Facing the 1992 individual tax return filing season: are you ready? (Cover Story)by Johnson, Janice M.
If a client has reached the age of 70 during 1991, it will be necessary for him or her to make a minimum distribution from his or her individual retirement account by April 1, 1992. Furthermore, the distribution is considered taxable income for 1991 and should be factored into calculations of required tax payments. You should note that the need to make annual distributions will continue in future years. This task becomes particularly cumbersome where a number of IRAs are maintained.
Be careful, when preparing returns, to review all statements from financial institutions to make sure that earnings on an IRA account are not mistakenly included in taxable income. This is easy to do, as many clients send their preparers every scrap of available financial information.
PHASE-OUT OF PERSONAL
EXEMPTIONS AND ITEMIZED
Your individual tax clients will probably be most affected by RRA 90's phase-out of the benefit of personal exemptions and itemized deductions. While your tax preparation software has the calculations down pat, you may want to refresh yourself with the details for discussions with clients.
Personal Exemptions. The deduction for personal exemptions is phased out as a taxpayer's adjusted gross income (AGI) exceeds $100,000 for single filers, $150,000 for joint returns, $125,000 for heads of households, and $75,000 for those married filing separately. Each exemption is phased out by 2% for each $2,500 (or fraction thereof) by which the taxpayer's AGI exceeds the applicable threshold amount. For a married person filing separately, the phase-out rate is 4%. The 2% phase-out serves to disallow personal exemption deductions for those with AGI of $122,501 in excess of the threshold amounts.
A New Limit on Itemized Deductions. The deductions allowed for all itemized deductions other than medical expenses, casualty and theft losses, and investment interest is reduced by 3% of AGI in excess of $100,000 ($500,000 for married taxpayers filing separately). However, total otherwise allowable deductions (aside from those for medical, casualty and theft losses, and investment interest) will not be reduced by more than 80%. Thus, if a taxpayer with AGI of $200,000 has charitable contributions of $20,000 and state taxes of $10,000 in 1991, total itemized deductions of $30,000 will be reduced by $3,000 3% x ($200,000-$100,000). On the other hand, if a taxpayer with AGI of $200,000 has medical deductions of $5,000, investment interest expense of $22,000 and state taxes of $3,000, total itemized deductions will only be reduced by $2,400 (the lesser of 3% of $100,000 or 80% of the $3,000 state tax deduction).
The game may have changed when it comes to the deductibility of points paid on some personal residence refinancings. Prepares with clients who have incurred mortgage refinancing costs during 1991 should consider the decision in Huntsman (CA-8, 90-2 USTC Par. 50,340). In Huntsman, the court ruled that points paid to refinance a three-year balloon mortgage were currently deductible because the refinancing was part of the permanent financing for the purchase of the home. The IRS has issued a nonacquiescence to Huntsman so that taxpayers relying on it outside the Eighth Circuit should make sure to make the proper disclosures on the returns of the treatment taken. It would appear that Huntsman does not open a window for the deductibility in the year paid of points incurred to refinance a mortgage to take advantage of a decline in interest rates. In that case, such payment would continue to be deductible over the life of the new loan. A complete discussion of Huntsman and the deductibility of points is scheduled for the March 1992 issue of The CPA Journal.
Also with respect to points, Notice 90-70 makes it clear that homeowners who make payments at closing sufficient to cover the amount of the points on their mortgage loans can treat such payments as deductible points, even if the payments are designated for other closing costs.
Once points are paid on the purchase of a second home or on the refinancing of a mortgage and it is determined that they do not qualify for full deductibility in the year of payment, it is easy for the taxpayer and the practitioner to forget to continue to amortize the points over the life of the loan. You will want to take steps to insure that any such points are included in a carryforward schedule that is maintained in the tax return file and that amortization deductions are taken in every year in which they are available.
Another case that affects the preparation of 1991 individual tax returns is Beyer (CA-4, 90-2 USTC Par. 50,536). Once again, the IRS did not acquiesce. In Beyer, the court held that a non-corporate taxpayer's investment interest expense that was disallowed because it exceeded net investment income could be carried forward in full as an expense of the following year, even if it exceeded taxable income. You will want to remember to utilize any investment interest carryovers in future years.
PASSIVE ACTIVITY LOSSES
Do not forget to take advantage of any suspended losses from a passive activity that has been disposed of during 1991. And while you are preparing the tax return for 1991 keep in mind the necessity of advising the client early in 1992 to take steps to free up passive losses, perhaps, by a sale of an activity, for use against 1992 taxable income.
Accurate carryforward schedules are essential. Without them, it is also easy to forget suspended passive activity losses, individual capital loss carryovers, charitable contribution carryovers, and alternative minimum tax credits, among other items. Are your carryforward workpapers in good order? You should update them now while there is still time.
Many taxpayers who are charitably inclined incur extensive out-of- pocket expenses in connection with their charitable work. Remind clients who are involved with charities that items such as mileage driven for charity, along with expenses such as parking, tolls, taxis, postage, and long distance calls incurred as a part of charitable activities, are all deductible. Remember that, for charitable purposes, the mileage deduction is fixed at 12 cents per mile.
CONSIDER MARRIED FILING
With the numerous limits on itemized deductions, it behooves all married couples (where each spouse has items of income) to consider filing separate returns. It may be worthwhile where there are significant medical expenses or miscellaneous itemized deductions. This is particularly true where the other spouse has extremely high adjusted gross income, such that the benefit of any itemized deductions could be lost under the phase-out described above.
Another related factor to consider is the phase-out noted above of the deduction for personal exemptions where AGI exceeds $150,000 for taxpayers who are married filing jointly. Each exemption is phase out by 2% for each $2,500 (or fraction thereof) by which the taxpayers' adjusted gross income exceeds the $150,000 threshold amount. For a married person filing a separate return, even though the phase-out rate is 4%, each spouse's threshold amount is $75,000.
Putting the two considerations together in an example, assume that one spouse had AGI of $60,000 and medical expenses of $10,000, while the other spouse had $300,000 of income and no medical expenses. If a joint tax return were filed, there would be no deduction for either medical expenses or personal exemptions. Filing separately, the spouse with $60,000 of AGI would get a deduction of $5,500 for medical expenses and the full deduction for his personal exemption. With all of the above limitations to consider, it is more important than ever to calculate whether married taxpayers can benefit from substantial tax savings by filing separately. If there is any question in your mind, use the "what-if" capabilities of your tax preparation software and calculate the tax both ways.
CALCULATING THE TAX ON
One of the biggest tax increases in RRA 90 is the increase, effective January 1, 1991, in wages and self-employment income subject to the Medicare hospital insurance tax. This tax is imposed at a rate of 1.45% for both employers and employees and 2.9% for the self-employed. The tax applies to the first $125,000 of wages and/or self-employment earnings. For 1991, for self-employed individuals the tax will be applied at a rate of 2.9% not just to the $53,400 in earnings subject to Social Security tax, but also to the additional earnings that bring the total up to a maximum of $125,000 in earned income. Thus, an employee who is over the $53,400 in earnings which are subject to the Social Security payroll tax and who has earnings from self-employment may forget that he or she has a Medicare hospital insurance tax liability on the self-employment earnings, to the extent they do not bring the total earnings over $125,000.
Properly, entered data in your tax-preparation software will result in the correct tax, as will the proper preparation of Form 1040SE. But be on guard--this could be easy to miss.
CHARITABLE GIFTS OF
Gifts to charity during 1991 (and only during 1991) of appreciated tangible personal property do not result in a tax preference item for purposes of the alternative minimum tax. Where such gifts create a contribution carryforward, they will still not generate a preference item in the carryforward years. It is very important to keep in mind that this "window of opportunity" only applies to gifts of tangible personal property and, therefore, is not available for gifts of appreciated securities or real estate.
USE THE EXPENSING
Taxpayers are entitled to deduct in a single tax year the first $10,000 in cost of depreciable property. This limitation is $5,000 for married taxpayers filing separately. The amount of the expensing deduction cannot exceed that part of the taxpayer's income that is derived from the active conduct of a trade or business. In addition, if the combined cost of qualifying property exceeds $200,000, the dollar limit is reduced by $1 for each $1 of excess. For tax clients with business income, you will want to inquire about purchases of depreciable property.
SELF-CHARGED ITEMS OF
INTEREST INCOME AND
Proposed regulations under IRC Sec. 469 issued in 1991 allow taxpayers who are owners of either partnerships or S corporations that are conducting passive activities, in effect, to net items of interest income or expense that are passing between themselves and the entities they own. Without this ability to net, the result could be taxable income to one of the parties, but with no interest expense deduction to the other. Under the proposed regulations, an owner is a person who directly holds any interest in the pass-through entity or indirectly holds at least a 10% capital and profits interest in the entity.
These regulations should be considered when preparing 1991 tax returns where the taxpayer holds an interest in a partnership or an S corporation engaged in a passive activity. You will want to review returns for open years, presumably 1988 and 1989, to see whether symmetry in treatment of interest income and expense did not exist because of passive activity losses and whether to file amended returns.
LOSSES ON REGULATED
Where your client has Sec. 1256 losses from trading in regulated futures contracts, don't forget that these losses can be carried back against any gain from trading in such contracts shown in the last three years' income tax returns. Many clients are trading in stock index options such as the S&P 100. These options are subject to Sec. 1256 treatment.
CALCULATE THE PENALTY ON
EARLY WITHDRAWALS FROM
Due to the poor state of the economy, many taxpayers were forced to make early withdrawals from their retirement accounts during 1991. If your client withdrew funds from a retirement account during 1991, had not yet reached age 59 1/2, and did not meet any of the other requirements for exemption from the penalty, you must not only calculate the income tax due on the withdrawal but you must also compute the 10% premature withdrawal penalty.
ADJUSTMENTS TO BENEFIT
AND CONTRIBUTION LIMITS
The following limits apply to contributions to qualified plans for 1991:
* Defined benefit plans--$108,963.
* Defined contribution plans--the limit remains at $30,000. It will not be increased until the defined benefit limit is over $120,000.
* Sec. 401(k) plans salary reduction (deferral amount)--$8,475.
* Annual compensation limit for figuring benefits and contributions-- $222,220.
* Annual threshold amount for excess distribution and excess accumulation penalty taxes--$136,204.
Care must be exercised when computing the allowable contribution to Keogh plans. Even though the annual addition limit for defined contribution Keogh plans is the lesser of $30,000 or 25% of compensation, because earned income is computed after taking into account amounts contributed to the plan on behalf of the self-employed individual and after the deduction for one-half the individual's self- employment taxes, the effective percentage limit on contributions is 20% of earned income computed after the self-employment tax deduction but before the contribution (1/1.25 = .80; 1.0 - .80 = .20).
For a self-employed individual who adopts only a profit-sharing plan, the effective percentage limit on the contribution is 13.0435% of earned income computed after the self-employment tax deduction but before the contribution (1/1.15 = .869565; 1.0 - .869565 = .130435).
In making the Keogh contribution, it is important to keep in mind that for 1991 the self-employment tax rate is 15.3% (12.4% for Social Security and 2.9% for Medicare) and the Social Security base is $53,400, while the Medicare base is $125,000. Thus, in 1991 the maximum self- employment tax is $10,246.60 (12.4% x $53,400 + 2.9% x $125,000).
PREPARER PENALTY AND
In OBRA 89 the system of preparer penalty and accuracy rules was totally revamped. During 1991, proposed regulations amplifying the law changes were issued. Those proposed regulations contain some surprises for preparers of 1991 tax returns.
Accuracy-Related Penalty. In general, a 20% accuracy-related penalty is imposed for negligence or disregard of rules and regulations or for substantial understatement of income tax liability or substantial valuation misstatements. A substantial understatement exists where the understatement exceeds the greater of 10% of the amount required to be shown on the return or $5,000 (10,000 for corporations).
Where an understatement is not substantial, a 20% penalty will be imposed only if the position does not have a "reasonable basis" and it is not disclosed. Reg. Sec. 1.6661-3(a)(2) states that the reasonable basis standard is satisfied by a position which is "arguable but fairly unlikely to prevail in court."
Valuation Misstatements. A substantial valuation misstatement exists where the value claimed is 200% or more of the correct amount. A 40% penalty rate applies to gross valuation misstatements (those where the value claimed is 400% or more of the correct amount). Again, no penalty is imposed unless the valuation misstatement results in an underpayment of tax that exceeds $5,000 ($10,000 for corporations).
Disclosure. Adequate disclosure will prevent imposition of the negligence or disregard penalty or the substantial understatement penalty (except for tax shelters), but it will not eliminate the penalty for valuation misstatements. One of the surprising provisions in the proposed regulations is that disclosure must be made on Form 8275 or in conformity with an annual revenue procedure that had not been issued at the time this article was written. Thus, plain-paper disclosure, even though it is clearly labelled as disclosure, will not suffice under the regulations as they have been proposed.
There is no need for disclosure where substantial authority for a position exists. Substantial authority requires a greater than one-in- three chance of success but less than one-in-two. Where a tax shelter exists, it must be "more likely than not" that the tax position taken is the correct one in order to avoid penalties.
There is also a reasonable cause exception from the accuracy-related penalty for taxpayers who acted in good faith.
A tax return preparer will be penalized for an undisclosed position which did not have a "realistic possibility of being sustained on its merits. Disclosure will avoid the imposition of penalties unless the return position was frivolous. The proposed regulations have defined "realistic possibility" to be an approximately one-in-three, or greater, likelihood of being sustained on the merits.
These standards create a conflict between taxpayers and preparers. A position may fail to satisfy the realistic possibility standard but satisfy the lower reasonable basis standard. In such a case, it would be in the taxpayer's best interest not to disclose the position, but nondisclosure would expose the preparer to the possible imposition of a preparer penalty. Thus practitioners find themselves literally between a rock and a hard place. One possibility is that preparers will include so many Forms 8275 with returns that they will no longer be a meaningful flag in attracting the attention of the IRS.
Signing Preparer Rule. Another consideration in the proposed regulations is that they allow for penalizing only one preparer from a particular firm--the preparer who signs the return. As a result, if a partner signing a return relies on the advice of another partner in the firm with respect to, let's assume, the employee benefits issues in the return, the signing partner cannot assign responsibility for that area, for penalty purposes, to the partner who was actually responsible for the position taken in the return. However, if the practitioner goes outside his or her firm to consult on specific areas of the return, responsibility for those portions of the return can be delegated to the consultant.
This is a strange result indeed, and the NYSSCPA has suggested to the IRS a method for assigning responsibility within the firm to certain professionals who agree that they are, in fact, the ones who should be responsible for particular portions of the return.
SENDING THE RETURN TO
When the individual income tax return absolutely, positively has to get there the next day (e.g., you are sending it to the IRS on April 14, 1992), you should make sure that the return is deposited in the U.s. Postal Service (with a proof of mailing) rather than sent by Federal Express or other express service.
In a recent case (Petrulis, Ca-7, No. 90-2447, 7/24/91), the Seventh Circuit considered the case of a taxpayer who delivered a Tax Court petition to Federal Express on the 90th day following the mailing of a notice of deficiency. The court deemed the petition not to have been timely filed, even though it was delivered to the Tax Court the next day, since IRC Sec. 7502 only contemplates use of the U.S. Postal Service.
EXTENDING THE INDIVIDUAL
INCOME TAX RETURN
The IRS had planned to go to a paperless extension system for 1991 individual income tax returns. However, in IR-91-86, issued August 16, 1991, it delayed implementation of the program, and it will not apply to extensions of 1991 returns. Thus, in order to extend the filing deadline for 1991 returns, paper extensions will have to be filed, just as they have been in prior years.
POWERS OF ATTORNEY
The Power of Attorney (Form 2848) has been revised. the new Power of Attorney has a revision date of March 1991 and must be used for all powers filed after June 30, 1991. The new Power of Attorney has been expanded from a two- to a four-page package, including instructions. On the new form, the authority to substitute another representative or to delegate authority must be specifically stated in Section 5.
The Limited Power of Attorney (Form 2848-D) has been discontinued. This means that it is now necessary to modify Section 5 of Form 2848 to limit the representative's power.
THERE ARE OTHER PIECES
TO THE PUZZLE
The above items all must be factored into the preparation of 1991 individual income tax returns, but they are, of course, not the only pieces of the puzzle. As mentioned throughout, with the increasing volume and complexity of the tax code and regulations and the cases and rulings thereunder, it now becomes more necessary than ever to use computer programs in the tax preparation process. Practitioners are also well advised to maintain carefully prepared and extensive documentary support for positions taken, supported by carryforward schedules of items that impact future years.
Janice M. Johnson, JD, CPA, is Director of Tax Policy of the NYSSCPA and Technical Editor, Taxes of The CPA Journal. Ms. Johnson is a frequent lecturer on tax issues and contributor to accounting and tax journals.
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