The forecast for Dec. 31, 2010: rising income tax rates, with a chance of higher estate taxes and lower estate value exemptions. The long-term forecast: a new tax on investment income in 2013, and a movement to subject some S corporation dividends to payroll taxes.
Never has there been a more urgent need to plan a multiyear tax strategy to address one of the most intense concentrations of tax changes in nearly a decade.
Contrary to conventional wisdom, many tax professionals are advising high income/high net worth taxpayers to recognize as much income as possible in 2010 in order to take advantage of this year’s relatively low tax rates. Likewise, many are recommending that taxpayers maximize their itemized deductions in 2010 since a higher threshold for allowable deductions is scheduled to take effect in 2011.
You’ve heard tax professionals say it before: “Defer income, accelerate deductions.” That’s good advice in a tax environment of stable or falling rates. But with the picture that is taking shape for 2011, many taxpayers will come out ahead if they put conventional wisdom aside and recognize income in 2010.
Individual income tax rates are set to increase to levels not seen since 2001, primarily affecting those with income of $200,000 or more. Long-term capital gains rates will jump from 15 percent to 20 percent; interest income rates from 35 percent to 39.6 percent; and qualified dividend income from 15 percent to 39.6 percent.
They will go even higher in 2013, when high-income taxpayers will face a new surtax on:
- Wages in excess of $250,000 for married couples and $200,000 for a single individual. The additional tax will be 0.09 percent.
- Net investment income, including interest, dividends, annuities, royalties, rents, realized capital gains and income from passive activities. The additional tax will be 3.8 percent.
Employees entitled to year-end bonuses should talk to their employer about accelerating payments to avoid higher taxes in 2011. Investors should consider accelerating capital gains, even though the down market may make capital gains hard to find. To make the best use of losses, consider not recognizing capital losses in 2010 so they can be harvested in later years to offset higher tax rates.
Shareholders in C corporations may be able to accelerate dividends in 2010 or consider a one-time dividend. Shareholders in S corporations with accumulated earnings and profits from prior years as a C corporation may also be able to accelerate distributions of C corporation earnings and profits to take advantage of the 15 percent rate. These elections can be made whether or not there were actually distributions made in 2010.
Limitations on itemized deductions and personal exemptions will be reinstated for high-income taxpayers in 2011. Consequently, taxpayers should consider accelerating itemized deductions that would be reduced or eliminated in 2011
The long-standing advice of making the maximum allowable contribution to a 401(k) plan or individual retirement accounts still applies in the current tax climate.
There is a movement afoot to pass legislation that would subject distributions from an S corporation to payroll taxes. It is the result of a perceived abuse of the current law that exempts such S corporation distributions from payroll taxes.
Currently, only the “reasonable” compensation paid to shareholders and employees of an S corporation is subject to payroll tax. The abuse would occur when S corporations with only a few shareholders would pay themselves a nominal salary (which is subject to payroll tax), and distribute most of the corporation’s profits as dividends. However, the IRS has always had the authority to define “reasonable” compensation, and in some cases, to reclassify a portion of distributions as compensation.
The proposed change would make distributions from all S corporations in services industries (attorney, doctors, accountants and consultants, for example) subject to payroll tax. One of the main benefits for shareholders in S corporations would disappear, while billions in new payroll taxes would be collected.
If passed before the end of 2010 (which is unlikely), these fundamental changes would not be expected to go into effect until at least 2011. So, a smart end-of-year move for S corporations may be to make distributions now under the more favorable 2010 laws.
As Bob Dylan famously sang nearly 50 years ago, “You don’t need a weatherman to know which way the wind blows.” Talk to your tax adviser about how you can prepare.
Butch Shoup is a tax partner in Clifton Gunderson’s office in Greenwood Village.