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Blake Christian
Blake Christian

2013 tax changes require thorough year-end tax planning

If Congress does not act before the end of 2012, tax planning will present many challenges (and opportunities) for taxpayers.

August 23, 2012
by Blake E. Christian, CPA

As the end of calendar 2012 and the November elections approach, the political debate over tax rates and which group of individuals is currently bearing their “proper” tax burden is intensifying. Following is a brief overview of the history of our current federal rate system and why the current rates will expire absent congressional action. In addition, this article reviews the federal tax increases resulting from the new health care taxes. In short, taxpayers making more than $250,000 (married filing jointly (MFJ)), or $200,000 (single), may experience 2013 marginal tax rate increases ranging from 13% to 189%—depending on the character of the income.

How did we get here?

The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), P.L. 107-16, was signed by President George W. Bush. EGTRRA lowered tax rates and simplified retirement and qualified plan rules. Some of the major tax areas affected included income tax, capital gains tax, qualified retirement plans, educational savings incentives, and estate and gift tax. EGTRRA was estimated as a $1.3 trillion tax cut over the initial 10-year period.

Subsequently, Congress passed the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), P.L. 108-27. JGTRRA increased the basic alternative minimum tax (AMT) exemption amount to $58,000 (MFJ) and $40,250 (single). It also established a maximum rate of 15% applicable to long-term capital gains and dividend income. JGTRRA reduced overall taxes by an additional $350 billion over 10 years.

Together, EGTRRA and JGTRRA have become known as “the Bush tax cuts.” Some of the more significant 2001 and 2003 tax breaks were as follows:

  • Personal income tax rates dropped from a top rate of 39.6% to 35% (taxable income at or above $311,950 MFJ or single taxpayers);
  • “Qualified dividend income” rates dropped from a maximum of 39.6% to 15%; and
  • Maximum long-term capital gains tax rates generally dropped from 20% to 15%.

Since Congress used the streamlined “reconciliation” process rather than the “normal” legislative process, the 2001 and 2003 tax cuts were set to expire at the end of 2010; however, due to the 2008 debt crisis and languishing economy, these provisions were extended by Congress for two additional years under the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010, P.L. 111-312, which was signed by President Barack Obama in December 2010.

Health Care Act Changes

In addition to the already scheduled income tax rate increases, the Patient Protection and Affordable Care Act (PPACA), P.L. 111-148, imposes, beginning in 2013, an additional 0.9% Medicare hospital insurance tax (HI tax) that will apply to wages or self-employment income of individuals with earnings exceeding $250,000 (MFJ), $200,000 (single), or $125,000 (married filing separately (MFS)). What is more, the PPACA will impose a new 3.8% “net investment income tax” on unearned income for individuals exceeding these same income thresholds. This 3.8% tax is on top of any tax rate increase in dividends, capital gains, and ordinary income.

The 3.8% tax will not apply to certain types of income, including qualified plan distributions or income from the disposition of “active” LLCs, partnerships, and S corporations. “Active” trade or business income will generally not be subject to the 3.8% net investment income tax (Sec. 1411(c)(2)). These higher rates apply to taxable income of trusts with undistributed net income in excess of the dollar amount at which the highest tax bracket for trusts begins ($11,650 in 2012).

A summary of the current and future rates are reflected in the following chart:

 

Income Type

Maximum Marginal Tax Rate

Maximum Marginal Tax Rate

New Medicare Hospital Insurance tax (HI tax)*

New Net Investment Income Tax (other than earned income)*

Combined Maximum Marginal Tax Rate

Net Percentage Increase

Current Law (Pre-1/1/13)

(Post-12/31/12)

(Post-12/31/12)

(Post-12/31/12)

(Post-12/31/12)

(2013 vs. 2012)

Wages and S/E income > $250,000 (MFJ)/>$200,000 (Single)

35%

39.6%

0.9%**

N/A

40.5%

15.7%

Long-Term Capital Gain — Maximum Rate***

15%

20%

N/A

3.8%

23.8%

58.67%

Qualified Dividends

15%

39.6%

N/A

3.8%

43.4%

189.33%

Passive Interest, Rents, Royalties, Other

35%

39.6%

N/A

3.8%

43.4%

24%

Flowthrough Income — Active Trade/Business

35%

39.6%

N/A

N/A

39.6%

13.14%

Flowthrough Income — Passive Trade/Business

35%

39.6%

N/A

3.8%

43.4%

24%

*Health Care Reform Increases > $250,000 (MFJ) > $200,000 (Single)
>$125,000 (MFS)

N/A

0.9% tax on earned income and 3.8% tax on investment income

 

 

 

 

**The 0.9% HI Payroll is an additional tax that applies to wages and self-employment income in addition to the current 1.45% Medicare and 6.2% Social Security taxes.
*** Lower capital gains rates apply to taxpayers in the 10% and 15% ordinary income brackets and to certain assets with holding periods over five years.

If Congress does not take any action before the end of 2012, year-end tax planning will present many challenges (and opportunities) for taxpayers, especially high-net-worth individuals. Contrary to traditional year-end planning, certain high-income taxpayers may want to consider accelerating income into 2012 rather than deferring income into the probable higher tax rates of 2013.

While the tax landscape will not come into clear focus until closer to year end, business owners and high-income individuals need to begin planning for the current year end.

For those taxpayers anticipating that they will fall into a higher tax rate in 2013, there are a number of tax planning ideas for 2012 year end:

  • As of Jan. 1, 2013, qualified dividends will be subject to ordinary income tax rates (an increase from 15% to up to 43.4% (including the new 3.8% Medicare tax). Accordingly, C and S corporations with excess earnings and profits (E&P) should consider making dividend payments before the end of 2012. Cash-poor corporations can also consider making either a cashless “deemed dividend” by year end under Sec. 1368(e)(3) and Regs. Sec. 1.1368-1(f)(3) for S corporations or a “consent dividend” under Sec. 565 for C corporations.
  • Taxpayers may want to accelerate the recognition of capital gains into 2012 instead of deferring the gains to future years, e.g., by selling appreciated stocks, bonds, real estate, and other assets held more than one year.
  • Advance planning is also necessary to mitigate the AMT, which affects millions of mid-to-high income taxpayers and kicks in for AMT income (AMTI) of $150,000 (MFJ) and $112,500 (single). However, once a taxpayer is subject to AMT in a given year, the general tax strategy changes to accelerating taxable income into the AMT year (at a 26% to 28% top marginal AMT rate) and deferring tax deductions into a non-AMT year because the regular tax marginal rates are often higher.
  • Other acceleration strategies for both “regular” and AMT individual taxpayers include exercising stock options; taking bonuses in 2012 vs. deferring; forgoing Sec. 1031 (like-kind exchanges) and/or Sec. 1033 (involuntary conversion) elections; and electing out of installment sales.
  • Tax deductions that taxpayers who own businesses may want to consider pushing into a higher tax year after 2012 include pension/retirement plan funding allocations, which are highly flexible between years; employee and owner bonuses; and timing and elections for asset purchases, such as Sec. 179 “expensing” elections; and not electing 50% “bonus” depreciation for 2012 (to increase depreciation deductions in later years). Evaluating accounting periods and methods may also yield benefits.
  • With the 3.8% net investment income tax on the horizon for 2013, taxpayers with a variety of business interests should be planning to ensure that characterization of activities as “passive” or “active” is optimal for minimizing the regular income tax, the 3.8% tax, and payroll taxes.
  • Finally, with estate and gift tax rates rising from the current 35% maximum rate to 55% and the lifetime exclusion amount decreasing to $1 million beginning in 2013 (down from the $5.12 million amount for 2012), a thorough estate plan review should also be undertaken before year end.

Current and forthcoming political and economic events make it difficult to determine if the Bush tax rates will be extended again for all, or only a subset of, taxpayers. The outcome of the upcoming presidential and congressional elections will strongly influence the direction of both the short-term and long-term U.S. tax system.

For a useful model that can be used for projection purposes, see “Ready to Prepare Your Clients for 2013 Tax Increases?CPA Insider, Aug. 13, 2012.

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Blake E. Christian, CPA, is a tax partner in the Long Beach, Calif., office of Holthouse, Carlin & Van Trigt LLP (www.hcvt.com).