Don’t Neglect to Elect
A wide range of federal tax elections gives individual taxpayers options for how they report certain income or expense items. Some of the more common elections for individuals concern retirement plans, medical expenses and interest expense. Each election has specific rules as to who can make the election, when and how it is made, and when it is most advantageous. Practitioners should be aware of these elections and know how to make them correctly. The following are some federal tax elections that affect many taxpayers but may be all too easily forgotten.
RETIREMENT PLANS
Nonspouse beneficiaries and IRAs. Nonspouse beneficiaries may elect under IRC § 402(c)(11) to roll all or any portion of a deceased employee’s eligible retirement plan into an IRA or individual retirement annuity established by the nonspouse beneficiary for the purpose of receiving this distribution from the decedent. This transfer is deemed to be an eligible rollover distribution, allowing the nonspouse beneficiary to defer tax on the rolled-over portion of the retirement plan, subject to the minimum required distribution (MRD) rules for inherited IRAs (see section 401(a)(9)). The election is valid even if the decedent had already begun taking distributions from the retirement plan. The election is deemed made when the plan is rolled over and the first MRD is made. The transfer must be directly trustee to trustee.
Spousal beneficiaries and IRAs. A surviving spouse can elect under the distribution rules for IRAs provided in sections 408(a)(6) and 408(b)(3) to treat a deceased spouse’s traditional or Roth IRA as if it were his or her own. In essence, this election allows the surviving spouse to become the owner of the IRA and treat it under the rules for retirement benefits, as opposed to those for death benefits. The election is possible whether or not the decedent had begun taking IRA distributions; however, the surviving spouse must be the sole beneficiary and have an unlimited right to draw from the account. If the decedent was required to have made an MRD in the year of death but did not do so, the surviving spouse, although electing to be the owner of the IRA, must calculate the MRD for that year as if it were made by the decedent. See Treas. Reg. § 1.408-8, especially Q&A no. 5. There are no forms to file, nor is there a specified due date to make the election.
Recharacterizations of IRA contributions. Taxpayers who mistakenly contribute to a traditional IRA when they intended to make a contribution to a Roth IRA or vice versa can undo the mistake by electing to recharacterize the contribution or contributions. This election also enables taxpayers who converted an IRA to a Roth IRA to undo the conversion. The recharacterization is not treated as a rollover for purposes of the one-rollover-per-year rule. The recharacterized IRA and its resulting earnings must be transferred together to the second IRA. No formal election is required; however, the taxpayer must notify the trustee of each IRA involved in the trustee-to-trustee transfer by the due date of the tax return (including extension) for the year in which the IRA contribution or Roth conversion occurred.
Appreciated employer securities. An individual who receives appreciated employer securities as part of a lump-sum distribution may elect under section 402(e)(4)(B) to have the net unrealized appreciation included as ordinary income in the year of the distribution. Generally, the net unrealized appreciation is excluded from income in the year of the lump-sum distribution. This election, however, allows the taxpayer to forgo that rule and step up the basis of the securities for the amount of net unrealized appreciation. The election can be made on the return of the year in which the distribution was made or on an amended return. The taxpayer makes the election by attaching a statement to the tax return and by including the net unrealized appreciation on the tax return, either as part of a distribution reported on Form 4972, Tax on Lump-Sum Distributions From Qualified Retirement Plans, or on the appropriate line of Form 1040 (line 44 for 2009 returns).
MEDICAL EXPENSE ELECTION
Generally, medical expenses unpaid at the date of death are not allowed as a deduction on the decedent’s individual income tax return but are a deduction for the estate tax return. Many taxpayers do not have an estate tax liability. In such cases, the executor of an estate can elect to treat any medical expenses paid out of the estate within one year of the date of death as an itemized deduction under section 213(c) on the decedent’s Form 1040, subject to the applicable percentage of adjusted gross income floor. This election allows the decedent to get some tax benefit. If the estate is subject to the estate tax, this election doesn’t make sense, as the benefit derived from the deduction at the estate level is likely to yield a greater benefit. The election is made by attaching a statement in duplicate containing the executor’s signature to the income tax return in which the medical expenses are claimed, and it must be made within the time limit for filing the individual income tax return for the year in which the medical expenses are claimed. See Treas. Reg. § 1.213-1(d).
QUALIFIED HOME EQUITY DEBT INTEREST ELECTION
In a difficult lending environment, many self-employed small business owners are unable to finance their businesses through normal commercial lending practices. They might refinance their home or obtain a home equity loan. Normally, interest on such indebtedness is treated as an itemized deduction by individual taxpayers under section 163(h)(3). However, by using the interest tracing rules, such taxpayers might elect to treat such debt as not secured by the qualified residence and deduct the related interest expense on Schedule C rather than Schedule A. This treatment reduces their self-employment income, self-employment tax and adjusted gross income. The election is made by the due date of the return, including extension, for the year in which the election is effective, by deducting the interest on the appropriate line of the tax return. It is also recommended that taxpayers attach a statement to the tax return. See Temp. Treas. Reg. § 1.163-10T(o)(5).
For all these potentially overlooked elections, return preparers should also consider the effect on state taxes. Many states accept elections made at the federal level, but it’s best to confirm such treatment.
By C. Andrew Lafond, CPA, DBA, (lafond@tcnj.edu) assistant professor, The College of New Jersey, and Jeffrey J. Schrader, CPA, (jjscpa@fast.net) shareholder in Jeffrey J. Schrader, CPA, PC, Trenton, N.J.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.
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