High-Income Earners Seek Strategies to Cut Year-End Tax Bite New York (November 15, 2013) By Margaret Collins and Richard Rubin Bloomberg (Bloomberg) The higher tax rates passed by Congress this year have some top U.S. earners seeking last-minute strategies to lower their tax bite as year-end calculations turn up unpleasant surprises. “There are many, many high-income taxpayers now who are finding themselves facing tax rates in excess of 50 percent,” said Suzanne Shier, a tax strategist and director of wealth planning at Chicago-based Northern Trust Corp. “That really gets their attention.” High earners are seeing a combination of federal tax increases for 2013: a top marginal rate of 39.6 percent, up from 35 percent; a 20 percent tax on long-term capital gains and dividends, up from 15 percent; and a new 3.8 percent tax on investment income. Also, limits on exemptions and deductions are taking effect for this tax year. Last minute year-end 2013 tax-saving moves for corporations As year-end approaches, it would be worthwhile for practitioners to consider whether corporate clients could benefit from the following last minute tax-saving moves, including adjustments to income to preserve favorable estimated tax rules for 2014, deferral of certain advance payments to next year, and fine-tuning bonuses to make the most of the Code Sec. 199 domestic production activities deduction. Accelerating or deferring income can preserve estimated tax break. Corporations (other than certain large corporations, see below) can avoid being penalized for underpaying estimated taxes if they pay installments based on 100% of the tax shown on the return for the preceding year. Otherwise, they must pay estimated taxes based on 100% of the current years tax. However, the 100%-of-last-years-tax safe harbor isnt available unless the corporation filed a return for the preceding year that showed a liability for tax. A return showing a zero tax liability doesnt satisfy this requirement. Only a return that shows a positive tax liability for the preceding year makes the safe harbor available. RIA recommendation: A corporation (other than a large corporation) that anticipates a small net operating loss (NOL) for 2013 (and substantial net income in 2014) may find it worthwhile to accelerate just enough of its 2014 income (or to defer just enough of its 2013 deductions) to create a small amount of net income for 2013. This will permit the corporation to base its 2014 estimated tax installments on the relatively small amount of income shown on its 2013 return, rather than having to pay estimated taxes based on 100% of its much larger 2014 taxable income. Also, by accelerating income from 2014 to 2013, the income may be taxed at a lower rate in 2013, e.g., at 15% instead of at 25% or 34%. However, where a 2013 NOL would result in a carryback that would eliminate tax in an earlier year, the value of the carryback should be compared to the cost of having to pay only a small amount of estimated tax for 2014. RIA recommendation: Generally speaking, a taxpayer will be treated as a large corporation for estimated tax purposes only if it had taxable income of $1 million or more in any one of the three preceding tax years. As a result, a corporation that didnt reach that threshold in 2011 or 2012, but expects net income of $1 million or more in 2013 and later tax years, will have an additional incentive for deferring income into (or accelerating deductions from) 2014. If such a shifting of income or deductions lets the corporation avoid reaching the $1 million threshold in 2013, it will be able to use the 100%-of-last-years-tax safe harbor in 2014. References: For corporate estimated taxes, see FTC 2d/FIN ¶ S-5320 et seq.; United States Tax Reporter ¶ 66,554 ; TaxDesk ¶ 609,200 et seq.; TG ¶ 5906 . Accrual basis business can take a 2013 deduction for some bonuses not paid till 2014. An accrual basis corporation can take a deduction for its current tax year for a bonus not actually paid to its employee until the following tax year if (1) the employee doesnt own more than 50% in value of the corporations stock, (2) the bonus is properly accrued on its books before the end of the current tax year, and (3) the bonus is actually paid within the first 2 — months of the following tax year (for a calendar year taxpayer, within the first 2 — months of 2014). References: For when year-end bonuses must be paid—the two and a half month rule, see FTC 2d/FIN ¶ H-3919 ; United States Tax Reporter ¶ 4044.16 ; TaxDesk ¶ 279,511 ; TG ¶ 7577 . For employees on the cash basis (for income that was deferred before it was earned), the bonus wont be taxable income until the following year. The 2013 deduction wont be allowed, however, if the bonus is paid by a personal service corporation to an employee-owner, or by an S corporation to any employee-shareholder, or by a C corporation to a direct or indirect majority owner. References: For deduction for accrued expenses owed to a related taxpayer, see FTC 2d/FIN ¶ G-2701 et seq.; United States Tax Reporter ¶ 2674 ; TaxDesk ¶ 442,027 ; TG ¶ 6225 . Accrual-basis taxpayers can defer inclusion of certain advance payments. Accrual-basis taxpayers generally may defer including in gross income advance payments for goods until the tax year in which they are properly accruable for tax purposes if the income inclusion for tax purposes isnt later than it is under the taxpayers accounting method for financial reporting purposes. An advance payment is also eligible for deferral—but only until the year following its receipt—if: 1. Including the payment in income for the year of receipt is a permissible method of accounting for tax purposes; 2. The taxpayer recognizes all or part of it in its financial statement for a later year; and 3. The payment is for (a) services, (b) goods (other than goods for which the deferral method discussed above is used), (c) the use of intellectual property (including by lease or license), (d) the occupancy or use of property ancillary to the provision of services, (e) the sale, lease, or license of computer software, (f) guaranty or warranty contracts ancillary to the preceding items, (g) subscriptions in tangible or intangible format, (h) organization membership, and (i) any combination of the preceding items. RIA illustration An accrual-basis calendar-year taxpayer received a payment on Nov. 1, 2013 for a contract under which it will repair a customers computer equipment for two years. In its financial statements, the taxpayer recognizes 25% of the payment in 2013, 50% in 2014, and 25% in 2015. For tax purposes, under the deferral method discussed above, the taxpayer can report 25% in 2013 and defer 75% to 2014. The deferral method cannot be used for (1) rent (unless its for items (c), (d), or (e), above), (2) insurance premiums, (3) payments on financial instruments (e.g., debt instruments, deposits, letters of credit, etc.), (4) payments for certain service warranty contracts, (5) payments for warranty and guaranty contracts where a third party is the primary obligor, (6) payments subject to certain foreign withholding rules, and (7) payments in property to which Code Sec. 83 applies. If an advance payment is only partially attributable to an eligible item, it may be allocated among its various parts, and the deferral rule may be used for the eligible part. Taxpayers wishing to change to the above method may use automatic consent provisions (with certain modifications). Advance consent procedures apply in certain cases, e.g., where advance payments are allocated. References: For advance payments received by accrual basis taxpayers, see FTC 2d/FIN ¶ G-2540 et seq.; TaxDesk ¶ 441,708 et seq.; United States Tax Reporter ¶ 4514.166 ; TG ¶ 6208 et seq. Making the most of the domestic production activities deduction. Businesses can claim a domestic production activities deduction under Code Sec. 199 to offset income from domestic manufacturing and other domestic production activities. The Code Sec. 199 deduction equals 9% of the smaller of— a. The taxpayers qualified production activities income or QPAI, for the tax year, or b. The taxpayers taxable income (modified adjusted gross income, for individual taxpayers), without regard to the Code Sec. 199 deduction, for the tax year. Qualified production activities eligible for the deduction include items such as: the manufacture, production, growth or extraction of qualifying production property (i.e., tangible personal property such as clothing, goods, or food as well as computer software or music recordings) by a taxpayer either in whole or in significant part within the U.S.; construction or substantial renovation of real property in the U.S., including residential and commercial buildings and infrastructure such as roads, power lines, water systems, and communications facilities; and engineering and architectural services performed in the U.S. and relating to the construction of real property. (Code Sec. 199(c)(4)) However, the Code Sec. 199 deduction cant exceed 50% of the W-2 wages of the employer for the tax year. Generally, these wages are the sum of the aggregate amounts that must be included on the Forms W-2 of employees under Code Sec. 6051(a)(3) (i.e., wages subject to withholding) and Code Sec. 6051(a)(8) (elective deferrals). The wages must be allocable to the taxpayers domestic production activities, and they include tips and other compensation as well as elective deferrals to 401(k) and other plans. (In addition, the otherwise allowable Code Sec. 199 deduction of a taxpayer with oil-related QPAI is subject to a special reduction.) It is important for businesses to calculate the tentative Code Sec. 199 deduction and the W-2 deduction cap before year-end. If the deduction cap will limit the otherwise available deduction—for example, in the case of a closely held business whose owners do not draw substantial salaries—the business may want to bonus out additional compensation to maximize the Code Sec. 199 deduction. Bear in mind that in some cases, an accrual-basis corporation can deduct a bonus that is declared before year-end but not paid until the following year (see discussion above). Taxpayers also need to factor the Code Sec. 199 deduction into other year-end tax planning strategies. For example, when determining whether to defer or accelerate income, a taxpayer must determine the marginal tax rate for each year. For this purpose, the Code Sec. 199 deduction will have the effect of decreasing the taxpayers marginal rate. References: For the domestic production activities deduction, see FTC 2d/FIN ¶ L-4385 et seq.; United States Tax Reporter ¶ 1994.001 ; TG ¶ 16545 ; TaxDesk ¶ 307,801 ; TG ¶ 16551. Some top earners are only now realizing they may owe much more by April 15 because they’ve been paying quarterly estimated taxes based on their liability for 2012, which the Internal Revenue Service allows in a “safe-harbor” rule, said Elda Di Re, a partner at Ernst & Young LLP. Others are absorbing the effects as they rush to implement strategies before Dec. 31 to limit the tax bite on earnings, market gains and stakes in businesses. States’ Take State taxes can push the bill higher for some high earners. In California, the top rate is 13.3 percent on income exceeding $1 million. Investors with significant portfolios are seeing some of the biggest increases this year, said Martin Kalb, co-chairman of the global tax group at Greenberg Traurig LLP. For wealthy taxpayers, the rate on long-term capital gains and qualified dividends now can be as much as 25 percent, including the new surtax and limits on deductions, Kalb said. That’s a 67 percent increase from 2012. The rate on other investment income such as royalties, interest and rents can exceed 43 percent. “Clients are a little startled at the amount of additional taxes they are paying,” said Maury Cartine, a partner at Marcum LLP whose clients include private equity and hedge fund managers. According to an analysis by Cartine, a married couple in New York with $600,000 in wages, $100,000 in qualified dividends and $300,000 in long-term capital gains—as well as $145,000 in itemized deductions for real estate taxes, mortgage interest and state and local taxes—would pay about 17 percent, or $37,000, more in U.S. taxes this year. $450,000 Threshold By comparison, a family with $600,000 in wages, no investment income and $105,000 in itemized deductions would see about a 2 percent, or $3,000 increase, he said. Congress set the top tax rate for income above $450,000 for married couples or $400,000 for individuals, after deductions. Those are the same thresholds for the top levy on long-term capital gains and dividends. Additionally, two new taxes to help finance the 2010 health-care law—a 3.8 percent surtax on investment income and 0.9 percent added levy on wages—apply to income of more than $250,000 a year for married couples and $200,000 for individuals. Lawmakers also reinstated phaseouts of personal exemptions and itemized deductions for adjusted gross income exceeding $250,000 for individuals and $300,000 for married couples. ‘Big Surprise’ “It’s going to be a big surprise when they find out they aren’t going to be able to take all of their itemized deductions,” said Tracy Green, a vice president in tax and financial planning in the advisory unit of Wells Fargo & Co. With less than two months left in the tax year, advisers and accountants are focusing on clients with closely held business stakes, mutual-fund holdings, charitable donations and retirement accounts to help maneuver around higher rates. To minimize the effect of the 3.8 percent tax, high earners are reviewing their interests in S corporations and other flow-through entities to see if they can become active rather than passive participants, said William Zatorski, a partner in PricewaterhouseCoopers LLP’s private company services practice. Business income from active participation isn’t subject to the surtax and that shift in S corporations doesn’t trigger self- employment tax, he said. This year’s stock market rally—the Standard & Poor’s 500 Index returned 25 percent through October—has tax implications for many investors with mutual funds, said Green of Wells Fargo Advisors. Capital Gains “This year the chances of having long-term capital gain distributions are going to be pretty good,” she said. Mutual fund companies are releasing estimates of distributions this month, which investors can use to plan, Green said. Those intending to sell a fund should do so before distributions, while investors seeking to buy shares should wait until after, she said. Some high earners may have to shift their usual year-end strategies because the new top rate means they are no longer subject to the alternative minimum tax, or AMT, said Di Re of Ernst & Young. Taxpayers not subject to the minimum tax can pre-pay state income or real estate taxes before Dec. 31 to lower their taxable income, Zatorski of PwC said. Bumping up charitable donations is another strategy, Kalb of Greenberg Traurig said. Taxpayers with gains in publicly traded stocks can donate them to a public charity or their own private foundation. They’d be eligible for a charitable deduction equal to the fair value of the security, and would avoid the long-term capital gains rates, he said. Retirement Plans Individuals age 70 1/2 or older should consider giving as much as $100,000 to a qualified charity directly from an individual retirement account, Wells Fargo’s Green said. The donation can meet all or a portion of the annual required minimum distribution for IRA owners and isn’t recognized as income. Also, high earners can maximize contributions to tax-advantaged retirement plans and realize some losses to offset capital gains, Green said. Another recommended strategy is to defer income by investing in private-placement life insurance and private annuities. These are designed for high net-worth individuals, Kalb said. Looking Ahead Beyond 2013, high-income investors can add tax-exempt bonds or convert some retirement savings to Roth accounts, Green said. When savers put money into Roth IRAs and Roth 401(k)s, they pay taxes on the money upfront in exchange for tax-free withdrawals later. Funds that capture losses throughout the year to offset gains will be especially attractive to investors because the strategy can reduce net income reported on tax returns at year-end, Shier of Northern Trust said. Once high earners figure out this year’s strategy, advisers are saying they should keep an eye on moves in Congress that could change their future tax picture. House and Senate panels are considering making the biggest changes to the U.S. tax code since 1986. Representative Dave Camp, chairman of the House Ways and Means Committee, wants to lower the top individual rate to 25 percent in a way that would require eliminating or curbing many tax breaks. Camp, a Michigan Republican, has said he will release a plan this year. Passage of any revisions would be difficult and wouldn’t happen until sometime in 2014, at the earliest. The possibility of more tax changes has some high earners taking advantage while they can of breaks such as the sales tax deduction, Kalb said. That benefit, which allows deducting sales tax instead of state income tax, is set to expire Dec. 31 along with some other breaks. “A lot of my clients are looking to buy very expensive assets that will pay a lot of sales tax, especially in Florida,” which doesn’t have a personal income tax, Kalb said. “If someone buys a $2 million boat this year, they can get the deduction for sales taxes.”
Posted on: Mon, 02 Dec 2013 20:01:11 +0000
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