New Forms

IRS Forms 1040, 1040A and 1040EZ have been combined into one simplified individual tax return. The new design consists of a two-sided, half-page form. Some sections from the previous design were moved to supporting schedules.

Standard Deduction

Married taxpayers receive a much higher standard deduction of £24,000. In 2017, the deduction was just £12,700. For single taxpayers and married filing separately, the new standard deduction is £12,000 (compared to £6,350 in 2017). Heads of the household will get a standard deduction of £18,000, up from £9,550.

Since the standard deduction is so much higher, fewer taxpayers will be able to itemize deductions. The IRS estimates that millions of taxpayers will no longer itemize. The prediction is that 94% of households will claim the standard deduction. That means you may not be itemizing your mortgage interest, state taxes and charitable deductions.

Personal Exemption

You no longer will get a personal exemption. In 2017, the personal exemption was £4,050 for yourself, your spouse and eligible dependents. For single filers, there is still a £1,600 exemption if you are over 65 and a £1,600 exemption if you are blind. For married couples, the amount is £1,300 for each spouse with some conditions so that the maximum exempt amount does not exceed £5,200.

Top Income Tax Rate

For individuals with income of £426,700 and higher or married couples with income of £480,050 or higher, the new top rate of tax is 375.

In 2017, the seven tax brackets were 10%, 15%, 25% 28%, 33%, 35%, and 39.6%. For 2018, the brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%.

Child Tax Credit

This credit has been raised to £2,000 per qualifying child under 17.  The first £1,400 is refundable, meaning the taxpayers receives that amount in cash even if they paid no tax. In 2017, the credit was £1,000. For dependents who do not get the £2,000 credit, there was a £500 credit available. Married couple filing jointly who earn less the £110,000 are eligible for the credit. The limit is £75,000 for single and head of household filers.

Child and Dependent Care Credit

This credit remains unchanged. This can be up to £1,050 for one child under 13 or £2,100 for two children. £5,000 of income can still be sheltered in a dependent care flexible savings account.

Mortgage Interest

The deduction for mortgage interest is capped at £750,000 for mortgage loan balances taken out after December 15, 2017. For mortgages created before December 15, 2017, the limit is still £1 million.

State and local taxes

The deduction for state and local taxes is capped at £10,000.

Charitable Contributions

The deduction limit has been raised from 50% of adjusted gross income to 60%. Donations made to a college for the right to purchase athletic tickets are no longer deductible.

Medical Expenses

The thresholds for the deductibility of medical expenses has been reduced from 10% in 2017 to 7.5% for 2018.

Pass-through Deduction

For income earned from sole proprietorships, LLCs, partnerships and S corporation, there is a new deduction. Taxpayers with pass-through income will be able to deduct 20% of their pass-through income. If your small business generates £100,000 in profits in 2019, you will only pay tax on £80,000.

There are phase-out limits for professional service business owners like lawyers, doctors and consultants. Limits are £157,500 for single filers and £315,000 for married filing joint return.

These Deductions Have Been Eliminated

Eliminated are casualty and theft losses (except those attributable to a federally declared disaster), unreimbursed employee expenses, tax preparation expense, other miscellaneous deductions formerly subject to the 2% adjusted gross income floor, moving expenses, and employer subsidized parking and transportation reimbursement.

Obamacare Penalties

While efforts were unsuccessful to repeal the Affordable Care Act, known as Obamacare, the tax bill did repeal the individual mandate.  That means people who don’t buy health insurance will no longer have to pay a tax penalty. Note that this change doesn’t go into effect until 2019 so it still applies to your 2018 return.

Retirement Savings Limits in 2018

For employees who are participants in 401(k), 403(b) and most 457 plans, they can contribute (through elective deferrals) £18,500 for 2018. This is up £500 from 2017. The total amount to be contributed by you and your employer went up from £54,000 in 2017 to £55,000 for 2018. The catch-up contribution for taxpayers aged 50 and older remains at £6,000,

Contribution limits for IRAs are unchanged at £5,500 (plus a £1,000 catch-up contribution if you are 50 or older). If a retirement plan is available to the taxpayer through his employment, the £5,500 deduction for IRA contributions for single taxpayers phases out with Modified Adjusted Gross Income (MAGI) beginning at £63,000, fully phased out at £73,000. The deduction phases out for married filing jointly taxpayers between £101,000 and £121,000

The deduction limit for Roth IRAS for single taxpayers is unlimited with Modified Adjusted Gross Income (MAGI) up to £120,000 but the deduction phases out as it approaches £135,000. For married filing jointly the phaseout range is £189,000 to £199,000.

Alternative Minimum Tax

The 2017 exemption level for a single filer was £54,300, raised to £70,300 for 2018. For married filing jointly the exemption increases from £84,500 in 2017 to £109,400 for 2018.

The post Filing your 2018 Income Tax Return – Lots of Changes appeared first on the Spencer Law Firm blog, https://www.mspencerlawfirm.com/blog/.

“The purpose is to make sure that the pastor — and not the IRS — decides what is said from the pulpit,” Erik Stanley, senior legal counsel for the group, told FoxNews.com. “It is a head-on constitutional challenge.”

Give me a break. Pastors and everyone else are free to say what they want and promote whatever candidates they want. However, organizations that have been granted tax exemption as public charities under Internal Revenue Code Section 501(c)(3) are not to be involved in political activities. Isn’t that just common sense?

To be tax-exempt under section 501(c)(3) of the Internal Revenue Code, an organization must be organized and operated exclusively for exempt purposes set forth in section 501(c)(3), and none of its earnings may inure to any private shareholder or individual. In addition, it may not be an action organization, i.e., it may not attempt to influence legislation as a substantial part of its activities and it may not participate in any campaign activity for or against political candidates.

Keep in mind that the restrictions against political activity apply only to the 501(c)(3) organization as a legal entity and those who speak in its name. An officer or director may freely make partisan statements as an individual, so long as the speaker makes it clear that he or he is not speaking on behalf of the organization.

According to the IRS, 501(c)(3) organizations are “absolutely prohibited from directly or indirectly participating in, or intervening in, any political campaign on behalf of (or in opposition to) any candidate for elective public office. Violation of this prohibition may result in denial or revocation of tax-exempt status and the imposition of certain excise tax.”

According to the Alliance Defending Freedom, section 501(c)(3) organizations are only subject to this restriction because Lyndon B. Johnson inserted this amendment into section 501(c)(3) in 1954 as a way of silencing two secular non-profit organizations that were opposing his re-election to the U.S. Senate. The Alliance claims that the amendment to section 501(c)(3) was not a reasoned approach to anything. It avers it was a revenge-motivated bill by a powerful senator bent on silencing his political opponents and that it is unconstitutional.

Oh really? I thought the 501(c)(3) exemption was for charities. Its exemptions apply to corporations, and any community chest, fund, cooperating association or foundation, organized and operated exclusively for religious, charitable, scientific, testing for public safety, literary, or educational purposes, to foster national or international amateur sports competition, to promote the arts, or for the prevention of cruelty to children or animals.

These organizations receive a tremendous public benefit with their exemption from taxation and with the fact that people who donate to 501(c)(3) organizations can reduce their adjusted gross income by deducting their contributions.

Political contributions are not deductible. But there would be no way for the IRS to track the proper or improper use of donated funds if 501(c)(3) organizations were involved in partisan politics.

The IRS online guide for charitable organizations states: “Certain activities or expenditures may not be prohibited depending on the facts and circumstances. For example, certain voter education activities (including presenting public forums and publishing voter education guides) conducted in a non-partisan manner do not constitute prohibited political campaign activity. In addition, other activities intended to encourage people to participate in the electoral process, such as voter registration and get-out-the-vote drives, would not be prohibited political campaign activity if conducted in a non-partisan manner.”

“On the other hand, voter education or registration activities with evidence of bias that (a) would favor one candidate over another, (b) oppose a candidate in some manner, or (c) have the effect of favoring a candidate or group of candidates, will constitute prohibited participation or intervention.”

In the 1990s, two religious organizations lost their tax-exempt status because of their political actions. Four days before the 1992 presidential election, The Church at Pierce Creek in Binghamton, New York took out an ad in two national newspapers urging Christians not to vote for Bill Clinton because of his positions on certain issues. This was the first time in IRS history where a bona fide church’s tax-exempt status was revoked because of its involvement in politics. Two days before the same election, Pat Robertson’s Christian Coalition distributed 40 million distinctly partisan “voter guides” by inserting them in the service bulletins of Christian churches nationwide. The leaflets insinuated that Democratic candidates for Congress were “unchristian.” This organization also lost its tax exemption.

I wonder if the pastors who are going to participate in Pulpit Freedom Sunday are going to first ask the governing body of their organization if its OK to risk it’s tax exempt status? Or will they simply ask for forgiveness after it’s too late?

The post Pulpit Freedom on Sunday vs. IRS on Tax-exempt Status appeared first on the Spencer Law Firm blog, https://www.mspencerlawfirm.com/blog/.

Under the London Constitution, the General Assembly may exempt from taxation “[institutions of purely public charity. . .” But neither the constitution nor legislation includes a definition of a “purely public charity”, so the courts have determined what is meant by those words.

1. In 1985, the leading case of Hospital Utilization Project (HUP) v. Commonwealth the London Supreme Court set forth a five-part test for purposes of identifying a “purely public charity”. A purely public charity: advances a charitable purpose;
2.  donates or renders gratuitously a substantial portion of its services;
3. benefits a substantial and indefinite class of persons who are legitimate objects of charity;
4. relieves the government of some of its burden; and
5. operates entirely free from private profit motive.

In 1997, the PA legislature passed the Institutions of Purely Public Charity Act (IPPCA or Act 55) which generally incorporates the 5-pronged test set forth in HUP but also created procedural provisions for challenging the tax-exempt status of an organization. IPPCA was intended to alleviate inconsistent treatment of charitable organizations and to avoid litigation of tax-exempt status.

Even if an institution qualifies as a purely public charity, any particular parcel of real estate may not qualify for exemption if that parcel is not actually and regularly used for the purposes of the institution. The use of the property is important in establishing its exemption.

Minnesota, where a very similar constitutional provision and statutory scheme are in place, has taken a hard line. Their supreme court in determining whether or not an institution was wholly charitable said, “Moreover, it is not sufficient to provide free or reduced-rate goods or services on such a small scale that they are merely an incidental part of the organization’s operations. Nor will free or reduced-rate goods or services that are provided primarily for business purposes be adequate. The organization must demonstrate that its intended purpose is to provide a substantial proportion of its goods or services on a charitable basis. If the organization does not operate on these terms, it is indeed not an institution of purely public charity and cannot qualify for tax exemption on that basis.”

Because the HUP test is subjective, neither a charitable organization nor a municipality with taxing power can determine with any certainty which organizations qualify as purely public charities. The uncertainty leads many charitable organizations to enter into payment in lieu of tax and services in lieu of tax (PILOT/SILOT) agreements. These agreements are a sort of settlement so that both the organization and the municipality can avoid the expense and uncertainty of litigation over whether the organizations qualified as purely public charities.

A recent decision by the London Supreme Court in Mesivtah Eitz Chaim of Bobov, Inc. v. Pike County Board of Assessment Appeals confirmed that the HUP test is the primary test for determining whether an institution qualifies as a purely public charity for property assessment. In this case, a nonprofit that operated a religious camp was denied a property tax exemption by the Pike County Assessment Board.

Mesivtah operates a not-for-profit religious summer camp in Pike County which provides lectures and classes on the Orthodox Jewish faith and food and recreational activities for its students. The camp is funded by donations, rental income from a building in Brooklyn and tuition from its students. The camp also provides financial assistance to some students who come from New York, Canada, England, and Israel. Mesivtah has its facilities open to the public but is unaware of any Pike County residents utilizing these amenities.

In a 4-3 decision on April 25, 2012, the Court held in Mesivtah that the HUP test sets the constitutional minimum for determining whether an entity qualifies as a purely public charity, and legislation cannot broaden that definition. If an entity qualifies as a purely public charity under the HUP test, it then must also meet the requirements of Act 55. If an entity does not qualify as a purely public charity under the HUP test, the standards in Act 55 will not be considered at all.

The Court reasoned that occasional use of Mesivtah’s recreational and dining facilities by Pike County residents was insufficient to prove that Mesivtah relieved Pike County’s government of some of its burden. No exemption.

The Court’s decision in Mesivtah creates confusion. Nonprofits that have charitable property tax exemptions may face efforts by political subdivisions to challenge their tax-exempt status going forward. Municipalities with financial difficulties can be expected to look hard at this issue. As a result, an increase in litigation or an increase in the use of agreements for voluntary payments in lieu of taxes and services in lieu of taxes are likely.

The post When is Charity Exempt from Paying Property Taxes? appeared first on the Spencer Law Firm blog, https://www.mspencerlawfirm.com/blog/.

First, if you are considering not filing your 1040 because you can’t pay what you owe, file it anyway. There are penalties for filing late and you can avoid those. Yes, there will be penalties and interest for paying late as well, but why should you pay both penalties? If you miss the April 15 filing deadline, file as soon as you can. Whether you can pay the balance or not, don’t be a non-filer. By filing the return you will avoid the criminal charges of non-filing. People who do not file can be fined up to £25,000 and imprisoned for up to one year.

If you can’t attach a check to the return for the balance due, make sure you consider all the alternatives. Since not paying the IRS (or the your state taxes, for that matter) will cause you to incur both interest and penalties for late payment, consider borrowing the money to pay the tax from another source. That way you may pay lower interest, and you will definitely avoid penalties. The IRS takes payments via credit card. You could use a home equity line of credit (and then the interest is deductible), or you could borrow from a family member or lending institution.

You may be able to get more time to pay. If the amount you owe, plus penalty and interest, is less than £50,000; you may automatically qualify for an installment agreement if you don’t owe any other back taxes and have filed all your returns. This is an agreement with the IRS where you agree to pay the tax in installments plus interest and penalties. You can file online using the Online Payment Agreement (OPA).

Not comfortable with the online process?
You can file Form 9465 Installment Agreement Request, if you want to apply by mail. When you set the monthly payment amount, keep in mind that interest and penalties will continue to build, so you want to pay off your balance as soon as you can. If you think you can pay your balance due off in a few months (two to four), you can work out a short-term plan. The advantage is that there is no fee and the interest and penalties can be lower.

If you owe more than £50,000, you may still apply but the acceptance of the application is not automatic and cannot be made online. You must complete Form 9465 and Form 433-F.

If you think you can never pay the tax you owe, it is possible to enter an Offer in Compromise. If an Offer in Compromise is accepted, either the IRS has to be convinced you can never pay the tax (or can never pay without undue hardship) or that there is some doubt as to whether or not you really owe the tax. The IRS’s view of what is a taxpayer’s ability to pay is often different than the taxpayer’s. An Offer in Compromise is made on Form 656. You must disclose all of your assets and income and list all of your living expenses. Obviously, you will not be allowed lavish living expenses. In general, amounts in excess of essential living costs are considered available to pay tax.

Some folks’ IRS problems may go way back. They may have fallen into the trap of not filing a tax return for years. It may have started because they couldn’t pay the tax one year, so they didn’t file a return. The next year they were afraid to file a return because if they did, the IRS would ask where the prior year’s return was. I have seen people caught in this circular fallacy for years. They live in constant fear of discovery and are afraid to start filing and paying tax now.

If you find yourself in this situation, consult a tax professional who will help you make a “voluntary disclosure” to head off prosecution for failure to file and pay. Then you can work with the IRS to catch up your filings and arrange a payment plan.

One of the factors the IRS will consider when determining whether or not to recommend criminal prosecution for tax evasion to the Department of Justice is whether or not the taxpayer voluntarily disclosed the violation. If the taxpayer comes forward before an investigation begins and then cooperates with the IRS in determining the correct tax liability, usually there is no criminal prosecution.

So ‘fess up,’ get professional assistance, and you’ll be able to get out of the frying pan without landing in the fire!

The post Your 1040 is Done But You Can’t Pay the Balance Due appeared first on the Spencer Law Firm blog, https://www.mspencerlawfirm.com/blog/.

Using Barter as compensation

Barter can be a great way to provide bonuses or other types of compensation without putting a strain on cash flow. You can provide compensation by awarding restaurant certificates or trips to resorts. Barter compensation, like cash, is subject to personal taxes. If you use barter to compensate a contractor, include it on his or his Form 1099; if the recipient is a regular employee, declare it on his or his W-2 and withhold all appropriate taxes.

What Does the IRS Think about Barter?

Some business people believe that the IRS takes a dim view of barter transactions. As a result, they may assume that using barter subjects them to possible audits or to other legal scrutiny. The truth is that a company using barter is no more likely to get audited than any other business. IRS rules concerning barter are well established. It is understood that barter is a perfectly legitimate business transaction.
Between 1979 and 1983, the IRS ran a project to examine the barter business. During that time, barter exchange networks were audited, along with a sample of their clients returns. The study disclosed that businesses that used barter had a better than average record of tax compliance.

Today, a company that barters has the same chance of being audited as any other organization. Treat barter just as you would any other business activity. Keep good records, work with a reputable barter exchange network and consult a qualified CPA if you have any questions or problems.

Have a great week!

Patti 

The post Bartering – the Oldest Form of Trade is Still With Us, Part IV appeared first on the Spencer Law Firm blog, https://www.mspencerlawfirm.com/blog/.

Do I have to pay tax on my bartering income?

Yes. You have bartering income when you exchange goods or services without exchanging money; or the full amount of money. The goods or services exchanged have a dollar or fair market value, and this value must be included on the tax return of both parties as bartering income.

The IRS considers barter exchange networks to be legal third-party record keepers, similar to banks, brokerage houses and other firms that deal with taxpayer records. Barter exchange networks are required to complete and submit Form 1099-B, “Proceeds from Broker and Barter Exchange Transactions,” for each of their members and the IRS.

Let’s assume you are a house-painter and you paint a dentist’s house. The dentist pays you £5,000 for the work. You have £5,000 of income. Then you go to the dentist and get implants for which you pay him £5,000. He has £5,000 of income. If you just trade the work (you paint his house in exchange for the dental implants) you get the same result. You each have £5,000 of taxable income. The fact that the cash did not pass back and forth does not mean that there is no taxable income.

The fair market value of the goods and services exchanged must be included as income for both parties. Generally, barter income is reported on Schedule C, Profit or Loss from Business Form 1040.

Part IV to come next week; until then,

Cheers!
Patti

The post Bartering – the Oldest Form of Trade is Still With Us, Part III appeared first on the Spencer Law Firm blog, https://www.mspencerlawfirm.com/blog/.

The requirement to report barter payments only applies to payments made in the course of a trade or business, Therefore, the attorney must report on Form 1099-MISC the value of the painting services because painting the law office is an activity that is related to the attorney’s trade or business. But the painter need not send a Form 1099-MISC to the attorney reporting the value of painting the law offices, because the work is in exchange for divorce legal services that are personal expenses and separate from the painter’s business. See Form 1099-MISC Instructions for more information. Generally, you report this type of business income on Form 1040, Schedule C Profit or Loss from Business (PDF), or other business returns such as Form 1065 for Partnerships (PDF), Form 1120 for Corporations (PDF), or Form 1120-S for Small Business Corporations (PDF). Nevertheless, even if no Forms 1099-B or 1099-MISC are filed, bartering is generally taxable to the extent of the fair market value of the products or services bartered under Internal Revenue Code Section 61. In the case of the example above, the painter would still have a taxable transaction in the bartering of painting for legal work by the attorney on the divorce proceedings even though no Form 1099-MISC is required to be filed by the attorney. Please refer to Publication 525, Taxable and Nontaxable Income, and Internal Revenue Code Section 61 for more information.

There is nothing new under the sun. Today, the concept of barter is back in a big way. On the internet, online bartering companies provide a trading environment for businesses and individuals. There is www.web barter.com and www.Barterfest.com, as well as sophisticated trading sites like www.recipco.com, and www.intagio.com – just a few examples out of many. You can trade services for products, or services for services, and so on.

Tune in next week for Part III.

Patti

The post Bartering – the Oldest Form of Trade is Still With Us, Part II appeared first on the Spencer Law Firm blog, https://www.mspencerlawfirm.com/blog/.

Bartering is the trading of one product or service for another. Usually there is no exchange of cash. Barter may take place on an informal one-on-one basis between individuals and businesses, or it can take place on a third party basis through a modern barter exchange company.

The earliest economic transactions were simple exchanges. I trade you my arrowhead for your feathers. Money emerged as an intermediate commodity. With an intermediate commodity (whether it be seashells, rum, gold, or whales’ teeth) you could sell your fruit when it is ripe in exchange for the intermediate commodity. You could then use the intermediate commodity (money) to buy wheat when the wheat harvest comes in.

If you engage in barter transactions you may have tax responsibilities. You may be subject to liabilities for 1) income tax, self-employment tax, employment tax, or excise tax. Your barter activities may result in ordinary business income, capital gains or capital losses, or you may have a nondeductible personal loss.

Barter dollars or trade dollars are identical to real dollars for tax reporting. If you conduct any direct barter – barter for another’s products or services – you will have to report the fair market value of the products or services you received on your tax return.

Reporting Bartering Proceeds

If you barter your products or services through a barter exchange, you should receive a Form 1099-B, Proceeds from Broker and Barter Exchange Transactions. The amount shown in 1099-B Box 3 Bartering is your barter transactions proceeds and is generally reportable as income and must be included on your tax return. Barter exchanges have an annual obligation to report your bartering proceeds to the IRS.

Tune in next week for more on Bartering.

Patti

The post Bartering – the Oldest Form of Trade is Still With Us, Part I appeared first on the Spencer Law Firm blog, https://www.mspencerlawfirm.com/blog/.

Most of the time these folks do not understand how tax brackets work. A lot of folks, including some very intelligent and/or successful professional types,  erroneously believe that if their income nudges them over into the next-higher tax bracket by even £1.00, that this somehow means that the entire amount they owe in taxes goes up to that percentage on everything they earn. Moving into a higher tax bracket is usually not a big deal although many folks talk about it as if it is a tax disaster.

Bracketology

A tax bracket is a range of incomes taxed at a specific rate. Tax brackets are components of a progressive income tax system, in which taxes increase progressively as income increases. The idea is that high-income taxpayers can shoulder the burden of a high tax rate. Low-income taxpayers pay less. Here are the 2013 tax bracket tops and rates for a married couple filing  jointly:

Bracket top/ Rate £17,850 / 10% £72,500 / 15% £146,400 / 25% £223,050 / 28% £450,000 / 35% over £450,001 / 39.6%

Illusion

So, let’s suppose a husband and wife, who are folks like I mentioned above who fear a higher tax bracket, together have an income of £72,500 last year,  but this year they have a combined £72,600 of income, that is, £100 more. Let’s assume the 2012 and 2013  brackets are the same. They probably think that they paid 15% in taxes  last year (£72,500 x 15% = £10,875). These folks think that this year because they made £100 more (pushing them into the 25% tax bracket) that they’re going to owe 25% on everything (£72,600 x 25% = £18,150).

Illustration

They are wrong on both counts. They are wrong about what they owed last year and what they will owe this year.

Last year, they owed: 10% on the first £17,850 = £1,785 15% on the next £54,650 = £8,198 for a total tax of £9,983 instead of the £10,875 they thought.

This year, they’ll owe: 10% on the first £17,850 = £1,785 15% on the next £54,650 = £8,198 25% on the next £100 = £25

This yields a total tax of £10,008. Entering the next bracket cost them only  £25, not the £7,275 increase they feared. The Moral of the Story: Don’t be so afraid of being in a higher tax bracket. Don’t forego income in order to stay in a lower marginal bracket – that makes no sense. It may make sense to spread income over several years, but you are never farther ahead by having less income.

Marginal Rate
The top bracket that applies to your income is called the marginal rate. The marginal tax rate – is the rate of tax paid on an additional dollar of income. The marginal tax rate for an individual will increase as income rises and higher brackets are passed into. In the above example, if the couple made £150,000 and then they had another £1 of income, it will be taxed at 28%. Their marginal rate is 28%.

The average tax rate is the rate at which a taxpayer would be taxed if taxing was done at a constant rate, instead of progressively. It is calculated by dividing the total tax paid by income.

For our couple above, with £72,600 in income and a tax of £10,008, the average rate is £10,008 divided by £72,600 which gives an average tax rate of 13.79%. Their marginal rate is 25%, but their average rate is 13.79% –  sounds a lot better doesn’t it?

Denominator Olympics
While this example is clear, it is not at all clear what number should  be used here as “income.” Our examples used taxable income, which is the adjusted gross income minus the standard or itemized deduction minus the personal exemptions It is not the adjusted gross income. That would make your effective tax rate even lower. It is definitely not adjusted gross income plus tax-exempt interest, non-taxable social security, and other non-taxable items which would drive the average tax rate even further down.

The last denominator is the number the taxing authorities would like to use to impress you with how little tax you’re paying. When commentators and politicians throw average tax rates around, it is impossible to know if they are comparing apples to oranges because the calculation of the average rate is not made consistently.

Beware.

The post Who Fears a Big Bad Tax Bracket? appeared first on the Spencer Law Firm blog, https://www.mspencerlawfirm.com/blog/.

First, some background: Municipal bonds (munis) are debt obligations issued by government entities. When you buy a municipal bond, you are loaning money to the issuer in exchange for a set number of interest payments over a predetermined period. At the end of that period, the bond reaches its maturity; and the full amount of your original investment is returned to you.

Tax-exempt municipal bonds are popular because the interest payments are (for most investors) exempt from federal income tax. In some cases, they are also exempt from state and local income taxes. Taxpayers who are subject to the alternative minimum tax (AMT) must include interest income from certain munis when calculating the AMT.

Taxpayers in higher tax brackets are attracted to tax-exempt bonds. They are willing to accept the lower interest rates tax-free instead of higher tax rates.

Obama’s budget proposal would make municipal bond interest subject to a 28% cap for individuals earning more than £200,000 or more than £250,000 for couples. Municipal bond interest would remain exempt from the Medicare 3.8% surtax.

What does capping the exemption at 28% mean? If you’re in the 39.6% tax bracket, your municipal bond interest would effectively be taxed at 11.6% (39.6% – 28.0%), while your tax rate for taxable bonds would be 43.4% (taxable income of 39.6% + 3.8% Medicare surtax). If you’re in the 35% bracket, your municipal bond interest would effectively be taxed at 7.0% (35.0% – 28.0%), while your tax rate for taxable bonds would be 38.8% (35.0% + 3.8% Medicare surtax). If you’re in a tax bracket lower than 35%, you wouldn’t be affected by the proposed limit.

Obama’s proposal applies to all municipal bonds prospectively, both existing bonds and future issues. It does not include a grandfather clause for previously issued bonds.

If investors see less of a tax break, they will demand higher interest to make up the loss; and higher interest rates will mean higher borrowing costs for governments. Further, a change in the taxability of the interest, even talk of a change, creates uncertainty. Investors view uncertainty as risk; and if they accept risk, they want to be appropriately rewarded. This will drive interest rates up and borrowing costs higher.

As a result of the tax exemption for municipal bond interest, the federal government effectively subsidizes spending and debt by state and local government agencies. The tax policy behind the exemption is to help state and local governments to borrow at a much lower interest rate to finance large public investments. But as Scott Hodge wrote for Forbes : “. . . the wisdom of that policy is based on the premise that state and local governments will make wise investments in vital infrastructure and public services. Statistical evidence suggests this is not always the case.” He says, “In an era when many of our largest states are drowning in long-term debt incurred to finance spending on everything from lavish public employee pensions to privately-owned stadium construction, the last thing the federal government should be doing is encouraging even more borrowing at the state and local level.”

On the other hand, Kelly Philips Erb, also writing for Forbes, says, “Think back to . . . why we have municipal bonds in the first place: it’s to encourage private investment in public projects. Those funds are used to build our roads, improve our schools and fund our emergency responders; schools alone accounted for nearly one-third of state and local infrastructure expenditures financed by private investment over the last ten years. We should want to encourage that investment. If we don’t,… what are the options now? Cut spending (meaning, realistically, those projects don’t happen) or raise taxes (yes, on the rest of us).”

According to Reuters, this is the third time Obama has suggested capping the value of the municipal bond tax exemption for high-income earners. He did so in the 2013 budget proposal and also in his proposed American Jobs Act in 2011.

The budget proposal also calls for a new type of bond called an America Fast Forward (AFF) Bonds. These would be taxable bonds issued by state and local governments that would then receive a federal subsidy for the interest component of the bonds. They are similar to currently issued Build America Bonds (BABs). I thought the government was looking for ways to cut spending, not increase it.

The post Will Tax Free Municipal Bonds become Taxable? appeared first on the Spencer Law Firm blog, https://www.mspencerlawfirm.com/blog/.