Moving into this year's year-end tax planning season, tax practitioners are faced with a considerable degree of uncertainty caused by congressional indecision. Not only does the uncertainty as this column goes to press surround whether a long list of extenders and small-business tax breaks will in fact apply retroactively to Jan. 1, 2010; it equally involves whether the massive EGTRRA '01 tax cuts, due to expire at the end of 2010, will be extended into 2011. Strategies to prepare for a probable change in the 2010 tax rate structure for 2011 are the focus of this present column, in part because the outcome is somewhat more predictable than the fate of the extenders and small-business relief, and in part because it may take more preparation for clients to make plans to meet the challenges of changed tax rates.
Current intelligence from Capitol Hill anticipates that Congress will keep rates for 2011 at 2010 levels for taxpayers now in the 10 percent-through-28-percent brackets. Those with taxable income within the two highest brackets, however, are likely to see their rates jump from 33 and 35 percent to 36 and 39.6 percent, respectively. The maximum capital gains rate, likewise, will remain the same except for those in new 36 and 39.6 percent brackets; they will be expected to pay capital gains tax at a maximum 20 percent rate.
The dollar brackets to which the 2011 rates will apply are anticipated to track the 2010 amounts, adjusted upward for inflation as is done every year, with one exception. The threshold for the resurrected 36 percent rate would start at a higher dollar level: $200,000 for single filers and $250,000 for joint returns (rather than at what would be inflation-adjusted bracket levels of $176,000 and $314,250, respectively). Following suit, the higher 20 percent maximum capital gains rate would also start at those levels. Dividends likewise may share that 20 percent rate or may revert to being treated as ordinary income.
PERSONAL TAX PLANNING
Generally, many of the traditional tax techniques that have applied to individuals expecting to be in a higher tax rate bracket in a future year because of higher income levels apply equally well to planning for the projected increase in the 33 and 35 percent rates to 36 and 39.6 percent.
Techniques that involve the shifting of income and expenses between one tax year and the next remain viable. However, in anticipating the rate and bracket amount changes likely to apply to higher-income taxpayers in 2011, planning should not just follow the traditional rule that income and deductions generally should be evenly balanced between years. Under a revised paradigm, the goal is for tax liability to remain relatively constant, with no one year's taxable income falling into a higher marginal tax bracket. The prospects for higher income tax and capital gains rates now require attention not only to taxable income for both years, but also to each year's bottom-line tax liability.
Higher rates for 2011 should place more value on two approaches that are the reverse of typical year-end tax strategies for clients otherwise not anticipating much change in their overall tax profile: accelerating more income in 2010, and deferring more expenses into 2011. This column examines income acceleration. When Congress finally decides what expense-related deductions will be extended in 2010 and/or 2011, we will tackle that part of the strategy in a future column.
APPRECIATED ASSETS
Accelerating gains on stock and other appreciated assets into 2010 by engaging in taxable sales in 2010 is a major strategy for taking advantage of a lower current tax-rate structure. Selling an asset for the sole purpose of recognizing the gain is not prohibited per se.
The wash sale rule applies to the sale of stock or securities in which losses are realized, but not recognized, because the seller acquires substantially identical stock or securities 30 days before or after sale. Non-recognition applies only to those losses; gains are recognized in full. Likewise, only losses on sales to related parties are specifically barred under the Tax Code. Nevertheless, the IRS may question the recognition of gain under the bona fide sale doctrine. If the transaction is a sham and simply used to accelerate gain without transferring underlying ownership and use rights, its treatment as a sale will be ignored.
Deferring the recognition of certain capital losses in 2010 also can fit into an overall strategy of maximizing the 15 percent rate on capital gains while it lasts in 2010. Capital loss transactions deferred into 2011 can offset capital gains realized and taxed in 2011, at the anticipated 20 percent rate. Of course, the assumption here is that a sale of this loss asset in 2010 would have been used in 2010 to offset net capital gains otherwise taxed at 15 percent.
ACCELERATED COMPENSATION
Under the doctrines of constructive receipt and economic benefit, compensation is included in income in the first year it is constructively received, or is set aside for the employee's exclusive economic benefit, and is not subject to a substantial risk of forfeiture. Manipulating year-end compensation to push income into 2010, however, must be done with added concern over close adherence to the rules. With the current IRS and Securities and Exchange Commission focus on executive compensation in general, special care must be taken in navigating these relatively complex waters.
Nonqualified deferred-compensation plans. Once salary is deferred under the nonqualified deferred-compensation rules of Code Sec. 409A, it generally may not be accelerated. Nonqualified deferred compensation already agreed to in 2010 generally is locked in and can no longer be amended. Code Sec. 409A provides that, in the case of any performance-based compensation based on services performed over a period of at least 12 months, an election to defer income may be made no later than six months before the end of the period.
A nonqualified deferred-compensation plan governed by Code Sec. 409A cannot permit the acceleration of the time or schedule of any payment under the plan. Limited exceptions exist, such as for a disability or unforeseen emergency that are outside of the taxpayer's control in implementing within an income acceleration strategy. Violation of 409A's distribution rules triggers significant interest and penalties.
Note: Even if deferred-compensation elections cannot be changed for 2010 services, the possibility of higher tax rates beyond 2011 should also be considered before making elections for 2011 services. Starting in 2013, the addition of the Medicare tax of 0.9 percent on wages over a $200,000 threshold ($250,000 for joint filers) and the 3.8 percent on net investment income will continue to make income acceleration strategies worthwhile.
Short-term deferrals. Compensation is not considered subject to Sec. 409A if it is actually or constructively received by the service provider within two-and-a-half months from the end of the first tax year (of the service provider or the service recipient) in which the amount is no longer subject to a substantial risk of forfeiture. Depending upon the taxpayer's negotiating position, such arrangements can be accelerated and income recognized in 2010.
Section 83(b) elections. A taxpayer can elect to accelerate recognition of income with respect to the transfer of restricted property for services. If a proper Section 83(b) election is made within 30 days of the transfer, the taxpayer is then taxed immediately and no additional income is recognized when property becomes substantially vested. If the election is made, the recipient of restricted property is treated as receiving ordinary income to the extent of the difference, if any, between the fair market value of the property without regard to any lapse restriction and the amount, if any, the recipient paid for the property. A taxpayer making the election must notify the person for whom the services were performed that he has elected early recognition of income on the property.
Reasonable compensation challenge. In closely held businesses, a large salary paid to an employee at the end of the company's tax year may be a factor indicating the compensation is unreasonable. The IRS and the courts have scrutinized year-end salary payments in the past to prevent attempts by companies to disguise nondeductible distributions of profits as deductible compensation.
ADVANCE/PREPAID INCOME
Traditionally, the IRS has been on the opposite side of the fence regarding advance payments, arguing for the most part that income from advance payments is income when received and cannot generally be deferred, whether the taxpayer is on the cash or the accrual basis method. In either case, payments received in advance are usually income in the year received, provided no restriction has been placed upon their use. Even advances that are returnable as refunds upon the happening of some specified condition generally cannot escape immediate taxation.
Under Rev. Proc. 2004-34, however, the IRS permits accrual-basis taxpayers to defer the inclusion of advance payments until the next tax year to the extent that the recipient's performance takes place after the year of receipt. An "advance payment" eligible for the "deferral method" generally includes payments for services; sale of goods; use of intellectual property; limited occupancy and use of property ancillary to providing services; sale, lease or license of computer software; ancillary guaranty and warranty contracts; subscriptions; and certain memberships.
Under the deferral method, the amount of the advance payment recognized in revenues in the taxpayer's applicable financial statement for the year of receipt (or, absent a financial statement, the amount earned in that year) must be included in taxable income for that year. The remainder of the advance payment is included in taxable income in the next tax year. Irrespective of qualification under Rev. Proc. 2004-34, a taxpayer that receives advance payments can always recognize them as income in the year received, under the full inclusion method.
TRADITIONAL IRAS
Assets held in traditional IRAs will eventually be taxed as ordinary income when distributed. Now may be a good time to reconsider when those distributions will occur. If a higher-bracket individual has reached age 59-1/2 or has another circumstance that avoids the 10 percent early-withdrawal penalty, a current distribution may provide a good way to accelerate income into the current lower-rate structure.
Another way to accelerate IRA income and enhance long-term retirement and estate planning is to convert to a Roth IRA. For a 2010 conversion, the taxpayer has the additional option of recognizing income evenly between 2011 and 2012, instead of all in 2010. While full income recognition in 2010 may appear to be the better choice now, this special election allows an individual to wait until their 2010 return is timely filed before making a final decision.
CONCLUSION
Usually, postponing the recognition of income pays dividends in that "time is money" and postponing income means postponing the payment of tax. If a taxpayer anticipates being in a significantly higher rate bracket in a subsequent year, however, this rule of thumb must give way. A variety of income acceleration techniques should be considered and prepared to be at the ready to implement swiftly once Congress makes a decision on the 2011 rates. The likelihood is that many more clients will require year-end tax planning this year because of these changes.
