Tax and Business Alert - March 2003

The Marriage Penalty- Saying "I Do" Could Mean Higher Taxes

You may have heard the term "marriage penalty" and wondered why you would be penalized for being married when you file your tax return. Generally, it is true that you and your spouse will pay more tax in filing a joint return than if you were able to file as two single taxpayers. This is referred to as the "marriage penalty." Following is some information on its more common causes and what is being done to eliminate it.

Tax Rates

Two single taxpayers will often be taxed at lower rates on their combined taxable income than a married couple with the same taxable income filing a joint return. For example, taxable income over $311,950 (in 2003) is taxed at 38.6%, regardless of whether the return is for a single person or a married couple filing a joint return. Thus, a married couple filing a joint return will pay tax at 38.6% on all taxable income over
$311,950, while two single taxpayers could potentially have combined taxable income of $623,900 ($311,950 x 2) before the 38.6% rate would apply.

Itemized Deduction Phase-out

The 3% phase-out of certain itemized deductions begins at an adjusted gross income (AGI) of$139,500 (in 2003) for both a single taxpayer and a married couple filing a joint return. Thus, two working spouses are more likely to experience the phase-out calculation than two single taxpayers.

Personal Exemption Phase-out 

In 2003, the phase-out of personal exemptions begins at an AGI of $139,500 for a single taxpayer and $209,250 for a married couple filing a joint return. Therefore, two single taxpayers could potentially have combined AGI's of $279,000 ($139,500 x 2) before the phase-out begins.

Standard Deduction 

In 2003, the standard deduction is $7,950 for a married couple filing a joint return and $4,750 for a single taxpayer, two single taxpayers are able to claim a combined standard deduction of $9,500 ($4,750 x 2), which is $1,550 more than the amount allowed to a couple filing a joint return.

What Is Being Done to Eliminate the Marriage Penalty? 

The Economic Growth and Tax Relief Reconciliation Act of 2001 (2001 Act) provided some current and future relief from the marriage penalty. For 2003, taxable income of up to $12,000 is taxed at the 10% tax rate (the lowest bracket) for married couples filing a joint return while single taxpayers can only use the 10% rate for taxable income up to $6000. And, beginning in 2005, the 15% tax bracket for a married couple filing a joint return will increase gradually each year until 2008 when it will be twice the amount for a single taxpayer.

In a similar fashion, the 2001 Act also provides that the standard deduction for married taxpayers filing a joint return will gradually increase beginning in 2005 until it is twice the amount for single taxpayers in 2009. In addition, the 2001 Act provides for the gradual elimination of the itemized deduction and personal exemption phase-outs for all taxpayers beginning in 2006 and ending with the complete elimination of the phase-outs in 2010. Further, at the time this article was written, the President has proposed legislation to accelerate all of the marriage penalty relief provisions to 2003.

What is the Alternative Minimum Tax?

As an individual taxpayer, you are subject to two tax systems, the regular income tax and the alternative minimum tax (AMT). You are liable for the larger, and only the larger, of the two taxes. The original purpose of the AMT was to ensure that taxpayers who were allowed special favorable treatment on certain tax items pay at least a minimum amount of tax on their economic income. As personal incomes tend to rise each year, more taxpayers have become subject to the AMT. This is primarily due to not indexing the AMT exemption for inflation (which reduces your exposure to the AMT) while your regular tax deductions and exemptions are indexed (increased) for inflation.

The AMT tax computation starts with your regular taxable income that is then increased for certain tax benefits (in the regular tax liability computation) called preferences and adjustments. These include certain itemized deductions, the standard deduction, personal exemptions, certain tax-exempt interest, and income related to exercising certain stock options. You then reduce the amount by the AMT exemption, which for some high-income taxpayers is phased-out. The AMT is then computed and, as previously stated, you pay the larger of the regular tax or the AMT.

The voluntary disclosure of an unreported tax liability has long been an important factor in deciding whether a taxpayer should be criminally prosecuted. In new revisions to the IRS's Internal Revenue Manual, this policy "has been modernized to allow more taxpayers to voluntarily comply with their obligations and to reduce the uncertainty over what constitutes a timely disclosure." As before, taxpayers must make a good faith arrangement with the IRS to pay the tax, interest, and penalties in full, and the disclosure policy does not apply to those with income from illegal sources.

In an unrelated matter, the IRS has finalized regulations prohibiting IRS employees from contacting third parties regarding the determination or collection of unpaid taxes without giving the taxpayer reasonable advance notice that such contacts will be made. Providing this notice allows taxpayers to come forward with required information before the IRS contacts any third parties.

Use these Websites to Locate Information on Your Favorite Charity

Have you ever wondered how the money you donate to a charity is spent or what percentage of the funds your charity collects pays for operating expenses? Information is available on the Internet to help answer these and other questions and concerns you might have about your favorite charity.

The Better Business Bureau's Wise Giving Alliance reports on nationally soliciting charities at www.give.org and rates them in relation to 23 provisions of the Council of Better Business Bureaus (CBBB) Standards for Charitable Solicitation. The website lists current Better Business Bureau Wise Giving Alliance reports on charities and other soliciting organizations. Charities are rated according to CBBB standards for charitable solicitation including public accountability, use of funds, solicitation and informational materials, fund raising practices, and governance.

The American Institute of Philanthropy (ALP) at www.charitywatch.org evaluates over 450 charities and gives them a grade from A through F based on their established rating criteria. The top ratings go to charities spending at least 75% of collected revenues on their designated programs. Special features focus on top salaries paid by charitable organizations, top rated charitable groups, and America's most popular causes.

Other organizations reporting information on public charities include Charity Navigator at www.charitynavigator.org and GuideStar at www.guidestar.org. Charity Navigator allows you to search a database of 1,700 charities for useful information and GuideStar offers the ability to search for information on 850,000 IRS-recognized nonprofits.

Tax-favored Methods to Reduce Health Care Costs

If you own a business, it comes as no surprise that employer health care costs are on the rise. Many employers, searching for ways to reduce those costs, are shifting a bigger portion to their employees. Discussed below are three methods to accomplish this expense transfer in a tax-effective manner.

Premium Only Plans (POPs). With a premium only .plan, your employees pay a portion of the premium for your employer-sponsored group health insurance coverage via payroll withholding. That amount is treated as a salary reduction for Federal Income Tax (FIT) and Social Security and Medicare Tax (FICA) purposes, which means that the employees are paying for their coverage with pretax dollars. The effect is the same as an income tax deduction along with the FICA tax savings for the employee.

Employers like POPs because they not only facilitate shifting a bigger share of health insurance costs to their employees, but also reduce employer FICA taxes since employee salary reduction amounts deemed contributed to the POP are exempt from FICA tax. For 2003, the employer's share of FICA is 7.65% of the first $87,000 of each employee's salary, and 2.9% of any salary in excess of $87,000. Thus, the FICA savings often exceed the administration costs of complying with the cafeteria plan rules that apply to these plans.

Generally, cafeteria plan rules require that the POP (a) have a written plan document, (b) cannot discriminate in favor of highly compensated employees, (c) cannot allow the amount of nontaxable benefits provided to key employees under the POP to exceed 25% of nontaxable benefits provided to all employees, and (d) cannot allow participation by self-employed persons.

Flexible Spending Accounts (FSAs). Under a health care FSA, the employee elects annually to have a specified dollar amount of salary withheld from his or her paycheck and contributed to a personal FSA. The FSA is then used to pay or reimburse qualified expenses, including the employee's uninsured medical costs, using pretax dollars.

As with the POP, the amount withheld from each employee's check is treated as a salary reduction, so the account is funded with pretax dollars for both FIT and FICA tax purposes. FSAs are also subject to the cafeteria plan rules previously discussed.

From the employee's perspective, FSAs differ from POPs in that they are subject to a rather unfair "use-it-or-lose-it" rule. If the employee fails to incur and submit enough qualified expenses to completely drain the account each year, any leftover dollars revert to the employer.

On the other hand, employers like FSA arrangements for the same reason they like POPs-both facilitate shifting a bigger share of health care costs to employees while reducing employer FICA taxes at the same time. Many employers hire third-party administrators to process their employee's medical expense reimbursement claims.

Medical Savings Account (MSA) Arrangements for Small Employers 

This arrangement (also known as an Archer MSA) combines coverage under a qualifying high-deductible medical insurance policy with IRA-like accounts set up for eligible employees of small employers. A business with 50 or fewer workers during either of the prior two years is eligible to establish an MSA. MSAs are attractive to small employers because high deductible policies usually are significantly cheaper than traditional policies. Either the employer or employee (but not both) can make annual deductible MSA contributions (limitations apply) to help fund the employee's uninsured medical expenses.

Employees maintain control over their MSAs, so they can withdraw funds at any time for any purpose (although withdrawals not used to pay qualifying medical expenses are taxable and subject to a 15% penalty). Contributions not withdrawn during the year continue to grow on a tax advantaged basis. Balances can be invested, with the earnings allowed to grow free of federal income tax (like an IRA). Employees can then take tax-free MSA withdrawals to pay for uninsured medical expenses, but not to pay for health insurance premiums. MSA balances are fully vested and portable.

Planning for Incapacity With a Durable Power of Attorney

A power of attorney (POA) is a simple, relatively inexpensive, legal document in which you, as principal, appoint another person as attorney-in-fact, or agent, to manage your financial or other affairs. A POA may be general, granting broad authority to make decisions concerning investments, tax matters, long-term care planning, and property transactions, or it may be limited, granting only limited authority to perform one or more specific duties such as closing the sale of your house on a date that you will be out of town.

State law governs the creation, termination, and uses of POAs. Thus, careful attention to state law, with expert assistance from competent legal counsel, is critical. Your legal counsel can explain all of the state-required document execution requirements.

POAs usually terminate if you, as the principal granting the power, become incompetent. However, durable powers of attorney remain in effect, despite incapacity or disability, until revoked. Actions taken by the attorney, in-fact while you are disabled have the same effect as if you had taken the action. Language clearly stating that the power of attorney is not affected by your subsequent disability is required to be included in a written document to accomplish a durable POA.

A durable POA can be used if you want the security of knowing your assets will be managed and your financial plans and responsibilities will be fulfilled without delay, even in the event you become permanently disabled or incapacitated. The durable power of attorney is appealing because it avoids the costly and time consuming process of court supervision of your affairs.

Example 1: Using a Durable POA to Complete Real Estate Transactions.

Dan and Suzanne are married and own a vacation home jointly. Dan has become permanently incapacitated, so Suzanne wants to sell the vacation home. Fortunately, while Dan was competent, he executed a durable POA that authorizes Suzanne to execute real estate transactions. Accordingly, Suzanne should be able to execute documents on Dan's behalf and sell the property.

Example 2: Using a Durable POA in Estate and Nursing Home Planning.

Harry, a widower with substantial net worth, wants to minimize potential estate tax. He also is concerned about protecting his assets in case he should require nursing home care. Harry understands that gifts and other forms of transfers may substantially reduce potential estate tax as well as preserve assets for family members while facilitating Medicaid qualification. By executing a durable POA that explicitly authorizes such gifts, Harry can permit his loved ones to engage in appropriate planning if Harry becomes incapacitated. Without a POA, Harry's loved ones would have to seek guardianship and court approval for such transfers, and there is no guarantee that the courts would approve the proposed planning.

A durable power of attorney is worth investigating, if only for the peace of mind it offers. Please call us for more details.