Year-End Tax Planning with the Fiscal Cliff

By Robert A. Green, CPA

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Tax planning is very tricky this year with the fiscal cliff. Most people hope Congress and President Obama will act soon — after the November election and before year-end — to bring clarity to the fiscal cliff, especially making a decision about the crucial Bush-era tax cuts.

Most years, taxpayers prefer to defer income and accelerate expenses, but this year is different.

Income tax rates are scheduled to skyrocket up in 2013 with expiration of the Bush-era tax cuts. Plus, the Affordable Care Act's new Medicare tax of 3.8% on unearned income goes into effect on Jan. 1, 2013 for taxpayers making more than $250,000 for married filing joint and $200,000 for single. Trading income is subject to that Medicare tax and an S-Corp can't help lower it. Read our

on the subject.

If the Bush-era tax cuts are not extended for your marginal tax bracket, it's probably a good idea to accelerate income of all kinds into 2012 — ordinary income, capital gains and dividend income. Consider selling investments with unrealized gains before year-end. While that's easy with marketable securities, it's more difficult with less liquid investments like real estate and private equity.

If you own a C-Corp, consider paying yourself qualifying dividends from retainer earnings, as the 15% 2012 rate jumps up to 39.6% plus the Medicare tax of 3.8 percent in 2013 (if you are over the threshold). Deal with those built-up retained earnings now.

In most years, taxpayers engage in “tax loss selling” to prune their portfolio of losing positions and lower capital gains taxes. This year, consider the reverse — “tax gain selling.” Instead of avoiding wash sales, maybe wash sales can be your friend by accelerating income into this year and deferring losses until next year.

Generally, when it's wise to accelerate income, it's also wise to defer expenses, as it has the same effect on lowering taxable income. But, this year is different and you should decouple those ideas: Accelerate income, but don't defer expenses.

Itemized deductions and many other tax expenditures may be closed in 2013 as part of promised tax reform. Gov. Romney's tax plan is to limit itemized deductions to $25,000 or similar amount for upper income taxpayers. Deductions could be reduced for the middle class too, even with Democratic plans. Most states are acting to limit itemized deductions. If you see a deduction allowed for 2012, take it. If it's wiped out with AMT tax for 2012, then defer it.

Gov. Romney's tax plan also includes zero income tax on portfolio income for taxpayers making under $200,000 per year, but it's unlikely to pass Congress if Democrats retain a filibuster. You can make this call with the election results.

Even if Congress can't agree on the Bush tax cuts, I hope they at least agree to pass the annual AMT patch for 2012. Otherwise, millions of additional taxpayers will be hit with a nasty AMT tax-hike surprise. AMT can give back some long-term capital gains rate benefit – since the AMT rate is much higher than the capital gains rate - and it doesn't allow most itemized deductions.

Business deductions for business traders and investment managers are safe because tax reform is focused on limiting itemized deductions, not business expenses. Just make sure you have business status in Q1 2013.

If you don't qualify for trader tax status (business treatment) for 2012, and expect to qualify in Q1 2013, then defer business expenses to 2013. Alternatively, you can spend the money in 2012 and capitalize the amount into Section 195 startup costs to amortize in 2013. But, remember the expense provision of Section 195 is only $5,000 with the rest being amortized over 15 years using the straight-line method.

Conversely, if you qualify for trader tax status in 2012, but might not in 2013, take your expenses in 2012. If you have investor tax status, take your chances with a miscellaneous itemized deduction in 2012, rather than in 2013.

Business traders and investment managers should not defer charity to 2013. But businesses can defer equipment purchases to business deductions in 2013. I don't have much faith in tax reform lowering rates much, so expense deferral is a good idea. Even if equipment expensing is scaled down with repeal of Bush-era tax cuts, there is plenty of room for 100% expenses with pre-Bush Section 179 depreciation allowances.

Consider a Roth IRA or Roth Mini 401k conversion in 2012. No matter what happens with the fiscal cliff, it's a good idea under most scenarios and even if it turns out to be a bad idea, you can reverse it. A Roth IRA conversion comes with a free “recharacterization” feature. Up until the due date of your tax return the following year, you can reverse the Roth conversion. We will have details on this process in upcoming Webinars and it's in Green's 2012 Trader Tax Guide, too.

Why not convert and check out your regular retirement accounts at lower Bush tax rates, and then trade your Roth IRA tax free for life? This will protect your trading gains from tax hikes in the future. Pass on these breaks to family members with estate planning, too.

If the Bush tax cuts do expire, pundits expect the market to sell off with calamity on the horizon. Why not cash out your investment positions before others try to do the same? After your conversion to the Roth IRA, you can trade and make new investments at lower prices as the markets recover.

(further reading for those interested in the politics of tax negotiations)

For invaluable additional insight into how the negotiations may play out, read Bob Woodward's best-selling book “The Price of Politics.” He makes one thing very clear: President Obama is dead set on raising tax rates on the rich, which means letting the Bush-era tax rates expire for the upper class. Obama says time and again he will not agree to balance budget cuts on the middle class and poor, without the rich paying the fair share. Senate Majority Leader Harry Reid and House Minority Leader Nancy Pelosi are on the same page.

On the other side of dysfunctional government negotiations is the Republican mantra to defend their tax-protection pledge not to raise taxes in any means other than through growth. Republicans swept the House in 2010 with Tea Party ascendance and the Young Guns are committed to growth through tax and spending reforms. Republicans certainly can't throw their new power and mandate under the bus.

In “The Price of Politics”, President Obama carried on five different negotiations over the debt ceiling, deficit and taxes, and Woodward paints a picture of the President impeding negotiations by throwing curve balls, not facing the reality of Republican mantra and trying to use the media too much. We ended up with sequestration and negotiation failure. In the third and final presidential debate over foreign policy, President Obama said defense spending sequestration will not happen. And, how won't it happen?

Republicans won't decouple and allow the Bush-era tax cuts to expire on the rich only, as they will then lose all leverage going forward on spending and tax reform and the debt-ceiling.

The Washington Post recently reported that Obama threatens to play his power card — to veto any legislation that allows the Bush-era tax cuts to continue for the upper income. He said he is prepared to allow the Bush-era tax cuts to expire as scheduled for everyone and the rush through tax cuts for the middle class in 2013. Republicans will insist on tax reform and they won't agree to greater progressivity with tax hikes on the rich and job creators.

Whether Obama wins or loses the election, I don't think he will allow Congress to extend the Bush-era tax cuts for the upper income again. For the President, it's a matter of principle and it will be part of his legacy. It's been the cornerstone of his tax plan starting with his 2008 presidential campaign and it's been included in every one of his annual budgets. I think President Obama is prepared to go out with bang based on his principles, and he won't want to cave into George W. Bush and his tax cuts! Democrats often assail ‘unpaid for tax cuts for the rich, which never produced jobs or trickle-down benefits to the middle class.'

If President Obama wins re-election, he might take his chances with a potential blow to the economy from going over the fiscal cliff. Let's get serious, we are going over the long-term fiscal cliff anyway. President Obama may not be that concerned with a stock market drop, as that affects rich people the most and Helicopter Ben (Bernanke) just passed unlimited QE to save the stock market. Obama may be more concerned with the economy and he doesn't believe tax hikes on job creators hurts jobs. He is more focused on future negotiations over the debt ceiling, spending and taxes, including tax reform. He may figure that he can do better starting from higher Clinton tax rates, giving him more room to maneuver, and more leverage. He can blame the tax hikes on Republicans.

Democrats need new tax revenue without growth, since CBO won't score growth. Republicans won't agree to tax rate hikes; they will only agree to tax revenue increases through growth. That's dead-end number one.

Democrats want to make the tax code more progressive, to have the rich pay more (a fairer share). They view tax reform as a Republican Trojan horse to lower rates and close deductions, which means deductions, which mean less progressivity and a tax hike on the middle class. Republicans view tax reform as being integral to overall government reform including spending reform. They want simplification, fewer government candy bars and fiscal policy handouts, and lower rates for job creators, on par with lower corporate rates, to be competitive around the world. Republicans argue that if you want more taxes, grow the economy and jobs and that generates more tax payments. Tax reform is dead-end number two.

With these two dead-ends, don't expect taxes to help solve the next debt-ceiling showdown, either. It will be all about spending again, which is just what Republicans want.

So, isn't the wise move for Obama to let the Bush tax cuts expire and get it while he can? Who can blame Obama for getting the Clinton rates back? If it's good for the goose (Clinton), it's good for the gander (Obama).

Tax reform is a red herring, since it means more progressivity to Democrats and less progressivity to Republicans. Democrats will agree to roll back Clinton rates to Bush rates for the rich, but they have to give up deductions a la Romney's plan. Romney wants rates dropped to 25%, not 35%.

Democrats won't close itemized deductions for the middle class, the middle class needs their housing, charity and (blue) state tax deductions. Republicans will never throw capital gains rates under the bus, which is what Democrats want in tax reform. Tax reform is at best hopeful and it will take six to 12 months per the Woodward book. The 2013 government is expected to be filibuster-proof, so either side can block tax reform in 2013. Republicans will never agree to just a promise of tax reform for a debt-ceiling increase and tax reform must be revenue neutral in their book. So, how can it be part of the upcoming debt-ceiling showdown by early 2013?

For Republicans, taxes are the third rail of politics and for Democrats, entitlement reform is the third rail. The last debt-ceiling showdown had to exempt taxes and punt the Bush-era tax cuts to this year-end, after the election — an absolute must of President Obama.

Negotiations were sure to fail with all of President Obama's heavy-handed monkey wrenches thrown into every behind-your-back negotiation. The only possible outcome was sequestration, with equal parts spending cuts on non-defense (Democrats) and defense (Republicans).

Don't wait until holiday time to sell stocks and do year-end planning. Contact us now early in Q4 and consider a Roth IRA conversion early on. A Roth conversion plan takes plenty of time with your accountants and it's usually wise to include your insurance agents and tax attorney for estate planning. By the way, the estate taxes will come back with a vengeance when the Bush tax cuts expire.

Even if you never worked with your accountant before for tax planning, you really should this year. General year-end tax planning content is great, but it's not enough. You should crunch the numbers with us on 2012, and have us estimate for 2013 and beyond. We factor in your facts, circumstances, plans and assumptions. Plus, your current and future cash flows. The savings can be in the hundreds of thousands of dollars over time. Let us help you save a fortune in taxes.