November 28, 2012
Year-end planning is a greater challenge this year than in past years. Unless the President and Congress work together, we will roll right off the “Fiscal Cliff” that I am sure you have read or heard about. But while we all hear calls for bipartisanship, the president and his spokesmen have stated repeatedly, including yesterday (November 27) that no deal will be considered unless tax rates are increased on those earning over $125,000, $200,000 and $250,000 (depending on filing status) and not to expect any social program or entitlement cuts. Wow, that’s really compromising! Sounds like a line in the sand to me! So while there are republican bills all over the place cutting here and increasing taxes in other places, I would not read too much into those plans unless the other side actually decides to “compromise.” Quite frankly my gut tells me forget it. I think the “cliff” will occur. ( and somehow the House of Representatives will get blamed, regardless of whose fault this is) The truth is these matters should have been dealt with last year. Senate Democrats are already on talk shows explaining that this “cliff” is really more of a “slope” anyway and it won’t be that bad. We can recover from a short “recession” quickly now anyway! Republicans are trying to push “limits” of itemized deductions for wealthy taxpayers (i.e. mortgage interest, etc). I just cannot see that happening. Besides, the President won easily on this very issue of a “balanced approach” of raising those tax rates. So I expect that. Please understand that the above is my opinion based on information available today. We have been surprised before, but I am obligated to tell you, my clients what I sense is right around the corner in the tax world.
WHO PAYS WHAT TAXES?
New IRS data reveal the 2010 (most recently released) taxpayer burden statistics.
Top 1% – Paid 37.4% of all taxes; 18.9% of all adjusted gross income ($369K+)
Top 5% – Paid 59.1% of all taxes; 33.8% of all adjusted gross income ($161K+)
Top 10%-Paid 70.6% of all taxes; 45.1% of all adjusted gross income ($116K+)
Bottom 50%- Paid 2.36% of all taxes; 45% of all adjusted gross income
What exactly is the “Fiscal Cliff”? Its actually a series of many laws and changes that can get complicated. Below I have attempted to simplify it somewhat for you by outlining key components. There are more pieces that I have not included.
1. Tax rate increases. If no bill or law is passed quickly (I do not expect one) all americans will face a sharp increase in their federal tax bill effective January 01, 2013. Current rates start at 10% and go up to 35%. Without the “Bush tax cuts” those rates would range from 15% to 39.6% (not including surtaxes and other new fees) The problem is the Democrats and the President want these rate increases to only impact people earning over (modified adjusted gross income) $125,000, $200,000, or $250,000 depending on filing status. Republicans do not want to increase anyone’s rates for fear of small business cutbacks when they absorb these tax increases. The average person should expect $50-$100 less weekly in their paycheck if these increases occur. The tax policy center recently published that, based on a average family of 4 earning $100,000 in MA the tax increase would be $6,632 while NH would see a $5,660 increase.
2. Alternative Minimum Tax This ugly tax can reach households with earnings under $100,000 under the right conditions unless a new “patch” is written. Even 2012 has no “patch” so you could owe tax April 2013 and beyond. for 2012, AMT exemptions have dropped and fewer personal credits can be used to offset the AMT. This is rarely talked about and separate from the “Bush tax cuts.” My guess? Congress will write some sort of patch as they have every year by December 31. IRS has already programmed computers expecting this fix. They announced last week that if the fix doesn’t come through, tax return filings could be delayed by several months! (March-April filings for many taxpayers)
3. Reduced itemized deductions and exemptionsThere has been talk, mostly as an alternative to rate increases, to deal with higher tax rates. Forget it (in my opinion). However, others the other part no-one talks about is already law effective January 01, 2013. As in several years past, if your modified adjusted gross income exceeds $160,000 or so, itemized deductions just “phase-out” as do exemptions. For simplicity, here is an example: Your (modified) AGI is $200,000 and your mortgage interest, taxes paid, and other itemized deductions total $40,000. A “phase-out” kicks in reducing the $40,000 by 3% of your AGI ($6,000) for a new itemized deduction allowed total of $34,000. Meanwhile, exemptions (about $4,000 per dependent) also get reduced by a more complex formula by about 2% for every $2,500 of income over thresh-hold amount. Based on years past, once your income hits about $350,00 for married filing joint ($175,000 filing separate) the exemption is reduced all the way to $0! These are estimated thresh-hold amounts, since the new 2013 amount has not been announced. This reduction is not even talked about but is already written into law!
4. Education credits/Child Tax Credit Rather than $1,000 per child (with no limit of kids) it reverts back to $600 per child, limit two. So if you had 4 children under age 17 and AGI $110,000 or less your credit (refundable) was $4,000. Now its $1,200. The education credit changes from the $2,500 per student to $500/$1000 limit two (the old Hope and Life Learning credit return)
5. Mandatory budget cuts (Sequestration) This has nothing to do with tax increases, but is part of the “fiscal cliff.” Since an agreement failed between the white house and congress to reduce the deficit, and an earlier “super-committee” failed, mandated $500 billion in defense & security spending (and related industries and contractors) and another $700 billion in non-defense spending (education, housing, etc) will all begin to take affect January 02, 2013. Additional annual cuts will continue for 9 years. By law the amounts cannot be individually tinkered with. I won’t go further here, as this is beyond the scope of my practice but provides useful information for this discussion.
6. Dividends and Capital Gains Currently taxed at 15%, dividends will be taxed the same as salary (ordinary) in 2013. Long term gains from stocks and other items will be taxed at 20% in 2013.
7. Obama’s “Affordable Care Act” These new taxes are law and play a part of the“Fiscal Cliff” problem. These are not subject to change and will occur as written.
(a) Additional Medicare Tax for Certain Employees and Self-employed Individuals Beginning in 2013, individuals who have wage and/or self-employment income exceeding $200,000 ($250,000 if married, filing a joint return; $125,000 if married, filing separately) will be subject to an additional 0.9% Medicare tax (i.e., 2.35% total) on their earned income exceeding the applicable threshold. Employers are required to withhold and remit the additional tax for any employee to whom it pays over $200,000. Self-employed individuals who pay both halves of the Medicare tax (i.e., 2.9%) will pay a total Medicare tax of 3.8% on earnings above the thresholds. The additional 0.9% tax will not be deductible for income tax purposes. Couples may have to make quarterly estimated tax payments to be sure they are not hit with an underpayment penalty when filing their income tax return each year.
(b) Medicare Tax on Investments
Through 2012, the Medicare payroll tax only applied to wages. Beginning in 2013, a 3.8% Medicare tax (i.e., the Medicare contribution tax) will, for the first time, apply to the net investment income of high-income taxpayers. The tax will be levied on single individuals with a modified adjusted gross income (MAGI) above $200,000 and on joint filers with MAGI over $250,000. The $250,000 threshold will also apply to a surviving spouse. Married individuals who file a separate return will have a $125,000 threshold. The amounts are not indexed for inflation. Net investment income generally includes gross income from interest, dividends, royalties, rents, gross income from a trade or business involving passive activities, and net gain from the disposition of property (other than property held in a trade or business)The tax will not apply to distributions from tax-deferred retirement accounts [e.g., 401(k) plans and IRAs]. However, those distributions may increase MAGI and, therefore, could cause an individual’s net investment income to be subject to the new tax.
Individuals May be Subject to Both Taxes
Individuals may be subject to both additional taxes, because their earnings are over the $200,000/$250,000 threshold and they have net investment income. These individuals must be especially diligent regarding their tax planning.
(c) Other taxes and fees from “Obamacare”
*Individual penalties The monthly penalty amount is an amount equal to one-twelfth of the greater of a flat dollar amount or an amount based on a percentage of the applicable individual’s income [IRC Sec. 5000A(c)(2)].
*Business penalties Under IRC Sec. 4980H, certain employers must offer health insurance coverage to full-time employees, or pay a penalty. However, IRC Sec. 4980H has the phrase “and their dependents” in parentheses, which makes it unclear if employers are required to offer coverage to full-time employees’ dependents. An applicable large employer, generally, is an employer that employed an average of at least 50 full-time equivalent (FTE) employees on business days during the preceding calendar year (1/1/2013)
*Other fines and penalties (1) A 40% excise tax will be levied on certain high-cost employer-sponsored health insurance coverage [IRC Sec. 4980I(a)]. These high-cost plans are also referred to as Cadillac plans. (2) Another penalty imposed by HHS under PHSA Sec. 2723(b)(2)(C) for failure to implement the PHSA provisions is $100-per-day for each individual for whom a violation has occurred. (3) An excise tax (i.e., penalty) of $100-per-day/per-affected-participant, applies to a group health plan The minimum excise tax for a violation that is discovered after the IRS has issued a notice of examination (i.e., after an IRS audit has begun) is $2,500 [IRC Sec. 4980D(b)(3)(A)]. This minimum tax is increased to $15,000 if the violation is considered more than a de minimis amount. The maximum excise tax for a single-employer plan for violations that are due to reasonable cause and not willful neglect is the smaller of 10% of the aggregate amount the employer (or a predecessor employer) paid for group health plans during the preceding year (i.e., the prior year’s cost of group health coverage), or $500,000 [IRC Sec. 4980D(c)(3)].
8. Estate tax increase. Currently, the federal estate tax affects gross estates with a value in excess of $5,300,000 and has a maximum tax rate of 35%. This increases to 55% January 01, 2013 and it now affects estates worth over $1,000,000. Remember, a gross estate includes all expected life insurance proceeds, and fair market value of any privately held business.
9. Increase in social security tax. Something else not talked about. The “temporary” two year reduction in the paycheck withholding of 5.65% FICA tax will return to the statutory 7.65%. So on an annual salary of $50,000, that’s a 2% or $1,000 increase for each paycheck in the household.
10. Other tax increases A number of tax provisions will expire at the end of 2012. Rules that expired at the end of 2011 include, for example, the research credit for businesses, the election to take an itemized deduction for State and local general sales taxes instead of the itemized deduction permitted for State and local income taxes, and the above-the-line deduction for qualified tuition. Rules that will expire at the end of this year include generous bonus depreciation allowances and expensing allowances for business, and expanded tax credits for higher education costs. More changes are outlined below in tax planning suggestions. Indeed, the prospect of higher taxes next year makes it even more important to engage in year-end planning this year. To that end, we have compiled a checklist of actions that can help you save tax dollars if you act before year-end. Many of these moves may benefit you regardless of what Congress does on the major tax questions of the day. Not all actions will apply in your particular situation, but you will likely benefit from many of them.
We can narrow down the specific actions that you can take once we meet with you to tailor a particular plan. In the meantime, please review the following list and contact us at your earliest convenience so that we can advise you on which tax-saving moves to make.
Year-End Tax Planning Moves for Individuals
•Increase the amount you set aside for next year in your employer’s health flexible spending account (FSA) if you set aside too little for this year. Keep in mind that beginning next year, the maximum contribution to a health FSA will be $2,500. And don’t forget that you can no longer set aside amounts to get tax-free reimbursements for over-the-counter drugs, such as aspirin and antacids.
•If you become eligible to make health savings account (HSA) contributions late this year, you can make a full year’s worth of deductible HSA contributions even if you were not eligible to make HSA contributions for the entire year. This opportunity applies even if you first became eligible in December. In brief, if you qualify for an HSA, contributions to the account are deductible (within IRS-prescribed limits), earnings on the account are tax-deferred, and distributions are tax free if made for qualifying medical expenses.
•Realize losses on stock while substantially preserving your investment position. There are several ways this can be done. For example, you can sell the original holding, then buy back the same securities at least 31 days later. It would be advisable for us to meet to discuss year-end trades you should consider making.
•If you are thinking of selling assets that are likely to yield large gains, such as inherited, valuable stock, or a vacation home in a desirable resort area, try to make the sale before year-end, with due regard for market conditions. This year, long-term capital gains are taxed at a maximum rate of 15%, but the rate could be higher next year as noted above. And if your adjusted gross income (as specially modified) exceeds certain limits ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 for all others), gains taken next year (along with other types of unearned income, such as dividends and interest) will be exposed to an extra 3.8% tax (the so-called “unearned income Medicare contribution tax”).
•If you are in the process of selling your main home, and expect your long-term gain from selling it to substantially exceed the $250,000 home-sale exclusion amount ($500,000 for joint filers), try to close before the end of the year (again, with due regard to market conditions). This can save capital gains taxes if rates go up and can save the 3.8% tax for those exposed to it.
•You may own appreciated-in-value stock and you want to lock in a 15% tax rate on the gain, but you think the stock still has plenty of room to grow. In this situation, consider selling the stock and then repurchasing it. You’ll pay a maximum tax of 15% on long-term gain from the stock you sell. You also will wind up with a higher basis (cost, for tax purposes) in the repurchased stock. If capital gain rates go up after 2012 and you sell the repurchased stock down the road at a profit, the total tax on the 2012 sale and the future sale could be lower than if you had not sold in 2012 and had just made a single sale in the future. This move definitely will reduce your tax bill after 2012 if you are subject to the extra 3.8% tax on unearned income.
•Consider making contributions to Roth IRAs instead of traditional IRAs. Roth IRA payouts are tax-free and thus immune from the threat of higher tax rates, as long as they are made (1) after a five-year period, and (2) on or attaining age 59-1/2, after death or disability, or for a first-time home purchase.
•If you believe a Roth IRA is better than a traditional IRA, consider converting traditional IRAs to Roth IRAs this year to avoid a possible hike in tax rates next year. Also, although a 2013 conversion won’t be hit by the 3.8% tax on unearned income, it could trigger that tax on your non-IRA gains, interest, and dividends. Reason: the taxable conversion may bring your modified adjusted gross income (AGI) above the relevant dollar threshold (e.g., $250,000 for joint filers). But conversions should be approached with caution because they will increase your AGI for 2012. And if you made a traditional IRA to Roth IRA conversion in 2010, and you chose to pay half the tax on the conversion in 2011 and the other half in 2012, making another conversion this year could expose you to a much higher tax bracket.
•Take required minimum distributions (RMDs) from your IRA or 401(k) plan (or other employer-sponsored retired plan) if you have reached age 70-1/2. Failure to take a required withdrawal can result in a penalty equal to 50% of the amount of the RMD not withdrawn. If you turn age 70-1/2 this year, you can delay the first required distribution to 2013, but if you do, you will have to take a double distribution in 2013—the amount required for 2012 plus the amount required for 2013. Think twice before delaying 2012 distributions to 2013—bunching income into 2013 might push you into a higher tax bracket or bring you above the modified AGI level that will trigger a 3.8% extra tax on unearned income such as dividends, interest, and capital gains. However, it could be beneficial to take both distributions in 2013 if you will be in a substantially lower bracket in 2013, for example, because you plan to retire late this year or early the next.
•This year, unreimbursed medical expenses are deductible to the extent they exceed 7.5% of your AGI, but in 2013, for individuals under age 65, these expenses will be deductible only to the extent they exceed 10% of AGI. If you have a shot at exceeding the 7.5% floor this year, accelerate into this year “discretionary” medical expenses you were planning on making next year. Examples: prescription sunglasses, and elective procedures not covered by insurance.
•Consider using a credit card to prepay expenses that can generate deductions for this year.
•Increase your withholding if you are facing a penalty for underpayment of federal estimated tax. Doing so may reduce or eliminate the penalty.
•If you expect to owe state and local income taxes when you file your return next year, consider asking your employer to increase withholding of state and local taxes (or make estimated tax payments of state and local taxes) before year-end to pull the deduction of those taxes into 2012 if doing so won’t create an alternative minimum tax (AMT) problem.
•Take an eligible rollover distribution from a qualified retirement plan before the end of 2012 if you are facing a penalty for underpayment of estimated tax and the increased withholding option is unavailable or won’t sufficiently address the problem. Income tax will be withheld from the distribution and will be applied toward the taxes owed for 2012. You can then timely roll over the gross amount of the distribution, as increased by the amount of withheld tax, to a traditional IRA. No part of the distribution will be includible in income for 2012, but the withheld tax will be applied pro rata over the full 2012 tax year to reduce previous underpayments of estimated tax.
•You may want to pay contested taxes to be able to deduct them this year while continuing to contest them next year.
•You may want to settle an insurance or damage claim in order to maximize your casualty loss deduction this year.
•Make gifts sheltered by the annual gift tax exclusion before the end of the year and thereby save gift and estate taxes. You can give $13,000 in 2012 to each of an unlimited number of individuals but you can’t carry over unused exclusions from one year to the next. The transfers also may save family income taxes where income-earning property is given to family members in lower income tax brackets who are not subject to the kiddie tax. Savings for next year could be even greater if rates go up and/or the income from the transfer would have been subject to the 3.8% tax in the hands of the donor.
Year-End Moves for Business Owners
•If your business is incorporated, consider taking money out of the business by way of a stock redemption if you are in the position to do so. The buy-back of the stock may yield long-term capital gain or a dividend, depending on a variety of factors. But either way, you’ll be taxed at a maximum rate of only 15% if you act this year. If you wait until next year to make your move, your long-term gains or dividends may be taxed at a higher rate if reform plans are instituted or the Bush-era tax cuts expire. And if your adjusted gross income (as specially modified) exceeds certain limits ($250,000 for joint filers or surviving spouses, $125,000 for a married individual filing a separate return, and $200,000 for all others), gains taken next year (along with other types of unearned income, such as dividends and interest) will be exposed to an extra 3.8% tax (the so-called “unearned income Medicare contribution tax”). Keep in mind that you will need expert help to plan and execute an effective pre-2013 corporate distribution.
•If you are thinking of adding to payroll, consider hiring a qualifying veteran before year-end to qualify for a work opportunity tax credit (WOTC). Under current law, the WOTC for qualifying veterans won’t be available for post-2012 hires. The WOTC for hiring veterans ranges from $2,400 to $9,600, depending on a variety of factors (such as the veteran’s period of unemployment and whether he or she has a service-connected disability).
•Put new business equipment and machinery in service before year-end to qualify for the 50% bonus first-year depreciation allowance. Unless Congress acts, this bonus depreciation allowance generally won’t be available for property placed in service after 2012. (Certain specialized assets may, however, be placed in service in 2013.)
•Make expenses qualifying for the business property expensing option. The maximum amount you can expense for a tax year beginning in 2012 is $139,000 of the cost of qualifying property placed in service for that tax year. The $139,000 amount is reduced by the amount by which the cost of qualifying property placed in service during 2012 exceeds $560,000 (the investment ceiling). For tax years beginning in 2013, unless Congress makes a change, the expensing limit will be $25,000 and the investment ceiling will be $200,000. Thus, if you anticipate needing property in early 2013, you may want to push the purchase into 2012 to gain a higher expensing deduction (if you are otherwise eligible to claim it). The time of purchase doesn’t affect the amount of the expensing deduction. You can purchase property late in the year and still get a full expensing deduction. Thus, property acquired and placed in service in the last days of 2012, rather than at the beginning of 2013, can result in a full expense deduction for 2012.
•If you are in the market for a business car, and your taste runs to large, heavy SUVs (those built on a truck chassis and rated at more than 6,000 pounds gross (loaded) vehicle weight), consider buying in 2012. Due to a combination of favorable depreciation and expensing rules, you may be able to write off most of the cost of the heavy SUV this year. Next year, the write-off rules may not be as generous.
•Set up a self-employed retirement plan if you are self-employed and haven’t done so yet.
•Increase your basis in a partnership or S corporation if doing so will enable you to deduct a loss from it for this year. A partner’s share of partnership losses is deductible only to the extent of his partnership basis as of the end of the partnership year in which the loss occurs. An S corporation shareholder can deduct his pro rata share of an S corporation’s losses only to the extent of the total of his basis in (a) his S corporation stock, and (b) debt owed to him by the S corporation.
These are just some of the year-end steps that can be taken to save taxes. Again, by contacting us, we can tailor a particular plan that will work best for you.
Very truly yours,
HENRY C KULIK, JR.
CERTIFIED PUBLIC ACCOUNTANT,LLC
114 Merriam Ave; Suite 201
Leominster, MA 01453