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By Editor, October 21, 2011

As we approach year-end, it’s again time to focus on last-minute moves you can make to save taxes-both on your 2011 return and in future years. Before we get to specific suggestions, here are two important considerations to keep in mind.

First, remember that effective tax planning requires considering both this year and next year-at least. Without a multiyear outlook, you can’t be sure maneuvers intended to save taxes on your 2011 return won’t backfire and cost additional money in the future. For example, postponing a stock sale gain until next year would reduce your 2011 adjusted gross income (good), but increase the 2012 figure (bad). Higher income next year could make you ineligible for the child tax credit; reduce or eliminate the credits or deduction for college expenses; limit deductible losses from your rental real estate investments; and so on.

Second, be on the alert for the Alternative Minimum Tax (AMT) this year. It’s an add-on tax over and above your “regular” tax. Although you may have never owed AMT in the past, your odds of being hit are higher now. Why? Because the tax brackets, standard deduction, and personal exemption allowances used in calculating your regular tax liability are all indexed annually for inflation. Most AMT parameters are not. The odds of owing the tax go up every year due to this factor alone. The risk goes up another notch or two if you deduct a significant amount of state and local taxes or miscellaneous itemized deductions (like unreimbursed employee business expenses) or claim multiple dependents. These deductions are not allowed against the AMT. Finally, if you exercised incentive stock options or recognized a large capital gain this year, consider yourself a likely AMT victim.

Here are a few tax-saving ideas to get you started. As always, you can call on us to help you sort through the options and implement strategies that make sense for you.

Ideas for Your Business

Take Advantage of Tax Breaks for Purchasing Equipment, Software, and Certain Real Property. If you have plans to buy a business computer, office furniture, equipment, vehicle, or other tangible business property or to make certain improvements to real property, you might consider doing so before year-end to capitalize on the following generous, but temporary tax breaks:

• Bigger Section 179 Deduction. Your business may be able to take advantage of the temporarily increased Section 179 deduction. Under the Section 179 deduction privilege, an eligible business can often claim first-year depreciation write-offs for the entire cost of new and used equipment and software additions. (However, limits apply to the amount that can be deducted for most vehicles.) For tax years beginning in 2011, the maximum Section 179 deduction is $500,000. For tax years beginning in 2012, however, the maximum deduction is scheduled to drop back to $125,000.
• Section 179 Deduction for Real Estate. Real property costs are generally ineligible for the Section 179 deduction privilege. However, an exception applies to tax years beginning in 2011. Under the exception, your business can immediately deduct up to $250,000 of qualified costs for restaurant buildings and improvements to interiors of retail and leased nonresidential buildings. The $250,000 Section 179 allowance for these real estate expenditures is part of the overall $500,000 allowance. This temporary real estate break will not be available for tax years beginning after 2011 unless Congress extends it.

Note: Watch out if your business is already expected to have a tax loss for the year (or be close) before considering any Section 179 deduction, as you cannot claim a Section 179 write-off that would create or increase an overall business tax loss. Please contact us if you think this might be an issue for your operation.

• 100% First-year Bonus Depreciation. Above and beyond the bumped-up Section 179 deduction, your business can also claim first-year bonus depreciation equal to 100% of the cost of most new (not used) equipment and software placed in service by December 31 of this year. For a new passenger auto or light truck that’s used for business and is subject to the luxury auto depreciation limitations, the 100% bonus depreciation break increases the maximum first-year depreciation deduction by $8,000 for vehicles placed in service this year. The 100% bonus depreciation break will expire at year-end unless Congress extends it.

Note: 100% bonus depreciation deductions can create or increase a Net Operating Loss (NOL) for your business’s 2011 tax year. You can then carry back a 2011 NOL to 2009 and 2010 and collect a refund of taxes paid in those years. Please contact us for details on the interaction between asset additions and NOLs.

Claim the Health Insurance Tax Credit for Small Employers. Qualifying small employers can claim a tax credit that can potentially cover up to 35% of the cost of providing health insurance coverage to employees. A qualifying small employer is one that: (1) has no more than 25 Full-time Equivalent (FTE) workers, (2) pays an average FTE wage of less than $50,000 and (3) has a qualifying healthcare arrangement in place. The allowable credit is quickly reduced under a complicated phase-out rule when the employer has more than 10 FTE employees or an average FTE wage in excess of $25,000. Please contact us if you have questions about this break.

Evaluate Inventory for Damaged or Obsolete Items. Inventory is normally valued for tax purposes at cost or the lower of cost or market value. Regardless of which of these methods is used, the end-of-the-year inventory should be reviewed to detect obsolete or damaged items. The carrying cost of any such items may be written down to their probable selling price (net of selling expenses). [This rule does not apply to businesses that use the Last-in, First out (LIFO) method because LIFO does not distinguish between goods that have been written down and those that have not].

To claim a deduction for a write-down of obsolete inventory, you are not required to scrap the item. However, in a period ending not later than 30 days after the inventory date, the item must be actually offered for sale at the price to which the inventory is reduced.

Ideas for Maximizing Nonbusiness Deductions

One way to reduce your 2011 tax liability is to look for additional deductions. Here’s a list of suggestions to get you started:

Make Charitable Gifts of Appreciated Stock. If you have appreciated stock that you’ve held more than a year and you plan to make significant charitable contributions before year-end, keep your cash and donate the stock (or mutual fund shares) instead. You’ll avoid paying tax on the appreciation, but will still be able to deduct the donated property’s full value. If you want to maintain a position in the donated securities, you can immediately buy back a like number of shares. (This idea works especially well with no load mutual funds because there are no transaction fees involved.)

However, if the stock is now worth less than when you acquired it, sell the stock, take the loss, and then give the cash to the charity. If you give the stock to the charity, your charitable deduction will equal the stock’s current depressed value and no capital loss will be available. Also, if you sell the stock at a loss, you can’t immediately buy it back as this will trigger the wash sale rules. This means your loss won’t be deductible, but instead will be added to the basis in the new shares.

Maximize the Benefit of the Standard Deduction. For 2011, the standard deduction is $11,600 for married taxpayers filing joint returns. For single taxpayers, the amount is $5,800. Currently, it looks like these amounts will be about the same for 2012. If your total itemized deductions are normally close to theseamounts, you may be able to leverage the benefit of your deductions by bunching deductions in every other year. This allows you to time your itemized deductions so that they are high in one year and low in the next. You claim actual expenses in the year they are bunched and take the standard deduction in the intervening years.

For instance, you might consider moving charitable donations you normally would make in early 2012 to the end of 2011. If you’re temporarily short on cash, charge the contribution to a credit card-it is deductible in the year charged, not when payment is made on the card. You can also accelerate payments of your real estate taxes or state income taxes otherwise due in early 2012. But, watch out for the AMT, as these taxes are not deductible for AMT purposes.

Bunch Deductions Subject to an Adjusted Gross Income Limit. Miscellaneous itemized deductions (such as unreimbursed employee business expenses) are deductible to the extent they exceed 2% of your adjusted gross income (AGI). (Your AGI is the number at the bottom of the first page of your return.) Medical expenses are deductible only to the extent they exceed 7.5% of AGI. To lessen the affect of these AGI limitations, try to bunch your miscellaneous and medical expense deductions into every other year.

Making the Most of Year-end Securities Transactions

For 2011 sales, you’ll generally owe only 15% on gains from investment assets held over one year (0% if the gains would otherwise fall into the 15% regular income tax bracket). Gains from investments held one year or less are taxed at your ordinary rates. So, the framework for year-end tax selling of investment securities is fairly simple. First, list those stocks, mutual fund shares, and bonds that you feel you could easily live without. You’ll probably have some winners (current market value above your cost) and some losers (value below cost) on the list.

Between now and year-end, you can sell enough losers to offset any capital gains recognized earlier this year. Plus, you can sell enough to generate another $3,000 in losses ($1,500 for married filing separate status), which then can be deducted against your income from all other sources. Because selling the losers reduces your income, the odds are increased that you’ll qualify for various other tax breaks.

If your year-to-date sales have resulted in an overall loss in excess of $3,000, you can sell enough winners between now and year-end to get back to the “negative $3,000″ level. Cashing in gains to that extent won’t add a cent to your federal tax bill, whether or not the assets have been held over 12 months. On the other hand, if your year-to-date sales are currently standing at zero or a net gain and you want to unload some winners, but no more losers, before year-end, try to sell only those you’ve owned over 12 months. Then, the resulting gains will be taxed at no more than 15%.

When selling stock or mutual fund shares, the general rule is that the shares you acquired first are the ones you sell first. However, if you choose, you can specifically identify the shares you’re selling when you sell less than your entire holding of a stock or mutual fund. By notifying your broker of the shares you want sold at the time of the sale, your gain or loss from the sale is based on the identified shares. This sales strategy gives you better control over the amount of your gain or loss and whether it’s long-term or short-term.

Secure a Deduction for Nearly Worthless Securities. If the dismal economy has left you with securities that are all but worthless with little hope of recovery, you might consider selling them before the end of the year so you can capitalize on the loss this year. You can deduct a loss on worthless securities only if you can prove the investment is completely worthless. Thus, a deduction is not available, as long as you own the security and it has any value at all. Total worthlessness can be very difficult to establish with any certainty. To avoid the issue, it may be easier just to sell the security if it has any marketable value. As long as the sale is not to a family member, this allows you to claim a loss for the difference between your tax basis and the proceeds (subject to the normal rules for capital losses and the wash sale rules restricting the recognition of loss if the security is repurchased within 30 days before or after the sale).

Employer Stock Options. If you own appreciated stock acquired by exercising Incentive Stock Options (ISOs) and are now considering selling as part of your overall year-end strategy, remember what it takes to qualify for the 15% rate. First, the shares must be held over two years from the option grant date (the date you received the ISO). Second, the shares must be held over 12 months after the exercise date (the date you acquired the stock by exercising your ISO). Selling sooner means all or part of your gain may be taxed at your higher ordinary tax rate.

What if you own nonqualified options? It may pay to exercise now, if there’s just a modest spread between market value and your exercise price and you expect the stock to appreciate. You’ll owe tax at your ordinary rate on the spread, but any future appreciation will qualify for the 15% rate if you’ve held the shares over 12 months by the time you sell.

If you already own shares from exercising nonqualified options, remember your post-exercise gains will qualify for the 15% rate as long as more than 12 months have passed since you acquired the stock. A shorter holding period means your gains will be taxed at your higher ordinary rate, unless you have offsetting capital losses from other transactions this year.

Ideas for Seniors Age 701/2 Plus

Make Charitable Donations from Your IRA. IRA owners and beneficiaries who have reached age 70½ are permitted to make cash donations totaling up to $100,000 to IRS-approved public charities directly out of their IRAs. These so-called Qualified Charitable Distributions, or QCDs, are federal-income-tax-free to you, but you get no itemized charitable write-off on your Form 1040. That’s okay because the tax-free treatment of QCDs equates to an immediate 100% federal income tax deduction without having to worry about restrictions that can delay itemized charitable write-offs. QCDs have other tax advantages too. Contact us if you want to hear about them.

Be careful-to qualify for this special tax break, the funds must be transferred directly from your IRA to the charity. Also, this favorable provision will expire at the end of this year unless Congress extends it. So, this could be your last chance.

Take Your Required Retirement Distributions. The tax laws generally require individuals with retirement accounts to take withdrawals based on the size of their account and their age every year after they reach age 701/2. Failure to take a required withdrawal can result in a penalty of 50% of the amount not withdrawn. There’s good news for 2011 though-QCDs discussed above count as payouts for purposes of the required distribution rules. This means, you can donate all or part of your 2011 required distribution amount (up to the $100,000 limit on QCDs) and convert taxable required distributions into tax-free QCDs.

Also, if you turned age 701/2 in 2011, you can delay your 2011 required distribution to 2012 if you choose. But, waiting until 2012 will result in two distributions in 2012-the amount required for 2011 plus the amount required for 2012. While deferring income is normally a sound tax strategy, here it results in bunching income into 2012. Thus, think twice before delaying your 2011 distribution to 2012-bunching income into 2012 might throw you into a higher tax bracket or have a detrimental impact on your other tax deductions in 2012.

Ideas for the Office

Maximize Contributions to 401(k) Plans. If you have a 401(k) plan at work, it’s just about time to tell your company how much you want to set aside on a tax-free basis for next year. Contribute as much as you can stand, especially if your employer makes matching contributions. You give up “free money” when you fail to participate to the max for the match.

Take Advantage of Flexible Spending Accounts (FSAs). If your company has a healthcare and/or dependent care FSA, before year-end you must specify how much of your 2012 salary to convert into tax-free contributions to the plan. You can then take tax-free withdrawals next year to reimburse yourself for out-of-pocket medical and dental expenses and qualifying dependent care costs. Watch out, though, FSAs are “use-it-or-lose-it” accounts-you don’t want to set aside more than what you’ll likely have in qualifying expenses for the year.

Married couples who both have access to FSAs will also need to decide whose FSA to use. If one spouse’s salary is likely to be higher than what’s known as the FICA wage limit (which is $106,800 for this year and will likely be somewhat higher next year) and the other spouse’s will be less, the one with the smaller salary should fund as much of the couple’s FSA needs as possible. The reason is the 6.2% social security tax levy for 2012 is set to stop at the FICA wage limit (and doesn’t apply at all to money put into an FSA). Thus, for example, if one spouse earns $115,000 and the other $40,000 and they want to collectively set aside $5,000 in their FSAs, they can save $310 (6.2% of $5,000) by having the full amount taken from the lower-paid spouse’s salary versus having 100% taken from the other one’s wages. Of course, either way, the couple will also save approximately $1,400 in income and Medicare taxes because of the FSAs.

If you currently have a healthcare FSA, make sure you drain it by incurring eligible expenses before the deadline for this year. Otherwise, you’ll lose the remaining balance. It’s not that hard to drum some things up: new glasses or contacts, dental work you’ve been putting off, or prescriptions that can be filled early. Although, over-the-counter drugs (e.g., aspirin and antacids) no longer qualify for reimbursement by healthcare FSAs, bandages and medical equipment (e.g., thermometers and blood pressure monitoring devices) do qualify.

Adjust Your Federal Income Tax Withholding. If it looks like you are going to owe income taxes for 2011, consider bumping up the Federal income taxes withheld from your paychecks now through the end of the year. When you file your return, you will still have to pay any taxes due less the amount paid in. However, as long as your total tax payments (estimated payments plus withholdings) equal at least 90% of your 2011 liability or, if smaller, 100% of your 2010 liability (110% if your 2010 adjusted gross income exceeded $150,000; $75,000 for married individuals who filed separate returns), penalties will be minimized, if not eliminated.

Don’t Overlook Estate Planning

For 2011 and 2012, the unified federal gift and estate tax exemption is a relatively generous $5 million. However, the exemption will drop back to only $1 million in 2013 unless Congress takes action. In addition, the maximum federal estate tax rate for 2011 and 2012 is 35%. For 2013 and beyond, it is scheduled to rise from the current 35% to a painfully high 55%. Therefore, planning to avoid or minimize the federal estate tax should still be part of your overall financial game plan. Even if you already have a good plan, it may need updating to reflect the current $5 million exemption. Contact us for more information on the best ways to minimize estate taxes for someone in your situation.

Conclusion

Through careful planning, it’s possible your 2011 tax liability can still be significantly reduced, but don’t delay. The longer you wait, the less likely it is that you’ll be able to achieve a meaningful reduction. The ideas discussed in this letter are a good way to get you started with year-end planning, but they’re no substitute for personalized professional assistance. Please don’t hesitate to call us with questions or for additional strategies on reducing your tax bill. We’d be glad to set up a planning meeting or assist you in any other way that we can.  

Contact Us

Circular 230 Notice: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

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By Editor, July 7, 2011

The recent storms have made the tax treatment of losses, and recoveries related to such events an important topic.  Special tax treatment is provided for Federally Declared Disaster Areas, including an option to claim the loss deduction on the 2010 (prior year) tax return and exclusion from taxation of Qualified Disaster Relief Payments.

The following counties in Alabama have been determined to be Federally Declared Disaster Areas as a result of the recent storms:

Autauga, Bibb, Blount, Calhoun, Chambers, Cherokee, Chilton, Choctaw, Clarke, Colbert, Coosa, Cullman DeKalb, Elmore, Escambia, Etowah, Fayette, Franklin, Greene, Hale, Jackson, Jefferson, Lamar Lauderdale, Lawrence, Limestone, Madison, Marengo, Marion, Marshall, Monroe,  Morgan, Perry, Pickens, Shelby, St. Clair, Sumter, Talladega, Tallapoosa, Tuscaloosa, Walker, Washington, and Winston.

The IRS provides the following information regarding casualty losses:

Casualty Losses – Definition

A casualty is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual.

• A sudden event is one that is swift, not gradual or progressive.
• An unexpected event is one that is ordinarily unanticipated and unintended.
• An unusual event is one that is not a day-to-day occurrence and that is not typical of the activity in which you were engaged.

Casualty Losses – Disaster Loss

A disaster loss is a casualty loss that occurred in an area determined by the President of the United States to warrant federal disaster assistance. These places are known as “Federally Declared Disaster Areas”.

Casualty Losses – Loss Proof

The following is information needed to support a casualty loss claim:

• The type of casualty (car accident, fire, storm, etc.) and when it occurred.
• That the loss was a direct result of the casualty.
• That you were the owner of the property, or if a lessee, that you were contractually liable for the damage.
• Whether a claim for reimbursement exists for which there is a reasonable expectation of recovery.
• Documentary evidence to support the claimed allowable loss.

Casualty Losses – To Prove a Loss

Records may have to be reconstructed. The information gathered will be used for tax purposes, as well as insurance reimbursement.

Casualty Losses – Claiming Disaster Losses on a Return

• Affected taxpayers in a Federal Disaster Area have the option of claiming disaster-related casualty losses on their federal income tax return either in the tax year the casualty occurred or the immediate preceding tax year.
• Depending on when the disaster occurred, claiming the loss on an original or amended return for last year may get the taxpayer an earlier refund. But, waiting to claim the loss on this year’s return could result in a greater tax saving, depending on other income factors.

Casualty Losses – Pub 547 and Pub 584

• Individuals may deduct personal property losses that are not covered by insurance or other reimbursements, but they must first subtract $100 for each casualty event and then subtract ten percent of their adjusted gross income from their total casualty losses for the year.
• Details on figuring a casualty loss deduction can be found in IRS Publication 547, Casualty, Disasters and Thefts.
• Publication 584, Casualty, Disaster and Theft Loss Workbook is designed to help you figure loss on personal-use property. It contains schedules to help you compute loss on your main home, personal property and your vehicles. However, the schedules are for information purposes only. You must file Form 4684 to report your loss on Form 1040.

Casualty Losses – Determination

To determine the amount of casualty loss to claim for damaged or destroyed property, you must:

• Determine the adjusted basis of the property before the disaster.
• Determine the decrease in Fair Market Value (FMV) of the property as a result of the disaster.
• Then, from the smaller of the adjusted basis or the FMV,
• Subtract any insurance or other reimbursement received.
• All individual losses are subject to:
  • 2% AGI limit if used for business by employee.
  • $100 deductible per event.
  • 10% AGI limit per annum.

Casualty Losses – Federally Declared Disaster Areas

In any federally-declared disaster area:

• No gain is recognized on any insurance proceeds received for “unscheduled” personal property that was part of the contents of a main home.
• Payments for the home and any scheduled property are treated as one payment. Any of this money used to replace any type of replacement property is not a recognized gain.
• Disaster relief payments or assistance do not reduce the casualty loss unless they replace lost or destroyed property.
• Disaster unemployment payments are unemployment income and are taxable.
• Post-disaster grants are generally not included in income. See IRC 139.  However, do not include as casualty losses any amounts covered by the grant payments.
• Taxpayers have the option to claim disaster-related casualty losses for either the year of occurrence or the prior year.  However, the State of Alabama allows a claim for the loss only in the year the loss occurs.
• Taxpayers should put the assigned Disaster Designation in red ink at the top of their tax forms. [For example, “Alabama/ Severe Storms, Tornadoes, Straight-line Winds and Flooding.” ]
• Taxpayers should include in income:
  • Temporary living payments from insurance that are in excess of the actual increase in temporary expenses.
  • The excess goes on line 21 of Form 1040.

Gains on Casualty Losses

If you receive an insurance payment or other reimbursement in excess of the adjusted basis of damaged or destroyed property you will have a gain:

• The gain is the amount received minus the adjusted basis in the property.
• If your main home is destroyed and the insurance proceeds result in a gain:
• You can treat this as a sale of residence subject to the same rules.
• If the home was not used or owned for 2 of the last five years a reduced maximum gain exclusion will apply.
• If located in a Federally Declared Disaster Area, you can postpone any “recognized” gain on your main home if you buy a new home within 4 years of the end of the year the disaster occurred, or
• You can recognize the gain and report it.
• You do not have to recognize gain on destroyed/damaged business property if it is replaced within two years of the end of the tax year in which the gain is realized.
• If received payment in 2011 resulting in a gain, you must replace the property prior to 1/1/2014 to defer the gain. 
• You cannot postpone the gain if you buy replacement property from a related party. This applies to:
  • C Corps
  • Partnerships in which more than 50% of the capital or profits is owned by a C Corp
  • All others if the total realized gain for the year is over $100,000.
• To defer the gain:
  • You must buy property specifically to replace the damaged or destroyed property in order to defer the gain.
  • The basis of the replacement property will be the adjusted basis of the property being replaced.

Reporting Casualty Gains/Losses

Report loss on return for year it occurred. If the event took place in a federally declared disaster, you can amend the prior year return.

The election to amend must be made by:

• Due date (without extensions) for filling your income tax return for the tax year in which the disaster actually occurred.
• Due date (with extensions) for filing the return for the preceding tax year.
• Once the election is made, it can be revoked within 90 days of making the election. The taxpayer must:
  • Return any refund or credit received from making the choice.
  • If revoked prior to getting a refund, must return refund within 30 days of receiving it for the revocation to be effective. 

Individual Returns:

• Losses go on Form 4684 and carry to Schedule A.
• Gains go on Form 4684 and carry to Schedule D.
• Includes losses on income-producing property and property used in performing services as an employee (held less than one year).
• Have the option to claim disaster-related casualty losses for either the year of occurrence or the prior year.

Business and income producing property:

• Losses are reported on Form 4684 and carry to various forms.
• Business use of home carries to Form 8829
• .Other business property carries to Form 4797.

Rental Properties:

• Report on Form 4684 and then on Form 4797.
• Have 2 years from the close of tax year when you realize the gain to replace the property and defer the gain.
• Losses are not limited by Form 8582.

Insurance Reimbursement after filing:

• If less than expected (and accounted for on casualty loss) include the difference as a loss on the return for the year when you can reasonably say you’re not getting any more money.
• If greater than expected (and accounted for on casualty loss) include the difference as income in the year received.

Reporting Casualty Gains/Losses –Net Operating Losses

• Individual or Business casualty losses can generate Net Operating Losses (NOL).
• NOLs generated by casualty losses can be carried back or forward the same as any other NOL.

Reporting Casualty Gains/Losses -What’s Not Included

Losses do not include:

• A reduction in profits or
• Loss of income.

The recent storms have been traumatic for many.  There is some tax relief to assist with recovery from these disasters.  Please contact us and we will help you take full advantage of the available tax relief.

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By Editor, March 4, 2011

Background

The Self-employed Health Insurance Deduction has long been available for the health insurance of the self-employed individual, his or her spouse, and any dependent children. But, there are a number of important taxpayer-friendly developments for 2010, including a surprising change in interpretation by the IRS.

IRC Sec. 162(l)(2) allows self-employed proprietors and partners, and more-than-2% S shareholders treated as partners for fringe benefits, to deduct 100% of their health insurance as a page 1, for-AGI income tax deduction. To be eligible for this deduction, the taxpayer must have a health insurance plan that can be considered as associated with a business activity. Also, the taxpayer must not be eligible to participate in a health insurance plan that is subsidized by any other employer. The deduction is limited to the taxpayer’s self-employment income, or in the case of an S shareholder, the wages subject to payroll taxes.

Nondependent Children under Age 27 Can Now Be Covered

One of the features of the Health Care legislation passed last March provides that effective as of 3/30/10, an employee may receive tax-free treatment for employer-provided health insurance for a child who has not attained age 27 by the end of the year, regardless of whether the child is eligible as a tax return dependent. Prior to this legislation, an employee would have had taxable compensation to the extent an employer paid for health insurance for a nondependent child.

This legislation made a corresponding change to the self-employed health insurance deduction of a self-employed taxpayer. If a self-employed individual pays the health insurance premium for a nondependent child who has not attained the age of 27 by 12/31/10, premiums paid after 3/30/10 are includable in the self-employed health insurance deduction.

Example 1: Phil, a self-employed proprietor, has been claiming the self-employed health insurance deduction for his family. The health policy covers himself, his spouse, and their 20 year-old dependent daughter, a college student. Phil’s older child, Flip, age 25, was recently laid off from his W-2 job in a nearby community and is again living at home. Phil is helping Flip by paying his separate health insurance policy and also covering a few other essential expenses. Beginning 3/30/10, Phil may include Flip’s health insurance premiums in computing the self-employed health insurance deduction on his Form 1040 .

Medicare Part B Premiums Can Count as Part of the Deduction

For several years, the IRS instructions to Form 1040, for the self-employed health insurance deduction line on page 1, have stated at that Medicare Part B premiums could not be treated as part of the deduction. Of course, this guidance was only applicable to someone over age 65 and older enrolled in Medicare who also had self-employment income. But many self-employed taxpayers stay active past age 65.

Surprisingly, the 2010 Form 1040 instructions, at line 29, now state “Medicare B premiums can be used to figure the deduction.”

We have not seen any other IRS guidance explaining this change in position. Earlier guidance on this point was informal: IRS instructions, an IRS Publication, and a 1995 Field Service Advisory memo (FSA 3042, 12/19/95). However, the current Form 1040 instructions can be relied upon, and apparently reflect an updated position of the IRS. Accordingly, the Medicare B premium should be claimed as part of the line 29 self-employed health insurance deduction beginning in 2010.

The Medicare B premium amount, of course, is disclosed on the Form SSA-1099 . For the last several years, the Medicare B premiums assessed by the Social Security Administration have been income-sensitive. For 2010, the annual amount ranges from approximately $1,300 to $4,200. Further, if both spouses are enrolled in Medicare, these amounts will generally be doubled.

Example 2: Ed and Edna, each age 67, both are enrolled in Medicare and receiving social security retirement benefits. Ed is still active as a self-employed partner in the farming partnership with their two sons. While Ed’s share of the partnership K-1 self-employment income is not large, he receives substantial rental income from the partnership for the use of his land, and he and Edna report a substantial AGI in their Form 1040. Their Medicare B premiums withheld from their social security benefits were the maximum in 2010 of $4,243 each. In preparing their Form 1040 for 2010, the IRS instructions indicate that Ed and Edna may claim the Medicare Part B premiums of $8,486 as additional self-employed health insurance.

For 2010 Self-employed Health Insurance

Is Deductible for SE Tax Purposes

In the September Small Business Jobs Act, Congress also adjusted the self-employed health insurance deduction in another manner. The legislation amended IRC Sec. 162(l)(4) to allow the deduction to be claimed both for income tax purposes and self-employment tax purposes in 2010. Previously, of course, the health insurance deduction had only been allowable for the income tax computation.

For 2010, this SE tax break makes the ability to claim post-3/30/10 health insurance for nondependent children (who do not attain age 27 by 12/31/10) more beneficial, and also makes the Medicare B premium deduction of greater value.

Other Implications of Reduced Self-employment Income in 2010

Does the reduction in self-employment income for 2010, because of the one-year deductibility of self-employed health insurance premiums, also affect other calculations driven by self-employment (SE) income? For example, a self-employed taxpayer’s earnings for qualified retirement plan purposes are based on SE income. So, for 2010, must SE income for this purpose be reduced by the health insurance deduction? And, the self-employed health insurance deduction itself is limited to the amount of the taxpayer’s SE income. Do we need to do a dreaded simultaneous equation to determine the health insurance deduction if SE income was low?

Here’s our analysis of these questions:

1. SE Income for Qualified Retirement Plan and IRA Funding. For both qualified plan and IRA purposes, earned income is defined by reference to IRC Sec. 401(c)(2) . In turn, IRC Sec. 401(c)(2) refers to net earnings from self-employment as defined in IRC Sec. 1402(a) . If the story ended here, we would need to reduce self-employed earnings for retirement plan funding in 2010 by the health insurance deduction. But the Committee Report to the legislation enacting the one year cut in SE income for health insurance says that “It is intended that earned income within the meaning of section 401(c)(2) be computed without regard to this deduction for the cost of health insurance.” It goes on to note that a technical correction to the legislation may be needed. As a result, SE income for retirement plan funding in 2010 should not be reduced for the health insurance deduction.

Income Limit for Self-employed Health Insurance Deduction. We won’t bore you with the citations on this one, as it is also addressed directly in the Committee Report of the September legislation. That language states that “earned income for purposes of the limitation applicable to the health insurance deduction is computed without regard to this deduction.” So again, we use SE income without the health insurance deduction as the business net income limit for this health insurance deduction (and no need to remember how to calculate a simultaneous equation!).