Dramatic tax increases scheduled to go into effect in 2013 make 2012 tax planning imperative. The following taxes may be impacted:

Not only are the Bush Administration tax cuts set to expire, but a new 3.8% surtax on investment income and a possible reinstated claw-back of itemized deductions could raise the tax rate on ordinary income to as high as an effective 44.6% for some taxpayers.

Similarly, the tax rate on long-term capital gains could increase from 15% to 20% and the rate on qualified dividends from 15% to an effective 44.6%.

Finally, if Congress doesn’t take action, the federal estate tax rate will increase from 35% to 55% and the exclusion amount will drop from $5,120,000 to $1,000,000.

This letter will suggest some ways to avoid or minimize the adverse effects of these changes. Planning for these likely tax changes is a major undertaking and many clients are beginning the process now rather than waiting for the fall elections. This is prudent because the additional time will allow you to become comfortable with the gifting process and provide time to custom design trusts for your family.

Gain Harvesting

For many taxpayers it will make sense to harvest capital gains in 2012 to take advantage of the current lower rates. You would sell appreciated capital assets and immediately reinvest in the same or similar assets. You would then hold the new assets until you would otherwise have sold them, so there would be no change in your investment strategy.

Deciding whether to use the strategy is not as simple as it might appear on the surface, however, because the lower tax rates must generally be weighed against a loss of tax deferral. By harvesting the gains in 2012 you would be paying a lower tax rate, but recognizing the gains earlier. The greater the differential in tax rates and the shorter the time before the second sale the more favorable gain harvesting would be.

In some cases, the correct decision will be clear without doing any analysis. If you are currently in the 0% longterm capital gains bracket, 2012 gain harvesting would always be favorable because it would give you a free basis step up. Gain harvesting would also be more favorable if you planned to sell the stock in 2013 or 2014 anyway.

The time value of the tax deferral would be small compared with the future tax savings.

At the other extreme, if you are currently in the 15% long-term capital gain bracket and plan to die with an asset and pass it on to heirs with a stepped-up basis, there is no reason to recognize the gain now. You would be incurring tax now without any offsetting future benefit. Nor would it make sense to harvest losses to create additional capital loss carryovers. These loss carryovers would be better employed to offset capital gains in the future when rates are expected to be higher.

We would be happy to work with you and your financial advisor to develop a plan and assist in identifying the appropriate assets to sell in order to take advantage of this planning opportunity.

Planning for the 3.8% Medicare Surtax

For tax years beginning January 1, 2013, the tax law imposes a 3.8% surtax on certain passive investment income of individuals, trusts, and estates. For individuals, the amount subject to the tax is the lesser of (1) net investment
income (NII), or (2) the excess of a taxpayer’s modified adjusted gross income (MAGI) over an applicable threshold amount.

Net investment income includes dividends, rents, interest, passive activity income, capital gains, annuities, and royalties. Specifically excluded from the definition of net investment income are self-employment income, income from an active trade or business, gain on the sale of an active interest in a partnership or S corporation, IRA or qualified plan distributions, and income from charitable remainder trusts. MAGI is generally the amount you report on the last line of page 1, Form 1040.

The applicable threshold amounts are shown below.

Married taxpayers filing jointly $250,000
Married taxpayers filing separately $125,000
All other individual taxpayers $200,000
A simple example will illustrate how the tax is calculated.

Example: Al and Barb, married taxpayers filing separately, have $300,000 of salary income and $100,000 of NII.

The amount subject to the surtax is the lesser of (1) NII ($100,000), or (2) the excess of their MAGI ($400,000) over the threshold amount ($400,000 -$250,000 = $150,000). Because NII is the smaller amount, it is the base on which the tax is calculated. Thus, the amount subject to the tax is $100,000 and the surtax payable is $3,800 (0.038 x $100,000).

Fortunately, there are a number of effective strategies that can be used to reduce MAGI and or NII and reduce the base on which the surtax is paid. These include (1) Roth IRA conversions, (2) tax-exempt bonds, (3) tax-deferred annuities, (4) life insurance, (5) rental real estate, (6) oil and gas investments, (7) timing estate and trust distributions, (8) charitable remainder trusts, (9) installment sales and maximizing above-the-line deductions. We would be happy to explain how these strategies might save you large amounts of surtax.

Accelerating Ordinary Income into 2012

A final opportunity that should be noted is accelerating ordinary income into 2012. Perhaps the best way to do this would be to convert a traditional IRA to a Roth IRA in 2012, if a conversion otherwise made sense. Ordinary income could also be accelerated by selling bonds with accrued interest in 2012 or selling and repurchasing bonds trading at a premium. Finally, you might consider exercising non-qualified stock options in 2012.

Estate Tax Provisions

The estate tax exemption is currently $5,120,000 per person and will revert to $1,000,000 on January 1, 2013, unless Congress acts. The President is suggesting a $3,500,000 exemption. The potential reduction in the estate tax exemption is resulting in many clients making large gifts, in trust, for their family. In some instances the trusts are for the spouse, children, and grandchildren and in others just for children and younger generations.

Most experts would define the savings at 35%, 45%, or 55% of the amount gifted over $1,000,000. On a $5,000,000 gift the savings would be $1,800,000 ($4,000,000 x 45%).

North Carolina Deduction for Business Income

Effective for tax years being on or after January 1, 2012, North Carolina has a new deduction for taxpayers who include business income in their federal taxable income. The law allows for a deduction up to $50,000 of net business income that is not considered passive (net business income is the aggregate of all business income and losses reported on Schedules C, E, and F). In the case of a married couple filing a joint return where both spouses report net business income, the maximum dollar amounts applies separately to each spouse’s net business income included in AGI (adjusted gross income), not to exceed a total of $100,000 (maximum of $50,000 each).

We are prepared to assist you in modeling scenarios to determine which strategies are right for you. Please don’t hesitate to call us at (919) 942-8700 to schedule an appointment to begin discussing your options.

About Blackman & Sloop CPAs, P.A.:

Blackman & Sloop is a full-service CPA firm headquartered in Chapel Hill, North Carolina and is actively involved in auditing, taxation, management consulting, financial planning, and related services. The firm directs a large part of its services toward providing management with advice on budgeting, forecasts, projections, financing decisions, financial analysis, and tax developments. The firm also performs review and compilation services and prepares not-for-profit, corporate, individual, estate, retirement plan, and trust tax returns as well as technology consulting services regarding installation and training on QuickBooks. Blackman & Sloop provides services in Raleigh, Durham, Chapel Hill, RTP, Hillsborough, Pittsboro, Charlotte, and the rest of North Carolina. To find out more please visit http://www.blackmansloop.com

Contact: CPA cpa@blackmansloop.com

Toll Free: 1-877-854-7530
The Exchange West
1414 Raleigh Rd, Suite 300
Chapel Hill, NC 27517