PREPARING FOR THE CHANGES AHEAD. Tax Planning in a Rising Tax Rate Environment

Transcription

1 PREPARING FOR THE CHANGES AHEAD. Tax Planning in a Rising Tax Rate Environment

2 Today s Session Tax Planning in a Rising Tax Rate Environment Opening Remarks Taxes are a Business Decision Planning for Individuals Planning for Businesses

3 Schedule of Federal Tax Rate Increases Current Law 2011 Obama Proposal 2013 Maximum marginal 35% 39.6% 39.6% 43.4%* income tax rate Maximum long term 15% 20% 20.0% 23.8%* capital gain rate Maximum qualified 15% 39.6% 20.0% 23.8/43.4%* dividend rate C Corporation 35% 35% 35% 35% * Includes 3.8% unearned Medicare contribution tax 3

4 Schedule of Federal Tax Rate Increases - Example Married Filing Jointly Taxable Income 2010 Rate Tax 2011 Current Law Rate Tax 2011 Obama Proposal Rate Tax $1 $16,750 10% $ 1,675 15% $ 2,513 10% $ 1,675 $16,751 $68,000 15% $ 7,687 15% $ 7,687 15% $ 7,687 $68,001 $137,300 25% $ 17,325 28% $ 19,404 25% $ 17,325 $137,301 $209,250 28% $ 20,146 31% $ 22,304 28% $ 20,146 $209,251 $237,300 33% $ 9,256 36% $ 10,098 28% $ 7,854 $237,301 $373,650 33% $ 44,995 36% $ 49,086 36% $ 49,086 Over $373,650 35% 39.6% 39.6% EXAMPLES: $150,000 $ 30,243 $ 33,541 (10.9%) $ 30,243 ( 0.0%) $250,000 $ 60,280 $ 66,578 (10.5%) $ 59,259 ( 1.7%) $500,000 $ 145,306 $ 161,126 (10.9%) $ 153,807 ( 5.9%) $1,000,000 $ 320,306 $ 359,126 (12.1%) $ 351,807 ( 9.8%) 4

5 Schedule of Federal Tax Rate Increases - Example Married Filing Jointly Taxable Income Current Law 2011 Obama Proposal Itemized Deduction Phase Out for Adjusted Gross Income above Personal Exemption Phase Out for Adjusted Gross Income above N/A Est. $165,000 $200,000 S $250,000 J N/A Est. $255,000 $200,000 S $250,000 J NOTE: Excludes 3.8% Medicare tax on net investment income (or excess of modified AGI over $200,000 S/$250,000 J if lower ) (2013) Excludes.9% employee Medicare tax on earned income over $200,000 S/$250,000 J (2013) Tax brackets will continue to reflect annual inflation adjustments (annual adjustments were NOT part of 2001 and 2003 tax legislation and therefore do not sunset) 5

6 Return on Investment Ordinary & Capital Gain 30% Tax Free IRR for Accelerating Income Ordinary Income & Capital Gain (See Appendix A for assumptions) 25% 20% 15% 10% 5% 0% Capital Gain Ordinary Income 6

7 Example: 2010 Tax on Ordinary Income Federal/State Income Tax: Ordinary Income 39.00% 43.60% Taxable Ordinary Income 1,000,000 1,000,000 Tax Rate on Ordinary Income 39.00% 43.60% Income Tax on Ordinary Income 390, ,000 Effective Tax Rate: Ordinary Income 39.00% 43.60% Tax Savings by Accelerating Income 46,000 Investment 390,000 Tax-Free IRR for Accelerating Income 11.79% 7

8 Example: 2010 Tax on Capital Gain Income Federal/State Income Tax: Capital Gain Income 19.00% 24.00% Taxable Capital Gain Income 1,000,000 1,000,000 Tax Rate on Capital Gain Income 19.00% 24.00% Income Tax on Capital Gains 190, ,000 Effective Tax Rate: Capital Gains 19.00% 24.00% Tax Savings by Accelerating Gain 50,000 Investment 190,000 Tax-Free IRR for Accelerating Income 26.32% 8

9 Example: 2010 Tax on Operating Income Federal/State Income Tax: Ordinary Income 34.00% 39.00% Taxable Income from Operations 1,000,000 1,000,000 Tax Rate on Income from Operations 34.00% 39.00% Income Tax on Operations 340, ,000 Effective Tax Rate: Operations 34.00% 39.00% 9

10 Example: 2010 Tax on Distributions C Corporation Flow Through Federal/State Income Tax: Distributions 19.00% 0.00% After tax Cashflow from Operations 660,000 1,000,000 Tax Rate on Distributions 19.00% 0.00% Income Tax on Distributions 125,400 Effective Tax Rate: Distribution of Earnings 12.54% 0.00% 10

11 Example: Summary 2010 Tax Rates C Corporation Flow Through Cost/(Savings) Tax Rate Differential Tax on Operations 340, ,000 (50,000) 5.00% Tax on Dividends 125, , % Total Tax 465, ,000 75, % Effective Rate 46.54% 39.00% 7.54% C corporations generally pay less federal tax than pass-through entities on operating income C corporations and their shareholders pay significantly more tax than pass-through entities when income is distributed C corporations can be advantageous when the distributions can be deferred far enough into the future so that the net present value (NPV) of the future tax cost is low when compared to the current tax savings C Corporations will be advantageous on a current basis when shareholders are in higher tax brackets 11

12 Tax Planning in a Rising Tax Rate Environment Individuals Defer recognition of capital losses If a taxpayer has investments with a fair market value less than the taxpayer s basis, consider delaying the recognition of this loss by selling the asset when income tax rates increase. The capital loss is worth more to the taxpayer when offsetting income which is subject to a higher income tax rate. 12

13 Tax Planning in a Rising Tax Rate Environment Individuals (cont.) Harvest capital gains on appreciated assets Selling appreciated assets which you plan on selling in the near future can force the recognition of your gains at the lower tax rates. If the taxpayer wants to hold on to the appreciated assets for the short term, consider selling the appreciated assets and buying it back at a later date ( wash sale rules do not apply). These strategies will most likely not be beneficial to a taxpayer that holds a stock as a long term investment. 13

14 Tax Planning in a Rising Tax Rate Environment Individuals (cont.) Consider Deferring: state and local tax deposits property taxes charitable contributions Be sure to consider the effects of: Itemized deduction phase-outs (reinstated for 2011) AMT (will be less common in 2011) 14

15 Tax Planning in a Rising Tax Rate Environment Individuals (cont.) Alternative Minimum Tax (AMT) Higher tax rates will increase the spread between regular tax and AMT which will reduce the likelihood that some taxpayers will be subject to AMT. The larger spread will make tax credits that are limited by AMT more utilizable for taxpayers. Taxpayers that may have forgone R&D credit studies due to AMT limitations may now want to reconsider them. 15

16 Tax Planning in a Rising Tax Rate Environment Alternative Minimum Tax EXAMPLE Current Law 2011 Obama Proposal Taxable Income $500,000 $500,000 $500,000 State Income and Property Taxes 40,000 40,000 40,000 Adjustments from K 1 10,000 10,000 10,000 Alternative Minimum Taxable Income $550,000 $550,000 $550,000 Tentative MinimumTax 150, , ,500 Regular Tax 145, , ,807 AMT $5,194 $0 $0 16

17 Tax Planning in a Rising Tax Rate Environment Individuals (cont.) Alternative Minimum Tax (AMT) (cont.) Small Business - Expansion of Utilization of General Business Credits Eligible small business corporation not publically traded, a partnership or a sole proprietorship whose average annual gross receipts for the prior 3 years do not exceed $50M. For general business credits determined in years beginning after 12/31/09. Extends the carryback period to 5 years. Allows general business credits to offset both regular and AMT tax. 17

18 Tax Planning in a Rising Tax Rate Environment Individuals (cont.) Convert traditional IRA accounts to a Roth IRA Individuals may utilize NOL s or other ordinary deductions to reduce or eliminate the tax cost of a Roth IRA conversion. If an individual is phased out of Roth IRA contribution, the individual may make a nondeductible IRA contribution and immediately convert to a Roth IRA. 401(k) balances can be rolled over to ROTH 401(k) accounts starting in 2010 if the participant is allowed to make a permitted in-service distribution. The Plan needs to be amended to adopt the rollover provision for in-service distributions. 18

19 Tax Planning in a Rising Tax Rate Environment C-Corporations Declare and Pay Dividends in 2010 If the corporation is in a position to pay dividends, the corporation may best serve its shareholders by paying a dividend while the shareholders enjoy a lower individual tax rate (15%) on qualified dividends. 19

20 Return on Investment Qualified Dividend 160% Tax Free IRR for Accelerating Income Qualified Dividends (See Appendix B for assumptions) 140% 120% 100% 80% 60% 40% 20% 0%

21 Tax Planning in a Rising Tax Rate Environment Net Operating Losses Carryover or Carryback? An NOL carryback will enable the taxpayer to receive a refund quickly, however, the NOL will be working to offset taxable income that was subject to a lower tax rate. Perhaps the NOL will be more valuable to the taxpayer as a carryover to offset future, higher taxed income. Consider the time value of money when analyzing whether to carryover or carryback a NOL and the cash flow needs of the company. 21

22 Tax Planning in a Rising Tax Rate Environment Pass-through entities may be disadvantaged: With the individual tax rates subject to an increase (as high as 43.4% for tax year 2013), pass-through entities may be disadvantaged. There is generally no entity-level tax for passthrough entities. Tax attributes flow through to the partners/shareholders, who are subject to tax. Therefore, the pass-through entities are only subject to one layer of tax. 22

23 Tax Planning in a Rising Tax Rate Environment Partnership Check the Box Election A partnership may elect to be taxed as a C- Corporation. Various rules must be met in order to avoid gain recognition. 23

24 Tax Planning in a Rising Tax Rate Environment Revocation of S-Election Revoking the S-Election can effectively lower the current tax rate on profits. The revocation of the S Election will subject the entity to corporate tax rates. This could subject corporate earnings to a second level of tax, but the shareholder level tax is only triggered upon the payment of a dividend or sale of shares. Five Year Rule before electing back 24

25 Tax Planning in a Rising Tax Rate Environment S-Corporations - Taking Advantage of the Qualified Dividend Rate Consent Dividends - A dividend that is not actually paid to a shareholder but is deemed to have been paid. The dividend is taxed to the shareholder at the 15% qualified dividend rate. The taxpayer s outside basis in the stock is increased by the deemed contribution. 25

26 Tax Planning in a Rising Tax Rate Environment S-Corporations Consent Dividends are best utilized under the following situations: 1. Tax basis or at-risk basis limitations 2. Cash flow needs 3. Sale of the company in the near future 4. Change in ownership Next generation 5. Elderly or near death shareholders 6. Excess net passive income tax avoidance 26

27 Tax Planning in a Rising Tax Rate Environment Accounting Methods Delay payment of certain liabilities to defer deductions based on payment, 2 ½, or 8 ½ month time periods. For example: Income taxes Property taxes Compensation (bonuses) Retirement plan payments Other 27

28 Tax Planning in a Rising Tax Rate Environment Accounting Methods (cont.) Select slower depreciation methods Elect straight-line depreciation Forgo Section 179 elections Opt out of Bonus Depreciation on new assets Defer cost segregation adjustments until 2011 Delay filing an accounting method change for one time deduction accelerations such as: Certain prepaid expenses Property taxes IBNR 28

29 Tax Planning in a Rising Tax Rate Environment Accounting Methods (cont.) Opt out of installment reporting Under installment reporting, the taxpayer is permitted to recognize income ratably over a period of years. The taxpayer may choose to forgo this treatment and recognize the entire amount in the current year. The result would be a larger tax bill in the current year but at lower rates. Accelerate existing installment agreement by getting paid or selling the note The taxpayer may be able to call the note due and recognize the entire amount of the note in the current period. Alternatively, if the taxpayer is not in a position to call the note due, the taxpayer may be able to sell or pledge the note. 29

30 Questions?

31 Contact Information Robert Shefferly III, CPA, MST Senior Tax Manager, National Tax Office Cheryl Surgo, CPA Senior Tax Manager, Tax Services Group

32 PREPARING FOR THE CHANGES AHEAD. Thank You.

33 Appendix A Return on Investment Ordinary & Capital Gain Capital Gain Assumptions [1] This model assumes highest marginal tax rates, including a 3.8% Medicare tax starting in 2013, and that the current 5-year 18% capital gain rate does not apply to this transaction or is rescinded prior to sale. It is also assumed that a state 4% income tax rate applies. A higher state tax rate will slightly reduce IRR, a lower rate will slightly increase it. [2] The primary "risks" to this IRR are a time horizon that extends beyond what is anticipated, economic values that deteriorate for the asset (generating a capital loss), and any future tax rate reductions. Ordinary Income Assumptions [1] This model assumes highest marginal tax rates, and that the 3.8% Medicare tax will apply starting in 2013 to this income (assumed passive). It is also assumed that a state 4% income tax rate applies. A higher state tax rate will slightly reduce IRR, a lower rate will slightly increase it. [2] The primary "risks" to this IRR are a time horizon that extends beyond what is anticipated, economic values that deteriorate (generating a loss), and any future tax rate reductions. 33

34 Appendix B Return on Investment Qualified Dividend Assumptions Qualified Dividend Assumptions [1] This model assumes highest marginal tax rates, including a 3.8% Medicare tax starting in 2013, and that the current law allowing dividends to be taxed at ordinary tax rates starting in 2011 will not be revised. It is also assumed that a 4% state income tax rate applies. A higher state tax rate will slightly reduce IRR, a lower rate will slightly increase it. [2] The primary "risks" to this IRR are potential tax rate revisions (taxing dividends at the capital gains rate for example), and a time horizon that extends beyond what is anticipated. 34