Blake Christian
What Do the Mid-term Elections Have in Store for CPAs?

Some potential bright spots with respect to future federal tax and fiscal policy to start with.

November 11, 2010
by Blake Christian, CPA, MBT

After two years of a crushing financial crisis, continuing banking challenges for closely held businesses, huge government deficits and the storm clouds of expiring Bush Tax Cuts [which were passed in June 2001, as the Economic Growth and Tax Relief Reconciliation Act (EGTRRA)], there seems to be little good news for U.S. business owners. However, the mid-term elections at the beginning of this month may offer some potential bright spots with respect to future federal tax and fiscal policy.

With the Republicans gaining sufficient seats in the House to take over the lower congressional chamber, the tax legislative process will likely take on a new life in the coming month.  However, due to the Democrats’ continuing control of the Senate and President Obama’s veto power, it is very difficult to predict what the future tax rates and rules will look like in 2011 and beyond.

While this combined legislative and economic landscape presents a challenging year-end tax planning environment for taxpayers and their CPAs, there are also numerous planning opportunities to take advantage of the potential tax hikes associated with the expiration of the Bush Tax Cuts. See Do You Remember? for a helpful review of some of the pre-Bush Tax Cut provisions, which may become operative in 2011.

Since the vast majority of businesses are structured as S Corps, LLCs or Partnerships and these changing rates fall primarily onto individual taxpayers, they will impact tax planning for virtually all business entities and individuals, as well as trusts and estates.

Bush Tax Cuts: Will They Stay or Will They Go?

The Bush Tax Cuts were passed into law in 2001 through the legislative “reconciliation” process, which limits the effective period of most laws to a 10-year period. Therefore, the federal income, estate and gift tax provisions contained in the 2000 legislation will generally run their course at the end of calendar 2010 (Note: The EGTRRA rates will continue to apply to fiscal filing individuals and trusts with tax years beginning in 2010, so adoption of a fiscal year-end trust or newly filing individual can be beneficial) and the various top marginal tax rates will increase as follows:


Current (2010) Top Marginal Federal Rates

Calendar 2011 Top Marginal Rates

 percent Increase

Individuals — Ordinary Income

35 percent

39.6 percent

13 percent

Individual — Qualified Dividend Income

15 percent

39.6 percent

164 percent

Individual — L/T Capital Gain Income

15 percent

20 percent

33 percent

Estate Rates

0 percent

55 percent

Gift Tax

35 percent

55 percent

57 percent

Based on the materiality of the foregoing increases, it is little wonder that extension of the Bush Tax Cuts for 12 months to 24 months has been a hot topic on the campaign trail. The CBO projects a 0.6 percent to 2.0 percent increase in real U.S. gross national product (GNP) over the next 24 months if there is a full extension of the Bush Tax Cuts through 2012. The logic for extending the current tax rates until the economy recovers in some fashion is championed by most Republicans in Congress, as well as a limited number of Democrats. The argument for not extending the current rates is that the wealthy have had a 10-year windfall from the current rate structure and the federal deficits need to be reeled in quickly.

Alliant Group National Managing Director, Dean Zerbe, believes an extension is likely. Zerbe predicts: "The Republicans campaigned on tax issues and will likely make the Bush Tax Cut extension a top legislative priority. Moderate Democrats in both houses also support a short-term extension of the current rates; therefore, President Obama can expect to see a tax package on his desk in the first few months of 2011. The potential wild card is whether Obama will play the veto card? That appears doubtful based on the voice of the electorate earlier this month."

The fiscal magnitude of extending the current tax rates is projected to add $2.3 trillion to the total 2018 federal debt, according to the Congressional Budget Office (CBO). Of course Supply Side economists such as Arthur Laffer believe that all or a portion of the lost tax revenues associated with the rate differential will be offset by incremental economic activity driven by these same lower tax rates.

2010 Year-End Tax Planning: Flying Without a Net

Due to the fact that the vast majority of new House and Senate legislators will not take their seats until after calendar year-end, and the Congressional Holiday recess will likely mean little legislative action for the remainder of 2010. It is highly unlikely we will see any significant tax changes for the rest of this year and will not have a clear picture of where Congress might settle on future income, estate and gift tax rates.

This leaves taxpayers and their advisors being forced to make some assumptions in how best to defer or accelerate income and expenses at year-end.

Therefore, the year-end planning process for 2010 should be started earlier than normal and time should also be spent on gathering as much information regarding the best estimates of taxpayers’ 2011 taxable income positions.

Forewarned Is Forearmed: The Time to Plan Is Now

Even though the current uncertainty about the 2011 federal tax-rate structure can cause some angst, there are numerous tax planning opportunities that can be considered now to give business owners and individual taxpayers an upper hand in choosing the most tax-effective strategy for reporting income and expenses in the current and future years.

Following are some general tax planning opportunities in light of the rate uncertainty:

  • For taxpayers who believe 2011 federal tax rates will be increasing, consideration should be given to:

    1. Accelerating income including service revenue, product sales, gain on sale of assets with inherent tax gains into calendar 2010 in order to secure lower 2010 federal tax as compared to inclusion in 2011. For example, the sale of a business or personal assets, including stock, LLC or partnership interests, can be sold by year-end and the gain can be reported in the current calendar year. An election out of installment sale treatment can allow for the full gain to be accelerated into 2010.
    2. A high percentage of high-net-worth (HNW) taxpayers are evaluating conversion of their individual retirement accounts (IRAs) and other retirement funds to Roth IRAs for the long-term tax-free withdrawal opportunity. While these taxpayers can elect to include the income from all of the converted funds in calendar 2010, or 50 percent in 2011 and 2012, those taxpayers expecting higher future rates will likely want to report the conversion in 2010. Since the election can be revoked prior to October 2011, this also gives taxpayers several months to evaluate 2011 congressional tax legislation, as well as their personal and business results through the early part of 2011.
    3. An evaluation of the wide variety of accounting methods and entity structures prior to year-end can also generate 2010 and future tax benefits. For example, taxpayers reporting on a LIFO (last-in, first-out, — the most recently purchased items are recorded as sold first) basis may prefer to reduce inventory levels and trigger inventory decrements; thereby accelerating income into 2010. Business operations with only flow-through entities may want to evaluate establishing a C Corp entity to report future income activity in order to take advantage of the favorable graduated rates on the first $100,000 of taxable income and access more advantageous tax rules for certain employer provided employee benefits.
    4. To the extent large capital gains are generated in 2010 or the individual taxpayer is in an Alternative Minimum Tax (AMT) position for 2010, the beneficial rate arbitrage can be even higher (e.g. max 28% AMT rate for 2010 vs. 2011 maximum ordinary rate of 39.6%). It is worth noting that since Congress has thus far not extended the AMT “patch,” taxpayers at relatively low income levels will be thrown into the AMT system. While this is bad news for those impacted, this can also provide added planning opportunities if the taxpayer expects their future marginal rate to be higher than the 2010 maximum AMT rate of 28 percent.
    5. Taxpayers with material portfolios of stocks generating “qualified dividends” which are currently being taxed at 15 percent may want to consider selling such stocks prior to year-end in order to avoid a post-2010 tax rate on future dividends of up to 39.6 percent. Those stocks that have appreciated and will generate a long-term gain on sale would also generate a one-third lower federal tax, 15 percent vs. 20 percent, if sold in 2010 vs. 2011.
    6. The 2010 Small Business Act passed in late September extended and liberalized the depreciation rules for acquiring tangible personal assets and certain real property improvements. While these valuable accelerated write-offs can be attractive, taxpayers expecting rates to increase may prefer to not accelerate these deductions and push out these expenses to future, higher tax years.
    7. A full evaluation of accounting periods and methods for business entities should be undertaken to take maximum advantage of the changing rates.

Other Year-End Considerations

Regardless of whether taxpayers believe rates are going up or down, with the ability to carry back net operating losses (NOLs) for up to two years, and general business credits back to the 5 prior years, the year-end planning strategies should carefully factor in the ability to recover prior year federal tax liabilities. By claiming the wide variety of accelerated depreciation incentives (other than IRC Section 179 for loss entities), deferring income, accelerating losses on business assets through disposition and accelerating other expenses, business owners and individual taxpayers can often generate tax losses which can immediately be carried back to profitable years and generate significant tax refunds.

Only time will tell how the 2011 tax rates will evolve, but in the meantime and certainly before year-end, CPAs and business owners should be spending the time necessary to ensure that taxpayers are well-positioned whether the current federal rates stay the same or increase significantly — as currently scheduled.

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Blake Christian, CPA, MBT is a tax partner with Holthouse, Carlin & Van Trigt LLP and Co-Founder of National Tax Credit Group, Inc. He can be contacted www.blakechristian.com.