This year, for the first time, tax planning for taxpayers with adjusted gross incomes over threshold amounts ($200,000 for single taxpayers; $250,000 for married taxpayers) must take into account the new 3.8% Medicare tax on Net Investment Income that was enacted as part of the Affordable Care Act of 2010. Net Investment Income includes interest, dividends, rents, royalties and annuity income, but also includes taxable income from trades or businesses that were passive activities of the taxpayer under IRC § 469.
You may recall that a passive activity is a trade or business in which the taxpayer does not actively participate. The temporary regulations under IRC § 469 set forth seven different tests to determine whether the taxpayer actively participated in the activity. (The 500 hour standard is the most commonly used test). Taxpayers (together with their tax advisors) should analyze whether they are on track to satisfy the material participation standards for their profitable trade or business activities. The expenditure of a few additional hours in the activity prior to year-end may permit exclusion of that activity's income from Net Investment Income, thus avoiding the 3.8% Medicare tax on that income.
Contemporaneous documentation of the time that the taxpayer devoted to the activity is imperative for these purposes. In our experience, IRS auditors tend to accord much greater credibility to records that are prepared prior to the filing of the related returns, in contrast to those that are generated at a later time in connection with the audit.
The timely recording of participation hours is, of course, also important to any taxpayer activities that are not profitable, in order to avoid the suspension of the deductibility of such losses under the passive activity loss rules.
We have compiled a checklist of actions that may help you save tax dollars if you act before year-end. Not all actions will apply in your particular situation, but you will likely benefit from many of them. We can narrow down the specific actions that you can take once we meet with you to tailor a particular plan. In the meantime, please review the following list and contact us at your earliest convenience so that we can advise you on which tax-saving moves to make.
Depending upon the individual circumstances of a taxpayer, customary year-end tax planning strategies might include the following:
- Increase the amount you set aside for next year in your employer's health flexible spending account (FSA) if you set aside too little for this year.
- If you become eligible to make health savings account (HSA) contributions in December of this year, you can make a full year's worth of deductible HSA contributions for 2013.
- Realize losses on stock while substantially preserving your investment position. There are several ways this can be done. For example, you can sell the original holding, then buy back the same securities at least 31 days later.
- Postpone income until 2014 and accelerate deductions into 2013 to lower your 2013 tax bill. This strategy may enable you to claim larger deductions, credits, and other tax breaks for 2013. These include IRA and Roth IRA contributions, child credits, higher education tax credits, the above-the-line deduction for higher-education expenses, and deductions for student loan interest. Postponing income is also desirable for those taxpayers who anticipate being in a lower tax bracket next year due to changed financial circumstances. Note, however, that in some cases, it may pay to actually accelerate income into 2013. For example, this may be the case where a person's marginal tax rate is much lower this year than it will be next year. Finally, taxpayers should realize that for tax years 2013 and after, the "Pease" phase out of itemized deductions is once again applicable.
- If you believe a Roth IRA is better than a traditional IRA, and want to remain in the market for the long term, consider converting IRA money that is invested in beaten-down stocks (or mutual funds) into Roth IRAs if eligible to do so. Keep in mind, however, that such a conversion will increase your adjusted gross income for 2013. Remember also to take your required minimum distributions from your IRA, 401(k) plan, or other qualified plan.
- It may be advantageous to try to arrange with your employer to defer a bonus that may be coming your way until 2014.
- If you own an interest in a partnership or S corporation, you may need to increase your basis in the entity so that you can deduct a loss from it for this year.
- Consider prepaying expenses that can generate deductions for this year.
- If you expect to owe state and local income taxes when you file your return next year, ask your employer to increase withholding of state and local taxes (or pay estimated tax payments of state and local taxes) before year-end to pull the deduction of those taxes into 2013, if doing so will not create an Alternate Minimum Tax (AMT) problem.
- Those facing a penalty for underpayment of federal estimated tax may be able to eliminate or reduce it by increasing their withholding prior to year-end.
- Estimate the effect of any year-end planning moves on the AMT for 2013, keeping in mind that many tax breaks allowed for purposes of calculating regular taxes are disallowed for AMT purposes. This includes the deduction for state property taxes on your residence, state income taxes (or state sales tax if you elect this deduction option), miscellaneous itemized deductions, and personal exemption deductions. Other deductions, such as for medical expenses, are calculated in a more restrictive way for AMT purposes than for regular tax purposes. As a result, in some cases, deductions should be deferred rather than accelerated to keep them from being lost because of the AMT.
- Businesses should consider making expenditures that qualify for the business property expensing option (under IRC § 179) for assets bought and placed in service this year.
- You may want to settle an insurance or damage claim in order to maximize your casualty loss deduction this year.
- If you are self-employed and have not done so yet, set up a self-employed retirement plan.
- If you are thinking of donating a used auto to charity, you may want to inquire whether the charity plans to sell the car or use it in its charitable activities, the latter may yield a bigger deduction for you.
- If you are age 70½ or older, own IRAs (or Roth IRAs), and are thinking of making a charitable gift before year-end, consider arranging for the gift to be made directly by the IRA trustee. Such a transfer can achieve important tax savings.
- Consider extending your subscriptions to professional journals, paying union or professional dues, enrolling in (and paying tuition for) job-related courses, etc., to bunch into 2013 miscellaneous itemized deductions subject to the 2%-of-AGI floor.
- Depending on your particular situation, you may also want to consider triggering a debt-cancellation event in 2013, electing to deduct investment interest against capital gains, or disposing of a passive activity to allow you to deduct suspended losses.
- Make gifts sheltered by the annual gift tax exclusion before the end of the year and thereby save gift and estate taxes. You can give $14,000 in 2013 to each of an unlimited number of individuals, but you cannot carry over unused annual exclusions from one year to the next. The transfers also may save family income taxes where income-earning property is given to family members in lower income tax brackets who are not subject to the kiddie tax. Certain taxpayers should also consider using some or all of their lifetime gift and estate tax exclusion (asset value equivalent of $5.25 million in 2013, increasing to $5.34 million for 2014) prior to year end.
- Purchase qualified small business stock (QSBS) before the end of this year. There is no tax on gain from the sale of such stock if it is (1) purchased after September 27, 2010 and before January 1, 2014, and (2) held for more than five years. In addition, such sales won't cause AMT preference problems. To qualify for these breaks, the stock must be issued by a regular C corporation with total gross assets of $50 million or less, and a number of other technical requirements must be met.
About the Author: Jack N. Rudel is a member of Jennings, Strouss & Salmon law firm. Mr. Rudel is a seasoned practitioner, having provided legal advice to international, national, regional and local business clients for over thirty-five years. Mr. Rudel is certified as a Tax Specialist by the State Bar Board of Specialization, and provides representation to such clients in tax (U.S. and International), general business planning, corporate law, mergers and acquisitions, and real estate matters. Mr. Rudel can be contacted by email firstname.lastname@example.org or 602.262.5951.