Year End Update: Federal & State Taxes
As we predicted in our Mid-Year Tax Update, Governor Corbett signed House Bill 465, officially known as Act 52, into law on July 9, 2013. Act 52 made some significant changes to the Pennsylvania tax code, which will affect both individuals and businesses. This Update will highlight some of the key changes by category.
a. Corporate Tax
Act 52 affects the taxation of corporations domiciled or doing business in Pennsylvania.
First, Act 52 takes a small step toward closing the “Delaware Loophole.” The Delaware Loophole works as follows: A Pennsylvania corporation transfers intangible property or debt certificates to a sister company in another state (typically Delaware). The Pennsylvania corporation then pays royalties or interest to the sister company, and claims the payments as business expenses, which are used as deductions for the purpose of calculating their Pennsylvania income tax. The overall effect of the Delaware Loophole is that millions of dollars in tax revenue are lost through corporate structuring.
Act 52 takes steps to eliminate this loophole by requiring corporations to add back to their income an “intangible expense or cost” or an “interest expense or cost” paid directly or indirectly to an affiliate. Determination of affiliate status is generally based on a 50% common ownership test. The “Add-Back” provision will become effective for the 2015 tax year, and is expected to generate between $40 and $60 million dollars in revenue per year.
Second, the capital stock and franchise tax (“CSFT”), which was scheduled to expire in 2014, has been extended for two more years, but at declining rates. In general terms, the capital stock and franchise taxes are additional taxes, beyond the income tax, levied on all domestic and foreign corporations operating in Pennsylvania. The taxes are imposed on a corporation’s capital stock value, or its net wealth. Under Act 52, the rate declines from 0.89 mills to 0.67 mills in 2014, declines again to 0.45 mills in 2015, and is completely eliminated in 2016. The elimination will end Pennsylvania’s run as the only state in the nation to tax businesses on both their income and assets.
Finally, Act 52 adopts “market-based” sourcing for determining the corporate tax liability of multi-state companies in tax years 2014 and beyond. The rules will now source taxable receipts from the sale of services by referring to the customer’s location, rather than the location of the income producing activity. Special rules will apply to satellite and mobile companies.
b. Personal Income Tax
Act 52 made some changes to the tax code that will affect certain taxpayers.
First, taxpayers will now be allowed to deduct $5,000 in start-up business expenses beginning in tax year 2014. This start-up deduction harmonizes the Pennsylvania tax code with the Internal Revenue Code (“IRC”).
Second, Act 52 provides a tax break to taxpayers involved in the natural gas and oil business. Taxpayers now have three options for handling intangible drilling and development costs for tax purposes. Taxpayers may treat the costs as ordinary and necessary business expenses similar to the treatment under IRC 263(c). Alternatively, taxpayers may elect to currently expense up to one-third of the costs, with the remainder recovered over a 10 year period. Finally, a taxpayer may choose not to take the election, capitalize the costs, and recover them over a 10 year period.
Finally, Act 52 eliminates the tax credit for foreign taxes paid beginning in the 2014 tax year.
c. Family Businesses
The Pennsylvania inheritance tax will no longer apply to a transfer from a decedent’s estate of a “qualified family business interest” to one or more “qualified transferees.” In effect, this means that the assets of a family-owned business, including real estate, may be passed tax-free, if a family member continues to own the business for 7 years. Families that take advantage of this tax break should beware, failure to hold the business for the statutory 7-year period will result in the imposition of taxes in the original amount plus interest calculated from the date of death. Furthermore, like the family farm exemption passed in last year’s budget, this provision may come under constitutional attack, so stay sensitive to this.
d. Pass-Through Entities and Trusts
Act 52 makes changes to reporting and withholding laws that will affect pass-through entities, trusts, and estates.
First, pass-through entities, like partnerships, whose income is taxed at the individual owner level, rather than at the entity level, will now be required to maintain accurate owner lists and submit informational returns. Further, pass-through entities with 11 or more partners or owners that underreport income by more than $1 million dollars can now have income tax assessed at the entity level. Partners and owners will receive credit for their share of the tax paid at the entity level in these situations.
Second, Pennsylvania trusts and estates will now be required to withhold Pennsylvania tax on Pennsylvania-source income from non-resident beneficiaries. Further, non-resident estates and trusts that have Pennsylvania-source income will be required to file a Pennsylvania return.
In our Mid-Year Update we filled you in on some of the major changes that resulted from the American Taxpayer Relief Act of 2012 (“Tax Act”). The Mid-Year Update contains a broad discussion of the Tax Act and is available at, https://www.nssh.com/2013/07/mid-year-update-federal-states-taxes/, if you wish to review it. Since we already covered the Tax Act in a general way, this Update will provide you with some specific information and suggestions tailored to assist you with your taxes as the 2013 tax-year draws to a close.
Taxpayers with actual earnings or a modified adjusted gross income (“MAGI”) over a threshold limit, $250,000 for marrieds filing jointly and $200,000 for singles and head of households, will be subjected to two separate surtaxes this year as a result of the health care reform legislation.
First, taxpayers who exceed the actual earnings threshold limit, whether the income derives from wages or self-employment income, will be subjected to a 0.9% Medicare surtax on all earnings over the threshold amount. This means that every dollar earned over the threshold amount will be subjected to a 3.8% Medicare tax, the base tax at a rate of 2.9% plus an extra 0.9% surtax. Employees who will be subjected to this surtax may want to ensure that their employers are withholding the proper amount to avoid a big payment in April.
Second, taxpayers who have a MAGI (adjusted gross income + tax free foreign earned income) will be subjected to a 3.8% Medicare surtax on net investment (capital gains) income this year. This surtax will be levied on either the filer’s net investment income or the excess of MAGI over the applicable threshold, whichever is smaller. Tax free interest is exempted from the calculation, along with payouts from retirement plans such as 401(k)s, IRAs, deferred pay plans, and pension plans.
Married couples should ensure that they are filing under the most advantageous tax filing status. Generally, married filing jointly will be the best approach, but in certain situations, married filing separately may give some couples tax advantages.
Married same-sex couples need to be aware that they are required to file under a married status this year, either jointly or separately. Further, same-sex couples may want to amend prior tax returns to take advantage of married tax filing status. See The Aftermath of the U.S. Supreme Court’s Decision on DOMA: Part 2 article for more detailed information on this subject.
c. Capital Gains Strategies
The American Taxpayer Relief Act increased the top rate on capital gains and dividends to 20% for “high earners.” In this context “high earners” are taxpayers in the highest ordinary income tax bracket, couples who earn more than $450,000 and singles who earn more than $400,000. The Medicare surtax, discussed above, can boost this rate to 23.8%. The capital gains rate remains the same for all other filers. Taxpayers in an ordinary income tax bracket below 15% qualify for a 0% rate on their capital gains, and all others will be subjected to a 15% rate.
To reduce the effect of the higher capital gains rate, tax filers can employ a number of strategies. Cash in losses to offset capital gains and $3,000 worth of ordinary income. Use gift-giving to reduce your income. For 2013, the annual gift tax exclusion is $14,000 for individuals and $28,000 for married couples making split-gifts. Alternatively, you could make a charitable donation. Make deductible IRA contributions. This will have two positive effects, more gains and dividends will be taxed at the 0% rate, and you will also receive income tax savings from the deduction. Finally, if you’re retired, take just enough distributions from your retirement account to stay in the 15% bracket, which will keep your capital gains rate at 0%.