The Fiscal Cliff

As the New Year approaches, we are in the midst of a highly uncertain period from a tax planning perspective. The “Bush-era tax cuts,” which I am sure everyone has heard of at this point, are set to expire on January 1, 2013. This means that everyone’s effective tax rates will increase. This newsletter is intended to help you mitigate the uncertainty surrounding these looming changes.

Changes Set to Occur on January 1, 2013

• An increase in the tax rate for the top income tax bracket from 35% to 39.6%.

• Marriage tax penalty relief for those in the 15% tax bracket will expire.

• An increase in the long term capital gains tax from 15% to between 18% and 20%.

• The preferential 15% tax rate for qualified dividends is set to expire, which means that they will be treated as ordinary income and taxed at each person’s marginal income tax rate.

• A decrease in the expense limit for new equipment purchases under Section 179 from $139,000 to $25,000. The 50-percent first-year bonus depreciation deduction is also set to expire for most types of assets.

• A reduction in itemized deductions, a phase-out of personal exemptions, and numerous other changes to deductions, credits, etc., including:
– Education expenses. The American Opportunity Tax Credit is set to expire. In 2012, the credit can be up to $2,500.
– Flexible Spending Arrangements. Contribution limits on FSAs under a cafeteria plan will be decreased to $2,500.
– Medical expenses. The threshold for deducting unreimbursed medical expenses will increase from 7.5% to 10% of adjusted gross income.

• The extremely favorable gift tax laws are scheduled to expire. The lifetime gift exclusion is set to decrease from $5.12 million to $1 million.

• An increase in the top estate tax rate from 35% to 55%, coupled with a decrease in the exemption amount from $5 million to $1 million.

• A new Medicare contribution tax which imposes a 3.8% surtax on certain unearned income (including interest, capital gains, and dividends) for those with adjusted gross income above $200,000 ($250,000 for married filing jointly). In addition, an additional 0.9% tax will be imposed on wages in excess of $200,000 ($250,000 for married filing jointly). These items are part of the Patient Protection and Affordable Care Act (commonly referred to as “ObamaCare”). Please note that ObamaCare will be enacted regardless of whether the Bush-era tax cuts are extended.

How You Can Prepare

• Adjust Your Income Tax Withholding. One strategy to avoid being surprised in 2013 is to adjust your income tax withholding. If the tax rates go up, so should your withholding. Keep in mind that the current 2% payroll tax (Social Security and Medicare) holiday is also scheduled to expire.

• Consider Recognizing Income Now, Rather Than Deferring to 2013. For most taxpayers, this should NOT be done until it is certain that no new legislation will be enacted prior to year-end. Taxpayers may want to recognize income in 2012 when lower tax rates are available, rather than deferring it to a future year. Also, higher income taxpayers should consider delaying deductions until 2013.

• Employee Bonuses Should Be Paid Prior to Year-end. To avoid increases in income tax and payroll tax and the additional Medicare taxes imposed by ObamaCare, employers should consider paying annual bonuses, as well as allowing the recognition of income on stock compensation plans, prior to December 31, 2012.

• New Equipment. Businesses should consider accelerating equipment purchases into 2012 to take advantage of the still generous Code 179 expensing and the bonus depreciation deduction.

• Harvesting Losses. Now is also a good time to consider loss-harvesting strategies to offset current gains or to accumulate losses to offset future gains (which may be taxed at a higher rate). Also, do not forget about the wash-sale rules.

• Gifts. The annual gift tax exclusion is $13,000 for 2012. Married couples may make combined tax-free gifts of $26,000 to each recipient. Use of the lifetime gift tax exclusion amount ($5.12 million for 2012) should also be considered.

• Charitable Giving. Taxpayers should consider accelerating any anticipated charitable contributions into 2012, prior to the return of the “Pease Limitation,” which generally requires higher income individuals to reduce their tax deductions for charitable contributions.

• Medical Expenses. While many medical expenses cannot be timed for tax deduction purposes, batching expenses into 2012, when the deduction threshold is still 7.5%, may make it more likely that the expenses will exceed that threshold.

• State Taxes. Many states are increasing their income tax rates in 2013. For example, New York has approved a supplemental tax beginning in the New Year. Fortunately, there are also several potential new tax credits for 2013. In New York, there is talk of a tax credit for angel investments into start-up companies.

• Mortgage Refinancing. This is not really a tax issue, but it’s still good advice: consider refinancing the mortgages on your primary and secondary homes. Even if you refinanced in the last 6-12 months, there may be an opportunity to lower your monthly payments as interest rates have dropped significantly in 2012.

Looking Forward

Although President Obama has claimed that he is “not wedded” to any particular provision in his most recently proposed tax plan, an actual compromise before year-end appears unlikely. Nevertheless, we can still take steps to prepare ourselves for the New Year.

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Audit Red Flags

The IRS audits approximately 1% of all individual tax returns. This is one instance where taxpayers might benefit from a lack of government funding – the IRS simply does not have the resources to examine every tax return (last year over 144 million individual income tax returns were filed).

That being said, the chances of being audited increase depending upon various factors, including your income level, whether you failed to report taxable income, the types of deductions or losses you claimed, the type of business in which you’re engaged and whether you own any foreign assets. Mathematical errors may draw IRS scrutiny, but they will rarely lead to a full-blown exam. Here is a list of red flags that may increase your chances of drawing unwanted attention from the IRS:

1. High income tax bracket

Although the overall individual audit rate is about 1.11%, the odds increase dramatically for higher-income filers. IRS statistics show that people with incomes of $200,000 or higher had an audit rate of 3.93%, or one out of slightly more than every 25 returns. Report $1 million or more of income? There’s a one-in-eight chance your return will be audited. The audit rate drops significantly for filers making less than $200,000: Only 1.02% of such returns were audited during 2011, and the vast majority of these exams were conducted by mail. We’re not saying you should try to make less money — everyone wants to be a millionaire. Just understand that the more income shown on your return, the more likely it is that you’ll be hearing from the IRS.

2. Failing to report all taxable income

The IRS gets copies of all 1099s and W-2s you receive, so make sure you report all required income on your return. IRS computers are pretty good at matching the numbers on the forms with the income shown on your return. A mismatch sends up a red flag and causes the IRS computers to spit out a bill. If you receive a 1099 showing income that isn’t yours or listing incorrect income, get the issuer to file a correct form with the IRS.

3. Taking large charitable deductions

We all know that charitable contributions are a great write-off and help you feel great about yourself. However, if your charitable deductions are disproportionately large compared with your income, it raises a red flag. That’s because IRS computers know what the average charitable donation is for folks at your income level. Also, if you don’t get an appraisal for donations of valuable property, or if you fail to file Form 8283 for donations over $500, the chances of audit increase. And if you’ve donated a conservation easement to a charity, chances are good that you’ll hear from the IRS. Be sure to keep all your supporting documents, including receipts for cash and property contributions made during the year, and abide by the documentation rules. And attach Form 8283 if required.

4. Claiming the home office deduction

The IRS is drawn to returns that claim home office write-offs because it has found great success knocking down the deduction and driving up the amount of tax collected for the government. If you qualify, you can deduct a percentage of your rent, real estate taxes, utilities, phone bills, insurance and other costs that are properly allocated to the home office. However, to take this write-off, you must use the space exclusively and regularly as your principal place of business. That makes it difficult to successfully claim a guest bedroom or children’s playroom as a home office, even if you also use the space to do your work. “Exclusive use” means that a specific area of the home is used only for trade or business, not also for the family to watch TV at night. Don’t be afraid to take the home office deduction if you’re entitled to it. Risk of audit should not keep you from taking legitimate deductions.

5. Claiming rental losses

Normally, the passive loss rules prevent the deduction of rental real estate losses. But there are two important exceptions. If you actively participate in the renting of your property, you can deduct up to $25,000 of loss against your other income. But this $25,000 allowance phases out as adjusted gross income exceeds $100,000 and disappears entirely once your AGI reaches $150,000. A second exception applies to real estate professionals who spend more than 50% of their working hours and 750 or more hours each year materially participating in real estate as developers, brokers, landlords or the like. They can write off losses without limitation. But the IRS is scrutinizing rental real estate losses, especially those written off by taxpayers claiming to be real estate pros. The agency will check to see whether they worked the necessary hours, especially in cases of landlords whose day jobs are not in the real estate business.

6. Deducting business meals, travel and entertainment

Schedule C is a treasure trove of tax deductions for self-employed people. But it’s also a gold mine for IRS agents, who know from experience that self-employed people sometimes claim excessive deductions. Big deductions for meals, travel and entertainment are always ripe for audit. A large write-off here will set off alarm bells, especially if the amount seems too high for the business. Agents are on the lookout for personal meals or claims that don’t satisfy the strict substantiation rules. To qualify for meal or entertainment deductions, you must keep detailed records that document for each expense the amount, the place, the people attending, the business purpose and the nature of the discussion or meeting. Also, you must keep receipts for expenditures over $75 or for any expense for lodging while traveling away from home.

7. Claiming 100% business use of a vehicle

When you depreciate a car, you have to list on Form 4562 what percentage of its use during the year was for business. Claiming 100% business use of an automobile is a major red flag for IRS auditors. They know that it’s extremely rare for an individual to actually use a vehicle 100% of the time for business, especially if no other vehicle is available for personal use. IRS agents are trained to focus on this issue and will scrutinize your records. Make sure you keep detailed mileage logs and precise calendar entries for the purpose of every road trip. Sloppy recordkeeping makes it easy for the revenue agent to disallow your deduction. As a reminder, if you use the IRS’ standard mileage rate, you can’t also claim actual expenses for maintenance, insurance and other out-of-pocket costs.

8. Writing off a loss for a hobby activity

Your chances of “winning” the audit lottery increase if you have wage income and file a Schedule C with large losses. And if the loss-generating activity sounds like a hobby — horse breeding, car racing and such — the IRS pays even more attention. Agents are specially trained to sniff out those who improperly deduct hobby losses. Large Schedule C losses are always audit bait, but reporting losses from activities in which it looks like you’re having a good time all but guarantees IRS scrutiny.

9. Running a cash business

Small business owners, especially those in cash-intensive businesses — think taxis, car washes, bars, hair salons, restaurants and the like — are a tempting target for IRS auditors. Experience shows that those who receive primarily cash are less likely to accurately report all of their taxable income. The IRS has a guide for agents to use when auditing cash-intensive businesses, telling how to interview owners and noting various indicators of unreported income.

10. Failing to report a foreign bank account

The IRS is intensely interested in people with offshore accounts, especially those in tax havens, and tax authorities have had success getting foreign banks to disclose account information. The IRS has also used voluntary compliance programs to encourage folks with undisclosed foreign accounts to come clean — in exchange for reduced penalties. The IRS has learned a lot from these programs and has collected a boatload of money ($4.4 billion so far).
Failure to report a foreign bank account can lead to severe penalties, and the IRS has made this issue a top priority. Make sure that if you have any such accounts, you properly report them when you file your return.

11. Engaging in currency transactions

The IRS gets many reports of cash transactions in excess of $10,000 involving banks, casinos, car dealers and other businesses, plus suspicious-activity reports from banks and disclosures of foreign accounts. A report by Treasury inspectors concluded that these currency transaction reports are a valuable source of audit leads for sniffing out unreported income. The IRS agrees, and it will make greater use of these forms in its audit process. So if you make large cash purchases or deposits, be prepared for IRS scrutiny. Also, be aware that banks and other institutions file reports on suspicious activities that appear to avoid the currency transaction rules (such as persons depositing $9,500 in cash one day and an additional $9,500 in cash two days later).

12. Taking higher-than-average deductions

If deductions on your return are disproportionately large compared with your income, the IRS may pull your return for review. But if you have the proper documentation for your deduction, don’t be afraid to claim it. There’s no reason to ever pay the IRS more tax than you actually owe.

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Tax Changes for 2012


The current tax rate structure ranging from 10% to 35% remains the same for 2012, but tax-bracket thresholds increase for each filing status. Standard deductions and the personal exemption have also been adjusted upward to reflect inflation. For details see Tax Brackets and Exemptions for 2012 below.

Alternate Minimum Tax (AMT)
AMT limits decrease for all taxpayers at $33,750 for singles, $45,000 for married filing jointly, and $22,500 for married filing separately.

“Kiddie Tax”
For years beginning in 2012, the amount that can be used to reduce the net unearned income reported on the child’s return that is subject to the “kiddie tax,” is $950. The same $950 amount is used to determine whether a parent may elect to include a child’s gross income in the parent’s gross income and to calculate the “kiddie tax”. For example, one of the requirements for the parental election is that a child’s gross income for 2012 must be more than $950 but less than $9,500.

For 2012, the net unearned income for a child under the age of 19 (or a full-time student under the age of 24) that is not subject to “kiddie tax” is $1,900, the same as 2011.

Health Savings Accounts (HSAs)
Contributions to a Health Savings Account (HSA) are used to pay current or future medical expenses of the account owner, his or her spouse, and any qualified dependent. Medical expenses must not be reimbursable by insurance or other sources and do not qualify for the medical expense deduction on a federal income tax return.

A qualified individual must be covered by a High Deductible Health Plan (HDHP) and not be covered by other health insurance with the exception of insurance for accidents, disability, dental care, vision care, or long-term care.

For calendar year 2012, a qualifying HDHP must have a deductible of at least $1,200 for self-only coverage or $2,400 for family coverage (unchanged from 2011) and must limit annual out-of-pocket expenses of the beneficiary to $6,050 for self-only coverage (up $100 from 2011) and $12,100 for family coverage (up $200 from 2011).

Medical Savings Accounts (MSAs)
There are two types of Medical Savings Accounts (MSAs), the Archer MSA created to help self-employed individuals and employees of certain small employers and the Medicare Advantage MSA, which is actually an Archer MSA as well, and is designated by Medicare to be used solely to pay the qualified medical expenses of the account holder. To be eligible for a Medicare Advantage MSA, you must be enrolled in Medicare and both MSAs require that you are enrolled in a high deductible health plan (HDHP).

Self-only coverage. For taxable years beginning in 2012, the term “high deductible health plan” means, for self-only coverage, a health plan that has an annual deductible that is not less than $2,100 (up $100 from 2011) and not more than $3,150 (up $150 from 2011), and under which the annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits do not exceed $4,200 (up $150 from 2011).

Family coverage. For taxable years beginning in 2012, the term “high deductible health plan” means, for family coverage, a health plan that has an annual deductible that is not less than $4,200 (up $150 from 2011) and not more than $6,300 (up $250 form 2011), and under which the annual out-of-pocket expenses required to be paid (other than for premiums) for covered benefits do not exceed $7,650 (up $250 from 2011).

Eligible Long-Term Care Premiums
Premiums for long-term care are treated the same as health care premiums and are deductible on your taxes subject to certain limitations. For individuals age 40 or less at the end of 2012, the limitation is $350. Persons over 40 but less than 50 can deduct $660. Those over age 50 but not more than 60 can deduct $1,310, while individuals over age 60 but younger than 70 can deduct $3,500. The maximum deduction $4,370 and applies to anyone over the age of 70.

Adoption Assistance Programs
For taxable years beginning in 2012, the amount that can be excluded from an employee’s gross income for the adoption of a child with special needs is $12,650. In addition, the maximum amount that can be excluded from an employee’s gross income for the amounts paid or expenses incurred by an employer for qualified adoption expenses furnished pursuant to an adoption assistance program for other adoptions by the employee is $12,650 (down from $13,360 in 2011).

The amount excludable from an employee’s gross income begins to phase out under for taxpayers with modified adjusted gross income (MAGI) in excess of $189,710 and is completely phased out for taxpayers with modified adjusted gross income of $229,710 or more.

Taxpayers adopting children are eligible for both the adoption credit (see below) and the adoption assistance exclusion of adoption expenses paid for through an employer’s adoption assistance plan. However, the same adoption expense cannot qualify for both the adoption credit and the adoption assistance exclusion.

Foreign Earned Income Exclusion
For taxable years beginning in 2012, the foreign earned income exclusion amount is $95,100, up from $92,900 in 2011.

Estate Tax
For an estate of any decedent dying during calendar year 2012, the basic exclusion amount is $5,120,000, up from $5,000,000 in 2011. Also, if the executor chooses to use the special use valuation method for qualified real property, the aggregate decrease in the value of the property resulting from the choice cannot exceed $1,040,000, up from $1,020,000 for 2011. The maximum tax rate remains at 35%.

Individuals – Tax Credits

Adoption Credit
For taxable years beginning in 2012, the credit allowed for an adoption of a child with special needs is $12,650. For taxable years beginning in 2012, the maximum credit allowed for other adoptions is the amount of qualified adoption expenses up to $12,650. The available adoption credit begins to phase out for taxpayers with modified adjusted gross income (MAGI) in excess of $189,710 and is completely phased out for taxpayers with modified adjusted gross income of $229,710 or more.

Child Tax Credit
For taxable years beginning in 2012, the value used to determine the amount of credit that may be refundable is $3,000.

Earned Income Credit
For tax year 2012, the maximum earned income tax credit (EITC) for low- and moderate- income workers and working families rises to $5,891, up from $5,751 in 2011. The maximum income limit for the EITC rises to $50,270, up from $49,078 in 2011. The credit varies by family size, filing status and other factors, with the maximum credit going to joint filers with three or more qualifying children. In addition, for taxable years beginning in 2012, the earned income tax credit is not allowed if certain investment income exceeds $3,200.

Additional Child Credit
The $1,000 per-child additional child tax credit has been extended through 2012. The credit will decrease to $500 per child in 2013.

Individuals – Education

Hope Scholarship, American Opportunity, and Lifetime Learning Credits
The maximum Hope Scholarship Credit allowable for taxable years beginning in 2012 is $2,500.
The modified adjusted gross income (MAGI) threshold at which the lifetime learning credit begins to phase out is $104,000 for joint filers, up from $102,000, and $52,000 for singles and heads of household, up from $51,000.

Interest on Educational Loans
For taxable years beginning in 2012, the $2,500 maximum deduction for interest paid on qualified education loans begins to phase out for taxpayers with modified adjusted gross income (MAGI) in excess of $60,000 ($125,000 for joint returns), and is completely phased out for taxpayers with modified adjusted gross income of $75,000 or more ($155,000 or more for joint returns).

Individuals – Retirement

Contribution Limits
The elective deferral (contribution) limit for employees who participate in 401(k), 403(b), most 457 plans, and the federal government’s Thrift Savings Plan is increased from $16,500 to $17,000. Contribution limits for SIMPLE plans remain at $11,500. The maximum compensation used to determine contributions increases to $250,000 (up $5,000 from 2011 levels).

Income Phase-out Ranges
The deduction for taxpayers making contributions to a traditional IRA is phased out for singles and heads of household who are covered by a workplace retirement plan and have modified adjusted gross incomes (AGI) between $58,000 and $68,000, up from $56,000 and $66,000 in 2011.

For married couples filing jointly, in which the spouse who makes the IRA contribution is covered by a workplace retirement plan, the income phase-out range is $92,000 to $112,000, up from $90,000 to $110,000. For an IRA contributor who is not covered by a workplace retirement plan and is married to someone who is covered, the deduction is phased out if the couple’s income is between $173,000 and $183,000, up from $169,000 and $179,000.

The AGI phase-out range for taxpayers making contributions to a Roth IRA is $173,000 to $183,000 for married couples filing jointly, up from $169,000 to $179,000 in 2011. For singles and heads of household, the income phase-out range is $110,000 to $125,000, up from $107,000 to $122,000. For a married individual filing a separate return who is covered by a retirement plan at work, the phase-out range remains $0 to $10,000.

Saver’s Credit
The AGI limit for the saver’s credit (also known as the retirement savings contributions credit) for low-and moderate-income workers is $57,500 for married couples filing jointly, up from $56,500 in 2011; $43,125 for heads of household, up from $42,375; and $28,750 for married individuals filing separately and for singles, up from $28,250.


Standard Mileage Rates
The rate for business miles driven is 55.5 cents per mile for 2012, unchanged from the mid-year adjustment that became effective on July 1, 2011.

Section 179 Expense
For 2012 the maximum Section 179 expense deduction for equipment purchases is $139,000 (down from $500,000 in 2011) of the first $560,000 (down from $2 million in 2011) of business property placed in service during the year.

Transportation Fringe Benefits
If you provide transportation fringe benefits to your employees, for tax years beginning in 2012 the maximum monthly limitation for transportation in a commuter highway vehicle as well as any transit pass is $125 (down from $230 in 2011). The monthly limitation for qualified parking is $240 (up from $230 in 2011).

Work Opportunity Credit
The work opportunity credit has been expanded to provide employers with new incentives to hire certain unemployed veterans. Businesses claim the credit as part of the general business credit and tax-exempt organizations claim it against their payroll tax liability. The credit is available for eligible unemployed veterans who begin work on or after November 22, 2011, and before January 1, 2013.

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Cyber Scams on the Rise

The Internal Revenue Service receives thousands of reports each year from taxpayers who receive suspicious emails, phone calls, faxes or notices claiming to be from the IRS. Many of these scams fraudulently use the IRS name or logo as a lure to make the communication appear more authentic and enticing. The goal of these scams – known as phishing – is to trick you into revealing your personal and financial information. The scammers can then use your information – like your Social Security number, bank account or credit card numbers – to commit identity theft or steal your money.

Here are five things the IRS wants you to know about phishing scams.

1. The IRS never asks for detailed personal and financial information like PIN numbers, passwords or similar secret access information for credit card, bank or other financial accounts.

2. The IRS does not initiate contact with taxpayers by email to request personal or financial information. If you receive an e-mail from someone claiming to be the IRS or directing you to an IRS site:

• Do not reply to the message.
• Do not open any attachments. Attachments may contain malicious code that will infect your computer.
• Do not click on any links. If you clicked on links in a suspicious e-mail or phishing website and entered confidential information, visit the IRS website and enter the search term ‘identity theft’ for more information and resources to help.

3. The address of the official IRS website is Do not be confused or misled by sites claiming to be the IRS but ending in .com, .net, .org or other designations instead of .gov. If you discover a website that claims to be the IRS but you suspect it is bogus, do not provide any personal information on the suspicious site and report it to the IRS.

4. If you receive a phone call, fax or letter in the mail from an individual claiming to be from the IRS but you suspect they are not an IRS employee, contact the IRS at 1-800-829-1040 to determine if the IRS has a legitimate need to contact you. Report any bogus correspondence. You can forward a suspicious email to

5. You can help shut down these schemes and prevent others from being victimized. Details on how to report specific types of scams and what to do if you’ve been victimized are available at Click on “phishing” on the home page.

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