Year-End Tax Strategies for Business Owners
Well-publicized legislation earlier this year added a new top bracket for higher-income individuals, but 2013 has a whole array of tax rate increases applying at varying income levels.
End of the 2 percent payroll tax cut
For 2011 and 2012, employees and self-employed taxpayers received a 2 percent cut in their lower-tier Social Security tax costs. But Congress let the cut expire for 2013. Wage earners have had this quietly withheld throughout 2013. But self-employed individuals who typically remit quarterly estimates based on the prior year tax, will get a real sticker shock this coming April 15. A taxpayer whose self-employment income fills the lower tier base of $113,700 will face roughly a $2,600 tax increase.
New ACA taxes beginning in 2013
The first is a new federal surtax of 3.8 percent on net investment income. This tax is imposed on items such as interest, dividends, annuity income, rents and royalties, passive business income, and most capital gains, other than those from an active participation business. The second tax is a 0.9 percent add-on to the Medicare tax applying to wages and self-employment income. Both of these taxes are imposed on single incomes above $200,000 and joint income above $250,000. For owners who use pass-through entities and pay all tax at the 1040 level, any salaries and any rental income from the business face a 3.8 percent added tax: 3.8 percent net investment income tax on the rent and a 3.8 percent combined Medicare tax (2.9 percent old plus 0.9 percent new) on wages or self-employment income.
Phase-out of itemized deductions and personal exemptions
Beginning in 2013, two back-door rate increases apply. As 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. Thus, a family of four moving through the phase-out range would have an additional 5 percent federal income tax rate increase.
New top-end brackets
The top rates on both ordinary income and capital gain were increased for 2013. A seventh ordinary income bracket of 39.6 percent was added for joint filers whose income exceeds $450,000 and single filers over $400,000. This income was previously taxed at 35 percent. And for those with capital gain and dividend income at these levels, the former 15 percent rate becomes 20 percent (23.8 percent, taking into account the net investment income tax).
The continuing AMT
The alternative minimum tax (AMT) continues as in the past, requiring a taxpayer to pay the greater of the regular tax computation or the AMT. Unfortunately, several of these new taxes, such as the 3.8 percent net investment income tax, 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 its exemption.
The difficult part of these rate changes is that identifying the tax cost of incremental income is no longer an easy matter. Your tax advisor will need to turn on the software and do a "before and after" to identify what the tax costs will be.
A capital gain, for example, could easily range anywhere from 15 percent to a 25 percent rate, depending on how it fits into other income reported on the 1040. For many upper-income filers, the tax cost increase from 2012 to 2013 will be eye-popping. A year-end tax projection may make sense, as it can identify the magnitude of the increase, and tell whether actions such as prepaying state income tax or accelerating quarterly estimates would be helpful.
End of first-year depreciation incentives
Since the beginning of the recession in 2008, Congress has been providing two first-year depreciation incentives to reward businesses for purchasing capital equipment and other depreciable improvements. The first-year Section 179 deduction was increased, and a 50 percent first-year bonus deduction has been allowed for most new, but not used, business property (other than real estate). These incentives both expire going into 2014.
Our expectation is that Congress will not extend either of these provisions. Fifty percent bonus depreciation will end on December 31, 2013, for all businesses, regardless of tax year. The Section 179 deduction, currently $500,000, will likely return to its former range, which with inflation indexing should be about $145,000. That decrease will be effective for the tax year beginning in 2014. Business owners with capital improvement needs will want to consider acquiring and placing in service those improvements before these incentives disappear.
Health care changes
The employer health insurance mandate facing those with 50 or more employees was postponed until 2015. That additional time is helpful, in the sense that small businesses face a complex hourly and monthly computation to sort out whether they are a large employer for the insurance mandate and new IRS reporting requirements. For those only slightly over the 50-employee threshold, there may be relief in the definition of the penalty computations, which focus on only the full-time employees (those regularly over 30 hours per week). The penalties can be avoided entirely if there are no more than 30 workers in this category.
For those subject to the health insurance mandate, the penalty is avoided if the employee portion of the premium is affordable based on the individual’s income, and if the policy meets “minimum value” standards. For most employers, the risk lies in the first test of affordability. Now is the time to run the demographics on individual employee income versus premium costs to measure the penalty risks to the business. CliftonLarsonAllen can help you meet the ACA’s annual reporting requirements and manage risk .
Employers who use stand-alone medical reimbursement plans or health reimbursement arrangements (i.e., Section 105 plans that reimburse employee health costs) will find that these are generally prohibited beginning in 2014. These plans generally violate the new ACA “market reforms” and will need to be dropped (or alternatively, narrowed to ancillary benefits such as dental or vision coverage).
Related party loans
It is common for closely held business owners to have loans to and from their businesses. To be respected for tax purposes, any loan, whether between individuals or businesses, must include adequate interest. The IRS publishes regular floating tables of these minimum interest rates. For open demand notes (i.e., those without a specified repayment term), the minimum interest rate for 2013 is only .22 percent. While this rate is nominal, it is important that interest be paid annually if the underlying transaction is to be respected as a loan by the IRS.
While rates have been low for a number of years, we are seeing a gradual increase in the monthly index rate published by the IRS. Those with substantial related party loans should consider whether it is an appropriate time to lock in a longer-term rate using the low rates available today. For example, for a term debt originating in November 2013, a long-term note (any maturity over nine years) can be set as low as 3.37 percent, whereas a mid-term duration (three to nine years) can be locked in at 1.73 percent.
In September of this year, the IRS issued final regulations on its important repair vs. capitalization project. These final regulations have been years in the making, and contain important guidance on when an expenditure is a capital asset versus a currently deductible supply or repair item.
Most businesses will want to adopt the de minimis accounting policy, in writing, that will allow smaller capital expenditures to be currently deducted. This policy can allow a current deduction of items up to $5,000 if the taxpayer has a formal financial statement (10-K, certified audit, or government-required financial), and is up to $500 per item for those without this type of financial statement. This policy must be in place by the beginning of the 2014 tax year, and accordingly must be in place as early as January 1, 2014, for calendar year taxpayers.
Estate and gift planning
Federal tax legislation at the beginning of the year provided certainty with respect to the transfer tax system. There is now roughly a $5 million per person gift and estate exemption. However, the rate on the excess was increased. For gifts or deaths in 2013, each individual has a $5.25 million unified exemption; the excess is subject to a 40 percent rate (formerly this rate was 35 percent). This exemption amount is adjusted for inflation.
As a result, a married couple can pass up to $10.5 million of assets to the next generation, based on their 2013 combined exemption amounts. For those significantly above this amount, estate reduction strategies make great sense. These strategies typically include a combination of lifetime gifts, possible split-interest charitable gifts, and a variety of discount strategies through the use of trusts and other entities.
For those safely below the exemption amount, and assuming no state gift or estate tax barriers, the focus should switch to simplification of the estate plan. This could include removing old strategies that may cause discounts and suppress the step-up in basis that otherwise occurs when assets pass through an estate.
The new portability feature is another reason why many need to examine their estate plans. Congress has made permanent the privilege that allows the unused estate exemption of the first spouse to die to pass to the surviving spouse. Again, this will allow many smaller estates to simplify asset ownership and testamentary bequests, and possibly avoid complicated trusts that are no longer necessary at the death of the first spouse.
How we can help
Contact your private client tax advisor for help in assessing the potential cost of these tax increases, and a discussion of strategies you may wish to consider.