Preparing for the Implications of 2013 Tax Changes

Kelly Postlewaite for BKD.com writes: With all of the tax changes planned for 2013, this is the year to revisit your tax planning. The increased individual tax rates in 2013 from the American Taxpayer Relief Act of 2012 (ATRA) and arrival of surtaxes embedded in thePatient Protection and Affordable Care Act require a fresh look at your choice of entity and its ownership structure as well as your organizing documents.

The top individual rate is now 39.6 percent in 2013 as a result of ATRA. In addition, we return to the phase-out provisions based on adjusted gross income on both itemized deductions and personal exemptions. These phase-outs can add more than 1 percent to your marginal rate. The 3.8 percent surtax on excess net investment income (including passive income from your business) or the 0.9 percent surtax on self-employment income (on top of the 2.9 percent already in place) can lead to a top federal marginal tax rate of about 45 percent. When state and local income taxes are considered, the combined marginal tax rate can rise above 50 percent.

Your choice of entity can alter the imposition of the self-employment tax, including the surtax. Limited liability company income could be subject to the full 3.8 percent tax, while income from S corporations (apart from adequate wage compensation) is not. While incorporating your business might save you some self-employment taxes, there are multiple considerations to review with your tax advisor along the way.

Prior to 2013, it was beneficial for income to be passive, because passive income can absorb losses from other passive activities. After 2012, this paradigm should be challenged, as passive income could attract the new 3.8 percent surtax on the lesser of (1) net investment income or (2) the amount that adjusted gross income—as modified for certain foreign income exclusions—exceeds the applicable threshold amount ($250,000 for joint taxpayers or $200,000 for single taxpayers). It is possible to plan around this surtax by reconsidering owner participation in various business activities. Another possibility may be to move business ownership into a qualifying trust where the trustee is active in the business. As with choice of entity, this requires careful planning with your tax advisor.

Finally, ownership agreements should be revisited to ensure distributions will satisfy the new, higher tax liabilities in 2013. Agreements specifying a fixed percentage of taxable income for tax distributions should be reviewed under the new rules. 

Tax planning is never simple, but it has never been more important because of the higher tax rates that apply this year and into the future.