Year-End-Tax-Planning Into the Unknown

I, as was a large part of the U.S. population, watched the second of three Presidential Debates.  At this point, it appears that either President Obama or Mit Romney could win the Presidential Election.  Both candidates have very different tax strategies that will certainly affect our tax situations for years 2013 and subsequent.  However, it is not unheard of to see new tax legislation retroactively applied in an election year.   This makes tax planning very difficult, especially when combined with the Congressional decision to delay any significant tax decision until after the Presidential Election.   In just over a decade, Congress has displayed a pattern of delaying any real tax changes and continued its inability to make clear decisions beginning with Congressionally enacted Economic Growth and Tax Relief Reconciliation Act of 2001 and the Jobs and Growth Tax Relief Reconciliation Act of 2003, which lowered overall tax rates and, by their terms, expired at the end of 2010.  Then, at the end of 2010, Congress enacted the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 with the effect of merely extending the above 2001 and 2003 Tax Acts for two more years.  Now, it’s two years later with no resolution.

Where do we go from here as we responsibility begin to plan for the 2012 year end?  If we assume that

Congress will continue to delay, then the following should be anticipated:

The following tables illustrate, for married individuals filing joint returns, the 2012 tax rates, the projected

2013 income tax rates if Congress does nothing, and the projected 2013 income tax rates if Congress again extends the lower rates.

Table 1. 2012 Rates

Table 2. Projected 2013 Rates if Congress Does Nothing.

Table 3. Projected 2013 Rates if Congress Extends The 2001 and 2003 Lower Rates.

The promise of increasing income tax rates frustrates the very core of modern tax planning. Nearly all tax- savings strategies are based on the two underlying principles that individuals benefit from:

1,  Since I began in the tax arena, deferring income and accelerating deductions has been a standard practice based on future tax legislation and time-value of money. This dual-principled approach is not working, since we may be expecting the tax rates to increase in 2013.  Instead, an analysis of one’s potential tax liability may well prove that payment of tax at current rates results in a lower overall tax burden than if the payment is delayed. Consequently, in anticipation of some adjustment next year in the higher tax rates, individual taxpayers affected by such higher rates may be best served, based on an analysis of a particular individual, by deferring deductions and accelerating income into this year. Qualified individuals should consider the following planning opportunities to take advantage of any future rate increase:

> Recognizing deferred compensation during 2012 as the lower tax year;

> Accelerating the execution of profitable commercial contracts into 2012 for recognition of lower tax rates;

> Postponing charitable cash contributions until 2013 when they will help offset the taxable income and its higher tax rates;  and

> Delaying mortgage interest or deductible health expenditures until 2013.

CAPITAL GAINS RATE

Since 2003, individuals have enjoyed a maximum tax rate of 15 percent on all long-term capital gains. In addition, dividends received by individuals have been taxed at the capital gains rate rather than being treated as ordinary income. Unless the law is changed, beginning January 2013, the capital gains rate will

revert to the pre-2003 rates of 20 percent instead of 15 percent; and taxpayers in lower brackets who did not pay capital gains tax under the 2010 Tax Relief Act will be subject to a 10 percent capital gains tax rate in

2013. Dividends will no longer be taxed as capital gains.

In preparation, you should consider implementing the following techniques where practical:

> Accelerating the sale of property with built-in gains into 2012 before the potential of a tax rate increase of 5% materializes;

> Avoiding realization of losses on sale of depreciated property until 2013 which will help reduce taxable income taxed at higher rates; and

> In the case of C corporations, declaring dividends this year before they are taxed at ordinary income tax rates.

ALTERNATIVE MINIMUM TAX

Congress has increased the Alternative Minimum Tax exemption over the last several years to protect many individuals who perhaps were not intended to be subject to the AMT. However, those increased exemptions expired at the end of 2011. If Congress does nothing, the Alternative Minimum Tax exemption will revert to $45,000 from the $74,450 level applicable prior to 2012, in the case of married taxpayers filing jointly.

MEDICARE CONTRIBUTION  TAX

Beginning in 2013, individuals, estates and trusts are subject to a tax at the rate of 3.8 percent on the lesser of net investment income or excess modified adjusted gross income for the year over a threshold amount. The tax is 3.8 percent of the lesser of the individual’s net investment income for the year or modified adjusted gross income in excess of $200,000 in the case of individuals, $250,000 in the case of joint filers and $125,000 in the case of married taxpayers filing separately.

In the case of an estate or trust, the tax is 3.8 percent of the lesser of undistributed net investment income or any excess of modified adjusted gross income over the dollar amount at which the highest bracket applicable to the year begins ($11,650 for 2012 and possibly $11,950 for 2013).

Separately, and also beginning in 2013, the employee’s share of the hospital insurance tax will be increased by 0.9 percent on wages in excess of $250,000 for married taxpayers filing a joint return, $125,000 for married taxpayers filing separately, and $200,000 in all other cases; as well as will be imposed on net earnings from self-employment.

OTHER CHANGING PROVISIONS

In addition to the increasing income tax, capital gains, dividend, and estate tax rates, other expiring taxpayer-favorable provisions include:

Phase-outofPersonal Exemptions: The personal exemptions for taxpayers with higher incomes will once again be subject to phase-out when their adjusted gross income exceeds an inflation- adjusted threshold. It is estimated that the inflation-adjusted threshold will be $261,650.
Reduction in Itemized Deductions: The overall limitation on itemized deductions under Section

68(g), generally known as the “Pease limitation” (named after the congressman who aided in the

creation of the legislation) will be fully restored so as to limit itemized deductions after December

31, 2012, which will have the effect essentially of further increasing tax rates. This limitation will not apply to deductions for medical and dental expenses, investment interest, and casualty and theft losses.

Reduction in Election to Expense Certain Depreciable Business Assets: Taxpayers may currently elect to expense certain depreciable business assets in the year of purchase rather than capitalize such costs. While the ability to make this election will continue into 2013, the limitations on the amounts for which a taxpayer may elect to expense under this election are drastically reduced.

Reduction of Child Tax Credit: The maximum child tax credit will be reduced from $1,000 to

$500 per child, and the credit may no longer be used to offset Alternative Minimum Tax liability.

Reduction in Credit for Household and Dependent Care Expenses: The dollar limitation for qualified expenses will decrease from $3,000 to $2,400 for one qualifying individual and $6,000 to $4,800 for two or more qualifying individuals. Further, the Applicable Percentage used to determine the amount of expenses that are allowed as a credit will be reduced from 35 percent to 30 percent.

Education Provisions

1.  Interest on Education Loans: The ability to deduct interest payments on student loan debt will only apply to interest paid during the first 60 months of the period in which interest payments are required. Also, the deduction will phase out at modified adjusted gross income amounts, which are estimated to be $75,000 for joint returns and $50,000 for all other returns.

2.  Qualified Tuition and Related Expense: The deduction provided for qualified tuition payments and certain related expenses will no longer be available.

3.  Coverdell: The increase of maximum annual contributions to Coverdell education savings accounts (also known as Educational IRAs) from $500 to $2,000 under Section

530(b)(1)(A)(iii) will be eliminated after December 31, 2012. Furthermore, the definitional expansion of qualified education expenses will revert to its pre-2001 limitation under Section 530(b)(2), which will include the elimination of the definition of elementary and secondary education expenses under Section 530(b)(3). Finally, Section

530(b)(4), allowing current-year contributions to be made until April 15 of the following year, will be eliminated.

Principal Residence Sales Exclusion: The $250,000 exclusion, per qualified person, from gross income of gain on the sale of a principal residence will no longer apply to heirs, estates and qualified revocable trusts that were treated as owned by the decedent immediately prior to death.

Increase in Floor for Deduction of Medical, Dental, etc. Expenses: As amended by the 2010

Patient Protection and Affordable Care Act, the current 7.5 percent of Adjusted Gross Income

floor for deduction medical and dental expenses will be increased to 10 percent.

ESTATE AND GIFT TAXES

The estate, gift and generation-skipping  transfer (GST) tax laws are also scheduled to change significantly on January 1, 2013. Currently the highest estate tax rate is 35 percent and the applicable exclusion per person from the estate and gift tax is $5,120,000. Without Congressional action to alter the scheduled changes, the highest estate tax rate will rise to 55 percent (with a 5 percent surcharge on certain large estates), and the applicable exclusion will decrease to $1,000,000 on January 1, 2013. In addition, portability of the estate tax exclusion will expire on January 1, 2013. The following chart illustrates the dramatic changes in rates and exclusions for the estate, gift and GST taxes.