Dear Clients, Colleagues and Friends:
Always up for a good challenge, your NDH friends will again attempt our annual tax planning newsletter without clear direction from Congress. As our nation rolls towards the fiscal cliff, a grand bargain becomes less likely and a significant tax rate increase becomes more certain. That certainty may only be temporary as commentators generally agree that we will have tax overhaul, but generally disagree what that overhaul will look like.
Without legislation, 2013 tax rates will go up 3-5% with the highest bracket going from 35% to 39.6%. Itemized deductions and personal exemptions will again be limited, effectively increasing these tax rates further. Corporate dividends will lose their favored tax status and become taxable at the maximum ordinary rate and many of the stimulus items we’ve grown accustomed to will fade. To make matters worse, 2013 will also bring the start of a new 3.8% Medicare tax for individuals making over $200k and couples making over $250k.
With all these moving pieces and so little clarity, planning can be very tricky. Expect higher rates, but be prepared for some relief in the form of more general tax reform in 2013. Act now to take advantage of the lower 2012 rates, but be cautious about acting too aggressively. Stay tuned as we expect more details to come.
On a brief personal note, we are celebrating our 10-year anniversary this month. Many thanks to our clients, colleagues, friends. Choosing to work with a small upstart takes a fair amount of trust. We very much appreciate the trust and loyalty you’ve given us and we look forward to the next ten years.
Please enjoy another round of year-end tax tips from your friends at NDH.
Individual Income Tax
Accelerate Income and Defer Deductions to Avoid Higher 2013 Rates
Look for opportunities to accelerate income otherwise recognizable in 2013 into 2012 to take advantage of the significantly lower 2012 tax rates. You should look to accelerate bonuses, IRA distributions, non-qualified stock option exercises, and other income events into 2012 if possible. Similarly, you should look to defer deductions into 2013 where their benefit can be claimed at higher rates. Use caution though, you do not want to accelerate income or defer deductions if you would pay a similar or lower rate in later years (i.e.: if you will not be in the highest bracket in 2013 or if you can smooth such income into later years utilizing lower brackets). Note also that future tax reform involving lower rates funded by reduced deductions could also wreak havoc with this strategy.
Lock-in Low Capital Gains Rates
With long-term capital gains rates rising by up to 8.8% in 2013, smartly managing your stock portfolio could generate substantial current tax savings. Investors with future liquidity requirements should consider selling appreciated stock prior to year-end and deferring capital losses. This nonconventional tax strategy locks in today’s low capital gains rates and generates bigger after-tax benefits when you sell your loss securities. You should not, however, trigger gains on assets that you plan to hold for the longer term. Recognizing a gain in 2012 will require a current tax payment. The ability to defer tax over several years tends to make up for the higher later tax rate.
Investors in the 10% and 15% tax brackets currently pay no tax on long-term capital gains. In 2013, this benefit is eliminated absent year-end Congressional action. Though planning can be incredibly difficult, wealthy individuals making most of their income from capital gains and qualified dividends may also be able to qualify for the zero rate on some of their long term capital gains and qualified dividends. Additionally, note children subject to the Kiddie Tax will not qualify.
Harvest Portfolio Losses in Stable Tax Rate Environment
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 2013. 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. Note that this strategy works well with stable or decreasing tax rates. See Lock in Low Capital Gains Rates for rising rate environments.
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. Note that dividends will be treated as regular ordinary income beginning in 2013 absent legislation.
- 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.
Medicare Surcharge Tax Planning
For tax years beginning after December 31, 2012, a 3.8% Medicare surcharge tax applies to net investment income including passive income and capital gains for married couples making over $250,000 ($125,000 if married filing separate and $200,000 in all other cases). Similarly, a 0.9% Medicare surcharge applies to wages and self-employment income for those above the same dollar thresholds making the total Medicare tax 3.8% on such earnings. While IRA and pension income is not subject to this surcharge, such income is considered in determining whether you are “high income”. For example, a $250,000 IRA distribution would make you “high income”, thereby making all of your investment income subject to the surcharge.
Business owners should consider strategies to mitigate application of the Medicare surcharge. Such strategies may include entity restructuring and/or grouping business activities. This planning can be very technical and complicated. Please don’t try this at home; seek professional guidance.
High income investors should also consider strategies to mitigate the Medicare surcharge. Absent full repeal the surcharge will be difficult to completely avoid, but investors should consider the following strategies:
- Structure investment portfolios to tilt toward growth assets and municipal bonds, and away from dividend paying stocks and taxable bonds.
- Manage other ordinary income to stay below the high income threshold (ie: Roth convert in 2012 to avoid high IRA distributions in later years).
- Divert some investment income to family members and trusts not subject to the surcharge. A family limited partnership would be useful here.
- Defer investment interest expense to 2013 if possible.
- Recognize capital gains in 2012.
Use caution in taking excessively drastic action as some commentators believe that this surcharge may ultimately be addressed in major tax reform.
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.
Time your Charitable Donations
With tax rates set to rise for higher income folks, consider delaying year end deductions until 2013 when the deductions will be more valuable. On the flipside, many fear that the charitable deduction will be limited in 2013 making 2012 deductions more valuable. A middle ground approach to charitable donations may be best this year given the legislative uncertainty.
As always with donations, the tax benefit is greatest when donating appreciated securities. Also, for all donations a written acknowledgement from the charitable organization for all donations exceeding $250 is required. You must retain written support for all cash contributions regardless of amount.
Establish a Donor-Advised Fund
Potential itemized deduction limitations in 2013 make 2012 a good time to set up a donor-advised fund. 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 2012 deduction.
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 2012 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 estimated tax penalties are clear. Pay in ratably through withholding or estimated tax payments 110% of last year’s tax liability or 90% of this year’s liability.
The Illinois estimated tax penalties are severe but a taxpayer-friendly rule exists that can help you mitigate your liability. Illinois residents with K-1 income can defer estimated tax payments until the fourth quarter. The rule provides that income earned through a K-1 is deemed received on the last day of the entity’s tax year for estimated tax purposes.
Alternative Minimum Tax (“AMT”) continues to be a problem and may become an even bigger problem this year if Congress doesn’t pass an “AMT patch” as it has done for each of the past several years. 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. Making matters worse, many upper-middle income taxpayers will find themselves perpetually in AMT, making even good planning worthless.
Conversely, increasing future marginal tax rates will make AMT less of an issue. Though counterintuitive, a taxpayer in AMT in 2012 may benefit by deferring preference deductions into 2013 (i.e.: state taxes and miscellaneous itemized deductions) or by accelerating income into 2012.
Fund Retirement Plans
You can save for retirement while deferring tax on current earnings by maximizing contributions to your employer-sponsored retirement plan. The 2012 limit for employee contributions to a 401(k) plan is $17,000 ($22,500 if 50 or older). In 2013 the limits go to $17,500 and $23,000, 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 ($6,000 if 50 or older) in 2012. The contribution limit increases to $5,500 in 2013 ($6,500 if 50 or older). If your employer does offer a retirement plan or if you are a high income taxpayer, you can still make a non-deductible contribution. Non-deductible IRA contributions can make a lot of sense to the extent you can convert those contributions into a Roth IRA.
Roth IRAs, which do not provide for a current deduction but whose future distributions are tax free, provide an attractive alternative for those eligible to contribute. The contribution limits are identical to Traditional IRAs and 2012 AGI phase-outs begin at $110,000 for single individuals and $173,000 for married taxpayers.
Elective deferrals to a SIMPLE IRA in 2011 and 2012 are limited to $11,500 and $12,000, respectively. Participants age 50 and older can make an additional $2,500 “catch-up” contribution each year. SEP-IRA limitations for 2012 are the lesser of $50,000 or 25% of compensation. The limitation increases to $51,000 in 2013.
Roth IRA and Roth Conversion
Single people with less than $125,000 of adjusted gross income and married couples with less than $183,000 should consider a Roth contribution. Anyone, regardless of income, can convert a traditional IRA to a Roth IRA, but will need to pay the tax on that conversion now. The impending increase to tax rates makes a 2012 Roth conversion an especially attractive planning solution. Don’t forget to make 2012 non-deductible IRA contributions if you plan to convert in 2012.
Roth IRA Recharacterization Basics
If you have made a 2012 Roth IRA conversion, continue to monitor the performance of the investment. The IRS allows you to undo the conversion up until the due date of the return, including extensions. This ability to undo a conversion (until October 2013) makes Roth conversion a safe strategy for tax rate planning in the face of uncertainty.
Children under age 19 (24 if a full-time student) pay tax at parents’ tax rates on investment income exceeding $1,900 in 2012. This threshold increases to $2,000 for 2013. 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. Note for married taxpayers, both spouses must have earned income to be eligible for the 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 at the end of the school year and 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 2012 for single taxpayers with modified AGI of $80,000 and $160,000 for married taxpayers. The 2012 Lifetime Learning Credit remains at $2,000 and begins to phase out at $52,000 and $104,000 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.
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. Your child may be eligible for one of the credits and does not need to pay the expenses directly. 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 plan today for a state tax deduction; you can distribute funds for tuition shortly afterward. You can also name yourself as the beneficiary, so consider setting up a plan for your own education costs.
Prepay State Taxes and Real Estate Taxes
If you itemize deductions, consider paying your fourth-quarter state tax estimate or projected 2012 state tax liability by December 31st. You may also want to consider prepaying 2012 real estate taxes due in 2013 – just be sure your tax collector considers this a payment and not a non-deductible deposit. Use caution in pre-paying taxes in 2012 because increasing rates may make those deductions more valuable in 2013. Also, because state income and real estate taxes are AMT preferences it is best to defer the payment 2013 if you’re in AMT.
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 2012, the maximum HSA contribution for an individual is $3,100 and $6,250 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 2012 can be made until April 15, 2013. 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.
Business Income Tax
Accelerate Fixed Asset Additions
Depreciation expense will be much less favorable after 2012. Therefore, consider accelerating planned asset acquisitions before year-end to maximize benefits.
For 2012 a business can deduct 50% of the cost of new equipment immediately, without regard to any limitations. Under current law, bonus depreciation will expire January 1, 2013. 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 2012 businesses can deduct up to $125,000 of qualifying property. The deduction begins to phase out after purchases exceed $500,000. Note that businesses must have taxable income to qualify. In 2013 the amount that can be expensed will decrease significantly to $25,000 and will begin to phase out after purchases exceed $200,000.
R & D Credit
The R&D credit expired at the end of 2011 and has not yet been extended. If extended, the R&D credit would continue to benefit several companies, from large manufacturing firms to smaller software and services companies. The credit is up to 20% of qualifying R&D expenditures, depending on the taxpayer’s elected method. 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
Many accrual basis taxpayers are carrying accounts receivable that are entirely or partially worthless. Depending on the situation, there may be an opportunity to take these bad debts as ordinary tax deductions. To take advantage, the account, or part of the account, must be written off by year end. 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 2012 year-end bonuses paid in 2013 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, 2013 holiday pay in 2012 if they accrue the liability in 2012 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.
FICA tax is paid on earnings up to $110,100 in 2012 and $113,700 in 2013. It is possible for self-employed and small businesses to minimize their employment taxes via appropriate structuring.
Standard Business Mileage Rate
In 2012 the standard business mileage rate is unchanged from the mid-year 2011 rate of 55.5 cents/mile. For charitable mileage, the rate is also unchanged at 14 cents/mile rate. For medical or moving purposes, the rate has decreased to 23 cents/mile.
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. No credit is allowed for any other tax year.
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 taxes 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. At this time, the maximum monthly limits remain the same in 2013: $125 for commuter transit and $240 for parking, a combined monthly limit of $365, and $20 for bicycle commuting expenses. However, it is possible that Congress will increase the 2013 commuter transit limit to $240 and also retroactively increase the 2012 limit to January 1, 2012.
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 the entity elects to do a Composite filing. Non-resident entities, however, may elect out by filing Form IL-1000-E. Note that non-resident individuals are not required to file an Illinois income tax return if their withholding covers 100% of their tax liability.
Small Business Health Care Tax Credit
There is a tax credit available to certain small businesses which 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. The credit phases out gradually for firms with the equivalent of 10 – 25 employees and with average annual wages between $25,000 – $50,000.
Gift and Estate Tax
2012 has been a busy year for estate planners. The estate and gift exemption will drop in 2013 to $1m and the rate will increase to 55%. When faced with a similar problem two years ago, Congress enacted a $5m exemption and 35% rate. While most expect some relief, few believe it will be as favorable as the 2012 law. Furthermore, the prospect for reform provides little comfort for many elderly folks facing a significant estate tax risk in 2013. This uncertainty combined with the historically high gift exemption in 2012 provides good reason to plan now.
Utilize your $5.12m Estate / Gift Exemption in 2012
The gift exemption is $5.12m through the end of 2012 ($10m for a married couple electing to gift split) and drops to $1m on January 1. Many wealthy folks are making $5m transfers today in an attempt to lock in the favorable 2012 exemption. Such large gifts are normally made to irrevocable trust for preservation and management.
Even some folks not considered ultra-wealthy have been making these large gifts to so-called SLATs (Spousal Lifetime Access Trust). These trusts not only give estate planners a fancy new acronym, but make the irrevocable transfer a little more palatable to those nervous about irrevocably transferring $10m.
Annual Exclusion Gifts
The annual gift exclusion is $13,000 in 2012 and will rise to $14,000 in 2013. 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. The low $1m estate exemption in 2013 gives even more incentive to not only make the 2012 gifts, but to make the 2013 gifts early in the year.
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 2012 can be made at a 0.95% 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.
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.
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.