Year-end tax tips for this uncertain time
October 19, 2010
Congress is procrastinating on 2010 year-end tax changes, so traders may want to deploy tax strategies that allow the use of hindsight changes later on.
As of mid-October, it’s hard to predict what will happen with the Bush tax cuts. President Obama and many Democrats want to extend them for middle- and lower-incomes only. Republicans and some Democrats want to extend them for all tax brackets. Plus, there are other important tax changes to be decided on including the tax extenders bill and the annual AMT patch.
Several Democrats are campaigning for extending the Bush tax cuts for everyone — enough to win that position in Congress — but can these incumbent Democrats be counted on to vote as they promised during a lame-duck session or the next Congress? If anything, the lame-duck session should strengthen the Republican Senatorial filibuster because a few Democrat Senators may be replaced by a Republican midterm election winner. Pollsters currently expect the next Congress to have significantly more Republican seats too. President Obama holds his veto rights no matter what happens with changes in Congress.
Tax planning is a mess
This added political intrigue and expiration of Bush tax cuts throws year-end tax planning maneuvers into special disarray. Do you need to do year-end tax planning based on three different “monstrosities of a tax code,” to borrow the term from past Bush Treasury Secretary Paul O’Neil? There’s the current tax code, the pre-Bush tax code, and President Obama’s plan to slice-and-dice the two tax codes to broaden progressive taxation by demanding the rich pay more. At this late juncture, the IRS, tax publishers and payroll processors all have said they can’t make the year-end deadlines with proper tax resources, forms, and formulas.
Hopefully, Congress will come to an agreement on most of these crucial tax changes. But there is a chance it may continue its gridlock and punt these crucial decisions until the next Congress in 2011. Remember how long health care reform took. If Congress acts in mid-2011, will it make the changes retroactive to Jan. 1, 2011? This makes 2010 year-end tax planning a gamble.
Two-year extension expected
Most betting men would say Congress will extend Bush tax cuts for everyone for two years, as that seems to be the easiest and most practical fix at this late juncture. Full extension of the Bush tax cuts is probably the safest way to avoid a double-dip recession by not attacking the job creators with a big tax increase.
China is still buying U.S. Treasuries (as of October) and the Chinese are probably more concerned with a brewing trade and currency war than with the U.S. deficit going up more with full scale Bush tax cut extension.
How to proceed if the tax cuts expire
Most tax professionals and publishers are focused on the Bush tax cuts expiring for the upper two marginal income tax brackets. They are suggesting a reverse strategy to most tax years and accelerating income into 2010 at the lower tax rates (considering they may rise in 2011).
Investors might consider selling open unrealized-gain positions before year-end to lock in a lower tax rate. (Wash-sale loss rules — buying back a security 30 days before or after — are only a concern on realizing losses.)
Even if the Bush tax cuts are extended for everyone, it may be temporary. Unfortunately, you can’t unwind a public stock transaction, so it’s a gamble if you sell before Congress acts on the tax cuts.
Consider the market and price levels too. If you feel it’s a good time to sell for market reasons, then it may be better tax-wise too. Generally, deferring capital gains taxes leads to higher compounded after-tax returns. It takes courage to pay taxes early.
Focus on moves providing hindsight
Wait as long as possible to see if Congress acts before year-end. If they don’t, look for tax strategies that can be executed before year-end and reclassified after. You can make a move based on expectation and unwind it if Congress makes different decisions later.
Roth IRA conversions
Beginning with 2010, all taxpayers may convert their retirement plans to a Roth IRA (or Roth qualified plan). Prior to 2010, a fairly low income threshold ($100,000) disallowed higher-income taxpayers from using this special tax break. Also, in 2010 taxpayers have a choice of taking their entire Roth-converted amounts into 2010 income or deferring the income to 2011 and 2012 (50 percent each). You have to convert before year-end; you can’t use this break after.
If the Bush tax cuts are extended for two years, you can choose to defer the taxes owed on the Roth conversion to 2011 and 2012 before the rates go up. If the Bush tax cuts are not extended at all or for just one year, then skip the deferral and report the converted income in 2010 at lower tax rates.
If you aren’t happy with the Roth conversion — suppose the converted assets drop in value by a large amount — you can unwind (recharacterize) the entire conversion before Oct. 15, 2011. Make sure to file a 2010 tax-return extension on April 15 so it’s easier to recharacterize. If your Roth IRA significantly drops in value after conversion, it’s better to convert the account after the losses.
Take advantage of qualifying dividend tax rates
Another important change when the Bush tax cuts expire is the qualifying dividend tax rate will skyrocket to much higher ordinary tax rates. The highest ordinary rate for 2010 is 35 percent and it’s scheduled to rise in 2011 to 39.6 percent, plus there are various phase-outs (meaning it’s closer to 41 percent). The long-term capital gains tax rate is 15 percent for 2010 and it’s scheduled to rise to 20 percent for 2011.
President Obama and Treasury Secretary Timothy Geithner hope Congress can strike a deal for the qualifying dividend tax rate to remain hitched to the long-term capital gains tax rate, so it would rise to 20 percent rather than 39.6 percent. They don’t want a skyrocketing dividend tax rate to hurt the stock markets and they are probably correct in that concern.
If Congress remains in filibuster-gridlock over making any tax law changes, the Bush tax cuts may expire for everyone. It’s possible the qualifying dividend tax rate may return to the ordinary rate. That being said, it may be prudent to take as many qualifying dividends as possible before year-end. Will corporations pay out higher dividends in 2010 and reduce them in 2011? Will some investors sell dividend stocks by year-end to rotate into growth companies or other investment choices? Be on the look out for ways in which tax changes could influence the financial markets. Usually it’s better to sell before others do the same, which can be at lower prices.
What should small businesses do?
If you own a small business and use a C-corp as part of your structure, you may be interested in this special strategy to lower your taxes over time. If the qualifying dividend tax rate goes up to either 20 percent, or the ordinary tax rate in 2011, it’s probably a good move to pay yourself as much of a qualifying dividend that you can arrange. A qualifying dividend is limited to retained earnings, and it also depends on how much additional tax you are willing to pay in 2010.
Some small-business owners operate a C-corp alone or with a flow-through entity like a multi-member LLC (taxed as a partnership) or S-corp. The key tax strategy is to take advantage of lower C-corp tax brackets on the first $75,000 of income each year.
C-corps have double taxation: once on the entity level and a second time when dividends are paid out. The IRS forces you to pay dividends eventually. Paying the double-taxation in later years could result in a much higher tax rate. Get those qualifying dividend tax rates while you can.
In some cases, a small business owner may be able to pay a large amount to the owner before year-end and later on decide whether it’s a dividend or a loan. That part provides hindsight, so you can see how Congress acts first.
Many business traders have the following conundrum: They want capital gains treatment to use up significant capital-loss carryovers, and they also want Section 475 MTM ordinary-loss treatment on new trading losses. If they knew which they would have, they could decide in advance. But they don’t, therefore MTM elections are a gamble.
Business traders do have a small hindsight window with Section 475 elections. New trading-business entities can wait to file an internal Section 475 MTM election within the first 75 days of inception. Conversely, existing taxpayers must file a 2011 election with the IRS (external) by the due date of their prior year’s tax return (April 15, 2011 for individuals and partnerships and March 15, 2011 for S-corps). That's 3.5 months of time for hindsight decision making.
If you defer large wash-sale losses on business-trading positions from 2010 to 2011, you can convert them to ordinary-loss treatment in 2011. You simply have to elect Section 475 MTM on time.
It also may be a smart tax move to defer unrealized tax losses to 2011, where they can be subject to Section 475 ordinary-loss treatment. Caution: You can’t use this strategy for investment positions; it’s only allowed on trading business positions. Section 724b and c disallows Section 475 MTM ordinary-loss treatment on investment positions contributed to a trading business.
Is year-end tax loss selling a good idea?
Isn’t deferring unrealized capital losses the reverse of normal year-end tax planning? Yes, it is, but it might be better in this unusual year-end situation. It may accelerate income into 2010, before possible hikes in 2011 if the Bush tax cuts are not extended.
You can sell a losing position before year-end, and if you decide it’s better to take the tax loss in 2011 — perhaps with Section 475 MTM ordinary loss election — you can create a wash sale deferral transaction for 2010. Simply buy back the same symbol within 30 days of the year-end sale, assuming you are okay to reenter this position market-wise. Use good trade accounting software to monitor your wash-sale losses.
If you have large capital loss carryovers and tax rates go up, those carryovers are of greater value to you, providing you can use them.
Our 2009 year-end tax planning articles are very helpful:
2009 year-end tax planning, part 1. Click here for blog article.
“Most years, taxpayers take every opportunity to kick the tax-can down the road, by deferring and accelerating income. This year and next should be different, because tax rates are likely heading higher for the upper and middle class starting in 2011.”
This article includes more information on Roth IRA conversions too.
2009 year-end tax planning, part 2. Click here for blog article.
Article headings in italics contain these updates:
Use good software for your year-end tax planning. It’s too late for software publishers to factor in all the possible outcomes with the Bush tax cut changes and it’s doubtful you will have good resources to help with year end tax planning.
Special 2009 tax breaks for homes and automobiles. Some of these breaks expired, others were continued and still others will be part of tax extender bills. Search online for the breaks you’re interested in.
Do NOL planning before year-end. For 2010 NOLs, the carryback rule reverts back to two years only (and 20 years forward too). The special allowances to carryback NOLs either two or up to five years back were for 2008 and 2009 tax years only. Don’t expect a five-year carryback allowance for 2010.
Don’t be aggressive on trader tax status determinations, the IRS may disagree. The IRS continues to turn up the heat on all taxpayers. Even if Republicans win more seats in Congress in the midterms, don’t expect the IRS to back down from its “close the tax gap” initiatives. New 1099-B reporting rules go into effect for 2011 with reporting of cost-basis and holding period.
An entity is helpful for trader tax status and it can give you a clean start in 2010. Same goes for 2011 too and the earlier you get started the better.
Either avoid AMT or embrace its historically low rate. AMT changes are unfortunately still wide open. Will Congress enact its annual AMT patch again? Hopefully, Congress won’t hold the AMT patch hostage inside a bigger Bush tax cut extension debate bill.
You can’t fool the IRS with offsetting positions.
Wash sales can be a royal pain.
Futures tax rates are headed higher too. Unless Bush tax cuts are extended.
Investment managers could lose carried interest tax breaks in 2011. President Obama’s 2010 budget sought repeal of carried interest tax breaks, but Senate Democrats couldn’t win a cloture vote to vote on that repeal. Carried-interest tax breaks and the SE tax loophole for S-Corps remain.
Year-end tax-loss selling is good for investors, but not needed for MTM traders.
The estate tax is coming back on radar screens again too.
Unless Congress acts quickly, the nasty federal estate tax comes back from the dead with a vengeance in 2011 for all taxpayers. The pre-Bush tax act exemption is puny ($1 million, 2002 exemption) and tax rates are very high too (top rate is 60 percent from 2001).
Hopefully, Congress will agree upon a lower estate tax rate and a higher exemption so middle-class income and other taxpayers are more protected. The estate tax rate was 45 percent for 2007 through 2009. The exemption was 3.5 million for 2009. I hope they can do even better.
As with the Bush income tax cuts, a new deal must be struck and a bill passed, because with no deal, the estate tax reverts to pre-Bush tax heights.
It’s been a confusing year for the families of taxpayers who passed away this year. First they felt lucky there was no federal estate tax in 2010, but then they realized they had to deal with income taxes on estate asset appreciation, whereas that was not a concern with stepped-up basis with the estate tax regime. Plus, most states didn’t repeal their estate tax for 2010, decoupling from federal rules.
2009 year-end tax planning, part 3. Click here for blog article.
“If you have a trading entity for 2010 and plan to use it for 2010 retirement plan and/or health insurance premium AGI-deduction strategies, you must take certain vital actions before year-end. You need to pay all earned income fees and officer salaries before year-end.”
Try to wait until you see the whites of Congress’ eyes before you pull the trigger on year-end tax planning maneuvers. Plenty of other investors may act on the same tax news and it could be a market-moving event. Use hindsight where available to beat others to the punch and to keep more options open. Hindsight is a wonderful thing and the IRS rarely gives you this privilege, so use it. There are plenty of good year-end tax planning articles in the media so read them too, since I focus more on business traders and investors. Also don’t forget to read about new recent tax cuts and take advantage of them too.
Posted 2 years, 9 months ago on October 19, 2010
The trackback url for this post is http://www.greencompany.com/blog/bblog/trackback.php/97/
Comments have now been turned off for this post