Only a handful of days remain to execute year-end tax strategies. Some techniques for this year reprise traditional advice that has legs year after year, while others, including reaction to whatever this year's lame-duck Congress has wrought, have a unique sense of urgency.
In a recent column, we focused on year-end tax planning strategies that accelerate or defer the recognition of gross income, use of which depends upon each taxpayer's present and anticipated tax bracket. This column examines the other side to the goal of lowering overall tax liability between 2010 and 2011: using deductions and credits efficiently. We also cover two "hot" topics for 2010 that have year-end tax planning implications in their own right: Roth conversions and rescissions.
Three aspects to maximizing the benefits of deductions and credits are particularly relevant at year end:
Identification of opportunities for deductions and credits in the current year before they are lost;
Assessment of strategies to maximize the value of deductions and credits by either accelerating or postponing them; and,
Execution of a plan that will ensure claiming the deduction or credits in the year intended.
Most deductions and credits are available on a per-calendar-year basis only. Furthermore, if you miss taking maximum advantage of them in one tax year, many prohibit you from trying again next year by adding that amount to next year's cap. The maximum $16,500 contribution level for 401(k) contributions, for example, cannot be doubled to $33,000 in 2010 for the taxpayer who made no contribution for the 2009 tax year.
Even more extreme, perhaps, are those deductions or credits that are temporary and end in 2010. For example, the consumer energy credit of $1,500 available over the 2009 and 2010 tax years will be lost to those who do not both purchase and install qualifying equipment by year-end 2010.
Depending upon what Congress has done between the writing of this article in November and its publication, the latter category of use-it-or-lose-it deductions and credits may include a number of additional "expiring provisions" that will not be available in 2011. This list may include, on the individual side, the itemized state and local sales tax deduction, the additional standard deduction for real property taxes, the deduction for qualified tuition/expenses, the deduction for teacher classroom expenses, and tax-free distributions from IRAs for charitable purposes in lieu of a direct itemized charitable deduction. On the business side looms the research credit that officially expired at the end of 2009. Notable, too, the Making Work Pay Credit of up to $400 ($800 for joint returns) also may end in 2010 without further congressional action.
Two initial questions should come into play in maximizing any deduction that may otherwise be available:
1. Is the deduction restricted by the taxpayer's adjusted gross income level or other ceiling or floor?
2. Given the taxpayer's anticipated income tax bracket in 2010 as compared to 2011, in which year will the deduction reduce a greater dollar amount of tax?
Although raising deductions in one year by deferring a disqualifying amount of AGI is an available technique, its use independent of any difference in the taxpayer's effective tax rates for the ending and upcoming years generally puts the cart before the horse. For those who will be in a higher rate bracket in 2011 than in 2010, whether because of a greater level of anticipated income or by act of Congress (at press time, the final individual income tax rates for 2011 had not yet been set by Congress), deferring deductions into 2011, rather than maximizing them in 2010 by lowering 2010 AGI, generally makes the most sense.
If a taxpayer's marginal rates for both 2010 and 2011 are equal, however, deferring income to lower 2010 adjusted gross income enough to qualify for a particular deduction or credit not otherwise available in 2010 is a strategy worth investigating. High on the list of AGI ceilings are education credits and deductions and the adoption expense credit, as well as certain IRA contribution levels. On the flip side, certain other deductions can sometimes increase as AGI decreases because of AGI floors associated with them. This group includes medical expense deductions, casualty loss deductions and miscellaneous itemized deductions.
Another twist that may be peculiar to 2010 year-end planning is, again, dependent upon what the lame-duck Congress may decide. Although for the first time since the late 1980s the 2010 tax year will see no reduction whatsoever in total itemized deductions based on income, the reprieve will be short-lived if the EGTRRA sunset takes its course and the so-called Pease deduction returns in full force in 2011. In shifting deductions into or out of 2011 this December, therefore, practitioners should confirm the current state of a possible renewed Pease deduction that would lower the available amount of certain 2011 itemized deductions.
In constructing a comprehensive year-end strategy, those deductions that are new for 2010 also should not be overlooked. Since most of them are also temporary, with many expiring at year-end 2010, decisive year-end action may be needed.
The Small Business Jobs Act of 2010 extended bonus depreciation through 2010; doubled Code Section 179 expensing through 2011; raised to 100 percent the exclusion for gain on qualified small-business stock acquired from Sept. 27 through Dec. 31, 2010; further relaxed the S corp built-in gain conversion rules for dispositions of built-in gain property starting in 2011; extended the carryback period to five years for eligible small-business credits in the first tax year starting after Dec. 31, 2009; enhanced the deduction for start-up expenses for 2010; and allowed a self-employment FICA tax deduction for 2010 health insurance costs.
The Patient Protection Act of 2010 provides for a small-employer health care tax credit starting in 2010. Also, effective Jan. 1, 2011, use of flexible spending accounts to reimburse for over-the-counter medications without a prescription will be prohibited, irrespective of when funds were deposited into the account.
Once the decision is made to accelerate or defer a particular deduction, some attention needs to be paid to the rules on when a particular expense is considered deductible. The rules vary, and double-checking them before incurring or deferring a particular year-end expense is often prudent.
Pre-paying expenses, such as real estate taxes or mortgage interest, does not necessarily translate into a larger deduction. A legal obligation to do so is also required. Prepaying medical expenses before the medical services are performed also won't win an earlier deduction, with the exception of certain lump-sum payments required to be paid for institutional care. Nor are pledges to make a charitable deduction the equivalent of actually making a charitable donation.
However, those who pay a spring college tuition bill in late December, instead of early January, will be able to use the payment for a 2010 American Opportunity Tax Credit (which may revert to the lower-level Hope Credit in 2011 if Congress does not renew it). Mailing versus receipt, trade date versus settlement date and other fine points round off rules peculiar to year-end planning that are always worth a second look.
Year-end tax planning is incomplete without a look at Alternative Minimum Tax exposure. It has become a growing problem. Unfortunately, Congress has been woefully late in retroactively passing an AMT "patch" that effectively raises the level of income exempt from the AMT and therefore lowers the reach of the AMT. For 2009, the AMT patch was $70,950 ($46,750 for singles). For 2010 at press time, it had been set to drop to $45,000 ($33,750). Ironically, congressional action in the lame-duck session may also impact on 2011 AMT liability, since the higher the regular tax liability caused by higher tax rates, the fewer taxpayers in theory will be subject to the AMT.
Irrespective of congressional action, however, certain year-end planning techniques only work if no AMT is anticipated. For example, standard deduction and personal exemption are not permitted for the AMT, so that year-end attempts to use them are fruitless. Miscellaneous itemized deductions also are not allowed. State, local and foreign property and income taxes, too, are removed as deductions against the AMT unless they are business expenses. And while deductions for medical expenses are allowed, they are subject to a higher AGI floor.
Since 2010 is the first year that taxpayers with adjusted gross income of more than $100,000 can convert their traditional IRAs into Roth IRAs, the year-end timing of conversions takes on added importance. To add to its importance, the Small Business Jobs Act of 2010 now allows 401(k) and 403(b) plans to permit participants to transfer pre-tax qualified distributions into a designated Roth IRA within the plan, effective for distributions after Sept. 27, 2010. What's more, the income on all 2010 reconversions will automatically be deferred into 2011 and 2012 unless an election to recognize it in 2010 is made.
Year-end timing of Roth conversions looks to the date that the funds are distributed. To qualify as a 2010 rollover or conversion to a Roth IRA, a traditional IRA or an employer-sponsored retirement plan must make the distribution in 2010. The conversion may occur directly, through a trustee-to-trustee transfer, or indirectly, via a distribution to the taxpayer that the taxpayer deposits into a Roth IRA within 60 days. While the distribution must happen in 2010 to qualify as a 2010 rollover or conversion, the deposit may take place in 2011, as long it occurs within 60 days of the distribution.
Taxpayers who in hindsight don't like the result of their Roth conversion can recharacterize it. Recharacterizing an IRA contribution requires transferring amounts previously contributed to a traditional or Roth IRA (plus any resulting net income or minus any resulting net loss) to another IRA of the opposite type and electing to treat the amounts as transferred to the second IRA at the time they were actually contributed to the first IRA. Taxpayers have until Oct. 17, 2011, to recharacterize a 2010 rollover or conversion to a Roth IRA, assuming the taxpayer timely files their 2010 return.
While moving from recharacterizing an IRA to the rescission of an entire transaction as a year-end planning technique may at first seem like a giant leap, both recharacterization and "rescission" carry the theme of "do-overs." The trigger for elevating rescissions to star status this past year was LTR 201008033. That ruling allowed a rescission of a complete sale of a subsidiary because two requirements were satisfied: The rescission occurred in the same year as the transaction, and the parties returned to a position as if the transaction never happened.
The news that has been made by this ruling is not over the doctrine of rescission per se, which has been around since a 1940 Fourth Circuit case. Rather, the ruling breaks ground by not requiring that the rescission be motivated by a defect in the initial underlying transaction. In other words, planners may now be free to use hindsight to undo a transaction that the taxpayer simply regrets as a business or investment decision.
It is inevitable that this expansion of the rescission doctrine will be tested. One central issue will revolve around how to determine when a transaction will be considered to be treated as if it never happened. In any event, for those who wish to test this development this year, remember that the rescission must occur in the same year as the original transaction.
Especially as the result of congressional brinkmanship on tax provisions that are essential components in determining year-end tax strategies, the remainder of December promises to be a busy period for many practitioners.
Nevertheless, the finality of December 31 also has its benefits, with an entirely new tax year ahead that promises exciting new challenges and opportunities.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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