Planning for 2013
Considerations to address now
Excerpted from The 2013 Essential Tax and Wealth Planning Guide
Earlier this year, the Supreme Court upheld the constitutionality of the individual mandate — the cornerstone of the Patient Protection and Affordable Care Act of 2010 (PPACA). It’s now virtually certain that new Medicare taxes enacted, which target earned and investment income of high-income individuals, will come into force in 2013. The Medicare taxes are not the only tax changes potentially on the horizon for high-income individuals. Without congressional intervention, the temporary estate tax regime and the Bush-era tax cuts — including lower marginal rates, preferential rate for dividends, 15% rate on long-term capital gains, and an end to limitations on itemized deductions, among other things — will sunset at the end of 2012.
With political parties and presidential nominees divided over their approach to tax reform and the taxation of high-income individuals, taxpayers should not expect the uncertainty over the future of rates to be resolved quickly. As this publication goes to press, it is too early to know if or when tax reform will be addressed prior to the scheduled expiration at the end of 2012. It is expected that the uncertainty will continue through the November 2012 elections, until it is resolved in one of the three potential outcomes: an extension of current rates, tax reform accompanied by lower rates, or tax reform accompanied by tax increases.
In planning for 2013, taxpayers will need to give thought to the impact of the Medicare taxes as well as Congress’ actions with respect to the Bush-era tax cuts. Next we will discuss the Medicare taxes and present potential planning considerations. Later in this section we will address various planning opportunities that may be applicable depending on your view about the future of tax rates.
As detailed in Still standing — Planning for the high-wealth tax increase ahead, in addition to facing uncertainty surrounding individual income tax rates for 2013, you also will need to consider an additional tax starting in 2013. The PPACA, as modified by the Health Care and Education Reconciliation Act of 2010 (“the Reconciliation Act”), includes rate increases applicable to high-income taxpayers in taxable years beginning after December 31, 2012. A significant portion of the revenue raised by the Act comes in the form of an additional Medicare tax hike that will affect higher-income taxpayers and a new net investment income tax levied on some types of unearned income.
Medicare Hospital Insurance (HI) tax: The top individual income tax rate in 2013 does not include the rate increases included in the Reconciliation Act. Rather, an additional 0.9% HI tax will apply to earnings of selfemployed individuals or wages of an employee received in excess of $200,000 ($250,000 if filing jointly). Selfemployed individuals will not be permitted to deduct any portion of the additional tax. If a self-employed individual also has wage income, then the threshold above which the additional tax is imposed will be reduced by the amount of wages taken into account in determining the taxpayer’s liability.
Net investment income tax: An additional 3.8% net investment income tax also will be imposed on unearned income (income not earned from a trade or business and income subject to the passive activity rules), such as interest, dividends, capital gains, annuities, royalties, rents, and income from businesses in which the taxpayer does not actively participate. Because the tax applies to “gross income” from these sources, income that is excluded from gross income, such as tax-exempt interest, will not be taxed. The tax is applied against the lesser of the taxpayer’s net investment income or modified AGI in excess of the threshold amounts. These thresholds are set at $200,000 for singles and $250,000 for joint filers. Some types of income are exempt from the tax, including income from businesses in which the taxpayer actively participates, gains from the disposition of certain active partnerships and S corporations, distributions from qualified plans and IRAs, and any item taken into account in determining selfemployment income.
For estates and trusts, the tax applies on the lesser of the undistributed net investment income or the excess of AGI over the dollar amounts at which the 39.6% tax bracket for estates and trusts will begin. This threshold may be as low as $12,000 in 2013. Because this threshold is so low, consideration should be given to distributing income to beneficiaries who may be in lower effective tax brackets.
Find Medicare tax planning tips and considerations for individuals and private enterprises for 2013 in The 2013 Essential Tax and Wealth Planning Guide.
Income tax rates
Regardless of whether Congress addresses the prospect of expiring individual income tax rates during a lame duck session after the 2012 presidential election or when the 113th Congress convenes in January 2013, tax reform is possible. As a basis for analyzing the impact of tax reform, the tax rate overview chart (see ahead) provides an overview of individual tax rates for the 2012-2013 tax years under the current law.
As previously discussed, when Congress does address tax reform, there are three broad possible outcomes: an extension of current rates; tax reform accompanied by lower rates and elimination of various tax preferences; or tax reform accompanied by tax increases that help reduce deficits. Another important set of considerations will be the decisions made with respect to the AMT and the rate differential between regular tax rates and AMT tax rates.
It is important to note that one outcome of tax reform could result in reduced top tax rates with corresponding reductions in low- and middle-income tax brackets. This rate reduction, however, likely would be paired with the elimination of many “tax expenditures,” provisions of the tax code that provide targeted benefits. The largest individual tax expenditures include the exclusion for employer-provided health benefits, the lower rates on capital gains and dividends, the incentives for retirement savings, and the deductions for mortgage interest and for state and local income taxes. Reducing individual tax rates will require reducing or eliminating these benefits, each of which has been the subject of reform efforts in the past.
Income tax planning considerations for individuals and private enterprises in 2013
Given the degree of uncertainty as we approach 2013, it is important that you closely monitor the continuing tax debate in Washington, D.C. Though it is tempting not to take action in the face of uncertainty, we believe that the best offense is a good defense. Many planning decisions take time to implement. Based on whether you expect the current rates to continue, decline, or increase beginning in 2013, it is imperative that you consider tax planning decisions immediately.
Regardless of your view as to how the continuing tax debate in Washington, D.C. will conclude, there are a number of factors to consider for income tax planning. At the core is an understanding that, by implementing a long-term commitment to thoughtful tax planning, you can help lessen your risks associated with the uncertainty regarding the future of tax rates. It may help to think about planning considerations in terms of categories of income, such as investment income, ordinary income, retirement savings, and deductions. This approach can provide a solid foundation on which to focus your planning options. Finally, you should test your plans under a range of possibilities.
Issues that you may wish to explore include accelerating or deferring income, shifting from investments that produce ordinary income to investments that produce capital gain, participating in business activities, saving for retirement, and analyzing when to take deductions in order to increase their value. Of course, it goes without saying that you should focus your planning on your own specific fact pattern and objectives, as there is no one-size-fits-all approach.
Investment income: Any decision to sell capital assets should be based on economic fundamentals, together with your investment goals; however, you also should consider the tax aspects and transaction costs associated with implementing any transaction. Having said that, if you believe capital gains tax rates will increase, there are a number of planning techniques to consider, some of which are similar to those covered earlier in this section as Medicare tax planning considerations, as they assist in planning for increasing capital gains tax rates as well as the 3.8% Medicare tax on unearned income.
Ordinary income: The economic analysis of whether to accelerate compensation may be easier than the analysis involved in evaluating capital gains, as in many cases you will incur little in the way of transaction costs by accelerating compensation, and all of the compensation is taxable. Additionally, once you realize the compensation, you can invest the after-tax earnings in alternatives that may generate capital gains or other tax-favored income.
Retirement savings: Sound retirement planning involves a range of economic and tax considerations. Most important, though, it involves consistent discipline to save. Taxpayers sometimes wonder whether they should skip making retirement plan contributions when it appears that tax rates will rise. Keep in mind that you cannot make up missed retirement plan contributions in later years, and you will lose the potential for tax-favored earnings on that amount. Regardless of your view on the future direction of tax rates, you should consider contributing the maximum amount to your retirement plans annually.
Deductions: With respect to deductions, the key planning issue is determining in which year the deduction will generate the greatest tax benefit. Understanding this allows you to determine the most appropriate timing for deductions. If your tax rate rises, deductions are likely to be more beneficial; conversely, if your tax rate declines, they likely will become less beneficial. You will need to model this analysis carefully, as the impact of the AMT, phaseouts and limitations on deductions, and the character of the income your deductions will offset, all will have significant bearing on the result.
For example, a taxpayer subject to AMT does not receive benefit for many of his or her deductions, including state taxes, real estate taxes, and 2% miscellaneous itemized deductions, whereas an individual in a lower rate environment who is not paying AMT may receive more benefit from deductions than an individual in a higher rate environment who is paying AMT. As ordinary income tax rates increase and more income, such as qualified dividends, is subject to higher rates, individual taxpayers are less likely to be in AMT. As such, performing multiyear AMT planning now with an emphasis upon whether acceleration versus deferral of deductions will reduce AMT exposure and, therefore, provide a more significant benefit for your tax deductions is very important. It is critical that you discuss your AMT situation with your tax advisor.
Business tax changes: While the focus of this publication is primarily individuals and their estates, certain business changes that have been discussed in the context of tax reform could adversely impact individuals who own businesses that use passthrough entities. Owners and their businesses should observe the legislative process closely and evaluate risks resulting from potential tax changes. Examples of specific issues that you may want to explore include changing accounting methods to accelerate or defer income, analyzing depreciation methods, evaluating transactions with related parties, considering a change in entity status, and analyzing opportunities surrounding investments in private enterprises with NOLs.
Planning in uncertain times
Steps should be taken now to evaluate your tax position for 2013 to determine the potential impact of tax increases. Planning for a higher tax burden requires careful analysis and should be done with the assistance of a trusted tax adviser. Whatever you conclude the future will hold for taxes, a long-term commitment to a thoughtful tax planning process can help mitigate risks as you approach what could be a dramatically different tax landscape in future years. To that end, you should:
- Adopt a multiyear perspective in reviewing your tax situation, evaluating the tax implications of shifting income or deductions.
- Consider the effect of the AMT. The expected outcome of deferring or accelerating income and deductions may be different after determining the AMT consequences. The result may not necessarily be intuitive.
- View transactions with regard to both their economic and tax implications.
- Stay engaged with understanding the tax changes debated or adopted by Washington, D.C. Be prepared to act quickly once Congress agrees on tax rates or reform.
- Review your tax situation with a trusted advisor regularly.
Find more planning tips for income tax rates in The 2013 Essential Tax and Wealth Planning Guide.