CBIZ Solutions+

Be Prepared for Anything – Uncertainty Dominates Tax Landscape

Posted on October 6, 2010 in CBIZ Solutions+

In 1789, Benjamin Franklin wrote to French physicist and writer Jean-Baptiste Leroy that “in this world nothing can be said to be certain, except death and taxes.” Thankfully, the Founding Father met with the former certainty before facing the eradication of the latter. No year in recent memory compares to 2010 when it comes to uncertainty in the federal tax landscape. It is no longer just a question of what tax law changes Congress and the Administration might implement. We must also ask “What happens if Congress does nothing at all?” A stalemate in Congress usually means the status quo prevails, but not this year. Significant tax cuts passed during the Bush Administration in 2001 and 2003 (“the Bush tax cuts”) were made temporary to comply with Congressional “pay-as-you-go” budget rules requiring future revenues to offset tax cuts.

Fast forward to 2010 and now most of these tax breaks will expire at the end of this year. This means that without Congressional action, the tax law pertaining to these tax breaks will revert back to early 2001, raising taxes on virtually all taxpayers – individuals, businesses and estates. In addition to the Bush tax cuts, several other temporary tax incentives meant to stimulate the sagging economy have either already expired or are set to expire at the end of 2010.

President Obama’s campaign platform included an extension of the Bush tax cuts, except for couples making over $250,000 ($200,000 for singles). For these individuals, tax rates and certain other provisions would revert to their early 2001 levels. Republicans, citing the flagging economy, generally believe it is unwise to raise taxes on anyone at this time. They argue that the increased taxes will negatively impact investment and job growth given that many of the affected individuals are owners of small businesses. The Administration counters that retaining the tax cuts for all taxpayers is simply too expensive as the budget deficit continues to spiral upwards.

The Republicans’ call to extend the Bush tax cuts for everyone, at least temporarily, is gaining some traction on the other side of the aisle. Combine this with the upcoming mid-term elections, where the Republicans are expected to make significant gains, and the tax increases on higher-income individuals that once seemed inevitable is no longer a certainty. It also means that the stalemate in Congress over these issues could drag past the elections and even into next year.

Taxpayers can take nothing for granted. No one anticipated that the estate tax would have been allowed to expire for even one day, let alone nine months, and yet here we are mired in Congressional inaction. Higher-income taxpayers must be prepared for the potential of significant tax increases in 2011. And it is not just an increase in marginal tax rates. Tax rates on dividends and capital gains, alternative minimum tax, the marriage penalty and phase-outs of itemized deductions and personal exemptions all may be affected by the actions or inaction of Congress this fall. The sunsetting of these tax breaks could impact a taxpayer in the highest bracket far beyond a 4.6% increase in marginal tax rates. This chart lists the major tax provisions set to expire, how the expiration will affect taxpayers, and the recent proposals that have been made to address the expiring tax cuts.

Planning for the Sunset Year

Tax planning often emphasizes minimizing or deferring income taxes by accelerating deductions into the current year and deferring income recognition until later years. Given the prospect of significant tax increases, you may want to take the opposite approach and accelerate income into 2010 and defer deductions until 2011 (assuming you will ultimately recognize the income or deduction).

For example, assume that you are able to generate an additional $50,000 of deductions and can control the year in which you take the deduction. By deferring that deduction until 2011, an individual in the highest bracket would save an additional $2,300 in federal income taxes (assuming the lower tax rates are allowed to expire). Take the deduction in 2010 and you will need to earn a one-year return of over 13% on that tax savings to equal the savings you would have realized by deferring the deduction until 2011. Note that other factors, such as state income taxes or the alternative minimum tax, may affect these results.

2010 may also be the year to accelerate income by paying out additional bonuses (assuming the compensation is reasonable), selling appreciated positions, exercising stock options, converting your IRA to a Roth IRA or even choosing not to defer income when business assets are sold in exchange for an installment note or would be available for like-kind exchange treatment.

Take a simplified example where a partnership, LLC or S corporation sells assets in 2010 in exchange for a five-year promissory note. The sale results in $4 million of long-term capital gain that passes through to the owners. Assuming the 15% capital gains rate is allowed to expire and the gain is deferred until 2011 and beyond, the total federal tax paid would equal $800,000, instead of $600,000 if the entire gain is recognized in 2010. Even when spreading the tax payments out over five years ($160,000 per year), you would have to discount those payments back to today’s dollars by more than 10% to equal a present value of $600,000. Shorten the deferral period and the results are even more dramatic.

Of course, other elements must be factored into the calculation, such as state income taxes and whether the cash is available to pay the accelerated tax liability without borrowing. Fortunately, the decision to elect out of installment sale treatment does not need to be made until your entity files its tax return, giving you more time to wait for the dust to settle in Congress before making a decision.

All of the uncertainty surrounding the 2011 tax landscape makes tax planning very difficult and complex. Taxpayers must hope for the best but plan for the worst. As pieces may not begin to fall into place until very late in the year or early next year, taxpayers must plan to take action but then wait as long as possible before implementing the plan. Actions that can be taken after year-end, such as certain elections or an automatic accounting method change, become that much more attractive.

Returning to the words of our sage, Mr. Franklin, remember that “Idleness and pride tax with a heavier hand than kings and parliaments.” So do not wait to start your assessment of how all of this uncertainty will affect you and your business. Your local CBIZ MHM tax advisors may not have crystal balls, but we can help you position yourself to minimize your tax liability now and in the future.

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