Working on a Roller Coaster: Federal Tax Planning in 2012
By Larry S. Blair, CPA, JD
Political gamesmanship in Washington is having a detrimental effect on federal tax planning. Practitioners should expect continued uncertainty for the foreseeable future. Congress and the administration have been unable to act promptly to resolve issues, particularly tax matters.
It was not until late 2010 that, after a contentious debate in Congress, President Barack Obama signed an extension of President George W. Bush’s tax cuts through 2012. More recently, Congress came to a stalemate over the 2 percent payroll tax reduction. This, too, got resolved late in the calendar year and in a quarrelsome way that only extended the cut for two months in order to continue negotiations, which were finally resolved in February. Congressional inaction in 2009 and 2010 also led to the federal estate tax expiring for a one-year time frame.
The contentious and hostile political environment, which is likely to continue at least through 2012, adds a high level of uncertainty to the tax environment.
Tax practitioners, however, must not allow this political uncertainty to paralyze them into a wait-and-see attitude of inaction. CPAs must assess each client’s factual situation and the rules as they currently exist and as they are set to change on Jan. 1, 2013. Should Congress take action in 2012, a presidential election year, be sure to have a contingency plan to deal with that remote possibility. A general wait-and-see attitude, however, will only create difficult and potentially costly situations if practitioners do not act on current circumstances.
Since 2012 is an election year, it is unlikely that Congress and the president will pass and sign into law any significant tax legislation. This obviously creates a situation of significant planning difficulty for practitioners. There may be some movement on certain provisions, but these, in all likelihood, will be patchwork extensions of expiring or expired provisions. During 2012, the Republican presidential candidate will present his positions to enhance his standing prior to being officially nominated this summer. President Obama will not offer any new proposals to fight with Congress about as he enters presidential re-election mode. The same shut-down policy will be embraced by candidates up for re-election in the U.S. Senate and House. Future control of both bodies remains unclear, so political infighting will be fierce and compromise on tax issues impossible. After the November election, the situation won’t get drastically better. The House and Senate, and possibly the presidency, will be in a lame-duck session until January 2013, when a new Congress is seated. If no tax legislation occurs during this time frame, the Bush-Obama tax reductions will phase out Dec. 31, 2012, and extremely high rates will come into effect Jan. 1, 2013. If this happens, it is impossible to guess whether Congress and the president will take action in 2013. Election results will influence but not guarantee future tax policies.
The path of tax trends appears clear. Democrats seem to be interested in tapping higher income and higher net worth taxpayers to pay more taxes. Republicans seem to want lower taxes across the board. CPAs cannot pause to see which hypothetical path is followed. Uncertainty in the tax environment has always been the norm, though recently there have been more last-minute tax legislation changes. Generally, tax practitioners have always faced the possibility of tax change and have had to plan accordingly. We cannot change this method of proactive planning based on current uncertainties. We know what the rules are today, and we need to develop appropriate plans.
What We Know
Despite the uncertainty, we do know certain “right now” realities for 2012 and 2013. We know that the basic federal tax environment for 2012 includes a maximum ordinary income rate of 35 percent, a maximum capital gain rate of 15 percent, and a maximum qualified dividend rate of 15 percent.
If Congress lets the Bush tax reductions and Obama extensions expire at the end of 2012, the maximum ordinary tax rates will increase to 39.6 percent, long-term capital gain rates will go to 20 percent, and dividend rates will go to a 39.6 percent maximum (see Medicare taxes below).
The Patient Protection and Affordability Care Act of 2010 included Medicare tax rate increases for high-income taxpayers that begin in taxable years after Dec. 31, 2012. An additional 0.9 percent Medicare health insurance tax will apply to wages or earnings of self-employed individuals on income in excess of $200,000 ($250,000 jointly). An additional 3.8 percent Medicare tax will be imposed on unearned income (such as interest and dividends, capital gains, royalties, and rents). This additional tax is applied against the lesser of the taxpayer’s net investment income or modified adjusted gross income in excess of the threshold amount set at $200,000 for single individuals and $250,000 for joint returns.
Looking only at the qualified dividend income rate in 2012 versus 2013 for higher net income individuals, the tax will go from a maximum 15 percent to 43.4 percent (39.6 percent plus 3.8 percent) beginning Jan. 1, 2013, under the current law if Congress takes no action. Saying this would be a dramatic increase in the tax on dividend income that high-income taxpayers receive from corporate investments would be an understatement.
There is much discussion about comprehensive tax reform. There has been talk of lower rates, fewer deductions, reduced benefits for certain deductions, and the flat tax. Based on the current political environment, do not expect to see comprehensive tax reform considered until late in 2013 or 2014, if then. Depending on the presidential election and the composition of Congress, comprehensive tax reform may not be a high priority for those setting the national agenda.
Based on the current and foreseeable (cloudy as it is) tax environment, it is important to consider the planning opportunities that do exist for clients before the end of the year. The following techniques may apply in particular client situations.
Consider accelerating wages and compensation into 2012. This technique would allow income to be taxed at 35 percent instead of 39.6 percent plus the 0.9 percent Medicare tax in 2013. In addition, accelerating income could have a positive impact on the 3.8 percent Medicare tax imposed on investment income in 2013. One way to accelerate income into this year that you could suggest to employers is to pay bonuses in 2012. Also, with the recovering stock market’s run-up, it may be appropriate to suggest to clients with nonqualified stock options to consider exercising them in 2012.
Business owners may want to consider special dividend payments to shareholders by the end of 2012. This transaction would assure a maximum federal rate of 15 percent, whereas this same income could be taxed at 43.4 percent in 2013.
For self-employed individuals, consider advising them to set up a Keogh, SEP, or single-member 401(k) plan to reduce income both in 2012 and 2013.
For clients who have investment interest expense, consider planning that elects not to treat qualified dividends and/or long-term capital gains as ordinary income or to use investment interest expense in 2012, but to delay usage until 2013.
Consider opportunities to convert traditional IRAs to Roth IRAs in 2012. This would reduce future income that could be subject to higher taxes. In addition, the conversion can have significant long-term benefit to beneficiaries and a favorable estate planning impact. This conversion analysis is complex, so be sure to consider it before the end of December 2012.
For taxpayers who are so inclined, there are many techniques available to reduce taxable income by making charitable contributions. Consider, for example, donating appreciated securities rather than cash. There is also the option of creating a private foundation to which the taxpayer would make charitable contributions or a charitable remainder trust to defer capital gains.
See if there are opportunities for your clients to generate long-term capital gains in 2012 rather than 2013. As indicated earlier, the maximum long-term rate in 2012 is 15 percent, but this rate is scheduled to increase to 20 percent in 2013, with an additional 3.8 percent Medicare tax on investment income.
If a client holds stock that was obtained in connection with an exercised incentive stock option, and the appropriate holding periods are met, consider disposing of that stock in 2012 to minimize capital gain tax exposure.
Work with your client’s investment advisor, if they have one, for an overall portfolio review to determine the best asset allocation structure. Many investment strategies have looked to the receipt of qualified dividend income. If laws do not change, the tax rates on this type of income will increase dramatically.
The Alternative Minimum Tax (AMT) remains a stealth tax that catches many middle-income taxpayers. As you consider certain planning techniques for your clients, do not ignore the possible impact of AMT on those strategies. For example, the AMT rules do not allow a deduction for state and local taxes or miscellaneous itemized deductions that are claimed as itemized deductions for regular tax purposes.
For those clients who receive restricted stock in 2012, consider making an IRC Section 83(b) election. The Section 83(b) election allows a taxpayer receiving restricted property, such as stock, to elect to include the current fair value in 2012 taxable income if a proper and timely election is made. This election also starts the holding period for capital gains purposes. If such an election is not made, the income is taxable in the year in which the restriction lapses, and the income is based on the fair market value of the stock when the restriction lapses. This technique can be a powerful tax savings strategy, yet it does have costs and risks.
Finally, as you consider these strategies, among others, do not forget the impact of state income taxes. The Pennsylvania rate has remained constant, generally a gross income tax rate of 3.07 percent with few deductions allowed. However, if a client is in a multistate tax environment, consider the impact of state taxes on all of these transactions.
Estate and Gift Tax
The trends in the federal estate and gift tax have been roller-coaster-like over the past several years. In 2009, there was a $3.5 million federal estate tax exemption. At the same time, the gift exemption was $1 million. In 2010, the federal estate tax was eliminated, but the gift tax exemption remained at $1 million. In 2012, the law generally offers an estate, gift, and generation-skipping tax exemption of $5.12 million per person, with a tax rate of 35 percent on any transfer in excess thereof. In 2013, this structure is set to change again. The law, as currently on the books, calls for a reduction on Jan. 1, 2013, of the federal estate tax, gift tax, and generation-skipping tax exemption to $1 million. In addition, the tax on any transfer in excess of this threshold will be at a rate of 55 percent.
Taxpayers have a unique opportunity in 2012 to consider the advantages of these significant changes to gifting and estate taxes. Even though an in-depth analysis of estate and gift tax planning techniques is beyond the scope of this article, practitioners must be sure to advise clients about these opportunities with ample time before Dec. 31, 2012. Doing so will provide enough time to determine whether it is appropriate to capitalize on these changes and appropriately implement new strategies.
As we continue to work through this turbulent and uncertain environment, practitioners must make sure that they properly advise clients to have certain documents in place and current so they can accomplish their ultimate planning objectives. Documents that clients should be reminded about include a will, power of attorney, living will (health care directive), buy-sell agreements, and other business documents. All these documents need to be current, so this is certainly an appropriate time to review them or have them reviewed.
These are difficult times for practitioners as they try to effectively plan for their clients. It is possible that the recent trend of significant last-minute changes made by Congress at year-end will continue, so practitioners must stay informed of possible legislative developments. The tax laws as currently written, however, state that taxes will go up in 2013 if Congress does not intercede. We can only assume that this will happen, so it is imperative that as we work with clients throughout the year we consider the existing 2012 opportunities and make the appropriate planning determinations.
Larry S. Blair, CPA, JD, is a partner with Metz Lewis Brodman Must O’Keefe LLC in Pittsburgh and a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at firstname.lastname@example.org.
LAST UPDATED 2/29/2012