Year-End Tax Planning with the Fiscal Cliff

Discussion in 'Taxes and Accounting' started by Robert A. Green, Oct 26, 2012.

  1. Do you think the Bush-era tax cuts will expire at year end 2012 on everyone, or just the rich, or be extended into 2013?

    New blog from Robert A. Green, CPA

    Tax planning is very tricky this year with the fiscal cliff. Most people hope Congress and President Obama will act soon — after the November election and before year-end — to bring clarity to the fiscal cliff, especially making a decision about the crucial Bush-era tax cuts.

    Consider accelerating income this year-end
    Most years, taxpayers prefer to defer income and accelerate expenses, but this year is different. Income tax rates are scheduled to skyrocket up in 2013 with expiration of the Bush-era tax cuts. Plus, the Affordable Care Act’s new Medicare tax of 3.8% on unearned income goes into effect on Jan. 1, 2013 for taxpayers making more than $250,000 for married filing joint and $200,000 for single. Trading income is subject to that Medicare tax and an S-Corp can’t help lower it. Read our "blog" on the subject.

    If the Bush-era tax cuts are not extended for your marginal tax bracket, it’s probably a good idea to accelerate income of all kinds into 2012 — ordinary income, capital gains and dividend income. Consider selling investments with unrealized gains before year-end. While that’s easy with marketable securities, it’s more difficult with less liquid investments like real estate and private equity.

    If you own a C-Corp, consider paying yourself qualifying dividends from retainer earnings, as the 15% 2012 rate jumps up to 39.6% plus the Medicare tax of 3.8 percent in 2013 (if you are over the threshold). Deal with those built-up retained earnings now.

    Tax gain selling
    In most years, taxpayers engage in “tax loss selling” to prune their portfolio of losing positions and lower capital gains taxes. This year, consider the reverse — “tax gain selling.” Instead of avoiding wash sales, maybe wash sales can be your friend by accelerating income into this year and deferring losses until next year.

    Deferring expenses may be unsafe
    Generally, when it’s wise to accelerate income, it’s also wise to defer expenses, as it has the same effect on lowering taxable income. But, this year is different and you should decouple those ideas: Accelerate income, but don’t defer expenses.

    Itemized deductions and many other tax expenditures may be closed in 2013 as part of promised tax reform. Gov. Romney’s tax plan is to limit itemized deductions to $25,000 or similar amount for upper income taxpayers. Deductions could be reduced for the middle class too, even with Democratic plans. Most states are acting to limit itemized deductions. If you see a deduction allowed for 2012, take it. If it’s wiped out with AMT tax for 2012, then defer it.

    Gov. Romney’s tax plan also includes zero income tax on portfolio income for taxpayers making under $200,000 per year, but it’s unlikely to pass Congress if Democrats retain a filibuster. You can make this call with the election results.

    AMT patch not resolved
    Even if Congress can’t agree on the Bush tax cuts, I hope they at least agree to pass the annual AMT patch for 2012. Otherwise, millions of additional taxpayers will be hit with a nasty AMT tax-hike surprise. AMT can give back some long-term capital gains rate benefit – since the AMT rate is much higher than the capital gains rate - and it doesn’t allow most itemized deductions.

    Businesses get the golden (tax) goose
    Business deductions for business traders and investment managers are safe because tax reform is focused on limiting itemized deductions, not business expenses. Just make sure you have business status in Q1 2013.

    If you don’t qualify for trader tax status (business treatment) for 2012, and expect to qualify in Q1 2013, then defer business expenses to 2013. Alternatively, you can spend the money in 2012 and capitalize the amount into Section 195 startup costs to amortize in 2013. But, remember the expense provision of Section 195 is only $5,000 with the rest being amortized over 15 years using the straight-line method.

    Conversely, if you qualify for trader tax status in 2012, but might not in 2013, take your expenses in 2012. If you have investor tax status, take your chances with a miscellaneous itemized deduction in 2012, rather than in 2013.

    Business traders and investment managers should not defer charity to 2013. But businesses can defer equipment purchases to business deductions in 2013. I don’t have much faith in tax reform lowering rates much, so expense deferral is a good idea. Even if equipment expensing is scaled down with repeal of Bush-era tax cuts, there is plenty of room for 100% expenses with pre-Bush Section 179 depreciation allowances.

    A Roth IRA or Mini 401k conversion is risk free
    Consider a Roth IRA or Roth Mini 401k conversion in 2012. No matter what happens with the fiscal cliff, it’s a good idea under most scenarios and even if it turns out to be a bad idea, you can reverse it. A Roth IRA conversion comes with a free “recharacterization” feature. Up until the due date of your tax return the following year, you can reverse the Roth conversion. We will have details on this process in upcoming Webinars and it’s in Green’s 2012 Trader Tax Guide, too.

    Why not convert and check out your regular retirement accounts at lower Bush tax rates, and then trade your Roth IRA tax free for life? This will protect your trading gains from tax hikes in the future. Pass on these breaks to family members with estate planning, too.

    If the Bush tax cuts do expire, pundits expect the market to sell off with calamity on the horizon. Why not cash out your investment positions before others try to do the same? After your conversion to the Roth IRA, you can trade and make new investments at lower prices as the markets recover.

    Part II – The Political Intrigue (further reading for those interested in the politics of tax negotiations). See the full blog for Part II.