Wednesday, March 20, 2013

11 Common Questions About Taxes, Answered

LearnVest for Forbes writes:  You really shouldn’t be embarrassed about not understanding taxes, because really, who does? Exemptions, filing status and freelance taxes—if any of these have you scratching your head, we can help. We talked to LearnVest Planning Services certified financial planner Samantha Vient for answers to all your (really, not that embarrassing) questions.
 
1. Are there any benefits to filing early? And what happens if I file after the deadline?
The main benefit of filing before April is getting your tax refund back sooner. But filing really close to the deadline could also cost you money. “If you’re working with a CPA and you dump your tax stuff on them two weeks before April 15th,” Vient says, “most people will charge you a premium.” And doing your taxes earlier will mean that if you hit a snag like a missing form or needing to resolve a big question, you have more time to solve it.
As for filing late, you can easily ask for an automatic extension if you think you won’t be able to file on time. But if you were just being absent-minded, didn’t ask for an extension and filed after the April 15th deadline, you’ll owe the I.R.S. fines and interest, which can be a big chunk of cash.

2. What’s the difference between an exemption, credit and deduction?
Exemptions and deductions work the same way. They reduce your taxable income, which lowers your tax bill. For (a grossly simplified) example, if you take a $1,000 deduction, and you’re in the 20% tax bracket, you could save $200 on your taxes. Or if you get a $3,800 exemption, that’s about $760 less in taxes.
The difference between exemptions and deductions lies in what you get and take them for. You can take deductions for a variety of stuff: student loan interest, charitable deductions, tax-preparation fees … the list goes on and on. But exemptions are what you get for people in your family. You get one for being you, one for a spouse, one for each child and one for any other dependents.  Credits work differently. They’re a straight-up discount on your tax bill. So if you get a $1,000 credit, you pay $1,000 less in taxes. You get credits for things like having a low income, buying a plug-in electric car and other stuff. 

3. I’m married but I want to file my taxes as married filing separately, because my spouse and I like to keep our finances separate. Is that OK?
It actually doesn’t matter if you and your spouse have completely separate bank accounts, as long as you are married. If you want to file separately, you can, but you might miss out on some advantages that couples who file jointly get. Jointly filing couples get a bigger standard deduction, can take two exemptions, and can take multiple credits like the Earned Income Tax Credit, the American Opportunity and Lifetime Learning Credits, the exclusion or credit for adoption expenses, and the Child and Dependent Care Credit. And filing separately could even lower how much you’re allowed save tax-free for retirement.  But it’s also possible you would pay less filing separately, perhaps because you want to deduct medical costs—a very big deduction—and filing jointly would mean your combined income is too high to do so. We could go through all the pros and cons, but it all depends on your specific situation. You can consult a tax preparer, who can give you a definitive answer on which will get you the bigger refund after looking at your situation. Or if both your finances are fairly simple, online tax filing software will compare your refund for filing separately and jointly.  There’s another thing to consider too: Filing jointly puts you on the hook for your spouse’s tax debt if he doesn’t pay, and any misinformation he puts on his return. If this makes you uncomfortable, even if you just know your spouse’s business has complicated taxes, by all means, file separately.

4. What receipts should I be saving throughout the year, so I can “write them off?”
Let’s back up a moment and define this. When people talk about ”writing off” items for tax purposes they mean that they’re deducting that expense from their taxable income. (See question 2, above.)  How you take your deduction is up to you: You can either take the standard deduction (from $5,950 to $11,900 for tax year 2012), or you can itemize, listing out a lot of different deductions in the hopes that they add up to be bigger than the standard deduction. So you should only save receipts for things like charitable donations if you’re itemizing. Otherwise, don’t worry about it. Find out if you should itemize.  But there are some deductions you can take without itemizing. Those include student loan interest, supplies if you’re a teacher (though only up to $250), moving expenses, alimony, tuition you’re currently paying and IRA contributions. So, save receipts and records of those regardless of whether you’re itemizing.

If you freelance, you don’t need to itemize to write your business-related expenses off. All those things will be listed out on your Schedule C. You can deduct as little as $5 for coffee with a business contact. So save your receipts for gas, taxi fare to meetings, materials, client dinners and other stuff necessary to running your business.

5. How do I know if I need an accountant? What should I look for?
Whether you need an accountant depends on how complicated your finances are. Going through a big life change, itemizing your deductions, owning your own business, being a freelancer, having complex investments or stock options are all situations in which an accountant would be a good investment. To get a more definitive answer, take our quiz.
If you do decide to hire an accountant, whoever it is should obviously be certified and registered with the I.R.S. Ask for their Preparer Tax Identification Number (PTIN). If you’re just doing your own personal taxes (not freelancing or business taxes) and you’re a full-time employee with simple finances, Vient suggests you go with an Enrolled Agent, which can cost you about 30% less than a CPA. More complicated situations call for a certified public accountant.

Next, look for someone with your values and who has gone or is going through your life stage: a parent if you have kids, or an older preparer if you’re retired, for example. If you’re in your early 30s, a 70-year-old might not be right for you, because they might not be as tech-savvy as you.
Finally, if you own your own business, you’re looking for someone who is skilled in dealing with business taxes. “You’re looking for someone to be your personal CFO,” Vient says. “They should be excited about your business.” And they should be proactive. “They should be emailing you quarterly, and contacting you in October to talk about tax planning.”

6. Since I’m freelancing, none of my taxes are being withheld from my paycheck. So … what do I do?
If you’re a sole proprietor (as in, you’re the only one running the “business” and you’re not legally incorporated), simulate withholding by sticking 25 to 30% of your income in a savings account. You should pay your taxes quarterly to the I.R.S. to avoid fines.

7. I don’t have kids or a mortgage. Are there any other big tax breaks I can take advantage of?
You’re right, you’re missing out on two of the biggest tax breaks. But you might have others. Everyone—really, everyone—should take advantage of the big tax break for retirement contributions. The more you contribute, the less you pay in taxes.
If you’re paying interest on student loans or are paying tuition currently, those are two other big deductions you shouldn’t miss. Learn more about tax breaks for tuition.
Finally, if you make below a certain income, you could qualify for the Earned Income Tax Credit. It has the potential to wipe out your tax bill completely! If you make less than $20,000, you could qualify. 

8. I never remember what W-4 withholdings actually mean during tax time. 0? 2? What is that?
They’re technically called “allowances,” but we know what you’re talking about. W-4 allowances are kind of similar to exemptions, but they’re not exactly the same. You might have more or fewer allowances than exemptions, depending on your situation. But the short answer is: the more allowances you have, the less money is withheld from your paycheck in anticipation of paying taxes.  You want to get an accurate number for this by correctly filling out your W-4. If you don’t withhold enough, you’ll have to scramble to pay your tax bill in April, instead of getting a refund. If you withhold too much, you’ll get a huge refund. That’s cool, until you remember you could have paid off your debt faster or invested that money.

9. I can’t afford to pay my taxes this year. What do I do?
First stop worrying—you’re not going to jail. You have several options:

  • Put it on a credit card (for smaller amounts)
  • Take out a personal loan from a bank or credit union
  • Set up an installment plan with the I.R.S.
  • Seek relief from the I.R.S. for the bill

10. Will I get audited? What happens if I do?
The short answer: probably not. If you make less than $200,000 there’s a 1 in 98 chance you could be audited, according to 2011 figures. This number might even go down in 2013, with I.R.S. budget cuts due to the sequester.  You’re more likely to get audited if you do something that the I.R.S. considers evidence that you’re trying to game the system, like taking really big deductions on a very low income or putting in nice, neat round numbers that all end in 00. Learn the most common audit triggers and how to avoid them.  But if you do get audited, it might not be so bad. Most likely, it will be conducted by mail (only about one in five audits involve your showing up in person or an auditor showing up to your business or home), and the I.R.S. will just ask for back-up documentation. That’s why you should be very organized and keep your documentation for deductions, retirement contributions, HSA distributions and anything else you claim around for several years, in case the I.R.S. asks for proof.

11. I realized after I filed that I made a mistake. What do I do?
Cop to it. The longer you wait, the more you’ll owe in interest and penalties if the I.R.S. finds out. You’ll need to fill out a new 1040 with the corrected information, and a 1040x form. We explain how to do all that, plus when and how you should file an amended return in our post on fixing a tax mistake.



Posted on 6:32 AM | Categories:

Home-Office Tax Deduction Refresher & When Work At Home Yields Tax Deductions

Patrick Clark for Bloomberg writes: To claim the home-office deduction, or not to claim? That’s a decision millions who work at home are wrestling with nowOn the one hand, the deduction can be quite valuable: When Karen E. Klein wrote about the subject for Bloomberg Businessweek last year, the executive director of H&R Block’s (HRB) research and analysis division estimated that the average home-office deduction was worth more than $2,600.  On the other hand, filing for the deduction is notoriously complex. Several years ago, I spent hours agonizing over the 43-line Form 8829 (PDF), then broke out a tape measure and a calculator to determine what percentage of my rental apartment’s square footage my home office occupied. For homeowners, the process is more complex, at least for those filers deducting portions of their mortgage payments and home depreciation. It’s no wonder that when the U.S. Department of the Treasury announced a plan to streamline the process beginning in tax year 2013—more on this below—the agency said that simplifying the process would save 1.6 million hours annually in tax prep time.

As a postscript to my home-office adventure, my returns for the following tax year were audited, and I’ve always believed that the IRS targeted me for my use of the deduction in a previous filing. It’s not really as simple as that: Claiming the home-office deduction may increase your chances of being audited, says Sandy Botkin, a former IRS lawyer and author of Lower Your Taxes—Big Time, but the deduction is only one factor in a complex formula.

With April 15 closing in, it’s worth revisiting Klein’s article. The key points: If you want to claim the deduction, you should make sure your home office really is an office—not a desk in the corner of the family den. Also, that you’re using the home office as your primary place of business, as defined by the IRS. If you meet the requirements, you can deduct a portion of your home’s expenses, including insurance, utilities, and rent.

An employee in a large company can claim the home-office deduction, too, if they meet the government’s requirements—which include the stipulation that the filer works from a home office for the convenience of her employer. It’s complicated, and you’ll want to read the IRS instructions (PDF) carefully or talk to someone who knows them well.

As far as the simplification push, starting with their 2013 returns, taxpayers will be able to skip some of the more complex calculations currently required for the deduction and simply write off $5 per square foot of home office, up to $1,500 or 300 square feet. Don’t rejoice too quickly: As Botkin wrote in a blog post after the new option was announced, the simplified process will save time, but for many taxpayers, the $1,500 cap will be less than what they would have claimed by completing the lengthier form.

When Work At Home Yields Tax Deductions

Robert R Wood for Forbes writes: You sometimes work at home, but should you claim a deduction on your taxes? People worry it will flag their return, yet more than half of working Americans own or work for a small business. Many are home-based or have home offices. Some businesses go virtual and recruit home-based employees.  But no matter how much you work at home, do you qualify for a deduction? Starting with 2013 tax returns filed in 2014, the IRS is easing some home office deductions. See IRS simplifies the home-office deduction, for 2013. In the meantime, Section 280A(c) of the tax code is strict.
To qualify, a home office must be used regularly and exclusively for business. You can’t use your home office as a family room and you shouldn’t have a TV or chess table in the corner. It sounds silly, but taxpayers lose over such details. In Bulas v. Commissioner, an accountant claimed one room—plus an adjacent hallway and bathroom—was exclusively for business. But because his children occasionally used the bathroom, it wasn’t exclusively for business.
In addition, the deduction is limited to income from the business. If you run a home-based eBay business from a spare room off your garage (and you don’t use that room for anything else), you could deduct the cost of utilities attributable to that space. You could even depreciate that portion of your home. But if you lose money on your eBay venture before you get to your home office deduction you don’t qualify. See IRS Tax Tip 2011-53.
Home office deductions involve filling out a 43-line form (Form 8829) with complex allocations of expenses, depreciation and carryovers of unused deductions. You generally must use part of your home exclusively and regularly:

  • As your principal place of business;
  • As a place to meet or deal with patients, clients or customers in the normal course of your business; or
  • If the business portion of your home is a separate structure not attached to your home, then “in connection with your trade or business” (a more watered-down standard).
  • Other deduction possibilities include certain storage use, rental use, or daycare-facility use. In these cases, you must use the property regularly for business, but not exclusively for business.
  • If you are an employee, the regular and exclusive business use must be for the convenience of your employer. That usually means the employer must require you to work at home (get it in writing).
A section of a room can qualify if it is clearly partitioned and you can show personal activities are excluded from the business portion. Still, these rules are unforgiving and the IRS tends to interpret them strictly.

 

Posted on 6:31 AM | Categories:

5 Smart Tax Tips For Job Hunters

Arnie Fertig for US News writes:  The April 15 deadline for filing tax returns looms for all Americans, but presents special challenges and opportunities for individuals who are out of work or who left their jobs in 2012. This is a particularly good time to review the tax implications of unemployment. Bill Rucci, CPA and partner in the 40-person firm Rucci, Bardaro & Falzone, PC in Malden, Mass., offered important information and guidelines:

1. Get a handle on your financial situation. Rucci stresses that while all people should takes steps to understand their finances, those who are unemployed should address this with special urgency. Use programs like Quicken or QuickBooks to track and understand your monthly expenses, and plan when you will need extra money to meet one-time or seasonal expenses.
Compare your expenses to your savings, and any benefits or other income you're receiving. By doing so, you can learn how long you can maintain your current lifestyle, and determine how to best limit expenses while your income is constricted.

2. Deduct job-hunting expenses. Just as a business can deduct expenses, so can the individual job hunter. "Keep records of everything you spend in your search for a new job," Rucci says.  If the expenses you incur for your job search surpass 2 percent of your adjusted gross income, you can itemize your deductions, listing them on Schedule A on your tax return. These deductions only apply in the year in which they were incurred, and cannot be carried forward to future years when (hopefully) your income will be greater. Rucci cites the following examples:

  • Expenses you incurred when creating a portfolio of your work to demonstrate your accomplishments to perspective employers.
  • Costs incurred for typing and printing your resume.
  • Money you pay for career counseling to improve your chances of finding work.
  • Legal and accounting fees.
  • Money you spend advertising for a job in your field.
  • Car mileage (55.5 cents per mile) for transportation to/from interviews or meetings associated with job hunting.
  • Any fees paid to a recruiter, employment agency or coach for job hunting.
  • Costs associated with news, business publications or books bought for the purpose of aiding a job hunt.   
  • 50 percent of the cost of meals and entertainment associated with a job hunt.
3. Unemployment compensation is income. "Many people don't realize it, but unemployment compensation is taxable at a person's regular tax rate," Rucci says. "Because it is added to other sources of income, it can have the effect of boosting you into a higher tax rate than expected."
If you didn't have taxes deducted from your unemployment benefits, you must pay the taxes for that portion of your income in April.

4. Be careful how you deal with severance. While you can't always do so, attempt to have any severance package distributed to you over the course of more than one year. Don't forget that it is taxable income, and you should have taxes withheld. By spreading the overall distribution to two or more years, depending on other factors, you may reduce your total income in each year enough to reduce your overall tax bracket.

5. Set yourself up as a company. When you're unemployed, Rucci suggests that you create a consulting company and declare yourself the sole employee. This can be accomplished most simply as a single member LLC, where you maintain a separate checkbook for job-hunting expenses. By doing so, you can greatly expand how you can take and use deductions.
Of course the advice offered in this column is of a general nature. Each individual and family has their own particular situation to deal with, and you are strongly urged to seek your own professional tax and financial adviser to determine how the points expressed here relate to your situation.

Few are the people who relish tracking income and all their expenses, especially at a time of little or no income. Yet when you take charge of your finances and maintain good records, you can claim the deductions that are legitimately yours at tax time, and maintain your best possible financial situation for both the short and long term.
Happy hunting!
Posted on 6:31 AM | Categories:

Planning For Potential Tax Increases In 2013

Mel Schwarz and Dustin Stamper for Grant Thornton write: Large tax increases are scheduled to take effect in 2013 unless Congress acts — making tax planning more important than ever. The decisions your business makes now may have a tremendous impact on your tax obligations in the future. Unfortunately, tax planning is also more difficult than ever. The November election and political gridlock have made the outlook for legislation uncertain.
The tax increases are scheduled to come primarily from the individual side of the tax code, with new Medicare taxes and the expiration of the 2001 and 2003 tax cuts. Partners and shareholders in pass-through businesses will be affected directly, and the tax increases will also affect executives and owners of other privately held businesses and even public companies.

Many businesses have begun considering whether 2012 is the year to reverse tax strategy and accelerate income and defer deductions. This should be approached very cautiously. First, you need to understand exactly which taxes are scheduled to increase and by how much, and how those increases would actually affect your business, its owners and its employees. You also need to understand the likelihood that these tax increases will actually occur. That's why it is prudent to prepare now but wait to act until the legislative outlook becomes clearer. This Tax Insights will help by:

  • explaining exactly which taxes are scheduled to increase and the outlook for legislation to prevent it,
  • discussing the factors you need to consider when deciding whether to defer or accelerate tax, and
  • discussing the specific tax issues and planning ideas that need to be addressed.

What's really coming?


Tax increases under current law

Both payroll and income taxes are scheduled to increase starting on Jan. 1, 2013 (see Tax Insights 2012-09 for a discussion of estate and gift taxes). Without legislative action, the 2001 and 2003 tax cuts will expire and new Medicare taxes enacted as part of the health care reform legislation in 2010 will take effect. The expiration of the 2001 and 2003 tax cuts would erase scores of benefits, including:

  • rate cuts across all income brackets,
  • the full repeal of the personal exemption phaseout (PEP) and "Pease" phaseout of itemized deductions,
  • the top rate of 15% for capital gains and dividends,
  • the zero rate for capital gains and dividends in the bottom brackets,
  • marriage penalty relief,
  • the $1,000 refundable child tax credit and increased dependent care credit,
  • the $12,650 adoption credit and $12,650 exclusion for employer adoption assistance,
  • the employer credit for child care facilities, and
  • several education-related incentives.
The loss of rate cuts is the most significant threat. The top ordinary income tax rate would increase from 35% to 39.6%, the top capital gains rate would increase from 15% to 20% (property held more than five years would be eligible for an 18% rate), and dividends would be taxed at ordinary income levels up to the top rate of 39.6%, up from 15%.



 
These tax increases will be compounded by additional Medicare taxes. First, the rate of the individual share of Medicare tax will increase from 1.45% to 2.35% on earned income above $200,000 for single and $250,000 for joint filers. The 1.45% employer share will not change, creating a top rate of 3.8% on self-employment income. In addition, investment income such as capital gains, dividends and interest will be subject for the first time to a new 3.8% Medicare tax to the extent AGI exceeds $200,000 (single) or $250,000 (joint).


 
The new tax on investment income will not apply to distributions from qualified retirement plans or active trade or business income. Active S corporation income not paid as salary will still not incur Medicare tax, as it is not earned income.
A two year partial payroll tax holiday, which cut the individual share of Social Security tax from 6.2 percent to 4.2 percent, is also scheduled to expire at the end of the year, but Social Security taxes are already capped annually ($110,100 in 2012).


 
The combined tax increases would severely affect top rates on all types of income. The top rates on dividends, interest and earned income would apply when income reached the top tax bracket ($388,350 in 2012), though the Medicare portion would apply at the $200,000 or $250,000 thresholds. The top rate of 23.8% on capital gains would be reached at the $200,000 or $250,000 thresholds.

Potential for legislation

Congress has so far made little progress. Both parties held votes on separate plans to extend the 2001 and 2003 tax cuts before adjourning for the August recess, but these votes were largely vehicles to stake out campaign positions. No legislation is expected until after the elections, when lawmakers are likely to return in November to work on a lame duck compromise. In a similar process in 2010, the president agreed to extend the 2001 and 2003 tax cuts for two years, but an agreement may be more difficult this year.
The bills voted on by Democrats and Republicans would both extend the tax cuts for one year, except the Democratic bill would allow the tax cuts to expire for income above certain thresholds ($200,000 minus the standard deduction and a personal exemption for singles and $250,000 minus the standard deduction and two personal exemptions for joint filers). Capital gains and dividends above these thresholds would be subject to a top rate of 20%, and PEP and Pease would be reinstated with phase-ins beginning at these thresholds.
Despite the political nature of the votes, they do offer insight into the outlook for eventual legislation. For one, lawmakers appear to have settled on an extension for just one year. A one-year extension is meant to give lawmakers time and leverage for a potential tax reform effort in 2013.

The votes also reveal that congressional Democrats are committed to campaigning on a promise to roll back the tax cuts above the $200,000 and $250,000 thresholds, although there may be room for negotiation in a lame duck session. Several Democratic lawmakers had previously floated the idea of extending the 2001 and 2003 tax cuts on income up to $1 million.
It may be significant that Republicans did not attempt to repeal the new Medicare taxes in their bill to extend the 2001 and 2003 tax cuts. Even though Republicans have already voted to repeal the Medicare tax in separate legislation, the failure to link repeal of the Medicare tax with an extension of the 2001 and 2003 tax cuts may make it more difficult to address the Medicare tax in a lame duck compromise on the other expiring tax cuts.

It is difficult to predict a final outcome. The results of the election will have an impact, but a bipartisan compromise will still be needed. If President Obama is re-elected, he will need to negotiate with Republicans in Congress. If Republicans take both chambers and the White House, they will still need to negotiate with Democrats in the Senate to overcome procedural hurdles. President Obama agreed to an extension of all the tax cuts in 2010, but he is now facing a more dire debt situation and has been more rigid in his calls for additional revenue. The extension of most of the 2001 and 2003 tax cuts remains likely, but the outcome for the tax cuts at high income levels is uncertain. The repeal of the Medicare tax may be an uphill battle given the current condition of the Medicare trust fund and the political sensitivity of the issue.

Considerations for determining whether to accelerate or defer

With the clear potential for tax increases, taxpayers may be tempted to accelerate tax into 2012 by deferring deductions and recognizing income. But a careful analysis of several factors should come first, and there are many reasons why accelerating tax is a bad idea.
First, determine whether the tax increases will apply to your business. No tax increases are scheduled at the entity level — they will instead affect the income of your business's owners and executives at the individual level. Tax increases are also unlikely to affect any income below the income thresholds of $200,000 (single) or $250,000 (joint). And it's possible taxes won't increase at all. Accelerating tax in 2010 provided little or no benefit when the tax cuts were eventually extended. That's why it will be prudent to prepare now but act only when the legislative outlook becomes clearer.

Because the tax increases will apply at the individual level, it will be important to understand the tax situations of individual shareholders and partners. Taxpayers subject to the alternative minimum tax may not benefit from any acceleration in tax. In addition, when comparing current and future tax rates, it is important to remember that many taxpayers will be in a lower tax bracket at retirement. Finally, taxpayers with significant estates need to consider transfer tax consequences. Triggering gain can backfire if an asset otherwise would have received a step-up in basis at death.

You also need to consider the actual rate change versus the time value of money. The tax increases would affect many types of income in different ways. When thinking about accelerating tax, it is important to understand exactly how much tax would be paid in the future and how long you otherwise could have deferred this tax. Even at today's low interest rates, the time value of money will still make deferral the best strategy in many situations. You probably do not want to trigger gain on property you would otherwise have held onto for years just to avoid a capital gain rate increase from 15% to 20%. Economic considerations should always come before any tax-motivated sale.

Specific issues and planning ideas that need to be considered

Once you understand how the tax increases would affect the business, there are several specific issues and planning opportunities to consider before the end of the year. Even if it appears unwise to accelerate tax, you want to carefully evaluate your typical year-end decisions. Your business controls the timing of many income and deduction items for both owners and employees. Regardless of your strategy, it's important to recognize how these decisions will affect the timing of tax.

Compensation

Businesses may have competing interests with employees. High-income employees may want to recognize income before tax increases take effect, while the owners of the business that employs them may want to save compensation deductions for the following year.
Year-end bonuses will be important. Frequently, accrual method employers will declare bonuses before the end of the year and then pay them during the first 2½ months of the following year. This allows the employer to deduct the bonuses in the year they are earned, while allowing the employee to defer including the bonus in income until the following year. Either side of this strategy can be reversed. If a deduction will be more meaningful in 2013 for the owners of a business, accrual method taxpayers may consider purposely postponing when they will satisfy the "all events" test in Section 461, which determines when a liability is taken into account. Accrual method taxpayers can also postpone the deduction to 2013 by paying the bonus more than 2½ months after the end of the year. Alternatively, employees concerned about increased tax rates may benefit if the bonus is both declared and paid in 2012.
Employers seeking to offer employees a chance to avoid tax increases should be careful not to give employees a choice on the timing of bonuses and other pay because this will likely cause taxation on the first date the compensation is available under the constructive receipt doctrine, regardless of the employee's choice.
Employers can also consider accelerating the vesting dates of restricted stock grants and nonqualified deferred compensation (NQDC). Employees recognize income from restricted stock on the vesting date and Medicare taxes are due on NQDC at the time of vesting. In addition, employers can point out several individual tax acceleration strategies to employees, including:

  • Exercising NSOs— The spread between the exercise price and the fair market value of nonqualified stock options (NSOs) is ordinary income when exercised. Exercising them early also starts the holding period for long-term capital gain treatment.
  • Exercising ISOs— Taxpayers who will not hold incentive stock options (ISOs) long enough to qualify for capital gain treatment can exercise them and sell them before rates increase.
  • Converting to a Roth account—Tax is due on the amount converted in the year of a conversion from a traditional IRA to a Roth IRA in exchange for no tax on future distributions.
  • Accelerating Medicare taxes on NQDC— Payroll taxes (including Medicare taxes) are generally due on defined benefit NQDC plans upon vesting. Employers are allowed to postpone the payment of these payroll taxes when the value of the future benefit payments cannot be ascertained. Employers could reverse this approach in 2012 and pay payroll taxes on accrued benefits by using assumptions to calculate an estimate of the value of future benefit payments. Employees with earned income above $200,000 (single filers) and $250,000 (joint filers) would then avoid the increase in Medicare taxes from 1.45% to 2.35%.

Business-level deductions and income for pass-throughs

S corporation shareholders and partners in a partnership are taxed on business income at the individual level, so recognizing business income and deferring business deductions could accelerate taxes for owners.
Many businesses have the power to control the timing of deductions and income based on the regulatory tests that determine when income is recognized or liabilities are taken into account. But be careful. Accounting method changes and other depreciation decisions can delay deductions, and decisions on advanced payments can accelerate income — but these decisions will continue to delay deductions and accelerate income incrementally in future years. It is NOT likely that there are many situations where these decisions will help.
Pass-through businesses, however, can easily control when to recognize capital gain. You can trigger gain and pay tax on stock and other securities without changing position. There is no wash sale rule on capital gains, so stock can be sold and bought back immediately to recognize the gain. If much of the net worth of your business is tied up in one asset because you're deferring the tax bill on a large gain, this might be a good time to reallocate that equity. Turning over assets besides securities will likely involve higher costs and more complications. Strategies that seek to recognize gain but allow a taxpayer to retain some control or use of the assets must satisfy rules that determine whether ownership has indeed been transferred effectively.
Taxpayers can also consider electing out of the deferral of gain recognition available for an installment sale. Deferred income on most installment sales can be accelerated by pledging the installment note for a loan.
Special opportunities exist for converted S corporations. Normally, distributions from a profitable S corporation are considered to come first from the income passed through to shareholders and taxed at their level. To prevent double taxation, these distributions are considered nontaxable to the extent they do not exceed the amount in the S corporation's accumulated adjustment account. However, an S corporation may elect to treat the distribution as first coming out of accumulated earnings and profits, and thus as being taxable. If insufficient cash is on hand, an election to make a "deemed" distribution is available under the S corporation regulations.

Special considerations for Medicare tax

The new Medicare tax on investment income includes an exception for active trade or business income and gain on the sale of trade or business assets or S corporation shares. Owners in pass-through businesses should start thinking of strategies to deal with the Medicare tax before it takes effect in 2013. If it is possible to reorganize business interests and activities so that they meet the test for active rather than passive income (without causing it to be considered self-employment income) this may save taxes in the future.

Corporation shareholder strategies

C corporations will not face any tax increases at the entity level, but shareholders will be concerned with the tax on distributions and the capital gains rate on their ownership interests. While publicly held C corporations cannot realistically tailor action to suit thousands of shareholders in different positions, privately held corporations should have opportunities.
The easiest way to allow shareholders to recognize income while the dividend rate is 15 percent is simply to pay dividends to them now. But many corporations will not be ready to distribute earnings. Instead, consider distributing dividends to shareholders with shareholders immediately recontributing the dividend back to the corporation — or issuing a note to shareholders. Mere bookkeeping entries may not be sufficient to accomplish the actual distribution and trigger the tax. Care should be exercised to ensure the dividend will be respected for tax purposes. It is also important to remember that distributions in excess of earnings of profit will reduce basis, which may be more valuable in the future if capital gains rates increase.

There are also corporate restructuring transactions that can be used to increase basis or trigger gains and dividends for shareholders. Transferring assets to a corporation in a transaction designed to fail tax treatment under Section 351 can trigger gains in assets and provide a step up to full market value in tax basis that the corporation then amortizes or depreciates. A transaction qualifying as a "cash D reorganization" under Section 368(a)(1)(D) can be used to trigger taxable income as a dividend or capital gain to shareholders. In addition to taking advantage of currently lower capital gain and dividend rates, in certain circumstances, these transactions can be structured with no income or dividend recognition pursuant to the Section 356 "boot within the gain" limitation.

Next steps

A number of strategies are available to deal with coming tax changes, but first you need to be comfortable with your own legislative assessment and understand how the changes may affect your specific situation.
Posted on 6:31 AM | Categories:

Application Of The Self-Employment Tax And 3.8% Net Investment Income Tax To Fund Managers

Robert A N Cudd and Michelle M Jewett for Morrison Foester write: With the imposition of a new 3.8% "net investment income tax" (the "NIIT") pursuant to Section 1411 of the Internal Revenue Code of 1986, as amended (the "Code") on passive income and the imposition of an additional .9% on the uncapped Medicare portion of the self-employment tax under Section 1401 of the Code (the "SET") beginning in 2013, individuals who act as private equity and hedge fund managers or advisors have been searching for ways to prevent the application of the NIIT and the SET to their distributive shares of the income from the fund. While certain fund managers may be able to escape the imposition of the SET on partnership income, the analysis is complex, and there is significant uncertainty with respect to how the Internal Revenue Service ("IRS") and courts will interpret the relevant statutory provisions. However, it is clear that if income is subject to the SET, it will not be subject to the NIIT and vice versa. The following is a general overview of how the NIIT and SET could apply to individual fund managers, and does not purport to be an exhaustive analysis of the subject.1

TAX ON SELF-EMPLOYMENT INCOME

The SET has two components: a 12.4% tax on income from self-employment up to a cap, and a 2.9% tax on self-employment income that is uncapped. Self-employed individuals can deduct one-half of their SET in calculating adjusted taxable income. Starting in 2013, the SET applies to self-employment income at a rate of 3.8% for income over a "threshold amount." The threshold amount is $250,000 for a joint return, $125,000 for a married taxpayer filing separately, and $200,000 for a single return. Notably, the additional .9% tax is not deductible for income tax purposes.

"Self-employment income" is broadly defined. Self-employment income includes income from "services" (other than as an employee), as well as income from a "trade or business" that is received by an individual directly or through a partnership engaged in a trade or business, with a significant exception for "limited partners."2 "Guaranteed payments" made to a limited partner, however, are subject to SET even though income allocated to such partner from the partnership is not. Notably, SET does not apply to income allocated to shareholders by an S corporation.

In spite of the seemingly clear statutory exemption from SET for income derived by limited partners, there is significant uncertainty regarding the meaning of "limited partner" for self-employment tax purposes. In 1997, the IRS issued proposed Treasury Regulations3 that have not yet been adopted addressing the meaning of "limited partner" for SET purposes. The proposed Treasury Regulations treat partners (including members of a limited liability company) as limited partners for this purpose only if (among other requirements) they work less than 500 hours per year in the business of the partnership, regardless of their status as a limited partner for state law purposes.

Individuals who are "limited partners" for state law purposes should be able take the position that the distributions they receive from the partnership would not be subject to self-employment tax based on the statutory exemption for limited partners under Section 1402(a)(13) of the Code. It is not clear whether members of a limited liability company are "limited partners" for purposes of the SET. Since members of an LLC are generally treated in the same manner as limited partners for all other tax purposes, it would be reasonable to conclude that they should be treated as limited partners for purposes of the SET. However, there is no definitive guidance on the issue. Accordingly, given this uncertainty, a limited partnership structure may be preferable to an LLC structure for purposes of minimizing SET.

Nevertheless, the IRS could assert that the limited partners are not "limited partners" for purposes of the self-employment tax, based on Renkemeyer, Campbell & Weaver, LLP v. Comm'r.4 The Tax Court reasoned that members of a law firm operating as an LLP were not "limited partners" for purposes of the SET because substantially all of the law firm's revenues were derived from legal services performed by the partners, and each partner contributed only a nominal amount of capital. The court noted that the LLP's income did not represent "earnings of an investment nature." Although Renkemeyer addresses whether a partner of an LLP, as opposed to a limited partnership, is a limited partner, the factors that the Tax Court considered in its decision demonstrate some support for the position of the IRS in the proposed Treasury Regulations.

Interestingly, if the IRS does adopt final regulations that contain a material-participation standard, a fund manager's share of fund income from the fund that includes carried interest income from the fund arguably should not be subject to SET, even though the manager is engaged in a trade or business. This is because the question of whether the income is trade or business income should depend on whether the fund itself (as opposed to the manager) is engaged in a trade or business. For funds that adopt a "hold and sell" strategy and therefore do not conduct enough activity to be engaged in a trade or business, the income that includes carried interest income should be exempt from SET. However, this will depend on how the Treasury Regulations are drafted.

NET INVESTMENT INCOME TAX

The NIIT is a 3.8% tax imposed on certain income ("net investment income") of individuals, estates, and trusts (other than tax-exempt trusts and grantor trusts). The NIIT applies to the lesser of: (i) net investment income; or (ii) adjusted gross income in excess of a "threshold amount." For individuals, the threshold amount is the same as for the SET. Net investment income includes investment income such as dividends, interest, annuities, royalties, and rents that are not derived in the ordinary course of a trade or business. Notably, however, net investment income does not include income that is subject to the SET.5
Net investment income also includes (i) passive activity income under Section 469 of the Code; (ii) all income attributable to trading in "financial instruments" or commodities, even if the income is not passive activity income under Section 469 of the Code and (iii) net gain attributable to the disposition of property, unless the property is held in a trade or business of the seller in which the taxpayer materially participates and which is not trading in financial instruments or commodities. Thus, net gain from the disposition of property will not be subject to the NIIT only if the partnership is engaged in a trade or business in which the taxpayer materially participates and is not income from trading in financial instruments or commodities. However, as noted in more detail below, in the case of a fund following a buy-and-hold strategy and therefore not engaged in any trade or business, net gains from the disposition of property will be subject to the NIIT because neither of the two exceptions will apply.

Passive activity income under Section 469 of the Code generally includes rental income and all other income from a trade or business if the recipient does not "materially participate" with respect to the trade or business. Under Treasury Regulations under Section 469 of the Code, there are safe harbors for determining when an individual "materially participates" in a trade or business of the entity generating such income, one of which applies to individuals who work more than 500 hours per year in the trade or business generating the income.6 The IRS has issued proposed regulations under Section 1411 of the Code providing additional guidance on the application of the material-participation tests.7 Thus, if a partner "materially participates" in the trade or business of the partnership generating such income, his or her income from the partnership will not be subject to NIIT attributable to trading financial instruments or commodities.

The proposed Treasury Regulations under Section 1411 of the Code indicate that the underlying partnership generating the income needs to be engaged in a trade or business in which the taxpayer materially participates. It is not sufficient for the taxpayer to materially participate in a partnership that provides services to the underlying fund. The proposed Treasury Regulations provide an example in which a lower-tier partnership is not engaged in a trade or business but the upper-tier partnership is, and the lower-tier partnership earns dividend income that is allocated to the upper-tier partnership.8 The example concludes that the income allocated from the lower-tier partnership is ineligible for the trade or business exception. Once the income is classified at the lower-tier partnership level as not derived from a trade or business, it will not be recharacterized merely because a partner, the upper-tier partnership, is itself engaged in a trade or business. For managers of funds that do not engage in a trade or business such as private equity funds with a buy-and-hold strategy where all activity is undertaken by an upper-tier management company, their income attributable to the fund, including capital gain, will be subject to NIIT, assuming that the proposed Treasury Regulations are adopted in current form.

As noted above, although net investment income specifically excludes all income with respect to which a taxpayer materially participates in the trade or business, the NIIT will apply to all income not attributable to trading in "financial instruments" or commodities ("trading income"). Proposed Treasury Regulations define "financial instruments" as including stocks, equity and debt instruments, options, derivatives, and commodities. Hedge funds and other funds that enter into the activity of buying and selling securities for their own accounts to generate profit from daily market swings would be considered to generate "trading income." Accordingly, managers of hedge funds would appear to be subject to the NIIT on income derived from such funds, even though such individuals materially participate in the business.

CONCLUSION
As demonstrated by the foregoing discussion, the application of the SET and NIIT to income of an individual investment manager of a fund is complex. In very narrow situations, such as where an individual materially participates in the trade or business of an investment manager that has an interest in a fund that is not engaged in trading in financial instruments or commodities but is engaged in a trade or business, it may be possible, with favorable statutory interpretation, to conclude that neither the SET nor the NIIT apply to such income. One thing that is clear is that an individual cannot be subject to both the SET and the NIIT. It is also clear that an individual who is a limited partner in a limited partnership under state law should not be subject to SET (which may make a limited partnership structure preferable as compared to an LLC structure), but both limited partners and members of LLCs could be subject to NIIT. Managers who receive management fees as well as income from the fund as a carried interest or otherwise could be subject to SET on the management fees and to NIIT on the fund income. Given the numerous factors that apply in determining whether the SET or the NIIT are applicable, investment managers should consult their tax advisors to address their own unique circumstances.

Footnotes
1 Note that somewhat different considerations apply with respect to managers of real estate funds that are beyond the scope of this alert.
2 Code Section 1402(a)(13).
3 Prop. Treas. Reg. Section 1.1402(a)-2. However, following the release of the Proposed Regulations, Congress imposed a one-year moratorium in August 1997 preventing the Treasury from adopting regulations dealing with the employment tax treatment of limited partners. The moratorium expired on July 1, 1998. The 1997 Proposed Regulations were never adopted, even after the moratorium expired.
4 136 TC 137 (2011) (Renkemeyer).
5 Code Section 1411(c)(6).
6 Treas. Reg. Section 1.469-5T(a).
7 The IRS is seeking comment on the proposed regulations; the deadline for written or electronic comments was March 5, 2013.
8 Prop. Treas. Reg. Section 1.1411-4(b)(3), Example 1.
Posted on 6:31 AM | Categories:

Protecting Your Wealth From Estate And Income Tax Changes

Dustin Stamper for Grant Thornton writes: Large tax increases are scheduled to take effect in 2013 unless Congress acts – threatening to drastically alter both transfer tax and income tax rules. High net worth taxpayers face the prospect of new taxes on both their income and their estates, but also an opportunity. You may have begun considering whether 2012 is the year to reverse your income tax strategy and accelerate income and defer deductions, and whether it's time to put transfer tax strategies into play while interest rates are low and transfer tax rules are favorable.
 
The November election and political gridlock have made the outlook for legislation uncertain. This makes tax planning not only difficult but also more important. The decisions you make now may have a tremendous impact on your tax obligations in the future. The tax increases are scheduled to come from various sources: new Medicare taxes, the expiration of the 2001 and 2003 income tax cuts, and the expiration of the estate and gift tax rules enacted in 2010.
Strategies to accelerate income tax should be approached very cautiously. Transfer tax strategies during legislative uncertainty also carry risks. First, you need to understand exactly which taxes are scheduled to increase and by how much, and how those increases would actually affect you. You also need to understand the likelihood that these tax increases will actually occur. That's why it is prudent to prepare now but wait to act until the legislative outlook becomes clearer. This Tax Insights will help by:
  • explaining the scheduled estate and income tax increases in detail and examining the potential for legislation to defer or prevent them,
  • discussing how to approach income and transfer tax planning in this environment, and
  • discussing the specific tax issues and planning ideas that need to be addressed.

What's really coming?

Tax increases on income

Both payroll and income taxes are scheduled to increase starting on Jan. 1, 2013. Without legislative action, the 2001 and 2003 tax cuts will expire and new Medicare taxes enacted as part of the health care reform legislation in 2010 will take effect. The expiration of the 2001 and 2003 tax cuts would erase scores of benefits, including:
  • rate cuts across all income brackets,
  • the full repeal of the personal exemption phaseout (PEP) and "Pease" phaseout of itemized deductions,
  • the top rate of 15% for capital gains and dividends,
  • the zero rate for capital gains and dividends in the bottom brackets,
  • marriage penalty relief and the $1,000 refundable child tax credit,
  • the increased dependent care credit and the employer credit for child care facilities,
  • the $12,650 adoption credit and the $12,650 income exclusion for employer adoption assistance, and
  • several education related incentives.
The loss of rate cuts is the most significant threat (see chart). Because the tax increases come on the individual side, they will affect both your individual income and any business income from privately held and pass-through businesses taxed at the individual level. And on top of these tax increases comes the new Medicare taxes.

Individual income tax rates*
Ordinary income tax brackets (2012 levels) Rates
Single Joint 2012 2013 +
$0–$8,700 $0–$17,400 10% 15%
$8,701–$35,350 $17,401–$70,700 15% 15%
$35,351–$85,650 $70,701–$142,700 25% 28%
$85,651–$178,650 $142,701–$217,450 28% 31%
$178,651–$388,350 $217,451–$388,350 33% 36%
Over $388,350 Over $388,350 35% 39.6%
Capital gains top rate 15% 20%
Dividend top rate 15% 39.6%
* Does not include Medicare taxes.
Top capital gains rate in 2013 will be 20% for assets held more than a year and 18% for assets held more than five years, not including the 3.8% Medicare tax.







First, the rate of the individual share of Medicare tax will increase from 1.45% to 2.35% on earned income above $200,000 for single filers and $250,000 for joint filers. The 1.45% employer share will not change, creating a top rate of 3.8% on self-employment income. In addition, investment income such as capital gains, dividends and interest will be subject for the first time to a new 3.8% Medicare tax to the extent AGI exceeds $200,000 (single) or $250,000 (joint). There is no cap on Medicare taxes.

Individual Medicare tax rates*
Earned income (salary, self-employment) 2012 2013 +
$0–$200k (single) $0–$250k (joint) 1.45% 1.45%
$200k + (single) $250k + (joint) 1.45% 2.35%
Investment income (dividends, cap gains, interest) 2012 2013 +
$0–$200k (single) $0–$250k (joint) 0% 0%
$200k + (single) $250k + (joint) 0% 3.8%
*Does not include 1.45% employer share on earned income, which also applies to self-employment income and will not change.







The new tax on investment income will not apply to distributions from qualified retirement plans or active trade or business income. Active S corporation income not paid as salary will still not incur Medicare tax, as it is not earned income.

A two-year partial payroll tax holiday, which cut the individual share of Social Security tax from 6.2 percent to 4.2 percent, is also scheduled to expire at the end of the year, but Social Security taxes are capped annually ($110,100 in 2012).

The combined tax increases would severely affect top rates on all types of income. The top rates on dividends, interest and earned income (see chart) would apply when income reached the top tax bracket ($388,350 in 2012), though the Medicare portion would apply at the $200,000 or $250,000 thresholds. The top rate of 23.8% rate on capital gains would be reached at $200,000 or $250,000 thresholds.

Combined top rates*
Type of income 2012 2013 +
Earned income 36.45% 41.95%
Interest 35% 43.4%
Dividends 15% 43.4%
Capital gains 15% 23.8%
*Includes only employee share of Medicare taxes

Tax increases on wealth transfers

The good news is that the transfer tax rates through the end of 2012 are at historic lows, and exemption levels are at historic highs. The bad news is that these rules are scheduled to change at the end of the year. The current rules (agreed to in 2010 as part of an extension of the 2001 and 2003 tax cuts) generally reunite the estate and gift taxes with the following rules:
  • 35% rate
  • $5.12 million exemption
  • Portability of estate tax exemption amounts between spouses
If no legislation is enacted, the estate, gift and generation-skipping transfer (GST) taxes will all revert to the rules in place in 2000, with a top rate of 55 percent and an exemption of just $1 million (see chart).

Exemptions and rates for estate, gift, and GST
2012 2013 +
Exemption $5.12 million $1 million
Rate 35% 55%




Potential for legislation

Congress has so far made little progress. Both parties held votes on separate plans to extend the 2001 and 2003 tax cuts before adjourning for the August recess, but these votes were largely vehicles to stake out campaign positions. No legislation is expected until after the elections, when lawmakers are likely to return in November to work on a lame duck compromise. In a similar process in 2010, the president agreed to extend the 2001 and 2003 tax cuts for two years, but an agreement may be more difficult this year.

The bills voted on by Democrats and Republicans would both extend the tax cuts for one year, except the Democratic bill would allow the tax cuts to expire for income above certain thresholds ($200,000 minus the standard deduction and a personal exemption for singles and $250,000 minus the standard deduction and two personal exemptions for joint filers). Capital gains and dividends above these thresholds would be subject to a top rateof 20%, and PEP and Pease would be reinstated with phase-ins beginning at these thresholds.

Regarding transfer taxes, Senate Democrats initially included a provision applying the rules in place in 2009 to 2013 ($3.5 million exemptions and a top rate of 45%), but backed away after several moderate Democrats in relatively conservative states said they may not support such a reversion. House Republicans proposed to extend the current transfer tax rules through 2013.
Despite their political nature, the votes do offer insight into the outlook for eventual legislation. For one, lawmakers appear to have settled on an extension for just one year. A one-year extension is meant to give lawmakers time and leverage for a potential tax reform effort in 2013.
The votes also reveal that congressional Democrats are committed to campaigning on a promise to roll back the tax cuts above the $200,000 and $250,000 thresholds, although there may be room for negotiation in a lame duck session. Several Democratic lawmakers had previously floated the idea of extending the 2001 and 2003 tax cuts on income up to $1 million. It is also clear that Democrats are far from unified on transfer taxes. This may give Republicans a slight advantage on the issue.

It is difficult to predict a final outcome. The results of the election will have an impact, but a bipartisan compromise will still be necessary. If President Obama is re-elected, he will need to negotiate with Republicans in Congress. If Republicans take both chambers and the White House, they will likely need to negotiate with Democrats in the Senate to overcome procedural hurdles. President Obama agreed to an extension of all the tax cuts in 2010, but is now facing a more dire debt situation and has been more rigid in his calls for additional revenue. The extension of most of the 2001 and 2003 tax cuts remains likely, but the outcome for the tax cuts at high income levels and for transfer tax rules is uncertain. The repeal of the new Medicare tax may be an uphill battle, given the current condition of the Medicare trust fund and the political sensitivity of the issue.

Considerations for your 2012 tax strategy

Income taxes and payroll taxes

With the clear potential for tax increases, taxpayers may be tempted to accelerate tax into 2012 by deferring deductions and recognizing income. But a careful analysis of several factors should come first, and there are many reasons why accelerating tax is a bad idea.
First, determine whether the tax increases will apply to you. Tax increases are unlikely to affect any income below the income thresholds of $200,000 (single) or $250,000 (joint), and it's possible taxes won't increase at all. Accelerating tax in 2010 provided little or no benefit when the tax cuts were extended. That's why it will be prudent to prepare now but act only when the legislative outlook becomes clearer.

If you're subject to the alternative minimum tax, you may not benefit from any acceleration in tax. In addition, remember you may be in a lower tax bracket at retirement. You also need to consider transfer tax consequences. Triggering gain can backfire if an asset otherwise would have received a step up in basis at death.

You also need to consider the actual rate change versus the time value of money. The tax increases would affect many types of income in many different ways. When thinking about accelerating tax, it will be important to understand exactly how much tax would be paid in the future and how long you otherwise could have deferred the tax. Even at today's low interest rates, the time value of money will still make deferral the best strategy in many situations. You probably do not want to trigger gain on property you would otherwise have held onto for years just to avoid a capital gain rate increase from 15% to 20%. Economic considerations should always come before any tax-motivated sale.

Transfer taxes

Transfer taxes are a different story. Given the legislative uncertainty and the current economic conditions, 2012 may provide a unique window for estate and gift tax planning. Interest rates are at historic lows, and values of property and other assets have declined because of past economic conditions, which now appear to be improving. When both of these conditions exist, property transfer is almost always beneficial, even if gift tax is incurred.

Specific issues and planning ideas that need to be considered

Income and payroll taxes

Once you understand how the tax increases would affect your particular situation, there are several specific issues and planning opportunities to consider before the end of the year. Even if it appears unwise to accelerate tax, you want to carefully evaluate your typical year-end decisions.  You may be able to control the timing of many types of ordinary income, including:
  • self-employment income,
  • bonuses,
  • consulting income, and
  • retirement plan distributions.
You may also be able to affect tax by timing how you exercise options. The spread between the exercise price and the fair market value of nonqualified stock options (NSOs) is ordinary income when exercised and the holding period for long-term capital gain treatment begins. If you do not plan to hold incentive stock options (ISOs) long enough to qualify for capital gain treatment, you can sell them before rates increase.
You can consider a conversion from a 401(k) or traditional IRA to a Roth IRA now while tax rates are low. Tax will be owed on the amount of the conversion now in exchange for no tax on future distributions if the conversion is made properly.
But the easiest thing to control is capital gains. You can trigger gain and pay tax on stock and other securities without changing position. There is no wash sale rule on capital gains, so stock can be sold and bought back immediately to recognize the gain. But if much of your net worth is tied up in one asset because you're deferring the tax bill on a large gain, this might be a good time to reallocate that equity. Turning over assets besides securities will likely involve higher costs and more complications. Strategies that seek to recognize gain but allow you to retain some control or use of the assets must satisfy rules that determine whether ownership has indeed been transferred effectively. You may also consider electing out of the deferral of gain recognition available in an installment sale. Deferred income on most installment sales can be accelerated by pledging the installment note for a loan.

Pass-through vehicles such as partnerships and S corporations are taxed at the individual level, so remember entity-level decisions can accelerate income and defer deductions for you as a partner or a shareholder. But remember that accounting method changes and other depreciation decisions can delay deductions, and decisions on advanced payments can accelerate income — but these decisions but will continue to delay deductions and accelerate income incrementally in future years. It is NOT likely that there are many situations where this will help.

Special considerations for Medicare tax

The new Medicare tax on investment income includes an exception for active trade or business income and gain on the sale of trade or business assets or S corporation shares. Owners in pass-through businesses should start thinking of strategies to deal with the Medicare tax before it takes effect in 2013. If it is possible to reorganize business interests and activities so that they meet the test for active rather than passive income (without causing it to be considered self-employment income) this may save significant taxes in the future.

Transfer taxes

Exhausting your gift tax exemption during your lifetime is often a solid transfer tax strategy. The estate and gift taxes are "reunified" in 2012, meaning that using your gift tax exemption will reduce your estate exemption at death. However, giving away assets now can save transfer taxes in the long run by removing any appreciation and annual earnings from your estate. Assuming modest 5% after-tax growth, $5.12 million can easily turn into more than $13.5 million over 20 years.

Making taxable gifts at the currently low 35 percent gift tax rate can also create benefits. For one, the amount of gift tax paid is removed from the estate. The gift tax is a "tax exclusive" tax because you do not pay tax on the gift tax itself, while the estate tax is "taxinclusive." For example, if you had a taxable estate of $1.35 million and gave it all away during your life, your heir could receive a full $1 million gift with your paying gift tax of $350,000 (35 percent). If your estate is instead transferred at death, your heir would receive only $877,500 after paying 35 percent, or $472,500, on the full $1.35 million. Even more important, making the gift now can remove future appreciation and earnings from your estate.

Many tax strategies can help you leverage your gift tax exemption and get more value from your gifts, and they are more valuable than ever with today's historically low interest rate and depressed asset values. These strategies include:
  • grantor retained annuity trusts (GRATs),
  • sales to intentionally defective grantor trusts (IDGTs),
  • transfers to a family limited partnership (FLPs), and
  • transfers to a charitable lead trust (CLTs).
Regardless of where the exemption amounts and rates end up, you should review your plan regularly to ensure it fits in with any changes in tax law and your circumstances.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
Posted on 6:30 AM | Categories: