Year-End Tax Planning in the Midst of Uncertainty
Laura House, CPA
The expiration of the “Bush tax cuts”, the temporary cut in social security taxes on December 31, 2012 and the implementation of the new income taxes on high income earners in 2013 passed under Obama’s 2010 Healthcare Act, is what has been coined the “fiscal cliff”. The fiscal cliff is expected to raise more than $500 billion in taxes in 2013. It appears that Washington is going to call on nearly all Americans to help reduce the deficit by raising taxes across the board on all taxpayers. Low-income tax earners will be most affected by the reduction in the childcare credit, the elimination of the 10% tax bracket and the expiration of the temporary cut in social security taxes. High-income households would be hit harder by higher tax rates on ordinary income, the expiration of the 15% tax rate on long term-capital gains and qualified dividends, the additional 3.8% Medicare tax on investment income and the .9% Medicare tax increase on earned income starting in 2013.
The suffering economy and the budget crisis have politicians arguing over conflicting tax policies. Even as we approach the end of 2012, there continues to be much uncertainty regarding what tax legislation will ultimately be imposed in 2013. No one knows for sure whether the Bush era tax cuts will actually expire at the end of 2012. What appears certain is that one way or another, taxes will go up either through increased income tax rates or the loss or limitation on deductions.
Although each taxpayer’s situation must be considered independently, we strongly encourage taxpayers to consult their tax advisors and to carefully consider whether any of the following tax planning strategies would be beneficial for them. The planning ideas listed below are not all inclusive of tax-planning strategies available, and they focus solely on federal income tax-saving opportunities. All readers should be aware that there are also potential state tax ramifications for every tax-planning strategy listed below. Please contact your tax advisor to discuss any potential state tax implications which are not addressed in this article.
2012 Year-End Tax Planning Strategies:
Consider the $5,120,000 estate and lifetime giving federal tax exemptions
The federal gift and estate tax exemption amounts are $5,120,000 through the end of 2012. This means that anyone can give up to $5,120,000 to any individual(s), including their grandchildren, without paying taxes on the money. For couples, the limit is $10,240,000. Gifts above that exemption amount are subject to a 35% tax. The $13,000 annual gift-tax exemption also remains in place and does not count against the $5.12 million threshold. The estate and lifetime gift tax exemption is currently scheduled to fall back down to $1,000,000 in 2013 with a 55% income tax being imposed on gifts and estates valued above that amount. For taxpayers who have the means and the intentions to transfer some of their estate, doing so before the end of the year may be a smart decision.
Open a donor-advised fund in 2012 in case the charitable deduction is limited in 2013
A donor-advised fund allows a person to put aside money now in order to get the income tax deduction, but gives the taxpayer some time to decide what charitable organizations will ultimately receive the money. Once the money is in the fund, it has been gifted from the perspective of the IRS. There has been speculation that itemized deductions, including charitable donations, may be limited in 2013 as part of Congress’ plan to reduce the deficit. Therefore, to ensure that you get to take a deduction for the full value for your charitable donation, you may want to consider setting up a donor-advised fund before the end of 2012. However, if charitable donations do not ultimately end up being limited, it would be advantageous to make the donation in 2013 when ordinary income tax rates will be higher and, thus, the deduction would achieve a greater tax benefit. This is the type of uncertainty that makes it difficult to know exactly what is the best planning strategy.
Use highly appreciated securities for charitable giving
Long-term capital gain rates are currently scheduled to increase to a maximum rate of 20%. For 2012, the maximum long-term capital gain rate is 15%. Instead of selling the security and recognizing the capital gain income on your personal income tax return, consider donating the appreciated security to a non-profit organization in which you had already intended to make a contribution. When you donate an appreciated security that you have held for more than one year, your charitable deduction equals the fair market value of the security on the date of the gift. By donating appreciated securities instead of cash, you eliminate the need to recognize capital gain income.
In 2013, for high-income earners, there is an additional 3.8% tax that will be imposed on the lesser of your investment income or your modified adjusted gross income (MAGI) over the designated threshold amount determined by your filing status. Donating an appreciated security in 2012 will ensure that you get the full deduction for your donation in case the deduction is limited in 2013. Donating the appreciated security in 2013 will avoid the 20% capital gains tax, and lower your MAGI and the amount of income that may be subject to the additional 3.8% tax.
Accelerate income and capital gains in 2012 to take advantage of likely lower ordinary income and capital gains rates
Ordinary income tax rates, along with long-term capital gains tax rates, are currently set to increase in 2013. Therefore, if you are thinking of selling an asset that is likely to yield a large gain, such as exercising valuable non-qualified stock options, selling an appreciated stock or selling a vacation home in a desirable resort area, you may want to consider executing the transaction before year-end to take advantage of the likely lower ordinary income and long-term capital gains tax rates for 2012.
If the gain were to be recognized in 2013, in addition to the gain being subject to the higher income tax rates, the gain may also be subject to the additional 3.8% tax if your modified adjusted gross income exceeds certain thresholds.
If the appreciated property is a valuable stock that you think still has plenty of room to grow, consider selling the stock and then repurchasing it. In 2012, you'll pay a maximum tax of 15% on the long-term capital gain from the stock sale, and your new tax basis in the stock will be the cost of your repurchased shares.
“Harvest” capital losses for 2013 instead of recognizing before year-end
Long-term capital gains tax rates and ordinary income tax rates are scheduled to increase starting in 2013. Therefore, taxpayers should consider holding onto securities that are worth less than your tax basis in them. Since capital losses are allowed to offset capital gains, there is likely to be a greater tax benefit to offsetting a capital gain in 2013 versus 2012 because of the likely higher tax rates to take effect in 2013.
2013 Tax Planning Strategies:
The 2010 Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act (“The Healthcare Act”) were passed under Obama’s administration. Two significant tax provisions taking effect in 2013 under the Health Care Act are a 3.8% tax on investment incomeand a .9% Medicare tax increase on wages and self-employment income.
Beginning in 2013, higher income earning individual taxpayers, along with trusts and estates, will be subject to a new 3.8% unearned income Medicare contributions tax if their modified adjusted gross income amount exceeds designated income thresholds determined by filing status.The current income thresholds have been set at $200,000 for single filers, $250,000 for married filing joint taxpayers and $12,000 for trusts. However, there is speculation that these thresholds may actually increase when Congress finalizes the tax legislation.
Make use of family limited partnerships
Family limited partnerships (LP) are a great tool you can use to give away a great deal of wealth while remaining in control of the underlying assets. If set up before the end of 2012, you can take advantage of the $5,120,000 gift tax exemption amount. A family LP can reap tax savings in 2013 by distributing income to more people and potentially lowering the amount of income subject to the additional 3.8% tax. Only the income above the designated thresholds is subject to the 3.8% tax, so by distributing the income to more people, you may reduce the amount of income subject to the 3.8% tax. Please note, however, that the use of a family limited partnership helps reduce the amount of income subject to the 3.8% tax on investment income but the “kiddie tax” may still apply.
Trusts should consider making distributions to beneficiaries to lower MAGI at the trust level
Estates and trusts with undistributed net investment income will be subject to the 3.8% tax when their adjusted gross income exceeds $12,000 in 2013. The threshold amount equals the dollar amount at which the highest marginal tax bracket begins for income tax purposes.
Therefore, estates and trusts that expect to have adjusted gross income well in excess of $12,000 should consider making income distributions to the trust beneficiaries who will be able to utilize the higher income thresholds for purposes of the 3.8% Medicare tax.
Invest in municipal bonds or dividend deferred investments
The definition of net investment Income for purposes of the 3.8% Medicare tax does not include federally tax exempt interest and dividends. Therefore, you may want to consider investing in state municipal bonds. You may also want to consider investing in non-dividend paying growth stocks or deferred annuities which do not increase your modified adjusted gross income or create investment income until the investment is sold.
Defer capital gain recognition and lower MAGI through use of installment sales
Using the installment method of accounting to report a gain on the sale of appreciated property sold will minimize the impact of the 3.8% Medicare tax by reducing both your modified adjusted gross income and net investment income in the year of sale.
Increase participation in business activities to achieve non-passive characterization
Net investment income potentially subject to the 3.8% Medicare tax does not include non-passive business income. Therefore, self-employment income, or income passing through to you from an interest held in a Partnership, Limited Liability Company or S Corporation in which you “materially participate”, will not be included in the computation of your net investment income. Business income is deemed non-passive if you materially participate in the activity. Material participation is determined using seven tests governed by IRC Sec. 469. Generally speaking, a taxpayer is deemed to materially participate in a business activity if they work more than 500 hours on that activity during the year. (The rules for material participation are very complex, and a taxpayer should consult his/her tax advisor for additional guidance regarding whether their participation in any business activity is deemed to be passive or non-passive.) A taxpayer should consider trying to meet one of the seven material participation tests to ensure that his/her allocable share of business income is excluded from his/her net investment income computation.
The tax-planning opportunities summarized above are based on current federal tax legislation. They may not ultimately be beneficial if changes are made to the existing federal laws. Each taxpayer’s financial situation must be considered independently, and the strategies above will not be beneficial for everyone. Please consult your tax advisor to consider whether any of the strategies listed are appropriate given your own personal facts and circumstances.
Be advised that this information was not intended or written to be used, and cannot be used, for the purpose of avoiding tax-related penalties; or for promoting, marketing, or recommending to another party any tax-related matters addressed herein. This article is designed to provide accurate and authoritative information and is distributed with the understanding that legal, tax, accounting and financial planning issues have been checked with resources believed to be reliable. Some material may be affected by changes in law or in the interpretation of such laws. Do not use the information in this article in place of professional assistance. Please contact us if you have any questions regarding the information provided in this article.