Year-end tax planning is always complicated by the uncertainty that the following year may bring and 2012 is no exception. Indeed, 2012 is one of the most challenging in recent memory for year-end tax planning. A combination of events – including possible expiration of some or all of the “Bush-era” tax cuts after 2012, the imposition of new so-called Medicare taxes on investment and wages, doubts about renewal of tax extenders, and the threat of massive across-the-board federal spending cuts – have many taxpayers asking how can they prepare for 2013 and beyond, and what to do before then. The short answer is to quickly become familiar with expiring tax incentives and what may replace them after 2012 and to plan accordingly.
INDIVIDUAL TAX PLANNING
“Bush-era” Tax Cuts – The phrase “Bush-era” tax cuts is the collective term for the tax measures enacted in the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) and Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA). EGTRRA and JGTRRA made over 30 major changes to the Tax Code that are scheduled to sunset at the end of 2012.
The 2010 Tax Relief Act extended the reduced individual income tax rates from the Bush-era tax cuts. Unless extended further, the reduced individual income tax rates will disappear after 2012 to be replaced by higher rates. The current 10, 15, 25, 28, 33 and 35 percent rate structure would be replaced by the higher pre-Bush 15, 28, 31, 36 and 39.6 percent rates.
Strategy: Traditional year-end planning techniques should be considered along with some variations on those strategies. Instead of shifting income into a future year, taxpayers may want to recognize income in 2012, when lower tax rates are available, rather than shift income to 2013. Another valuable year-end strategy is to "run the numbers" for regular tax liability and alternative minimum tax (AMT) liability. Taxpayers may want to explore whether certain deductions should be more evenly divided between 2012 and 2013, and which deductions may qualify, or will not be as valuable, for AMT purposes.
Qualified Capital Gains – Unless Congress takes action, the tax rates on qualified capital gains are also scheduled to increase significantly after 2012. The current favorable rates of zero percent for taxpayers in the 10 and 15 percent brackets and 15 percent for all other taxpayers will be replaced by pre-2003 rates of 10 percent for taxpayers in the 15 percent bracket and a maximum 20 percent rate for all others.
Strategy: Now is also a good time to consider tax loss harvesting strategies to offset current gains or to accumulate losses to offset future gains (which may be taxed at a higher rate). The first consideration is to identify whether an investment qualifies for either a short-term or long-term capital gains status, because one must first balance short-term gains with short-term losses and long-term gains with long-term losses. Remember also that the "wash sale rule" generally prohibits one from claiming a tax-deductible loss on a security if one repurchases the same or a substantially identical asset within 30 days of the sale.
Dividends – Under current law, tax-favorable dividends’ tax rates are scheduled to expire after 2012. Qualified dividends are currently eligible for a maximum 15 percent tax rate for taxpayers in the 25 percent and higher brackets and zero percent for taxpayers in the 10 and 15 percent brackets.
If Congress takes no action, qualified dividends will be taxed at the ordinary income tax rates after 2012 (with the highest rate scheduled to be 39.6 percent not taking into account the 3.8 percent Medicare contribution tax for higher income individuals).
Strategy: Qualified corporations may want to explore declaring a special dividend to shareholders before January 1, 2013.
3.8 Percent Medicare Contribution Tax – Taking effect immediately on January 1, 2013, the Medicare surtax will be imposed on a taxpayer’s “net investment income” (NII) and will generally apply to passive income. The Medicare surtax will also apply to capital gains from the disposition of property. However, the Medicare surtax will not apply to income derived from a trade or business, or from the sale of property used in a trade or business. For individuals, the Medicare surtax is based on the lesser of the taxpayer’s NII or the amount of “modified” adjusted gross income (MAGI) above a specified threshold.
The MAGI thresholds are:
- $250,000 for married taxpayers filing jointly
- $200,000 for single
NII includes:
- Gross income from interest, dividends, annuities, royalties and rents, provided this income is not derived in the ordinary course of an active trade or business;
- Gross income from a trade or business that is a passive activity;
- Gross income from a trade or business of trading in financial instruments or commodities; and
- Net gain from the disposition of property, other than property held in an active trade or business.
NII does not exclude:
- Distributions from qualified retirement plans or IRAs
- Veterans’ benefits
- Gain excluded on sale of principal residence
- Interest on tax exempt bonds
Strategies:
- Do not postpone the first year IRA distribution to 2013 on reaching age 70.5.
- Trust returns are also subject to the Medicare Contribution Tax. Trust income will often reach the highest tax brackets much quicker than individuals. Make sure that all income has been distributed from the trust before year end.
Additional 0.9 Percent Medicare Tax – Also effective January 1, 2013, higher income individuals will be subject to an additional 0.9 percent HI (Medicare) tax. This additional Medicare tax should not be confused with the 3.8 percent Medicare surtax. The additional Medicare tax means that the portion of wages received in connection with employment in excess of $200,000 ($250,000 for married couples filing jointly) will be subject to a 2.35 percent Medicare tax rate. The additional Medicare tax is also applicable for the self-employed.
Strategy: Taxpayers may want to explore the possibility of accelerating income into 2012.
End of Payroll Tax Holiday – For the past two years, an employee’s share of Old Age, Survivors and Disability Insurance (OASDI) taxes has been reduced from 6.2 percent to 4.2 percent (with comparable relief for the self-employed). Under current law, that reduction is scheduled to expire after December 31, 2012. On January 1, 2013, an employee’s share of OASDI taxes will revert to 6.2 percent, effectively increasing payroll taxes across the board.
Strategy: Taxpayers may want to explore the possibility of accelerating bonuses and wages into 2012.
Alternative Minimum Tax – The alternative minimum tax rates (26 and 28 percent on the excess of alternative minimum taxable income over the applicable exemption amount) are not scheduled to change in 2013. However, exposure to the AMT may change as a result of the scheduled sunset of the regular tax rates. Because the determination of AMT liability requires a comparison between regular tax and AMT computations, the higher regular tax rates post-2012 may help lower AMT exposure by the same amount.
However, taxpayers should not ignore the possibility of being subject to the AMT, as this may negate certain year-end tax strategies. For example, if income and deductions are manipulated to reduce regular tax liability, AMT for 2012 may increase because of differences in the income and deductions allowed for AMT purposes.
As in past years, taxpayers are waiting to see if Congress will enact an AMT “patch” for 2012. The last patch, which provided for increased exemption amounts and use of the nonrefundable personal credits against AMT liability, expired after 2011. If another “patch” is not enacted by Congress, the AMT exemption will drop from $74,450 (married taxpayers filing jointly) in 2011 to $45,000 in 2012.
Personal Exemption/Itemized Deduction Phaseouts – Higher income taxpayers may also be subject to the return of the personal exemption phaseout and the so-called Pease limitation on itemized deductions. Both of these provisions were repealed through 2012. However, they are scheduled to return after 2012 unless the repeal is extended.
Revival of the personal exemption phaseout rules would reduce or eliminate the deduction for personal exemptions for higher income taxpayers starting at “phaseout” amounts that, adjusted for inflation, would start at $267,200 AGI for joint filers and $178,150 for single filers.
In addition, return of the Pease limitation on itemized deductions (named for the member of Congress who sponsored the legislation) would reduce itemized deductions by the lesser of:
- Three percent of the amount of the taxpayer’s AGI in excess of a threshold inflation-adjusted amount projected for 2013 to be $178,150 (joint filers), or
- 80 percent of the itemized deductions otherwise allowable for the tax year.
Strategy: Taxpayers should watch AGI limitations when determining deductions and credits to report in 2012/2013. Taxpayers should consider paying deductible items in 2013 when tax rates are higher and could result in a more advantageous tax benefit.
Education – American Opportunity Tax Credit. In 2009, Congress enhanced the Hope education credit and renamed it the American Opportunity Tax Credit (AOTC). The temporary enhancements, including a maximum credit of $2,500, availability of the credit for the first four years of post-secondary education, and partial refundability for qualified taxpayers, are scheduled to expire after 2012. Under current law, less generous amounts will be available with the revived Hope education credit.
Coverdell Education Savings Accounts. Similar to IRAs, Coverdell Education Savings Accounts (Coverdell ESAs) are accounts established to pay for qualified education expenses. Under current law, the maximum annual contribution to a Coverdell ESA is $2,000, and qualified education expenses include elementary and secondary school expenses. Unless extended, the maximum annual contribution for a Coverdell ESA is scheduled to decrease to $500 after 2012.
Employer-Provided Education Assistance. Under current law, qualified employer-provided education assistance of up to $5,250 may be excluded from income and employment taxes. However, the 2010 Tax Relief Act only made the exclusion available through 2012.
Student Loan Interest. Individual taxpayers with MAGI below $75,000 ($150,000 for married couples filing a joint return) may be eligible to deduct interest paid on qualified education loans up to a maximum deduction of $2,500, subject to income phaseout rules. The enhanced treatment for the student loan interest deduction is scheduled to expire after 2012. The student loan interest deduction would be limited to the first 60 months of payment.
Higher Education Tuition Deduction. The above-the-line higher education tuition deduction expired after 2011. The maximum $4,000 deduction was available for qualified tuition and fees at post-secondary institutions, subject to income phaseouts.
Child Tax Credit – Taxpayers who claim the child tax credit need to plan for its scheduled reduction after 2012. Absent Congressional action, the child tax credit, at $1,000 per eligible child for 2012, will be $500 per eligible child, effective January 1, 2013.
Sales Tax Deduction – Before 2012, qualified taxpayers could deduct state and local general sales taxes in lieu of deducting state and local income taxes. The 2010 Tax Relief Act last extended the optional itemized deduction for state and local general sales taxes, which had been available since 2004, to tax years 2010 and 2011. Unless extended again, the deduction for state and local general sales taxes will not be available for tax year 2012 and beyond.
Qualified Mortgage Insurance Premiums – For the period 2007 through 2011, premiums paid for qualified mortgage insurance could be treated as qualified residence interest and deducted as an itemized deduction, subject to certain restrictions. Renewal of this tax break into 2012 is uncertain at this time.
ESTATE/GIFT TAX PLANNING
There have been few areas of the Tax Code that have been subject to as much uncertainty as the federal estate tax. In 2001, Congress passed legislation that repealed the estate tax in the calendar year 2010. Under the 2010 Tax Relief Act, federal estate taxes applied to decedents dying after December 31, 2009 but before January 1, 2013. Through 2012, each individual taxpayer can gift up to $5.12 million out of their estate without paying gift taxes. Any gifts over the exemption amount are subject to a maximum tax rate of 35%. Starting in 2013, the estate/gift tax exemption amount is reduced to $1 million and the maximum tax rate jumps up to 55%.
Strategy: A comprehensive estate plan should be implemented to take advantage of this opportunity to transfer $5 million out of an individual’s estate. This transfer could ultimately save over $2 million in estate taxes. Individuals should consider transferring real estate or investments to their beneficiaries now to avoid the estate taxes later.
BUSINESS TAX PLANNING
Code Sec. 179 expensing – Code Sec. 179 gives businesses the option of claiming a deduction for the cost of qualified property all in its first year of use rather than claiming depreciation over a period of years. For 2010 and 2011, the Code Sec. 179 dollar limitation was $500,000 with a $2 million investment ceiling. The dollar limitation for 2012 is $139,000 with a $560,000 investment ceiling. Under current law, the Code Sec. 179 dollar limit is scheduled to drop to $25,000 for 2013 with a $200,000 investment ceiling.
Strategy: Businesses should consider accelerating purchases into 2012 to take advantage of the still generous Code Sec. 179 expensing. Qualified property must be tangible personal property, which one actively uses in one’s business, and for which a depreciation deduction would be allowed. The amount that can be expensed depends upon the date the qualified property is placed in service; not when the qualified property is purchased or paid for. Additionally, Code Sec. 179 expensing is allowed for off-the-shelf computer software placed in service in tax years beginning before 2013.
Bonus depreciation – The first-year 50 percent bonus depreciation deduction is scheduled to expire after 2012 (2013 in the case of certain longer-production period property and certain transportation property). Unlike the Section 179 expense deduction, the bonus depreciation deduction is not limited to smaller companies or capped at a certain dollar level. To be eligible for bonus depreciation, qualified property must be depreciable under Modified Accelerated Cost Recovery System (MACRS) and have a recovery period of 20 years or less. The property must be new and placed in service before January 1, 2013 (January 1, 2014 for certain longer-production period property and certain transportation property).
Businesses also need to keep in mind the relationship of bonus depreciation and the vehicle depreciation dollar limits. Code Sec. 280F(a) imposes dollar limitations on the depreciation deduction for the year a taxpayer places a passenger automobile in service within a business, and for each succeeding year. Sport utility vehicles and pickup trucks with a gross vehicle weight rating in excess of 6,000 pounds are exempt from the luxury vehicle depreciation caps.
Expiring business tax incentives – Many temporary business tax incentives expired at the end of 2011. In past years, Congress has routinely extended these incentives, often retroactively, but this year may be different. Confronted with the federal budget deficit and across-the-board spending cuts scheduled to take effect in 2013, lawmakers allow some of the business tax extenders to expire permanently. Certain extenders, however, have bipartisan support, and are likely to be extended. They include the Code Sec. 41 research tax credit, the Work Opportunity Tax Credit (WOTC), and 15-year recovery period for leasehold, restaurant and retail improvement property.
Small employer health insurance credit – A potentially valuable tax incentive has often been overlooked by small businesses, according to reports. Employers with 10 or fewer full-time employees paying average annual wages of not more than $25,000 may be eligible for a maximum tax credit of 35 percent on health insurance premiums paid for tax years beginning in 2010 through 2013. Tax-exempt employers may be eligible for a maximum tax credit of 25 percent for tax years beginning in 2010 through 2013.
The credit is scheduled to climb to 50 percent of qualified premium costs paid by for-profit employers (35 percent for tax-exempt employers) for tax years beginning in 2014 and 2015. However, an employer may claim the tax credit after 2013 only if it offers one or more qualified health plans through a state insurance exchange.
Today’s uncertainty makes doing nothing or adopting a “wait and see” attitude very tempting. Instead, multi-year tax planning, which takes into account a variety of possible scenarios and outcomes, should be built into one’s approach.
Please contact our office for more details on developing a tax strategy in uncertain times that includes consideration of certain tax-advantaged steps that may be taken before year-end 2012.
Nienow & Company, LLP News 