Uncertainty is a factor in most tax planning decisions, but this year it is greater than ever.
The recent decision by Congress to adjourn without addressing the expiring Bush tax cuts, as well as other items that expired at the end of 2009, leaves many tax advisors in the lurch.
With both political parties staking out irreconcilable positions - from the Republicans releasing a "Pledge for America" that calls for more tax cuts and the permanent extension of the Bush tax cuts, to the Democrats insisting on not extending them for those making over $250,000 - and both hoping the November 2 mid-term elections will put them in the driver's seat, the uncertainty looks certain to continue.
"There's been universal frustration at the delays," said Robert Kerr, director of government relations at the National Association of Enrolled Agents. "The trend in the last few years has been to pass extenders at the end of the year. The extenders package, in addition to the tax rates, are up in the air. We go into November not knowing simple things such as whether the R&D credit exists, the deductibility of state and local sales taxes, or the Alternative Minimum Tax patch."
"The AMT patch on the individual side is probably the most significant, and advisors are in a tough spot because they don't know how to advise their clients on withholding for the rest of the year," he explained. "People are in a position where they have to over-withhold to meet their obligations under current tax law. The trouble is, no one believes it will be current tax law at the end of the year, but you're stuck as a tax advisor because you have to advise based on the law as it is. You're reduced to suggesting, 'Here's how I believe the tax law will be, but it's not there yet.'"
Moreover, Congress is becoming increasingly difficult to predict said Kerr.
"Things that are 'must-pass' are passed later and later, or don't pass at all. For example, most people throughout 2009 said that if Congress does one thing this year, they'll not adjourn without making sure the estate tax does not expire. But they didn't do it, despite the fact that there was a large Democratic majority in both chambers," Kerr said. "The conventional wisdom was that they would pass it, but they didn't."
Yet planning, though difficult, is still possible and absolutely necessary, according to Greg Rosica, a tax partner in Ernst & Young's Tampa, Fla., office and a contributing author to the Ernst & Young Tax Guide.
"We're in a time of greater uncertainty when it comes to planning," he said. "But just because the legislative process has been delayed, it doesn't mean that taxpayers should. If they do delay, they might not be able to execute on ideas that make sense."
Rosica recommended planning a series of alternative scenarios based on the possibilities that might come out of the post-election process. "Instead of traditional year-end planning, we consider at least two different sets of assumptions," he said. "For example, Action List A would be the things to do if things stay the way they are. Action List B sets out the path to take based on various legislative changes. Once we get clarity as to what direction the rates will go, people can look at the list and execute the plan with the time remaining in the calendar year. Once we know what happens, we know what actions to take."
"We don't know where the rates will be," he added. "They're scheduled to go back to where they used to be, but there are different legislative possibilities, as well as the president's proposed budget to look at. So we have ideas, but no certainty until we get there."
For private C corporations, Rosica recommended a look at accelerating dividends from 2011 to 2010. "If the corporation pays dividends, it should consider paying all its dividends, or as much as possible, in 2010 in light of the fact that there is currently a 15 percent tax rate on dividends that is scheduled to go up to 39.6 percent in 2011," he said.
Pass-through entities, such as partnerships and S corps, should re-evaluate their entity status, advised Rosica. "Is the S corporation or partnership status going to continue to make sense versus converting to a C corp? C corporation rates are not scheduled to change, but the flow-through rates are, so it's important to check where you are from an entity perspective," he said. "Even with an S corporation, there may be accumulated earnings and profits from a previous C corporation, so by accelerating some of these dividends there may be a more favorable tax result."
"When you look at individuals, customary planning is 180 degrees different this year," said Rosica. "Traditionally you're looking to defer income and accelerate dividends, but now it's the opposite - accelerate income into 2010, and defer deductions till 2011, because income is worth more at lower tax rates, and deductions are worth more at higher tax rates. Real estate taxes, year-end deferred-compensation decisions, and charitable contributions are areas to consider."
"The important thing is to develop a plan with at least two different scenarios now so you will be able to execute it when the time comes. If you wait, you will be pushing up against a difficult time," he said.
There are three separate areas still up in the air, explained Barbara Weltman, a New York-based tax attorney and author of J.K. Lasser's Small Business Taxes. "The dozens of provisions that expired at the end of 2009 are still awaiting an extension," she said. "Among them are the provisions that allowed an individual age 70-1/2 or older to transfer money from an IRA to charity and not pay tax, itemized deductions for state sales tax in lieu of income tax, and the above-the-line deduction for educator expenses. These aren't controversial. Both parties in Congress want them, they just haven't gotten around to extending them, probably because they can't find the money to pay for them."
The expiring Bush tax cuts are critical, in Weltman's view: "There are so many possibilities that could occur. Congress could just take the chicken way out and extend everything for one year, or extend the cuts for everyone except the upper-income earners, or simply let everything expire. There are so many variables."
"If government wants the economy to improve, there has to be certainty about taxes. We can't continue with doing things retroactively or only for a year," she said. "We need certainty beyond what next year will bring, and we don't even know that."
SMALL BIZ IN LIMBO
Small-business owners are hampered by the uncertainty of not knowing their tax rates, agreed Bill Rys, tax counsel at the National Federation of Independent Business. "It's frustrating for them to be so close to the end of the year and not know what their tax liability will be for next year," he said. "Seventy-five percent of small businesses are pass-through entities, so they pay tax at the individual level," he said. "They're stuck in a situation where they don't know what the tax rates will be. And they can't plan for any type of continuity because they don't know what the estate tax will look like for 2010 or 2011."
And there is no guarantee that a lame-duck session of Congress will solve everything, according to Dean Zerbe, former senior tax counsel to the Senate Finance Committee and national managing director of alliantgroup. "Some of the Republican gains in the Senate can be seated immediately, which would make it more difficult to reach a compromise," he said. "And the normal Republican moderates that Democrats would reach out to are holding very firm, and will not go along with anything other than a full extension of the Bush cuts."
"A lot is still uncertain," he echoed. "Capital gains will go to 20 percent, and [Sen. Max] Baucus has said that dividends will stay at 20 percent. More likely than not, the estate tax will still be up in the air. They will try to get the extenders done, so they can deal with the estate tax later."
The NAEA's Kerr said that the worst-case scenario would be that Congress goes into a lame-duck session and doesn't get anything done. "We have to start thinking of things that were previously inconceivable as being at least theoretically conceivable," he said. "If they can't get anything done by the first week in December, there will be payroll services that don't know how to withhold for January. On top of all this, they're addressing in November a tax law that expired at the end of 2009, so it will be current for the better part of five weeks. It's an environment in which people simply cannot plan."
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