2010 Year-end Tax Planning Requires New Strategies

Year- end tax planning typically involves finding ways to defer income and accelerate deductions to reduce current year tax. However, because we soon will experience the biggest tax increases in nearly 17 years (and the first increase in capital gains taxes in 24 years), effective year-end tax planning should focus on accelerating income and postponing deductions (other than itemized deductions – more on this later).

Accelerating income (and deferring above the line deductions) is the preferred strategy for most individuals (except those in the lower tax brackets) and pass-through entities such as partnerships, LLCs and S corporations. The usual deferral strategies continue to apply to closely-held C corporations since corporate tax rates will remain the same in 2011. However, any strategy (including acceleration) that permits a C corporation to pay more taxable compensation or ordinary dividends to its shareholders in 2010 should be maximized.

At the end of 2010, the so-called Bush tax cuts expire. If Congress does not act soon, tax rates will automatically go up for all individual taxpayers, including those subject to the lowest tax rates. At the same time, the dreaded marriage penalty returns. The Obama Administration has proposed extending the tax cuts only to taxpayers in the low to middle income tax brackets while allowing the two highest tax brackets, now 33% and 35%, to return to 36% and 39.6% in 2011. At the time of this writing, however, it appears that time may have run out for Congress to pass the legislation necessary for extending the cuts.

Taxes on income earned from net long-term capital gains (LTCGs) and qualified dividends also will be increasing from the current maximum rate of 15%. Without new legislation, beginning in 2011 capital gains tax rates will increase to 20% for taxpayers subject to marginal income tax rates greater than 15%, while dividends will be taxed at ordinary income tax rates.

To make matters worse, after 2010 the overall limitation on itemized deduction (i.e., the so-called “Pease limitation”) will be restored. As a result, itemized deductions (other than medical expenses, casualty losses, investment interest, and gambling losses) will be reduced by the lesser of (1) 3% of the amount of the taxpayer’s income exceeding the applicable threshold or (2) 80% of the deductions subject to the limit. Taxpayer’s with AGI in excess of $171,100 will lose $1 of itemized deductions for every $33.33 of AGI in excess of the threshold (subject to the 80% overall limit). As a result, it still makes sense to accelerate itemized deductions to 2010 because pushing these deductions into 2011 may cause them to go unused as a result of the return of the phase-out of itemized deductions. Because there is no limitation on itemized deductions in 2010, this strategy will be unaffected by the acceleration of ordinary income.

After 2010 the $3,650 personal exemption will be fully phased-out for individuals and married couples with adjusted gross income in excess of $289,300/$372,700 respectively (based on 2009 limits). Accelerating income in 2010 will not reduce the amount of personal exemptions any taxpayer can claim.

There are a number of other Bush era tax cuts that normally would be extended including the inflation-adjusted AMT exemption, nonrefundable personal tax credits, and above-the-line deduction for qualified higher education tuition and fees. Given the current climate in Washington, it seems likely that any extension will not include higher income taxpayers.

Adding to this misery are the pending tax increases resulting from the passage of health care legislation this past year. Starting in 2013 individual and married taxpayers with income in excess of $200,000/$250,000 respectively will pay a 0.9% surcharge on earned income and a 3.8% surtax on investment income (dividends, interest, long-term and short-term capital gains, passive income, rents and royalties).

The return of higher tax rates and reduced deductions and exemptions means that in most cases the decision to accelerate income and defer deductions (other than itemized deductions) to 2011 will be clearly advantageous. This position is further supported by the fact that it is difficult to generate even modest investment returns (thereby reducing the opportunity cost of paying the tax early).

Six Specific Strategies for 2010

1. Individuals should convert traditional IRA to Roth IRA and make the special election to realize 100% of the income in 2010. This strategy accelerates ordinary income to 2010, but may be disadvantageous from an investment and retirement perspective if the payment of the tax cannot be made with available funds outside of the converted IRA.
2. Owners of closely held C corporations should review the amount of accumulated earnings and profits (E&P) attributable to their businesses and accelerate its distribution to 2010. If the business does not have available cash to make the distributions, the shareholders could agree to consent dividends (which are treated as cash distributions on the last day of the year followed by a contribution to capital). A better alternative is to make cash distributions and have the shareholders loan the money to the corporation which will facilitate the removal of otherwise doubled-taxed income in the future. 
3. S corporations should accelerate accumulated E&P from subchapter C years before distributing accumulated earnings of the S corporation. If this by-pass election is made, all distributions during the tax year are taxable dividends to the extent of the corporation's accumulated E&P. The election applies on a year-by-year basis, only part of the accumulated E&P needs to be distributed. 
4. Accelerate capital gains to 2010 and elect out of installment treatment. The election out of installment basis applies on an all-or-nothing basis. If the taxpayers wants to election out of only part of the gain, multiple notes must be used followed by a pledge to trigger gain. 
5. Distribute real estate from C corporations to avoid future double tax, take advantage of significantly lower valuations and accelerate taxable dividends to 2010. Distributing real estate from S corporations can be done to accelerate capital gains provided the distribution is made in a manner that avoid ordinary income treatment under section 1239 (i.e., to an individual). 
6. Convert existing C corporations to LLCs using a statutory conversion. Future double tax can be avoided by accelerating the gain to the current year when the inherent gain on liquidation should be at a low point. Any loss on liquidation will be allowed since the related party disallowance rules do not apply to corporate liquidations.