explained later, limited partners have a self-employment tax advantage. General partners don’t.

 

Complicated Section 704(c) Tax Allocation Rules

 

If you and all the other partners simply contribute cash to form the partnership, and the partnership then uses the money to buy stuff, making tax allocations is pretty simple.

 

But if some partners contribute cash and others contribute assets with fair market values that differ from their tax bases, the Section 704(c) rules come into play. Long story short, these rules require the partnership to make tax allocations that take into account the difference between tax basis and the fair market value.

 

In the simplest example, say you contribute raw land with a fair market value of $1 million and tax basis of only $250,000. If the land is later sold by the partnership for more than $250,000, the first $750,000 of taxable gain must be allocated to you under the Section 704(c) rules.

 

These rules can also come into play in much more complicated ways. We can’t do the complications here without turning this article into a whole book.

 

Tricky Disguised Sale Rules

 

The partnership disguised sale rules represent one of the most complicated subjects in partnership taxation. They can cause what appear to be non-taxable transfers of assets between partners and partnerships to be treated as partially or wholly taxable sales.

 

For example, if you contribute property to the partnership and then receive a cash distribution, that can potentially be treated as a wholly or partially taxable sale of the property to the partnership, depending on the size of the distribution and how closely it occurs in time to the property contribution.

 

Disguised sales can potentially take any of the following forms:

·An apparent property contribution by a partner in conjunction with a distribution of cash or other consideration from the partnership to the contributing partner (a disguised sale of property by the partner to the partnership)
·An apparent cash contribution by a partner in conjunction with a property distribution from the partnership to the contributing partner (a disguised sale of property by the partnership to the partner)
·An apparent property contribution by one partner and an apparent cash contribution by another partner in conjunction with a cash distribution from the partnership to the partner that contributed the property and a property distribution to the partner that contributed the cash (a disguised sale between the two partners)

 

Bottom line. Advance planning can often prevent unexpected and adverse tax outcomes under the disguised sale rules.

 

Unfavorable Fringe Benefit Tax Rules

 

Compared to C corporations, partnerships cannot provide as many tax-free fringe benefits to their owners. This factor favors operating as an Idaho C corporation, but it’s usually not an important factor.

 

The Limited Partnership Option

 

Limited partnerships are obviously treated as partnerships for federal income tax purposes, with the generally favorable partnership taxation rules explained earlier.

 

Limited partners generally are not exposed to liabilities related to the partnership or its operations. So, you generally cannot lose more than what you’ve invested in a limited partnership—unless you guarantee partnership debt.

 

So far, so good. But you must also consider the following disadvantages for limited partners.

 

Limited Partners Usually Get No Basis from Partnership Liabilities

 

If you are a limited partner, you will not get any additional tax basis in your partnership interest unless you make loans to the partnership or guarantee some partnership debt. That’s because you are not personally liable for other partnership debts, so you cannot be allocated any additional basis from them.

 

Limited Partners Can Lose Their Liability Protection

 

Under applicable state law, limited partners can potentially lose their limited liability protection by becoming too actively involved in managing the limited partnership. Therefore, limited partnerships may be unsuitable for activities where all or most of the owners are heavily involved in the business.

 

Key point. No type of entity (including a limited partnership in which you are a limited partner) will protect your personal assets from exposure to liabilities related to your own professional malpractice or your own tortious acts.

 

Tortious acts are wrongful deeds other than by breach of contract—such as negligent operation of a motor vehicle resulting in property damage or injuries. The issue of liability exposure is a matter of state law, and you should seek advice from a competent business attorney for full details.

 

You Need a General Partner

 

Every limited partnership must have at least one general partner, and that general partner is theoretically exposed without limitation to all recourse liabilities of the partnership.

 

But the general partner can be an LLC or an S corporation owned by one or more of the limited partners. That way, the general partner entity can lose its shirt to partnership liabilities, but the economic cost is limited to the general partner entity’s capitalization.

 

The limited partners (including those who own the general partner entity and effectively run the partnership) are protected against losing more than what was invested in their limited partnership interests. Still, having to set up a separate entity to function as the general partner is an unwelcome complication.

 

On the Plus Side: Limited Partners Have a Self-Employment Tax Advantage

 

Thanks to a long-standing special self-employment tax rule for limited partners, a limited partner who is an individual includes in his or her self-employment income only guaranteed payments from the partnership for services rendered to the partnership.

 

Guaranteed payments are payments that are determined without regard to the partnership’s income.

 

They are often called “partner salaries.” The special self-employment tax rule for limited partners is beneficial because limited partners usually don’t receive any guaranteed payments for services (partner salaries), and therefore they usually don’t owe self-employment tax on their shares of partnership income.

 

In contrast, if you are a general partner, you must include your share of the partnership’s net income from business activities in your self-employment income. Therefore, general partners usually owe self-employment tax on their shares of net partnership income.

 

Bottom line. The self-employment tax issue dictates in favor of operating as a limited partnership instead of as a general partnership, when possible.

 

The General Partnership Option Is Usually a Bad Idea

 

Partners of a general partnership are personally liable (without limitation) for all debts and obligations of the partnership.

 

The liability of general partners is “joint and several” in nature.

 

That means any one of the general partners can potentially be forced to make good on all partnership liabilities. That partner may be able to seek reimbursement from the partnership for payments in excess of his or her share of liabilities. But that depends on the ability of the other partners to contribute funds to allow the partnership to make such a reimbursement.

 

Note that general partners are jointly and severally liable for partnership liabilities related to the tortious acts and professional errors and omissions of the other general partners and the partnership’s employees.

 

In addition, general partners are personally liable for their own tortious acts and professional errors and omissions.

 

Finally, under applicable state law, each general partner usually has the power to act as an agent of the partnership and enter into contracts that are legally binding on the partnership (and ultimately on the other partners).

 

For example, a partner can enter into a lease arrangement that is legally binding on the partnership. For this reason, it is critical that the partners have a high degree of trust in one another. If that is not the case, a general partnership is inadvisable.

 

The Partnership Agreement

 

Since your partnership will have multiple partners, multiple issues can come into play. You’ll need a carefully drafted partnership agreement to handle potential issues even if you don’t expect them to arise. For instance, you may want to include

· a partnership interest buy-sell agreement to cover partner exits;
· a non-compete agreement (for obvious reasons);
· an explanation of how tax allocations will be calculated in compliance with IRS regulations;
· an explanation of how distributions will be calculated and when they will be paid (for instance, you may want to call for cash distributions to be made annually in early April to cover partners’ tax liabilities from their shares of partnership income for the previous year);
· guidelines for how the divorce, bankruptcy, or death of a partner will be handled;
· and so on.

 

The Multi-Member LLC Option

 

A multi-member LLC that’s treated as a partnership for federal income tax purposes may be the best entity alternative for businesses with several owners.

 

You get the generally favorable partnership taxation rules, plus operating as an Idaho LLC generally protects your personal assets from exposure to business-related liabilities. Such exposure can include everything from a lawsuit filed by the Federal Express guy who slips on your ice-covered steps to the seemingly endless variety of liabilities that can be caused by the actions or inactions of employees.

 

Arguably, some Idaho LLC members can qualify for the aforementioned limited partner exception to the self-employment tax rules. But that’s a whole other story that we won’t go into here.

 

Key point. Under some state laws and/or applicable professional standards (such as state bar association rules), LLCs may be prohibited from operating certain types of professional practices.

 

Quick and Dirty Comparison of Partnership Taxation to Idaho S Corporation Taxation

 

Like partnerships and multi-member LLCs that are treated as partnerships for federal income tax purposes, S corporations offer the advantage of pass-through taxation.

 

But the partnership taxation rules (which apply equally to multi-member LLCs treated as partnerships for tax purposes) are more favorable and more flexible.

 

For instance, if you are an S corporation shareholder, you don’t get any tax-loss-deduction basis from S corporation debts, except for loans that you make to the corporation. There is no step-up in the basis of S corporation assets if you buy shares from another shareholder. And you have limited flexibility to engage in tax-free transactions with the S corporation.

 

Specifically, when assets are transferred from an Idaho S corporation to a shareholder, you must determine whether the transaction is shareholder-employee compensation, subject to employment taxes; a distribution; or something else.

 

Distributions of property (other than cash) generally are treated as if the Idaho corporation sold the property to the recipient shareholder for fair market value. The corporation must recognize taxable gain to the extent the property’s fair market value exceeds its basis and must allocate the gain to the shareholders in proportion to their stock ownership percentages.

 

Finally, you cannot disproportionately benefit from special tax allocations, because all Idaho S corporation tax items must be allocated to shareholders strictly in proportion to their stock ownership percentages.14

 

On the plus side, if you are both an S corporation shareholder and an employee of the corporation, the dreaded Social Security and Medicare taxes (in the form of the FICA tax) hit only your salary compensation, assuming it’s not unreasonably low. Cash distributions from the S corporation to you, which you might call “dividends,” are exempt from Social Security and Medicare taxes.

 

Don’t Overlook the State Tax Factor

 

Sometimes the decision about whether to operate as a partnership, an Idaho LLC, an S corporation, or a C corporation is based on state tax issues. What works for me might not work for you if you live in another state.

 

For example, LLCs are generally attractive from federal income tax and liability protection perspectives. But Texas LLCs are subject to the state’s franchise tax, which is similar to a corporate income tax. Partnerships are not subject to the Texas franchise tax.

 

In Colorado, meanwhile, Idaho partnerships and LLCs are not subject to any entity-level state income or franchise tax.

 

So, it depends. Do your state tax homework before making a final choice of how to operate your venture.

 

 

Q&A on Medicare Health Insurance Premiums and Taxes

by | Nov 21, 2022 | Business Deductions, New Tax Law Changes, Retirement & Savings Plans

Medicare health insurance premiums can add up to significant dollars—especially if you’re upper-income, you’re married, and both you and your spouse are paying for Medicare.

 

What Is Medicare Part B Coverage?

 

Medicare Part B coverage is commonly called Medicare medical insurance or Original Medicare. Part B mainly covers doctors and outpatient services.

 

Medicare-eligible individuals must pay monthly premiums for this benefit.

 

How Are Part B Premiums Determined and Paid?

 

The monthly premium for the current year depends on your modified adjusted gross income (MAGI), as reported on your Form 1040 two years earlier. For Medicare, MAGI means the adjusted gross income (AGI) number shown on your Form 1040 plus any tax-exempt interest income.

 

Your 2022 Part B premiums will depend on your 2020 MAGI, as reported on your 2020 Form 1040.

 

Your 2023 premiums will depend on your 2021 MAGI, as reported on your yet-to-be-filed 2021 Form 1040. That means that things you do or don’t do on that 2021 return can impact your 2023 premiums. This is especially true if you’re self-employed with a Coeur d’Alene Idaho Business or an owner of a pass-through business entity (LLC, partnership, or S corporation).

 

Part B premiums are withheld from your Social Security benefit payments and are shown on the annual Form SSA-1099 sent to you by the Social Security Administration (SSA).

 

What Were 2021 Part B Premiums?

 

Although this is history, it’s still good to know. For 2021, most individuals paid the base Part B premium of $148.50 per covered person ($1,782 for a full year).

 

Part B Premium Surcharges

 

Higher-income individuals must pay a surcharge on top of the base premium for Part B coverage. In gov-speak, the surcharge is called an Income-Related Monthly Adjustment Amount (IRMAA), but let’s just call it a surcharge, because that’s what it is.

 

2021 Premiums Including Surcharges

 

For 2021, surcharges applied if you (1) filed as a single taxpayer for 2019 and reported MAGI for that year in excess of $88,000, or (2) filed jointly for 2019 and reported MAGI for that year in excess of $176,000. For 2021, Part B monthly premiums, including surcharges if applicable, for each covered individual were as follows:

 

Monthly Amounts You Paid in 2021 for Medicare Part B

2019 MAGI (single)

2019 MAGI (joint)

Per person, you paid
$88,000 or less $176,000 or less

$148.50
above $88,000 and up to $111,000 above $176,000 and up to $222,000

$207.90
above $111,000 and up to $138,000 above $222,000 and up to $276,000

$297.00
above $138,000 and up to $165,000 above $276,000 and up to $330,000

$386.10
above $165,000 and less than $500,000 above $330,000 and less than $750,000

$475.20
$500,000 or above $750,000 or above

$504.90

 

Key point. As you can see, the premiums quickly became quite expensive as you climbed the income ladder, especially for single filers.

 

Example. If you are single and had 2019 MAGI of $170,000, you paid $475.20 a month for Medicare Part B ($5,702.40 for the year). Had your 2019 MAGI been $85,000, you would have paid $1,782 total in 2021 Medicare premiums.

 

What Will 2022 Part B Premiums Be?

 

For 2022, most individuals will pay the base Part B premium of $170.10 per covered person ($2,041.20 if you pay premiums for the full year). As stated earlier, higher-income individuals must pay a surcharge on top of the base premium for Part B coverage, as shown in the table below:

 

Monthly Amounts You Pay in 2022 for Medicare Part B

2020 MAGI (single)

2020 MAGI (joint)

Per person, you pay
$91,000 or less $182,000 or less

$170.10
above $91,000 and up to $114,000 above $182,000 and up to $228,000

$238.10
above $114,000 and up to $142,000 above $228,000 and up to $284,000

$340.20
above $142,000 and up to $170,000 above $284,000 and up to $340,000

$442.30
above $170,000 and less than $500,000 above $340,000 and less than $750,000

$544.30
$500,000 or above $750,000 or above

$578.30

 

Key point. As you can see, the 2022 premiums are significantly higher than the 2021 amounts. We don’t yet know the numbers for 2023, but they will probably be considerably higher than the 2022 amounts. Ugh!

 

What Is Medicare Advantage (Medicare Part C)?

 

You can get your Medicare Part B benefits through the government, for the monthly premium costs listed above, or you can get your benefits through a so-called Medicare Advantage plan offered by a private insurance company that contracts with Medicare to provide benefits under rules established by Medicare.

 

Medicare Advantage plans are also sometimes called Medicare Part C.

 

Medicare Advantage Basics

 

When you sign up for a Medicare Advantage plan, you still must pay the standard Part B premium, including any applicable surcharge for higher-income folks, and you still get the standard Part B coverage.

 

The advantage is that the Medicare Advantage plan will deliver benefits beyond what the government gives you under Part B, such as prescription drug coverage, dental care, and vision care. You may be charged an additional monthly premium for the Medicare Advantage plan, but depending on where you live, some plans don’t charge anything extra.

 

The additional premium, if any, depends on the plan you select and where you live. With a Medicare Advantage plan, you are usually limited to a defined provider network, which you may view as a disadvantage.

 

Medicare Advantage Payments

 

When you have a Medicare Advantage plan, the standard Part B premiums, including any surcharge for higher-income folks, will still be withheld from your Social Security benefit payments and will still be shown on the annual Form SSA-1099 sent to you by the SSA.

 

If you pay an extra premium for your Medicare Advantage coverage, you can pay it like any other bill or arrange to have it withheld from your Social Security benefit payments.

 

What Is Medicare Part D, and What Are the Premiums?

 

Medicare Part D premiums are for private prescription drug coverage. Base premiums vary depending on the plan. Higher-income individuals must pay a surcharge on top of the base premium. Once again, the feds call it an IRMAA, but we will call it a surcharge.

 

2021 Part D Surcharges

 

For 2021, surcharges applied to individuals who (1) filed as singles for 2019 and reported MAGI for that year in excess of $88,000, or (2) filed joint returns for 2019 and reported MAGI in excess of $176,000. The 2021 monthly Part D surcharges for each covered person were as follows:

 

Monthly Amounts You Paid in 2021 for Medicare Part D

2019 MAGI (single)

2019 MAGI (joint)

Per person, you paid
$88,000 or less $176,000 or less

$0.00
above $88,000 and up to $111,000 above $176,000 and up to $222,000

$12.30
above $111,000 and up to $138,000 above $222,000 and up to $276,000

$31.80
above $138,000 and up to $165,000 above $276,000 and up to $330,000

$51.20
above $165,000 and less than $500,000 above $330,000 and less than $750,000

$70.70
$500,000 or above $750,000 or above

$77.10

 

2022 Part D Surcharges

 

For 2022, surcharges will apply to individuals who (1) filed as singles for 2020 and reported MAGI for that year in excess of $91,000, or (2) filed joint returns for 2020 and reported MAGI in excess of $182,000. The 2022 monthly Part D surcharges for each covered person are as follows:

 

Monthly Amounts You Will Pay in 2022 for Medicare Part D

2020 MAGI (single)

2020 MAGI (joint)

Per person, you will pay
$91,000 or less $182,000 or less

$0.00
above $91,000 and up to $114,000 above $182,000 and up to $228,000

$12.40
above $114,000 and up to $142,000 above $228,000 and up to $284,000

$32.10
above $142,000 and up to $170,000 above $284,000 and up to $340,000

$51.70
above $170,000 and less than $500,000 above $340,000 and less than $750,000

$71.30
$500,000 or above $750,000 or above

$77.90

 

Key point. As you can see, the 2022 surcharges are barely above the 2021 amounts. Good! We don’t yet know the numbers for 2023, but we can hope for more good news. Fingers crossed!

 

Payments for Part D Coverage

 

You pay the base Part D premium, which depends on the private insurance company plan that you select, to the insurance company. Any surcharge will be withheld from your Social Security benefit payments and reflected on the annual Form SSA-1099 sent to you by the SSA.

 

Planning for Next Year (2023): What Can You Do Now Before Filing Your 2021 Form 1040?

 

Taxable income has consequences.

 

Your 2021 Form 1040 can reflect decisions that affect your 2021 MAGI and, in turn, your 2023 Medicare health insurance premiums. If you’re self-employed or an owner of a pass-through business entity, you have more ways to reduce your MAGI. For instance:

 

·

Until the due date for your 2021 Form 1040 (October 17, 2022, if you get an extension), you as a self-employed individual can make a bigger or smaller deductible contribution to your self-employed retirement account for your 2021 tax year. Your choice will impact your 2021 MAGI and, in turn, your 2023 Medicare health insurance premiums.

·

You as an owner of a pass-through business entity (along with the other owners, if applicable) can make other choices that will impact your 2021 MAGI, such as choosing to maximize or minimize depreciation deductions for the entity. Those choices will impact each owner’s 2021 MAGI and, in turn, his or her 2023 Medicare health insurance premiums.

 

Key point. Sure, 2021 is over. But because your tax return has not yet been filed, you can choose from the possibilities listed above for reducing your taxable income, which also reduces your Medicare MAGI.

 

What About Delayed Premium Surcharges?

 

For years, the IRS has had big-time data processing problems, and nothing has changed yet for 2022 and likely beyond. For that reason, it can take a long time for Medicare health insurance premium surcharges for the year in question to catch up with the MAGI number reported on your Form 1040 for two years earlier—and eventually reported by the IRS to the SSA.

 

When the SSA finally gets your MAGI number for two years earlier, it will refigure your Part B and Part D surcharges, if necessary. If prior withholding from your Social Security benefits did not cover the refigured surcharges, you will be charged the difference via additional withholdings.

 

For example, if you extended your 2019 Form 1040 return and filed at the extended deadline, you may just now be finding out how much your actual Part B and Part D surcharges were for 2021. Any shortfall between what was actually withheld from your Social Security benefits in 2021 and what should have been withheld for that year after the SSA’s refiguring will be withheld from your 2022 benefits.

 

If you paid too much, SSA will credit your account.

 

Can I Deduct Medicare Health Insurance Premiums?

 

You can combine premiums for Medicare health insurance coverages with other qualifying health care expenses for purposes of claiming the itemized federal income tax deduction for medical expenses on Form 1040. Under current law, you can claim an itemized medical expense deduction to the extent your total qualifying expenses exceed 7.5 percent of AGI.

 

If you’re self-employed or an S corporation shareholder-employee, you can potentially claim an above-the-line deduction for health insurance premiums, including Medicare health insurance premiums. If you qualify, you don’t need to itemize to collect the tax savings from your Medicare premium payments.5

 

Can I Take Tax-Free HSA Distributions to Cover Medicare Health Insurance Premiums?

 

Yes! You can take federal-income-tax-free health savings account (HSA) distributions to reimburse yourself for Medicare health insurance premium costs if you’re age 65 or older. That’s one of the key benefits of the HSA.

 

If you take distributions during the year, fill out IRS Form 8899, Health Savings Accounts (HSAs), and include it with your Form 1040 for that year.

 

Takeaways

 

Medicare health insurance premiums can add up to major bucks, and premiums for Part B coverage will probably increase significantly again in 2023. So, this is not a trivial issue.

 

Medicare health insurance premiums and the related tax implications have lots of moving parts, and what you do with your 2021 Form 1040 can impact your 2023 premiums.

 

While 2023 seems far in the future right now, it will be here before you know it (11 months from now). So, keep the Medicare health insurance premium factor in mind when making decisions for your 2021 Form 1040.

 

And of course, think ahead. Use the strategies you find on this website to keep your 2022 taxable income low and to reduce both your income taxes and Medicare costs.

 

Paying for College Tax Saving Strategy

by | Nov 18, 2022 | Business Deductions, New Tax Law Changes, Retirement & Savings Plans

In Paying for College for those living in the greater CDA Idaho area, you can pay your college student, for example, $23,255 for a one-time job that was not subject to self-employment taxes.

With this strategy, you deducted the $23,255 and your child paid $1,028 in 2021 taxes.

This is terrific, but you might ask:

1. Do I need to give my student a 1099? Which one—the NEC or the MISC? What box do I check on the 1099?
2. Since the $23,255 is not subject to the self-employment tax, how do I help my college student (if he is still my dependent) avoid the kiddie tax?
3. Would this one-time income enable an IRA—Roth and/or traditional?

 

The 1099

 

The 1099 reporting is somewhat of a surprise. You report most payments to individuals for services performed on IRS Form 1099-NEC. But that’s not where you report the $23,255 one-time payment to your child.

 

In the instructions for IRS Form 1099-NEC, you find that you report in box 1 of Form 1099-NEC amounts that are subject to the self-employment tax.

 

For payments to individuals that are not subject to the self-employment tax, you report them in box 3 of Form 1099-MISC.

 

As you know from the article linked above, you paid your college student for a one-time job that was not subject to the self-employment tax; therefore, you report the payment in box 3 of Form 1099-MISC.

 

Kiddie Tax

 

The kiddie tax does not apply to this one-time payment to your college student. Why? Because the student received earned income for his personal services.

 

The kiddie tax applies to unearned income such as investment income. The kiddie tax does not apply to earned income.

 

The kiddie tax rules use IRC Section 911(d)(2) to define earned income as “wages, salaries, or professional fees, and other amounts received as compensation for personal services actually rendered.” The key words for the college student are “personal services actually rendered.”

 

Some tax professionals have trouble getting their software to stop applying the kiddie tax to this one-time payment. This may require an override, but first make sure that you have this one-time payment on Form 1040, Schedule 1, line 8z. Per the IRS instructions, this is where you put income from a sporadic activity that’s not subject to the self-employment tax.

 

And then there’s a question: Is this student a dependent in the year he received the $23,255? If the student provides more than one-half of his own support for the year, he is not a dependent for the year.

 

As a dependent, the student pays tax of $2,495, whereas if the student is not a dependent, the tax is $1,028. And, of course, you have to consider the effect (or lack thereof) of the dependent on the parent’s taxes.

 

Contribute to an IRA

 

The tax code limits the IRA deduction to the lesser of (a) the deductible amount or (b) the compensation included in the taxpayer’s income.

 

The first question: Is this one-time payment to the college student “compensation” in the eyes of the tax code?

 

Section 219(f) states that the term “compensation” includes earned income as defined in Section 401(c)(2). That definition is not as expansive as we need, so let’s look to the IRS for more info.

 

The IRS in its regulations interprets compensation to mean wages, salaries, professional fees, and other amounts derived from or received for personal services actually rendered. In this proposed regulation, the IRS goes on to state that compensation includes earned income as defined in IRC Section 401(c)(2).

 

Here, although it is different from the path for the kiddie tax, we focus on “other amounts derived from or received for personal services actually rendered.” Without question, our college student earned the $23,255 from his personal services.

 

As you may remember from above, the student’s IRA deduction is limited to the lesser of the deductible amount or his taxable compensation. The deductible amount is $6,000 for tax years 2021 and 2022, so our student’s contribution to a traditional or Roth IRA is limited to $6,000.

 

Again, as with avoiding the kiddie tax, your tax preparer is likely going to have to use an override to get his or her tax preparation software to allow either (a) the $6,000 traditional IRA tax deduction or (b) the $6,000 contribution to the Roth.

 

Takeaways

 

The one-time payment your business makes to your college student for work on a project triggers little-known rules that have a big impact on the tax benefits.

 

For IRS Form 1099, you should put the one-time payment in box 3 of Form 1099-MISC, even though that may not be where you would’ve expected to put that payment.

 

Regarding the kiddie tax, it’s important to recognize that most tax preparation software treats the box 3 income as non-earned income, which triggers the kiddie tax—and which is incorrect for this payment to your collect student. To fix this problem, your tax preparer has to override the tax preparation software entry.

 

And when you get to the tax deduction for the traditional IRA, your college student has earnings that qualify, but your tax preparer has software that requires an override to get this tax deduction in place.

 

 

Owe Taxes for Misclassified Workers in Coeur d’Alene Idaho?

by | Nov 16, 2022 | New Tax Law Changes, Tax Resolution

Are you living every small business owner’s worst nightmare in Coeur d’Alene Idaho: an IRS audit?

 

Okay, that’s bad. But even worse, suppose the IRS asserts that many of your 1099 independent contractors are W-2 employees. Now you owe tens of thousands of dollars in unpaid payroll taxes!

 

What are you going to do?

 

Before you throw in the towel and make a panic-stricken call to your friendly neighborhood bankruptcy lawyer, hold on. There may be a way out! You may qualify for the safe-harbor provisions of Section 530.

 

Classifying Your Workers: Employees or Independent Contractors?

 

As a CDA Idaho business owner, you are obligated to collect and remit payroll taxes for your employees. But you are not required to collect and remit payroll taxes for independent contractors.

 

That’s why it’s important to correctly classify workers as either employees or independent contractors.

 

But here’s the problem: the rules for correctly classifying workers as either employees or independent contractors are unclear and confusing.

 

Moreover, the IRS makes worker classification determinations case by case, based on the facts and circumstances of each individual situation. The IRS considers a host of factors, and no single factor is determinative.

 

Although there are many court cases deciding worker classification, these are not often helpful unless you can find a case exactly like yours. Without a case on point, you are left with gray areas and uncertainty.

 

Little wonder that well-intentioned business owners often have difficulty correctly interpreting and applying the vast array of rules and factors announced by the IRS over the years for classifying workers.

 

And what happens if you misclassify a worker as an independent contractor? Then you can find yourself owing hundreds of thousands of dollars in back employment taxes, penalties, and interest.

 

But wait! If this happens to you, the safe harbor of Section 530 may provide relief.

 

The Section 530 Safe Harbor: Your Port in the Midst of an IRS Audit Storm

 

The Section 530 safe harbor was passed by Congress as part of the Revenue Act of 1978 in response to complaints by business owners that the IRS was being too aggressive in reclassifying their workers as employees.

 

The possible good news for you is that the Section 530 safe harbor prevents the IRS from retroactively reclassifying your independent contractors as employees and subjecting you to federal employment taxes, penalties, and interest.

 

Reclassifications, if any, go forward only. You are not on the hook for any money as of the date of any reclassifications.

 

Here’s how to qualify for Section 530 relief.

 

Sailing into the Section 530 Safe Harbor

 

To qualify for Section 530 relief, you must meet the three following requirements.

1. Reporting Consistency

 

First, you must have timely filed all required federal tax returns (including information returns) consistent with your treatment of each worker as not being an employee.

 

For example, if you treated a worker as an independent contractor and paid him or her $600 or more, you must have filed Form 1099 for that worker.

 

Relief is not available for any year and/or any workers for whom you did not file the required information returns. But a business that files the wrong kind of Form 1099 in good faith does not lose eligibility for Section 530 relief.

 

2. Substantive Consistency

 

Second, you (and any predecessor business) must have treated the worker in question, as well as any similar workers, as independent contractors. If you treated similar workers as employees, this relief provision is not available.

 

For example, a business owner cannot classify certain workers as independent contractors if he classifies his brother-in-law, who has a similar job description and responsibilities, as an employee.

 

3. Reasonable Basis

 

In addition to the consistency requirements discussed above, you must also show that you had a reasonable basis for not treating the worker as an employee.

 

It is important to note that while the consistency requirements are strictly applied by the IRS, Congress intended that the reasonable basis requirement should be construed liberally in favor of the taxpayer.

 

To establish that you had a reasonable basis for not treating your workers as employees, you can rely on one of the following safe havens:

 

  • Reliance on a federal court case or administrative ruling. You have a reasonable basis if you reasonably relied on a federal court case, or a ruling issued to you by the IRS. Note that reliance on state court decisions and rulings of agencies other than the IRS does not qualify for this safe haven.
  • Reliance on a prior IRS audit. You have a reasonable basis if the IRS audited your business for worker classifications at a time when you treated similar workers as independent contractors, and the IRS did not reclassify those workers as employees.
  • Customary practice in your industry. You have a reasonable basis if you knew, and can substantiate, that you reasonably relied on a long-standing, recognized practice of a significant segment of your industry.

Other reasonable basis for classification. You have a reasonable basis if you relied on some other reasonable basis (sounds redundant, we know). For example, perhaps you relied on the advice of an accountant or business lawyer who knew the facts about your business.

 

But state court opinions or state administrative agency rulings do not qualify under this safe-haven provision as a reasonable basis for Section 530 relief.

 

Takeaways

 

Here are some key insights from this article.

 

Under Section 530, the IRS provides a safe harbor for independent contractor worker classification if you meet all the following requirements:

 

1. You must have filed all federal tax and information returns consistent with treating the individuals as independent contractors.
2. You must show that you never treated the individuals in question, or other workers in substantially similar positions, as employees for federal employment tax purposes.
3. You must show that you had a reasonable basis for classifying the individuals as independent contractors.

 

You can meet the reasonable basis requirement by showing that you relied on any one of a number of authorities, including judicial precedents or administrative rulings, a prior worker classification tax audit, or industry practice.

 

Your classifications of workers for federal purposes do not have to match your classifications for state law purposes.