The recent election result’s potential impact on the tax change and the prospect of comprehensive tax reform during 2017 have become important considerations for 2016 year-end tax planning. As discussed in BKD’s article, “Election Results May Lead to Tax Changes in the New Year,” it’s difficult to predict the potential or substance of any 2017 tax reform, making decisions regarding tax moves before the end of 2016 particularly challenging.
Traditional year-end planning strategies focus on deferring income, accelerating deductions, recognizing losses and more to reduce your current-year tax bill. With the prospect of lower tax rates for some on the horizon, implementing such strategies before year-end may have an even larger tax benefit if tax change occurs and tax rates decrease next year. Here are some year-end planning strategies to consider if you expect a lower tax rate environment in 2017.
Timing When You Receive Income
Republican control of the White House and the 115th Congress means the tax proposals of President-elect Trump and House Republicans likely will heavily influence any tax change. At the time of writing, the top individual rate on ordinary income would decrease with both President-elect Trump’s campaign tax proposal and the House Ways and Means Committee’s blueprint of tax reform, A Better Way: Our Vision for a Confident America (Better Way Blueprint). These tax proposals would reduce the current top individual rate of 43.4 percent (including the 3.8 percent net investment income tax) to 33 percent and reduce the current seven tax brackets to three, adding an important consideration for some as discussed later.
If you're an employee, reviewing the timing of certain discretionary bonuses or other lump sum payments not subject to the rules governing deferred compensation plans with your employer may allow you to take advantage of these proposed rate reductions by receiving these payments in a lower tax rate year.
Waiting to take action until 2017 also may be beneficial if you have stock options. Those with nonqualified stock options, which allow you to choose to exercise the option some time between the vesting and expiration date, generally will include the difference between the stock’s fair market value and exercise price in ordinary income in the year the options are exercised. Waiting to exercise vested nonqualified stock options until 2017 may be less taxing than doing so in 2016, given current reform proposals. A decision to exercise stock options should take into consideration your taxable income in the year you exercise your options as well as the overall outlook of the stock market; contact your BKD tax and investment advisors for assistance in making this decision. All investment advisory services are provided separately by BKD Wealth Advisors, LLC, a SEC registered investment adviser.
It's important to note that while the current tax proposals feature reductions in the top ordinary tax rate, some taxpayers may actually face a higher rate on this income if the proposals are adopted due to the condensing of the tax brackets. The following is a comparison of the proposed tax brackets for single and married filing joint taxpayers under President-elect Trump’s plan and the Better Way Blueprint to the 2017 tax brackets for ordinary income under current law:
If you anticipate an increase in your tax rate on ordinary income due to the possible condensing of the tax brackets, consider accelerating rather than deferring income before year-end while managing your overall 2016 taxable income to avoid moving to a higher tax bracket. Please consult your BKD advisor to discuss tax bracket management when accelerating income.
Recognize Losses/Defer Gains
President-elect Trump and the Better Way Blueprint both call for a reduction in taxes paid on the gain on the sale of long-term appreciated securities or other capital assets, i.e., assets held for more than one year. With possible tax reductions of the top capital gains rate from 23.8 percent (including the 3.8 percent net investment income tax) to 20 percent with President-elect Trump’s plan and 16.5 percent with the Better Way Blueprint, now is the time to analyze your investment portfolio and consider action before year-end in light of the potential for decreasing tax rates in 2017. Realizing capital losses in 2016 will allow you to use those losses to offset long-term capital gains taxed at current rates or deduct up to $3,000 of net capital losses against ordinary income, providing you with greater tax savings than using these losses to offset gains taxed at the proposed lower rates in 2017 and beyond.
Waiting to realize capital gains until 2017 or later may allow you to take advantage of the potential lower capital gains tax rate under the current tax proposals. Delaying the sale of a business, property or realignment of your portfolio allocation until 2017 also may allow you to sell at a more favorable tax cost. Where a sale cannot be delayed, consider structuring the deal as an installment sale. With an installment sale, at least a portion of the proceeds is payable beyond the year of sale. The gain an eligible seller recognizes under the installment method is that proportion of the payments received during the tax year to which the gross profit bears to the total contract price. Installment reporting does not apply to losses.
While both President-elect Trump and the Better Way Blueprint provide for lower taxes paid on capital gains, compromise may be necessary to garner the bipartisan support to advance any tax reform legislation in 2017. This could include a full or partial elimination of the preferential long-term capital gain rate. An elimination of this preference also could be used to offset the cost of the proposed reduction in the tax rate on ordinary income. If this were to occur, a higher capital gain tax rate in 2017 or later would cause any year-end moves to accelerate losses and defer gains to backfire. As a result, careful consideration must be given to decisions related to capital gains and losses before year-end.
As a final and important consideration, as with the individual rate on ordinary income, the possible condensing of the tax brackets also may result in a higher capital gains tax rate for some taxpayers. The following is a comparison of the proposed tax brackets for single and married filing joint taxpayers under President-elect Trump’s plan and the Better Way Blueprint to the 2017 tax brackets for capital gains and qualified dividends under current law:
If you anticipate an increase in your tax rate on capital gains, consider recognizing gains before year-end and deferring losses until after year-end while managing your overall 2016 taxable income to avoid moving up to a higher tax bracket. Please consult your BKD advisor to discuss tax bracket management when recognizing gains.
Delay Paying Dividends
As demonstrated in the tables above, the current tax proposals also call for a reduction in the tax rate on qualified dividends. If you own a C corporation with earnings and profits or an S corporation with prior C corp earnings and profits, you may be able take advantage of a lower tax rate on qualified dividends by delaying taxable dividend distributions from your corporation until 2017 or beyond. Please consult your BKD tax advisor for more information on the timing and tax impact of these distributions.
IRA & Annuity Distributions & Conversion of Your Traditional IRA to a Roth IRA
Taxable distributions from an individual retirement account (IRA) or an annuity before the end of 2016 may cause you to incur more income tax this year and possibly result in higher withholding or safe harbor estimated tax payments next year if ordinary tax rates decrease in 2017. Waiting to take first year required minimum distributions or elective distributions from an IRA until 2017 would allow you to do so at lower tax rates on the amounts distributed if tax rates decrease next year.
Waiting to convert a traditional IRA to a Roth IRA until 2017 or later also may be advisable if you anticipate the proposed ordinary tax rates will be lower than your expected tax bracket at the time of IRA distributions. A conversion from a traditional IRA to a Roth IRA requires you to incur tax on the value of your traditional IRA in the year of the conversion in excess of basis. Please consult your BKD tax advisor if you are considering a Roth conversion.
Evaluate Your 2016 Itemized Deductions
The benefit of itemized deductions (such as charitable contributions and income, real estate and personal property taxes) decreases as tax rates decrease. In addition, both President-elect Trump and the Better Way Blueprint call for additional limitations on or eliminations of itemized deductions as well as an increased standard deduction from $6,300 for single filers ($12,600 MFJ) to $15,000 ($30,000 MFJ) under the Trump plan and $12,000 ($24,000 MFJ) under the Better Way Blueprint. As a result, many taxpayers who currently itemize would not be able to do so with the current proposals. Therefore, the potential for tax change in 2017 may mean that accelerating your 2016 itemized deductions when possible may improve your tax benefit to the extent you can control the timing of these deductions. This analysis also should take into consideration other factors including the phaseout of itemized deductions based on income and potential alternative minimum tax implications of state and local tax payments.
Timing Your Business Deductions
As with itemized deductions discussed above, business deductions will generate a greater tax benefit in 2016 than in 2017 if the lower rates of the current tax proposals are incorporated into 2017 tax reform. A cash-basis taxpayer generally deducts business expenses in the year they are paid and reports income in the year it is received. If you are a cash-basis taxpayer and own a business you operate as an S corp, partnership or sole proprietorship, accelerating the payment of business expenses into 2016 when tax rates may be higher will generate a greater benefit for you. An accrual basis taxpayer can shift deductions into an earlier year by accelerating the time the expenses are incurred.
In addition, if you have net operating loss carryovers, you may benefit by accelerating income into 2016 or deferring expenses into 2017, allowing you to offset income taxed at current, potentially higher ordinary rates.
To learn more about how the election and outlook for tax changes may affect your situation and discuss planning opportunities, contact your BKD advisor.