November 26, 2013

Expenses that Reduce Net Investment Income

Anders has been busy blogging about the new Net Investment Income Tax and what it means to taxpayers as they begin their 2013 year-end planning.  Taxpayers with adjusted gross income exceeding $250,000 ($200,000 for single filers) will incur a 3.8% tax on some or all of their net investment income (NII). We have previously explained what types of income are included in the net investment income calculation; now we’re going to cover expenses that reduce net investment income. The proposed regulations allow your net investment income to be reduced by certain properly allocable deductions; here are a few examples:

  1. Investment interest expense – including carry forward amounts
  2. Investment advisory and brokerage fees
  3. State and local income taxes

Item three is of particular interest because it presents an interesting twist on traditional advice.  Net investment income is reduced by an allocable portion of a taxpayer’s Schedule A state and local tax deduction.  This allocation can be determined using “any reasonable method”, but the IRS has provided a safe harbor allocation based on the ratio of investment income to gross income.

When investment income is a large percentage of gross income, the reduction to NII could substantially reduce one’s exposure to the 3.8% tax.  Historically, taxpayers subject to the alternative minimum tax would not pre-pay state tax, as the deduction is disallowed for AMT purposes.  Therefore, taxpayers with large NII might rethink this conventional advice if they project to be subject to AMT on an annual basis.

It is important to note that reductions to NII are phased-out based on adjusted gross income in a manner consistent with the traditional Schedule A phase-outs.

As you can see, in order to plan for year end, it is important to understand not only what income, but also what deductions, are comprehended to arrive at net investment income. The stakes are certainly high, and thankfully you can always call an Anders advisor to discuss a tax strategy that fits your needs.

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November 20, 2013

Anders Opens New Office at 800 Market Street

Anders’ Downtown and Brentwood offices combined into approximately 45,000 square feet on the Fifth Floor of the Atrium at Bank of America Plaza Downtown St. Louis.  Our new office opened December 30. The new address is:

800 Market Street
Suite 500
St. Louis, MO 63101

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November 14, 2013

IRS Allows $500 Carryover for Unused Healthcare FSAs

The IRS just announced a new exception to the longstanding “use or lose” rule for healthcare flexible spending account (FSA) plans. Under the exception, if you have an unused balance in your FSA at the end of the plan year, you can carry over up to $500 of that unused balance to the following year.

Without such a carryover privilege, any unused balance is forfeited to your employer under the use-or-lose rule. Bottom line: The ability to carry over an unused balance is a big help for those who over-estimate their out-of-pocket medical expenses for the year. But an employer must amend its plan to offer the new carryover privilege. Otherwise, nothing changes.

Healthcare FSA Basics

Under a healthcare FSA plan, you make an election to contribute a designated amount of your salary to your personal healthcare FSA. The maximum amount you can contribute for both 2013 and 2014 is $2,500 per year.

Your contribution is withheld in installments from your paychecks. Throughout the year, you can use the FSA money to reimburse yourself for out-of-pocket medical expenses, such as amounts paid to satisfy health insurance deductibles and co-pays, as well as amounts paid for prescription drugs, dental care, and vision care. The contribution withheld from your paychecks is treated as a salary reduction for federal income, Social Security and Medicare tax purposes. It’s usually a salary reduction for state tax purposes, too. Reimbursements from the FSA to cover qualified out-of-pocket medical expenses are tax-free to you.

To put it another way, the healthcare FSA arrangement allows you to pay for all or a portion of your out-of-pocket medical expenses with pretax dollars. That is the same as getting an income tax deduction combined with a reduction in your Social Security and Medicare tax withholding. The tax savings are permanent — not just a timing difference.

The only downside to the FSA deal is the use-or-lose rule. If you fail to incur enough qualified medical expenses to drain your healthcare FSA each year, any leftover balance generally goes back to your employer. In other words, before the new $500 carryover privilege, the use-or-lose rule meant you could never carry over any unused healthcare FSA balance to the following year. That money was just lost.

However, some plans currently allow a grace period of up to 2 1/2 months to ease this concern. If so, you have until March 15 of the following year to incur enough expenses to soak up your unused healthcare FSA balance from the previous year. But if there is still an unused balance at the end of the grace period, that money is gone forever.

The new $500 unused balance carryover privilege is an alternative to — rather than an addition to — the grace period deal. So, your company’s healthcare FSA can offer either the new carryover privilege or the familiar grace period, but not both.

New Healthcare FSA Carryover Option

Thankfully, the IRS has now given employers the option of amending their healthcare FSA plans to allow a carryover of up to $500 of any balance that remains unused at the end of any plan year. Any unused balance in excess of the $500 limit is forfeited.

Subject to the $500 limit, the carryover privilege can be used to cover qualified out-of-pocket medical expenses incurred any time during a subsequent plan year. The carryover amount does not count against or reduce the healthcare FSA contribution cap for the subsequent year ($2,500 for 2014). If desired, your company can specify a lower carryover limit than the $500 maximum. In any case, the same carryover limit must apply to all participating employees.

A plan that has a carryover provision cannot also provide a grace period that falls within the plan year to which unused amounts can be carried over. For example, a calendar-year healthcare FSA plan that is amended to permit a carryover to 2014 of unused 2013 balances (up to the $500 limit) cannot have a grace period that extends into 2014. However, a calendar-year plan that does not allow a carryover until 2015 (of unused 2014 balances) can have a grace period for the 2013 plan year that extends through as late as March 15, 2014.

Deadlines for Plan Amendments

To adopt the new unused balance carryover privilege, your company must amend its healthcare FSA plan by no later than the last day of the plan year from which amounts may be carried over. However, for plan years that begin in 2013, the IRS will allow the amendment to be made at any time up to the last day of the plan year that begins in 2014. Therefore, a calendar year FSA plan — which most plans are — can be amended by as late as December 31, 2014 to allow the unused balance carryover privilege for unused balances from the 2013 plan year.

If a healthcare FSA plan currently provides for a grace period and is being amended to add the new carryover deal, the plan must be amended to eliminate the grace period by no later than the end of the plan year from which amounts may be carried over. Therefore, a calendar-year plan that currently includes a grace period, and that will be amended to adopt the carryover privilege or unused balances from the 2013 plan year, must be amended to eliminate the grace period provision by no later than December 31, 2013.

What’s the Catch?

The new carryover privilege for unused healthcare FSA balances is a welcome improvement to FSA plans in the eyes of most employees. But employers must amend FSA plans for employees to benefit. The primary downside to adopting the carryover privilege is the requirement to eliminate any existing grace period provision. Contact your company employee benefits department to learn what the company intends to do.

Copyright 2013

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November 12, 2013

How does the 3.8% Net Investment Income Tax Apply to Real Estate Professionals?

As you’ve probably noticed, a CPA’s answer to almost every question is, “It depends”.  So, when you ask your accountant how you’ll be impacted by the new 3.8% net investment income tax, you already know the answer, right?  But what does it depend upon?  There are actually quite a few variables.

Generally speaking, if your 2013 adjusted gross income (AGI) exceeds $250,000 ($200,000 for single filers) you will incur an additional 3.8% tax on your net investment income (NII).  NII includes portfolio income (interest, dividends, and capital gains), annuity income, income from passive investments, and rental income.

There are, however, some possible exceptions to the new law.  The following items are not subject to the new 3.8% Surtax:

  1. S corporation distributions to owners who materially participate
  2. Rents received by ‘real estate professionals’ who materially participate in the underlying activity
  3. Grouping of rental activities with businesses in which owners materially participate
  4. Recharacterized rents received from businesses in which the owner materially participates
  5. Non-portfolio capital gains or losses attributable to property held by an entity in which the owner materially participates.

Some aspects of these exceptions require additional explanation and, to some degree, are subject to interpretation because the proposed regulations outlining the new 3.8% tax are not yet final.

One somewhat controversial aspect of the 3.8% Surtax is how it will apply to self-rented property.  It’s a common tax planning strategy for business owners who own their own building to hold it separately from their operating entity and to pay themselves rent.  The IRS requires income from self-rented property to be categorized as non-passive income regardless of the material participation rules.  The question is whether or not this ‘non-passive’ income is subject to the 3.8% Surtax.  The answer is, of course, it depends…

While tax law isn’t always clear, it is clear that your Anders advisors are adept at interpreting tax law and we’re always available to discuss how to minimize your tax liability; please contact us to discuss these concepts in more detail.

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November 5, 2013

Annual Budget – Friend or Foe?

A few days before last Christmas, I was at the mall shopping when I got a phone call from my best friend Ella, a graphic designer for a manufacturer and distributor of home furnishings.  “What are you up to?” she asked.  “Last minute Christmas shopping”, I answered. “So am I”, said Ella.  “My boss told me to hurry up and order a new drafting table.  He said we have money left in the budget and we need to spend it before the year is over.”

“Don’t you need one?” I asked.  “Not really”, she answered, “but my boss says we need to spend the money now or we won’t see it next year”.  She joked “I haven’t yet found out anything expensive enough to use up the leftover money.  Our business development manager has an even longer shopping list. She didn’t spend her money earlier this year either”.

My first thought was “sounds like Ella’s company needs to hire people with better ethics.” But Ella always praises her boss for being an exceptional manager, and their company is growing fast – so the business development manager must be doing something right, after all.  Chances are Ella and her coworker are not the only ones at their company in a hurry to spend the budget allocations before the end of the year.

Does Ella’s Company Have a “People Problem” or a “Numbers Problem”?
The answer is probably “both”.  Any company is only as good as its employees.  But good employees who get the wrong message – “here’s your budget, stick to it” – can be very easily steered in the wrong direction.  Like in Ella’s company, many managers are afraid that their department will lose their budget allocation next year if they under spend in the current year so “use it or lose it” mentality replaces good judgment.

Are Budgets a Bad Thing for Business?
Not necessarily.  But there are budget pitfalls that the company leadership should be aware of:

  • First, it’s hard to plan a year ahead.  Nobody has a crystal ball to predict what the future will be a year, a few months, or a few days from today.  Will the company lose a key customer?  Will the market crash?  Will the pending RPF double the company’s revenues?  Nobody knows for sure.  While it’s definitely important to think and plan for the future, the planning process needs to be more flexible and responsive to the changes in the internal and external environment.
  • Second, human nature should not be underestimated.  The traditional budget creates an opportunity for “gaming” the system.  Managers are much more inclined to set lower revenue targets or overstate their future spending needs so as not to be at fault if they underperform on revenue side or if expenses end up higher.  Budgets also foster a conflict of interest if the company’s incentive compensation is tied to reaching the budget goals.  Managers are incented to negotiate the lowest acceptable level of revenues or highest expenses they possibly can to maximize their bonuses.   If the company leadership doesn’t recognize the importance of these factors and what role they plan in the company’s performance, than the company is very likely to end up like Ella’s company – with good people making bad choices.

Rolling Forecasting vs. Budgeting
While budgets are probably not going to disappear from the management’s toolset, there are definitely good alternative (or at least complimentary) tools to consider.   One of them is called “rolling forecasting”.

If you are not familiar with it, you are not alone.  While this concept has been around for years, it is adopted only by a handful companies.  And here are a few reasons they are transitioning from budgets to forecasting:

  •  Traditional budgets are becoming too “stiff” to effectively navigate in the rapidly changing economy;
  • “Millennials” have a much more flexible mindset compared to older generations which helps them to be more effective in working with models that require continuous adjustments;
  • And finally, the technology has caught up with the needs of the marketplace – more and more of the modern accounting systems have advanced forecasting tools built in that feed from the data in the general ledger and generate various scenarios based on user-defined parameters and forecasting models.

So for many companies, the time to rethink if an annual budget is the best tool for them is now.

Are you a “Budget Believer?”
Can’t think of not having a budget? Then please look into your company’s spending in the last few days or weeks of the year and see if you see any spikes in revenues or expenses.  If the answer is “yes” – you probably need to shred that budget, after all, and look for other solutions.

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