|'Stealth' Tax and High-Income Taxpayers
Why tax practitioners should not overlook the impact of these taxes on their clients.
October 15, 2009
Few people have the privilege of beginning their working careers in high paying jobs. As a result, most people climb the corporate ladder in the traditional way, starting at entry-level positions and gradually transitioning to positions of higher responsibility and pay scales. Along the way, taxpayers are introduced to the concept of how marginal tax brackets apply to earning progressively higher incomes. Add a working spouse and the impact of additional income on taxable income and the resulting increase to tax liability really becomes apparent. However, not all increases to tax liability are so obvious.
Impact of Stealth Taxes
Stealth taxes sneak up on unsuspecting or unknowing taxpayers. They reduce or cutback otherwise fully allowable deductions from adjusted gross income (AGI) thus increasing the taxpayer's effective tax rate and ultimately, his or her tax liability. The two stealth taxes that most commonly impact middle- to upper-class taxpayers are the phase-outs of the standard deduction and the personal/dependent exemptions.
Phase-out of Itemized Deductions
Code Section 68(a) applies a phase-out or reduction to itemized deductions for taxpayers filing jointly and whose adjusted gross income exceeds $166,800. Certain itemized deductions such as medical expenses, investment interest, and wagering losses (only to extent of wagering gains) are not subject to this provision, but common itemized deductions such as home mortgage interest, charitable contributions, and miscellaneous itemized deductions are subject to the reduction. Once the total of the itemized deductions subject to the phase-out is determined, a two-step procedure is then applied to determine the full amount of the cutback. This amount is then reduced so that only one-third of the actual cutback amount is used to reduce the total of itemized deductions. This addition to an individual's tax burden is set to sunset after December 31, 2009, so unless Congress decides to reinstate this part of the tax code, taxpayers will no longer need to worry about it after then.
Phase-out of Personal/Dependent Deductions
Just as Code Section 68(a) does with itemized deductions, Code Section 151(d)(3)(A) applies a phase-out to personal and dependent exemptions. Although this additional burden to taxable income is scheduled to sunset after December 31, 2009, also, for the remainder of 2008 returns to be filed or amended as well as returns for 2009 still must contend with its effects. For 2009 returns, this phase-out begins once AGI exceeds $250,200 for taxpayers filing married, filing jointly. The amount at which the phase-out begins depends on the filing status of the taxpayer. The effect on taxpayers is to reduce the amount of personal and dependent exemption deductions claimed on the tax return. The procedure for determining the phase-out amount involves six steps. The maximum amount each exemption can be reduced in 2009 is $1,117; therefore, all taxpayers will be allowed at least $2,433 for each personal and dependent exemption. Although not specifically a tax, its effect is to increase taxable income on high-income taxpayers.
Although both of these stealth tax increases have affected taxpayers since 1991, Congress has deemed it appropriate to allow both to end at the end of tax year 2009. Since the effect of both of these phase-outs has been slowly reduced since 2005, it appears unlikely they will be reinstated.
While it may be true that most individuals have little control over the amount of wage or salary income they receive, taxpayers subject to these phase-outs can benefit from tax-planning advice that focuses on untaxed income or these type taxes. By increasing the amount of federal tax withheld from their paychecks they will avoid the nasty surprise at the end of the year that comes from a lack of awareness of the standard deduction and personal and dependent exemption phase-outs. Alternatively, taxpayers can be advised to make or increase the amounts of their quarterly estimated tax payments.
Rarely have I found taxpayers happy about unplanned tax liabilities. By being proactive and including this type of tax advice and planning into your practice, you will undoubtedly increase your value to your clients. While they may not be happy to be subject to stealth taxes, they will be happy their CPA was aware enough of their situation to advise them properly.
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Mark Washburn, CPA/MST, is a Senior Lecturer in Accounting at the University of Texas at Tyler. He teaches both Individual and Corporation tax courses at the undergraduate level. He is a certified public accountant licensed in Texas and holds a Master of Science in Taxation from the University of Texas at Arlington.