Steve Parrish, Contributor
Using my experience to help save business owners a headache or two.
We’ve had over a month to digest the American Tax Relief Act
of 2012 (ATRA). The law is starting to take shape, and planners are
devising strategies to leverage the good provisions and avoid the costly
ones. Naturally, those of us who deal with these things each time they
come around are being asked to make predictions about where this law
will take us.
Predictions can be dangerous. What we take for prescience when the prediction is made may end up as being, well, foolish when the facts are all in. In the 19th century, the U.S. Geological Survey announced there was little or no chance of oil being discovered in California. In the 20th century, Neville Chamberlain famously declared peace for our time after signing the non-aggression pact with Nazi Germany. And, in the 21st century, the words mission accomplished come to mind.
Even with something as mundane as tax law, I’m hesitant to make predictions. I confess to past predictions such as ROTH conversions will be big and Congress will not let the estate tax expire in 2010. Time proved me wrong. So, instead of predictions I offer tax trends. These are my expectations for what may happen with tax planning as a result of the passage of ATRA.
Predictions can be dangerous. What we take for prescience when the prediction is made may end up as being, well, foolish when the facts are all in. In the 19th century, the U.S. Geological Survey announced there was little or no chance of oil being discovered in California. In the 20th century, Neville Chamberlain famously declared peace for our time after signing the non-aggression pact with Nazi Germany. And, in the 21st century, the words mission accomplished come to mind.
Even with something as mundane as tax law, I’m hesitant to make predictions. I confess to past predictions such as ROTH conversions will be big and Congress will not let the estate tax expire in 2010. Time proved me wrong. So, instead of predictions I offer tax trends. These are my expectations for what may happen with tax planning as a result of the passage of ATRA.
- Income tax planning will take on an increased importance in business planning. With a slower economy translating to both lower earnings and lower yields, the incremental cost of increased income taxes will represent a larger potential drag on gains. Further, even though many individual income tax provisions have been made permanent, most of the business income tax provisions are temporary in nature. This may cause businesses to leverage business tax savings while they are available. Section 179 expensing, bonus depreciation and research & development (R&D) tax benefits are temporary at best, and businesses will take a hard look at enjoying these provisions before they expire.
- Tax diversification will have new meaning to business owners. In the Great Recession many business owners learned they couldn’t have all of their eggs in one basket — their businesses. Asset diversification is already a trend, but with increased taxes, there will also be a movement towards tax diversification. Business owners will, of course, look to qualified plans for immediate tax deductions, but they will consider tax advantaged products such as life insurance and annuities. The question is not just income tax deferral, but the nature of the income once it comes out. For example: accumulation-oriented life insurance policies will become more popular. That’s because they offer death protection and tax deferral during accumulation, plus tax-favored distributions where the owner can control the amount and timing of the income stream.
- Pass-through tax status will no longer be the only choice for smaller businesses. While electing S Corp or LLC (taxed as a pass-through) status will continue to be the default assumption for many closely-held businesses, tax planners are blowing the dust off of C Corporation (C Corp) law and giving it another look. One reason is tax brackets. The top C Corp tax bracket is 35%, while the top personal bracket is 39.6%. Further, C Corps offer tax favored benefits that are not equally available with pass-through entities. Group term life insurance, disability income plans and to an extent, health insurance, all enjoy preferred tax status for business owners when offered through a C Corp. Deferred compensation plans can truly defer some of an owner’s wages when structured through a C Corp tax status. Speaking of deferring compensation ….
- Deferred compensation plans will be very popular. With the passage of ATRA, top tax rates have gone up, and there is little reason NOT to defer tax if and where possible. Additionally, there will be tax points where the marginal cost of additional tax can be significant. For example: a couple may be well advised to keep its income below $250,000 in order to avoid the 3.8% Medicare surtax. Or, they may want to keep income below $300,000 to avoid the wasting away of their personal exemptions and itemized deductions. Many wage-earning taxpayers will seek to model these tax points in advance and, using deferred compensation plans from their companies, push off the sting of additional taxes until later.
- Estate planning will be noticeably different, depending on the estate side. With the exclusion from estate tax at the $5.25 million level ($10.5 for a couple), there are some interesting planning challenges. In many states, this means business owners won’t have to worry about the liquidity challenge of state or federal estate taxes in their planning. However, in other states, although safe from the Feds, they will have to consider local taxes. Another complicating factor is that once the estate exceeds the exclusion, the taxes are large and the planning opportunities are even larger. The 40% rate that applies above the exclusion is onerous, but the law allows many opportunities to avoid it. Consequently, we will likely see a very different set of estate planning approaches, depending on the projected size of the estate at the time of death.
- Nothing is so certain as change. From the conversations I’ve had with business owners and their advisors, many are not buying that we’ve seen the last of tax law changes in the near future. We have so many deficit and budget issues to wrestle with in the coming weeks and months, many believe that Congress may be forced to revisit taxes sooner rather than later. Of course, I don’t mean this as a prediction.
These
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