With 2013 fast approaching, now is the time for taxpayers and their advisors to assess the potential impact of impending tax increases scheduled to take effect in the new year. While Congress could act to modify or delay these changes, taking a wait-and-see attitude might leave taxpayers with too little time to implement any tax saving strategy. The best approach is to develop a plan assuming these increases will come, but leaving enough flexibility to change course if events warrant it.
This brief overview lays out the major developments to anticipate in 2013: the end of the so-called Bush tax cuts and the imposition of a new 3.8% Medicare tax. We also offer a few ideas as a starting point for planning.
Sunset Of Bush Tax Cuts — What Does It Mean?
On December 31, 2012, the tax reductions enacted under President Bush will expire and tax rates will revert to the higher levels in effect before these cuts.
Income Tax Rates Leap Up
Effective January 1, 2013 most individual tax rates will rise, with the highest bracket on ordinary income going from 35% to 39.6%. These rates also apply to ordinary income that flows through to individuals from partnerships, LLCs, and S corps.
What can I do?
Where it makes business sense, accelerate income to 2012 and defer deductions until 2013 or later. Taking bonuses or exercising stock options in 2012 might be to your advantage. Some may benefit from converting their regular IRAs to Roth IRAs in 2012, taking the tax hit at the lower rate in exchange for tax-free distributions later.
Repeal Of Favorable Treatment For Qualified Dividends
Beginning in 2013, all dividends will be taxed at the full ordinary income rates instead of the favorable 15% rate that has applied to qualified dividends since 2001.
What can I do?
To the extent possible, closely held corporations should distribute dividends before the end of 2012. This might be particularly helpful for S corps that still have earnings from a prior C corp period, and can elect to distribute these earnings first in 2012.
Increase In Long-Term Capital Gain Rate
The long-term capital gain tax rate rises from 15% to 20%.
What can I do?
Where sensible, sell appreciated stock or other capital assets in 2012 and defer recognizing losses. For closely held corporations, a stock buyback may make sense. In certain circumstances, it could be beneficial to elect out of installment sale treatment on the sale of property such as real estate and pay the full capital gain tax in 2012.
New Medicare Tax — What Does It Mean?
With the recent Supreme Court decision upholding the Obamacare law, the additional 3.8% Medicare tax on “unearned income” that is part of that law will initiate in 2013. This tax is on top of the increase from 1.45% to 2.35% on the employee’s share of the Medicare payroll tax on wages over $200,000 ($250,000 for joint filers). This, as well, is in addition to the regular income tax already levied on unearned income, which includes net investment income and business income earned by passive participants.
The new 3.8% tax will be imposed on net unearned income of individuals with modified adjusted gross income (MAGI) over $200,000 ($250,000 for joint filers). Net unearned income encompasses interest, dividends, royalties, and capital gains on investment assets. It also includes income from activities classified as “passive” under the current rules restricting the ability to claim losses from passive activities, among them most rental real estate. However, if the MAGI exceeds the $200,000 ($250,000) threshold by an amount less than the total net unearned income, the tax will be imposed on this lesser amount. The tax also applies to trusts and estates on net unearned income in excess of approximately $12,000 that isn’t paid out to beneficiaries.
Weighing the combined impact of the new tax rates and the Medicare tax, in 2013 long-term capital gains could be taxed as high as 23.8% — a more than 50% increase over the current 15% rate. The tax on dividends could skyrocket from 15% to as high as 43.4% — an incredible increase of almost 200%!
What can I do?
Beyond accelerating the payment of investment income where possible, consider adjusting your investment mix to include more tax-exempt products that are not subject to either regular tax or the new Medicare tax. Another strategy for certain taxpayers is to file 2012 returns reflecting “active” rather than “passive” status with respect to business activities, especially rental real estate. If it is feasible to establish “active” status for 2012, this could give credibility to this position for 2013 and assist in avoiding the 3.8% tax. These rules are extremely complex, and may not apply to everyone, so first consult with your tax adviser.
Take Control While Time Is On Your Side
This is a lot to digest, and every decision requires that you balance the tax and economic effects and factor in the impact of the AMT. But, the sooner these issues are tackled in a plan constructed to minimize the impact of these tax increases, the more wiggle room you’ll have to act if the situation changes.
Financial Focus: Accounting & Tax Services News
G.R. Reid Associates, LLP