It may be a good idea to pay more tax this year. This is not what you usually expect to hear from an accountant. However, when we are planning in a time of potential tax rate increases it may be the perfect time to recognize more income and pay tax now at a lower rate.
Bush-era tax cuts will expire if Congress takes no action by the end of the year, resulting in major increases in income, estate, dividend and capital gains taxes, along with more than 50 other major changes in the Federal Tax Code.
While some members of Congress have advocated for an extension of current tax rates to stimulate economic growth, Congress took no action before its pre-election recess. An extension of the current tax rates is still possible but it's a good idea to prepare for the worst.
So what can you do to help your clients prepare?
Planning Opportunities
Regardless of what happens, it is important to help your client develop a plan. Make certain you understand your clients' financial goals and objectives, and know what matters most to them.
Once a plan is in place, many actions can be taken, but we'll focus on five ways to prepare.
1. Convert traditional IRAs to Roth IRAs. Even if Congress were to extend the tax cuts, taxes are likely to increase in the long term to fund the national debt and as health care reform kicks in. Medicare is practically insolvent, and a 3.8% tax on investment income is scheduled to begin in 2013 to help fund it. Medicaid and Social Security are also approaching insolvency and we'll also have to find a way to deal with long-term care and underfunded pension plans.
So wouldn't it be nice to have a source of retirement income that will be tax free, regardless of future tax rates?
Although funds invested in Roth IRAs are taxed up-front, they can grow without being subject to additional taxation. Owners of Roth IRAs are not required to take required minimum distributions and Roth IRAs can even be transferred to heirs, although heirs will be required to take minimum distributions. Since income from Roth IRAs is not included in AGI for calculating federal income taxes, it can also be used in combination with distributions from other retirement accounts to lower the account holder's tax rate during retirement.
Until 2010, conversions were allowed only for taxpayers with adjusted gross income (AGI) of less than $100,000 a year. Now anyone can convert traditional IRAs to Roth IRAs.
If a Roth conversion is appropriate for your client, there are two options with regard to recognition of Roth IRA conversion income:
1) Elect to recognize 100% of the fair market value on the date of conversion as income in 2010 and pay tax at the current tax rates, or
2) Taxpayers can convert in 2010 and defer the recognition of the income until 2011 (50%) and 2012 (50%).
When determining which option is best for your client it is important to note that if the client decides to defer the income recognition until 2011 and 2012 they will pay taxes based on the rates in effect at that time.
There are many other factors to consider in determining if a Roth conversion is right for a particular client. However, consideration of a conversion should be part of everyone's year-end planning process.
2. Make charitable contributions. One strategy for dealing with that hefty tax bill (including the tax on a Roth IRA conversion) is to reduce the tax liability by making charitable contributions. Cash contributions to donor-advised funds (DAF) and public charities are deductible up to 50% of AGI, or 30% of AGI when donating to private foundations.
Contributions of securities or real property held long term that has appreciated in value can provide even better tax benefits. While the deduction is limited to 30% of AGI when donating to a public charity or DAF, and 20% when donating to a private foundation, your client can receive a charitable deduction for the full fair market value of the assets, not just what they paid for them. They will also eliminate capital gains tax that would otherwise be due on a sale.
Charitable contributions, of course, have the dual advantage of reducing taxes and helping your clients achieve their philanthropic goals.
3. Gift assets. The federal estate tax was eliminated for 2010, although heirs will not be able to take a step-up in basis for assets they inherit this year. Next year, if Congress takes no action, assets will be subject to a federal estate tax of up to 55%, with an exemption on the first $1 million in assets. Add in a 5% federal surtax and a 16% Massachusetts rate, and estate taxes may total as much as 76% of asset value!
Death is an unattractive alternative even when it provides a considerable tax benefit, but there are other ways to take advantage of this year's tax rates. One is to suggest that clients gift some of their assets to heirs this year. Taxpayers can gift assets valued up to $13,000 ($26,000 for married couples) to as many people as they want annually without subjecting themselves to the gift tax. In addition, each taxpayer is allowed a lifetime gift exemption of $1 million.
Your clients can leverage their gifts by giving away assets expected to increase in value, such as stocks that have recently fallen in value. They can also gift stock in their business at a discount; if they are gifting minority shares of their company, the stock is worth less than whatever percentage of ownership in their company it represents, because it is not a controlling interest.
They can also gift unlimited assets and pay the gift tax at the current rate, which is equal to the top federal income tax rate of 35%. Next year, if no action is taken, the gift tax rate will be the same as the estate tax rate, with a top rate of 55%.
Grandparents should also be aware that they can make gifts to grandchildren this year without paying a generation-skipping transfer (GST) tax. The GST tax is scheduled to return in 2011 at the same rate as the estate tax, but with a $1 million lifetime exemption. While gifts are exempt from the GST tax this year, gift tax rules still apply.
4. Maximize 2010 income and capital gains. For many taxpayers, the long-term federal capital gains tax rate is scheduled to increase from 15% to 20% on January 1. Additionally, unless Congress acts, the top income tax rate is scheduled to increase from 35% to 39.6%-a 4.6% increase. Qualified dividends will be taxed as ordinary income, instead of at the 15% rate, so some taxpayers would pay nearly 40 cents (versus the current 15 cents) on a dollar of dividend income.
Clients can take advantage of current lower rates by selling securities and other property that has appreciated in value before year end, by accelerating taxable income into this year and by delaying deductions whenever possible. Retired clients may consider taking distributions in excess of the required minimum this year to take advantage of current rates.
5. Take advantage of the Small Business Jobs Act. The Small Business Jobs Act includes several provisions that can benefit business owners and investors.
Increased IRC Section 179 expense limits. Effective through 2011, businesses that purchase qualifying property under IRC Section 179 can expense up to $500,000 during the year of purchase, up from $250,000. In addition, taxpayers can place into service up to $2 million in property before the $500,000 begins to phase out. The definition of qualified property was expanded to include qualified real property. Up to $250,000 of the total $500,000 which can be expensed under Sec. 179 can be qualified real property. Qualified real property includes, qualified leasehold improvements, qualified restaurant property, and qualified retail improvement property. There are limitations and planning opportunities which should be explored prior to year-end.
Extended bonus depreciation. The additional 50% first-year depreciation deduction that was in effect for 2008 and 2009 was extended for one year for qualified property acquired and placed in service during 2010. Certain long-lived property and transportation property placed in service during 2011 will also qualify.
Business credit carry-back enhancement. For 2010, privately held companies will be able to carry back, for up to five years, unused general business credits to offset both regular and alternative minimum tax liabilities. Only those companies that have average annual gross receipts, for the three-tax-year period preceding the tax year, of no more than $50 million can qualify for this provision.
Small business stock exclusion. In general, no regular tax or alternative minimum tax will be imposed on the sale of qualified small business stock issued and acquired between September 27, 2010, and January 1, 2011, if the stock is held for at least five years.
S Corporation built-in gain. Generally, a C corporation converting to an S corporation must hold onto any appreciated assets for ten years or face a built-in gain tax at the highest corporate rate of 35%. The 2010 Small Business Jobs Act temporarily shortens the holding period of assets subject to the built-in gains tax to five years if the fifth tax year in the holding period precedes the tax year beginning in 2011.
In Summary
While these suggestions can help reduce the blow of a potential tax increase, any major changes your clients consider making should be reviewed in the context of their overall financial goals and objectives.
For example, investors who are considering investing in a small business are likely to want to make the investment now and take advantage of 100% relief from capital-gains taxes rather than wait until next year, when the tax break drops to 50%. But investing in a business is a decision not to be taken lightly and investors are unlikely to rush into it just to take advantage of the tax break.
Likewise, individual taxpayers will need to review their personal goals carefully. For example, converting a traditional IRA to a Roth IRA may be a good idea for some taxpayers, but may not be for those who are close to retirement and do not have a long period during which their earnings can grow tax free. Conversions are also not recommended for those who lack the means to pay taxes on the conversion.
Planning would be much easier if we knew for certain what changes will take place in the Federal Tax Code next year. However, given that we may not know what will happen until very late this year, it is important to work closely with your clients and plan now.
Laura Barooshian, CPA, MST, is a principal in the Private Clients group at DiCicco, Gulman & Company, a Woburn-based CPA and business consulting firm. In the course of providing tax planning and compliance services to high-net-worth individuals, she regularly presents clients with philanthropic planning alternatives. Laura can be reached at 781-937-5332 or [email protected].
Joel Rothenberg, CPA, JD, LLM, is a partner in the firm's Commercial Business group. He specializes in sophisticated tax matters affecting high-net-worth individuals, including owners and advisors for closely held companies and other entrepreneurs. Joel can be reached at 781-937-5135 or [email protected].