Taxmageddon II: Is This Any Way to Run an Economy?
Remember the fall of 2010, when the American economy faced a series of tax increases that threatened to blow up the economy? Well, as that eminent philosopher Yogi Berra might say, "It's deja vu all over again."
In 2010, with the national economy growing slowly, a lame-duck Congress acted to extend most of these tax breaks in December of 2010. Fast forward to 2012, and the same situation is causing the same level of uncertainty among employers: What tax breaks, if any, will survive?
Depending on your political point of view, the expirations will either produce more tax revenue – $5.4 trillion between 2013 and 2022, according to the Congressional Budget Office – to help reduce the deficit, or derail necessary investment and the mild recovery to boot.
No matter what your perspective, is this uncertainty with where tax rates are set any way to make tax policy?
"I would expect that a lot of these will be extended," said Kory Stoehr, lead tax partner for McGladrey. "It's just hard to say. We don't know who is going to win the election. We don't know what the Congress is going to look like. There are just too many variables right now.
"If the rates get extended, so be it. It does make it difficult to do any planning, though."
Plan for what you know
Among the tax breaks that expire at year's end are the so-called Bush tax cuts, in which the top tax bracket was reduced but could revert back to the prior rate of 39.6%, but this package did not just cut income tax rates. The package also includes cuts to the capital gains and dividends rate (both now 15%), marriage penalty reductions, and an increase in the child tax credit.
Also set to expire are the payroll tax cut, the Alternative Minimum Tax patch, middle-class tax cuts contained in the 2009 stimulus law, 50% expensing for bonus depreciation, Section 179 expensing (now up to $139,000 for qualified purchases, it drops to $25,000 in 2013), the current estate tax (now at 35% with a $5 million exception, it goes to a $1 million exemption and maximum rate of 55% per decedent), and various tax extenders.
And then, beginning on Jan. 1, 2013, certain tax hikes to help fund the Affordable Care Act will go into effect. They include a 0.9% tax increase on wages and self-employment income if total wages are in excess of $250,000 for married couples filing jointly, 125,000 if married filing separately, or 200,000 for single heads of households. There also is a 3.8% surtax on large capital gains ($500,000 or more) on the sale of a residence.
Stoehr's advice is not to bother planning for what some are calling "Taxmageddon," but instead to plan for what you know. "There are some opportunities, if you're a business owner, to take cash out of the company today while you are paying only a 15% rate on dividends and capital gains," he said. "Right now, the thought is that the dividend rate would go from 15% back up to the ordinary rate.
"If you are a high earner and you've got a business, there is a good chance that you are going to be paying 39.6% on those dividends."
Bob Porter, a partner with Porter & Sack, offered similar advice on transactions with the potential for a capital gain. "The [15%] rate we've got is a huge motivator for a business owner to sell today, close the deal, and recognize the gain this year," Porter advised. "Even real estate owners should consider trying to sell property this year rather than waiting until next year. That [potential rate change] is a real large swing, with big dollars."
Diane Nienow, a tax manager with Smith & Gesteland, agreed that businesses may want to accelerate some purchases of qualified expenses to take advantage of depreciation at the 50% rate, or the higher limits on 179 expensing, but there are some exceptions.
"If you have flow-through income that is taxed at ordinary rates, and you're going to get into a higher amount and potentially be subject to the [new] tax because it's an LLC and a business that is selling widgets, not a real estate investment company, then you might also be subject to the surtax of 0.9%," she explained. "So the maximum rate for ordinary income this year is 35%. Next year, if Congress does not act, it's 39.6%, plus potentially another 0.9%, or 40.5%."
If this is a passive investment in that you own S-Corp stock as an investment because you're not operating the business, that would still be subject to the 39.6% rate because it's ordinary income. However, it also could be subject to the 3.8% additional health care tax to get to a 43.4% rate, Nienow added. "This year, that same dollar would be subject to 35%, so if that's the situation for the shareholders in the company, you probably don't want to accelerate deductions because you'll get more bang for the buck next year.
"This is where the crystal ball needs to come into play, and it's got a nasty crack in it. I think the main thing is you need to do some good planning. You need to be able to project your income and expenses into the future and your equipment needs. Do you have a huge amount of income for some reason this year? Say you've got a big contract and that's really unusual for your business, and you expect it to go back to normal levels next year, maybe we take advantage of some write-offs this year."
Continuing with situational examples, Nienow said that if a business is growing and envisions "going gangbusters" in the next several years, the best play is taking normal depreciation and having those write-offs in future years.
If you conduct business on a cash basis, and the venture will likely remain at the same income level, you might accelerate some income into 2012 so that you tax it at 35% versus 39.6%. "There is only so much you can do because if you're a service corporation or a service enterprise, you generally must have performed the service and gotten your bill out, and then hope they pay you. Rather than hold onto a bill, you should make sure it gets out very promptly.
"That is the usual year-end type planning for cash enterprises. Certainly that ability to maneuver income between years is one of the reasons they put a lot of people on an accrual basis, which means when you perform the service and have a right to the money, then the amount will be taxable to you, not when you collect it."
Another option is the gift or transfer tax, which now carries a $5 million exemption. For years, the exemption had been at $1 million or less, and it will revert back to that level in 2013. So a business owner interested in transferring the venture to the next generation might want to do it in 2012.
In addition, if there is real estate that you want to transfer to another generation, Nienow said this would be the perfect time because real estate is still depressed and unlikely to rise any time soon. "You can get a valuation and get more of the property transferred, but you've got to get rid of it then," she counseled. "A gift has to be a completed gift, which means you don't have any control over it anymore."
To maintain at least the current level of economic momentum, Stoehr would restore what he views as the truly stimulating tax breaks: the research credit, which has already expired, and the current level of bonus depreciation on equipment.
"With the fact we've got deficits and issues with global competition, and that we're constantly losing jobs to China, we need to incentivize U.S. business with things like the research credit," he said. "If something like this doesn't get put back on the books, and our current tax rate stays at a high level from a corporate standpoint, I'd be concerned that it could put us back into somewhat of a mild recession."
Porter cited talk of Band-Aids at the end of the year with regard to the various tax extenders, with nothing significant getting done on the other tax breaks until well into 2013, a scenario also mentioned by Stoehr. "It's just up in the air," Porter said. "Nobody knows for sure what is going to happen, which makes it difficult for tax planning."
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