Tax Connections Newsletter – Fall 2012
Frank L. Washelesky

Make Sure Your Tax Payments Are on Track

The IRS doesn’t wait until returns are filed to collect income taxes from taxpayers. Most people are required to pay tax during the year by making quarterly estimated tax payments to the IRS or having their employers withhold income taxes from their paychecks. It’s important to pay at least as much estimated tax as the tax law requires so you won’t owe an underpayment penalty.

How Much Is Enough?

The total amount of estimated tax you’re required to pay depends on your adjusted gross income (AGI) for the previous year. If your 2011 AGI was $150,000 or less ($75,000 or less as a married taxpayer filing separately), you should aim to pay the lower of:

  • 90% of your 2012 tax liability or
  • 100% of your 2011 tax liability

If your 2011 AGI was more than $150,000 ($75,000 as a married taxpayer filing separately, pay the lower of:

  • 90% of your 2012 tax liability or
  • 110% of your 2011 tax liability

Generally, estimated tax payments must be made in four equal quarterly installments due on the 15th of April, June, September, and January. However, if you receive income unevenly (because you have a seasonal business, for example), you may be able to vary the amounts of your payments and still avoid penalty using what’s known as the “annualized income” method. Note that withheld tax is treated as though it were paid in equal amounts on each installment due date.

Under a special rule, you won’t owe an underpayment penalty if the tax shown on your 2012 return, after reduction for withholding tax paid, is less than $1,000. The underpayment penalty also won’t apply if you had no tax liability last year and you were a U.S. citizen or resident for the whole year.

See Where You Stand

At this point, you may want to review your 2012 tax situation and see where you stand with respect to your tax payments. As nice as it is to get a refund, overpaying your taxes during the year is like giving the IRS an interest-free loan. On the other hand, many people don’t want to face a large tax bill in April — especially if it’s a bill they weren’t anticipating. A tax projection can give you a clearer picture of your situation. Now is also a good time to discuss potential year-end tax planning moves with us.

Good Intentions, Bad Tax Result

A recent Tax Court case* illustrates what can go wrong when taxpayers don’t have all the documentation required to support their deductions for charitable contributions. The case involves a couple who had made a series of cash donations totaling approximately $25,000 to a tax-exempt organization (their church). They claimed a deduction for their contributions, and the IRS disallowed it on audit.

First round. The couple defended their deduction by producing records of the contributions. The records included copies of their canceled checks and a letter from the organization acknowledging the donations. But that wasn’t enough proof to satisfy the IRS.

Why? The letter failed to state whether the organization had provided any goods or services in consideration for the contribution. This statement, along with a description and good faith estimate of the value of any goods and services provided, must be included in acknowledgments of contributions of $250 or more. (The value of any goods and services provided is subtracted from the amount contributed to determine the deductible amount.)

Second round. The couple then obtained a second letter that included the required information. However, this still wasn’t good enough. The reason: The letter hadn’t been provided to them contemporaneously (they didn’t have it when they filed their return) — another substantiation rule.

In court. The couple argued they had substantially complied with the regulations, but the court did not agree. The statement about goods and services is necessary to determine the amount of a charitable contribution, and the second letter that contained the statement was not contemporaneous. As a result, the couple couldn’t claim the deduction.

* David P. Durden, et ux. v. Comm’r (TC Memo. 2012-140, 5/17/2012)

Caution: This Estate Includes IRD

Here’s a fictional story you may find interesting if you’re planning your estate.

Ted’s Tale

Ted was a successful executive. He had a large estate when he died, all of which he left to his two children, Tina and Tom.

Under Ted’s estate plan, Tina will receive land valued at $1 million. Tom is the beneficiary of Ted’s 401(k) account, also worth $1 million. The children will divide the remainder of Ted’s estate equally, as his will directs.

Fair enough, or so it seemed until Tom received a communication from the 401(k) plan outlining his distribution options. The problem? Tom has learned he’ll have to pay income tax on the money he receives from the plan. He can defer the tax by rolling the money into an individual retirement account (IRA), but withdrawals from the IRA will be taxable to him at his ordinary tax rate. And he can’t leave all his money in the rollover IRA indefinitely — under tax law rules, he’ll have to withdraw at least a minimum amount annually.

With federal income-tax rates now as high as 35% — and even higher rates scheduled to take effect in 2013 — income tax will take a significant bite from Tom’s inherited plan assets. Meanwhile, Tina won’t owe any income tax on the land she receives. So much for 50-50!

Why are the inherited 401(k) benefits subject to income tax while the land is not?

The Culprit: IRD

Retirement plan benefits have the dubious distinction of being considered “income in respect of a decedent” (IRD) under the tax law. Essentially, IRD is income a person earned and was entitled to receive but did not actually receive before death. IRD is not reported on a decedent’s final income-tax return. Instead, IRD is generally taxed to the recipient.

  • Qualified retirement plans and traditional IRAs are common sources of IRD. Other examples include:
  • A decedent’s final paycheck for wages earned but not paid until after death
  • Bonuses and sales commissions earned but not paid until after death
  • Deferred compensation
  • Uncollected payments on an installment note
  • Accrued interest
  • An IRD recipient may be entitled to an income-tax deduction for any federal estate tax attributable to inclusion of the right to receive the IRD in the decedent’s gross estate.

A Potential Trap

Generally, if property has appreciated, its fair market value at the time of death becomes the new owner’s cost basis for tax purposes. For example, Tina’s basis in the property she inherited is $1 million. If she decides to sell the land, she’ll be taxed only on any gain over and above the property’s $1 million date-of-death value (her tax basis).

IRD doesn’t receive the same basis step-up. Sometimes, taxpayers inadvertently create an IRD situation — and their heirs pay the tax price. For example, Ted could have created an IRD issue for Tina if he’d sold the land on the installment basis just before he died. With an installment sale, capital gain is generally recognized over time as payments are received from the buyer. As beneficiary of the installment note, Tina would have been required to pay the related capital gains tax as she collected payments on the note.

As Ted’s tale illustrates, IRD is a tax issue that shouldn’t be overlooked when planning an estate.

Saving for Retirement – Tax Benefits Can Help

Setbacks in the financial markets and a long road to economic recovery haven’t made the job of saving for retirement any easier. But if you have a 401(k) or similar retirement savings plan at work, there is some good news: The basic tax benefits you receive as a plan participant are still in place. You can take advantage of them to help build up your savings.

Pretax Contributions

If you contribute to your plan on a pretax basis, you see one tax benefit of plan participation every payday. Your contributions aren’t included in your taxable wages for federal (and possibly state) income tax purposes. Your full contribution goes into your plan account, but some of that money is effectively put back into your pocket in the form of immediate tax savings.

Tax Deferral on Earnings

Plan investment earnings are also tax-deferred. Not having to withdraw money from your savings every year to pay income taxes on earnings means you can leave more money invested.

Rollover Opportunity

Distributions from a pre-tax plan account are generally taxable. However, if you change jobs or retire, you may roll over eligible plan distributions tax-free into another employer’s plan or an individual retirement account (IRA). A rollover delays income taxation. In general, you must begin taking annual required minimum distributions (RMDs) once you reach age 70½.

Roth Option

Some plans allow participants to make after-tax Roth contributions. Although there’s no upfront tax benefit, you do get another meaningful tax break: After you reach age 59½ and meet other requirements, distributions from a Roth account are income-tax-free.

Maximizing Contributions

The tax law generally limits 401(k) salary deferrals to $17,000 in 2012 — plus another $5,500 in catch-up contributions for individuals age 50 or older. Check your plan for details regarding its contribution limits. If you’re not maximizing your contributions, you’re missing out on valuable tax benefits and the chance to accumulate savings for your future.

The general information in this publication is not intended to be nor should it be treated as tax, legal or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purpose of avoiding tax penalties.

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