The American Taxpayer Relief Act of 2012 ("ATRA") eliminated the uncertainty that had plagued taxpayers for several years by finally determining the permanent fate of the Bush tax cuts. Unfortunately, along with the certainty of knowing the tax rates for the next several years comes another certainty — knowing that your taxes are most likely to go up. With the return of higher tax rates, restored itemized deduction and personal exemption limitations, and the new Medicare taxes on both earned income and investment income, many taxpayers will see a significant tax increase in 2013. Fortunately, taxpayers facing this increased tax burden can take action before year end to minimize the damage.

Summary of the Increased Tax Burden

While the results would have been much worse had the Bush tax cuts simply been left to expire, taxpayers in the higher tax brackets still will face a significant tax increase in 2013. The new Medicare taxes on earned and investment income only exacerbate the problem. This list summarizes the new or increased taxes taking effect in 2013:

• The highest marginal tax rate increases from 35% to 39.6%, applicable to couples with taxable income in excess of $450,000 ($400,000 for single filers).
• The highest tax rate on long term capital gains and qualified dividends increases from 15% to 20%, applicable to couples with taxable income in excess of $450,000 ($400,000 for single filers).
• A new 3.8% Medicare tax on net investment income goes into effect on couples with modified adjusted gross income (AGI) in excess of $250,000 ($200,000 for single filers). The tax is 3.8% multiplied by the lesser of net investment income or modified AGI in excess of the threshold.
• A new 0.9% Medicare tax on earned income goes into effect on couples with wages or net self-employment income in excess of $250,000 ($200,000 for single filers).
• The overall limit on itemized deductions is reinstated for couples with AGI in excess of $300,000 for couples ($250,000 for single filers). This limitation reduces otherwise allowable itemized deductions by 3% of AGI in excess of the threshold (not to exceed an 80% reduction in itemized deductions). Certain deductions, such as medical expenses and investment interest, are not subject to the limitation.
• The personal exemption phase-out is reinstated for couples with AGI in excess of $300,000 for couples ($250,000 for single filers). The phase-out reduces the total amount of exemptions by 2% for each $2,500, or portion thereof, by which AGI exceeds the threshold.

Investing Strategies

Between increased tax rates on both ordinary and investment income and the new 3.8% Medicare tax on net investment income, taxpayers need to manage their investments in the most tax-efficient way possible. While you never want to make investment decisions solely on the tax implications, those consequences cannot be ignored. Here are some strategies to consider before year end:

• Consider investments that do not generate current taxable income, such as growth stocks that do not pay dividends, tax-exempt investments such as municipal bonds or whole life insurance policies.
• Consider holding on to appreciating investments for at least 12 months, even if it means watching the value of your investment decline slightly. The tax rate differential between a short-term and long-term capital gain can be as high as 19.6%. If you believe a short-term investment has peaked, evaluate how much the value could drop before it qualifies as a long-term asset and whether that drop in value would exceed the additional taxes you would pay by selling now. Your tax advisor can help you calculate that break-even point based on the current value of the investment, your cost basis and the applicable tax rates.
• Review your year-to-date recognized capital gains and losses in your portfolio. If you have recognized gains, scan your portfolio for loss positions that you can harvest to shelter those gains. Similarly, if you have recognized losses (or capital loss carryovers from prior years), review your portfolio for unrealized gains that you can recognize to absorb those losses.
• When selling securities to generate gains to offset recognized losses or vice versa, pay attention to the holding period associated with those gains and losses. Short-term gains and losses are netted against each other first before they are netted against long-term gains and losses and vice versa. Always try to make sure net short-term gains are minimized since they are taxed at ordinary tax rates. For example, assume you have already recognized $50,000 of short-term gains and $50,000 of long-term gains and are looking to recognize some capital losses to shelter these gains. If you trigger, for example, $50,000 of long-term capital losses, your net capital gain will be $50,000 but it all will be taxed at short-term rates as high as 43.4%. Had you generated $50,000 of short-term capital losses instead, you still would have a net capital gain of $50,000 but it would be taxed at only 23.8% — a savings of $9,800.
• When looking to trigger capital losses to offset recognized capital gains, beware of the wash sale rules. If a security is sold at a loss and is then reacquired within 30 days, the loss will be disregarded. If you don't want to give up on that investment, either wait until you are beyond the 30 day window to reacquire the security or look for another security to invest in with a similar investment profile.
• If you are contemplating selling some gain positions before year end to absorb capital losses, be mindful of the fact that many mutual funds will pay sizeable capital gain dividends at the end of the year. Consider these impending dividends when evaluating how much in capital gains you need to generate.
• Watch for the distribution record date when contemplating mutual fund purchases at year end. If you purchase a fund shortly before the record date, you may pay an inflated price for the fund because of the impending distribution and then will need to pay taxes almost immediately on the distribution when it is paid. By waiting until after the record date, you should be able to acquire the fund at a lower price and avoid the distribution and related tax.
• When selling shares of a security that you have acquired at various times over the years, your cost basis in any subset of those shares can vary significantly depending on when they were acquired. The default method used by your broker to determine which shares of a security to sell, or how to calculate the cost basis of those shares, may not produce the most beneficial result. Ask your tax or investment advisor to determine which specific shares or cost basis calculation method will produce the optimal gain or loss recognized.

Shifting Income to Reduce Family Tax Burden

The increased disparity in tax rates between the highest and lowest income levels provides taxpayers even more incentive to transfer investment assets to their children as a way to reduce the family's overall tax burden. These goals must be managed against the gift tax implications of those transfers and the kiddie tax rules.

Taxpayers in the highest income tax bracket pay federal taxes on interest and short-term capital gains at 43.4% and on qualified dividends and long-term capital gains at 23.8% (including the new 3.8% Medicare tax on unearned income). Meanwhile, taxpayers in the lowest two income tax brackets pay federal taxes on interest and short-term capital gains at 10 – 15% and don't pay any taxes on qualified dividends and long-term capital gains (see the end of this article for the 2013 tax rate tables). Parents should consider gifting appreciated and/or income producing investments to their children to reduce, or even eliminate, federal taxes on capital gains and current income attributable to those investments.

While this may be a long-term tax planning strategy, taking action before year end can produce immediate benefits. Gifting mutual funds shares to children before the December record date will shift the income from those capital gain distributions (potentially significant given the market's performance this year) to your children. The same logic applies to transfers before a security's ex-dividend date or interest payment date. Transferring securities prior to their sale will also shift the resulting gains to the children, which may escape federal tax entirely if the gains are long-term capital gains.

Generally, this strategy only works with gifts to adult children who do not qualify as your dependents. Investment income of dependent children under the age of 19, or dependent full-time students under the age of 24, generally is taxed at the parents' tax rates. If the child files his or her own tax return, however, that income generally will not be subject to the 3.8% Medicare tax on net investment income unless the child has income in excess of the $200,000 threshold (for single taxpayers).

In addition to the income tax implications, parents looking to transfer investment assets to their children must also consider the gift tax implications of the transfers. In 2013, a taxpayer can gift up to $14,000 of assets to another person without using a portion of his lifetime gift exclusion. A taxpayer and spouse can elect to split gifts and jointly gift up to $28,000 to another person without gift tax implications.

Because of the tax rate differential, parents who traditionally make annual exclusion gifts to their children should consider gifting appreciated securities instead of cash. Parents who are just beginning a gifting program can bunch their annual exclusions by gifting $28,000 per person (assuming they elect to split gifts) in December and gifting an additional $28,000 per person next January. For 2013, the lifetime gift exclusion is $5,250,000 (or $10.5 million for a married couple) so couples may find it beneficial to use up part of the lifetime exclusion now in order to make larger gifts and remove the future appreciation of those assets from their estate.

If you wish to make large transfers of assets to your children without necessarily giving them complete control over the funds, a variety of trusts or other gifting vehicles, such as family limited partnerships, can help you accomplish this. Note that gifts using some of these vehicles may not qualify for the annual gift exclusion.

Charitable Giving Strategies

You can support your favorite causes and save taxes by making gifts to qualified charitable organizations. While cash donations are great, you potentially can save more taxes by donating appreciated property or using more complex charitable vehicles.

Donate appreciated securities instead of cash – Donating publicly traded stock and other securities that you've held for more than 12 months provides a double tax benefit: 1) you get a charitable deduction equal to the fair market value of the securities, and 2) you don't have to pay the tax that you would have owed had you sold the security and then donated the proceeds. The one drawback to donating appreciated securities is that your current year deduction is limited to 30% of your AGI (as opposed to 50% of AGI for cash donations), but the excess can be carried forward up to five years. Make sure you do not donate securities worth less than your cost basis. Instead, sell the investment, recognize the loss, and then donate the proceeds.

Donate to a donor-advised fund – If you would like to make a large donation before year end but haven't decided on which charities you want to support, consider donating to a donor advised fund (DAF). A DAF is similar to a private foundation in that it will make grants to multiple charities over time but you receive your charitable deduction upon your contribution to the DAF. Unlike with a private foundation, you can only make recommendations to the DAF on how to spend your donation, but your donation is not subject the more restrictive deduction limits that apply to private foundations.

Form a charitable remainder trust – A charitable remainder trust (CRT) lets you sell highly appreciated assets without incurring any current income or tax on the sale. You reserve a stream of payments from the CRT for many years for yourself or beneficiaries that you designate. At the end of the trust term, the charity gets the remainder. By using a CRT, you can avoid the tax on a large gain, get a current income tax deduction (based on the projected present value of the remainder), and leave the remainder to charities of your choice.

Timing Income and Deductions

Some traditional year-end tax planning strategies take on added significance this year because of the rate increases and new taxes. To the extent that these strategies involve the timing of itemized deductions, remember that some itemized deductions, such as state income taxes, home equity loan interest, investment expenses and unreimbursed employee business expenses, are not deductible for alternative minimum tax (AMT) purposes. Therefore, some of these strategies may not work in years in which you are subject to the AMT.

Spread out income recognition – Try to avoid spikes in income by spreading the recognition of income between years, especially if a spike will push you into a higher tax bracket. While you cannot always control when income will be recognized, you may have the ability to control the timing of certain types of income, such as retirement plan distributions, initial Social Security distributions, bonuses and self-employment income, exercises of stock options and gains from the dispositions of investment assets.

Use losses to shelter income – If you have a net operating loss carryforward or a large loss passing through from a partnership, LLC or S corporation, use that loss to shelter a large influx of income, such as from a sizeable capital gain or from the conversion of a traditional IRA to a Roth IRA. The new 3.8% Medicare tax on net investment income makes Roth IRAs even more attractive. While neither traditional nor Roth IRAs are subject to the 3.8% tax, traditional IRA distributions do increase your modified AGI which could indirectly increase the amount of 3.8% tax that you pay. If you don't have any losses with which to shelter your Roth IRA conversion amount, time your conversion in a year when your other net investment income is minimal to mitigate the 3.8% Medicare tax on net investment income.

Accelerate deductions – Consider paying certain expenses early to accelerate the deduction into the current year, such as fourth quarter state estimated tax payments, January mortgage payments and the second half of your real estate taxes. Conversely, if you expect a large spike in income next year that will push you into a higher tax bracket, you may consider deferring some of those deductions until next year so you receive the benefit at a higher tax rate. These timing strategies may not benefit you if you are subject to the AMT.

Bunch deductions – Certain itemized deductions are only deductible to the extent they exceed a floor based on your AGI, such as medical expenses (10% floor for most taxpayers) and miscellaneous itemized deductions (2% floor) including investment expenses, unreimbursed employee business expenses and professional fees. Consider bunching these types of deductions into a single year to maximize the amount of deductions in excess of the floor. Alternatively, if you anticipate a large change in your AGI between years, concentrate those deductions in a year when your AGI is lower. Again, these strategies may not benefit you if you are subject to the AMT.

Avoiding Estimated Tax Penalties

With taxes expected to go up in 2013 for many taxpayers, the specter of the estimated tax penalty takes on increased significance. Individuals will be assessed an estimated tax penalty if their income taxes are not paid (or deemed paid) to the IRS evenly throughout the year. Taxpayers can avoid the estimated tax penalty if they pay in evenly an amount equal to 90% of the current year tax liability or 110% of the prior year tax liability (100% for taxpayers with AGI below $150,000). Regular income tax, AMT, self-employment tax and the new 3.8% and 0.9% Medicare taxes are all taxes for purposes of the estimated tax penalty.

Taxpayers who have not paid in enough taxes year-to-date can make or increase a fourth quarter estimated tax payment (due January 15th) to mitigate the penalty. Since the penalty is calculated quarterly, however, a large fourth quarter payment will not completely eliminate the penalty. Withholding on wages is deemed to be paid in evenly throughout the year, regardless of when the withholding actually takes place. Therefore, taxpayers with wages who are facing an estimated tax penalty should consider asking their employers to withhold additional taxes for the balance of the year to minimize the penalty. Withholding on IRA or other retirement plan distributions is also treated as being paid ratably throughout the year, even if the distributions were taken in December.

The new 0.9% Medicare tax on earned income presents some withholding complications for married couples. Employers are required to withhold the 0.9% tax once an employee's taxable wages exceeds $200,000. Because the 0.9% tax is based on a married couple's joint earned income, however, the additional withholding may or may not occur at the proper time. For example, a taxpayer and spouse who each have taxable wages of $150,000 will be subject to the 0.9% tax on $50,000 of wages ($300,000 less the $250,000 threshold). Their employers will not have withheld the additional 0.9% tax, however, because neither employee had wages in excess of $200,000. Conversely, a taxpayer with $230,000 of taxable wages will be subject to the additional withholding even if the combined wages of the taxpayer and spouse are less than $250,000. Any excess withholding would be available to offset other taxes on the couple's tax return.

Managing Income Allocations between Estates and Trusts and Their Beneficiaries

Individuals are not the only taxpayers impacted by some of these tax increases; trusts and estates are affected as well, and at much lower thresholds:

• The highest marginal tax rate increases from 35% to 39.6%, applicable to trusts and estates with taxable income in excess of $11,950.
• The highest tax rate on long term capital gains and qualified dividends increases from 15% to 20%, applicable to trusts and estates with taxable income in excess of $11,950.
• The new 3.8% Medicare tax on net investment income goes into effect on trusts and estates with taxable income in excess of $11,950. The tax is 3.8% multiplied by the lesser of net investment income or taxable income in excess of the threshold.

Executors and trustees should consider making distributions to beneficiaries before year end as those distributions generally will pass out a corresponding amount of taxable income to the beneficiaries which may be taxed at lower rates.

Trusts that are required to distribute all of its income currently each year often will not distribute capital gains since capital gains generally are excluded from distributable net income by rule. There may be an ability to distribute capital gains, however, depending on the terms of the trust agreement, local law and the source of the gains (e.g., gains passing through from a partnership). The executor or trustee should consult with an attorney or tax advisor to determine whether it is possible to distribute capital gains currently to the beneficiaries.

Conclusion

While there only may be a few weeks left in the year, there is still time to make a significant dent in your 2013 tax liability if you act quickly. Consult with your CBIZ MHM tax advisor to discuss which of these strategies may benefit you. For tax strategies that your business should consider before year end, refer to our companion Tax Alert, Year-End Tax Planning for Businesses.

2013 Tax Rate Tables

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