Personal Income Tax

For most taxpayers, ordinary income tax rates in 2013 will remain about the same as 2012. A key exception is individuals with taxable income exceeding $400,000 for single filers or $450,000 for married couples filing jointly, who are now subject to a top marginal rate of 39.6 percent. (See table.)

New Net Investment Income Tax and Additional Medicare Tax

Starting in 2013 many higher-income taxpayers will be subject to two new taxes: the net investment income tax (NIIT), and the additional Medicare tax. You may be subject to both, but not on the same type of income.

The new tax of 3.8 percent on net investment income applies when modified adjusted gross income (MAGI) exceeds a threshold of $200,000 for single filers and $250,000 for married couples filing jointly. Created by the Health Care and Education Reconciliation Act of 2010, the NIIT applies to US citizens and residents. (The tax also applies to estates and trusts, but for these the threshold is only $11,950.) If a taxpayer’s MAGI exceeds the threshold and has net investment income (see table), the NIIT equals 3.8 percent of the lesser of the taxpayer’s net investment income or the amount by which the taxpayer’s MAGI exceeds the threshold.

Net investment income includes interest, dividends, capital gains, rents and royalty income, nontrade or business income, and any other passive income (meaning the taxpayer doesn’t “materially participate” in the business). Certain types of income are excluded from net investment income: wages, self-employment income, active trade or business income, retirement plan distributions (from IRA, Roth IRA, and other qualified plans), unemployment compensation, Social Security benefits, alimony, interest from tax-free bonds (such as municipal bonds), and Alaska Permanent Fund Dividends.

The new 0.9 percent additional Medicare tax applies to FICA wages and self-employment income exceeding $200,000 for single filers and $250,000 for married couples filing jointly.

EXAMPLE
Consider a single taxpayer with $100,000 in net investment income and $300,000 in wages, for a total of $400,000 in MAGI. How much NIIT and additional Medicare tax will she have to pay?

Additional Medicare tax: $300,000 (wages) – $200,000 (single-filer threshold) = $100,000 x 0.9% = $900
NIIT: $400,000 (MAGI) – $200,000 (single-filer threshold) = $200,000 or the lesser of $100,000 of net investment income. $100,000 in net investment income x 3.8% = $3,800.
Total additional Medicare tax and NIIT = $4,700

Higher-income taxpayers should evaluate their liability for both the NIIT and the additional Medicare tax. If you expect to be subject to one or both of the taxes, you may want to adjust your withholding or estimated tax payments to account for the increase.

To further limit your tax exposure to the NIIT:

• In light of the federal income tax rate increase and the NIIT, consider basing your decision to defer or accelerate income at the end of 2013 or beginning of 2014 on the best use of deductions and losses between the two years.
• Rebalance your investment portfolio to include municipal bond investments, growth-oriented stocks that pay out lower dividends, and investments (such as in real estate, energy, and natural resources) that produce income sheltered by depreciation or depletion
• Maximize your contributions to qualified retirement plans to reduce current MAGI. Note also that distributions from retirement plans such as an IRA or 401(k) aren’t subject to the NIIT.
• If you’re age 70 1/2 or older and planning to make charitable contributions, consider making a qualified charitable distribution (QCD) from your IRA. You can make tax-free distributions from your IRA of up to $100,000 directly to charitable organizations as a QCD. The distributions are excluded from your taxable income and could reduce the amount of NIIT you owe.
• Use like-kind exchanges with rental or business real estate to defer triggering taxable gains.
• Sell qualified assets on the installment method to spread out gains.
• Pay special attention to how your activities are classified (active or passive) and grouped with other activities, since passive activity income is investment income for purposes of the NIIT. There are ways to become active in a trade or business to reduce the NIIT, such as increasing the amount of time devoted to a particular activity or restructuring entities.
• Consider gifting income-producing assets to children. While this won’t allow you to avoid the “kiddie tax,” the child may avoid paying the tax on up to $200,000 of net investment income.
• Trustees should consider whether net investment income left in the trust will be subject to the NIIT and if so whether it would be better to distribute income to beneficiaries who may have MAGI below the applicable threshold such that they won’t be subject to the NIIT.
• Business owners with self-employment income on their individual income tax returns might consider incorporating and electing to be taxed as an S corporation. While you’d need to take a salary for the value of your service to the business, pass-through income from an active trade or business S corporation isn’t considered net investment income, and owners can take distributions of previously taxed profits that aren’t subject to tax. Furthermore, business owners conducting business using a single-member LLC can elect to be taxed as an S corporation and receive this same tax treatment. There are, however, federal and state tax and nontax issues to consider when changing from one form of entity to another, so you should review any such change carefully with your Moss Adams tax advisor.

Note that both the NIIT and the additional Medicare tax have complex implications—some of which remain unclear. For example, shareholders in certain foreign entities have Subpart F inclusions and income from qualified electing funds that must be included in MAGI for NIIT purposes, but the timing and reporting of their NIIT tax payments require additional clarification from the IRS. As we await that clarification—which we expect in the next few months—contact your Moss Adams tax advisor if you have questions about how to treat certain kinds of income for tax purposes.

Capital Gain Rate Changes

For tax years starting in 2013, the tax rate for capital gains and dividends increase to 20 percent (23.8 percent with NIIT) if the taxable income exceeds $450,000 for a married couple filing jointly ($225,000 if the tax return is filed separately), $425,000 for heads of household, and $400,000 for single filers. For taxpayers with taxable income below those thresholds, the capital gain rate remains at 15 percent (18.8 percent with NIIT).

With that in mind, it’s a good idea to:

• Review unrealized loss positions within investment accounts and consider realizing the losses. Consult your financial advisor for tax-loss harvesting strategies and to rebalance your investment portfolio, incorporating additional tax-efficient investments to help reduce taxes.
• If you plan to make charitable donations, consider donating appreciated capital gain assets that have been held for more than one year, rather than cash. By doing so, you could receive a charitable deduction for the full fair market value of the assets and avoid the capital gains tax and the 3.8 percent NIIT had the assets otherwise been sold.

Deduction Planning: Medical Expenses, Itemized Deductions, Charitable Contributions

• The phaseout of itemized deductions is back for the 2013 tax year. Consider accelerating or deferring expenditures to take full advantage of deductions, since your deduction will be reduced or lost if your AGI exceeds a certain threshold.
• Bunch medical expenses into tax years when they’ll exceed 10 percent of your AGI (7.5 percent of AGI if over age 65).
• Consider paying your fourth-quarter estimated state income tax payment and real estate property tax in December 2013 or January 2014, depending on which year provides the best income tax benefit. In certain instances deferring state income taxes and real estate property taxes to the following year may make the payment subject to penalties; however, the value of the deduction when planned properly could more than offset these penalties.
• If you plan to make sizable donations, consider setting up a charitable remainder trust. When you fund the trust, you may take the deduction and the remaining assets will be passed to charitable organizations at the end of the trust term.

Alternative Minimum Tax

• Be on the lookout for warning signs that you may need to pay alternative minimum tax (AMT)—for example, if you have large deductions for state income and real estate taxes, large miscellaneous itemized deductions, and sizable capital gains.
• For taxpayers perpetually subject to AMT because of deductions, carefully consider the deferral of these payments to the period that provides the greatest tax benefit.
• If you’re planning to exercise incentive stock options (ISOs), consult your tax advisor to avoid unexpected tax consequences, since the exercise might trigger AMT liability and increase your overall tax liability. It’s important to carefully consider the timing of ISO exercises and future sales of stock acquired through ISOs to reduce the impact of AMT. In years when ISOs have been exercised, you should also pay particular attention to the other deductions that could impact your AMT tax liability.

Tax Issues for Gay and Lesbian Married Couples

In 2013 the Supreme Court struck down a key provision in the Defense of Marriage Act, clearing the way for federal recognition of same-sex married couples. The IRS further clarified in August 2013 that same-sex married couples in jurisdictions that recognize same-sex marriage will be treated as married for federal tax purposes regardless of where they reside, effectively extending federal marriage-related benefits to same-sex married couples in all states. As a result:

• Gay and lesbian married couples must change their 2013 tax filing status to married filing jointly or married filing separately.
• Consider whether to amend prior-year tax returns (back to 2010) to capture benefits from filing joint returns.
• Consider income tax planning opportunities for filing a joint 2013 return using combined income, deductions, credits, and rates.
• Amend estate plans and estate tax returns to include current estate and gift tax provisions.
• Stretch distributions from a deceased spouse’s qualified retirement plan.
• Deduct alimony paid to a spouse or former spouse.
• Understand the new opportunities available to same-sex married couples through employee benefit programs, the Affordable Care Act, and Social Security and incorporate these into your joint tax planning strategy.
• If you’re contemplating marriage, plan for its impact on your income tax in advance.

College Education Planning

• The American Opportunity Tax Credit has been extended and will be available through 2017. The credit, available for the first four years of education, has more liberal income limitations than prior education credits and provides for a portion of the credit to be refundable.
• If you’re paying for postsecondary education and aren’t eligible for the American Opportunity Tax Credit, you may be still eligible for the Lifetime Learning Credit or the Tuition and Fees deduction. Consult your tax advisor to determine your eligibility.
• Section 529 accounts can be used to accumulate funds for college-related expenses. Appreciation of the investments within the account is tax-free for qualified distributions. If college funds are currently maintained in taxable accounts, it may make sense to shift these funds to a Section 529 account to reduce future taxable income.

Discharged Home Mortgage Debt

• The 2012 American Taxpayer Relief Act has extended the exclusion of cancellation of indebtedness income in certain circumstances related to home mortgages through 2013. Consult with your tax advisor before agreeing to any loan modifications.

Energy Incentives

• Until 2016 the Residential Energy Efficient Property Credit is available for the installation of certain energy-efficient property, such as photovoltaic panels or solar water heaters. The credit can be used to offset both regular and AMT, and any unused credit can be carried forward to future years.

Estate and Gift Planning

Lifetime Gifts

The American Taxpayer Relief Act of 2012 made permanent changes to federal estate and gift tax rates that provide substantial estate tax relief with slight changes in rates from previous years. The amount you can give during your lifetime without incurring any gift tax is $5.25 million for 2013 (with an annual exclusion of $14,000 per recipient). This amount will index for inflation annually. The gift tax rate for gifts greater than $5.25 million is 40 percent. This rate is a permanent tax law change and isn’t set to expire or change.

• Maximize the $14,000-per-recipient annual exclusion by giving assets that match your cash flow needs and long-term estate planning goals. Remember that a spouse can also gift $14,000 per recipient.
• When considering lifetime gifts above the annual exclusion, consult with your Moss Adams estate planning professional to help you reduce estate and gift tax through proper planning. For example, should the gifts be in cash or property? Outright or in trust? Should you give the entire asset now, or should it be given over time? How should the transfers be completed?
• Consider state inheritance tax issues as part of your estate and gift planning process.

Low Interest Rate and Low Valuation Opportunities

• Applicable federal rates (AFRs), which are the minimum interest rates that must be charged for bona fide loans between related parties, remain at historic lows. As such, it may be possible to refinance loans between family members or with a closely held business and significantly reduce interest payments.
• The combination of the $5.25 million gift tax exemption with historically low AFRs creates a significant opportunity to transfer large amounts of wealth to your heirs through the use of leverage and certain types of trusts. These types of structures are complex, and you should consult with a Moss Adams estate tax professional and your estate attorney to determine how you could benefit from this type of planning.
• Certain assets have declined in value as a result of the economy. If you’re holding assets you believe might rebound in value, it might be advantageous to consider making a lifetime gift to—or a lifetime sale for—your beneficiaries. Your Moss Adams estate tax professional can evaluate your assets and help you determine whether this strategy makes sense for your individual situation.

Develop or Update a Long-Term Estate Plan

• Understand your goals and the effect of federal and state estate taxes. Work with a Moss Adams estate tax professional as well as your estate attorney to make sure your plan addresses your cash flow, business, and family needs as well as your charitable wishes.
• Confirm that your assets are properly titled and the beneficiary designations are correct.
• If you’re one of the many business owners who will sell your business to a new owner in the next five to 10 years, make sure your estate plan is closely aligned with your business and personal goals. A smooth transition of ownership interests will also help protect your wealth after the sale of your business.
• Gain an understanding of how the permanent federal and state estate tax laws will affect you:
  • As of 2013 every estate will have a federal exemption of $5.25 million per spouse and a top rate of 40 percent, including full step-up in basis for most estate assets.
  • Portability or the ability to use a deceased spouse’s unused estate federal tax exemption remains a viable planning technique and should be considered in your planning.
  • Many states have their own estate tax, and in many cases the exemption amounts are lower than the federal amounts. Don’t overlook gifting and estate planning opportunities as they relate to applicable state inheritance tax.

Retirement Planning

Retirement Plans

• Certain plans, such as 401(k) and Keogh plans, allow larger tax deductions but must be established by year-end, even though contributions don’t need to be made by that time. If considering options for a company retirement plan, be sure to have it in place prior to year-end.

Roth IRA Conversion

• Any taxpayer can now convert a traditional IRA to a Roth IRA, regardless of income. Certain qualified plans may allow for an “inside the plan” conversion. These should also be considered where appropriate.

Child’s Earned Income

• If a child has earned income, there are various strategies he or she can use to contribute to a traditional or Roth IRA. Consider employing children in the business to generate earned income. Those earnings can be contributed or funds could be gifted into the IRA accounts.

Charitable Giving

Appreciated or Depreciated Property

• Consider giving appreciated capital gain property held for more than one year to a charity instead of cash. You’ll get a deduction for the fair market value, and you’ll avoid paying tax on the capital gain.
• When investment assets that have declined in value will be used to make charitable contributions, these should be sold first, and the cash donated to charity. That way you’ll get the benefit of the capital loss in addition to the charitable deduction.

Timing of Larger Charitable Gifts

• Determine whether larger charitable contributions should be made in 2013 or 2014 to maximize the benefit.
• You can make year-end charitable contributions using your credit card. The gift must be processed and charged to your card by December 31 to be deductible on your 2013 tax return. Checks to charities must be written and postmarked by December 31 for a 2013 deduction.
• If a large charitable deduction is desirable for 2013 but you haven’t decided on a charity (or charities) to receive the gift, consider making a charitable contribution by year-end to a donor-advised fund. This will allow you to receive the large charitable deduction in the current year, but you can give the money to charities over time. If the charitable contribution is large enough, you may also consider establishing a private foundation. Before forming a private foundation, discuss the costs and benefits with your Moss Adams tax advisor.

Charitable Giving as Part of Your Overall Estate Plan

• Incorporate any charitable contribution planning into your long-term estate plan strategy, taking into account the various tax- and cash flow–efficient ways to structure your gifts. Blend your lifetime charitable planning with your estate plan to help increase cash flow for yourself and your heirs.

IRA Distributions

• As discussed previously, if you’re age 70 1/2 or older and planning to make charitable contributions, you may make tax-free distributions from your IRA of up to $100,000 directly to charitable organizations as a qualified charitable distribution. These distributions are excluded from your taxable income and not subject to the limitation of charitable contribution percentage.

Investment Management

Coordinated Advice

Numerous tax law changes mean getting coordinated advice from your tax and investment advisors is more important than ever.

• Because of the potential for NIIT, consider investing in municipal bonds for the tax-free interest where appropriate.
• Work with your investment advisor to manage net capital gains and take advantage of any inherent capital losses that may be in your account (tax-loss harvesting).

Investment Strategy

• In light of recent economic performance, review your investment strategy to determine whether it’s consistent with your personal goals.
• Reevaluate tax-exempt yields versus taxable yields in light of current market conditions and the new 3.8 percent NIIT.

Personal Financial Planning

Create a Road Map and Start the Process

• For those without a clear set of short- and long-term personal financial goals, take the time to create a personal financial plan and begin to monitor your progress toward those goals.

Update Existing Plans in Light of Recent Economic Performance

• The uncertainty owing to the economic events of the past few years is a good reason to update an existing personal financial plan and verify progress toward achieving your goals.

Insurance

• If your circumstances have changed, review your life insurance policies to ensure they’re in accordance with your current wealth management needs, transfer goals, and liquidity concerns. Pay particular attention to policy type, coverage amounts, ownership, and beneficiary designations.
• Lower premiums may be available to current policyholders. Consider contacting your insurance agent to check that existing policies are operating efficiently and as expected.
• For employer-owned policies, be certain that required formalities are being followed on the purchase of new life insurance for any employee. Failure to do so could trigger the proceeds to become taxable income when received and increase the corresponding tax liability.

Health Care Reform: What Individuals and Families Need to Know

In addition to the NIIT and the additional Medicare tax discussed earlier, there are a number of Affordable Care Act provisions that individuals and families (if not covered by an employer’s plan) may want to take into consideration with respect to tax planning.

State Health Insurance Marketplaces

• Open enrollment for state health insurance marketplaces begins October 1, 2013, with coverage beginning January 1, 2014. US citizens and legal residents are eligible to purchase coverage in their state’s marketplace unless they’re age 65 and over (eligible for Medicare) or they qualify for Medicaid. The open enrollment period continues through March 31, 2014. Outside of this open enrollment period, individuals and families can purchase insurance on the marketplace for 2014 only if they have a qualifying event, such as change in marital status, birth of a child, job loss, or move. A new enrollment period for 2015 will begin on October 1, 2014.
• Each state’s marketplace will offer a choice of health plans, provide plan information and options in a standardized format, provide a mechanism for enrollment in the marketplace, and administer any premium tax credits or subsidies for eligible individuals. Plans offered on the marketplaces will include a comprehensive set of services known as the “essential benefits package.” This will help consumers decide which plan best fits their needs.

Individual Shared Responsibility Provision

• All US citizens and legal residents are required to have qualifying health coverage starting January 1, 2014. You and your family must have either health care coverage or an exemption from coverage or make a payment when you file your 2014 tax return in 2015.
• If you get your health coverage through a state marketplace, you may be eligible for a premium tax credit or cost-sharing subsidy. Individuals with household incomes below four times the federal poverty limit—$45,960 for an individual and up to $94,200 for a family of four—will qualify for either a premium tax credit or cost-sharing subsidy to help offset the cost of qualifying health insurance purchased through the marketplace.
• The 2014 penalty for not obtaining qualifying health coverage is the greater of $95 or 1 percent of household income. In 2016 the penalty increases to the greater of $695 or 2.5 percent of household income for 2016. The penalty will be indexed for inflation after 2016.
• The maximum penalty for a family is three times the penalty of an adult individual. The penalty for dependents under age 18 is one-half the penalty of an adult individual.
• There are some exemptions from the individual shared responsibility provision—for example, for individuals without coverage for less than three months, those with a religious conscience objection, and those for whom the purchase of coverage would represent a financial hardship.

Insurance Reform

Several important insurance reforms will take effect on January 1, 2014, including:

• A prohibition on denial or renewal of coverage based on an individual’s health status.
• A prohibition on annual limits of coverage.
• Limits on how much and the circumstances under which premiums can vary among individuals.