Saving Taxes Six Ways to Sunday
(Half a Dozen Ways to Save Taxes by Year-End)
Stan Rose, Managing Director, Tax Practice
Somehow we are at the end of another year that seems as if it just began. With it comes the end of time to take action that could impact your 2016 tax return. The primary purpose of this article is to summarize half a dozen moves you can make by year-end to reduce your taxes.
I will caution that the advice that follows is based on laws in place at this time. Earlier this month, we released an explanation of President-elect Donald Trump’s tax plans. It included some tentative advice taxpayers can consider between now and year end, under the assumption that his plans will become law. To state the obvious, those plans are not yet law. While we can speculate that much of it will pass, the material available raises a lot of questions. Some portions of it are very unclear, and seem to carry unintended consequences and nearly un-workable components. With a relatively friendly majority in Congress, Trump’s tax plans seem likely to come to fruition in one form or another, but which portions of it are unknown.
Our Trump tax plan analysis provides some year-end planning tips that will make sense if (and only if) his plans are implemented, but the material that follows is based on existing laws. For the dwindling balance of 2016, the astute planner will be very mindful of both.
The mad scramble of “extenders” is fondly absent this year
First, it is worthwhile expressing our appreciation to Congress for passing tax laws that apply to 2016 before 2016 concluded. In fact, the laws were passed before 2016 started! For many recent years, we did not know until the end of the year exactly what tax rules we had been operating under for the past 12 months. Only as the year came to a close did Congress pass a number of annually-renewed-at-the-last-minute “extenders,” thereby retroactively putting the paddles of life back onto a number of provisions that would then apply backward for nearly 365 days but forward for just a few short hours before collapsing again.
This approach of course was nuttier than rat droppings in a pistachio factory. Last year Congress apparently realized this (or perhaps simply tired of putting us through those sadistic games), and passed the 2015 Path Act, which made many such annually-expiring rules permanent.
The Path Act finally gave taxpayers the welcome ability to make financial decisions throughout the 2016 year in better awareness of their tax impact. For the first time in a number of years, we have been able to counsel our clients prior to the holiday season regarding the impact of the following significant provisions:
- Section 179 limits (up to $500,000 in write-offs)
- Full exclusion of taxable gain on disposal of qualified small business stock
- 15 year depreciation for qualified leasehold improvements
- Research credit
- American Opportunity education tax credit
- Exclusion from income of direct charitable donation of IRA funds up to $100,000
- State and local sales tax deduction in lieu of state income tax deduction
Temporarily extended benefits
- 5-year extension of bonus depreciation (50% for 2016 & 2017, 40% for 2018, and 30% for 2019)
- Nonbusiness energy property credit and fuel cell motor vehicle credit (through 2016 – but certain solar, geothermal, and wind equipment qualifies through 2021)
- Mortgage insurance premium itemized deduction (through 2016)
- Tuition & fees deduction (through 2016)
Granted, we do not know how President-elect Trump’s current tax plan will impact 2017 and beyond, but for 2016, we have operated with the above rules well-known, and have less need to scramble at this time. Nevertheless, there still are tax maneuvers to be made, and following are six of the more meaningful ones for you to consider before the year comes to a close:
1 - Now or never deductions
Review the temporary benefits listed above. Accelerating some of these planned expenditures could produce permanent tax savings, because there is no assurance that these deductions will survive into future years. So many of the extenders were made permanent with the Path Act that it alleviated pressure for Congress to address the others.
2 - A better way to donate to charity
Charitable contributions offer a pair of useful tax-savings opportunities for those who are willing to undertake a modest amount of incremental effort beyond simply writing a check – which we will refer to as the “default” method of donating. In the examples below, let’s assume you plan to donate $20,000.
One of the now permanent benefits is the ability to transfer IRA funds directly from the IRA to a charity. If you used the default method to donate to charity and withdrew the same amount from your IRA, your income would increase by $20,000, and your deductions potentially would increase by the same $20,000 when you wrote the check to the charity. However, the withdrawal and payment appear in two different places on a tax return – and therein lies the problem in need of a solution. An IRA withdrawal increases “adjusted gross income (AGI),” and that can set in motion some unintended consequences, because several benefits are phased out as AGI increases. For high income earners, itemized deductions and exemptions both are at least partially phased out if AGI is too high. Meanwhile, for low income earners, Social Security income might be non-taxable if AGI remains low, as opposed to as much as 85% taxable if it climbs too high. Keeping AGI low is helpful to both categories of earners. Direct donations from IRAs to charities will bypass AGI and itemized deductions completely. (Contrast this with the default method, where income and deductions both increase and potentially offset.) The primary impacts of the two methods seemingly are identical, but the secondary impact achieved by keeping the IRA out of AGI is where the benefit lies. Favorably, the direct transfer also constitutes a “required minimum distribution,” so those who are required to receive an annual payment from their IRAs (those aged 70 ½ or more) can meet that need by using this strategy.
A second, and potentially more potent way to deduct charitable contributions involves use of appreciated securities instead of cash. If you are planning to make a donation using proceeds of security sales (or simply will incur sales in the same year as a charitable contribution), the sale may produce taxable gain (increasing income) and writing the check to charity will generate an itemized deduction (reducing taxable income). However, if you instead donate the stock or mutual fund shares directly to the charity (without first selling them), you will receive a potential deduction equal to their value on the date of transfer but – significantly – will not (now or ever) have to include that gain in your income. This only holds true for shares you have held for more than one year, and it represents an excellent way to permanently avoid taxes on the increase in value from the date of purchase through the date of donation. This method of contributing also helps to keep AGI low, which as explained above provides other benefits as well. (As Cousin Eddie told Clark Griswold in Christmas Vacation regarding the jelly of the month club membership that he received instead of a bonus, “it’s the gift that keeps on giving!”)
3 - Fixed asset purchases near year-end
A fixed asset must be “placed in service” to generate its initial tax depreciation deduction, including the Section 179 expense, bonus depreciation, or the first year’s round of regular deductions. This means that to start the clock on any deductions, it must be available and ready for use – typically on site. You do not necessarily have to have paid for it; in fact, many fixed asset additions legitimately are depreciated while purchased on credit. But it is not enough to buy, possess, or take title to the asset and merely drop it off in its box at your place of business; it must be readied for use. A similar standard is used for energy-efficient property that generates tax credits. Failing to place the property into service by year end will delay deductions and credits to the following year.
You are expected to install batteries and get your children’s electronic toys up and running after they open their Christmas gifts, and Congress expects you to do the same with your fixed asset purchases if you want your tax deduction this year instead of next. Do not be your own Grinch.
4 - Accelerate deductions; delay income
Cash basis taxpayers (including individuals) may have certain payments due in January that could be front-loaded into December. That one-month outlay acceleration can result in a one-year deduction acceleration. Deductible mortgage interest, property tax, rent, or state income taxes are common examples. The American Opportunity Tax Credit can generate up to $2,500 in savings for those who qualify, and assuming you have not already reached the cap, prepayment of a spring semester’s tuition bill in December will accelerate that deduction.
Cash basis taxpayers can also delay recognition of income by not collecting it until after New Year’s Eve. Note that if that money is made readily available to you, you will be considered to have constructively received it, and it is then taxable. (You cannot retrieve your mail, realize with horror that it contains a large check, nearly sever your tongue trying frantically to re-seal the envelope, and throw the wet, bloody envelope into a desk drawer until January.) A more polished approach would be this: If you are considering sending invoices close to year-end, and do not need the funds immediately, simply send them late enough in the year that the payment will not arrive until after year-end.
5 - Capital gains/losses
Communicate with your broker and your accountant to offset gains with losses. Some taxpayers have prior year capital loss carry-overs that are available to offset 2016 gains. Know those amounts, and consider selling securities that have built-in gains that will be absorbed by the prior losses without impacting your taxable income. Even in the absence of loss carry-forwards from last year, be sure that you are aware of gains and losses produced in the current year, and consider generating opposing gains or losses to offset them. Obviously the tax tail should not always wag the investment dog, but if it makes sense to harvest some losses or trigger some gains to optimize taxes, do not overlook that opportunity between now and December 31.
In doing so, be aware of the “wash sale rules.” If you generate a loss by selling a security, but within 30 days (before or after) acquire the same or nearly identical security, the loss is not deductible. Instead, you adjust the cost basis in the replacement security upward by the amount of the loss (preserving the loss for a later date when the IRS will be more accommodating). Not surprisingly, wash sale rules only apply to losses. If you reacquire a security sold at a gain, the gain is taxed immediately and the government coffers stand ready for your contribution. In other words, the wash sale rules only apply when they benefit the IRS.
6 - Retirement plans
For those who have not established a retirement plan for a business, there are a number of alternatives. For some, it is too late to establish one for 2016 (Simple IRA, Safe Harbor 401(k)). Others must be established by year-end (Solo or conventional 401(k) plans, profit-sharing plans, and cash balance plans). Others may be established in the following year (SEP and regular IRAs). Funding deadlines vary widely, and many allow contributions to take place following year-end. Most business-related plans require inclusion of employees and funding for the accounts. However, some are allowed for the self-employed, and can exist only for the benefit of the sole proprietor. Rather than trying to cover all the variables in this space, I will instead encourage you to look into this quickly if you do not yet have a retirement plan. Depending on the type of plan and a number of other factors, these arrangements can shelter varying amounts of current income by making a contribution now, or even partway through next year.
Filing deadlines have changed
No CPA worth his or her salt would conclude a year-end tax planning discussion without a reminder that filing deadlines for several common income tax returns have changed, and that anything about to hit the fan will do so on a different date than in prior years. Corporate returns that formerly were filed by March 15 are now due on April 15. Partnership returns that used to be filed by April 15 are now due March 15. FinCEN 115 forms (who makes up these names?) are now due April 15, but can for the first time ever be extended. BNN colleague Jim Moran explained these rules in more detail here. We are still waiting for many states to make up their minds regarding whether they will follow these changes, but it seems unlikely that many will leave intact a filing requirement that predates the federal deadline.
We hope you find this update useful and entertaining, and sincerely hope our readers have experienced an enjoyable and profitable 2016.
If you have any questions, please contact your BNN tax professional at 1.800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.