As you begin preparing for year-end, and the subsequent tax year, here is a list of items that may assist you in your tax planning, given the potential approval of President Trump’s tax reform in 2018. Effective year-end tax planning must take into account each person’s particular tax status and planning goals.
Individual taxpayers need to consider, among other things:
the effect of the highest tax bracket (currently 39.6%, scheduled to be reduced to 35%);
the reduced tax rate on long-term capital gains and qualified dividends (currently 20%);
the phase-out of some deductions and personal exemptions (phase-out begins with adjusted gross income of $261,500 ($313,800 for married couples filing jointly);
the alternative minimum tax (AMT), and
the 3.8% Medicare Tax on net investment income.
You should consider whether income deferral or acceleration of deductions will serve you well, because in some instances such deferral or acceleration may have the opposite effect. You must also acknowledge that any decision to save taxes by accelerating income also accelerates tax liability.
10 terms to note
- Individual Tax Status. Changes in an individual's tax status may lead to US tax and reporting obligations. A change in tax status may arise due to divorce, marriage, loss of head of household status, sustaining US residency, receiving (or surrendering) a permanent resident status (green card), becoming (or ceasing to be) a US citizen, or moving to a foreign country permanently, among other events.
- Capital Gains. Currently, long-term capital gains (capital gains with respect to an asset that has been held for more than 12 months), are taxed at a rate of 20% (if such gain would have been taxed at a rate of 39.6% had such gain been treated as ordinary income), 15% (if such gain would have been taxed at a rate between 15% and 39.6% had such gain been treated as ordinary income), or 0% (if such gain would have been taxed at a rate of 10% or 15% had such gain been treated as ordinary income). On top of these rates, there is an additional 3.8% net investment income tax that may apply. For year-end planning, a taxpayer's approach to minimize or eliminate this 3.8% net investment tax will depend on the taxpayer’s estimated modified adjusted gross income and net investment income for the year. Taxpayers should consider alternative ways to minimize modified adjusted gross income and/or net investment income for the balance of the year.
- Capital Losses. Individuals who lost money in the stock market in 2017, and have other investment assets that have appreciated in value, should consider selling appreciated assets before year end thereby offsetting gains with the stock market losses. The Internal Revenue Code differentiates between long-term and short-term capital loss. Long-term capital losses are used first to offset long-term capital gains before they are available to be used against short-term capital gains. Short-term capital losses must be used first to offset short-term capital gains before they available to be used against long-term capital gains.
- Net Operating Losses. A taxpayer who sustained net operating losses in 2017 may be able to use these losses, and recover a portion of the taxes paid in prior years, by filing for a net operating loss carryback refund. This type of refund may be of particular value if indeed tax rates will be reduced in 2018, as the loss will have more value in years that had a higher tax rates. The carryback is also valuable to a financially troubled business that needs a fast cash transfusion.
- Dividend. A qualified dividend is taxed at the same favorable tax rates that apply to long-term capital gains. Converting investment income taxable at regular rates into qualified dividend income can achieve tax savings and result in higher after-tax income. However, it must also be noted that the 3.8% surtax on net investment income may apply.
- Distributing Subpart F income of a CFC. The Code provides several anti-deferral rules applicable to US shareholders of foreign corporations. Among these are a set of rules applicable to US persons holding 10% or more in controlled foreign corporations (CFC). The rules applicable to a US shareholder of a CFC require such US shareholder to include as income such shareholder’s pro-rata share of the company’s subpart F income, as if such income has been distributed to such US shareholder at the last day of the tax year. Such undistributed income may be taxed by the CFC’s country of residence upon actual distribution and may create an unresolved double tax. To avoid paying taxes in the US on undistributed income and later paying tax on the same income, upon distribution, US shareholders should consider ways to reduce the CFC’s subpart F income or should distribute dividends prior to the end of the taxable year.
- Expensing Deductions. The Code allows a current deduction of the entire cost of certain property that is “placed in service” during and after 2017. However, the Code limits the maximum amount that may be expensed at $510,000 (the “Accelerated Depreciation”). The Accelerated Depreciation amount can be reduced if the cost of the property placed in service during the taxable year exceeds $2,000,000. Alternatively, businesses may consider buying machinery and equipment at year-end so they can deduct the cost under a “de minimis” safe harbor election. Such safe harbor election is more restrictive than the Accelerated Depreciation; however, the amount is not limited. Another depreciation alternative is the “first-year depreciation deduction”. Most new machinery and equipment bought and placed in service in 2017 qualifies for the 50% bonus first-year depreciation deduction.
- Alternative minimum tax (AMT). AMT applies to individuals and to corporations earning a certain amount. A decision to accelerate an expense or to defer an item of income to reduce taxable income for regular tax purposes may not save taxes if the taxpayer is subject to the AMT. Careful consideration should be made because accelerating income or deferring deductions may move the taxpayer from being subject to the “normal” tax system rather than the AMT system. Note that the Trump tax proposal, if adopted, would revoke the AMT.
- Charitable contributions. The timing of charitable contributions can have an important impact on year-end tax planning. Taxable contributions made in 2017 shall have a higher (tax) value if tax rates will be reduced in 2018.
- Debt Cancellation Income and Worthless Securities and More. The Code allows taxpayers, as a deduction against their income, the claim of bad debt which becomes worthless within the taxable year, unless such debt is non-business debt. Additionally, the Code allows a taxpayer to claim a loss with respect to worthless securities held by the taxpayer, unless the taxpayer is compensated by insurance or otherwise. Therefore, any worthless security which is a capital asset, or bad debt that is uncollectable during the year, can be used to offset taxable income. US taxpayers should consider whether they have any debt or security that can be claimed as bad debt or worthless securities prior to the end of the year, especially if tax rates are reduced in 2018.