As previously discussed in Part I of our series on mid-year tax planning, 2014 is an unusually uncertain year in terms of the tax laws that will apply. Most of the typical tax planning ideas still may apply, but, as we will discuss below, the uncertainty raises some concerns.
Other than the provisions that expired on December 31, 2013, the tax law is relatively unchanged from 2013 to 2014. For those provisions that have adjustments for inflation, there are new amounts for 2014.
Increased tax rates still apply for high-income individuals – the top ordinary income tax rate from 2013 of 39.6% on taxable income exceeding $400,000 for single filers and $450,000 for married taxpayers filing joint income tax returns applies again in 2014.
Long-term capital gains and dividends – the increased long-term capital gains rates and qualifying dividend rates from 2013 remain at 20% for taxpayers in the 39.6% ordinary income tax bracket.
Estate and gift tax – the estate and gift tax exemption amount is $5,340,000 for 2014, with the 40% top tax rate that began in 2013. The portability of unused exemption amounts between spouses continues to be allowed in 2014.
Limitations on itemized deductions and personal exemption phase-outs – The phase-outs that were reinstated in 2013 continue in 2014. For married couples filing jointly, the phase-out begins at adjusted gross income (“AGI”) amounts over $305,050, with full phase-out being reached at $427,500. For individuals, the phase-out begins at AGI amounts over $254,200, with full phase-out being reached at $376,700.
Bonus depreciation – expired in 2013 and we will have to wait to see if it will be extended for 2014.
Section 179 expense – The election that allowed increased expensing expired and, without being extended, the expensing amount is back to only $25,000 with an investment ceiling of $200,000.
Research credit – The credit expired on December 31, 2013, so absent extension, will not be in place for 2014.
Qualified leasehold improvements – 15-year life for qualified leasehold improvements, qualified retail improvements and qualified restaurant property only applies to assets placed in service before January 1, 2014. Several bills have been introduced to extend 15-year life permanently, but there is little chance that a standalone bill will be enacted. This is one of the provisions that would be extended if the current version of the Expiring Provisions Improvement Reform and Efficiency Act of 2014 (or EXPIRE) is enacted.
Medicare tax on investment income or net investment income tax (“NIIT”) – Unfortunately, this isn’t going away any time soon. TRA 2014 (discussed in Part I), would leave this tax in place, although the alternative minimum tax would be repealed. The NIIT is discussed in more detail below.
Following are some common transactions and planning ideas that should be considered.
- If incurring a capital gain, the amount of gain and all other expected income must be reviewed in advance. Based on the anticipated total income in the year of sale, by delaying the capital gain or by delaying other income, the resulting capital gain may be taxed at 15% rather than 20%.
- If taxable income is in the 0 – 15% tax bracket, capital gains at this income level are taxed at 0%; this occurs for married taxpayers filing joint returns on taxable income up to $73,800 and $36,900 for single taxpayers.
- If no immediate desire to sell assets, still consider taking advantage if taxable income is in the 0 – 15% tax bracket. Sell assets such as stocks or bonds when in the 0 – 15% tax bracket and incur no capital gain tax and then repurchase the asset. This will create a new, higher basis in the asset that can be used in the future to reduce gain on sale. This is beneficial if taxpayers expect to be in a higher tax bracket in the future when they want to sell the asset. This potentially not only reduces capital gain taxes, but reduces the effect on NIIT.
- If incurring a capital gain, the timing and magnitude of the gain may result in, or avoid, additional tax. If the gain is from an investment activity or from a passive activity, the NIIT would apply, depending on the amount of the taxpayer’s total income.
- Consider entering into an installment sale. By electing the installment method for tax purposes, gain can be deferred beyond the current year. An installment sale can smooth income over a period of years and perhaps reduce the capital gains tax from 20% to 15% (or lower) and can also reduce or eliminate the NIIT, as well. Depending on the situation and income levels, electing out of an installment sale may be desirable if income is expected to increase in the future.
- If selling real or personal property and acquiring other “like-kind” property, consider taking advantage of the benefits of a like-kind exchange under Section 1031. As we mentioned in Part I, eliminating or changing Section 1031 may be a revenue enhancer that will be used to pay for extending some of the expiring provisions. If Section 1031 is eliminated, it is likely to be prospective. That means that exchanges started in 2014 (even if not completed in 2014) would still likely get tax deferral treatment. If you are able to take advantage of Section 1031, gain is deferred until an ultimate taxable sale of the replacement property. Absent repeal, continued Section 1031 exchanges can be done for ongoing deferral of gain. For older taxpayers, continued exchanges has resulted in the term “swap ‘til you drop,” meaning continue exchanging to avoid taxes on sales and then, upon the death of the taxpayer, the potential income tax is eliminated through the estate step-up in basis (but make certain that the basis step-up does not get repealed!). State income tax rules need to be considered as well for conformity, lack of conformity, with the Federal rules on Section 1031.
- If selling real or personal property, by taking steps to structure as a Section 1031 tax-free exchange, even if the exchange fails and replacement property is not acquired, it may be possible to move the gain and tax into the next tax year. This is a possibility if the property sold as the first step of a like-kind exchange is sold during the last half of the taxpayer’s tax year (so that less than 180 days remain in the tax year).
- Harvest losses. If capital gains have already been incurred, consider taking losses presently unrealized on assets held, such as in a stock or bond portfolio. Take available losses now to offset gains rather than waiting until closer to year end when the losses may not be available. After taking a loss, the same security can be re-acquired after waiting 30 days.
- Harvest gains. Normally, accelerating income by pulling income into the current year from subsequent years is not good tax planning. If, however, income is lower this year than expected next year, consider selling assets this year to manage the tiered capital gain tax rates and the NIIT.
- Plan for eventual sale of personal residence. Consider the exemptions available for gain on personal residence sales – $500,000 for married taxpayers filing a joint return and $250,000 for single filers. Gains in excess of exemptions are taxable capital gains and subject to the NIIT. The installment sales method can be utilized in a residence sale to defer gain, if the seller takes back a note and defers payment to future year(s).
- Review activities to determine or re-assess if active or passive. This implicates the ability to take losses from flow-through entities and whether income will be subject to the NIIT.
- Consider making a grouping election under Section 469 in 2014 to combine activities in order to meet the material participation hour tests. This can change passive business income into active business income not subject to the NIIT.
- The grouping election can also create the opportunity to deduct what would otherwise be passive losses instead as active losses that reduce all income.
- Review income and potential income from trusts and estates and level of activity of executors and trustees in underlying activities to determine how and if the NIIT will apply. Note that there is some recent taxpayer-friendly case law development on this topic.
- Trusts are subject to the NIIT at a much lower income threshold than individuals ($12,150). Consideration should be made, when allowable under the trust document, to distribute income to the beneficiaries if it better manages the NIIT. Care should be taken that the goals of the overall estate plan are not compromised by making distributions.
- Assess level of shareholders’ salaries from S corporations; salary will be taxed at 1.45% Medicare tax and an additional .9% Medicare tax; S corporation income will not be subject to either the 1.45% or the additional .9% Medicare taxes, but the S corporation income will be subject to the NIIT if it is a passive activity.
- For S corporations in which the shareholders are active, but have not been taking salary, the shareholders should consider taking some level of salary in order to demonstrate material participation. No salary could make the IRS’s job easier to determine that the income is passive and subject to the NIIT. Note: active status is determined based on hours worked and ownership, but not taking reasonable salaries could indicate to the IRS that adequate hours are not worked.
- Review basis in pass-through entities. Insufficient basis can restrict the ability to deduct flow-through losses and can result in gain if distributions are paid in excess of basis. Income and distribution projections should be made to estimate basis. If basis is estimated to be deficient, steps can be taken to restore basis or manage distributions.
- Consider maximizing retirement plan contributions to reduce AGI.
- Consider converting regular IRAs to Roth IRAs; future IRA distributions are includable in AGI. In general, the higher the AGI, the more likely that the NIIT will apply as well as deduction phase-outs. Roth distributions are not includable in income (subject to certain rules) and therefore do not increase AGI.
- axes should be considered when making and managing investments, however investment decisions should not be made solely from a tax perspective. In light of the NIIT, consideration should be given to:
- Tax-free municipal bonds – Municipal interest is not included in income, reducing AGI and the NIIT.
- Common stock paying qualified dividends – qualified dividends are taxed at maximum rates of 15% or 20%, depending on the taxpayer’s income level and could possibly be taxed at 0% if the taxpayer is in the 0 – 15% tax bracket.
- Preferred stocks paying qualified dividends – are also taxed at the maximum rates of 15% or 20%, depending on the level of taxable income; could possibly be taxed at 0% if taxable income is in 0 – 15% tax brackets.
- Preferred stocks paying floating rate qualified dividends – advantages same as above and provide increased dividends if interest rates rise.
Qualified dividends, while taxed at lower tax rates, are nonetheless still included in AGI and the NIIT.
Investment outlook, risk tolerance, time horizon and portfolio allocations must be considered before making any investments.
- Consider other tax-sheltered investments such as rental real estate providing depreciation deductions. Depreciation deductions reducing operating income would reduce regular tax and the NIIT.
Managing Deductions and Credits for Businesses
Normally, we would discuss bonus depreciation, Section 179 expensing, the research credit, and the 15-year depreciation life for qualified leasehold improvements/retail improvements/restaurant property here, but as of right now, none of those are available. Note that all are currently included in EXPIRE. It still makes sense to consider each of these tax benefits for 2014, as the odds are that at least a few of these benefits will be extended effective to January 1, 2014. At present, be mindful that these benefits may be available (or not) for 2014 by the time your 2014 federal income tax return is prepared.
- IC-DISC. For U.S. companies exporting products that they manufacture, it is probably worthwhile to establish an interest charge – domestic international sales corporation or IC-DISC. The operating company pays a commission to the IC-DISC. The associated tax benefit is approximately the tax differential on the commission between the qualified dividend tax rate and the top ordinary tax rate. The NIIT may apply to the dividend.
Managing Deductions for Individuals
- Use Non-Cash Assets for Charitable Deductions. Rather than writing a check to make a charitable deduction, give appreciated assets, such as stocks and bonds. This technique avoids capital gain tax, reduces income and the NIIT on investment income.
Through 2013, taxpayers 70 ½ and older, who were required to take minimum distributions from their IRAs and were charitably inclined, could donate their IRA distribution directly to charity. This avoided income recognition on the minimum distribution. This provision expired at the end of 2013. A bill, H.R. 3944, was introduced in January 2014 to extend this provision through 2014, but it has stalled and is not likely to be enacted. The provision is included in the current version of EXPIRE.
- In 2014, the following gifts can be made free of gift tax, thereby avoiding gift tax as well as future estate tax on the gift and on all of the potential growth in value on the gift:
- Annual exclusion gifts per recipient of $14,000
- Lifetime exemption equivalent of $5,340,000 (minus prior lifetime gifts made in excess of the annual exclusion)
- There are many ways of making gifts to take advantage of available exemptions. Married couples not ready to completely part with assets should consider a spousal trust for the other or two trusts (one for each). Assets in the trust grow free of estate tax; the beneficiary-spouse can access the trust during the beneficiary-spouse’s lifetime. All types of assets can be given to the trust, including personal residences. A personal residence can be a good gift to a spousal trust because the couple won’t need to worry about losing needed income, as the residence is not an income-producing asset. Caution must be taken, however, because on the death of the beneficiary-spouse, the remainder-spouse will not be able to access the trust (rather, the successor beneficiaries have access to the trust assets) and rent will likely be required. Spousal trusts can provide asset protection. Legal counsel should be consulted regarding the asset protection benefits.
- If purchasing life insurance for family protection in case of the loss of the breadwinner or to fund estate taxes, consideration should be given to the use of an irrevocable insurance trust to acquire life insurance. Structured properly, this technique allows the insurance proceeds to avoid inclusion in the insured’s estate and the insurance proceeds are protected from the insured’s and trust’s beneficiaries’ creditors’ claims.
- Problem caused by disparity in Federal and certain States’ estate tax exemptions. With the Federal estate tax exemption equivalent to $5,340,000 in 2014, many states, including Illinois, have exemptions of lower amounts. Under certain otherwise sound estate plans for Federal estate tax purposes, while Federal estate taxes may not be due, state estate taxes may apply. Estate plans should be reviewed for this issue and how to minimize state estate taxes.
Our philosophy is that year end tax planning is often too late and ineffective; mid-year is an excellent time to review your tax plan. FGMK can assist in reviewing and implementing all of the ideas presented herein as well as other tax planning strategies to create a sound customized tax plan for you, your family and your business activities.
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