We continue to receive queries from clients as to whether tax rates will be raised by Congress in 2011. The question revolves around the issue as to whether income should be accelerated into 2010 to take advantage of the current low tax rates versus an unknown tax rate in 2011. Traditionally tax planning has taken the form of deferring income and accelerating deductions. In 2010 taxpayers might consider doing both.
Congress Does Not Have to Pass Legislation In Order for Taxes to Increase in 2011.
A common misconception is that Congress needs to pass legislation for taxes to increase. That is incorrect. In 2001 and 2003 President Bush championed tax cuts, but under the legislation the tax cuts will expire on December 31, 2010 with rates reverting as of midnight to those in effect in 2000. Consequently, on January 1, 2011the following tax rates will become effective.
The 10% tax rate will disappear.
The 15% tax rate will become the lowest tax.
The 25% tax rate will increase to 28%.
The 28% tax rate will increase to 31%.
The 33% tax rate will increase to 36%.
The 35% tax rate will increase to 39.6%.
Personal exemptions will again be phased out and itemized deductions will become subject to a reduction factor. The child tax credit will revert from $1,000 to $500 per child and the standard deduction will decrease. The tax on dividends will increase form 15% to 39.6% and the tax on long term capital gains will increase from 15% to 20%.
The estate tax which expired in 2010 will revert to a $1,000,000 exemption and a top tax rate of 55%.
President Obama’s Position
Allow the tax cuts to expire only for married filing joint return with earned income over $250,000 and single returns with earned income over $200,000. Phase out personal exemptions and itemized deductions. In addition, for taxpayers who will be in the 36% and 39.6% tax bracket, the tax benefit of itemized deductions will at a 28% tax rate. The estate tax will revert to the 2009 tax rate of 45% with a $7,000,000 exemption for married couples and a $3,500,000 exemption for individuals.
Other Expiring Tax Provisions
Individuals who are over 70 ½ years old can donate up to $100,000 a year to charity directly from their IRA’s. The pay out from the IRA is not subject to tax and the donation is not deductible. What is the benefit of doing so? If you take $100,000 out of your IRA you need to pay income tax on this amount. And a charitable contribution of $100,000 is limited to 50% of your income, so if your only income was $100,000 your maximum charitable deduction would be $50,000, with the balance carrying forward. And the $100,000 of income would also trigger the 7.5% medical deduction floor. Accordingly, wealthy senior citizens are campaigning for an extension of this provision.
2011 Changes to Reporting of Capital Gains
Financial institutions are required by current tax law to report to the Internal Revenue Service on Form 1099-B the gross sales and/or redemption proceeds received by an individual from the sale of securities. The most frequent question we ask a client when preparing a tax return is “when did you buy the stock you sold and how much did you pay for it”? Most clients do not keep records of their stock purchases, many financial institutions do not report gain/loss information to their clients, and the capital gains schedule in the tax return is in many cases a “guesstimate”. The Treasury Department recognized this problem and as of 2011 financial institutions will be required to also report on Form 1099-B the cost basis of the securities sold as well as the holding period information.
This change will be phased in as follows:
Stage 1 – stock acquired after January 1, 2011
Stage 2 – mutual fund shares acquired after January 1, 2012
Stage 3 – all other securities acquired after January 1, 2013
Taxpayers will still have to provide information relating to stock sold after January 1, 2011 that was acquired prior to January 1, 2011.
To enable the financial institution to comply with this change in the tax law, they are asking their clients to pre-select the method that they prefer to use in identifying the purchase date of the security sold when the same security had been purchased on multiple dates. The choices being offered are:
FIFO (First In First Out)
High cost
Low Cost
Long term high cost
With mutual funds a fifth option is offered and that is to use an average cost basis where there have been multiple purchases. If you decline to pick an option the financial institution will automatically use the FIFO option.
While the above methodology will help the financial institution comply with the tax law, it deprives the individual of the opportunity to do tax planning. For example, suppose you bought a stock for $5 in 2002, $25 in 2006, $50 in 2010 and the fair market value today is $40. If you sold one share tomorrow, you have a choice of selling the stock you bought in 2002 and reporting a long term capital gain of $35, selling the stock you bought in 2006 and reporting a long term capital gain of $15, or selling the stock you bought in 2010 and reporting a short term capital loss of $10. Your choice would take into consideration paying a long term capital gains tax of 15% today versus at least 20% in 2011, or you may already have realized other capital gains in 2010 and want to use the short term loss to offset your gains. But you also need to consider that using the short term loss to offset long term gains in 2010 will only yield a 15% tax benefit whereas if you waited to sell the loss position in 2011 you would realize at least a 20% tax benefit.
Consequently, having to identify today what security you choose to sell in 2011 and beyond will enable the financial institution to comply with the change in the tax law but will deprive you of a tax planning opportunity. Prior to contacting your broker with a sell order in 2011 and thereafter, it would be prudent to identify the purchase date of the security you want sold.
Pursuant to the requirements relating to practice before the Internal Revenue Service, any tax advice in this communication is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties imposed under the United States Internal Revenue Code, or (ii) promoting, marketing or recommending to another person any tax related manner.
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