With less than 30 days remaining in 2017 and impending tax legislation in Congress that could significantly change our current tax system, making year-end planning decisions may be a challenge. Both the House and the Senate passed their own versions of tax reform and now the bills are headed to a conference committee to reconcile the differences before year-end. Even with the tax legislation uncertainty there are some tax planning techniques that should be considered. This article is not intended to be all-inclusive, but it is a general overview of some of the more prevalent planning opportunities and considerations. Therefore, not every subject discussed in this article is appropriate for all taxpayers.
Traditional tax planning strategies: Timing income and deductions
Both the House and Senate tax bills alter the tax rates and brackets for individual taxpayers effective for the 2018 tax year. Depending on an individual’s circumstances, a potential lower tax rate and the elimination of certain deductions in 2018 may make accelerating deductions into 2017 and deferring income to 2018 beneficial. Taxpayers may want to defer bonuses, harvest capital losses (but continue to defer the recognition of capital gains), prepay state income taxes, or fund retirement accounts. Individuals considering converting a regular IRA into a ROTH IRA may also want to postpone the move until 2018 to defer income from the conversion.
Additionally, taxpayers seeking tax deductible losses should review any suspended losses, such as those from activities in which the taxpayer is passive, and consider disposing of that interest. Generally, such a complete disposal of an activity should allow those previously suspended losses to become immediately deductible.
Before implementing these timing strategies, taxpayers should analyze their exposure to the alternative minimum tax (AMT), which may affect the benefit of the deduction for state income tax payments, among other things. We generally recommend that a year-end projection be prepared to identify and evaluate potential tax reduction opportunities. The House bill repeals the AMT, however the Senate bill increases income limits that apply to AMT for the 2018 tax year. Therefore, certain strategies that may cause AMT complications, such as exercising incentive stock options (ISO), should be deferred.
The House and the Senate tax bills reduce the taxation of qualified business income from pass-through entities such as partnerships and S corporations. However, personal-services business, such as those in the fields of law, accounting, and investment services are excluded from the benefit. Because investment managers are likely not eligible for the benefits, traditional year-end planning techniques should be utilized. For example, cash method fund managers should consider whether management fees could be deferred to 2018. Accrual method employers, including fund managers, may benefit from accelerating deductions by carefully timing the payment of employee bonuses. Provided that the bonuses are fixed, determinable and subject to a written plan, non-owner employee bonuses that are paid within 75 days (i.e. two and a half months) after year-end may be deductible when calculating the business’ taxable income. The result is an accelerated deduction for the employer and a deferral of the employee’s bonus, which the employee may welcome.
Both the House and Senate tax bills increase the 50 percent bonus depreciation for property placed in service during 2017 to 100 percent, as well as increasing the thresholds for IRC section 179 expensing. Therefore, businesses should consider deferring purchases of new property until 2018 if the tax legislation is signed into law before year-end.
Estimated tax payments
Taxpayers who are required to pay estimated taxes but have underpaid their tax liability may be subject to certain penalties. Unfortunately, under such circumstances, making a larger-than-required fourth quarter estimated tax payment to “catch up” will not remove these penalties. To remediate this concern, taxpayers who receive employer paid wages could increase their wage withholding for the rest of 2017. Unlike estimated tax payments, which are solely applied to a particular quarter’s estimated tax due, wage withholding is proportionately allocated to all four quarters of the year and may therefore compensate for any missed or underpaid estimated taxes. Additionally, both the House and Senate tax bills eliminate the state and local deduction (with certain exceptions for real property tax) for individuals, therefore increasing withholding in 2017 may allow individual taxpayers to benefit from a current deduction that may not be available if in 2018.
One way to reduce taxable income is to contribute cash or property to qualified charities or donor advised funds. Taxpayers who own appreciated assets, such as stocks, real estate, or artwork should consider donating the property directly to charity. A contribution of appreciated property is often a more tax efficient approach because the donor does not incur any capital gains tax on the appreciation of the property while still benefiting from a deduction for the full fair market value of the property. Neither the House nor the Senate bill repeal the charitable deduction, but individuals should consider accelerating some charitable giving into 2017 to offset taxable income that cannot be deferred.
Additionally, taxpayers age 70 ½ or older could satisfy their required minimum distribution requirement by making charitable contributions of up to $100,000 directly from their IRA. Although no charitable deduction would be allowed, the donated funds would be excluded from the taxpayer’s income for purposes of calculating income tax and the net investment income (NII) surtax.
Taxation of trusts
In contrast to individuals, who generally do not pay tax at the highest rate until they have over $418,400 of taxable income ($470,700 for married filing jointly), trusts are subject to the top 39.6 percent income tax rate once they have income over $12,500. Therefore, it may be worthwhile to distribute the income that a trust accumulated during 2017 to beneficiaries, especially those in low income tax brackets. Such distributions may also be helpful to minimize or avoid the NII surtax, which applies to a trust’s undistributed income. Since trustees and personal representatives may elect to treat distributions made within 65 days after the end of the year as a distribution from the previous year, distributions made in early 2018 may still be utilized as a 2017 tax planning tool.
Both the House and Senate bills increase the estate tax exemption amount to $10MM in 2018, with the House bill phasing out the estate tax entirely by 2024. For those taxpayers searching for tax-free ways to transfer assets out of their taxable estates in the near future should consider making gifts up to the federal annual gift tax exclusion amount, which remains at $14,000 for 2017. Because the $14,000 limit applies on a donor and recipient-basis, a taxpayer could gift up to $14,000 to an unlimited number of people without incurring any federal gift tax. Married taxpayers may combine this exclusion with their spouse to gift up to $28,000 to any individual. Gifts between spouses generally are tax-free; however, if the receiving spouse is a non-U.S. citizen, the 2017 exclusion amount is limited to $149,000.
In addition to transfers to individuals, the annual exclusion is in some circumstances available for transfers to trusts where the beneficiaries have certain withdrawal rights. While not limited to year-end distributions, any such transfers to a trust that will occur before year-end should be accompanied by timely written instructions from the trustee to the beneficiary to avoid triggering adverse tax consequences.
In addition to the $14,000 annual exclusion, a donor has a lifetime exemption amount that is not subject to gift or generation skipping transfer tax. This lifetime amount was adjusted to $5.49MM for 2017, representing an increase of $40,000 from the 2016 lifetime exclusion amount. Therefore, if an individual already exhausted their federal gift tax exemption before 2017, they can now gift this additional $40,000 amount tax-free, beyond the $14,000 per-person exclusion.
For taxpayers with estates that will be subject to the estate tax, certain estate planning techniques such as grantor retained annuity trusts, sales to intentionally defective grantor trusts, and charitable lead trusts, become significant estate planning tools in light of the current low interest rates and concerns that interest rate may begin rising in the near future.
Additionally, the Treasury has withdrawn the proposed regulations that restricted valuation discounts for transfers to family limited partnerships, making this a planning technique viable for 2017 family tax planning.
Private equity and hedge fund considerations
Hedge funds should review the past year’s trading activity to determine whether an existing IRC section 475(f) election remains appropriate, particularly in light of changes to the fund’s trading strategy, which may have eliminated the benefits of the election. This mark-to-market election is now an automatic change of accounting method, and it is therefore significantly easier to revoke this election than in past years. Conversely, funds should also consider whether a 475(f) election is beneficial in light of the past year’s activity or the implementation of new trading strategies.
As a follow up to the new regime for entity-level IRS audits of partnerships, the IRS issued regulations detailing the scope and method for early adoption of this regime. Fund managers should coordinate with their tax and legal advisors to address the impact of entity-level audits on their operations and fund documents to reflect the replacement of the tax matters partner with the partnership representative.
Given budgetary shortfalls that require state legislatures to raise revenues, many states are aggressively imposing taxes based on an economic nexus that broadly expands the judicial boundaries of otherwise permissible taxation. Therefore, fund managers should diligently monitor whether its operations, including travel and telecommuting employees, generate tax filings in multiple states other than the state where the fund manager’s operations are located.
With tax legislation expected to pass before year-end, taxpayers should be ready to move quickly with any last minute planning. This summary represents a number of useful year-end tax planning suggestions, however, we recommend that you discuss your particular end-of-year goals or concerns with your Cohen & Company advisor to tailor a planning strategy that meets your needs. For further information, please feel free to contact us at 855-787-0001 or via email at firstname.lastname@example.org.