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Annette Nellen

Client service idea for the 2012 filing season

Help make sense of tax reform proposals.

April 12, 2012
by Annette Nellen, Esq. CPA

With a presidential race heating up, 60 tax breaks that expired at the end of 2011 and more to expire at the end of 2012, talk of lowering the corporate tax rate, and a growing national debt, “frameworks” and proposals for tax reform seem to abound. While the “what” and “when” of tax reform are uncertain, there are opportunities to provide information to clients to help them understand some of the proposals.

Preparers should consider offering clients information on how some of the proposed changes may affect their tax liabilities. While the calculations based on possible reforms would be rough estimates because many proposals are really just “frameworks” or principles, rather than final legislative language, and enactment is uncertain, the information does provide a starting point for tax planning discussions with clients. Any tax projections, of course, should be accompanied with appropriate caveats and related information on how individuals might be indirectly affected by possible reforms.

This article presents one tax reform proposal with suggestions on how it can be used to help clients understand its effect on their tax liabilities, and what caveats and cautions should accompany the numbers.

S. 727: Bipartisan Tax Fairness and Simplification Act

S. 727 (112th Congress), introduced by Sens. Ron Wyden, D-Ore., and Dan Coats, R-Ind., calls for reforms to both the individual and corporate income taxes. Per the sponsors, the proposal is intended to make the income tax “simpler, fairer, and more fiscally responsible” (157 Cong. Rec. S2132 (4/5/11)).

The chart below can be used to illustrate how the client’s 2011 tax return items would be taxed under S. 727 . For example, under the proposal, capital gains and dividends would be taxed as ordinary income, but 35% of those amounts would be excluded from income before the higher rate was applied.


2011

2011 computed under
S. 727

Taxable income

 

+ Qualified dividends

 

+ Capital gains

 

+ Miscellaneous itemized deduction amount (S. 727 eliminates this deduction)

 

- Standard deduction adjustment (S. 727 increases the standard deduction for each filing status when it is claimed instead of itemized deductions)

 

+ Amounts excluded under current law (these items would no longer be excluded from income):

 

Certain employee achievement awards (Sec. 74(c))

 

Group term life insurance for employees (Sec. 79)

 

Meals and lodging furnished for convenience of employer (Sec. 119)

 

Cafeteria plan benefits (Sec. 125)

 

Fringe benefits (Sec. 132 other than subsection (a)(5) for qualified transportation benefit)

 

Earned income of U.S. citizens or residents living abroad (Sec. 911)

 

Certain allowances (Sec. 912)

 

Tax-exempt bond interest (a new Code section would include state and local bond  interest in income but also provide a partially offsetting tax credit)

 

+ Moving expense deduction would be repealed (Sec. 217)

 

- 35% of qualified dividends and gains from capital assets held over six months

 

- 35% of other capital gains (limited to $500,000 of such gains)

 

Revised taxable income

 

S. 727 tax rate structure (three progressive rates) (note that the married filing jointly tax bracket is double that for single filers):


Filing status:
Taxable income
category:

Married Filing Jointly

Head of Household

Single

15% of amount not over

$75,000

$56,250

$37,500

25% of amount over
+

$75,000
$11,250

$56,250
$8,437.50

$37,500
$5,625

35% of amount over
+

$140,000
$27,500

$105,000
$20,625

$70,000
$13,750

Adjustments to tax to derive a rough estimate of the individual’s S. 727 tax liability:

  • Earned income tax credit
  • Dependent care credit for 2011
  • Child credit for 2011
  • Foreign tax credit
  • 25% of state/local bond interest (nonrefundable credit)

S. 727 would repeal the alternative minimum tax. The proposal would also consolidate education provisions and create new retirement savings accounts and American dream accounts to provide opportunities for tax-free savings. It includes a few other adjustments, such as to Sec. 501(c)(9) voluntary employees’ beneficiary associations, that are unlikely to affect many individuals. The above calculations are intended to provide a rough estimate of the tax effect of S. 727. To incorporate all elements of the proposal, read the complete text of S. 727.

Additional information for clients

In addition to the estimated tax liability under the reform proposal, the following information for both the current system and the proposed reform can be useful:

  • The marginal tax rate (the rate that applies to the next dollar of income)
  • The average or effective tax rate (tax divided by taxable income)

In addition, let clients know how planning might change under the proposal. For example, how does the proposal affect retirement plans, capital gains, tax-exempt interest income, employer-provided benefits, and itemized deductions? S. 727 would repeal the miscellaneous itemized deduction. Employees with significant unreimbursed employee business expenses may want to renegotiate their wage and expense plan with their employers, if possible, to reduce the impact of the lost deduction.

Caveats and cautions
Tax reform proposals are just that—proposals. Thus, the details might change, and some details may be missing. For example, S. 727 suggests that some credits may be repealed, but does not specify any to be repealed (see Section 115 of S. 727).

The impact of a proposal on one type of taxpayer can be affected by how the proposal changes the tax liabilities of other taxpayers. For example, if a proposal lowers the corporate rate below the top individual rate, some passthrough entities might convert to corporate form, which would then change the taxable income of the owners. Also, removing the exclusion for certain fringe benefits may result in employers’ no longer offering these benefits, but it would be difficult to determine the effect on employee wages and out-of-pocket expenses. Be sure clients are aware of these caveats.

To eliminate any exposure to penalties for improper use of taxpayer information and to be sure they want an estimate of the effect of tax reform proposals on their tax liabilities, it is a good idea to obtain clients’ permission to use current tax return data for the projections. (For more information on this, see Secs. 6713 and 7216 as well as AICPA resources.)

Other reform proposals

This article examines just one reform proposal to illustrate how a practitioner can estimate a tax liability. Such an estimate can serve a dual purpose of helping individuals better understand reforms and providing an opportunity to serve clients better by illustrating the tax effect of possible legislative changes. Similar calculations can be made for President Barack Obama’s and others’ proposals.

For a list of key proposals as well as a table listing elements of reform from the Obama administration, see the author’s tax reform website. Calculation templates for a few more reform proposals will be included in the author’s presentation at the AICPA Small Business Practitioners Tax Conference co-located with the new AICPA Conference on Tax Controversy on May 2–4, which will also include tax updates and tips relevant for 2011 returns due (on extension) by Oct. 15, 2012.

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Annette Nellen, Esq., CPA, is a tax professor and director of the MST Program at San José State University. Nellen is an active member of the tax sections of the AICPA, ABA and California State Bar. She chairs the AICPA’s Individual Income Taxation Technical Resource Panel. She has several reports on tax reform and a blog.