During these uncertain times of pending tax legislation, it can be difficult to determine appropriate action to perform effective tax planning*. There may be year-end strategies that can be employed in late December as it becomes clearer from Congress which provisions of each bill will be final. Despite the uncertainty, it is important for taxpayers to be ready to execute strategies for effective tax planning.
Key areas for consideration this tax season include potential tax reform, identity theft concerns, and increased scrutiny of foreign reporting, and this isn’t expected to change any time soon. Some of the major changes for individuals are identified below, starting with the rates.
Tax Rates: Both versions of the bill call for a change in tax rates. For some taxpayers, the rates may be higher and for some lower, depending on the amount and type of taxable income they are reporting. Simply having a higher marginal rate suggests that the tax on each incremental dollar of ordinary income would be subject to that higher rate. Under both versions of the bill, flow-through income from businesses (partnerships, S corporations, and sole proprietorships) will be subject to a different rate structure. It is expected that the long-term capital gains and qualified dividend rates will not change under either version of the bill.
Absent non-tax cash-flow considerations, taxpayers who believe their tax rate will decrease following the enactment of tax reform should consider strategies of deferring income and accelerating deductions for 2017. This is generally consistent with conventional tax planning when tax rates remain steady year over year. Taxpayers should remain cautious however; as such strategies can subject taxpayers to the alternative minimum tax (AMT) and have a reduced benefit from the 3% haircut on itemized deductions, thereby resulting in a higher overall tax liability. The effect of AMT can eliminate any perceived benefit of tax planning if not considered thoroughly. Furthermore, the type of income should also be considered as deductions offsetting income at the qualified dividends and long-term capital gains rate may not be as valuable as offsetting ordinary income in a subsequent year when analyzed on a combined basis. It is strongly encouraged that taxpayers work with their tax advisers to determine the potential impact of prepaying expenses. Taxpayers who believe their tax rate will increase following the enactment of tax reform should consider strategies of accelerating income and deferring deductions for 2017 (absent any time value of money considerations and other limitations). Since individuals are cash basis taxpayers, income is earned when actually or constructively received and allowable expenses are deductible in the year payments are made.
Income deferral opportunities exist by contributing to qualified retirement plans, deferral of stock options, harvesting capital losses, utilizing installment sales or like-kind exchange opportunities, and deferring retirement plan/IRA distributions (other than required distributions). Generally, it is difficult for W-2 wage earners to shift wage income as they may not be in control of the timing of their cash wages. Opportunities may exist for certain earners with respect to the timing of the exercise of options or the timing of certain income as part of a nonqualified deferred compensation plan. Despite the version of the bill that may pass, taxpayers should consider making the maximum contribution to their 401(k) retirement plan given the impact of compounding interest and tax-deferred income accumulation. These contributions lower current-year taxable income while the earnings grow tax-deferred. Moreover, if an employer offers an employer matching contribution, employees should review their contributions made to date to maximize their employer matching contributions in advance of year-end.
Possible deduction increases come from using business losses, pre-paying business expenses, applying accelerated depreciation strategies for business use assets, offsetting ordinary income via SEP-IRAs and solo 401(k) plans, etc. Possible deductions are dependent on each taxpayer’s facts and circumstances.
The increased standard deduction may cause many taxpayers to lose the benefit of any itemized deductions in subsequent years. For example, under the House bill, the standard deduction for married filing jointly increases to $24,400. Therefore, only those with allowable mortgage interest, property taxes, and charitable contributions in excess of $24,400 would receive any tax benefit. Consequently, taxpayers should focus on accelerating itemized deductions into 2017 if their itemized deductions are generally above the current standard deduction, but below the higher proposed standard deduction. These items include medical expenses, state and local income taxes, real estate taxes, charitable deductions, tax preparation fees, investment fees, etc. For example, a charitable contribution of $15,000 absent other deductions would provide benefit for a married couple to itemize on their 2017 tax return, but the tax benefit from those donations wouldn’t under the proposed higher standard deduction. After considering AMT exclusions, cash-flow considerations, and tax-rate analysis, it may be beneficial to pre-pay some of these items. Please work with your tax adviser to determine how best