Year-End Tax Planning for 2013

How the American Taxpayer Relief Act Affects Individuals and Businesses

This year's tax planning could be significantly productive for CPAs, because of the higher tax rates on high-income earners for regular income taxes, capital gains, and dividend income enacted by the American Taxpayer Relief Act of 2012 (ATRA). Also effective for 2013 are an increased payroll tax (0.9%) and a new tax on net investment income (3.8%) enacted by the Patient Protection and Affordable Care Act of 2010 (ACA). Without new legislation from Congress, 2013 might be the last chance for taxpayers to take advantage of many popular tax breaks. CPAs should consider the planning opportunities presented below in order to help both individual taxpayers and business owners.

Estate and Gift Tax

The ATRA set the maximum federal estate tax and the generation-skipping tax rates at 40% for decedents dying in 2013 and later. The annual estate tax exclusion was set at $5 million for 2012, and is subject to annual adjustments for inflation ($5.25 million for 2013; $5.34 million for 2014).

In addition, the portability provisions between spouses-set to expire for decedents dying after December 31, 2013-were permanently extended. Portability allows the estate of a deceased spouse to elect to permit the surviving spouse to use the unused exclusion of the first spouse to die. The executor of the first spouse's estate must file an estate tax return in order to make the portability election. Filing Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, may not be required, but failure to file the return of the first spouse to die is deemed an affirmative election out of portability.

The ATRA also addressed gift taxes: for gifts made in 2012 and later, the federal gift tax will be unified with the federal estate tax of individuals dying in 2012 and beyond. For 2013, the combined lifetime exclusion amount is $5.25 million, the maximum tax rate is 40% (rates not subject to change), and the annual gift tax exemption per donee is $14,000. There is no limit on the number of donees, and spouses should split gifts to the maximum number of donees annually in order to take advantage of the federal gift-splitting provisions and the annual exclusion per donee.

New York State residents should note that New York State has no gift tax. Accordingly, elderly New York State residents with substantial assets over $ 1 million should consider making annual gifts to multiple donees.

Planning for Individuals

There is no change in income tax rates between 2013 and 2014 with the exception of inflation adjustments, according to a formula under Internal Revenue Code (IRC) section 1(f). The effect of these provisions in 2013 is that unmarried individuals with taxable income greater than $400,000 ($450,000 for married taxpayers filing jointly and surviving spouses, $425,000 for head of household, and $225,000 for married filing separately) will be taxed at a 39.6% rate.

Taxpayers falling in these new brackets for 2013 will also be subject to taxation at the new 20% rate on qualified dividends and qualified net long-term capital gains (previously 15%). In addition, CPAs should caution taxpayers about spikes in taxable income that can push an individual into a higher tax bracket, such as individu- al retirement account (IRA) distributions, conversion to Roth IRAs, or the sale of assets. Taxpayers should try to manage these in order to avoid bunching them up in one year.

Net investment income tax (3.8%). Starting with 2013, the ACA imposes an additional 3.8% tax on net investment income, to the extent that modified adjusted gross income (MAGI) exceeds a certain threshold ($200,000 for single filers, $250,000 for joint returns and surviving spouses, and $125,000 for single filers). MAGI will be the same as AGI for most individuals, unless they live abroad and have foreign income under IRC section 911.The 3.8% rate is applied to the net lesser of 1) new investment income or 2) the amount by which MAGI exceeds the threshold.

Net investment income includes interest, dividends, capital gains, annuities, royalties, and net nonbusiness rent income; however, it does not include tax-exempt income or distributions from qualified retirement plans or income recognized upon conversion to a Roth IRA. Nonexcluded gain on sale of a home is included, as well as ordinary income or capital gains from a passive trade or business. Estates and trusts are subject to this tax on undistributed net investment income, with certain limitations.

Because investment income includes capital gains and dividends, taxpayers should try to minimize investment income by employing one or more of the following techniques:

* Use an installment sale to spread gains into 2014 and later.

* Sell assets with potential capital losses. These losses can reduce capital gains and even provide a deductible loss up to $3,000. Watch out for the wash sale rule (e.g., a taxpayer buys back the same security sold at a loss within 30 days before or after the loss sale), which applies even if the taxpayer sells at a loss in a taxable account and has an IRA repurchase within 30 days. (Note, however, that a "bond swap" at a loss does not trigger the wash sale rule, even if the same issuer is involved, as long as the maturity date or interest rate is different.)

* Be careful buying a mutual fund that pays dividends late in the year, after a purchase has been made. Because the price will drop to reflect the dividend payout, taxpayers will have effectively created dividend income. Instead, taxpayers should wait until the year-end dividend is paid and call the fund for the payout information before buying.

* Invest in tax-exempt bonds. Tax-exempt interest is not included in computing MAGI, nor is it included in net investment income.

* Reduce investment income by making gifts of income-producing assets; avoid gifting assets that have declined in value because of the reduced-basis rule related to the sale of assets received as a gift. For example, taxpayers should set up an IRC section 529 plan. Transferred assets are omitted from the donor's estate. The annual exemption is currently $14,000 per donee. Donors can also take advantage of the five-year accelerated gifting option ($14,000 x 5 years = $70,000 per donee). A husband and wife can gift $140,000 ($70,000 x 2) per donee; however, no other excluded gifts may be made by the donors to corresponding donees during the next five years. Furthermore, if the donor dies within five years of making an accelerated gift, the estate must prorate the exclusion based on the number of years that the donor survived after the gift was made. Note that making a five-year IRC section 529 gift requires the filing of gift tax returns. The donor does, however, retain control of the money in the plan and can change the beneficiary.

Additional Medicare tax (0.9%). This payroll tax applies to individuals with wages over a certain threshold ($200,000 for single taxpayers, $250,000 for married individuals filing jointly, and $125,000 for married individuals filing separately). The 0.9% surtax is only applied to the wages or self-employment net income in excess of the designated amounts. Employers must withhold the additional 0.9% on each employee's earnings over $200,000. If the employer doesn't withhold the amounts (e.g., each spouse earns $150,000), individuals are personally liable. The additional Medicare tax similarly applies to the net profits of self-employed individuals and to the self-employment earnings of partners in partnerships.

Income tax rate tables for estates and trusts. All prior tax rates were retained for all existing tax brackets, except for the highest rate bracket, which rose to 39.6% (previously 35%) starting in 2013. The new top bracket for 2013 is projected to start at $11,950 of taxable income for estates and trusts. Because the highest income tax rate for estates and trusts starts at such a low level of taxable income, distributions should be made to beneficiaries before the year's end; this will generally causing the income to be taxed at the individual level.

"Permanent" alternative minimum tax (AMT) provisions. The ATRA increased the AMT exemption amounts starting in 2012 and indexed the AMT exemption amounts to inflation starting in 2013; thus, annual congressional patches are no longer needed. The ATRA also provided for the allowance of nonrefundable personal credits up to the full amount of an individual's combined income tax and AMT.

In planning to minimize the AMT, taxpayers should remember that some tax deductions are not allowed for AMT purposes- for example, property taxes on a residence, state income taxes (or sales taxes if elected in lieu of income taxes), miscellaneous itemized deductions, and personal exemptions.

Phaseout of itemized deductions and personal exemptions. Starting with 2013, itemized deductions and personal exemptions will be reduced to the extent that a taxpayer's AGI exceeds specified amounts. Hie phaseout of itemized deductions will be calculated at 3% of AGI exceeding the threshold amounts. The phaseout will not apply to medical expenses; investment interest; and allowable losses from casualty, theft, or wagering. The reduction cannot exceed 80% of itemized deductions. Hie phaseout of itemized deductions does not apply to estates and trusts.

Personal exemptions are phased out at tie rate of 2% for each $2,500 increment or part thereof in excess of AGI above certain threshold amounts ($250,000 for single filers, $300,000 for joint filers and surviving spouses, $275,000 for heads of household, and $150,000 for married individuals filing separately). The phaseout amounts are subject to inflation adjustment after 2013.

Elimination of standard deduction 'marriage penalty. ' The ATRA permanently extended the standard deduction marriage penalty relief for 2013 and later; thus, the basic standard deduction for married couples filing jointly will be double the basic standard deduction for an unmarried individual filing a single return. In addition, the basic standard deduction for married couples filing separately will equal the basic standard deduction for single filers.

Medical expense deduction floor. Itemized deductions are currently allowed for medical expenses paid during the year, to the extent that they exceed 7.5% of AGI. For 2013 and later, this increases to 10%, except that for 2013-2016, the 7.5% limitation still applies to taxpayers or their spouses who are 65 years or older by year-end (IRC section 213[f]). Note that payment before medical services are rendered does not accelerate the deduction absent a prepayment requirement by the service provider; moreover, credit card charges are deductible in the year charged.

Health flexible spending arrangements (FSA). The ATRA caps the annual contribution to health FSAs at $2,500, indexed for inflation after 2013. The advantage of an FSA is that contributions reduce taxable income and Social Security taxes, while allowing for the payment of family medical expenses on a pretax basis. Taxpayers that have an underfunded FSA should maximize their contributions, keeping in mind the FSA's "use it or lose it" feature.

Other deductions extended to December 31, 2013, for individuals. The ATRA extended through 2013 the election to claim an itemized deduction for state and local sales taxes (in lieu of state and local income taxes), as well as mortgage insurance premiums (which treats the cost of mortgage insurance premiums as deductible qualified residence interest). In addition, the ATRA extended the educators' classroom expenses deduction to the end of 2013. Deductions expiring December 31,2013, should be paid before the year's end when feasible.

Tax credits extended, enhanced, or made permanent. The ATRA extended, enhanced, or made permanent various credits, including the following:

* Adoption credit-a nonrefundable credit allowed for qualified adoption expenses with a maximum credit of $12,970. In addition, qualified adoption expenses paid by an employer to or on behalf of an employee are excluded from the employee's income (see Exhibit 1).

* Child and dependent care credit-a nonrefimdable credit made permanent by the ATRA for 2013 and beyond for working parents who need child care in order to go to work (see Exhibit 1).

* Child tax credit-$1,000 per qualifying child (including stepchildren and eligible foster children), with a maximum credit of $2,000. The child must be under 17 in order to be claimed as a dependent by the taxpayer. This credit is generally nonrefundable, but becomes refundable to the extent of 15% of tie taxpayer's earned income in excess of an inflation-adjusted amount.

* American opportunity tax credit-an enhanced version of the Hope Scholarship credit extended to 2017. The maximum credit for 2013 is $2,500; 40% of the credit continues to be refundable through 2017.

* Earned income credit-a refundable credit designed to encourage low-wage individuals to work. (See Revenue Procedure 2013-15 for a table [adjusted for inflation] to assist in the calculation of the allowable credit for 2013.)

In addition to the foregoing credits, $500 lifetime nonrefundable credits are also permitted for energy-related improvements to the taxpayer's principal residence. These include-

* tie nonbusiness energy property credit for consumers who purchase and install products, such as energy-efficient windows, insulation, doors, roofs, and heating and cooling equipment (IRC section 25C) and * the residential energy efficient credit under IRC section 25D for individuals who make improvements to existing residences that result in increased energy efficiency (e.g., solar, wind, geothermal heaters). Because IRC section 25C is set to expire on December 31, 2013- whereas IRC section 25D will not expire until December 31, 2016-taxpayers should purchase and install IRC section 25C products before the end of this year.

Exclusion of cancellation of indebtedness income on principal residence. Cancellation of debt generally leads to income to the debtor, unless one of the statutory exclusions applies. The ATRA extended through 2013 the provision that excludes from income the cancellation of mortgage debt on a principal residence (up to $2 million). This exclusion applies only to debt for acquisition or improvement of a principal residence; this must be done by December 31,2013.

Charitable contributions. The ATRA extended the provision allowing a tax-free IRA distribution for up to $100,000 per taxpayer per year through December 31, 2013. The taxpayer must be 70V2 or older. The ATRA also extended to December 31, 2013, the special rule related the increased allowable deduction for contributions of capital gain real property for conservation purposes.

Expiring on December 31, 2013, is a special provision (i.e., the "incentive rule") that permits S corporation shareholders a benefit when donating appreciated corporate property. The general rule is that shareholders deduct the fair market value of donated property and must correspondingly reduce the basis of their shares of stock in the corporation by the same amount; however, the incentive rule provides that shareholders reduce the basis of their stock by their pro rata share of the adjusted basis of donated property.

Planning for Businesses

Equipment purchases-expensing (IRC section 179). If qualified equipment, including qualified real property and computer software, is put into use by December 31, 2013, the maximum writeoff is $500,000. This $500,000 limitation phases out dollar-for-dollar for assets greater than $2 million placed into service during the tax year. Both new and used IRC section 1245 assets qualify. There is no proration based on when the property was acquired during the year, but the deduction cannot exceed the taxpayer's taxable income. Under Treasury Regulations section 1.179-2(c)(6)(iv), employees are considered to be engaged in the active conduct of the trade or business from their employment. Therefore, a small-business worker who is also an employee may include wages and salary derived from employment in determining taxable income for purposes of this limitation.

If Congress does not act, the maximum write-off will decrease to $25,000 in 2014; thus, taxpayers should take advantage of this provision by the year's end. In fact, due to the greatly reduced election in later years (i.e., $25,000), it might not pay to elect more than the taxable income allowable write-off in 2013.

Equipment purchases-50% bonus depreciation (IRC section 168[k]). Bonus depreciation allows companies to write off 50% of the cost of new modified accelerated cost recovery system (MACRS) assets with useful lives of 20 years or less. The other 50% is recovered by normal depreciation. Generally, property must be placed in service by December 31,2013. This provision also applies to leasehold improvements made to the interior of commercial buildings. There is no dollar limit on the total amount of this deduction, nor is the deduction prorated, regardless of when the property was acquired during the year. If both the election to expense and bonus depreciation are elected, the expensing election must be calculated first; then, the remaining balance is subject to bonus depreciation.

The bonus depreciation provision expires by the year's end, unless extended by Congress, so taxpayers should complete this by December 31, 2013. Certain transportation and long-term production property is eligible for the 50% bonus depreciation until the end of 2014.

Equipment purchases-special vehicles. Also expiring on December 31,2013, are the special provisions for luxury cars, heavy SUVs, and pickup trucks. Luxury cars purchased and placed in service by the year's end are permitted an additional $8,000 first-year depreciation deduction cap on luxury cars under IRC section 280(f), in addition to the regular MACRS deduction. For heavy SUV purchases (exceeding 6,000 pounds), most of the cost can be deducted in 2013.

For example, a $60,000 new SUV can be written off to the extent of $46,000, as follows: $25,000 by expensing under IRC section 179(b)(5), $17,500 (50% of the balance) by bonus depreciation under IRC section 168(k), and $3,500 (20% of the $17,500 balance) by normal MACRS depreciation. For pickup truck purchases that exceed 6,000 pounds, the entire cost of the purchase can be expensed, provided the cargo bed is at least six feet long and cannot be accessed from the cab (IRC section 179[b][5][B][ii]).

Equipment purchases-qualified leasehold improvements, retail improvements, and restaurant improvements. A 15-year recovery period for qualified leasehold improvements, retail improvements, and restaurant property improvements expired on December 31, 2011. The ATRA extended this 15-year provision for such property placed in service prior to January 1,2014 (IRC section 168[e][3][E]). The expensing provisions are similarly extended, up to $250,000 (IRC section 179[f][l]). With regard to bonus depreciation, no changes were made to the mies that govern qualified retail improvements; qualified restaurant improvements do not qualify for bonus depreciation (IRC section 168[e]). Qualified leasehold improvement property, however, does qualify for bonus depreciation under IRC section 168(k)(3).

Charitable contributions of ordinary income property (e.g., inventory). The standard rule has been that a charitable deduction equals the fair market value of the donated property, reduced by any potential gain that would have been realized if the property were sold at fair market value; however, the enhanced charitable deduction rule (which allows a larger deduction for contributions of certain inventory food for human consumption) expires on December 31, 2013 (IRC 170[e]). Taxpayers should make such contributions before that date.

Other extended or expiring provisions. Many other provisions of the tax code that were scheduled to expire were extended to December 31, 2013, by the ATRA. Some of the more popular provisions affected are noted in Exhibit 2.

Noteworthy Items. The following are additional items that preparers should take note of:

* Revenue Procedure 2013-30 and 201336 IRB 173. The 1RS recently announced exclusive simplified methods for taxpayers to request late S corporation elections and to request relief for late Electing Small Business Trust (ESBT) elections, late Qualified Subchapter S Trust (QSST) elections, late Qualified Subchapter S Subsidiary (QSub) elections, certain late corporate classification elections, and pending letter ruling requests.

Revenue Procedure 2013-30 combines existing S corporation relief procedures into one document and extends some relief provisions. In general, it expands the time for requesting relief for these late elections to three years and 75 days after the date the election was intended to be effective; however, for simple late S election requests, there is no deadline for requesting relief if certain requirements are met (see Exhibit 5).

* Reduction in S corporation recognition period for built-in gains. Prior to the passage of the ATRA, no built-in gains tax was imposed on unrecognized built-in gain of an S corporation if the fifth year in the recognition period preceded the 2011 tax year. Under the ATRA, for years beginning in 2012 and 2013, the recognition period is the five-year period beginning with the first day of the first tax year for which the corporation was an S corporation. Accordingly, if S corporation assets with built-in gains are not disposed prior to January 1, 2014, the former 10-year recognition period will be reinstated.

* Final 1RS regulations relating to repairs and capitalizations. The 1RS recently released final regulations governing "repairs," clarifying when such expenditures may be deducted and when they must be capitalized. The new regulations are described as favorable to taxpayers, but they are complex, spanning more than 200 pages. The new rules are effective Januaiy 1, 2014, but tax preparers should study them before the year's end to determine if taxpayers need to take any action before then.

* Same-sex marriages. On June 26,2013, the U.S. Supreme Court upheld the legality of same sex marriages, regardless of the state in which the parties reside or were married (U.S. v. Windsor, 570 U.S. _, No. 12-307). The 1RS subsequently issued Revenue Ruling 2013-17, recognizing same-sex marriages nationwide for income, gift, and estate tax purposes. Nevertheless, states may still refuse to recognize samesex marriages. 1RS recognition of samesex marriages does not apply to registered domestic partners, individuals in a civil union, or similar nonmarital relationships.

For tax years 2013 and later, same-sex spouses must file using married filing separately or joint status. For tax years 2012 and prior, same-sex spouses who filed an original tax return on or after September 16, 2013 (the effective date of Revenue Ruling 2013-17) generally must file using married filing separately or joint returns. For tax year 2012 and earlier, however, taxpayers who filed their original tax returns prior to September 16, 2013, may choose (but are not required) to amend their federal tax returns to married filing separately or jointly status, provided the period of limitations for amending the return has not expired.

General Year-End Actions to Consider

Year-end tax planning considerations for business taxpayers including setting up and funding a retirement plan, delaying sales of assets with potential gains, selling securities with potential losses, writing off uncollectible accounts receivable, delaying payment of corporate dividends, electing installment sale reporting for qualified sales, and reducing year-end inventory.

Year-end tax planning considerations for individual taxpayers include donating to charities; paying billed medical expenses; making gifts of income-producing assets; taking required minimum distributions in cash or in kind; expediting casualty losses by settling with an insurance company; deferring interest income by purchasing certificates of deposit (CD) maturing after December 31, 2013 (provided interest is not available by the year's end); utilizing passive activity losses (PAL) by generating passive income or selling the passive activity; and contributing to a traditional or Roth IRA.

Note that IRA contributions can be converted from a traditional IRA to a Roth (or vice versa). Such conversions can subsequently be undone; transfers must be trustee to trustee. Although conversion of a traditional IRA to a Roth IRA will cause taxable income to be recognized, its tax-saving significance upon later withdrawals should be considered. Conversion by December 31,2013, starts the five-year clock running from January 1, 2013 (with respect to nontaxability). Roth conversions work best if tax rates are higher in future years, asset values have dropped, funds are available to pay the taxes due upon conversion, and the conversion will not push the taxpayer into a higher tax bracket. If the value of the converted assets has declined, the conversion can be undone and "recharacterized" up until the extended due date of the return (Treasury Regulations section 1.408A-5).

Due to the ever-changing tax landscape, diligent year-end planning can produce significant tax savings. There is little time left for many taxpayers to minimize their taxes through the strategies discussed above. Without Congressional action beforehand, many popular rules that apply to large segments of taxpayers are slated to expire at the end of 2013. ?

The ATRA increased the AMT exemption amounts starting in 2012 and indexed the AMT exemption amounts to inflation starting in 2013.

Jack Angel, CPA, Grace Conway, CPA, and R Bruce Swensen, PhD, are all associate professors of accounting, finance, and economics at Adelphi University, Garden City, N.Y.