Just in case Congress doesn’t get around to passing another extension of the Bush tax cuts by the end of the year, tax experts are advising their clients to take some proactive steps.
Matthew K. Becker, CPA, a tax partner and West Michigan tax business line leader at BDO USA, told me Monday that he is counseling clients to follow the opposite of his usual advice.
“Clients who are used to deferring income and accelerating deductions may in fact find themselves in a position where they would be better served to accelerate income and defer deductions,” he said. “We have talked to clients on many levels about potential ways in which that can be done. In a very basic sense, for individuals who are generally cash basis taxpayers, by simply controlling the timing of certain payments, they can control the timing of deductions. To the extent you have the ability to influence, especially through negotiation, the timing of any income, you’d be well served to try to accelerate that income. The balance is between the time value of money: if you accelerate income, you’re going to pay at a lower rate, but you’re giving up some time value on the cash tax. It’s a matter of balancing the two effects and trying to come up with a series of transactions that present a net benefit to the taxpayer.”
He acknowledged that for a small business that is accounted for on a cash basis, there may be more planning that needs to be done than for a larger and more complex business that is accounting for income and expenses on an accrual basis. “It’s important that each taxpayer take a look at the potential change in rates and consider any planning that needs to be done with that anticipation considered,” said Becker.
He is also talking with clients about running projections of when is the best time for payments that generate deductions. “On the individual side, one would think that making a charitable contribution in January might be better than making the same contribution in December because you’d be deducting the contribution against the higher tax rate,” said Becker. “What also needs to considered, however, is that the phase-out of itemized deductions also comes back in 2013. So high-income taxpayers will have a percentage of their deductions phased out based on the size of their income. It’s important to not just assume when a deduction might be better but to actually calculate the impact on the deduction of the various tax law changes. It’s important not to consider any single tax law change in a vacuum.”
Tracy Larsen, managing partner of law firm Barnes & Thornburg’s Michigan office and co-chair of the firm’s corporate department, said he is operating under the premise that under current law the Bush tax cuts will phase out at the end of this year. “At best there is uncertainty as to whether there will be any extension,” he added. “A lot of people are predicting that there won’t be any extension for political reasons.”
Unless there is an extension, under current law, the capital gains tax rates will increase 66 percent and dividend tax rates will go up nearly 200 percent. “Many companies are looking into strategies to take advantage of tax planning,” said Larsen. “Some are simply management of expenses and income this year, assuming the extension does not happen.”
Like Becker, Larsen too believes that many companies will accelerate their income and defer deductions to take advantage of the current lower rates. “Anticipated changes in tax rates historically have always driven corporate transactions,” said Larsen. “We’re seeing a variety of transactions that are in fact driven by anticipated tax law changes, including leveraged recapitalizations, dividends, and merger and acquisition transactions. All of those have some tax motivations. For example, for sellers who can claim capital gains next year, as opposed to next year, there is essentially a significant economic advantage.
"Your equity would have to increase over 13 percent simply to stay on par on a net tax basis, so a lot of sellers are coming to market this year to try to obtain the benefit of what is historically the lowest capital gains rates we have ever seen, and likely will never see at that level again," he added. "Likewise we’re seeing companies taking a look at leveraging their balance sheets to provide distributions to their shareholders, again to take advantage of what is currently a 15 percent dividend rate, which after this year, assuming no legislative change, will increase to ordinary income tax rates, and that’s nearly a 200 percent increase in tax rates. It’s a significant increase, so we’re seeing a lot of planning.”
Larsen acknowledged that none of the transactional opportunities can happen immediately. “Companies need to start planning now, particularly if a merger or acquisition transaction is involved,” he said. “They really need to start that immediately. In fact, they’re a little bit behind the curve on that. We’re not just seeing sellers coming to market to take advantage of the lower capital gains tax rate, but we’re seeing buyers aggressively canvasing sellers to try to encourage them to sell this year. Buyers are very active trying to create deals.”