Year-end tax planning......what should we do?

Congress adjourned in late September without a bi-partisan agreement to extend the tax cuts before the election; apparently many members of Congress were more concerned about saving their own jobs than they were about coming to an agreement on these important tax laws. And important they are: according to the Wall Street Journal, if the existing tax cuts are not continued, taxes will increase for more than 150 million Americans. This issue is now left to the lame-duck session of Congress.

The Bush tax cuts aside, here’s a look at what is clear at this point.

Energy Tax Credit (IRC Section 25C)

This popular industry tax credit expires on December 31, 2010. It allows a taxpayer a 30% tax credit on the installed cost of qualifying equipment (high efficiency furnaces, boilers, water heaters, air conditioners, heat pumps, and wood stoves and main air circulating fan). This credit applies to existing principal residences only. The maximum allowable credit is $1,500 so the credit is maxed out at installation costs of $5,000 and above. This is not an annual credit. If you took any credit in 2009, that amount must be subtracted from the $1,500 limit to see what, if any, credit amount is available for 2010. This provision is not expected to be extended even if the Bush tax cuts are.

Businesses Taxes

Typically, an asset purchased must be depreciated (written off) over a number of years. Section 179 of the Internal Revenue CodeThis deduction allows a business to immediately expense qualified property in the year it is bought.

The Section 179 deduction limits have been increased for 2010 and 2011. The maximum deduction is now $500,000 and the maximum investment limit is now $2,000,000. Any asset purchases in excess of $2,000,000 will reduce the allowable Section 179 deduction dollar-for-dollar from the $500,000 limit. The allowable Section 179 deduction is limited to the taxable income of the business. Any amounts not deductible in the current year may be carried forward. The allowable deduction for luxury autos (i.e. SUVs) is $25,000. The remaining cost is depreciated over five years.

The 50% bonus depreciation provision that expired at the end of 2009 was re-instated for 2010 only by the Small Business Jobs Act passed by Congress in late September. This allows a taxpayer to write off an additional 50% of the adjusted basis of the property placed in service during the year. Again, this revived provision expires December 31, 2010. First year depreciation limits for luxury autos are capped at $10,96011,060 (including the bonus depreciation). First year depreciation limits for light trucks and vans are capped at $11,06011,160 (including the bonus depreciation).

The Work Opportunity Tax Credit allows a business to claim a credit equal to 40% of the first $6,000 of wages paid to employees in a targeted group. The employee must work over 400 hours during the year. Otherwise, the credit is reduced to 25% for those who work at least 120 hours during the year. The 12 targeted groups include qualified veterans of service in the U.S. Armed Forces, vocational rehab individuals, ex-convicts and disconnected youth. For the complete list of targeted groups, go to the U.S. Department of Labor website (www.doleta.gov). This program is administered at the state level. This credit expires on December 31, 2010 as well.

If you are an “S” corporation that previously was a “C” corporation, the built-in gains (BIG) tax holding period for 2010 is seven years. That means any conversions before 2003 can now sell appreciated assets and avoid the BIG tax (35%). Recent legislation has decreased the holding period to five years in 2011.

If you are considering selling your business, you may avoid higher tax rates by closing the sale in 2010. You may also consider electing out of the installment method and recognizing the entire gain in 2010. It’s important that you do the calculations to make sure it makes sense in your situation. You should also consider selling and recognizing the gain on any other appreciated property.

You also may consider paying out “C” corporation dividends prior to the end of the year. The current dividend rate (maximum 15%) is much more favorable than the dividend rate would be in 2011 if the rates are allowed to increase. In that case, dividends would be taxed at ordinary income rates, which would be as high as 39.6%.

Individual Taxes

In this environment, it is extremely difficult to offer year-end tax planning guidance. Traditional general tax planning strategy is to defer (postpone) taxable income and capital losses and accelerate (pull into 2010) deductions. If the Bush tax cuts are allowed to expire, then the strategy would be reversed: you would accelerate taxable income into 2010 and defer above-the-line deductions into 2011. Above-the-line deductions include: IRA contributions, health savings account, self-employed health insurance, self-employment taxes and alimony, among others. Whether itemized deductions (medical expenses, real estate taxes, mortgage interest, charitable contributions, etc.) should be deferred into 2011 would be determined on a case-by-case basis. This is especially true if the itemized deduction phase-out provision returns for higher-income taxpayers.

The following chart shows the ordinary income tax rates for this year and 2011 if the Bush tax cuts are not extended.

Tax Rates
2010 2011
10.00% 15.00%
15.00% 28.00%
25.00% 31.00%
28.00% 36.00%
33.00% 39.60%
35.00%


The dividend tax rate (currently 0% for those in the 10 & 15% brackets and 15% for all others) would go to ordinary income rates (which could be as high as 39.6% for some taxpayers)! The long-term capital gain tax rate (currently 0% for those in the 10 & 15% tax brackets and 15% for all others;) would go to 10% for the 15% bracket and 20% for all others (different rates for qualified five-year gain property).

Estate Taxes

There currently is no estate tax for 2010. The estate tax returns for 2011 with the exclusion amount (amount exempt from estate taxes) scheduled to be $1 million and a top tax rate of 55%. In 2009, the exclusion amount was $3.5 million and the top tax rate was 45%. I expect that the estate tax issue will be addressed very quickly by Congress, as five billionaires have died so far in 2010, including New York Yankees owner George Steinbrenner. The government has lost over $8 billion in estate taxes from these five families alone because of this.

As you can see, with all this uncertainty surrounding the tax laws, it is difficult for businesses and individuals to do their year-end tax planning. While I expect that many of the Bush tax cuts will be extended, it may be well into 2011 before this gets resolved. At this point, my best advice is to pay close attention to news reports coming out of Washington, D.C. and stay in close touch with your CPA or tax preparer.

U.S. Treasury Department Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that, unless expressly stated otherwise, any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. This article is not intended to be comprehensive in nature and competent professional tax advice should be sought in determining the issues that impact your specific situation.