Jon P. Karp, CPA, PFS

Whitley Penn, LLP8343 Douglas Avenue, Suite 400 

Dallas, TX  75225Direct: (214) 393-9400Main: (214) 393-9300

Fax: (214) 393-9401Email: jon.karp@whitleypenn.com

Income Tax Planning Strategies for 2012

Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication, including attachments, was not written to be used and cannot be used for the purpose of (i) avoiding tax-related penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any tax-related matters addressed herein.  If you would like a written opinion upon which you can rely for the purpose of avoiding penalties, please contact us.

The Fiscal Cliff

• http://www.youtube.com/watch?v=bjTb_c4Mq48&feature=player_detailpage

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Increasing Tax Rates in 2013

• Bush tax cuts scheduled to expire at the end of 2012

• Rates will likely be higher in 2013

• Creates planning opportunities for the rest of 2012

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SingleQualified

Widow(er)

Married Filing Jointly

Married Filing

SeparatelyHead of

Household

10% Tax Rate $8,700 $17,400 $17,400 $8,700 $12,400

15% Tax Rate $35,350 $70,700 $70,700 $35,350 $47,350

25% Tax Rate $85,650 $142,700 $142,700 $71,350 $122,300

28% Tax Rate $178,650 $217,450 $217,450 $108,725 $198,050

33% Tax Rate $388,350 $388,350 $388,350 $194,175 $388,350

35% Tax Rate > $388,350 > $388,350 > $388,350 > $194,175 > $388,350

• Capital Gain Rates– 0% rate if you are in the 10% or 15% bracket– 15% rate if you are in the 25%, 28%, 33% or 35% bracket

2012 Income Tax Brackets

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Comparison of 2012 vs. 2013 Tax Rates

20122013 & Beyond

10% 15%

15% 15%

25% 28%

28% 31%

33% 36%

35% 39.6%

2012 2013& Beyond*

0% 10%

15% 20% (23.8% if surtax applies

Ordinary IncomeLong-Term

Capital Gains

2012 vs. 2013 Tax Rates

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Gain Harvesting

Accelerating income into 2012

Avoiding the 3.8% Medicare surtax

2012 Income Tax Planning Opportunities

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Gain Harvesting

• Sell assets with long-term capital gains in 2012 to take advantage of low 2012 rates

• Repurchase same or similar assets

• Sell assets whenever you would have sold them otherwise

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Gain Harvesting--Tradeoff

• On the surface, it appears that taxpayers should always harvest gains

• But, the gain harvesting strategy introduces a tradeoff between lower tax rates and loss of tax deferral

• You pay tax at a lower rate but you pay it sooner• Paying the capital gains tax in 2012 could be thought of as an

investment to avoid paying a larger amount of tax in the future• Conceptualizing the transaction in this way enables you to

calculate a return on investment (ROI) for the 2012 tax payment

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ROI Calculation--Example

• Facts– Bill owns XYZ stock that he has held for several years with a basis of $50,000 and FMV of $100,000

– His tax rate on LTGs is 15% in 2012 and 23.8% in 2013

– Bill sells the stock in 2012, recognizing a long-term capital gain of $50,000 and paying tax of $7,500

– He repurchases the stock the following day

– The stock grows at 5% per year

– Bill sells the repurchased stock at some future date

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Example—Results

• The following chart shows how Bill’s ROI on the $7,500 investment varies depending on the year of the second sale Year ROI

2013 54.86%2014 22.82%2015 13.61%2016 9.21%2017 6.59%2018 4.84%2019 3.55%2020 2.55%

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Should you Harvest Gains?Easy Cases

• Very short time horizon– Gain harvesting will almost always be favorable because the benefit of tax deferral is small

• Very long time horizon– Gain harvesting will almost always be unfavorable because the benefit of tax deferral is large

• Taxpayer in the 0% long-term capital gains bracket in 2012– Gain harvesting will always be favorable from a tax perspective because it gives you a free

basis step up• Taxpayer plans to die with assets and pass them on to heirs with a stepped-up basis

– Gain harvesting unfavorable because any gain would have been wiped out at death • Taxpayer has realized loss carryovers from prior years

– Losses would be better used to offset gains in later years when long-term capital gains rates are higher

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Should You Harvest Gains?More Difficult Fact Patterns

• In many cases, the answer will not be clear without doing a ROI calculation

• Use AICPA software

• Decision Rule: • Harvest gains when ROI > opportunity cost of capital

• Opportunity Cost of Capital– What rate of return could you have expected if you had invested the money

used to pay the 2012 tax in an alternative investment with comparable risk?

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Gain Harvesting--Caveat

• IRS might try to apply the economic substance doctrine (IRC § 7701(o))

• 20% penalty if sale/repurchase lacks economic substance• 40% if transaction not reported on tax return• Penalty might apply if you repurchased the same asset

immediately after the gain harvesting sale• Safer to repurchase assets that are similar but not identical, leave

the sale proceeds in cash and/or put a significant amount of time between the sale and repurchase

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Accelerating Income to 2012

• Certain types of ordinary income can be accelerated into 2012:

– Bond interest– Annuity income– Traditional IRA income– Compensation income– Stock options– Roth Conversions

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Accelerating Interest Income--Example

Art is current in the 35% ordinary income tax bracketOn December 22, 2012, he has $100,000 of accrued bond interest that will be paid on 1/3/2013.Art sells the bonds at par on that date, paying $35,000 in taxIf Art had waited until 2013 to recognize the interest income he would have paid tax at a 43.4% rate (counting the surtax)Thus, the interest harvesting strategy saves Art $8,400 ($43,400 - $35,000)

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3.8% Medicare Surtax

• Imposed on individuals, trusts and estates for tax years beginning on and after January 31, 2013

• Applies to the lesser of:– Net investment income (NII), or– MAGI over an applicable threshold amount (ATA)

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Net Investment Income

• Included items– Interest– Dividends – Rents– Annuities– Capital gains– Royalties– Passive activity income

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Net Investment Income

• Items specifically excluded– Self-employment income– Non-resident aliens– Active Trade or business income– Gain on the sale of an active interest in partnership or

S corporation– IRA or qualified plan distributions– Trusts for charity (except Charitable lead trusts)

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MAGI

• Amount reported at bottom of page 1, Form 1040 (AGI)

• + net amount excluded as foreign earned income under section 911(a)(1)

• For most taxpayers it is the same as AGI

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3.8% Surtax -Example

• Warren, a single taxpayer, has $170,000 of investment income and received a $65,000 required minimum distribution (RMD) from his traditional IRA in 2013.

• The RMD is not NII, but it is included in MAGI, increasing it to $235,000

• The surtax applies to the lesser of NII ($170,000) or the excess of MAGI over the $200,000 threshold amount for single taxpayers ($35,000).

• Thus, $35,000 is subject to the surtax and the amount payable is $1,330 (.038 x $35,000).

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Applicable Threshold Amounts

• Married taxpayers filing jointly...........$250,000

• Married taxpayers filing separately....$125,000

• All other individual taxpayers.............$200,000

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Minimizing the Surtax

• Strategies to reduce net investment income--

– Tax exempt bonds– Tax deferred annuities– Life insurance– Rental real estate– oil and gas investments– choice of accounting year for trusts and estates– timing of estate and trust distributions

• Strategies to reduce MAGI--

– Roth IRA conversions– charitable remainder trusts– charitable lead trusts– Installment sales– above-the-line deductions

Climbing back up23

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Circular 230 Disclosure

Pursuant to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, nothing contained in this communication was intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose. No one, without our express prior written permission, may use or refer to any tax advice in this communication in promoting, marketing, or recommending a partnership or other entity, investment plan or arrangement to any other party.

For discussion purposes only. This work is intended to provide general information about the tax and other laws applicable to retirement benefits. The author, his firm or anyone forwarding or reproducing this work shall have neither liability nor responsibility to any person or entity with respect to any loss or damage caused, or alleged to be caused, directly or indirectly by the information contained in this work. This work does not represent tax, accounting, or legal advice. The individual taxpayer is advised to and should rely on their own advisors.