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How to Claim Tax Refund while Your Prior Bonus was Taken Back?

A few clients were unfortunately asked to return the bonuses previously issued to them resultant from companies' performances not meeting expectations. This situation called for a special tax return: Claim of Rights tax credit. This is an uncommon tax credit. For example, a hedge fund partnership did not meet investment expectations, the company decided in 2022 to withdraw its partners' bonuses issued in 2021. In this case, the correction was not a result of mistakes, the company could choose to make amendments through a mechanism called “Clawback”, instead of reissuing K-1 (amended partnership tax return). At this time, similarly the individuals did not need to correct the prior year tax returns. Rather they could claim their refunds in their current tax return through a process that IRS calls Claim of Rights.  As the bonus withdrawal is a rare event fortunately, I suppose 95% of CPAs did not have experiences applying for Claim of Rights tax credits.​

Passive Foreign Investments and Tax Planning

 
We often help clients with foreign investments decide to declare their foreign investment funds, and more importantly develop a near to mid-term tax plan under current tax policies and codes. These questions are best addressed by understanding the PFIC tax rules (Passive Foreign Investment Company) which apply to all passive investments outside the US, not limited to a specific country.

A PFIC is defined as a foreign company that meets one of these two conditions: 1) income: 75% or more of its gross income is passive income, e.g., income from leased property, limited partnerships, or other non-actively participating businesses; and 2) assets: 50% or more of the company's assets generate passive income, e.g,, overseas mutual funds, hedge funds, insurance products, and pension plans. There are three tax filing options for PFIC income:

1) Do nothing. In this option all earnings of the investment, including capital gains from the sale of stocks, are treated as ordinary income vs. more favorable Long-Term Capital Gains (LTCGs). In addition, if the investment income of the current year exceeds 125% of the average return of previous three years, the excess income will be evenly spread over the prior years and taxed at the highest rate of the previous years (e.g, 37%), plus the interests on the previous year's amended tax returns. Obviously, the doing nothing option is the least tax advantageous. To avoid the punitive Excess Distributions described above, US tax law allows investors two alternatives: Qualified Selection Funds (QEF) and Market Value Declaration (Mark-to-Market).

2) QEF, Qualified Electing Fund Election. By filing Form 8621 and selecting PFICs investors can enjoy LTCGs tax rates. However, this option requires an annual QEF Statement from the investment company which is not always readily accessible overseas. For example, Chinese funds rarely issue QEF Statements to investors. The PFIC Statement must contain the following information: the scope to which the annual statement applies, the shareholder's share of ordinary income and capital gains for the year, the values of cash or other assets distributed during the year, and a statement that the foreign company allows the shareholder to view the details of the earnings calculation.

3) Now let's look at option three Mark-to-Market, which recognizes annual earnings at year-end market values, regardless of whether the shares have been sold. This option requires the investment has open stock market prices. All gains are taxed as ordinary income, not capital gains.

You can see all three options are punitive in nature with the first option being the least favorable to investors. Option two is the most favorable of the three, but this option may be constrained due to the required QEF Statements. Although option three is better than option one, the investments are taxed as ordinary income. The punitive nature of these options is fundamentally due to the current tax codes encouraging money to return to the US.  Clients will need to keep this in mind for near or mid-term tax planning.​

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                President Biden Tax Return Analysis

President Biden is 81 years old and Ms. Biden is 73. Ms. Biden has been a teacher for a long time, and she still works at Northern Virginia Community College.

President Biden's 2022 Adjusted Gross Income was $579,514, with federal taxes of $137,658. His total household income in 2023 was $619,976, with federal taxes of $146,629. The President earned $400,000 a year, and Ms. Biden earned more than $90,000. The Biden household had $39,455 in bank interest income in 2023 and no direct securities or stock investment income.  According to the tax returns, Mr. and Ms. Biden each hold a small investment in an S-Corp, and the investment cost at the beginning of 2022 was about $93,000, and the company's revenue in 2022 was $5,092, and the company's income in 2023 was $4,115. The Biden family had an estimated $35,000 in pension income (IRA and Pension minimum distributions) each year in the past two years. In addition, they had more than $60,000 in social security pensions in 2023 ($42,842 for Mr. Biden and $21,412 for Ms. Biden), in line with most high-wage earners in the U.S. In the past two years, the President's family has given more than $20,000 to charity each year. They paid more than $23,000 in property taxes and about $20,000 in mortgage interests every year. According to media reports, the net worth of the Biden family is about $10 million, including two properties worth $7 million in Delaware.

In general, except for higher salaries, the Biden’s income is in line with the income of the U.S. middle-class. In addition, folks in the U.S. generally have home loans, even if they have enough cash assets. Loan interest rates in the U.S. are low compared to paybacks from investments. Therefore, many folks choose to keep loans on their properties as the President does.

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              How Gifting Stocks to Children Help Avoid Taxes and Passes Down Wealth?

Gifting stocks is one of the most frequently used means of tax avoidance and family wealth preservation by high-net-worth families in the US. First, let’s review charitable donations of stocks. Donating stocks can save more on taxes than donating cash. This is because the gift of appreciated stocks can completely avoid the realized capital gains tax, and you can deduct from your taxable income per the average market price of the gifted stocks on the day. Note that you can only donate stocks that have been held for more than one year and have appreciated in value. Two points are noteworthy here: 1) the IRS stipulates that the gift of stocks that have been held for less than one year can only be calculated at cost price; 2) gifting stocks that have been losing value is not worth it due to the lower market price of the stocks. You can't deduct the stock loss from your taxable income either.

Next, let’s look at the role of non-charitable donations in tax avoidance. The US has progressive tax rates, meaning the higher the income, the higher the tax rate. Donating stocks to people with low tax rates to sell will save taxes. Two points are noteworthy here: 1) each person can only give a maximum of $16,000 a year to a certain person without reporting gift tax (does not take up the lifetime gift tax exemption); 2) Don't gift underaged children to sell stocks, because the Kiddie Tax clause in the tax law stipulates the tax rate for investment income above $2300 for the minor is the same as the highest tax rate for the parents. An example is that a son donated his greatly appreciated stocks to his foreign father who is not a US tax resident, and he declared the gift tax himself (less than the lifetime tax exemption, no tax). The father did not need to pay US taxes either for the gains in the US stock market.

Lastly, let’s review the benefits of stocks in passing down family wealth. The US inheritance tax law allows the cost price of the inheritance to step up, that is, the cost price of the stocks received by the heirs of the inheritance will automatically increase to the market price on the day of the death of the family member. Therefore, the heirs can avoid taxes on the appreciation of those stocks when they sell them in the future. For the deceased, there is no difference in estate tax while leaving cash or appreciated stocks of the same value. However leaving appreciated stocks or other non-cash assets can save capital gains tax on the appreciation.

To the person who receives the stocks as a gift, the new cost price of the stocks is a common point of confusion. As described above, the appreciated stocks acquired through inheritance will receive the market price on the day of the death as the new cost price. However, if the stocks are in a state of loss when the stocks are gifted, the cost price of the recipient at this time is undetermined and will be determined by the profit and loss when the stocks are sold. For instance, a grandfather donates stocks to his grandson. The cost price of the grandfather’s stock is $10/share, and the market price at the time of gift is $5/share. If the grandson sells those stocks at $15/s in the future, the cost price for the grandson is the original cost of $10/s; If the stocks are sold at $3/s, the cost price is $5/s. If the stocks are sold at a price between $5/s and $10/s, the grandson will have no loss or profit.  This cost-price rule also shows there is little tax benefit to gift stocks that are losing value.

How Could Personal Tax Rates Change in a War?

 
As the Russia-Ukraine war soon may enter its third year, and tensions across the Taiwan Strait intensifies, some folks may become concerned about the impact of wars on their assets. There are reasons for those concerns. Tax rates alone may become more aggressive during war time. Let's take a look at the tax rates in the past century in the US.

The US personal taxes are progressive, meaning the higher the income, the higher the tax rate. Let’s review the historical evolution of the top tax rates. First, the impact of a major war on US tax rates was enormous, even if the battle was fought outside of the US. For example, after the WWI (1914-1918) the top tax rate soared from 7% (pre-war, 1913-1915) to 77% in 1918. The maximum tax rate in WWII (1939-1945) was 94%, and in the 35 years after the end of WWII (1946-1980), the top tax rate never fell below 70%. In the past 100 years, the lowest personal tax rate in the US was 24% (1929, when the Great Depression began).

Another factor that influences the top tax rates is economic prosperity.

The first few years of the Great Depression were the lowest in 100

years in the US, with a maximum of 24%-25% in 1925-1931, but the

maximum tax rate soared to 63% (1932-1935) as soon as the stimulus

was in place. The current personal tax rate is at 37% (since 2018),

which is at the lower-middle level in the past 100 years.

We picked out some quick numbers: in the 100 years between 1920

and 2019, there were 16 years in which the tax rate was higher than

90%, 8 years in the 80%-90% range, 23 years in the 70% range, 5

years in the 60% range, 7 years in the 50% range, 1 year in the 40%

range, 30 years in the 30% range, and 10 years in the 20% range.

In short, the years of peace and the period of moderate economic

development are the years when tax rates are lowest. Trump's tax

reform policy is expected to end at the end of 2025, which means

that the current top personal tax rate may change in 2026.

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                Trump Tax Return Analysis 2023

On December 30, 2022, the Ways and Means Committee of the US House of Representatives released the tax returns of former President Trump for the six years from 2015 to 2020. We downloaded and read the tax forms.  Here's our quick analysis from seasoned CPAs' perspective.

During the six years from 2015 to 2020, Trump paid $4,435,961 in federal taxes, an average of $740,000 in federal taxes per year. During the six-year period, Trump had zero taxable income in four years. The highest taxable income in 2018 was $22,951,389.

As a billionaire, it is somewhat unexpected to have zero tax income for four years. A main reason was that prior to 2015, Trump had $105M in uncollected business losses that could be used against future profits. It has been known that Trump had several large companies go bankrupt, and the loss of more than $100M was likely to come from the previously failed companies.  Corresponding to the deferred loss of more than $100M, Trump recognized a total of $113M in debt forgiveness income during the four-year period from 2015 to 2018. This is in line with previous rumors about Trump.

Judging from Trump's sources of income, his real estate investment was relatively heavy. There was about $10M in interest income per year, most of which came from several real estate companies. However, most of its physical management companies were losing money, with an average annual loss of $14M, which was in line with the characteristics of real estate profitability in US metropolises. The profit lies in the appreciation of the property while the rental loses money. Trump's total capital gains over those six years were $90M, $6M over his operating losses during that period.

What’s more interesting is that prior to becoming the President, Trump also had a wide variety of self-employment income (Schedule C) in addition to his real estate and other investments. His businesses included real estate, management, sales, actors, speeches, helicopters, private airliners, golf courses, ice rinks, restaurants, loan brokers, and more.  Furthermore, Trump had many foreign investments across the world, including the UK, Ireland, China, India, Canada, the Philippines and more than 20 countries. Trump had bank accounts in China, which was broadly criticized by the media.

Trump had given away more than $4M in cash to charities over the past six years but made no donations in 2020.  The media criticized Trump for only paying $750 taxes annually in 2016 and 2017. In fact, those descriptions were usually inaccurate. For example, in 2017, although Trump’s taxable income was little, his Alternative Minimum Tax (Alternative Minimum Tax) was $7,435,857.  It took $7,435,107 of General Businesses Credit (I speculate most of that was the rehabilitation tax credits received from his real estate investment) to reduce his tax of $7M income to $750 in 2017. Including other odds and ends such as investment income tax and self-employment payroll tax, his 2017 effective tax was $284,718, and his 2016 effective tax was $614,299. Tax credit was legit for redevelopment and renovation of old properties. Wealthy individuals pay relatively little taxes for many reasons, often not the result of illegal tax evasion.

Until 2017 the IRS allowed deductions for tax preparation expenses. Trump paid $573,581 for accountants in 2015 and $1,295,385 in 2016. Evidently Trump took tax returns seriously. In addition, based on the connections between the years before and after those tax returns, the IRS may have audited and adjusted Trump's tax returns. For example, his 2015 tax return declared a non-cash donation of $21,078,900. Due to the limitation of the taxable income of that year, all donations were rolled over to the following year for deduction. However, on his 2016 tax return, the annual carryover donations (carryover) became only $5,273,458, which means that 75%+ or $15.8M in non-cash donations were cut out by the IRS.

Trump made investments around the world in real estate and many other areas. Discounting the losses prior to 2015 and the donations in those six years, he may have earned ~$70M in those six years. Those earnings were low compared to his self-proclaimed $3B net worth.

Now you can speculate why Trump had been reluctant to release his tax returns unlike other Presidents. His history of huge losses, hundreds of millions of dollars in debt forgiveness, and years of operating losses (in addition to capital gains) may paint a picture apposite of what had been presented to the public.  In addition, extensive foreign investments likely bring on many issues to the Presidency.
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QSBS - Tax Exemptions for Startup Founders and Investors

Since 1993, the IRS has given significant tax incentives to founders and venture capitalists of startups to encourage entrepreneurship, and the tax law is called Section 1202, QSBS (Qualified Small Business Stock Capital Gain Exclusion). This tax law allows taxpayers to waive $10 million in capital gain income for direct investment in qualified startups who have held the stock for >5 years. This is currently the single largest personal tax incentive for startup investors. Although the tax law has undergone three major amendments, the basic requirement for holding shares for >5 years has not changed. The original shares acquired between 8/11/1993 and 2/17/2009 enjoy a 50% income exemption; the original stock acquired between 2/18/2009 and 9/27/ 2010 was granted a 75% income waiver; acquired after 9/27/2010 with 100% income exemption. The waiver is capped at $10 million net income or more (see below).

There are two ways to realize this exemption, and you can choose the calculation method with the largest benefit. One calculation method is that the cumulative exemption limit of a single company's stock income in one year or reaches $10 million; The other is to exempt a single stock from 10 times the cost of investing in it within a year. For example, if your startup stock costs $3 million, and you sell it for $30 million after 5 years, you can completely waive the $30 million income. When the cost of stock is low, you may only be entitled to a $10 million waiver.

​So what stocks qualifies as Small Company Stocks? "Company" refers to a US-based C Corporation, not an S Corp. or LLC.  "Small" means that the total assets of the Company can’t exceed $50M when you acquire the Company's shares, including the total assets of the Company immediately before or after the offering of new shares. Qualified companies can’t be people-oriented service companies, e.g, lawyers, engineers, consultants, nor can they be banking, insurance, leasing, or other financial investment companies. There is also an 80% limit, meaning the Company must use at least 80% of its assets for its own business activities each year, and can’t use >20% of its assets for unrelated investments, e.g, real estate.

Who is a Qualified Shareholder? Eligible stockholders must be shares acquired directly from the Company and can’t be purchased from a third party. However, shares acquired through an estate or gift can be considered exempt on an equal basis as the original holder. If your exempt income has reached the limit, you could give it to your family. Each person receiving a gift also has an income exemption of at least $10 million. Options or stock warrants held by employees of the Company are not considered eligible stocks, and only when the options are exercised, and the stock is fully vested.

What about state exemptions? The above is the federal tax law, and most states grant those exemptions in state taxes except CA, NJ, PA, AL and MI. Massachusetts only gives a fixed preferential tax rate of 3% for companies incorporated after 12/31/2010. Most U.S. tax laws have a number of additional restrictions that can be far more complex than discussed here. Consult with your accountant as needed.​

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   How to Reduce Taxes on Stock Options and Restricted Stock Units?

To optimize returns on stock options and stocks, it is important for CEOs, founders, executives and startup employees to understand the various tax implications. Presently there are generally two types of stock options for US companies: ISO and NSO.

An ISO (Incentive Stock Option), used to award the company employees, is generally set to be valid for <10 years, and exclude those shareholders who have already owned >10% of the company. The granting price of an ISO cannot exceed the stock's market price at the time, and the market value that can be exercised in the first year cannot exceed $100,000. An ISO also has vesting limitations. An ISO is favorable in terms of personal taxes because Its income is taxed as Long-Term Capital Gains (rates 15%~23.8%). There are two requirements on the holding period. An ISO is required to be held 1) for at least two years from the granting date, and 2) for at least one year from the exercising date. One disadvantage of an ISO is that the difference between the exercise price and the stock's current market price is taxed as Alternative Minimum Tax (AMT) for the year. Thus you likely will end up paying more taxes even if you do not sell the stock that year.

An NSO (Non-Qualified Stock Option) has fewer restrictions, therefore many companies currently adopt this incentive mechanism. The annual award amount can reach really high. An NSO is mainly taxed in two ways. 1) When the NSO is exercised, the difference between the market price and the exercised price is taxed as ordinary income of the year. The unrealized income of the difference will be added to your W-2. 2) When the NSO is sold, the difference between the sale price and the market price at the time of exercising is taxed as capital gains. An NSO held for over a year is Long-Term Capital Gains, otherwise Short-Term Capital Gains (rate 40.8%).

Additionally, many companies use RSUs (Restricted Stock Unit) to incentivize their employees. Note a RSU is no longer a stock option, rather a company stock. A RSU has a certain value while a stock option might end up worthless. When the RSU becomes vested, the market price on the vesting day is taxed as your ordinary income with possible highest rate of 37%. If you expect your RSU to significantly increase in market price in down the road, you may make a written election within 30 days of the granting date (IRS 83(b) Election), in order to apply the current market price in ordinary income tax calculations. Some companies form a new entity to take advantage of this election. The new entity awards employees with low market price RSUs. As the new entity performs as expected, the company incrementally introduces higher value assets into the new entity to help lift the stock price of the new entity. When the RSU becomes vested and sold in the future, the income from the RSU becomes Long-Term Capital Gains taxed at much lower rates than ordinary income.​

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                How Corporate Transparency Act Affects Company Shareholders?

A new US regulation similar to FBAR was promulgated on September 30, 2022. Simply put, the federal government wants to know who are behind small businesses and foreign companies. It was said the intent is to control financial crimes such as money laundering and tax evasion.

As a result starting from January 1, 2024, all companies formed in the US or registered to do business in the US (while formed in other countries) including corporations, LLCs, etc., need to submit annual reports to the Financial Crimes Enforcement Network (FinCEN) of the Treasury Department to disclose 1) company name, address, tax ID, and the state where the company is registered; 2) report the name, date of birth, address, and tax ID of the shareholders who own >25% of the company or individuals who have significant decision-making capacities on the company. This rule does not apply to listed companies, financial institutions registered with the SEC, and charities. Companies with revenues > $5B and >20 full-time employees in the US are also exempt.

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