Category Archives: TAX LAW

2014 tax breaks: Congress letting 55 tax breaks expire at year end

WASHINGTON – In an almost annual ritual, Congress is letting a package of 55 popular tax breaks expire at the end of the year, creating uncertainty — once again — for millions of individuals and businesses.

Lawmakers let these tax breaks lapse almost every year, even though they save businesses and individuals billions of dollars. And almost every year, Congress eventually renews them, retroactively, so taxpayers can claim them by the time they file their tax returns.

2014 tax breaks: Congress letting 55 tax breaks expire at year endNo harm, no foul, right? After all, taxpayers filing returns in the spring won’t be hurt because the tax breaks were in effect for 2013. Taxpayers won’t be hit until 2015, when they file tax returns for next year.

Not so far. Trade groups and tax experts complain that Congress is making it impossible for businesses and individuals to plan for the future. What if lawmakers don’t renew the tax break you depend on? Or what if they change it and you’re no longer eligible?

“It’s a totally ridiculous way to run our tax system,” said Rachelle Bernstein, vice president and tax counsel for the National Retail Federation. “It’s impossible to plan when every year this happens, but yet business has gotten used to that.”

Some of the tax breaks are big, including billions in credits for companies that invest in research and development, generous exemptions for financial institutions doing business overseas, and several breaks that let businesses write off capital investments faster.

Others are more obscure, the benefits targeted to film producers, race track owners, makers of electric motorcycles and teachers who buy classroom supplies with their own money.

There are tax rebates to Puerto Rico and the Virgin Islands from a tax on rum imported into the United States, and a credit for expenses related to railroad track maintenance.

A deduction for state and local sales taxes benefits people who live in the nine states without state income taxes. Smaller tax breaks benefit college students and commuters who use public transportation.

A series of tax breaks promote renewable energy, including a credit for power companies that produce electricity with windmills.

The annual practice of letting these tax breaks expire is a symptom a divided, dysfunctional Congress that struggles to pass routine legislation, said Rep. John Lewis of Georgia, a senior Democrat on the tax-writing House Ways and Means Committee.

“It’s not fair, it’s very hard, it’s very difficult for a business person, a company, to plan, not just for the short term but to do long-term planning,” Lewis said. “It’s shameful.”

With Congress on vacation until January, there is no chance the tax breaks will be renewed before they expire. And there is plenty of precedent for Congress to let them expire for months without addressing them. Most recently, they expired at the end of 2011, and Congress didn’t renew them for the entire year, waiting until New Year’s Day 2013 — just in time for taxpayers to claim them on their 2012 returns.

But Congress only renewed the package though the end of 2013.

Why such a short extension? Washington accounting is partly to blame. The two-year extension Congress passed in January cost $76 billion in reduced revenue for the government, according to the nonpartisan Joint Committee on Taxation. Making those tax breaks permanent could add $400 billion or more to the deficit over the next decade.

With budget deficits already high, many in Congress are reluctant to vote for a bill that would add so much red ink. So, they do it slowly, one or two years at time.

“More cynically, some people say, if you just put it in for a year or two, then that keeps the lobbyists having to come back and wine-and-dine the congressmen to get it extended again, and maybe make some campaign contributions,” said Mark Luscombe, principal tax analyst for CCH, a consulting firm based in Riverwoods, Ill.

This year, the package of tax breaks has been caught up in a debate about overhauling the entire tax code. The two top tax writers in Congress — House Ways and Means Committee Chairman Dave Camp, R-Mich., and Senate Finance Committee Chairman Max Baucus, D-Mont. — have been pushing to simplify the tax code by reducing tax breaks and using the additional revenue to lower overall tax rates.

But their efforts have yet to bear fruit, leaving both tax reform and the package of temporary breaks in limbo. When asked how businesses should prepare, given the uncertainty, Camp said: “They need to get on board with tax reform, that’s what they need to do.”

Further complicating the issue, President Barack Obama has nominated Baucus to become U.S. ambassador to China, meaning he will soon leave the Senate, if he is confirmed by his colleagues.

As the Senate wound down its 2013 session, Democratic leaders made a late push to extend many of the tax breaks by asking Republican colleagues to pass a package on the floor of the Senate without debate or amendments. Republicans objected, saying it wasn’t a serious offer, and

the effort failed.

So should taxpayers count on these breaks as they plan their budgets for Income Tax 2014?

“The best thing I would say is, budget accordingly,” said Jackie Perlman, principle tax research analyst at The Tax Institute. “As the saying goes, hope for the best but plan for the worst. Then if you get it, great, that’s a nice perk. But don’t count on it.”

Discuss this and more at the Income Tax Forums.

Late filing your 2012 Tax Return

Late filing your 2012 Income Tax Return? 

If you’re getting an income tax refund, no need to panic. You don’t even need to file an extension.

2012 tax returns that are due a refund have until April 15, 2016 (October 15, 2016 with an extension) to be filed with the IRS before the statute of limitations on the refund runs out. If you don’t file by then, the U.S. Treasury simply keeps your “donation.”

However, if you owe additional tax, file your return as soon as you can, even if you can’t pay your tax bill right away.

The penalties for not filing are much higher than the penalties for not paying, and the longer you wait, the worse it gets. See the What are the penalties for filing late? section below.

Can I e-file after the April 15 deadline?

Filing Income Tax Return LateYes, you can e-file your 2012 tax return through October 15, 2013. After that, the IRS shuts down e-filing to get ready for the following tax year, and you will need to file a conventional paper return.

Click here for tax year 2012 filing deadlines.

What are the penalties for filing late?

It all depends.

  • There is no penalty if you’re getting a refund, provided you file within the allotted 3-year timeframe.
    • After 3 years, the “penalty” is forfeiture of your tax refund, as mentioned above.
  • There is no penalty if you filed an extension and paid any additional taxes owed by April 15, as long as you file your return by the October 15 deadline.
  • late filing penalty applies if you owe taxes and didn’t file your return or extension by April 15.
    • This penalty also applies if you owe taxes, filed an extension, but didn’t file your return by October 15.
    • The late filing penalty is 5% of the additional taxes owed amount for every month (or fraction thereof) your return is late, up to a maximum of 25%.
    • Tip: The late filing penalty is 10 times higher than the late payment penalty. If you can’t pay your tax bill and didn’t file an extension, at least file your return as soon as possible! You can always amend it later.
  • late payment penalty applies if you didn’t pay additional taxes owed by April 15, whether you filed an extension or not.
    • The late payment penalty is 0.5% (1/2 of 1 percent) of the additional tax owed amount for every month (or fraction thereof) the owed tax remains unpaid, up to a maximum of 25%.

Example: Let’s say you didn’t file your return or extension by April 15, and you still owe the IRS an additional $1,000.

Best-case scenario: You file your return on April 29, 2 weeks late, and submit your payment for $1,000. You would owe an additional $50 for filing late ($1,000 x .05) plus another $5 for late payment ($1,000 x .005) for a total penalty of $55.

(Had you filed your extension by the deadline, your total penalty would only be $5. It pays to file an extension!)

Worst-case scenario: You file your 2012 return in April of 2018, 5 years late, and submit your payment for $1,000. You would owe an additional $250 for filing late ($1,000 x the maximum .25) plus another $250 for late payment ($1,000 x the maximum .25), for a total penalty of $500.

What happens if I do not file, period?

You’ll probably receive a letter from the IRS reminding you to file your tax return, particularly if W-2 or 1099 forms were reported to the IRS by your employers. For additional information, refer to the IRS article What Will Happen If You Don’t File Your Past Due Return or Contact The IRS.

If you are due a refund, you’ll forfeit your refund if you do not file by April 15, 2016 (or October 15 of 2016 if you filed an extension).

Self-Employed?

You must file returns reporting your self-employment income within three years of the original filing deadline in order to receive Social Security credits toward your retirement. Don’t lose your Social Security benefits by not filing!

Are there any situations which allow me to file late?

Filing late return with IRSyou are out of the country on the April filing deadline, you are allowed two extra months (June 17, 2013) to file your return and pay the amount due, without needing to request an extension.

You’re considered out of the country if:

  • You live outside of the United States or Puerto Rico and your main place of work is outside of the United States or Puerto Rico; or
  • You are in military or naval service outside of the United States or Puerto Rico.

If you still need more time after the automatic June 17 deadline, you can request four additional months by filing an extension along with paying any taxes you owe.

Other Special Situations

  • Residents of Suffolk County, Massachusetts have until July 15, 2013 to file their 2012 returns and pay taxes due. More info
  • Taxpayers living in the Midwest or South who were unable to file their 2012 returns on time because of severe weather around the April 15 deadline may qualify for late filing without penalty. More info

Late Start for I.R.S. 2012 Income Tax Processing

Bad news coming out of the IRS today. The IRS will not start processing 2012 Income Tax Returns until January 30th, 2013.

Here is the article from the IRS:

IRS Plans Jan. 30 Tax Season Opening For 1040 Filers

IR-2013-2, Jan. 8, 2013

WASHINGTON — Following the January tax law changes made by Congress under the American Taxpayer Relief Act (ATRA), the Internal Revenue Service announced today it plans to open the 2013 filing season and begin processing individual income tax returns on Jan. 30.

The IRS will begin accepting tax returns on that date after updating forms and completing programming and testing of its processing systems. This will reflect the bulk of the late tax law changes enacted Jan. 2. The announcement means that the vast majority of tax filers — more than 120 million households — should be able to start filing tax returns starting Jan 30.

The IRS estimates that remaining households will be able to start filing in late February or into March because of the need for more extensive form and processing systems changes. This group includes people claiming residential energy credits, depreciation of property or general business credits. Most of those in this group file more complex tax returns and typically file closer to the April 15 deadline or obtain an extension.

“We have worked hard to open tax season as soon as possible,” IRS Acting Commissioner Steven T. Miller said. “This date ensures we have the time we need to update and test our processing systems.”

The IRS will not process paper tax returns before the anticipated Jan. 30 opening date. There is no advantage to filing on paper before the opening date, and taxpayers will receive their tax refunds much faster by using e-file with direct deposit.

“The best option for taxpayers is to file electronically,” Miller said.

The opening of the filing season follows passage by Congress of an extensive set of tax changes in ATRA on Jan. 1, 2013, with many affecting tax returns for 2012. While the IRS worked to anticipate the late tax law changes as much as possible, the final law required that the IRS update forms and instructions as well as make critical processing system adjustments before it can begin accepting tax returns.

The IRS originally planned to open electronic filing this year on Jan. 22; more than 80 percent of taxpayers filed electronically last year.

Who Can File Starting Jan. 30?

The IRS anticipates that the vast majority of all taxpayers can file starting Jan. 30, regardless of whether they file electronically or on paper. The IRS will be able to accept tax returns affected by the late Alternative Minimum Tax (AMT) patch as well as the three major “extender” provisions for people claiming the state and local sales tax deduction, higher education tuition and fees deduction and educator expenses deduction.

Who Can’t File Until Later?

There are several forms affected by the late legislation that require more extensive programming and testing of IRS systems. The IRS hopes to begin accepting tax returns including these tax forms between late February and into March; a specific date will be announced in the near future.

The key forms that require more extensive programming changes include Form 5695 (Residential Energy Credits), Form 4562 (Depreciation and Amortization) and Form 3800 (General Business Credit). A full listing of the forms that won’t be accepted until later is available on IRS.gov.

As part of this effort, the IRS will be working closely with the tax software industry and tax professional community to minimize delays and ensure as smooth a tax season as possible under the circumstances.

Updated information will be posted on IRS.gov.

More information here.

Tax Rate Changes 2013

Much has been written about changes to the estate and gift tax law scheduled to occur on January 1, 2013, particularly the reduction of the lifetime estate and gift tax exemption amount from its 2012 level of $5,120,000 to $1 million. The exemption for the generation-skipping transfer tax will also decrease from its 2012 level of $5,120,000 to a base level of $1 million. It is indexed for inflation from 2001, however, and is currently estimated to be $1,430,000. Significant changes to the income tax law are also scheduled to take effect at the same time, but these changes are only now beginning to receive similar attention. While Congress could still act to avert some or all of the changes, the divided nature of this Congress makes the prospect of any action before January 1, 2013, uncertain. This alert summarizes the most significant of the changes to the income tax law that will take effect on January 1, 2013, and suggests some steps you might consider to mitigate their impact.

Tax Rates

The maximum federal income tax rate on ordinary income will increase from its present level of 35 percent to 39.6 percent. The tax rate on long-term capital gain income will increase from its present level of 15 percent to 20 percent. The most dramatic increase will be to the rate at which qualified dividends are taxed. Qualified dividends are currently taxed at the same 15 percent rate as long-term capital gain income. Beginning January 1, 2013, dividends will be treated the same as other ordinary income and taxed at a maximum income tax rate of 39.6 percent.

Additional Medicare Taxes

Now that the U.S. Supreme Court has upheld the Patient Protection and Affordable Care Act of 2010, the additional Medicare taxes will take effect January 1, 2013, as planned, unless Congress acts to change them.

Employees currently pay a Medicare hospital insurance tax of 1.45 percent on their wages. Self-employed individuals pay 2.9 percent of net earnings from self-employment. Unlike taxes on wages and self-employment income for Old Age, Survivors and Disability Insurance, which are capped, the Medicare component of the social security tax has no ceiling. Beginning January 1, 2013, an additional 0.9 percent tax will apply to wages in excess of $250,000 for a married person filing a joint return ($125,000 for married persons filing separately) or $200,000 for an unmarried individual. This will make the total Medicare tax for these individuals 2.35 percent on their wages above the threshold amount. For self-employed individuals, the additional 0.9 percent will apply to their earnings from self-employment in excess of $250,000 for a married person filing a joint return ($125,000 for married persons filing separately) or $200,000 for an unmarried individual. The total Medicare tax for these individuals will be 3.8 percent on their earnings above the threshold amounts, which are not currently indexed for inflation.

Medicare Tax on Investment Income

A new Medicare tax on net investment income will also take effect beginning January 1, 2013. The rate for this new tax will be 3.8 percent and will apply to the lesser of an individual’s i) net investment income; or ii) the excess of the individual’s “modified adjusted gross income” over $250,000 in the case of a married couple filing a joint return ($125,000 for married persons filing separately or an unmarried individual). Modified adjusted gross income is the adjusted gross income increased by the amount of the foreign earned income exclusion. For most taxpayers, their modified adjusted gross income will be the same as their adjusted gross income. The threshold amounts are not currently indexed for inflation.

In the case of an estate or trust that accumulates part of its income, the tax will apply to the lesser of i) its undistributed net investment income; or ii) the excess of its adjusted gross income over the dollar amount at which the highest tax bracket in Section 1(e) begins for the taxable year. This amount currently is scheduled to be $7,500. Since this is a much lower threshold amount than applies to individuals, in many cases, net investment income may be subject to the Medicare tax if it accumulated at the trust level, while it would not be subject to the tax if it is distributed to beneficiaries whose adjusted gross income is less than $250,000 if they file a joint return, or $200,000 if they are unmarried.

Net investment income is gross investment income reduced by those allowable deductions that are properly allocable to such income. Investment income includes interest, dividends, annuities, royalties, and rents, provided that this income is not derived from a trade or business that is not a passive activity for the taxpayer. It also includes gains from the disposition of property, so capital gains realized on the sale of appreciated investments will be subject to this new tax, as well as income derived from the business of trading financial instruments or commodities. If a business that is a passive activity for the taxpayer earns any of the above types of income, that income is also subject to the tax.

The tax does not apply to amounts distributed from qualified retirement plans. It also does not apply to any amount that is subject to the self-employment tax. This rule prevents the Medicare tax from applying twice to the same income. While income from a trade or business that is not a passive activity of the taxpayer will not be subject to the 3.8 percent Medicare tax on investment income, much of that income may be subject to the 3.8 percent Medicare tax on self-employment income. Some limited types of income may not be subject to either tax, but a lot of the detail on how the new tax will apply is still missing.

Phase-out of Itemized Deductions and Personal Exemptions

The phasing out of itemized deductions will also return to the tax law in 2013. Once again, an amount of a taxpayer’s itemized deductions equal to 3 percent of adjusted gross income in excess of $100,000 (adjusted for inflation) will be disallowed, but not in excess of 80 percent of the taxpayer’s total itemized deductions. The disallowance rule applies to all of a taxpayer’s itemized deductions except for medical expenses, investment interest, and casualty and theft losses. For 2009, the last year to which the phase-out previously applied, the $100,000 amount had been inflation adjusted to $166,800. The amount for 2013 should be announced soon.

The personal exemption deduction of $3,700 (2011 amount) per taxpayer and dependent will once again be phased out. The deduction is phased out at the rate of 2 percent of the deduction for each $2,500 by which the taxpayer’s adjusted gross income exceeds a threshold amount. The amount is inflation adjusted and for 2009, the last year to which the phase-out applied, was $250,200 for taxpayers filing a joint return. The deductions were completely lost if the taxpayer’s adjusted gross income exceeded $372,700. The deduction amount and the threshold amount where the phase-out begins for 2013 should be announced soon.

What Should You Do to Prepare for 2013?

You should be prepared to take certain steps after the November elections and before the end of the year if it becomes apparent that Congress will not act to extend the current tax regime into 2013. Some of the considerations are described below.

Should You Sell Appreciated Capital Assets in 2012?

The idea of selling appreciated capital assets in 2012 and paying a federal tax of 15 percent, as compared to a tax of 23.8 percent after 2012, certainly has appeal, since the applicable rate is increasing by 58.67 percent of its present level. Even if you do not wish to part with a particular position, in the case of publicly traded securities, you can easily re-base an appreciated securities position by selling it and then buying the same security. No “wash gain” rule comparable to the wash sale rule for losses applies, and you can sell an asset at a gain today and buy the same asset tomorrow.

Whether this strategy will prove to be a winner over time, however, depends on a number of factors that often are difficult to quantify. Selling earlier than you otherwise would have sold means paying the resulting tax sooner, and once you pay the tax, that money no longer generates further returns for you. By keeping the amount you would have paid in taxes invested on a pre-tax basis, you might eventually generate enough additional return to offset the higher tax rate, or more.

You can model various scenarios, but the result the model generates will only be as accurate as the assumptions you build into it. You will need to predict the time you would otherwise sell the asset, how much the asset might appreciate between now and that time, and the tax rate that might apply. You must also take into account the transaction costs of selling and re-establishing the position. Taxpayers who are elderly or in failing health may want to hold appreciated positions because a basis increase to fair market value at death will still apply.

At the extremes, you can pretty easily determine what to do. For example, if you have a substantially appreciated stock position that you believe you would normally sell in 2013, it almost certainly will be advantageous to sell that holding in 2012. On the other hand, if you have a position that you expect to hold for 15 more years, you are most likely better off just keeping the position and not reducing your invested assets by paying tax now. Over a period of 15 years, by keeping the amount of tax you would pay now invested and generating additional return, you will most likely earn enough to pay the increased amount of income tax that will be due at the time you do sell the asset. You also need to consider the most effective use of capital loss carryovers you might have.

Between these extreme cases, however, the analysis becomes more difficult. The future holding period of the asset and the future return on it are inversely correlated. As the asset’s future rate of return increases, the additional time that the asset must be held to overcome the higher tax rate decreases. As a rule of thumb, you might at least consider re-basing positions that you expect to sell within the next five years, and we are available to assist you in evaluating specific situations. Also, do not forget that the early payment of any applicable state income taxes will further diminish the amount of your invested capital going forward.

Many people have done quite well by operating on a philosophy that says the future is uncertain and you should never pay any tax until you absolutely must, a reasonable position to adopt in many cases.

Do Dividend-yield Stock Portfolios Still Make Sense?

If your investment portfolio is significantly weighted in favor of high-dividend-paying stocks, you should probably ask your investment advisor whether this strategy continues to make sense for you in an environment where the tax rate on dividends is nearly three times what it was when the portfolio was established. While a greater emphasis on growth stocks or other asset classes may be appropriate, you should make that decision only after a discussion with your investment advisor.

Should You Accelerate Ordinary Income?

The acceleration of ordinary income into 2012 could have certain advantages. The 2012 maximum federal income tax rate on ordinary income is 35 percent, as compared to the 2013 rate of 39.6 percent, or 43.4 percent if the income is investment income subject to the 3.8 percent Medicare tax on net investment income. Having a higher adjusted gross income in 2012 and a comparatively lower adjusted gross income in 2013 may also ameliorate to some degree the impact of the itemized deduction phase-out that will apply again in 2013. Acceleration of income is even more attractive if you will be paying AMT (Alternative Minimum Tax) in 2012 and can recognize additional ordinary income subject to a 28 percent tax rate.

If you have discretion to accelerate a bonus or other earned income into 2012 instead of 2013, you can also avoid the 0.9 percent increase in the Medicare tax on wages or net earnings from self-employment that will occur in 2013.

If you are able to control the payment of dividends by a “C” corporation or an “S” corporation that has accumulated earnings from prior “C” corporation years, it may be advantageous to pay dividends in 2012 while the federal income tax rate is 15 percent, as compared to 2013 and later years when the rate may be as high as 43.4 percent.

Consider Roth IRA Conversions

It may also be worthwhile to visit or re-visit the subject of Roth IRA conversions before the end of 2012. The maximum income tax rate that will apply to the taxable amount of a Roth conversion in 2012 is 35 percent, as compared to 39.6 percent if the conversion occurs in 2013 or later. While income from a qualified retirement account is not subject to the 3.8 percent Medicare tax on net investment income, the income from the conversion will increase your adjusted gross income. In 2013 or later, if a Roth conversion causes your adjusted gross income to increase from an amount below $250,000 (on a joint return) to an amount above $250,000, the conversion will result in at least a part of your net investment income becoming subject to the Medicare tax. A Roth conversion after 2012 will also result in an additional disallowance of itemized deductions, since that disallowance also increases as your adjusted gross income increases.

What about Itemized Deductions?

Whether you are better off accelerating or deferring itemized deductions is somewhat complicated. Superficially, deferring discretionary payments (e.g., many charitable contributions and some state income taxes) from 2012 to 2013 makes sense because the deduction may result in greater tax savings due to the higher tax rate that will apply in 2013. The phase-out of itemized deductions will also have an impact, however. If a significant portion of the deduction would be disallowed under the phase-out rules in 2013, then you may be better off taking the deduction in 2012, albeit against a lower tax rate. In the case of charitable contributions, another risk of deferring contributions to 2013 is that Congress could always eliminate the deduction at fair market value for contributions of appreciated property. Certain itemized deductions, such as state income taxes, are not deductible for purposes of computing the AMT, so you are better off paying those kinds of expenses in a year where you have less exposure to the AMT.

Conclusion

While other changes to the income tax law also will take effect in 2013, the ones summarized above are the most significant for higher-income taxpayers. If you would like our assistance in evaluating your particular situation and determining your best course of action, please feel free to contact us.

Tax Rate Changes to Take Affect January 1st 2013

Much has been written about changes to the estate and gift tax law scheduled to occur on January 1, 2013, particularly the reduction of the lifetime estate and gift tax exemption amount from its 2012 level of $5,120,000 to $1 million. The exemption for the generation-skipping transfer tax will also decrease from its 2012 level of $5,120,000 to a base level of $1 million. It is indexed for inflation from 2001, however, and is currently estimated to be $1,430,000. Significant changes to the income tax law are also scheduled to take effect at the same time, but these changes are only now beginning to receive similar attention. While Congress could still act to avert some or all of the changes, the divided nature of this Congress makes the prospect of any action before January 1, 2013, uncertain. This alert summarizes the most significant of the changes to the income tax law that will take effect on January 1, 2013, and suggests some steps you might consider to mitigate their impact.

Tax Rates

The maximum federal income tax rate on ordinary income will increase from its present level of 35 percent to 39.6 percent. The tax rate on long-term capital gain income will increase from its present level of 15 percent to 20 percent. The most dramatic increase will be to the rate at which qualified dividends are taxed. Qualified dividends are currently taxed at the same 15 percent rate as long-term capital gain income. Beginning January 1, 2013, dividends will be treated the same as other ordinary income and taxed at a maximum income tax rate of 39.6 percent.

Additional Medicare Taxes

Now that the U.S. Supreme Court has upheld the Patient Protection and Affordable Care Act of 2010, the additional Medicare taxes will take effect January 1, 2013, as planned, unless Congress acts to change them.

Employees currently pay a Medicare hospital insurance tax of 1.45 percent on their wages. Self-employed individuals pay 2.9 percent of net earnings from self-employment. Unlike taxes on wages and self-employment income for Old Age, Survivors and Disability Insurance, which are capped, the Medicare component of the social security tax has no ceiling. Beginning January 1, 2013, an additional 0.9 percent tax will apply to wages in excess of $250,000 for a married person filing a joint return ($125,000 for married persons filing separately) or $200,000 for an unmarried individual. This will make the total Medicare tax for these individuals 2.35 percent on their wages above the threshold amount. For self-employed individuals, the additional 0.9 percent will apply to their earnings from self-employment in excess of $250,000 for a married person filing a joint return ($125,000 for married persons filing separately) or $200,000 for an unmarried individual. The total Medicare tax for these individuals will be 3.8 percent on their earnings above the threshold amounts, which are not currently indexed for inflation.

Medicare Tax on Investment Income

A new Medicare tax on net investment income will also take effect beginning January 1, 2013. The rate for this new tax will be 3.8 percent and will apply to the lesser of an individual’s i) net investment income; or ii) the excess of the individual’s “modified adjusted gross income” over $250,000 in the case of a married couple filing a joint return ($125,000 for married persons filing separately or an unmarried individual). Modified adjusted gross income is the adjusted gross income increased by the amount of the foreign earned income exclusion. For most taxpayers, their modified adjusted gross income will be the same as their adjusted gross income. The threshold amounts are not currently indexed for inflation.

In the case of an estate or trust that accumulates part of its income, the tax will apply to the lesser of i) its undistributed net investment income; or ii) the excess of its adjusted gross income over the dollar amount at which the highest tax bracket in Section 1(e) begins for the taxable year. This amount currently is scheduled to be $7,500. Since this is a much lower threshold amount than applies to individuals, in many cases, net investment income may be subject to the Medicare tax if it accumulated at the trust level, while it would not be subject to the tax if it is distributed to beneficiaries whose adjusted gross income is less than $250,000 if they file a joint return, or $200,000 if they are unmarried.

Net investment income is gross investment income reduced by those allowable deductions that are properly allocable to such income. Investment income includes interest, dividends, annuities, royalties, and rents, provided that this income is not derived from a trade or business that is not a passive activity for the taxpayer. It also includes gains from the disposition of property, so capital gains realized on the sale of appreciated investments will be subject to this new tax, as well as income derived from the business of trading financial instruments or commodities. If a business that is a passive activity for the taxpayer earns any of the above types of income, that income is also subject to the tax.

The tax does not apply to amounts distributed from qualified retirement plans. It also does not apply to any amount that is subject to the self-employment tax. This rule prevents the Medicare tax from applying twice to the same income. While income from a trade or business that is not a passive activity of the taxpayer will not be subject to the 3.8 percent Medicare tax on investment income, much of that income may be subject to the 3.8 percent Medicare tax on self-employment income. Some limited types of income may not be subject to either tax, but a lot of the detail on how the new tax will apply is still missing.

Phase-out of Itemized Deductions and Personal Exemptions

The phasing out of itemized deductions will also return to the tax law in 2013. Once again, an amount of a taxpayer’s itemized deductions equal to 3 percent of adjusted gross income in excess of $100,000 (adjusted for inflation) will be disallowed, but not in excess of 80 percent of the taxpayer’s total itemized deductions. The disallowance rule applies to all of a taxpayer’s itemized deductions except for medical expenses, investment interest, and casualty and theft losses. For 2009, the last year to which the phase-out previously applied, the $100,000 amount had been inflation adjusted to $166,800. The amount for 2013 should be announced soon.

The personal exemption deduction of $3,700 (2011 amount) per taxpayer and dependent will once again be phased out. The deduction is phased out at the rate of 2 percent of the deduction for each $2,500 by which the taxpayer’s adjusted gross income exceeds a threshold amount. The amount is inflation adjusted and for 2009, the last year to which the phase-out applied, was $250,200 for taxpayers filing a joint return. The deductions were completely lost if the taxpayer’s adjusted gross income exceeded $372,700. The deduction amount and the threshold amount where the phase-out begins for 2013 should be announced soon.

What Should You Do to Prepare for 2013?

You should be prepared to take certain steps after the November elections and before the end of the year if it becomes apparent that Congress will not act to extend the current tax regime into 2013. Some of the considerations are described below.

Should You Sell Appreciated Capital Assets in 2012?

The idea of selling appreciated capital assets in 2012 and paying a federal tax of 15 percent, as compared to a tax of 23.8 percent after 2012, certainly has appeal, since the applicable rate is increasing by 58.67 percent of its present level. Even if you do not wish to part with a particular position, in the case of publicly traded securities, you can easily re-base an appreciated securities position by selling it and then buying the same security. No “wash gain” rule comparable to the wash sale rule for losses applies, and you can sell an asset at a gain today and buy the same asset tomorrow.

Whether this strategy will prove to be a winner over time, however, depends on a number of factors that often are difficult to quantify. Selling earlier than you otherwise would have sold means paying the resulting tax sooner, and once you pay the tax, that money no longer generates further returns for you. By keeping the amount you would have paid in taxes invested on a pre-tax basis, you might eventually generate enough additional return to offset the higher tax rate, or more.

You can model various scenarios, but the result the model generates will only be as accurate as the assumptions you build into it. You will need to predict the time you would otherwise sell the asset, how much the asset might appreciate between now and that time, and the tax rate that might apply. You must also take into account the transaction costs of selling and re-establishing the position. Taxpayers who are elderly or in failing health may want to hold appreciated positions because a basis increase to fair market value at death will still apply.

At the extremes, you can pretty easily determine what to do. For example, if you have a substantially appreciated stock position that you believe you would normally sell in 2013, it almost certainly will be advantageous to sell that holding in 2012. On the other hand, if you have a position that you expect to hold for 15 more years, you are most likely better off just keeping the position and not reducing your invested assets by paying tax now. Over a period of 15 years, by keeping the amount of tax you would pay now invested and generating additional return, you will most likely earn enough to pay the increased amount of income tax that will be due at the time you do sell the asset. You also need to consider the most effective use of capital loss carryovers you might have.

Between these extreme cases, however, the analysis becomes more difficult. The future holding period of the asset and the future return on it are inversely correlated. As the asset’s future rate of return increases, the additional time that the asset must be held to overcome the higher tax rate decreases. As a rule of thumb, you might at least consider re-basing positions that you expect to sell within the next five years, and we are available to assist you in evaluating specific situations. Also, do not forget that the early payment of any applicable state income taxes will further diminish the amount of your invested capital going forward.

Many people have done quite well by operating on a philosophy that says the future is uncertain and you should never pay any tax until you absolutely must, a reasonable position to adopt in many cases.

Do Dividend-yield Stock Portfolios Still Make Sense?

If your investment portfolio is significantly weighted in favor of high-dividend-paying stocks, you should probably ask your investment advisor whether this strategy continues to make sense for you in an environment where the tax rate on dividends is nearly three times what it was when the portfolio was established. While a greater emphasis on growth stocks or other asset classes may be appropriate, you should make that decision only after a discussion with your investment advisor.

Should You Accelerate Ordinary Income?

The acceleration of ordinary income into 2012 could have certain advantages. The 2012 maximum federal income tax rate on ordinary income is 35 percent, as compared to the 2013 rate of 39.6 percent, or 43.4 percent if the income is investment income subject to the 3.8 percent Medicare tax on net investment income. Having a higher adjusted gross income in 2012 and a comparatively lower adjusted gross income in 2013 may also ameliorate to some degree the impact of the itemized deduction phase-out that will apply again in 2013. Acceleration of income is even more attractive if you will be paying AMT (Alternative Minimum Tax) in 2012 and can recognize additional ordinary income subject to a 28 percent tax rate.

If you have discretion to accelerate a bonus or other earned income into 2012 instead of 2013, you can also avoid the 0.9 percent increase in the Medicare tax on wages or net earnings from self-employment that will occur in 2013.

If you are able to control the payment of dividends by a “C” corporation or an “S” corporation that has accumulated earnings from prior “C” corporation years, it may be advantageous to pay dividends in 2012 while the federal income tax rate is 15 percent, as compared to 2013 and later years when the rate may be as high as 43.4 percent.

Consider Roth IRA Conversions

It may also be worthwhile to visit or re-visit the subject of Roth IRA conversions before the end of 2012. The maximum income tax rate that will apply to the taxable amount of a Roth conversion in 2012 is 35 percent, as compared to 39.6 percent if the conversion occurs in 2013 or later. While income from a qualified retirement account is not subject to the 3.8 percent Medicare tax on net investment income, the income from the conversion will increase your adjusted gross income. In 2013 or later, if a Roth conversion causes your adjusted gross income to increase from an amount below $250,000 (on a joint return) to an amount above $250,000, the conversion will result in at least a part of your net investment income becoming subject to the Medicare tax. A Roth conversion after 2012 will also result in an additional disallowance of itemized deductions, since that disallowance also increases as your adjusted gross income increases.

What about Itemized Deductions?

Whether you are better off accelerating or deferring itemized deductions is somewhat complicated. Superficially, deferring discretionary payments (e.g., many charitable contributions and some state income taxes) from 2012 to 2013 makes sense because the deduction may result in greater tax savings due to the higher tax rate that will apply in 2013. The phase-out of itemized deductions will also have an impact, however. If a significant portion of the deduction would be disallowed under the phase-out rules in 2013, then you may be better off taking the deduction in 2012, albeit against a lower tax rate. In the case of charitable contributions, another risk of deferring contributions to 2013 is that Congress could always eliminate the deduction at fair market value for contributions of appreciated property. Certain itemized deductions, such as state income taxes, are not deductible for purposes of computing the AMT, so you are better off paying those kinds of expenses in a year where you have less exposure to the AMT.

Conclusion

While other changes to the income tax law also will take effect in 2013, the ones summarized above are the most significant for higher-income taxpayers. If you would like our assistance in evaluating your particular situation and determining your best course of action, please feel free to contact us.

IRS – An Examination of the 1040 & The Income Tax Law


TRANSCRIPT:

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Quarterly Tax Payments Information

For all the freelancers, small business owners and self-employed individuals out there, staying on top of when the estimated tax payments are due is important to help you stay within the IRS tax payment guideline and avoid penalty. Making estimated tax payments also helps you avoid financial shortfall when you file your tax returns. Here’s the full schedule for 2012 and 2013 tax year.

Quarter Period 2012 Due Dates 2013 Due Dates
Q1 January 1 – March 31 April 17, 2012 April 15, 2013
Q2 April 1 – May 31 June 15, 2012 June 17, 2013
Q3 June 1 – August 31 September 17, 2012 September 16, 2013
Q4 September 1 – December 31 January 15, 2013 January 15, 2014

Remember you have to pay both the IRS and your State. Hopefully, you have been saving up for this and have money in a savings account to cover the tax payments.

Frequently Asked Questions

Shouldn’t the June date actually be July?

June the correct date. Q2 payment is due faster than the rest and you only have to pay taxes against 2 months’ worth of earnings (April and May). Subsequently, this means Q3 payment occurs in September and Q4 payment encompasses 4 months of income instead of three.

 

How can I lower my tax payments?

You can lower your tax liabilities by participating in a retirement plan designed for self-employed individuals and business owners.

Will the IRS send me the quarterly estimated tax forms in order for me to send in my estimated tax?

No, you have to calculate the amount for both the Federal and States taxes. For Federal, you have to complete Form 1040-ES and send it along with your payment. For State, you have to search online for the appropriate form, complete it and send it in with your payment.

Alternatively, you can submit your Federal payment electronically via EFTPS; and most States should have the online equivalent.

Where should I send the estimated tax payments?

For Federal payment, the answer depends on where you live. Check the instruction included in Form 1040-ES for the correct mailing address. Similarly, check with your State tax department for the correct mailing address for your State payment.

Do quarterly tax payments have to be received by the due date or just post marked by then?

The deadline is the postmarked date.

Can the quarterly payment amount change each quarter?

Yes, the amounts can be different for each quarter depending on your earnings.

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