The summer months create a tremendous opportunity to review your tax situation and provide ample time to implement strategies to reduce or at least project any tax liabilities. Last December, Congress made “permanent” dozens of tax provisions previously referred to as extender provisions. (See Wipfli Alerts & Updates: URGENT – Congress passes PATH Act – includes permanent and temporary tax relief provisions—published December 18, 2015.) As a result, for the first time in almost 16 years taxpayers finally have permanent and relatively certain tax laws to plan with today.
Of course, the true definition of “permanent” in the tax world is “…until things change.” This November, a new president will be elected, and the balance of power in Congress may change also. Both Hillary Clinton and Donald Trump have started to release detailed tax policy proposals. As these and others become more solidified, we will share the potential impact of the proposals with you.
Despite the potential for change, we firmly believe now is a great time to consider tax planning with the law we know is on the books today. This email only highlights several planning strategies and reminders to think about for the second half of 2016. Please contact your Wipfli relationship executive to discuss how these and many other strategies may apply in your specific situation.
Key 2016 facts and figures. We now know the marginal tax rates, standard deduction, personal exemption, and other figures for 2016. Click here to reference our valuable 2016 Tax Rate Quick Guide.
Review your withholding levels and estimated tax payments. By now, most taxpayers have filed their 2015 income tax returns (some may be on extension yet until October 17, 2016). Consider whether 2016 will be a higher or lower income year than 2015 or 2017. The amount you need to pay in to avoid interest and penalties may change dramatically each year. In addition, note that the way you pay your taxes (withholding versus estimated tax payments) can make a dramatic difference because withholding is considered as being paid evenly throughout the year regardless of when it is actually paid. An estimated tax payment, on the other hand, is considered as being paid the date it is mailed to the IRS or state taxing authority. As a result, withholding offers some flexibility and use of hindsight that cannot be offered with estimated tax payments. If you have sources of income such as pending IRA distributions, bonuses, or others, you may be able to schedule withholding amounts to your advantage. Of course, with this added flexibility comes added risk if the amounts are incorrect.
Holding on longer can lower your taxes. If you hold appreciated securities in taxable accounts, owning them for at least one year and a day is necessary to qualify for the preferential long-term capital gains tax rates. In contrast, short-term gains are taxed at your regular rate, which can be as high as 39.6% (43.4% if the net investment income tax applies). Be sure to consider this when evaluating your investment portfolio. Whenever possible, try to meet the more-than-one-year ownership rule for appreciated securities held in your taxable accounts. Of course, while the tax consequences are important, they should not be the only consideration for making a buy or sell decision.
Take advantage of retirement plan options. The earnings on most retirement accounts are tax deferred. With Roth IRAs, they’re normally tax-free. Thus, the sooner you fund such an account, the quicker the tax advantage begins. If you can come up with the cash now, there’s no need to wait until year-end or the tax deadline next April to make your 2016 contributions. However, if your employer offers a 401(k) or SIMPLE IRA plan at work, you’ll probably want to contribute enough to that plan to receive a full employer match before making an IRA contribution. Some retirement plan contributions can be changed or withdrawn later on, also, if facts change (e.g., Roth contributions can be re-characterized later on if you are ultimately ineligible to make contributions).
Make charitable donations from IRAs. This provision is one that Congress made permanent last year, after several years of waiting until the last minute. If you’ve reached age 70½, you can arrange to have up to $100,000 of otherwise taxable IRA money paid directly to specified tax-exempt charities. These so-called qualified charitable distributions (QCD) are federal income tax free to you, but you don’t get to claim any itemized deductions on your Form 1040. However, the tax-free treatment equates to a 100% write-off, and you don’t have to itemize your deductions to get it. Furthermore, you can count the distribution as part of your required minimum distribution that you’d otherwise be forced to receive and pay taxes on this year. Be careful, though: To qualify for this special tax break, the funds must go directly between your IRA and the charity.
Increase participation in otherwise passive activities. The so-called passive activity rules prevent many taxpayers from currently deducting losses from business activities in which they do not “materially participate.” These losses are typically from partnerships in which they are not personally involved or do not participate to the extent required by the tax rules. Taxpayers can normally satisfy any one of several tests (e.g., spending more than 500 hours per year in day-to-day operations, performing substantially all of the work in the activity, or completing more than 100 hours per year and more than anyone else) to meet the material participation standard. If you’re expecting a current-year loss from an activity (or have a loss carrying over from an earlier year), with proper planning between now and year-end you may be able to increase your involvement in the activity and thus avoid having the loss disallowed under the passive activity rules.
Take advantage of the generous Section 179 deduction and first-year bonus depreciation. Under the Section 179 deduction privilege, an eligible business can often claim first-year depreciation write-offs for the entire cost of new and used equipment and software additions and eligible real property costs. For tax years beginning in 2016, the maximum Section 179 deduction is $500,000. However, this maximum deduction is reduced to the extent you purchase more than $2.01 million of qualifying property during the tax year. Also, a much lower limit applies for amounts that can be deducted for most vehicles.
Above and beyond the Section 179 deduction, your business can also claim first-year bonus depreciation equal to 50% of the cost of most new (not used) equipment and software placed in service by the end of this year.
Note that you cannot claim a Section 179 write-off that would create or increase an overall tax loss from your business. This limit does not apply to first-year bonus depreciation deductions, which can create or increase a net operating loss (NOL) for your business’s 2016 tax year. You can then carry back the NOL to 2014 and/or 2015 and collect a refund of taxes paid in one or both of those years. Please contact us for details on the interaction between asset additions and NOLs.
Consider the potential impact of the lucrative research and development (R&D) credit. Businesses may be able to claim a federal tax credit (a direct reduction in the amount of taxes paid) for increases in their qualified R&D spending. Over the past 30 years, however, there have been a number of changes in how the credit is calculated and which activities qualify. Contrary to popular belief, the R&D tax credit isn’t limited to high-tech, biotech, and pharmaceutical companies. If your company does any of the following, you may qualify for the R&D credit:
- Design and/or manufacture products
- Produce parts to customer part prints or specifications
- Custom design and build machines for sale or use in operations
- Develop new, improved, or more reliable products/processes/formulas
- Design tools, fixtures, jigs, molds, or dies
- Develop or apply for patents
- Develop software
Businesses are allowed to use one of two calculation methods, the Regular Credit method or the Alternative Simplified Credit (ASC) method. The Regular Credit method has a higher credit rate (20%) but may be more difficult to compute because the base period is tied to the 1984-1988 time period. The ASC method may be easier to compute because the base period relies on the prior three years; however, it has a lower credit rate (14%) than the Regular Credit method.
In addition, beginning in 2016, for eligible businesses with average annual gross receipts of $50,000,000 or less for the prior three years, the credit can offset both the regular tax and the Alternative Minimum Tax (AMT). In 2010, Congress provided this provision as a one-time opportunity for the same taxpayers. This provision is now included permanently. Many businesses that are flow-through entities have been eligible for the credit. However, the owners were subject to AMT and, even with planning, might not have been able to fully utilize the credit but will now receive a significant opportunity to reduce their tax liability.
Congress also added a new provision that allows small start-up businesses to elect to offset payroll taxes with the credit. This provision applies to start-ups with less than $5,000,000 of gross receipts and that did not have gross receipts in any of the preceding five-taxable-years period.
Proper understanding of the tax law can result in substantial savings. Wipfli’s dedicated team of tax professionals specializing in R&D tax law is ready to help you maximize your opportunities. Please contact Scott Schumacher, Valerie Fedie, Christopher Blaylock, or your Wipfli relationship executive for assistance. To learn more about the R&D credit and the benefits your business can gain from claiming it, please click here.
Consider selling rather than trading in vehicles used in business. Although a vehicle’s value typically drops fairly rapidly, the tax rules limit the amount of annual depreciation that can be claimed on most cars and light trucks. Thus, when it’s time to replace the vehicle, it’s not unusual for its tax basis to be higher than its value. If you trade in the vehicle for a new one, the undepreciated basis of the old vehicle simply tacks on to the basis of the new one (even though this extra basis generally doesn’t generate any additional current depreciation because of the annual depreciation limits). However, if you sell the old vehicle rather than trading it in, any excess of basis over the vehicle’s value can be claimed as a deductible loss to the extent of your business use of the vehicle.
Consider reimbursing employees’ out-of-pocket business expenses. Employees normally receive little or no tax benefit from paying business expenses because they’re deductible only to the extent they exceed (1) 2% of the employee’s adjusted gross income and, (2) when combined with the employee’s other itemized deductions, the employee’s standard deduction. Thus, for example, an employee whose compensation is $2,000 higher than it would otherwise be because he’s expected to incur about $2,000 in unreimbursed business expenses isn’t being fairly compensated for the out-of-pocket expense. After paying income and payroll taxes on the $2,000, he has less than this amount to spend on the business expenses. A better approach would be for the company to reimburse at least part of the employee’s business expenses (and renegotiate the employee’s compensation accordingly). Because properly documented expense reimbursements aren’t considered compensation, both the company and the employee save payroll taxes on this arrangement. Plus, the employee comes out better on income taxes as well.
Employ Your kid. If you are self-employed, you might want to consider employing your child to work in the business. Doing so has tax benefits, in that it shifts income (which is not subject to the Kiddie Tax) from you to your child, who normally is in a lower tax bracket, or may avoid tax entirely because of your child’s standard deduction. There can also be payroll tax savings, since wages paid by sole proprietors to their children age 17 and younger are exempt from Social Security, Medicare, and federal unemployment taxes. Employing your children has the added benefit of providing them with earned income, which enables them to contribute to an IRA. Children with IRAs, particularly Roth IRAs, have a great start on retirement savings, since the compounded growth of the funds can be significant.
Remember a couple of things when employing your child. First, the wages paid must be reasonable given the child’s age and work skills. Second, if the child is in college or entering soon, too much earned income can have a detrimental impact on the student’s need-based financial aid eligibility.
Wealth transfer and estate tax planning. For 2016, the unified federal gift and estate tax exemption is a generous $5.45 million, with a top federal estate tax rate of 40%. For most married couples, the combined exemption amount is $10.9 million. For gifting purposes, the federal annual exclusion amount remains $14,000 per donor per year. This is the amount that can be gifted annually to any number of donees before losing a portion of your estate and gift tax exemption.
We strongly recommend a periodic review of any current estate planning documents such as wills, trusts, IRA or 401(k) beneficiary designation forms, or life insurance policies. Your plan may not adequately account for recent changes in federal estate and gift tax rules or your home state’s property law. Also, you may need to make some changes that have nothing to do with taxes, such as asset protection or creditor-related issues.
Current tax law affords tremendous planning opportunities for transferring hard-to-value assets such as closely held business interests, real estate, and others. Most tax advisors believe Congress will eventually close many of the favorable planning tools currently available.
In addition, estate planning today often centers on maximizing the favorable step up in basis rules applicable to assets held at death. We can review your financial and estate situation to determine which assets should be kept or disposed of prior to death.
This Wipfli Alerts & Updates communication highlights the more common areas and ideas that may or may not apply in your specific situation. We greatly welcome the opportunity to sit down with you and discuss how these and many other tax planning ideas may help lower or eliminate your tax burdens.
If you have questions, please contact Rick Taylor, Ryan Laughlin, or your Wipfli relationship executive.