Time is Running Out to Plan for 2013 Tax Rate Changes
Effective January 1, 2013, FBT clients will be forced to cope with one brand new tax and significantly higher income, estate and gift tax rates.
Higher income taxpayers are subject to higher Medicare tax on earned income, plus a 3.8% tax on passive net investment income
Taxpayers with adjusted gross incomes exceeding $200,000 ($250,000 for a married couple) will be subject to a new 3.8% tax on unearned income, including capital gains, dividends, interest (excluding municipal bond interest), rental income, annuities, royalties and passive business income. No portion of this tax is deductible against income taxes. This new tax will begin at the same time as an extra .9% is added to Medicare taxes now paid on earned income (either from self-employment or wages), so the gross effective rate on earned income over these levels will also be 3.8%.
Planning ideas: (1) move sales of capital assets into 2012 (including electing out of installment sale treatment); (2) spread sales of business assets through installment sales over several years to reduce a taxpayer's income to an amount below the taxing threshold; (3) invest in assets that rely on capital appreciation (the Warren Buffett - Berkshire Hathaway model) rather than on distributions or sales; (4) hold municipal bonds and fully fund tax exempt retirement plans; and (5) increase "tax distribution" percentage from pass-through entities to reflect increased rates and the new Medicare tax.
Because the Medicare tax on investment income is linked to definitions of passive income (for which tax losses have historically been limited), a planning opportunity exists to minimize Medicare taxes through the use of an S corporation. This plan works for individuals who invest in businesses similar in nature to their full-time business or professional activities. For example, physicians who are adequately compensated for their professional services may receive additional profit allocations from income generated by non-physicians in their practice or allocations from other medical-field investments through appropriate entity structuring. These individuals are ideal candidates for planning utilizing an S corporation.
The "stated" long term capital gains rate will increase from 15% to 20% (18% for assets purchased after December 31, 2000 and held longer than five years). This increase is on top of the 3.8% Medicare tax on capital gains.
Planning ideas: (1) move sales of capital assets into 2012 (including electing out of installment sale treatment); and (2) invest in assets that rely on capital appreciation over time (the Warren Buffett – Berkshire Hathaway model) rather than on dividends or interim sales.
The tax rate on most dividends will increase from a flat rate of 15% to the taxpayer's ordinary income rate (graduated up to 39.6%). Again, this is on top of the new 3.8% Medicare tax.
Planning ideas: (1) insure that stock redemptions are properly structured to avoid dividend treatment; and (2) avoid dividend-generating investments (again, municipal bonds, fully funding retirement plans and capital appreciation vehicles become relatively more attractive).
The 33% and 35% tax brackets in effect for 2012 will increase to 36% and 39.6%, respectively. Certain itemized deductions for high-income taxpayers will be subject to phase-out of up to 80%. Personal exemptions for high-income taxpayers will be subject to phase-out of up to 100%. President Obama has proposed to hold rates at their current level for all but the highest income brackets, but in an election year and a divided Congress, the only certainty is that rates will increase if nothing is done.
Planning ideas: (1) although accelerating income is usually not a good planning strategy, consideration should be given to the possibility of accelerating ordinary income into 2012; and (2) municipal bond income, fully funding retirement plans and investments that rely on capital appreciation become relatively more attractive.
The marginal gift and estate tax rates and the generation skipping tax rate will each increase from 35% to 55% and there will be an additional 5% surtax on estates between $10,000,000 and $17,184,000.
The gift and estate tax exclusion will drop from $5,120,000 to $1,000,000 and the generation skipping tax exemption will decrease to around $1,400,000 (the uncertainty is due to inflation adjusting of the GST). While President Obama has proposed making permanent the 2009 rates and exclusions, which would provide a for $3,500,000 estate tax exclusion, $1 million gift tax exclusion and a 45% estate and gift tax rate, gridlock in Washington may prevent this from occurring.
Planning ideas: consideration should be given to making large gifts during 2012 rather than waiting until the exclusion amounts go down and rates go up.