Fiscal Cliff: Tax Planning and Reform

Fiscal Cliff: Tax Planning and Reform

Sarah Brown

August 7, 2013

Agenda

What has passed?

2013 Tax Planning Opportunities

What is on

horizon—Tax

Reform

?

Questions?

Each right-hand bar

shows what did happen under ALTRA. The average increase in federal tax rates will be less than 2 percent this year–not even half the increase if we’d tumbled over the edge.

 The

bars on the left

for each income group show what would have happened if we had toppled over the cliff.

Each bar

also shows the elements of that tax hike—how much would have come from the end of the Bush-era tax cuts, the expiration of the payroll tax cut etc.

What has Passed?

American Taxpayer Relief Act of 2012

Health Care Taxes

Top Individual Tax Rates

Capital Gain & Dividend Rates

Alternative Minimum Tax

Itemized Deduction LimitationPhase-out of Personal ExemptionsEstate & Gift Tax

R&D Credit

50% bonus depreciation extended thru 2013

Section 179 expensing Limitation

Energy Provisions

Exclusion for Gain on Sale of Qualified Small Business Stock

Major Individual Tax Provisions

Major Business Tax Provisions

New Medicare Taxes in Effect

for

incomes above $200,000 single/$250,000 joint

Increase of 0.9% in the employee share of tax

(from 1.45% to 2.35%) Employee and employer combined tax rate of 3.8% on wages below threshold.Rate increase of 0.9% applies also to self-employment income (from 2.9% to 3.8%)

3.8% tax on net investment income

Applies to lesser of investment income or MAGI above threshold.

Includes interest, dividends, rents, royalties, capital gains and business income from passive activities

.

Earned IncomeUnearned Income

NII—Example

:

Married couple filing jointly has MAGI of $300,000; $10,000 of which is net investment income. Because the couples MAGI is above the $250,000 threshold, the new tax applies.

How much is the tax?

The tax is an additional $380.00

2013 Top Individual Tax Rates

for incomes above $400,000 single/$450,000 joint

Wage Income

Interest Income

Dividends

Capital Gains

2013 Top Rate

39.6%

39.6%

20.0%

20.0%

Base High Income Payroll Tax (Employee Share)

+1.45%

-

-

-

2013

Phase Out of Itemized Deductions (“Pease”)

+1.2%

+1.2%

+1.2%

+1.2%

2013 High Income Surtax+0.9%+3.8%+3.8%+3.8%2013 Combined Top Rate43.15%44.6%25.0%25.0%

Note:

Rates shown represent the top marginal rate of each dollar earned in top income tax bracket. Applicable for tax years beginning after December 31, 2012.

Alternative Minimum Tax

The Act permanently increases the exemption amounts for 2012 and provides indexing for inflation for taxable years beginning in 2013

.

Increase exemption amount from:

$33,750 to $50,600 (Single)

$45,000 to $78,750 (Joint)Why this matters:Provides some stability surrounding which taxpayers will be subject to this tax by eliminating the annual need for a last minute or retroactive “patch”.

Itemized Deduction Limitation

The Act repealed the limitation for taxpayers with AGI under $250,000 (Single) and $300,000 (Joint) for tax years beginning after December 31, 2012.

Deductions are reduced by 3% of the amount by which AGI exceeds the threshold.

You can’t lose more than 80% of the itemed deductions that are affected.

Deductions NOT subject to limitation include:

Medical expenses

Investment interest expense

Casualty and theft losses

Gambling

losses

Phase-out of Personal Exemptions

The Act initiated the phase-out for taxpayers with AGI above $250,000 (Single) and $300,000 (Joint) for tax years beginning after December 31, 2012.

For each $2,500 of AGI over the threshold, personal exemptions are reduced by 2%.

$3,900 Exemption amount for 2013

Why this matters:

Individuals with high income may want to forgo claiming a dependency exemption.

Estate & Gift Tax

$5 million exemption (adjusted for inflation) made permanent. Sets the top tax rate at 40% for estates of decedents dying after December 31, 2012.

The Act also unified estate and gift taxes, providing for a single exemption and single rate schedule for the two taxes.

Why this matters:

Eliminated uncertainty surrounding the wavering exemption amount. Taxpayers that put gift and estate planning on hold can move forward.

Business Tax Provisions

R&D

Credit

The R&D Credit was a Reagan Administration initiative encouraging private sector innovation and competition with foreign competitors. The R&D Credit has since been expanded to apply to more types of businesses, and the Obama Administration has proposed both making it permanent.  The R&D Credit, although labeled a “temporary tax feature,” has been extended over 15 times.

Credit based on “Qualified Research Activities and Expenses”

Why this matters? This credit applies to many businesses who aren’t aware of its application to their industry/process.Whenever some new “thing” is created, a potential exists for the R&D Credit. It applies to all industries, NOT just manufacturing.

How Handsome.

Business Tax Provisions

Bonus

Depreciation

Extends one year the 50% bonus depreciation for qualified property under sec 168(k).

Placed in service before Jan. 1, 2014 (before Jan 1, 2015 for certain long-lived and transportation assets).

Generally, qualified property includes:Property with a MACRS recovery period of 20 years or lessCertain computer software

Water utility property

Qualified leasehold improvement property

Why it matters

?

First-Year Bonus Depreciation can matter significantly in lowering TI

Extends the

15-year

straight-line cost recovery through 2013

for:

certain leaseholdsrestaurant retail improvements new restaurant buildingsWhy it matters?Without this extension, leasehold improvements would revert back to a 39-year

life which would mean smaller incremental depreciation and deferred tax benefitsBusiness Tax Provisions Leasehold Improvements

For property placed in service during 2013, increased limitation for expensing under section 179 rather than depreciating property.

Limitation is

raised to $500,000

and would be reduced if the cost of section 179 property placed in service exceeds the $2M phase-out amount.

Allows the taxpayer to expense up to $250,000 of the cost of qualified leasehold improvement property, qualified restaurant property, and qualified improvement property.

These limitation amounts will return to an allowance of $25,000 and $200,000 respectively, after 2013.

Why it matters?

Exceeds benefit of 50% bonus depreciation!!

Business Tax Provisi

ons

Section 179 Expensing Limitations

Extension of Tax Credits for construction of energy-efficient everything:

New homes

Improvements to existing homes

Appliances

Further incentives for biodiesel, renewable diesel, alternative fuel, alternative fuel mixtures

Extension of production tax credit for wind through 2013Why it matters?As companies are making improvements, energy efficiency needs to be a considerationBusiness Tax Provisions

Energy

Provisions

Encourages non-corporate investors to support small, emerging businesses

Extended the time period, through 2013, where non-corporate purchasers of small business stock are eligible for the 100% gain exclusion upon later sale of said stock

Exclusion of Gain only applies to certain scenarios:

Gain must equal $10M or 10 times the aggregate tax basis in the stock

Investor must hold stock for at least 5 years

Business Tax Provisions Exclusion from Taxable Gain on Sale of Small Business Stock

2013 Tax Planning Opportunities

Individual Tax Planning

Reassess plan for gift giving now that $5M exemption is permanent & estate tax rate is at 40%.

Have a 401(k)?

Distribute to a Roth

Charitable distributionCapital gain planningOptimal timing of gain or loss recognition

Coordinate with ordinary income Combine tax treatment of more than one provision:Have a dependent with earned income?

Pay their college tuition?

Phased out of exemptions?

Would it be more tax advantageous to gift the tuition to dependent and have them claim tuition expense as an above the line deduction on their tax return?

Client

Discussions—Examples

Think outside the box

3.8% Surtax on Investment Income

Category #1

– Interest, dividends, annuities, royalties and rent.

Exception if generated in trade or business

Category #2 – Business income from a passive activity or a business of trading in financial instruments/commodities.Coordination with 469 rules for material participation

Category #3 – Net gain “to the extent taken into account in computing taxable income”.Net gain defined as: “gain attributable to the disposition of property other than property held in a (non-passive) trade or business”. What about the sale of S-Corp stock or Partnership Interest? Special Rule…

What is “Net Investment Income”?

Note: Classification of trade/business

vs.

investment income is made at the partnership level. However, trade/business income to partnership will be taxed as investment income to an inactive owner.

3.8% Surtax on Investment Income

You are a 50% partner in an active business.

You sell your 50% partnership interest for a gain, which would be subject to the 3.8%

surtax. Assume

that if the partnership sold all of its assets, because you are active in the business, that would be the sale of business assets that is not subject to the 3.8% surtax. Because none of your share of the gain from a hypothetical sale would be subject to the 3.8% surtax, none of your gain on the sale of your partnership interest would be subject to the 3.8% surtax.

Example—Sale of Partnership Interest

3.8% Surtax on Investment Income

Wages, salary and other compensation income

Ex:

Guaranteed

PaymentsIncome on the exercise of compensatory optionsIncome on the vesting of restricted stockQualified retirement plan distributions

What is NOT “Net Investment Income”?

Escaping the 3.8% tax

Understanding the interplay between NII and

“other income”

NII is fairly fixed, can control other income

Other income is fairly fixed, can control NIIIncrease participation to make passive income non-passiveSeven pieces of how a partner will be considered an active part of the partnership’s business under Reg. 1.469-5T

Review how your passive activities are aggregatedOne time regrouping of activities for taxpayers with net investment income (Prop. Reg. 1.469-11(b)(3)(iv))Use of the S-corporationFlow-through income from an S-corp is not subject to SE

What are

Some Planning Opportunities

?

Escaping the 3.8% tax

Three buckets of income:

Employee wages and SE income

Subject to the 2.9% rate and will be subject to 3.8% rate if exceed earned income threshold

Investment IncomeSubject to the 3.8% rate to the extent income exceeds threshold

Other items included in gross income but not subject to Medicare taxesGoal—More income in this bucket! Aka “Sweet Spot”

Not all income is either earned or unearned…

Escaping the 3.8% tax

Taxation

of flow-through income

General Partner

All business income is subject to SE, regardless of participationLimited Partner

Active – Guaranteed payment subject to SE, remaining business income is not subject to Medicare taxesInactive – All business income is subject to NIIPartnership Interests

S-Corp Shareholder

Active – Reasonable compensation taxed as wages, remaining business income is not subject to Medicare taxes

Inactive – All business income is subject to NII

What is on the horizon—Tax Reform?

Tax Reform: What are the MACRO factors?

What is the “appropriate” level of federal taxation?

What is the distribution of the federal tax burden on American households?

Which provisions of the tax code promote economic growth?

Which provisions of the tax code impeded economic growth?

How do we stay or reduce the deficit?

Are We Really Paying a lot in Taxes?

Who’s paying NO Taxes?

Corporate & Pass-thru

Shares

of

business income

Gov Revenue Estimates for Repealing Selected Tax Expenditures

Provision

($ Billions, 2012-2021)

Portion related to C Corporate Taxpayers

Total for All

Business TaxpayersRepeal MACRS

and apply Alternative Depreciation System

506.8

724.1

Repeal expensing of research and experimental expenditures

152.2160.2

Repeal Section 199 domestic production activities deduction127.0

163.9

Repeal LIFO inventory accounting

method

62.7

69.7

Repeal

credit for low income housing

33.0

34.8

Repeal deferral of gain on like kind exchanges

16.018.2Repeal completed contract method13.913.9

Other Corporate Tax Expenditures

Provision

(2012-2016)

5 year amount

($

Billions)Deferral of active income of controlled foreign corporations239.7

Equipment depreciation in excess

of alternative depreciation system

Includes bonus depreciation and general acceleration under MACRS

(5.5)

Deduction for income attributable for domestic production activities53.2Exclusion of interest on public purpose tax-exempt bonds

47.4Inventory property sales source rule exception16.9

Tax credit

for low income housing

32.4

Expensing of research and experimental expenditures

30.3

LIFO

method

22.0

Reduced rates for first $100,000 of corporate

taxable income

17.1

Obama Administration FY 2014 Proposed Revenue Raising Budget Components

Individual

Tax Reform

Proposal

10 year amount ($ Millions)28% Cap on Value of certain Individual deductions and exclusions

529,261

30% Minimum Tax on Individuals

with income of over $1M

53,387

Modify Gift/Estate Tax Provisions78,559Carried

Profit Interests being Taxed as Ordinary Income***15,909

President Obama’s

Framework

for

Business Tax Reform

Reduce corporate rate from 35% to 28%

Provide 25% rate for certain domestic manufacturing incomeIncrease research credit and make permanentFully offset with base broadening optionsAddress depreciation schedulesReduce bias toward debt financingEstablish greater parity between large corporations and non corporation businesses.

Limit deferral of

U.S.

tax on foreign earnings

Minimum tax on foreign earnings

Rejects “pure” territorial systemPromote transparency

Other Tax Reform

Proposals

for

Business/Individual Tax Reform

Last major tax reform was 1986….

This month (July 2013), the U.S. Senate Finance Committee (Baucus-Hatch) is setting out a bi-partisan path to “start from scratch” with a pledge to hold all lobbyists accountable for every loopholeZero-based

tax reform:

Eliminate all deductions, exclusions and credits that reduce taxable income

Require all tax expenditure support to justify its proposal as if it were being proposed for the first time (historical data not relevant)

This concept has been mirrored by The House Ways and Means Committee (Camp) suggesting possible momentum and agreement between the House and Senate.

Questions?

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