A gift is any transfer to an individual, either directly or indirectly, where full consideration (measured in money or money’s worth) is not received in return. The donor is generally responsible for reporting these gifts via an annual gift tax return (along with paying any tax should it apply).
Generally, any gift is a taxable gift. However, there are many exceptions to this rule. Usually, the following gifts are not taxable gifts:
- Gifts that are not more than the annual exclusion for the calendar year (see below for limits).
- Tuition or medical expenses you pay for someone directly to the institution (the educational and medical exclusions).
- Gifts to your spouse.
- Gifts to charitable organizations**
- Gifts to a political organization for its use.
**Gifts to qualifying charitable organizations are deductible from the value of the gift(s) made.
For 2016, the annual gift exclusion remains the same at $14,000 (2017 is currently at $14,000 as well). This essentially means that the first $14,000 of gifts in present interest to each donee during the calendar year is subtracted from total gifts in figuring the amount of taxable gifts. For a gift in trust, each beneficiary of the trust is treated as a separate donee for purposes of the annual exclusion. A taxpayer can give away $14,000 to as many individuals as he or she wishes. A husband and wife can each make $14,000 in gifts annually to respective children, grandchildren, friends, etc. By way of example, a couple could make $14,000 gifts to each of their four grandchildren, for a total of $112,000. The annual exclusion gifts do not count towards the lifetime gift exemption (below).
If you gave gifts to someone in 2016 totaling more than $14,000, reporting must be completed via Form 709 (US Gift Tax Return) and is due by April 15th of the following year (similar to your personal return).
For 2016, the estate and gift tax exemption is $5.45 million per individual ($5.49 million for 2017), up from $5.43 million in 2015. This means an individual can leave $5.45 million to heirs and pay no federal estate or gift tax. A married couple will be able to shield $10.9 million from federal estate and gift taxes. Gifts made in excess of the annual gift exclusions throughout a person’s lifetime count against his or her estate tax exemption amount. The Federal estate and gift tax exemptions have increased significantly over the years due to various legislative changes and indexing for inflation.
This made the estate and gift exemption increase from $675,000 in 2001 to $1,000,000 in 2003, $2,000,000 in 2008 and ultimately, $5,450,000 in 2016. The top federal estate tax rate is 40%.
States often follow different rules within the estate and gift tax realm. For example, Massachusetts does not have a gift tax and instead has in place a $1 million filing threshold for estate tax purposes. While Massachusetts does not have its own gift tax, adjusted Federal taxable lifetime gifts are taken into account for purposes of determining whether the $1 million filing threshold has been met. Once the filing threshold has been met in Massachusetts, the full value of the estate is subject to Massachusetts estate tax applying tax rates from 1% to as high as 16%. Lifetime gifts can be an effective strategy to reducing Massachusetts estate tax and should be considered in conjunction with personal income tax planning.
There are many planning opportunities available to assure that you maximize the transfer of wealth to your chosen beneficiaries and minimize the amount of estate taxes paid at death. Gifting may be an important part of your overall estate plan. At Newburg & Company, LLP we provide our clients with comprehensive estate planning to protect their assets from unnecessary taxation and ensure their wishes are carried out in an organized and cost effective fashion.
March 2010, the Foreign Account Tax Compliance Act (FATCA) was signed into law creating new reporting requirements for offshore assets and accounts. FATCA requires US citizens and US residents to report all offshore assets on Form 8938 with their tax return as well to file Form 114, Report of Foreign Bank and Financial Accounts (FBAR) if the account values surpass certain thresholds. For individual taxpayers that are citizens or US residents, the 8938 threshold is $50,000 of total offshore assets on the last day of the year or over $75,000 at any point during the year ($100,000 and $150,000 for married filing jointly). Taxpayers must file the Form 114 (FBAR form) if their aggregate total of all foreign accounts exceeds $10,000. It should be noted that these requirements apply if you have a financial interest or signature authority over a foreign financial account. Please also note that effective in 2017, taxpayers will have to file Form 114 by April 15th, with a 6 month extension available. The previous June 30th deadline is no longer applicable.
In recent years the IRS has been cracking down on foreign reporting in the United States. Prosecution and large penalties are charged to individuals who willfully avoid filing the required FATCA forms. The issue many US citizens and residents have come across is lack of knowledge of the FATCA reporting requirements. To help alleviate the penalties imposed on taxpayers for not filing these forms on a non-willful basis, the IRS has enacted several procedures to allow taxpayers to report their accounts for prior years with marginal to no penalization. The most common procedure is the Streamline Voluntary Disclosure Program.
The Streamline program is separated into two categories:
- Streamlined Domestic Offshore Procedures
- Streamlined Foreign Offshore Procedures
The procedures are specifically for taxpayers who are able to certify that they did not file the required FATCA forms due to negligence, inadvertence, mistake, or misunderstanding of the requirements.
The Streamline Domestic Offshore Procedures is designed for US citizens residing within the US. Taxpayers are required to file the most recent 3 years of amended or delinquent tax returns recording the foreign account information not previously included on any filed returns, and 6 years of FBARs. Taxpayers are responsible for paying any additional tax due on the new returns filed including interest. In addition, participants of the Streamlined Domestic Offshore Procedures are required to pay a 5% penalty on the highest aggregate balance recorded at year-end over the last six years. For example, if the highest aggregate balance at year-end over the last six years was $50,000, a payment of $2,500 would be due under this program.
The Streamline Foreign Offshore Procedures is designed for US citizens residing outside the US. Participants in the Streamlined Foreign Procedures program follow the same filing requirements as the Streamlined Domestic Offshore Procedures. Similar to the Domestic Procedures, taxpayers need to pay any additional tax due on the three years of returns filed. However, under the Foreign Procedures, taxpayers are not subject to interest or late filing penalties, nor are they required to pay the 5% penalty on the FBAR account balances. These procedures are particularly helpful to US Citizens residing outside of the US that were unaware of their requirement to file tax returns.
Please contact us should you have any questions regarding foreign reporting or the streamline voluntary disclosure programs.
The IRS assesses penalties for underpayment of income tax. If you did not pay enough tax throughout the year, either through withholding or by making estimated tax payments, you may have to pay a penalty for underpayment of estimated tax.
What are the requirements to avoid penalties?
The required annual payment for most individuals is the LOWER of 90% of the tax shown on the current year’s return or 100% of the tax shown on the return for the previous year. Certain high-income individuals must meet a more rigorous requirement. If the adjusted gross income on your previous year’s return is over $150,000 (over $75,000 if you are married filing separately), you must pay the lower of 90% of the tax shown on the current year’s return or 110% of the tax shown on the return for the previous year.
Can you provide some examples?
For example, if your AGI was less than $150,000 (married filing jointly), and your total tax paid on the 2016 tax return was $10,000 and you are anticipating significantly higher income for 2017, the IRS is content as long as you pay in $10,000 via withholding or through even quarterly payments. The balance due on the 2017 tax return will need to be paid with the 2017 filing by April 15, 2018.
Should your income decrease significantly in the subsequent year, you would default to the 90% of tax shown on the current year return. By way of example, if you paid in $100,000 in tax for 2016, and you expect your income tax to be 50% less than it was in 2016, you would need to pay in 90% of $50,000 or $45,000 to avoid penalty. In this situation, we often recommend considering a tax projection to make sure you are adequately paid in.
What if I change from a salaried employee to self-employed?
This will require that you switch to quarterly estimated tax payments and adhere to the 90% current year tax or 100% of prior year tax rule as stated above.
What if I am a salaried employee and my withholdings are not adequate?
You would be subject to penalties if you do not update your W-4 kept on file by your employer. We recommend that you review and update your W-4 form. The W-4 form provides you the option to claim an additional set withholding amount over and above what they are taking. It is not uncommon to be filing Married 0 exemptions and still be short on your required payments due to other income circumstances, lack of deductions, etc. Your other alternative would be to pay in the difference via quarterly estimated tax payments.
What if your self-employment income is not steady throughout the year?
Most individuals make estimated tax payments in four installments. In other words, we determine the required annual payment, then divide that number by four and make four equal payments by the due dates. But you may be able to make smaller payments under the annualized income method. This method is useful to people whose income flow is not uniform over the year, perhaps because of a seasonal business. For example, if your income comes exclusively from a business that you operate in a resort area during June, July, and Aug., no estimated payment is required before Sept. 15. You may also want to use the annualized income method if a significant portion of your income comes from capital gains on the sale of securities which you sell at various times during the year.
Are there circumstances where the underpayment penalties do not apply?
- If the total tax shown on your return is less than $1,000 after subtracting withholding tax paid; if you were a U.S. citizen or resident for the entire preceding year, that year was 12 months, and you had no tax liability for that year;
- If you are a farmer or fisherman and pay your entire estimated tax by Jan. 15 of the following year, or pay your entire estimated tax by Mar. 1 of the following year and also file your tax return by that date; or
- For the fourth (Jan. 15) installment, if you aren’t a farmer or fisherman, file your return by Jan. 31 of the following year, and pay your tax in full.
Will an extension buy me some time to pay my taxes?
No. An extension of time to file a tax return is NOT an extension of time to pay the tax due under the return. You must pay in 90% of the anticipated tax come extension time to avoid penalties.
How are the penalties and interest calculated?
The addition to tax is one-half of 1% of the tax not paid, for each month (or part of the month) it remains unpaid, up to a maximum of 25%. The penalty increases to 1% per month beginning with either the 10th day after notice of levy is given or the day on which notice and demand is made. Interest on underpayments of tax is imposed at the federal short-term rate plus three percentage points. These rates are adjusted quarterly.
In addition, IRS may waive the penalty if you received excess advance payment of the premium tax credit from a Marketplace and you are current with your filing and payment obligations. The penalty may be waived if the failure was due to casualty, disaster, or other unusual circumstances and it would be inequitable or against good conscience to impose the penalty. The penalty can also be waived for reasonable cause during the first two years after you retire (after reaching age 62) or become disabled.
Please contact us if you have any specific questions about how the estimated tax and underpayment penalty rules apply to you.
If you’re concerned about your family’s financial well-being after you’re gone, life insurance can provide peace of mind. Going a step further and setting up an irrevocable life insurance trust (ILIT) to hold the policy offers additional estate planning benefits.
If you’re concerned about your heirs’ money management skills, an ILIT may be the answer. Why? Your loved ones won’t receive the proceeds directly, as they would if they were the policy beneficiaries. Rather, they’re the beneficiaries of the trust, and the trust controls when they receive proceeds.
You can also establish conditions for distributing funds from an ILIT. For example, you might instruct the trustee to withhold funds from a beneficiary who drops out of school or develops a substance abuse problem.
A properly drafted ILIT can also protect trust assets against your and your beneficiaries’ creditors, particularly if it’s established in a state with favorable asset protection laws.
Estate tax savings
Placing your life insurance policy in an ILIT removes it and its proceeds from your taxable estate. Contributing an existing life insurance policy to an ILIT constitutes a taxable gift to the trust beneficiaries of the policy’s fair market value (which generally approximates its cash value). With the combined gift and estate tax exemption currently at $5.49 million, now may be a good time to make such a gift.
Future ILIT contributions to cover premium payments will be taxable gifts. You may, however, be able to apply your annual gift tax exclusion to reduce or eliminate the tax — provided the ILIT is structured appropriately and certain other requirements are met.
Bear in mind that a repeal of the federal estate tax has been proposed by President Trump and the Republican-led Congress. A repeal or other estate tax law changes could have a significant impact on an ILIT’s estate tax benefits.
An ILIT does have some significant limitations you need to be aware of. After you transfer a policy to the trust, you can no longer:
- Change or add beneficiaries,
- Assign, surrender or cancel the policy, or
- Borrow against or withdraw from the policy’s cash value.
In addition, you’re not allowed to alter the ILIT’s terms or act as trustee.
Nevertheless, you can design the trust to adapt to changing circumstances and provide that children or grandchildren born after you establish the trust be automatically added as beneficiaries.
Contact us for additional details if you’re considering using an ILIT.
The decision relative to what basis of accounting you should select for tax purposes is an important one. The two primary methods available are the cash basis method or the accrual basis method. The core difference between these two methods of accounting pertains to when revenue and expenses are recognized. The cash basis method recognizes revenues when cash is received and expenses when they are paid out. The accrual basis method recognizes revenues in the period earned and expenses are recognized in the period incurred regardless of when cash is actually received or paid out.
Which Method is Ideal for My Business?
The answer to this question much depends on the industry you are in and often the timing of payments to vendors as opposed to collections from clients. The cash basis method tends to provide the most flexibility with respect to when profits are recognized as it is primarily driven by cash received and cash paid. Alternatively, if your company tends not to have significant receivables by nature of the industry, often the accrual basis of accounting can prove favorable. For example, restaurants utilizing the accrual method of accounting can be afforded the benefit of recording accruals and payables owed to vendors and receive tax benefits even though the expenses have not been paid.
When is the Accrual Method Required?
The overall cash method of accounting is available to S corporations, partnerships (that do not have a C corporation as a partner), and personal service corporations (PSCs). A PSC performs activities in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting; and substantially all the stock of the corporation is held by employees performing services for the corporation in connection with those activities.
IRC §448 expressly prohibits C corporations, partnerships which have a C corporation as a partner, and tax shelters from using the cash basis method. However, within a C Corporation context,the cash basis method is available if their average annual gross receipts for the prior three tax years are less than $5 million. For a group of C corporations that files a consolidated return, the gross receipts of all the corporations in the group are aggregated for the $5 million test.
Entities that produce, purchase, or sell merchandise in the ordinary course of business where inventory is an integral component of their business must use the accrual method for purchases and sales of merchandise. There are certain exceptions in which a qualifying sole proprietorship or qualifying small business taxpayer can use the cash method of accounting even if they produce, purchase, or sell merchandise.
To be a qualifying sole proprietorship, the following must be met:
- The average annual gross receipts for the past 3 taxable years is $1 Million or less
- The business is not a tax shelter
To be a qualifying small business taxpayer, the following must be met:
- Average annual gross receipts for past 3 taxable years is more than $1 million but not more than $10 million
- The principal business activity is an eligible business
Cash to Accrual Conversions
A taxpayer will choose a permitted method of accounting when filing their initial tax return. This method must be consistently applied from year to year. If a taxpayer desires to change his/her method of accounting he/she needs to obtain IRS approval via Form 3115. Depending on the industry, one method may be more advantageous than the other. For example, a software company that has annual subscriptions may benefit greatly by converting to the accrual basis as it can take advantages of deferred revenue for cash received but not yet earned.
A taxpayer that converts his/her methods of accounting will need to compute the cumulative difference between the present and proposed method of accounting. Generally the accounting areas of focus will be Accounts Receivable, Accounts Payable, Prepaid Expenses, and Accrued Expenses. The adjustment for change in accounting method is computed as of the beginning of the taxable year for which the method is being changed. If the adjustment results in a decrease to income then the taxpayer generally recognizes the adjustment in the year of change.
If the adjustment results in an increase to income, the taxpayer can recognize the adjustment over a four year period starting with the year of the change.
If you have any questions regarding your current accounting method or are considering a change, please do not hesitate to contact us.