Every year, it seems as though the tax profession is faced with year-end legislation, late forms, and radical changes that add to the complexity and headache of preparing a client's tax return. At the same time, though, most practitioners realize that it's the complexity and confusion that drives clients their way.
This year, however, promises to be unlike any year ever. Not only are there expiring provisions that may or may not be extended -- there are provisions that already expired last year that may or may not be retroactively reinstated, and 21 new taxes under the Affordable Care Act, which may or may not be repealed in whole or in part.
"This is probably one of the most difficult years for planners and taxpayers to plan for year end," said Rick Bailine, principal-in-charge of McGladrey LLP's Washington National Tax Office.
"One of the possibilities for small and midsized businesses is to consider deferring income from 2012 to 2013, if possible, and to accelerate deductions," he said. "Both Romney and Obama have advocated a reduced corporate tax rate, Obama down to 28 percent except for manufacturers, and Romney down to 25 percent. Normally that would be a no-brainer -- defer income to 2013 when the rates will be lower, and accelerate deductions because they will be worth more in 2012. However, what we've seen is that because of the impasse in Congress, neither side is able to push their agenda very well."
"Whoever wins will very likely push for some sort of comprehensive tax reform," Bailine said. "It could happen, but there's a lot of disagreement on what comprehensive tax reform should look like. Unless the two sides show a willingness to come together and compromise, it's not likely. What is more likely to be passed are the Bush tax cuts, because they can be tied to the debt ceiling."
"The compromise in 2011 happened because the Republicans were willing to vote for an increase in the debt ceiling as long as the Democrats pushed for tax cuts. It will come up again, probably before December 31, so it may well be tied to the debate on whether and how to raise the debt ceiling," he said.
Practitioners advising small and midsized businesses should consider if there is excess cash in the business, Bailine indicated. "If there is, consider paying dividends. If nothing happens and the tax goes up from 15 percent to 44 percent, the best use of cash would be to pay a dividend under very favorable tax rates, which may go away even if there is a compromise. Traditionally, dividends are taxed as ordinary income, but that's not true of capital gains."
Something similar goes for individuals regarding capital gains, he noted: "If Congress does nothing, the capital gains rate will go up to 24 percent. That's not as high as the dividend rate, but it's still something to consider if your client is planning to sell stock."
Likewise, the change in estate tax rates will affect planning, Bailine observed. "High-net-worth individuals need to sit down with their tax advisors. This year, you can give away over $5 million per donee tax-free. Embedded within that is a planning opportunity. If you give an income-producing asset to your minor child, the kiddie tax becomes operative -- but the 3.8 percent tax on investment income imposed by the Affordable Care Act is not subject to the tax. Many see this as a loophole, and it may be changed, but currently it can be done."
NEGATIVE KNOWLEDGE
Although the current political environment makes tax planning difficult at best, at least we know what will happen if nothing is done, noted Edward Smith, director in the Tax and Accounting Department at Morrison, Brown, Argiz & Farra in the Private Client Wealth Services Group.
"We're trying to get people to plan for the future, especially year-end planning as it relates to estate tax issues, the new Medicare 3.8 percent tax, and for potential expiring tax extenders," he said. "The 3.8 percent Medicare surtax will apply to individuals, trusts and estates if certain criteria are met, and is imposed on the lesser of net investment income (which includes interest, dividends, royalties, annuities, rents, income from passive activities, and most capital gains) or the amount by which the taxpayer's modified adjusted gross income exceeds a threshold amount. If a taxpayer doesn't make over $200,000 or $250,000, if he or she files a joint return, or if they exceed that amount but have no net investment income, then they don't have to be concerned about the surtax. If they do, they may want to consider re-allocating their portfolio, restructuring pass-through entities and using certain IRS and other strategies to reduce their net investment income or modified adjusted gross income."
Estate planners are faced with the potential that the gift tax exemption may drop from its current $5.12 million to $1 million per person if Congress fails to address this issue, while the maximum rate will jump from 35 percent to 55 percent, Smith observed. "While most think there will be some compromise at some point, there's no real guarantee in this environment," he said. "So get as much out in gifting as you can. The consensus is that there won't be a clawback of taxes. In other words, if you give away $5 million this year and pass away next year, the IRS most likely won't be looking at taxing the gifts you made this year. There are many strategies to gift assets, and Congress has not closed the door to discounts for gifts of closely held family entities yet."
While clients with significantly high net worth have no problem gifting away the amount of the exemption, there are those who might be hesitant and uncertain if they can afford to make gifts now, according to Smith: "This window may not be open for much longer, so they might consider creating non-reciprocal gift trusts. An irrevocable trust could be created for the spouse that grants the spouse certain access to the trust's income, but will still be considered completed gifts in trust and ultimately benefit and pass to the children and grandchildren."
These have to be carefully drafted, because if both husband and wife set up trusts that are mirror images of each other, the IRS could invoke the reciprocal trust doctrine to bring the assets back into the estate.
"Each spouse can create an irrevocable trust, but they can't have the same terms and the same beneficiaries or the IRS will view them as an attempt to avoid estate or gift taxes," Smith said.
WAIT -- THERE'S MORE
Many other issues are facing practitioners as the end of the year approaches, observed Smith. "Long-term capital gains rates will increase if nothing is done; the regular tax brackets will change and go up; the payroll and self-employment tax, which were reduced by two points, will go up; higher-income families will be faced with the itemized deduction phase-out and the exemption phase-out. The biggest issue is probably the Alternative Minimum Tax patch. If they don't fix that, approximately 26 to 31 million taxpayers could be subject to the AMT."
Practitioners with clients in an installment agreement with the IRS should make sure they don't overpay, advised Marty Davidoff, of E. Martin Davidoff & Associates. Taxpayers on an installment agreement often overlook a tax refund. "Suppose the taxpayer owes $22,000 and is paying $400 a month," Davidoff explained. "If he's due a $2,500 refund, the IRS will take it and he still will have to pay the $400 per month. He's paying down the debt, but he could have saved $2,500 for current living. It's fine if you want to pay down, but it should be intentional."
The uncertainty regarding the tax landscape is unique this year, according to Roger Harris, president and chief operating officer of Padgett Business Services: "In the good old days, we could apply tax law to a taxpayer's unique situation and reasonably estimate their most favorable tax position. But for 2012 and 2013, we are guessing at what the tax law may be and what possible affect it could have on the taxpayer's tax position."
The IRS is waiting for Congress along with the rest of us, noted Harris, a former chairman of the IRS Advisory Council. "Tax law changes will require new and modified federal tax forms, which is a lengthy process and could result in delayed filing, extended deadlines, and amended returns," he said. "State tax forms could also be affected."
"Common sense tells us to prepare for a crazy filing season, as there could be delays in refunds and processing returns. Whether you wait until after the elections or begin tax planning today, this year will be like no other," he emphasized. "It comes down to being flexible and staying in the know so that whatever the outcome, you are prepared and can act quickly."
