Many of our clients have finalized their tax planning for the year. For those who have not and with only weeks remaining in 2013, there are still a number of opportunities to do some last-minute planning to save as much as possible.
For most taxpayers, year-end provides the last opportunity for tax planning. Unlike previous years, however, tax planning for 2013 will be more challenging due to the comprehensive tax law changes made by the American Taxpayer Relief Act of 2012 ("the Act"), the provisions of and confusion with the Affordable Care Act and the recent Supreme Court decision on same-sex marriage. In addition, many tax incentives are scheduled to expire after 2013, unless Congress chooses to extend them. Such uncertainty is likely to further compound effective planning.
While last year's strategy was more often than not to accelerate income and postpone deductions due to the anticipated higher tax rates in 2013 than 2012, this year, many would likely benefit from reversing such strategy and instead accelerate deductions and postpone income.
To assist you in navigating your year-end tax options through the myriad of changes, we highlight below key changes and offer practical year-end planning tips for individuals and businesses with respect to the changes. It is important to note that year-end tax planning should not occur in a vacuum and each taxpayer's particular situation and goals should be considered with the aim of minimizing taxes to the greatest extent possible over a two-year period (not only for 2013 but also for 2014). Before making any moves, taxpayers may want to consult with their tax advisors.
Planning for Individuals
Top Tax-Bracket Increases
While the Bush-era tax cuts for lower- and middle-income taxpayers were extended permanently in 2013, the 39.6% bracket was restored, increasing the highest rate by 13%, from 35%. Your federal income-tax bracket is determined by two factors: your taxable income and your tax-filing status. The top brackets start at the following income levels:
Click here to view table.
For those with income greater than the amounts listed in the chart above, your tax bill will likely increase. For example, wage earners making between $500,000 and $600,000 will likely owe between $10,000 and $15,000 more this year.
Manage Your Tax Bracket
The lower your tax bracket, the lower your tax obligation. One way to lower your tax bracket is to defer income and accelerate deductions. For individuals, deferring income may also help to reduce or avoid adjusted gross income-based (AGI) phase-outs of various itemized deductions and credits.
Select income deferral strategies to consider include:
- Postpone asset sales that generate gains until 2014.
- Defer receipt of bonuses until 2014.
- Delay stock option exercises.
- Transfer funds from interest-bearing accounts to Treasury bills.
- Maximize retirement plan contributions.
- Consider like-kind exchanges.
- Enter into installment sale agreements.
Select options for accelerating deductions to consider include:
- Prepay 2014 property and state income taxes in 2013.
- Prepay January 2014 mortgage payment in December.
- Bunch large out-of-pocket medical expenses into one year to overcome the 10% of AGI threshold for taxpayers under age 65.
- Accelerate large charitable deductions into 2013, rather than 2014.
- Gift appreciated stock to avoid tax on the appreciation while obtaining a deduction for the full value of the stock.
- Sell loss stocks.
- Establish a health savings account (HSA) and contribute the maximum amount allowed.
Caveat: Beware of the Alternative Minimum Tax (AMT). A decision to accelerate a deduction or to defer an item of income to reduce taxable income for regular tax purposes may not always provide a tax benefit because of the AMT. If you determine that you will be subject to the AMT, you may benefit from reversing the strategy. Since the AMT rate (up to 28%) is lower than the maximum regular tax rate (39.6%), you may actually reduce your overall tax liability by accelerating income into 2013 and deferring deductions that typically trigger AMT to 2014 (assuming 2014 is a non-AMT year). See our discussion under AMT below for methods to manage exposure to AMT.
Executors and trustees should consider distributing income to avoid the compressed tax brackets for estates and trusts. The highest rate for estates and trusts kicks in at only $11,950 for 2013.
Increased Capital Gains and Qualified Dividends Tax Rates
Long-term capital gains and qualified dividends receive preferential tax treatment, although not as favorable as years before 2013. For 2013 and later, this income is taxed at the following rates:
- 20% for taxpayers in the highest (39.6%) tax bracket (up from 15%);
- 15% for taxpayers in or above the 25% tax bracket, but below the 39.6% tax bracket; and
- 0% for taxpayers below the 15% tax bracket.
The 28% and 25% rates still apply for collectibles and unrecaptured Code Section 1250 gains (e.g., gain from sale of real estate), respectively. Complex netting rules apply when a taxpayer has both short- and long-term capital losses. Only long-term gains are eligible for the favorable tax rate; however, long-term losses may offset ordinary income up to $3,000 ($1,500 if married filing separately).
- Consider holding capital assets for 12 months or more to avoid tax at ordinary income tax rates for short-term capital gains.
- Consider utilizing prior-year capital loss carryforwards by generating capital gains.
- Consider efforts to avoid unusual nonrecurring income, which could push capital gains into the higher capital gains bracket. Spreading this income over 2013 and 2014 may escape the increased rate.
- Consider taking advantage of the netting rules to minimize the net gain or loss subject to tax.
- Consider converting investment income taxable at regular rates, such as interest from bond funds, into qualified dividend income from dividend paying stocks to take advantage of the preferential tax rate for qualified dividends.
New 3.8% Medicare Tax on Net Investment Income
In addition to the increased rates in 2013, there is now the new 3.8% tax on net investment income (NII). The tax applies to most investment income, including capital gains and dividend income; most rental income (excluding rental income derived by real estate professionals); passive activity income; royalties; and net gain attributable to the disposition of property other than property held in a trade or business. Gain from the sale of interests in partnerships and S-corporations is also considered NII.
Taxpayers with modified adjusted gross income (MAGI) over $200,000 who file individually or $250,000 for married couples filing jointly ($125,000 if married and filing separately) could be subject to this new tax.
Luke, a single filer, has $180,000 in wages. The taxpayer also received $90,000 from a passive partnership interest, which is considered NII. Luke's MAGI is $270,000.
Luke's MAGI exceeds the threshold of $200,000 for single taxpayers by $70,000. Luke's NII is $90,000.
The NII Tax is based on the lesser of $70,000 (the amount that Luke's MAGI exceeds the $200,000 threshold) or $90,000 (Luke's NII). Luke owes NII tax of $2,660 ($70,000 x 3.8%).
Caveat: While distributions from retirement plans are not subject to the NII tax, you should be aware that a large distribution could push MAGI above the threshold. Taxpayers near the threshold should consider revising the timing of distributions from retirement plans or accelerating above-the-line deductions, such as classroom expenses for teachers and educators; student loan interest deductions; health savings account deductions; moving expenses; self-employment health insurance; retirement plan contributions; alimony; and domestic production activities deduction for certain types of businesses, to name a few.
- Consider shifting taxable investments to tax-exempt investments.
- Consider selling loss stocks to offset capital gains recognized earlier in the year.
- Consider installment sale treatment for 2013 sales to spread income over multiple years.
- Take steps to increase participation in a passive activity to qualify as a material participant and potentially avoid the NII tax.
- Consider an election to group multiple passive activities to qualify as a material participant. Taxpayers subject to the NII tax have a unique opportunity in 2013 or 2014 to regroup their pass-through and/or rental activities. Special rules allow taxpayers to group certain rental and/or trade or business activities based on the facts and circumstances surrounding the relation of those activities and will allow taxpayers to group activities together if they constitute an appropriate economic unit. This strategy may potentially allow taxpayers to utilize suspended passive losses to offset non-passive income. As these rules are complex, it may be worthwhile to consult with a qualified tax professional before making these moves.
- Consider contributing to a Roth IRA instead of a traditional IRA. Qualified Roth IRA distributions are not included in either MAGI or NII, while traditional IRA distributions increase MAGI.
New Additional 0.9% Medicare Tax on Wages/Self-Employment Income
An additional 0.9% Medicare tax is now imposed on wages and self-employment income above the NII thresholds detailed above. Unlike Social Security tax, there is no cap on the amount of wages subject to the new Medicare tax. Employers are required to withhold the additional tax to the extent an employer pays wages to an employee in excess of $200,000 during a calendar year, regardless of the taxpayer's filing status or other wages and/or compensation.
Caveat: Although married taxpayers may individually fall below the withholding threshold, their combined wages may exceed $250,000, thus subjecting them to the additional tax when they file their return. The same issue may also arise for taxpayers working for more than one employer. Failure to ensure adequate withholding and/or estimated tax payments could result in the imposition of the underpayment of estimated tax penalty.
Married taxpayers whose combined wages exceed the threshold and taxpayers with combined wages from more than one employer that exceed the threshold should consider increasing their withholding by filing an updated Form W-4 with their employer or making an estimated tax payment to potentially avoid underpayment of tax penalties.
Alternative Minimum Tax (AMT) Considerations
The AMT was originally aimed at preventing the most affluent taxpayers from avoiding tax. However, since it was not indexed for inflation, the AMT has impacted an increasing number of middle-income taxpayers each year. Congress attempted to correct this by annually "patching" the AMT with increased exemption amounts.
Taxpayers who traditionally monitor their exposure to AMT should continue to do so, as certain items will continue to trigger AMT. They include, but are not limited to:
- Medical expenses;
- Certain mortgage interest from home equity indebtedness;
- Real estate taxes;
- State and local income taxes;
- Miscellaneous itemized deductions, such as investment expenses;
- Income generated by the exercise of incentive stock options; and
- Installment sales.
- Taxpayers not liable for AMT in 2013 but who were liable in prior years may be eligible for a minimum tax credit against their regular tax liability.
- Taxpayers not expecting an AMT liability in 2013 but could experience one for 2014 should consider accelerating some of the deductions that typically trigger AMT. It may be prudent not to accelerate too many expenses, as you will creep toward AMT.
If you determine that you will be subject to the AMT, you may benefit from reversing the strategy of accelerating deductions and deferring income. Since the AMT rate (up to 28%) is lower than the maximum regular tax rate (39.6%), you may actually reduce your overall tax liability by accelerating income into 2013 and deferring deductions to 2014 (assuming 2014 is a non-AMT year).
Select methods for accelerating income to consider include:
- Cash basis taxpayers can speed up their billing and collection process.
- Cash basis taxpayers who sell property and realize a large long-term capital gain in 2013 can accelerate income by electing out of the installment method.
- Accelerate IRA and other retirement plan distributions into 2013.
- Harvest gains from investment portfolios.
- Convert a traditional IRA to a Roth IRA.
- Settle lawsuits or other claims that will generate taxable income.
As a result of the Supreme Court decision in U.S. v. Windsor and a related IRS Revenue Ruling issued shortly thereafter, same-sex married couples may now file joint federal income-tax returns. The state where a couple was married rather than the state where a couple resides determines a same-sex couple's marital status for federal tax purposes. Civil unions and registered domestic partnerships recognized under state law do not qualify.
Caveat: Beginning in 2013, legally married, same-sex couples must file either as married filing jointly or married filing separately.
For tax years prior to 2013, same-sex spouses should consider consulting their tax advisor to determine whether any refund opportunities are available for amending prior-year returns with the filing status change. The statute for a refund claim is open for three years from the date the return was filed, or two years from the date the tax was paid, whichever is later.
Contributions can be an effective way of reducing taxable income. They are also a sizeable itemized deduction that is not added back when figuring taxable income for purposes of the AMT. Subsequently, the timing of charitable contributions can have a key impact on year-end tax planning.
Caveat: IRS audits are on the rise, so be sure to obtain acknowledgement letters for donations greater than $250. Cancelled checks alone are insufficient to support a gift greater than $250.
- For taxpayers expecting to be in a higher tax bracket in 2014, consider deferring a sizeable charitable contribution into 2014. Alternatively, for taxpayers expecting a lower 2014 tax bracket, consider accelerating contributions into the current year.
- Consider gifting appreciated stocks held more than one year to avoid capital gains tax while still getting a deduction for the fair market value of stock.
- Taxpayers over age 70½ should consider making a tax-free distribution of up to $100,000 from an IRA to a qualified charity. This option is currently set to expire at the end of 2013.
Itemized Deduction and Personal Exemption Phase-Outs
The phase-out of itemized deductions (often called the "Pease" Limitation) has returned for 2013. The Pease Limitation was temporarily suspended from 2010 to 2012 and allowed taxpayers to enjoy the full benefit of their itemized deductions, regardless of their adjusted gross income. For 2013, if taxpayers filing as married filing jointly have adjusted gross income of $300,000 or higher ($250,000 for single, $150,000 for married filing separately and $275,000 for head of household), itemized deductions will be reduced by 3% of the amount by which their adjusted gross income exceeds the thresholds. This reduction is capped at 80% of itemized deductions.
A similar phase-out will also occur for personal exemptions where the total amount of the exemption is reduced by 2% for each $2,500 (or portion thereof) by which the taxpayer's adjusted gross income exceeds the same thresholds mentioned above.
The phase-out of personal exemptions and the limitation on itemized deductions both reduce exemptions and deductions for certain taxpayers and, therefore, increase the amount of federal income tax by typically 1% to 2%.
Barbara and Vince have AGI of $412,500 for 2013 and two children. The threshold for a married couple is $300,000; thus, their income exceeds the threshold by $112,500.
Personal exemption phase-out: Dividing that sum by $2,500 equals 45. So (45 x 2%) of their $15,600 exemption allowance [four exemptions totaling $15,600 (4 x $3,900)] is phased out, leaving them with a reduced exemption deduction of $1,560. Assuming Barbara and Vince are in the 33% federal tax bracket, the phase-out costs them an additional $4,633 ($15,600 x 90% x 33%) in tax.
Pease Limitation – Assuming itemized deductions total $24,000, they must reduce their itemized deductions by $3,375 (3% of $112,500), but the reduction must not exceed 80% of the deductions. The phase-out is the lesser of $3,375 or $4,800, which is 80% of $24,000, or $19,200. The Pease Limitation will cost them an additional $1,114 ($3,375 x 33%).
- Taxpayers affected by these phase-outs should consider adjusting estimated taxes or withholding amounts to avoid underpayment of tax penalties.
- Deploying some of the AGI-reducing techniques throughout this Alert should help reduce the impact of the Pease Limitation and personal exemption phase-out.
Roth IRA Conversions
Taxpayers have the option of converting their traditional IRA into a Roth IRA, although the conversion is not tax-free. Amounts converted are includible in adjusted gross income, but may no longer be spread over two years. A conversion will not be subject to the 10% early withdrawal penalty. Taxpayers who believe that a Roth IRA is more advantageous than a traditional IRA, and who want to remain in the market for the long term, should consider converting traditional IRA money invested in beaten-down assets into Roth IRAs if they are eligible to do so. They can also recharacterize their conversion back to a traditional IRA if they determine the investment has underperformed subsequent to the conversion. This "recharacterization" must be done before October 15 of the subsequent tax year.
Caveat: Although the conversion amount is not included in NII for purposes of the new NII tax, it is included in MAGI for use in establishing the threshold for the same. It is essential to consider the impact of conversion upon NII tax.
Take Advantage of Expiring Individual Tax Incentives
Many popular tax incentives are set to expire at the end of 2013, unless Congress extends them. Since there are no guarantees, you should consider taking advantage of these expiring provisions in 2013.
- State Tax Deductions - Taxpayers living in states with no individual income tax may elect to claim sales and use taxes as an itemized deduction instead of state income taxes. This election may also be advantageous for retired taxpayers receiving payments from retirement funds not subject to a state-level income tax.
- Teachers' Classroom Expense Deduction - An above-the-line deduction for certain expenses incurred by elementary and secondary school teachers is allowed.
- Exclusion of Cancellation of Indebtedness on Principal Residence - Income discharge of qualified principal residence indebtedness, up to $2 million ($1 million for married taxpayers filing separately), which applied to discharges before January 1, 2013.
- Mortgage Insurance Premium Deduction - Mortgage insurance premiums are treated as qualified residence interest.
- Tuition Expenses - An above-the-line deduction for qualified tuition and related expenses is allowed.
- Residential Energy-Efficiency Tax Credit - A 10% credit is available for the cost of (1) qualified energy-efficiency improvements and (2) residential energy property expenditures, with a lifetime credit limit of $500 ($200 for windows and skylights). Taxpayers considering such improvements may wish to accelerate these expenditures into 2013.
- Alternative Fuel Vehicle Refueling Property Credit - Taxpayers may claim a 30% credit for qualified alternative fuel vehicle refueling property placed in service in 2013. Credits are also available for energy-efficient new homes and appliances.
Planning for Businesses
Similar to individuals, businesses seeking to maximize tax savings through year-end planning should consider the use of tried-and-true timing techniques for income and deductions, as well as utilizing tax incentives that are set to expire. Additionally, pass-through entities, such as partnerships, limited liability companies and S corporations, should consider the impact year-end planning strategies may have on their business owners.
Take Advantage of Operating Losses
A business with a loss in 2013 may be able to use that loss to generate cash in the form of a quick net-operating-loss carryback refund. This type of refund may be of particular value to a financially troubled business that needs a fast cash infusion. It may be prudent to forego carrying the net-operating-loss back to previous years and to save it for future years since tax rates will be higher. Individual net operating losses can be carried forward for a period of 20 years.
Take Advantage of Expiring Business Tax Incentives
Many popular business tax incentives are also set to expire at the end of 2013, unless Congress extends them. Consider taking advantage of these expiring provisions.
- Section 179 Depreciation Deduction - The Section 179 depreciation deduction is set to drastically decrease if Congress fails to extend the current limits into 2014. For tax years beginning in 2013, the expensing limit is $500,000 and the investment ceiling limit is $2,000,000. A limited amount of expensing (up to $250,000 of the $500,000 limitation) may also be claimed for qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property. Unless Congress changes the rules, for tax years beginning in 2014, the dollar limitation will drop to $25,000, and the beginning-of-phase-out amount will drop to $200,000. Expensing will also not be allowed for qualified real property as referenced above. The generous dollar ceilings that apply in 2013 mean that many small- and medium-sized businesses that make timely purchases will be able to currently deduct most if not all of their outlays for machinery and equipment.
- First-Year Bonus Depreciation - Most new machinery and equipment (as well as software) bought and placed in service in 2013 qualifies for a 50% bonus first-year depreciation deduction. Unless Congress extends this tax break, property bought and placed in service in 2014 (other than certain specialized property) will not qualify for the 50% bonus first-year depreciation deduction. Thus, businesses planning to purchase new depreciable property may want to do so in 2013.
- Shorter Recovery Period for Certain Leasehold Improvements - Special rules permit qualified leasehold improvement property, qualified restaurant property and qualified retail improvement property to be depreciated over a 15-year recovery period rather than the normal 39-year recovery period used for nonresidential real property. These provisions expire at the end of 2013. Thus, if your business is contemplating any such improvements, placing such improvements in service in 2013 may significantly increase your depreciation deductions.
- Work Opportunity Credit - For 2013, businesses are eligible for a 40% tax credit for qualified first-year wages paid or incurred during the tax year to individuals who are members of a targeted group of employees, generally those working in excess of 400 hours annually. The credit is reduced for those employees working less than 400 hours. This credit is not available after 2013.
- Special S Corporation Basis Rules for Charitable Contributions of Property - For 2013, the decrease in an S shareholder's stock basis by reason of a charitable contribution of property is equal to the shareholder's pro rata share of the adjusted basis of such property. This provision expires for contributions made in tax years beginning after 2013. As a result, for contributions made in tax years beginning after 2013, the amount of the basis reduction is the shareholder's pro rata share of the fair market value of the contributed property.
- Expiration of Reduced Recognition Period for S Corporation Built-in Gains - An S corporation may owe tax if it has net recognized built-in gain during the applicable recognition period. Generally, the applicable recognition period is 10 years. However, for purposes of determining the net recognized built-in gain for tax years beginning in 2012 or 2013, the recognition period was reduced from 10 to five years. Thus, no tax is imposed on the net recognized built-in gain of an S corporation if the fifth tax year in the recognition period preceded 2012 or 2013. This favorable rule applies separately with respect to any C corporation asset transferred in a carryover basis transaction to the S corporation. After 2013, the recognition period returns to 10 years. Thus, to escape gain recognition on property with built-in gain, you would have to hold the property for more than 10 years.
New Business Provisions
Businesses are also impacted by the many tax law changes in 2013. Select provisions are highlighted below.
- Disposition of Business Interests Subject to New Investment Tax - The new 3.8% percent tax on NII above the threshold, discussed above, became effective in 2013. This new tax generally covers sales of interests in a partnership or S corporation that are considered passive activities on the taxpayer's individual income tax return.
- Patient Protection and Affordable Care Act - The Patient Protection and Affordable Care Act (ACA) includes several provisions that may affect employers, including the shared responsibility provisions, also known as the "employer mandate." Originally, the employer mandate was scheduled to take effect on January 1, 2014. However, this has been delayed, and the shared responsibility provisions will not take effect until January 1, 2015. Under the employer mandate, a penalty is imposed on certain large employers that do not offer health insurance coverage, offer health insurance coverage that is unaffordable or offer health insurance coverage that consists of a plan under which the plan's share of the total allowed cost of benefits is less than 60%.
- New Rules Apply to Dispositions of Business Property - The IRS recently issued rules dealing with dispositions of property, applicable to tax years beginning after December 31, 2013. The new regulations preserve the potential benefit of claiming a loss on disposed structural components without requiring taxpayers to use the general asset account rules.
- The regulations provide that the building, including its structural components, is the asset for disposition purposes. Therefore, taxpayers are not required to recognize a loss on the disposition of a structural component; however, they may elect to claim a loss on the disposition of a structural component without having to identify the component as a separate asset before the disposition event.
- Similar to the rules for capitalization and repairs, these rules can also be retroactively adopted.
The IRS also released final regulations governing how taxpayers treat materials and supplies, as well as repairs and maintenance costs for tangible and real property. These regulations are lengthy and complex in nature, and taxpayers should consult with their tax advisors to gain an understanding of the new regulations and set a policy for how these business expenses are treated subsequent to the required adoption date of tax years beginning after December 31, 2013.
- New Rules Apply to Property Purchased by Businesses - The IRS recently issued final repair regulations governing when taxpayers must capitalize and when they can deduct their expenses for acquiring, maintaining, repairing and replacing tangible personal property, which impact virtually all businesses. While these new rules apply to tax years beginning after December 31, 2013, businesses can adopt them retroactively back to the start of 2012. Because these rules are quite taxpayer-friendly, retroactive adoption of these rules could result in significant tax refunds. The new rules are extremely complex in nature and relate to materials and supplies, repairs and maintenance, among others.