Year-End Tax Planning
Year-End Tax Planning as Influenced by the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010
It is late. I shall be brief. Because of the brevity of the explanation which follows, please call my office if you have questions about these opportunities or wish to discuss them further to determine how they may benefit you, your family, and your tax planning.
But first, why is it late? It is late because the United States Congress decided on December 16, 2010 what US income, gift, estate, and generation tax rates would be in 2011 and 2012. This shortens the window for year-end tax planning. Consequently, instead of the usual litany of year-end planning maneuvers designed to shift income into next year and accelerate deductions into this year, this message focuses on three planning opportunities that disappear on January 1.
If you are contemplating a Roth conversion do it in 2010. Roth conversions can be done in 2010 or 2011 (or even after 2011). However, the advantage to converting traditional IRAs to Roth IRAs in 2010 is that the income resulting from the Roth conversion will be taxed in equal amounts over the next two years. This happens automatically. No election is necessary. (Although by election the entire amount of the income can be taxed in 2010.) Not only is the income deferred, but it is spread over two years. For most taxpayers this will reduce the rate at which the income is taxed. You can still convert your traditional IRA to a Roth IRA in 2011. However, the income from the conversion will be recognized in 2011. Now that Congress has confirmed that income tax rates are not increasing in 2011 and 2012 and the suspension of the phase out of itemized deductions and personal exemptions will also be extended for another two years, conversion in 2010 is the correct choice for most taxpayers.
Take advantage of the temporary repeal of the generation-skipping transfer tax in 2010. As a result of the 2010 tax legislation, estate and generation-skipping transfer taxes return for decedents dying and transfers made after 2010. There are, however, two opportunities to take advantage of the temporary repeal of the generation-skipping transfer tax which do not require dying in 2010.
First, make a generation-skipping transfer in 2010. This is done by either a direct gift to grandchildren or more remote descendants or by making a gift to a trust which benefits grandchildren or more remote descendants. For gifts made in 2010, there is a one million dollar per transfer or lifetime gift tax exemption. (There is also a thirteen thousand dollar per transferee annual exclusion.) Thus, a grandparent who has not previously taken advantage of her million dollar gift tax exemption and not otherwise made gifts to her grandchildren in 2010 could transfer thirteen thousand dollars in cash or other assets to each grandchild or great grandchild and spread an additional one million dollars in cash or other assets among them. No gift tax will be incurred because the gifts are sheltered by grandmother’s gift tax exemption and annual exclusions. No generation-skipping transfer tax applies. Because of the temporary repeal of the generation-skipping transfer tax for transfers made in 2010, grandmother’s five million dollar generation-skipping transfer tax exemption will also not be reduced by the gifts to her grandchildren and great grandchildren.
The second opportunity created by the temporary repeal of the generation-skipping transfer tax relates to existing generation-skipping trusts. In the case of a trust from which distributions will be subject to a generation-skipping transfer tax, distributions can be made in 2010 to the settlor’s grandchildren or more remote descendants who are beneficiaries of the trust without triggering a generation-skipping transfer tax. Further, if it is possible to terminate the trust in 2010 by distributing to the settlor’s grandchildren and more remote descendants who are beneficiaries of the trust, consideration should be given to doing so because of lack of a generation-skipping transfer tax. Workouts: Cancelation of Indebtedness Income. A taxpayer who is successful in negotiating a reduction in the amount owed to a lender realizes income in an amount equal to the difference between the old debt and the new debt. In the case of debts incurred in a trade or business which are reduced as a result of cancelation, reacquisition, or modification of a loan in 2010 the income realized from the reduction of the obligation or discounted payoff can be deferred until 2014 and recognized ratably (twenty percent a year) over a five year period through 2018. In order to be eligible for the deferral an election must be made under Internal Revenue Code Section 108(i). The election is made by attaching a statement to the taxpayer’s timely filed Federal income tax return for 2010. If the debtor is a partnership, S corporation, or other pass through entity, the election is made on the tax return of the entity. However, the income resulting from the election by the entity can be allocated among the partners. If you are uncertain as to whether the cancellation of indebtedness income occurred in 2010, the election may be made on a protective basis, as well.
Avoid pitfalls in deferring income and accelerating deductions. Traditional year-end planning revolves around deferring income into the following year and incurring tax deductible expenses in the present year. At heart, this is nothing more than an exercise of time value of money. However, this traditional year-end planning should not be undertaken without preparation of tax projections by a certified public accountant. This is due primarily to complexities created by the Alternative Minimum Tax (“AMT”) regime. For example, making charitable contributions, paying state and local income taxes, or paying health care costs before December 31, 2010 allows deductions to be claimed for those expenses in 2010. However, these deductions may be wasted for individuals subject to alternative minimum tax (“AMT”). The AMT eliminates or reduces the Federal income tax savings for medical expenses, state and local taxes, and miscellaneous itemized deductions. If you expect to pay AMT in one year and not the other, you may want to shift deductions into the non-AMT year. In addition, since medical expenses are only deductible if they exceed 7.5% of adjusted gross income, bunching those expenses in one year as opposed to another may affect their deductibility.
All of the year-end tax planning strategies have their nuances and complexities. Despite the late hour, there is still time to take advantage of these opportunities before year end. However, action must be taken quickly. If you have an interest in pursuing any of these strategies please contact my office as soon as possible in order that we may assist you before the clock strikes midnight on New Year’s Eve.
Best regards and best wishes for a happy holiday season and a healthy and prosperous new year.