When people think about high-net-worth individuals they envision people with a team of tax experts to suggest tax-saving strategies and guide them every step of the way. There’s a perception that such people can even dodge taxes entirely. The reality is that wealthy people face tax rules that restrict their ability to take deductions to which less wealthy people may be entitled. What’s more they have some tax issues unique to their financial status. Here are some of these issues.
Note that there is no single definition of high net worth. For income-tax purposes it hinges on the size of income; for estate taxes it depends on the amount of assets.
Phaseouts of certain tax breaks
Once income exceeds a certain amount, some tax breaks can be lost:
- Personal and dependency exemptions. Some or all of these deductions are lost when adjusted gross income (AGI) exceeds a threshold amount. For 2015, the phaseout begins with AGI of $258,250 ($309,900 for married couples filing jointly). There is a complete phaseout with AGI at $380,750 ($432,400 for married couples filing jointly).
- Itemized deductions. Up to 80% of deductions for charitable contributions, home mortgage interest, real estate taxes and state income taxes are lost when AGI exceeds a threshold amount. For 2015, the phaseout begins at the same level as for personal and dependency exemptions.
To the extent that high-net-worth individuals can receive income that is not currently taxed (e.g., tax-exempt interest on municipal bonds, deferred compensation), they can minimize or avoid the phaseouts.
Additional tax burdens
Being a high-net-worth individual may mean paying two additional taxes:
- 0.9% on earned income. This additional Medicare tax applies to wages and other taxable compensation as well as self-employment income when modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 for married persons filing jointly). These thresholds are not adjusted annually for inflation.
- 3.8% on net investment income. This second additional Medicare tax applies to investment income reduced by investment expenses. More specifically, the tax applies to the lesser of net investment income, or the amount by which MAGI exceeds the same threshold amount used for the additional tax on earned income (see above). This tax creates an effective tax rate for those in the top income tax bracket of nearly 24% (20% basic capital gains rate plus 3.8% net investment income tax).
It’s not uncommon for high-net-worth individuals to have offshore bank accounts and other foreign holdings. There’s nothing illegal about this, but it triggers special reporting requirements and can increase audit risk for these individuals.
U.S. citizens and residents must report income from foreign sources (if they paid taxes on this income abroad they may qualify for a foreign tax credit or deduction on their U.S. tax return). (For more, see Understanding Taxation Of Foreign Investments.)
In addition, they must do the following reporting:
- File Form 3938 with Form 1040. This is required when the value in the account(s) exceeds a certain amount on the last day of the year (the amount varies for single or married persons and for those living in the U.S. or abroad).
- FinCEN Report 114. This is an annual return filed electronically with the Treasury by June 30. It is separate and apart from any income-tax filings or taxes and is required if the aggregate value of all foreign financial accounts exceeds $10,000 at any time during the calendar year.
Most high-net-worth individuals give away wealth each year to benefit various causes, despite the reduction in the deduction for their donations (explained earlier). The way in which these donations are made raises tax issues to contend with.
- Donating property requires a qualified appraisal. The failure to obtain one can prevent an otherwise legitimate deduction. For example, an owner of the Jackson-Hewitt tax service was denied a deduction for donation of his privately held stock because he didn’t get the requisite appraisal.
- Setting up foundations entails reporting requirements. Those with the funds to make sizable donations and pay related legal and administrative costs to set up foundations can target their philanthropy. How the funds are used as well as reporting and other disclosure requirements can trip up anyone despite the best of intentions. (Take note of recent problems with the Clinton Foundation and its refiling of prior returns.)
- Granting conservation easements has specific hurdles. Donors can effectively keep using their property while garnering a current tax deduction if they grant a specific type of easement to benefit the public. Numerous cases over the years show how easy it is for people with high-paid tax advisors to make mistakes. For example, easements can’t be granted if there is any mortgage on the property unless the lender agrees to subordinate it (put its right to collect by means of foreclosure after the right of the charity to keep the property). The donor can’t retain the right to substitute property or recoup it if the IRS disallows the deduction.
Accumulating wealth is one thing; passing it on to the next generation is another. Federal tax law allows each person to pass on tax-free only so much before a 40% federal estate tax applies. (There may also be state death taxes, which can hit estates at lower levels than the federal estate tax.) While most people need not be concerned with federal estate tax because of a generous exemption amount ($5.43 million in 2015) as well as full deductions for amounts passed to spouses or charities, some high-net-worth individuals still need to plan for this tax. About 10,000 estates each year have to file federal estate tax returns, and planning is needed to protect business interests, works of art and other property so that it won’t have to be liquidated to pay the estate tax.
While audit rates are low, wealthier individuals, especially those who are self-employed, continue to have higher rates than other individuals. For example, in 2014 the IRS audited 7.5% of households with income over $1 million compared with an overall individual audit rate of 0.86%. Such individuals can’t change the audit rates; they can only follow tax rules and make sure they have all the backup needed for the positions claimed on their returns in case they are examined. )
The Bottom Line
Wealth brings benefits, but from a tax perspective it creates special challenges. Needless to say, high-net-worth individuals should work with tax professionals to take advantage of all the breaks to which they are entitled and to avoid tax problems.