2012 Estate Planning. Martin Inc. Shenkman
or other appreciated property and sell them before year end to assure favorable long-term capital gain treatment. Similarly, appreciated assets held in grantor trusts might be sold to trigger current gain to the grantor.
For all this planning, be certain to have your CPA consider the so-called alternative minimum tax (AMT). Revisit any estimated tax payments to avoid penalties, especially if you pursue any of the above planning. It may change the required estimated taxes.
When pursuing income tax planning, don’t let the tax tail wag the economic dog. If you have, for example, concentrated stock positions or other non-diversified assets, focus on the economic issues and decisions first, then maximize the tax benefits in light of the broader economic decisions.
Capital Gains Rates
The 2001 Act (EGTRRA) created low capital gains tax rates of 0 percent for taxpayers in the 10 percent and 15 percent income tax brackets, and 15 percent for others. These rates continue through the end of 2012 but, unless Congress acts, will expire in 2013. If you anticipate higher capital gains rates, look into diversifying concentrated positions now by selling in 2012 before rates are increased in 2013. Obviously, those strategies are not assured to be successful given the political uncertainty. If you don’t act in 2012, and capital gains rates do rise in 2013, then the use of a charitable remainder trust (CRT) to soften the income tax blow on diversification of a concentrated stock position could be considered.
There has also been discussion of reducing the tax-favored treatment for capital gains over a number of years to minimize the impact on the markets. This might take the form of higher rates on those earning over certain income thresholds. The $200,000/$250,000 thresholds that have popped up in a number of contexts might be the threshold selected for such changes.
The combination of higher capital gains rates coupled with the Medicare tax on unearned income (see the discussion that follows), and other potential changes, could have a surprising impact on taxpayers. For taxpayers in high-tax states who face a higher combined capital gains rate, coupled with Medicare tax on investment income and no federal deduction for state income taxes on the gains realized, the bottom line result could be quite costly.
There has even been some discussion of treating capital gains and qualified dividends as ordinary income. The sales pitch for this is it will simplify the tax code and planning. Since the marginal tax rates will be relatively low, perhaps this might be saleable. In fact, all those rates were the same for a short time after 1986. But the naysayers are concerned about the impact on the nascent economic recovery.
The proposed changes could have a wide-ranging impact on a host of investment, business, and other transactions. Depending on the nature of the various changes, they could distort investment and planning decisions in many ways from what taxpayers and advisers alike are presently use to. Dealer versus investor status, lease versus sale, hedging transactions, holding periods, and a host of other planning concepts could all require reconsideration in the new tax paradigm.
Medicare Tax on Wages and Investment Income
Starting in 2013, a 0.9 percent Medicare tax will be imposed on wages and self-employment income over $200,000 for single taxpayers and $250,000 for married couples. Also, in 2013, a 3.8 percent Medicare tax will apply to a taxpayer’s net investment income if adjusted gross income (AGI) exceeds $200,000 for a single taxpayer (or $250,000 for a joint filer).
Generally, wages are subject to a 2.9 percent Medicare payroll tax. Workers and employers each pay half, or 1.45 percent. If you are self-employed, you pay the entire tax but receive an income tax write-off for half. This Medicare tax is assessed on all earnings or wages without a cap (that is, regardless of how great the wages). These taxes fund the Medicare hospital insurance trust fund that pays hospital bills for those 65+ or disabled. Starting in 2013, a 0.9 percent Medicare tax will be imposed on wages and self-employment income over $200,000 for singles and $250,000 for married couples. That makes the individual’s marginal Medicare tax rate 2.35 percent (or 3.8 percent if self-employed).
Under current law, only wages and earnings are subject to the Medicare tax but, starting in 2013, the 3.8 percent Medicare tax will apply to net investment income if the taxpayer’s adjusted gross income (AGI) is over $200,000 single ($250,000 joint) threshold amounts.
The impact of much higher marginal rates will be significant. The income tax benefit of charitable deductions, to the extent one remains, will be reduced. The calculus of when to purchase tax exempt versus taxable bonds could be affected. Perhaps taxpayers who have become overly concentrated in municipal bonds should begin the weaning process now.
PLANNING NOTE: If the Medicare tax on passive income applies to a complex trust that accumulates earnings, but would not apply to the beneficiaries if the trustee made current distributions of trust income because of the number of beneficiaries and their lower brackets, how will this affect trustees’ decisions to make distributions under the new rules?
Itemized Deductions
The repeal of the itemized deduction phase out and the personal exemption phase out will sunset (expire) in 2013. This might help taxpayers qualify to deduct more, but the restrictions may make that exercise academic by making it more difficult if not impossible to deduct certain expenses. You should still be cautioned that other restrictions such as the 7.5 percent (increasing to 10 percent) medical expense threshold, and 2 percent floor on miscellaneous itemized deductions, must still be contended with.
One proposal provides for the maximum tax benefit from itemized deductions and other tax benefits to be capped at 28 percent.
Possible deductions that are up for restriction might include the full laundry list of common tax deductions. Overall these changes may spur taxpayers to restructure transactions and the manner in which they handle their affairs. The family limited partnership (FLP) formed to take advantage of valuation discounts presently permitted under the gift and estate tax valuation rules may morph into a new purpose. If discounts are restricted or repealed (and for perhaps 99 percent of taxpayers it’s all academic if the $5 million inflation-adjusted exemption remains law) FLPs instead of being dissolved (which for asset protection reasons alone probably should not be) may be the only vehicle left to secure certain income tax deductions as itemized deductions are restricted.
Restricting deductions for charitable contributions has been talked about with increasing frequency. One proposal was to limit the charitable deduction for individuals to amounts over 2 percent of adjusted gross income (AGI). However, if medical deductions are restricted and miscellaneous itemized deductions eliminated, there may be less incentive to peg contributions to a percentage of AGI and instead just provide for a direct reduction of the amount that can be deducted. A restriction on the amount of a charitable contribution deduction, perhaps somewhat offset by increased tax rates, could have a combined impact of undermining any tax incentives for donations and of confounding potential donors as to the ground rules.
Deductions for certain medical expenses may be eliminated. Under current law, you can only deduct, as an itemized deduction, medical expenses to the extent that they exceed 7.5 percent of your AGI. This restriction is in addition to the others that limit the tax benefits of itemized deductions. Beginning in 2013, taxpayers will only be able to deduct medical expenses as an itemized deduction if they exceed 10 percent of AGI. Few individuals take advantage of this benefit, and of those that do most are generally old/sick. Congress provided that for those who are 65 and older the 7.5 percent rule will remain in place until the end of 2016.
State and local tax deduction for individuals has been talked about as a target. If this deduction is eliminated, the disparate impact on taxpayers could be significant.
All miscellaneous itemized deductions for individuals have been proposed for elimination. As discussed next, this might drive many taxpayers