In fact, in some years (like 2012) we still haven’t been given the final laws for this year, such as many of the “extender provisions” like the AMT patch or whether the Research Tax Credit will be available for 2012. Therefore, tax planning has become about what-if scenarios and often guessing at what will happen with the laws. While these what-if scenarios are important, it is equally important to focus on what is known. As 2013 approaches there are several things that are certain that business owners and their tax advisors need to remember. Considering these items will help bring some clarity to your crystal ball.
Higher tax rates in 2013
Despite all the uncertainty of the “fiscal cliff” rhetoric, after the election, one thing is almost certain: federal income tax rates are increasing for higher income taxpayers.
There is still much debate whether this will apply to taxpayers with income greater than $1 million, or as low as $250,000. There also is debate whether these taxpayers will still get the benefit of the lower tax rates or whether these higher rates be retroactive back to the first dollar. Hopefully these details will be hammered out in Washington in the coming weeks. However, this is one of the few times in recent history when business owners have faced increasing federal income tax rates. For 2012, the highest federal income tax rate is 35 percent, but in 2013 the current law has the highest rate increasing to 39.6 percent.
Often business owners have some ability to defer or accelerate the recognition of income or the deduction of expenses from one year to the next. For example, electing out of installment sale treatment is one way to recognize income now rather than over the course of multiple tax years. Businesses can also use the advanced expensing provisions of Section 179 or “bonus” depreciation to deduct fixed assets over a shorter period of time. Traditional tax planning strategy suggests deferring income as long as possible and accelerating tax deductions as soon as possible. However, knowing that next year’s federal income tax rates will be higher challenges these traditional strategies. Careful consideration has to be given to decide if those traditional strategies still provide the best result.
Increased Medicare tax
Another certainty for 2013 is a pair of taxes that are a result of the Affordable Care Act, which was upheld by the Supreme Court in June. The first of these two new taxes is a 0.9 percent increase to the Medicare tax. This increase will go into effect on Jan. 1. It affects wage earners who have payroll taxes deducted from their paychecks, and business owners who pay self-employment tax including active owners in partnerships and LLCs, sole proprietors or working interest owners in oil and gas investments.
This increased tax will only affect taxpayers over a specific threshold. For married taxpayers filing jointly, this tax applies to each dollar of “earned” income exceeding $250,000. For single taxpayers the threshold is $200,000, for married taxpayers filing separately, the threshold is $125,000. This new tax adds significance to the discussion about whether business owners should use traditional tax planning techniques of deferring income and accelerating deductions in 2012 or recognize the income in 2012 and save the deductions for 2013 and later years.
New tax on unearned income
The second tax that kicks in on Jan. 1 as a result of healthcare reform is a 3.8 percent tax on unearned income. This tax applies to portfolio income such as interest and dividends; investment income such as capital gains; and passive income such as rents, royalties and passive income from partnerships or S corporations.
This new tax on unearned income only applies to income over similar threshold amounts as the increased Medicare tax. The dollar amounts are the same as the increased Medicare tax amounts, however rather than only counting earned income in determining the threshold, modified adjusted gross Income is used instead for this new tax on unearned income. Therefore, this includes all sources of taxable income, less some modifications for foreign income.
One specific trap, or opportunity, integrated into this new tax is that it applies to rental income. Many business owners have a separate company that owns the real estate or equipment they use and rents it to the operating company owned by the same or similar owners. These self-rental activities have some special rules. However, they received no special treatment as it relates to this new tax on unearned income. Rental income is specifically identified as a source of income to which this new tax applies. Therefore, starting in 2013 business owners need to be careful about the amount of taxable income their own rental company generates, because it could result in having a higher tax rate.
Clinton Baker is a member with Kennedy and Coe LLC. He specializes in tax consulting and frequently is a public speaker on the tax implications of health care reform.