ax planning is only as valuable as the quality of information used to make projections. When a CPA helps a client assess the tax cost or benefit of a proposed transaction, the client’s marginal tax rate is generally considered the rate to apply. However, finding the correct marginal rate for tax planning purposes is not always easy.
CPAs frequently use the bracket rates of 15%, 28%, 31%, 36% and 39.6% as marginal rates. While they may be the right ones, incorrect use of these rates may lead CPAs to make erroneous conclusions because of increasingly common stealth or backdoor taxes—making the correct marginal tax rate difficult to find. At the same time, rising incomes subject more taxpayers to these hidden taxes, and the alternative minimum tax increases the challenge of finding the correct marginal rate.
The CPA’s task is made doubly difficult because the provisions governing these hidden taxes are not uniform and taxpayers won’t know their actual income until yearend. The more knowledgeable a CPA is about the nuances of the tax law, the greater the likelihood of using the correct marginal rate in tax planning and of being able to warn clients of the potential tax costs they face in advance.
BEWARE OF STEALTH TAXES
This article has four case studies to illustrate how improper reliance on the bracket rates can lead to incorrect conclusions. In some, the errors are small; in others, they are more dramatic. While all four cases are based on year 2000 tax rates (see exhibit 1 ), taxpayers will experience nearly identical problems with 2001 rates. Unless otherwise indicated, the taxpayer is assumed to be filing a joint return using the standard deduction. About 70% of all individual taxpayers take the standard deduction, including a number of upper-income taxpayers.
Case 1. Brian wants to know the tax cost of selling an investment that will result in a $30,000 capital gain. Assume he will report the following income for the year if he does not sell the investment:
Brian cashed in $6,000 of series EE bonds to pay his dependent daughter’s qualified higher education expenses in 2000. The $6,000 consists of $2,000 of interest and $4,000 of principal.
A simple analysis of these facts suggests Brian is in the 28% marginal tax bracket, since an additional $30,000 of gross income will not move him into a higher bracket. However, selling the investment will presumably result in $30,000 of capital gain income. Thus, a CPA’s first question in determining Brian’s correct marginal tax rate is whether the investment holding period is short-term or long-term. If it is short-term (one year or less), the marginal tax rate is 28%. However, if Brian has held the investment longer than one year, the situation is trickier. The tax rate on the gain could be either 28%, 25%, or 20% (and in a few years, possibly 18% on capital assets purchased after December 31, 2000 and held over five years) or a combination thereof.
Brian’s minimum marginal tax rate on the gain is 20%—the normal rate on long-term capital gains. His maximum marginal rate is 28%. This rate will apply if the gain is either short-term or a long-term gain arising from the sale of a “collectible” or an IRC section 1202 gain, which results from sales of certain small business stock. A 25% rate will apply to any portion of the gain that represents IRC section 1250 unrecaptured income. The 28% rate will also apply to any ordinary income recapture. Hence, the marginal tax on the gain could range from 20% to 28%, resulting in an increase in tax from $6,000 to $8,400.
But there is another, hidden tax. Before the sale, the $2,000 of interest on the series EE bonds was fully excluded from Brian’s income under IRC section 135 and thus not reflected in the above numbers. The gain from the sale of the investment will cause Brian to lose all of this exclusion due to phase-outs in section 135. The tax rate on the interest income will thus rise from 0 to 28%. Hence, there is a $560 hidden tax, making the final tax cost of selling the investment anywhere from $6,560 to $8,960. Exhibit 2 shows the magnitude of the hidden tax assuming a long-term gain subject to a 20% tax rate.
Case 2. Jordan, who is married and has one dependent, wants to know the tax cost of selling a stock that will result in a $15,000 gain. If she does not sell the stock Jordan will report the following:
Jordan also incurred $2,000 of interest on a loan that she used to pay her spouse’s qualifying educational expenses under IRC section 221. As in case 1 above, the sale of the stock will result in a capital gain. Since the asset is stock, CPAs can ignore the added complexity of the collectibles and unrecaptured section 1250 gain rules. For a short-term gain, on naive first glance one might conclude that $2,590 of the gain should be taxed at 15% ($43,850 tax bracket breakpoint less $41,260 of taxable income), with the $12,410 balance taxed at 28%. This will result in $3,863 of additional tax, with an effective or average rate of 25.8% on the gain. Similarly, if the gain is long term, one might conclude that $2,590 of it should be taxed at 10%, with $12,410 taxed at 20%. This will result in $2,741 of additional tax, with an effective rate of 18.3%.
But hidden taxes come into play once again. The $2,000 of interest on the education loan is initially fully deductible for or toward AGI under section 221. However, with an additional $15,000 of income, this deduction is completely phased out. This phase-out—in conjunction with the capital gain—increases Jordan’s AGI by $17,000. As a result, she now loses the medical expense and miscellaneous itemized deductions. Thus, if Jordan sells the stock, she and her husband will report:
If the gain is short-term, the actual tax increase will be $4,701 ($10,890 – $6,189), which is $838 higher ($4,701 – $3,863) than the earlier analysis. This results in an effective or average rate of 31.3% on the capital gain. The total tax due on a long-term gain is computed by applying the regular rates in exhibit 1 , schedule Y to the $44,250 of ordinary income ($59,250 taxable income less the $15,000 capital gain) and then adding 20% of the $15,000 long-term gain. The $9,690 total tax is $3,501 higher ($9,690 – $6,189) than the total tax before the $15,000 gain was recognized, for an effective rate of 23.3% on the capital gain. The actual tax is $760 higher ($3,501 – $2,741) than the initial analysis suggested since the capital gain resulted in the loss of the medical expense, miscellaneous and interest deductions. (See exhibit 3 .)
In both examples so far, the hidden taxes involve deductions. When the backdoor taxes involve credits, tax costs escalate quickly, as illustrated in case 3.
Case 3. Morty is facing large educational expenses for his children and himself. He wants to know the tax cost of selling some stock to help pay these expenses. Morty has held the stock for more than one year and will have a $20,000 gain. He and his wife have two children attending college, both of whom meet the requirements to qualify for the maximum Hope Scholarship Credit (100% of the first $1,000 of qualifying educational expenses plus 50% of the next $1,000 to a maximum of $1,500). Morty himself incurred $1,000 of educational costs that qualify for the Lifetime Learning Credit (20% of up to $5,000 in qualifying expenses, to a maximum credit of $1,000). If they do not sell the stock Morty and his wife will report the following:
Since Morty is already in the 28% tax bracket, a quick analysis might lead to the conclusion that the tax due on the long-term capital gain will be $4,000 (20,000 x 20%). However, the gain will totally phase out the education credits. Hence, the increase in tax will be $7,200 (4,000 + 3,200) for an effective rate of 36% on the capital gain—16 percentage points higher than usual. (See exhibit 4 .) Morty might find that borrowing money to pay for the education costs is more prudent than selling his stock. Or he might examine his portfolio to see if he can sell stock with a smaller gain.
Morty and his family have another option. IRC section 25A suggests that if a student qualifies as another taxpayer’s dependent, only the parents (or supporting taxpayer) can claim the Hope Scholarship credit, not the student. However, proposed regulation section 1.25A-1(g) says, “if the taxpayer is eligible to, but does not claim the student as a dependent, only the student may claim the education credit for the student’s qualified tuition and related expenses.”
Thus, if Morty is willing to forego the dependency exemptions, apparently his children can claim the Hope Scholarship credits on their own returns. Dropping the students as dependents will carry an additional tax cost of $1,568 ($5,600 x 28%), bringing the total cost of the capital gain to $8,768. But each child can then potentially claim a $1,500 credit for a net family cost of $5,768—better than the $7,200 above. Unfortunately, the students’ tax liabilities may not be large enough to allow the full use of the credits, since they are not refundable.
Case 4. Gwen and Tom are married with six children. They are scheduled to report the following:
Under these circumstances, any additional income will force the couple into the phase-out area for personal and dependency exemptions. Higher taxes would result. Suppose the couple unexpectedly receives a $1 dividend from a stock they own. Although the couple is in the 36% tax bracket, the dividend pushes them over the phase-out threshold, making the marginal tax rate on the dividend an astounding 16,100%, not 36%, as the following analysis shows.
The $1 dividend forces the couple into the phase-out area for exemptions. (See exhibit 5 .) The amount of exemptions lost is computed as follows:
There would have been both good and bad news if Gwen and Tom had one more dependent (nine in total). In that case, their income level would make them subject to the AMT. The bad news is that the AMT is higher than the regular tax. The good news is the couple would owe only another $.26 in tax on the $1 dividend (for a 26% marginal rate):
When clients are not subject to the AMT, it will clearly pay for them to come up with a small deduction for or toward AGI. CPAs should watch for tax planning strategies as taxpayers approach various phase-out areas that will trigger hidden taxes. Exhibit 6 describes some important phase-outs CPAs should keep an eye on.
STEER CLEAR OF PHASE-OUTS
As these cases
illustrate, hidden taxes and the AMT can wreak havoc on the
expected tax cost of a transaction vs. the actual or true
cost. CPAs should check to see if phase-outs apply to a
taxpayer’s situation and suggest appropriate tax planning
strategies. These could include postponing planned
transactions that will trigger phase-outs, qualifying the
transaction for installment reporting or nontaxable exchange
treatment or finding transactions that will generate
deductions for or toward AGI to lower income levels below
the phase-out thresholds.