In-Depth: Year-End Tax Planning for INDIVIDUALS in Light of Uncertainty Regarding Tax Extenders.
(Parker Tax Publishing November 2014)
As the end of the year approaches, it's time for practitioners to reach out to clients and schedule an end-of-year meeting on what can be done to lessen the client's 2014 tax bill. The following article on year-end planning for individuals is the first of two installments in Parker's year-end tax planning series. For an in-depth discussion of year-end planning for businesses, See our final installment Year-End Business Tax Planning Focuses on Tangible Property Rules and Tax Extenders.
Practice Aid: See Sample Client Letter: 2014 Year End Tax Planning for Individuals and Sample Client Letter: 2014 Year End Tax Planning for Businesses.
There are several things to consider when assessing a client's year-end tax liability: (1) substantial changes in income expected in the following year; (2) recent or anticipated tax law changes; (3) life changes that may affect the client's tax situation; and (4) any developments during the year that may present opportunities to reap a tax refund.
With respect to recent or anticipated tax law changes, many taxpayer-favorable provisions expired at the end of 2013. Earlier this year, the Senate Finance Committee passed the Expiring Provisions Improvement Reform and Efficiency (EXPIRE) Act of 2014, which would extend a number of these expired provisions to 2014 and 2015. Congressional gridlock has prevented these "tax extenders," from being voted on by Congress. Many believe that Congress is waiting until after the November elections to move forward on these provisions. Alternatively, any movement on the provisions may not come until 2015. Congress has been known to pass, and make retroactive, legislation in a tax year after the year to which the legislation applies. The tax-extenders include the following items which may impact an individual's 2014 tax return:
(1) Above-the-line deduction for higher education expenses - This provision would extend an above-the-line tax deduction for qualified higher education expenses. The maximum deduction, for 2014 and 2015, would be $4,000 for taxpayers with AGI of $65,000 or less ($130,000 for joint returns) or $2,000 for taxpayers with AGI of $80,000 or less ($160,000 for joint returns).
(2) Deduction for expenses of elementary and secondary school teachers - This provision allows teachers and other school professionals a $250 above-the-line tax deduction in 2014 and 2015 for expenses paid or incurred for books, supplies (other than non-athletic supplies for courses of instruction in health or physical education), computer equipment (including related software and service), other equipment, and supplementary materials used by the educator in the classroom.
(3) Increased exclusion from income for employer-provided mass transit and parking benefits - This provision would increase, for 2014 and 2015, the monthly exclusion from income for employer-provided transit and vanpool benefits from $130 to $250, so that it would be the same as the exclusion for employer-provided parking benefits. The provision also modifies the definition of qualified bicycle commuting reimbursement to include expenses associated with the use of a bike sharing program.
(4) Deduction for mortgage interest premiums - Under this provision, for 2014 and 2015, taxpayers would be able to deduct the cost of mortgage insurance on a qualified personal residence. The deduction would be phased-out ratably by 10 percent for each $1,000 by which adjusted gross income (AGI) exceeds $100,000. Thus, the deduction would be unavailable for a taxpayer with an AGI in excess of $110,000.
(5) Deduction for state and local general sales taxes - This provision would extend for two years the election to take an itemized deduction for state and local general sales taxes in lieu of the itemized deduction permitted for state and local income taxes.
(6) Special rules for contributions of capital gain real property made for conservation purposes - This provision would extend for two years the increased contribution limits and carry-forward period for contributions of appreciated real property (including partial interests in real property) for conservation purposes.
(7) Mortgage debt forgiveness - Under this provision, up to $2 million of forgiven mortgage debt would be eligible to be excluded from income ($1 million if married filing separately) through tax year 2015.
(8) Tax-free distributions from individual retirement plan for charitable purposes - This provision would allow an individual retirement arrangement (IRA) owner who is age 70-1/2 or older generally to exclude from gross income up to $100,000 for 2014 and 2015 in distributions made directly from the IRA to certain public charities.
Income Subject to Top Tax Rate
For 2014, the amount of income subject to the top tax rate of 39.6 percent increased from the 2013 amounts to $457,600 (married filing jointly), $406,750 (single individuals), $432,200 (head of household) and $228,800 (married filing separately).
Net Investment Income Tax
Besides applying to investment income, the 3.8 percent net investment income tax also applies to income from trades or businesses that are passive activities. An activity is not generally considered passive if the taxpayer materially participates. If a client is engaged in an income-producing activity which is characterized as passive and thus has the potential to generate the net investment income tax, practitioners may want to evaluate the seven factors that determine material participation to see if the client's business can escape the net investment income tax by meeting one of the material participation tests.
Affordable Care Act ("Obamacare")
It is important to note the impacts of the Patient Protection and Affordable Care Act to individual taxpayers. Beginning in the 2014 tax year, most individual taxpayers will be required to obtain health insurance, either through their employer or independently on a health insurance exchange marketplace, or risk facing a tax penalty. In 2014 the penalty is either $95 per adult ($47.50 per child) or 1% of income, whichever is higher. The total of the minimum penalty amounts is capped at $285 per family, but there is no cap on the 1% of income penalty if it applies. In some situations, the amounts of these penalties will increase in 2015. For clients who do not have health insurance, it may make sense for practitioners to help the client compare the amount of the potential penalties with the cost of obtaining coverage.
Alternative Minimum Tax
If a client is subject to the alternative minimum tax (AMT), his or her deductions may be limited. In such cases, consideration of the timing of the deductions to potentially avoid being limited, should be considered.
In 2014, the waiting-period rule on IRA rollovers changed, and not for taxpayers' benefit. The rule used to be that the one-year waiting period between rollovers applied on an IRA-by-IRA basis. This strategy allowed taxpayers to string together multiple separate IRA rollovers and gain the use of IRA funds for an extended period of time. However, in Bobrow v. Comm'r, T.C. Memo. 2014-21, the Tax Court held that the rollover provisions apply on an aggregate basis instead. This means that taxpayers cannot make a tax-free IRA-to-IRA rollover if they made such a rollover involving any IRAs in the preceding one-year period. This new rule applies beginning in 2015.
Practice Tip: This rule does not affect a taxpayer's ability to transfer funds from one IRA trustee directly to another, because such a "trustee-to-trustee transfer" is not a rollover and, therefore, is not subject to the one-waiting period.
Several recent cases provide cautionary tales of what can go wrong with self-directed IRAs. Self-directed IRAs have become increasingly popular in recent years because they allow an IRA owner to have more control over the type of investments that will be held in the IRA. This higher degree of flexibility in choosing IRA investments allows the IRA owner to invest in assets with greater wealth-building potential. However, as seen in Berks v. Comm'r, T.C. Summary 2014-2, the large amount of money held in self-directed IRAs makes them attractive targets for fraud promoters. Thus, self-directed IRA can be costly if not properly managed. In addition, as seen in Peek v. Comm'r, 140 T.C. No. 12 (2013), because of the types of investments taxpayers with self-directed IRAs can make, taxpayers have a greater risk of running afoul of the prohibited transaction rules. The prohibited transaction rules impose an excise tax on certain transactions - such as sales of property, the lending of money or extension of credit, or the furnishing of goods, services, or facilities - between an IRA and a disqualified person. Practitioners with clients who have a self-directed IRA should review the specifics of the arrangement to ensure it is legitimate and that there is proper documentation of the transactions.
For self-employed clients with businesses that have shown losses for the past several years, there is a danger that the IRS will consider the business a hobby and disallow deductions in excess of revenue. Practitioners should review the factors in Reg. Sec. 1.183-2(b) to determine if a loss from an activity is subject to the hobby loss rules and whether changes to the client's business model could prevent the activity from being characterized as a hobby. In reviewing the factors, practitioners should address whether additional documentation is available to reinforce the business nature of the activity, such as documenting the business-like manner in which the business is carried on, and whether any new techniques were adopted or whether unprofitable methods were abandoned.
The IRS has issued new rules on the capitalization and expensing of tangible property used in a trade or business. If tangible property is a part of a client's business, these rules will most likely impact current year taxes and may require certain actions by year end. For example, one of the more favorable rules in the tangible property regulations is the $5,000 de minimis safe harbor election for expensing an item rather than capitalizing it. In order to take advantage of this election, the taxpayer must have had written accounting procedures in place at the beginning of the year and have been following those rules for book, as well as tax, purposes. If such procedures were in place at the beginning of 2012 or 2013, the election can be made for those years as well but will require amended returns. If the taxpayer did not have such procedures in place, it's not too late to put them in place for 2015; but it must be done by the end of this year.
S Corporation Shareholders
In 2014, the IRS loosened the rules relating to S corporation shareholder debt. Under the new rules, it is easier for shareholder loans to the S corporation to give the shareholder basis against which to deduct losses from the S corporation. The rules eliminated the "actual economic outlay" test and made the changes retroactive. Thus, if an S shareholder previously could not deduct S corporation losses because loans to the S corporation did not meet the actual economic outlay doctrine, amended returns may be in order.
Other Steps to Consider Before the End of the Year
The following are some of additional actions a practitioner might recommend before year end if they make sense in the client's situation. Obviously, the focus should not be entirely on tax savings; these strategies should be adopted only if they make sense in the context of the taxpayer's total financial picture.
Accelerating Income into 2014
It may be prudent for a client to accelerate income into 2014 if the client will have more income in 2015, with the potential of being in a higher tax bracket. One common strategy is harvesting gains from the client's investment portfolio. However, in doing so, practitioners must take into account whether such acceleration will cause the client to be subject to the 3.8 percent net investment income tax and the .9 percent Medicare tax.
Another option is to have a client with a 401(k) plan that includes a qualified Roth contribution program transfer an amount from his or her regular pre-elective deferral account into a designated Roth account in the same plan. While the transfer is subject to regular income tax, no early distribution penalty applies.
Besides harvesting gains, other options to accelerate income into 2014 include:
(1) if a client owns a traditional IRA or a SEP IRA, converting it into a Roth IRA and recognizing the conversion income this year;
(2) taking IRA distributions this year rather than next year;
(3) for self-employed clients with receivables on hand, getting clients or customers to pay before year end, but being mindful of the .9 percent additional Medicare tax on self-employment income over $200,000 ($250,000 for joint returns); and
(4) settling lawsuits or insurance claims that will generate income.
Deferring Income into 2015
For high-income clients, especially those that may be subject to the 3.8 percent net investment income tax or the .9 percent Medicare tax, it may make sense to defer income into 2015 if the client expects to have a decrease in income in 2015 or to be in a more advantageous tax situation. Potential options include:
(1) if a client is due a year-end bonus, having the employer pay the bonus in January 2015;
(2) if a client is considering selling assets that will generate a gain, postponing the sale until 2015;
(3) delaying the exercise of any stock options;
(4) considering an installment sale if property is being sold;
(5) parking investments in deferred annuities;
(6) establishing an IRA, if the applicable income requirements are met; and
(7) putting the maximum salary allowed into a 401(k) before year end.
Deferring Deductions into 2015
If a client expects to move into a higher tax bracket in 2015, or anticipates a substantial increase in taxable income or net investment income next year, deferring deductions into 2015 might be the right approach. Two alternatives to consider are:
(1) postponing year-end charitable contributions, property tax payments, and medical and dental expense payments until next year; and
(2) postponing the sale of any loss-generating property.
With respect to postponing the payment of medical and dental expenses, it's important to remember that, for tax years ending before January 1, 2017, a 7.5 percent of AGI threshold, rather than the 10 percent of AGI threshold, for deducting such expenses applies if the taxpayer or the taxpayer's spouse is at least age 65 before the close of the tax year.
Accelerating Deductions into 2014
Where a client's income is expected to decrease in 2015, accelerating deductions into 2014 may be prudent. Some options for accelerating deductions into the current year include:
(1) prepaying property taxes in December;
(2) prepaying a January mortgage payment in December;
(3) prepaying any state income taxes due, but only if the client doesn't owe AMT since there is no state tax deduction for AMT purposes, so the deduction would be wasted;
(4) since medical expenses are deductible only to the extent they exceed 10 percent of AGI for taxpayers under age 65, bunching large medical bills not covered by insurance into one year may help overcome this threshold;
(5) making any large charitable deductions in 2014, rather than 2015;
(6) gifting appreciated stock to avoid paying tax on the appreciation but obtaining a deduction for the full value of the stock;
(7) selling loss stocks; and
(8) if the client qualifies for a health savings account, setting one up and making the maximum contribution allowable.
Certain life events can also affect a client's tax situation. If the client got married or divorced, had a birth or death in the family, lost or changed jobs, retired during the year, practitioners should discuss with their clients the tax implications of these events.
Finally, some additional miscellaneous items practitioners should consider when doing year-end planning:
(1) Encourage clients that have a health flexible spending account with a balance to spend it before year end (unless their employer allows them to go until March 16, 2015, in which case they'll have until then).
(2) For clients with a vacation home that was rented out during the year, determine the number of days it was used for business versus pleasure to see if there is anything that can be done to maximize tax savings with respect to that property. For example, if the client spent less than 14 days at the home, it may make sense to spend a few more days and have the house qualify as a second residence, with the interest being deductible. For a rental home, rental expenses, including interest, are limited to rental income.
(3) Consider having clients shift income to a child so that the tax on the income is paid at the child's rate.
(4) Impress upon clients the importance of disclosing any foreign asset holdings so that the proper tax forms can be prepared and the onerous penalties for not disclosing such assets avoided. (Staff Editor Parker Tax Publishing)
Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.
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