Rarely has there been such a major difference between the laws in effect in one year and the next. The maximum income tax rates next year could be as high as 43.4% on ordinary income (44.6% if the potential impact of reinstated limitations on itemized deductions is taken into account) and 23.8% on long-term capital gains (or 25% if itemized deduction limitations are factored in). In addition, unless Congress acts, millions of additional taxpayers will be liable for the alternative minimum income tax (AMT) for 2012 because the most recent AMT patch expired at the end of 2011. Further, the current 2% payroll tax holiday is scheduled to expire at the end of this year.
Few taxpayers are prepared for the impact of these changes, and many have, for the most part, chosen to ignore them in the hope that they will just go away. Smart practitioners will see this as an opportunity to help clients deal with a difficult situation and demonstrate how a CPA can add value. Fortunately, there are abundant planning opportunities; in particular, CPAs can help clients avoid or minimize the impact of scheduled tax increases resulting from the expiring Bush tax cuts, especially the impact of higher tax rates on all income, including capital gains, and the new 3.8% Medicare surtax. Quick action is imperative. It is essential to “run the numbers” and then determine the appropriate steps to minimize the impact of these potential new taxes. This article focuses on some of the more significant changes on the horizon and how practitioners can help clients deal with them.
DEALING WITH THE NEW MEDICARE SURTAXES
Starting in 2013, a surtax of 3.8% of net investment income will apply to certain individuals, trusts, and estates. The surtax applies to individuals with modified adjusted gross income (MAGI) over $250,000 for married taxpayers filing jointly; $125,000 for married taxpayers filing separately; and $200,000 for taxpayers filing single or as a head of household. The tax is imposed on the lesser of the individual’s net investment income for the tax year or MAGI in excess of those thresholds. For trusts and estates, the surtax will apply when the trust or estate is in the highest tax bracket for the year (approximately $12,000 in 2013).
Net investment income is the excess of the sum of the following items, less any allowable deductions properly allocable to such income or gain:
- Gross income from interest, dividends, annuities, royalties, and rents unless derived in the ordinary course of a trade or business (excluding a trade or business that is a passive activity or a trade or business of trading financial instruments/commodities);
- Other gross income from any passive trade or business or a trade or business of trading financial instruments/ commodities; and
- Net gain included in computing taxable income that is attributable to the disposition of property (including the taxable portion of gain on the sale of a personal residence) other than property held in any trade or business that is not a passive trade or business or a trade or business of trading financial instruments/commodities.
In addition to the new 3.8% Medicare surtax on net investment income, starting in 2013 a new 0.9% Medicare surtax will apply to wages and self-employment income of taxpayers with MAGI in excess of these threshold amounts. Whether income is subject to the 3.8% or the 0.9% additional Medicare tax will depend on:
- Type of income; and
- Taxpayer’s other income, deductions, etc.
As a result, although counterintuitive, 2012 may be the year to accelerate rather than defer income. For example, taking salary (or bonuses) in 2012 will avoid higher tax brackets applicable in 2013 and will avoid the new 0.9% Medicare surtax applicable to high-income taxpayers. Selling off investments this year that will be subject to the new Medicare surtax on net investment should be considered, as should exercising nonqualified stock options that are “in the money.”
Also, taxpayers may consider deferring deductions that reduce AGI into 2013 where they may provide a greater tax benefit. For example, if compensation accrued in 2012 is paid more than two and one-half months after the employer’s tax year ends, Temp. Regs. Sec. 1.404(b)-1T will apply to delay the deduction until 2013. Similarly, if the taxpayer makes qualified plan contributions for 2012 after the extended due date of the 2012 return (i.e., after the grace period in Sec. 404(a)(6)), these deductions will be pushed into 2013. Business taxpayers may be able to defer deductions to 2013 that might otherwise be deducted in 2012 under the recurring items exception contained in Sec. 461(h)(3).
Can the taxpayer benefit from inventory write-downs for lower of cost or market valuations or for lost, missing, or abandoned inventory? Accelerating billing or collecting receivables for sole proprietors, rentals, or passthrough operations as well as factoring receivables may also be options. Also, taxable conversions of corporate entities into LLCs or other taxable liquidation events should be considered; however, the potential future impact on self-employment tax must be evaluated. If the client will have a net operating loss (NOL) in 2012, consider whether to carry back the NOL or waive the carryback and then carry it forward to 2013.
While accelerating itemized deductions for individuals is generally a good planning strategy, it may be especially so in 2012. The Pease limitation, which reduces itemized deductions for high-income taxpayers, is scheduled to return next year. Therefore, accelerating itemized deductions may be particularly beneficial this year. Clients who deduct sales tax, as opposed to state/ local income taxes, should consider making big ticket purchases by year end in case the deduction for state sales taxes is extended into 2012. If the client is considering making charitable contributions, note the potential for significantly increased limits on charitable contributions next year. Bunching deductions (e.g., taxes, charitable contributions, accountants’ fees, and possibly medical expenses) in one year while claiming the standard deduction in intervening years may produce a better tax result.
While accelerating income to take advantage of currently lower tax rates or deferring deductions to offset income being taxed at higher rates later is an attractive option, the impact on cash flow and the present value of money must be considered. These factors will vary depending on the tax rates and interest rate applicable to the deferral periods. Again, this is why it is essential to run the numbers to determine the appropriate steps to minimize the impact of these new taxes.
Practitioners should also be on the lookout for worthless securities and bad debts. These are deductible in the first year they become wholly worthless. Business clients frequently feel that their reserve for doubtful accounts, which is not deductible, is sufficient to cover their bad debts, so they do not specifically write off bad debts.
Perhaps the big question from a planning perspective is whether S corporations will be the new entity of choice because there is no 3.8% surtax on flowthrough business income, and flowthrough business income is not subject to the 0.9% surtax on earned income. Family partnerships may also see a rebound. Parents and grandparents may be able to spread investment income subject to the 3.8% Medicare surtax among multiple family members who are under the MAGI threshold.
Trusts should consider paying distributions to beneficiaries to avoid the 3.8% Medicare surtax, which kicks in for trusts at approximately $12,000 of taxable income in 2013. The surtax on these distributions, if any, will then be paid by beneficiaries if they are over the $200,000 or $250,000 threshold. The 65-day rule in Sec. 663(b) can be used to defer distributions to as late as March 6 of the following year and still have them apply to the current year.
Keep in mind, however, that clients who are nonresident aliens are not subject to the 3.8% surtax since they will not benefit from Social Security.
As previously discussed, timing is critical in determining whether income is subject to the 3.8% Medicare surtax. Income received in 2012 is not subject to it, and the lower 2012 tax rates still apply, so, in most cases, income received in 2012 will be taxed at lower rates than in future years. Depending on income level, these higher rates may or may not apply in future years. So again, it’s essential to run the numbers.
A closely held C corporation with accumulated income should consider paying a dividend in 2012. Its shareholders would pay tax at 15% in 2012, while the tax rate might be as high as 43.4% in 2013. On a $1 million dividend, this would save $284,000.
Also, married couples compute MAGI based on their combined income. Therefore, if a husband’s salary is $150,000 next year and his wife’s salary is $175,000, their combined income of $325,000 is $75,000 over the MAGI threshold. Because each is individually under the threshold, they may not be having enough withheld on their salaries to cover the 0.9% Medicare tax ($675). They need to consider this in calculating their estimated tax, or they could request their employers withhold additional tax from their salaries. If this couple also had $50,000 of net investment income in 2013, the $1,900 of 3.8% Medicare surtax on this income, as well as the additional $675 of 0.9% Medicare surtax on their salaries, must be taken into account in determining their estimated tax in 2013.
Distributions from IRAs are not subject to the 3.8% Medicare surtax, but distributions from traditional IRAs and qualified plans are included in MAGI. This could result in other investment income being subject to the surtax. For example, for the couple above, if the husband’s and wife’s salaries were $100,000 each instead of $150,000 and $175,000, and they also took a taxable IRA distribution of $25,000, $25,000 of their $50,000 net investment income is now subject to the 3.8% Medicare surtax even though none would have been subject to the surtax had they not taken the IRA distribution. While regular IRA and qualified plan distributions are included in MAGI, distributions from Roth IRAs are not. This may make converting a traditional IRA into a Roth IRA an even more attractive option in 2012.
Dividing certain deductions, such as state income taxes, between 2012 and 2013 may reduce income subject to the AMT. Prepaying expenditures eligible for the American opportunity tax credit, which expires at the end of this year, may also make sense, although the lifetime learning credit will still be available after the end of this year.
Capital gains will most likely be subject to much higher taxes in 2013 (the tax on long-term gains is scheduled to increase from 15% to 23.8%; and the tax on short-term gains from 35% to 43.4% for taxpayers in the highest brackets), so consider accelerating gains into 2012 and paying tax at lower rates now. Future higher capital gain rates may not be of concern to elderly taxpayers, particularly those in poor health, who will not have a taxable estate. They can pass these assets to their heirs with a stepped-up basis tax free. Of course, anyone who currently qualifies for the 0% capital gains rate, which is scheduled to expire at the end of 2012, should definitely take advantage of this special rate.
It may be better to pay tax on the entire gain from an installment sale in 2012 by electing out of installment sale treatment under Sec. 453(d), rather than deferring tax on the gain to 2013 and beyond to avoid the surcharge as well as possibly keeping MAGI in those years under the threshold. Conversely, installment sale treatment may be an even more attractive option in the future since spreading out this income over a period of years may keep the taxpayer under the MAGI threshold.
Since the 3.8% Medicare surtax is based on net investment income, deductions such as depreciation and operating expenses that are properly allocable to investment income are especially valuable starting in 2013. Clients with real property used in a trade or business, including rental properties, can maximize depreciation with cost-segregation studies. If they have multiple properties, they could spread out these studies, doing one or more for 2013 and then another for the following year and so forth. Doing this should help to minimize their taxable and net investment income and may keep them under the MAGI thresholds.
Depreciation expense can also be “controlled” by timing when assets are purchased and when they are placed in service, as well as by selecting the depreciation method. Whether to elect to expense assets under Sec. 179 can also affect taxable income greatly, as can whether to claim bonus depreciation for assets placed in service that year. Advisers should also consider the impact on taxable income of implementing the new tangible property regulations (T.D. 9564).
Grouping elections for passive activities may reduce the amount taxable as net investment income. Under Regs. Sec. 1.469-4, a rental building used in a related active trade or business can be classified as a nonpassive activity, which avoids the 3.8% Medicare surtax, but will subject the rental income to the 0.9% additional Medicare tax on earned income over the MAGI threshold.
Maximizing contributions of pretax compensation to qualified plans can benefit taxpayers in two ways: Lowering their AGI may keep them under the MAGI threshold, and investment gains in qualified plans are not subject to the 3.8% Medicare surtax. As mentioned above, distributions from qualified plans are included in MAGI and may therefore cause other investment income to be subject to the 3.8% Medicare surtax by pushing the taxpayer over the MAGI threshold.
In consultation with the client’s investment adviser, portfolio balancing should be considered. A focus on growth investments rather than investments that produce dividends or interest income can help avoid the 3.8% Medicare surtax. Tax-exempt interest is not subject to this surtax and also does not increase MAGI. Similarly, the buildup of value in an insurance policy is not subject to this surtax, nor are death benefits generally taxable.
Annuities defer recognition of income. It may be possible to “leapfrog” over high tax years subject to surtax and defer tax into lower-income years when the taxpayer will be subject to lower tax brackets and not subject to the surtax. Oil and gas investments and rental real estate may generate current losses that reduce MAGI and net investment income while generating positive investment returns.
Bond investment strategies include selling bonds in 2012 to recognize accrued interest. For example, a taxpayer could sell bonds in December 2012 that have $100,000 of accrued bond interest that would otherwise be paid in January 2013. If the taxpayer is in the maximum federal tax bracket, the taxpayer’s tax on the accrued interest would be $35,000 in 2012, but $43,400 if the interest were collected in 2013, resulting in a tax savings of $8,400. If the taxpayer were to purchase another bond in January 2013, the accrued interest purchased on the new bond could offset interest received during the year.
Taxpayers with investment interest expense in excess of net investment income should consider not making an election under Sec. 163(d)(4)(B)(iii) to treat net capital gain from the disposition of property held for investment and qualified dividend income as investment income in order to deduct the investment interest expense in the current year. Not making this election will allow the excess investment interest expense to be carried over to future years when it could offset investment income, which may be subject to both higher tax rates and the Medicare surtax.
Charitable remainder trusts enable donors to defer capital gains. Also, those charitably inclined should consider donating appreciated securities. They will receive a charitable contribution deduction and avoid tax on capital gains. Of course, if those securities have declined in value, the taxpayer should sell them and then donate the sale proceeds to the charity. The loss on the sale will be available to offset other gains and may help to reduce the taxpayer’s MAGI.
By accelerating medical expense deductions into 2012 for certain expenses that taxpayers can control the timing of, such as elective surgery, dental work, eye exams, etc., taxpayers under 65 can avoid the increase in the medical expense deduction threshold, which increases from 7.5% to 10% in 2013. For tax years before 2017, this increase in the medical expense deduction threshold does not apply if a taxpayer or his or her spouse has attained age 65 before the close of the tax year.
Also health care insurance for self-employed individuals may be more valuable starting in 2013. They can deduct these premiums for health care insurance above the line, which will reduce their MAGI. They may, therefore, want to consider an insurance plan with better coverage, since they can deduct the insurance cost while reducing out-of-pocket medical bills for which they will likely get little or no benefit.
BUSINESS / OTHER CHANGES
Advisers should be aware that health insurance plans that existed as of March 23, 2010, (the date of enactment of the health care law) are subject to only some of the provisions of the act. These plans are known as “grandfathered plans.” Employers and individuals who are still covered by these plans should check to determine what changes relating to their health coverage apply to them.
Practitioners should also search for tax credits, such as the small employer health insurance tax credit and the work opportunity tax credit for unemployed veterans and unemployed veterans with service-connected disabilities. Perhaps CPAs should consider using a firm that specializes in identifying employee tax credits to maximize this benefit.
Starting in 2012, all employers required to file 250 or more Forms W-2, Wage and Tax Statement, for the year are required to disclose the aggregate cost of their applicable employer-sponsored coverage on their employees’ W-2s, under interim guidance in Notice 2012-9. The interim guidance in Notice 2012-9 is effective until the IRS issues further guidance. Practitioners should be familiar with this notice since it provides information on what employers must disclose as well as other optional disclosures.
While not addressed in this article, practitioners should also be mindful of the dramatic changes that are scheduled to occur regarding estate and gift taxes and take these changes into account when advising their clients.
President Barack Obama’s reelection essentially eliminated any possibility for full repeal of health care reform, but as of this writing the potential for changes to the tax provisions during the lame-duck session were uncertain. We may see changes in 2013, but it is unlikely that any significant legislative changes will occur quickly. Practitioners should therefore assume that these new taxes will be in place next year and plan accordingly.
CPAs can add a lot of value for their clients, and they should take advantage of the unique opportunities available at this time to help them.
The Bush tax cuts are scheduled to expire at the end of 2012, causing tax rates to increase dramatically beginning in 2013. A number of new tax provisions related to the health care law, such as the 3.8% surtax on net investment income, are also scheduled to be effective beginning in 2013.
It is likely that there will not be any significant legislation repealing these tax increases before they go into effect.
A number of ways to reduce income that would be subject to the 3.8% tax on net investment income are explained in this article.
There are also a number of strategies for shifting income from 2013 to 2012 and shifting deductions from 2012 to 2013 to lower clients’ taxes.
Because each client’s situation is different, CPAs can provide valuable tax planning to clients by running the numbers on different strategies and advising clients of the best options for their situation.
Steven F. Holub (firstname.lastname@example.org) is a (retired) tax partner at Cherry Bekaert LLP in Tampa, Fla.
To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at email@example.com or 919-402-4828.
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