As 2015 draws to an end, the time to review and implement year-end tax planning strategies has arrived. As indicated in our July 2015 tax planning article, over 50 largely taxpayer-friendly provisions expired at the end of 2014. There has been movement in Congress to extend them for another two years, and to make some permanent. In a recent interview, Representative Kevin Brady, the new House Ways & Means Committee Chairman, indicated he is supportive of making some of the extenders permanent. There is disagreement between the Obama administration and Congress as to which specific extenders should be made permanent.
Following is our July 2015 tax planning article, updated to reflect any recent developments. While year-end tax planning for 2015 should be finalized now, it is never too early to start thinking about tax planning strategies for 2016.
Tax Reform and Tax Extenders
With the Presidential election campaign cycle beginning, the prevailing wisdom is that comprehensive tax reform is very unlikely until after the new administration takes office in 2017. The best that can be anticipated from Congress is the extension of over 50 tax provisions that expired at the end of 2014. Last December, and at the proverbial last minute, Congress extended for one year, from the end of 2013 to the end of 2014, over 50 largely taxpayer-friendly tax provisions that had expired. As of January 1, 2015, those provisions expired, and there has been movement in Congress to extend them once again. On July 21, 2015, the Senate Finance Committee passed a bill extending the expired provisions for two years. However, there is no certainty as to when the extending legislation may move through Congress and reach the President's desk for signature, making effective tax planning challenging.
Some Notable Tax Changes in 2015
Change to rules regarding IRA rollovers: A rollover is a distribution from an IRA to the account owner that the account owner then deposits into another deferral-eligible retirement account. This is in contrast to a "trustee-to-trustee" transfer or direct transfer in which assets are transferred directly from the old IRA to the new IRA without passing through the hands of the owner. In the case of a rollover, the account owner takes temporary possession of the distribution check before re-depositing it into another IRA.
Once an individual has made a rollover, he must wait at least one year from the date of receipt of the withdrawal before becoming eligible to engage in another rollover. Historically, the IRS applied this rule on an IRA-by-IRA basis, rather than on a taxpayer-by-taxpayer basis. So, a taxpayer with multiple IRAs could roll over amounts from each IRA during a 12-month period, as long as the taxpayer did so only once per IRA. Starting in 2015, the once-per-12-month rule applies on a taxpayer-by-taxpayer basis. Thus, if a taxpayer has multiple IRAs, a rollover from one of the IRAs prevents the taxpayer from rolling over again within 12 months with respect to any of the other IRAs. The one-per-12-month rule does not apply to trustee-to-trustee or direct transfers.
Impending IRS regulations are likely to reduce or eliminate the use of valuation discounts for intra-family transfers: An IRS attorney indicated that new regulations to be issued will likely reduce or eliminate the use of valuation discounts on intra-family gifts. Valuation discounts are often used in conjunction with family limited partnerships to obtain substantial estate or gift tax discounts. The window for using this strategy may be closing. Although the effective date of these regulations is unknown, it is likely that only transfers completed prior to the effective date would be grandfathered.
IRS proposes changes to partnership liability allocation rules: The IRS has issued proposed regulations to the Section 752 regulations that would significantly impact how partnerships allocate their liabilities to their owners for at-risk and basis purposes. The purpose of the proposed regulations is to end "paper guarantees" and to require that guarantees be commercially reasonable before they can be respected for at-risk purposes. If these proposed regulations are adopted, they would reduce the use of "bottom dollar guarantees" (i.e., arrangements in which partners guarantee the least risky portion of the debt), impose net worth requirements on guarantors, and possibly impact how nonrecourse liabilities are allocated amongst partners.
Inflation Adjusted Amounts and Other Matters for 2015
Other than the provisions that expired on December 31, 2014, federal tax law remains relatively unchanged from 2014 to 2015. For those provisions that have adjustments for inflation, there are new amounts for 2015.
The impact of the net investment income tax (NIIT): The NIIT became effective in 2013, and is a 3.8% tax on the net investment income of high-income individuals (i.e., married and single taxpayers with modified adjustment gross income (MAGI) in excess of $250,000 and $200,000, respectively) and certain estates and trusts (with undistributed income in excess of $12,300 for 2015). Net investment income is generally comprised of gross income from interest, dividends, annuities, royalties, and rents not derived in the ordinary course of a trade or business (Category 1 income); gross income from passive activities and from trading in securities or commodities (Category 2 income); and net gain attributable to the disposition of property other than property from a non-passive trade or business (Category 3 income). Deductions allowed for federal tax purposes are allocated to the above categories to arrive at net investment income (NII).
Higher tax rates still apply to high-income individuals: The top ordinary income tax rate of 39.6% still applies to individuals. The 39.6% bracket begins at taxable income of $464,850 for married taxpayers and $413,201 for individual taxpayers.
Long-term capital gains and qualifying dividends: The long-term capital gains rates and qualifying dividend rates remain at 20% for taxpayers in the 39.6% ordinary income tax bracket, 15% for most individuals, and 0% for individuals in the 10% or 15% income tax brackets.
The Affordable Care Act (ACA) individual shared responsibility payment increases: The "penalty" (technically called the "shared responsibility payment") for "applicable individuals" who do not have health insurance significantly increases in 2015. The penalty is the greater of the flat-dollar-amount penalty or the percentage-of-income penalty. For 2015, the flat-dollar-amount penalty for an individual over age 18 increases from $95 to $325 (and from $47.50 to $162.50 for individuals ages 18 and under). The percentage-of-income penalty increases from 1% in 2014 to 2% in 2015.
Estate and gift tax: The estate and gift tax exemption is $5,430,000 for 2015, along with the 40% top tax rate. The portability of unused exemption amounts between spouses continues to be allowed in 2015.
Limitations on itemized deductions and personal exemption phase-outs: The phase-outs continue for 2015. For married couples filing jointly, the phase-out begins at adjusted gross income ("AGI") amounts over $309,900. For single individuals, the phase-out begins at AGI of $258,250. Personal exemptions phase out completely at AGI of $432,400 for married couples filing jointly, and at AGI of $380,750 for single taxpayers.
Bonus depreciation: Expired at the end of 2014. The Senate Finance Committee bill extends bonus depreciation for two years. The House Ways & Means Committee voted in September to make bonus depreciation permanent, but the White House is currently opposed to that action.
Section 179 expense: The election that allowed increased expensing of certain asset acquisitions expired and, without being extended, the expensing amount is back down to only $25,000 with an investment ceiling of $200,000. The Senate Finance Committee bill extends for two years the increased Section 179 expensing of $500,000, reduced by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $2,000,000.
Research credit: The research credit expired on December 31, 2014, and absent an extension, will not be in place for 2015. The research credit has expired numerous times in the past and has always been extended by Congress. Presently, the Senate Finance Committee bill extends the research credit for two years.
Qualified leasehold improvements: A 15-year life for qualified leasehold improvements, qualified retail improvements, and qualified restaurant property only applies to assets placed in service before January 1, 2015. The Senate Finance Committee extends this 15-year life for two years for qualifying assets placed in service before January 1, 2017.
Tax Planning Ideas
• If realizing capital gains, the amount of gain and all other expected income must be reviewed in advance. Depending 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% bracket, capital gains at this income level are taxed at 0%; this occurs for married taxpayers filing joint returns on taxable income up to $74,900 and $37,450 for single taxpayers.
• If there is no immediate desire to sell assets, still consider taking advantage if taxable income is in the 0 - 15% tax bracket. With marketable securities that have unrealized gains, it can be beneficial to sell them when in the 0 - 15% tax bracket and incur no capital gain tax and then repurchase the assets. This will create a new, higher basis in the assets 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 of the NIIT.
• If realizing capital gains, 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, taxable gain recognition can be deferred beyond the current year. An installment sale can spread income over a period of years and perhaps reduce the capital gains tax from 20% to 15% (or lower) and possibly reduce or eliminate the NIIT. Conversely, and 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 a like-kind exchange under Section 1031. If you are able to take advantage of Section 1031, gain is deferred until the ultimate taxable sale of the replacement property that is received in the exchange. For senior taxpayers, a series of ongoing exchanges has resulted in the term "swap 'til you drop." Under this strategy, a taxpayer engages in consecutive exchanges to defer taxes on sales. Upon the death of the taxpayer, the potential income tax on the cumulative gain is eliminated through the estate step-up in basis (subject to the estate basis step-up being repealed). State income tax rules need to be considered as well for conformity or 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 defer the gain and tax into the next tax year. This is a possibility if the property to be disposed of as the first step of a like-kind exchange is sold during the last half of the taxpayer's tax year (so that fewer 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 reacquired after waiting 30 days to avoid the wash sale rules.
• Harvest gains. Normally, accelerating income by pulling income into the current year from future 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 as capital gains and subject to the NIIT as well. The installment sales method can be utilized with a residence sale to defer gain, if the seller takes back a note and defers receipt of payments to future years.
• Review activities to determine or reassess if active or passive. The nature of the activity impacts the ability to take losses from flow-through entities as well as the application of the NIIT.
• Consider making a grouping election under Section 469 in 2015 to combine activities in order to meet the material participation tests. This can change passive business income into active business income that is not subject to the NIIT.
• The grouping election can also create the opportunity to deduct what would otherwise be passive losses as active losses that can offset other income.
• Review income and potential income from trusts and estates, and the level of activity of executors and trustees in underlying activities to determine how and whether the NIIT will apply. Note that there is recent taxpayer-friendly case law on this topic.
• Trusts are subject to the NIIT at a much lower income threshold than individuals ($12,300). Consideration should be given, when allowable under the trust document, to distributing income to the beneficiaries if it better manages the overall NIIT cost. Care should be taken that the goals of the overall estate plan are not compromised by making distributions.
• Assess levels of shareholders' salaries from S corporations -For shareholders who materially participate in an S corporation, the receipt of reasonable salaries is important to help support their level of activity in the company. Material participation is required to avoid NIIT on the S corporation income. The absence of a salary could make it easier for the IRS to assert that the income is passive and subject to the NIIT. Note: active status is determined based on hours worked and ownership, but not drawing 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 made 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 making retirement plan contributions to reduce AGI.
• Consider converting regular IRAs to Roth IRAs. Regular IRA distributions are taxable and includable in AGI, but distributions from Roth IRAs are tax-free. Once a taxpayer begins taking distributions from IRAs, regular IRA distributions will increase AGI and increase taxable income, make it more likely for the NIIT to apply, and impact the itemized deduction phase-outs. Roth IRA distributions, in contrast, will have no such impact as the distributions are not taxable. Therefore, consideration should be given to converting regular IRAs into Roth IRAs. Although the conversion is a taxable event, all future growth will be tax-free.
• Taxes 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 federal taxable income, reducing AGI and the NIIT.
• Common and preferred 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 tax-free if the taxpayer is in the 0 - 15% bracket.
• Preferred stock paying floating rate qualified dividends-the dividends are taxed at the maximum rates of 15% or 20%, and these securities have the advantage of providing increased dividends if interest rates rise. Qualified dividends, while taxed at lower tax rates, are still included in AGI and are potentially subject to 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 reduce operating income and thus reduce regular tax and the NIIT. However, the passive activity loss limitations need to be considered.
Managing Deductions and Credits for Businesses
Normally, we would discuss bonus depreciation, Section 179 expensing, the research and experimentation credit, and the 15-year depreciation life for qualified leasehold improvements/retail improvements/restaurant property. But, as of this writing, all of those provisions have expired. As of July 21, 2015, the Senate Finance Committee has passed a bill for a two-year extension of these provisions, but the timing of final enactment into law is uncertain. There has also been an attempt in Congress to make some of the extenders permanent.
• IC-DISC-For U.S. flow-through companies exporting products that are manufactured in the U.S. with at least 50% U.S. content, it may be worthwhile to establish an interest charge-domestic international sales corporation, or IC-DISC. The operating flow-through company pays a deductible export commission to the IC-DISC that generates a deduction in the hands of the flow-through entity's owners at (up to) 39.6%. Subsequently, the IC-DISC distributes its net income in the form of a "qualified" dividend to the flow-through owner, and that dividend is taxed to the owners of the flow-through entity at no more than 23.8% (federal tax, including the NIIT.) This generates a "tax arbitrage" opportunity equal to 15.8% of the DISC commission.
• De minimis safe harbor rule under the new repair regulations – This is an annual elective safe harbor and is made by attaching a statement to a timely filed return (including extensions) each year. The safe harbor provides that a taxpayer with applicable financial statements (i.e., audited financial statements) may deduct up to $5,000 per item of tangible personal property purchased. A taxpayer without applicable financial statements may deduct up to $500 per item of tangible personal property purchased. The taxpayer must have a written policy for book purposes adopting the expensing policy. As an example, a taxpayer with applicable financial statements that purchases 10 laptops at a cost of $2,000/each that expenses the laptops, and takes the $20,000 deduction under its book policy, can similarly expense them for tax purposes, rather than capitalize and depreciate them over a number of years.
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 gains tax, and reduces income and the NIIT on investment income.
• Charitable contribution of IRA distribution -Through 2014, taxpayers 70 ½ and older who were required to take minimum distributions from their IRAs and were charitably inclined could donate up to $100,000 of their IRA distribution directly to a charity. The IRA distribution was excluded from the owner's gross income. The contribution was not deductible by the taxpayer, but the exclusion from the taxpayer's gross income had the same impact. This provision expired on December 31, 2014, but the Senate Finance Committee bill extends this provision for two years.
The media regularly report on different variations of proposed international tax reform legislation. There are two things we can say with relative certainty: first, whatever you read about today isn't likely to be the version of tax reform that is enacted; and second, it's highly unlikely that anything material will be enacted before the next presidential election. So rather than speculate about future tax reform, this section is a reminder for our clients who conduct business internationally. In particular:
• Keep in mind your ability to elect the "entity classification" of foreign business entities in order to obtain, or avoid, flow-through tax results. (This "check-the-box" election is available for many limited liability types of entities, other than those that are considered "per se" public corporate entities.) Obtaining flow-through status in a foreign entity can have beneficial features, including:
• Flowing through foreign start-up losses into the income of the U.S. parent entity and offsetting the losses against U.S. income;
• Permitting the use of foreign taxes paid in the foreign country as taxes that may be creditable against U.S. taxes imposed on foreign source income;
• Avoiding the application of disadvantageous anti-deferral tax rules (such as Subpart F and Section 956) that apply to "Controlled Foreign Corporations;"
• Simplifying the U.S. tax reporting requirements with respect to the ownership of foreign entities.
However, there is a trade-off between accessing foreign tax credits on the one hand, and the maximum US tax rate on foreign "qualifying dividends" on the other. Dividends from a foreign corporate legal entity that can make "qualifying dividend" payments to a U.S. individual shareholder, directly or through a US pass-through entity, are subject to a maximum federal tax rate of 23.8% (including NIIT.) If the effective foreign tax rate, including withholding taxes, on the foreign corporation's income is relatively low, it is often less expensive to the U.S. shareholder to access the 23.8% rate than to obtain a foreign tax credit on flow-through foreign source income that would be taxed in the U.S. at up to 39.6% (not including state taxes). Consult your FGMK tax advisor regarding this trade-off before making a foreign check-the-box election.
• Remember that doing business outside the U.S. entails a variety of tax and treasury reporting requirements. In addition to reporting the ownership of foreign entities on Forms 5471 (corporations,) 8865 (partnerships) or 8858 ("disregarded entities,") US taxpayers must report contributions to foreign corporations (Form 926,) ownership of foreign financial assets (Form 8938,) ownership of an interest in a Passive Foreign Investment Company (Form 8621), transactions with foreign trusts, or foreign gifts (Form 3520,) and foreign trusts with a U.S. owner (Form 3520-A.) Moreover, the U.S. Department of the Treasury requires the reporting of foreign financial accounts on Form FinCEN 114, an on-line form that is due on June 30 and cannot be extended. Failure to follow these and other international reporting requirements entails penalties and prevents the audit statute limitations from running.
• Finally, note that almost all cross-border transactions come with tax pitfalls, tax opportunities and U.S. and /or foreign tax reporting requirements. To the extent that your business or investment profile has expanded to encompass cross-border transactions or cross-border investments, the "old tax rules" may no longer apply. The international tax portion of the Internal Revenue Code acts as an "overlay" on top of the domestic portions, and frequently overrides simpler domestic provisions to cause transactions to be taxable, subject to reporting, or both, when the domestic rules would not. Be sure to consult your FGMK tax advisor and advise her or him of any international expansion of your business or your investments.
• In 2015, the following amounts can be gifted free of gift tax, thereby avoiding gift tax as well as any future estate tax on the gift and on all of the potential growth in value of the gift.
• Annual exclusion of gifts per recipient of $14,000
• Lifetime combined gift and estate tax exemption of $5,430,000 (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, and the beneficiary-spouse can access the trust during the beneficiary-spouse's lifetime. All types of assets can be contributed 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 assets. Rather, the successor beneficiaries will have access to the trust assets, and rent will likely be required. 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 the trust's beneficiaries creditors' claims.
• As indicated previously, the IRS has stated that it will issue new regulations reducing or eliminating the use of valuation discounts on intra-family gifts. The window for using this strategy for estate and gift tax savings may be closing soon.
• Problem caused by the disparity in federal and certain States' estate tax exemptions. Although the federal combined gift and estate tax exemption is $5,430,000 in 2015, many states, including Illinois, grant 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.
Effective and timely implementation of tax planning strategies is key. FGMK can assist you in reviewing and implementing all of the ideas presented herein, as well as other tax planning strategies, to create a sound and customized tax plan for you, your family, and your business activities. Contact Steven Bokiess, Fuad Saba or Randy Markowitz.
FGMK is a leading professional services firm providing assurance, tax and advisory services to privately held businesses, global public companies, entrepreneurs, high-net-worth individuals and not-for-profit organizations. FGMK is among the largest accounting firms in Chicago and one of the top ranked accounting firms in the United States. For more than 40 years, FGMK has recommended strategies that give our clients a competitive edge. Our value proposition is to offer clients a hands-on operating model, with our most senior professionals actively involved in client service delivery.