Planning for Rising Income Taxes by Accelerating Income

Benjamin Franklin once said, "In this world nothing can be said to be certain, except death and taxes." Post-election, it now appears that rising income tax is now going to be a certainty.

Although we do not know whether Congress will extend the Bush-era tax cuts, who will be affected, for how long, and when any changes might go into effect, we do know the planned rate increases that will go into effect short of any action by Congress.   The long-term capital gain rate is currently scheduled to increase in 2013 to 20% from 15%. The maximum dividends and ordinary income tax rates are increasing to 39.6%, from 15% and 35%, respectively. The 2% exemption on the employee portion of payroll taxes will also expire at the end of the year for those with wage income.  Additionally, The Patient Protection and Affordable Care Act (also known as Obamacare) which adds a 0.9% tax on earned income and a 3.8% surtax on investment income goes into effect on January 1, 2013. So, even if the Bush-era tax cuts are temporarily extended, a capital gain of $100,000 realized in January, 2013 will result in a $3,800 increase in tax. If the rates increase as currently scheduled, an $8,800 increase in tax actually occurs.

In most recent years, it was generally advised to defer income and accelerate deductions while considering adverse forces such as the alternative minimum tax (AMT) and/or phase-outs of certain itemized deductions. Contrary to that axiom, the principal focus of this article is dealing with the real possibility of increasing personal income tax rates and the attempt to answer the question of how one actually accelerates taxable income into a particular year and save future taxes.

One way to accomplish this goal is to exercise stock options or sell appreciated property before year-end, recognize the built-in gain, and step-up the tax basis by repurchasing the property.  Unlike assets with losses, selling at a profit to relatives or a related company to recognize gain is not prohibited.  The wash sale rules also do not apply. For example, if you anticipate selling an asset with a $2,000,000 gain in January and the capital gains are subject to a total tax rate of 23.8%, you may have been able to sell it in December when the capital gains rate is only 15%, producing a tax savings of $176,000. If you are not certain when you might actually sell the asset in the near term, consider utilizing an installment sale to a related party.

Cash basis taxpayers can accelerate income through advancing collections. The key is not when to send the bill, but whether you can actually receive payment before year-end. Sending the bill earlier is probably just good business practice. However, you may even consider giving small discounts for pre-year-end accelerated payments. Also consider settling any open lawsuits or insurance claims that could generate taxable income.

The ability to defer losses and deductions can normally be just as beneficial in a rising tax-rate environment as accelerating income. Payments can easily be deferred until the following year for items such as real estate taxes, interest expenses, charitable contributions, medical and dental expenses, or even year-end bonus payments to employees. Proper timing adjustments of even one day can make a sizable difference in the tax benefit. You can also make certain elections to max out or defer an investment interest expense. However, you must keep an eye on Congress regarding the possibility of placing hard caps or increasing the phase-outs on certain or all itemized deductions, as discussed during the campaign season, which would potentially impact the proper decision to defer those deductions. 

For business owners, consider utilizing basis and at-risk limitations on pass-through entities to defer loss recognition until future years through suitable timing of intercompany loans and capital contributions. If the tax rate on dividends significantly increases, a leveraged capitalization could allow you to borrow money for a quick distribution of cash of corporate earnings and profits just before year-end.   Another method to minimize the negative effect of increasing tax rates on dividends is to consider distributing appreciated property instead of cash. If you are selling your business, consider electing out of installment sale treatment when either a note is utilized or earn-outs exist, thus locking in a lower tax rate by accelerating gain recognition. 

Largely bantered about over the last couple of years is the new ability for higher income taxpayers to accelerate income and to never pay income taxes again on the appreciating property in their Individual Retirement Account (IRA) by converting it to a Roth IRA. Other Roth IRA advantages include no mandatory distribution requirement and tax-exempt income to heirs on future distributions from inherited IRAs.

In summary, many variables have to be considered when planning for an increasing income tax rate environment. Although effective planning techniques exist, the current federal tax code is extremely complex and likely to change. Further, the interaction of diverse state tax laws along with the hidden traps of the AMT and phase-out of itemized deductions must be taken into account. Since there is an economic cost of accelerating taxes, sufficient modeling and scenario analysis should be a fundamental part of the planning process.