Certain special circumstances have unique tax implications that financial planners must understand. These include taxation of insurance products, investments, business entities, and international aspects. This lesson covers the tax treatment of these special circumstances, providing a comprehensive overview of advanced tax topics relevant to financial planning.
Taxation of Insurance Products:
Life insurance and annuities have special tax treatment. Life insurance death benefits are generally tax-free to the beneficiary. The cash value of a life insurance policy grows tax-deferred. Policy loans are not taxable as income. However, if the policy lapses with an outstanding loan, the loan may be taxable.
Taxation of Annuities:
Annuities grow tax-deferred. Withdrawals are taxed on a last-in, first-out (LIFO) basis, meaning earnings are taxed before principal. Withdrawals before age 59½ may be subject to a 10% penalty. Annuities are taxed as ordinary income when withdrawn.
Taxation of Mutual Funds:
Mutual funds distribute income and capital gains to shareholders. Distributions include dividends, interest, and capital gains. Capital gains distributions are taxed as capital gains, even if they are reinvested. Shareholders pay tax on the distributions they receive.
Taxation of Real Estate Investment Trusts (REITs):
REITs distribute at least 90% of their taxable income to shareholders. Distributions are generally taxed as ordinary income. A portion of the distribution may be classified as return of capital or capital gains. REITs are not taxed at the entity level if they meet distribution requirements.
Taxation of Business Entities:
Sole Proprietorship:
Income is reported on the owner’s personal tax return. The owner pays income tax and self-employment tax on net income. Business losses can offset other income.
Partnership:
The partnership files an information return. Income and losses flow through to the partners. Partners pay tax on their share of income. Partners may also be subject to self-employment tax.
S-Corporation:
The S-corporation files an information return. Income and losses flow through to shareholders. Shareholders pay tax on their share of income. S-corp shareholders may be subject to employment tax on reasonable compensation. S-corp shareholders avoid self-employment tax on distributions.
C-Corporation:
The C-corporation pays corporate income tax on its earnings. Shareholders pay tax on dividends received. This creates “double taxation” of corporate earnings. C-corps may have certain tax advantages, such as the deduction for dividends received.
Taxation of Retirement Accounts:
Traditional IRA:
Contributions are tax-deductible. Earnings grow tax-deferred. Withdrawals are taxed as ordinary income. Required minimum distributions (RMDs) begin at age 73.
Roth IRA:
Contributions are not tax-deductible. Earnings grow tax-free. Withdrawals are tax-free if qualified. Qualified withdrawals are tax-free after age 59½ and a five-year holding period. Roth IRAs have no RMDs.
401(k) Plans:
Traditional 401(k) contributions are pre-tax; earnings grow tax-deferred; withdrawals are taxed as ordinary income. Roth 401(k) contributions are after-tax; earnings grow tax-free; withdrawals are tax-free if qualified.
Taxation of Social Security Benefits:
Social Security benefits may be taxable depending on the taxpayer’s income. Up to 85% of Social Security benefits may be taxable. The taxable portion is based on the taxpayer’s provisional income.
Taxation of Alimony:
For divorce agreements executed after 2018, alimony payments are not tax-deductible to the payer and are not taxable to the recipient. For agreements executed before 2019, alimony is deductible to the payer and taxable to the recipient.
Taxation of Gambling Income:
Gambling income is taxable. Winnings must be reported on the taxpayer’s tax return. Losses can be deducted to the extent of winnings, but only if the taxpayer itemizes deductions.
Taxation of Scholarships and Fellowships:
Scholarship income may be tax-free if used for tuition, fees, books, and required supplies. Amounts used for room and board are taxable.
Taxation of Foreign Income:
US citizens and residents are taxed on their worldwide income. Foreign tax credits are available to avoid double taxation. Foreign earned income may be excluded under the Foreign Earned Income Exclusion. Tax treaties may affect the taxation of foreign income.
Taxation of Cryptocurrency and Digital Assets:
Cryptocurrency is treated as property for tax purposes in the US. Gains on the sale or exchange of cryptocurrency are taxable as capital gains or ordinary income. Mining income is taxable as ordinary income.
Inherited IRA Distributions:
Inherited IRAs have special distribution rules. The SECURE Act changed the distribution rules for most beneficiaries, requiring distributions to be completed within 10 years of the original owner’s death. Certain beneficiaries are exempt from the 10-year rule.
Taxation of Unearned Income of Minor Children:
The “kiddie tax” taxes a child’s unearned income at the parent’s rate. The kiddie tax applies to children under 19 and full-time students under 24. The first $1,250 of unearned income is tax-free; the next $1,250 is taxed at the child’s rate; unearned income above $2,500 is taxed at the parent’s rate.
Taxation of Business Expenses:
Business expenses are deductible if they are ordinary and necessary for the business. Deductible expenses include advertising, insurance, legal fees, office supplies, rent, repairs, and utilities. Entertainment expenses are generally not deductible. Meals are subject to a 50% deduction limit (subject to change).
Taxation of Home Office Expenses:
Home office expenses may be deductible if the space is used exclusively and regularly for business. The simplified method allows a deduction of $5 per square foot, up to 300 square feet. The regular method allows the deduction of actual expenses.
Taxation of Hobby Income:
Income from a hobby is taxable. Expenses are deductible to the extent of income, but only if the taxpayer itemizes deductions. The hobby loss rules limit deductions to the amount of hobby income.
Taxation of Cancellation of Debt (COD) Income:
Generally, COD income is taxable as ordinary income. Exclusions apply for bankruptcy, insolvency, and certain other circumstances. Mortgage debt forgiveness may be excluded for certain principal residences.
Taxation of Damages and Settlements:
Taxation of damages depends on the nature of the claim. Personal injury settlements are generally tax-free. Punitive damages and interest are taxable.
Taxation of Foreign Accounts:
US persons with foreign financial accounts must report them on FinCEN Form 114 (FBAR) and Form 8938. Penalties for non-compliance can be significant.