Income Tax Update – Winter 2011

By Scott C. Miller

While you have many pulls on your time, we ask you to take a few minutes to read through this newsletter.  In this communication, we hope to provide you with some things to consider that might affect your income taxes in 2011 and beyond. Effective tax strategy can involve planning for permanent reductions in taxes, but it often involves moving tax liabilities from the current year to the next, which means that good tax planning can be as simple as deferring your tax liability. No major tax acts have been passed thus far in 2011, but Congress has shown in the past that they have no problem changing tax laws or creating new tax laws with little warning. As a reminder, the consensus is that tax rates will increase in the future, especially for upper income taxpayers, and preferred rates on dividends and capital gains could be threatened. With those caveats, we have arranged the following into sections affecting Individuals and Businesses.

INDIVIDUALS

Alternating Standard and Itemized Deduction Years by Prepaying Deductible Expenditures

If you are just under, or just over, the itemized deductions threshold amount every year, consider “bunching” together expenditures for itemized deduction. That strategy may allow you to itemize every other year, while claiming the standard deduction in the intervening years. The 2011 standard deduction for married joint filers is $11,600, single filers $5,800, and $8,500 for heads of households.

To illustrate: assume a joint filer has itemized deductions of about $4,000 of annual property taxes and about $8,000 of home mortgage interest. If the 2012 real estate taxes (remember these are really 2011 taxes, if you live in Illinois) are prepaid by December 31 of this year, the taxpayer could claim $16,000 of itemized deductions on the 2011 return ($4,000 of 2011 property taxes, plus another $4,000 for the 2012 bill, plus the $8,000 of mortgage interest). Next year, only the $8,000 of interest is deductible, but the standard deduction could be claimed, which will be about $12,000. With this method, the overall taxable income could be reduced over the two-year period. This can work with medical bills, state estimated tax payment, mortgage interest and other expenses as well, but the expenses must be current obligations and not prepayments.

Consider Deferring Income

Another timing consideration – it may be beneficial to defer some taxable income from this year into next year, especially if you expect to be in a lower tax bracket in 2012. For example, if you are a sole proprietor using the cash-method of accounting, you can delay recognizing taxable income by waiting until late in the year to send out client invoices. That way, you won’t receive the income until early 2012, which is when the income would be taxable to you. The flip side of the coin also works in that you can also postpone taxable income by accelerating some deductible business expenditures into this year. In addition, shifting income can also be helpful if you’re adversely affected by phase-out rules that reduce or eliminate various tax breaks (child tax credit, education tax credits, and so forth). However, if tax rates increase in the future, you may prefer to pay taxes at today’s lower rates.

Consider Investment Gains and Losses

While reviewing your investments held in your brokerage firm accounts, you should consider the impact of selling appreciated securities this year. The maximum federal income tax rate on long-term capital gains realized from 2011 sales of securities held over a year is only 15%. As a result, it often makes sense to hold appreciated securities for at least a year and a day before selling.

Cleaning out the losers in your portfolio by selling before year-end can also be a good idea. The resulting capital losses can offset capital gains from other sales this year, including short-term gains from securities owned for one year or less, which would otherwise be taxed at higher ordinary income rates. The bottom line is that you don’t have to worry about paying a higher tax rate on short-term gains if you have enough capital losses to shelter the gains.

As with most things in the tax world there is a limit.  If your capital losses are greater than your capital gains you can use that net capital loss to shelter up to $3,000 of this year’s high-taxed ordinary income ($1,500 if you’re married and file separately). Any excess net capital loss is carried forward to next year.

Since your can carry forward the excess net capital losses into 2012 and beyond, having net capital losses that exceeds what you can use in the current year can be useful. This will give you some extra investing flexibility in 2012 and beyond because you won’t have to hold appreciated securities for over a year to get better tax results. Subject to any changes by Congress, the maximum federal income tax rate on long-term capital gains is scheduled to increase to 20% for 2013 and beyond (up from the current 15%). Also, the top two federal rates on ordinary income (including net short-term capital gains) are scheduled to increase for 2013 and beyond to 36% and 39.6% (up from the current 33% and 35%).

Charitable Contributions

Gifts to Relatives – Avoid giving away securities with losses (securities currently worth less than their cost). Instead sell the securities, take advantage of the resulting capital loss and then, give the cash proceeds to the relative. On the other hand, securities that have increased in value are ideal for gifting to relatives. In many cases, the relatives will be in a lower tax bracket and will pay less tax if they sell the securities. In fact, people who are in the 10% or 15% federal income tax brackets will generally pay a 0% federal tax rate on long-term gains from securities that were held for over a year before being sold. Even if the securities were held for one year or less before being sold, the relatives will probably pay a lower tax rate than you would (typically only 10% or 15%). However, note that gains recognized by a relative who is under age 24 may be taxed at his or her parent’s higher rates under the “Kiddie Tax” rules.

Gifts to Charities – The advice for gifts to relatives also works for gifts to IRS-approved charities. Sell securities with losses and claim the loss on your return, then give the cash to the charity and claim the resulting charitable write-off (assuming you itemize deductions). This results in a double tax benefit – a capital loss and a charitable contribution. With securities with gains, you should give the security to charity instead of giving cash. For publicly traded shares that have been held for over a year, your charitable deduction equals the full current market value at the time of the gift. In addition, you effectively “give” away the related capital gains (the charity will not pay tax on the gain). This strategy also “gives” away the capital gain and creates a charitable contribution.

Make Charitable Donations from an IRA – The law permits IRA owners and beneficiaries who have reached age 70½ to make cash donations totaling up to $100,000, to IRS-approved public charities, directly out of their IRAs. These “Qualified Charitable Distributions”, or QCDs, are federal-income-tax-free to you, but you get no itemized charitable write-off on your Schedule A. The good news, however, is that the QCD counts towards your required minimum distributions. If you’re interested in taking advantage of the QCD strategy for 2011, you will need to arrange with your IRA trustee for money to be paid out directly to one or more qualifying charities before year-end. This privilege is scheduled to expire at the end of 2011, unless Congress extends it.

Convert Traditional IRA into Roth IRA

Converting your traditional IRA into a Roth IRA is always worth considering, but the timing for a conversion may be good if the market value of your traditional IRA has declined this year. If your traditional IRA account has declined in value, the tax hit from converting your traditional IRA into a Roth IRA would also be less than it would have been at the market peak earlier this year. Remember that a Roth conversion is treated as a taxable liquidation of your traditional IRA, followed by a nondeductible contribution to the new Roth IRA. There will be a tax burden, even if it is reduced, but it is often beneficial to take the current tax hit in order to enjoy the future benefits of the Roth IRA. After the conversion to a Roth, all the income and gains that accumulate in the Roth, as well as all withdrawals, will be totally free of any federal income taxes as long as the investment has been held for 5 years and the taxpayer is age 59 ½. In contrast, future withdrawals from a traditional IRA are taxable at ordinary tax rates.

This decision is not without challenge.  You have to have the immediate cash resources to pay the up-front conversion tax bill and it has to make sense in your overall financial and estate planning circumstances. For example, converting a big account all at once could push you into much higher 2011 tax brackets, which might have repercussions on your available cash and investing objectives. You must also make assumptions about future tax rates, how long you will leave the account untouched, the rate of return earned on your Roth IRA investments, estate planning goals, and so forth. If the Roth conversion idea intrigues you, please contact us for a full analysis of the relevant variables.

BUSINESSES

Section 179 Deduction

A business may be able to take advantage of the current Section 179 deduction. Under Section 179, an eligible business can claim a first-year depreciation write-off for the entire cost of new and used equipment and software purchases. For tax years beginning in 2011, the maximum Section 179 deduction is $500,000. For tax years beginning in 2012, however, the maximum deduction is scheduled to drop back to $125,000. One restriction is that a Section 179 deduction is not allowed to create or increase a loss, so the deduction may be limited for 2011 (any unused deduction would be carried over).  Another restriction is that the Section 179 deduction will need to be recaptured if you sell or dispose of the equipment before the recapture period has expired.

Generally, real property improvement costs are ineligible for the Section 179 deduction. However, in 2011 a Section 179 election of up to $250,000 can be taken for qualified improvement costs for the following types of real property:

-       Interiors of leased nonresidential buildings

-       Qualified restaurant property

-       Qualified retail improvements

The $250,000 Section 179 allowance for real estate improvements is part of the overall $500,000 allowance. This temporary real estate break will not be available for tax years beginning after 2011 unless Congress extends it. Again, the Section 179 deduction for qualified real property can not create or increase a loss.

100% First-Year Bonus Depreciation

In addition to a possible Section 179 deduction, a business can also claim first-year bonus depreciation equal to 100% of the cost of most new (not used) equipment and software placed in service by December 31 of this year. For a new passenger auto or light truck that’s used for business and is subject to the luxury auto depreciation limitations, the 100% bonus depreciation break increases the maximum first-year depreciation deduction by $8,000 for vehicles placed in service this year. Again this is a provision slated to expire at year-end unless Congress extends it.

Please note that unlike Section 179, the 100% bonus depreciation deductions can create or increase a net operating loss (NOL) for your business’s 2011 tax year. You can then carry back a 2011 NOL to 2009 and 2010 and collect a refund of taxes paid in those years.

S Corp Conversions – Limited Built-in Gains Tax Break

When a C corporation converts to an S corporation status, there is often a corporate-level “built-in gains” tax that can apply when certain assets (such as receivables and inventories) are turned into cash or sold within the recognition period. The recognition period is normally the 10-year period that begins on the conversion date. However, for tax years beginning in 2011, there is an exemption from the built-in gains tax if the fifth year of the recognition period preceded the 2011 tax year. Therefore, making asset sales that would trigger built-in gains this year (instead of in future years) is something to consider if those gains would be exempt from the built-in gains tax.

Illinois Increased Rates and Reduced NOL Carryovers

Effective January 1, 2011, the Illinois income tax rates have been increased.  For C corporations, the Illinois corporate income tax rate increased from 4.8% to 7% (a 46% increase).  C corps also pay “replacement” tax at a rate of 2.5%, which did not increase, bringing the total C corp tax rate to 9.5%.  For individuals, trusts and estates the rate increased from 3% to 5% (an effective increase of 67%).  If not planned for properly, these rate increases will lead to unanticipated tax liabilities when the 2011 Illinois returns are filed. Also be aware that Illinois has suspended the ability for C corporations to utilize any net operating losses (“NOLs”) for tax years ending after December 31, 2010 through December 31, 2014.  If a net operating loss is incurred in 2011, for instance, a C corp will not be allowed to carry the loss back to a prior year to get a refund of prior taxes paid. Many businesses have historically counted on these carrybacks to provide cash during difficult economic times.

Estate Planning

For 2011 and 2012, the unified federal gift and estate tax exemption is a relatively generous $5 million. However, the exemption will drop back to only $1 million in 2013 unless Congress takes action. In addition, the maximum federal estate tax rate for 2011 and 2012 is 35%. For 2013 and beyond, it is scheduled to rise from the current 35% to 55%. Therefore, planning to avoid or minimize the federal estate tax should still be part of your overall financial plan. Even if you already have an estate plan, it may need updating to reflect the current $5 million exemption.