The objective of tax planning is to minimize one’s tax liability. Early planning can aid tax avoidance by paying only what one is required to pay and nothing more. One of the most widely used tools in planning is deferral of revenue and acceleration of expenses.
Generally, tax planning is performed towards the end of the year when there is more predictability of what the year’s end results will be. The year 2012 may be a crucial year in which to conduct planning for future years due to the possibility of tax rate hikes and the expiration of various deductions and credits.
Consider the impact of the following changes:
• Expiration of Bush-era tax cuts, resulting in higher tax rates for most individual taxpayers (between 3 to 5 percent)
• Higher tax rates on long-term capital gains (between 5 to 15 percent)
• Expiration of the payroll tax holiday on wages and self-employment income (increase in tax on qualifying income of 2 percent)
• New Medicare tax on higher-income employee wages and self-employment income (additional 0.9 percent)
• New surtax on investment income of higher-income taxpayers (3.8 percent)
• Application of estate and gift taxes to more taxpayers (estate and gift exemption drops from $5 million to $1 million) and at higher tax rates (increases from 35 to 55 percent)
• Severe cutbacks in the amount of business equipment that can be expensed in a year
The lame duck Congress goes back into session mid-month and tax matters are but one important issue it is under pressure to address before adjourning. It is unknown what Congress and the President will come to agree on and pass, if anything.
Tax Planning for Business
Timing of expense payments and income recognition
When a business operates on the cash basis, expenses and revenues are usually recognized for tax purposes when cash is paid or received versus when expenses are incurred or revenue is earned (accrual basis). A cash basis taxpayer has some additional control over its taxable income through the timing of when it pays bills or collects for its services.
Usually a cash basis taxpayer will try to decrease current year income. However, if individual tax rates increase next year, the opposite would hold true, as pass-through entities could save tax by accelerating income to be taxed at more favorable 2013 rates. Note that pass-through entities do not pay tax at the corporate level as net income is passed through to the individual members and taxed at their respective individual rates. As of now, if Congress is able to act at all, it may extend current tax rates for some or all taxpayers, but a decrease in rates for 2013 is highly unlikely.
Make contributions to a qualifying retirement plan
Qualifying business retirement plans have higher contribution limits than IRAs. Through contributing to traditional qualifying plans, business owners and employees can defer more income tax and have larger amounts grow tax-free until withdrawn.
Accelerated depreciation for equipment purchases
Taxpayer-friendly rules governing accelerated rates of depreciation are scheduled to decrease significantly after this year. For 2012, Section 179 expensing is available for up to $139,000 for new and used items placed in service during 2012. This expense may not be available to businesses with a current year loss and begins to phase out when total additions exceed $560,000.
In situations where Section 179 expensing is limited, one may qualify for Section 168 50 percent bonus first year depreciation for assets bought new and placed in service during 2012. Unlike the Section 179 deduction, there are no restrictions on the amount of qualifying property nor is there a taxable income limitation. However, bonus depreciation rules only apply to the purchase of new equipment, not used. Unless Congress acts to extend the bonus depreciation, it will not be available for 2013 and Section 179 expense will be scaled back to $25,000 and become limited when total additions exceed $200,000.
Tax Planning for Individuals
Individual taxpayers should be aware that most of the scheduled tax changes apply to them.
Plan for changes in tax rates
The expected tax rate increase on ordinary income and capital gains encourage recognition of income in 2012 and deferral of deductions to 2013. The maximum capital gains tax rate is scheduled to increase from 15 percent to 20 percent.
Make taxable gifts in 2012
Currently in place is a $13,000 annual exemption on gifts one can make to reduce one’s taxable estate without triggering a tax filing requirement. In 2012, there is a unique opportunity to move investments, real estate, or business holdings to the next generation tax-free. For this year only, you may make gifts of up to $5,120,000 in excess of the annual exemption without incurring gift tax. That amount, as well as the estate tax exemption, is scheduled to decrease to $1,000,000 in 2013.
As with most things tax-related, even exceptions to the rules have exceptions. It is very important to consult your qualified tax professional to see if any of these tax saving strategies apply to your own unique tax situation.