To Our Clients and Friends:
Although this year is half over, we've already seen legislation with major tax changes, and more are almost certainly on the way. The 2010 federal income tax environment is still quite favorable, however we may not be able to say that for 2011 and beyond. Therefore, tax planning actions taken between now and year-end may be more important than ever. This letter presents some planning ideas for you, family members, and your business.
Traditional Strategy of Deferring Income
Be careful when considering the time-honored strategy of deferring taxable income from this year into next year. The strategy still makes sense if you’re confident you’ll be in the same or lower tax bracket next year, but the tax picture for 2011 is blurry.
The top two rates are widely expected to increase the current 33% and 35% to 36% and 39.6%, respectively, unless Congress intervenes which is unlikely. Therefore, individuals in the top two brackets might want to consider reversing the traditional strategy and accelerating income into 2010 to take advantage of this year’s presumably lower rates.
Higher-income Individuals May Benefit from Accelerating Itemized Deductions
For 2010, the dreaded phase-out rule that previously reduced write-offs for the most popular itemized deduction items (including home mortgage interest, state and local taxes, and charitable donations) is gone. However, the phase-out rule is scheduled to come back with a vengeance in 2011 unless Congress takes action to prevent it, which looks increasingly unlikely. If the phase-out rule comes back as expected, it will wipe out $3 of affected itemized deductions for every $100 of Adjusted Gross Income (AGI) above the applicable threshold. Individuals with very high AGI can see up to 80% of their affected deductions wiped out. For 2011, the AGI threshold will probably be around $170,000, or around $85,000 for married individuals who file separate returns.
Comment: Depending on your AGI, you may get more tax-saving benefit from accelerating your January 2011 mortgage interest payment, your state and local tax payments that are due early next year, and some charitable donations. However, things get a bit tricky if you’ll be subject to the Alternative Minimum Tax (AMT) this year. Please contact us if you have questions about the advisability of accelerating some itemized deductions into this year.
Investment Gains and Losses
As you evaluate investments held in your taxable brokerage firm accounts, consider the impact of selling appreciated securities this year instead of next year. The maximum federal income tax rate on long-term capital gains from 2010 sales is 15%. However, that low 15% rate only applies to gains from securities that have been held for more than a year. In 2011, the maximum rate on long-term capital gains is scheduled to increase to 20% unless Congress takes action.
Using capital losses to shelter short-term capital gains is especially helpful because short-term gains will be taxed at your regular rate (which could be as high as 35%) if they are left unsheltered. If selling losers would cause your capital losses for this year to exceed your capital gains, you will have a net capital loss for 2010. You can then use that net capital loss to shelter up to $3,000 of this year’s high-taxed ordinary income from salaries, bonuses, self-employment, and so forth ($1,500 if you’re married and file separately). Any excess net capital loss gets carried forward to next year.
Comment: Harvesting tax loss benefits is only one consideration when choosing to hold or sell an investment. Also, remember that acquiring identical securities within 30 days of a sale wipes out the loss (wash sale rule).
For Gifts: Give appreciated securities but Sell losers (and Give the Cash)
Say you want to make some gifts to favorite relatives and/or charity. Here’s how to get the best tax results from your generosity.
Gifts to Relatives. Don’t give away loser shares (currently worth less than what you paid for them). Instead sell the shares, and take advantage of the resulting capital loss. Then, give the cash sales proceeds to the relative. Do give away winner shares to relatives. Most likely, they will pay lower tax rates than you would pay if you sold the same shares. In fact, relatives who are in the 10% or 15% federal income tax brackets will generally pay a 0% federal tax rate on long-term gains from shares that were held for over a year before being sold this year. Hopefully, the same will be true if they sell appreciated shares next year. (For purposes of meeting the more-than-one-year rule for gifted shares, you get to count your ownership period plus the recipient relative’s ownership period, however brief.) Even if the shares are held for one year or less before being sold this year, your relative will probably pay a lower tax rate than you would (typically only 10% or 15%). However, beware of one thing before employing this give-away-winner-shares strategy. Gains recognized by a dependent under age 24 may be taxed at his or her parent’s higher rates under the so-called Kiddie Tax rules. (Contact us if you’re concerned about this issue.)
Gifts to Charities. The strategies for gifts to relatives work equally well for gifts to IRS-approved charities. So, sell loser shares and claim the resulting tax-saving capital loss on your return. Then, give the cash sales proceeds to the charity and claim the resulting charitable donation write-off (assuming you itemize deductions). As you can see, this idea results in a double tax benefit (tax-saving capital loss plus tax-saving charitable donation deduction). With winner shares, give them away to charity instead of giving cash. Here’s why. For publicly traded shares that you’ve owned over a year, your charitable deduction equals the full current market value at the time of the gift. Plus when you give winner shares away, you walk away from the related capital gains tax. So this idea is another double tax-saver (you avoid capital gains tax on the winner shares, and you get a tax-saving charitable donation write-off to boot). Because the charitable organization is tax-exempt, it can sell your donated shares without owing anything to the IRS.
Convert Traditional IRA into Roth IRA
Here’s the best scenario for this idea: Your traditional IRA is (or was) loaded with equities and took a major beating in the most recent stock market downturn. So your account is still worth considerably less than it once was. Correspondingly, the tax hit from converting your traditional IRA into a Roth IRA right now would also be a lot less than before, since a Roth conversion is treated as a taxable liquidation of your traditional IRA followed by a nondeductible contribution to the new Roth IRA. While even the reduced current tax hit from converting is unwelcome, it may be a small price to pay for future tax savings. After the conversion, all the income and gains that accumulate in your Roth IRA, and all withdrawals, will be totally free of any federal taxes—assuming you meet the tax-free withdrawal rules. In contrast, future withdrawals from a traditional IRA could be hit with tax rates that are higher than today’s rates (potentially much higher).
Of course, conversion is not a no-brainer, but partial conversion is also an option. .You have to be satisfied that paying the upfront conversion tax bill makes sense in your circumstances. In particular, converting a big account all at once could push you into higher 2010 tax brackets, which would not be good. However, for 2010 conversions, there is the option to split the taxable income into tax years 2011 and 2012. Clearly, you must also make assumptions about future tax rates, how long you will leave the account untouched, and the rate of return earned on your Roth IRA investments.
Comment: Before 2010, there were two big restrictions on the Roth IRA conversion privilege. First, your Modified Adjusted Gross Income (MAGI) could not exceed $100,000. Second, you were completely ineligible if you used married filing separate status. For 2010, both restrictions are eliminated. If the Roth IRA conversion idea intrigues you, please contact us for further analysis of all the relevant variables.
Watch out for Alternative Minimum Tax
While many recent tax-law changes have been helpful in reducing your 2010 regular federal income tax bill, they didn’t do much to reduce the odds that you’ll owe the dreaded AMT. Therefore, it’s critical to evaluate all tax planning strategies in light of the AMT rules before actually making any moves. Because the AMT rules are complicated and we still don’t know exactly what they will be for 2010, this potential impact must be considered.
Claim New Health Insurance Tax Credit for Small Employers
Qualifying small employers can claim a new tax credit that can potentially cover up to 35% of the cost of providing health insurance coverage to employees. A qualifying small employer is one that: (1) has no more than 25 Full-time Equivalent (FTE) workers, (2) pays an average FTE wage of less than $50,000 and (3) has a qualifying healthcare arrangement in place.
A qualifying arrangement is one that requires the employer to—(1) pay at least 50% of the cost of each enrolled employee’s coverage, and (2) pay same percentage for all employees. For tax years beginning in 2010, however, a favorable transition rule allows the credit to be claimed when the employer does not pay the same percentage for each enrolled employee, but instead pays for each enrolled employee an amount equal to at least 50% of the cost of single coverage (even if the employee has more-expensive family or self-plus-one coverage).
The allowable credit is quickly reduced under a complicated two-tiered phase-out rule when the employer has more than 10 FTE employees or an average FTE wage in excess of $25,000..
Take Advantage of Temporary Business Tax Breaks
Several favorable business tax provisions have a limited shelf life that may dictate taking quick action.
Big Section 179 Deduction. Your business may be able to take advantage of the temporarily increased Section 179 deduction. Under the Section 179 deduction privilege, an eligible business can often claim first-year depreciation write-offs for the entire cost of new and used equipment and software additions. For tax years beginning in 2010, the maximum Section 179 deduction is a whopping $250,000 (same as last year). For tax years beginning in 2011, the maximum deduction is scheduled to drop to only $25,000. (Congress may increase the number, but it is not assured.)
Increased Carryback Period for Net Operating Losses (NOLs). Legislation passed last year allows businesses to carry back Net Operating Losses (NOLs) generated in tax years beginning in 2009 for up to five years (versus the two-year carryback rule that usually applies). If your business uses a fiscal tax year (say one that began last October), you may still have time to take actions that will create or increase an NOL for the current tax year. That NOL can then be carried back for up to five years to recover taxes paid in those years.
Social Security Tax Exemption for Wages Paid to New Hires. Wages paid to a qualified new employee between March 19, 2010 and December 31 2010 are exempt from the employer’s portion of the Social Security tax (the employer portion equals 6.2% of wages up to $106,800). The exemption doesn’t apply to the employee’s portion of the Social Security tax (also 6.2% of wages of up to $106,800). Qualified new employees are full-time or part-time workers who—(1) start work after February 3, 2010 but no later than December 31, 2010, and (2) were not employed more than 40 hours during the 60-day period ending on the start date. The new worker cannot displace a current employee unless that person quit voluntarily or was discharged for cause. Wages paid to workers who are related to an owner of the employer are typically ineligible, but a spouse may qualify under certain circumstances. Please contact us if you think your business may be eligible.
Tax Credit for Retaining New Hires. Above and beyond the Social Security tax exemption, employers can also claim a new tax credit of up to $1,000 for wages paid to each qualified new employee (defined the same way as for the Social Security tax exemption). However, there are some additional requirements to collect this break. You must keep the worker on the payroll for at least 52 consecutive weeks, and wages during the second 26 weeks must equal at least 80% of wages paid during the first 26 weeks. The credit equals the lesser of—(1) 6.2% of qualifying wages paid during the 52-consecutive-week period or (2) $1,000. To claim the maximum $1,000 credit, the worker must be paid at least $16,130 during the 52-week period.
Final Comments
This letter is intended to give you just a few ideas to get you thinking about tax planning moves for the rest of this year. The potential for further tax legislation in 2010 is always a possibility and we will follow up with you on additional developments in that area. The 2010 Health Act also included many significant tax changes that take effect in years 2011-2013, so look for additional information in a separate briefing from us on these future changes.
In many cases, your personal situation will determine the extent of applicability of the tax concepts discussed, so please contact us with follow up questions or for more details.
We extend our best wishes during this summer season.
From the Team at
Houlihan, LLP
