Proactive Tax Planning Takes on Greater Significance for 2013

 Jim Guarino  for MFA-CPA.com  writes: Over the course of my career as a tax advisor, I’ve witnessed an interesting phenomenon. Many individuals refrain from proactive tax planning in the same way some of us might balk at eating raw vegetables. Although we know that it's something we should do, the alternatives just seem more appealing. Making the decision to "bite the broccoli" on proactive tax planning can be difficult for taxpayers, except of course in situations where it seems absolutely necessary, such as:

• Accounting for an unusual or one-time taxable event occurring during the tax year
• Year-end tax planning (last minute review of tax strategies before the December 31st clock strikes midnight)

The complicated new rules brought about by the recent passage of the American Taxpayer Relief Act of 2012 (ATRA) effectively serve as a third bullet on this list for upper-income taxpayers. Although proactive tax planning may still not seem appetizing, let's take a look at this most recent reason why taxpayers should be loading up their plates.

Why Proactive Tax Planning?

Self-employed business owners and individuals reporting significant investment income are already aware of the importance to proactively monitor their tax planning. These taxpayers do not pay their tax as employees do (via tax withheld from their wages); instead they pay their tax on a quarterly basis, based on their projected tax liability. Their estimated tax payments are generally computed using a safe harbor method or, in some instances, reviewed and re-computed quarterly. Using either of these methods as part of a strategic and proactive tax plan can result in many advantages. For example, they can help you:

• Minimize the possibility of either substantially overpaying or underpaying tax during the year
• Eliminate the potential of incurring a penalty for underpayment of tax
• Avoid the stress of paying an unexpectedly large tax liability on April 15^th
• Control cash-flow throughout the year
• Avoid unintentionally providing an interest free loan to the government due to a large overpayment of tax during the year

How Does ATRA Change Things?

The passage of ATRA has made calculation of projected tax liability a complicated process for many upper-income taxpayers. As discussed in my recent blog post, Uncertainty Resolved, Complexity Increased for Upper-Income Taxpayers, these taxpayers have several new income thresholds to keep in mind, and whether or not they hit them can drastically affect the taxes they ultimately owe. For individuals, this new playing field includes an increased overall income tax rate as well as a higher tax rate applied to capital gain and dividend income if taxable income exceeds $400,000. It also includes application of the Personal Exemption Phase-out (PEP) and the Limitation on Itemized Deductions if adjusted gross income (AGI) exceeds $250,000. Finally, there is a Medicare surtax on earned income and net investment income that applies to individual taxpayers with modified adjusted gross income (MAGI) exceeding $200,000. (Higher thresholds apply to married filing joint and head of household taxpayers.)

If that’s not enough to be concerned about, taxpayers may still fall victim to the ever-present Alternative Minimum Tax, which continues to present tax planning challenges for taxpayers and tax advisors alike. Paying close attention to tax liability changes throughout the year can help one determine if the ATRA tax law changes will impact them and whether the Medicare surtax will apply to one’s earned and net investment income.

What Can Tip the Scale?

Why might a taxpayer find themselves on the other side of a tax threshold, you might wonder? Here are a few examples of how someone might end up in such a situation:

• An investor sells shares of stock for a much higher gain than he had anticipated.
• A corporate executive receives an unexpected mid-year bonus that substantially boosts her compensation income for the year.
• A family limited partnership takes advantage of a rare opportunity to sell partnership assets, and the gain is allocated among the various general and limited partners as part of their annual K-1 reporting.

In these and other situations, the unanticipated income could effectively nudge the taxpayer over one or more of the thresholds we have described. Crossing one of these thresholds could have far-reaching consequences. In a case where one is pushed past the respective Medicare surtax and ATRA thresholds, a taxpayer's effective tax rate can markedly change. In these instances, not only does the taxpayer’s marginal tax bracket increase, but itemized deductions can be significantly reduced and personal exemptions completely eliminated.

The Importance of Proactive Tax Planning

As you can surmise, proactive tax planning is even more important with the Medicare surtax and ATRA influencing this year's tax planning landscape. More so now than in recent memory, a failure to monitor and project one’s taxable income can result in tax consequences. Depending on the complexity of your personal tax situation, it may be advisable for you to consult with your tax professional at multiple points throughout the year. If you would like further insight and clarification regarding ATRA and potential 2013 tax planning strategies, please feel free to contact me or my colleagues.