2013 Year End Planning Letter

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December 2, 2013

Dear Client:

As January 1, 2014 gets closer, year-end tax planning considerations should be starting to take shape. New tax legislation has brought greater certainty to year-end planning, but has also created new challenges. The number of changes made to the Tax Code and the opportunities these changes bring may seem overwhelming. However, early planning will help you to maximize your potential tax savings and minimize your tax liability. This letter is intended to be a mile-high view of some key year-end tax planning strategies.

Early in 2013, the 2012 Taxpayer Relief Act was enacted and the “Bush-era” tax cuts, which were scheduled to sunset at the end of 2012, were permanently extended and modified. This legislation is significant because without its enactment, individual tax rates on all income groups would have increased, taxpayer-friendly treatment of capital gains and dividends would have disappeared, and many other popular but temporary incentives would no longer be available.

PERMANENT GENERAL TAX PROVISIONS
Income tax. The lower income tax rates of 10, 15, 25, 28, 33, and 35 percent are made permanent, and a new tax rate of 39.6 percent is imposed on taxable income over a threshold amount. For 2013, these threshold amounts are:
•    $450,000 for married taxpayers filing jointly and surviving spouses
•    $225,000 for married taxpayers filing separately
•    $425,000 for heads of households
•    $400,000 for single taxpayers

Marriage penalty relief. The basic standard deduction and the size of the 15 percent income tax bracket for a married couple filing a joint return remain twice the size as that for a single taxpayer.

Capital gains tax. The favorable rate of zero percent for taxpayers in the 10 and 15 percent brackets remains unchanged. The 15 percent rate for taxpayers is now applicable to those in the 25, 28, 33, and 35 percent brackets, and a new 20 percent rate applies to higher-income taxpayers that are subject to the 39.6 percent income tax rate.

Tax on dividends. Qualified dividends received from domestic corporations and qualified foreign corporates continue to be taxed at the same rates that apply to capital gains. Certain dividends do not qualify for the reduced rates, including dividends paid by credit unions, mutual insurance companies, and farmers’ cooperatives.

Alternative minimum tax. Permanent alternative minimum tax (AMT) exemption amounts, which are annually adjusted for inflation, are provided by the 2012 Taxpayer Relief Act. For 2013, the AMT exemption amounts are:
•    $80,800 for married taxpayers filing jointly and surviving spouses;
•    $51,900 for unmarried taxpayers and heads of household, other than surviving spouses; and
•    $40,400 for married taxpayers filing separately.

Exemptions for the AMT are phased out as taxpayers reach high levels of alternative minimum taxable income (AMTI). Generally, the exemption amounts are phased out by an amount equal to 25 percent of the amount by which an individual’s AMTI exceeds a threshold level. Beginning in 2013, the threshold amounts for calculating the exemption phaseout are adjusted for inflation as follows:
•    $153,900 for married taxpayers filing jointly and surviving spouses (complete phaseout at $477,100);
•    $115,400 for unmarried taxpayers and heads of household, other than surviving spouses (complete phaseout at $323,000); and
•    $76,950 for married taxpayers filing separately (complete phaseout at $238,550).

The AMT rates (26 and 28 percent on the excess of alternative minimum taxable income (AMTI) over the applicable exemption amount) remain the same in 2013. However, beginning this year, the threshold amounts are adjusted for inflation.

PERMANENTLY REINSTATED PHASEOUTS
Higher income taxpayers are again subject to the personal exemption phaseout and the so-called Pease limitation on itemized deductions beginning in 2013. Both of these provisions were repealed through 2012.

Itemized deduction phaseout. The return of the Pease limitation on itemized deductions (named for the member of Congress who originally sponsored the legislation) reduces itemized deductions for higher-income taxpayers. Beginning in 2013, the itemized deduction phaseout reduces itemized deductions when AGI exceeds the following threshold amounts, which will be adjusted for inflation beginning in 2014:
•    $300,000 for married taxpayers filing jointly and surviving spouses;
•    $275,000 for heads of households;
•    $250,000 for unmarried taxpayers who are not surviving spouses or heads of households; and
•    $150,000 for married taxpayers filing separately (equal to one-half of the amount for a joint return or surviving spouse, after any adjustment for inflation).

Personal exemption phaseout. The revival of the personal exemption phaseout rules reduces or eliminates the deduction for personal exemptions for higher income taxpayers. Under the personal exemption phaseout, the total amount of exemptions that may be claimed by a taxpayer is reduced by two percent for each $2,500, or portion thereof (two percent for each $1,250 for married couples filing separate returns) by which the taxpayer’s AGI exceeds the applicable threshold. The same threshold limits used in the Pease limitation above apply to the personal exemption phaseout.

PERMANENT CHILD-DRIVEN TAX BENEFITS
Child and dependent care (CDC) credit. The increased credit amounts and higher expense limits for the CDC are permanently extended. For 2013, the maximum amount of qualifying expenses to which the credit may be applied is $3,000 for individuals with one qualifying child or dependent (for a maximum credit of $1,050), or $6,000 for individuals with two or more qualifying children or dependents (for a maximum credit of $2,100). For taxpayers with AGI between $15,000 and $43,000, the 35 percent credit rate is reduced by one percentage point for each $2,000 of AGI until the credit percentage is 20 percent for taxpayers with AGI of $43,000.

Child tax credit (CTC). The increased amount of $1,000 for the CTC and the ability to offset CTC against both regular income tax and AMT are permanent. However, the reduced earned income threshold amount of $3,000 for purposes of the refundable component of the credit is extended only through December 31, 2017.

PERMANENT EDUCATION BENEFITS
Coverdell Education Savings Accounts (ESAs). The increased maximum contribution amount of $2,000 is made permanent, along with corresponding rules and provisions. Taxpayers who have not contributed the maximum amount to a Coverdell ESA should do so before year end.

Educational assistance programs. Employees are allowed to exclude from gross income and wages up to $5,250 in annual educational assistance provided under an employer’s nondiscriminatory “educational assistance plan.” Employer-provided educational benefits may also be excludable as working condition fringe benefits.

Scholarship programs. Any amount received as a qualified scholarship and used for qualified tuition and related expenses is excludable from income. The exclusion does not apply to any portion of the amount received which represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship.

However, scholarship recipients with obligatory service requirements under the NHSC or Armed Forces Scholarship Program can exclude from income qualified tuition and related expenses, as well as amounts that represent payment for services.

Student loan interest deduction. The increased phaseout thresholds for the student loan interest deduction were made permanent, and continue to be adjusted each year for inflation. In addition, the 60-month limitation on the deduction and the restriction that makes voluntary payments of interest nondeductible are permanently repealed.

EXTENDED TAX BENEFITS
Although some tax benefits were extended through 2017, others were extended only through the 2013 tax year.   If any of the tax relief applicable to your situation is set to expire after 2013, you should try to take advantage of it in the current year.

American Opportunity Tax Credit (AOTC). The AOTC is extended to apply to tax years beginning before 2018, including the $2,500 maximum credit per eligible student, the higher income phaseout ranges of $80,000 to $90,000 for single filers ($160,000 to $180,000 for joint filers), the eligibility extension to the first four years of post-secondary education, the inclusion of text books and course materials as eligible expenses, and the 40 percent refundable credit component.

Higher education tuition deduction. The above-the-line deduction for qualified tuition and related expenses is extended through 2013. Since the deduction is an adjustment to gross income, it can be taken even if the taxpayer does not itemize deductions, and it is not subject to the two-percent-of-AGI floor or the overall limitation on itemized deductions. However, an individual who can be claimed as a dependent by another taxpayer cannot take a deduction for qualified tuition and related expenses.

Popular extenders. Unless extended by Congress, the following popular tax benefits may not be available after 2013:
•    the $250 above-the-line annual deduction for a professional educator’s qualified unreimbursed expenses, including books, supplies, computers, and software;
•    the exclusion from gross income for discharges of qualified principal residence indebtedness;
•    the itemized deduction for mortgage insurance premiums;
•    the election to claim an itemized deduction for State and local general sales taxes in lieu of State and local income taxes;
•    the exclusion from gross income of qualified charitable distributions for individuals aged 70½ or older; and
•    the residential energy property credit (lifetime limit remains at $500, and no more than $200 of the credit amount can be attributed to exterior windows and skylights).

NEW TAX PROVISIONS FOR 2013

Health Care Reform
Since the U.S. Supreme Court upheld the constitutionality of the health care reform provisions, individuals must comply with those requirements already in effect, and others that are applicable in 2013 or later. Beginning in 2014, some of the most far reaching provisions of this legislation will become effective: the individual mandate to carry minimum essential health coverage for taxpayers and their dependents; the ability to obtain coverage through an insurance exchange; and a special tax credit to help offset the cost of insurance.

The following revenue-raising health care reform provisions become effective in 2013:

Net Investment Income Tax (NIIT). Taking effect on January 1, 2013, a Medicare surtax of 3.8 percent is imposed on the lesser of net investment income (NII) or modified adjusted gross income (MAGI) above a specified threshold. However, the Medicare surtax is not imposed on income derived from a trade or business, nor from the sale of property used in a trade or business.

NII includes the following investment income reduced by certain investment-related expenses, such as investment interest expense, investment brokerage fees, royalty-related expenses, and state and local taxes allocable to items included in net investment income:
•    Gross income from interest, dividends, annuities, royalties, and rents, provided this income is not derived in the ordinary course of an active trade or business;
•    Gross income from a trade or business that is a passive activity;
•    Gross income from a trade or business of trading in financial instruments or commodities; and
•    Gain from the disposition of property, other than property held in an active trade or business.

Individuals are subject to the 3.8 percent NIIT if their MAGI exceeds the following thresholds (which are not adjusted for inflation):
•    $250,000 for married taxpayers filing jointly or a qualifying widower with a dependent child;
•    $125,000 for married taxpayers filing separately; and
•    $200,000 for single and head of household taxpayers.

Additional HI (Medicare) Tax. Beginning in 2013, higher income individuals are subject to an additional 0.9 percent HI (Medicare) tax, not to be confused with the 3.8 percent Medicare surtax on NII. The additional Medicare tax means that the portion of wages received in connection with employment in excess of $200,000 ($250,000 for married couples filing jointly and $125,000 for married couples filing separately) is subject to a 2.35 percent Medicare tax rate. The additional Medicare also applies to self-employed individuals. To avoid an underpayment penalty related to this tax or the NIIT, you can instruct your employer to withhold an additional amount of federal income tax from your wages before year end.

Increased medical expense threshold. In 2013, the threshold for the itemized deduction for unreimbursed medical expenses increases from 7.5 percent of AGI to 10 percent of AGI for regular income tax purposes. For AMT purposes, medical expenses remain deductible only to the extent they exceed 10 percent of AGI. However, taxpayers (or their spouses) who are age 65 and older before the close of the tax year are exempt from the increased threshold of 10 percent for the 2013 through 2016 tax years. These taxpayers can continue to deduct qualified medical expenses that exceed 7.5 percent of AGI.

EXPIRING PROVISIONS
Bonus Depreciation and Code Sec. 179 Expense Deduction
The 2012 Taxpayer Relief Act extends the additional 50 percent bonus depreciation allowance for one year to apply to qualifying property acquired and placed in service before January 1, 2014 (or before January 1, 2015, in the case of property with a longer production period and certain noncommercial aircraft). There is no limit on the total amount of bonus depreciation that may be claimed.

Qualified property. Property that is eligible for bonus depreciation must be new property (i.e., property the original use of which begins with the taxpayer) that is:
•    tangible property
•    that is depreciable under MACRS, with a recovery period not exceeding 20 years;
•    purchased computer software;
•    water utility property;
•    or qualified leasehold improvement property.

The fifty-percent bonus depreciation deduction is taken before regular depreciation is computed for the year property is placed in service. As with any accelerated depreciation, however, a large current depreciation deduction results in smaller future deductions.

Vehicles. For passenger automobiles placed in service in 2013, the deduction limitations for the first three years are $3,160 ($11,160 if bonus depreciation applies), $5,100, and $3,050, respectively, and $1,875 for each succeeding year. For trucks and vans first placed in service in 2013, the deduction limitations for the first three years are $3,360 ($11,360 if bonus depreciation applies), $5,400, and $3,250, respectively, and $1,975 for each succeeding year.

The expense deduction allowed by Code Sec. 179 is independent of the bonus depreciation allowance. The Code Sec. 179 deduction is computed first, and the taxpayer’s basis in the qualifying property is reduced by the amount of that deduction. Any bonus depreciation deduction is computed on the remaining basis in the property.

For tax years beginning in 2012 and 2013, the 2012 Taxpayer Relief Act increases the Code Sec 179 dollar limit to $500,000 and the investment limit to $2 million. For purposes of Code Sec. 179, qualifying property is depreciable tangible property that is purchased for use in an active trade or business. This includes off-the-shelf computer software placed in service before 2014.

A taxpayer may also elect to treat qualified real property as Code Sec. 179 property. However, only $250,000 of the cost of qualified real property may be expensed. Qualified real property generally consists of qualified leasehold improvements, qualified retail improvement property, and qualified restaurant improvement property.

Both bonus depreciation and the increases in the Code Sec. 179 expense deduction and investment limits are meant to provide temporary incentives for business investment and are set to expire at the end of 2013. Unless there is further legislative action, the deduction limit is set at $25,000, and the investment limitation is set at $200,000 for tax years beginning in 2014.

Tax Credits
Research Credit. The 2012 Taxpayer Relief Act extends the research credit to apply to any amounts paid or incurred for qualified research and experimentation before January 1, 2014.

Work Opportunity Credit. The work opportunity credit for all targeted groups is extended through December 31, 2013. Therefore, the credit applies with respect to wages paid to persons who begin work for the employer before January 1, 2014.

Targeted groups include, among others:
•    qualified individuals in families receiving certain government benefits;
•    qualified individuals who receive supplemental social security income or long-term family assistance;
•    veterans who are members of families receiving food stamps, who have service-connected disabilities, or who are unemployed;
•    qualified summer youth employees; and
•    ex-felons hired no more than one year after the later of their conviction or release from prison.

Recognition Period for S Corporation Built-in Gains
For tax years beginning in 2012 and 2013, for purposes of computing the built-in gains tax, the recognition period is the five-year period beginning with the first day of the first tax year for which the corporation was an S corporation.

Small Business Stock
The 100-percent exclusion allowed for gain on the sale or exchange of qualified small business stock under Code Section 1202 has been extended. The stock must be acquired before January 1, 2014, and then held for more than five years by noncorporate taxpayers. Preferential AMT treatment also applies. The exclusion under Code Section 1202 after 2013 reverts to 50 percent.

Some Other Provisions Expiring at 2013 Year-End
•    Enhanced deduction for charitable contributions of food inventory;
•    Tax incentives for empowerment zones;
•    Indian employment credit;
•    Low-income tax credits for non-federally subsidized new buildings;
•    Low-income housing tax credit treatment of military housing allowances;
•    Adjusted-basis reduction of stock after S corporation charitable donation of property.

OTHER ITEMS TO CONSIDER

Revised Repair/Capitalization Rules
The IRS recently issued long-awaited comprehensive final rules on the treatment of payments to acquire, produce or improve tangible property. Starting January 1, 2014, businesses must use these new rules in determining whether they can deduct their costs as repairs under Code Sec. 162(a) or must capitalize the costs, to be recovered over a period of years under Code Sec. 263(a). Businesses will benefit if certain procedures for treating expenses are put into place by January 1, 2014. Some businesses will be better off if they start applying the new rules retroactively to the 2012 and 2013 tax years. Many of these decisions require advance planning.

Planning for health care changes

Before year-end, individuals need to review how the Affordable Care Act will impact them. The Affordable Care Act brings a sea-change to our traditional image of health insurance. The law requires individuals, unless exempt, to either carry minimum essential health care coverage or make a shared responsibility payment (also known as a penalty). Most employer-sponsored health insurance is deemed to be minimum essential coverage, as is coverage provided by Medicare, Medicaid, and other government programs. Self-employed individuals and small business owners should revisit their health insurance coverage, if they have coverage, before year-end and weigh the benefits and costs of obtaining coverage in a public Marketplace (or a private insurance exchange) for themselves and their employees. Small businesses may be eligible for a tax credit to help pay for health insurance. Individuals may qualify for a premium assistance tax credit, which is refundable and payable in advance, to offset the cost of coverage. Please contact our office for more details about the Marketplaces, and health insurance coverage for small businesses and individuals.

Individuals with health flexible spending accounts (FSAs) and similar arrangements should take a look at their spending habits for 2013 and predict how they will use these tax-favored funds in the future. In 2013, the maximum salary-reduction contribution to a health FSA is $2,500.

Planning for gifts

Gift-giving is often overlooked as a year-end planning strategy. For 2013 and 2014, individuals can make tax-free gifts (no tax consequences for the giver or the recipient) of up to $14,000 to any individual. Married couples may “split” their gifts to each recipient, which effectively raises the tax-free gift to $28,000. Gifts between spouses are always tax-free unless one spouse is not a U.S. citizen. In that case, the first $143,000 in gifts made in 2013 are tax-free.  This figure increases to $145,000 in 2014.  Please also note that the lifetime unified credit exemption equivalent increased from $5,250,000 in 2013 to $5,340,000 in 2014.

There are special rules for gifts made for medical care and education that can be a valuable component of a year-end tax strategy, especially for individuals who want to help a family member of friend. Monetary gifts given directly to a college to pay tuition or to a medical service provider are tax-free to the person making the gift and the person benefitting from education or medical care.

Gifts to charity also are frequently made at year-end. Through the end of 2013, taxpayers age 70 ½ and older can make a tax-free distribution from individual retirement accounts to a charity. The maximum distribution is $100,000. Individuals taking this option cannot claim a deduction for the charitable gift.

Planning for retirement savings

Year-end is a good time to review if your retirement savings plans and tax strategies complement each other. For 2013, the maximum amount of contributions that can be made to an IRA is $5,500, with a $1,000 catch-up amount allowed for individuals over age 50. Keep in mind that the maximum amount that can be contributed to a Roth IRA begins to decrease once a taxpayer’s adjusted gross income crosses a certain threshold. For example, married couples filing jointly will begin to see their contributions begin to phase out when their AGI is $178,000. Once their AGI reaches $188,000 or more, they can no longer contribute to a Roth IRA. For single filers the corresponding income thresholds for 2013 are $112,000 and $127,000. Please note that 2013 contributions, for tax purposes, may be made until April 15, 2014.

Traditional IRAs and Roth IRAs are very different savings vehicles. A traditional IRA or Roth IRA set up years ago may not be the best savings vehicle today or for the immediate future if employment and other personal circumstances have changed. Some individuals may be contemplating rolling over a workplace retirement plan into an IRA. Very complex rules apply in these situations and rollovers should be carefully planned. The same is true in converting a traditional IRA to a Roth IRA and vice-versa. Every individual has unique goals for retirement savings and no one size fits all. Please contact our office for a more detailed discussion of your retirement plans.

Traditional Tax Planning
Traditional year-end planning techniques nevertheless remain important for 2013. As always, tax planning requires a combination of multi-layered strategies, taking into account a variety of possible scenarios and outcomes. The income deferral and deduction/credit acceleration techniques may be used to reduce an individual taxpayer’s income tax liability:

Income Deferral:
•    Defer billings and collections
•    Receive bonuses earned for 2013 in 2014
•    Sell appreciated assets in 2014
•    Offset tax losses against current gains (loss harvesting)
•    Postpone the redemption of U.S. Savings Bonds
•    Declare any special dividends in 2014
•    Delay Roth conversions to 2014
•    Defer debt forgiveness income if possible
•    Minimize retirement distributions
•    Execute like-kind exchange transactions
•    Take corporate liquidation distributions in 2014

Deductions/Credit Acceleration:
•    Bunch itemized deductions into 2013/Standard deduction into 2014
•    Accelerate bill payments into 2013
•    Pay last state estimated tax installment in 2013 instead of 2014
•    Minimize the effect of  AGI limitations on deductions/credits
•    Maximize net investment interest deductions
•    Match passive activity income and losses

ON A FINAL NOTE

The IRS continues to focus its examination efforts on higher income individuals. A study conducted by the Government Accountability Office (GAO) determined that both correspondence and field exams in the higher income group produced more direct revenue per dollar of cost than exams of lower-income taxpayers. Their recommendation to allocate more enforcement resources to audits of higher income individuals will be implemented by the IRS.

As you can see, the more complex issues faced by higher-income individuals creates a challenging planning environment for the 2013 tax filing season.  This letter illustrates only some of the many year-end tax planning strategies that could help you minimize your 2013 income tax bill and properly plan for necessary cash flow to timely meet your income tax obligations.  Every tax situation is different, requiring careful and comprehensive analysis of each individual situation.  We can assist you in aligning traditional year-end techniques with strategies for dealing with any unconventional issues that you may have.

If we have not already contacted you directly, and have your 2013 tax planning underway, please review the information contained in this letter and call our office for the advice and help you may need.  The month of December is a busy month for our tax professionals.  We encourage you to call as soon as possible to discuss your 2013 tax situation with the tax professionals that are directly assigned to provide these services to you.  Do not hesitate to call, so that your 2013 income tax preparation; that will be completed after the end of the year, will not result in an outcome you are not prepared for.

As always, we appreciate the opportunity to continue to provide our services to you.