There are many factors contributing to tax uncertainty at this time. For individuals and tax practitioners alike, planning over the next several years is going to be challenging, to say the least, because of this uncertainty. Still, working within the framework of what is known can produce tax savings for those who take appropriate action. Understand the forces at work and the opportunities available now.
What is contributing to uncertainty?
There are several pieces of legislation that intersect, resulting in some tax provisions expiring, some taking effect, and others simply unknown:
- The Budget Control Act of 2011 (P.L. 112-25), enacted in August to save the country from default, could result in changes from the bipartisan joint committee authorized to raise $1.5 trillion over 10 years. What these changes might be is entirely unknown at this time. Proposals are scheduled to be voted on in Congress before the end of this year.
- A jobs bill, following the President’s plan for job creation, could introduce new tax incentives for employers. Again, what these changes might be, when they would take effect, and how long they would run, is also unknown. The President proposes but it is up to Congress to enact.
- About two dozen tax provisions affecting individuals and businesses, which were extended temporarily by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312), are set to expire at the end of 2011.
- Core provisions, including income tax rates, estate and gift tax rules, and other rules under the so-called Bush tax cuts, which were also extended temporarily by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 (P.L. 111-312), are scheduled to expire at the end of 2012.
- Several tax increases are set to begin in 2013 under the Patient Protection and Affordable Care Act of 2010 (PPACA) (P.L. 111-148), but constitutional challenges to this law may undo scheduled tax hikes. Also, the 2012 presidential race, along with elections in Congress, could produce dramatic political changes. These changes could lead to new or different tax policies, depending on who the winners are. What does all this mean for tax planning? It is necessary to drill down to the fine points of tax law to find tax-saving opportunities that can be used now.
Income tax planning
Because there is no long-term certainty about tax rates or other tax rules, it is difficult to nail down long-term planning strategies. Short-term savings can, however, be achieved by taking advantage of expiring provisions:
- Homeowners who have not previously made energy-saving improvements may want to do so before the end of the year (Code Sec. 25C). A federal tax credit of up to $500 may be claimed. There may also be state-level tax breaks for energy improvements (find state-level incentives at www.dsireusa.org).
- Homebuyers who obtain mortgage insurance to swing the purchase before the end of this year can deduct the premiums as home mortgage interest if income is below set limits (Code Sec. 163(h)(3)).
- Those age 70-1/2 or older can transfer up to $100,000 from their traditional IRA to a public charity tax free (Code Sec. 408(d)(8)), minimizing their adjusted gross income. Besides reducing income tax, it can minimize or avoid a Medicare surtax for Part B premiums in 2013 (which is based on 2011 adjusted gross income.
- Buying business equipment, which can be fully deductible using 100% bonus depreciation for new property (Code 168(k)(5)) or up to $500,000 under first-year expensing for pre-owned property (Code Sec. 179). Next year, bonus depreciation is set to be 50%, while first-year expensing will be only $125,000 (adjusted for inflation).
- Leasehold, restaurant, and retail improvements made before the end of this year qualify for 100% bonus depreciation (Code Sec. 168(k)(5)). Next year, bonus depreciation is set to be 50%; the balance of the cost of these improvements will have to be depreciated.
- Making certain charitable contributions, which entitles certain businesses making specific types of donations (e.g., books, food inventory, computers) to enhanced deductions (Code Sec. 170(e)).
- Expensing of certain capital business costs, including film and television production costs (Code Sec. 1818(f)), environmental remediation costs (Code Sec. 198), and mine safety equipment (Code Sec. 179E)).
- Investing in a qualified small business (a domestic C corporation involved in manufacturing, technology, retail, or wholesale activities) in order to qualify for a 100% exclusion on gain from the sale of stock held more than five years (Code Sec. 1202).
Some or all of these breaks could be extended beyond 2011, but there is no guarantee. The Joint Committee on Taxation has a complete list of provisions set to expire this year through 2020 at www.jct.gov/publications.html?func=startdown&id=3722.
Understanding slated changes
Changes set to become effective in 2013 may lead to some tax action now. (As mentioned earlier, these changes could be eliminated by court decisions on the PPACA or by a new Congress.) In 2013, there are two key tax changes that are scheduled to apply:
- There is a 0.9% Medicare tax on wages and self-employment income over $200,000 for single individuals and $250,000 for married couples (Code Sec. 3101(b)(2)). This additional tax applies only to the employee share of Medicare tax and the employee portion of the Medicare tax within the self-employment tax.
- There is a 3.8% Medicare tax on investment income if modified adjusted gross income (MAGI) exceeds $200,000 for single individuals and $250,000 for married couples (Code Sec. 1411). The tax applies to the greater of net investment income or MAGI over the $200,000/$250,000.
The result of these changes could be realignment of investment portfolios. For example, tax-exempt bonds may become more attractive, despite current low yields, in view of these Medicare surtaxes for higher-income individuals. Conversions to Roth IRAs before 2013 will help to reduce MAGI when taxpayers would otherwise have to begin to take required minimum distributions (note that the surtax does not apply to IRA distributions). Deferred annuities and life insurance may also be attractive.
Wealthy individuals may want to take another look at using family limited partnerships and family limited liability companies to hold investments for the family. These entities will not pay the Medicare surtaxes. However, these entities should only be set up with the assistance of tax professionals who are knowledgeable in estate planning to ensure the entities have a business purpose and meet other tax rules so they will not be disqualified.
For small businesses, there may be a shift from sole proprietorships and limited liability companies (LLCs) to S corporations to minimize the 0.9% surtax on wages and self-employment income. Self-employed individuals, including LLC members in most cases, pay self-employment tax (which includes the Medicare tax) on their share of business profits, while S corporation owner-employees only pay FICA (which includes the Medicare tax) on wages. Thus, S corporations can be used to limit this surtax for business owners.
Estate tax planning
Currently, there is a $5 million exemption amount for transfers during life or at death. This exemption amount applies through 2012. What the estate, gift, and generation-skipping transfer tax rules will be after 2012 remains to be seen.
Lifetime transfers are a way to reduce the size of an estate, and some wealthy individuals may want to take full advantage of the exemption for lifetime transfers. Those who utilized the former $1 million lifetime exemption amount for gifts can now make an additional $4 million in gifts tax free.
All individuals probably want to review their estate plans. The goal for many individuals will be to retain flexibility for these plans so they are adaptable to tax changes that may result.
Between now and the end of the year, individuals can make tax-free gifts that do not erode the lifetime exemption amount. The annual exclusion limit for gifts in 2011 is $13,000 per individual ($26,000 if a spouse consents to the gift). This limit applies on a per-donee basis. Thus, a single grandparent with four married grandchildren could give away $104,000 ($13,000 x 8, which is 4 grandchildren and 4 of their spouses).
Those who want to add funds to a child’s or grandchild’s 529 college savings plan can do so to optimize lifetime transfers. A contribution of $65,000 can be made gift-tax free; under a special rule, five times the annual exclusion limit, or $65,000 ($13,000 x 5) can be made in a single year.
Final word
Any tax changes enacted before the end of 2011 could produce saving opportunities. Stay alert to possible new tax laws and actions to take as a result.
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