Careful Planning Can Lessen Your Tax Burden
By KRISTINA DRZAL HOUGHTON, CPA, MSTU.S. taxpayers are facing more uncertainty than usual as they approach the 2014 tax-planning season. Many may feel trapped in limbo while Congress has been preoccupied with the November midterm election and its results — leaving legislation that could alter the current tax picture up in the air.
Since D.C. lawmakers are unlikely to pass, extend, or modify tax provisions anytime soon, tax planning may seem pointless. But, actually, careful planning is wise regardless of the situation and even more important during uncertain times.
Even though the federal tax laws haven’t changed much from last year, your circumstances may have changed. And some rules that expired on Dec. 31, 2013 may yet be restored, even retroactively, to Jan. 1, 2014. It could be the perfect time for you to get a fresh perspective.
To make sure you’re taking all the appropriate steps to minimize your individual and business taxes, you should anticipate possible changes with the informed guidance of your tax professional.
Tax Strategies for Individuals
Before you can make wise planning decisions about your individual taxes, you need to be aware of your current tax situation.
Can you control when you receive income, or at least determine when deductible expenses are paid? If you can control timing, you have a valuable planning tool that can enable you to reduce your taxable income and tax liability.
Maximize your tax strategies by forecasting income-tax positions for 2014 and, to the extent possible, subsequent years. Evaluate not only the amount of your income but also the types of income you anticipate generating, your marginal tax bracket, net investment income, wages and self-employment earnings, and capital gains and losses.
Before deciding to accelerate or defer income and prepay or delay deductible expenses, you need to gauge the possible effect of the alternative minimum tax (AMT) on these tax-planning strategies. Having a number of miscellaneous itemized deductions, personal exemptions, medical expenses, and state and local taxes can trigger AMT.
The opportunity to take advantage of income timing exists particularly for taxpayers who are:
• In a different tax bracket in 2014 than in 2015;
• Subject to the AMT in one year but not the other;
• Subject to the 3.8% net investment income (NII) tax in one year but not the other; or
• Subject to the additional 0.9% Medicare tax on earned income in one year but not the other.
The 3.8% NII tax and the 0.9% Medicare tax apply when your modified adjusted gross income exceeds threshold amounts. Net investment income includes dividends, rents, interest, passive activity income, capital gains, annuities, and royalties. Passive pass-through income is subject to the NII tax.
The NII tax does not apply to non-passive income, such as:
• Self-employment income;
• Income from an active trade or business;
• Portions of the gain on the sale of an active interest in a partnership or S corporation with investment assets; and
• IRA or qualified plan distributions.
Remember that the additional 0.9% Medicare payroll tax applies to earnings of self-employed individuals and wages in excess of the thresholds in the table above.
After analyzing your specific tax situation, if you anticipate that your income will be higher in 2015, you might benefit from accelerating income into 2014 and possibly postponing deductions, keeping the AMT threat in mind.
On the other hand, if you think you may be in a lower tax bracket in 2015, look for ways to defer some of your 2014 income. For example, you could delay into 2015:
• Collecting rents;
• Receiving payments for services;
• Accepting a year-end bonus; and
• Collecting business debts.
Also, if you itemize deductions, consider prepaying some of your 2015 tax-deductible expenses in 2014. The following expenses are commonly prepaid as part of year-end tax planning:
• Charitable contributions. You may take a tax deduction for cash contributions to qualified charities of up to 50% of adjusted gross income (AGI). When contemplating charitable contributions, consider contributing appreciated securities that you have held for more than one year. Usually, you will receive a charitable deduction for the full value of the securities, while avoiding the capital-gains tax that would be incurred upon sale of the securities.
• State and local income taxes. You may prepay any state and local income taxes normally due on Jan. 15, 2015 if you do not expect to be subject to the AMT in 2014.
• Real-estate taxes. You can prepay in 2014 any real-estate tax due early in 2015. But you should keep in mind how the AMT could affect both years when preparing to pay real-estate taxes on your residence or other personal real estate. However, real-estate tax on rental property is deductible and can be safely prepaid even if you are subject to the AMT.
• Mortgage interest. Your ability to deduct prepaid interest has limits. But, to the extent your January mortgage payment reflects interest accrued as of Dec. 31, 2014, a payment before year end will secure the interest deduction in 2014.
• Miscellaneous itemized deductions. These include unreimbursed employee business expenses, tax-return preparation fees, investment expenses, and certain other miscellaneous itemized deductions that together are in excess of 2% of AGI.
The amount of itemized deductions you can claim on your 2014 tax return is reduced by 3% of the amount by which your AGI exceeds the thresholds, which began as low as $152,000. However, deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses are not subject to the limitation. Taxpayers cannot lose more than 80% of the itemized deductions subject to the phaseout.
Know Your Tax Rates, Exemptions, and Phaseouts
A personal exemption is usually available for you, your spouse if you are married and file a joint return, and each dependent (a qualifying child or qualifying relative who meets certain tests). The personal exemption for 2014 is $3,950.
But the total personal exemptions to which you are entitled will be phased out, or reduced, by 2% of the amount that your AGI exceeds the threshold for your filing status. The threshold amounts for the personal-exemption phaseout are the same as for itemized deductions.
Even when federal income-tax rates are the same for you in both years, accelerating deductible expenses into 2014 and/or deferring income into 2015 or later years can provide a longer period to benefit from money that you will eventually pay in taxes.
Beware the Alternative Minimum Tax Trap
As mentioned previously, determining whether you are subject to the alternative minimum tax in any given year figures prominently in tax planning.
Every year the IRS ties, or indexes, to inflation the AMT exemption and related thresholds based on filing status. If it’s apparent that you will be subject to the AMT in 2014, you should consider deferring certain tax payments that are not deductible for AMT purposes until 2015. For example, you may defer your 2014 state and local income taxes and real-estate taxes, except taxes on rental property, which are not subject to the AMT. Also consider deferring into 2015 your miscellaneous itemized deductions, such as investment expenses and employee business expenses.
However, if the AMT will not apply to your taxes in 2014, but could apply in 2015, you may want to prepay some of these expenses to lock in a 2015 tax benefit. Just be careful that your prepayment does not make you subject to AMT in 2014.
If you do not expect to be subject to the AMT in either year, the age-old strategy of deduction ‘bunching’ could apply. If this is expected to be a high year for miscellaneous itemized deductions, consider accelerating next year’s expenses into this year.
Or, if this is a low year for these deductions, try to defer these expenses for the rest of the year into next year. This method helps you maximize the likelihood that these deductions will result in a tax benefit.
Exploit Long-term Capital Gains
While avoiding or deferring tax may be your primary goal, to the extent there is income to report, the income of choice is long-term capital gain thanks to the favorable tax rate available. Short-term capital gain is taxed at your ordinary income tax rate.
If you hold a capital asset for more than one year before selling it, your capital gain is long-term. For most taxpayers, long-term capital gain is taxed at rates no higher than 15%. But taxpayers in the 10% to 15% ordinary income-tax bracket have a long-term capital-gain tax rate of 0%.
Taxpayers whose income exceeds the thresholds set for the relatively new 39.6% ordinary tax rate are subject to a 20% rate on capital gain.
If the long-term capital-gain rates of 0%, 15%, or 20% are not complicated enough, keep in mind that special rates of 25% can apply to certain real estate, and 28% to certain collectibles. Also, gains on the sale of certain C corporations held for more than five years can qualify for a 0% rate. Talk to your tax adviser before you assume the long-term capital gains rate that would apply.
Remember that you can use capital losses, including worthless securities and bad debts, to offset capital gains. If you lose more than you gain during the year, you can offset ordinary income by up to $3,000 of your losses. Then you can carry forward any excess losses into the next tax year.
However, you should be careful not to violate the ‘wash sale’ rule by buying an asset nearly identical to the one you sold at a loss within 30 days before or after the sale. Otherwise, the wash-sale rule will prevent you from claiming the loss immediately. While wash-sale losses are deferred, wash-sale gains are fully taxable. It’s important to discuss the meaning of nearly, or ‘substantially,’ identical assets with your tax adviser.
Contribute to a Retirement Plan
You may be able to reduce your taxes by contributing to a retirement plan. If your employer sponsors a retirement plan, such as a 401(k), 403(b), or SIMPLE plan, your contributions avoid current taxation, as will any investment earnings until you begin receiving distributions from the plan. Some plans allow you to make after-tax Roth contributions, which will not reduce your current income, but you will generally have no tax to pay when those amounts, plus any associated earnings, are withdrawn in future years.
You and your spouse must have earned income to contribute to either a traditional or Roth IRA. Only taxpayers with modified AGI below certain thresholds are permitted to contribute to a Roth IRA. If a workplace retirement plan covers you or your spouse, modified AGI also controls your ability to deduct your contribution to a traditional IRA.
If you would like to contribute to a Roth IRA, but your income exceeds the threshold, consider contributing to a traditional IRA for 2014, and convert the IRA to a Roth IRA in 2015. Be sure to inquire about the tax consequences of the conversion, especially if you have funds in other traditional IRAs.
In addition to the SIMPLE IRA, self-employed individuals can have a simplified employee pension (SEP) plan. They may contribute as much as 25% of their net earnings from self-employment, not including contributions to themselves. The contribution limit is $52,000 in 2014. The self-employed may set up a SEP plan as late as the due date, including extensions, of their 2014 income tax return.
An individual, or solo, 401(k) is another option for the self-employed. For 2014, a self-employed individual, as an employee, may defer up to $17,500 ($23,000 for age 50 or older) of annual compensation. Acting as the employer, the individual may contribute 25% of net profits, excluding the deferred $17,500, up to a maximum contribution of $52,000.
Withholding and Estimated Tax Payments
If you expect to be subject to an underpayment penalty for failure to pay your 2014 tax liability on a timely basis, consider increasing your withholding between now and the end of the year to reduce or eliminate the penalty. Increasing your final estimated tax deposit due Jan. 15, 2015 may reduce the amount of the penalty but is unlikely to eliminate it entirely.
Withholding, even if done on the last day of the tax year, is deemed withheld ratably throughout the tax year. Underpayment penalties can be avoided when total withholdings and estimated tax payments exceed the 2013 tax liability or, in the case of higher-income taxpayers, 110% of 2013 tax.
Tax Strategies for Business Owners
The main tax issue to keep in mind if you’re a business owner is that a number of tax provisions, such as 50% bonus depreciation, expired at the end of 2013. In addition, the Section 179 deduction has been limited significantly.
Congress may pass legislation to renew or modify these tax breaks — perhaps retroactively. Of course, you can’t count on that possibility, so if you have used these provisions to reduce your taxes in the past, it might be advisable to adjust your withholding and estimated tax payments for 2014.
Special 50% Bonus Depreciation
Through 2013, businesses could use the special bonus depreciation to deduct up to 50% of the cost of such assets as new equipment, computer software, and other qualifying property placed into service by year end. The 50% bonus depreciation did not apply to used equipment. Unless Congress acts, it will not be available at all in 2014.
Section 179 Deduction
Under Section 179 of the IRS Tax Code, businesses could expense the full cost of new and used equipment, including technology, in the year of purchase instead of over a number of years. They still can. However, the amount they can expense has dropped from an upper limit of $500,000 in 2013 to $25,000 in 2014 — a sizable difference. If your company has nearly reached the $25,000 expensing limit, you may want to postpone further purchases until 2015.
The 2014 limit on equipment purchases qualifying for Section 179 treatment is $200,000. After a business reaches the maximum amount, the available tax deduction phases out on a dollar-for-dollar basis. In other words, once a business buys $225,000 of equipment, the deduction is reduced to zero. You should monitor your company’s total purchases to prevent the phaseout.
The IRS and the U.S. Treasury have issued final tangible property regulations (TPRs) that become mandatory for tax year 2014. These TPRs will likely require most businesses to file additional tax returns and supporting statements and/or include in their returns certain annual elections. Those new, additional returns are referred to as IRS Form 3115, Change in Accounting Method.
If you have multiple trades or businesses, more than one building, or leasehold improvements, whether or not these are contained in separate legal entities, such as LLCs, or disregarded entities, we may have to prepare numerous, separate Form 3115s, as well as make numerous TPR annual elections. Since the changes required by the TPR are so widespread, starting on the various analysis prior to year end is highly suggested.
While the preparation of the IRS form 3115 will be done, in the majority of cases, by this 2014 tax-return filing, certain new annual elections related to the TPRs are anticipated to be required and/or chosen for every income-tax filing subsequent to your adoption of the new TPRs.
You should discuss with your tax adviser the TPR elections choices. While they will certainly advise you on the alternatives or choices that are available for you regarding these TPR annual method elections, please remember the final choices are yours to make. The three common annual method TPR elections are the following:
• The de minimis safe harbor for writeoff of property acquisitions and non-incidental material and supplies costing less than your book writeoff policy, such as items costing less than a certain dollar amount (for example, less than $500 per item);
• If applicable, the safe harbor for small taxpayers, where you can elect not to capitalize improvements or repairs on eligible building property (i.e., your buildings with depreciable basis less than $1 million per building; and
• The partial asset disposition elections under §1.168(i)-8(d)(2). This election is made annually to enable you to apply this section to a disposition of a portion of a prior asset that you have replaced with a subsequent improvement. An example of the application of this method is where you replace a roof on one of your buildings, and you are then able to write off the remaining depreciable basis of the prior roof. You’d make this election to avoid a situation where you will depreciate two roofs at the same time, instead of recording a loss on the disposition of the original roof.
In addition to filing these changes in accounting methods, and the making of the annual TPR elections outlined above, your internal processes that may have to be modified include:
• Accounting for ‘non-incidental’ material and supplies; and
• Establishment of a capitalization writeoff policy dictating a certain writeoff amount (e.g., “our policy is that we are going to expense all purchases under $500”). If you do not, you may be limited to a $200 per item write-off policy, including the creation of an internal writing of what actions, expenditures, or items would require capitalization (such as improvements, acquisitions, restorations, betterments, adaptions, etc.), as opposed to expenditures that would be categorized as repair and maintenance expenses.
If you do not currently have a written and communicated capitalization policy, we advise you that, in order to take advantage of the annual de minimis writeoff safe harbor described above, you must create and execute that writing and communication before Jan. 1, 2015, if you desire to employ the writeoff policy in next year’s tax returns, since the policy needs to be adopted prior to the beginning of the effected tax year. Also, review your depreciation schedules to see what assets on that list may qualify for writeoff in the 2014 tax year.
In preforming the analysis for these changes, you may find that, in applying the TPRs, your business can benefit from an additional deduction in 2014.
As the 2014 tax season approaches, taxpayers have a lot of questions. Will expired tax provisions be reinstated? If so, will they apply retroactively to the beginning of the year? Will they be altered? Will new tax laws make it through the legislative process?
Most importantly, how will these decisions affect your taxes?
These are legitimate concerns. Unfortunately, no one can predict the future. But we can suggest that you and your tax professionals should diligently watch the tax landscape for pending legislation that could have an impact on your taxes. Your safest course of action in the midst of uncertainty is to remain in close communication with your tax adviser for the latest guidance.
Kristina Drzal Houghton, CPA, MST is a partner with the Holyoke-based accounting firm Meyers Brothers Kalicka, and director of the firm’s Taxation Division; [email protected]