Year end tax planning typically involves finding ways to defer income and accelerate deductions to reduce current year tax, but at the end of 2010 (December 31, 2010) U.S. Taxpayers are scheduled to experience the largest tax increases in nearly 17 years and the first increase in capital gains taxes in 24 years! As a result of these pending tax changes, this year we may have to flip our usual planning scenario and instead of deferring income and accelerating deductions we may wish to accelerate income and defer deductions (other than itemized deductions).
I use the word “may” in the preceding paragraph, because I am writing this article on November 4, 2010, two days after the midterm elections that resulted in a giant shift of power in the House of Representatives. Just in case you had not yet heard, the Republican Party won a landslide victory gaining 60 new seats in the House of Representatives. As a result of the elections, the Republican Party will officially have control as of January 3, 2011, but until then, the current line up of Members of the House of Representatives will return November 18, 2010 for a “lame duck” session. Given the landslide victory, President Obama appears to be indicating that he may work with Republicans to extend some of the Bush Tax Cuts. Clearly, raising taxes in the middle of an economic crisis would only serve to further to delay an economic recovery and may increase the risk of a longer recession.
If the Bush Tax Cuts are allowed to sunset and expire tax rates will automatically go up for all individual taxpayers, including those subject to the lowest tax rates, (i.e., the poorest Americans). At the same time, the dreaded marriage penalty returns. The Obama Administration has proposed extending the tax cuts only to taxpayers in the low to middle income tax brackets while allowing the two highest tax brackets, now 33% and 35%, to return to 36% and 39.6% in 2011.
Additionally, as mentioned at the beginning of this article (if the prior tax cuts expire) taxes on income earned from net long-term capital gains (LTCGs) and qualified dividends also will be increasing from the current maximum rate of 15%. to 20% for taxpayers subject to marginal income tax rates greater than 15%, while dividends will be taxed at the new ordinary income tax rates.
To make matters worse, after 2010 the overall limitation on itemized deduction (i.e., the so-called “Pease limitation”) will be restored. As a result, itemized deductions (other than medical expenses, casualty losses, investment interest, and gambling losses) will be reduced by the lesser of (1) 3% of the amount of the taxpayer’s income exceeding the applicable threshold or (2) 80% of the deductions subject to the limit. Taxpayer’s with AGI in excess of $171,100 will lose $1 of itemized deductions for every $33.33 of AGI in excess of the threshold (subject to the 80% overall limit). As a result, it still makes sense to accelerate itemized deductions to 2010 because pushing these deductions into 2011 may cause them to go unused as a result of the return of the phase-out of itemized deductions. Because there is no limitation on itemized deductions in 2010, this strategy will be unaffected by the acceleration of ordinary income.
After 2010 the $3,650 personal exemption will be fully phased-out for individuals and married couples with adjusted gross income in excess of $289,300/$372,700 respectively (based on 2009 limits). Accelerating income in 2010 will not reduce the amount of personal exemptions any taxpayer can claim.
There are a number of other Bush era tax cuts that normally would be extended including the inflation-adjusted AMT exemption, nonrefundable personal tax credits, and above-the-line deduction for qualified higher education tuition and fees. Given the current climate in Washington, it seems likely that any extension will not include higher income taxpayers.
Adding to this drag on the economy (and individual financial stress) are the pending tax increases resulting from the passage of The Obama Health Care legislation this past year. Starting in 2013 individual and married taxpayers with income in excess of $200,000/$250,000 respectively will pay a 0.9% surcharge on earned income and a 3.8% surtax on investment income (dividends, interest, long-term and short-term capital gains, passive income, rents and royalties).
Finally, the estate tax issues are huge! If someone passes away in 2010 there is effectively no estate tax due but on December 31, 2010 Cinderella’s carriage turns into a big fat pumpkin. The Unified Credit (the amount of money you can pass tax free during life, or at death, to beneficiaries tax free) drops from 3.0 million dollars per person (6 million per married couple) to 1.0 million per person (2.0 per married couple). Moreover, the more liberal members of Congress have been considering passing legislation, which would take the Unified Credit back to $650,000 per person and/or take it all the way down to zero! The tax on anything over the Unified Credit amount can be as high as 55%.
The return of higher tax rates and reduced deductions and exemptions means that in most cases the decision to accelerate income and defer deductions (other than itemized deductions) to 2011 will be clearly advantageous. This position is further supported if one is having difficulty generating even modest investment returns (thereby reducing the opportunity cost of paying the tax early). But what is most important to remember is to make an appointment to discuss your year end tax planning strategies. Many tax savings have to be employed before the end of the tax year. So don’t wait and find yourself doing all the wrong things for 2010.
Seven strategies for 2010:
- Review the value of your gross estate (the value of all your assets, bank accounts, properties, retirement funds, life insurance values) to determine whether you have a taxable estate. I highly recommend working with a tax attorney as estate planning is one of the highest areas of malpractice of any area of law. If indeed you have a taxable estate, there is still time before December 31, 2010 to do some planning to take advantage of current Unified Credit amounts and move assets into trusts. There are various estate planning tools that can allow you to have income for life, or voting control of assets, while removing the assets from your taxable estate before Unified Credit amounts drop.
- Accelerate capital gains to 2010 and elect out of installment treatment. The election out of installment basis applies on an all-or-nothing basis. If the taxpayers wants to election out of only part of the gain, multiple notes must be used followed by a pledge to trigger gain.
- Individuals should also consider converting traditional IRA to Roth IRA and make the special election to realize 100% of the income in 2010. This strategy accelerates ordinary income to 2010, but may be disadvantageous from an investment and retirement perspective if the payment of the tax cannot be made with available funds outside of the converted IRA.
- Owners of closely held C corporations should review the amount of accumulated earnings and profits (E&P) attributable to their businesses and accelerate its distribution to 2010. If the business does not have available cash to make the distributions, the shareholders could agree to consent dividends (which are treated as cash distributions on the last day of the year followed by a contribution to capital). A better alternative is to make cash distributions and have the shareholders loan the money to the corporation which will facilitate the removal of otherwise doubled-taxed income in the future.
- S corporations should accelerate accumulated E&P from subchapter C years before distributing accumulated earnings of the S corporation. If this by-pass election is made, all distributions during the tax year are taxable dividends to the extent of the corporation’s accumulated E&P. The election applies on a year-by-year basis, only part of the accumulated E&P needs to be distributed.
- Distribute real estate from C corporations to avoid future double tax, take advantage of significantly lower valuations and accelerate taxable dividends to 2010. Distributing real estate from S corporations can be done to accelerate capital gains provided the distribution is made in a manner that avoid ordinary income treatment under section 1239 (i.e., to an individual).
- Convert existing C corporations to LLCs using a statutory conversion. Future double tax can be avoided by accelerating the gain to the current year when the inherent gain on liquidation should be at a low point. Any loss on liquidation will be allowed since the related party disallowance rules do not apply to corporate liquidations.
Remember, that the tax laws are changing very quickly and with the new Congressional make up and a “lame duck” Presidential session we will likely see some quick moves to appease voter / taxpayers before the 2012 elections. Will we be saved from these taxes in the last days of the year by the preverbal knight on a white horse? This is yet to be seen. All I can say is hope is alive and well and as of today (November 2, 2010) at 4:00 p.m. all indications are that some of the Bush Tax cuts may be extended and others will sunset with the dawn of 2011. As such, any planning based on this article should be checked and double checked with your tax attorney before year end!
As always Kingman Winslow, LLC is here to assist you in your year end tax planning needs.