Tax planners and their clients face the prospect of a darker tax climate in 2013 for investment income and gains. Under current law, higher-income taxpayers will face a 3.8% surtax on their investment income and gains under changes made by the Affordable Care Act. Additionally, if the EGTRRA and JGTRRA sunsets go into effect, all taxpayers will face higher taxes on investment income and gains, and the vast majority of taxpayers also will face higher rates on their ordinary income.
Reduce exposure to higher post-2012 taxes on investment income & gains:
Taking money out of the corporation
A lot of complicated rules make it difficult to take money out of a corporation by means of a stock redemption and have the transaction produce capital gains. However, the good news here is that a maximum 15% rate will apply in 2012 whether the distribution in redemption is treated as a dividend or as a payment for stock entitled to long-term capital gains treatment, or indeed if a pro rata distribution is made to all the shareholders without regard to any redemption. (Even though the maximum rate is the same for both dividends and long-term capital gains, there is an extra benefit in getting capital gain treatment in that basis in the stock redeemed will reduce the amount subject to tax. This is not so if the redemption distribution is treated as a dividend.)
When a corporation buys stock from a shareholder, he may be treated as exchanging the stock for the redemption proceeds (capital gain) or the redemption proceeds may be treated as a dividend to the extent it does not exceed earnings and profits (E&P). A redemption payment is a distribution taxable as a dividend unless it is (1) a complete termination of a shareholder’s interest in the corporation , (2) a distribution that is substantially disproportionate in its effect on the shareholder, or (3) a distribution that is not substantially equivalent to a dividend . Other provisions provide non-dividend treatment of certain partial liquidation payments to noncorporate shareholders, and payments to pay the estate tax of a deceased taxpayer. These rules are complicated and difficult to negotiate, and often make it hard to take money out of a corporation at anything other than ordinary dividend rates. On the other hand, as pointed out above, it doesn’t matter as much for 2012 transactions since the 15% maximum rate will apply in any case.
However, if the cash is taken out of the corporation after 2012, under current law it will face the 3.8% surtax on investment income and gains. And the picture gets bleaker if the EGTRRA/JGTRRA sunsets actually take place at the end of 2012 (or take place for higher-income taxpayers only); see part one of this year-end planning article for details). If the transaction yields capital gain, it could be exposed to a higher maximum rate (apart from the surtax). And if the withdrawal is treated as a dividend, it could be taxed as ordinary income, subject to a higher marginal tax rate, and face a 3.8% surtax.
illustration 1: Taxpayer, an individual, is in a maximum tax bracket of 35% in 2012. He has shares in Corporation in which he has a basis of $100,000, and which he has owned for three years. Assume his shares are redeemed before the end of 2012 for $1 million, in a transaction that qualifies as a complete termination of his interest and thus produces long-term capital gain of $900,000. Under the 2012 tax rates, he pays $135,000 in taxes (15% of $900,000). If he receives the same gain in 2013, he will pay a tax of:
- $169,200 if capital gain continues to be taxed at a maximum rate of 15%, and he pays the 3.8% surtax on investment income and gains ([.15 maximum tax on capital gain + .038 surtax] × $900,000 = $169,200). That would amount to a 25.3% increase in tax ([$169,200 − $135,000 tax he would pay on a 2012 sale] ÷ $135,000).
- $214,200 if his gain will be exposed to a 20% maximum rate, and he pays the 3.8% surtax on investment income and gains ([.20 capital gain tax + .038 surtax] × $900,000 = $214,200). That would amount to a 58.7% increase in tax ([$214,200 − $135,000 tax he would pay on a 2012 sale] ÷ $135,000).
illustration 2: Same facts as in illustration (1) except that the distribution in redemption is treated as an ordinary income dividend. If the distribution is made in 2012, Taxpayer would pay a tax of $150,000 (15% of total distribution of $1 million since there is no reduction in the taxable amount for his basis in the stock). On the other hand, if the distribution is delayed until 2013, he will pay a tax of:
- $188,000 if qualified dividends continue to be taxed at the same maximum rate as capital gain (i.e., 15%), and he pays the 3.8% surtax tax on investment income and gains ([.15 maximum tax on qualified dividends + .038 surtax] × $1,000,000 = $188,000). That would amount to a 25.3% increase in tax ([$188,000 − $150,000 tax he would pay on a 2012 sale] ÷ $150,000).
- $434,000 if Taxpayer is subject to a 39.6% tax bracket in 2013, his dividends are taxed the same way as ordinary income, and he pays the 3.8% surtax tax on investment income and gains ([.396 regular tax + .038 surtax] × $1,000,000 = $434,000). That would amount to a 189.3% increase in tax ([$434,000 − $150,000 tax he would pay on a 2012 sale] ÷ $150,000).
observation: If the EGTRRA/JGTRRA sunset rules go into effect at the end of 2012 and dividends are taxed at ordinary income rates up to 39.6% in 2013, it seems highly unlikely that such dividends also would be subjected to a 3.8% surtax on net investment income (i.e., Congress would at least repeal the surtax). Even without the surtax, however, Taxpayer in illustration (2) would pay $396,000 on his $1 million gain, a 164% increase in tax ([$396,000 − $150,000 tax he would pay on a 2012 sale] ÷ $150,000).
observation: As noted above, the 15% maximum rate is available this year whether the redemption route is followed or if outright distributions are made. However, in addition to applying basis to reduce the taxable amount of the distribution, using a redemption that qualifies for capital gain treatment also has the advantages of (1) accomplishing a shift in relative ownership percentages (e.g., where the object is to shift control to younger family members), and (2) not having to make a distribution to all shareholders.
caution: The downside of making a pre-2013 distribution now is that it is impossible to know what the rates will look like next year.
recommendation: The best strategy, if possible, would be to do the groundwork now for a possible pre-2013 corporate distribution, and then be in the position to quickly execute such a distribution late this year if it becomes clear that a substantial tax increase on capital gains and dividends will go into effect next year.