While the presidential election may be complete, there is still significant uncertainty surrounding the future of tax policy. Although we know President Obama will serve a second term, we don’t know whether a divided Congress will reach an agreement on the fate of the soon-to-expire Bush tax cuts. And if congressional gridlock does in fact rule the next two months, the country faces its most dramatic tax law changes in decades when these cuts expire on Jan. 1, 2013.
In the absence of partisan agreement, tax rates will rise for every American in 2013. As a result, during the remaining days of 2012, tax planning takes on a heightened level of importance.
To that end, here are five planning ideas that may help you save significant tax dollars:
1. Accelerate year-end bonuses into 2012. There is one axiom on which almost all tax planning opportunities are based: defer income, accelerate deductions. But in the waning months of 2012, high-income taxpayers will want to give strong consideration to taking a contrarian approach and accelerating income into the current year.
The maximum personal tax rate is currently 35 percent. With the expiration of the Bush tax cuts, this rate will rise to 39.6 percent in 2013. In addition, beginning next year taxpayers earning wage income in excess of $200,000 ($250,000 for married filing jointly) will pay an additional 0.9 percent Medicare tax on wages in excess of those thresholds.
Crunching the numbers, assuming you already reside in the highest tax bracket, accelerating a year-end bonus from January 2013 into December 2012 could save you up to 5.5 percent, (40.5 percent to 35 percent) in federal tax.
2. Accelerate corporate dividends into 2012. Currently, qualified dividends are taxed at a preferential 15 percent tax rate. Absent any further legislation, however, dividends will again be taxed at ordinary income rates as high as 39.6 percent in 2013. Tack on the additional 3.8 percent surtax imposed upon net investment income (primarily interest, dividends and capital gains) for taxpayers earning in excess of $200,000 ($250,000 for married filing jointly) that is slated to begin in 2013, and wealthy taxpayers will experience a near-tripling in their dividend rate, from 15 percent to 43.4 percent.
As a result, owners of corporations should consider accelerating any planned 2013 dividends into 2012 to take advantage of the lower rates.
3. Sell your business. The sale of corporate stock, an interest in a partnership, or the assets of a sole proprietorship generally results in capital gains. As does the sale of real estate, except to the extent the gain is attributable to previous depreciation deductions.
At the moment, the tax rate applied to these gains — provided the assets have been held longer than one year — is 15 percent. If the Bush tax cuts expire, this rate will rise to 20 percent, and beginning in 2013, the additional 3.8 percent surtax on net investment income discussed above may apply as well, raising the maximum rate on long-term capital gains for some taxpayers to a high of 23.8 percent.
Quite obviously, this increased tax could become prohibitive. To illustrate, imagine you own real estate valued at $1.2 million that you purchased years ago for a minimal investment. For simplicity’s sake, assume a sale of the property generates $1 million of long-term capital gain. In 2012, this gain would generate a federal income tax bill of $150,000, leaving you with $1,050,000 of after-tax cash.
Wait until January, however, and the tax rate on this same $1 million gain may well be 23.8 percent, leaving you with a $238,000 federal tax bill and only $962,000 of after-tax cash, a decrease of a rather substantial $88,000.
4. Elect out of the installment method. Should you sell your business or real estate in 2012 for a string of payments, at least one of which is to be received in a future year, you may be tempted to report the gain on the installment method. Under this method, you would be permitted to defer portions of the underlying gain until the related payments are subsequently received. But as previously highlighted, 2012 might not be the time to seek deferral.
The downside of the installment method is that you do not “lock in” to the tax rates in place during the year of sale for use against all future gain recognition. Instead, you are at the mercy of Congress, and if the tax rates rise during subsequent years, any gain recognized during those years is subject to the increased rates.
Consequently, if you sell an asset during 2012, you should consider electing out of the installment method and recognizing the full amount of gain on your 2012 tax return. This will allow you to pay tax at the current 15 percent rate, rather than at a potential 23.8 percent rate in 2013.
Fortunately, you don’t have to make that decision in the next two months, as the election to opt out of the installment method is made upon the filing of a tax return. This means taxpayers have until October 2013 — assuming a timely extension is filed — to take in the fate of the Bush tax cuts before making any decisions.
5. Die. I’m joking, of course, but if you haven’t been consulting with a competent estate tax attorney, it’s not the worst idea in the world. If you have a sizable estate, that estate is currently subject to a $5,120,000 lifetime exemption and a 35 percent tax rate. Should Congress fail to act by year-end, those amounts are set to return to $1,000,000 and 55 percent, respectively. So if you really want to provide for future generations, you may have to take one for the team before New Year’s Day. The family will miss you, but extra cash can heal a lot of pain.
Tony J. Nitti, CPA, MST, is a partner with WithumSmith+Brown, PC in Aspen.