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Year-End Income Tax
Planning For The 1%
Opportunities & Traps
The University of Alabama –
66th Federal Tax Clinic
Mark D. Puckett, CPA, MST
Tax Partner
BDO USA, LLP
Memphis, Tennessee
November 16, 2012
901-680-7608
The Agenda
• Introduction & Overview
• Current income tax landscape
• Specific tax planning ideas & opportunities
• Traps & pitfalls for our clients and us
Page 3
Introduction & Overview
Page 4
Who Are The 1%?
• Adjusted gross income of $343,927 or more
• 1.4 million taxpayers
• Earned 16.9% of all U.S. taxable income
• Paid 37% of all U.S. individual income taxes
IRS Income Statistics - 2009
Page 5
Our Goal
Tax planning is not the ultimate
goal – growing our clients’ net
worth over time is.
Page 6
Growing our Client’s net worth over time requires
us to focus on four fundamental objectives when
we formulate a tax plan.
I call it the “four things” you can do with a
potential tax liability:
•Eliminate it
•Defer it
•Convert it
•Pay it
Page 7
Our Goal (cont.)
Current Income Tax Landscape
Page 8
Increasing Complexity
The law = words in the Internal Revenue Code
Year No. of Words
1995 700,000 2
2001 1,395,000 1
2005 2,100,000 2
2007 3,700,000 3
2012 4,500,000 4
1Joint Committee on taxation study 2Tax Foundation, Dec. 2005 report 3Librarian – IRS Office of Chief Counsel 4Educated guess
Page 9
Tax Compliance “Outsourcing” From
The IRS And States To Tax Professionals
• More questions (e.g., Form 990)
• More detailed forms (e.g., Schedule D)
• More information (e.g., Form 1120 –
Schedule UTP)
• More penalties (e.g., Foreign account
reporting, Form 5471, etc.)
• Tax preparer registration – PTIN program
Page 10
The Challenge As complexity grows to an unprecedented level and with
changes coming at us at an increasingly rapid rate – we must
be:
• Better communicators
• Better at identifying issues (this is KEY!!!)
• Better at accessing resources to do our jobs
• Maintaining a trained staff
• Having a cadre of experts to call
• Employing state of the art technologies
Page 11
Specific Tax Planning
Ideas & Opportunities
Page 12
Top Individual
Income Tax Rates
Earned Capital
Income Gains Dividends
2012 Top Rate 35% 15% 15%
2013 Top Rate 39.6% 20% 39.6%
Medicare Surtax 0.9% 3.8% 3.8%
2013 Combined Rate 40.5% 23.8% 43.4%
(Assumes expiration of 2001/2003 tax cuts after 2012)
Page 13
Medicare Surtax
The 2010 Health Care Act added:
• A new 3.8% Medicare tax on net investment
income of individuals, estates and trusts
• An additional 0.9% Medicare tax on wages and
self-employment income over threshold
amounts
Effective: Tax years beginning after
December 31, 2012
Page 14
The 3.8% Medicare Tax
Applies to the lesser of:
• “Net investment income,” or
• The excess (if any) of “modified adjusted gross
income” over the “threshold amount”
Page 15
Net Investment Income
Equals the sum of gross investment income over allocable
investment deductions
Investment income includes non-trade or business:
• Interest
• Dividends
• Annuities
• Royalties
• Capital gains
• Passive activity income
Page 16
Net Investment Income (cont.)
Investment income does not include:
• Active trade or business income
• IRA or other qualified retirement plan
distributions
• Wages or self-employment income (taken into
account for 0.9% Medicare tax)
Page 17
Modified Adjusted Gross Income
(MAGI)
MAGI equals:
• Adjusted Gross Income, plus
• Net foreign income excluded under § 911(a)(1)
Page 18
The “Threshold Amount”
The “threshold amount” subtracted from MAGI is:
• Married filing jointly - $250,000
• Married filing separately - $125,000
• All others - $200,000
• Trusts and estates - $11,650 (top bracket in
2012)
Page 19
Wages & Self-Employment Income
An additional 0.9% Medicare Tax on wages and
self-employment income applies to income that
exceeds:
• Married filing jointly - $250,000
• Married filing separately - $125,000
• All others - $200,000
Page 20
Planning Considerations
If tax rates are set to increase in 2013 :
• Consider accelerating income and gains into
2012
• Consider postponing deductions and losses into
2013
This to take advantage of tax rate “arbitrage”
Page 21
Example – Harvesting Capital Gains
Sell and repurchase long-term capital gain property in
2012
Assume $2,000,000 of securities with a basis of
$1,000,000 are sold in 2012 versus 2013:
2013 sale taxed at 25% 250,000
2012 sale taxed at 15% 150,000
Potential 40% tax “arbitrage” (67% ROI) 100,000
(2013 tax rate of 20% plus 3.8% Medicare tax plus
estimated loss of deductions due to phase-out)
Page 22
Gain Harvesting Considerations
• ROI on tax “investment” is high if a short-
term investment horizon
• Makes sense for taxpayers in a 0% capital
gains bracket in 2012
• Fluctuating market values can skew results
• Assets held at death get a stepped-up basis
• Long-term gains can be permanently
avoided if donated rather than sold
Page 23
Harvesting Losses
• Losses may be better used to offset gains in
later years when capital gains tax rates are
higher
Page 24
Loss Harvesting Considerations
• Watch out for the wash sale rule (§ 1091 “30
day rule”)
• Use long-term losses to offset short-term
gains
• Avoid using short-term losses to offset long-
term gains
Page 25
Ordinary Income Considerations
Unless a lower tax bracket is anticipated for 2013 –
consider:
• Conversion to a ROTH IRA
• Take income from traditional IRAs, retirement plans or
annuities (caution if under age 59½)
• Recognize interest income by selling bonds with
accrued taxable interest
• Accelerate bonus payments into 2012
• Exercise non-qualified stock options that are close to
expiration
Page 26
Planning for Estates
• Elect a fiscal year that ends before December
2012 for a 2012 decedent’s estate
• The 3.8% Medicare tax on investment income
applies to taxable years beginning after
December 31, 2012
• For example: by adopting a November, 2012
year-end the surtax is avoided for 11 months in
2013
Page 27
Strategies for 2013
• Reduce MAGI
• Reduce net investment income:
• Tax exempt interest
• Tax deferred annuities
• Life insurance inside build-up
• Low dividend paying stocks
• Rental real estate (depreciation deductions)
• Energy related investments (depletion and IDC)
Page 28
“It’s not the will to win that
matters – everyone has that. It’s
the will to prepare to win that
matters.” Paul “Bear” Bryant
Blocking & Tackling
(in the income tax planning sense)
“Work that is not glamorous but necessary”
- John Caddell (Marketing & Information expert)
• Effective blocking & tackling is covering the basics well
(always pick the “low hanging fruit”)
• The vast majority of opportunities are found in basic tax
planning techniques
• Given your knowledge of the client and the circumstances –
what are the available opportunities?
Page 30
Blocking & Tackling “Misses”
•Donating cash vs appreciated capital assets (Warren
Buffett knows this)
•Failure to maximize contributions to qualified plans
(or not having in place the most effective plan type)
•Failure to harvest capital losses in high gain years
•Failure to establish adequate basis to claim losses
from pass-through entities
•Ineffective tax strategy for qualified plan
investments
Page 31
Review
The four things that can be done with a tax – you
can:
•Eliminate it
•Defer it
•Convert it
•Pay it
Page 32
Elimination Strategies
Elimination Strategies (permanent tax savings)
examples:
•Estate planning (“paying estate taxes is
optional”)
•Tax exempt income
•Tax credits
•Holding appreciated assets until death
•Charitable giving techniques
Page 33
Elimination Strategies (cont.)
More examples:
•Effectively supporting compensation deductions
to shareholder - employees
•Planning with insurance
•Exclusion of income from discharge of
indebtedness
•Not wasting deductions
Page 34
Not Wasting Deductions
•Accelerate income (e.g. ROTH conversion) to
avoid wasting tax deductions:
• Large medical deductions
• Expiring charitable contributions
• Large itemized deductions
Page 35
Not Wasting Deductions (cont.)
•AMT planning – run the numbers to highlight
“wasted deductions” – examples:
• Consider capitalizing real estate taxes and carrying
charges on land (§266 election)
• Postpone payment of taxes until a later year to
reduce AMT
• Disallowed depreciation on aircraft due to use
by “specified individuals” (§274 (e)(2)(B)) does
not reduce taxable basis (Reg. §1.274-
10(f)(1)(i))
Page 36
Deferral Strategies
Deferral Strategies (deferral of income and/or
acceleration of deductions)
Income deferral examples:
• Use of qualified and non-qualified deferred
compensation plans
• Secondary valuation benefit in a closely-held
corporation due to deferred compensation liability
• Deferred exchanges, casualty loss reinvestments,
etc.
Page 37
Deferral Strategies (cont.)
• Installment sales
• Utilize most advantageous accounting methods –
cash method of accounting, advance payment
deferral, non-accrual experience method
• ESOP – sale of stock to an ESOP with a reinvestment
in qualified replacement securities (§1042)
Deduction acceleration examples:
• Depreciation planning –effective use of bonus, §179,
expense versus capitalization determinations
• Avoid “at-risk” traps and basis inadequacy
Page 38
Deferral Strategies (cont.)
• Utilize most advantageous accounting methods –
LIFO, 12-month rule, passive activity groupings, real
estate professional election, etc.
• Charitable planning – use of “donor advised funds” to
bunch charitable deductions
• Triggering short-term capital gains to generate
investment income to enable the deduction of
investment interest expense (electing to use long-
term gains-costly-but less so in 2013)
Page 39
Conversion Strategies
Strategy involves paying tax now or in the future
but at a lower tax rate
• Real estate – ordinary deductions now, capital gain
upon sale
• Carried interest for partnerships
• Avoiding “dealer” status on investment real estate
• Shareholder loans to enable the taking of losses in an
S Corporation – use notes to ensure capital gain upon
repayment
• Take advantage of family members in lower tax
brackets
Page 40
Payment Strategies
Payment strategies involve the payment of taxes
in the most cash flow efficient manner
• Extension of time for payment of estate taxes
(§6166)
• Annualization of income versus “safe estimate”
• Use of withholding versus quarterly estimates
• Effective selection of fiscal year for estates
• Corporations can adopt “non-standard”
annualization periods by electing on Form 8842
Page 41
Traps & Pitfalls for Our Clients & Us
Page 42
Offshore Accounts
• “FBAR” reporting requirement – Form T.D. F. 90-22.1
(Report of Foreign Bank and Financial Accounts)
• Required to be filed by a U.S. person with a financial
interest or signature authority over a foreign
financial account
• Required if the value of such financial account
exceeds $10,000 at any time during the calendar
year
Page 43
Offshore Accounts (cont.)
• Willful failure to file a report can result in severe
civil penalties or criminal prosecution
• In 2012, the IRS reopened the Offshore Voluntary
Disclosure Program (OVDP) – opened indefinitely
until otherwise announced
Page 44
Charitable Contributions
Recent Cases:
• Durden v. Commissioner, T.C. Memo 2012-140,
(May 17, 2012)
• Mohamed, Sr. v. Commissioner, T.C. Memo 2012-
152, (May 29, 2012)
• Upen G. Patel, et ux. v. Commissioner, 138 T.C.
No. 23, (June 27, 2012)
• Avery T. v. Commissioner, T.C. Memo 2012-198,
(July 16, 2012)
• Trout Ranch LLC v. Commissioner, 110 AFTR 2d
2012-5621, (August 16, 2012)
Page 45
Documentation of Charitable
Contributions
Americans gave away $291 billion to charity in 2010 (1)
A taxpayer making a contribution in excess of $250 must
receive a “contemporaneous written acknowledgement” of
the contribution by the donee organization that must state
(§170(f)(8)):
• The amount of cash and a description (but not value) of any
property other than cash contributed
• Whether the donee organization provided any goods or
services in consideration, in whole or in part, for the property
contributed (1) According to Giving USA 2011 Annual Report on Philanthropy
Page 46
Unreasonably Low Wages to S Corp
Shareholder - Employees
The Service was successful in recharacterizing a
portion of S Corporation distributions as wages
subject to FICA taxes
David E. Watson, P.C. v. United States, 668 F. 3d 1008
(8th Cir. 2012)
Page 47
§183 Hobby Losses
Leon Solomon Verrett III and Charlotte I. Verrett
v. Commissioner, T.C. Memo 2012-223 (August 2,
2012)
Court referred to 9 “nonexclusive” factors set
forth in Reg. §1.183-2(b)
Page 48
§183 Hobby Losses (cont.)
9 Factors:
•Manner in which the taxpayer conducts the
activity
•The expertise of the taxpayer or advisors
•The taxpayer’s time and effort in the activity
•Expectation that property used in the activity
may appreciate
•Taxpayer’s success in other similar activities
Page 49
§183 Hobby Losses (cont.)
9 Factors (cont.):
•History of income or losses
•Amount of occasional profits
•Financial status of the taxpayer
•Elements of personal pleasure or recreation
Page 50
Service as a Director
Hazards of Being a Volunteer…
Volunteer director of a non-profit organization
held liable for unpaid federal employment taxes
Bunch v. Commissioner, 109 AFTR 2d 2012-1335
(March 8, 2012)
Page 51
Service as a Fiduciary
Fiduciaries held liable for unpaid estate taxes
U.S. v. Johnson, 109 AFTR 2d 2012-2253 (May 23,
2012)
Fiduciaries held liable for unpaid gift taxes
U.S. v. MacIntyre, et al., 110 AFTR 2d 2012-5151
(June 25, 2012)
Page 52
§6662 Accuracy-Related Penalties
If no substantial authority or disclosure of a
material return position, the taxpayer’s efforts to
properly determine the tax liability is key to
avoiding a penalty
Seven W. Enterprises, Inc., 136 T.C. 539(2011)
McGowen, T.C. Memo 2011-186
Campbell, 658 F.3d 1255 (11th Cir. 2011)
Fuhrman, T.C. Memo 2011-236
Page 53
Preparer Error
Where a preparer’s efforts are limited to tax
preparation and do not rise to professional advice
on a material item, such efforts may not shield a
client from an accuracy-related penalty if
imposed.
Woodsum, 136 T.C. 585 (2011)
Page 54
Page 55
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member firms.
BDO is the brand name for the BDO network and for each of the BDO Member Firms.
To ensure compliance with Treasury Department regulations, we wish to inform you that, unless expressly stated otherwise
in this communication (including any attachments) any tax advice that may be contained in this communication is not
intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax-related penalties under the Internal
Revenue Code or applicable state or local tax law provisions or (ii) promoting, marketing or recommending to another party
any tax-related matters addressed herein.
