Federal Tax Planning Strategies for Individuals and Small Businesses
Federal Tax Planning Strategies for Individuals and Small Businesses
Every year, to minimize their overall liability, taxpayers should start giving consideration to moves that may either lower their current year tax bill or equalize their tax liability over a two-year period. Some of the ideas presented below are traditional planning suggestions involving timing of income, deductions, and other payments qualifying for tax credits. But consider also the Alternative Minimum Tax and proposed changes that the new Trump Administration may enact.
As a result of the Protecting American from Tax Hikes, Act (PATH)—hereafter referred to as “the Act”—the individual marginal tax rates are 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%.
For 2017, a new rate of 39.6% is imposed on taxable income over $418,400 for single filers; $444,550 for head-of-household filers; and $470,700 for married taxpayers filing jointly ($235,350 for married filing separately).
Standard Deduction and Proposed Exemptions Amounts for 2016 and 2017
|Married individuals filing joint returns and surviving spouses||
|Heads of households||
|Unmarried individuals (other than surviving spouses and heads of households)||
|Married individuals filing separate returns||
For taxable years beginning in 2016, the standard deduction amount for an individual who may be claimed as a dependent by another taxpayer cannot exceed the greater of (1) $1,050 or (2) the sum of $350 and the individual’s earned income.
For taxable years beginning in 2016, the additional standard deduction amount for the aged or the blind is $1,250. The additional standard deduction amount is increased to $1,550 if the individual is also unmarried and not a surviving spouse.
For taxable years beginning in 2017, the personal exemption amount is $4,050. The reinstatement of the phase-out of personal exemptions and itemized deductions are reinstated at the higher threshold of $261,500 for single taxpayers; $287,650 for head of household; and $318,300 for married filing jointly.
Capital Gains and Dividend Rates
- The rate for both capital gains and dividends will be 20% if the income is in excess of: $415,050 (individual filers); $441,000 (head of household); $466,950 (married filing joint); and $233,425 (married filing separately).
- The rate for both capital gains and dividends will continue to be 0% for taxpayers below the 25% bracket.
- The rate for both capital gains and dividends will continue to be 15% for those in the 25%, 28%, 33%, and 35% brackets.
It should be noted that if income without regard to long-term gains is in the 10% or 15% tax bracket, profits on the sales of assets owned over a year are tax-free until the gains push the taxpayer into the 25% bracket. That bracket starts at $75,300 of taxable income for couples and $37,650 for singles. If part of the gain is taxed at 0% and the rest is taxed at 15%, claiming more itemized deductions or making a deductible IRA payment gives you two tax breaks: the income tax savings from the deduction, and more gain being taxed at 0%.
Even though the gains subject to the rate are not taxed, taking additional tax-free gains will boost adjusted gross income. The extra AGI can cause more Social Security benefits to be taxed. State income tax bills may also jump because many states tax gains as ordinary income.
Alternative Minimum Tax (AMT)
It is more important than ever to recognize that under federal structure there is a dual tax system: the regular tax and the alternative minimum tax. When running any tax computation, the alternative minimum tax—the actual tax that many of you are paying—must be calculated. If you have an abundance of credits and deductions (including state income tax deduction), the alternative minimum tax may well apply.
The only way to know for sure if the alternative minimum tax affects you is to calculate the tax both ways. This may impact many planning strategies, including prepaying state income tax, creating basis in passive activities, installments sales, and miscellaneous itemized deduction planning. Lower regular tax rates increase likelihood of application of the AMT.
The exemption amounts for 2017 were increased as follows (note the exemption amount is permanently indexed for inflation, and nonrefundable personal credits are allowed against the AMT):
|Joint returns or surviving spouses||
|Unmarried individuals (other than surviving spouses)||
|Married individuals filing separate returns||
|Estates and trusts||
The 2017 AMT exemption is phased out as follows:
|Status||Exemption||Begins at||Ends at|
|Single or Head of Household||$54,300||$120,700||$335,300|
Additional Credits and Items of Interest
The amounts for calculating the child-care credit continue to be up to $3,000 of expenses for one child and up to $6,000 of expenses for two or more.
With regards to IRC section 529 Accounts and Able Accounts, the Act expands the definition of qualified higher education expenses to include computer equipment and technology if such equipment is used primarily by the beneficiary during the years that the beneficiary is enrolled at an eligible education institution.
The Act allows Able Accounts (tax-preferred savings accounts for disabled individuals) to be set up in the state program that best fits their needs. Previously, these accounts could only be set up in the beneficiary’s state of residence.
The exclusion for employer-provided educational assistance ($5,250 per year) may be excluded from an employee’s gross income for income and employment tax purposes. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) expanded this provision for undergraduate and graduate educations, and the expanded exclusion is extended for all taxable years beginning after Dec. 31, 2012.
For 2017, the American Opportunity Tax Credit for qualified education expenses paid for an eligible student for the first four years of higher education is $2,500 per eligible student. The income limits for the full credit are $80,000 or less for single taxpayers and $160,000 for married taxpayers filing jointly.
The Hope Scholarship Tax Credit increased to $2,500 for 2017, and the same rules apply for this credit. Income limits are $80,000/$90,000 for single filers and $160,000/$190,000 for married taxpayers filing jointly. Qualified expenses now include course materials.
For taxable years beginning in 2016, the $2,500 maximum deduction for interest paid on qualified education loans begins to phase out under for taxpayers with modified adjusted gross income in excess of $65,000 ($130,000 for joint returns) and is completely phased out for taxpayers with modified adjusted gross income of $80,000 or more ($160,000 or more for joint returns).
The annual contribution amount for Coverdell Accounts is reinstated at $2,000, and the definition was expanded to include elementary and secondary school expenses under EGTRRA.
The Act makes permanent the $250 above-the-line deduction for teachers and other school professionals for expenses paid or incurred for books, supplies, computer equipment, other equipment, and supplementary materials used by an educator in the classroom. The Act indexes the deduction to inflation for years beginning in 2016.
The Act extended through 2016 the amount of up to $2 million of forgiven debt eligible to be excluded from income ($1 million if married filing separately). The Act also provides that mortgage discharge is eligible for exclusion as long as it was pursuant to an arrangement dated prior to Jan. 1, 2017.
The Act extended through 2016 the ability to deduct the cost of mortgage insurance on a qualified personal residence. The deduction is phased-out ratably by 10% for each $1,000 by which the taxpayer’s AGI exceeds $100,000. This provision had been extended through 2015.
The Act extends the above-the-line tax deduction for qualified education expenses. The deduction is capped at $4,000 for an individual whose AGI does not exceed $65,000 ($130,000 for joint filers) or $2,000 for an individual whose AGI does not exceed $80,000 ($160,000 for joint filers).
The Act permanently extends the ability of individuals age 70½ and older to make tax-free distributions to charity from their IRAs of up to $100,000 per taxpayer per taxable year. These distributions will qualify as part of the taxpayer’s annual required minimum distribution. Once again, this reduces modified adjusted gross income and also possibly affects the dependency exemption and itemized deductions.
Net Investment Income Tax
Net investment income consists of investment income—which includes income from interest, dividends, annuities, royalties, rents, and net gain from disposition of property, other than such income derived in the ordinary course of a trade or business—reduced by investment expenses such as early withdrawal penalties, interest expense, advisor fees, and state and local income taxes allocated to items included in the investment income category. These reductions are subject to certain itemized deduction limitations. Taxpayers should consider paying—prior to Jan. 1, 2016—the full amount of these expenses as they relate to their 2015 calendar year investment income, even if the taxpayer is subject to AMT.
The net investment income tax is 3.8% of the lesser of the individual’s net investment income for the tax year or the amount the individual’s modified AGI exceeds a threshold amount. The threshold amounts are $250,000 for married taxpayers filing jointly and surviving spouses; $125,000 for married taxpayers filing separately; and $200,000 for all others.
The threshold for the itemized deduction for unreimbursed medical expenses has increased to 10% of AGI for regular income tax purposes. There is one exception to the increased threshold: In years 2013-2016, if either the taxpayer or the taxpayer’s spouse has turned 65 before the end of the tax year, the increased threshold does not apply and the current threshold remains at 7.5% of AGI.
There may also be some medical expenses that were overlooked in the process. Travel expenses to and from medical treatments will get at allowance of 19 cents per mile for the 2016 tax season. Medically necessary costs, as prescribed by the taxpayer’s doctor, can be written off. If, for example, a doctor recommends a humidifier to help with breathing, then it is potentially deductible. As always, make sure there is documentation to back it up.
Planning Strategies and Techniques
For many, the traditional strategy of deferring income and accelerating expenses is still effective. By postponing income until the next year and accelerating expenses into the current year, the current year tax bill will potentially be lowered and the taxpayer gains the use of his or her money for an extra 12 months.
If, however, a taxpayer expects to be in higher bracket in the following year as compared to the current year, just the opposite approach may be appropriate—in other words, accelerating income now and deferring expenses until the next year. Income accelerated into the following year may be taxed at a lower rate, while any deductions for the current year will be available to offset income in a higher tax rate. The Alternative Minimum Tax must also be considered, and we will need to see what the current or new administration may do in terms of possible increases in the brackets.
One of the key opportunities that many executives and other wage earners have is to defer the receipt of bonuses until January of the following year. Many employers will cooperate with this planning, and—in most cases—it will not adversely affect the employer’s tax situation. Many companies also offer their key employees the opportunity to defer income for several years or until retirement—when many people are in a lower tax bracket. Be aware, however, that the 2004 tax law created new restrictions under IRC section 409(a) for 2005 and later years.
It is possible to shift income from the current year to the next by acquiring investments that do not mature until January or February of the following year. For example, income on Treasury bills is not recognized until it actually matures. Thus, you could purchase Treasury bills with a maturity date that falls into January or February of the next year. It is always best to speak with an investment professional to implement this type of strategy.
Investing in tax-free municipal bonds of your resident state can be a prudent means to save taxes. Interest on bonds that are issued in the state in which you reside is usually tax-free. For example, a tax-free municipal bond yielding 5% is equal to a taxable bond yielding 7.81% in the 36% tax bracket. Thoroughly consider the risk and maturity of any bond before any investment is made.
Another way to reduce the amount of income subject to tax is to shift some part of it to another family member. With the income tax rate as high as 39.6%, “high-income” parents should consider shifting income to lower-taxed family members age 19 and over, who may be taxed at a rate as low as 15%. In many cases, this will serve to lower the family’s overall exposure to increased taxes. Each family member’s current and future tax rate bracket should be reviewed in connection with this planning opportunity. The “kiddie tax” should be considered.
Prior to the end of the year, a taxpayer should review his or her stocks and bonds portfolio to determine what built-in losses, if any, may be available to offset capital gains. If these capital losses can be recognized before year-end, they can offset any recognized capital gains that may have occurred during the year. The stock can be repurchased after 31 days. Any net capital losses (net of capital gains) can be deducted to the extent of $3,000, with carryovers available. It is also advantageous to review the basis of any capital assets sold so that the highest or lowest basis assets are selected for sale to maximize the tax benefits. Unless the sold lots are specifically identified, a first-in, first-out (FIFO) method is used.
If a taxpayer will owe state income taxes, he or she may want to pay before the end of the year so they are deductible in the current tax year. Many real estate taxes are payable on Dec. 31 and should be paid on or before this due date to secure a deduction for the current year. Many states also structure their fourth-quarter estimated state tax payment to be paid on Jan. 15 of the following year. It may make sense to pay these estimated payments by year-end. Two key points for the tax practitioner to consider: First, review all deductible taxes that will be paid shortly after year-end to determine if it is wise to prepay any of these amounts—in many cases, it will. Second, taxes that are deductible as itemized deductions are an add-back for AMT purposes.
Making charitable donations can save significant tax dollars. For those who itemize, cash charitable deductions of up to 50% of their AGI remain fully deductible. For those who will be in a higher tax bracket this year than in the next, any contributions made early will be more valuable. Remember, however, the substantiation requirements for any donation of $250 or more. A cancelled check is no longer adequate proof—a contemporaneous receipt must be obtained from the charitable organization.
A double tax break is available for donations of appreciated property. First, if the property is held for more than one year, a deduction can generally be claimed for the property’s fair market value. Secondly, if a taxpayer donates appreciated property, he or she would never pay tax on the appreciation. This is an often-overlooked opportunity. Thus, each taxpayer situation should be reviewed to determine if appreciated property—rather than cash—can be gifted. As a general rule, cash should always be a second choice after appreciated property.
A 401(k) contribution is still one of the best tax shelters. It lowers taxable income (directly reducing the taxpayer’s W-2 salary), and the contribution amount—including any earnings—grows tax-free until retirement. Many employers also match part of their employees’ contributions.
For self-employed workers, a Keogh or SEP plan may be the best retirement option. In general, a taxpayer is allowed to contribute and deduct up to 25% of his or her net self-employment income or up to $53,000 for 2016 and 2017—whichever is less. An additional amount may be contributed for those over 50 if the Solo 401(K) is used. The current catch-up amount is $6,000.
Maximizing IRA contributions still makes sense for you and many can still deduct their IRA contributions. Those who are not covered by an employer-sponsored pension plan (including defined benefit, profit sharing, and 401(k) plans) can take a full deduction for a contribution of up to $5,500 ($6,500 for those ages 50 or older). Anyone who is covered by a pension plan may still be able to take the deduction, depending upon his or her AGI. Married couples with AGIs of less than $50,000 and single taxpayers with AGIs of less than $35,000 qualify for a full or partial deduction. Even if a deduction is not available, contributions still make sense because the earnings on the contributions grow tax-deferred until retirement. It even makes sense for a child who has earned income to contribute to an IRA.
Tax law is complicated and taxpayers need to understand the rules in terms that they understand. Planning early in the year gives us more time to consider alternatives that benefit our clients, but a year-end review is also necessary to make sure nothing has changed and nothing was missed. This article has not given attention to potential changes in the tax law under a Republican president and Congress. Because it is likely that rates will be reduced and some deductions and credits altered or even eliminated, the planning ideas reflected here are only likely to benefit taxpayers.
Warren M. Bergstein, CPA, AEP, has over 40 years of experience providing tax and accounting services to high net worth individuals, entrepreneurs, and sole proprietors. He is an adjunct professor of accounting and taxation at LIU-Brooklyn and New Jersey City University. Mr. Bergstein is a member of the NYSSCPA and the AICPA. He can be reached at 212-382-0404 or firstname.lastname@example.org
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