As Americans, we are experiencing unprecedented levels of uncertainty in the tax laws, which wreak havoc on any hopes of year-end tax planning. Not having a consistent long-term tax policy in place creates a negative effect on the overall economy. Small business owners are reluctant to make large purchases, hire employees or expand their businesses because they are unsure of the costs. Without clear leadership and coherent policy from the Administration and Congress, there will be no effective solution.
Congress has failed to act on tax laws that have already expired, which may or may not be retroactively reinstated, and others that will expire at the end of this year. There are also 21 new taxes that are slated to go into effect Jan. 1, under the Affordable Care Act, also known as Obamacare, which may or may not be repealed in whole or in part.
How You May Be Affected Jan. 1
If Congress takes no action, the Bush-era tax cuts will expire and new tax laws will take effect. Most American taxpayers will experience a tax increase. Here’s what to expect:
- Long-term capital gains rates will increase from 15 to 20 percent. The tax rate on qualified dividends will jump from 15 to 39.6 percent.
- The 2 percent payroll tax cut expires, resulting in higher taxes for about 163 million working Americans.
- 21 new taxes imposed by the 2010 Obamacare legislation take effect. I will not address these at this time because some or all could be changed by the new Congress.
Increases affecting low, middle class
- The lowest tax bracket will be 15 percent. The 10 percent bracket will disappear entirely. Everyone who pays income taxes will pay more.
- Many families may lose $500 of the Additional Child Tax Credit for each qualified dependent child on their tax return.
Increases for High-income Families
High-income families will experience many of the tax increases addressed above, as well as the following:
- The top rates on ordinary income increase from 35 to 39.6 percent.
- Self-employment taxes/Social Security taxes will now be due on earnings up to $113,700.
- The Medicare portion of Social Security and self-employment taxes increase from 2.9 to 3.8 percent on earned income topping $200,000 for single persons or $250,000 for joint filers.
- There’s a new 3.8 percent “Unearned Income Medicare Contribution” (which sounds so much better than “tax”) on “net investment income” (interest, dividends, capital gains, rents, royalties and annuities) for those with total income more than $200K for single or $250K for joint filers.
- Many high-income Americans will experience phase-outs of their itemized deductions and personal exemptions costing them more in taxes.
- If the Alternative Minimum Tax (AMT) patch is not reinstated, AMT reverts back to the 2000 year level, which could subject 29 million more families to the AMT, causing them to pay much more in taxes than they did in the prior year.
- Estate taxes, which currently start at 45 percent on estates more than $5 million, will jump to 55 percent on estates over just $1 million.
When You Can File
Tax season could be delayed, if in this post-election moment the lame-duck Congress fails to finalize the tax laws or does not do so until late December. Or, the delay could come from the Democrats who decide to address the issues in January with their majority members in place. If that were to happen, and Congress made its intentions known, the IRS would not be able to move forward implementing the tax filing season. The reason is, they would not know which tax provisions would ultimately become the law of the land. After all, perhaps the new Congress would be successful in making the new tax laws retroactive.
According to a report from the Joint Committee on Taxation, JCX 1-12, there are 101 tax provisions that expired in 2011 or will expire in 2012. Will some be extended? Will some be made retroactive? The more time Congress takes to deal with the expiring tax provisions, the less likely tax season will start on time.
Once we have the new tax laws in place, the IRS would need time to develop the official tax forms, create instructions and worksheets, distribute that information to the tax software providers and update their computer systems.
This happened once before, when tax season was delayed in 2010. We were not able to file most tax returns that year until mid-February because the IRS needed time to implement the changes that Congress waited to make in mid-December of the prior year, when they passed tax extender legislation. If, this time, the final tax provisions are not decided until late January, it could be mid-March before we’re able to file our tax returns.
What You Can Do In 2012
The following is based on what we know for sure, which isn’t much. I cannot address any tax changes made after the writing of this article (early November), in the final six weeks of the year, if Congress indeed decides to act. Here’s what you can do based on what we know at this point in time:
- Do not defer income until next year — taxes are going up. This is the opposite of what we usually preach, but this year is unprecedented.
- Accelerate payment of deductible expenses. Purchase any equipment or supplies in December you were planning to buy early next year, even if you have to charge it on your credit card. Even though you may save a little by taking the deduction next year when taxes are higher, by doing this before the end of the year, you are able to accelerate your tax deduction a year early. Expenses paid on credit before the end of the year are deductible for the current year even though the bill is to be paid next year.
- Consider incorporating if you are a sole proprietor or partnership. By doing so, you may be able to save a substantial amount in self-employment taxes, if your corporation is set up properly. You will need to run the numbers with your tax consultant (or contact us) to see if this strategy works for you. Also, consider the fact that sole proprietorships are audited by the IRS at a rate of about 30:1, more often than the rate for corporations.
- Fund your IRAs or set up a self-employed retirement plan. This may save you a few dollars now with the tax deduction, but if taxes are high when you take distributions in the future, your tax savings could be minimal — but, at least, you will have the funds for your retirement years. Roth IRA contributions are not deductible, but your money will compound tax-free.
- Consider setting up a Medical Expense Reimbursement Plan (MERP). Many small business owners already deduct their health insurance premiums as a self-employed health insurance deduction, but a MERP can allow you to convert your medical expenses into pre-tax benefits as well, if you qualify. It is pre-tax for both income tax and self-employment tax purposes. (This is not the best plan for S-corporation owners).
- A Health Savings Account (HSA) can be a great plan for those who are not eligible for the MERP, such as the S-corporation owner. HSAs can reduce income taxes, but there’s no self-employment tax advantage, like there is with the MERP.
- Sell appreciated assets. Because capital gains rates are scheduled to increase, you may save some money by selling appreciated assets now to lock in the gains at the lower rate. Consider holding onto some of your loser investments for a couple of months to sell early next year, thereby offsetting the higher capital gains amount.
Well, I hope the best for all of us who are small business owners as our politicians wrestle with the deficit. A little fiscal responsibility on their part would be nice. Hopefully when they are through tinkering with the tax laws, we will be left with enough money to run our businesses and provide for our households.
EDITOR’s NOTE: The preceding is intended to provide general information, not specific tax or legal advice. For specific advice you should contact your tax adviser.
Randy Roth is a tax, estate and business consultant with Incompass Tax, Estate & Business Solutions. His practice concentrates in the areas of tax preparation and planning for individuals, businesses, estates, trusts and nonprofit organizations. He is knowledgeable in the issues affecting contractors and compliance requirements for the trades businesses, as well as real estate matters.