- December 6, 2010
It is advisable in any year to take stock and consider tax planning before the year draws to an end. In 2010, in particular, Congress’ continuing failure to resolve the current uncertainties surrounding the “Bush tax cuts” has created a profound dilemma for both individuals and businesses looking to optimize tax planning before year end. Some of the key issues and strategies to be aware of prior to the close of the 2010 year-end window of opportunity are discussed below.
1. The Bush Tax Cuts. As most everyone is aware, the 2010 tax rate applicable to both capital gains and dividend income is 15%. In the event the Bush tax cuts expire at year-end, the 2011 capital gains rate will rise to 20% and dividend income will be taxed as ordinary income with rates as high as 39.6%. The potential expiration of the Bush tax cuts has left many taxpayers and their advisors in a quandary regarding whether to accelerate or defer proposed property sales and recognition of income and expense.
As this issue of the newsletter goes to press, it is not certain whether the Bush tax cuts will be extended. It also is not clear whether, given an extension, such an extension will be temporary or permanent, and whether the ceiling above which the cuts will be made ineffective will be $250,000 (as currently proposed) or $1 million (as has been recently proposed as an alternative). The most widely believed view at the moment is that the Bush tax cuts will be extended for all taxpayers for at least 2011.
2. Dividend Planning. In the event that the Bush tax cuts are not extended, as mentioned above, the highest tax rate applicable to dividend income will increase from 15% to 39.6%. Therefore, for corporations with available earnings and profits, it would be prudent to begin contingency planning for special dividends or increasing planned dividends before year end. Liquidity concerns may be mitigated with a debt-financed distribution or a distribution of a note where applicable.
Although the Bush tax cuts may in fact be extended before the end of the year, it is important to ensure that the proper corporate law actions and financing are in place to allow for any year-end dividends if necessary. Moreover, in the absence of new legislation, starting in 2011 qualification of corporate redemptions by closely-held corporations as capital gains rather than as dividends (already important to avoid deemed dividends to non-redeeming shareholders) will have increased importance (as such redemptions will be subject to tax at a maximum capital gains rate of 20% rather than the 39.6% applicable to dividends).
3. S Corporation Planning. In the absence of legislation extending the Bush tax cuts, traditional tax planning for S corporations — accelerating deductions and deferring income — may be reversed in 2010. In general, accelerating income and deferring deductions (other than itemized deductions) this year may be advantageous for S corporation shareholders. In addition, S corporations with subchapter C earnings and profits may wish to elect, with the consent of all affected shareholders, to have 2010 distributions made first from subchapter C earnings rather than from the accumulated adjustments account. This election will apply to all distributions in 2010 and will cause these distributions to be taxable to shareholders as dividends to the extent of subchapter C earnings and profits at a 15% tax rate. If the Bush tax cuts are not extended, S corporations should consider distributing all subchapter C earnings prior to year-end in order to pre-pay the corresponding tax at 15%. The distributed earnings can be recontributed to capital with a corresponding increase in basis. The increase in basis will prevent such amounts from being taxed in the future upon distribution. In short, S corporations and their shareholders should already be working closely with their respective accountants to determine whether additional distributions should be made during 2010 to take advantage of the current rate of tax on dividends.
4. Small Business Jobs Act of 2010. The Small Business Jobs Act of 2010 (the “Jobs Act”) was signed into law by the President on September 27, 2010. Note that several of these changes are particularly important for tax planning this year and next because the changes are only applicable to the 2010 and/or 2011 tax years as indicated below. The Jobs Act includes the following provisions, among others:
A. 100% Exclusion of Gain from Sale of Small Business Stock — 2010. Non-corporate taxpayers can generally exclude up to 50% (and, in certain circumstances, up to 60%) of the gain realized on the sale of qualified small business stock that the taxpayer has held for more than five years. Qualified small business stock generally includes stock of a C corporation that: (a) has gross assets that do not exceed $50 million; (b) was engaged in an active trade or business during the taxpayer’s holding period; and (c) was acquired at its original issue. Prior to the Jobs Act, the American Recovery and Reinvestment Act of 2009 (the “Recovery Act”) increased the exclusion from 50% to 75% for stock acquired between February 17, 2009 and January 1, 2011. The Jobs Act increases the exclusion to 100% for qualified small business stock acquired after September 27, 2010 and before January 1, 2011.
B. Reductions of S Corporation Holding Period for Built-In Gains Tax — 2011. If a C corporation elects to convert to S corporation status, the S corporation will be taxed at the highest corporate rate (currently 35%) on the built-in gains of the corporation that existed at the time of the conversion if such gains are recognized by the S corporation during the 10-year period following the conversion. The Recovery Act reduced the 10-year recognition period to 7 years if the recognition event occurs in 2009 or 2010. The Jobs Act further reduces the 10-year recognition period to 5 years if the recognition event occurs in 2011 (i.e., if the conversion occurred prior to January 1, 2006, then the S corporation may recognize the built-in gain in 2011 without incurring the 35% corporate level tax).
C. Section 179 Expensing. Generally, businesses recover the costs of certain capital expenses over time through depreciation. In order to help small businesses quickly recover the cost of certain capital expenses, the Jobs Act allows small business owners to write off the cost of these expenses in the year of acquisition Under prior law, taxpayers could expense up to $250,000 of qualifying property — generally, machinery, equipment and certain software — placed in service in tax years beginning in 2010. This annual expensing limit was reduced (but not below zero) by the amount by which the cost of qualifying property placed in service in tax years beginning in 2010 exceeded $800,000. Under the Jobs Act, for tax years beginning in 2010 and 2011, the $250,000 limit is increased to $500,000 and the $800,000 limit to $2,000,000.
D. Extension of 50% bonus first-year depreciation. Businesses are allowed to deduct the cost of capital expenditures over time based on depreciation schedules. In previous legislation, businesses were allowed to deduct more rapidly capital expenditures of most new tangible personal property, and certain other new property, placed in service in 2008 or 2009 (2010 for certain property), by permitting the first-year write-off of 50% of the cost. The Jobs Act extends the first-year 50% write-off to apply to qualifying property placed in service in 2010 (2011 for certain other property).
E. Carryback period of general business credits for 5 years. Generally, a business’s unused general business credits can be carried back to offset taxes paid in the previous year, and the remaining amount can be carried forward for 20 years to offset future tax liabilities. Under the Jobs Act, for the first tax year of the taxpayer beginning in 2010, eligible small businesses can carry back unused general business credits for five years. Eligible small businesses consist of sole proprietorships, partnerships and non-publicly traded corporations with $50 million or less in average annual gross receipts for the prior three years.
F. Increased deduction for start-up expenditures. The Jobs Act allows a new business to deduct start-up expenditures of up to $10,000 in 2010 ($5,000 under prior law). The $10,000 figure is reduced by the excess of the total start-up costs over $60,000 ($50,000 under prior law).
G. Temporary Deduction for Healthcare Costs for Self-Employment Tax Purposes — 2010. A taxpayer is generally permitted to reduce her taxable income by the amount paid for health insurance for the taxpayer and the taxpayer’s (a) spouse, (b) dependants, and (c) children under the age of 27. Normally, self-employed taxpayers are not allowed to take this deduction when determining how much of their income is subject to self-employment tax. However, the Jobs Act provides that health insurance costs are deductible for self-employment tax purposes during 2010.
5. IRA Suspension Rules. In general, required minimum distributions (“RMDs”) from IRAs must begin in the year you attain age 70½ (with the exception that the first year’s payout may be deferred until the following April). For 2009, RMDs from retirement plans and IRAs were suspended. This did not impact someone who turned 70½ in 2008 and chose to wait until April 1, 2009 to get their first RMD — they still had to take that RMDin 2009; they just did not have to take a second one (the normal 2009 RMD) in 2009.
For 2010, the suspension of the rules governing RMDs has been lifted. All RMDs must be taken following the usual timetable. For individuals turning 70½ in 2010, you have until April 1, 2011 to take your first mandatory withdrawal.
6. Planning for Increased Form 1099 Reporting in 2012. The Patient Protection and Affordable Care Act (The “Health Care Act”) expanded the scope of Form 1099 reporting such that Form 1099 reporting is now required for most payments of $600 or more, including purchases of property, to payees (now including corporations). As a result, taxpayers will need to provide Forms 1099 to the IRS and to each corporate provider of property or services of $600 or more. Further, this vast expansion of information reporting responsibilities also increases the potential liability for backup withholding if TINs are not properly collected prior to the time of payment from payees who were previously exempt from information reporting. Although there are legislative proposals to repeal or modify the expanded Form 1099 reporting and the proposal does not take effect until 2012, it is important for all business owners to evaluate and modify their internal systems, procedures and processes so that they can timely comply with the new law if necessary.
7. Proposed Regulation for the Tax Treatment of Series LLCs. On September 14, 2010, the Internal Revenue Service (“IRS”) formally published in the Federal Register its proposed regulation regarding the classification for Federal tax purposes of series limited liability companies (“series organizations”) and each underlying series of a series organization (a “series”). The proposed regulation will be finalized following the IRS’s review of public comments submitted in response to questions raised in the proposed regulations. It is not likely that the final regulation will modify the proposed regulation in any material respect.
In general, under the proposed regulation the IRS has decided to establish a bright line methodology that each series files as a separate entity in order to avoid implementing a facts and circumstances approach that would have required taxpayers to look to state law and terms of the applicable operating agreement to elect between a separate entity or single entity approach.
The proposed regulation specifically defines a series organization as a “[legal] entity that establishes and maintains, or under which is established and maintained, a series.” A “series” is defined as a “segregated group of assets and liabilities that is established pursuant to a series statute by agreement of a series organization.”
8. “Protective” Disclosures for Year-End Transactions In Light of Codification of the Economic Substance Doctrine. The Health Care Act codified the economic substance doctrine and introduced a 20% strict liability penalty for underpayments attributable to a transaction that is determined to lack economic substance. Importantly, this penalty is increased to 40% if the taxpayer does not disclose the transaction in its return. While disclosure is not required until the return is filed, taxpayers should consider whether “protective” disclosure of any year-end transactions would be prudent in order to avoid the increased 40% penalty. Furthermore, if they have not done so already, taxpayers should be certain to discuss with their accountants whether procedures and processes to ensure that such “protective” disclosures are considered with respect to all transactions on a going-forward basis.
9. 2010 Tax Legislation Affecting Future Tax Years.
A. The Health Care Act of 2010 Medicare tax increase. Beginning in 2013, the Health Care Art imposes an additional 0.9% Medicare Hospital Insurance (HI) tax on self-employed individuals and employees with respect to earnings and wages received during the year above specified thresholds. This additional tax applies to earnings of self-employed individuals or wages of an employee received in excess of $200,000. If an individual or employee files a joint return, then the tax applies to all earnings and wages in excess of $250,000 on that return.
B. Unearned income Medicare contribution. Beginning in 2013, the Health Care Act imposes a 3.8% unearned income Medicare contribution levied on “unearned” income, including income from interest, dividends, capital gains (including otherwise taxable gain on the sale of a personal residence), annuities, royalties, and rents. Excluded income includes distributions from qualified plans and income that is derived in the ordinary course of a trade or business and not treated as a passive activity. The tax is applied against the lesser of the taxpayer’s net investment income or modified adjusted gross income (AGI) in excess of the threshold amounts. These thresholds are set at $200,000 for single filers and $250,000 for joint filers. For estates and trusts, the tax applies on the lesser of the undistributed net investment income or the excess of AGI over the dollar amounts at which the 39.6% tax bracket for estates and trusts begins.
C. Limit on health flexible spending arrangements. Beginning with years after 2012, the Health Care Act imposes a limit of $2,500 per taxable year on employee salary reductions for coverage under a cafeteria plan FSA. The limit, which does not apply to health reimbursement arrangements, is indexed for inflation after 2013. If a cafeteria plan does not contain the required limitation, then benefits from the FSA will not be qualified benefits.
D. Itemized deduction for medical expenses. The Health Care Act increases the threshold for claiming an itemized deduction for unreimbursed medical expenses for regular tax purposes from 7.5% of the taxpayer’s AGI to 10%. The Health Care Act does not change the current-law 10% of AGI threshold that applies under the AMT. The change generally applies for taxable years beginning after December 31, 2012. For any taxpayer who is age 65 and older or whose spouse is 65 or older, the threshold for regular tax purposes remains at 7.5% until 2017.
Given the change in leadership in Congress following the November elections, it is not clear whether some or all of the tax changes enacted as part of the Health Care Act will be modified or eliminated. While it seems a certainty that the new rules governing 1099 reporting will be modified given the onerous impact such rules will have on small businesses, it is not as clear whether other portions of the Health Care Act will likewise be modified.
Please give Julia Turk 312/840-7033, Greg Winters 312/840-7059 or Rich Lieberman 312/840-7011 a call to discuss these and the many other tax changes enacted during 2010.