Peering Over the Cliff

The too-close-to-call presidential election may be interesting from some perspectives, but it makes tax planning for 2012 particularly difficult.  The impending “fiscal cliff” includes all kinds of tax changes, including the expiration of the latest version of the “Bush tax cuts”.  In addition 60 tax provisions expired at the end of 2011 and 41 more are due to expire this year.  Most of these can be reinstated retroactively (and have been in the past) but right now we don’t know.  Among the big provisions in play are;  Alternative minimum tax thresholds , the ability to deduct state and local sales taxes in lieu of income taxes and the deductibility of mortgage insurance.

So besides investing in Kleenex stock, what is a tax planner to do?  I’m falling back on the old, “prepare for the worst and hope for the best” approach.  One important thing to note is even if there is unusually pro active action by Congress related to tax legislation – it’s unlikely that taxes will stay this low.   For most the 1990s and a little into the 2000s long term capital gains were taxed at 28% and dividends at 39.6%.  Currently the maximum rate for both is 15%.  In addition, as mentioned in an earlier post, higher-income tax payers are due to start paying an additional 3.8% on net investment income and 0.9% for Medicare taxes starting in 2013. 

If you agree that tax rates are likely headed up, the next question is when to take action on this.  Like market timing questions for investors, there’s no bullet-proof answer.  There are things you can do though to be poised for moving either way.  This year, instead of increasing your IRA contribution (fully deductible) you may want to convert to a Roth IRA.  It would mean paying the taxes on the conversion amount this year.  Should tax rates go up, that will look like a good move.  If however, tax rates aren’t changing for the foreseeable future at the end of 2012, you can undo any damage by “recharacterizing” the conversion by October 15^th of 2013.  (That means you convert it back to an IRA.) 

Another thought to consider this year is moving to a high deductible health insurance plan and contributing to a Health Savings Account (HSA) .  That HSA money will stay tax free as long as it’s used for medical expenses.  The likelihood of medical care costs is so high, there’s no need to think about a do over on this strategy. 

It's "ill-eagle"

Today’s New York Times, in between some serious news stories, carries the tale of an IRS enforcement action that would be funny if it were not true.  The heirs of art dealer Ileana Sonnabend paid quite an estate tax bill when they got the $1 billion or so art collection that she left behind.  However, they did not pay taxes on a sculptural piece by Robert Rauchenberg, because it contains a stuffed bald eagle.  As it is illegal to sell a stuffed bald eagle art appraisers valued the piece at $0 because it has no market value.  (The restriction on the sale is no joke.  In fact, the heirs can’t have custody of the piece as the former owner had to agree to keep it on exhibit in a museum as part of complying with the law around the conservation issue.)

The IRS does assess taxes on artwork based on “market value”.  In fact they even have an Art Advisory Panel that helps determine the true value of the piece.  This panel came up with a figure of about $65 million for the piece, not knowing that it couldn’t be sold.  The IRS is aware of the restriction, but has decided to assess tax because the heirs could choose to sell the piece illegally.  Which while they could do this, they actually haven’t.

The good news is this is an unprecedented case.  Lawyers interviewed for the article couldn’t cite anything that showed the IRS using a hypothetical black market value to compute a tax liability.  An example of this distinction is Al Capone.  He was sent to jail for not paying taxes on ill-gotten gains, but he had in fact gotten said gains.  The bad news is when you fight the IRS without paying up front; they keep piling on the penalties and interest. At this point the heirs’ tax bill is up an additional almost $12 million on that amount alone.  There has to be better way.

Tax Truths

This past week I was at a lunch where a real estate professional was bemoaning the “house tax” associated with the Affordable Care Act.  When I suggested that the health care legislation didn’t include a house-tax I was met with much skepticism.  I explained there was a capital gains tax change that could involve houses, but that didn’t get much traction.  Finally someone used their iPhone to visit an Internet site that confirmed that the tax increase relates to capital gains.  While it’s possible to pay capital gains tax on the sale of your primary residence – it’s unusual. (Right now it’s unusual for a house to sell for more than it cost in the first place!)  In an effort to expand my outreach on this subject, I thought it would be helpful to go into more detail here.

Part of the health-care overhaul legislation includes a new 3.8% Medicare tax on “unearned” net investment income.  (This piece was actually added in the second bill, called the Health Care and Reconciliation Act of 2010.)  It will impact taxpayers with incomes greater than $200,000 (or $250,000 for people who are married).  This is a 3.8% tax on income from sources that are not from the ordinary course of trade or business.  There’s a long list of examples in the legislation (Section 1402 if you want to read it for yourself) but basically we’re talking about investment income here.   While I don’t expect to do many tax returns with a house that gets this tax, it is likely to create more taxes for people with investment income.  Call it a stock-tax or mutual-fund-tax and I’ll be nodding in agreement.

This is where the home issue comes up.  When you sell your primary residence, most people do not pay a capital gains tax on the sale. The reason is there is an exclusion  for the first $250,000 (for married people it’s $500,000) of profit on the sale.  That means if you sell a half million dollar home for $700,000 you don’t pay any taxes on the difference – even though you got $200,000 more than you paid for it.  Now let’s say you sell this same house for more than a million dollars.  You would have to pay capital gains tax on the amount of profit that exceeded your threshold for the exclusion.    You would pay the Medicare surcharge tax (the additional 3.8%) on the profit that was more than the exclusion amount, if the combination of that and your income adds up to more than $200,000 ($250,000 married).  OK I get that it’s confusing.  Clearly I should really reconsider my complaints about congress and taxes.  Without such convoluted provisions, being an accountant could get boring. 

The Elusive Audit Cure

As someone who is following the current travails of JP Morgan Chase thinking about the audit challenges, I’ve been looking at ideas for improving an auditor’s ability to detect defects in internal controls.  This is an area getting much thoughtful attention, but it’s also a tough nut to crack.   

A piece written in March of this year by Keith L. Johnson suggests that auditors should try to take a more diagnostic approach to their tasks.  He suggests that current audit procedures focused on financial and operational metrics are doomed to miss things because they don’t consider how organizations and humans actually behave.  He recommends a medical exam paradigm that would think of the current audit testing as similar to lab test results.  Then he would add the financial equivalent of behavioral and genetic risk factors.  He also wants some forward-looking evaluations of ongoing health and sustainability. 

Frankly it sounds more like what a stock analyst is tasked with doing than what an auditor does.  I don’t think the track record of stock analysts is such that anyone thinks they would increase the reliability of audits.  What audits already have in common with medicine is a requirement that you design testing so that it can be replicated.  The outcomes of sampling and testing can be manipulated either on purpose or in error.  However, with proper documentation, one can determine where the potential for bias and error was introduced.  That seems an area where the model already works.

Audit reports are based on a sum of the investigatory results, which are then used to form an opinion. Simply adding more opinions to the mix isn’t going to help build clarity.  Auditors are tasked with using professional judgment, which could be another way of articulating some of the considerations raised by this “medical model”.   

Joshua Ronen proposes the use of an insurance product associated with the financial statements.  His theory is to provide a market based incentive to get at the truth of the matter.  As an alumni employee of a bond insurance company I’m concerned that execution of this approach would also be very difficult to do effectively. 

One of my favorite nuggets of time management is that you need to prioritize between what is urgent and important.  Unfortunately, finding a more consistently effective method for auditing financial statements appears to meet both criteria. So I’ll keep reading…. 

There's a Whale in the Fish Tank!

While no one can put a number to the JP Morgan trading problem yet, in the vocabulary of auditors, the results likely will be material.  Using the word material in this context means that it would influence the decisions of folks relying on the financial statements.   Coming in the midst of efforts to improve both regulatory and financial controls for banks, it points out how much work remains to be done on the topic of appropriate risk management and reporting.

 It strains credibility that the bank’s CEO started to realize they had a problem when he read about the “London Whale” on the front page of the Wall Street Journal.  The trade was executed as part of what was supposed to be the bank’s risk management strategy.  If there’s a whale in your fish tank it shouldn’t take a third party to make you notice. 

While JP Morgan messed up in many ways here, you have to give them credit for keeping the conversation focused on how risky and complex the trade was.  No one can dispute that the speed and complexity of global financial transactions make them difficult to manage.  However, this focus misses the point that the bank is supposed to have internal control infrastructure that doesn’t allow them to get into a place where they make trades that have indeterminate impact.  

Anyone who has worked in a big organization knows that risk culture doesn’t change quickly in either direction.  There must be senior people at the bank today who didn’t have to read the Wall Street Journal to find out there was a problem.  Apparently the Treasurer’s position at the bank wasn’t filled during the time much of the controversial trading was going on.  However, before he left the bank, the person in the role apparently was concerned.  This is someone who was reporting the bank’s CFO.  GMI, an independent corporate ratings agency gave JP Morgan Chase an “F” for corporate governance policies in advance of the loss being made public.  This grade is typically given to less than 5% of the companies they rate.  GMI also ranked JP Morgan’s financial statements lower than 92% of comparable firms in terms of accounting and governance risk. 

Group On auditors’ found the company had a material weakness in its internal controls.  The tools are available today to highlight when controls don’t appear to be in good condition.  An error of the scale that occurred at JP Morgan Chase should not happen in an effective internal control environment.  It is hard to believe the deterioration of these controls happened suddenly since the last audit report.