Fall 10 - Uncertainty Clouds End-of-Year Tax Planning
Cuts in federal income tax rates, some of which have been in effect since 2001, are due to expire at the end of 2010. Unless Congress acts, the top marginal personal income tax rate is due to increase from 35 to 39.6 percent, its pre-2001 level. The tax rate on capital gains will increase from 15 to 20 percent, and dividends will be taxed at ordinary rates.
Numerous fixes have been discussed on Capitol Hill, but it’s possible — even likely — there will be no final congressional action until after the November election. Many predict a temporary, partial extension of some of the existing rates, however. This would give Congress time to review the upcoming report, due in December, of a presidential commission on the federal deficit.
With so much uncertainty, year-end tax planning will be especially challenging this year. While your final decisions will depend on congressional actions, now is the time to begin considering how you might respond to various scenarios.
Rethinking Traditional Year-End Strategies
Year-end tax planning usually involves finding ways to defer income or gain while accelerating expenses, losses and other deductions. No one wants to pay tax sooner than necessary.
This year, that traditional strategy could be turned on its head. If rates do indeed increase in 2011, business owners could be advised to at least consider doing the exact opposite — accelerating income and postponing deductions — so that tax is paid under the lower rates.
In addition, without congressional action, one study estimates the number of families affected by the Alternative Minimum Tax may jump from 4 million last year to 28.5 million in 2011 — which could be another reason to accelerate income into 2010.
There are no hard and fast rules, and the potential tax consequences of any action must always be weighed against other financial and strategic considerations. With these precautions in mind, however, it is worth thinking about some possible tax strategies.
Accelerate Capital Gains?
Hikes in tax rates for capital gains and dividends could have many implications for contractors. For example, this could be the year to opt out of receiving installment payments on a previous sale of property, and instead recognize the gain before the end of the year. The use of a like-kind exchange to defer income might also become less advantageous due to rising tax rates.
Contractors who are considering selling all or part of their business to family members might want to consider consummating that transaction before year-end, in order to lock in any anticipated capital gain at the 15 percent rate. Again, however, there are many other factors to consider.
Personal Tax Rates And Corporate Decisions
An increase in marginal tax rates on personal income could raise many questions regarding the timing of certain taxable business events. For example:
- When does the business pay bonuses or make profit-sharing contributions? How would a change in personal tax rates affect this?
- What about the timing of payments for prepaid accounts, such as insurance premiums or maintenance contracts?
- Should disputed sales or bad debts be delayed in case tax rates go up, which would make the write-off more valuable next year?
On a larger scale, if a closely held C corporation owns significant assets, this could be the year to transfer those assets to the individual stockholders to minimize future C corporation double-taxation issues.
Other tax provisions scheduled to expire include small business expensing of equipment purchases up to $250,000. Unless Congress acts, this deduction will revert to $25,000 in 2011.
Individual Tax Strategies
At the individual level, common tax strategies such as investments in tax-free municipal bonds could also be affected. The higher the effective tax rate, the more attractive a tax-free investment becomes. For instance:
- Do you plan on converting a traditional IRA to a Roth IRA? Should you accelerate that decision in anticipation of a tax rate increase?
- When is the best time to exercise a stock option? Uncertainty over tax rates adds one more factor to consider.
- What about charitable contributions? Should you delay a contribution until 2011 to maximize your potential tax benefit?
Again, the examples discussed here are predicated on the assumption that individual tax rates are allowed to revert to their pre-2001 levels, which is by no means certain. Despite the uncertainty — or perhaps because of it — now is the time to start exploring strategies to employ in response to the various tax rate scenarios that will be playing out over the next few months.
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The Construction Advisor is produced quarterly by Bober Markey Fedorovich. For more information about our services, please contact our team leader, Dale A. Ruther, CPA, CIT, partner, at (330) 762-9785 or by email.