As explained in our prior advisories, a variety of tax credits, exemptions and reduced tax rates are scheduled to expire at the end of 2012. Through a series of advisories on the changes most likely to affect you – our clients – Nutter’s Tax Group hopes to provide insight and guidance about ways that you may achieve the greatest tax efficiencies by taking advantage of current tax provisions.
This advisory focuses on changes that may affect investors, including not only those with large investment portfolios, but also anyone who invests in securities, who has an asset that has appreciated in value or who receives dividends. Everyone in this position should be thinking now about steps that might mitigate the adverse impact of the scheduled 2013 tax increases. Each situation is unique, so there is no single course of action to be taken, but here are a few ideas to think about:
- Selling Appreciated Assets. Certainly if a person is considering selling an asset in early to mid-2013, he or she should consider accelerating the sale instead into 2012. This would allow any long-term gain from the sale to qualify for the current 15% federal rate, which is scheduled to rise to as much as 23.8% (including the Medicare tax) on January 1, 2013. Assuming, for example, that an asset has $100,000 of appreciation, a sale in 2012 versus 2013 could mean savings of as much as $8,800 in taxes. Accelerating the sale into 2012 would mean an earlier payment of the tax attributable to the sale, but with interest rates so low, the time value of money associated with that prepayment would be minimal compared to the taxes to be saved.
- Electing Out of Installment Sale Treatment. It may be possible to qualify a gain for the lower 2012 tax rates even if part of the purchase price is not actually paid by the buyer until 2013 or later. So long as the original sale takes place in 2012, sellers can do this by “electing out” of installment sale treatment for their transaction. Although this will cause the full gain to be taxable in 2012, the year of sale, rather than in the year actual payments are received, a quick comparison of the two scenarios and the resulting tax savings can give the seller a good sense of whether electing out of installment sale treatment makes sense. Any final decision can be made as late as the due date for the seller’s 2012 tax returns.
- Timing Dividend Income. Shareholders in public companies have little say about when the dividends are declared, but investors who own shares in a closely held corporation may have greater control over the timing of dividend payments. If no sale of a C corporation is on the horizon for several years, investors may want to consider distributing some of the corporation’s accumulated earnings and profits before January 1, 2013 in order to qualify the distribution for the 15% rate applicable to “qualified dividends” through December 31, 2012. Dividends paid after that date are scheduled not only to be subject to higher ordinary income rates of as much as 39.6%, they also will be subject to the 3.8% Medicare tax, bringing the effective tax rate on the dividends to 43.4%, or almost 300% more than 2012. This approach may be most attractive to investors whose tax basis for their shares is near zero, since distributing profits by way of dividends in 2012 will have no greater tax cost to these investors than would a sale of some of their shares.
- Roth IRA Conversion. Investors holding assets in traditional IRA’s should consider the pros and cons of converting those IRA’s to a Roth IRA. Unlike traditional IRA’s, distributions from Roth IRA’s are not subject to federal income tax. To qualify for this tax exemption, Roth distributions must satisfy certain minimum holding requirements, including a minimum 5-year delay between the account’s establishment and its first distribution. Traditional IRA’s that are converted to Roth IRA’s will not result in an early withdrawal penalty for persons under age 59 ½; however, the amount converted will be taxed as a distribution in the year of conversion. Thus, income tax will be due upon the conversion on the value of the IRA account balance (excluding any prior nondeductible contributions). In addition to taking advantage of the 2012 tax rates, several other factors may counsel in favor of a Roth conversion. For example: (1) retired individuals will not have to take required minimum distributions from the Roth IRA in future years; (2) investment values of the IRA assets may not have recovered to their highs; and (3) if the income tax can be paid from assets other than the IRA itself, the tax-free compounding is optimized.
- Liquidating A Closely Held C Corporation. If an investor controls a business currently conducted as a C corporation, now may be the time to eliminate the double tax trap inherent in C corporations by liquidating the corporation, paying capital gains taxes at 15% on the appreciated value of the investor’s shares and operating thereafter as a limited liability company taxable as a partnership. Care must be taken, however, to limit liquidations to those C corporations that do not have significantly appreciated assets “inside” the corporation, because that appreciation would have to be recognized (and a tax paid) at the corporate level in order to get the assets out of corporation solution.
- Accelerating Investment Expenses. If an investor has expenses associated with an investment portfolio, such as investment advisory fees, subscriptions, etc., he or she should consider whether an acceleration of the payment of 2013 expenses into 2012 could result in tax savings. The balance to strike here is between a 2012 deduction that is not subject to any phase out, and a 2013 deduction that can be used to offset income taxed at a higher rate in that year, but that will be subject to possible disallowance in part through the phase out. The phase out, in effect for years prior to 2009, returns for 2013 and reduces all itemized deductions by an amount equal to 3% of the investor’s adjusted gross income over a specified amount. That amount was $159,950 for 2008, the last year the phase out applied, and is increased for inflation each year thereafter.