2016 Year-End Newsletter
Dear Clients & Friends:
When implementing tax planning moves, we look for certainty in tax rates and regulations from one year to the next. The good news is that there is little uncertainty for the year 2016. This is welcome relief compared to prior years when we’ve awaited last minute retroactive legislation. The uncertainty for 2017 and future years however is immense. There are a number of provisions set to expire at the end of this year – notably, many energy credits, the exclusion from income of discharge of indebtedness from a principal residence, the qualified tuition deduction, and a few others. But the elephant in the room of course is what tax changes a new administration will bring.
Year-end planning for individuals
Determine your marginal tax bracket – In order to evaluate the effects of year-end maneuvers, there is no single piece of information more important than one’s marginal tax bracket. The regular 2016 federal tax rates can be found at http://taxfoundation.org/article/2016-tax-brackets. These rates apply to federal taxable income. If one is subject to the alternative minimum tax (AMT) the marginal rate may be 26% or 28%. Furthermore, a whole slew of deductions and credits are phased out as income increases yielding even higher effective marginal tax rates. Throw in the 3.8% tax on net investment income (NIIT) if applicable, and the top Oregon marginal rate of 9.9% and it’s conceivable to have an effective marginal tax rate of well over 50%. In that case, if for example, you donate $10,000 to charity or spend another $10,000 on business expenses, you may only be out of pocket for half of the cost.
Let’s review quickly how the 3.8% net investment income tax works – The tax applies to net investment income which is generally interest, dividends, net capital gains, and net gains from non-passive businesses, less certain deductions. The term non-passive refers to the passive activity rules that were enacted in 1986 and encompasses (generally) rental income and income from businesses in which the taxpayer doesn’t “materially participate”. There is a special rule causing the rental income of qualifying “real estate professionals” to be non-passive if requirements are met. The 3.8% tax is applied to the lesser of (1) net investment income or (2) adjusted gross income before any foreign earned income exclusion, over the threshold. The threshold is $250,000 for married filing joint taxpayers, $125,000 for married filing separately taxpayers, and $200,000 for all other individuals. Given this formula, one can sometime save tax dollars by reducing investment income, and other times by reducing adjusted gross income in whatever fashion.
Example – Thea, who is single, has income from a retirement pension of $100,000 and dividend income of $125,000. Thea’s net investment income is $125,000. Thea’s adjusted gross income is $225,000. Thea’s NIIT is equal to 3.8% times $25,000 (because her AGI less the $200k threshold is less than her net investment income) which is $950. In this case, Thea’s NIIT is driven by her total income, not her investment income. If she were to reduce her retirement income by $20,000, her tax would decrease to $190.
Variation – Thea’s retirement income is $300,000 and her dividend income is $10,000. In this case, Thea’s NIIT is equal to 3.8% times $10,000 (because her net investment income is less than the excess of her adjusted gross income over the threshold) which is $380. Were she to recognize a capital loss of $3,000, her net investment income would decrease to $7,000 and her tax to $266. In this case, Thea’s NIIT is driven by her net investment income, not her total income.
Some ideas to lower your 2016 and/or future year tax bills:
- Contribute to an IRA by April 17th of 2017. Note that the deduction phases out as income increases if one or both spouses (if married) are covered by an employer plan. That aside, maximum contributions for 2016 have not changed from 2015 – $5,500 plus another $1,000 catch-up contribution for those who are age 50 or older as of 12/31/16. You or your spouse must have earned income to contribute. Also note that if you are subject to the 3.8% net investment income tax which is driven by adjusted gross income, a deductible contribution will reduce that tax as well.
- Contribute to a Roth IRA – If you are willing to forego a current tax deduction, consider a Roth IRA instead. Although you won’t save any taxes today, the earnings in the account are never taxed, even upon withdraw, if you follow the rules.
- Convert your traditional IRA to a Roth – If your tax bracket is unusually low this year, consider converting a traditional IRA to a Roth IRA – especially if the investments in your IRA are down. As of the date of this letter, the market is up considerably making this a less likely choice. Still, in the right fact scenario, it could work well.
- Consider bunching your itemized deductions in one year instead of spreading them over two years.
- Sell loss stocks before year-end if you expect net capital gains for the year.
- Recognize long term gains – Net long term capital gains and qualified dividends are subject to a favorable federal tax rate. The maximum federal rate is 20% (plus the 3.8% NIIT if applicable) but drops to 15% for those in the 25%, 28%, 33%, and 35% regular tax brackets. It drops to 0% for those in the 10% or 15% regular tax brackets. Therefore, if your taxable income is reasonably low, you might be able to recognize long term capital gain or qualified dividend income at no federal tax cost. State taxes will of course apply.
- Pay state taxes before year-end – If you expect to owe state income taxes for 2016 next April, consider paying them prior to December 31st to avail yourself of the deduction unless you expect to be subject to AMT in which case the deduction would provide no benefit.
- Contribute to an FSA – If your employer offers a flexible spending account, sign up!
- Consider an installment sale of property vs an outright sale for cash in order to spread revenue over multiple years.
- Consider disposing of passive activities with suspended losses to unrelated parties prior to year-end.
- Consider the status of business activities as passive or non-passive – The effects of classification are many, including deductibility of passive losses, income subject to the 3.8% NIIT, and application of Oregon’s special reduced pass thru entity rate.
- Make charitable donations of appreciated stock held for longer than one year. This avoids taxation of the gain and yields a full fair market value deduction.
- Gift appreciated stock held for over a year to a child in a low tax bracket assuming the child is not subject to the “kiddie tax”. Your holding period and basis carry over to the child, who can sell and recognize long term capital gain. If their other income is sufficiently low, they may incur zero federal tax cost on the sale. See estate and gift tax rules below however.
- Consider donating to the Oregon Cultural Trust – If you donate up to $500 on a single return or $1,000 on a married filing joint return to qualifying cultural organizations, you can donate a like amount to the OCT and receive a 100% Oregon tax credit. This has the potential to save you more than the donation amount! More info is available at culturaltrust.org.
- Consider ability to transfer up to $100,000 tax-free from a traditional IRA to charity for owners who have reached age 70 ½ – This tax-free rollover can even satisfy an owner’s required minimum distribution for the year.
- Make expenditures that qualify for one of several energy credits – Given the fact that these credits may expire at the end of this year, it may be now or never. Examples of qualifying expenditures are home insulation, high efficiency HVAC systems and water heaters, and qualified fuel cell motor vehicles.
Year-end planning for businesses
- Purchase fixed assets before year end and take the section 179 deduction – Businesses can expense up to $500,000 of qualifying fixed asset purchases for years beginning in 2016. The dollar limitation phases out dollar for dollar as total qualifying purchases exceed $2,010,000. In other words, if a business purchases $2,100,000 of qualifying assets, the 179 limitation is $410,000. The limitation and phase out levels for 2017 are $510,000 and $2,030,000. Assets can be new or used and generally include tangible personal property, although some real property qualifies – notably qualified leasehold improvement, restaurant, and retail improvement property.
- Purchase fixed assets before year end and take bonus depreciation – For those who either purchase assets in excess of their 179 dollar limitation and/or are limited due to the phase out rules, bonus depreciation is the next best thing. For assets placed in service in 2016 and 2017, the first year bonus rate is 50%. For assets placed in service in 2018, the rate is 40%. And for assets placed in service in 2019, it’s 30%. After that, it’s gone, unless extended. Qualifying assets must be new and have a depreciable life of 20 years or less or be “qualified improvement property”. The rules are too voluminous to recite here but suffice it to say that you may be able to write off 50% of certain real property improvements in the year placed in service.
- Determine whether your business qualifies for the Work Opportunity Tax Credit – This credit applies to employers who hire individuals in groups whose members historically have low employment such as veterans, ex-felons, TANF recipients, and many more.
- Create basis to absorb owner losses – Make sure the owner(s) of an S corporation or partnership have ample basis to deduct losses prior to year-end.
- Consider whether your business activities in another state create “nexus” requiring the filing of a state tax return and payment of the taxes that go along with it. It is sometimes possible to manage activities so that nexus is not created; each state’s rules are different. It is worth noting that states have increasingly abandoned the physical presence nexus standard in favor of an economic presence nexus standard.
- Does your business qualify for research and development credits? The R&D credit is now a permanent tax credit. If your business engages in activities which are intended to develop or improve a product or process, is technological in nature, and which uses a process of experimentation to resolve technical uncertainty, you might qualify.
Estate & gift environment
The United States has a unified transfer tax system which limits the amount one can transfer to others during their lifetime and at death combined without paying transfer taxes. For 2017, the estate and gift tax exemption is $5,490,000 and the top federal estate and gift tax rate is 40%. The top Oregon estate tax rate is 16%. Note that Oregon has no gift tax! During 2016 and 2017, an individual can make gifts of $14,000 per donee without using any of the exemption amount. If your net worth is over the $5,490,000 threshold, it makes great sense to consider making annual gifts to whittle some of the excess away. If your net worth is less than the federal exemption amount, consider larger gifts to save Oregon estate tax.
In early 2013, Congress made the estate tax portability rules permanent. This means that if one spouse dies without using up all of their exemption amount, the unused amount can, if an election is made, be used by the surviving spouse upon their death. The election must be made on a timely filed federal estate tax return for the first deceased spouse.
In August of this year, the treasury department issued proposed regulations which, if finalized, will significantly reduce the ability to apply lack of marketability and control discounts to the value of interests in businesses. If you are thinking of gifting an interest in a business that might qualify for such discounts, you might want to act quickly. Of course it’s possible that the rules will be changed or delayed indefinitely by the new administration.
Other notable information
- New filing deadlines for W-2s and 1099’s take effect in January – Previously, employers and payors were required to provide W-2s and 1099’s to recipients by January 31st but could file the forms with the social security administration and the IRS as late as March 31st. Effective for 2016 reporting forms filed in 2017, the due date for the government fillings is January 31st.
- New due dates for certain types of returns – Effective for tax years beginning after 12/31/15, partnership returns are due the 15th day of the third month after year end, C corporation returns are due the 15th day of the fourth month after year end, and foreign bank account (FBAR) returns have a due date that coincides with individual income tax returns. An unusual exception exists for C corporations with a June 30 year end delaying the new due date until after December 31, 2025. These returns will still be due the 15th day of the 9th month until then.
What changes is the new administration likely to bring?
It’s hard to say what changes will actually make it through both houses of congress but here’s a quick laundry list of what the Trump administration is focused on. A reduction in corporate tax rates; a reduction in the top individual tax rate by 6.6% to 33%; an increase in the standard deduction to $30,000 for individuals filing jointly and $15,000 for single filers; imposition of a cap on total itemized deductions; elimination of the head of household filing status; reduction of the tax rate applicable to business income (including that from pass-thru entities) to 15%; repeal of AMT; repeal of the estate tax (but not necessarily the gift tax); and repeal of the affordable care act (or provisions thereof) including the 3.8% net investment income tax.
Given the fact that Trump pledged not to add to the deficit or national debt, it’s hard to imagine how many of the above provisions could be implemented. One thing’s for sure – it’s bound to be a wild ride.
We hope the year has been happy and prosperous for your family and loved ones. We are grateful for our client and business relationships and hope we can meet your expectations and give you the service and attention you deserve.
Zirkle, Long & Associates, LLC