2009 Year End Tax Guide


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Grant Thornton\'s 2009 Year End Tax Guide discusses recent tax law changes and provides an overview of strategies to help you reduce your tax liability. It will show you how to tax-efficiently invest for education and retirement, and transfer your wealth to family members. For action steps to jump-start the planning process, look for our top 20 tax planning opportunities.

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2009 Year End Tax Guide

  1. 1. Year-end tax guide for 2009
  2. 2. Charts 5 Chart 1: Individual income tax rates 18 Chart 6: Tax differences based on business structure 6 Chart 2: Employment tax rates 19 Chart 7: AGI-based limits on charitable contributions 9 Chart 3: AMT rate schedule and exemptions 23 Chart 8: AGI phaseout levels for education tax breaks 11 Chart 4: Top tax rates according to character of income 27 Chart 9: Retirement plan contribution limits 17 Chart 5: Corporate income tax rates 31 Chart 10: Gift and estate tax rates and exemptions Top 20 tax planning opportunities 6 Opportunity 1: Increase withholding instead of 20 Opportunity 10: Give directly from an IRA if you’re estimated tax payments 70½ or older 8 Opportunity 2: Bunch itemized deductions to get 20 Opportunity 11: Give appreciated property to over AGI floors enhance savings 8 Opportunity 3: Take full advantage of above-the-line 24 Opportunity 12: Make payments directly to deductions educational institutions 10 Opportunity 4: Accelerate income to “zero out” the AMT 24 Opportunity 13: Plan around gift taxes with your 529 plan 12 Opportunity 5: Avoid the wash sale rule with a bond swap 28 Opportunity 14: Wait to make your retirement 12 Opportunity 6: Don’t fear the wash sale rule to account withdrawals accelerate gains 30 Opportunity 15: Get kids started with a Roth IRA 14 Opportunity 7: Defer investment interest for a bigger deduction 30 Opportunity 16: Roll yourself over into a Roth IRA 16 Opportunity 8: Consider an 83(b) election on your 32 Opportunity 17: Review and update your estate plan restricted stock 32 Opportunity 18: Exhaust your gift-tax exemption 18 Opportunity 9: Set salary wisely if you’re a corporate 34 Opportunity 19: Use second-to-die life insurance employee-shareholder for extra liquidity 34 Opportunity 20: Zero out your GRAT to save more 1
  3. 3. Year-end tax guide 2009 How much will you pay? Managing your finances and tax burden can feel like juggling Contents and jumping through hoops: You’ve got lots of moving pieces and only two hands. But tax planning has never been more 3 Chapter 1: Tax law changes: What’s new this year important. Drastic changes in the economic environment can 5 Chapter 2: Getting started: Ordinary income taxes, force a shift in tax strategy, especially if your own situation is evolving. rates and rules On top of that, the tax code is only becoming more complex. 7 Chapter 3: Basic strategies: Timing and deductions The economic turmoil of the last year has spurred the passage of more new tax laws. While there are now more ways than ever to 9 Chapter 4: Alternative minimum tax help you reduce your tax liability, taking full advantage of them 11 Chapter 5: Investment income is becoming harder. The outlook for future tax legislation can be even more confusing. You need to think farther ahead, employ 15 Chapter 6: Executive compensation clearer strategies and use every tax break you can. 17 Chapter 7: Business ownership To help you save as much as possible, this Grant Thornton guide discusses recent tax law changes and provides an overview 19 Chapter 8: Charitable giving of strategies to help you reduce your tax liability. It will show 23 Chapter 9: Education savings you how to tax-efficiently invest for education and retirement, and transfer your wealth to family members. For action steps to 27 Chapter 10: Retirement savings jump-start the planning process, look for our top 20 tax planning 31 Chapter 11: Estate planning opportunities. However, this guide simply can’t cover all possible strategies. So be sure to contact us to find out what will work best for you. As of the publication date of this guide, Congress was still considering legislation that could have major tax implications, including a healthcare reform bill and an estate tax reform bill. While the 2009 tax laws won’t likely be affected, new legislation could change your planning strategies. Our National Tax Office tracks tax legislation as it moves through Congress, so visit our website regularly to read updates at www.GrantThornton.com/yearendtaxguide. 2
  4. 4. Chapter 1: Tax law changes: What’s new this year Relief and opportunity Congress and the president enacted a major economic stimulus Did you make any home improvements? bill in 2009, which came just a few months after a number of You may be entitled to a larger tax credit than you think important tax provisions were extended in a financial rescue bill if you made energy-efficient improvements to your home in late 2008. More tax legislation was still possible as this guide this year. The stimulus bill enhanced both the Section 25C went to print, but the stimulus bill alone included $326 billion home improvement tax credit and the Section 25D residential in new tax cuts. Virtually no revenue raisers were included. energy-efficient property tax credit. Lawmakers decided that with the economy in trouble, it was Section 25C provides a credit for installing energy-saving not the right time to apply the kinds of tax increases that have property, such as insulation, energy-efficient windows and roofs, been used to pay for legislation in past years. and highly efficient air conditioners, furnaces and water heaters. Most of the tax provisions from the new tax bills are In 2008, the credit rate was 10 percent and had a lifetime limit of designed either to stimulate economic activity or provide relief $500. For 2009, the credit rate has been increased to 30 percent to taxpayers that have suffered from the downturn. Many are with an additional $1,500 added to the lifetime limit. geared toward individuals, and these will provide scores of Section 25D provides a 30-percent personal tax credit taxpayers with fresh opportunities for tax savings. for energy-efficient property, such as solar water heaters, geothermal heat pumps and fuel cells. Previously, this credit Take a new look at education incentives was generally capped between $500 and $4,000 depending on You may need to reexamine education credits this year, even the property. The stimulus bill eliminates the credit caps for if you assumed you earn too much to qualify. The stimulus bill solar, geothermal and wind property and allows the use of enhanced the Hope Scholarship credit for 2009 and 2010 and subsidized energy financing. renamed it the American Opportunity credit. The credit is now more generous, equal to 100 percent of the first $2,000 of tuition Did you buy a car this year? and 25 percent of the next $2,000, for a total credit of up to The “cash for clunkers” program stole all the press this year, $2,500. It is also 40 percent refundable. but many car-buyers who didn’t have a clunker to trade in But most importantly, it is allowed against the alternative will still get a substantial deduction for a new car purchase. minimum tax (AMT) and phases out at a much higher income The stimulus bill created an above-the-line deduction for state level. For 2009 and 2010, the credit will phase out between and local sales tax on new car purchases made between Feb. 17 adjusted gross incomes of $80,000 and $90,000 for single and the end of the year. filers and $160,000 and $180,000 for married couples filing The deduction is allowed for taxes on the first $49,500 of jointly. (See page 23 for a full discussion of tax planning for the car’s price, and the phaseout range is unusually high for this education expenses.) type of targeted benefit. The deduction phases out between the adjusted gross income (AGI) levels of $125,000 and $135,000 for single individuals and $250,000 and $260,000 for joint filers. Above-the-line deductions are especially valuable because they reduce AGI (see more on this strategy on page 8), but this deduction is not available if you elect to claim state and local taxes as an itemized deduction. 3
  5. 5. Would you consider investing in a small business? against taxes paid in prior years. Normally, the net operating Qualified small business (QSP) stock has become an even more loss carryback period is only two years, but businesses that attractive investment. The stimulus bill increased the exclusion meet all the restrictions in the bill can elect a carryback period on the gain from the sale of QSP stock from 50 percent to of three, four or five years. 75 percent for stock bought after Feb. 17, 2009, and before The stimulus bill also will allow taxpayers to defer Jan. 1, 2011. This stock is taxed at a long-term capital gains cancellation of debt (COD) income incurred in 2009 and rate of 28 percent, so the increased exclusion drives the effective 2010. COD income arises from virtually any “forgiveness” rate down from 14 percent to 7 percent. Investments in qualified of debt, whether it comes from retiring a debt at a discount, small business stock also come with several other tax benefits. refinancing an existing debt, exchanging an old debt for a new (See page 12 for more details.) one or any other modification. The deferred COD income will be recognized ratably over the five years beginning in 2014. Are you required to make distributions from your The stimulus bill also lowered withholding and estimated retirement plan? tax requirements for certain taxpayers with AGIs under Normally, taxpayers must begin making required minimum $500,000 who earn at least half of their income from a small distributions (RMDs) from tax-preferred retirement savings trade or business. Qualifying taxpayers will only need to pay accounts such as IRAs, 401(k)s, 403(b) plans and some 457(b) the equivalent of 90 percent of their 2008 tax throughout 2009 plans once they reach age 70½. These distributions are calculated to avoid 2009 underpayment penalties, rather than 100 percent using your account balance and life expectancy table and or 110 percent. (For a more detailed discussion on payment generally must be taken each year by Dec. 31. If not, you can requirements, see page 6.) be charged a 50-percent penalty on the amount that should have been withdrawn. Be aware of what Congress hasn’t done yet Lawmakers late last year were concerned that the As this guide went to print, Congress was still considering distribution requirements were unfair to taxpayers whose several bills that could have major tax implications. Most retirement accounts were battered by the downturn, so they significantly, a healthcare reform bill, if enacted, is likely enacted a provision to waive all RMDs for 2009. The normal to carry a large tax component. RMD rules are suspended completely, so no taxpayer has to Congress was also planning to consider a bill to reform the make an RMD for 2009. This includes taxpayers reaching 70½ estate tax before it is scheduled to disappear for one year in 2010. during calendar-year 2009. The suspension is permanent. You (For more information on the estate tax, see page 31.) That bill will not have to increase distributions in a later year to make could also extend many popular tax provisions that remain in up for 2009. (See Tax planning opportunity 14 for strategies on place for 2009, but are scheduled to expire in 2010. While these dealing with RMDs.) changes won’t likely affect the tax laws in 2009, they could change planning strategies right away. Are you a business owner? Call Grant Thornton to find out the latest status of Business owners should be aware of several additional tax legislation and to discuss any tax-saving opportunities opportunities provided by the stimulus bill. The bill allows arising from provisions enacted this year. qualifying small businesses with under $15 million in annual gross receipts to carry 2008 losses farther back to receive refunds 4
  6. 6. Chapter 2: Getting started: Ordinary income taxes, rates and rules Our tax system Our income tax system seems straightforward at first glance. In 2009, the personal exemption of $3,650 that taxpayers Individuals are taxed according to their income, with rates receive for themselves, their spouses and their dependents phases increasing as income goes up. So, the more you make, the out by $24.33 for every $2,500 (or fraction thereof) of adjusted higher percentage of tax you’re expected to pay. These gross income (AGI) above a designated high-income threshold. increasing rates are often referred to as “tax brackets.” The This threshold in 2009 is: top rate that applies to you, or your tax bracket, is usually • $166,800 for single filers, considered your marginal tax rate. It’s the rate you will pay • $250,200 for joint filers, on an additional dollar of income. • $208,500 for heads of household, and For 2009, the ordinary income tax brackets range from • $125,100 for married couples filing separately. 10 percent to 35 percent. (See chart 1 for the full schedule.) Ordinary income includes things such as salary and bonuses, In 2009, each personal exemption can be reduced to no self-employment and business income, interest, retirement plan lower than $2,433. distributions and more. Looking beyond the tax brackets Unfortunately, the tax brackets for ordinary income don’t tell the whole story. Your effective marginal rate may be much different than the actual rate in your tax bracket. For one, not everything is ordinary income. Different types of income are taxed in different ways. (See page 11 for information on investment income.) But more importantly, hidden taxes that kick in at higher income levels when you reach the top tax brackets can drive your marginal tax rate higher. Many tax credits and deductions phase out as your income increases, meaning an extra dollar of income actually increases your tax liability more than the top tax rate. Two of the most costly phaseouts apply to your personal exemptions and itemized deductions. Chart 1: 2009 individual income tax brackets Married filing jointly Tax rate Single Head of household Married filing separately or surviving spouse 10% $0 – $8,350 $0 – $11,950 $0 – $16,700 $0 – $8,350 15% $8,351 – $33,950 $11,951 – $45,500 $16,701 – $67,900 $8,351 – $33,950 25% $33,951 – $82,250 $45,501 – $117,450 $67,901 – $137,050 $33,951 – $68,525 28% $82,251 – $171,550 $117,451 – $190,200 $137,051 – $208,850 $68,526 – $104,425 33% $171,551 – $372,950 $190,201 – $372,950 $208,851 – $372,950 $104,426 – $186,475 35% Over $372,950 Over $372,950 Over $372,950 Over $186,475 5
  7. 7. The phaseout for itemized deductions operates a little Chart 2: Employment taxes differently. Some deductions — such as medical expenses, Social Security Medicare Total tax investment interest, casualty losses and certain contributions to disaster relief — are not included in the phaseout. But 2009 income limit $106,800 no limit NA Employee rate 6.2% 1.45% 7.65% many of the most popular and valuable deductions — such Employer rate 6.2% 1.45% 7.65% as mortgage interest and employee business expenses — are Self-employed rate 12.4% 2.90% 15.30% affected. In 2009, the affected deductions are reduced by an amount equal to one percent of any AGI that exceeds $166,800 an above-the-line deduction for 50 percent of the total tax. ($83,400 for married couples filing separately) up to a maximum There are also special employment tax considerations if you’re reduction of 26.67 percent. a business owner who works in the business. (See Tax planning The effects of the phaseouts of both itemized deductions opportunity 9.) and personal exemptions have been shrinking gradually thanks to a 2001 tax bill. In 2010, both are scheduled to disappear Taxes are due year round completely for one year. But in 2011, they are scheduled to Although you don’t file your return until after the end of come back at triple their 2009 rates. If that occurs, beginning the year, it’s important to remember that you must pay in 2011 your personal exemptions can be eliminated completely tax throughout the year with estimated tax payments or and the applicable itemized deductions can be reduced by up withholding. You will be penalized if you haven’t paid enough. to 80 percent. If your AGI was over $150,000 in 2008, you can generally It’s worth noting that both of these phaseouts are tied to avoid penalties by paying at least 90 percent of your 2009 AGI, as are nearly all of the tax-benefit phaseouts in the code tax liability or 110 percent of your 2008 liability through that apply to individuals. That’s why above-the-line deductions withholding and estimated taxes (taxpayers under $150,000 are so valuable. They reduce AGI. Most other deductions and need only pay 100 percent of 2008 liability). Additionally, the credits only reduce taxable income or tax, itself, without affecting stimulus bill enacted in February 2009 allows certain taxpayers AGI. (See Tax planning opportunity 3 for information on taking with a 2008 AGI of under $500,000, and at least half their income full advantage of above-the-line deductions.) from a small business, to prepay an amount equal to just 90 Phaseouts of tax benefits aren’t the only things you need to percent of their 2008 liability. worry about. Many high-income taxpayers could also face the If your income is often irregular due to bonuses, investments alternative minimum tax (see page 9 on the AMT), and anyone or seasonal income, consider the annualized income installment with earned income will have to pay employment taxes. method. This method allows you to estimate the tax due based on income, gains, losses and deductions through each estimated Employment taxes take a bite tax period. If you’ve found you’ve underpaid, try and have the Employment taxes are made up of Social Security and Medicare shortfall withheld from your salary or bonus. (See Tax planning taxes and apply to earned income. Social Security taxes are opportunity 1.) capped, but you must pay Medicare tax on all of your earned You also want to avoid early withdrawals from tax- income. (See chart 2 for the current employment tax rates and advantaged retirement plans, such as 401(k) accounts and Social Security tax ceiling.) individual retirement accounts (IRAs). Distributions generally If you are employed and your earned income consists of must be made after reaching the age of 59½ to avoid penalties. salaries and bonus, your employer will withhold your share Distributions from these plans are treated as ordinary income, of these taxes and pay them directly to the government. If you and you’ll pay an extra 10-percent penalty on any premature are self-employed, you must pay both the employee and the withdrawals. This can raise your effective federal tax rate to employer portions of employment tax, though you can take as high as 45 percent on the income. Tax planning opportunities 1 Make up any estimated tax shortfall with increased withholding, not estimated tax payments If you’re in danger of being penalized for not paying enough tax throughout the year, try to make up the shortfall through increased withholding on your salary or bonuses. Paying the shortfall through an increase in your last quarterly estimated tax payment can still leave you exposed to penalties for underpayments in previous quarters. But withholding is considered to have been paid ratably throughout the year. So a big bump in withholding on high year-end wages can save you in penalties when a similar increase in an estimated tax payment might not. 6
  8. 8. Chapter 3: Basic strategies: Timing and deductions Timing income and expenses Why pay tax now when you can pay tomorrow? Deferring tax There are many reasons to believe that existing tax is a traditional cornerstone of good tax planning. Generally this benefits scheduled to expire in 2011 will be extended, at least means you want to accelerate deductions into the current year for taxpayers with incomes below $250,000 (for a married couple and defer income into next year. So it’s important to review your filing a joint return). President Obama has proposed an extension income and deductible expenses well before Dec. 31. You need of current tax benefits for these taxpayers, and Republican to take action before the new year to affect your 2009 return. leaders have indicated they support an even broader extension. However, deferring income and accelerating deductions Legislation addressing this issue may not be considered until may not always make sense. If you are going to be subject to 2010. So call Grant Thornton to discuss the latest legislative the alternative minimum tax (AMT) in one year and not another, developments and to find out how you, personally, may want it can affect your timing strategy. (See page 9 for more on coping to approach timing. with the AMT). More importantly, if you believe that tax rates Whether it eventually makes more sense for you to defer are going up, you may feel it is beneficial to do the opposite. In or accelerate your taxes, there are many items with which you that case, you want to realize more income now when rates are may be able to control timing: low and save your deductions for later when rates are higher. Timing your income and expenses properly can clearly Income reduce your tax liability. Currently, many tax benefits are • Bonuses scheduled to remain in place and even improve from 2009 • Consulting income to 2010, but then disappear in 2011. Taxpayers may want to • Other self-employment income consider deferring tax into 2010 and then accelerating income • Real estate sales ahead of a potential tax increase in 2011. • Other property sales But be cautious. Legislative action is likely to make a big • Retirement plan distributions difference in this area, as will your personal situation. Income acceleration can be a powerful strategy, but it should only Expenses be employed if you are comfortable with your own political • State and local income taxes analysis and are prepared to accept the consequences if you • Real estate taxes are wrong. • Mortgage interest • Margin interest • Charitable contributions It’s important to remember that prepaid expenses can be deducted only in the year they apply. So you can prepay 2009 state income taxes to receive a 2009 deduction even if the taxes aren’t due until 2010. But you can’t prepay state taxes on your 2010 income and deduct the payment on your 2009 return. But don’t forget the AMT. If you are going to be subject to the AMT in both 2009 and 2010, it won’t matter when you pay your state income tax, because it will not reduce your AMT liability in either year. 7
  9. 9. Timing deductions can make a big difference Keep in mind that medical expenses aren’t deductible if Timing can often have the biggest impact on your itemized they are reimbursable through insurance or paid through a deductions. How and when you take these deductions is pretax Health Savings Account or Flexible Spending Account. important because many itemized deductions have AGI floors. The AMT can also complicate this strategy. For AMT purposes, For instance, miscellaneous expenses are deductible only to only medical expenses in excess of 10 percent of your AGI the extent they exceed two percent of your AGI, and medical are deductible. expenses are only deductible to the extent they exceed 7.5 You also want to take full advantage of above-the-line percent of your AGI. Bunching these deductions into a single deductions to the extent possible. They are not subject to the year may allow you to exceed these floors and save more. AGI floors that hamper many itemized deductions. They even (See Tax planning opportunity 2 to find out how to make reduce AGI, which provides a number of tax benefits. (See Tax this strategy work.) planning opportunity 3.) Tax planning opportunities 2 Bunch itemized deductions to get over AGI floors Bunching deductible expenses into a single year can help you get over AGI floors for itemized deductions, such as the two-percent AGI floor for miscellaneous expenses and the 7.5-percent floor for medical expenses. Miscellaneous expenses you may be able to accelerate and pay now include: • deductible investment expenses, such as investment advisory fees, custodial fees, safe deposit box rentals and investment publications; • professional fees, such as tax planning and preparation, accounting and certain legal fees; and • unreimbursed employee business expenses, such as travel, meals, entertainment, vehicle costs and publications — all exclusive of personal use. Bunching medical expenses is often easier than bunching miscellaneous itemized deductions. Consider scheduling your non-urgent medical procedures and other controllable expenses into one year to take advantage of the deductions. Deductible medical expenses include: • health insurance premiums, • prescription drugs, and • medical and dental costs and services. In extreme cases, and assuming you are not subject to AMT, it may even be possible to claim a standard deduction in one year, while bunching two years’ worth of itemized deductions in another. 3 Take full advantage of above-the-line deductions Above-the-line deductions are especially valuable. They aren’t reduced by AGI floors like many itemized deductions and have the enormous benefit of actually reducing AGI. Nearly all of the tax benefits that phase out at high income levels are tied to AGI. The list includes personal exemptions and itemized deductions, education incentives, charitable giving deductions, the alternative minimum tax exemption, some retirement accounts and real estate loss deductions. Above-the-line deductions that reduce AGI could increase your chances of enjoying other tax preferences. Common above-the-line deductions include traditional Individual Retirement Account (IRA) and Health Savings Account (HSA) contributions, moving expenses, self-employed health insurance costs and alimony payments. Take full advantage of these deductions by contributing as much as possible to retirement vehicles that provide them, such as IRAs and SEP IRAs. Don’t skimp on HSA contributions either. When possible, give the maximum amount allowed. And don’t forget that if you’re self-employed, the cost of the high deductible health plan tied to your HSA is also an above-the-line deduction. 8
  10. 10. Chapter 4: Alternative minimum tax Don’t let the AMT take you by surprise The alternative minimum tax (AMT) is perhaps the most The AMT includes a large exemption, but this exemption unpleasant surprise lurking in the tax code. It was originally phases out at high-income levels. And unlike the regular tax conceived to ensure all taxpayers paid at least some tax, but system, the AMT isn’t adjusted regularly for inflation. Instead, has long since outgrown its intended use. Congress must legislate any adjustments. Congress has been The AMT is essentially a separate tax system with its own doing this on an approximately year-by-year basis for several set of rules. How do you know if you will be subjected to the years, and they have already made an adjustment for 2009. AMT? Each year you must calculate your tax liability under the But it’s important to remember that so far, Congress has only regular income tax system and the AMT, and then pay the increased the exemption amount with each year’s “patch,” higher amount. while the phaseout of the exemption and the AMT tax The AMT is made up of two tax brackets, with a top rate brackets remain unchanged. (See chart 3.) of 28 percent. Many deductions and credits are not allowed under the AMT, so taxpayers with substantial deductions that are reduced or not allowed under the AMT are the ones stuck paying. Common AMT triggers include: • state and local income and sales taxes, especially in high-tax states; • real estate or personal property taxes; • investment advisory fees; • employee business expenses; • incentive stock options; • interest on a home equity loan not used to build or improve your residence; • tax-exempt interest on certain private activity bonds; and • accelerated depreciation adjustments and related gain or loss differences on disposition. Chart 3: 2009 individual AMT rate schedule and exemptions AMT brackets AMT exemption 26% tax rate 28% tax rate Exemption Phaseout Single or head of household $0 – $175,000 Over $175,000 $46,700 $112,500 – $299,300 Married filing jointly $0 – $175,000 Over $175,000 $69,950 $150,000 – $429,800 Married filing separately $0 – $87,500 Over $87,500 $34,975 $75,000 – $214,900 9
  11. 11. Proper planning can help you mitigate, or even If you have to pay the AMT, you may be able to take eliminate, the impact of the AMT. The first step is to work advantage of an AMT credit that has become more generous with Grant Thornton to determine whether you could be recently. You can qualify for the AMT credit by paying AMT subject to the AMT this year or in the future. In years you’ll on timing items like depreciation adjustments, passive activity be subject to the AMT, you want to defer deductions that adjustments and incentive stock options. The credit can be taken are erased by the AMT and possibly accelerate income to against regular tax in future years, as it is meant to account for take advantage of the lower AMT rate. (See Tax planning timing differences that reverse in the future. opportunity 4 on zeroing out your AMT.) The AMT credit may only provide partial relief, but just got Capital gains and qualified dividends deserve special a little more generous. A tax bill enacted late in 2008 now allows consideration for the AMT. They are taxed at the same you to use AMT credits at least four years old in 50-percent 15-percent rate either under the AMT or regular tax increments over a period of two years, even in years when the structure, but the additional income they generate can AMT continues to apply. The AGI phaseout of this special tax reduce your AMT exemption and result in a higher break has also been removed. AMT bill. So consider your AMT implications before selling any stock that could generate a large gain. Tax planning opportunities 4 Accelerate income to “zero out” the AMT You have to pay the AMT when it results in more tax than your regular income tax calculation, typically because the AMT has taken away key deductions. The silver lining is that the top AMT tax rate is only 28 percent. So you can “zero out” the AMT by accelerating income into the AMT year until the tax you calculate for regular tax and AMT are the same. Although you will have paid tax sooner, you will have paid at an effective tax rate of only 26 percent or 28 percent on the accelerated income, which is less than the top rate of 35 percent that is paid in a year you’re not subject to the AMT. If the income you accelerate would otherwise be taxed in a future year with a potential top rate of 39.6 percent, the savings could be even greater. But be careful. If the additional income falls in the AMT exemption phaseout range, the effective rate may be a higher 31.5 percent. The additional income may also reduce itemized deductions and exemptions (as discussed on page 6), so you need to consider the overall tax impact. 10
  12. 12. Chapter 5: Investment income Making tax-smart investment decisions Not all income is created equal. The character of income Chart 4: Top tax rates of different types of income under current code determines its tax rate and treatment. Investment income 2009–10 2011+ alone comes in a variety of forms. Income such as dividends and interest arises from holding investments, while capital Ordinary income 35% 39.6% Qualifying dividends 15% 39.6% gains income results from the sale of investments. Short-term capital gains 35% 39.6% Investment income is often treated more favorably than Long-term capital gains 15% 20% ordinary income, but the rules are complex. Long-term capital Key exceptions to regular gains and qualifying dividends can be taxed as low as 15 percent, capital gains rates 2009–10 2011+ Qualified small business stock while nonqualified dividends, interest and short-term capital held more than 5 years1 7%2 14% gains are taxed at ordinary income tax rates as high as 35 percent. Gain that would be taxed in the 10% or 15% Special rates also apply to specific types of capital gains and other brackets based on the taxpayer’s income level3 0% 10% investments, such as mutual funds and passive activities. But 1 The effective rate for qualified small business stock is based on 28% rate and the these rates aren’t scheduled to last forever. Unless Congress acts, applicable gain exclusion. rates will increase on all types of income in 2011. (See chart 4.) 2 The 7% effective rate applies for stock acquired after Feb. 17, 2009, and before Jan. 1, 2011. Otherwise qualified small business stock will have 14% effective rate. The various rules and rates on investment income offer 3 The 10% bracket is scheduled to disappear in 2011. many opportunities for you to minimize your tax burden. Understanding the tax costs of various types of investment Capital gains and losses income can also help you make tax smart decisions. But To benefit from long-term capital gains treatment, you must remember that tax planning is just one part of investing. hold a capital asset for more than 12 months before it is sold. You must also consider your risk tolerance, desired asset Selling an asset you’ve held for 12 months or less results in less allocation and whether an investment makes sense for your favorable short-term capital gains treatment. Several specific financial and personal situation. types of assets have special, higher capital gains rates, and taxpayers in the bottom two tax brackets enjoy a zero rate on their capital gains and dividends in 2009 and 2010. Your total capital gain or loss for tax purposes is generally calculated by netting all the capital gains and losses throughout the year. You can offset both short-term and long-term gains with either short-term or long-term losses. Taxpayers facing a large capital gains tax bill often find it beneficial to look for unrealized losses in their portfolio so they can sell the assets to offset their gains. But keep the wash sale rule in mind. You can’t use the loss if you buy the same — or a substantially identical — security within 30 days before or after you sell the security that creates the loss. 11
  13. 13. There are ways to mitigate the wash sale rule. You may If you have adult children in these tax brackets, consider be able to buy securities of a different company in the same giving them dividend-producing stock or long-term appreciated industry or shares in a mutual fund that holds securities much stock. They can sell the stock for gains or hold the stock for like the ones you sold. Alternatively, consider a bond swap. dividends without owing any taxes. (See Tax planning opportunity 5 on bond swaps.) Keep in mind there could be gift tax and estate planning It may prove unwise to try and offset your capital gains consequences. (See page 32 to learn about gifting strategies.) at all. Up to $3,000 in net capital loss can be claimed against Gifts to children up to the age of 23 can also be subject to the ordinary income (with a top rate of 35 percent in 2009 and “kiddie tax.” (See page 26 for more information.) 2010), and the rest can be carried forward to offset future short-term loss or ordinary income. More importantly, long- Mutual fund pitfalls term capital gains rates in 2009 and 2010 are a low 15 percent, Investing in mutual funds is an easy way to diversify your but are scheduled to increase to 20 percent in 2011. It may portfolio, but comes with tax pitfalls. Earnings on mutual actually be time to consider selling assets with unrealized funds are typically reinvested. Unless you (or your broker or gains now to take advantage of the current low rates. (See investment advisor) keep track of these additions to your basis, Tax planning opportunity 6 for more on recognizing gains.) and you designate which shares you are selling, you may report Be careful, however. The 15-percent rate could be extended more gain than required when you sell the fund. beyond 2010, at least to the extent the net capital gain does not It is often a good idea to avoid buying shares in an equity push taxable income above $250,000 for a married couple filing mutual fund right before it declares a large capital gains a joint return. (See page 7 for more on the legislative prospects distribution, typically at year-end. If you own the shares on of tax increases.) the record date of the distribution, you’ll be taxed on the full Regardless of whether you want to accelerate or mitigate distribution amount even though it may include significant gains a net capital gain, the tax consequences of a sale can come as a realized by the fund before you owned the shares. Worse yet, surprise, unless you remember the following rules: you’ll end up paying taxes on those gains in the current year — • If you bought the same security at different times and even if you reinvest the distribution in the fund and regardless prices, you should specifically identify in writing which of whether your position in the fund has appreciated. shares are to be sold by the broker before the sale. Selling the shares with the highest basis will reduce your gain or Small business stock comes with tax rewards increase your losses. Buying stock in a qualified small business (QSB) comes • For tax purposes, the trade date and not the settlement date with several tax benefits, assuming you comply with specific of publicly traded securities determines the year in which requirements and limitations. If you sell QSB stock at a loss, you you recognize the gain or loss. can treat up to $50,000 ($100,000, if married filing jointly) as an ordinary loss, regardless of your holding period. This means you Use zero capital gains rate to benefit children can use it to offset ordinary income taxed at a 35-percent rate, Taxpayers in the bottom two tax brackets pay no taxes on such as salary and interest. long-term capital gains and qualifying dividends in 2009 and You can also roll over QSB stock without realizing gain. 2010. If income from these items would be in the 10-percent If you buy QSB stock with the proceeds of a sale of QSB stock or 15-percent bracket based on a taxpayer’s income, than the within 60 days, you can defer the tax on your gain until you tax rate is zero. dispose of the new stock. The new stock’s holding period for long-term capital gains treatment includes the holding period of the stock you sold. Tax planning opportunities 5 Avoid the wash sale rule with a bond swap Bond swaps are a way to maintain your investment position while recognizing a loss. With a bond swap, you sell a bond, take a capital loss and then immediately buy another bond of similar quality from a different issuer. You’ll avoid the wash sale rule because the bonds are not considered substantially identical. 6 Don’t fear the wash sale rule to accelerate gains Remember, there is no wash sale rule for gains, only losses. You can recognize gains anytime by selling your stock and repurchasing it immediately. This may be helpful if you have a large net capital loss you don’t want to carry forward or want to take advantage of today’s low rates. Waiting until after 2010 to pay tax on unrealized gains could result in a larger tax bill, if rates do indeed go up. 12
  14. 14. Most importantly, you may only have to pay an effective It’s also important to reallocate your retirement plan assets rate as low as seven percent on long-term gain of QSB stock. periodically. For example, the allocation you set up for your The gain is normally taxed at a 28-percent rate, but a 50-percent 401(k) plan 10 years ago may not be appropriate now that you’re exclusion allows for an effective tax rate of 14 percent. However, closer to retirement. (See page 27 on saving for retirement.) the stimulus bill enacted in February 2009 allows taxpayers to exclude 75 percent of the gain from qualifying stock bought after Planning for passive losses Feb. 17, 2009, and before Jan. 1, 2011, for an effective tax rate of There are special rules for income and losses from a passive just seven percent. activity. Investments in a trade or business in which you don’t materially participate are passive activities. You can prove your Rethinking dividend tax treatment material participation by participating in the trade or business for The tax treatment of income-producing assets can affect more than 500 hours during the year or by demonstrating that investment strategy. Qualifying dividends generally are taxed your involvement represents substantially all of the participation at the reduced rate of 15 percent, while interest income is taxed in the activity. at ordinary-income rates of up to 35 percent. So, dividend- The designation of a passive activity is important, because paying stocks may be more attractive from a tax perspective passive activity losses are generally deductible only against than investments like CDs and bonds. But there are exceptions. income from other passive activities. You can carry forward Some dividends are subject to ordinary-income rates. disallowed losses to the following year, subject to the same These may include certain dividends from: limitations. There are options for turning passive losses into • money market mutual funds, tax-saving opportunities. • mutual savings banks, You can increase your activity to more than 500 hours. • real estate investment trusts (REITs), Alternatively, you can limit your activities in another business • foreign investments, to less than 500 hours or invest in another income-producing • regulated investment companies, and business that will be passive to you. Either way, the other • stocks, to the extent the dividends are offset by margin debt. businesses can give passive income to offset your passive losses. Finally, consider disposing of the activity to deduct Some bond interest is exempt from income tax. Interest on all the losses. The disposition rules can be complex, so consult U.S. government bonds is taxable on your federal return, but with a Grant Thornton tax advisor. it’s generally exempt on your state and local returns. Interest on Rental activity has its own set of passive loss rules. Losses state and local government bonds is excludible on your federal from real estate activities are passive by definition unless you’re return. If the state or local bonds were issued in your home state, a real estate professional. If you’re a real estate professional, you interest also may be excludible on your state return. Although can deduct real estate losses in full, but you must perform more state and municipal bonds usually pay a lower interest rate, than half of your personal services in real property trades and their rate of return may be higher than the after-tax rate of businesses annually and spend more than 750 hours in these return for a taxable investment. services during the year. If you actively participate in a rental real estate activity but Review portfolio for tax balance you aren’t a real estate professional, you may be able to deduct You should consider which investments to hold inside and up to $25,000 of real estate losses each year. This deduction is outside your retirement accounts. If you hold taxable bonds subject to a phaseout beginning when adjusted gross income to generate income and diversify your overall portfolio, (AGI) reaches $100,000 ($50,000 for married taxpayers filing consider holding them in a retirement account where there separately). won’t be a current tax cost. Bonds with original issue discount (OID) build up “interest” Leveraging investment expenses as they rise toward maturity. You’re generally considered to You are allowed to deduct expenses used to generate investment earn a portion of that interest annually — even though the bonds income unless they are related to tax-exempt income. Investment don’t pay you this interest annually — and you must pay tax on expenses can include investment firm fees, research costs, it. They also may be best suited for retirement accounts. security costs such as a safe deposit box, and most significantly, Try to own dividend-paying stocks that qualify for the investment interest. Apart from investment interest, these 15-percent tax rate outside of retirement plans so you’ll benefit expenses are considered miscellaneous itemized deductions from the lower rate. and are deductible only to the extent they exceed two percent of your AGI. 13
  15. 15. Investment interest is interest on debt used to buy assets Your home as an investment held for investment, such as margin debt used to buy securities. There are many home-related tax breaks. Whether you own Payments a short seller makes to the stock lender in lieu of one home or several, it’s important to take advantage of your dividends may be deductible as an investment interest expense. deductions and plan for any gains or rental income. Your investment interest deduction is limited to your net Property tax is generally deductible as an itemized deduction. investment income, which generally includes taxable interest, Even if you don’t itemize, a provision scheduled to expire in dividends and short-term capital gains. Any disallowed 2010 allows you an above-the-line deduction of up to $500 interest is carried forward for a deduction in a later year, ($1,000 if filing jointly) on personal property taxes. But which may provide a beneficial opportunity. (See Tax remember, property tax isn’t deductible for alternative planning opportunity 7.) minimum tax (AMT) purposes. If you don’t want to carry forward investment interest You can also deduct mortgage interest and points on your expense, you can elect to treat net long-term capital gain or principal residence and a second home. The deduction is good qualified dividends as investment income in order to deduct for interest on up to $1 million in total mortgage debt used to more of your investment interest, but it will be taxed at purchase, build or improve your homes. In addition, you can ordinary-income rates. Remember that interest on debt used to deduct interest on a home equity loan with a balance up to buy securities that pay tax-exempt income, such as municipal $100,000. Consumer interest isn’t deductible, so consider using bonds, isn’t deductible. Also keep in mind that passive interest home equity debt (up to the $100,000 limit) to pay off credit expense — interest on debt incurred to fund passive activity cards or auto loans. But remember, home equity debt is not expenditures — becomes part of your overall passive activity deductible for the AMT unless it’s used for home improvements. income or loss, subject to limitations. When you sell your home, you can generally exclude up to $250,000 ($500,000 for joint filers) of gain if you’ve used it as Be wary of deferral strategies your principal residence for two of the preceding five years. But Deferring taxes is normally a large part of good planning. under a recently enacted provision, you will have to include gain But with capital gains rates scheduled to go up, the benefits of on a pro-rata basis for any years after 2009 that the home was deferring income may be outweighed by the burden of higher not used as your principal residence. Maintain thorough records tax rates in the future. If you believe your rates will go up, to support an accurate tax basis, and remember, you can only consider avoiding or fine tuning strategies to defer gain, such deduct losses attributable exclusively for business or rental use as an installment sale or like-kind exchange. (subject to various limitations). Like-kind exchanges under Section 1031 allow you to The rules for rental income are complicated, but you can rent exchange real estate without incurring capital gains tax. Under out all or a portion of your primary residence and second home a like-kind exchange, you defer paying tax on the gain until you for up to 14 days without having to report the income. No rental sell your replacement property. expenses will be deductible. If you rent out your property for An installment sale allows you to defer capital gains on most 15 days or more, you have to report the income, but can also assets other than publicly traded securities by spreading gain claim all or a portion of your rental expenses — such as utilities, over several years as you receive the proceeds. If you’re engaging repairs, insurance and depreciation. Any deductible expenses in in an installment sale, consider creating a future exit strategy. excess of rental income can be carried forward. You may want to build in the ability to pledge the installment If the home is classified as a rental for tax purposes, you can obligation. Deferred income on most installment sales made deduct interest that’s attributable to its business use but not any after 1987 can be accelerated by pledging the installment note interest attributable to personal use. for a loan. The proceeds of the loan are treated as a payment on the installment note itself. If legislation is enacted that increases the capital gains rate in the future (or makes clear the scheduled increase will occur), this technique can essentially accelerate the proceeds of the installment sale. Tax planning opportunities 7 Defer investment interest for a bigger deduction Unused investment interest expense can be carried forward indefinitely and may be usable in later years. It could make sense to carry forward your unused investment interest until after 2010, when tax rates are scheduled to go up and the 15-percent rate on long-term capital gains and dividends is scheduled to disappear. The deduction could save you more at that time if rates do go up. 14
  16. 16. Chapter 6: Executive compensation Thinking through your options You may be compensated with more than just salary, fringe ISOs have several potential tax benefits benefits and bonuses. Many people are rewarded with incentives • There is no tax when the options are granted. like stock options, deferred compensation plans and restricted • Long-term capital gains treatment is available if stock. These benefits come with complicated tax consequences, the stock is held for one year after exercise and giving you perils to avoid and opportunities to consider. two years after the grant date. • There is no tax when the options are exercised Benefitting from incentive stock options as long as the stock is held long enough to qualify Stock options remain one of the most popular types of incentive for long-term capital gains treatment. compensation, and incentive stock options (ISOs) deserve special attention in your tax planning. If your options qualify as ISOs, However, there is potential alternative minimum tax (AMT) you may be able to take advantage of favorable tax treatment. liability when the options are exercised. The difference between ISOs give you the option of buying company stock in the the fair market value of the stock at the time of exercise and the future. The price must be set when the options are granted and exercise price is included as income for AMT purposes. The must be at least the fair market value of the stock at that time. liability on this bargain element is a problem because exercising Therefore, the stock must rise before the ISOs have any value. the option alone doesn’t generate any cash to pay the tax. If the If it does, you have the option to buy the shares for less than stock price falls before the shares are sold, you can be left with they’re worth on the market. a large AMT bill in the year of exercise even though the stock actually produced no income. Congress has provided some relief from past ISO-related AMT liabilities, and a new more generous AMT credit is also available. (See page 10 for more information on the AMT credit.) Talk to a Grant Thornton advisor if you have questions about AMT-ISO liability. If the stock from an ISO exercise is sold before the holding period for long-term capital gains treatment expires, the gain is taxed at ordinary income tax rates in a disqualifying disposition. The employer is entitled to a compensation deduction only if the employee makes a disqualifying disposition. If you’ve received ISOs, you should decide carefully when to exercise them and whether to sell immediately or hold the shares received from an exercise. Waiting to exercise until immediately before the ISOs expire (when the stock value may be highest) and then holding on to the stock long enough for long-term capital gains treatment is often beneficial. 15
  17. 17. But acting earlier can also be advantageous However, there are drawbacks. Employers cannot deduct in some situations any NQDC until the executive recognizes it as income, and • Exercise earlier to start the holding period NQDC plan funding is not protected from an employer’s for long-term capital gains treatment sooner. creditors. Employers also must now be in full compliance with • Exercise when the bargain element is small or the relatively new IRS rules under Section 409A that govern NQDC market price is low to reduce or eliminate AMT liability. plans. The rules are strict, and the penalties for noncompliance • Exercise annually and buy only the number of shares that are severe. If a plan fails to comply with the rules, plan will achieve a break-even point between the AMT and participants are taxed on plan benefits immediately with interest regular tax. charges and an additional 20-percent tax. The new rules under Section 409A made several important But beware; exercising early accelerates the need for funds changes. Executives generally must make an initial deferral to buy the stock. It also exposes you to a loss if the value of election before the year they perform the services for the the shares drops below your exercise cost and may create a tax compensation that will be deferred. So, an executive who wants cost if the exercise generates an AMT liability. If the stock price to defer some 2010 compensation to 2011 or beyond generally may fall, you can also consider selling early in a disqualifying must make the election by the end of 2009. Additionally: disposition to pay the higher ordinary-income rate and avoid • Benefits must either be paid on a specified date according the AMT. Tax planning for ISOs is truly a numbers game. to a fixed payment schedule or after the occurrence of a With the help of Grant Thornton, you can evaluate the risks specified event — defined as a death, disability, separation and crunch the numbers using various assumptions. from service, change in ownership or control of the employer, or an unforeseeable emergency. Considerations for restricted stock • The timing of benefit payments can be delayed but Restricted stock provides different tax considerations. Restricted not accelerated. stock is stock that’s granted subject to vesting. The vesting is • Elections to change the timing or form of a payment often time-based, but can also be performance-based, so that the must be made at least 12 months in advance of the vesting is linked to company performance. original payment commencement date. Income recognition is normally deferred until the restricted • New payment dates must be at least five years after stock vests. You then pay taxes on the fair market value of the the date the payment would have been made originally. stock at the ordinary-income rate. However, there is an election under Section 83(b) to recognize ordinary income when you It is also important to note that employment taxes are receive the stock. This election must be made within 30 days generally due when the benefits become vested. This is true even after receiving the stock and can be very beneficial in certain though the compensation isn’t actually paid or recognized for situations. (See Tax planning opportunity 8.) income tax purposes until later years. Some employers withhold an executive’s portion of the tax from the executive’s salary or Understanding nonqualified deferred compensation ask the executive to write a check for the liability. Others pay Nonqualified deferred compensation (NQDC) plans pay the executive’s portion, but this must be reported as additional executives in the future for services being performed now. taxable income. They are not like many other traditional plans for deferring compensation. NQDC plans can favor certain highly compensated employees and can offer executives an excellent way to defer income and tax. Tax planning opportunities 8 Consider an 83(b) election on your restricted stock With an 83(b) election, you immediately recognize the value of the restricted stock as ordinary income when the stock is granted. In exchange, you don’t recognize any income when the stock actually vests. You only recognize gain when the stock is eventually sold. So why make an 83(b) election and recognize income now, when you could wait to recognize income when the stock actually vests? Because the value of the stock may be much higher when it vests. The election may make sense if the income at the grant date is negligible or the stock is likely to appreciate significantly before income would otherwise be recognized. In these cases, the election allows you to convert future appreciation from ordinary income to long-term capital gains income. The biggest drawback may be that any taxes you pay because of the election can’t be refunded if you eventually forfeit the stock or the stock’s value decreases. But if the stock’s value decreases, you’ll be able to report a capital loss when you sell the stock. 16
  18. 18. Chapter 7: Business ownership How to structure your enterprises How you structure, buy and sell business interests has never Chart 5: 2009 corporate income tax brackets been more important. There are many tax considerations that Tax rate Tax bracket can cost or save you money. The most important factor may be the structure you choose for your company. 15% $0 – $50,000 25% $50,001 – $75,000 34% $75,001 – $100,000 Tax treatment of business structures 39% $100,001 – $335,000 Business structures generally fall into two categories: C 34% $335,001 – $10,000,000 corporations and pass-through entities. C corporations are 35% $10,000,001 – $15,000,000 38% $15,000,001 – $18,333,333 taxed as separate entities from their shareholders and offer 35% Over $18,333,333 shareholders limited liability protection. (See chart 5 for corporate income tax rates.) Note: Personal service corporations are taxed at a flat 35% rate. Pass-through entities effectively “pass through” taxation to individual owners, so the business income is taxed at the can affect the ability to finance the business and may determine individual level. (See page 5 for more on individual taxes and which exit strategies will be available. Each structure has its own the individual rate schedule.) Some pass-through entities, such pluses and minuses, and you should examine carefully how each as sole proprietorships and general partnerships, don’t provide will affect you. Call a Grant Thornton advisor to discuss your limited liability protection, while other pass-through entities, individual situation in more detail. such as S corporations, limited partnerships, limited liability If you work in a business in which you have an ownership partnerships and limited liability companies, can. interest, you need to think about employment taxes. Generally Because some pass-through entities can offer the same all trade or business income that flows through to you from limited liability protection as a C corporation, tax treatment a partnership or limited liability company is subject to self- should be a major consideration when deciding between the two employment tax — even if the income isn’t actually distributed structures. (See chart 6 for an overview of key differences.) The to you. But if you’re an S corporation or C corporation biggest difference is that C corporations endure two levels of employee-owner, only income you receive as salary is subject taxation. First, a C corporation’s income is taxed at the corporate to employment taxes. How much of your income from a level. Then the income is taxed again at the individual level when corporation comes from salary can have a big impact on how it is distributed to shareholders as dividends. The income from much tax you pay. (See Tax planning opportunity 9 for more pass-through entities is generally only taxed at the individual information.) owner level, not at the business level. Although this benefit is significant, it is not the only Don’t wait to develop an exit strategy consideration. There are many other important differences in Many business owners have most of their money tied up in their the tax rules, deductions and credits for each business structure business, making retirement a challenge. Others want to make that also need to be considered. You always want to assess sure their business — or at least the bulk of its value — will be the impact of state and local taxes where your company does passed to their family members without a significant loss to business, and owners who are also employees have several other estate taxes. If you’re facing either situation, now is the time to unique considerations. Also, the choice of business structure start developing an exit strategy that will minimize the tax bite. 17
  19. 19. Chart 6: Tax differences based on business structure Pass-through entity C corporation Tax treatment One level of taxation: Two levels of taxation: • Income is not taxed at business level and flows through • Income taxed at corporate level at corporate rates to owners where it is taxed at individual rates • Shareholders then taxed on any dividends they receive Loss treatment • Losses flow through to the owners where they can be • Losses remain at the corporate level and are carried backward taken individually (subject to basis and at-risk limitations) or forward to offset past or future corporate-level income Tax rates • Top individual tax rate is currently 35%, but is scheduled • Top corporate tax rate is generally 35% to increase in 2011 • Income distributed as dividends is taxed a second time, generally at 15% (scheduled to increase to 39.6%) An exit strategy is a plan for passing on responsibility for Sellers should also consider whether they prefer a taxable running the company, transferring ownership and extracting sale or a tax-deferred transfer. The transfer of ownership of a your money. To pass on your business within the family, you corporation can be tax-deferred if made solely in exchange for can give away or sell interests. But be sure to consider the gift, stock or securities of the recipient corporation in a qualifying estate and generation-skipping tax consequences. (See page 31.) reorganization, but the transaction must comply with strict A buy-sell agreement can be a powerful tool. The agreement rules. Although it’s generally better to postpone tax, there are controls what happens to the business when a specified event advantages to performing a taxable sale: occurs, such as an owner’s retirement, disability or death. Buy- • Tax rates are scheduled to increase in 2011. sell agreements are complicated by the need to provide the • The seller doesn’t have to worry about the quality buyer with a means of funding the purchase. Life or disability of buyer stock or other business risks that might insurance can often help and can also give rise to several tax and come with a tax-deferred sale. nontax issues and opportunities. • The buyer benefits by receiving a stepped-up basis One of the biggest advantages of life insurance as a funding in the acquisition’s assets and does not have to deal method is that proceeds generally are excluded from the with the seller as a continuing equity owner, as would beneficiary’s taxable income. There are exceptions to this, be the case in a tax-deferred transfer. however, so be sure to consult a Grant Thornton tax advisor. • The parties don’t have to meet the stringent technical You may also want to consider a management buyout or an requirements of a tax-deferred transaction. employee stock ownership plan (ESOP). An ESOP is a qualified retirement plan created primarily so employees can purchase A taxable sale may be structured as an installment sale if the your company’s stock. Whether you’re planning for liquidity, buyer lacks sufficient cash or the seller wants to spread the gain looking for a tax-favored loan or supplementing an employee over a number of years. Contingent sales prices that allow the benefit program, an ESOP can offer you many advantages. seller to continue to benefit from the success of the business are common. But be careful, the installment sale rules create a trap Assess tax consequences when buying or selling for sellers if the contingency is unlikely to be fulfilled. Also, When you do decide to sell your business — or are acquiring installment sales may not make as much sense in the current another business — the tax consequences can have a major environment because tax rates are scheduled to go up. (See page impact on your transaction’s success or failure. 14 for more information on installment sale considerations when The first consideration should be whether to structure your tax rates have the potential to increase.) transaction as an asset sale or a stock sale. If it’s a C corporation, Careful planning while the sale is still being negotiated is the seller will typically prefer a stock sale for the capital gains essential. Grant Thornton can help you see any trap and find treatment and to avoid double taxation. The buyer will generally the exit strategy that best suits your needs. want an asset sale to maximize future depreciation write-offs. Tax planning opportunities 9 Set salary wisely if you’re a corporate employee-shareholder If you are an owner of a corporation who works in the business, you need to consider employment taxes in your salary structure. The 2.9-percent Medicare tax is not capped and will be levied against all income received as salary. S corporation shareholder-employees may want to keep their salaries reasonably low and increase their distributions of company income in order to avoid the Medicare tax. But C corporation owners may prefer to take more salary (which is deductible at the corporate level), because the Medicare tax rate is typically lower than the 15-percent tax rate they would pay personally on dividends. But remember to tread carefully. You must take a reasonable salary to avoid potential back taxes and penalties, and the IRS is cracking down on misclassification of corporate payments to shareholder-employees. 18
  20. 20. Chapter 8: Charitable giving Saving more by giving better Giving to charity is one of the best tax planning opportunities Outright gifts of cash (which include gifts made via check, because you enjoy not only a sizable tax deduction, but also credit card and payroll deduction) are the easiest. The key is to the satisfaction of doing good. Plus you can control the timing make sure you substantiate them. Cash donations under $250 to maximize your tax benefits. Well-planned gifts can trim the must be supported by a canceled check, credit card receipt or estate tax while allowing you to take care of your heirs in the written communication from the charity. Cash donations of manner you choose. $250 or more must be substantiated by the charity. Despite the simplicity and high AGI limits for outright cash gifts, it Choosing what to give may prove more beneficial to make gifts of property. The first thing to determine is what you want to give to charity: Gifts of property are a little more complicated, but they cash or property. There are adjusted gross income (AGI) limits may provide more tax benefits when planned properly. Your on how much of your gift you get to deduct depending on deduction depends in part on the type of property donated: what you give and who you give it to. Giving directly from long-term capital gains property, ordinary-income property an individual retirement account (IRA) may lower your AGI. or tangible personal property. (See Tax planning opportunity 10 to find out if you are eligible.) Ordinary-income property includes items such as stock held Contributions disallowed due to the AGI limit can be carried less than a year, inventory and property subject to depreciation forward for up to five years. (See chart 7 for the deduction limit recapture. You can receive a deduction equal to only the lesser by donation and the type of charity.) of fair market value or your tax basis. Long-term capital gains property includes stocks and other securities you’ve held more than one year. It’s one of the best charitable gifts because you can take a charitable deduction equal to its current fair market value. Consider donating appreciated property to charity because you avoid paying tax on the long- term capital gain you’d incur if you sold the property. (See Tax planning opportunity 11.) But beware. It may be better to elect to deduct the basis rather than the fair market value because the AGI limitation will be higher. Whether this is beneficial will depend on your AGI and the likelihood of using — within the next five years — the carryover you’d have if you deducted the fair market value and the 30-percent limit applied. Chart 7: AGI limitations on charitable contribution deductions The deduction for your total charitable contributions for the year is subject to a limitation based on your adjusted gross income (AGI) and the type of charity. Public charity or operating foundation Private nonoperating foundation Cash, ordinary-income property and unappreciated property 50% 30% Long-term capital gains property deducted at fair market value 30% 20% Long-term capital gains property deducted at basis 50% 30% 19
  21. 21. Tangible personal property can include things such as a piece So long as certain requirements are met, the property is of art or an antique. Your deduction depends on the type of deductible from your estate for estate tax purposes and you property and the charity, and there are several rules to consider: receive a current income tax deduction for the present value • Personal property valued at more than $5,000 of the remainder interest transferred to charity. You don’t (other than publicly traded securities) must be immediately pay capital gains tax if you contribute appreciated supported by a qualified appraisal. property. Distributions from the CRT generally carry • If the property isn’t related to the charity’s tax-exempt taxable income to the noncharitable beneficiary. If someone function (such as a painting donated for a charity auction), other than you is the income beneficiary, there may be gift your deduction is limited to your basis in the property. tax consequences. • If the property is related to the charity’s tax-exempt A CRT can work particularly well in cases where you own function (such as a painting donated to a museum), non-income-producing property that would generate a large you can deduct the property’s fair market value. capital gain if sold. Because a CRT is a tax-exempt entity, it can sell the property without having to pay tax on the gain. The trust Benefit yourself and a charity with a CRT can then invest the proceeds in income-producing property. This A charitable remainder trust (CRT) may be appropriate if you technique can also be used as a tax-advantaged way to diversify wish to donate property to charity and would like to receive your investment portfolio. (or would like someone else to receive) an income stream for To keep CRTs from being used primarily as tax avoidance a period of years or for your expected lifetime. The property tools, however, the value of the charity’s remainder interest must is contributed to a trust and you, or your beneficiary, receive be equal to at least 10 percent of the initial net fair market value income for the period you specify. The property is distributed of the property at the time it’s contributed to the trust. There are to the charity at the end of the trust term. other rules concerning distributions and the types of transactions into which the trust may enter. Tax planning opportunities 10 Give directly from an IRA if 70½ or older Congress just extended a helpful tax provision that allows taxpayers 70½ and older to make tax-free charitable distributions from individual retirement accounts (IRAs). Using your IRA distributions for charitable giving could save you more than taking a charitable deduction on a normal gift. That’s because these IRA distributions for charitable giving won’t be included in income at all, lowering your AGI. You’ll see the difference in many AGI-based computations where the below-the-line deduction for charitable giving doesn’t have any effect. 11 Give appreciated property to enhance savings Think about giving property that has appreciated to charity. You avoid paying the capital gains taxes you would incur if you sold the property, so donating property with a lot of built-in gain can lighten your tax bill. But don’t donate depreciated property. Sell it first and give the proceeds to charity so you can take the capital loss and the charitable deduction. 20
  22. 22. Reverse the strategy with a CLT Keep control with a private foundation A grantor charitable lead trust (CLT) is basically the opposite Consider forming a private foundation if you want to make of the CRT. For a given term, the trust pays income to one or large donations but also want a degree of control over how that more charities and the trust’s remaining assets pass to you or money will be used. A foundation is particularly useful if you your designated beneficiary at the term’s end. When you fund haven’t determined what specific charities you want to support. the trust, you receive an income tax deduction for the present But be aware that increased control comes at a price: You value of the annual income expected to be paid to the charity. must follow a number of rules designed to ensure that the private (You also pay tax on the trust income.) The trust assets remain foundation serves charitable interests and not private interests. in your estate. There are requirements on the minimum percentage of annual With a non-grantor CLT, you name someone other than payouts to charity and restrictions on most transactions between yourself as remainder beneficiary. You won’t have to pay tax the foundation and its donors or managers. on trust income, but you also won’t receive an income tax Violations can result in substantial penalties. Ensuring deduction. The trust assets will be removed from your estate, compliance with the rules can also make a foundation expensive but there also may be gift tax consequences. Alternatively, the to run. In addition, the AGI limitations for deductibility of trust can be funded at your death, and your estate will receive contributions to nonoperating foundations are lower. an estate tax deduction (but not an income tax deduction). A CLT can work well if you don’t need the current income but want to keep an asset in the family. As with other strategies, consider contributing income-producing stocks or other highly appreciated assets held long-term. 21
  23. 23. Provide influence with a donor-advised fund If you’d like to influence how your donations are spent but you want to avoid the tight rules and high expenses of a private foundation, consider a donor-advised fund. They are offered by many larger public charities, particularly those that support a variety of charitable activities and organizations. The fund is simply an agreement between you and the charity: The charity agrees to consider your wishes regarding use of your donations. This agreement is nonbinding, and the charity must exercise final control over the funds, consistent with the charitable purposes of the organization. To deduct your contribution, you must obtain a written acknowledgment from the sponsoring organization that it has exclusive legal control over the assets contributed. Key rules to remember Whatever giving strategy ultimately makes the most sense for you, keep in mind several important rules on giving: • If you contribute your services to charity, you may deduct only your out-of-pocket expenses, not the fair market value of your services. • You receive no deduction by donating the use of property because it isn’t considered a completed gift to the charity. • If you drive for charitable purposes, you may deduct 14 cents for each charitable mile driven. • Giving a car to charity only results in a deduction equal to what the charity receives when it sells the vehicle unless it is used by the charity in its tax-exempt function. • If you donate clothing or household goods, they must be in at least “good used condition” to be deductible. 22