Same-sex Marriage and Paycheck Withholdings – An Unpleasant Surprise on 2014 Tax Returns

Image courtesy of user Nemo on Pixabay.com
Image courtesy of user Nemo on Pixabay.com

A trend I noticed this year with my clients who are in same-gender marriages: an unpleasant surprise at tax time because of changes to their paycheck withholdings in 2014.

Some of my clients went from getting a refund of several-thousand dollars in prior years to owing several-thousand dollars on their 2014 tax return.

What’s Going On?

(For all of these examples, I am using the withholding tables in Publication 15 for 0 exemptions.)

This issue has everything to do with how much income tax is withheld from a person’s paycheck. Contrary to what the H&R Block and TurboTax commercials imply, there’s no magic that a preparer can work to give people a bigger refund — tax refunds are almost always determined by how much tax was withheld from wages during the year.

With paycheck withholdings, there are two withholding options: single or married. More taxes are withheld under the single rates than the married rates. Note: this refers only to how much tax is taken out of paychecks, not to how much tax a person will owe on their tax return.

Here are examples of how this affects couples in same-sex marriages:

EXAMPLE 1

Lloyd and Floyd are married. In 2013 (the year the Supreme Court struck down the Defense of Marriage Act), Lloyd and Floyd’s employers considered them single for withholding purposes and withheld at the single rates.

Lloyd makes $1,000 per payday and is paid twice a month. Floyd makes $2,000 per payday and is also paid twice a month. Assume that they claim 0 exemptions.

Using the withholding tables in IRS Publication 15, Lloyd will have $118 withheld from his paycheck each payday ($2,832 per year) and Floyd will have $303 withheld each payday ($7,272 per year). Total withholding between the two of them is $10,104.

Let’s assume Lloyd and Floyd file as married in 2013, using the standard deduction. No kids, no credits, etc.

Their gross income is $72,000. Exemptions of $3,900 each = $7,800. The standard deduction for a married couple in 2013 was $12,200. Their taxable income is: $72,000 – $7,800 – $12,200 = $52,000. The tax owed on $52,000 by a married couple in 2013 was $6,911.

Lloyd and Floyd would have received a refund of $3,193. ($6,911 tax liability minus withholding of $10,104.)

EXAMPLE 2:

Now it’s 2014. The employers of both Lloyd and Floyd have now switched to withholding at the “married” levels.

Now Lloyd has $68 withheld each paycheck ($1,632 per year) and Floyd has $216 withheld each paycheck ($5,184 per year). Total withholding is $6,816.

Their gross income remains $72,000. Exemptions nudged up to $3,950 each = $7,900. The standard deduction for a married couple in 2014 is $12,400. Their taxable income is: $72,000 – $7,900 – $12,400 = $51,700. The tax owed on $51,700 by a married couple in 2014 is $6,851.

Since their withholding dropped by so much, they end up owing $35 dollars this time around: a swing of more than $3,200.

Note that their tax liability actually dropped slightly in 2014, but they still end up owing because of the big shift in withholding.

With some of my clients this year, the shift resulted in them owing thousands of dollars.

SOLUTION

Married people can elect to have their withholding come out at the single level, and that’s the best thing to do if a couple in a same-gender marriage finds themselves owing thousands of dollars at tax time.

In Lloyd and Floyd’s case, they could also choose to leave things as-is, as owing $35 means they nailed their withholding exactly right during the year … but that’s another topic for another day.

Glossary: Capital Gain/Capital Loss

income-tax-491626_1280 (2)In the tax world, a capital gain or capital loss results from the sale of an asset.

To calculate the gain or loss, you need to know two things:

  1. Your basis in the asset
  2. How much you received when you sold the asset

Basis

Basis means your stake in the asset. For most assets, your basis will be what you originally paid for it, minus any depreciation deductions taken against the asset.

If the asset is an investment in a partnership or S-Corporation, your basis is what you originally paid for your ownership stake, adjusted by the yearly profit or loss of the business, any withdrawals you’ve taken or additional money you’ve paid in, and various other factors.

(Note: this is a very, very basic overview of basis.)

Gain or Loss

If you sold the asset for more than your basis, you have a capital gain. If you sold the asset for less than your basis, you have a capital loss.

The tax treatment of that gain or loss varies. Long-term gains result from the sale of assets you’ve held for more than one year. Special tax rates apply to long-term gains. Short-term capital gains are typically considered ordinary income, meaning no special tax rates apply.

This is a general discussion of gains and losses. It can get complicated if you’re selling business property and depreciation was claimed, some or all of the gain may be considered short-term, even though you’ve held the asset for more than one year. This is called depreciation recapture, and is a different topic for a different day.

Losses

Capital losses can be deducted on your personal tax return but are generally limited to a maximum deduction $3,000 per year.

Marriage in the Tax Code, Part 7: 1920s Court Battles

wedding-rings-150300_1280The IRS issued a ruling on community property laws in 1920, and then modified its stance several times throughout the 1920s.

The IRS originally said only spouses in Texas and Washington could apply community property laws, and then only on non-wage income (dividends, interest, etc.).

The U.S. Attorney General then jumped in and concluded that community property laws applied to all income in every community property state – except California. (For more information, see this research paper by Professor Pat Cain.)

A couple from California named Robbins challenged the Attorney General’s ruling. The couple had, in 1918, filed separate returns using community property law, even though Mrs. Robbins had no income herself.

The couple was victorious in Federal District Court in 1925. But the government appealed to the U.S. Supreme Court, and the Supreme Court ruled against the couple and in favor of the government in 1926.

The Supreme Court ruling was based on an interpretation of California community property law as giving the husband complete control over all community income. Therefore, the husband should report – and pay tax on – all community income, even income earned by the wife.

The Robbins ruling caused the Treasury Department to revisit its stance on community property rules. Now they proposed that community property rules do not apply in any community property state and that husbands should be taxed 100% on all income, even if the wife had her own separate earnings.

Taxpayers and elected officials in community property states protested. The Attorney General responded by holding public hearings, which ultimately ended in new guidance being issued — culminating with another Supreme Court ruling.

More on that in Part 8.

What to Do with a K-1 with a Fiscal Year End

K-1Question: I received a K-1 from a partnership I’m invested in. Their fiscal year-end is September 30th.

The K-1 for the year ended September 30, 2014 shows that it’s a 2013 K-1. I received the K-1 in 2015. What year do I report this K-1?

Answer: for taxpayers receiving a Form K-1, the information is reported based on the fiscal year-end. In this example, the information would be reported on the taxpayer’s 2014 tax return because the K-1 relates to the year ended September 30, 2014.

The fact that the form says it’s a 2013 form is relevant on the partnership side (the partnership’s tax return for the FYE 9/30/14 is considered a 2013 filing on the partnership side). But this isn’t relevant for the recipient.

Send a 1099-C to a Non-Paying Customer? Updated

invoice-153413_1280
Image courtesy of user OpenClips on Pixabay.com

More than 2 years ago, I wrote a post about whether or not it was okay for a business to issue a Form 1099-C to a customer or client who failed to pay an invoice.

I researched the issue heavily at the time, and turned up almost no information. Based on what little I could find, I concluded that it was probably okay to send a 1099-C to a deadbeat customer, but that I thought it was a bad idea.

We now know a little more about the IRS’s view on this subject, at least as it relates to tax professionals sending deadbeat clients a 1099-C. The IRS addressed the issue in an alert from the Office of Professional Responsibility dated February 5, 2015.

The alert is worth reading in its entirety, but here’s the bottom line from the IRS:

It is difficult to conceive of a situation in which a tax professional, principally engaged in providing tax services will be an “applicable entity” justifying the use of Form 1099-C to attribute income to an arguably scofflaw client for the nonpayment.

This alert from the IRS specifically addresses tax pros, but I think the concept could apply to all businesses in general. As I wrote in my original post:

Personally, I wouldn’t issue a 1099-C to a deadbeat client. I realize there may be some satisfaction in threatening a deadbeat and seeing them sweat. But I think it would cause more harm than good to go down the 1099-C route …. I would just fire them, move on with my life and replace the deadbeat with a better client.