Why is this Topic Important to wealth managers? General classification and taxation of insurance professionals is governed by statute.  Therefore, a basic discussion of the law as it applies to wealth managers and tax is presented below.

Generally speaking common law classifications have determined under which circumstances an individual will be treated as an employee versus an independent contractor for tax purposes. Nevertheless, under statute, an individual who meets the legal common law definition of an independent contractor may still be considered an “employee” for tax purposes. “Independent contractors” who are classified statutorily as “employees” are usually referred to as “Statutory Employees”.  As the name implies, Congress created a law that states some individuals who would normally be considered independent contractors under common law are treated as employees for all purposes relating to the tax code.  Among the categorization of “Statutory Employees”, according to the Code is “full-time life insurance salesman.” [1]

A full-time life insurance salesman means “[a]n individual whose entire or principal business activity is devoted to the solicitation of life insurance or annuity contracts, or both, primarily for one life insurance company”. [2] The Treasury Regulations state that a full time life insurance salesman “ordinarily uses the office space provided by the company or its general agent, and stenographic assistance, telephone facilities, forms, rate books, and advertising materials are usually made available to him without cost.” [3]

On the contrary, an individual is not considered a full time life insurance salesman when he “is engaged in the general insurance business… the individual’s principal business activity” is not the, “solicitation of life insurance or annuity contracts, or both, for one company”.[4] Likewise, “any individual who devotes only part time to the solicitation of life insurance contracts, including annuity contracts, and is principally engaged in other endeavors, is not a full-time life insurance salesman.” [5] Also, some producer groups have contractual relationships with multiple insurance companies, so life-insurance salespeople are sometimes able to sell products for more than one company, generally excluding them from statutory employee definition.

So what’s the difference? Generally, the tax treatment of the two dissimilar arrangements is significantly different.  On the one hand employees are subject to withholding of federal income taxes on wages as well as withholding for Medicare and Social Security taxes. Generally, independent contractors operate as sole-proprietors or some incorporated or limited liability business structure.  Meeting the definition of a trade or business, generally, these individuals will have gain or loss treatment in relation to their income.

As a general rule, independent contractors will calculate taxable income by determining income minus expenses. Income in this context is included in Internal Revenue Code Section 61 “Gross Income” which includes “all income from whatever source derived,” including “compensation for services, [and] fees”. [6] Expenses or deductions from gross income for a trade or business are determined using Section 162 of the Code which states that a deduction may be taken for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business”.[7]

Some expenses that the trade or business may incur include, but are not limited to:

• cost of goods sold
• compensation
• salaries and wages
• repairs and maintenance
• bad debts
• rents
• depreciation
• taxes
• travel
• interest, and
• advertising

To arrive at net taxable income, expenses are generally deducted from gross income.   The taxpayer can then determine the tax liability based on the tax rate found in IRC Section 1 or by using income and percentage charts provided by the Internal Revenue Service.

For a detailed analysis regarding independent contractors, see Tax Facts Q 814. How are business expenses reported for income tax purposes?

For a detailed analysis regarding the tax treatment of life insurance agent, see Tax Facts Q 361. Who is an owner-employee for purposes of the qualification requirements?

Tomorrow’s blogticle will continue to discuss issues related to wealth mangers and estate planning generally.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] 26 U.S.C.A. § 3121(d)(3)(b).

[2] 26 C.F.R. § 31.3121(d)-1.

[3] Id.

[4] Id.

[5] Id.

[6] 26 U.S.C.A. 61(a), 26 U.S.C.A. 61(a)(1).

[7] 26 U.S.C.A. 162(a)

Why is this Topic Important to Wealth Managers? This blogticle provides discussion and analysis of health insurance costs for self-employed individuals. The topic is relevant to those wealth managers with small business clients as well as self-employed wealth managers themselves, as it discusses treatment of deductions and the calculation of self-employment income with regards to health insurance costs.

In calculating adjusted gross income for income tax purposes, self-employed individuals may deduct the cost of health insurance for themselves and their spouses, dependents, and any children who have not attained age 27 as of the end of the taxable year. [1]

The deduction is not available for any month in which the self-employed individual is eligible to participate in an employer-subsidized health plan (maintained by the employer of the taxpayer or the taxpayer’s spouse). Moreover, the deduction may not exceed the earned income (within the meaning of section 401(c)(2)) derived by the self-employed individual from the trade or business with respect to which the plan providing the health insurance coverage is established.[2] The deduction applies only to the cost of insurance (i.e., it does not apply to out-of-pocket expenses that are not reimbursed by insurance).

The Self-Employment Contributions Act (‘‘SECA’’) imposes taxes on the net earnings from self-employment of self-employed individuals (‘‘self-employment income’’). The tax is composed of two parts: (1) the old age, survivors, and disability insurance (‘‘OASDI’’) tax; and (2) the hospital insurance (‘‘HI’’) tax. The rate of the OASDI portion of SECA taxes is equal to 12.4 percent of self-employment income and generally applies to self-employment income up to the Federal Insurance Contributions Act (‘‘FICA’’) taxable wage base ($106,800 in 2010). The current rate of the HI portion is equal to 2.9 percent[3] of self-employment income and there is no cap on the amount of self-employment income to which the rate applies.

For purposes of computing net earnings from self-employment, taxpayers are permitted a deduction equal to the product of the taxpayer’s earnings (determined without regard to this deduction) and one-half of the sum of the rates for OASDI (12.4 percent) and HI (2.9 percent), i.e., 7.65 percent of net earnings. This deduction reflects the fact that the FICA rates apply to an employee’s wages, which do not include FICA taxes paid by the employer, whereas the self-employed individual’s net earnings are economically equivalent to an employee’s wages plus the employer share of FICA taxes.

The deduction allowable for the cost of health insurance for the self-employed individual and the individual’s spouse, dependents, and children who have not attained age 27 as of the end of the taxable year for income taxes is not taken into account in determining an individual’s net earnings from self-employment for purposes of SECA taxes.[4]

Under Section 2042 of the Small Business Jobs Act of 2010,[5] the deduction for income tax purposes allowed to self-employed individuals for the cost of health insurance for themselves, their spouses, dependents, and children who have not attained age 27 as of the end of the taxable year 2010 was taken into account, and thus was also allowed, in calculating net earnings from self-employment for purposes of SECA taxes for taxable year 2010 only.

However, the provision only applied to tax year 2010 and the treatment for health insurance costs for self-employed individuals reverted back to its original treatment in 2011.

Tomorrow’s blogticle will continue our series on tax law changes related to wealth managers in 2011.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] IRC Sec. 162(l)(1). See Notice 2010–38 for a discussion of the deduction for children who have not attained age 27 as of the end of the taxable year.

[2] IRC Sec. 162(l)(2).

[3] IRC Sec. 1401; However, under section 9015 of the Patient Protection and Affordable Care Act, Pub. L. No. 111–148, for remuneration and self-employment income received for taxable years beginning after December 31, 2012, the HI tax under SECA is increased by an additional tax of 0.9 percent on self-employment income received in excess of a threshold amount.

[4] IRC Sec. 162(l)(4).

[5] Public Law 111–240.

Why is this Topic Important to Wealth Managers? Discusses self-employment taxes with regards to closely held corporations.  Provides insight from a recent court decision regarding how distributions may be treated.

Earlier this month we reported on legislation affecting closely held businesses and the self-employment tax.   We note that Stephen Sternberger, attentive AdvisorFX subscriber and tax lawyer, pointed out in his comments to that article that the the legislation had not passed.  However, that topic (Self-Employment Tax on wages versus distributions), has reared its head again – as shown by the recent Federal District Court case involving David E. Watson. [1]

The C.P.A. recently disputed and lost to the Government’s position which recharacterized dividend and loan payments from David E. Watson, P.C. (a Subchapter S corporation) to its sole shareholder and employee, David E. Watson.  The IRS assessed additional employment taxes, interest and penalties against Watson for each of tax years in which Watson’s salary was significantly lower than his total distributions.

The taxpayer made the contention that the closely held business unquestionably intended to pay Watson compensation of $24,000 per year, and that amounts distributed to Watson in excess of that amount were properly classified as dividends and/or loans.  Watson wanted to take a lower salary and larger distributions because wages or salaries are generally subject to self-employment taxes while distributions are not.  The self-employment tax rate is 15.3%.

The question the Court reviewed was whether the characterization of funds disbursed by an S corporation to its employees or shareholders is a salary or otherwise.  The Court determine that the answer to this question turns on an analysis of whether the “payments at issue were made . . . as remuneration for services performed.”

The Court made clear that a determination of whether funds are “remuneration for services performed,” must be made “in view of all the evidence.”   While intent is unquestionably a consideration in the analysis, it is by no means the only one.  Other relevant considerations include, but are not limited to:  1) the employee’s qualifications; 2) the nature, extent and scope of the employee’s work; 3) the size and complexities of the business; 4) a comparison of salaries paid with the gross income and the net income; 5) the prevailing general economic conditions; 6) comparison of salaries with distributions to stockholders; 7) the prevailing rates of compensation for comparable positions in comparable concerns; 8) the salary policy of the taxpayer as to all employees; and 9) in the case of small corporations with a limited number of officers the amount of compensation paid to the particular employee in previous years.

The Court’s analysis concluded that payments to Watson were, in fact, “remuneration for services performed” and that a portion of those payments were subject to the self-employment tax.

The Wall Street Journal reported that Mr. Watson will appeal the decision. [2] Quoting Watson stating, “The IRS can disallow a tax deduction for unreasonably high compensation, but the law doesn’t give it the authority to raise pay in order to collect extra payroll taxes,”  The Journal also reported that “independent tax expert Robert Willens in New York says [Watson’s position] will be a hard argument to win.”

Tomorrow’s blogticle will revert back to 2011 market opportunities for wealth managers.

We invite your opinions or questions by posting them below, or by calling the Panel of Experts

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[1] David E. Watson, P.C. v. U.S. 107 A.F.T.R.2d 2011-311 (December 2010)(Westlaw).  Full case available at http://ia700202.us.archive.org/4/items/gov.uscourts.iasd.37557/gov.uscourts.iasd.37557.35.0.pdf.  Last accessed 10/25/2011.

[2] Laura Saunders.  Wall Street Journal.  The IRS Targets Income Tricks.  January 22, 2011.  http://online.wsj.com/article_email/SB10001424052748703951704576092371207903438-lMyQjAxMTAxMDIwMjEyNDIyWj.html.  Last accessed 10/25/2011.

A member of the U.S. military who takes a leave of absence from his private sector job in order to go on active duty will often face a pay cut—the differential between his military and private sector pay.   Some employers make up this differential by paying employees who are on active duty a partial salary.  Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of the Tax Relief Act of 2010 in Advisor�s Journal, see Obama Tax Compromise Provides 100 Percent Bonus Depreciation of Business Assets Through 2011 (CC 11-01), Obama’s Social Security Tax Holiday: Penny Wise and Pound Foolish? (CC 10-119), Does the New Estate Tax Make the Bypass Trust Obsolete? (CC-10-122), and 2010 Estates: To Elect or Not to Elect (CC 10-124).

Some taxpayers are going to have to wait until mid-to-late February to file their 2010 income tax returns, delaying much needed refunds and potentially clogging up the system for other taxpayers. The IRS is blaming the filing delay on Congress waiting until the end of December to pass the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010, H.R. 4853 (Tax Relief Act), which includes a bevy of tax provision extensions, a new two-year estate tax, and a one-year, 2 percent Social Security tax holiday.  Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of the Tax Relief Act of 2010 in Advisor’s Journal, see Obama Tax Compromise Provides 100 Percent Bonus Depreciation of Business Assets Through 2011 (CC 11-01), Obama’s Social Security Tax Holiday: Penny Wise and Pound Foolish? (CC 10-119), Does the New Estate Tax Make the Bypass Trust Obsolete? (CC-10-122), and 2010 Estates: To Elect or Not to Elect (CC 10-124).

In a tax plan full of surprises, President Obama’s unexpected proposal to give workers a one-year, 2 percent Social Security tax holiday is perhaps the most surprising part.   But Social Security experts caution workers not to party just yet because the holiday could destabilize Social Security.   And, although a 2 percent paycheck bump is better than nothing, it is not the tremendous boon to workers it is being presented as.  The Social Security tax holiday would essentially offset the loss of the Making Work Pay tax credit, which expires at the end of 2010 and is not renewed by the tax cut bill.  The Making Work Pay tax credit gives taxpayers making at least $5,000 and no more than $75,000 annually a refundable $400 tax credit.

Opponents also characterize the proposed tax holiday as an attempt to shift retirement savings from the Social Security Administration to Wall Street.  Undoubtedly, many taxpayers will, smartly, divert the 2 percent tax break into their 401(k)s and IRAs, but a majority of taxpayers are likely to spend the money, barely noticing the tiny bump in their paychecks.  Read this complete article at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For previous coverage of the debate over the expiring Bush tax cuts in Advisor’s Journal, see Obama Tax Agreement Faces Stiff Resistance in Congress (CC 10-112) and What Lies Beyond the Sunsetting 2010 Tax Provisions (CC 10-88).

Why is this Topic Important to Wealth Managers? Discusses relevant provisions of the “Obama Tax Cuts”.  Provides a topical overview of pertinent provisions for wealth managers.

On Friday, President Obama signed into legislation, what is quickly becoming known as the Obama Tax Cuts, which extend tax breaks initially created by the George Bush Administration about a decade ago.  For the previous discussions and various versions of this “long and winding road” of the passage of this new tax law – see Tax Deal Reached

The new tax law “The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (HR. 4853)“ provides an extension for two years (unless otherwise noted), of generally the following (not all inclusive):

The continuation of the 10, 15, 25, 28, 33, 35-percent regular income tax brackets.  Sec 101.

The continuance of the removal of itemized deduction limit and personal exemption phase-out.  Sec 101.

Child tax credit extensions along with increased earnings threshold for credit determination.  Sec. 101 and 103.

Increases the basic standard deduction for a married couples filing jointly to twice that of the standard deduction for unmarried individuals.  Sec 101

Extends certain earned income tax credit provisions including for determination of application of tax credit to income tax liability. Sec 101 and Sec 103.

Extends qualified dividend income taxable at net capital gains rates. Sec 102

Extends the maximum rate of tax on adjusted net capital gains to 15 percent. Sec 102.

Extends Hope and American Opportunity Tax Credit with regards to secondary education.  Sec 103.

Alternative Minimum Tax (AMT) exemption amounts for taxable years 2010; $72,450, for married filing jointly and $47,450, for unmarried individuals, and 2011; $74,450, for married filing jointly, and $48,450 for unmarried individuals. Sec 201.

The provision reinstates the estate and generation skipping transfer taxes with exclusion amount of $5 million, with a maximum estate tax rate of 35 percent.  Sec 301-304.

For gifts made in 2010, exclusion amount is $1 million, and the gift tax rate is 35 percent, for gifts made December 31, 2010, the gift tax is reunified with the estate tax, with an applicable exclusion amount of $5 million and a top estate and gift tax rate of 35 percent.  Sec 301-304.

The generation skipping transfer tax exemption continues in an amount of $5 million.  Generation skipping transfer tax rate for transfers made during 2010 is zero percent. The generation skipping transfer tax rate for transfers made after 2010 is equal to the highest estate and gift tax rate in effect for such year (35 percent for 2011 and 2012).  Sec 301-304.

Repeals the modified carryover basis rules—now a recipient of property acquired from a decedent will generally receive a “step-up” or fair market value basis. Sec 301-304.

Extends and expands the additional first-year depreciation to equal 100 percent of the cost of qualified property placed in service after September 8, 2010 and before January 1, 2012, and provides for a 50 percent first-year additional depreciation deduction for qualified property placed in service after December 31, 2011 and before January 1, 2013.  Sec 401.

Starting in 2012, the maximum amount a taxpayer may expense is $125,000 of the cost of qualifying property placed in service for the taxable year. The $125,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $500,000.  Sec 402.

Reduces the employee FICA tax by two percentage points for one year (2011 only). Also reduces self-employment taxes tax by two percentage points for taxable years of individuals that begin in 2011. Sec  601.

The Act extends the rules regarding contributions of capital gain real property for conservation/charity purposes for two years for contributions made in taxable years beginning before January 1, 2012. Sec 725.

We provide a link below to the actual Bill (now new law) that you may look at each section listed above after each change.  Then, we provide a link to the Congressional explanation of the changes:

The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (HR. 4853) Bill: http://www.gpo.gov/fdsys/pkg/BILLS-111hr4853eas2/pdf/BILLS-111hr4853eas2.pdf Last Accessed 12/19/2010.

Joint Committee on Taxation.  Technical Explanation of the Revenue Provisions Contained in the “Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010” Scheduled For Consideration By The United States Senate. JCX-55-10.  December 10, 2010.  Accessible through: http://www.jct.gov/publications.html?func=startdown&id=3716.  Last Accessed 12/19/2010.

Tomorrow’s blog will discuss certain provisions of the tax cuts in more detail.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.