Portfolio - Investment Insights
Plan Alternative Scenarios for Next Year’s Tax Rates
by: Michael Cohn
Friday, November 9, 2012
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It may be some time before Congress and the Obama administration decide what to do about the tax rates for next year, so it’s a good idea to plan for various alternative scenarios just in case.

Greg Rosica, a tax partner in Ernst & Young’s Personal Tax Services who leads the firm’s Southeast Area Private Client Services practice, and a contributing author to the Ernst & Young Tax Guide 2013, advises accountants to sit down with their clients and do some what-if planning.

“As we enter these last two months of the year and look at what people should do with the current situation that we have, we know what our tax rates are today, and we know that on January 1, they’re scheduled to go up significantly, back to where they were at the beginning of 2001 and 2003,” he said. “In addition to that, we have the Medicare add-on that’s coming. That’s what we know today. What people should really do is sit down and come up with some alternative planning scenarios for their situation.”

In one scenario, he recommends that clients look at their situation if the change in tax rates planned under current law occurs, and what they should do. In areas where they have some control, it might make sense to accelerate their income or defer deductions.

If they’re self employed, for example, they have some control over the timing of when they’re taking in revenues, billing and collecting from customers, selling certain assets, and paying expenses at either the end of this year or the beginning of next year.

If they’re wage earners, they may have itemized deductions over which they can control the timing, such as charitable contributions and real estate tax payments. “There are a lot of things that are within the control of the taxpayer to be able to accelerate or defer income and/or deductions,” said Rosica. “For someone who might be an executive at a public company, they certainly might have things like restricted stock or stock options or nonqualified deferred comp plans, many of which have tax triggers that are controlled by the individual taxpayer, so they can look at those situations to see whether it makes sense to trigger some of those this year, or wait till next year.”

They should also build a different scenario in which potential tax changes occur before next year. In some cases, they might need to wait as long as they can, perhaps until the last week of December, to take action. In other cases, if they’re dealing with stock options, for example, there might be windows in which they have to pull the trigger earlier.

“Look at what the situation is,” Rosica advises. “It’s certainly possible there may be a deferral of this expiration, if Congress and the President get together and they decide that they’re going to do some kind of deferral to give time to come up with some kind of tax reform.”

Rosica noted that Obama mentioned tax reform in his acceptance speech on Tuesday night as one of the items that he needs to get done (see Obama Wins Re-election, Pledging to Reform Tax Code). “There are certainly indications that there will be something coming and changing, so we need to build some plans to take into account, if we hear something before the end of the year, what course of action we would take,” he said. “And if we don’t, then based on what we’re feeling and seeing at that point in time, whether we should pull the trigger on some of these items based on what happens in 2013 or not.”

For example, with long-term capital gains currently taxed at a 15 percent rate today and rising to 20 percent in January, plus a 3.8 percent Medicare tax, the taxes could go up nearly 24 percent. “If we knew that was certain to be the tax for all of 2013 and beyond, then that might drive someone who was otherwise going to sell their position in a stock to trigger that this year,” said Rosica. “There is a breakeven point for doing that. If you were to sell it today, recognize the gain, and perhaps purchase that same stock and then hold it, there is a point for that breakeven versus just holding onto that stock and subjecting the entire gain to 23.8 percent down the road. Those are not two-year or three-year breakevens. They’re more like five years on those kinds of things. And the question is: who is really comfortable with what the taxes are going to be five years out? They could be something completely different, so are you willing to pay the toll and pay the tax today for something that has a five-plus-year breakeven or do you want to just let it ride and then pay the taxes once you eventually sell that position or not? It requires some analysis in those situations to really be postured so that you can pull the trigger on the one that makes the most sense.”

Rosica believes that while the information on future tax rates is not yet available, the framework is available to come up with those scenarios and then be ready to make a decision. “At some point, when it’s December 31, it’s time to make the decision, right? You have to go one way or the other on this,” he said. “And if there’s no more clarity than we have today, then you probably don’t do some of those things, but if there is, then you may.”

Rosica advises clients not to wait until the end of the year. “If you wait until we get clarity, it could be the last week in December before we get some, and you then have to figure out what strategies you should implement based on that,” he said. “I think it’s going to be too late to get anything done. Line up some strategies based on understanding what your situation is, and the types of income you have, such as what is and is not subject to the Medicare tax, because we have that kicking in January 1. Despite what happens with other tax rates, that doesn’t seem like something that’s necessarily going to change based on the administration that’s in office now. It’s a change that would require some significant negotiation. So understand the types of income that you have, whether it’s wage income, self-employed income, interest or dividends, and what’s going to be subject to which tax. How much is that going to cost, and how can you plan around some of those items based on what your situation is? Just prepare yourself now to understand what actions you might take. Be ready to execute any of those strategies so if we get any more clarity, you will know which way to go, and if we don’t, you’ll know what to do in that situation as well.”

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