Critical year-end tax planning advice for small business owners

Daniel Acker/BLOOMBERG - Balbirer offers a comprehensive look at many of the looming tax changes for 2013.

An unprecedented number of tax law changes are on the horizon, and as we near the end of the year, that poses a number of tax-planning challenges for business owners. Moreover, because we are in an election year, we can’t easily predict which if any of these changes will actually take place in 2013.

The resulting uncertainty requires tax practitioners to help their clients prepare alternative plans that facilitate different strategies, depending on which laws are enacted. Once we get closer to the end of the year and the landscape begins to settle, we will be in a better position to advise on the best strategy to implement.

Congress still must decide which tax provisions will expire and which new ones will take effect. But for now, these are some of the scheduled changes looming in 2013:

Expiring provisions related to individuals: Individual income tax rates will increase to a maximum of 39.6 percent, long-term capital gains rates will increase to 20 percent, and the qualified dividend rate will cease to be taxed at 15 percent and will instead be subject to the maximum ordinary income tax rate of 39.6 percent.

Expiring provisions related to businesses: Section 179 expense will decrease to $25,000 and the 50 percent percent bonus depreciation provision will expire.

Expiring provisions related to estate and gift: The estate and gift tax exemption will decrease from $5.12 million to $1 million and estates with assets greater than the $1 million exemption will see tax rates increase next year.

New provisions: A new 3.8 percent Medicare surtax on net investment income for certain taxpayers and increase in employee Medicare tax of 0.9 percent.

Capital Gains and Losses

Based on the changes above, it is imperative to begin planning immediately. You should consider several key strategies if rates rise as indicated above. The strategies seem very contrary to the traditional planning we are used to providing for our clients like deferring income, accelerating deductions, and offsetting gains and losses if possible. If the upcoming changes become reality, the planning approach will be very different.

This year, individuals should consider accelerating income, deferring losses and deductions. Consider harvesting gains in your investment portfolio to take advantage of the lower rates before the end of 2012. Selling in 2013 could result in more tax due to the higher capital gains rate. This acceleration would be especially beneficial if the funds are used for living expenses in the upcoming year, anyway.

In addition, some clients will pay no tax on their capital gains in 2012, but the minimum tax rate is scheduled to rise to 10 percent (or 8 percent if the property was held for more than five years). The analysis really hinges on attempting to minimize taxes in the next 12 to 18 months.

Alternatively, if you don’t need the funds but believe the investment will continue to increase in value, consider selling the asset and then repurchasing the security and holding it. The wash sale rules do not prohibit the recognition of gains on the repurchase of the same security. The repurchase will create a clean step-up in basis in the security further eliminating tax on the original gain at a higher rate. As a corollary, it would be prudent to defer realizing losses until 2013 when they could offset gains that will be taxed at higher rate.

Qualified Dividends

Closely held C corporations and S corporations with earnings and profits need to seriously consider declaring and paying a dividend by year-end if the qualified dividend rate is allowed to expire. In 2012, a qualified dividend will be taxed at a federal income tax rate of 15 percent. In 2013 the same dividend will be taxed at the highest marginal income tax rate of 39.6 percent and may be subject to the additional 3.8 percent Medicare surtax on high income earners for a combined rate of 43.4 percent before considering the state income tax implications.

Business Structure

Choice of entity will again be a point of discussion with the increases of Medicare taxes on high income earners and the increased Medicare tax on net investment income. It may be time to revisit electing S corporation status for new and existing business.

Additionally, there has been significant discussion about increasing the amount of wages subject to the social security tax. Included in the discussion is increasing the tax on self-employment earnings in excess of $250,000. This could include income from businesses organized as partnerships or LLCs treated as partnerships for federal income tax purposes. Since all ordinary income generated and passed through to owners from an active trade or business under the partnership rules could be subject to the proposed increased tax, utilizing an S corporation could minimize the impact.

Wages paid to an S corporation owner that are considered “reasonable compensation” may be less than a share of partnership ordinary income. This would lower the potential tax on self-employment income. The balance of the profit could be distributed by the S corporation. The distributions will not be subject to the 3.8 percent tax on investment income assuming it is engaged in an active trade or business.

Business asset expensing

As noted above, other taxpayer favorable provisions scheduled to be reduced or eliminated in 2013 include the reduction of the Section 179 deduction from $139,000 in 2012 to $25,000 in 2013 if Congress doesn’t take action.

Tangible personal property actively used in a trade or business for which a depreciation deduction would be allowed is eligible for the Section 179 expense. The property must be purchased and be used at least 50 percent for business. Software is eligible in 2012.

Additionally, the 50 percent bonus depreciation provision is only effective through the end of 2012. Qualifying property must be purchased and used in 2012 and be either eligible for (a) the modified accelerated cost recovery system (MACRS) with a depreciation period of 20 years or less, (b) water utility property, (c) off-the-shelf computer software, or (d) qualified leasehold property.

Original use of the property must begin with the taxpayer claiming the bonus depreciation. Although income tax rates are scheduled to rise, the current opportunity to expense purchases of fixed assets may still outweigh the benefit of deductions over time.

Itemized deductions / Personal xxemptions

Also scheduled to expire are the elimination of the phase out of itemized deductions and personal exemptions. Effectively, high income taxpayers will lose up to 3 percent of their itemized deductions and their personal exemptions. The result of these two eliminations will essentially raise the effective tax rate for high income taxpayers without raising the statutory tax rate.

Like-kind exchanges

Taxpayers should reconsider the tax deferral provisions of Section 1031 in the future if capital gain tax rates do rise. This section allows the non-recognition exchange of like-kind property. It is not applicable to all capital assets (stock for instance), but it is well suited for real estate. While capital gains rates were at 15 percent, many taxpayers opted to sell the property, pay the tax and increase the tax basis in replacement property. With the potential increase in capital gains rates, deferring recognition of gains on appreciated property may prove to be a better strategy.

Estate and gift

Finally, with the proposed and enacted changes listed above,there are planning opportunities in the area of estate and gift. The federal gift tax remains in effect this year and is expected to continue into the future.

The annual gift tax exclusion is $13,000 in 2012. The 2012 rate is 35 percent and is scheduled to increase to 55 percent in 2013. The lifetime individual gift tax exemption is $5.12 million for 2012 (the total available exemption for a married couple is $10.24 million).

Any gifts above that amount would be taxed at a 35 percent rate. The exemption is scheduled to decrease to $1 million per taxpayer in 2013, and the rate is scheduled to increase to 55 percent. Therefore, taxpayers should consider making significant gifts before the end of 2012.

Gifts to grandchildren either outright or in trust for their benefit utilizing the $5.12 million generation-skipping transfer tax exemption in 2012 should also be considered. The generation-skipping transfer tax exemption is scheduled to be reduced to $1.4 million in 2013.

If you are considering gifts to children and grandchildren, remember that payments made directly to an education provider and medical expenses paid directly to a medical care provider are not considered gifts for purposes of calculating the exemption.

The current gift tax exemption could provide a unique opportunity to transfer significant gifts to beneficiaries including persons involved in same-sex relationships, civil unions and common law marriages and similar relationships.

The new Medicare 3.8 percent tax on investment income will also apply to the unearned income of estates and trusts. An estate or trust will incur the Medicare tax on investment income based on the lesser of the estate or trust’s undistributed net income, or the excess of the state or trust net investment income over the threshold at which the estate or trust is taxed at the highest marginal tax rate - in 2012 that figure is $11,650.

The difference between the trust threshold and the individual threshold amount for the highest tax bracket is an opportunity to distribute income to beneficiaries who may not have reached the higher brackets. For single taxpayers the threshold amount is $200,000 and for married taxpayers filling jointly the threshold is $250,000. Simply distributing income from the trust or estate could reduce your overall tax burden by 3.8 percent.

Due to all of the uncertainty about which provisions will expire, which will be extended, and what will be changed or amended, it is critical to develop several tax plans heading into next year. Speak with your tax practitioner about the alternatives and how to implement the most effective strategies to reach your personal goals. Continue to follow up with them through the end of the year as the dust settles, making sure you carefully execute the right plan.

Louis Balbirer, CPA, MST, is a director of tax services with Kaufman, Rossin & Co. He has 20 years of experience providing tax and accounting services to clients and can be reached at lbalbirer@kaufmanrossin.com.

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