Smart Year-End Tax Moves for Investors

There are plenty of reasons for taxpayers to scream. Here it is, year-end tax-planning time, when investors must decide whether to take gains or harvest losses and make important retirement-account choices. Yet crucial questions remain—not only about next year's tax law but also about this year's.
If Congress doesn't pass an extension of the Bush-era tax rates for upper-income earners, the top rate on long-term capital gains will rise by one-third next year—an increase that is double the rise in rates on ordinary income. The rate on dividends, meanwhile, could nearly triple. And many taxpayers are still waiting for answers on the 2010 alternative minimum tax, the estate tax and the gift tax.
Adding to taxpayers' anxiety, two serious overhaul proposals were just announced in Washington—one from President Obama's deficit commission and the other from the independent Bipartisan Policy Center. While it is unlikely they would be enacted in current form, they take aim at many prized benefits, from the mortgage-interest deduction to low capital-gains rates. It's natural to fear that moves made now could prove useless later, or even backfire.
Given all the uncertainty, is your annual year-end tax-planning session worth the effort this year? Yes—in fact it is crucial, because it could be your last chance to take advantage of today's low rates.
Congress will address taxes in December, and may (or may not) clear up 2010 and 2011 issues before year-end. Advisers like Mark Nash of PricewaterhouseCoopers LLP in Dallas are urging clients to get ready to pounce once the law becomes clear. "We are making plans [for clients] now that can be executed quickly before the end of the year, or looking at moves—like Roth IRA conversions or installment-sale elections—that can be revised next year," he says.
Even if Congress merely extends current law, understanding "wash sale" rules, loss-harvesting and Roth IRA conversions now can pay off later.
That is because the window is closing on current investment tax rates, now at historic lows. Already, many investors face a substantial tax increase in 2013 passed by Congress as part of the health-care overhaul. Every financial and political analyst interviewed for this story expects taxes on investments to rise more than taxes on wages in coming years.
The good news? Investors have enviable flexibility when it comes to timing income and deducting losses—far more than wage earners. There's so much to say about investment tax planning that we're saving other year-end tips for next week.

Capital Gains and Losses

If Congress extends the Bush 2001-03 tax rates for couples earning more than $250,000 ($200,000 for singles), then the top rate on long-term capital gains (those held longer than a year) will remain 15% for a year or two. If lawmakers don't extend the current law, then on Jan. 1 the top rate on gains will rise to 20%.

Whatever the outcome, a new 3.8% tax on investment income takes effect in 2013 as a result of the health-care overhaul. It applies to income from rents, royalties, dividends, capital gains and interest (except municipal-bond interest) for nearly everyone with adjusted gross incomes over $250,000 ($200,000 for singles). (For details, see "How the New Wealth Taxes Will Hit You," June 12.)

What you can do. People with liquid investments should prepare to act quickly this year if the Bush cuts aren't extended, or later if they are. That means understanding some important details of current law.
• Loss harvesting. If you sell an investment at a loss, you can use up to $3,000 per year of the loss to offset ordinary income like wages and "carry forward" the rest to shelter future investment gains. (Note: These rules apply only to investments held in taxable accounts, not tax-sheltered retirement plans such as individual retirement accounts and 401(k) plans.) Short-term losses are those from investments held a year or less, and long-term losses are from those held longer.
The rules on overall gains and losses are intricate but give investors room to optimize results. "Smart investors pay close attention to the timing of gains and losses in order to minimize taxes," says independent tax analyst Robert Willens.
If tax rates rise next year, it may make sense to hold off taking losses until January, when their value will be greater. On the other hand, many investors still have losses they took during the terrible downturn of 2008. If they can take short-term gains this year, Mr. Willens suggests doing so to use some of those losses. This can often work with proper planning.
Why use the losses this year instead of next if tax rates are going up? Although the losses would in theory be more valuable next year, Mr. Willens and others usually advise using them as soon as possible, because the market could change and waiting too long could erode their value.
Here's an example. Susan has $40,000 of losses left from 2008. This year, she has $50,000 of potential gains: $30,000 is long-term and $20,000 is short-term. She wants to use her loss and is worried about the prospects of the stock with the short-term gain. So she sells all the stock with the $20,000 short-term gain and enough of the long-term holding to realize $17,000 of gain.
The result: $37,000 of short- and long-term gains are sheltered this year, with $3,000 of losses left to offset her wage income. Why save $3,000 of the loss to offset wages? Because ordinary income is taxed at much higher rates than long-term gains, it's a more lucrative offset.
• Understand the wash-sale rules. If you sell an investment at a loss, you don't get the loss if you also buy the same holding 30 days before or after the sale. What many don't know is that these rules apply only to losses, not to gains. In the above example, Susan was free to re-acquire the stock she sold right away at a higher cost basis, which will reduce her taxable gain in the future. As long as transaction costs are low, it often makes sense to "scrub" your gains if you have losses.
• Mix and match. When reckoning gains and losses, remember that those on mutual funds and exchange-traded funds can offset gains from stocks, and vice versa.
Tax strategist Robert Gordon of Twenty-First Securities Corp. in New York notes that many taxable bonds have appreciated as interest rates have fallen. If an investor holds individual bonds with long-term gains, he suggests selling the bonds, in effect converting interest payments taxable at ordinary rates to long-term capital gains with a top rate of 15%. If the investor buys the bond back right away, he should elect to deduct the premium from the interest payments over the remaining life of the bond.
What if you are selling an entire business instead of a liquid investment? Many are pushing to finish deals before the end of the year, says Mr. Nash. Failing that, he says, some people with deals under way are selling the business to a trust before the end of the year to take advantage of the 15% rate, and letting the trust sell it next year. This is a complex move but could be useful this year for people selling substantial assets who have a buyer.

Dividends

If lawmakers extend the Bush 2001-03 tax cuts for upper-end taxpayers, the top rate on dividends will remain 15%. If they don't, the top rate may stay linked with the one for capital gains and rise to 20% (as requested by the Obama budget), or dividends will once again be treated as ordinary income, with a top rate of 39.6%.

What you can do. Individual investors can do little. Those who control companies can have them pay dividends before the end of the year. Several public companies, including Wynn Resorts Ltd., Limited Brands Inc. and Progressive Corp., have paid special or extraordinary dividends recently, ahead of possible changes next year.

Stock Options and Restricted Shares

So-called nonqualified stock options and restricted stock are now the most common forms of executive stock compensation. Employees who receive either type usually owe ordinary income taxes and payroll taxes (FICA) on the stock's value at current market prices when they exercise the options or the restricted stock vests. If they continue to hold shares more than a year after that, appreciation is taxed at long-term capital-gains rates, without payroll taxes.
If the Bush tax cuts aren't extended for all, the top rate on ordinary income will rise to 39.6% from 35% and on capital gains to 20% from 15%. In addition, there is the new 3.8% tax on investment income (described above) coming in 2013. The 2013 tax also adds a 0.9% payroll tax to the wages of couples making over $250,000 ($200,000 for singles). It would apply to income recognized when options are exercised or restricted stock vests.
What you can do. Plan not only for this year but also the next two, with the 2013 taxes in view. There is a lot to consider: ordinary tax rates, capital gain rates and holding periods, plus the stock's current price and its future prospects.
Eddie Adkins, a benefits specialist with Grant Thornton LLP, says he sees savvy executives planning now to avoid the 2013 increases. Because it may be hard to come up with the cash required to acquire shares or pay taxes, many are doing "cashless" transactions in which some shares are sold in order to cover the costs of keeping others, he says.
One caveat: The wash-sale rules (described above) come into play here. A grant of options or restricted stock, or an option exercise, count as buying stock, so be careful not to harvest losses from the same stock within 30 days before or after.

Roth IRA Conversions

Roth IRAs are in many ways the gold standard of retirement accounts. Assets in them can grow and be paid out income-tax-free, and there are no mandatory distributions for the owner, as there are with regular IRAs. Tax-free Roth payouts don't count in calculations for alternative minimum tax, Social Security tax, Medicare premiums or the 3.8% investment income tax coming in 2013, at least for now.
This is the first year all taxpayers may convert other IRAs to Roth accounts regardless of their income. Many have jumped to do it, even though that means paying full income taxes on the transfer. Roth sponsors have experienced a surge, with Fidelity Investments and Vanguard Group reporting four to five times the number of conversions as of this time last year.

A key Roth boon is that people who convert can reverse the transaction as late as Oct. 15 of the following year. This has led some to put different asset classes into separate Roth accounts with plans to undo the ones that have lost value or grown less. (See Tax Report, Aug. 14.) For 2010 only, investors may also split the conversion income and report half in 2011 and half in 2012, paying taxes at then-current rates. If the Bush cuts are extended, taking advantage of the deferral could make sense.

What you can do. Remember that Roth conversions work best when the following are true: Your tax rate will be the same or higher in the future; asset values have been beaten down; you have outside money to pay the tax; and you can transfer assets without moving into a higher tax bracket. In some cases, a conversion that raises income may help you avoid the alternative minimum tax.
Even a small conversion will start an important five-year clock running. Once the five years is up, Roth payouts of both principal and earnings are tax-free for those over 59½; if not, only payouts of principal are tax-free until five years is up. A December conversion starts this clock running as of the previous January.
But January is often a good time to convert to a Roth IRA, because this leaves the longest possible time to undo the conversion: almost 22 months. Those who convert in January 2011 will have almost until the 2012 elections to decide whether to undo the transfer.
Many taxpayers fear that if they pay to convert, Congress will change the rules in the future. The issues are many, but at least one expert familiar with tax theory and history, Columbia University Law School Professor Michael Graetz, plans a partial Roth conversion early next year.
"Waiting until next year gives until October 2012 to undo the conversion, and we should know more about where Congress is heading," says Prof. Graetz.
For one group of taxpayers who want to save for retirement—those who don't have current IRAs—a Roth conversion is close to a no-brainer. These investors can open a "nondeductible" IRA, put in up to $5,000—$6,000 if they're at least 50—and immediately convert to a Roth IRA with little or no tax.
This strategy doesn't work well for those who already have large IRAs, unless they're converting all their accounts. That's because partial conversions have to be prorated among pretax and after-tax IRAs. PricewaterhouseCoopers's Mr. Nash notes that this move can work for executives who have earned too much to have a deductible IRA, and sometimes their spouses as well.

2010 Year-end Tax Planning — Time to ‘Kick It Up A Notch!’

We are reminded every day of the current uncertain tax environment. The more news our clients read, the more confused they become. I am constantly looking at prior tax laws trying to predict Congress’ next move. What advice should we give clients in these tough times?
Reading articles and going to conferences gives you all the raw material you need to construct good planning ideas for your clients. If you need planning strategies, you don’t have to look very far. Using these tax law strategies and adding creativity, objectivity and analytical skills have always been the strength of CPA tax planning. But as it stands now, that is not enough.
This year’s planning meetings will give us an opportunity to help clients with making decisions when clear vision does not exist. We have all seen some level of uncertain times, but this is the worst i that I have seen. See if any of the following situations sound familiar:

While speaking to clients about the Roth conversion, Charlie CPA was pointing out that his strategy was very sound mathematically. (This strategy has been adequately described in articles and webcast from the AICPA’s PFP and TAX divisions all year). Charlie found that while the basis of his recommendation was sound, clients were not jumping at the chance to convert. Charlie thought clients believed that “if it looks too good to be true, it probably is.” But he later discovered a different dynamic. He found two reasons they were hesitant to convert. First, some clients do not want to give the government money — no matter what. (Have you ever seen a client’s hand shake when writing a big tax check? Some of us have.) Second, some “do not trust government” when it comes to tax planning. Clients all rationalized this with “Congress will just take away the Roth benefits and I will lose.” 

This situation is becoming common. In a recent meeting with a business client, Sue CPA suggested accelerating income to take advantage of lower tax rates for dividends achieved in a strategic business restructuring. The client was presented with a well-thought-out strategy (using key assumptions) that would save money. Sue was certain this strategy was good for this client which had always implemented her strategies in the past. This year, the client was frozen with inaction due to the uncertainty and lack of trust in the current tax system. Most clients are “common sense wise” even if they may be “tax law illiterate.” Sue’s clients just didn’t feel right paying tax in advance of when it was absolutely required.
Lindsay CPA has been presenting planning options to clients related to the much-publicized Bush tax cuts and the possible (maybe probable?) higher tax rates in the coming years. When presented with a well-thought-out strategy to accelerate income into the current year, her clients are still reluctant to act. They are concerned about playing a “game” in which rules can change both before and after they make a decision. We often have clients ask, “Can the government really pass tax laws after I have implemented my tax strategy retroactively?” And the answer is “yes.” 
Estate and gift tax uncertainty may be the most egregious example of poor congressional tax policy. Clients have a right to know how to structure their affairs to reduce tax liability. I have found that this is not about avoiding paying tax. Many of my clients expect to pay some tax. I find they care more about not paying more tax than their neighbor! They want the tax rules to be fair, predictable and simple. Given the dramatic changes and uncertainty surrounding estate and gift tax laws, it’s easy to see why clients are reluctant to discuss planning.
What clients need from CPAs (in addition to well-thought-out strategies) is a “total analysis” and objective advice. Advice is the key word. Too often, CPAs lay out an outstanding analysis that concludes in two or three options and then ask clients to choose one. Clients usually don’t understand the tax law and look to CPAs for help to make tax decisions. Clients want this question answered: “What would you do if you were in my shoes?” And in the past, our analytical and logical skills showed us a clear path. Every situation is different, but CPAs are challenged, more than ever, to not just lay out options, but to also help clients make a decision. Client indecision is a decision and will often be the wrong decision. 
Be prepared to address questions on your client’s mind, such as: What are the possibilities for tax changes? Will I be better off taking income this year or in 2011? Should I do estate planning when so many unanswered questions loom? Will I be better off on the sidelines while the tax law becomes predictable? No one is in a better position than CPAs to show clients the tax action plan that is custom designed for them. 
More than ever it’s important to put yourself in your client’s situation. Consider their family situation. Think about their financial situation. What is their tolerance for planning strategies with no certainty of success? These issues allow you to custom design action steps for them.
If you tailor your recommendations to each client you will be able to take him or her from “options” to “action.” CPAs cannot guarantee the results of tax planning. What we can guarantee is the process we take to formulate our recommendations. Each recommendation should contain the following:

• Analytical comparison of all options to formulate an objective list of solutions
• Review of the client’s situation to check how the various solutions fit this client
• Consideration of the client’s tolerance for taking risks to achieve above average results

I compare these times to the recent financial meltdown. Clients wanted answers and advisers did not have them. I was very impressed watching CPA peers, particularly those with the Personal Financial Specialist (PFS) credential, stand with their clients during those horrible times. They helped clients and each other make the tough decisions to survive. Many other advisers hid and did not answer the phone because they did not have answers.

CPAs have a unique opportunity to stand by our clients during this stressful time and help them make appropriate tax planning decisions. Clients appreciate and value CPAs’ objective advice and assistance. Time to step up year-end planning a notch (or two)! BAM!

More small businesses will be hiring

CLICK ON THE LINK

Small businesses the engine of job growth are preparing to pick-up the pace, according to McLean-based Capital One Financial Corp. Thirty percent of small businesses polled by Capital One in the third quarter plan to hire workers in the next six months, 4 percent more than in the bank\'s second-quarter survey. The majority of small businesses are still on the sidelines. Sixty-three percent said in the survey, they would not be adding employees in the next six months. Most businesses will hold the line on other spending in the half year ahead. Capital One said 66 percent of small businesses say they plan to keep business development and investment spending at current levels, while only 16 percent plan to increase their spending. Fifteen percent said the would decrease spending. The modest improvement in hiring plans is more significant when considering the small business community\'s outlook in the third quarter. Just 27 percent of small businesses in the survey expect that economic conditions for their business were improving in the third quarter, down from 32 percent in the second quarter, and 39 percent in the first.Slightly more than half (51 percent) of businesses in the survey said their firm s financial position had held steady relative to one year ago, while 30 percent felt their firm s financial position had improved. Eighteen percent reported that their financial position had worsened.The survey was conducted for Capital One by Braun Research of Princeton, N.J., which interviewed a nationally representative sample of 1,901 for-profit small businesses in the U.S. Samples were also taken in New York, New Jersey, Louisiana, Texas and the Washington, D.C., area.

What Is the Future Outlook for Small Business?

It’s that time of year when we begin looking ahead to the coming year. In fact, with 2010 drawing to a close (can you believe it?), it’s that time when business owners begin looking ahead to the coming decade. If you want to know what the next 10 years have in store, take a closer look at a new report from Intuit.
Intuit 2020 Report: 20 Trends That Will Shape the Next Decade builds on more than five years of research led by the Institute for the Future and Emergent Research. It is the first in a series of reports looking at key trends affecting consumers and businesses in the coming years. Subsequent reports will drill down into specific trends and industries, but the current report presents a broad overview.

What’s the takeaway? “The coming decade will be complex, volatile and uncertain, but it will also provide many new opportunities for small businesses and their customers in the United States and abroad,” the report notes. Here are some points I found especially interesting and that have big implications for the future of innovation:
Small businesses will get ever more specialized. Customers will increasingly seek customized products and services. The rise of innovations such as cloud computing, a flexible workforce and lower-cost manufacturing options will make it easier for small businesses to seek out product and service niches.
Startup will get easier and cheaper. In response to growing niche market opportunities, lower equipment costs and better technology, it will be easier than ever to launch a business without a big investment. This means more innovation, as new ideas can be tested without much risk – and startup companies will proliferate.
Big and small firms will join forces. Collaborative partnerships with big companies will increase, as small companies bring to the table innovative practices, market agility and intimate customer knowledge. What will big firms offer small businesses? Marketing and distribution power so that they can take their innovations to broader markets.
One prediction I’m not so sure I agree with: “The Web and mobile technologies will become the great equalizer of big and small, with customers no longer knowing – or even caring – about the size of the firm that provides their goods and services.” In a niche economy where personalization is sought after, will being a small company actually be an advantage? I think consumers may, in many cases, prefer to do business with small firms provided their needs are being met.
And here’s one innovation I particularly hope to see – and I think most busy business owners wish for as well: “The hardware and software we use on a daily basis will get smarter, helping people make everyday decisions and streamline complex tasks,” the report contends. That’s especially good news given that data will become even more critical to competitiveness. Information overload isn’t going away – so smart machines to help us deal with it will be very welcome.
Be sure to check out the full report. You can also find related materials at the Intuit website.

Editor’s Note: This article was previously published at OPENForum.com under the title: “What Does the Future Hold for Small Business?” It is republished here with permission.

IRS to Get Tougher on Sole Proprietor Audits

The Internal Revenue Service will be taking additional steps to check on whether sole proprietors are hiding sources of income during field audits.
A report by the Treasury Inspector General for Tax Administration found that IRS field examiners are generally effective in checking for unreported income during field audits of sole proprietors. However, the report recommended that the IRS could take further steps to determine if additional sources of income need to be reported.

While IRS field examiners generally check for unreported income, TIGTA found that the IRS could improve the accuracy of its preliminary cash transaction analyses by taking greater advantage of performance feedback mechanisms and ensuring that appropriate personal-living-expense data are being used. The preliminary cash transaction analysis involves little or no taxpayer burden, but uses tax return and personal expense data to determine whether the sole proprietor’s income and expenses are roughly equal.
“Tests for unreported income during IRS audits of sole proprietors are critical to the process of verifying that the correct amount of tax is reported,” said TIGTA Inspector General J. Russell George in a statement. “Our results indicate that sole proprietors may have avoided tax and interest assessments of over $8 million in fiscal year 2008.”

The IRS’s National Research Program estimated that unreported business income by sole proprietors accounted for $68 billion (or 20 percent) of the $345 billion tax gap. This is due in large part to resource constraints and the need to balance audit coverage across other segments of the tax return filing population, such as corporations and partnerships.

TIGTA recommended that the IRS issue guidance to group managers to provide specific written feedback to examiners on the adequacy of their tests for unreported income, and that the IRS reinforce the requirement and importance of using appropriate personal-living-expense data in preliminary cash transaction analyses. The IRS agreed with these recommendations and plans to take the appropriate corrective actions.