1. FEDERAL INSURANCE CONTRIBUTION ACT (FICA)
The Social Security or OASDI wage base is $110,100 ($106,800 in 2011). At the time of publication, the employee’s OASDI tax rate will remain at 4.2% for two months as Congress agrees to extend the payroll tax cut into 2012. The employer's portion remains at 6.2%.  The maximum annualized 2012 OASDI tax per employee at time of publication will be $6,459.20. The Medicare Hospital Insurance or HI wage base is unlimited. The employer’s and employee's HI tax rate will be 1.45%.

2. CALIFORNIA DISABILITY INSURANCE (SDI)
The wage base for CA SDI tax is $95,585 ($93,316 in 2011). The 2012 tax rate is 1.0% (down from 1.2% in 2011). The maximum SDI tax for each employee will be $955.85 (down from $1,119.79 in 2011).

3. SELF-EMPLOYMENT TAX
The wage base for self-employment OASDI tax is $110,100 ($106,800 in 2011). The self-employment HI tax wage base is unlimited. At the time of publication, the annualized OASDI and HI self-employed tax rate on the first $110,100 of earnings will be 14.97% (OASDI at 12.07% and HI at 2.9%). At the time of publication, the maximum 2012 OASDI and HI tax on the first $110,100 of earnings for the self employed is $16,481.97.

4. FEDERAL UNEMPLOYMENT TAX (FUTA)
The FUTA tax rate is 0.9% and is applied to the first $7,000 of taxable wages.

5. SUPPLEMENTAL WAGE WITHHOLDING
Employers may either (1) add supplemental wages payments (bonuses, commissions, or other types of supplemental pay) to regular wages and compute withholding on the whole amount or (2) apply a flat percentage to the supplemental wage amount only, without allowance for exemptions or credits. The 2012 Federal flat withholding rate on supplemental wages is 25% (35% in certain circumstances). The 2012 California flat withholding rate is 6.6% for supplemental wages and 10.23% for bonus payments and stock option exercise income.

  If you have any questions regarding the application of these reporting requirements to your business,
please do not hesitate to contact us to discuss your specific situation.

The IRS has released much-anticipated temporary and proposed regulations on the capitalization of costs incurred for tangible property. They impact how virtually any business writes off costs that repair, maintain, improve or replace any tangible property used in the business, from office furniture to roof repairs to photocopy maintenance and everything in between. They apply immediately, to tax years beginning on or after January 1, 2012.

These so-called “repair regulations” are broad and comprehensive. They apply not only to repairs, but to the capitalization of amounts paid to acquire, produce or improve tangible property. They are intended to clarify and expand existing regulations, set out some bright-line tests, and provide some safe harbors for deducting payments.

The regulations are an ambitious effort to address capitalization of specific expenses associated with tangible property. The regulations affect manufacturers, wholesalers, distributors, and retailers—everyone who uses tangible property, whether the property is owned or leased. The rules provide a more defined framework for determining capital expenditures.

Most taxpayers will have to make changes to their method of accounting to comply with the temporary regulations and will need to file Form 3115. Taxpayers who filed for a change of accounting method following the issuance of the 2008 proposed regulations will probably have to change their accounting method again.

The IRS has promised to issue two revenue procedures that will provide transition rules for taxpayers changing their method of accounting, including the granting of automatic consent to make the change. The regulations require taxpayers to make a Code Sec. 481(a) adjustment; this means that taxpayers will have to apply the regulations to costs incurred both prior to and after the effective date of the regulations.

The new regulations provide rules for materials and supplies that can be deducted, rather than capitalized. The rules provide several methods of accounting for rotable and temporary spare parts, and allow taxpayers to apply a de minimis rule so that they can deduct materials and supplies when they are purchased, not when they are consumed.

Costs to acquire, produce or improve tangible property must be capitalized. The regulations address moving and reinstallation costs, work performed prior to placing property into service, and transaction costs. Generally, costs of simply removing property can be deducted, but costs of moving and then reinstalling property may have to be capitalized.

To determine whether a cost incurred for property is an improvement, it is necessary to determine the unit of property. Generally, the larger the unit of property, the easier it is to deduct expenses, rather than have to capitalize them. The regulations provide detailed rules for determining the unit of property for buildings and for non-building tangible property. For buildings, the IRS identified eight component systems as separate units of property, requiring more costs to be capitalized. However, the new rules also provide for deducting the costs of property taken out of service, by treating the retirement as a disposition.

The new regulations require virtually every business to review how repairs, maintenance, improvements and replacements are handled for tax purposes, with both mandatory and optional adjustments made to past treatment as appropriate.

Please feel free to call this office for a more targeted explanation of how these new regulations impact your business operations.

The fate of the employee-side payroll tax cut along with a host of tax extenders and other expired provisions could be decided in coming weeks. A conference committee of House and Senate members is negotiating a full-year extension of the payroll tax cut and could add some or all of the tax extenders to a final package. Lawmakers also could extend the payroll tax cut without acting on any tax incentives.

Payroll tax cut

The Temporary Payroll Tax Cut Continuation Act of 2011 extended the employee-side OASDI tax cut through the end of February 2012. The employee-share of OASDI taxes is 4.2 percent for the two-month period, rather than 6.2 percent. The employer-share of OASDI taxes remains at 6.2 percent for the two month period. Self-employed individuals also benefit from a two percentage point reduction in OASDI taxes.

Unless extended, the employee-share of OASDI taxes is scheduled to revert to 6.2 percent after February 29, 2012. The White House and the leaders of the two parties in Congress agree that the payroll tax cut should be extended a full-year. They disagree, however, how to pay for the extension; even if it should be paid for at all.

Congress could extend the two-month payroll tax cut through the end of 2012 without paying for it. The 2011 payroll tax cut was unfunded. Congress appropriated to the Social Security trust funds amounts equal to the reduction in payroll tax revenues. The 2011 payroll tax cut was estimated by the Congressional Budget Office cost approximately $111 billion. Extending it through the end of 2012 is estimated to cost just as much if not more.

House Republicans reportedly have proposed a number of revenue raisers to offset the cost of extending the payroll tax cut through the end of 2012. One GOP proposal would extend the current pay freeze for employees of the federal government. Another GOP proposal would require higher-income individuals to pay increased Medicare premiums.

One possible revenue raiser, increasingly under discussion by Democrats, is a change in the taxation of so-called carried interest. Current law generally taxes carried interest as capital gains and not as ordinary income. Past efforts to change the tax treatment of carried interest have failed to pass Congress.

Extenders

The so-called tax extenders, popular but temporary tax provisions, expired at the end of 2011. Many taxpayers are surprised to learn that their particular tax break, whether it be the state or local sales tax deduction, the teachers’ classroom expense deduction, or the research tax credit, are temporary. The extenders have been routinely revived many times in the past. This year, however, could be different. Faced with record federal budget deficits, lawmakers may decide to extend only some of the expired provisions.

President Obama’s FY 2013 proposals

President Obama is expected to release his fiscal year (FY) 2013 federal budget proposals in early February, which will reignite debate over the Bush-era tax cuts. President Obama is expected to urge Congress to allow the Bush-era tax cuts to expire after 2012 for higher-income taxpayers, which President Obama defines as individuals earning more than $200,000 or families earning more than $250,000. In recent weeks, there has been speculation that President Obama may revisit those definitions in his FY 2013 budget, possibly raising the amounts.

Few Capitol Hill observers expect Congress to take any action on the Bush-era tax cuts before the November elections. Instead, Congress may take up some of President Obama’s other proposals. As in past budgets, President Obama will likely propose to extend some energy tax breaks for individuals and businesses, extend tax incentives for education and provide some targeted-tax breaks to businesses. President Obama has also promised to introduce proposals to encourage U.S. companies to “insource” jobs at home.

On some issues, such as energy and education, lawmakers may find common ground but negotiations are likely to go down to the wire. Our office will keep you posted of developments.

If you have any questions about the payroll tax cut, tax extenders or the various tax proposals under discussion, please contact our office.

The IRS reopened its offshore voluntary disclosure program in early 2012 in response to what the government described as strong interest among taxpayers. The reopened program, the third of its type in recent years, encourages taxpayers with unreported foreign accounts to make full disclosures in exchange for a reduced penalty framework. Like its predecessors, the terms and conditions of the reopened program are very complex. The IRS has promised to provide more details. In the meantime, the prior offshore disclosure programs are guides to how the IRS intends to implement the third, reopened program.

Previous disclosure programs

The IRS launched two previous offshore disclosure initiatives: one in 2009 and another in 2011. Both programs offered reduced penalties in exchange for full disclosure. In early 2012, the IRS reported it received 33,000 voluntary disclosures from the 2009 and 2011 offshore initiatives. The government has collected over $4.4 billion from the 2009 and 2011 programs. The IRS predicted it will collect more revenue as it continues to work cases.

Reopened program

The reopened program operates very similarly to the 2009 and 2011 programs but with some key differences. The previous programs were temporary. The 2011 program ended in mid-September 2011. The reopened program has no set end date. The IRS cautioned, however, that it could close the program at some future date. The decision to end the program is solely at the discretion of the IRS.

The reopened program requires taxpayers to file all original and amended tax returns and include payment for back-taxes and interest for up to eight years as well as pay accuracy-related and/or delinquency penalties. Additionally, taxpayers must pay a penalty of 27.5 percent of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the eight full tax years prior to the disclosure. In comparison, the highest penalty in the 2011 program was 25 percent. IRS officials have said that the penalty was increased because the agency does not want to reward taxpayers who did not participate in the 2009 or 2011 disclosure programs because they anticipated that a future penalty would be lower.

In limited circumstances, taxpayers may qualify for a 12.5 percent penalty or a five percent penalty. Generally, taxpayers whose offshore accounts or assets did not surpass $75,000 in any calendar year may qualify for the 12.5 percent penalty.

The requirements for the five percent penalty are very narrow. The IRS has explained that taxpayers must meet four conditions: (1) The taxpayer did not open or cause the account to be opened; (2) the taxpayer exercised minimal, infrequent contact with the account, for example, to request the account balance, or update account holder information such as a change in address, contact person, or email address; (3) except for a withdrawal closing the account and transferring the funds to an account in the United States, the taxpayer did not withdraw more than $1,000 from the account in any year for which the taxpayer was non-compliant; and (4) the taxpayer can show that all applicable U.S. taxes have been paid on funds deposited to the account (only account earnings have escaped U.S. taxation).

The penalty amounts in the reopened program are not set in stone, the IRS cautioned. It may eventually increase penalties in the program for all or some taxpayers or defined classes of taxpayers.

Quiet disclosures

One goal of the three programs is to caution taxpayers against so-called “quiet disclosures.” A quiet disclosure occurs when a taxpayer files an amended return and pays any tax delinquency without making a formal voluntary disclosure. The IRS warned taxpayers making quiet disclosures that they risked being sanctioned to the fullest extent allowed by law.

Critics

The offshore disclosure programs were not without their critics. The National Taxpayer Advocate recently told Congress that the IRS should streamline what is a very complicated process. The National Taxpayer Advocate also reported that IRS examiners were assuming that all violations were willful unless a taxpayer presented evidence to the contrary. It is possible that the IRS may revisit some of the terms and conditions of the reopened program in light of the National Taxpayer Advocate’s report.

If you have any questions about the reopened offshore voluntary disclosure program, please contact our office.

Taxpayers with children should be aware of the numerous tax breaks for which they may qualify. Among them are: the dependency exemption, child tax credit, child care credit, and adoption credit. As they get older, education tax credits for higher education may be available; as is a new tax code requirement for employer-sponsored health care to cover young adults up to age 26. Employers of parents with young children may also qualify for the child care assistance credit.

Dependency Exemption

In addition to the personal exemption an individual taxpayer may take for him or herself to reduce taxable income (Line 42 on Form 1040), that taxpayer may also take an exemption for each qualifying dependent who has lived with the taxpayer for more than half of the tax year. A dependent may be a natural child, step-child, step-sibling, half-sibling, adopted child, eligible foster child, or grandchild, and generally must be under age 19, a full-time student under age 24, or have special needs. The amount of the exemption is the same as the taxpayer’s personal exemption, $3,700 for the 2011 tax year and $3,800 for the 2012 tax year.

Child Tax Credit

Parents of children who are under age 17 at the end of the tax year may qualify for a refundable $1,000 tax credit. The credit is a dollar-for-dollar reduction of tax liability, and may be listed on Line 51 of Form 1040. For every $1,000 of adjusted gross income above the threshold limit ($110,000 for married joint filers; $75,000 for single filers), the amount of the credit decreases by $50.

Child and Dependent Care Credit

If a taxpayer must pay for childcare for a child under age 13 in order to pursue or maintain gainful employment, he or she may claim up to $3,000 of his or her eligible expenses for dependent care. If one parent stays home full-time, however, no child care costs are eligible for the credit.

Adoption Credit

Taxpayers who have incurred qualified adoption expenses in 2011 may claim either a $13,360 credit against tax owed or a $13,360 income exclusion if the taxpayer has received payments or reimbursements from his or her employer for adoption expenses. For 2012, the amount of the credit will decrease to $12,650, and in 2013 to $5,000.

Higher Education Credits

There are two education-related credits available for 2012: the American Opportunity credit and the lifetime learning credit. The American Opportunity credit amount is the sum of 100 percent of the first $2,000 of qualified tuition and related expenses plus 25 percent of the next $2,000 of qualified tuition and related expenses, for a total maximum credit of $2,500 per eligible student per year. The credit is available for the first four years of a student's post-secondary education. The credit amount phases out ratably for taxpayers with modified AGI between $80,000 and $90,000 ($160,000 and $180,000 for joint filers). The lifetime learning credit is equal to 20 percent of the amount of qualified tuition expenses paid on the first $10,000 of tuition per family. The phaseout for 2012 ranges from $52,000 to $62,000 ($104,000 to $124,000 for joint filers). Parents also find tax relief in saving for college though Coverdell accounts, section 529 plans and specified U.S.. savings bonds.

Extended Health Care Coverage

Effective since September 23, 2010, the new health care law requires plans to provide coverage for children until they attain age 26. Further, effective on or after March 30, 2010, children under the age of 27 are considered dependents of a taxpayer for purposes of the general exclusion from income for reimbursements for medical care expenses of an employee, spouse, and dependents under an employer-provided accident or health plan. Therefore, a plan must provide coverage to a child who is still a dependent up to age 26; but can do so up to age 27 without income tax consequences. A child includes a son, daughter, stepson, or stepdaughter of the taxpayer; a foster child placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction; and a legally adopted child of the taxpayer or a child who has been lawfully placed with the taxpayer for legal adoption.

Child Care Assistance Credit (for businesses)

Employers may take up to $150,000 of the eligible costs of providing employees with child care assistance as tax credit. These costs may include a portion of the costs of acquiring, constructing, improving, and operating a child care facility.

If you have any questions about these provisions and how they may benefit you, please contact our office.

The Treasury Department is authorized to offset a taxpayer’s tax refund to satisfy certain debts. A spouse who believes that his or her portion of the refund should not be used to offset the debt that the other spouse owes may request a refund from the IRS.

Offset

If an individual owes money to the federal government because of a delinquent debt, the Treasury Department’s Financial Management Service (FMS) can offset that individual's tax refund (and certain other federal payments) to satisfy the debt. The debtor will be notified in advance of the offset.

A taxpayer’s refund may be reduced by FMS and offset to pay:

• Past-due child support
• Federal agency non-tax debts
• State income tax obligations, or
• Certain unemployment compensation debts owed a state.

FMS advises taxpayers by written notice of an offset. FMS has explained that the notice will reflect the original refund amount, the taxpayer’s offset amount, the agency receiving the payment, and the address and telephone number of the agency. FMS will notify the IRS of the amount taken from your refund.

Form 8379

If a taxpayer filed a joint return and is not responsible for the debt of his or her spouse, the taxpayer may request his or her portion of the refund by filing Form 8379, Injured Spouse Allocation, with the IRS. Form 8379 may be filed with the original return or by itself after the taxpayer is aware of the offset.

The IRS has instructed taxpayers filing Form 8379 by itself to attach a copy of all Forms W-2 and W-2G for both spouses, and any Forms 1099 showing federal income tax withholding to Form 8379. Failure to attach these items may result in a delay in processing by the IRS.

The IRS has reported on its website that it generally processes Forms 8379 that are filed after a joint return has been filed in approximately eight weeks. The timeframe for processing a Form 8379 that is attached to a joint return is approximately 11 weeks (14 weeks if the joint return is filed on paper).

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of February 2012.

February 1

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates January 25–27.

February 3

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates January 28–31.

February 8

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 1–3.

February 10

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

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 4–7.

February 15

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 8–10.

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

February 17

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 11–14.

February 23

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 15–17.

February 24

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 18–21.

February 29

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 22–24.

March 2

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 25–28.

March 7

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 29–March 2.

Estimated tax is used to pay tax on income that is not subject to withholding or if not enough tax is being withheld from a person's salary, pension or other income. Income not subject to withholding can include dividends, capital gains, prizes, awards, interest, self-employment income, and alimony, among other income items. Generally, individuals who do not pay at least 90 percent of their tax through withholding must estimate their income tax liability and make equal quarterly payments of the "required annual payment" liability during the year.

Estimated tax is used to pay tax on income that is not subject to withholding or if not enough tax is being withheld from a person's salary, pension or other income. Income not subject to withholding can include dividends, capital gains, prizes, awards, interest, self-employment income, and alimony, among other income items. Generally, individuals who do not pay at least 90 percent of their tax through withholding must estimate their income tax liability and make equal quarterly payments of the "required annual payment" liability during the year.

Basic rules

The "basic" rules governing estimated tax payments are not always synonymous with "straightforward" rules. The following addresses some basic rules regarding estimated tax payments by corporations and individuals:

Corporations. For calendar-year corporations, estimated tax installments are due on April 15, June 15, September 15, and December 15. If any due date falls on a Saturday, Sunday or legal holiday, the payment is due on the first following business day. To avoid a penalty, each installment must equal at least 25 percent of the lesser of:

-- 100 percent of the tax shown on the corporation's current year's tax return (or of the actual tax, if no return is filed); or

-- 100 percent of the tax shown on the corporation's return for the preceding tax year, provided a positive tax liability was shown and the preceding tax year consisted of 12 months.

A lower installment amount may be paid if it is shown that use of an annualized income method, or for corporations with seasonal incomes, an adjusted seasonal method, would result in a lower required installment.

Individuals. For individuals (including sole proprietors, partners, self-employeds, and S corporation shareholders who expect to owe tax of more than $1,000), estimated tax payments are due on April 15 (April 18 for 2011), June 15, and September 15 of 2011, and January 15 of 2012. Individuals who do not pay at least 90 percent of their tax through withholding generally are required to estimate their income tax liability and make equal quarterly payments of the "required annual payment" liability during the year. The required annual payment is generally the lesser of:

-- 90 percent of the tax ultimately shown on your return for the 2011 tax year, or 90 percent of the tax due for the year if no return is filed;

-- 100 percent of the tax shown on your return for the preceding (2010) tax year if that year was not for a short period of less than 12 months; or

-- The annualized income installment.

For higher-income taxpayers whose adjusted gross income (AGI) shown on your 2010 tax return exceeds $150,000 (or $75,000 for a married individual filing separately in 2011), the required annual payment is the lesser of 90 percent of the tax for the current year, or 110 percent of the tax shown on the return for the preceding tax year.

Adjusting estimated tax payments

If you expect an uneven income stream for 2011 your required estimated tax payments may not necessarily be the same for each remaining period, requiring adjustment. The need for, and the extent of, adjustments to your estimated tax payments should be assessed at the end of each installment payment period.

For example, a change in your or your business's income, deductions, credits, and exemptions may make it necessary to refigure estimated tax payments for the remainder of the year. Likewise for individuals, changes in your exemptions, deductions, and credits may require a change in estimated tax payments. To avoid either a penalty from the IRS or overpaying the IRS interest-free, you may want to increase or decrease the amount of your remaining estimated tax payments.

Refiguring tax payments due

There are some general steps you can take to reconfigure your estimated tax payments. To change your estimated tax payments, refigure your total estimated tax payments due. Then, figure the payment due for each remaining payment period. However, be careful: if an estimated tax payment for a previous period is less than one-fourth of your amended estimated tax, you may be subject to a penalty when you file your return.

If you would like further information about changing your estimated tax payments, please contact our office.

Under the Patient Protection and Affordable Care Act (PPACA) enacted in March 2010, small employers may be eligible to claim a tax credit of 35 percent of qualified health insurance premium costs paid by a taxable employer (25 percent for tax-exempt employers). The credit is designed to encourage small employers to offer health-insurance to their employees.

Under the Patient Protection and Affordable Care Act (PPACA) enacted in March 2010, small employers may be eligible to claim a tax credit of 35 percent of qualified health insurance premium costs paid by a taxable employer (25 percent for tax-exempt employers). The credit is designed to encourage small employers to offer health-insurance to their employees.

Employees and wages

An employer can claim the maximum 35 percent credit if it has no more than 10 full-time equivalent (FTE) employees receiving average annual wages of $25,000 or less. The credit is phased out as the number of FTEs increases to 25 and as average annual wages increase to $50,000.  An employer with 25 or more employees, or paying average annual wages of $50,000 or more per employee, will not receive a credit.

In counting FTEs, the employer should not include owners and family members.  Seasonal employees are not counted unless they work at least 120 days during the year. In determining average annual wages, employers must count all wages, bonuses, commissions or other compensation, including sick leave and vacation leave.

Applicable years

The credit took effect in 2010.  It did not expire at the end of 2010 but can be claimed from year to year.  The credit applies at the 35/25 percent levels for four years, through 2013. After 2013, the maximum credit increases to 50 percent for for-profit employers and 35 percent for tax-exempt employers, but only for two years. Thus, the credit can be claimed every year for the six years from 2010 and 2015.  The credit is recalculated every year based on the total health insurance premiums paid. Only non-elective employer premiums are counted; salary reduction contributions paid through a cafeteria plan or other arrangement are not counted.

Premiums

An employer must pay at least 50 percent of the premium cost of health insurance coverage, and must pay the same uniform percentage of costs for each employee who obtains health insurance through the employer. A transition rule for 2010 treats an employer as satisfying the uniformity rule as long as the employer pays at least 50 percent of the coverage costs of each employee, based on the cost of employee-only (single) coverage, even if the employer does not pay the same percentage of costs for each employee.

The premiums must be paid for qualified health insurance, such as a hospital or medical service plan or health maintenance organization. It includes coverage for dental, vision, long-term care, nursing home care, and coverage for a specified disease or illness.  Coverage does not accident insurance, disability income insurance, and workers' compensation.

Claiming the credit

The credit is determined on Form 8941, Credit for Small Employer Health Insurance Premiums. For-profit employers report the amount of the credit on Form 3800, General Business Credit, and attach the forms to their income tax return. As a general business credit, any unused credit (in excess of taxable income) can be carried back one year (except for a credit arising in 2010, the first year) or carried forward 20 years.  For-profit employers deduct the credit from the premiums paid for health insurance, when computing the deduction for health insurance premiums.

Tax-exempt employers report the credit on Form 990-T, Exempt Organization Business Income Tax Return, regardless of whether the organization is subject to tax on unrelated business income. The credit is refundable for tax-exempt employers, provided it does not exceed the employer’s income tax withholding and Medicare taxes. The credit is not refundable if the employer does not claim the credit on Form 990-T.

The tax rules surrounding the dependency exemption deduction on a federal income tax return can be complicated, with many requirements involving who qualifies for the deduction and who qualifies to take the deduction. The deduction can be a very beneficial tax break for taxpayers who qualify to claim dependent children or other qualifying dependent family members on their return. Therefore, it is important to understand the nuances of claiming dependents on your tax return, as the April 18 tax filing deadline is just around the corner.

The tax rules surrounding the dependency exemption deduction on a federal income tax return can be complicated, with many requirements involving who qualifies for the deduction and who qualifies to take the deduction. The deduction can be a very beneficial tax break for taxpayers who qualify to claim dependent children or other qualifying dependent family members on their return. Therefore, it is important to understand the nuances of claiming dependents on your tax return, as the April 18 tax filing deadline is just around the corner.

Dependency deduction

You are allowed one dependency exemption deduction for each person you claim as a qualifying dependent on your federal income tax return. The deduction amount for the 2010 tax year is $3,650. If someone else may claim you as a dependent on their return, however, then you cannot claim a personal exemption (also $3,650) for yourself on your return. Additionally, your standard deduction will be limited.

Only one taxpayer may claim the dependency exemption per qualifying dependent in a tax year. Therefore, you and your spouse (or former spouse in a divorce situation) cannot both claim an exemption for the same dependent, such as your son or daughter, when you are filing separate returns.

Who qualifies as a dependent?

The term "dependent" includes a qualifying child or a qualifying relative. There are a number of tests to determine who qualifies as a dependent child or relative, and who may claim the deduction. These include age, relationship, residency, return filing status, and financial support tests.

The rules regarding who is a qualifying child (not a qualifying relative, which is discussed below), and for whom you may claim a dependency deduction on your 2010 return, generally are as follows:

-- The child is a U.S. citizen, or national, or a resident of the U.S., Canada, or Mexico;

-- The child is your child (including adopted or step-children), grandchildren, great-grandchildren, brothers, sisters (including step-brothers, and -sisters), half-siblings, nieces, and nephews;

 -- The child has lived with you a majority of nights during the year, whether or not he or she is related to you;

 -- The child receives less than $3,650 of gross income (unless the dependent is your child and either (1) is under age 19, (2) is a full-time student under age 24 before the end of the year), or (3) any age if permanently and totally disabled;

 -- The child receives more than one-half of his or her support from you; and

 -- The child does not file a joint tax return (unless solely to obtain a tax refund).

Qualifying relatives

The rules for claiming a qualifying relative as a dependent on your income tax return are slightly different from the rules for claiming a dependent child. Certain tests must also be met, including a gross income and support test, and a relationship test, among others. Generally, to claim a "qualifying relative" as your dependent:

-- The individual cannot be your qualifying child or the qualifying child of any other taxpayer; -- The individual's gross income for the year is less than $3,650; -- You provide more than one-half of the individual's total support for the year; -- The individual either (1) lives with you all year as a member of your household or (2) does not live with you but is your brother or sister (include step and half-siblings), mother or father, grandparent or other direct ancestor, stepparent, niece, nephew, aunt, or uncle, or inlaws. Foster parents are excluded.

Although age is a factor when claiming a qualifying child, a qualifying relative can be any age.

Special rules for divorced and separated parents

Certain rules apply when parents are divorced or separated and want to claim the dependency exemption. Under these rules, generally the "custodial" parent may claim the dependency deduction. The custodial parent is generally the parent with whom the child resides for the greater number of nights during the year.

However, if certain conditions are met, the noncustodial parent may claim the dependency exemption. The noncustodial parent can generally claim the deduction if:

-- The custodial parent gives up the tax deduction by signing a written release (on Form 8332 or a similar statement) that he or she will not claim the child as a dependent on his or her tax return. The noncustodial parent must attach the statement to his or her tax return; or

-- There is a multiple support agreement (Form 2120, Multiple Support Declaration) in effect signed by the other parent agreeing not to claim the dependency deduction for the year.

On December 17, 2010 President Obama signed into law the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (2010 Tax Relief Act). This sweeping new tax law includes a two-year extension of the Bush-era tax cuts, including extension of the current, lower individual tax rates and capital gains/dividend tax rates. The new tax law - the largest in over ten years - also includes a temporary estate tax compromise, as well as the extension of many popular individual and business tax incentives, an alternative minimum tax (AMT) "patch" for 2010 and 2011, 100 percent bonus depreciation for businesses, and more. The much-anticipated legislation provides tax relief to taxpayers across-the-board. Here is a review of the 2010 Tax Relief Act's major provisions:

Individuals

Income tax rates. Among the most valuable tax breaks for individuals in the new law is a two-year extension of individual income tax rate reductions. The new law retains the current 10, 15, 25, 28, 33, and 35 percent individual tax rates for two years, through December 31, 2012. If Congress had not passed this extension, the individual tax rates would have jumped significantly for all income levels.

The new law also extends the full repeal of the limitation on itemized deductions and the personal exemption phaseout for higher-income taxpayers, through December 31, 2012.

Capital gains/dividends. The new law extends reduced capital gains and dividend tax rates for two years, through December 31, 2012. For 2011 and 2012, individuals in the 10 and 15 percent rate brackets can continue to take advantage of a zero percent capital gains and dividend tax rate. Individuals in higher rate brackets will enjoy a maximum tax rate of 15 percent on capital gains and dividends, as opposed to a 20 percent rate on capital gains and ordinary income tax rates on dividends.

Marriage penalty relief. Married couples filing jointly will benefit from provisions designed to provide relief from the marriage penalty. For 2010, the standard deduction for a married couple filing a joint return is twice the single taxpayer's amount. The 2010 Tax Relief Act extends the increased standard deduction for married taxpayers for two years, through December 31, 2012. The 2010 Tax Relief Act extends the expanded 15 percent rate bracket for married couples filing a joint return for two years, through December 31, 2012.

Payroll tax cut. The new law provides a payroll tax cut for employees. Effective for calendar year 2011, the employee share of the OASDI portion of Social Security taxes is reduced from 6.2 percent to 4.2 percent, up to the taxable wage base of $106,800. Self-employed individuals will get an equivalent tax break, paying 10.4 percent on self-employment income up to the wage base (reduced from the normal 12.4 percent rate). The payroll tax cut replaces the Making Work Pay credit that has been in place for 2009 and 2010, but generally offers a much higher benefit. Unlike the Making Work Pay credit, the payroll tax cut does not exclude individuals based on their earnings. Thus the payroll tax cut can provide significantly higher benefits -- a maximum payroll tax reduction of $2,136 on wages, compared to a maximum $800 Making Work Pay credit for married couples filing jointly and $400 for unmarried individuals.

AMT patch. The new law provides an AMT "patch" for 2010 as well as 2011 at higher exemption amounts. The 2010 Tax Relief Act raises the exemption amounts for 2010 to $47,450 for individuals, $72,450 for married taxpayers filing joint returns, and $36,225 for married taxpayers filing separately. For 2011, the amounts are increased to $48,450 for individuals, $74,450 for married taxpayers filing jointly, and $37,225 for married taxpayers filing separately.

More incentives. Along with all these incentives, the new law extends many popular but temporary tax breaks. Extended for 2011 and 2012 are:

• $1,000 child tax credit;
• Enhanced earned income tax credit;
• Adoption credit with modifications;
• The enhanced dependent care credit; and
• Deduction for certain mortgage insurance premiums.

The new law also extends retroactively some other valuable tax incentives for individuals that expired at the end of 2009. These incentives are extended for 2010 and 2011 and include:

• State and local sales tax deduction;
• Teacher's classroom expense deduction;
• Charitable contributions of IRA proceeds; and
• Charitable contributions of appreciated property for conservation purposes.

Businesses

Bonus depreciation. Businesses can use bonus depreciation to immediately write off a percentage of the cost of depreciable property. The new law provides 100 percent bonus depreciation for qualified investments made after September 8, 2010 and before January 1, 2012. It also continues bonus depreciation, albeit at 50 percent, on property placed in service after December 31, 2011 and before January 1, 2013. There are special rules for certain longer-lived and transportation property. Additionally, certain taxpayers may claim refundable credits in lieu of bonus depreciation.

Code Sec. 179 expensing. Along with bonus depreciation, the new law also provides for enhanced Code Sec. 179 expensing for 2012. Under current law, the Code Sec. 179 dollar and investment limits are $500,000 and $2 million, respectively, for tax years beginning in 2010 and 2011. The new law provides for a $125,000 dollar limit (indexed for inflation) and a $500,000 investment limit (indexed for inflation) for tax years beginning in 2012 (but not after). Otherwise, those caps would have dropped to a $25,000/$200,000 level.

Research credit. Congress extended the research tax credit for two years, for 2010 and 2011.

More incentives. Other valuable business incentives in the new law include extensions of:

• 100 percent exclusion of gain from qualified small business stock;
• Transit benefits parity;
• Work Opportunity Tax Credit (with modifications);
• New Markets Tax Credit (with modifications);
• Differential wage credit;
• Brownfields remediation;
• Active financing exception/look-through treatment for CFCs;
• Tax incentives for empowerment zones; and
• Special rules for charitable deductions by corporations and other businesses.

Energy Tax Breaks

Businesses. The new law extends some energy tax breaks for businesses. One of the most valuable energy incentives is the Code Sec. 1603 cash grant in lieu of tax credits. This incentive encourages the development of alternative energy sources, such as wind energy. Other business energy incentives extended by the new law include excise tax and other credits for alternative fuels, percentage depletion for oil and gas from marginal wells, and other targeted incentives.

Individuals. The new law also extends some popular energy tax incentives for individuals. Individuals who made energy efficiency improvements to their homes in 2009 or 2010 can benefit from the Code Sec. 25C energy tax credit, which rewards individuals who install energy efficient furnaces, add insulation, or make other similar improvements to reduce energy usage. The new law extends the credit through 2011 but reduces some of its benefits.

Education

The Tax Code includes a number of incentives to encourage individuals to save for education expenses. Many incentives are temporary and expired at the end of 2009, or were set to expire at the end of 2010. The new law extends for two years, through December 31, 2012, the following popular education tax breaks:

• The American Opportunity Tax Credit (previously the Hope education credit);
• Student loan interest deduction;
• Exclusion for employer-provided educational assistance;
• Enhanced Coverdell education savings accounts; and
• Special rules for certain scholarships.

The higher education tuition deduction was extended through 2011.

Estate and gift taxes

Beginning in 2011, the estate tax had been scheduled to revert to its pre-2001 levels of a 55 percent tax rate and a $1 million exclusion. For 2010, estates were subject to no federal estate tax but heirs had to take inherited property under a modified carryover tax basis regime.

Estate tax. The new law revives the estate tax through 2012, but at a reduced maximum estate tax rate of 35 percent and a $5 million exclusion. The revived estate tax applies to estates of decedents dying in 2011 and 2012. However, for 2010, the new law gives estates the option to apply the estate tax at the 35 percent/$5 million level, with a stepped-up basis, or to elect no estate tax but with modified carryover basis. The new law also allows "portability" between spouses of the maximum exclusion (for a combined $10 million benefit) and extends some other taxpayer-friendly provisions originally enacted in 2001.

This far-reaching tax package affects almost every taxpayer. Please contact our office if you have any questions on how you can start maximizing your savings within this sweeping $800 billion tax law.

Congress not only extended the current, lower individual income tax rates through 2012 in the recently enacted Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Relief Act); it also extended a number of beneficial tax breaks for families and individuals. Through 2012, the law extended significant tax incentives for education, children, and energy-saving home improvements.

Individual Tax Rates

The 2010 Tax Relief Act extends all of the current lower individual tax rates across the board, for all taxpayers, at 10, 15, 25, 28, 33, and 35 percent for two years, through 2012. In addition, under the new law the size of the 15 percent tax bracket for married couples filing jointly and surviving spouses remains double that of the 15 percent tax bracket for individual filers, thus continuing to provide "marriage penalty" relief.

State and local sales tax deduction. Congress also extended the deduction for state and local sales taxes in lieu of the state and local income tax deduction through 2011.

More marriage penalty relief

In addition to expanding the 15 percent income tax rate bracket, the 2010 Tax Relief Act also maintains the increased basic standard deduction for joint filers. Through 2012, the standard deduction for married taxpayers filing a joint return (and surviving spouses) is twice the basic standard deduction amount for single individuals. For example, the standard deduction for individuals for 2011 is $5,800; for married taxpayers filing jointly, the standard deduction for 2011 will be $11,600.

No personal exemption phaseout

Higher-income individuals and families will also benefit from the ability to claim an unreduced personal exemption. Before 2010, taxpayers with income over certain amounts were subject to phaseout of their personal exemption. However, under the 2010 Tax Relief Act, personal exemptions are not reduced, for an additional two years through 2012.

Expanded child tax credit

The 2010 Tax Relief Act extends the $1,000 child tax credit for two years, through December 31, 2012. The child tax credit can be claimed for each qualifying child under age 17 (at the close of the year) that the taxpayer can claim as a dependent. However, the amount of the credit is reduced as a taxpayer's income increases. The credit is reduced (but not below zero) by $50 for each $1,000 of modified adjusted gross income (AGI) above $110,000 for joint filers and above $75,000 for others. The new law also extends other enhancements to the credit, including the ability to offset both the regular tax and alternative minimum tax.

Expanded earned income tax credit

The 2010 Tax Relief Act extends the enhanced earned income tax credit (EITC) for two years, through 2012. The new law also simplifies computation of the EITC.

Adoption credit

Through 2012, the new law expands the adoption credit and the exclusion from income for employer-provided adoption assistance. However, the new law does not extend certain changes made by the Patient Protection and Affordable Care Act of 2010 (PPACA) for 2010 and 2011. Therefore, the credit is not refundable after 2011 and the additional $1,000 under the PPACA is not available after 2011. For 2012, the maximum credit therefore is $12,170 (indexed for inflation after 2010) and is phased out ratably for taxpayers with modified AGI over $182,520.

Dependent care credit

The 2010 Tax Relief Act extends the enhanced dependent care credit for two years, through 2012. A taxpayer who incurs expenses to care for a child under age 13 or for an incapacitated dependent or spouse, in order to enable the taxpayer to work or look for work, is eligible to claim the dependent care credit. The maximum expenses that can be claimed through 2012 are $3,000 for one qualifying individual and $6,000 for more than one qualifying individual. Additionally, the maximum credit rate is 35 percent. Thus, for 2010, the maximum dependent care credit is $1,050 (35 percent of up to $3,000 of eligible expenses) for one qualifying individual and $2,100 for more than one qualifying individual (35 percent of up to $6,000 of qualified eligible expenses).

Tax breaks for education

The 2010 Tax Relief Act extends a number of tax incentives to help defray the costs of education. The new law extends the American Opportunity Tax Credit (AOTC), the student loan interest deduction, the exclusion from income for employer-provided assistance, and more. The AOTC, which is 40 percent refundable, can be claimed for expenses incurred for the first four years of a student's post-secondary education. The credit equals 100 percent of the first $2,000 of qualified higher education tuition and related expenses (including course materials), and 25 percent of the next $2,000 of expenses. In effect, a maximum credit of $2,500 a year can be claimed for each eligible student.

Through 2012, employees who receive educational assistance from their employer can continue to exclude up to $5,250 in employer-provided educational assistance from their income and employment taxes. Graduate school tuition also qualifies for the exclusion.

Taxpayers will also continue to benefit from the $2,500 above-the-line student loan interest deduction through 2012. The new law also expanded the modified AGI range for the phaseout of the deduction. For 2010, for instance, the deduction phases out ratably for taxpayers with modified AGI between $60,000 and $75,000 ($120,000 and $150,000 for joint filers).

Coverdell education savings accounts (ESAs) provide taxpayers with another mechanism to save for education. The 2010 Tax Relief Act enables taxpayers to continue to contribute up to $2,000 a year to a Coverdell ESA for beneficiaries under age 18 (as well as special needs beneficiaries of any age). In addition to higher education expenses, Coverdell ESAs can be used to pay for elementary and secondary education expenses through 2012. However, the amount that can be contributed is subject to income phaseouts.

Incentives for energy-efficient improvements

The 2010 Tax Relief Act also rewards individuals and families who make energy-saving improvements to their home. For example, the new law extends through 2011 (only one year) the popular Code Sec. 25C tax credit, which provides a credit for expenses for qualified energy efficiency improvements and property, such as furnaces, water heaters, insulation materials, exterior windows, skylights, doors, and other items.

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. Although the tax does not take effect until 2013, it is not too soon to examine methods to lessen the impact of the tax.

Net investment income

"Net investment income" includes interest, dividends, annuities, royalties and rents and other gross income attributable to a passive activity. Gains from the sale of property not used in an active business and income from the investment of working capital are also treated as investment income. Further, 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 under Code Sec. 121, and gains from the sale of a vacation home. However, contemplated sales made before 2013 would avoid the tax.

The tax applies to estates and trusts, on the lesser of undistributed net income or the excess of the trust/estate adjusted gross income (AGI) over the threshold amount ($11,200) for the highest tax bracket for trusts and estates, and to investment income they distribute.

However, the tax will not apply to nontaxable income, such as tax-exempt interest or veterans' benefits.

Deductions

Net investment income is gross income or net gain, reduced by deductions that are "properly allocable" to the income or gain. This is a key term that the Treasury Department expects to address in guidance, and which we will update on developments. For passively-managed real property, allocable expenses will still include depreciation and operating expenses. Indirect expenses such as tax preparation fees may also qualify.

For capital gain property, this formula puts a premium on keeping tabs on amounts that increase your property's basis. It also focuses on investment expenses that may reduce net gains: interest on loans to purchase investments, investment counsel and advice, and fees to collect income. Other costs, such as brokers' fees, may increase basis or reduce the amount realized from an investment. As such, taxpayers may want to consider avoiding installment sales with net capital gains (and interest) running past 2012.

Thresholds

The tax applies to the lesser of net investment income or modified AGI above $200,000 for individuals and heads of household, $250,000 for joint filers and surviving spouses, and $125,000 for married filing separately. MAGI is your AGI increased by any foreign earned income otherwise excluded under Code Sec. 911; MAGI is the same as AGI for someone who does not work overseas.

Example. Jim, a single individual, has modified AGI of $220,000 and net investment income of $40,000. The tax applies to the lesser of (i) net investment income ($40,000) or (ii) modified AGI ($220,000) over the threshold amount for an individual ($200,000), or $20,000. The tax is 3.8 percent of $20,000, or $760. In this case, the tax is not applied to the entire $40,000 of investment income.

Exceptions to the tax

Certain items and taxpayers are not subject to the 3.8 percent Medicare tax. A significant exception applies to distributions from qualified plans, 401(k) plans, tax-sheltered annuities, individual retirement accounts (IRAs), and eligible 457 plans. There is no exception for distributions from nonqualified deferred compensation plans subject to Code Sec. 409A. However, distributions from these plans (including amounts deemed as interest) are generally treated as compensation, not as investment income.

The exception for distributions from retirement plans suggests that potentially taxable investors may want to shift wages and investments to retirement plans such as 401(k) plans, 403(b) annuities, and IRAs, or to 409A deferred compensation plans. Increasing contributions will reduce income and may help you stay below the applicable thresholds. Small business owners may want to set up retirement plans, especially 401(k) plans, if they have not yet established a plan, and should consider increasing their contributions to existing plans.

Another exception is provided for income ordinarily derived from a trade or business that is not a passive activity under Code Sec. 469, such as a sole proprietorship. Investment income from an active trade or business is also excluded. However, SECA (Self-Employment Contributions Act) tax will still apply to proprietors and partners. Income from trading in financial instruments and commodities is also subject to the tax.

The additional 3.8 percent Medicare tax does not apply to income from the sale of an interest in a partnership or S corporation, to the extent that gain of the entity's property would be from an active trade or business. The tax also does not apply to business entities (such as corporations and limited liability companies), nonresident aliens (NRAs), charitable trusts that are tax-exempt, and charitable remainder trusts that are nontaxable under Code Sec. 664.

Income tax rates

In addition to the tax on investment income, certain other tax increases proposed by the Obama administration may take effect in 2011. The top two marginal income tax rates on individuals would rise from 33 and 35 percent to 36 and 39.6 percent, respectively. The maximum tax rate on long-term capital gains would increase from 15 percent to 20 percent. Moreover, dividends, which are currently capped at the 15 percent long-term capital gain rate, would be taxed as ordinary income. Thus, the cumulative rate on capital gains would increase to 23.8 percent in 2013, and the rate on dividends would jump to as much as 43.4 percent. Moreover, the thresholds are not indexed for inflation, so more taxpayers may be affected as time elapses.

Please contact our office if you would like to discuss the tax consequences to your investments of the new 3.8 percent Medicare tax on investment income.