Planning For Pending Federal Income Tax Increases

The so-called “Bush tax cuts” that were enacted in 2001 and 2003, and extended by President Obama in 2010, are scheduled to expire automatically for tax years beginning after 2012.  Additionally, starting in 2013, the federal Health Care and Education Reconciliation Act of 2010 imposes a new 3.8% tax on net taxable investment income[1] of families earning over $250,000 a year.  The new health reform act’s investment income tax, coupled with the expiration of the Bush tax cuts, will result in:

  • The maximum federal income tax rate on ordinary compensation income of individuals rising in 2013 from 35% to 39.6%, an increase of over 13%;
  • The maximum federal income tax rate on most long-term capital gains of individuals rising in 2013 from 15% to 23.8%, an increase of roughly 60%;
  • The maximum federal income tax rate on dividend income of individuals increasing in 2013 from 15% to 43.4%, an increase of around 190%;[2] and
  • The maximum federal income tax rate on all other net investment income (e.g., interest, net rents, short-term capital gains, etc.) of individuals rising in 2013 from 35% to 43.4%, an increase of nearly 24%.

Democrats and Republicans currently are at loggerheads as to the extent to which the Bush tax cuts should be extended.  Democratic leaders have stated that they are only willing to extend the Bush tax cuts for families earning below $250,000; Republicans want to extend the Bush tax cuts for all taxpayers. Absent a legislative fix, the Bush tax cuts will expire automatically for tax years after 2012.

At this juncture, it is unclear how the issue of extending the Bush tax cuts will play out.  Resolution of the issue prior to the November presidential election seems remote.  An Obama victory in November would likely increase the risk that the Bush tax cuts will expire for married couples earning over $250,000 a year; a Romney victory increases somewhat the odds of the Bush tax cuts being extended at all income levels, albeit perhaps retroactively after Romney takes office.  There are also scenarios, however, under which the legislative process produces some other compromise or perhaps no extension of the Bush tax cuts for anyone regardless of who wins the presidential race.

Businesses, investors and executives who believe the political odds favor expiration of the Bush tax cuts for higher income persons may wish to consider the following actions this year to soften the direct and indirect effects of the resulting future tax increases:

  • Selling appreciated long-term capital gain assets (including equity interests in closely-held businesses, publicly-traded securities, land and other capital assets) in 2012 to take advantage of the low long-term capital gain tax rates still in effect.  Note that you can sell appreciated marketable securities this year to lock in a long-term capital gain, and then promptly repurchase those or similar securities to continue your investment, without application of any federal income tax restriction of the type that applies to “wash sales” of securities at a loss.[3]  Also, be aware that gains from deferred payment sales of capital assets reported on the installment method are taxed at the income tax rates in effect in the year the installment sale proceeds are received;
  • In the case of C corporations, accelerating the payment of dividend distributions to individual shareholders into 2012;
  • In the case of individual investors who hold stocks paying a high dividend rate (including mutual funds passing through significant corporate dividend income), selling those investments before 2013;
  • Exercising non-qualified stock options in 2012 before tax rates on the wage income from such option exercises increase next year;
  • With respect to restricted stock or similar property to be received later in 2012, making a Code Section 83(b) election within 30 days after receipt to accelerate the taxability of such compensatory equity grants into 2012; and
  • Postponing the timing of charitable contributions and other material, discretionary deductible expenditures until 2013 when tax rates (and thus the value of deductions) may be higher. This may include waiting until 2013 to “harvest” investment losses (i.e., to sell or otherwise recognize loss positions) if incurring and using those losses in 2012 would otherwise result in the reduction of 2012 income that will be taxed at lower rates than income expected to be recognized in 2013.

Because the likelihood and probable breadth of any extension of the Bush tax cuts should become clearer after the presidential election in November, interested persons will be inclined to postpone their tax-planning around this issue until the presidential ballots are counted.  Doing so, however, may only leave a narrow window in which to act by year-end. 

Additionally, taxpayers should take into account the fact that irrespective of any extension of the Bush tax cuts, the new 3.8% federal health reform act tax on net investment income of higher income taxpayers is also scheduled to take effect January 1, 2013. 

If you have any questions about this subject, please contact Kenneth Tillou, Dale Hansen or Chase Manderino at the numbers below.

Kenneth Tillou                         801-257-7946    

Dale Hansen                           801-257-7917    

Chase Manderino                   801-257-7982    

[1]The new 3.8% tax generally applies to net taxable “unearned income” including, dividends, interest, capital gains, net rental income, and pass-through operating income from LLCs, partnerships and S corporations in which the taxpayer does not actively participate.

[2] Because C corporation profits distributed as dividends are also subject to taxation at the corporate level at federal income tax rates of up to 35%, the maximum combined federal income tax rate on such distributed profits would effectively increase in 2013 to over 63%.  

[3] Your capital gain holding period on the re-investment will not begin, however, until you repurchase the securities.