Why You Should Expect Increased Taxes after the Death of a Spouse —Even with One Less Social Security Income

 But You Can Do Something About It!

The opportunity for income smoothing can arise for those normally in 22% or higher brackets when they temporarily have low taxable incomes and are subject to zero, 10% and 12% marginal tax rates. The same idea holds for those in 32% and higher brackets when temporarily in 22% or 24% brackets. This commonly occurs when taxpayers are young, experience financial hardships during recessions, when a spouse stops working, or when large deductible losses occur (most commonly, qualifying casualty, stock or business/rental losses). This concept can also be used to plan in the years leading up to the death of a spouse, after which the filing status changes from “joint” to “single” and tax brackets, deductions and credits mostly get cut in half. Except for the loss of one Social Security “benefit,” income generally remains the same, yet both the total tax and marginal tax rate (the tax on the last “chunk” of income) increase substantially. Taking more income before a spouse dies is a superb method of reducing family tax rates and total taxes over time.

A word of warning: this is not a DIY project, as there are numerous variables to consider before implementing such a strategy—that is what we are here for! For example, these ideas can be taken too far if there is not enough income potential left in pre-tax retirement accounts to offset future deductions for large medical costs (think: qualified assisted living or nursing home residency). Those planning to move should consider relative state income tax rates. If the marginal tax rate at your income level is expected to be higher in the new state, accelerate income (or defer deductions). If the expected marginal tax rate will be lower, defer income (or accelerate deductions).

The sets of examples that follow show clear cases in which income should be accelerated, up to a point. We will assume the larger age 65 and over 2019 standard deduction and 2019 tax rates. The total tax and relative marginal rates for joint filers is compared with those for single survivors.

Note in the $25,000 non-Social Security (SS) income example on the next page (example # 1), while total income drops by $15,000 (the decedent’s Social Security), the federal tax on the survivor more than triples. In the $40,000 non-SS income example (example # 2), with the same loss of income, the tax more than doubles. Absent other variables, achieving long-term tax savings requires an acceleration of income while both spouses are alive, often by accelerating withdrawals or conversions from pre-tax retirement accounts.

This serves to reduce future Required Minimum Distributions and, therefore, future income—often saving a ton of future taxes!

Low-to moderate-income retirees

* The "real" marginal rate is the real, not advertised, percent tax on the last dollar of income, including the tax on up to 85% of Social Security "benefits"; these horrifying rates are a result of the waya Social Security "benefits" are phased into the taxable base.

** We want to show the analysis varies tremendously by state. Each has its own tax rates and rules: Colorado, for example, excludes some pension (including Social Security) income, doesn’t differentiate filing statuses, uses the federal standard deduction (California’s is a fraction of that) and phases in Social Security the same way the feds do after the pension income exclusion.

*** Increase in overall federal and CA marginal tax rates = (22.2% - 18.5%) + (2% - 0%) = 5.7%; (40.7% - 22.2%) + (6% - 0%) = 24.5%.

Similarly, federal tax increases by 40% ($15,000 - $10,700 = $4,300) for the single filer with $75,000 non-SS income (example # 4). California tax more than triples (from $1,125 to $3,500), while Colorado tax increases by about ($2,800 - $2,225 = $575; $575/$2,225 = ) 26%. At this income level (and, in fact, with only a tad more income than for the $60,000 non-SS income filer), another hidden tax comes into play: Income-Related Monthly Adjustment Amount on Medicare premiums, or “IRMAA” (aka “Medicare Premium Surcharge”). You can see the $800 surcharge in the example below. 

Middle-income retirees

Check out the tax increases on the single survivors in examples #5 and #6 on the next page. 

Upper-middle-income retirees

Upper-income retirees

* That the IRMAA is larger for the couple than for the single survivor is an artifact of the crazy patchwork of cliff-like phase-ins, which are beyond the scope of this article.

Because many are reluctant to deal with the eventual death of a spouse, income smoothing strategies (which hardly anyone else understands—we invented "income smoothing" decades ago!) are rarely considered. Total tax and marginal tax rates increase across the board for nearly all surviving filers. Multiply any of the "additional tax" in the lower right corner of any of the charts above by, say, ten—because this strategy can easily be implemented ten years prior to a spouse's death—and you will see there are frequently tens of thousands of tax dollars at stake. Considering the fact taxes could increase after 2020, email us now so we can use this "income smoothing strategy" and save you a boatload of tax in the future.

The War on Small Business is a War on People

• Minimum wage laws. Consider the productivity value of a Costco employee, who rings up more sales in an hour than most small businesses do in a day: his/her value to Costco is much greater than a clerk is to a low-volume rural outpost (or even an urban boutique).
• Innumerable and complex labor laws. Required lunches, overtime, sick pay, and other such rules are nearly impossible to track by small business owners, who can easily run afoul of these edicts. One draconian penalty can wipe out a small business owner (arguably, violating the 8th Amendment to the U.S. Constitution, which proscribes “excessive fines”). The fear of penalties serves to reduce the number of new business owners. Many would-be business owners/entrepreneurs opt to be employees, resulting in fewer new small businesses.
• Arcane “Affordable Care” Act rules. These incentivize the demise of small family medical practices in favor of large, less personal hospital practices. Fifty percent fewer doctors operate on their own than a mere eight years ago.
• Now, the Virus. Local and state responses shut down millions of “non-essential” businesses without warning—unless you are a Wal-Mart or a Costco. Because they sell “necessities” such as food, they also got to sell clothing, furnishings, toys and a myriad of other things (in most states). If you sell only clothing, furniture or toys, you were forced to shut your doors. Not only will millions of brick and mortar small businesses (and many large ones) fail, new ones won’t take their place. Fewer will risk their hard-earned savings and 80-hour work weeks on a new business enterprise when capricious government edicts could shut them down in an instant.
• Further, riots and looting, and lack of police protection of private property amidst this anarchy. This helped ensure the permanent demise of more small businesses, including many minority-owned ones. They will be hard-pressed not only to raise capital to start over but may find it impossible to find insurance even if reimbursed for their monumental losses. This is a lack of enforcement of the one set of rules government should enforce: those prohibiting thugs from harming you and your property. (Marxists and other fascists favor this anarchy because they believe property is theft and, hence, do not believe in protecting property rights.)

In totalitarian systems, government either directly (socialism) or indirectly (economic fascism) owns the means of production; in the latter, nominally privately-owned means of production are regulated and controlled by government. Such economic fascism is easier when there are fewer, larger, and more monolithic businesses—essentially, government-sanctioned monopolies—to control. Home Depot co-founder Bernie Marcus says he could not have started Home Depot with today’s rules and regulations. Yet, Home Depot and other mega-giants thrive.

• AB5: California’s new labor law attacks independent contractors.California enacted AB5 (Assembly Bill 5), which Presidential candidate Joseph Biden explicitly supports and would establish across the entire country. Promulgated in California in 2019, effective January 1, 2020, AB5 requires all businesses to turn independent contractors (ICs) into employees unless they meet all three of these requirements:

A. The person is free from the control and direction of the hiring entity in connection with the performance of the work, both under the contract for the performance of the work and in fact, AND

B. The person performs work that is outside the usual course of the hiring entity’s business, AND

C. The person is customarily engaged in an independently established trade, occupation, or business of the same nature as that involved in the work performed  for the hiring entity.

Tests A and C have long been requirements under common law. The California State legislature codified Test B after the state Supreme Court introduced this test in the “Dynamex” case. This upends longstanding employment law—if you are paid as an IC, you must do work that is unrelated to the main business of the employer; otherwise, you become an employee, regardless of how long you intend to work for the payer and however independent you may be. A band leader who hires other musicians to play for a gig must pay them as employees even if they only play one gig! However, musicians, among many industry groups, have received specific exemptions (the latest, including musicians, in a recent amendment to AB5). Because of these numerous exceptions,* AB5 arguably violates the Equal Protection Clause of the 14th Amendment to the U.S. Constitution, which requires equal application of the law to all people and businesses (and the libertarian Independent Institute, in its amicus brief to the court, agrees).                       

Penalties for misclassifying an independent contractor start at $5,000. A penalty imposed on a truck dispatcher who hires five truckers with their own trucks as ICs starts, then, at ($5,000 x 5 =) $25,000. If the “employer” engages in a “pattern or practice” of violating the law, penalties start at $10,000 per violation, the 8th Amendment (“excessive fines shall not be imposed”) to the U.S. Constitution notwithstanding. **

Even if exempt from AB5, California and all other states are subject to Borello-like rules, discussed next.

Common law questions to determine employment status were adopted decades ago by the IRS and the courts 

For decades, the IRS used a “20-factor” test to determine whether a payee was an employee or independent contractor. The test was based on long-established employment law. Since 1989, the state of California has used the “Borello” test (from a court decision regarding S. G. Borello and Sons, Inc.), while the IRS uses a test similar to Borello. The IRS and courts examine the evidence, giving some factors, like “control,” greater weight than others. Under this test, a trucker who owns his truck, an Uber driver who owns her car or a musician working various gigs with his own instruments are clearly self-employed. There are many who fall into gray areas; in one case (long ago) I argued that actors and musicians who received dozens of W-2s each year were self-employed; I even won an audit on that issue. Relative weighing of different factors is impossible under the AB5 test, as it is absolute. The “Borello” test questions follow, with our discussion immediately following each bolded question, in which we try to make sense of the seeming incomprehensible.

1. Does the person to whom services are rendered have the right to control the manner and means of accomplishing the result desired? Essentially, who controls whom? Because the Borello test is not specific, we suggest using several of the original 20-factor test questions. (“Yes” = employee, because an employer wields control over aspects of when, how and the way work is done; however, we have no idea how many of these count as an overall “yes”.)

A. Is the worker required to comply with the payer’s instructions about when, where, and how to do the work?

B. Is the worker personally required to render services? An employee is personally required to complete the task, while an IC must only ensure the job is done.

C. Is the worker prohibited from hiring, supervising, and paying assistants? An IC can usually hire others to help do the job.

D. Are hours specified during which a worker must work? Employees usually work set hours while ICs need only complete the job.

E. Is a worker required to work substantially full time for the payer? An IC is more likely to work for multiple payers.

F. Is the order or sequence of work set by the payer? For ICs, the focus is on the result.

G.Must the worker submit oral or written reports of ongoing activities to the payer? ICs generally submit final reports only.

3. Is the person performing services engaged in a distinct occupation or business? This is a terrible choice of words; we think it’s asking whether the worker works for only one or multiple related payers at a time vs. multiple unrelated payers. We think it also asks, can or does the worker offer the same services to the public. (One or related payers = employee.)

4. What is the occupation of the payee, with reference to whether the work is usually done under the direction of the payer or by a “specialist [the payee] without supervision?” This is the worst of many poorly worded questions. Simply, must the payee work with more experienced co-workers? The 20-factor test also asked whether training and/or attendance at payer’s meetings was required. (Supervision generally = employee.)

5. Are specialized skills required of the particular occupation? How specialized are the skills? (Less specialized = employee.)

6. Does the worker supply the “instrumentalities,” tools, and place of work for the person doing the work? This combines four questions under the 20-factor test:

A. Does the work have to be performed on the payer’s premises or place of payer’s choosing?

B. Does the worker supply his own tools and materials?

C. Are expenses paid for or reimbursed by the payer?

D. Does the employer provide facilities? Non-employees generally do not work under the payer’s roof.

“Employees” who move from job to job are generally not reimbursed for work tools and equipment: think construction workers and TV/studio workers. Incredibly, AB5 not only requires many if not all of these to be employees; independent truck drivers, who own their own big rigs, must also be treated as employees. (Payer-provided tools, materials and place of work = employee.)

7. The length of time for which the services are to be performed. The 20 factors test asks, does a continuing relationship exist between the worker and payer? (Continuing relationship generally = employee.)

8. Method of payment, whether by time or by the job. Is pay by the hour, or otherwise regular amounts at set intervals? (Regular pay = employee.)

9. Is the work part of the regular business of the payer? The 20-factor question is, “are the worker's services an integral part of business operations?” This closely reflects California’s AB5 Test “B,” which elevates this to one of three essential tests for California workers. I never even considered this among the most important factors, and still don’t for workers in other states—the fact it is number nine under “Borello” suggests no one else thought it crucial, either! Under AB5, taxi drivers with their own cars can no longer be treated as non-employee ICs for taking a fare for another taxi company; same with truckers, including those owning their own trucks. (Part of the regular business of payer = employee.)

10. Do the parties believe they are creating an employer-employee relationship? That the intent of the parties is relevant is surprising, even if it is number 10. (This belief = employee.)

11. Is a worker essentially precluded from suffering a loss from the provision of services? If the worker pays few or no expenses, this is almost a given. (Loss precluded = employee.)

A “safe harbor” exists for “close” situations if the employer has always treated the worker as an IC and the employer had a reasonable basis for treating the worker as a non-employee, if all required 1099s have always been filed reporting payments to the worker. AB5 revokes this safe harbor for California employees.                                                     Why is independent contractor status so important? Countless successful entrepreneurs get their initial training from their experience as small business owners and independent contractors. As employees, they will be less likely to get the requisite experience and learn what it takes to run successful businesses. Fewer businesses will be started and, perhaps, fewer too will succeed. There will be fewer future Apple’s, Home Depot’s, Wal-Mart’s and Costco’s. If any variation of AB5 stands, or is passed nationally, we will see fewer business innovations. Society will be vastly poorer for it.

* The California legislature, in an amendment to AB5 passed in August 2020, partly eviscerated the law by exempting a host of additional occupations from its draconian edicts. However, the fact they passed AB5 at all, and that many are still affected by it, should be cause for great concern to those who value fairness and freedom, opportunity and equality under the law.

** I suspect (Democrat) California state legislators did not want so much to stick it to the Ubers of the world as to hand their union supporters a gift. If countless ICs are deemed employees, there are many more potential union members than without such a requirement, even if many of those jobs disappear due to a decrease in demand (which will happen if Uber’s estimate of a 100% increase in their prices is anywhere close to reality). The libertarian view is that no majority, even 99.9%, has the right to force anyone to join or contribute their own resources to any group, including unions. Voluntary associations are, of course, perfectly consistent with freedom. Anyone who shudders at this is welcome to email and ask me to explain the differences between government, private sector and a sub-category of private sector, movie and TV studio unions, which are far less crippling to productivity and less enabling of unproductive and substance-addicted employees than, notably, government mandated teacher and police unions. That is not to say I am not a huge supporter of good teachers and good law enforcers—I am. I am simply opposed to compulsion, which includes compulsory unions.

Catastrophic Long-Term Economic, Financial and Other Effects of Lockdowns

And How This May Affect Your Tax and Investment Strategies