TAX-FREE INCOME
During these difficult times it’s time to enjoy what is free. This delicious fruit jello is completely fat-free, sugar-free and virtually calorie-free too. You can never go wrong when tasty and free go together.
Double Your Benefits
Many people ask me how they can get tax-free income. The answer is that there are many, many ways because the Internal Revenue Code is filled with exceptions to the general rule (stated in IRC Section 61) that all sources of income are taxable. So here, in this short article, I’m going to provide a comprehensive listing of twenty-one important ways you can get money and legally avoid owing income tax on it. For even more ways to enjoy tax-free income see IRS Publication 525. For some types of non-taxable benefits employees can receive income completely tax-free while the employer gets a full deduction. This is a double benefit where everyone wins.
Unfortunately, few people are familiar with these exceptions. So read on and find out how you can get money without owing tax. If you are an employer looking to stretch your compensation dollars further you will find here many ways to give tax-free benefits to your workers while still getting a full tax deduction. These are powerful tools that make you more efficient and more effective when you spend or receive money.
It’s always been hard to get money, and easy to lose it. But the times we live in today have made it even harder. Get smart with your money and use it wisely so you have more after-tax income, less spending, and more bang for your buck.
Tax-Free Income for Employees (And Deductions for Employers)
( (1) Foreign Earned Income Exclusion
This is one of the best deals in the entire tax code. If you work abroad for 330 days in any specified period or if you become a bona fide resident of a foreign country then you can exclude up to $95,100 for 2012 (IRS Revenue Procedure 2011-52.) For married couples where both spouses qualify up to $190,200 can be excluded from taxation for 2012.
Some people think only income derived from sources in the US is subject to US tax. This is wrong. American citizens are taxed on worldwide income. And since astronauts earn their salaries from NASA even in outer space, we can truly say that American citizens are taxed on Universe-wide income. Where you earn the money doesn’t matter to the IRS.
( (2) Working Condition Fringe Benefits
This is a very broadly defined fringe benefit provided by IRC Section 132 which can be offered to targeted groups of employees. Unlike many other benefits, the “non-discrimination” rules don’t apply to working condition fringe benefits. Non-discrimination rules mean what they sound like: employers can’t pick and choose who to offer the benefit to. But with working condition fringe benefits employers can decide who to give these benefits to. Executive and managerial employees routinely receive working condition fringe benefits.
Working condition fringe benefits include:
Employee Use of a Company Vehicle
Travel and Lodging Expenses
Reimbursements for Computer and Internet Services
Entertainment Expenses
Some Club Memberships
This type of fringe benefit is great because it is tax-free to the employee and fully deductible to the employer. And because these benefits are not taxed as compensation, the employer doesn’t have to pay the 7.65% social security tax on them. So for each $1,000 dollars of salary reclassified as a working condition fringe benefit the employer will save $76.50 in payroll taxes. Under current law (2012), the employee will save $56.50 per $1,000 of benefit in payroll taxes plus the income taxes the employee will avoid on $1,000 previously taxed as salary or wages. See Table 2-1 of IRS Publication 15-B.
( (3) Employer Provided Cell Phones
Pursuant to IRS Notice 2011-72 business use of employer-provided cell phones is tax-free to employees and tax deductible to employers. De minimis personal use of the cell phone is also tax-free. You cannot consciously intend to use this benefit as compensation.
( (4) Qualified Moving Expenses
Most moving expenses incurred by an employee in connection with their employment can be reimbursed by the employer tax-free. Meanwhile the employer can claim a full deduction for such reimbursements. IRC Section 132(g).
( (5) Child and Dependent Care Benefits
This benefit is especially valuable to employees with children under age 13. Pursuant to IRC Section 129 up to $5,000 of employer provided reimbursements for child care is tax-free to the employee and fully deductible by the employer. The employer must have a written plan and must report the benefit on the employee’s Form W-2. This type of benefit cannot be discriminatory, i.e., it must generally be offered to all full-time employees.
(6) Education Assistance
Pursuant to IRC Section 127 and Revenue Ruling 96-41 employer reimbursements of employee education expenses for undergraduate and graduate level classes are tax-free to the employee and tax deductible by the employer. Up to $5,250 per year in employer reimbursements for the cost of tuition, fees, books and supplies qualifies for this benefit. The classes covered by the employer do NOT need to be job related. In the past employers had to file Form 5500 to report such reimbursement plans to the IRS. However, since 2002, pursuant to IRS Notice 2002-24 this requirement has been suspended. There is still a requirement for employers to have a written plan and maintain records of transactions.
( (7) Cafeteria Plans
Cafeteria plans established under IRC Section 125 offer employees a choice of receiving either cash or tax-free benefits. If an employee chooses cash he or she will be taxed. If the employee chooses non-cash benefits then the benefit is tax-free to the employee. In either case the benefit is tax-deductible by the employer. The following types of benefits may be offered with a cafeteria plan:
Accident and Health Insurance
Dependent care assistance
Disability coverage
Group-term life insurance
Health Savings Accounts
401(k) retirement plans
Cafeteria plans must be non-discriminatory, i.e., they generally must be offered to all full-time employees. As is the case with educational assistance, the IRS has suspended the reporting requirements for cafeteria plans although there is still a requirement to have a written plan and to maintain records.
( (8) Health Reimbursement Arrangements & Health Savings Accounts
HRA’s consist of employer funded tax-free accounts from which employees can pay for medical costs including health insurance premiums. Unused amounts must be carried forward to future years pursuant to IRS Revenue Ruling 2002-41. There must be no conscious intent to use an HRA as a substitute for taxable compensation.
HSA’s are tax-free accounts used to purchase high-deductible health insurance plans with pre-tax dollars and are an efficient way to manage expensive health insurance premiums. IRC Section 223(c)(1).
(9) 401(k) Employer Contributions
IRC Section 401(k) plans are powerful tools for shielding income from taxes while building wealth for retirement. Most 401(k) plans are built on the concept of an “employer match”, i.e., for each dollar an employee contributes to the 401(k) from his own salary, the employer will match by a stated amount or percentage. The employer contribution to the plan is tax-free to the employee and tax deductible by the employer.
For 2012 employees can elect to have up to $17,000 of their salary contributed pre-tax to a 401(k) retirement plan per IRS News Release IR–2011–103.
401(k) plans require reporting to the IRS on Form 5500. Employees should be careful about the investments made by the 401(k). The non-discrimination rules fully apply to 401(k) plans.
(10) S Corporation Tax Free Distributions
Pursuant to IRC Section 1368(b) and IRS Regulation Section 1.1368-1(c) employee-owners of S Corporations may receive tax-free distributions of company profits. These distributions are very similar to dividends except they are generally non-taxable. Distributions are not an expense for the company but instead reduce its equity. IRS Revenue Ruling 74-44 requires that the company pay reasonable salary to employee-owners.
Other Tax-Free Income
( (1) Disability Income
Pursuant to IRC Section 104 payments for loss of bodily functions and occupational disability are completely tax-free. Note however that under IRC Section 104(a)(2) punitive damage awards are fully taxable. And pursuant to IRS Revenue Ruling 96-65, back pay received for emotional (not physical) distress is fully taxable.
( (2) State and Municipal Bond Interest (Seniors Beware)
Interest from state and local bonds is generally exempt from federal tax pursuant to IRC Section 103(a). Certain “private activity bonds” may be taxable because of the Alternative Minimum Tax. Mutual funds that invest in state or local bonds may pay dividends derived from tax-exempt sources and, therefore, such dividends are tax-free.
There is a very nasty surprise for seniors who receive social security income as well as municipal bond interest. Many uninformed or even incompetent financial advisors will encourage seniors to buy municipal bonds without considering all the income tax impacts. The truth is that pursuant to IRC Section 86(b)(2)(B), municipal bond interest INCREASES taxable social security benefits. Also see IRS Publication 915. This is a sneaky, back-door way to indirectly tax municipal bonds. But the government has the authority to do this.
Think of the mistake many poorly informed seniors are making by buying municipal bonds. They invest in a product that pays a lower rate of return because the income is supposed to be tax-free. But municipal bond interest increases the amount of social security benefits that are taxed. Thus, a senior still pays tax but gets a lower rate of return. This is a devastating mistake.
Always seek competent financial advice including retirement planning services from those with the knowledge and skill to give you the best possible results. What you don’t know can cost you a fortune, especially if the very same mistake is repeated year after year. And it’s wise to seek advice from professionals not salesmen. Salesmen are ultimately interested in earning a commission by selling you financial products. CPA’s and financial planners like myself do not charge a commission and never sell you anything other than advice. My initial consultation for new clients is always free.
( (3) Zero Percent Tax Rate on Capital Gains
This provision is largely unknown even to many accountants. For 2012 the tax rate on long-term capital gains is ZERO for joint returns with total income (including capital gains) of $70,700 or less, or single individuals with other income less than $35,350. (IRC Section 1(h)(1)). Thus if a couple earns total combined salaries of $50,000 in 2012 and has a long-term capital gain of $20,700 they will pay zero tax on the capital gain. In this example they will still owe ordinary taxes on their salary income.
(4) Life Insurance Proceeds
IRC Section 101 excludes from tax all life insurance proceeds. Further, viatical settlements paid prior to death for an insured individual who is terminally or chronically ill also qualify for the exclusion.
( (5) Cancellation of Debt Income
The general rule is that if a loan is cancelled and you are relieved of the legal obligation to repay it then you have taxable income. However, pursuant to IRC Section 108 many types of cancellation of debt income can be excluded from taxation. You can exclude cancellation of debt income from taxation if you file bankruptcy, if you are insolvent (debts including the debt that was cancelled exceed fair market value of your assets), or if the loan being cancelled qualifies under Section 108.
Handling cancellation of debt income is complex and it is essential you obtain professional advice. IRS Form 982 must be filed with your tax return to report the cancellation of debt income and the reason(s) why you are exempting it from tax.
Many types of loans may qualify for exclusion from taxation including home mortgages reduced or cancelled through foreclosure or debt restructuring, credit card debt, some student loan debt, medical bills, farm debt, and others.
This is a highly relevant current topic since many individuals today are stuck with debt they cannot afford to repay. Make sure the income tax treatment of your cancelled loans is handled properly. Otherwise, you will be getting a bill from the IRS.
( (6) Sale of Primary Residence
Pursuant to IRC Section 121(b) gain from the sale of your primary residence is tax-free up to $250,000 for singles and $500,000 for joint tax returns. Primary residence is defined as your principal abode and the place where you lived for at least 2 years out of a five year look-back period ending on the date of the sale. There should be a substantial and consistent paper trail proving that a given address is in fact your principal residence. Such a paper trail would include utility bills, driver’s licenses, voter and vehicle registrations, insurance policies, and of course tax returns.
These rules are moderated for exceptional circumstances such as members of the military forced to relocate abroad, or the death of a taxpayer. In some cases the amount that may be excluded from tax is pro-rated. See IRS Regulation Sections 1.121-1 and 1.121-3.
( (7) Frequent Flyer Airline Miles and Credit Card Points
(A) Frequent Flyer Miles
This is a complex and evolving area of tax law and a great deal of confusion exists on whether and when frequent flyer miles are taxed or not. The only official guidance on the taxability of frequent flyer miles was provided in 2002 by IRS Announcement 2002-18 where the IRS stated it would not pursue the issue for now. Thus, frequent flyer miles are not taxable. However, the IRS is free to change its policy anytime on a prospective basis.
The idea behind the IRS policy is that frequent flyer miles are a rebate or reduction in the cost of air travel. If the air travel is personal then the rebate is tax-free because personal expenses are non-deductible. If travel relates to business use then the rebate would generally be taxable but for the fact the IRS has announced it will not pursue the matter at this time.
The recent (2012) Citigroup case is not covered by this rule because Citigroup gave away frequent flyer miles as a promotion, not a rebate. In 2012 Citigroup gained notoriety for issuing customers Form 1099-MISC reporting taxable income on frequent flyer miles provided to new customers for opening an account. Because these customers had not paid anything the free miles were treated as a taxable promotion. This treatment is correct. The fact that Citigroup appears to have overstated the fair market value of the promotion in order to maximize their own deduction is another matter. If you think you have been victimized by this type of scheme call your accountant.
In reading IRS guidance on this issue it is crucial to distinguish between taxable income as defined in IRC Section 61 and the airline excise tax imposed on air fares by IRC Section 4261. The first has nothing to do with the second.
( (B) Credit Card Points
Credit card points relating to personal (non-business) purchases are tax-free because they are treated as rebates, or a reduction in the cost of an item. Points related to business purchases are taxable because they reduce the cost of a business deduction. In 2002 the IRS issued PLR 200228001 which applied these rules and cited earlier guidance from Revenue Rulings 76-96 and 84-41.
( (8) Gifts and Inheritances
The receipt of gifts and inheritances is tax-free pursuant to IRC Section 102.
( (9) Hire Your Children
This is more like getting a deduction but the effect is the same as enjoying tax-free income. Dependent children with earned income are entitled to a standard deduction of $5,950 for 2012. The parent’s business could deduct $5,950 of salary for services provided by the children. But the children would have no income tax because of the standard deduction.
This scenario assumes the business of the parents can legitimately claim a salary deduction for actual services performed by the children. All business expenses must satisfy the “ordinary and necessary” standard of IRC Section 162. Salary expense is specifically deductible pursuant to IRS Regulation Section 1.162-7. And paying your child is a great way to teach responsibility and the value of work.
The parents (as employer) and children (as employees) would still owe a total of 13.3% (in 2012) social security tax on the income paid to them. But as long as the average effective federal and state income tax rate of the parents exceeds 12.35%, and assuming the parent’s business is an S corporation, then this strategy makes sense and reduces overall taxes. (Slightly different rules and outcomes apply to farms and unincorporated businesses.)
Proof:
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CASE 1: DO NOTHING |
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Family |
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|
Parent |
Child |
Total |
|
|
Business Income |
$50,000 |
$0 |
$50,000 |
|
Child's Salary |
N/A |
$0 |
$0 |
|
Child's Standard Deduction |
$0 |
$0 |
|
|
Taxable Income |
$50,000 |
$0 |
$50,000 |
|
Income Tax Rate |
12.35% |
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|
Total Taxes |
$6,175 |
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|
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CASE 2: PAY SALARY TO CHILD |
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|
Family |
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|
Parent |
Child |
Total |
|
|
Business Income |
$50,000 |
$0 |
$50,000 |
|
Child's Salary |
($5,950) |
$5,950 |
$0 |
|
Child's Standard Deduction |
($5,950) |
($5,950) |
|
|
Business Deduction of |
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|
Employer's Social Security Tax |
($455) |
$0 |
($455) |
|
Taxable Income |
$43,595 |
$0 |
$43,595 |
|
Income Tax Rate |
12.35% |
N/A |
12.35% |
|
Income Taxes |
$5,384 |
$0 |
$5,384 |
|
Employer Taxes |
$455 |
$0 |
$455 |
|
Child's Social Security Taxes |
N/A |
$336 |
$336 |
|
Total Taxes |
$5,839 |
$336 |
$6,175 |
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CONCLUSION |
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If the parent's average effective federal and state income tax rate exceeds |
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12.35% then this strategy of paying salary to the child will produce net tax benefits. |
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For each one percent that the parent's rate exceeds this break-even rate, net tax savings |
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of $64 will be realized. If the parent's rate is 32.35% tax savings will be $1,281 per year |
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per child. Further indirect tax savings may be realized by reducing the parent's income, |
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which may increase the amount of various tax credits for families that are based on |
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the parental income. |
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(10) Like Kind Exchanges
Pursuant to IRC Section 1031, qualified like-kind property can be exchanged tax-free for property that is the same kind. The rules governing like kind exchanges are complex. Always consult with a competent professional on such issues. Also note that like-kind exchanges merely defer when you pay the tax related to a property. Whenever you ultimately sell a property for cash any gain will be fully taxable at that time.
Income That Was Taxed That Should Not Have Been: Claim of Right
The claim of right doctrine is an equitable principle of tax law designed to ensure that taxpayers pay the correct and fair amount of tax. If you become legally obligated to repay to a third party an amount you were taxed on as income in a previous year the claim of right rule will ensure proper matching of tax rates and the deduction for the repayment.
The amount you have to repay may be claimed as a deduction pursuant to IRC Section 1341. If the repayment exceeds $3,000 you may instead claim a tax credit (not a deduction) based on the tax rate that applied in the year you were previously taxed on this income.
For example, assume you earn business income from a contract in the amount of $10,000 in the year 2009. Your tax rate in 2009 was 25%. In 2011 your business is sued and a court orders you to repay the entire $10,000. Assume that your tax rate in 2011 is 18%. Pursuant to IRS Regulation Section 1.1341-1 you may claim a tax credit of $2,500 on your 2011 tax return for the repayment. If the tax rate in the year of repayment is greater than the tax rate in the year you declared the item as income you may choose to claim a deduction instead of a tax credit. If the amount repaid is less than $3,000 you may only claim a deduction.
The claim of right rule protects taxpayers from paying taxes on income that is ultimately either eliminated (you have to give the money back) or reduced.
Use Prudent Skepticism About Tax-Free Income
I’ve seen and heard many claims that certain kinds of income are tax-free. Be cautious when evaluating such statements. The general rule of our tax system is that everything, absolutely all increases in wealth, are items of taxable income per IRC Section 61(a). The only legal way to avoid taxation is to find an internal revenue code section, official IRS guidance, court case, or tax treaty which affirmatively excludes an item of income from this general rule.
The structure of the Internal Revenue Code reflects the fact that everything is taxable unless specifically excluded. IRC Sections 101 through 140 represent the statutory laundry list of items Congress has chosen to exempt from tax.
If you or your accountant make the decision, by action or inaction, to exclude something from tax be ready to do one thing: prove it. You may have noticed that every single item of tax-free income mentioned here is corroborated by a supporting reference. Income may be exempt from tax; the tax-exemption is never exempt from proof.
It is extremely dangerous to allow lawyers and bureaucrats to own the law. The people own the law. Know it so you can use it. The Internal Revenue Code is available for free online at:
http://www.law.cornell.edu/uscode/text/26
“The power to tax is the power to destroy.”
John Marshall, First Chief Justice of the U.S. Supreme Court
George Adams
Certified Public Accountant Master of Business Administration
Tel: (207) 989-2700 E-Mail: GeorgeAdams@IntelligenceForRent.com
450 South Main Street: The HQ of IQ
Brewer, Maine 04412-2339
©2015 Copyright George Adams CPA MBA. All Rights Reserved.