Qualified educational institution

Any amount received as a “qualified scholarship” or fellowship is not required to be reported as income if your child is a candidate for a degree at an educational institution.  For the college that your child attends to be treated as an educational organization, it must (1) be an institution that has as its primary function the presentation of formal instruction, (2) normally maintain a regular faculty and curriculum, and (3) have a regularly enrolled body of students in attendance at the place where the educational activities are regularly carried on.  Your child has received a qualified scholarship if he or she can establish, that in accordance with the conditions of the scholarship, the funds received were used for qualified tuition and related expenses. Therefore, the entire amount is generally taxable if your child is not a candidate for a degree. Athletic scholarships are also tax-free if they meet the above-mentioned requirements.

Qualified tuition and expenses

Qualified tuition and related expenses include tuition and fees required for enrollment or attendance at the educational institution, as well as any fees, books, supplies, and equipment required for courses of instruction at the educational institution.  To be treated as related expenses, the fees, books supplies, and equipment must be required of all students in the particular course of instruction.  Incidental expenses, such as expenses for room and board, travel, research, equipment, and other expenses that are not required for either enrollment or attendance at the educational institution are not treated as related expenses. Any amounts that are used for room, board and other incidental expenses are not excluded from income.

Example. Assume this year your son received a scholarship in the amount of $20,000 to pay for expenses at a qualified educational institution.  His expenses included $12,000 for tuition; $1,100 for books; $900 for lab supplies and fees; and $6,000 for food, housing, clothing, laundry, and other living expenses.
The $14,000 that your son paid for tuition, books and lab supplies and fees is considered to be qualified educational expenses and therefore would not have to be reported as income.  The $6,000 that he spent on housing and the other living expenses is considered to be incidental expenses and would have to be reported in his income.

A note on student loans. “Financial aid” in the form of student loans is not counted as a scholarship. However, student loans are not included in income, generally, and student loan interest can be deducted up to $2,500 a year. If a student loan is partly or wholly forgiven, however, the amount forgiven by the lender is included in income unless specific exceptions apply.

Reduced tuition

If you or your spouse is or was an employee of the school, your child may be entitled to reduced tuition. If so, the amount of the reduction is not taxable as long as the tuition is not for education at the graduate level.

There can be all sorts of complicating factors in assessing whether a particular scholarship will be taxed, such as the treatment of work-study scholarships, educational sabbaticals, scholarships paid by an employer, and stipends to cover the tax on the non-tuition portion of attending a university.  If you need additional assistance in determining the taxability of scholarships funds, please contact our office.

Individual tax rates

For many taxpayers, the greatest uncertainty is over the fate of the 2001 individual income tax rate reductions. After December 31, 2010, the individual marginal income tax rates for all taxpayers will rise when the reduced rates expire. President Obama has asked Congress to extend all of the 2001 individual marginal income tax reductions except for the top two rates.

Change is coming regardless of whether Congress approves the president’s proposal or allows the reduced rates to expire entirely. The likely prospect of higher income tax rates significantly impacts tax planning for individuals and business owners.

Individuals may benefit from many traditional planning techniques. Individuals expecting to be in a higher tax rate in a future year because of higher income levels may want take into account the timing of income or deductible expenses in one tax year or another. An individual may find that accelerating income into 2010, so it is taxed at a lower rate, may be advantageous. You may be able to accelerate payments due to you. Another strategy may be to take withdrawals from retirement savings, either as part of a Roth IRA conversion plan or otherwise, to accelerate income into 2010. Similarly, deferring deductions into 2011 may help offset income that is expected to be taxed at a higher rate. You may consider holding off on a charitable contribution until 2011. Our office can help you design a strategy that works best for you.

Individuals in the highest tax brackets also should consider the likely reinstatement of the limitation on itemized deductions. For 2010 - and 2010 only - the limitation on itemized deductions for higher income taxpayers is completely repealed. The provision limits the total amount of otherwise allowable itemized deductions for higher income taxpayers. President Obama has asked Congress to allow the limitation on itemized deductions to return but to modify it for 2011 and beyond.

Capital gains/dividends

Also expiring after December 31, 2010 are reduced capital gains and dividends tax rates. For 2010, the maximum capital gains and dividends tax rate is 15 percent (zero percent for taxpayers in the 10 and 15 percent brackets). President Obama has asked Congress to impose a 20 percent capital gains and dividends tax rate on higher-income individuals for 2011 and beyond. All other taxpayers would pay capital gains and dividends taxes of 15 percent unless they qualify for the zero percent tax rate. Generally, the 20 percent tax rate would apply to individuals with incomes over $200,000 and married couples filing a joint return with incomes over $250,000.

Small business

The House and Senate have tried several times this year to send a small business tax relief bill to the White House but have failed. House-passed bills stalled in the Senate. The stalemate in the Senate may break this fall because lawmakers are eager to show voters they support “jobs” bills.

Some of the small business tax relief measures that enjoy bipartisan support are:

–Expansion of the small business stock exclusion to 100 percent; –Reform of the Code Sec. 6707A penalties for reportable transactions; –An increase in the deduction for qualified start-up expenses; –Enhanced Code Sec. 179 expensing; and –Bonus depreciation.

Homebuyers

The popular first-time homebuyer tax credit (and the reduced credit for long-time residents) has expired. The credit was popular because Congress made it fully refundable and certain lenders allowed purchasers to monetize the credit toward a down payment. Recent reports about sales of new homes reaching record lows may encourage Congress to consider extending the incentive. However, Congress must find a way to pay for the credit if it decides to extend it.

Estate tax

Nine years ago, Congress repealed the federal estate tax. Because of budget concerns, Congress delayed full repeal until 2010. For individuals dying in 2010, the traditional stepped-up basis rules are replaced with a modified carryover basis regime. Again, because of budget concerns, full repeal expires after December 31, 2010. If Congress takes no action on the estate tax before year-end, the exemption level will be $1 million in 2011 and the maximum estate tax rate will be 55 percent.

The House has approved legislation to make permanent the estate tax rules as they were in 2009. The House bill has languished in the Senate over not only its cost but also concerns over whether to make it retroactive to January 1, 2010. Some states have already passed bills to protect older wills based on formula dispositions, which may not have anticipated repeal of the estate tax in 2010.

Extenders

A package of tax extenders has stalled in the Senate and is unlikely to pass as a single bill because of its price tag. Instead, Democratic leaders in the Senate have indicated that they may enact some of the extenders in other bills, especially the extenders that have support from both parties. House Democrats would prefer the Senate keep the extenders in one bill but will likely acquiesce in enacting some of the extenders rather than none.

Among the extenders that enjoy bipartisan support are:

–Research tax credit; –State and local sales tax deduction; –Teachers’ classroom expense deduction; –Higher education tuition deduction; and –Energy incentives for consumers.

Offsets

Congress must find offsets to pay for any tax cuts and its options are dwindling. Two House-approved revenue raisers, a change in the tax treatment of carried interest and the imposition of self-employment taxes on service S corps, died in the Senate and are unlikely to be revived. Less controversial are reforms to grantor retained annuity trusts (GRATs) and the cellulosic biofuel credit. Congress could also abolish the Code Sec. 199 production activities deduction and raise taxes on oil and gas producers.

Lawmakers have a short window in which to try to pass critical tax bills before year-end. Our office will keep you posted of developments. Please contact our office if you have any questions.

For business taxpayers, some of the tax incentives to be extended include the research tax credit, New Markets Tax Credit, differential pay credit, and the 15-year recovery period under the Modified Accelerated Cost Recovery System (MACRS) for qualified leasehold improvements, and qualified restaurant and retail improvement property.

A host of charitable and energy tax incentives would also be extended through 2010. The charitable extenders include the ability to make a charitable IRA contribution of up to $100,000 for individuals age 70 1/2 and older, and the tax deductions for contributions of real property, food inventory, computer and book inventory to public schools, and S corporation charitable contribution deductions.

Small business tax relief/”jobs” bill

The House has twice passed a package of small business tax incentives. The bills includes three major incentives for small business: (1) a 100 percent exclusion of gain from the sale of qualified small business stock, (2) an enhanced deduction for start-up expenses, and (3) penalty relief for taxpayers that failed to disclose transactions with the potential for tax evasion. The Small Business Jobs Tax Relief Act of 2010, passed by the House in June, would increase the exclusion for qualified small business stock sold by an individual from 75 percent to 100 percent for stock acquired after March 15, 2010 and before January 1, 2012.

Increased start-up expenses. The bill increases the deduction for qualified start-up expenses from $5,000 to $20,000. It also increases to $75,000 the threshold amount by which the $20,000 deduction would be reduced.

Decreased Code Sec. 6707A penalties. The legislation would also provide for lower penalties under Code Sec. 6707A for taxpayers who fail to disclose “reportable transactions” in which they participate. This change is intended to help ameliorate the impact of the penalty on small businesses, which can currently reach a maximum of $200,000 for businesses failing to report listed transactions and $50,000 for failing to report reportable transactions. Many businesses have been assessed these penalties for engaging in transactions they did not know were tax shelters.

New limits on GRATs. To pay for the small business tax incentives, the bill places new limits on grantor retained annuity trusts (GRATs), a popular estate and gift planning vehicle. GRATs would be required to have a minimum 10-year term, carry a remainder interest with a value greater than zero, and prohibit any decreases in annuity payments during the GRAT’s term. The new limits would be imposed for transfers after the date of enactment.

3.8 percent tax Medicare tax on investment income

The health care reform package (the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010) imposes a new 3.8 percent Medicare contribution tax on the investment income of higher-income individuals. The tax will apply to the lesser of net investment income or modified adjusted gross income above $200,000 for individuals and $250,000 for joint filers and surviving spouses, and $125,000 for married couples filing joint returns.

Although the tax will not take effect until 2013, it is important for individuals who will be affected by the tax to start examining ways to lessen the impact now.   Net investment income includes interest, dividends annuities, royalties, rents, and other gross income attributable to passive activities. Gain from the sale of property not used in an active business (for example, your personal residence) and income from the investment of working capital are also treated as investment income. The tax won’t apply, however, to nontaxable income such as tax exempt interest, or to veterans’ benefits. An individual’s capital gains income will be subject to the tax. This includes gain from the sale of a principal residence, unless the gain is excluded from income.

A significant exception to the 3.8 percent Medicare tax applies for distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. These will not be subject to the tax.

Interplay with other tax changes. In addition to the 3.8 percent Medicare tax, taxpayers also face other tax increases taking effect in 2011. The top two marginal income tax rates for individuals will rise from 33 and 35 percent to 36 and 39.6 percent, respectively. The maximum tax rate on long-term capital gains is set to increase from 15 to 20 percent. Dividends, which are currently capped at the 15 percent long-term capital gains tax rate, will be taxed at ordinary income tax rates.

Estate tax fix

The federal estate tax does not apply to decedents dying after December 31, 2009 and before January 1, 2011. Also, beginning in 2010, the stepped up basis at death rules are replaced with modified carryover basis at death rules applicable to estates holding assets with unrealized capital gains of more than $1.3 million. In December 2009, the House passed the Permanent Estate Tax Relief Act, which would permanently extend the top federal estate tax rate of 45 percent with a $3.5 million exclusion ($7 million for married couples). The Senate, however, has failed to take up the House bill. Some action this year is expected. The estate tax will revert to a 55 percent tax rate beginning in 2011. Proposals in Congress range from setting the exemption level at $5 million for individuals and reducing the tax rate to 35 percent.

May 5

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates April 28-30.

May 7

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 1-4.

May 12

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 5-7.

May 10

Employees who work for tips. Employees who received $20 or more in tips during April must report them to their employer using Form 4070.

May 12

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 5-7.

May 14

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 8-11.

May 17

Monthly depositors. Monthly depositors must deposit employment taxes for payments in April.

May 19

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 12-14.

May 21

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 15-18.

May 26

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 19-21.

May 28

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates May 22-25.

Estate tax

Effective for decedents dying on or after January 1, 2010, the traditional federal estate tax with its stepped-up basis at death rules no longer apply. New carryover basis at death rules apply. In addition, the generation skipping transfer (GST) tax does not apply to generation skipping transfers made after December 31, 2009. The federal gift tax, however, does continue, albeit in modified form from 2009.

All of these changes were set in motion by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), which abolished the federal estate tax for 2010 but only for 2010. At that time, supporters expected the temporary elimination of the federal estate tax to be made permanent before 2010. They lacked sufficient support in Congress to make that happen. During 2009, many lawmakers in Congress proposed an extension of the 2009 estate tax rules with a $3.5 million exclusion ($7 million for married couples) and a top tax rate of 45 percent. In fact, the House passed such a bill. The Senate, however, did not approve the House bill before the end of 2009. Consequently, the rules put in place in 2001 have come into effect in 2010.

What does this mean? The flux in the estate tax adds to uncertainty in estate planning. However, Congress is expected to remedy the situation shortly. Congress will enact retroactive legislation in January or early in 2010 to extend the 2009 estate tax regime with its $3.5 million exclusion and 45 percent top tax rate for 2010. Carryover basis at death is expected to be short-lived.

Please contact our office if you have any questions about your estate plan. Congress’ inaction at the end of 2009 has caused confusion. We will review your plan and make sure you are well prepared for Congress’ expected extension of the 2009 estate tax treatment.

AMT

Another area of uncertainty is the AMT. The AMT was designed to ensure that very wealthy individuals did not evade federal taxes. However, Congress did not index the AMT for inflation. Consequently, the AMT has encroached on more middle income taxpayers, especially two income couples in high tax states.

In recent years, Congress has passed an AMT “patch” to help middle income taxpayers avoid the AMT. The patch provides higher exemption amounts and other relief. Congress enacted a patch for 2009 but recessed for the December holidays before passing a patch for 2010. One stumbling block is the cost of a patch and disagreements in the House and Senate whether the cost should be offset by revenue raisers. We will keep you updated of developments.

Health care

House and Senate Democrats are drafting a final health care reform bill for passage by both chambers, possibly in January. In December, the House and Senate passed similar health care reform bills but with important differences in revenue raisers. The Senate passed, by a vote of 60-39, the Patient Protection and Affordable Care Act late on Christmas Eve. The chief revenue raiser in the House bill is a proposed surtax on higher income individuals (individuals with incomes over $200,000 and families with incomes over $250,000). The Senate rejected the House surtax and instead approved a new excise tax on high-dollar insurance plans. Other revenue raisers under negotiation include new limits on health flexible spending arrangements and health savings accounts, a new excise tax on indoor tanning, an additional Medicare tax for higher-income individuals, and more.

The final conference bill is expected to require employers to provide health insurance to their employees.  Employers that do not will be subject to an additional tax with an exception for small employers. The final bill could classify a small employer as one with 50 or fewer full time employees or use a lower threshold; for example, 25 full-time employees. The conference bill is also expected to provide tax credits to help small businesses purchase health insurance for their employees. Individuals without coverage generally would be liable for an additional tax unless covered by Medicare or other qualified coverage.

The conference bill will change the fundamental landscape of health care in the U.S. The tax-related provisions in themselves are monumental. To complicate matters, some provisions go into force immediately and some are delayed for up to three years. Please contact our office if you have any questions about this important legislation.

COBRA

COBRA continuation coverage provides eligible individuals the opportunity to continue their employer-provided health insurance coverage after a layoff or other qualified event. However, COBRA requires individuals to 100 percent self-pay their premiums. The cost makes COBRA out of reach for many individuals.

In the American Recovery and Reinvestment Act of 2009, Congress created a temporary subsidy to help eligible individuals pay for COBRA coverage. Eligible individuals pay 35 percent of the premium cost and the former employer pays 65 percent, which it recovers through a payroll tax credit. Under the 2009 Recovery Act, eligibility for COBRA premium assistance expired after December 31, 2009.

Congress provided a temporary extension in the Fiscal Year (FY) 2010 Defense Appropriations Bill. This bill extends eligibility for COBRA premium assistance through February 28, 2010.

COBRA premium assistance is limited to eligible individuals (and certain beneficiaries) who are involuntarily terminated from employment. Generally, this means a lay-off or furlough but other separations from employment may also qualify. If you have experienced a separation from employment, please contact our office. You may qualify for COBRA premium assistance.

Jobs bill

Just before recessing for the December holidays, the House approved the Jobs for Main Street Act. The House jobs bill would extend eligibility for COBRA premium assistance through June 30, 2010. The House bill would also extend unemployment benefits and make the child tax credit available to more taxpayers.

The Senate did not take up the House jobs bill in December. Democrats in the Senate are drafting their own jobs bill, the details of which are expected to be revealed early this year. The Senate bill may include some tax incentives for businesses, such as an extension of bonus depreciation and enhanced Code Sec. 179 expensing. These incentives expired after December 31, 2009.

More bills

On January 1, 2010, the state and local sales tax deduction, the higher education tuition deduction and many other tax deductions and credits expired. These popular incentives are temporary and are known as extenders because Congress usually extends that every year. The House voted to extend these provisions through 2010 but the Senate recessed in December without taking up the House bill. The extenders bill could be put on the back burner until spring.

Congress is also debating whether to impose tougher rules on the reporting of foreign bank accounts owned by U.S. taxpayers. In December, the House passed a bill that would impose new penalties on taxpayers that fail to disclose certain foreign accounts on their tax returns. The House bill would also encourage foreign banks to enter into agreements with the IRS to voluntarily disclose the existence of certain accounts. The Senate did not vote on the House bill before its December recess. The provisions are popular in the Senate, which in the past has promised to crack down on so-called tax havens and Americans who hide money and assets offshore.

Planning

As 2010 unfolds, we’ll have a clearer picture of when these and other tax bills will be enacted. In the meantime, please contact our office if you have any questions about the bills we have discussed or any others.