It is commonly understood that muni bond taxation is favorable. Typically, an investor will not owe federal income tax on the dividends.
State income taxes will often be levied, but generally not when you are investing in municipal bonds from your own state of residence. I suppose you could call that a 4th situation where your muni bonds are not tax-free: when you are investing in another state’s munis.
However, today’s post from James Enriquez demonstrated three different scenarios in which owning muni bonds could lead you to owe federal taxes.
James Enriquez is a partner of Adaptive Tax Planning, LLC. He holds a Master of Science in Personal Financial Planning and a Master of Science in Taxation. He also holds the Enrolled Agent and CFP designations. He can be reached at [email protected]
Muni Bond Tax: 3 Situations Where “Tax-Free” Bonds Are Not
With income taxes such a hot button issue, many financial advisors tout the benefits of “tax-free” municipal bonds, and affluent investors in high tax brackets tend to favor these types of investments because they do not want to increase their taxable income.
There are, however, some situations where municipal bonds can actually increase one’s tax burden. The remainder of this post will discuss three such situations: private activity municipal bond interest subject to the alternative minimum tax, muni bond interest impacting taxation of social security benefits, and municipal bonds owned by S Corporations.
Alternative minimum tax (AMT)
The US has two parallel tax systems: the regular and alternative minimum tax. Taxpayers must calculate their potential tax burden under both systems and pay the higher amount of tax due.
While the AMT mostly impacts high-income earners, taxpayers attempting to reduce their federal income taxes through various deductions typically impacted most because many deductions are added back in the AMT calculation.
Granted, the Tax Cuts and Jobs Act increased the AMT exemption amount substantially to the point that very few people are exposed to the AMT anymore. According to the Tax Policy Center, only .1 percent of households in 2019 were exposed to the tax.
That number is down from three percent in 2017, but do not let the low percentage fool you. The majority of households subject to the tax were “high income” households: 23.3 percent of households with income between $200,000-$500,000, 63.8 percent of households with income between $500,000 – $1 million, and 24.2 percent of taxpayers with income more than $1 million.
Even though fewer people pay the AMT, it is still possible for municipal bond interest to increase one’s tax burden through the interest being included in one’s alternative minimum taxable income. Barring an act of Congress (no pun intended), the current AMT rules are scheduled to sunset at the end of 2025.
Why does all of this matter? Tax-free municipal bond interest is free from federal income tax, but private activity municipal bond interest is subject to AMT.
Private activity municipal bond interest is tax free unless the issue is a taxable municipal bond. Private activity municipal bonds are bonds used to finance bridges, hospitals, private universities, and airports.
If a taxpayer is not subject to the AMT, private activity municipal bond interest will continue to enjoy tax-free treatment, but if the taxpayer is subject to the AMT, the interest will be exposed to the alternative minimum tax.
The taxation of Social Security benefits depends on a recipient’s “provisional income” or “combined income.” Provisional income is calculated by taking half of the Social Security benefits and all tax-free income added back to adjusted gross income.
If this number is less than $25,000 or $34,000 for single and joint taxpayers, respectively, then none of the Social Security benefits are taxable.
If provisional income is at least $25,000 or $34,000 for single and joint taxpayers, respectively, then up to 50 percent of benefits are taxable, and up to 85 percent of benefits are taxable if provisional income is over $34,000 or $44,000 for single and joint taxpayers, respectively.
While the interest would remain tax-free, it could cause some of the Social Security benefits to become taxable if there is enough interest to increase the provisional income. You may have heard of this phenomenon referred to as the “tax torpedo.”
Bonds Owned by an S Corporation
There are a few different potential issues with this topic: appreciated bonds distributed to shareholders, penalty tax on excess passive income, and distributions being recharacterized as a taxable dividend.
According to IRC Section 311(b), the distributing corporation recognizes gain when appreciated property is distributed to a shareholder.
The tax treatment is as if the shareholder purchased the property from the corporation, and since an S Corporation is a pass-through entity, that tax treatment is passed along to the shareholder.
With the introduction of the new 199A deduction, some C Corporations may be considering making an S election. Sometimes when this is done, an S Corporation will have accumulated earnings and profits. This is not necessarily a “bad” thing; it’s just something to be aware of when it comes to distributions.
According to IRC Section 1375, a tax is imposed on an S Corporation’s “excess passive income” when there are accumulated earnings and profits and passive income exceeds 25 percent of gross receipts.
Here is an example from the Regulations:
Example: Assume an S corporation with subchapter C earnings and profits has tax-exempt income of $400, its only passive income, gross receipts of $1,000 and taxable income of $250 and there are no expenses associated with the tax-exempt income.
The corporation’s excess net income for the taxable year would total $150 (400 × ((400 − 250 / 400)). This amount is subject to the tax imposed by section 1375, notwithstanding that such amount is otherwise tax-exempt income.
Similar to muni bond interest causing Social Security benefits to be taxable, this is another indirect way muni bond interest could lead to higher taxes.
Lastly, S Corporations with accumulated earnings and profits should be aware of the distribution rules provided by IRC Section 1368(c).
They are as follows: distributions to the extent of the positive AAA balance are treated as if made from an S corporation without accumulated earnings and profits; distributions greater than the AAA balance and up to the accumulated earnings and profits balance are treated as dividends; distributions larger than the accumulated earnings and profits are treated as if made from an S Corporation with no accumulated earnings and profits.
Let’s take a look at an example:
Example: Jack and Jill MD PA, an S Corporation, has $10,000 of ordinary income, which increases their AAA to $10,000, and they also had $24,000 of tax-exempt interest. Additionally, there are $14,000 of accumulated earnings and profits from their years as a C Corporation.The shareholder received $12,000 of distributions throughout the year, and the first $10,000 will be treated as a tax-free distribution from the AAA. The additional $2,000 of the distribution would be considered a taxable dividend since it’s less than the accumulated earnings and profits.
Subchapter S Corporations without accumulated earnings and profits from years as a C Corporation do not need to be concerned with the excess passive income tax penalty or distributions being recharacterized as taxable dividends.
Municipal bond interest is not always completely tax free. Even if the interest does not end up being tax free, there may be other reasons to own municipal bonds.
Consult your financial advisor and tax pro to see if and how you should own municipal bonds. While these circumstances are something to be aware of, they may not even apply to you.
Do you own municipal bonds? Are you at risk for increased taxes as a result?