Dear Clients, Colleagues and Friends: With 2011 winding down, Congress has not passed major year-end tax legislation for the first time in recent memory. Major changes to your income tax rates and estate and gift exemptions remain on the horizon but will likely be deferred until the end of next year. Don’t rest on your laurels, however, as many temporary tax provisions are set to expire and inaction could prove costly. We encourage you to use our year-end tax tips to help you expertly navigate these transient tax rules. Taxes still dominate the political landscape despite relative year-end tax complacency. Partisan bickering continues with Congress’ fight over the extension of the 2% employee payroll tax cut. The Democrats and Republicans generally agree to extend this middle class tax benefit but disagree on how to pay for it. The Democrats want to impose a Millionaire surcharge while the Republicans refuse to increase taxes on any taxpayers. Stay tuned as we expect year-end fireworks over this issue. Switching gears, one year from now we will be celebrating our 10-year anniversary. Time has flown by, but our mission has largely remained the same. We aim to provide the highest quality accounting and tax solutions to our sophisticated clients using technology and talented professionals. Currently, with twelve professionals and future expansion plans, we’re as excited today about our business as we were nine years ago when we hatched our crazy plan. We continue to grow and enjoy the challenges our clients bring. Be on the lookout for a website re-launch in early 2012 and continue to stay in touch. Please enjoy another round of year-end tax tips from your friends at NDH. Sincerely, NDH Group Individual Income Tax | Business Income Tax | Gift and Estate Tax
Individual Income Tax
Harvest Portfolio Loss
Sell loss positions in your investment portfolio prior to year-end. Such capital losses will offset capital gains and up to $3,000 of ordinary income. Any realized but unused capital losses will be carried to 2012. Beware, however, of the wash sale rules which will disallow the loss if you repurchase the same or a substantially identical asset within 30 days before or after the sale. Savvy mutual fund investors can lock-in losses and mitigate this 30-day requirement by purchasing similarly classed mutual funds containing a different mix of stocks.
Lock-in Low Capital Gains Rates
For most investors, long-term capital gains are taxed at 15% through 2012. Absent new legislation, the rate will increase to 20% in 2013. Also beginning in 2013, capital gain income to high income taxpayers will be subject to an additional 3.8% Medicare tax. Because the expected tax increase outpaces projected interest rates, investors with future liquidity requirements should consider selling before 2013. Long-term investors should purchase securities before year-end for a last opportunity to meet the one-year long-term capital gains holding period and to lock in the low 15% capital gains rate before it increases. Investors in the 10% and 15% tax brackets currently pay no tax on long-term capital gains. In 2013, this benefit is eliminated absent Congressional action. Selling securities prior to 2013 locks in a huge tax benefit.
Practice Tax-Efficient Investing
Taxes have a major impact on investment returns and not all investment income is taxed alike. Although your financial objectives should drive your investment decisions, keep in mind the following tax basics of investing:
- Avoid excessive portfolio turnover in your brokerage and/or mutual fund accounts. Capital appreciation is taxed every time a security is sold.
- Avoid purchasing a mutual fund at year-end before its distribution date; otherwise, you may be purchasing an unexpected tax obligation.
- Favor investments generating qualified dividends and long-term capital gains, which will be taxed at a favorable rate vs. interest income taxed at the maximum ordinary rate.
- Beware of tax-exempt private activity bonds – interest is taxable for AMT purposes.
- Consider exchange-traded funds which often make fewer tax distributions than mutual funds and have lower expense ratios.
Efficiently Utilize Debt
When debt is appropriately utilized as part of a personal or business investment strategy, significant post-tax benefits can be achieved. Businesses may consider utilizing debt to make year-end asset acquisitions. With historically low borrowing costs and taxpayer-friendly depreciation rules, financing an asset acquisition can create substantial economic benefits. Investors may consider debt as an alternative to selling assets or as a mechanism to shelter investment income. Taxpayers should review their debt positions annually to ensure they are paying the lowest after-tax rate. Note that not all interest expense is deductible. Interest on home acquisition indebtedness up to $1M is deductible, as is interest of up to $100,000 of home equity indebtedness. Investment interest expense is deductible to the extent of investment income. Interest on borrowing used in a trade or business is generally deductible in full.
Accelerate Your Charitable Donations
Make donations by year-end for a 2011 deduction. Donations charged to your credit card prior to year-end are deductible in 2011 even if paid in 2012. Increase the tax benefit of your donation by donating appreciated securities. As usual, donation substantiation rules must be followed. A written acknowledgement from the charitable organization for all donations exceeding $250 is required. You must also retain written support for all cash contributions regardless of amount.
Establish a Donor-Advised Fund
Donor-advised funds are a popular way to make deferred charitable gifts. Donors receive a current year charitable deduction for contributions made to the fund and can later direct distributions to charities of their choice. Donor advised funds are low cost and administratively easy, but they do require a couple weeks to set-up. Act now if you want a 2011 deduction.
Donate Your IRA to Charity
Taxpayers 701/2and older can still contribute up to $100,000 of IRA distributions directly to a qualified charity in 2011. If you file a joint return, both you and your spouse can each contribute up to the maximum. Directly donated IRA distributions are not taxable and will count towards your minimum required distribution. This option is especially helpful to those individuals who claim the standard deduction or who face contribution limitations. Note that unless extended, this benefit expires at the end of the year.
Increase Withholding to Eliminate Estimated Tax Penalties
If you face estimated tax penalties and have failed to make sufficient estimated tax payments this year, consider increasing your withholding in the final 2011 pay periods. Income tax withholding is deemed paid evenly throughout the year and can help eliminate penalties when a year-end estimated tax payment may not. The rules for avoiding federal penalty are clear. Simply pay in ratably, through withholding or estimated tax payments, 100% of last year’s tax liability (110% for high income taxpayers) or 90% of this year’s liability. Illinois’ 2011 “safe harbor” rules require paying 150% of last year’s liability or 90% of this year’s liability due to the recent tax increase. Illinois residents with substantial K-1 income can defer large estimated tax payments until the fourth quarter. Income earned through a K-1 is deemed received on the last day of the entity’s tax year for estimated tax purposes in Illinois. Illinois’ recent tax increase makes this strategy more valuable than in previous years.
Alternative Minimum Tax (“AMT”) continues to be a problem in 2011. AMT has the effect of disallowing certain deductions and credits, but in application, it’s more complicated. Therefore, it is usually very difficult to tell whether someone will be subject to AMT without running a detailed tax projection. Even with a projection, there are limited options for planning around the AMT, and those options are not much better than paying AMT (i.e: deferring decutions and accelerating income). Making matters worse, many upper-middle income taxpayers will find themselves perpetually in AMT, making even good planning worthless.
Fund Retirement Plans
You can save for retirement while deferring tax on current earnings by maximizing contributions to your employer-sponsored retirement plan. The 2011 limit for employee contributions to traditional 401(k) plans is $16,500. Participants age 50 and older can make an additional $5,500 “catch-up” contribution. In 2012 the limits go to $17,000 and $22,500 respectively. If your employer makes matching contributions, be sure to minimally contribute enough to receive the full match. If your employer doesn’t offer a retirement plan, you can contribute up to $5,000 to a deductible IRA. Those 50 and older can make an additional $1,000 “catch-up” contribution. Elective deferrals to a SIMPLE IRA in 2011 and 2012 are limited to $11,500. Participants age 50 and older can make an additional $2,500 “catch-up” contribution. SEP-IRA limitations for 2011 are the lesser of $49,000 or 25% of compensation. The limitation increases to $50,000 in 2012. Roth IRAs, which do not provide for a current deduction but whose future distributions are tax free, provide an attractive option for those eligible to contribute. The maximum 2011 contribution is $5,000 plus a $1,000 “catch-up contribution for those 50 and older. 2011 phase-outs begin at $107,000 for single individuals and $169,000 for married taxpayers.
Roth IRA Conversion
If you were on the fence regarding a Roth IRA conversion in 2010 or you recharacterized your 2010 conversion, you can still convert regardless of overall income in 2011. The benefits of conversion continue to apply, however the two-year income deferral option on the conversion is gone. Don’t forget to make 2011 non-deductible IRA contributions if you plan to convert in 2011.
Roth IRA Recharacterization Basics
If you previously converted to a Roth IRA, continue to monitor the performance of the investment. The IRS allows you to undo the conversion if you choose. To maximize tax efficiency, recharacterization of the Roth IRA to a traditional IRA should be considered when:
- The value of the investment in the Roth IRA has declined since the conversion took place;
- The taxpayer’s income in the year of the conversion was higher than expected or the additional income from a Roth IRA conversion pushed the taxpayer into a higher income tax bracket than anticipated;
- The taxpayer does not have the cash needed to pay taxes on the conversion or must use part of the converted IRA assets to pay the tax; or
- The taxpayer now believes his taxable income in retirement will be less than previously estimated, offsetting the advantages of a Roth IRA’s tax-free distributions.
The deadline for recharacterization is the extended due date of your tax return for the year of the original contribution. The ability to recharacterize for 2010 conversions has passed, but continue to monitor for any conversion in 2011.
Children under age 19 (24 if a full-time student) pay tax at parents’ tax rates on investment income exceeding $1,900 in 2011 and 2012. Parents should look for opportunities to direct investment income to their children up to these limits to utilize the child’s lower tax brackets. This is commonly accomplished by gifting assets that generate investment income through an UTMA account or trust.
Dependent Care Credit
The dependent care credit is up to $600 for one qualifying dependent with a $3,000 expense limit. If you have two or more qualifying dependents, the credit is up to $1,200 with a $6,000 expense limit. Make sure to include all your qualifying dependents on Form 2441, regardless of how many dependents actually had expenses, as the $6,000 expense limit is still used to compute your credit.
Illinois Credit for K-12 Education Expenses
Illinois taxpayers with children enrolled in kindergarten through twelfth grade may qualify for an Illinois tax credit up to $500. The tax credit is 25% of qualified education expenses in excess of $250 for any number of qualifying students. Qualifying student(s) must be an Illinois resident under 21 attending a public or private school in Illinois.
Education Tax Provisions
The American Opportunity Tax Credit provides a $2,500 credit per eligible student for qualified educational expenses including tuition, fees and course materials. The credit is available for the first four years of post-secondary education and is partially refundable. Phase-outs begin in 2011 for single taxpayers with modified AGI of $80,000 and $160,000 for married taxpayers. The 2011 Lifetime Learning Credit remains at $2,000 and begins to phase out at $51,000 and $102,000 for single and married taxpayers, respectively. Though set to expire at year-end, the Tuition and Fees Deduction provides an alternative to the education credits and may generate greater tax benefits. Run your return multiple ways to determine which option is best. Note the above credits and deduction cannot be claimed on qualifying expenses paid through 529 plans. See your tax advisor on tips for maximizing your savings.
Education Tax Credits Planning
If your child is in college and you are not eligible to claim one of the education credits, consider having your dependent child claim them on his/her return. You lose your ability to claim a dependency exemption for your child, but the net benefit to the family may be worth it. Run the numbers to determine the best strategy.
Deduct the Cost of Your MBA
Part-time MBA candidates may obtain larger tax benefits by deducting their education costs as employee business expenses versus taking the Lifetime learning Credit or the Tuition and Fees Deduction, which expires at year-end. Qualifying part-time MBA candidates can deduct their education costs if the classes maintain or improve skills used in their current job. The deduction is a 2% miscellaneous itemized deduction and provides no benefit for taxpayers in AMT. Note that the IRS heavily scrutinizes this deduction, so be sure you qualify.
529 Education Plan
A 529 Plan is an educational savings vehicle that helps families save for future college costs. The donor’s investments grow tax-free and qualifying distributions are non-taxable. Although contributions provide no federal benefit, many states offer deductions or credits for contributions – Illinois allows a deduction up to $20,000 for married taxpayers. Deductions for Illinois are only allowed for contributions made to the “Bright Start”, “Bright Directions” and “College Illinois” programs. Even if you have a child attending college, consider contributing to a 529 today for a state tax deduction; you can distribute funds for tuition shortly afterward.
Prepay State Taxes and Real Estate Taxes
If you itemize deductions, consider paying your fourth-quarter state tax estimate or projected 2011 state tax liability by December 31st. You may also want to consider prepaying 2011 real estate taxes – just be sure your tax collector considers this a payment and not a non-deductible deposit. Pay attention to AMT, as state tax and real estate tax payments are preference items and not deductible for AMT.
The Job Creation Act of 2010 extended the energy efficiency tax credits into 2011 but reduced the benefit. The 2011 credit is limited to 10% of the cost of qualifying improvement up to $500. The new statutes create a $500 lifetime limit; if you received more than $500 from this credit in years 2006 – 2010, you are not eligible for any additional creditamount in 2011.
Health Savings Account
Consider establishing a Health Savings Account (“HSA”) to pay for qualified medical expenses with pre-tax dollars. An HSA is a tax-favored savings account which is paired with a high-deductible health insurance plan. For 2011, the maximum HSA contribution for an individual is $3,050 and $6,150 for a family. Individuals age 55 and older may make a “catch-up” contribution of $1,000. Funds not used in your HSA account will roll forward and earn interest tax-free. Contributions for 2011 can be made until April 15, 2012. Note that when you become eligible for Medicare you can no longer contribute to your HSA, but you can continue to use your HSA funds tax-free for qualified medical expenses.
Home Mortgage Forgiveness Exclusion
By now we are all aware of the housing market crises and the high foreclosure rates. What may not be known is the relief provided by the 2008 Economic Stabilization Act. Though typically included in income, taxpayers are allowed to exclude up to $2M of debt forgiven on their principal residence. The basis of the residence must be reduced by the amount excluded and taxpayers must still be cognizant of gain-on-sale issues. Nonetheless, this provision can be extremely beneficial for taxpayers. Note this exception expires on December 31, 2012, giving taxpayers just over a year to realize this exclusion.
Qualified Small Business Stock (Section 1202 Stock)
Many venture capitalists and entrepreneurs are unaware of a special rule allowing them to exclude 100% of the gain on the disposition of their qualified small business stock purchased after September 27, 2010 and before January 1, 2012. The stock must be originally issued by a C corporation with less than $50M in assets, purchased prior to year-end and held for 5 years to qualify for the favorable treatment.
Business Income Tax
Accelerate Fixed Asset Additions
Depreciation expense is set to be much less favorable after 2011. Therefore, consider accelerating planned asset acquisitions before year-end to maximize benefits.
For 2011 a business can deduct 100% of the cost of new equipment immediately, without regard to any limitations. Under current law, bonus depreciation will decrease to 50% in 2012. If a business has income in 2011 and plans on acquiring depreciable property, it may be worthwhile making the investment in 2011. There is a small window of opportunity, as qualifying equipment must be purchased and placed into service before the end of the year. Note that Code Sec. 179 depreciation should be used before bonus depreciation as bonus requires an Illinois modification. Also, consider electing out of bonus for passive real estate investments to avoid an Illinois income pick-up without a corresponding federal deduction.
Code Sec. 179
In 2011 businesses can deduct up to $500,000 of qualifying property. The deduction begins to phase out after purchases exceed $2M. Note that businesses must have taxable income to qualify. In 2012 the amount that can be expensed will decrease significantly to $139,000 and will begin to phase out after purchases exceed $560,000. Also for 2012, though historically limited to tangible personal property, certain leasehold improvements will now qualify for accelerated depreciation.
R & D Credit
The Tax Relief Act of 2010 extended the R&D credit through the end of 2011. Large manufacturing firms are not the only ones who benefit, as smaller software and service companies can qualify as well. The tax credit is up to 20% of qualifying R&D expenditures, depending on the taxpayer’s elected method. Some of the eligible costs include improvements to existing processes, testing for new or improved products and certain software development. Though no longer offsetting AMT, unused credits can be carried back one year or forward 20 years. Talk with your advisor if you haven’t previously qualified as new computational methods may be available.
U.S. manufacturers can deduct up to 9% of Qualified Production Activity Income (net income from U.S. manufacturing activities, natural resource production, film production, construction, engineering and architecture). For S corporations and partnerships, the benefit is determined at the shareholder or partner level, so both passive and non-passive investors can qualify.
Write-off Bad Debts
Accrual taxpayers can claim a tax deduction by writing down receivables that become wholly or partially worthless during the year. Note that it is not enough to simply provide a reserve; you must identify specific receivables which have become worthless during the year.
Holiday Pay and Bonuses
Accrual businesses can currently deduct 2011 year-end bonuses paid in 2012 as long as: 1) the employee, combined with immediate family, does not own more than 50% of the company’s stock; 2) the bonus is accrued on the company’s books before year-end; and 3) the company pays the bonus within two and half months after year-end. Accrual taxpayers can also generally deduct January 1, 2012 holiday pay in 2011 if they accrue the liability in 2011 and it is supported by the company’s holiday pay policy.
Employ Your Minor Children
Business owners with minor children should consider paying them compensation. The business will receive a deduction and the children will pay little or no tax. Furthermore, the child’s earnings could be invested in a Roth IRA for even more tax efficiency.
The limitation for FICA tax increases from $106,800 to $110,100 in 2012. It is possible for self-employed and small businesses to minimize their employment taxes via appropriate structuring.
Standard Business Mileage Rate
In 2011 the standard business mileage rate is 51 cents/mile from January 1st through June 30th and 55.5 cents/mile from July 1st through December 31st. For charitable mileage, the rate is 14 cents/mile for the whole year. For medical or moving purposes, the rate is 19 cents/mile from January 1st through June 30th and 23.5 cents/mile from July 1st through December 31st.
Small Employer Pension Plan Startup Cost Credit
A small employer pension plan startup cost credit is allowed for small businesses that did not have a pension plan during the previous three years. Eligible expenses include those to start and administer a new employee retirement plan and retirement-related education of employees. For an eligible small employer, the credit is 50% of the qualified startup costs paid or incurred during the tax year. The credit is limited to $500 per year for the first credit year and each of the following two tax years.
Section 125 Plans
Many small businesses require employees to fund medical insurance plans with after-tax contributions despite a relatively easy fix. Payroll providers have become more cost-efficient in providing Section 125 benefit plans, including premium only plans (“POP”). With a plan in place, employees can use pre-tax dollars to pay their share of medical premiums. Employers also save, as they are not required to pay the corresponding employment tax on the amounts contributed by the employee under a Section 125 Plan.
Section 132 Qualified Transportation Expenses
Code Section 132 allows employees to pay for specific qualified transportation costs with pre-tax dollars under an employer plan. Standardization has increased the cost-effectiveness of these plans. For those with established plans, note that for 2012 the maximum monthly amount for mass transportation decreases from $230 to $125 and qualified parking increases from $230 to $240 (making the combined limit $365). Bicycle commuting expenses remain at $20.
Illinois Pass-Through Entity Withholding Requirements for Non-Resident Owners
Do not forget that Illinois-resident Partnerships, S corporations and trusts are required to remit tax on behalf of their non-resident owners to ensure compliance with Illinois tax laws. Payments are made with Form IL-1000 and are due by the original due date of the entity’s return. Unlike with many other states, non-resident individuals cannot elect out of withholding treatment unless they elect to do a Composite filing. Non-resident entities, however, may elect out by filing Form IL-1000-E. Note that non-residents are not required to file an Illinois income tax return if their withholding covers 100% of their tax liability.
HIRE Act and New Hire Retention Credit
For employers who hired employees meeting the HIRE Act qualifications in 2010, don’t forget to claim an additionalgeneral business tax credit on your 2011 income tax returns. The credit is 6.2% of wages paid, up to a maximum of $1,000 per employee. To qualify, an employee must be retained for at least 52 consecutive weeks.
Small Business Health Care Tax Credit
The government is offering a tax credit as an incentive for small businesses to provide health care coverage. The credit is up to 35% of health care premium costs for for-profit employers and 25% for nonprofit employers. A qualifying employer must cover at least 50% of the cost of health care coverage for its employees and must employ the equivalent of 25 or fewer full-time employees. Average annual wages must be $50,000 or less. The credit phases out gradually for firms with average wages between $25,000 – $50,000 and for firms with the equivalent of between 10 – 25 full-time employees. The IRS provides three simple steps to determine if you qualify, so work with your accountant to determine if the credit can benefit your business.
Gift and Estate Tax
After a few years of wild uncertainty in the gift and estate tax law, 2011 has provided a small island of tranquility. In December 2010 Congress enacted compromise estate and gift tax legislation which expanded the estate and gift exemption to $5 million, re-unified the estate and gift tax, reinstated a 35% maximum rate and provided portability of estate exemptions among spouses. However, the legislation only applies to 2011 and 2012. Therefore, without legislation in 2012, we will be back to 2000 law which provides only a $1M exemption, a 55% maximum rate and no portability. It will again be a year of uncertainty in 2012 as we await legislation for 2013. Most commentators believe that Congress will come to agreement on a plan similar to 2011 law. However, this belief will provide little comfort for many small estates which will again face the real prospect of a tax liability in 2013 should Congress fail to act promptly. This uncertainty may also motivate large estates to make transfers today while exemptions remain historically high. This continued uncertainty provides good reason to continue with planning strategies and ensure that your estate documents are flexible and current.
Annual Exclusion Gifts
The annual gift exclusion is $13,000 per year for 2011 and 2012. This is the amount that each person can give to any other person without tax. Annual exclusions are a use-it-or-lose-it proposition, so those facing a taxable estate should not let them go to waste without good reason. Those apprehensive about gifting outright, but wanting to take advantage of exclusions, should consider a Crummey trust.
Irrevocable Life Insurance Trust
Purchase life insurance via an irrevocable life insurance trust. If appropriately structured, ILITs will keep the insurance proceeds out of your estate.
Utilize Historically Low Interest Rates
Intra-family loans must bear a minimum interest rate or interest will be imputed for income and gift tax purposes. The minimum applicable interest rates are at historic lows (i.e.: a nine year loan made in December 2011 can be made at a 1.27% interest rate). These low interest rates provide a great opportunity to make loans to family members as part of an estate and gift planning strategy.
Consider Asset Protection
Wealthy individuals should consider from time-to-time whether their asset holdings could be structured to more efficiently protect them from creditor claims. Trusts, entities, insurance and retirement plans can all play a key role in protecting assets from legal claims.