News & Tech Tips

Tax and other financial consequences of tax-free bonds

If you’re interested in investing in tax-free municipal bonds, you may wonder if they’re really free of taxes. While the investment generally provides tax-free interest on the federal (and possibly state) level, there may be tax consequences. Here’s how the rules work.

Purchasing a bond

If you buy a tax-exempt bond for its face amount, either on the initial offering or in the market, there are no immediate tax consequences. If you buy such a bond between interest payment dates, you’ll have to pay the seller any interest accrued since the last interest payment date. This amount is treated as a capital investment and is deducted from the next interest payment as a return of capital.

Interest excluded from income

In general, interest received on a tax-free municipal bond isn’t included in gross income although it may be includible for alternative minimum tax (AMT) purposes. While tax-free interest is attractive, keep in mind that a municipal bond may pay a lower interest rate than an otherwise equivalent taxable investment. The after-tax yield is what counts.

In the case of a tax-free bond, the after-tax yield is generally equal to the pre-tax yield. With a taxable bond, the after-tax yield is based on the amount of interest you have after taking into account the increase in your tax liability on account of annual interest payments. This depends on your effective tax bracket. In general, tax-free bonds are likely to be appealing to taxpayers in higher brackets since they receive a greater benefit from excluding interest from income. For lower-bracket taxpayers, the tax benefit from excluding interest from income may not be enough to make up for a lower interest rate.

Even though municipal bond interest isn’t taxable, it’s shown on a tax return. This is because tax-exempt interest is taken into account when determining the amount of Social Security benefits that are taxable as well as other tax breaks.

Another tax advantage

Tax-exempt bond interest is also exempt from the 3.8% net investment income tax (NIIT). The NIIT is imposed on the investment income of individuals whose adjusted gross income exceeds $250,000 for joint filers, $125,000 for married filing separate filers, and $200,000 for other taxpayers.

Tax-deferred retirement accounts

It generally doesn’t make sense to hold municipal bonds in your traditional IRA or 401(k) account. The income in these accounts isn’t taxed currently. But once you start taking distributions, the entire amount withdrawn is likely to be taxed. Thus, if you want to invest retirement funds in fixed income obligations, it’s generally advisable to invest in higher-yielding taxable securities.

We can help

These are only some of the tax consequences of investing in municipal bonds. As mentioned, there may be AMT implications. And if you receive Social Security benefits, investing in municipal bonds could increase the amount of tax you must pay with respect to the benefits. Contact us if you need assistance applying the tax rules to your situation or if you have any questions.

© 2022

SEC Chair Gensler warns about conflicts of interest

Securities and Exchange Commission (SEC) Chair Gary Gensler spoke during a recent webcast to commemorate the 20-year anniversary of the Sarbanes-Oxley Act. Gensler recommended that the SEC take a “fresh look” at its rules on the issue of auditor conflicts of interest. He also asked the Public Company Accounting Oversight Board (PCAOB) to add auditor independence standards to its 2023 agenda.

Here’s why independence matters for public and private entities alike and what you can do to identify and minimize potential conflicts of interest.

SEC oversight

Enacted in the aftermath of the Enron and WorldCom accounting scandals, the Sarbanes-Oxley Act directed the SEC to create barriers between auditors and other parts of their firms. This caused many firms to spin off their consulting businesses into separate entities. “Over the past 20 years, however, many of these firms went on to rebuild them again. PCAOB inspections continue to identify independence — and lack of professional skepticism — as perennial problem areas,” said Gensler.

Under Rule 2-01 of Regulation S-X, when investigating auditor independence, the SEC considers whether an engagement:

  • Creates a mutual or conflicting interest,
  • Puts the auditor in a position of auditing his or her own work,
  • Results in the auditor acting as a member of management or an employee of its audit client, or
  • Puts the auditor in a position of being the client’s advocate.

The SEC’s guidance applies to audit firms, covered people in those firms and their immediate family members. The concept of “covered people” extends beyond audit team members. It may include individuals in the firm’s chain of command who might affect the audit process, as well as other current and former partners and managers.

For example, an audit firm might not be independent if, at any time during the audit engagement, a former partner or professional employee is in an accounting or financial reporting oversight role at an audit client. Such an arrangement may be particularly problematic if the former partner has a buyout arrangement that’s contingent on the firm’s operating results.

AICPA guidance

Conflicts of interest are an area of concern for all organizations, not just public companies. According to the American Institute of Certified Public Accountants (AICPA), “A conflict of interest may occur if a member performs a professional service for a client and the member or his or her firm has a relationship with another person, entity, product or service that could, in the member’s professional judgment, be viewed by the client or other appropriate parties as impairing the member’s objectivity.” Management should be on the lookout for potential conflicts when:

  • Hiring an external auditor,
  • Upgrading the level of assurance from a compilation or review to an audit, and
  • Using the audit firm for a nonaudit purposes, such as investment advisory services and human resource consulting

Determining whether a conflict of interest exists requires an analysis of facts. Some conflicts may be obvious, while others may require in-depth scrutiny.

For example, suppose a company asks its audit firm to provide financial consulting services in a legal dispute with another company that’s also an existing audit client. Here, given the inside knowledge the audit firm possesses of the company it audits, a conflict of interest likely exists. The audit firm can’t serve both parties to the lawsuit and comply with the AICPA’s ethical and professional standards.

Diligence is critical 

Before the start of audit season, it’s important to re-evaluate whether there’s been any change in circumstances this year between your organization and your audit firm that could create potential conflicts of interest. Examples include staffing changes, M&A activity and new service offerings. This is a matter our firm takes seriously and proactively safeguards against. If you suspect that a conflict exists, contact us to discuss the matter and determine the most appropriate way to handle it.

© 2022

Investing in the future with a 529 education plan

If you have a child or grandchild who’s going to attend college in the future, you’ve probably heard about qualified tuition programs, also known as 529 plans. These plans, named for the Internal Revenue Code section that provides for them, allow prepayment of higher education costs on a tax-favored basis.

There are two types of programs:

  1. Prepaid plans, which allow you to buy tuition credits or certificates at present tuition rates, even though the beneficiary (child) won’t be starting college for some time; and
  2. Savings plans, which depend on the investment performance of the fund(s) you place your contributions in.

You don’t get a federal income tax deduction for a contribution, but the earnings on the account aren’t taxed while the funds are in the program. (Contributors are eligible for state tax deductions in some states.) You can change the beneficiary or roll over the funds in the program to another plan for the same or a different beneficiary without income tax consequences.

Distributions from the program are tax-free up to the amount of the student’s “qualified higher education expenses.” These include tuition (including up to $10,000 in tuition for an elementary or secondary public, private or religious school), fees, books, supplies and required equipment. Reasonable room and board is also a qualified expense if the student is enrolled at least half time.

Distributions from a 529 plan can also be used to make tax-free payments of principal or interest on a loan to pay qualified higher education expenses of the beneficiary or a sibling of the beneficiary.

What about distributions in excess of qualified expenses? They’re taxed to the beneficiary to the extent that they represent earnings on the account. A 10% penalty tax is also imposed.

Eligible schools include colleges, universities, vocational schools or other postsecondary schools eligible to participate in a student aid program of the U.S. Department of Education. This includes nearly all accredited public, nonprofit and for-profit postsecondary institutions.

However, “qualified higher education expenses” also include expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private or religious school.

A school should be able to tell you whether it qualifies.

The contributions you make to the qualified tuition program are treated as gifts to the student, but the contributions qualify for the gift tax exclusion amount ($16,000 for 2022, adjusted for inflation). If your contributions in a year exceed the exclusion amount, you can elect to take the contributions into account ratably over a five-year period starting with the year of the contributions. Thus, assuming you make no other gifts to that beneficiary, you could contribute up to $80,000 per beneficiary in 2022 without gift tax. (In that case, any additional contributions during the next four years would be subject to gift tax, except to the extent that the exclusion amount increases.) You and your spouse together could contribute $160,000 for 2022 per beneficiary, subject to any contribution limits imposed by the plan.

A distribution from a qualified tuition program isn’t subject to gift tax, but a change in beneficiary or rollover to the account of a new beneficiary may be. Contact us with questions about tax-saving ways to save and pay for college.

© 2022

FASB proposes last-minute changes to lease accounting rules

Accounting Standards Codification Topic 842, Leases, requires organizations to report the full magnitude of their long-term lease obligations on their balance sheets — a historic first. For private companies and nonprofits, the changes take effect this year. Public entities adopted the rules in 2019. While the Financial Accounting Standards Board (FASB) conducts its post-implementation review of the new-and-improved lease standard, the guidance is concurrently being adopted by private organizations.

A major issue that has surfaced relates to leases under common control. In a surprise move, the FASB voted on September 21 to propose changes to address stakeholder concerns.


Practical expedient for related-party leases

Topic 842 requires an organization to account for a lease that’s under common control on the basis of the legally enforceable provisions. Problems arose for private companies because some don’t have written documentation of related-party leases, and they’re confused about what’s “legally enforceable.”

FASB members unanimously agreed to propose a practical expedient for private entities to simplify the guidance for determining whether a lease exists for arrangements between entities under common control. A practical expedient is an accounting workaround with a simpler approach to arriving at the same answer as the initial rule.

The proposal specifies that entities would only consider the written terms and conditions when determining whether a lease exists, and the classification and accounting for that lease. Entities wouldn’t be required to determine whether those written terms and conditions are legally enforceable. Moreover, if no written terms and conditions exist, an entity would apply Topic 842 to any verbal or implicit terms and conditions. If no lease exists, other rules would apply.


Clarity on leasehold improvements

An affiliated issue that came up during the FASB’s review of Topic 842 is how to handle the treatment of leasehold improvements when there’s a verbal related-party transaction. In many cases, the life of the related-party lease could substantially differ from the actual life of the underlying lease asset.

The term “leasehold improvement” generally refers to changes, buildouts or upgrades to real property made by a commercial tenant. For example, you might paint, update lighting, install new carpet or make repairs to a space.

FASB members voted 4-3 to propose an amendment to Topic 842 that would specify that leasehold improvements associated with leases between entities under common control be “amortized by the lessee over the useful life of the improvements (regardless of the lease term) as long as the lessee continues to use the underlying asset.” If the lessee stops using the leased asset, it would then be “accounted for as a transfer between entities under common control.”

To be clear, if approved, this change would apply to both public and private entities. Public companies already implemented the updated standard in 2019.

It’s important to note that three FASB members dissented to proposing changes to leasehold improvement rules. The dissenters said that they didn’t have enough information to vote to propose changes for public companies and were uncertain about any secondary or indirect implications of the proposal. The members who were in favor of the proposal indicated that public companies would largely be unaffected by the changes. Their leases tend to be arm’s length, written agreements, regardless of whether the lessors are third parties or under common control.


Stay tuned

Since the updated lease guidance was issued in 2016, it has been deferred twice and amended five times. Once these two last-minute proposals are issued, there will be a 45-day comment period. In the meantime, private organizations must continue pushing forward with adopting the updated guidance for 2022. Contact us for help onboarding the changes, including any amendments for leases under common control.

© 2022

Year-end tax planning ideas for individuals

Now that fall is officially here, it’s a good time to start taking steps that may lower your tax bill for this year and next.

One of the first planning steps is to ascertain whether you’ll take the standard deduction or itemize deductions for 2022. Many taxpayers won’t itemize because of the high 2022 standard deduction amounts ($25,900 for joint filers, $12,950 for singles and married couples filing separately and $19,400 for heads of household). Also, many itemized deductions have been reduced or abolished under current law.

If you do itemize, you can deduct medical expenses that exceed 7.5% of adjusted gross income (AGI), state and local taxes up to $10,000, charitable contributions, and mortgage interest on a restricted amount of debt, but these deductions won’t save taxes unless they’re more than your standard deduction.


Bunching, pushing, pulling

Some taxpayers may be able to work around these deduction restrictions by applying a “bunching” strategy to pull or push discretionary medical expenses and charitable contributions into the year where they’ll do some tax good. For example, if you’ll be able to itemize deductions this year but not next, you may want to make two years’ worth of charitable contributions this year.

Here are some other ideas to consider:

  • Postpone income until 2023 and accelerate deductions into 2022 if doing so enables you to claim larger tax breaks for 2022 that are phased out over various levels of AGI. These include deductible IRA contributions, child tax credits, education tax credits and student loan interest deductions. Postponing income also is desirable for taxpayers who anticipate being in a lower tax bracket next year due to changed financial circumstances. However, in some cases, it may pay to accelerate income into 2022. For example, that may be the case if you expect to be in a higher tax bracket next year.
  • If you’re eligible, consider converting a traditional IRA into a Roth IRA by year end. This is beneficial if your IRA invested in stocks (or mutual funds) that have lost value. Keep in mind that the conversion will increase your income for 2022, possibly reducing tax breaks subject to phaseout at higher AGI levels.
  • High-income individuals must be careful of the 3.8% net investment income tax (NIIT) on certain unearned income. The surtax is 3.8% of the lesser of: 1) net investment income (NII), or 2) the excess of modified AGI (MAGI) over a threshold amount. That amount is $250,000 for joint filers or surviving spouses, $125,000 for married individuals filing separately and $200,000 for others. As year-end nears, the approach taken to minimize or eliminate the 3.8% surtax depends on your estimated MAGI and NII for the year. Keep in mind that NII doesn’t include distributions from IRAs or most retirement plans.
  • It may be advantageous to arrange with your employer to defer, until early 2023, a bonus that may be coming your way.
  • If you’re age 70½ or older by the end of 2022, consider making 2022 charitable donations via qualified charitable distributions from a traditional IRA — especially if you don’t itemize deductions. These distributions are made directly to charities from your IRA and the contribution amount isn’t included in your gross income or deductible on your return.
  • Make gifts sheltered by the annual gift tax exclusion before year end. In 2022, the exclusion applies to gifts of up to $16,000 made to each recipient. These transfers may save your family taxes if income-earning property is given to relatives in lower income tax brackets who aren’t subject to the kiddie tax.

These are just some of the year-end steps that may save taxes. Contact us to tailor a plan that will work best for you.

© 2022