A 2013 Tax Planning Guide

Perisho.com is the first CPA firm we've seen publish a tax planning guide for 2013, they 

write: With tax increases going into effect for many higher-income taxpayers this year and 

continued uncertainty about the economy, tax planning is more important than ever. You 

need to proactively look for ways to reduce your taxable income and take advantage of every

 tax break you’re entitled to.  This is exactly what our 2013 Tax Planning Guide is designed to

 help you do. We hope you find this complimentary copy helpful in identifying year-round 

strategies to make the tax laws work for you. - Perisho Tombor Brown, CPAs

Tax Planning Basics

Tax law changes make planning both complicated and critical

Last year, tax planning was a major challenge because of uncertainty about whether significant tax increases scheduled for 2013 would go into effect. On Jan. 1, 2013, Congress passed the American Taxpayer Relief Act of 2012 (ATRA), which made lower ordinary-income tax rates permanent for most taxpayers, but some taxpayers previously in the 35% bracket now face a higher rate. (See “What’s new! Top ordinary-income tax rate of 39.6% returns in 2013”)

Then there’s the alternative minimum tax (AMT), which was designed to ensure wealthy taxpayers with “excessive” deductions would pay some income tax. The top AMT rate is lower than the top regular income tax rate on ordinary income (salary, business income, interest and more). (See the Chart “2013 individual income tax rate schedules.”) But the AMT rate typically applies to a higher taxable income base. So if you plan only for regular income taxes, it can result in unwelcome tax surprises.

You also need to consider the various tax deductions or credits that could reduce your tax liability. There’s some more tax law certainty on this front, too, because ATRA makes some breaks permanent — though it extends others only temporarily. On the other hand, income-based phaseouts and other limits can reduce or eliminate the benefits of these breaks, effectively increasing your marginal tax rate.

That’s why it’s important to review your income, expenses and potential tax liability throughout the year, keeping in mind the many rates and limits that can affect income tax liability — and keeping an eye out for additional tax law changes. Only then can you time income and expenses to your advantage.

AMT triggers

Before you take action to time income or expenses, determine whether you’re already likely to be subject to the AMT — or whether the actions you’re considering might trigger it. Many deductions used to calculate regular tax aren’t allowed under the AMT (see the Chart “Regular tax vs. AMT: What’s deductible?”) and thus can trigger AMT liability. Some income items also might trigger or increase AMT liability:

• Long-term capital gains and dividend income, even though they’re taxed at the same rate for both regular tax and AMT purposes,


• Accelerated depreciation adjustments and related gain or loss differences when assets are sold, and


• Tax-exempt interest on certain private-activity municipal bonds. (See the AMT Alert under “Income investments.”)

Finally, in certain situations incentive stock option (ISO) exercises can trigger significant AMT liability.

Avoiding or reducing AMT

With proper planning, you may be able to avoid the AMT, reduce its impact or even take advantage of its lower maximum rate. ATRA makes planning for the AMT easier because it includes long-term AMT relief.
Before the act, unlike the regular tax system, the AMT system wasn’t regularly adjusted for inflation. Instead, Congress had to legislate any adjustments. Typically, it did so in the form of a “patch” — an increase in the AMT exemptions. ATRA sets higher exemptions permanently, which will be “automatically” adjusted for inflation in future years. In other words, the IRS will issue adjustments annually; Congress won’t have to legislate them. Also annually adjusted will be the income phaseout ranges for the exemption as well as the AMT tax brackets. (See the Chart “2013 individual income tax rate schedules.”)
Even with permanent AMT relief in place, it’s critical to work with your tax advisor to determine whether:
You could be subject to the AMT this year. Consider accelerating income and short-term capital gains into this year, which may allow you to benefit from the lower maximum AMT rate. Also consider deferring expenses you can’t deduct for AMT purposes until next year — you may be able to preserve those deductions.
Additionally, if you defer expenses you can deduct for AMT purposes to next year, the deductions may become more valuable because of the higher maximum regular tax rate. Finally, carefully consider the tax consequences of exercising ISOs.
You could be subject to the AMT next year. Consider taking the opposite approach. For instance, defer income to next year, because you’ll likely pay a relatively lower AMT rate. And prepay expenses that will be deductible this year but that won’t help you next year because they’re not deductible for AMT purposes. Also, before year end consider selling any private activity municipal bonds whose interest could be subject to the AMT.

The AMT credit

If you pay AMT in one year on deferral items, such as depreciation adjustments, passive activity adjustments or the tax preference on ISO exercises, you may be entitled to a credit in a subsequent year.
In effect, this takes into account timing differences that reverse in later years. But the credit might provide only partial relief or take years before it can be fully used. Fortunately, the credit’s refundable feature can reduce the time it takes to recoup AMT paid.

Timing income and expenses

Smart timing of income and expenses can reduce your tax liability, and poor timing can unnecessarily increase it.
When you don’t expect to be subject to the AMT in the current year or the next year, deferring income to the next year and accelerating deductible expenses into the current year typically is a good idea. Why? Because it will defer tax, which is usually beneficial.
But when you expect to be in a higher tax bracket next year the opposite approach may be beneficial: Accelerating income will allow more income to be taxed at your current year’s lower rate. And deferring expenses will make the deductions more valuable, because deductions save more tax when you’re subject to a higher tax rate. Warning: Timing strategies could be especially important for higher-income taxpayers who, beginning in 2013, may face a higher marginal ordinary-income tax rate on taxable income and a new Medicare tax on earned income. (See “What’s new! Top ordinary-income tax rate of 39.6% returns in 2013” and “What’s new! You may face an additional 0.9% Medicare tax this year.”)
Also keep in mind that the adjusted gross income (AGI)-based reduction limiting the benefit of many deductions has returned for 2013. (See “What’s new! Deduction reduction and exemption phaseout are back.”) Its impact should be taken into account when considering timing strategies.
Whatever the reason you’d like to time income and expenses, here are some income items whose timing you may be able to control:

• Bonuses,


• Consulting or other self-employment income,


• U.S. Treasury bill income, and


• Retirement plan distributions, to the extent not required. (See “Required minimum distributions.”)

And here are some potentially controllable expenses:

• State and local income taxes,


• Property taxes,


• Mortgage interest,


• Margin interest, and


• Charitable contributions.

Warning: Prepaid expenses can be deducted only in the year to which they apply. For example, you can prepay (by Dec. 31) property taxes that relate to this year but that are due next year, and deduct the payment on this year’s return. But you generally can’t prepay property taxes that relate to next year and deduct the payment on this year’s return.

Miscellaneous itemized deductions

Many expenses that may qualify as miscellaneous itemized deductions are deductible for regular tax purposes only to the extent they exceed, in aggregate, 2% of your AGI. Bunching these expenses into a single year may allow you to exceed this “floor.”
Carefully record your potential deductions throughout the year. If as the year progresses they get close to or start to exceed the 2% floor — and you don’t expect to be subject to the AMT this year — consider paying accrued expenses and incurring and paying additional expenses by Dec. 31, such as:

• Deductible investment expenses, including advisory fees, custodial fees and publications,


• Professional fees, such as tax planning and preparation, accounting, and certain legal fees, and


• Unreimbursed employee business expenses, including travel, meals, entertainment and vehicle costs.

Health care breaks

Medical expenses are another deduction you may be able to bunch. If your medical expenses exceed the applicable AGI floor you can deduct the excess amount. Eligible expenses can include:

• Health insurance premiums,


• Long-term care insurance premiums (limits apply),


• Medical and dental services, and


• Prescription drugs.

Consider bunching nonurgent medical procedures and other controllable expenses into one year to exceed the AGI floor. Bunching may be an especially important strategy now because, beginning in 2013, the floor has increased from 7.5% to to 10% under the health care act. (For taxpayers age 65 and older, the floor isn’t scheduled to increase until 2017.)
If one spouse has high medical expenses and a relatively lower AGI, filing separately may allow that spouse to exceed the AGI floor and deduct some medical expenses that wouldn’t be deductible if the couple filed jointly.
Also remember that expenses that are reimbursed (or reimbursable) by insurance or paid through one of the following accounts aren’t deductible:
HSA. If you’re covered by qualified high-deductible health insurance, a Health Savings Account allows 2013 contributions of pretax income (or deductible after-tax contributions) up to $3,250 (up from $3,100 for 2012) for self-only coverage and $6,450 (up from $6,250 for 2012) for family coverage. Moreover, account holders age 55 and older can contribute an additional $1,000.
HSAs bear interest or are invested and can grow tax-deferred similar to an IRA. Withdrawals for qualified medical expenses are tax-free, and you can carry over a balance from year to year.
FSA. You can redirect pretax income to an employer-sponsored Flexible Spending Account up to an employer-determined limit (not to exceed $2,500 for plan years beginning in 2013). The plan pays or reimburses you for qualified medical expenses. With limited exceptions, you have to make your election before the start of the plan year. What you don’t use by the end of the plan year, you generally lose. If you have an HSA, your FSA is limited to funding certain “permitted” expenses.
Warning: Before 2013, employers could set whatever limit they wanted — so your contribution limit may have dropped substantially this year.

Sales tax deduction

ATRA has extended through 2013 the break allowing you to take an itemized deduction for state and local sales taxes in lieu of state and local income taxes. The deduction can be valuable to taxpayers residing in states with no or low income tax or who purchase a major item, such as a car or boat. If you’re contemplating a major purchase, you may want to make it in 2013 to ensure the sales tax deduction is available. (See the Case Study “Benefiting from the sales tax deduction.”)

Employment taxes

In addition to income tax, you must pay Social Security and Medicare taxes on earned income, such as salary and bonuses. For 2011 and 2012, the employee portion of the Social Security tax was reduced from 6.2% to 4.2%, but this payroll tax break hasn’t been extended to 2013. So taxpayers will see a two percentage point Social Security tax increase on earned income up to the Social Security wage base of $113,700 (up from $110,100 for 2012).
Warning: All earned income is subject to the 2.9% Medicare tax (split equally between the employee and the employer). And beginning in 2013, many higher-income taxpayers will pay additional Medicare taxes under the health care act. (See “What’s new! You may face an additional 0.9% Medicare tax this year.”)

Self-employment taxes

If you’re self-employed, your employment tax liability typically doubles, because you also must pay the employer portion of these taxes. Fortunately, there’s no employer portion for the additional 0.9% Medicare tax. The employer portion of self-employment taxes paid (6.2% for Social Security tax and 1.45% for Medicare tax) is deductible above the line.
As a self-employed taxpayer, you may benefit from other above-the-line deductions as well. You can deduct 100% of health insurance costs for yourself, your spouse and your dependents, up to your net self-employment income. You also can deduct contributions to a retirement plan and, if you’re eligible, an HSA for yourself. Above-the-line deductions are particularly valuable because they reduce your AGI and MAGI, which are the triggers for certain additional taxes and the phaseouts of many tax breaks.

Employment taxes for owner-employees

There are special considerations if you’re a business owner who also works in the business, depending on its structure:
Partnerships and limited liability companies. Generally, all trade or business income that flows through to you for income tax purposes is subject to self-employment taxes — even if the income isn’t actually distributed to you. But such income may not be subject to self-employment taxes if you’re a limited partner or an LLC member whose ownership is equivalent to a limited partnership interest. Whether the additional 0.9% Medicare tax on earned income or the new 3.8% Medicare contribution tax on net investment income (see “What’s new! Will you owe the 3.8% Medicare tax on investment income?”) will apply also is complex to determine. So, check with your tax advisor.
S corporations. Only income you receive as salary is subject to employment taxes and, if applicable, the 0.9% Medicare tax. To reduce these taxes, you may want to keep your salary relatively (but not unreasonably) low and increase your distributions of company income (which generally isn’t taxed at the corporate level or subject to the 0.9% or 3.8% Medicare tax).
C corporations. Only income you receive as salary is subject to employment taxes, and, if applicable, the 0.9% Medicare tax. Nevertheless, you may prefer to take more income as salary (which is deductible at the corporate level) as opposed to dividends (which aren’t deductible at the corporate level, but are taxed at the shareholder level and could be subject to the 3.8% Medicare tax) if the overall tax paid by both the corporation and you would be less.
Warning: The IRS is cracking down on misclassification of corporate payments to shareholder-employees, so tread carefully.

Estimated payments and withholding

You can be subject to penalties if you don’t pay enough tax during the year through estimated tax payments and withholding. To avoid such penalties, make sure your estimated payments and withholding equal at least 90% of your tax liability for this year or 110% of your tax last year (100% if your AGI last year was $150,000 or less or, if married filing separately, $75,000 or less).
Here are some more strategies that can help you avoid underpayment penalties:
Use the annualized income installment method. This method often benefits taxpayers who have large variability in income by month due to bonuses, investment gains and losses, or seasonal income (especially if it’s skewed toward the end of the year). Annualizing computes the tax due based on income, gains, losses and deductions through each estimated tax period.
Estimate your tax liability and increase withholding. If as year end approaches you determine you’ve underpaid, consider having the tax shortfall withheld from your salary or year end bonus by Dec. 31. Because withholding is considered to have been paid ratably throughout the year, this is often a better strategy than making up the difference with an increased quarterly tax payment, which may still leave you exposed to penalties for earlier quarters.
Warning: You also could incur interest and penalties if you’re subject to the new 0.9% Medicare tax on earned income and it isn’t withheld from your pay. (See “What’s new! You may face an additional 0.9% Medicare tax this year.”) •

Investing

Tax planning for investments gets
even more complicated this year

Tax treatment of investments can vary dramatically based on several factors — including type of investment, type of income it produces, how long it’s been held, whether any special limitations or breaks apply, and potentially changing tax rates and rules. Consequently, tax planning for investments is always complicated. So, while tax consequences should never drive investment decisions, it’s critical that they be considered before making any moves — especially this year.

Why? Because although the American Taxpayer Relief Act of 2012 (ATRA) made 2012 tax rates on investments for most taxpayers permanent, higher-income taxpayers may face more taxes on their investment income in the form of the returning 20% top long-term capital gains rate and a new 3.8% Medicare tax — kicking in at different income levels based on different definitions of income. (See “What’s new! Top capital gains rates increase in 2013” and “What’s new! Will you owe the 3.8% Medicare tax on investment income?”)

Capital gains tax and timing

Although time, not timing, is generally the key to long-term investment success, timing can have a dramatic impact on the tax consequences of investment activities. A taxpayer’s long-term capital gains rate can be as much as 20 percentage point lower than his or her ordinary-income tax rate. The long-term gains rate generally is 15% and applies to investments held for more than 12 months. (Higher long-term gains rates apply to higher-income taxpayers and to certain types of assets — see the Chart “What’s the maximum capital gains tax rate?”)

Holding on to an investment until you’ve owned it more than a year may help substantially cut tax on any gain — even if higher long-term gains rates apply. Also, remember that appreciating investments that don’t generate current income aren’t taxed until sold, deferring tax and perhaps allowing you to time the sale to your tax advantage — such as in a year when you have capital losses to absorb the capital gain. To determine capital gains tax liability, realized capital gains are netted against any realized capital losses.

If you’ve already cashed in some big gains during the year and want to reduce your tax liability, before year end look for unrealized losses in your portfolio and consider selling them to offset your gains.

The wash sale rule

If you’re trying to achieve a tax loss with minimal change in your portfolio’s asset allocation, keep in mind the wash sale rule. It prevents you from taking a loss on a security if you buy a substantially identical security (or option to buy such a security) within 30 days before or after you sell the security that created the loss. You can recognize the loss only when you sell the replacement security.

Fortunately, there are ways to avoid triggering the wash sale rule and still achieve your goals. For example, you can:

• Immediately buy securities of a different company in the same industry or shares in a mutual fund that holds securities much like the ones you sold,


• Wait 31 days to repurchase the same security, or


• Before selling the security, purchase additional shares of that security equal to the number you want to sell at a loss, and then wait 31 days to sell the original portion.

You also can do a bond swap, where you sell a bond, take a loss and then immediately buy another bond of similar quality and duration from a different issuer. Generally, the wash sale rule won’t apply because the bonds aren’t considered substantially identical. Thus, you achieve a tax loss with virtually no change in economic position.

Loss carryovers

If net losses exceed net gains, you can deduct only $3,000 ($1,500 for married taxpayers filing separately) of the net losses per year against ordinary income. You can carry forward excess losses to future years indefinitely.

By determining whether, year to date, you have excess losses, you can time sales of other investments before year end to achieve your tax planning goals. For example, loss carryovers can be a powerful tax-saving tool in future years if you have a large investment portfolio, real estate holdings or a closely held business that might generate substantial future capital gains.

But if you don’t expect substantial future gains, it could take a long time to fully absorb a large loss carryover. So, from a tax perspective, you may not want to sell any more investments at a loss if you won’t have enough gains to absorb most of it. (Remember, however, that capital gains distributions from mutual funds can also absorb capital losses.) Plus, if you hold on to an investment, it may recover its lost value.

Nevertheless, if you’re ready to divest yourself of a poorly performing stock because you think it will continue to lose value — or because your investment objective or risk tolerance has changed — don’t hesitate solely for tax reasons.

Paying attention to details

If you don’t pay attention to the details, the tax consequences of a sale may be different from what you expect. For example, the trade date, not the settlement date, of publicly traded securities determines the year in which you recognize the gain or loss.

And if you bought the same security at different times and prices and want to sell high-tax-basis shares to reduce gain or increase a loss and offset other gains, be sure to specifically identify which block of shares is being sold.

The 0% rate

ATRA made permanent the 0% rate for long-term gain that would be taxed at 10% or 15% based on the taxpayer’s ordinary-income rate. If you have adult children in one of these tax brackets, consider transferring appreciated or dividend-producing assets to them so they can enjoy the 0% rate, which also applies to qualified dividends. (See the Case Study “Just because you don’t qualify doesn’t mean you can’t benefit from the 0% rate.”)

Warning: If the child will be under age 24 on Dec. 31, first make sure he or she won’t be subject to the“kiddie” tax. Also consider any gift tax consequences.

Mutual funds

Investing in mutual funds is an easy way to diversify your portfolio. But beware of the tax pitfalls. First, mutual funds with high turnover rates can create income taxed at ordinary-income rates. Choosing funds that provide primarily long-term gains can save you more tax dollars because of the lower long-term rates.

Second, earnings on mutual funds are typically reinvested, and unless you (or your investment advisor) keep track of these additions — and increase your basis accordingly — you may report more gain than required when you sell the fund. Since 2012, brokerage firms have been required to track (and report to the IRS) your cost basis in mutual funds acquired during the tax year.

Third, buying equity mutual fund shares later in the year can be costly tax-wise. Such funds often declare a large capital gains distribution at year end. If you own the shares on the distribution’s record date, you’ll be taxed on the full distribution amount even if it includes significant gains realized by the fund before you owned the shares. And you’ll pay tax on those gains in the current year — even if you reinvest the distribution. (See the Case Study “Mutual fund distributions can cost you taxes.”)

Small business stock

By purchasing stock in certain small businesses, you can diversify your portfolio. You also may enjoy preferential tax treatment:

Conversion of capital loss to ordinary loss. If you sell qualifying Section 1244 small business stock at a loss, you can treat up to $50,000 ($100,000, if married filing jointly) as an ordinary, rather than a capital, loss — regardless of your holding period. This means you can use it to offset ordinary income, reducing your tax by as much as 35% of this portion of the loss. Sec. 1244 applies only if total capital invested isn’t more than $1 million.

Tax-free gain rollovers. If within 60 days of selling qualified small business (QSB) stock you buy other QSB stock with the proceeds, you can defer the tax on your gain until you dispose of the new stock. The rolled-over gain reduces your basis in the new stock. For determining long-term capital gains treatment, the new stock’s holding period includes the holding period of the stock you sold.

To be a QSB, a business must be engaged in an active trade or business and must not have assets that exceed $50 million.

Exclusion of gain. Generally, taxpayers selling QSB stock are allowed to exclude up to 50% of their gain as long as they’ve held the stock for at least five years. But, depending on the acquisition date, the exclusion may be greater: The exclusion is 75% for stock acquired after Feb. 17, 2009, and before Sept. 28, 2010, and 100% for stock acquired after Sept. 27, 2010, and before Jan. 1, 2014. (The latter acquisition deadline had been Dec. 31, 2011, but ATRA retroactively extended it. This can be a powerful tax-saving tool, especially for higher-income taxpayers. (See the Case Study “Investing in QSB stock before year end can be a powerful long-term tax-saving strategy for higher-income taxpayers.”)

The taxable portion of any QSB gain will be subject to the lesser of your ordinary-income rate or 28%, rather than the normal long-term gains rate. (See the Chart “What’s the maximum capital gains tax rate?”) Thus, if the 28% rate and the 50% exclusion apply, the effective rate on the QSB gain will be 14% (28% × 50%).

Keep in mind that all three of these tax benefits are subject to specific requirements and limits. Consult your tax and financial advisors to be sure an investment in small business stock is right for you.

Passive activities

If you’ve invested in a trade or business in which you don’t materially participate, remember the passive activity rules. Why? Passive activity income may be subject to the 3.8% Medicare contribution tax on net investment income (See “What’s new! Will you owe the 3.8% Medicare tax on investment income?”), and passive activity losses generally are deductible only against income from other passive activities. You can carry forward disallowed losses to the following year, subject to the same limits.

To avoid passive activity treatment, typically you must participate in a trade or business more than 500 hours during the year or demonstrate that your involvement constitutes substantially all of the participation in the activity. (Special rules apply to real estate; see “Real estate activity losses.”) If you don’t pass this test, consider:

Increasing your involvement. If you can exceed 500 hours, the activity no longer will be subject to passive activity rules. If the business is structured as a limited liability company (LLC), proposed IRS regulations may make it easier for you to meet the material participation requirement. Check with your tax advisor for more information.

Grouping activities. You may be able to group certain activities together to be treated as one activity for tax purposes and exceed the 500-hour threshold. But the rules are complex, and there are potential downsides to consider.

Disposing of the activity. This generally allows you to deduct all the losses — including any loss on disposition (subject to basis and capital loss limitations). But, again, the rules are complex.

Looking at other activities. Another option if you have passive losses is to limit your participation in another activity that’s generating income, so that you don’t meet the 500 hours test, or invest in another income-producing trade or business that will be passive to you. Under both strategies, you’ll have passive income that can absorb your passive losses.

Income investments

ATRA makes long-term capital gains tax treatment of qualified dividends permanent. So the tax rate on such dividends generally will be 15% (or 0% for taxpayers in the 10% or 15% ordinary-income tax bracket). But higher-income taxpayers may face a tax increase, because under ATRA a 20% long-term capital gains rate generally applies if taxable income exceeds $400,000 (singles), $425,000 (heads of households) or $450,000 (married couples filing jointly). However, this is still a lower rate than these taxpayers would have paid if dividends had returned to being taxed at ordinary-income rates, as had been scheduled for 2013.

Interest income continues to generally be taxed at ordinary-income rates, which for 2013 are as high as 39.6%. So stocks that pay qualified dividends currently may be more attractive tax-wise than other income investments, such as CDs, money market accounts and bonds. But there are exceptions.

Some dividends are subject to ordinary-income rates. These may include certain dividends from:

• Real estate investment trusts (REITs),


• Regulated investment companies (RICs),


• Money market mutual funds, and


• Certain foreign investments.

Warning: Beginning in 2013, a new Medicare tax also may apply to your dividend and interest income. (See “What’s new! Will you owe the 3.8% Medicare tax on investment income?”)

The tax treatment of bond income varies. For example:

• Interest on U.S. government bonds is taxable on federal returns but generally exempt on state and local returns.


• Interest on state and local government bonds is excludible on federal returns. If the bonds were issued in your home state, interest also may be excludible on your state return.


• Corporate bond interest is fully taxable for federal and state purposes.


• Bonds (except U.S. savings bonds) with original issue discount (OID) build up “interest” as they rise toward maturity. You’re generally considered to earn a portion of that interest annually — even though the bonds don’t pay this interest annually — and you must pay tax on it. (See the Case Study “The dangers of ‘phantom’ income.”)

Keep in mind that, although state and municipal bonds usually pay a lower interest rate, their rate of return may be higher than the after-tax rate of return for a taxable investment, depending on your tax rate. To compare apples to apples, calculate the tax-equivalent yield, which incorporates tax savings into the municipal bond’s yield. The formula is simple:

Tax-equivalent yield = actual yield / (1 - your marginal tax rate)

Investment interest expense

Investment interest — interest on debt used to buy assets held for investment, such as margin debt used to buy securities — is deductible for both regular tax and AMT purposes. But special rules apply.

Your investment interest deduction is limited to your net investment income, which generally includes taxable interest, nonqualified dividends and net short-term capital gains (but not long-term capital gains), reduced by other investment expenses. Any disallowed interest is carried forward, and you can deduct it in a later year if you have excess net investment income.

You may elect to treat net long-term capital gains or qualified dividends as investment income in order to deduct more of your investment interest. But if you do, that portion of the long-term capital gain or dividend is taxed at ordinary-income rates.

Payments a short seller makes to the stock lender in lieu of dividends may be deductible as an investment interest expense. But interest on debt used to buy securities that pay tax-exempt income, such as municipal bonds, isn’t deductible.

Also keep in mind that passive interest expense — interest on debt incurred to fund passive activity expenditures — becomes part of your overall passive activity income or loss, subject to limitations. •

Real Estate

Why tax planning for real estate is becoming more important

As the real estate market slowly recovers and potential taxes go up for many, tax planning for real estate — whether your home, your vacation home or a rental property — is becoming more important. Higher-income taxpayers could see the benefit of some of their home-related deductions reduced and face higher income tax rates plus the new 3.8% Medicare tax on real estate income and gains. (For information on some changes to temporary breaks for owners of leasehold, restaurant or retail properties, see “What’s new! 3 depreciation-related breaks extended, but only through 2013”)

Home-related tax breaks

There are many tax benefits to home ownership — among them, various deductions. But the return of the itemized deduction reduction (see “What’s new! Deduction reduction and exemption phaseout are back”) could reduce your benefit from some of these breaks:

Property tax deduction. If you’re looking to accelerate or defer deductions (see “Timing income and expenses”), property tax is one expense you may be able to time. You can choose to pay your bill for this year that’s due early next year by Dec. 31, and deduct it this year. Or you can wait until the due date and deduct it next year.

Mortgage interest deduction. You generally can deduct (for both regular tax and AMT purposes) interest on up to a combined total of $1 million of mortgage debt incurred to purchase, build or improve your principal residence and a second residence. Points paid related to your principal residence also may be deductible.

Home equity debt interest deduction. Interest on home equity debt used for any purpose (debt limit of $100,000) may be deductible. So consider using a home equity loan or line of credit to pay off credit cards or auto loans, for which interest isn’t deductible.

Debt forgiveness exclusion. Homeowners who receive debt forgiveness in a foreclosure or a mortgage workout for a principal residence generally don’t have to pay federal income taxes on that forgiveness. Warning: This break is scheduled to expire after 2013. (It had been scheduled to expire after 2012, but the American Taxpayer Relief Act of 2012 (ATRA) extended it.)

Home office deduction

If your use of a home office is for your employer’s benefit and it’s the only use of the space, you generally can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses. Further, you can take a deduction for the depreciation allocable to the portion of your home used for the office. You can also deduct direct expenses, such as a business-only phone line and office supplies.

For employees, home office expenses are a miscellaneous itemized deduction, which means you’ll enjoy a tax benefit only if your home office expenses plus your other miscellaneous itemized expenses exceed 2% of your AGI. If, however, you’re self-employed, you can use the deduction to offset your self-employment income and the 2% of AGI “floor” won’t apply.

Recently, the IRS announced a new simplified home office deduction, which is available beginning in 2013. The optional deduction is $5 per square foot for up to 300 square feet of home office space. So the maximum annual deduction is $1,500. If you choose this option, you can’t deduct depreciation for this portion of your home. But you can take itemized deductions for otherwise allowable mortgage interest and property taxes without allocating them between personal and business use.

Of course, there are numerous exceptions and caveats. If this break might apply to you, discuss it with your tax advisor in more detail.

Home rental rules

If you rent out all or a portion of your principal residence or second home for less than 15 days, you don’t have to report the income. But expenses directly associated with the rental, such as advertising and cleaning, won’t be deductible.

If you rent out your principal residence or second home for 15 days or more, you’ll have to report the income. But you also may be entitled to deduct some or all of your rental expenses — such as utilities, repairs, insurance and depreciation. Exactly what you can deduct depends on whether the home is classified as rental property for tax purposes (based on the amount of personal vs. rental use):

Rental property. You can deduct rental expenses, including losses, subject to the real estate activity rules. You can’t deduct any interest that’s attributable to your personal use of the home, but you can take the personal portion of property tax as an itemized deduction.

Nonrental property. You can deduct rental expenses only to the extent of your rental income. Any excess can be carried forward to offset rental income in future years. You also can take an itemized deduction for the personal portion of both mortgage interest and property taxes. In some situations, it may be beneficial to reduce personal use of a residence so it will be classified as a rental property.

Home sales

When you sell your principal residence, you can exclude up to $250,000 ($500,000 for joint filers) of gain if you meet certain tests. Gain that qualifies for the exclusion also will be excluded from the new 3.8% Medicare contribution tax. (See “What’s new! Will you owe the 3.8% Medicare tax on investment income?”) To support an accurate tax basis, maintain thorough records, including information on your original cost and subsequent improvements, reduced by casualty losses and any depreciation that you may have claimed based on business use.

Warning: Gain on the sale of a principal residence generally isn’t excluded from income if the gain is allocable to a period of nonqualified use. Generally, this is any period after 2008 during which the property isn’t used as your principal residence. There’s an exception if the home is first used as a principal residence and then converted to nonqualified use.

Losses on the sale of a principal residence aren’t deductible. But if part of your home is rented or used exclusively for your business, the loss attributable to that portion will be deductible, subject to various limitations.

Because a second home is ineligible for the gain exclusion, consider converting it to rental use before selling. It can be considered a business asset, and you may be able to defer tax on any gains through an installment sale or a Section 1031 exchange.

Or you may be able to deduct a loss, but only to the extent attributable to a decline in value after the conversion.

Real estate activity rules

Income and losses from investment real estate or rental property are passive by definition — unless you’re a real estate professional. Why is this important? Passive income may be subject to the 3.8% Medicare tax (see “What’s New! Will you owe the 3.8% Medicare tax on investment income?”), and passive losses are deductible only against passive income, with the excess being carried forward. To qualify as a real estate professional, you must annually perform:

• More than 50% of your personal services in real property trades or businesses in which you materially participate, and


• More than 750 hours of service in these businesses during the year.

Each year stands on its own, and there are other nuances to be aware of. If you’re concerned you’ll fail either test and be stuck with passive activities, consider increasing your hours so you’ll meet the test. Keep in mind that special rules for spouses may help you meet the 750-hour test.

Tax-deferral strategies for investment property

It’s possible to divest yourself of appreciated investment real estate or rental property but defer the tax liability. Such strategies may be less risky from a tax perspective now that ATRA has made capital gains tax rates permanent. (See the Chart “What's the maximum capital gains tax rate?”) Nevertheless, tread carefully if you’re considering a deferral strategy such as the following:

Installment sale. An installment sale allows you to defer gains by spreading them over several years as you receive the proceeds. Warning: Ordinary gain from certain depreciation recapture is recognized in the year of sale, even if no cash is received.

Sec. 1031 exchange. Also known as a “like-kind” exchange, this technique allows you to exchange one real estate investment property for another and defer paying tax on any gain until you sell the replacement property. Warning: Restrictions and significant risks apply. •

Business & Executive Comp.

A mix of good and bad tax news requires careful planning

The good news: Many breaks — and break enhancements — for businesses have been extended by The American Taxpayer Relief Act of 2012 (ATRA). The bad news: Flow-through entities, such as partnerships, limited liability companies (LLCs) and S corporations, may be affected by ATRA’s increase to the top ordinary-income tax rates for individuals, from 35% to 39.6%. So businesses need to plan carefully to take advantage of the breaks available to them this year while minimizing the impact of higher rates if applicable.

Also, if you own the business, it’s likely your biggest investment, so thinking about long-term considerations, such as your exit strategy, is critical as well. And if you’re an executive, you likely have to think about not only the company’s taxes, but also tax considerations related to compensation you receive beyond salary and bonuses, such as stock options. Planning for executive comp gets even more complicated this year, because of the potential impact of higher tax rates and expanded Medicare taxes.

Projecting income

Projecting your business’s income for this year and next will allow you to time income and deductions to your advantage. It’s generally — but not always — better to defer tax, so consider:

Deferring income to next year. If your business uses the cash method of accounting, you can defer billing for your products or services. Or, if you use the accrual method, you can delay shipping products or delivering services. But don’t let tax considerations get in the way of making sound business decisions.

Accelerating deductions into the current year. This also will defer tax. If you’re a cash-basis taxpayer, you may want to make an estimated state tax payment before Dec. 31, so you can deduct it this year rather than next. But consider the alternative minimum tax (AMT) consequences first. Both cash- and accrual-basis taxpayers can charge expenses on a credit card and deduct them in the year charged, regardless of when the credit card bill is paid.

Warning: Think twice about these strategies if you’re experiencing a low-income year. Their negative impact on your cash flow may not be worth the potential tax benefit.

Taking the opposite approach. If it’s likely you’ll be in a higher tax bracket next year, accelerating income and deferring deductible expenses may save you more tax.

Depreciation

For assets with a useful life of more than one year, you generally must depreciate the cost over a period of years. In most cases the Modified Accelerated Cost Recovery System (MACRS) will be preferable to the straight-line method because you’ll get a larger deduction in the early years of an asset’s life.

But if you make more than 40% of the year’s asset purchases in the last quarter, you could be subject to the typically less favorable midquarter convention. Careful planning during the year can help you maximize depreciation deductions in the year of purchase.

Other depreciation-related breaks and strategies also are available:

50% bonus depreciation. ATRA extended this additional first-year depreciation allowance, generally to qualifying assets acquired and placed in service in 2013 (2014 for certain long-lived and transportation property). Qualified assets include new tangible property with a recovery period of 20 years or less (such as office furniture, equipment and company-owned vehicles), off-the-shelf computer software, water utility property and qualified leasehold-improvement property.

Corporations can accelerate certain credits in lieu of claiming bonus depreciation for qualified assets acquired and placed in service through Dec. 31, 2013. (For certain long-lived and transportation property, the deadline is Dec. 31, 2014.)

If you’re eligible for full Section 179 expensing, it may provide a greater benefit because it can allow you to deduct 100% of an asset acquisition’s cost. Plus, generally only Sec. 179 expensing is available for used property. However, bonus depreciation may benefit more taxpayers than Sec. 179 expensing, because it isn’t subject to any asset purchase limit or net income requirement. Also consider state tax consequences.

Section 179 expensing election.This break provides another way to deduct (rather than depreciate) more of your asset purchase costs. (See “What’s new! Enhanced Sec. 179 expensing extended through 2013.”)

Accelerated depreciation. ATRA revived through 2013 the break allowing a shortened recovery period of 15 years — rather than 39 years — for qualified leasehold-improvement, restaurant and retail-improvement property.

Cost segregation study. If you’ve recently purchased or built a building or are remodeling existing space, consider a cost segregation study. It identifies property components and related costs that can be depreciated much faster and dramatically increase your current deductions. Typical assets that qualify include decorative fixtures, security equipment, parking lots, landscaping and architectural fees allocated to qualifying property.

The benefit of a cost segregation study may be limited in certain circumstances — for example, if the business is subject to the AMT or located in a state that doesn’t follow federal depreciation rules. (For information on some changed breaks for owners of leasehold, restaurant or retail properties, see“What’s new! 3 depreciation-related breaks extended, but only through 2013.”)

Vehicle-related tax breaks

Business-related vehicle expenses can be deducted using the mileage-rate method (56.5 cents per mile driven in 2013) or the actual-cost method (total out-of-pocket expenses for fuel, insurance and repairs, plus depreciation).

Purchases of new or used vehicles may be eligible for Sec. 179 expensing, and purchases of newvehicles may be eligible for bonus depreciation. However, many rules and limits apply. For example, the normal Sec. 179 expensing limit generally applies to vehicles weighing more than 14,000 pounds, but the limit is only $25,000 for SUVs weighing more than 6,000 pounds but no more than 14,000 pounds.

Vehicles weighing 6,000 pounds or less don’t satisfy the SUV definition and thus are subject to the passenger automobile limits. For autos placed in service in 2013, the depreciation limit is $3,160 (the same as the 2012 limit). The limit is increased by $8,000 for autos eligible for bonus depreciation. The amount that may be deducted under the combination of MACRS depreciation, Sec. 179 and bonus depreciation rules for the first year is limited under the luxury auto rules.

In addition, if a vehicle is used for business and personal purposes, the associated expenses, including depreciation, must be allocated between deductible business use and nondeductible personal use. The depreciation limit is reduced if the business use is less than 100%. If business use is 50% or less, you can’t use Sec. 179 expensing, bonus depreciation or the accelerated regular MACRS; you must use the straightline method.

Manufacturers’ deduction

The manufacturers’ deduction, also called the “Section 199” or “domestic production activities deduction,” is 9% of the lesser of qualified production activities income or taxable income. The deduction is also limited to 50% of W-2 wages paid by the taxpayer that are allocable to domestic production gross receipts.

The deduction is available to traditional manufacturers and to businesses engaged in activities such as construction, engineering, architecture, computer software production and agricultural processing. It isn’t allowed in determining net earnings from self-employment and generally can’t reduce net income below zero to create a net operating loss (NOL). But it can be used against the AMT.

Employee benefits

Including a variety of benefits in your compensation package can help you not only attract and retain the best employees, but also manage your tax liability:

Qualified deferred compensation plans. These include pension, profit-sharing, SEP and 401(k) plans, as well as SIMPLEs. You can enjoy a tax deduction for your contributions to employees’ accounts, and the plans offer tax-deferred savings benefits for employees. Certain small employers may also be eligible for a credit when setting up a plan. (For more on the benefits to employees, see “401(k)s and other employer plans.”)

HSAs and FSAs. If you provide employees with qualified high-deductible health insurance, you can also offer them Health Savings Accounts. Regardless of the type of health insurance you provide, you also can offer Flexible Spending Accounts for health care. If you have employees who incur day care expenses, consider offering FSAs for child and dependent care.

Fringe benefits. Some fringe benefits, such as group term-life insurance (up to $50,000), health insurance, parking (up to $245 per month for 2013), mass transit / van pooling (also up to $245 per month for 2013 because ATRA extended transit benefit parity through 2013) and employee discounts, aren’t included in employee income. Yet the employer still receives a deduction for the portion, if any, of the benefit it pays and typically avoids payroll tax as well.

Certain small businesses providing health care coverage to their employees may be eligible for a taxcredit.

Warning: Beginning in 2015, if you’re considered a large employer and don’t offer full-time employees sufficient health care coverage, you could be at risk for penalties under the health care act. The effective date has already been extended once, the rules are complex, and additional IRS guidance is expected. Contact your tax advisor for the latest information.

NQDC. Nonqualified deferred compensation plans generally aren’t subject to nondiscrimination rules, so they can be used to provide substantial benefits to executives and other key employees. But the employer generally doesn’t get a deduction for NQDC plan contributions until the employee recognizes the income.

NOLs

A net operating loss occurs when operating expenses and other deductions for the year exceed revenues. Generally, an NOL may be carried back two years to generate a refund. Any loss not absorbed is carried forward up to 20 years.

Carrying back an NOL may provide a needed influx of cash. But you can elect to forgo the carryback if carrying the entire loss forward may be more beneficial, such as if you expect your income to increase substantially or tax rates to go up.

Tax credits

Tax credits reduce tax liability dollar-for-dollar, making them particularly valuable. Here are a few credits to consider:

Work Opportunity credit. This credit, designed to encourage hiring from certain disadvantaged groups, had expired Dec. 31, 2011, for most groups, and an expanded credit for qualifying veterans had expired Dec. 31, 2012. ATRA has extended the credit for most eligible groups through 2013.

Examples of qualifying groups include food stamp recipients, ex-felons and nondisabled veterans who’ve been unemployed for four weeks or more, but less than six months. For hiring from these groups, the credit generally equals 40% of the first $6,000 of wages paid, for a maximum credit of $2,400 per qualifying employee.

A larger credit of up to $4,800 may be available for hiring disabled veterans. And, if you hire veterans who’ve been unemployed for six months or more in the preceding year, the maximum credits are even greater: $5,600 for nondisabled veterans and $9,600 for disabled veterans.

Health care coverage credit for small businesses. For tax years 2010 to 2013, the maximum credit is 35% of group health coverage premiums paid by the employer. To get the credit, you must contribute at least 50% of the total premium or of a benchmark premium. The full credit is available for employers with 10 or fewer full-time equivalent employees (FTEs) and average annual wages of less than $25,000 per employee. Partial credits are available on a sliding scale to businesses with fewer than 25 FTEs and average annual wages of less than $50,000.

Retirement plan credit. Small employers (generally those with 100 or fewer employees) that create a retirement plan may be eligible for a $500 credit per year for three years. The credit is limited to 50% of qualified startup costs.

Research credit. The credit generally is equal to a portion of qualified research expenses. (See “What’s new! Research credit revived through 2013.”)

Other credits. Examples of other expired credits that ATRA extended through 2013 include various energy-related credits, the new markets credit and the empowerment zone credit. Contact your tax advisor to learn which credits might apply to you.

Business structure

Income taxation and owner liability are the main factors that differentiate one business structure from another. Many businesses choose entities that combine flow-through taxation with limited liability, namely limited liability companies (LLCs) and S corporations. (See the Chart “Income tax differences based on business structure” to compare the tax treatment for pass-through entities vs. C corporations.)

After ATRA, the top individual rate is higher (39.6%) than the top corporate rate (generally 35%), which might affect business structure decisions. For tax or other reasons, a structure change may be beneficial in certain situations, but there may be unwelcome tax consequences, so be sure to consult your tax advisor.

Some tax differences between structures may provide planning opportunities, such as those related to salary vs. distributions. (See “Employment taxes for owner-employees.”)

Exit planning

An exit strategy is a plan for passing on responsibility for running the company, transferring ownership and extracting your money from the business. This requires planning well in advance of the transition. Here are the most common exit options:

Buy-sell agreements. When a business has more than one owner, a buy-sell agreement can be a powerful tool. The agreement controls what happens to the business when a specified event occurs, such as an owner’s retirement, disability or death. Among other benefits, a well-drafted agreement:

• Provides a ready market for the departing owner’s shares,


• Sets a price for the shares, and


• Allows business continuity by preventing disagreements caused by new, unwanted owners.

A key issue with any buy-sell agreement is providing the buyer(s) with a means of funding the purchase. Life or disability insurance often helps fulfill this need and can give rise to several tax and nontax issues and opportunities.

One of the biggest advantages of life insurance as a funding method is that proceeds generally are excluded from the beneficiary’s taxable income. There are exceptions, however, so be sure to consult your tax advisor.

Succession within the family. You can pass your business on to family members by giving them interests, selling them interests or doing some of each. Be sure to consider your income needs, how family members will feel about your choice, and the gift and estate tax consequences.

Now may be a particularly good time to transfer ownership interests through gifting. If your business has lost value, you can transfer a greater number of shares without exceeding your $14,000 gift tax annual exclusion amount. Valuation discounts may further reduce the taxable value. (See “Gift interests in your business.”) And, with the lifetime gift tax exemption at a record-high $5.25 million for 2013, this may be a great year to give away more than just your annual exclusion amounts.

Management buyout. If family members aren’t interested in or capable of taking over your business, one option is a management buyout. This may provide for a smooth transition because there may be little learning curve for the new owners. Plus you avoid the time and expense of finding an outside buyer.

ESOP. If you want rank and file employees to become owners as well, an employee stock ownership plan (ESOP) may be the ticket. An ESOP is a qualified retirement plan created primarily to purchase your company’s stock. Whether you’re planning for liquidity, looking for a tax-favored loan or wanting to supplement an employee benefit program, an ESOP can offer many advantages.

Selling to an outsider. If you can find the right buyer, you may be able to sell the business at a premium. Putting your business into a sale-ready state can help you get the best price. This generally means transparent operations, assets in good working condition and minimal reliance on key people.

Sale or acquisition

Whether you’re selling your business as part of your exit strategy or acquiring another company to help grow it, the tax consequences can have a major impact on the transaction’s success or failure. Here are a few key tax considerations:

Asset vs. stock sale. With a corporation, sellers typically prefer a stock sale for the capital gains treatment and to avoid double taxation. Buyers generally want an asset sale to maximize future depreciation write-offs.

Taxable sale vs. tax-deferred transfer. A transfer of ownership of a corporation can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization. But the transaction must comply with strict rules. Although it’s generally better to postpone tax, there are some advantages to a taxable sale:

• The seller doesn’t have to worry about the quality of buyer stock or other business risks that might come with a tax-deferred transfer.


• The buyer benefits by receiving a stepped-up basis in its acquisition’s assets and not having to deal with the seller as a continuing equity owner, as it would in a tax-deferred transfer.


• The parties don’t have to meet the technical requirements of a tax-deferred transfer.

Installment sale. A taxable sale may be structured as an installment sale, due to the buyer’s lack of sufficient cash or the seller’s desire to spread the gain over a number of years. Spreading out the gain may be especially desirable now because it may allow you to stay below thresholds that would trigger additional tax. (See “What’s new! Top capital gains rates increase in 2013” and “What’s new! Will you owe the 3.8% Medicare tax on investment income?”) Installment sales are also useful when the buyer pays a contingent amount based on the business’s performance. But an installment sale can backfire on the seller. For example, depreciation recapture must be reported as gain in the year of sale, no matter how much cash the seller receives. And, if tax rates increase, the overall tax could wind up being more. Of course, tax consequences are only one of many important considerations when planning a merger or acquisition.

Incentive stock options

If you’re an executive with a larger company, you may receive incentive stock options (ISOs). ISOs receive tax-favored treatment but must comply with many rules. ISOs allow you to buy company stock in the future (but before a set expiration date) at a fixed price equal to or greater than the stock’s fair market value (FMV) at the date of the grant.

Therefore, ISOs don’t provide a benefit until the stock appreciates in value. If it does, you can buy shares at a price below what they’re then trading for, as long as you’ve satisfied the applicable ISO holding periods. Here are the key tax consequences:

• You owe no tax when the ISOs are granted.


• You owe no regular tax when you exercise the ISOs.


• If you sell the stock after holding the shares at least one year from the date of exercise and two years from the date the ISOs were granted, you pay tax on the sale at your long-term capital gains rate.


• If you sell the stock before long-term capital gains treatment applies, a “disqualifying disposition” occurs and any gain is taxed as compensation at ordinary-income rates.

If you’ve received ISOs, plan carefully when to exercise them and whether to immediately sell shares received from an exercise or hold them. Waiting to exercise ISOs until just before the expiration date (when the stock value may be the highest, assuming the stock is appreciating) and holding on to the stock long enough to garner long-term capital gains treatment often is beneficial. But there’s also market risk to consider.

Plus, in several situations, acting earlier can be advantageous:

• Exercise early to start your holding period so you can sell and receive long-term capital gains treatment sooner.


• Exercise when the bargain element is small or when the market price is close to bottoming out to reduce or eliminate AMT liability.


• Exercise annually so you can buy only the number of shares that will achieve a breakeven point between the AMT and regular tax and thereby incur no additional tax.


• Sell in a disqualifying disposition and pay the higher ordinary-income rate to avoid the AMT on potentially disappearing appreciation.

On the negative side, exercising early accelerates the need for funds to buy the stock, exposes you to a loss if the shares’ value drops below your exercise cost, and may create a tax cost if the preference item from the exercise generates an AMT liability.

The timing of ISO exercises could also positively or negatively affect your liability for the 39.6% ordinary income tax rate (see “What’s new! Top ordinary-income tax rate of 39.6% returns in 2013”), the 20% long-term capital gains rate (see “What’s new! Top capital gains rates increase in 2013”) or the expanded Medicare taxes (see “What’s new! You could owe expanded Medicare taxes on your exec comp”). With your tax advisor, evaluate the risks and crunch the numbers using various assumptions to determine the best strategy for you.

Nonqualified stock options

The tax treatment of nonqualified stock options (NQSOs) is different from that of ISOs: NQSOs create compensation income (taxed at ordinary-income rates) on the bargain element when exercised (regardless of whether the stock is held or sold immediately), but they don’t create an AMT preference item.

You may need to make estimated tax payments or increase withholding to fully cover the tax on the exercise. Keep in mind that an exercise could trigger or increase exposure to top tax rates (see “What’s new! Top ordinary-income tax rate of 39.6% returns in 2013” and “What’s new! Top capital gains rates increase in 2013”) and expanded Medicare taxes. (see “What’s new! You could owe expanded Medicare taxes on your exec comp”).

Restricted stock and RSUs

Restricted stock is stock that’s granted subject to a substantial risk of forfeiture. Income recognition is normally deferred until the stock is no longer subject to that risk or you sell it. You then pay taxes based on the stock’s fair market value when the restriction lapses and at your ordinary-income rate.

But, under Section 83(b), you can elect to instead recognize ordinary income when you receive the stock. This election, which you must make within 30 days after receiving the stock, can be beneficial if the income at the grant date is negligible or the stock is likely to appreciate significantly before income would otherwise be recognized. Why? Because the election allows you to convert future appreciation from ordinary income to long-term capital gains income and defer it until the stock is sold.

There are some disadvantages of a Sec. 83(b) election: First, you must prepay tax in the current year — and you could trigger or increase your exposure to the 39.6% ordinary-income tax rate (see “What’s new! Top ordinary-income tax rate of 39.6% returns in 2013”) or the additional 0.9% Medicare tax (see “What’s new! You could owe expanded Medicare taxes on your exec comp”). But if a company is in the earlier stages of development, the income recognized may be small. Second, any taxes you pay because of the election can’t be refunded if you eventually forfeit the stock or you sell it at a decreased value. But you’d have a capital loss when you forfeited or sold the stock.

Work with your tax advisor to map out whether the Sec. 83(b) election is appropriate for you in each particular situation.

If you've been awarded restricted stock units (RSUs), however, the Sec. 83(b) election won't be available. But RSUs still providing tax planning opportunities. (See the Case Study “Restricted stock units may provide planning advantages.”)

NQDC plans

Nonqualified deferred compensation plans pay executives in the future for services to be currently performed. They differ from qualified plans, such as 401(k)s, in several ways. For example, unlike 401(k) plans, NQDC plans can favor highly compensated employees, but any NQDC plan funding isn’t protected from the employer’s creditors.

One important NQDC tax issue is that employment taxes are generally due once services have been performed and there’s no longer a substantial risk of forfeiture — even though compensation may not be paid or recognized for income tax purposes until much later. So your employer may withhold your portion of the payroll taxes from your salary or ask you to write a check for the liability. Or it may pay your portion, in which case you’ll have additional taxable income.

Keep in mind that the rules for NQDC plans are tighter than they once were, and the penalties for noncompliance can be severe: You could be taxed on plan benefits at the time of vesting, and a 20% penalty and potential interest charges also could apply. So check with your employer to make sure it’s addressing any compliance issues. •

Family & Education

Tax-planning opportunities abound for parents, students — even grandparents

If you’re a parent, a student or even a grandparent, valuable deductions, credits and tax-advantaged savings opportunities may be available to you or to your family members. Some child- and education-related breaks had been scheduled to become less beneficial in 2013, but the tax-saving outlook is now brighter because the American Taxpayer Relief Act of 2012 (ATRA) extended most enhancements — in many cases, making them permanent.

Tax credits

Tax credits reduce your tax bill dollar-for-dollar. (See the Chart “Tax deductions vs. credits: What’s the difference?”) So make sure you’re taking every credit you’re entitled to. ATRA made the benefits of the following credits permanent:

• For each child under age 17 at the end of the year, you may be able to claim a $1,000 credit.Warning: The credit phases out for higher-income taxpayers.


• For children under age 13 (or other qualifying dependents), you may be eligible for a credit for a portion of your dependent care expenses. Eligible expenses are limited to $3,000 for one dependent, $6,000 for two or more. Income-based limits reduce the credit but don’t phase it out altogether. The credit’s value had been scheduled to drop in 2013, but ATRA made higher limits permanent.


• If you adopt, you may be able to take a credit or use an employer adoption assistance program income exclusion; both are limited to $12,970 for 2013. An income-based phaseout also applies.

For more information on the income-based phaseouts that apply to these credits, see the Chart “2013 family and education tax breaks: Are you eligible?”

Dependent care FSA

You can redirect up to $5,000 of pretax income to an employer-sponsored child and dependent care Flexible Spending Account. The plan then pays or reimburses you for child and dependent care expenses. You can’t claim a tax credit for expenses reimbursed through an FSA.

Employing your children

If you own a business, consider hiring your children. As the business owner, you can deduct their pay, and other tax benefits may apply. They can earn as much as the standard deduction for singles ($6,100 for 2013) and pay zero federal income tax. They can earn an additional $5,500 in 2013 without paying current tax if they contribute it to a traditional IRA. Warning: They must perform actual work and be paid in line with what you’d pay nonfamily employees for the same work.

Roth IRAs for teens

Roth IRAs can be perfect for teenagers because they likely have many years to let their accounts grow tax-free.

The 2013 contribution limit is the lesser of $5,500 or 100% of earned income, reduced by any traditional IRA contributions. Contributions aren’t deductible, but if the child earns no more than the standard deduction for singles ($6,100 for 2013) and has no unearned income, he or she will pay zero federal income tax anyway. If a child’s earned income exceeds the standard deduction, the income likely will be taxed at only 10% or 15%. So the tax-free treatment of future qualified distributions will probably be well worth the loss of any current deduction.

If your children or grandchildren don’t want to invest their hard-earned money, consider giving them the amount they’re eligible to contribute — but keep the gift tax in mind.

The “kiddie tax”

The income shifting that once — when the “kiddie tax” applied only to those under age 14 — provided families with significant tax savings now offers much more limited benefits. Today, the kiddie tax applies to children under age 19, as well as to full-time students under age 24 (unless the students provide more than half of their own support from earned income).

For children subject to the kiddie tax, any unearned income beyond $2,000 (for 2013) is taxed at their parents’ marginal rate rather than their own, likely lower, rate. Keep this in mind before transferring assets to them.

Saving for education

Coverdell Education Savings Accounts (ESAs) and 529 savings plans offer parents (or anyone else, such as grandparents) a tax-smart way to fund education expenses:

• Contributions aren’t deductible for federal purposes, but plan assets grow tax-deferred.


• Distributions used to pay for qualified expenses — such as tuition, mandatory fees, books, equipment, supplies and, generally, room and board — are income-tax-free for federal purposes and may be tax-free for state purposes.


• You remain in control of the account — even after the child is of legal age.


• You can make rollovers to another qualifying family member.

There's also now more certainty about the benefits of ESAs going forward. (See “What’s new! Valuable ESA benefits made permanent.”) Which plan is better depends on your situation and goals. You may even want to set up both an ESA and a 529 plan for the same student.

529 plan pluses and minuses

For many taxpayers, 529 plans are better than ESAs because they typically offer much higher contribution limits (determined by the sponsoring state). Plus, there are no income-based limits for contributing — and there’s generally no beneficiary age limit for contributions or distributions. Finally, your state may offer tax benefits to residents who invest in its own 529 plan.

With a prepaid tuition plan, if your contract is for four years of tuition, tuition is guaranteed regardless of its cost at the time the beneficiary actually attends the school. The downside is that there’s uncertainty in how benefits will be applied if the beneficiary attends a different school.

A college savings plan, on the other hand, can be used to pay a student’s expenses at most postsecondary educational institutions. Distributions used to pay qualified expenses (such as tuition, mandatory fees, books, equipment, supplies and, generally, room and board) are income-tax-free for federal purposes and typically for state purposes as well.

The biggest downside may be that you don’t have direct control over investment decisions; you’re limited to the options the plan offers. Additionally, for funds already in the plan, you can make changes to your investment options only once during the year or when you change beneficiaries. For these reasons, some taxpayers prefer Coverdell ESAs. (See “What's new! Valuable ESA benefits made permanent.”)

But each time you make a new contribution to a 529 savings plan, you can select a different option for that contribution, regardless of how many times you contribute throughout the year. And you can make a tax-free rollover to a different 529 plan for the same child every 12 months.

Jumpstarting a 529 plan

To avoid gift taxes on 529 plan contributions, you must either limit them to $14,000 (up from $13,000 for 2012) annual exclusion gifts or use up part of your lifetime gift tax exemption. Fortunately, a special break for 529 plans allows you to front-load five years’ worth of annual exclusion gifts and make a $70,000 contribution (or $140,000 if you split the gift with your spouse). And that’s per beneficiary.

If you’re a grandparent, this can help you achieve your estate planning goals. (See the Case Study “A 529 plan can be a powerful estate planning tool for grandparents.”)

Education credits

If you have children in college or are currently in school yourself, you may be eligible for a credit:

American Opportunity credit. This tax break covers 100% of the first $2,000 of tuition and related expenses and 25% of the next $2,000 of expenses. The maximum credit, per student, is $2,500 per year for the first four years of postsecondary education. The credit had been scheduled to revert to the less beneficial Hope credit in 2013, but ATRA extends the American Opportunity credit through 2017.

Lifetime Learning credit. If you’re paying postsecondary education expenses beyond the first four years, check whether you’re eligible for the Lifetime Learning credit (up to $2,000 per tax return).

Both a credit and a tax-free 529 plan or ESA distribution can be taken as long as expenses paid with the distribution aren’t used to claim the credit.

Be aware that income-based phaseouts apply to these credits. (See the Chart “2013 family and education tax breaks: Are you eligible?”) If you don’t qualify for one of the credits because your income is too high, your child might. However, you must forgo your dependency exemption ($3,900 for 2013) for the child (and the child can’t take the exemption).

But because of the return of the exemption phaseout (see “What’s new! Deduction reduction and exemption phaseout are back”), you might lose the benefit of your exemption anyway. So this may be an easy decision.

Education-related deductions

If you don’t qualify for one of the credits, you might be eligible to deduct up to $4,000 of qualified higher education tuition and fees — now that ATRA has extended this break, which had expired after 2011, though 2013. The deduction is limited to $2,000 for taxpayers with incomes exceeding certain limits and is unavailable to taxpayers with higher incomes. Check with your tax advisor for the income limits.Warning: You can’t claim the deduction for the same year you claim an education credit or if anyone else is claiming an education credit for the same student for the same year.

If you’re paying off student loans, you may be able to deduct up to $2,500 of interest (per tax return). An income-based phaseout applies. (See the Chart “2013 family and education tax breaks: Are you eligible?”) ATRA makes permanent various enhancements to the deduction that were scheduled to expire after 2012. Contact your tax advisor for details. •

Charitable Giving

Your donations may be more powerful in 2013

Donations to qualified charities are generally fully deductible for both regular tax and AMT purposes, and they may be the easiest deductible expense to time to your tax advantage. After all, you control exactly when and how much you give. So not only can charitable giving provide much-needed support to causes you care about, but it also can be a powerful tax-saving tool. Your 2013 donations may be even more powerful if you’re a higher-income taxpayer. (See “What’s new! Top ordinary-income tax rate of 39.6% returns in 2013.”) On the other hand, you also could be subject to the return of the reduction of itemized deductions, which could reduce the tax benefit of your charitable gifts. (See “What’s new! Deduction reduction and exemption phaseout are back.”)

To ensure your gifts do as much as possible for both your favorite charities and your tax bill, discuss with your tax advisor which assets to give and the best ways to give them.

Cash donations

Outright gifts of cash (which include donations made via check, credit card and payroll deduction) are the easiest. The key is to substantiate them. To be deductible, cash donations must be:

• Supported by a canceled check, credit card receipt or written communication from the charity if they’re under $250, or


• Substantiated by the charity if they’re $250 or more.

Deductions for cash gifts to public charities can’t exceed 50% of your adjusted gross income (AGI). The AGI limit is 30% for cash donations to nonoperating private foundations. Contributions in excess of the applicable AGI limit can be carried forward for up to five years.

Stock donations

Publicly traded stock and other securities you’ve held more than one year are long-term capital gains property, which can make one of the best charitable gifts. Why? Because you can deduct the current fair market value and avoid thecapital gains tax you’d pay if you sold the property.

Donations of long-term capital gains property are subject to tighter deduction limits — 30% of AGI for gifts to public charities, 20% for gifts to nonoperating private foundations. In certain, although limited, circumstances it may be better to deduct your tax basis (generally the amount paid for the stock) rather than the fair market value, because it allows you to take advantage of the higher AGI limits that apply to donations of cash and ordinary-income property (such as stock held one year or less).

Don’t donate stock that’s worth less than your basis. Instead, sell the stock so you can deduct the loss and then donate the cash proceeds to charity.

Other types of donations

Gifts of cash are simple and gifts of stock can be tax-smart, but many taxpayers make other types of donations, such as vehicles, collectibles, services and even use of property. For an overview of the deductibility of various types of donations, see the Chart “What’s your donation deduction?”

Making gifts over time

If you don’t know which charities you want to benefit but you’d like to start making large contributions now, consider a private foundation. It offers you significant control over how your donations ultimately will be used.

You must comply with complex rules, however, which can make foundations expensive to run. Also, the AGI limits for deductibility of contributions to nonoperating foundations are lower.

If you’d like to influence how your donations are spent but avoid a foundation’s down sides, consider a donor-advised fund (DAF). Many larger public charities offer them. Warning: To deduct your DAF contribution, you must obtain a written acknowledgment from the sponsoring organization that it has exclusive legal control over the assets contributed.

Charitable remainder trusts

To benefit a charity while helping ensure your own financial future, consider a charitable remainder trust (CRT):

• For a given term, the CRT pays an amount to you annually (some of which generally is taxable).


• At the term’s end, the CRT’s remaining assets pass to one or more charities.


• When you fund the CRT, you receive an income tax deduction for the present value of the amount that will go to charity.


• The property is removed from your estate.

A CRT also can help diversify your portfolio if you own non-income-producing assets that would generate a large capital gain if sold. Because a CRT is tax-exempt, it can sell the property without paying tax on the gain at the time of the sale. The CRT can then invest the proceeds in a variety of stocks and bonds. You’ll owe capital gains tax when you receive CRT payments, but because the payments are spread over time, much of the liability will be deferred. Plus, only a portion of each payment will be attributable to capital gains; some will be considered tax-free return of principal. This may help you reduce or avoid exposure to the new 3.8% Medicare contribution tax and the return of the 20% top long-term capital gains rate. (See “What’s new! Will you owe the 3.8% Medicare tax on investment income?” and “What’s new! Top capital gains rates increase in 2013”)

You can name someone other than yourself as income beneficiary or fund the CRT at your death, but the tax consequences will be different.

Charitable lead trusts

To benefit charity while transferring assets to loved ones at a reduced tax cost, consider a charitable lead trust (CLT):

• For a given term, the CLT pays an amount to one or more charities.


• At the term’s end, the CLT’s remaining assets pass to one or more loved ones you name as remainder beneficiaries.


• When you fund the CLT, you make a taxable gift equal to the present value of the amount that will go to the remainder beneficiaries.


• The property is removed from your estate.

For gift tax purposes, the remainder interest is determined assuming that the trust assets will grow at the Section 7520 rate. The lower the Sec. 7520 rate, the smaller the remainder interest and the lower the possible gift tax — or the less of your lifetime gift tax exemption you’ll have to use up. If the trust’s earnings outperform the Sec. 7520 rate, the excess earnings will be transferred to the remainder beneficiaries tax-free. Because the Sec. 7520 rate currently is low, now may be a good time to take the chance that your actual return will outperform it. Plus, with the currently high gift tax exemption, you may be able to make a larger transfer to the trust this year without incurring gift tax liability.

You can name yourself as the remainder beneficiary or fund the CLT at your death, but the tax consequence will be different. •

Retirement

Build and preserve your nest egg with tax-smart planning

Retirement planning is one area that was only minimally affected by the American Taxpayer Relief Act of 2012 (ATRA). But that doesn’t mean it shouldn’t be an important element in your tax planning this year. Tax-advantaged retirement plans can help you build and preserve your nest egg — but only if you contribute as much as possible, carefully consider your traditional vs. Roth options, and are tax-smart when making withdrawals.

Maximizing your contributions to a traditional plan could even keep you from being pushed into a higher tax bracket (see “What’s new! Top ordinary-income tax rate of 39.6% returns in 2013”) or becoming subject to the new Medicare contribution tax on net investment income (see “What’s new! Will you owe the 3.8% Medicare tax on investment income?”). But when it comes to distributions, traditional plans could have the opposite effect — pushing you into the 39.6% bracket or triggering the 3.8% tax. So careful planning is critical.

401(k)s and other employer plans

Contributing to an employer-sponsored defined contribution plan, such as a 401(k), 403(b), 457, SARSEP or SIMPLE, is usually the first step in retirement planning:

• Contributions are typically pretax, so they reduce your taxable income.


• Plan assets can grow tax-deferred — meaning you pay no income tax until you take distributions.


• Your employer may match some or all of your contributions — also on a pretax basis.

See the Chart “Retirement plan contribution limits for 2013” for the annual limits for employee contributions to 401(k), 403(b), 457 and SARSEP plans. If you’re age 50 or older, you may be able to make an additional “catch-up” contribution. Because of tax-deferred compounding, increasing your contributions sooner rather than later can have a significantimpact on the size of your nest egg at retirement. If, however, you’re age 50 or older and didn’t contribute much when you were younger, you may be able to partially make up for lost time with “catch-up” contributions. (See the Case Study “Making the most of catch-up contributions.”)

If your employer offers a match, at minimum contribute the amount necessary to get the maximum match so you don’t miss out on that “free” money.

If your employer provides a SIMPLE, it’s required to make contributions (though not necessarily annually). But the employee contribution limits are lower than for other employer-sponsored plans. (See the Chart “Retirement plan contribution limits for 2013.”)

Traditional IRA

If your employer doesn’t offer a retirement plan, consider a traditional IRA. You can likely deduct your contributions, though your deduction may be limited based on your adjusted gross income (AGI) if your spouse participates in an employer-sponsored plan. You can make 2013 contributions as late as April 15, 2014. (See the Chart “Retirement plan contribution limits for 2013.”)

Roth options

A potential downside of tax-deferred saving is that you’ll have to pay taxes when you make withdrawals at retirement. Roth plans, however, allow tax-free distributions; the tradeoff is that contributions to these plans don’t reduce your current-year taxable income:

1. Roth IRAs. In addition to tax-free distributions, an important benefit is that Roth IRAs can provide estate planning advantages: Unlike other retirement plans, Roth IRAs don’t require you to take distributions during your lifetime. So you can let the entire balance grow tax-free over your lifetime for the benefit of your heirs.

If, for example, you name your child as the beneficiary, he or she will be required to start taking distributions upon inheriting the Roth IRA. But the distributions will be tax-free and spread out over his or her lifetime, and funds remaining in the account can continue to grow tax-free for many years to come.

But Roth IRAs are subject to the same low annual contribution limit as traditional IRAs (see the Chart “Retirement plan contribution limits for 2013”), and your Roth IRA limit is reduced by any traditional IRA contributions you make for the year. It may be further limited based on your AGI.

2. Roth conversions. If you have a traditional IRA, consider whether you might benefit from converting all or a portion of it to a Roth IRA. A conversion can allow you to turn tax-deferred future growth into tax-free growth and take advantage of a Roth IRA’s estate planning benefits.

There’s no longer an income-based limit on who can convert. But the converted amount is taxable in the year of the conversion.

Whether a conversion makes sense for you depends on a variety of factors, such as your age, whether the conversion would push you into a higher income tax bracket (see “What’s new! Top ordinary-income tax rate of 39.6% returns in 2013”) or trigger the Medicare contribution tax on your net investment income (see “What’s new! Will you owe the 3.8% Medicare tax on investment income?”), your tax bracket now and expected tax bracket in retirement, and whether you’ll need the IRA funds in retirement.

3. “Back door” Roth IRAs. If the income-based phaseout prevents you from making Roth IRA contributions and you don’t have a traditional IRA, consider setting up a traditional account and making a nondeductible contribution to it. You can then wait until the transaction clears and convert the traditional account to a Roth account. The only tax due will be on any growth in the account between the time you made the contribution and the date of conversion.

4. Roth 401(k), Roth 403(b) and Roth 457 plans. If the plan allows it, you may designate some or all of your contributions as Roth contributions. (Any employer match will be made to a traditional plan.) No AGI-based phaseout applies, so even high-income taxpayers can contribute. Under ATRA, plans can now more broadly permit employees to convert some or all of their existing traditional plan to a Roth plan.

Plans for business owners and the self-employed

If most of your money is tied up in your business, retirement can be a challenge. So if you haven’t already set up a tax-advantaged retirement plan, consider setting one up this year. If you might be subject to the new Medicare tax on net investment income (see “What’s new! Will you owe the 3.8% Medicare tax on investment income?”), this may be particularly beneficial because retirement plan contributions can reduce your MAGI and thus help you reduce or avoid the 3.8% tax. Keep in mind that, if you have employees, they generally must be allowed to participate in the plan, provided they work enough hours. Here are a few options that may allow you to make large contributions:

Profit-sharing plan. This is a defined contribution plan that allows discretionary employer contributions and flexibility in plan design. You can make deductible 2013 contributions (see the Chart “Profit-sharing plan vs. SEP: How much can you contribute?”) as late as the due date of your 2013 income tax return, including extensions — provided your plan existed on Dec. 31, 2013.

SEP. A Simplified Employee Pension is a defined contribution plan that provides benefits similar to those of a profit-sharing plan. But you can establish a SEP in 2014 and still make deductible 2013 contributions (see the Chart “Profit-sharing plan vs. SEP: How much can you contribute?”) as late as the due date of your 2013 income tax return, including extensions. Another benefit is that a SEP is easier to administer than a profit-sharing plan.

Defined benefit plan. This plan sets a future pension benefit and then actuarially calculates the contributions needed to attain that benefit. The maximum annual benefit is generally $205,000 for 2013 — or 100% of average earned income for the highest three consecutive years, if less. Because it’s actuarially driven, the contribution needed to attain the projected future annual benefit may exceed the maximum contributions allowed by other plans, depending on your age and the desired benefit.

You can make deductible contributions until the due date of your 2013 return, provided your plan existed on Dec. 31, 2013. Warning: Employer contributions are generally required and must be paid quarterly if there was a shortfall in funding for the prior year.

Early withdrawals

If you’re facing financial challenges this year, it may be tempting to make withdrawals from your retirement plans. But generally this should be a last resort. With a few exceptions, retirement plan distributions made before age 59½ are subject to a 10% penalty, in addition to any income tax that ordinarily would be due on a withdrawal.

This means that, if you’re in the top federal tax bracket of 39.6% (for 2013 and beyond), you can lose nearly half of your withdrawal to federal taxes and penalties. If you’re also subject to state income taxes and/or penalties, the total of your taxes and penalties almost certainly will exceed 50%. Even if you’re in a lower bracket, you can lose a substantial amount to taxes and penalties. Additionally, you’ll lose the potential tax-deferred future growth on the amount you’ve withdrawn.

If you have a Roth account, you can withdraw up to your contribution amount without incurring taxes or penalties. But you’ll still be losing the potential tax-free future growth on the withdrawn amount.

So if you’re in need of cash, you’re likely better off looking elsewhere. For instance, consider tapping your taxable investment accounts rather than dipping into your retirement plan. Long-term gains from sales of investments in taxable accounts will be taxed at the lower long-term capital gains rate, and losses on such sales can be used to offset other gains or carried forward to offset gains in future years.

Another option to consider, if your employer-sponsored plan allows it, is to take a loan from the plan. You’ll have to pay it back with interest and make regular principal payments, but you won’t be subject to current taxes or penalties.

Leaving a job

When you change jobs or retire, avoid taking a lump-sum distribution from your employer’s retirement plan because it generally will be taxable, plus potentially subject to the 10% early-withdrawal penalty. Here are options that will help you avoid current income tax and penalties:

Staying put. You may be able to leave your money in your old plan. But if you’ll be participating in a new employer’s plan or you already have an IRA, this may not be the best option. Why? Because keeping track of multiple plans can make managing your retirement assets more difficult. Also consider how well the old plan’s investment options meet your needs.

A rollover to your new employer’s plan. This may be a good solution if you’re changing jobs, because it may leave you with only one retirement plan to keep track of. But also evaluate the new plan’s investment options.

A rollover to an IRA. If you participate in a new employer’s plan, this will require keeping track of two plans. But it may be the best alternative because IRAs offer nearly unlimited investment choices.

If you choose a rollover, request a direct rollover from your old plan to your new plan or IRA. Otherwise, you’ll need to make an indirect rollover within 60 days to avoid tax and potential penalties. Warning:The check you receive from your old plan may be net of 20% federal income tax withholding. If you don’t roll over the gross amount (making up for the withheld amount with other funds), you’ll be subject to income tax — and potentially the 10% penalty — on the difference.

Required minimum distributions

Normally once you reach age 70½ you must take annual required minimum distributions (RMDs) from your IRAs (except Roth IRAs) and defined contribution plans. If you don’t comply, you can owe a penalty equal to 50% of the amount you should have withdrawn but didn’t. You can avoid the RMD rule for a Roth 401(k), Roth 403(b) or Roth 457 by rolling the funds into a Roth IRA.

So, should you take distributions between ages 59½ and 70½, or more than the RMD after age 70½? Distributions in any year your tax bracket is low may be beneficial. But also consider the lost tax-deferred growth and, if applicable, whether the distribution could: 1) cause your Social Security payments to become taxable, 2) increase income-based Medicare premiums and prescription drug charges, or 3) affect other deductions or credits with income-based limits.

Warning: While retirement plan distributions aren’t subject to the health care act’s new 0.9% or 3.8% Medicare tax, they are included in your MAGI and thus could trigger or increase the 3.8% tax on your net investment income. (See “What’s new! Will you owe the 3.8% Medicare tax on investment income?”)

If you’ve inherited a retirement plan, consult your tax advisor regarding the distribution rules that apply to you. •

Estate Planning

More certainty comes to estate planning

Estate planning may be a little less challenging now that we have more certainty about the future of estate, gift and generation-skipping transfer (GST) taxes. The American Taxpayer Relief Act of 2012 (ATRA) makes exemptions and rates for these taxes, as well as certain related breaks, permanent. Estate taxes will increase somewhat, but not as much as they would have without the legislation. And the permanence will make it easier to determine how to make the most of your exemptions and keep taxes to a minimum while achieving your other estate planning goals. However, it’s important to keep in mind that “permanent” is a relative term — it simply means there are no expiration dates. Congress could still pass legislation making estate tax law changes.

Estate tax

Under ATRA, for 2013 and future years, the top estate tax rate will be 40%. This is a five percentage point increase over the 2012 rate, but significantly less than the 55% rate that was scheduled to return for 2013, and it’s still quite low historically. The estate tax exemption will continue to be an annually inflation-adjusted $5 million, so for 2013 it’s $5.25 million. This will provide significant tax savings over the $1 million exemption that had been scheduled to return for 2013. (See the Chart “Transfer tax exemptions and highest rates.”)

ATRA also makes permanent exemption “portability” between spouses. (See “What’s new! Exemption portability for married couples now permanent.”)

It’s important to review your estate plan in light of these changes. It’s possible the exemption and rate changes could have unintended consequences on your plan. A review will allow you to make the most of available exemptions and ensure your assets will be distributed according to your wishes.

Gift tax

Under ATRA, the gift tax continues to follow the estate tax exemption and rates. (See the Chart “Transfer tax exemptions and highest rates.”) Any gift tax exemption used during life reduces the estate tax exemption available at death.

But keep in mind that you can exclude certain gifts of up to $14,000 per recipient each year ($28,000 per recipient if your spouse elects to split the gift with you or you’re giving community property) without using up any of your gift tax exemption. This reflects an inflation adjustment over the $13,000 annual exclusion that had applied for the last few years. (The exclusion increases only in $1,000 increments, so it typically goes up only every few years.)

GST tax

The generation-skipping transfer tax generally applies to transfers (both during life and at death) made to people two generations or more below you, such as your grandchildren. This is in addition to any gift or estate tax due.

Under ATRA, the GST tax also continues to follow the estate tax exemption, and the GST tax rate continues to be the same as the top estate tax rate. (See the Chart “Transfer tax exemptions and highest rates.”) ATRA also preserved certain GST tax protections, including deemed and retroactive allocation of GST tax exemptions, relief for late allocations, and the ability to sever trusts for GST tax purposes. Warning: Exemption portability between spouses doesn’t apply to the GST tax exemption.

State taxes

ATRA makes permanent the federal estate tax deduction (rather than a credit) for state estate taxes paid. Keep in mind that many states impose estate tax at a lower threshold than the federal government does. To avoid unexpected tax liability or other unintended consequences, it’s critical to consider state law.

The nuances are many; be sure to consult a tax advisor with expertise on your particular state.

Tax-smart giving

Giving away assets now will help you reduce the size of your taxable estate. (See the Case Study “Making lifetime gifts can substantially reduce estate taxes.”)

Here are some additional strategies for tax-smart giving:

Choose gifts wisely. Consider both estate and income tax consequences and the economic aspects of any gifts you’d like to make:

• To minimize estate tax, gift property with the greatest future appreciation potential.


• To minimize your beneficiary’s income tax, gift property that hasn’t already appreciated significantly since you’ve owned it.


• To minimize your own income tax, don’t gift property that’s declined in value. Instead, consider selling the property so you can take the tax loss and then gift the sale proceeds.

Plan gifts to grandchildren carefully. Annual exclusion gifts are generally exempt from the GST tax, so they also help you preserve your GST tax exemption for other transfers. For gifts that don’t qualify for the exclusion to be completely tax-free, you generally must apply both your GST tax exemption and your gift tax exemption.

So, for example, if you make an annual exclusion gift to your grandson and you want to give him an additional $30,000 in the same year to help him make a down payment on his first home, you’ll have to use $30,000 of your GST tax exemption plus $30,000 of your gift tax exemption to avoid any tax on the transfer.

Gift interests in your business. If you own a business, you can leverage your gift tax exclusions and exemption by gifting ownership interests, which may be eligible for valuation discounts. So, for example, if the discounts total 30%, in 2013 you can gift an ownership interest equal to as much as $20,000 tax-free because the discounted value doesn’t exceed the $14,000 annual exclusion. Warning: The IRS may challenge the value; a professional, independent valuation is strongly recommended. (For more on transferring interests in your business, see “Succession within the family.”)

Gift FLP interests. Another way to benefit from valuation discounts is to set up a family limited partnership. You fund the FLP and then gift limited partnership interests. Warning: The IRS is scrutinizing FLPs, so be sure to set up and operate yours properly.

Pay tuition and medical expenses. You may pay these expenses for a loved one without the payment being treated as a taxable gift, as long as the payment is made directly to the provider.

Make gifts to charity. Donations to qualified charities aren’t subject to gift taxes and may provide an income tax deduction. (See the “Charitable Giving” section for more information.)

Trusts

Trusts can provide significant tax savings while preserving some control over what happens to the transferred assets. Here are some trusts you may want to consider and the estate tax benefits they provide:

Credit shelter trust. Also referred to as a “bypass trust,” this is funded at the first spouse’s death to take advantage of his or her full estate tax exemption. The trust primarily benefits the children, but the surviving spouse can receive income, and perhaps a portion of principal, during his or her lifetime, and the trust provides some advantages over the exemption portability election. (See “What’s new! Exemption portability for married couples now permanent.”)

QDOT. A qualified domestic trust can allow you and your non-U.S.-citizen spouse to take advantage of the unlimited marital deduction.

QTIP trust. A qualified terminable interest property trust passes trust income to your spouse for life, with the remainder of the trust assets passing as you’ve designated. The trust gives you (not your surviving spouse) control over the final disposition of your property and is often used to protect the interests of children from a previous marriage.

ILIT. An irrevocable life insurance trust owns one or more policies on your life, and it manages and distributes policy proceeds according to your wishes. An ILIT keeps insurance proceeds, which could otherwise be subject to estate tax, out of your estate (and possibly your spouse’s). You aren’t allowed to retain any powers over the policy, such as the right to change the beneficiary. The trust can be designed so that it can make a loan to your estate for liquidity needs, such as paying estate tax.

Crummey trust. This trust allows you to enjoy both the control of a trust that will transfer assets at a later date and the tax savings of an outright gift. ILITs are often structured as Crummey trusts so that annual exclusion gifts can fund the ILIT’s payment of insurance premiums.

GRAT and GRUT. Grantor-retained annuity trusts and grantor-retained unitrusts allow you to give assets to your children today — removing them from your taxable estate at a reduced value for gift tax purposes (provided you survive the trust’s term) — while you receive payments from the trust for a specified term. At the end of the term, the principal may pass to the beneficiaries or remain in the trust. In a GRAT, the income you receive is an annuity based on the assets’ value on the date the trust is formed. In a GRUT, the payments are a set percentage of the assets’ value as redetermined each year. These trusts may be especially beneficial in a low-interest rate environment like we have today.

QPRT. A qualified personal residence trust is similar to a GRAT except that, instead of holding assets, the trust holds your home — and, instead of receiving annuity payments, you enjoy the right to live in your home for a set number of years. At the end of the term, your beneficiaries own the home. You may continue to live there if the trustees or owners agree and you pay fair market rent.

Dynasty trust. The dynasty trust allows assets to skip several generations of taxation. You can fund the trust either during your lifetime by making gifts or at death in the form of bequests. The trust remains in existence from generation to generation. Because the beneficiaries have restrictions on their access to the trust funds, the trust is excluded from their estates. If any of the beneficiaries have a real need for funds, the trust can make distributions to them. If you live in a state that hasn’t abolished the rule against perpetuities, special planning is required.

Life insurance

Life insurance can replace income, offer a way to equalize assets among children active and inactive in a family business, provide cash to pay estate tax or be a vehicle for passing leveraged funds free of estate tax.

Life insurance proceeds generally aren’t subject to income tax. But, if you own the policy, the proceeds will be included in your estate:

• Ownership is determined by several factors, including who has the right to name the beneficiaries of the proceeds. Generally, to reap maximum tax benefits you must sacrifice some control and flexibility as well as some ease and cost of administration.


• Determining who should own insurance on your life is a complex task because there are many possible owners, including you or your spouse, your children, your business, and an ILIT.


• To choose the best owner, consider why you want the insurance, such as to replace income, to provide liquidity or to transfer wealth to your heirs. You must also determine the importance to you of tax implications, control, flexibility, and ease and cost of administration. •