This blog was prepared with the assistance of Peter A. Weitsen, CPA, partner at WithumSmith+Brown, PC.
Much of what you do when you prepare your income tax return does not require making choices. For instance, your income is what your income is. But there also are plenty of categories that involve choosing among various options—so-called tax elections.
It’s not always evident which elections you should make. Some need to be made before you engage in a transaction, some during and some afterward. Some elections are made by declaring them on your return, and some by filing a form or letter with the IRS.
Following are some of the more common tax elections for individuals. Not included are elections specific to businesses that are not reported on a client’s individual tax return. Some of these are extremely technical, and the advice of a knowledgeable tax adviser should be obtained prior to the transaction.
Section 83b election. This is an election to have the current value of employer stock with a delayed vesting schedule taxed when received and not when the employee can sell it. This election is made by a letter filed with the IRS within 30 days of receiving the employer stock. This election would be made for shares that are expected to greatly increase in value between the grant date and the vesting date. This also can apply to stock options that are granted to an employee.
Section 754 election. This is made when an inherited partnership interest in real estate has a value greater than the basis of the property on the partnership’s books. This also can be made when a partnership interest is purchased at a cost much greater than the basis of the underlying assets in the partnership. This election is made on the first tax return filed by the partnership for the year in which the transfer of ownership occurred. The election is made by attaching a statement to the return making the election. Eligible entities include partnerships, LLCs and any other entity eligible to file a Form 1065.
Employer’s publicly held stock received from a 401(k). You can make an election to pay tax on an employer’s publicly held stock received from the employer’s 401k plan and not roll it over to a traditional IRA. When this is done, the amount taxed will be the value of the stock when it was contributed by the company to the plan—not its current value. The net unrealized appreciation (NUA) will be taxed at capital gains rates when the stock is eventually sold.
There are also other benefits that should be kept in mind. The holding period for these shares is automatically considered as long term, so it can be immediately sold and the capital gains tax rates will apply. However, any appreciation after receipt would not be subject to the capital gains rates until the stock is held for more than a year. The amount distributed will be subject to withholding taxes by the employer. If the recipient is under age 55 when the recipient leaves the job, he/she will be subject to the early withdrawal penalty. This election is simply made by recording the value on the taxpayer’s individual return for the year the distribution was made. Caution: This only applies if the employee terminated his service and the employer made a full distribution of the 401(k) account in a single calendar year.
IRA rollover. When a lump-sum distribution is received from an employer’s retirement plan and it is rolled over within 60 days to an IRA, it will not be taxed at that time. The election is made by reporting the entire distribution on the return and showing the taxable amount as zero. Such a rollover can be done only once in a 365-day period. The better way to do this is to have a direct distribution to the IRA by the employer’s retirement plan.
Investment interest can be deducted to the extent there is investment income. Where there is insufficient investment income in a year, the excess interest can be carried forward to a later year. An election can be made on Form 4952 that is attached to the taxpayer’s individual return to treat some of the qualified dividends and long-term capital gains as investment income to get a full deduction for the investment interest in the current year and not have to carryover the unused investment interest.
Bond premium election to amortize the premium paid on taxable bonds can be made and applies to all bonds held at the beginning of the year in which the election is made and all bonds acquired thereafter. The amortized premium can be deducted from the interest received during each year, thereby reducing the taxable interest income. If the election is not made, the loss on the premium when the bond is redeemed or disposed of would be a capital loss. Dealers in bonds cannot make this election. The election is made by attaching a statement to the return and by claiming the deduction on the return. For tax-exempt bonds, the amortization of the premium is mandatory.
401(k) participants that are still employed past age 70½ and who are less than a 5% owner do not have to start their required minimum distributions (RMDs) until their employment is terminated. The election is made simply by not taking the RMD.
Section 1031 exchange. An election can be made to roll over gains on real estate under Section 1031 by acquiring like kind property of an equal or greater value. This applies to investment or business property only. There is a strict timeline for this transaction that must be followed. There must be written agreements and binding contracts as applicable between the seller, buyer, seller of the replacement property and a qualified intermediary. The election is made by filing Form 8824 with the tax return for the year in which the exchange occurred.
Qualified business income (QBI) deduction aggregation election to qualify more fully for the 20% deduction permitted under Section 199A. When a taxpayer has more than one trade or business (including sole proprietorships, partnerships, LLCs and S corporations), aggregation may allow better utilization of wages and other factors in the calculating of the QBI deduction. This is done by providing detailed information on the tax return claiming the deduction. No special form is required, but follow-up statements must be attached each year.
Qualified joint venture. An election for married couples jointly owning an unincorporated business can be made to not file a partnership return but instead to have each spouse report their portions of the transactions on separate Schedule Cs that are included with their individual tax returns. The election is made by filing the separate Schedule Cs. The Schedule Cs are easier to prepare and do not require a balance sheet as does the Form 1065 partnership tax returns. This does not apply to an LLC or limited partnership.
Installment sale election is made when property or stock in a nonpublicly traded company is sold. This enables the gain to be taxed in the years that payments are received and not in the year of sale. The election is made on Form 6252 filed with the return for the year in which the sale took place.
The above is a sampling of some of the more common elections that taxpayers seem to overlook and is certainly not a complete listing. There are many other elections that taxpayers should be aware of. Some of these are made when starting a business, when depreciable equipment is acquired, when shares in a small business corporation are acquired, when certain tax credits are applicable and many other circumstances.
Elections must all be made on timely filed returns, including extensions, and must follow the exact IRS procedures. It is best to use a knowledgeable tax adviser to assure the rules are being followed.
If an election is being considered, you should run the numbers and see the effect with and without the election before making the decision. A final tip is to read all the questions on the tax form and the instructions and make sure they are understood and determine which are applicable for you.