Tax Reform Muted the AMT: Holders of Incentive Stock Options, Take Note

Article Highlights

  • Alternative Minimum Tax
  • Deterrent to Tax Shelters
  • Tax Reform Changes
  • Tax Deductions and Preferences
  • Incentive Stock Options
  • Tax Planning Opportunity

Although Congress, as part of the recent tax reform, promised to do away with the alternative minimum tax (AMT), it only did so for C corporations; as a result, the AMT still applies to individuals.

Congress originally developed the AMT in 1969 as a means to prevent high-income individuals from using tax shelters to reduce their taxes. For the AMT, federal income tax is calculated without certain deductions and tax preferences. This tax applies if it is greater than the regularly computed income tax. Although it has since been indexed to inflation, the AMT at one point began to apply to middle-income taxpayers, who are not the intended targets of this punitive tax.

The AMT computation includes a tax-exempt amount, but this amount begins to phase out for taxpayers whose adjusted gross income (AGI) exceeds a certain threshold (depending on their filing status). Although the tax reform did not eliminate the AMT, it did mute that tax considerably by increasing the AMT exemptions and by substantially raising the exemption-phaseout thresholds, as illustrated below. The exemptions and AGI phaseout thresholds will be inflation-adjusted in future years.

AMT EXEMPTIONS ($)
Status20172018
Married Filing Jointly or Surviving Spouse84,500109,400
Single or Head of Household54,30070,300
Married Filing Separately42,25054,700

 

EXEMPTION-PHASEOUT AGI THESHOLDS
Status20172018
Married Filing Jointly or Surviving Spouse160,9001,000,000
Single or Head of Household120,700500,000
Married Filing Separately80,450500,000

These are the tax deductions and preferences that most often affect the average taxpayer:

  • Some itemized deductions are allowed for the regular tax computation but not for the AMT computation.
  • Tier II miscellaneous itemized tax deductions are not allowed for the AMT computation; in addition, for the years 2018 through 2025, they are also not allowed for the regular tax computation. This category primarily includes employee business expenses, investment expenses, and legal fees. As these expenses aren’t currently deductible in either tax calculation, there is no adjustment for the AMT calculation.
  • The AMT computation does not allow the itemized deduction for interest on home-equity debt; such debt also is not deductible in the regular computation through 2025, which eliminates another difference in the two computations.
  • Employee incentive stock option tax preferences are also handled differently in the two computations, as is discussed in more detail later in the post.

As a result of the increased exemptions, the higher AGI thresholds for the exemption phaseout, and the reduction or elimination of differences in deductions, the AMT typically no longer affects average taxpayers.

Incentive stock options – Employers sometimes grant employees qualified stock options (i.e., incentive stock options), as motivation to become more involved in the company’s success and to share in the company’s stock appreciation.

For these options, the employer grants the employee an opportunity to purchase the company’s stock at a preset price on a future date. An option is usually accompanied by a vesting schedule that details the date when the options can be exercised (i.e., when the stock can be purchased). Once the employees has held these shares for more than a year—and for at least two years after the option was granted—any subsequent gains from sales of the stock are subject to the capital-gains tax instead of the ordinary (less favorable) income tax.

The Catch – The catch for incentive stock options is that, in the year when the employee exercises the option and purchases the stock, the difference (often referred to as the “bargain element”) between the stock’s current market value and the price that the employee paid as part of the option is treated as a tax preference. Thus, this difference is added to the employee’s AMT income but is not included in the regular tax income. In the past, this usually triggered the AMT, which meant that the employee had to pay tax on the phantom income in the year of the option, even though there was no actual stock sale. As a result, many employees have shied away from taking full advantage of incentive stock options; rather than holding the stock for the required qualifying period, they have been selling the stock in the year when they exercised the option, resulting in the profit being classified as ordinary income.

(Note that nonqualified stock options are not eligible for the beneficial tax treatment that incentive stock options are afforded. When a nonqualified option is exercised, the bargain element is included in the employee’s wages as ordinary income for the year when the option is exercised. However, this ordinary income is not a preference item for AMT purposes. Most employees who exercise nonqualified stock options immediately sell the stock so that they have money to pay the payroll taxes related to the resulting ordinary income. The paperwork that the employer provides when awarding the option states whether the option is qualified or nonqualified.)

Opportunity – The changes in the AMT present low- to moderate-income taxpayers with an opportunity to exercise incentive stock options without triggering the AMT.

If you hold incentive stock options, it may be possible to develop a plan—perhaps a multiyear plan—that will allow you to exercise your options without incurring phantom income in the AMT calculation. Please call this office for assistance in developing such a plan.

Employees’ Fringe Benefits after Tax Reform

Article Highlights:

  • Qualified Parking
  • Transit Passes
  • Bicycle Commuting
  • Commuting
  • Moving Deduction
  • Achievement Awards
  • Group Term Life Insurance
  • Dependent Care Benefits
  • Qualified Educational Assistance Programs

Tax reform made a lot of changes, some of which impacted employees’ fringe benefits. This article reviews the most frequently encountered fringe benefits, including those that were and were not impacted by tax changes. These changes can affect both a business’s bottom line and its employees’ deductions.

BENEFITS IMPACTED BY TAX REFORM

Qualified Transportation Fringe Benefits – Qualified transportation fringe benefits include parking, transit passes, commuter (van pool) transportation, and bicycle commuting.

  • Qualified parking – The tax-free fringe benefit for qualified parking is still available to employees and is capped at $265 per month for 2019, up from $260 in 2018.
  • Transit Passes – The tax-free fringe benefit for transit passes is also still available to employees, up to $265 per month for 2019, an increase from $260 in 2018.
  • Bicycle Commuting – Unfortunately, tax reform did away with the $20-per-month tax-free reimbursement for the cost of an employee commuting to work on a bicycle.
  • Commuting – Tax reform killed the monthly commuting fringe benefit (which was $260 in 2018) except when necessary for ensuring the safety of an employee. When allowed, the maximum amount is the same as the transit pass fringe benefit.

However, even though they are excludable fringe benefits for employees, after 2017, employers can no longer deduct their expenses for parking or mass transit passes or commuter highway vehicle transportation provided to their employees.

Moving expenses – Before 2018 and after 2025, taxpayers who move because of a change in work location who meet certain distance and time requirements are able to deduct their moving costs in excess of any tax-free reimbursement from their employer. However, that deduction is suspended for 2018 through 2025, and any employer reimbursement is taxable and included in the employee’s W-2.

There is one exception: moving expenses are still deductible for military members on active duty for moves pursuant to military orders.

Achievement awards – Employee achievement awards are excludable from income only to the extent that the award does not exceed $400 for any one employee or $1,600 for a qualified plan award. A qualified plan award means an employee achievement award awarded as part of an established written plan or program of the business that does not discriminate in favor of highly compensated employees.

Tax reform added the provision that to be tax-free, the award must be a tangible item. So awards of the following would be taxable to the employee recipient: cash, cash equivalents, gifts cards, gift coupons, gift certificates (other than if the employer pre-selected or pre-approved a limited selection), vacations, meals, lodging, tickets for theater or sporting events, stock, bonds, or similar items.

BENEFITS NOT IMPACTED BY TAX REFORM

Group Term Life Insurance – The first $50,000 of group term life insurance coverage provided by an employer is a tax-free fringe benefit that does not add anything to the employee’s overall tax bill. But the cost of employer-paid group term coverage in excess of $50,000 is treated as taxable income and added to the employee’s W-2. The cost of that insurance coverage is based on an IRS table and is frequently higher than the employer is actually paying for the insurance, which creates phantom income.

For older employees, the after-tax cost of the additional coverage frequently exceeds the cost for an individual term policy. It may be appropriate for certain employees to only utilize the first $50,000 in coverage and acquire an individual policy for any additional needed coverage.

Dependent Care Benefits – Employers can establish dependent care assistance plans for the exclusive benefit of their employees. The payments received under the plan that are used by employees to pay dependent care expenses are excludable from employees’ income, up to the lower of:

  1. The employee’s earned income (for married employees, this is the earned income of the lower-paid spouse) or
  2. $5,000 ($2,500 for married filing separate).

Dependent care assistance that exceeds the limits must be included in an employee’s income for the year the dependent care is provided, even though it is not paid to the employee until later.

Qualified Educational Assistance Programs – If an employer has a written qualified educational assistance program, an employee may receive, on a tax-free basis, up to $5,250 each year for any form of instruction or training that improves or develops his or her capabilities, whether or not it is job-related or part of a degree program. However, no deduction or credit may be taken by the employee for any amount excluded from the employee’s income as an education assistance benefit.

These are just a few of the fringe benefits that may have tax consequences. Please give this office a call if you have any questions related to them or other possibly excludable fringe benefits.

Tax Reform Has Substantially Altered the Tax Benefits of Home Ownership

Article Highlights:

  • Pre-Tax Reform Home Mortgage Interest Deduction
    o Home Acquisition Debt
    o Home Equity Debt
  • Tax Reform Mortgage Interest Deduction Changes
    o Home Acquisition Debt
    o Home Equity Debt
  • Tracing Equity Debt
  • Refinancing
  • Property Taxes

As part of the recent tax reform, the Tax Cuts and Jobs Act of 2017, the deduction for home mortgage interest and property taxes has undergone substantial alterations. These changes will impact most homeowners who itemize their deductions each year.

Mortgage Interest – Prior to the tax reform, a taxpayer could deduct the interest he or she paid on up to $1 million of acquisition debt and $100,000 of equity debt secured by the taxpayer’s primary home and/or designated second home. This interest was claimed as an itemized deduction on Schedule A of the homeowner’s tax return. This tax deduction was often cited as one of the reasons to purchase a home, rather than renting a place to live.

Qualified home acquisition debt is debt incurred to purchase, construct, or substantially improve a taxpayer’s primary home or second home and is secured by the home.

Home equity debt is debt that is not acquisition debt and that is secured by the taxpayer’s primary home or second home, but only the interest paid on up to $100,000 of equity debt had been deductible as home mortgage interest. In the past, homeowners have used home equity as a piggy bank to purchase a new car, finance a vacation, or pay off credit card debt or other personal loans – all situations in which the interest on a consumer loan obtained for these purposes wouldn’t have been deductible.

The old law continues to apply to home acquisition debt by grandfathering the home acquisition debt incurred before December 16, 2017, to the limits that applied prior to the changes made by the tax reform. As explained later in this article, equity debt interest didn’t survive the tax reform’s legal changes.

New Acquisition Debt Limits: Under the new law, for home acquisition loans obtained after December 15, 2017, the acquisition debt limit has been reduced to $750,000. Thus, if a taxpayer is buying a home for the first time, the deductible amount of the acquisition debt interest will now be limited to the interest paid on up to $750,000 of the debt. If the home acquisition debt exceeds the $750,000 limit, then a prorated amount of the interest will still be deductible. If a taxpayer already has a home with grandfathered acquisition debt and wishes to finance a substantial improvement on the home or acquire a second home, the total of the prior acquisition debt and the new debt, for which the interest would be deductible, would be limited to $750,000 less the grandfathered acquisition debt existing at the time of the new loan.

This may be a tough pill to swallow for many future homebuyers, since the cost of housing is on the rise, while Congress has seen fit to reduce the cap on acquisition debt, on which interest is deductible.

Equity Debt: Under the new law, equity debt interest is no longer deductible after 2017, and this even applies to interest on existing equity debt, essentially pulling the rug out from underneath taxpayers who had previously taken equity out of their homes for other purposes and who were benefiting from the itemized deduction. Note: Equity debt used to purchase, construct or substantially improve one’s home or second home is not treated as equity debt for tax purposes, it is instead treated as acquisition debt (See acquisition debt limits above).

Tracing Equity Debt Interest: Because home mortgage interest rates are generally lower than business or investment loan rates and easier to qualify for, many taxpayers have used the equity in their home to start businesses, acquire rental property, or make investments, or for other uses for which the interest would be deductible. With the demise of the Schedule A home equity debt interest deduction, taxpayers can now trace interest on equity debt to other deductible uses. However, if the debt cannot be traced to a deductible purpose, unfortunately, the equity interest will no longer be deductible.

Refinancing: Under prior law, a taxpayer could refinance existing acquisition debt, and the allowable interest would be deductible for the full term of the new loan. Under tax reform, the allowable interest will only be deductible for the remaining term of the debt that was refinanced. For example, under the old rules, if you refinanced a 30-year term loan after 15 years into a new 25-year loan, the interest would have been deductible for the entire 25-year term of the new loan. However, under tax reform, the interest on the refinanced loan would only be deductible for 15 years – the remaining term of the refinanced debt.

Property Taxes – Prior to the tax reform, homeowners could deduct all of the state and local taxes they paid as an itemized deduction on their federal return. These taxes were primarily real property taxes and state income tax (taxpayers had and still have the option to replace state income tax with sales tax). Beginning in 2018 and through 2025, the deduction for taxes is still allowed but will be limited to a total of $10,000. Thus, if the total property tax and state income tax exceeds $10,000, homeowners may not get the benefit of deducting the full amount of the property taxes they paid. In addition, this requires an analysis when the return is being prepared of whether to claim sales tax instead of state income tax, since when state income tax is deducted, if there’s a state tax refund, it may be taxable on the federal return for the year when the refund is received.

Determining when and how much home mortgage interest was deductible was frequently complicated under the prior tax law, and the new rules have added a whole new level of complexity, including issues related to property taxes. Please call this office if you have questions about your particular home loan interest, refinancing, equity debt interest tracing circumstances, and tax deductions.

Increased Business-Vehicle Deductions Due to Tax Reform

Article Highlights:

  • Annual Mileage
  • Optional (Standard) Mileage Method
  • Actual-Expense Method
  • Vehicle Depreciation
  • Luxury-Vehicle Limits
  • SUVs
  • Interest Expenses
  • Business-Vehicle Sales or Trade-ins
  • Employees
  • Plug-in Electric Vehicle Credits

The Tax Cuts and Jobs Act of 2018 and other tax reforms have brought about significant changes in the way that vehicle use is deducted for business purposes. Before getting into these changes, it is appropriate to first provide a review of the two methods for deducting the use of a business vehicle.

It is important to understand that both methods require keeping track of (1) the vehicle’s total annual mileage and (2) the vehicle’s annual mileage for business purposes. When using the optional mileage rate (also referred to as the standard mileage rate), only business miles are counted. When using the actual-expense method, the operating expenses and depreciation must be prorated based on the proportion of the total mileage that was for business purposes. To document the total mileage, deduct the odometer reading on the first day of the year from that on the last day of the year. For the business mileage, keep a daily record in an appropriate ledger. Keep in mind that the IRS states that all vehicles are used personally to some extent; it will look for a proration between business and (nondeductible) personal use.

Optional Mileage Rates – The standard mileage rates for the business use of a car, van, or pickup or panel truck are shown below:

OPTIONAL MILEAGE RATES FOR BUSINESS USE
Year

Deduction per Business Mile

Imputed Depreciation*per Business Mile

2018
54.5 cents
25.0 cents
2019
58.0 cents
26.0 cents
*This is the amount of depreciation included in the optional mileage rate.

However, a business cannot use the standard mileage rates if it has previously used the actual-expense method (via Sec. 179, bonus depreciation, or depreciation). This rule is applied on a vehicle-by-vehicle basis. In addition, the standard mileage rate for business use cannot be applied to any vehicle that is used for hire, such as taxi, or to more than four vehicles simultaneously.

Actual-Expense Method – Taxpayers always have the option of calculating the actual costs of a vehicle’s business use rather than using the standard mileage rates. Using the actual-expense method in the year when a vehicle is placed into business service may be worthwhile due to the potential for higher fuel prices, the extension and expansion of the bonus depreciation, or increased depreciation limitations for passenger vehicles as a result of the Tax Cuts and Jobs Act. Actual expenses include the costs of the following:

  • Gasoline
  • Oil and Other Fluids
  • Lubrication
  • Repairs
  • Registration
  • Insurance
  • Depreciation (or lease payments)
  • Interest

Vehicle Depreciation – The so-called luxury-vehicle rules limit the annual depreciation deduction for vehicles that weigh 6,000 pounds or less.

The recent tax reform substantially increased these limits by providing much larger first- and second-year deductions for more expensive vehicles. The table below displays the limits for vehicles that were placed into service in 2018. These rates will be adjusted based on inflation in future years.

The recent tax reform also included the option for the taxpayer to add a 100% bonus depreciation to the first-year luxury-vehicle rates (see the amount for “First Year with Bonus” in the table below). However, if a vehicle was purchased before September 28, 2017 (but was not put into service until 2018), the first-year depreciation cap with the bonus is reduced from $18,000 to $16,400.

Prior to 2018, the depreciation values for vans and light trucks were different from those for cars. In 2018, the depreciation limits are the same for both categories, but in future years, the limits may diverge because separate inflation adjustments will apply to the two categories.

LUXURY-VEHICLE DEPRECIATION LIMITS
2018
2019
First Year
$10,000
These rates will be inflation-adjusted, but the IRS has not yet provided the 2019 amounts.
First Year with Bonus
$18,000
Second Year
$16,000
Third Year
$9,600
Each Year Thereafter
$5,760

SUVs – Because vehicles that weigh more than 6,000 pounds are not subject to the luxury-vehicle limits, the first-year deductions for such vehicles can be larger than those for smaller vehicles. The bonus depreciation for SUVs is 100% (through 2022), so the portion of the use that is for business can be fully expensed in the year when the SUV is placed in service. SUVs with gross vehicle weight of more than 6,000 pounds but less than 14,000 pounds are qualified for Sec. 179, which allows a business to expense up to $25,000 if the vehicle is placed in service during 2018 or $25,500 if it is put into service in 2019.

Interest Expenses – Self-employed taxpayers may also deduct the business-use portion of the interest paid on vehicle loans on Schedule C. regardless of whether they use the standard mileage rate or the actual-expense method.

Business-Vehicle Sales or Trade-ins – Under prior law, a good tax strategy was to trade in a vehicle instead of selling it if the sale would result in a gain, as this would defer the gain into the replacement vehicle and thus avoid tax on the gain. Conversely, it was good practice to sell a vehicle for a loss so as to take advantage of the tax loss. Unfortunately, since the recent tax reform, tax-deferred exchanges are no longer allowed, except for real estate. The aforementioned strategies are thus no longer valid, and all vehicle trade-ins are treated as sales: Any gain is taxable, and any loss is deductible. However, if a vehicle is used solely for personal purposes, a loss from a sale is not deductible; if a vehicle is used for both business and personal reasons, then only the business portion of a loss on a sale is deductible.

Employees – The recent tax reform also eliminated the itemized deductions for employees’ business expenses. Before 2018, employees could deduct the business use of their vehicles, but, starting with the 2018 returns, employees can no longer deduct business-vehicle expenses.

Plug-in Electric Vehicles – Purchasing a plug-in electric vehicle may qualify a taxpayer for a tax credit of up to $7,500 (depending on the manufacturer) in the year of the purchase. The credit for a given car is based on the kilowatt capacity of its battery; the full credit applies to the first 200,000 vehicles that each manufacturer sells, after which there is a phase-out regime. Tesla is the first manufacturer to enter the phase-out period, as it reached the 200,000-vehicle cap in 2018. Thus, the credit for 2019 is limited to $3,750 for Tesla vehicles acquired in January through June and $1,875 for those acquired in July through December. After 2019, there will be no credit for Tesla purchases. The amount of credit for each vehicle is available on the IRS’s website. Note that this credit is per vehicle, not per taxpayer, so a taxpayer who purchases multiple vehicles during a given year can claim the credit for each (subject to certain limitations).

When a plug-in electric vehicle is used for both business and personal purposes, its credit is prorated based on the mileage for each usage. The personal portion of the credit is a nonrefundable personal credit that cannot be carried over. The business portion of the credit is also nonrefundable, but it is added to the general business credit and can be carried backward for one year and forward for 20 years or until the credit is used up, whichever occurs first.

The tax rules for business vehicles can be quite complicated. To maximize your benefits, please contact this office for assistance.

Relief from the Affordable Care Act Penalty for Not Being Insured

Article Highlights:

  • Tax Reform
  • Penalty for Not Being Insured
  • Premium Tax Credit
  • Employer Penalty
  • Coverage Exemptions
  • Hardship Exemptions

Thanks to the tax reform, beginning in 2019, the penalty for not having adequate health insurance, which the government refers to as the “individual shared responsibility payment,” will no longer apply.

The elimination of this penalty as of 2019 does not impact the health care subsidy for low-income families, which is known as the premium tax credit and which is available for policies acquired through a government insurance marketplace. This elimination also does not affect the penalties assessed on employers that do not offer affordable insurance to employees and that have 50 or more full-time-equivalent employees.

However, the penalty still applies for individual taxpayers who did not have minimum essential health coverage for 2018 and is the greater of the sum of the family’s flat dollar amounts or 2.5% of the amount by which the household’s income exceeds the income-tax-filing threshold.

For 2018, the flat dollar amounts are $695 per year ($57.92 per month) for each adult and half that amount ($347.50; $28.96 per month) for each child under the age of 18; the maximum family penalty using this method is $2,085 per year ($173.75 per month).

As an example, say that a family of four (2 adults and 2 children) has a household income that exceeds the income-tax-filing threshold by $100,000. This family would have a maximum penalty equal to the greater of the flat dollar amount ($695 + $695 + $347.50 + $347.50 = $2,085) or 2.5% of the income amount (2.5% × $100,000 = $2,500). Thus, the maximum penalty would be $2,500. However, the penalties are applied separately per month, and they do not apply in a given month if certain exceptions are met.

There are a number of exceptions to the penalty, as listed below. For details related to qualifying for any of these exceptions, please give this office a call. Some of the penalty exceptions apply to the entire year, and some only apply to a specific month in the year. If penalty relief applies to a specific month, it also applies to the months just preceding and following that month. The table below lists the various exceptions and the code number the government assigned to that exception.

COVERAGE EXCEPTIONS
CODE NUMBER
Income below the tax-filing threshold.
No code
Coverage considered unaffordable.
A
Short coverage gap (less than 3 months).
B
Certain U.S. citizens or resident aliens living abroad.
C
Member of a health care ministry.
D
Member of an Indian tribe.
E
Incarcerated.
F
Aggregate self-only coverage unaffordable.
G
Resident of a state that did not expand Medicaid.
G
Member of tax household born or adopted during the year.
H
Member of tax household died during the year.
H
Member of certain religious sects.
ECN*
Ineligible for Medicaid based on a state decision not to expand Medicaid.
ECN*
Coverage considered unaffordable based on projected income.
ECN*
Certain Medicaid programs that are not minimum essential coverage.
ECN*
* Certain hardship exemptions.
G – See list below
* ECN standards for “exception certification number,” which must be applied for and provided through the government marketplace.

In addition to the general exceptions included in the table above, hardship exemptions are also available. The most common of these exemptions are:

  • Being homeless.
  • Evicted or facing eviction because of foreclosure.
  • Received a shut-off notice from a utility company.
  • Experienced domestic violence.
  • Death of a family member.
  • Fire, flood or other disaster that caused substantial damage.
  • Filed for bankruptcy.
  • Medical expenses could not cannot be paid, resulting in substantial debt.
  • Increased necessary expenses to care for an ill, disabled or aging family member.
  • Claiming a child who was denied Medicaid or CHIP coverage.
  • Ineligible for coverage because state didn’t expand Medicaid.
  • Financial or domestic circumstances, including an unexpected natural or human-caused event, causing an unexpected increase in essential expenses, which prevented obtaining coverage under a qualified health plan.
  • The expense of purchasing a qualified health plan would have caused the taxpayer to experience serious deprivation of food, shelter, clothing or other necessities.

To claim a hardship exemption, an individual must obtain an ECN through the normal application process, or for 2018, they may self-certify the hardship. However, an individual who is self-certifying is cautioned to retain documentation that demonstrates qualification for the hardship exemption, in case it is later challenged by the IRS.

A person is eligible for a hardship exemption for at least the month before, the month(s) during and the month after the specific event or circumstance that created the hardship.

This may all seem complicated; however, this office can assist you with avoiding the lack-of-health-insurance penalty. Please call with any questions you might have.