To Our Clients and Friends:
Late last year, Congress made many of the long-favored tax breaks (so-called extenders) permanent (for now anyway). This means that for the first time in a long while, taxpayers can finally determine with relative certainty the impact of these tax provisions on their long-term financial and business planning decisions. Despite this good news, tax laws remain staggeringly complicated. For 2016, the top federal income tax rate is 39.6%, but higher-income individuals can also be hit by the 0.9% additional Medicare tax on wages and self-employment income and the 3.8% Net Investment Income Tax (NITT), which can both result in a higher-than-advertised marginal federal income tax rate. Finally, you must consider whether you are exposed to Alternative Minimum Tax (AMT). If so, tax planning moves that work for most folks may not work for you.
The summer months are a great time to take stock of where you are and where you want to be. Then, you can put a plan into place to get you there while there is still plenty of time to evaluate and implement moves for this year. Use the following ideas as a starting point. Some of the ideas may apply to you, some to family members, and others to your business.
Take a Look at Your Investments
The 2016 federal income tax rates on long-term capital gains and qualified dividends are 0%, 15%, and 20%, with the maximum 20% rate affecting taxpayers with taxable income above $415,050 for single taxpayers, $466,950 for married joint-filing couples, and $441,000 for heads of households. High-income individuals can also be hit by the 3.8% NITT, which can result in a marginal long-term capital gains/qualified dividend tax rate as high as 23.8%. Still, that is substantially lower than the top regular tax rate of 39.6% (43.4% if the NITT applies).
Holding on Longer Can Lower Your Taxes. If you hold appreciated securities in taxable accounts, owning them for at least one year and a day is necessary to qualify for the preferential long-term capital gains tax rates. In contrast, short-term gains are taxed at your regular rate, which can be as high as 39.6% (43.4% if the NITT applies). Be sure to consider this when evaluating your investment portfolio. Whenever possible, try to meet the more-than-one-year ownership rule for appreciated securities held in your taxable accounts. (Of course, while the tax consequences are important, they should not be the only consideration for making a buy or sell decision.)
Sell the Right Shares. Generally, when you sell stock or mutual fund shares, the shares you purchased first are considered sold first, which is good news if you are trying to qualify for the long-term capital gain rate. But, there may be situations where you’re better off selling shares that have been held a year or less rather than those held longer. Selling recently purchased shares at little or no gain (because you purchased them at a higher price) may be better than selling shares held for more than one year if that sale would produce a significant gain. Whenever you want to sell shares other than those you purchased first, you must properly notify your broker as to the specific shares you want sold.
Don’t Pass up Tax-free Income
Take Advantage of Retirement Plan Options. The earnings on most retirement accounts are tax-deferred. (With Roth IRAs, they’re normally tax-free.) Thus, the sooner you fund such an account, the quicker the tax advantage begins. If you can come up with the cash now, there’s no need to wait until year-end or the April 15 tax filing deadline to make your 2016 contributions. However, if your employer offers a 401(k) or SIMPLE-IRA plan at work, you’ll probably want to contribute enough to that plan to receive a full employer match before making an IRA contribution.
Invest in Tax-free Securities. The most obvious source of tax-free income is tax-exempt securities, either owned outright or through a mutual fund. Whether these provide a better return than the after-tax return on taxable investments depends on your tax bracket and the market interest rates for tax-exempt investments. These factors change frequently, so it’s a good idea to periodically compare taxable and tax-exempt investments. In some cases, it may be as simple as transferring assets from a taxable to a tax-exempt fund.
Make Charitable Donations from IRAs. If you’ve reached age 70½, you can arrange to have up to $100,000 of otherwise taxable IRA money paid directly to specified tax-exempt charities. These so-called Qualified Charitable Distributions (QCDs) are federal-income-tax-free to you, but you don’t get to claim any itemized deductions on your Form 1040. However, the tax-free treatment equates to a 100% write-off, and you don’t have to itemize your deductions to get it. Furthermore, you can count the distribution as part of your required minimum distribution that you’d otherwise be forced to receive and pay taxes on this year. Be careful though—to qualify for this special tax break, the funds must go directly between your IRA and the charity.
Make Good Use of the Available Deductions
Make the Standard Deduction Work for You. The tax rules allow you a deduction equal to the greater of your itemized deductions or a flat amount known as the standard deduction. Thus, itemized deductions only lower your taxable income to the extent they exceed the standard deduction. For 2016, the standard deduction is $12,600 for married taxpayers filing joint returns. If you are single, the amount is $6,300 (unless you qualify as head of household, in which case it’s $9,300). If you’re at least 65, you receive an additional standard deduction of $1,250 if you’re married (plus another $1,250 if your spouse is also 65 or older) or an additional $1,550 if you’re single. In 2017, these amounts will all likely be slightly higher after adjustment for inflation.
If your total itemized deductions are normally close to whichever standard deduction applies to you, you may be able to leverage the benefit of your deductions by bunching them in every other year. This allows you to time your itemized deductions so that they are high in one year and low in the next. You claim actual expenses in the year they are bunched and take the standard deduction in the intervening years. (Deductions you may be able to shift between years include charitable contributions and your state and local income and property taxes. However, watch out for AMT, as these taxes aren’t deductible for AMT purposes.)
Increase Participation in Otherwise Passive Activities. The so-called passive activity rules prevent many taxpayers from currently deducting losses from business activities in which they do not “materially participate.” These losses are typically from partnerships in which they are not personally involved or do not participate to the extent required by the tax rules. Taxpayers can normally satisfy any one of several tests (e.g., spending more than 500 hours per year in day-to-day operations, performing substantially all the work in the activity, or completing more than 100 hours per year and more than anyone else) to meet the material participation standard. If you’re expecting a current-year loss from an activity (or have a loss carrying over from an earlier year) with proper planning between now and year-end, you may be able to increase your involvement in the activity and, thus, avoid having the loss disallowed under the passive activity rules.
Maximize Your Business Deductions
Take Advantage of the Generous Section 179 Deduction and First-year Bonus Depreciation. Under the Section 179 deduction privilege, an eligible business can often claim first-year depreciation write-offs for the entire cost of new and used equipment and software additions and eligible real property costs. For tax years beginning in 2016, the maximum 179 deduction is $500,000. However, this maximum deduction is reduced to the extent you purchase more than $2.01 million of qualifying property during the tax year. Also, a much lower limit applies for amounts that can be deducted for most vehicles.
Above and beyond the Section 179 deduction, your business can also claim first-year bonus depreciation equal to 50% of the cost of most new (not used) equipment and software placed in service by the end of this year.
Note: You cannot claim a Section 179 write-off that would create or increase an overall tax loss from your business. This limit does not apply to first-year bonus depreciation deductions, which can create or increase a Net Operating Loss (NOL) for your business’s 2016 tax year. You can then carry back the NOL to 2014 and/or 2015 and collect a refund of taxes paid in one or both those years. Please contact us for details on the interaction between asset additions and NOLs.
Consider Selling Rather Than Trading-in Vehicles Used in Business. Although a vehicle’s value typically drops fairly rapidly, the tax rules limit the amount of annual depreciation that can be claimed on most cars and light trucks. Thus, when it’s time to replace the vehicle, it’s not unusual for its tax basis to be higher than its value. If you trade the vehicle in on a new one, the undepreciated basis of the old vehicle simply tacks onto the basis of the new one (even though this extra basis generally doesn’t generate any additional current depreciation because of the annual depreciation limits). However, if you sell the old vehicle rather than trading it in, any excess of basis over the vehicle’s value can be claimed as a deductible loss to the extent of your business use of the vehicle.
Consider Reimbursing Employees’ Out-of-pocket Business Expenses. Employees normally receive little or no tax benefit from paying business expenses because they’re deductible only to the extent they exceed (1) 2% of the employee’s adjusted gross income and, (2) when combined with the employee’s other itemized deductions, the employee’s standard deduction. Thus, for example, an employee whose compensation is $2,000 higher than it would otherwise be because he’s expected to incur about $2,000 in unreimbursed business expenses isn’t being fairly compensated for the out-of-pocket expense. After paying income and payroll taxes on the $2,000, he has less than this amount to spend on the business expenses. A better approach would be for the company to reimburse at least part of the employee’s business expenses (and renegotiate the employee’s compensation accordingly). Because properly documented expense reimbursements aren’t considered compensation, both the company and the employee save payroll taxes on this arrangement. Plus, the employee comes out better on income taxes as well.
Employ Your Kid. If you are self-employed, you might want to consider employing your child to work in the business. Doing so has tax benefits in that it shifts income (which is not subject to the Kiddie tax) from you to your child, who normally is in a lower tax bracket or may avoid tax entirely due to your child’s standard deduction. There can also be payroll tax savings since wages paid by sole proprietors to their children age 17 and younger are exempt from Social Security, Medicare, and federal unemployment taxes. Employing your children has the added benefit of providing them with earned income, which enables them to contribute to an IRA. Children with IRAs, particularly Roth IRAs, have a great start on retirement savings since the compounded growth of the funds can be significant.
Remember a couple of things when employing your child. First, the wages paid must be reasonable given the child’s age and work skills. Second, if the child is in college or entering soon, too much earned income can have a detrimental impact on the student’s need-based financial aid eligibility.
Set up a Retirement Plan. If your business doesn’t offer a retirement plan, now might be the time to take the plunge. Current retirement plan rules allow for significant deductible contributions. Even if your business is only part-time or something you do on the side, contributing to a SEP-IRA or SIMPLE-IRA can enable you to reduce your current tax load while increasing your retirement savings. With a SEP-IRA, you generally can contribute up to 20% of your self-employment earnings, with a maximum contribution of $53,000. A SIMPLE-IRA, on the other hand, allows you to set aside up to $12,500 plus an employer match that could potentially be the same amount. In addition, if you’re age 50 or older by year-end, you can contribute an additional $3,000 to a SIMPLE-IRA.
Don’t Overlook Estate Planning
For 2016, the unified federal gift and estate tax exemption is a generous $5.45 million, and the federal estate tax rate is a historically reasonable 40%. Even if you already have an estate plan, it may need updating to reflect the current estate and gift tax rules. Also, you may need to make some changes that have nothing to do with taxes. Contact us if you think you could use an estate planning tune-up.
This letter is intended to give you just a few ideas to get you thinking about planning for 2016. We would like to discuss your situation in detail to see how these and other planning ideas can be used to reduce your tax bill. Please don’t hesitate to call us if you would like more details or would like to schedule a tax planning strategy session.
Charles S. Smith, CPA
Partner, Williams Scarborough Smith Gray LLP