Shareholder tax strategies in an uncertain year
Now is the time to prepare for potentially adverse tax law changes in 2013
Shareholders are facing a significant risk of unfavorable tax changes heading into 2013. The tax provisions known as the Bush tax cuts are scheduled to expire at the end of this year. The US Congress is currently debating whether these provisions will be extended beyond 2012. As of July 2012, there is still no clear indication of how Congress will vote on the issue or when. Divided along party lines, the debate has been contentious. Even the US Supreme Court's upholding of the health care law may not end the partisan debate over certain provisions of the tax code, and in fact, may even intensify or prolong it in coming months.
For those shareholders who can afford to wait until Nov. 4, the outcome of the presidential and congressional elections may offer some clarity as to the future direction of income, estate and gift tax laws. Other taxpayers however will not have the luxury of waiting. For them, delaying tax planning much longer could adversely affect their overall tax status. For this group, now is the time to prepare for the very real possibility that the Bush tax cuts will expire on Dec. 31, 2012.
In view of the uncertainties of our current tax environment, this article will review how income, estate and gift tax laws will be affected under two scenarios – one, the consequences of the tax cuts expiring and two, of the tax cuts being extended. Special attention will be given to estate and gift tax issues since the expiration of these laws poses the greatest risk to business owners. The article will also offer some general guidance on tax planning strategies designed to mitigate the risk of any tax law changes.
A tale of two scenarios
Income and capital gains taxes
Effective Jan. 1, 2013, assuming no extension, the maximum tax rate will be increased from 35 percent to 39.6 percent. The impact to married taxpayers filing jointly would be as follows:
|Taxable income||Bush tax rates extended||Bush tax rates expired|
Under the two scenarios, the effects on the standard deduction and personal exemption would be as follows:
|Taxable income||Bush tax rates extended||Bush tax rates expired|
With respect to investment tax rates, without an extension, there will be an increase in capital gains rates and an elimination of Qualified Dividend Treatment. The top capital gains rate would increase from 15 percent to 20 percent, and all dividends would be taxed at ordinary income tax rates. Under 2012 tax law, qualified dividends are taxed at a 15 percent tax rate as long as certain criteria are met (e.g., dividend must be paid between 2003 and 2012, must be paid by a U.S. corporation, and other possible limitations and exclusions).
Social Security and Medicare taxes
Social Security taxes were reduced by recent economic stimulus legislation, but some of the reductions are only effective through the end of 2012. The effective payroll taxes for 2012 break down as follows:
- The Social Security tax rate for employees is 4.2 percent effective through the end of the year. This amount reverts back to 6.2 percent in 2013.
- The Social Security tax rate for employers is 6.2 percent.
- The Medicare tax rate is 1.45 percent for employees and employers.
- For self-employed individuals, the Social Security tax rate is 10.4 percent through the end of the year, and the Medicare tax rate is 2.9 percent.
Following the US Supreme Court decision of June 28, 2012, the health care reform law appears to be on track to be implemented. To pay for its benefits and features, the law contains a number of new tax increases, including the following:
- A new 3.8 percent Medicare tax on investment income for individuals making more than $200,000 a year and couples making more than $250,000.
- An additional 0.9 percent Medicare payroll tax for a total tax rate of 2.35 percent on wages above $200,000 for individuals and $250,000 for married couples filing jointly.
- An increase of the medical deduction floor from 7.5 percent to 10 percent before medical expenses become deductible.
- A $2,500 limit on employer-sponsored Flexible Spending Accounts.
Other potentially adverse income tax changes
There are a number of other potentially unfavorable tax law changes on the horizon. While too complex to spell out in detail here, some of them include:
- Restoration of income limits for taking full advantage of personal exemptions and itemized deductions
- Reinstatement of the marriage penalty
- Reduction of family tax credits
- Loss of education benefits
- Loss of the Alternative Minimum Tax patch
Income and capital gains tax strategies
To address these risks, the key planning strategy is tax rate arbitrage; that is, accelerating income and capital gains to take advantage of the lower rates available this year. This allows the taxpayer to avoid the phase outs of personal exemptions and itemized deductions that will occur if the law is not extended. Also, taxpayers should consider accelerating deductions, particularly the charitable deduction, to avoid the loss of its tax value due to the phase out of itemized deductions.
Other tax strategies that taxpayers should consider are as follows:
- Acceleration of income tax into the current year.
There are some tax strategies that are beyond the dominion and control of the taxpayer. Nevertheless, there are other strategies where income can be accelerated by the taxpayer to bring about tax rate arbitrage. This can be accomplished in a number of ways, including:
- By converting a Standard IRA to a Roth IRA. Aside from the acceleration of tax through a Roth conversion, there are additional benefits to this election, such as the future tax free growth of properly converted Roth IRAs and the elimination of the post age 70-1/2 required minimum distributions that are otherwise required of traditional IRAs. Due to these additional benefits, the planning behind Roth IRAs then become estate planning focused since these additional benefits create the greatest advantage to the children of the Roth IRA holder – particularly if the taxpayer is wealthy enough to use other assets, besides the Roth, to fund his or her retirement plan.
The downside to a conversion is the acceleration of income that otherwise remains deferred under a traditional IRA. Because accelerating this income tax provokes anxiety in some taxpayers, this issue should be discussed with his or her tax advisor before deciding to convert the plan.
- By accelerating S Corporation activity. S Corporation shareholders may be able to control the receipt of income and deductions to either frontload or backload the tax liability. Because S corporation activity flows through to the individual shareholder's Schedule K-1, it will affect the personal activity of the K-1. Please note that this is fairly clean planning when dealing with one or two shareholders; however, it can be problematic when dealing with multiple shareholders – not all of whom may want to accelerate taxable income. In a perfect world, all of the S Corporation shareholders will be enrolled to execute this planning strategy.
- Through Section 83(b) elections on restricted stock grants. Many executives receive employee bonus plans, such as restricted stock grants. These types of grants typically have a vesting schedule over several years that allows the executive to defer the income tax recognition until the stock has vested. The taxation of these grants can be accelerated by making a Section 83(b) election to recognize the ordinary income tax at the date of the stock grant. This accelerates the income tax recognition to the grant date based upon the fair market value of the stock at the date of grant.
If the company has high expectations for future growth, then this future appreciation avoids ordinary income tax recognition. The restricted stock would have a basis equaling the amount of income recognized on the date of this Section 83(b) election. Upon sale, any future appreciation would be taxed at the more favorable capital gains rate.
Please note that this planning strategy does not come without risk. Whether a Section 83(b) election is made or not, the executive is deemed an unsecured creditor of the company for the restricted stock grant. If the company's financial stability is at risk, then the executive is for the most part last in line to claim his benefit. Therefore, such an election would only be made with companies that have a very strong and long-term financial profile.
- By accelerating capital gains activity. This strategy would be a response to the projected increase of the capital gains tax with the termination of the Bush tax cuts. Please note that the 2013 projected capital gains rate is still a favorable one. It is acceptable to accelerate gains if these capital assets would have been sold in any event. It is not advisable however to accelerate capital gains at the expense of the taxpayer's long term investment plan. Taxpayers should discuss this strategy with their investment advisors to ensure that any acceleration of capital gains is done in proper context with the taxpayer's overall investment plan.
The more problematic issue is the elimination of qualified dividends that are subject to capital gains tax treatment. With the elimination of this Bush tax provision, these dividends would revert back to ordinary income tax treatment. As stated above, taxpayers should consult with their investment advisors to determine whether investment changes should be made to account for this tax, and to determine whether the taxpayer should pursue other investments.
- Acceleration of itemized deductions to avoid phase out limitations
Itemized deductions is one area over which taxpayers have a large amount of control. In particular, income tax charitable deductions could be accelerated to avoid the potential phase out of this deduction in 2013. Proper charitable planning can lead to exceptionally positive outcomes, since it has benefits for both income and estate tax. For example, large charitable gifts can create an income tax deduction while also removing the asset from the taxpayer's estate for estate tax purposes.
This invites more sophisticated planning strategies, such as charitable lead annuity trusts. These trusts create a great opportunity to claim an income tax charitable deduction, remove the funded assets from the taxpayer's estate and provide a gift tax free opportunity to pass asset appreciation to designated beneficiaries. Under our current low interest rate environment, the charity is entitled to the future value of payments made in subsequent years. The interest rate used to calculate this future value is the Internal Revenue Code Section 7520 rate which is currently at 1.2 percent. Asset appreciation above this amount passes to designated beneficiaries after the promises made to the charity are met. This can result in a profound value passing to beneficiaries on a tax free basis.
Estate and gift tax planning
Business owners stand to be affected profoundly by the expiration of current estate and gift tax laws on Dec. 31, 2012. The current law allows for a $5.12 million lifetime estate and gift tax exemption and a 35 percent maximum tax bracket. On Jan. 1, 2013, this exemption will revert back to the 2001 tax regime, which provides for a $1 million estate and gift tax exemption and a 55 percent maximum tax bracket.
Overtures have been made by both political parties to carry the current estate and gift tax regime over into the next two years. The intent of this measure is to provide more time for legislators to develop estate and gift tax laws that meet the intent of Congress. However, this would require some measure of accord between the two parties. It is worth remembering that the parties failed to reach an accord on this issue in 2009, resulting in the repeal of the estate tax in 2010. If history serves as a lesson, a failure of the parties to agree on this issue in coming months could result in a reversion to the adverse 2001 tax regime.
The Obama administration's Feb. 13, 2012 budget proposal would eliminate a number of planning strategies otherwise available this year. It specifically recommended a reversion of the estate and gift tax rates and exemptions back to 2009 levels. Under this proposal, the maximum tax rate would increase to 45 percent, the lifetime estate tax exemption would fall back to $3.5 million, and the gift tax lifetime exemption would fall back to $1 million. The rollback of the estate, generation-skipping and gift tax lifetime exemptions would be made permanent.
The planning behind Grantor Retained Annuity Trusts (GRATs), sales to defective trusts and dynasty trusts would be dramatically limited under the administration's proposal. That, along with the low interest rate environment that we currently enjoy, underscore the vital importance of tax planning sooner rather than later. The opportunity cost under the Obama administration's proposal could result in an increased gift tax liability of up to $1,828,780. This opportunity cost is a result of the proposed decrease of the lifetime gift tax exclusion from the current $5.12 million level down to the $1,000,000 level in 2013.
To execute an appropriate gift plan takes careful planning. Special assets, such as Limited Liability Companies (LLCs), Family Limited Partnerships (FLPs) and closely held business interests will require a qualified appraisal. An appraisal will best substantiate the true value of the transferred asset, including possible valuation discounts. Absent an appraisal, the risk of an IRS examination is heightened substantially. The more support you have for the valuations you use, the better your chances of prevailing in an examination.
Other proposed estate and gift tax changes
- Tightened availability of valuation discounts. Valuation discounts would be disallowed for transfers of an interest in a family-controlled entity, typically an LLC or an FLP, to a member of the family if, after the transfer, the restriction will lapse or may be removed by the transferor or the transferor's family. This provision is meant to discourage the use of valuation discounts for intra-family transfers of FLP and LLC interests funded with liquid assets.
- Restrictions regarding the use of Grantor Retained Annuity Trusts (GRATs). GRATs would be required to have a minimum term of 10 years and a maximum term of the life expectancy of the annuitant plus 10 years. It should be noted that the donor would have to survive the term of the GRAT to complete the gift. Otherwise, the gift would be undone, and the appreciated assets would revert back to the donor. Also, the remainder interest would have to have a value greater than zero at the time the interest is created, and any decrease in the annuity during the GRAT term would be prohibited. These rules would apply to trusts created after the enactment date. GRATs have historically served as a highly favorable way to transfer appreciated assets at little to no gift tax cost. The Obama administration has historically viewed GRAT planning as an abusive tax planning strategy and would use this provision as a means to discourage its use. If the administration's viewpoint prevails, it would certainly eliminate the use of GRATs by retirees.
- Elimination of the tax benefits associated with sales to an Intentionally Defective Grantor Trust (IDGT). The sale by a grantor of appreciating assets to an IDGT has served as a great estate freezing technique with little to no capital gains tax consequences. The administration's proposal would completely eliminate the value of this planning strategy by including the appreciated IDGT assets in the grantor's gross estate for estate or income tax purposes.
- Limitation on duration of Generation-Skipping Transfer (GST) tax exemption. On the 90th anniversary of the creation of a gift trust or upon the 90th anniversary of the death of the grantor of a revocable living trust, the GST exclusion allocated to the trust would terminate. This provision would limit the value of dynasty trusts. Dynasty trusts are designed to completely shelter trust assets from estate tax liability in the hands of the trust beneficiaries over multiple generations. With proper planning, these trusts can last for centuries without the impact of an estate tax. The administration's proposal would eliminate this tax advantage by requiring the vesting of the trust assets on the 90th anniversary date.
Finally, taxpayers should seek out guidance from qualified tax advisers to help them develop a personal tax diagnostic. Such an analysis would quantify the taxpayer's current and projected tax liabilities, while highlighting the savings associated with proper tax planning. It should conclude with an executive summary of the strategies that are appropriate for the individual taxpayer and which are recommended to mitigate projected tax liabilities.
For more information on developing your tax strategy, please contact Charles Schultz, partner, Washington National Tax, estate and gift tax planning, McGladrey LLP at 312.634.5373.
The information contained herein is general in nature and based on authorities that are subject to change. McGladrey LLP guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. McGladrey LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer.
This article represents the views of the author or authors only, and does not necessarily represent the views or professional advice of McGladrey.