2011 Tax Planning Update

Compared to this time last year, a relative degree of certainty exists for 2011 tax planning. However, it's not time to sit back as there are a multitude of changes coming after 2012. It's important to be aware of what could happen down the road as you finish your 2011 planning.

Politics play an important role in tax planning. When the Bush tax cuts were originally passed in 2001, they were scheduled to expire in 2010. After nearly a decade of debate, Congress agreed last year to extend these laws, but only until December 31, 2012. Without further legislation, these laws will expire which could cause your tax liability to increase. That being said, 2012 is a presidential election year. Major tax legislation is unlikely to occur before the November 2012 elections, which will make planning for the 2012 tax year even more difficult.

Only time will tell what the tax situation will look like after 2012. Here are some tax items to keep in mind for your tax plan.

Individual Income Tax Rates

The lower tax rates enacted with the Bush tax cuts have been extended through 2012. Therefore, the same rates that applied in 2010 will continue to apply for 2011 and 2012. Depending on your personal taxable income, you will fall into the 10%, 15%, 25%, 28%, 33%, or 35% rate brackets. These rates are set to increase with a top rate of 39.6% in 2013. Speculation will continue to build next year, but we could be in a wait-and-see scenario until after the November 2012 elections.

Capital gains and qualified dividends will be taxed at reduced rates again in 2011 and 2012. The top tax rate on capital gains and qualified dividends is 15%. If the reduced rates are not extended again, capital gains will be taxed at 20% and qualified dividends will be taxed as ordinary income beginning in 2013.

Tax planning normally involves trying to accelerate deductions into the current year and deferring income until later tax years. However, if you believe the tax rates will increase in 2013, you may want to consider accelerating income into 2011-2012, if possible, while the tax rates are lower.

Gift and Estate Tax

The gift and estate tax lifetime exemptions and top tax rates were reunified in 2011. The lifetime exemption is $5 million with a top rate of 35% for both tax systems. Without legislative action, the lifetime exemption will drop to $1 million in 2013 with a top rate of 55%. If you anticipate making large gifts in the near future, you may want to make the gift in 2011 or 2012 to ensure that you can take advantage of the larger exemption and lower tax rate.

For taxpayers who die in 2011 or 2012, the unused exemption can be used by the surviving spouse. In order to utilize this portability, the executor of the estate must make an election on the deceased's estate tax return to transfer the unused exemption to the surviving spouse. Since this is an election, it's important to file an estate tax return, even if it would not otherwise be required. The surviving spouse can then use the remaining lifetime exemption on his/her gift tax returns or estate tax return. This portability can only be used once and does not apply to people who die after 2012.

Depreciation Issues

Bonus depreciation has been extended for property acquired and placed in service during 2011-2012. The additional first-year depreciation is 100% of qualifying additions in 2011. The bonus depreciation deduction drops to 50% for property acquired and placed in service in 2012. Currently, no bonus depreciation will be allowed for property acquired in 2013 and beyond.

Section 179 expensing has also been expanded for 2011. Section 179 allows immediate expensing for qualifying property additions. In 2011, the limit is $500,000 of additional expense with an investment ceiling of $2,000,000. This is scheduled to drop in 2012 to $125,000 of additional expense with the phase out beginning at $500,000. For 2011, certain qualified real property can also be expensed under §179 but only $250,000 can be expensed for this type of property.

Qualified leasehold improvement property can be depreciated on the straight-line method over a 15-year recovery period. To qualify for this treatment, the property must be placed in service before January 1, 2012.

Surtax on Unearned Income

In March 2010, two laws were passed to overhaul the healthcare system. To help pay for this initiative, the Medicare tax will be imposed on unearned income beginning in 2013. The surtax of 3.8% will be imposed on the lesser of your net investment income or the excess of taxable income over the income threshold ($200,000 or $250,000 depending on your filing status).

Unearned income includes taxable capital gains, dividends, royalties, and interest income. It also includes net rental income and taxable gains on the disposition of rental real estate if the rental activity is a passive activity (i.e. the tax will not apply to taxpayers' net rental income if they are active in the rental activity). Unearned income also includes the income earned on the disposition of an interest in a partnership, LLC, or S corporation if the taxpayer was passive in the activity.

Alternative Minimum Tax

The original intent of the alternative minimum tax (AMT) was to require high income taxpayers who use tax shelters to pay a minimum amount of income tax. However, more taxpayers are becoming subject to AMT because legislative action is required to increase the AMT exemption; it's not automatically indexed for inflation. The latest AMT patch in the form of an increased AMT exemption is only effective through 2011. Congress will likely try to get another fix later this year. As it stands right now, the AMT exemption amounts will drop significantly in 2012, which will cause a lot more taxpayers to become subject to AMT.

Form 1099 Reporting

The expanded Form 1099 reporting requirements for landlords for payments made after 2010 has been repealed. To help pay for healthcare reform, additional information reporting would have been required to help the IRS identify unreported income. This legislation would have required landlords to file information returns, typically Form 1099-MISC, to report any payments of $600 or more to any service provider. Also, the reporting requirements would have been expanded to include payments made for goods and to include payments made to corporations. The repeal of these provisions was drafted to negate the expanded Form 1099 requirements. Therefore, the law reverts to its status before the enactment of these two provisions.

Conclusion

The tax area is constantly changing. A majority of the tax items discussed above are subject to change beginning in either 2012 or 2013 unless Congress extends the current tax laws. As the New Year approaches, pay attention to the tax legislation because this will impact your planning for the future. In addition, please also consider the impact of your state tax rules, as many states have decided to not follow the federal tax benefits including the bonus depreciation and estate rules. These various state rules should also be considered in your tax planning. The earlier you start planning, the more effective your tax plan can be.

Eric Tuck, McGladrey & Pullen LLP, Managing Director/Partner
Allison Stevens, McGladrey & Pullen LLP, Senior Associate