Taxable Talk

The IRS announced today a "clarification" of the rules for self-employed health insurance deductions for S Corporations. This is bad news overall, and especially bad news for California S Corporations.

The self-employed health insurance deduction allows sole proprietorships, partnerships, LLCs (those treated as partnerships or as disregarded entities) to deduct their health insurance premiums "above the line;" that is, an adjustment to AGI rather than as an itemized deduction subject to a 7.5% limitation on AGI. This is a large tax savings for the self-employed.

The IRS announcement indicates that for S Corporations to be eligible for this deduction, the policy must be in the name of the corporation. But if you do this, the health insurance premiums will be included as compensation on your W-2 (although they are exempt from FICA and medicare).

Additionally, many states, including California, do not allow single-employee corporations of any kind to obtain health insurance. This ruling means that California single-member S Corporations (a single individual is the employee and owner) are generally ineligible for this deduction.

For example, my health insurance premiums run about $5,000 annually. If I were impacted by this ruling and were in the 25% tax bracket, my federal tax bill just went up $1,250.

If you're impacted by this ruling I urge you to write your Representatives and Senators. I'm certain this is not what Congress intended when they enacted this deduction.

That's not a typo in the subject of this post. The tax bill that was signed last week by President Bush is titled "The Tax Increase Prevention and Reconciliation Act of 2005." Apparently Congress didn't look at a calendar....

Here are the good points of the bill, such as they are:

1. AMT Relief, but just for one year. The bill increases the AMT exemption to $62,500 for Married Filing Jointly and $42,500 for single filers for 2006. However, yet another tax bill will need to be passed in 2007 to further extend AMT relief or millions of taxpayers will find themselves in AMT hell.

That's the long list, in my view, of the good points. Now, here are the probable good points of the bill...but these could change, as they're all in the future:

2. Dividend and Capital Gains Cuts Extended. This bill extends the dividend and capital gains tax cuts (these were scheduled to expire in 2008) until 2010. Note that nothing prevents Congress from extinguishing this extension next year.

3. Roth IRA Conversions. In 2010 anyone will be able to convert a regular IRA into a Roth IRA. Regular IRAs give taxpayers a tax deduction today but distributions (upon retirement) are taxable. Roth IRAs do not give a tax deduction today but the proceeds (in retirement) are tax-free. The tax owed for these conversion must be paid in 2011 and 2012. It's quite possible that this new tax break could itself be broken by Congress between now and 2009.

Now let's examine the negative points of the bill.

4. Offers in Compromise. Do you want to make an Offer in Compromise (OIC) with the IRS? You had better do it very soon—you have until July 15th to make an OIC without making a 20% OIC deposit. If your OIC is rejected by the IRS you will lose that deposit. I doubt we'll see many OICs after July 15th.

5. Kiddee Tax Increase. If you're wealthy, one tax strategy is to shift income to your children. The kiddee tax used to end at age 14...but the new bill extends it until age 18.

6. Expatriate Tax Increase. While the new bill does increase the Foreign Earned Income Exclusion (to $82,400), it greatly reduces the housing allowance for Americans living abroad. Additionally, the tax rate for investment income of expatriates is increased dramatically. The International Herald Tribune has an excellent story on this.

7. Changes to Section 199. If you're a manufacturer (or a business that qualifies for this deduction), the Section 199 Deduction is now limited to 50% of W-2 earnings.

What's not in the bill? Plenty. Tuition deduction, educators deduction, estate tax...the list is endless. A second bill is likely to emerge from Congress this Fall.

Republican negotiators in Congress sent tax legislation out of conference committee. The highlights of this generally lackluster legislation:

- AMT Relief extended, with a new higher exclusion of $62,550 for 2006;

- 15% capital gains rate extended for two more years, through 2010;

- Section 179 depreciation at $100,000 extended to 2010, from 2008;

- Roth IRA conversions allowed for everyone. This, as Joe Kristan correctly notes, increases tax revenues today, but drastically impacts tax revenues in a few years. Roth IRAs are not tax deductible today. However, when you retire and starth withdrawing the funds, they are tax-free;

- The Section 199 Production Deduction (the deduction from hell) has been toughened. The deduction will now be limited to 50% of W-2 wages; and

- Mandatory payments for Offers in Compromise (OIC) of 20% of the OIC. This will discourage OICs.

There's plenty more, but it's mostly arcane stuff. There's a lot of budget shenanigans. As Joe Kristan noted, corporate estimated tax payments are definitely being played around with:

"The 2006 estimated tax payment installments due in July, August or September (third quarter, for calendar year taxpayers) will be 105% of the amount otherwise due for the quarter. The same installment in 2012 will be 106.25% of the amount otherwise due; in 2013, the magic number will be 100.75% of the amount otherwise due.

-In 2010, 20.5% of the third quarter installment due September 15 will be payable October 1; in 2011, 27.5% of the third quarter installment is payable in October.

The government has a September 30 fiscal year, and these rules obviously shuffle income among the fiscal years to meet some arcane budget rule, at least on paper and in a laughably phony manner."

Of course, the whole procedure is that way. Many of the delayed tax increases will never see the light of day. They're only in the legislation so that it meets the $70 billion tax cut limitation; if the tax cut were larger than that, the bill would be subject to a fillibuster in the Senate. It cannot be fillibustered.

For more information:
Text of the Bill (HR 4297);
Los Angeles Times News Story;
Roth Tax Updates Post;
and TaxProf Roundup on the legislation.