Implementing tax strategies at year-end always presents unique challenges and opportunities. The impact of recent tax legislation and significant IRS rule changes during 2016 raises the stakes. The Protecting Americans from Tax Hikes Act (PATH Act), passed in late 2015, changed both dramatically the dynamics of planning for the expiration of various tax breaks and the permanence of others. The IRS for its part has been busy creating safe-harbor benefits under the “repair regulations,” clarifying the definition of marriage for tax purposes, fine-tuning Affordable Care Act requirements, and more, all of which immediately impact the 2016 tax year.
WHAT’S NEW FOR INDIVIDUALS
Tax Rate Exposure
Balancing the impact of the existing tax rates on a variety of transactions during the year and at year-end can be challenging: ordinary income tax rates, the capital gain rates, the net investment income tax rate, and the alternative minimum tax (AMT), all may play a role:
Ordinary income tax rates—The creation of the 39 .6 percent bracket, up from a top 35 percent rate in the past three years.
Net Investment Income (NII)—the tax rate is 3.8% on the lesser of net in vestment income or the excess of modified adjusted income over the threshold amount.
Capital Gains and Dividends– The tax rates on qualified capital gains (net long term gains) and dividends range from zero to 20 percent, depending upon the individual bracket.
Capital losses. Individuals can deduct up to $3,000 of additional losses, whether net long-term or short-term; losses above $3,000 can be carried over and deducted in succeeding years
STRATEGY–Initiating traditional techniques designed to accelerate deductions and delay income (or vice versa depending upon prospects for next year) can yield substantial tax savings
The Path Act “Extender”
On December 18, 2015, the President signed into law the Protecting Americans from Tax Hikes Act of 2015 (PATH Act). The new law extends several tax provisions retroactive to the beginning of 2015 and as well, makes some provisions permanent. The PATH Act permanently extended many tax incentives that were previously temporary, removing for the first time in many years the year-end concern over their temporary applicability.
CAUTION. Not all “extenders” however were extended beyond 2016 and some were modified in the process. Others were extended but with the intention to eventually replace them within more sweeping tax reform
Additional Child Tax Credit: When the $1,000 per Child Tax Credit exceeds the taxpayer’s tax liability, the taxpayer may be eligible for a refundable credit called the “Additional Child Tax Credit”. For taxpayers with one or two children, the additional Child Tax Credit is the lesser of: The disallowed portion of the regular Child Tax Credit, or 15% of the taxpayer’s earned income in excess of $3,000. The $3,000 threshold amount was originally $10,000. Previous legislation had temporarily reduced this amount to $3,000. The $3,000 threshold was scheduled to go back to $10,000 for tax years after 2017. The extender legislation made the $3,000 threshold permanent.
The American Opportunity Credit: The American Opportunity Credit was originally called the Hope Credit. The Hope Credit applied for the first two years of the student’s post-secondary education and equaled 100% of the first $1,000 of qualified expenses and 50% of the next $1,000 of qualified expenses. Beginning in 2009, the credit was increased to equal 100% of the first $2,000 of qualified expenses and 25% of the next $2,000 of qualified expenses. The American Opportunity Credit was also expanded to allow up to 40% of the credit as a refundable credit in cases where the credit exceeds the taxpayer’s regular tax liability. The expanded provisions under the American Opportunity Credit were scheduled to expire for tax years after 2017. The extender legislation made these provisions permanent.
STRATEGY. An education tax credit is generally allowed only for payments of qualified tuition and related expenses for an academic period beginning in the same tax year as the year the payment is actually made. However, if qualified expenses are paid during one tax year for an academic period that begins during the first three months of the following tax year, the academic period is treated as beginning during the tax year in which the expenses were paid
Educator Expenses: Eligible educators can deduct up to $250 (per taxpayer) of qualified out-of-pocket expenses paid during the year. The $250 above-the-line deduction had expired for tax years after 2014. The new law retroactively reinstated the deduction for 2015 and made the provision permanent. The new law also indexes the $250 maximum deduction for inflation, and provides that expenses for professional development be included in the definition of qualified out-of-pocket expenses for tax years after 2015.
Extenders Expiring at End of 2016
The PATH Act renewed several extenders related to individuals retroactively for only two years through 2016, so they are up for renewal again at the end of 2016.
Tuition and fees deduction. The PATH Act extended the above-the-line deduction for qualified tuition and related expenses for two years, for expenses paid before January 1, 2017. The maximum amount of the tuition and fees deduction is $4,000 for an individual whose AGI for the tax year does not exceed $65,000 ($130,000 in the case of a joint return), or $2,000 for other individuals whose AGI does not exceed $80,000 ($160,000 in the case of a joint return).
STRATEGY. Payments by year-end 2016 may be particular61 critical to taking this deduction. There is some -but not un limited– flexibility regarding the deductibility of tuition paid before a semester begins. As with the AOTC. the deduction is allowed for expenses paid during a tax year, in connection with an academic term beginning during the year or the first three months of the next year.
Exclusion for discharge of indebtedness on principal residence. The PATH Act extended the exclusion from gross income of discharged qualified principal residence indebtedness, applicable to discharges of qualified principal residence indebtedness occurring before January 1, 2017, or discharges that are subject to an arrangement that is entered into and evidenced in writing before January 1, 2017.
Mortgage insurance premium deduction. The PATH Ace extended the treatment of qualified mortgage insurance premiums as qualified residence interest retroactively for two years, to apply to amounts paid or accrued through 2016, and not properly allocable to a period after December 31, 2016.
Nonbusiness energy property credit. The PATH Act extended the nonrefundable nonbusiness energy property credit allowed to individuals, making it available for qualified energy improvements and property placed in service before January 1, 2017
STRATEGY. Several overall Limitations apply. A credit amount for qualified energy efficiency improvements equals 10 percent of the amount paid or incurred during the tax year and 100 percent of the amount paid or incurred far qualified energy property during the tax yea: The maximum credit amount for qualified energy property varies depending upon the type of property; further all nonbusiness energy property carries a $500 maximum lifetime credit cap.
More incentives extended through 2016 include: Fuel cell motor vehicle and Electric motorcycles credit.
Life Events
Life events such as marriage, birth or adoption of a child, a new job or the loss of a job, and retirement, all impact year-end tax planning. The PATH Act permanently extended many tax incentives that were previously temporary, removing for the first time in many years the yearend concern over their temporary applicability.
Marriage. Marital status (single, married or divorced) for the entire tax year is deter mined on December 31″. Because the income tax brackets vary depending upon filing status,
a marriage penalty or a marriage benefit may result for any particular couple.
Dependents. A child born at any time during the tax year is consider a child for that entire tax year. Subject to AGI limits, a child born at year-end 2016 entitles the parent co a full $4,050 personal exemption, a full $1,000 child credit, and up to a $3,000 child care credit if eligible.
Retirement. Taxpayers may want to take a look at a number of different provisions at year-end in anticipation of retirement, at the point of retirement, or after retirement. Many of these provisions have opportunities and deadlines keyed to the tax year. These strategies especially stand out for year-end consideration:
- Minimum distribution requirements. Most retirement arrangements (other than Roth IRAs) require that participants be gin co cake annual payments of benefits in the year they turn age 70½. While distributions generally muse be made at the end of the calendar year, distributions for the first year can be delayed until April 1 of the succeeding
- Roth conversions/ reconversions. A traditional IRA may be converted to a Roth IRA. As with rollovers co traditional IRAs, the 10-percent additional tax on early distributions does not apply; however, unlike rollovers to traditional IRAs the amount converted is taxable in the year of
- Roth re-conversion. Once a Roth IRA has been recharacterized back to a (new) traditional IRA, the (new) traditional IRA can be (re)converted to a Roth IRA, pro vided the taxpayer meets the eligibility requirements in the reconversion year. This reconversion option is most often used to allow a “do-over” when assets that are transfer lose value before year
STRATEGY: Any amount converted to a Roth IRA is included in gross income as distribution for the tax year in which the amount is distributed or transferred from the traditional IRA. When a rollover spans two tax years, the taxable amounts from the traditional IRA are included in gross income in the year in which the amounts are withdrawn from the traditional IRA
Affordable Care Act—Individuals
Year-end planning for individuals with regards to the ACA may generally be more prospective than retrospective but there are some year-end moves that may be valuable, particularly with health-related expenditures.
Individual Shared Responsibility Payments—For 2016, the individual shared responsibility payment is the greater of2.5 percent of house hold income that is above the tax return filing threshold for the individual’s filing status or the individual’s flat dollar amount, which is $695 per adult and $347.50 per child, limited to a family maximum of $2,085, but capped at the cost of the national average premium for a bronze level health plan available through the Marketplace in 2016.
STRATEGY– Open enrollment for coverage through the Health Insurance Marketplace for 2016 has dosed. However; some qualifying life events may make an individual eligible for non–filing season special enrollment.
Medical expense deduction—Taxpayers who itemized deductions (for regular tax purposes) may claim a deduction for qualified unreimbursed medical expenses to the extent those expenses exceed 10 percent of adjusted gross income (AGI), unless the tax payer falls within an age-based exception. Taxpayers (or their spouses) who are age 65 or older before the close of the tax year, may apply the old 7.5 percent threshold for tax years but only through 2016.
STRA TEGY– Taxpayers who are age 65 or older may consider accelerating medical costs into 2016 if they want to itemize deductions since the AGI floor for deductible expenses rises from 75 percent to 10 percent in 2017 For deductions by cash-basis taxpayers in general, including far purposes of the medical expense deduction, is permitted only in the year in which payment for services rendered is actually made.
GENERAL TIMING STRATEGIES
Year-end tax planning, especially if done “at the eleventh hour,” requires some understanding of the timing rules: when in come becomes taxable and when it may be deferred; and, likewise, when a deduction or credit is realized and when it may be deferred into next year or beyond.
Income Acceleration/Deferral
Taxpayers using the cash method basis of accounting (generally most individuals) can defer or accelerate income using a variety of strategies. These may include:
Sell appreciated assets. If a taxpayer has current losses that may cover these gains that are “locked into” certain assets until they are sold, realizing gains may make sense. For example, identical appreciated securities may be sold and repurchased. Their cost basis would be reset with, at worst, a downside of some accelerated tax liability. The “wash sale” rule only applies to losses.
Bonuses. If an accrual-basis employer delays paying a properly-accrued bonus in the year of service (for example, 2016) until up to 2½ months into 2017, the employer can get its deduction in 2016 while the employee (if “unrelated” for tax purposes) will be taxed in2017.
Installment contracts. Income on a sale reported under the installment method is realized pro-rata over the years in which the installment payments are made. To accelerate income realization, the taxpayer simply sells the remainder of the installment con tract to a third party for a lump sum.
U.S. Savings Bonds. For cash-basis taxpayers, interest on series E, EE and I bonds is generally taxed at the earliest of disposition, redemption or final maturity of the bond (however, the taxpayer can elect to report the interest as ic accrues).
Debt forgiveness income. Determination of the time of debt forgiveness requires a practical assessment of the facts and circumstances relating to the likelihood of payment. Convincing the lender to issue a Form 1099-C, Cancellation of Debt, for the 2016 tax year, should also form part of the process.
Like-kind exchanges. Taxpayers may also avoid tax deferred, like-kind exchanges by taking steps to disqualify the transaction
from Code Sec I 031 treatment. Such seeps might include delaying identification of replacement property, transferring cash to an intermediary, or switching to a sale-and reinvestment arrangement.
Deduction Acceleration/Deferral
A cash basis taxpayer generally deducts an expense in the year it is pa.id, although prepayment of an expense generally will not accelerate a deduction. There are exceptions.
Year-end payments. It is not necessary to pay cash to make a payment with the goal of attaining a deduction or other tax benefit for2016. Tax payers can write checks or can charge an item by credit card and treat these actions as payments.
STRATEGY. It does not matter for example, when the recipient receives a check mailed by the payo1; when a bank honors the check, or when the taxpayer pays the credit card bill, as long as done or delivered “in due course.” The same treatment applies for a gift – sending a check is treated as a payment and will qualify for the current year gift tax exclusion.
Package payments. An agreement for services or ocher deliverables that require full upfront payment may gain a full, immediate deduction, depending upon the circumstances (for example, payment up front for an orthodontia program as a medical expense deduction).
Tuition. Payments made in2016 for tuition for an academic period beginning in2016 or during the first three months of2017 qualify for an education credit taken in2016.
Estimated state taxes. Although the deadline under state law is generally not until January 15, 2017, payment of fourth quarter state and local estimated taxes before year-end 2016 is deductible for2016 for federal tax purposes.
WHAT’S NEW FOR ITEMIZED DEDUCTIONS
State and Local General Sales Taxes
A taxpayer can elect to deduct state and local general sales taxes instead of income taxes on Schedule A, Form 1040. New Law: The law allowing a deduction for state and local general sales taxes expired on January 1, 2015. In December 2015, a new law extended the deduction retroactively to January 1, 2015, and made it permanent.
Charitable Contributions of IRA Distributions
Taxable distributions from IRAs increase the taxpayer’s AGI, which can affect other tax provisions that are phase-out based on AGI. Under a temporary provision, IRA distributions are excluded from gross income to the extent they are qualified charitable distributions (QCD). The temporary provision under the QCD rules expired for tax years beginning after December 31, 2014. The new law retroactively reinstates the provision for 2015 and makes it permanent. There is no provision under the new law to provide extra time to make a QCD for the 2015 tax year. To be treated as a 2015 QCD, the direct transfer from the IRA to the charity must have been completed by December 31, 2015.
The Tax Relief and Health Care Act of 2016
Set forth provisions to treat qualified mortgage insurance premiums paid or accrued for qualified mortgage insurance contracts as deductible qualified residence interest. Form 1098 generally provides that any person who, in the course of a trade or business, receives from any individual premiums for mortgage insurance aggregating $600 or more for any calendar year, shall make an information return.
Mortgage insurance premiums
The Tax Relief and Health Care Act of 2006 set forth provisions to treat qualified mortgage insurance premiums paid or accrued for qualified mortgage insurance contracts as deductible qualified residence interest. In the case of prepaid qualified mortgage insurance premiums, the deduction is limited to the amount allocable to the tax year.
Qualified mortgage insurance is insurance provided by the Veterans Administration, the Federal Housing Administration, or the Rural Housing Administration, and private mortgage insurance (as defined by section 2 of the Homeowners Protection Act of 1998. New Law: Prior to enactment of the legislation, taxpayers could not deduct premiums paid for mortgage insurance as qualified residence interest. The new law retroactively extends the deduction for private mortgage insurance premiums for two years. The provision applies to amounts paid or accrued in 2015 and 2016.
WHAT’S NEW FOR BUSINESS
Businesses seeking to maximize tax benefits through 2016 year-end tax planning may want to consider several general strategies, such as use of
traditional timing techniques for income and deductions, in addition to the role of the tax extenders (chose made permanent and chose expiring at the end of 2016), as well as strategies targeted to their particular business.
Permanent Extensions for Businesses
The PATH Act makes permanent many business-related provisions. Code Sec. 179 expensing. The PATH Act permanently secs the Code Sec. 179 expensing limit at $500,000 with a $2 million over all investment limit before phase out (both amounts indexed for inflation, for 2016 at $500,000 and $2.01 million, and for 2017 at $510,000 and $2.03 million, respectively). The PATH Act also permanently allows for tl1e expensing of off-the-shelf computer software.
STRATEGY. When comparing the possible benefits of the Code Sec. 179 deduction versus bonus depreciation, keep in mind that Code Sec. 179 is available for both new and second-hand/used property that is purchased and placed in service by a taxpayer. Howeve1 bonus depreciation is available only for new (first-time use) property.
More business incentives made permanent by the PATH Act include:
- Shorter recovery period for leasehold improvement, restaurant and retail improvement property made
- Recognition period for S corporation’s built-in gains tax made
- Shareholder’s basis reduction for S corporation’s charitable donations made permanent.
Five-Year Extensions for Businesses
The PATH Act extended several business-related provisions for five years
Bonus Depreciation. The PATH Act extended bonus depreciation (additional first-year depreciation) under a phase-down schedule. In addition to extending bonus depreciation, a number of modifications have been made that enhance the incentive.
STRATEGY. Because bonus depreciation can be elected on the 2016 return filed in 2017, it is not necessary for business to make an immediate decision on its use, although qualifying property must nevertheless be purchased and placed in service in 20I6. Bonus depreciation is optional and businesses can elect not to use it. Electing out may be appropriate if the business wants to spread its depreciation deductions over future years more evenly.
Work Opportunity Tax Credit (WOTC). The PATH Act extended the (WOTC). In addition, the credit has been expanded and is available
to employers who hire qualified long term unemployment recipients
Business Extenders Scheduled To Expire At The End of 2016
A few business extenders are scheduled to expire if not renewed by Congress: Film and TV production expense provisions, Energy efficient commercial buildings deduction, Mine safety equipment expense election, and Additional depreciation for biofuel plant property.
Business Use of Vehicles
Please note that several year-end strategies involving both business expense deductions for vehicles and the fringe-benefit use of vehicles by employees involve awareness of certain rates and dollar caps chat change annually.
Standard Mileage Rate. Beginning January 1, 2017, the standard business mileage allowance rate is cents-per-mile (down from 54 cents-per mile for 2016)
Affordable Care Act—Businesses
Despite several delays and legislative tweaks, the basic structure of the ACA for businesses, both large and small, generally remains intact. If an employer is an applicable large employer (ALE), this triggers the employer shared responsibility provisions and the employer information reporting provisions. Small businesses, however, are not unaffected by the ACA and should take the ACA into account in year-end planning. Some incentives in the ACA could help maximize tax savings for small businesses.
Section 179 Limits:
In prior years, the Section 179 limit was as high as $500,000. The increased limit expired for tax years beginning after 2014, reverting to a $25,000 deduction limit and a $200,000 investment limit. Congress increased the $25,000 deduction limit to $500,000 and the $200,000 investment limit to $2,000,000. These increased limits do not apply to sport utility vehicles (SUVs), which have their own $25,000/$200,000 limitations. The new law retroactively reinstated this provision for 2015 and makes it permanent. For tax years after 2015, the $500,000/$2,000,000 limitations are indexed for inflation. Also, in prior years, the Section 179 deduction for qualified real property was limited to $250,000. For taxable years beginning after 2015, the new law removes the $250,000 limitation related to the amount of Section 179 property that may be attributable to qualified real property.