2017 Year-End Tax Planning Tips
As the end of another year approaches, we thought it would be useful to provide some ideas and tips that people can discuss with their tax advisors over the next several weeks. When doing so, it’s wise to remember a few things:
- year-end tax planning can go beyond just reducing this year’s tax bill, as it can include looking into future years too;
- planning for business, estate, and gift taxes can be as important as planning for individual income taxes;
- start discussions now – you might need lead time to carry out any plan by year-end.Individual tax planning
- In early November, 2017, both the House of Representatives and Senate released proposals for tax reform. If enacted, these proposals would alter a number of the strategies contained in this article. As these are merely proposals, our focus remains on the opportunities under current law.
- Timing of income and deductions. In most cases, income tax planning consists of maximizing the deductions available and minimizing the amount of income recognized in the current year. That strategy is reversed, however, when a person expects to be in a lower income tax bracket in the future. Below are common strategies used when considering income tax timing issues:
- Alternate between itemized and standard deductions. Individual taxpayers are permitted to take whichever deduction is higher: the standard deduction, or the amount of the taxpayer’s itemized deductions.
The 2017 standard deduction is $6,350 for a single taxpayer, and $12,700 for those married filing jointly.
One strategy is to maximize, or bunch, itemized deductions in the current year by paying now those deductible expenses that normally would occur next year, and then in the next tax year take the standard deduction instead of itemizing.
Example. Consider a married couple with two types of itemized deductions. Annually, they normally pay real estate taxes of $5,000 and make $10,000 of charitable contributions, for a total of $15,000 of itemized deductions.
In 2016, they had decided to “double-up” on their charitable contributions and the payment of real estate taxes (paying immediately the real estate tax bill they received in December 2016). This provided them $30,000 of itemized deductions in 2016. Now, in 2017, they won’t itemize but will instead use the $12,700 standard deduction.
In total, they were able to take $42,700 of deductions over two years, as opposed to $30,000 ($15,000 each year) of itemized deductions.
- Evaluate expenses subject to AGI thresholds. Certain expenses can only be deducted to the extent that they exceed a specified percentage of the taxpayer’s adjusted gross income (AGI). For example, unreimbursed –
- medical and dental expenses can be deducted only to the extent that they exceed 10% of AGI; and
- employee expenses and investment expenses can be deducted only to the extent that they exceed 2% of AGI.Example: Based on year-to-date income, a married couple expects to have AGI of $150,000 in 2017 and similar income in 2018. They have $12,500 in medical expenses so far this year (including eligible long-term care insurance premiums). They plan to have certain dental work and medical treatments over the next year that they expect to cost $7,000.If the remaining expenses are instead incurred and paid – even with a credit card – during 2017, they will be able to deduct $4,500 in 2017.
- If they wait until 2018 to incur the anticipated medical and dental expenses, they won’t be able to deduct any amount with respect to the expenses in either 2017 or 2018 because each year the expenses will not exceed their 10% AGI threshold of $15,000.
- To maximize the deductibility of these expenses, a taxpayer could bunch them into a single tax year, so that they are large enough to exceed the applicable AGI threshold. (Note that expenses that are paid with a credit card are treated as paid in the year charged, and not when the payment is later made to the credit card company.)
- Harvest capital losses (or gains). High-income taxpayers could be taxed at 23.8% in 2017 on long-term capital gains (20% capital gains tax rate, plus the 3.8% net investment income tax). Some taxpayers might have already realized capital losses this year that could be offset by selling investments to produce capital gains (or, if they’ve already realized capital gains, can sell other assets that are underwater to realize offsetting losses). If the capital losses exceed capital gains, up to $3,000 of that excess can offset ordinary income now, with the remaining losses being carried over to deduct in future tax years. But beware of the “wash sale” rule: if a taxpayer sells stock or securities at a loss and (re)purchases substantially identical stock or security within 30 days before or after the sale, the wash sale rule denies the ability to take the capital loss.
- Avoid tax penalties by increasing withholding. The federal income tax is a pay-as-you-go system, which taxpayers must satisfy to avoid underpayment penalties either through withholding or by making estimated tax payments. With the 39.6% top federal income tax rate in effect, when a high-income individual receives an irregular increase in income – perhaps due to payment of nonqualified deferred compensation – the taxpayer should pay attention to the amount of tax withholding. These fortunate souls should contact their tax advisors as soon as possible to determine whether sufficient estimated taxes have been paid to avoid underpayment penalties. If it looks like penalties could apply, taxpayers should increase their tax withholding for the rest of the year. Paying additional estimated taxes in the fourth quarter merely stops penalties from accruing, but does not prevent penalties from being applied for the first three quarters. In contrast, withholding is treated as having been paid in equally over the course of the tax year. Employees can file a new Form W-4 withholding certificate requesting increased withholding, and an employer has up to 30 days to give effect to the changes. After the additional amounts are withheld, the employee should make sure to submit a new Form W-4 to change the withholding back, if so desired. Another option is to take a distribution from an IRA and request that the IRA administrator withhold tax. The IRA owner can then return the full amount of the distribution to the IRA through a 60-day rollover (using outside money to cover the amount withheld for taxes).
- Getting married next year, in 2018? Tying the knot can affect tax timing decisions (and other things too, we hear). If both individuals already make significant income, they are likely to trigger higher income tax rates for more of their income after marriage. Therefore, if the wedding is planned for 2018, they might want to accelerate income to 2017 to use lower income tax brackets, or push deductible expenses into 2018. They can accelerate income by making efforts to collect in 2017 any amounts owed them for past services, or by taking before the end of the year any IRA distributions they planned to take soon anyway. But if one of the betrothed has much lower income than the other, married filing jointly might save total taxes, so they might want to defer taking whatever income they can until the year of marriage.
- Defer 2017 bonuses or 2018 compensation. An employee might be able to push the receipt of any anticipated 2017 bonus into the beginning of next year by asking the employer to delay payment. If the bonus is paid within the first 2.5 months of 2018, it generally won’t trigger any IRC Section 409A concerns, but the devil is in the details in this area, so the employer and employee better review the plan with their tax advisor. Some actions must be taken now to reduce income for next year, 2018. If an employer has a nonqualified deferred compensation plan that permits elective deferrals, employees must elect before the end of this year, 2017, to defer any income that would normally be paid in 2018.
- Contribute to an IRA or 401(k). To the extent their budgets permit, taxpayers generally should contribute the maximum amount allowable to a Roth IRA, traditional IRA, or 401(k). As the chart below shows, some of these contributions can be made as late as April 17 of 2018.
(age 50 or over)
|401(k)||$18,000||$6,000||December 31, 2017|
|Traditional IRA||$5,500||$1,000||April 17, 2018|
|Roth IRA||$5,500||$1,000||April 17, 2018|
Deductible contributions to 401(k)s and traditional IRAs reduce taxable income today (contributions to Roth IRAs and Roth 401(k)s are not deductible). An added benefit is that, after the contributions are made, the growth inside a 401(k) or IRA is tax deferred. This means that the growth does not generate income that can trigger the 3.8% net investment income tax. In addition, distributions avoid the 3.8% tax too. Distributions from the Roth accounts are not taxable at all if certain requirements are met, and even taxable distributions from traditional IRAs and 401(k)s are specifically excluded from the net investment income tax (although they admittedly increase modified adjusted gross income, making the imposition of that tax on other income more likely). Roth IRA conversions. A taxpayer holding a traditional IRA could convert all or part of that account to a Roth IRA. This triggers income tax currently, but the overall tax burden might be reduced in the long run. This is particularly true if the IRA owner is able to let the Roth IRA grow tax-deferred over many years, and if he or she will be in a higher income tax bracket when ultimately taking distributions, in which case the income tax-free nature of Roth IRA distributions will be especially valuable. Taxpayers who have made a Roth conversion recently also have the opportunity to review the performance of the Roth account and determine whether they should recharacterize the account back into a traditional IRA. This can be a valuable move if the account lost value after conversion to a Roth, as recharacterizing the account would avoid income tax from the (undone) conversion – it’s as if it never happened – limiting the downside to the investment loss. The taxpayer has until the due date of the tax return for the year in which the conversion occurred, including extensions, to recharacterize the converted amounts back to a traditional IRA.
- Charitably-inclined taxpayers. For taxpayers who are charitably inclined, the end of the year is a good time to consider how to get the maximum tax value for their charitable contributions.
- Contribute cash or property to charity. Charitable contributions continue to be an avenue for high-income earners to reduce their overall income tax burden. As an alternative to gifts of cash, donations of highly appreciated property to charitable organizations are even more attractive because, in addition to the income tax deduction, the donor can also avoid capital gains tax on the appreciation. Appreciated marketable securities (where the gain is long-term) that are donated to a charity can be deducted at their fair market value, even if donated to a private foundation. In this situation, the amount deductible is limited to 30% of the taxpayer’s AGI for contributions to public charities, and 20% of AGI for contributions to private foundations. Provided that there is no plan in place for the sale of the stock, the taxpayer can deduct the value of the stock and then, when the charity sells the stock, there is no tax on the gain.
- IRA Charitable Rollovers. For taxpayers who are age 70.5 and older, they can transfer up to $100,000 from their IRA to a charity or donor advised fund, and they won’t have to include that contributed amount in income. Even though not included in income, the transferred amount counts toward the IRA owner’s required minimum distribution (RMD). This is better than treating the distribution as if it were first taxable to the individual, and then (potentially) deductible as a charitable contribution, as AGI limits would apply and could reduce the deductible amount. For example, if the taxpayer instead took a distribution of $100,000 cash from the IRA (and had no other income), and then donated this amount to charity, the charitable contribution deduction would be limited to $50,000 (50% of AGI) with the remaining amount carried forward up to 5 years. In the past, Congress regularly installed this rule for one year only, then renewed it each year. Such shenanigans are over; the rule is now permanent.
Planning for business owners
- Flow-through planning. The activities, income, and deductions of partnerships, S corporations, and sole proprietorships flow through to their owners and impact their individual tax returns. In addition to planning related to incurring expenses or deferring income, there are also elections that a business might want to make for the 2017 tax year.
- Maximize the tax benefit of capital expenditures. Owners of a flow-through business entity can sometimes get an immediate tax deduction for the purchase of a capital asset, instead of having to get the benefit over a period of years through depreciation deductions. Under IRC § 179, a taxpayer can elect to currently expense, rather than depreciate, up to $500,000 of the cost of certain capital assets. There are limits based on the total amount invested and income earned by the taxpayer. The taxpayer may also be able to expense otherwise low-cost capitalizable expenses if the taxpayer has an accounting policy that satisfies the requirements of the de minimis safe harbor election under the tangible personal property regulations. Finally, a taxpayer can use the so-called bonus first-year depreciation for certain assets (deducting 50% of basis in the first year). Taxpayers who anticipate making capital expenditures in their business should consult with their tax advisors to determine whether there is a benefit to accelerating the purchase to 2017 to take advantage of any of the enhanced deductions.
Example. A partnership purchases a computer for $5,000 that would generally need to be depreciated over a five-year period. By electing to expense the cost under Section 179, the partnership can pass the entire cost through to the partners this year to be reflected as a deductible expense on the partners’ individual income tax returns. If the partnership is unable to make the Section 179 election, the purchase should be eligible for bonus first-year depreciation treatment and at least $2,500 could be deducted in the year of purchase.
- Free up suspended partnership losses. The ability to use partnership losses can be limited for a number of reasons, such as a lack of tax basis in the partnership interest, or as a result of the passive loss rules of Section 469. The unused losses are “suspended” until they can be used. Suspended losses can be freed up either when the reason that they were suspended no longer exists (e.g., the basis increases) or when the interest in the partnership is fully terminated.
- Benefit planning For Entities. Business owners are unable to use many of the common tax-free employee benefits that companies provide to their employees. There are, however, some strategies available to business owners that should be considered before the end of the year.
- Qualified retirement plans. The individual contribution limit for an IRA is $5,500 (plus catch-up if over 50), but employers can contribute up to $54,000 (2017) on a pre-tax basis for employees under a qualified defined contribution plan. There are many qualified plan options that an owner-employee could use to maximize pre-tax contributions for retirement funding. Typical plan options for small business owners or self-employed individuals include SEP and SIMPLE IRAs and qualified plans (both defined benefit and defined contribution plans). Other than SIMPLE plans which need to be established by October 1 of a calendar year, there is still time for a business owner to set up a qualified retirement plan for 2017. Also, as long as a qualified defined contribution plan is established by December 31, 2017, the employer could delay making contributions until the extended due date for its tax return and still deduct the contribution on the 2017 tax return.
- Consider obtaining long-term care insurance. Self-employed individuals can pay for long-term care (LTC) insurance and deduct up to the “eligible long-term care premium amount.” This amount is often not as large as the actual premium paid on the policy, but self-employed taxpayers can deduct the full eligible LTC premium amount without having to exceed the 10% AGI threshold that applies to individuals purchasing LTC insurance without the involvement of a trade or business.
- What’s more, if the employer is a C Corporation and provides the LTC benefit to an owner-employee due to employee status, or if any employer provides LTC insurance coverage to a non-owner employee, the premium actually paid – rather than the mere eligible LTC premium amount – would generally be entirely deductible for the business and altogether excluded from the employee’s income (just like employer-provided health insurance).
Gift and estate tax planning
Clients often implement gift and estate planning strategies with the goals of transferring wealth to younger generations while minimizing the transfer tax hit.
- Annual exclusion gifts. The tried and true strategy of making maximum annual exclusion gifts still constitutes good tax planning. For 2017, a donor can give $14,000 per donee, or $28,000 per donee for gifts from a married couple. Taxpayers might want to consider giving income-producing assets to children in lower income tax brackets to reduce the overall tax burden to the family. Keep in mind that unearned income of children under 18 (or 24 if a full-time student) above $2,100 (2017) is taxed at their parent’s marginal income tax rate.
- Planning for education. Combining education savings with gifts can accomplish multiple goals with one plan. Gifts to a Section 529 savings plan can use up to 5 years of a donor’s annual exclusion gifts in one year without creating a taxable gift ($70,000 in 2017). Assets in the 529 plan are not income taxed as they grow, and can escape income tax forever if used for qualified higher education expenses. What’s more, the value of the 529 plan is not included in the account owner’s (e.g., Mom’s) estate, even if she retains all power over the account up to the day she dies. In addition to and separate from gifts to 529 plans, a donor can make direct payments of education expenses to educational institutions – without any maximum limit – and these are not counted as gifts at all, not even chipping away at the $14,000 annual exclusion.
Planning with low interest rates
The continued existence of historically low interest rates makes a number of sophisticated estate planning strategies very attractive. Specifically, the applicable federal rate (“AFR”) and the § 7520 rate are two interest rates set by the IRS monthly that are used in various estate planning strategies. Clients might want to consider locking in these low interest rates before they start to increase.
- Premium financing and split dollar loans. Just as someone might borrow from another to buy a house or car, purchasers of life insurance might find it smart to borrow from another party to pay for premiums. When the lender is the insured or someone related to the insured (think of a grantor lending to a trust that owns a policy), this is often called a “private loan” or “split dollar loan.” When the lender is an unrelated third party like a bank, it is often labeled “premium financing.” Regardless of the parties involved, a low interest rate environment makes it less expensive to create new loans or refinance existing ones. As long as the rate used on the loan is at least as large as the AFR, the parties will avoid the application of the often annoying and costly below-market loan rules of Section 7872 that impute transfers of interest between the parties (i.e., treating the lender as if it transferred an interest amount to the borrower who in turn transferred an interest amount back to the lender, with corresponding tax effects). For example, an insured could make a mid-term loan (over 3 years, but less than 9 years) to his irrevocable trust to buy life insurance, and based on rates issued by the IRS for October 2017, could charge just an annual rate of 1.85% and still avoid Section 7872.
- Installment sale to grantor trust. When wealthy individuals do not want to make a large gift of assets to an irrevocable trust (maybe because they’ve used their lifetime exemption, or maybe because they want to preserve some wealth for themselves), they can sell those assets to the trust. To avoid any income tax on the sale, the irrevocable trust can be drafted as a grantor trust under IRC Section 671. To have it treated as a bona fide sale even though the trust does not have nearly enough assets to pay the individual, the trust buys the assets for an installment note. As with any loan, the note must charge at least the AFR to avoid the imputation of interest rules under the below market loan provisions of Section 7872. Fortunately, when the AFR is low as it is now, there is a good chance that the assets transferred by the individual – appreciating assets that produce income are best – will generate enough funds for the trust so that it can pay interest to the grantor and also have amounts left over for investment or other purposes (perhaps to pay for needed life insurance). Given that the donor is owed only the value of the note – i.e., the value of the assets when they were transferred to the trust, plus interest – any appreciation of those assets after being owned by the trust escape estate taxation. For example, if an installment sale were entered into in October 2017 with a long-term note (over 9 years), the loan would need to bear interest at no less than 2.50% to avoid Section 7872.
- GRAT. Grantor retained annuity trusts (GRATs) facilitate the giving of assets to an ultimate donee – i.e., the GRAT’s remainder beneficiary – where the value of those assets ends up being greater than what was predicted by IRS growth rate assumptions. As such, the donor reports a value today for the gift that is lower than the actual present value of the assets that will reach the donee in a future year (and the grantor pays low gift tax or avoids it altogether). This good outcome occurs if the assets transferred to the GRAT actually grow faster than the government had predicted they’d grow, as expressed by the government’s so-called § 7520 rate (which is 120% of the mid-term AFR). When the § 7520 rate is low – as it is nowadays – it is more likely that the assets transferred to the GRAT will outperform that rate. This in turn increases the likelihood that the value of the assets eventually passing to the GRAT’s remainder beneficiaries (could be a child or, say, another irrevocable trust holding life insurance) will exceed the value taken into account on the grantor’s gift tax return.
- CLAT. A charitable lead annuity trust (CLAT) is very similar to a GRAT, except that the annuity paid from the trust is not paid back to the donor, but instead is paid to a charity. With a GRAT, this annuity interest is not gift taxable because it is not a gift at all, as it is paid back to the grantor. With a CLAT, this annuity interest is not gift taxable because it is paid to a charity, to which gifts are deductible. As such, with both CLATs and GRATs, the only gift that might trigger gift tax for the donor is the value of that which is going to the remainder beneficiary after the initial annuity interest has been fulfilled. As it is with GRATs, CLATs are attractive when the § 7520 rate is low and thus can more likely be outperformed by the assets placed in the trust.
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