A host of federal tax breaks are set to expire on Dec. 31 unless Congress takes action. Collectively, they are part of what is being called the “fiscal cliff.” Some of the tax breaks are part of the tax cuts enacted during the George W. Bush administration that were set to expire at the end of 2010 but were extended by Congress nearly two years ago.
Some of the biggest changes that could occur on Jan. 1 would affect high-income individuals and business owners in particular:
• A reduction in the lifetime estate and gift tax exemption from $5 million to $1 million, along with an increase in the top estate tax rate from 35 percent to 55 percent.
• An increase in the top tax rate on dividends from 15 percent to 43.4 percent.
• An increase in the top rate on most capital gains from 15 percent to 23.8 percent.
• An increase in the top rate on ordinary income from 35 percent to 39.6 percent and to 43.4 percent for passive investors.
Other tax breaks that are set to expire include the American Opportunity Tax Credit, the Earned Income Tax Credit and the Child Tax Credit. The 2 percent payroll tax cut, which reduced the federal withholding rate in paychecks, is also due to expire.
We asked Brian Crotty, manager of HDH Advisors LLC, and Mike Collins, a partner with Denman & Co., about some of the strategies they’re giving clients to avoid pain in 2013.
What are you advising on the estate tax change?
Crotty: Most of our clients who have estates greater than $1 million are business owners; the majority of their estate is stock in the business. If they do the right kind of tax planning now, they can either give that stock away to their kids, or lower the value of that company, which the IRS calls “discounts for lack of control and marketability.” So they can essentially move as many assets as they want out of the estate to the benefit of their children or whoever they want to give it to, as long as they do it before Dec. 31.
Are a lot of clients taking this advice?
Crotty: That’s a good question. I would say maybe half are proactive about it, whereas the other half will read this story and say, “Oh, geez, I should have done this sooner.” A lot of business owners are wary, too, about giving away too much stock to their children. But there are a lot of things you can do in that process to make sure dad still has control over the company.
I hear most professionals say that Congress is bound to do something to avoid the fiscal cliff. Your thoughts?
Crotty: We’ve all read the same opinions. It’s just a matter of whether you wait until after the fact and react to what’s happening, or take that proactive stance now for your benefit and locking it in, as opposed to waiting and trying to deal with it after the fact. It’s going to be a different comfort level for every business owner.
What about the Bush-era tax cuts that could be ending? Are there any strategies to address that?
Collins: My advice is to at least think about it and be ready to do something. If Congress were to happen to change the law between now and year’s end, you don’t want to act too early, but at least be ready. Some of the things that will expire that people might not notice right away is the 2 percent payroll tax cut. You may not notice that because you’re not writing a check. Probably the closely held companies may want to accelerate income this year; the normal process is to defer income.
Some examples of how that might be done?
Collins: If you have control over invoicing your customers, you can do invoicing earlier rather than putting it off until after year’s end. Of course, the flip side is that your customers may not want to pay you as soon because they’ll want the deduction probably later to offset the higher tax rate.
Crotty: Or they could increase bonuses or compensation to pay lower taxes now.
Are your clients hesitant about making capital expenditures this year, or should they move forward and invest in their businesses?
Collins: With the depreciation rules that are in place for this year that will not be in place next year, I think most of them are wanting to accelerate those into this year so they can get faster write-offs, even though the tax rates will be higher for next year.
Crotty: I personally have seen a couple of our clients sell certain assets or take more dividends to try to avoid the higher capital gains rate next year. That’s one thing where I’ve seen people be proactive; they’ll be thinking about selling off certain assets if they think they can lock in on the 15 percent capital gains rate before it goes up. That’s the one thing that Congress has really only talked about raising, if anything, at least for higher-income earners.
Collins: Specifically for C corporations, or S corporations that used to be C corporations that have built-up earnings, they may want to look at paying out dividends this year from those C corporation earnings. It may not be appropriate for everybody, but you can take advantage this year of the 15 percent capital gains rate on those dividends, whereas in the future they could be at ordinary rates, up to 39.6 percent. Plus we have a 33.8 percent tax on investment income if you’re above certain income levels, too. So that goes from 15 percent up to 40-plus; it’s a big difference.
What are you advising middle-income clients?
Collins: One of the things that could happen is that the alternative minimum tax, which is patched every year, is currently not patched for 2012. The estimate is that if it’s not patched, an additional 24 million would be subject to that tax. That could affect people under $200,000 in income, so that could sneak up on them. Also, the earned income credit and child tax credit are due to expire, which would affect low- to middle-income families. The marriage penalty relief also goes away, and the American Opportunity Tax Credit for people with kids in college expires at the end of the year.
Crotty: The problem with some of these credits that expire for low- and middle-class income, there is far less opportunity for them to mitigate these increased taxes. If you’re just a wage earner, you’re just going to end up paying more taxes. It would be very tough to just try to make that up somehow. Business owners obviously have more flexibility, so potentially I think it would be a higher impact on the lower and middle class, because they don’t have the control to fix these things if something doesn’t get fixed.