United States: Tips For Jump-Starting Year-End Tax Planning For Individuals And Businesses

This article was written by practitioners in the Tax Accounting Group of Duane Morris

With carefree summer days behind us and the arrival of fall, now may be a good time to jump-start implementation of tax-planning strategies available to you through the end of this year to potentially minimize your tax burden.

Potential Impact of Presidential and Congressional Elections

With the 2016 presidential election cycle in full swing, the outcomes of both the U.S. Presidency and the elections in the House and Senate have the possibility of significantly altering the tax landscape.

Hillary Clinton has proposed a series of tax changes that would increase income taxes on high-income filers, as well as increase estate and gift taxes. Specifically, Clinton proposes a 4-percent surcharge on adjusted gross income (AGI) above $5 million ($2.5 million for married couples filing separately), requiring filers with AGI greater than $1 million to pay a 30-percent effective tax rate, limiting the tax value of specified exemptions and deductions to 28 percent and increasing the estate tax. The Tax Foundation estimates that taxpayers in the top 1 percent of the income distribution (those with adjusted gross income of more than $465,000) would see a reduction in after-tax income of 2.7 percent, essentially a tax increase. The top 10 percent of taxpayers (those with adjusted gross income of more than $133,000) would see a reduction in after-tax income of 1.7 percent, while the bottom 90 percent would see their after-tax incomes decline by between .9 percent and 1 percent.

Clinton's plan also calls for the creation of a new tax schedule for capital gains. Assets held less than two years would be taxed as short-term gain at ordinary income tax rates, while the 23.8-percent capital gains rate would apply only to assets held six or more years (rather than the current holding period of one year). The plan also proposes to reduce the tax threshold for estates to $3.5 million ($7 million for married couples) from the present tax threshold of $5.45 million per individual ($10.9 million for married couples).

Donald Trump's recently revised proposed tax plan would significantly reduce marginal tax rates on individuals and businesses, increase the standard deduction and curtail many tax expenditures. Specifically, Trump's plan would collapse the current seven tax brackets, which range from 10 percent to 39.6 percent, into three brackets of 12 percent, 25 percent and 33 and more than double the standard deduction from $6,300 to $15,000, and from $12,600 to $30,000, for single and joint filers, respectively. The plan also calls for the repeal of the federal estate and gift taxes.

In addition, Trump's plan proposes to reduce the corporate tax rate from 35 percent to 15 percent and ensure that income from pass-through entities is taxed at no more than 15 percent (down from up to 39.6 percent presently). It also calls for the repeal of the net investment income tax and both the individual and corporate alternative minimum tax.

While Trump's plan would decrease tax rates and increase after-tax income at all levels, the bottom 80 percent of income groups would see only modest increases of .8 percent to 1.9 percent, while those between the 80th and 100th percentiles (adjusted gross income of more than $112,000) would see higher after-tax incomes of 4.4 percent to 6.5 percent. For those in the top 1 percent (adjusted gross income of more than $465,000), the income growth from tax cuts would be between 10.2 percent and 16 percent.

For this tax year—2016—we see the present law continuing, although the results of the elections may require personal and business adjustments when setting long-term objectives.

For now, Congress recently made many of the long-favored tax breaks, commonly known as "extenders," permanent. For the first time in years, taxpayers can not only determine with relative certainty the impact of these tax provisions on their long-term financial and business planning decisions, but they can also do so well in advance of year-end.

Despite this welcome news, tax laws remain exceedingly complex. For 2016, the top federal income tax rate is 39.6 percent, but higher-income individuals can also be hit by the 0.9-percent additional Medicare tax on wages and self-employment income and the 3.8-percent Net Investment Income Tax (NITT), which can both result in a higher marginal federal income tax rate. Finally, taxpayers should consider whether they are exposed to Alternative Minimum Tax (AMT). If so, certain tried-and-true tax-planning moves may not be advantageous, and alternative strategies should be considered.

Early fall, while ample time remains to implement desired strategies, is the perfect juncture to evaluate and employ tax saving moves for 2016. Below are a few simple, yet powerful, strategies available to individuals and businesses this year.

Individuals

  • Tax Rates The 2016 federal income tax rates on long-term capital gains and qualified dividends are 0 percent, 15 percent and 20 percent, with the maximum 20-percent rate affecting taxpayers with taxable income above $415,050 for single taxpayers, $466,950 for married joint-filing couples and $441,000 for head-of-household filers. High-income individuals can also be hit by the 3.8-percent NITT, which can result in a marginal long-term capital gains/qualified dividend tax rate as high as 23.8 percent. Still, that is substantially lower than the top regular tax rate of 39.6 percent (43.4 percent if the NITT applies). To take advantage of these low preferred rates, consider investing in stocks that will generate qualified dividends. Qualified dividends are those paid to investors in common and preferred stock of U.S. corporations. Whether dividends from mutual funds are classified as qualified depends on the underlying securities held by the fund. Also, when selling securities, consider identifying tax lots that will result in long-term capital rates upon sale.

Investment Strategy

  • Holding Period – If you hold appreciated securities in taxable accounts, owning them for at least one year and a day is necessary to qualify for the preferential long-term capital gains tax rates. In contrast, short-term gains are taxed at your regular rate, which can be as high as 39.6 percent (43.4 percent if the NITT applies). Whenever possible, try to meet the more-than-one-year ownership rule for appreciated securities held in your taxable accounts. Of course, while it is prudent to consider tax consequences, don't let the tax tail wag the investment dog. The tax impact is just one of many factors, such as investment objectives and cash flow considerations, to consider when making buy or sell decisions.
  • Optimize Tax Lots – Typically, when selling stock or mutual fund shares, the shares purchased first are considered sold first (FIFO method – first in first out), which is good news when trying to qualify for long-term capital gain rates. However, there may be situations where it's better to sell shares that have been held less than a year rather than those held longer (LIFO method – last in first out). Selling recently purchased shares at little or no gain (because they were purchased at a higher price) may be better than selling shares held for more than one year if that sale would produce a significant gain. In situations where the LIFO method is preferred, it may be prudent to properly notify your broker as to the specific tax lot that should be sold. Another related consideration with respect to optimizing tax lots relates to the charitable donations. When contemplating a substantial charitable contribution, donating highly appreciated stock instead of cash can result in significant tax savings.

Tax-Free Income

  • Take Advantage of Retirement Plan Options – The earnings on most retirement accounts are tax-deferred. (With Roth IRAs, they're normally tax-free.) Thus, the sooner you fund such an account, the quicker the tax advantage begins. If cash flow is not a concern, there's no need to wait until year-end or the April or October tax filing deadlines to make 2016 contributions. However, contributions to an employer-sponsored 401(k) or SIMPLE-IRA plan should take priority over non-deductible IRA contributions to ensure receipt of a full employer match.
  • Invest in Tax-Free Securities – A major source of tax-free income is tax-exempt securities, either owned outright or through a mutual fund. Whether they provide a better return than the after-tax return on taxable investments depends on your tax bracket and the market interest rates for tax-exempt investments. Since these factors change frequently, it is essential to periodically compare taxable and tax-exempt investments. In some cases, it may be as simple as transferring assets from a taxable to a tax-exempt fund.
  • Make Charitable Donations from IRAs – Taxpayers who have reached age 70½ and must take annual minimum required distributions from their IRA can arrange to have up to $100,000 of otherwise taxable distributions paid directly to qualified charities. These so-called Qualified Charitable Distributions (QCDs) are exempt from federal income tax. Instead of including the IRA distribution in income and then claiming a charitable deduction on Schedule A, the entire QCD is excluded from income. However, the devil is in the detail—to qualify for this special tax break, the funds must go directly from your IRA and the charity.
  • Increase Participation in Otherwise Passive Activities – The so-called passive activity rules prevent many taxpayers from currently deducting losses from business activities in which they do not "materially participate." These losses are typically from partnerships in which they are not personally involved or do not participate to the extent required by the tax rules. Taxpayers can normally satisfy any one of several tests to meet the material participation standard. For taxpayers expecting a current-year loss (or with a carryover loss from an earlier year) from an activity, proper planning between now and year-end can help ensure those losses are not disallowed under the passive activity rules.

Businesses

  • Consider Taking Advantage of the Generous Section 179 Deduction – Under the Internal Revenue Code Section 179 rules, eligible businesses can often claim first-year depreciation write-offs for the entire cost of new and used equipment and software additions, as well as eligible real property costs. For tax years beginning in 2016, the maximum Section 179 deduction is $500,000. However, this maximum deduction is reduced to the extent more than $2 million of qualifying property is purchased during the tax year. Also, a much lower deduction limit applies to most vehicles.
  • First-year Bonus Depreciation – Above and beyond the Section 179 deduction, businesses may also claim first-year bonus depreciation equal to 50 percent of the cost of most new (not used) equipment and software placed in service by the end of 2016. Unlike Section 179 deductions, first-year bonus depreciation can create or increase a Net Operating Loss (NOL) for a business' 2016 tax year. The NOL may then be carried back to 2014 and/or 2015 to collect a refund of taxes paid in one or both of those years.
  • Sell Rather Than Trade-in Vehicles Used in Business. Although a vehicle's value typically drops quite rapidly, the tax rules limit the amount of annual depreciation that can be claimed on most cars and light trucks. Thus, when it comes time to replace the vehicle, it is not unusual for the vehicle's tax basis to be higher than its fair market value. When the vehicle is traded in for a new one, the undepreciated basis of the old vehicle simply tacks onto the basis of the new one. However, by selling the old vehicle rather than trading it in, any excess of basis over the vehicle's value can be claimed as a deductible loss to the extent of the business use of the vehicle.
  • Employ Your Kid. If you are self-employed, you should consider employing your child to work in the business. Doing so allows the shifting of income (not subject to the harsh Kiddie tax) from parent to child, typically to a lower tax bracket and may avoid income tax entirely due to the child's standard deduction. Payroll tax savings are also available for wages paid by sole proprietors to their children age 17 and younger who are exempt from Social Security, Medicare and federal unemployment taxes. Employing your children has the added benefit of providing them with earned income, which enables them to contribute to an IRA. Children with IRAs, particularly Roth IRAs, get a jump start on their retirement savings since the compounded growth of the funds can be significant. Other key considerations when deciding whether to employ your child include reasonable compensation issues and other non-tax factors, such as determining whether the wages may negatively impact a student's financial aid eligibility.
  • Set Up a Retirement Plan. For businesses that do not currently offer a retirement plan, now may be the time to take the plunge. Retirement plan rules allow for significant deductible contributions. There can be meaningful benefits even for part-time businesses as contributions to a SEP-IRA or SIMPLE-IRA can reduce your current tax load while increasing your retirement savings. SEP-IRAs generally allow contributions of up to 20 percent of self-employment earnings, with a maximum contribution of $53,000. SIMPLE-IRAs, on the other hand, allow taxpayers to set aside up to $12,500 plus an employer match that could potentially be the same amount. In addition, taxpayers age 50 or older by year-end can contribute an additional $3,000 to a SIMPLE-IRA.

Estate Planning

Income tax savings should not be the sole tax planning consideration. Income tax planning moves often impact a taxpayer's estate plan, and it is prudent to coordinate the two to ensure your income tax and estate planning goals are aligned. For 2016, the unified federal gift and estate tax exemption is a generous $5.45 million, and the federal estate tax rate is a historically reasonable 40 percent. A periodic review of your estate plan is essential to ensure it reflects current estate and gift tax rules.

A myriad of estate planning tools are available to help you achieve your tax, investment and gifting goals. The assortment of available tools include simple steps, such as reviewing and updating account titles and/or beneficiary designations, to more sophisticated planning techniques, including the use of various trusts. These types of trusts include: irrevocable trust (shields assets from estate tax); charitable remainder trust (defers capital gains by placing appreciated property into a trust giving regular distributions with remainder at the end of the trust term going to charity); and grantor retained annuity trust (transfers wealth at significant gift tax discount, pays a fixed rate annuity and growth in excess of low IRS interest rate passed to beneficiaries tax-free), among others; and private foundations. It is worthwhile to prioritize your family goals and work with your trusted advisors who will evaluate your unique situation and form a plan that fits your family's needs.

If you would like more information about this topic or your own unique situation, please contact any of the practitioners in the Tax Accounting Group. For information about other pertinent tax topics, please visit our publications page located here.

Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.

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