Year-End Tax Planning for Attorneys and Law Firms
Some of the most significant tax changes in recent memory took effect in 2013. It’s going to take some careful year-end planning for professionals in the legal services industry to minimize the impact of higher tax brackets and a whole array of rate increases that will apply at varying income levels.
“The sheer number of interrelated rates and phase-outs make it extremely difficult to project anticipated tax liabilities,” observes Hod Dahl, principal with CliftonLarsonAllen. “We expect some upper bracket taxpayers will experience ‘sticker shock’ when their 2013 returns are filed if their withholdings and/or estimated tax payments haven’t kept pace with the tax rate increases.”
Although the 2013 tax year may be challenging for attorneys and law firms, a year-end tax projection can identify the magnitude of the increases and indicate which strategies would be most effective in reducing individual and business tax burdens.
Rising tax rates
The highest federal tax bracket increased in 2013 from 35 percent to 39.6 percent for taxable income of $400,000 (single) or $450,000 (joint). The highest rate on long-term capital gains and qualified dividends rose from 15 percent to 20 percent with the same income thresholds. There is also a new hospital insurance tax of 0.9 percent on wages and/or self-employment income on amounts exceeding $200,000 (single) or $250,000 (joint).
A new 3.8 percent surtax on net investment income (NII) is calculated on the lesser of NII or the excess of modified adjusted gross income exceeding the threshold amount of $200,000 (single) or $250,000 (joint).
The ever-present AMT
Contrary to the hopes of attorneys and legal professionals, the alternative minimum tax (AMT) did not go away in 2013. High-earning taxpayers are still required to pay the greater of the regular tax computation or the AMT. Unfortunately, several of the new taxes, such as the 3.8 percent net investment income tax (NIIT), are independent add-ons. In addition, the AMT rate itself can impart a higher-than-expected 35 percent rate at incomes as low as $200,000, due to the phase-out of some exemptions.
State income taxes, real estate taxes, and miscellaneous itemized deductions are not deductible under the AMT. However, charitable contributions remain deductible under the AMT, so they can still be an important part of your tax-reducing arsenal.
Itemized deductions and personal exemptions phased out
Beginning in 2013, two back-door rate increases apply. As Form 1040 income moves above $250,000 (single) or $300,000 (joint), both itemized deductions and personal exemptions are gradually phased out. These phase-outs are designed to raise rates by 1 percent for the itemized adjustment and another 1 percent per person on the personal exemption phase-out. In this way, a family of four moving through the phase-out range would have an additional 5 percent federal income tax rate increase.
Although each of the changes outlined above may not be large, collectively they could have a significant impact on your tax liability.
“For many upper-income filers, the tax cost increase from 2012 to 2013 will be significant,” says Dudley Ryan, a tax principal with CliftonLarsonAllen. “The bottom line is that even if your income and deductions are exactly the same as in 2012, there is a very good chance that your 2013 tax bill will be higher.”
He says that for top income earners, the combined federal and state marginal tax rate can exceed 50 percent.
You need a year-end game plan
Depending on your income, assets, and ownership level in your firm, you can deploy various strategies to minimize your tax liabilities. The key is to take action before the end of the year.
Considerations for business-related expenses
Unreimbursed business expenses — You may deduct unreimbursed business expenses on your individual tax return. This includes mileage, gifts (within limits), 50 percent of meals and entertainment, travel, subscriptions, and other business expenses for partners. The unreimbursed payments for your cell phone and data plan can be deducted on Schedule E of the 2013 Form 1040 (employees deduct these items on Schedule A subject to the 2 percent threshold).
Asset purchases — Property, such as automobiles, computers, and furniture that is acquired personally to support or advance your trade or business, can be depreciated over its estimated useful life. In addition, generous provisions, such as Section 179 and bonus depreciation (see below), allow you to accelerate the deductions. If the property use is mixed between personal and business, some limits may apply.
Section 179 and bonus depreciation — For tax years beginning in 2013, the expensing limit for qualified depreciable property acquisitions is $500,000 and the investment ceiling limit is $2 million. A limited amount of expensing may be claimed for qualified real property. Unless Congress changes the rules for tax years beginning in 2014, the dollar limit will drop to $25,000 and the phase-out amount will drop to $200,000.
Pre-pay state taxes — If you expect to owe state and local income taxes when you file your 2013 return next year, consider paying the estimated state taxes before year-end to pull the deduction of those taxes into 2013. There is one caution: Be sure to evaluate if prepaying state taxes will create an AMT problem on your federal return.
Charitable gifting of stock as an alternative to cash — If you are in a position to have stock that has appreciated more than your cost and you have held it for at least 12 months, consider donating it to a charity. Using this strategy you will not have to pay tax on the gain and will still be able to deduct the fair market value of the stock at the time of the gift.
Charitable gift documentation — Recent court cases continue to emphasize the importance of carefully adhering to charitable documentation rules. In a recent case, the donor had more than $6,000 in cancelled checks to his church, but lacked a receipt that was dated before his tax return filing date. The result was disallowance of the entire deduction because each check exceeded $250 and was not supported by a receipt as the tax law now requires. Also, be cautious of large donations of personal goods and other assets to charity. If the total exceeds $5,000, an independent appraisal is required.
Sale of securities — If you have unrealized losses in securities consider selling them to offset gains that you may have already taken. Capital losses will first offset capital gains generated in the year. Any excess loss can be used to offset $3,000 of ordinary income for the year with the remainder carrying over into future years.
Miscellaneous other tax items
Maximize your contribution to a health savings account (HSA) — To the extent practical, maximize your HSA contributions for 2013.
Roth conversion — If you believe a Roth individual retirement account (IRA) offers greater benefits than a traditional IRA and want to remain in the market for the long term, consider converting traditional IRA funds into a Roth (if you are eligible to do so). Keep in mind, however, that such a conversion will increase your adjusted gross income and your tax in 2013.
Annual gift tax exclusion — Make gifts sheltered by the annual gift tax exclusion before the end of the year to save gift and estate taxes. You can give $14,000 in 2013 to each of an unlimited number of individuals, but you can't carry over unused exclusions from one year to the next. The transfers may also 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.”
The year is coming to a close with much more tax certainty than 2012, but timely tax planning remains critical for the legal services industry. Early discussions with your tax advisors will help ensure a smooth tax return process and offer thoughtful consideration of all the opportunities for you and your firm.