Tax Planning—What a Difference a Day Makes
posted Jan 5, 2012 by Norman LeBlanc, CPA
As a tax planner, thinking ahead to the following year is a critical part of the planning process. After all, how can one reduce a client’s tax burden without understanding the changing landscape from one year to the next? Now that 2012 is upon us, the changes for 2013 (already enacted in the tax law) seem all that more relevant than just a few days ago.
Through 2012, the Bush tax cuts which include a 35% maximum tax rate, a 15% maximum tax rate on long term capital gains and a 15% maximum tax rate on qualified dividends all survive. Without legislation, those rates are in stark contrast to what lies ahead for 2013 when the maximum tax rate on ordinary income rises to 39.6%, qualified dividends lose their preferential status (and are subject to ordinary income rates) and the maximum rate on long term gains increases to 20%. Moreover, for certain high earners (most of my clients), investment income is subject to an additional 3.8% Medicare contribution in addition to normal income tax.
In particular, I think of the not so uncommon client profile generating no other income except for $2,000,000 of qualified dividends. In 2012 (as they did in many of the prior tax years since the Bush cuts), this client pays $300,000 in federal tax ($2M x 15%). Looking ahead somewhat simplistically to 2013, this client will pay $868,000 ($2M x 43.4% (39.6% + 3.8%)), an increase in tax of 289%!! While this example is striking, the increase in tax for many high earners, while not quite so dramatic, is worthy of our attention.
The increase in Medicare contribution of 3.8% applies to married taxpayers with modified adjusted gross income over a $250,000 threshold ($200,000 for singles). The 3.8% tax is imposed on the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over the threshold amount. Taxpayers earning close to the threshold amounts may be able to structure their affairs so as to avoid the additional Medicare tax. Certain planning techniques may include deferral of social security benefits, the migration to tax exempt bonds or the acceleration of income into 2012. Consideration should be given to selling highly appreciated securities in 2012 rather than subjecting the appreciation to the additional Medicare tax in future years.
Investment income, on which the tax is assessed, consists of a broad range of income including not only interest and dividends but also annuities, royalties, passive rents and passive income from other sources as well as gain from the sale of assets producing such income. Most notably, the tax applies to the gain on the sale of most real estate including a personal residence (except for the excluded gain on the sale of a primary residence).
As tax rates increase from 2012 into 2013 and beyond, tax planning takes on added importance. The timing and character of income and deductions need to be reviewed. The question of whether or not one elects out of installment sale treatment for a 2012 asset sale comes to mind? Typically, we would advise clients to defer income; for 2012 I am not sure that conventional wisdom works. Do owners of business look to modify rental arrangements with a view to reducing rent (less investment income) and increasing wages or vice versa? Given the uptick in tax rates looming ahead, the 2012 tax year seems to be the year in which these and other tax planning questions take on increased relevance.
If you have any questions, please let us know or contact your KLR Tax Advisor