Windfall Income Tax Planning!

You receive a call from a very excited client: your lawyer client settled a large case. Or your client won a large judgment. Or your client won the lottery. Now your client is about to receive a very large check: $1,000,000. $5,000,000. More? That’s the good news.

The bad news is that it is ordinary income, and large lump sums of ordinary income are taxed at the highest marginal rates and do not have easy tax planning “solutions.”
What alternatives should you help your client consider? In this discussion we will use $1,000,000, since you can multiply that figure by as much as necessary to make it interesting, and we will assume that all of it is in the maximum federal (and state) income tax brackets.
First, if at all possible, see if your client can split the receipt of the funds between this year and next year. Of course be sure that deferral does not jeopardize receipt of the funds or significantly reduce the value of the second year’s payment (due to the time value of money).
Why do this? Usually not because the client is likely to be in a lower bracket in the later year. Instead, this is because the best tax technique—a pension—works best when there are contributions in multiple years.

Second, seriously consider simply paying the tax and pocketing the difference. On $1,000,000 the tax will be 39.6% federal, leaving $604,000. In the highest taxed state, California, the tax would be (13.3% x (100 – 39.6 = ) 60.4% = ) 8.0332% net, meaning a total of 47.6332%, leaving $523,668.
The advantage of this approach is the KISS principle: Keep It Simple. Your client can put the $604,000 (or $523,668) in the bank; in tax-free muni bonds; in first trust deeds on real property; or your client can buy a building, depending upon investment preference, all without worrying about “tax structuring.”

Third, the most conservative tax structure is a pension plan. How much of a deduction can your client get? Probably a lot more than you think. A 45-year-old with a same-age spouse, both of whom have past service, can probably achieve a deduction of $320,000. The figure increases to $530,000 for a 55-year-old. There are ways to increase those figures. And there is a method that might allow that figure to triple in certain situations. (Of course, 99% of all plan consulting firms are not up to this task.) Pension plans are so safe and so important that it does not make sense to discuss other options until this one has been fully exhausted.

Fourth, a captive insurance company can be an attractive structure. A premium of as little as $400,000 can be economically appropriate, given the costs involved. And a premium of as much as $1,200,000 can be received by your client’s insurance company without incurring an income tax under Internal Revenue Code Section 831(b).

Of course, compared to the $3,500 per year cost of a third party administrator for a two-person pension plan, the captive costs run 10 to 20 times as much. However, in the right situations, this can be a terrific result in terms of risk management, estate and gift tax planning, asset protection planning, and income tax planning.

Fifth, a charitable limited liability company is a way to get a deduction of 85 percent or so of the funds. This is primarily of interest to people who have a favorite charity that they would like to support. However, for those people, this is a wonderful result. The client ends up with an LLC that is full of money that can be used for investment, including loans for business opportunities; and the charity receives a steady stream of revenue for its membership interest.

Sixth, a charitable lead annuity trust, or CLAT, can create a large percentage deduction. For example, contributing $1,000,000 to a 20-year term 5% payout generates an 88.436% deduction. For a 10-year term, the deduction is 46.853%. The cost of the upfront deduction is that the client is taxable on the trust’s earnings. However, that cost can be mitigated by investing the trust corpus into muni bonds. Although it is not currently easy to find muni bonds at 5%, even if the bonds generate only generate a significant portion of the 5% payout this can be an excellent result, especially for a client who is interested in a particular charity and/or trying to fund his or her own family foundation. This structure is also attractive psychologically: the client gets a large upfront deduction and then, at the end of 10 or 20 years, gets all of the assets back, probably at a time when the client will appreciate them even more.

Seventh, a charitable remainder unitrust, CRUT, for the lives of two people both age 65 provides a 34% charitable deduction. The deduction increases to 49% if the couple are both age 75. Like the CLAT, this works well as a part of an overall tax plan for the client with the windfall. The advantage to the CRUT is that the client retains the income for life, which is especially attractive for clients who either have no children or whose children have already been otherwise provided for.

Eighth, investment in an oil or gas drilling partnership typically results in a deduction of 100 percent of the investment. The primary challenge is the economics, not the tax results.
Ninth, investments in real estate involving agriculture—such as grapes, avocados and pistachios—gives the advantage of the upside historically associated with land plus the heavy tax benefits provided by Congress to farmers.

Finally, when all else fails, buy a good building and use component depreciation. Depending upon the building, you may be able to depreciate up to 40 percent of the value of the building within the first five years.

When your client is about to receive a windfall of ordinary income, you need to review the list of alternatives. Leave your preconceptions at the door. Some clients will prefer to simply pay the tax. Some will be satisfied with a pension plan. But some few will want a meticulous analysis of all of the alternatives and will, in the end, surprise you by allocating funds to many of them.

Start Next Year’s Tax Planning NOW!

It’s not too early to start tax planning for 2013. The 2012 tax filing season is over for nearly all of us. Even those who filed an extension will probably be taking the next few months off, because they now have until October 15th to file. However, to minimize your taxes for 2013, it might help to start planning your tax strategy now… especially when it comes to avoiding tax mistakes.

One of the most common mistakes made by investors is selling an investment too soon and realizing a short-term gain instead of a long-term gain. Whenever possible, hold an investment for at least 12 months to minimize taxes. The capital gains rate depends on how long the investment is held, and the difference is significant.

Long-term capital gains are taxed at 0% for taxpayers in the 10% or 15% tax bracket. Realizing a $10,000 long-term capital gain costs nothing. Unfortunately, if this taxpayer sold the same investment before the one year mark, their tax bill could be $1,500.

A capital gains rate of 15% applies to long-term capital gains for taxpayers in the 25%, 28%, 33%, or 35% tax brackets. A $10,000 gain would cost $1,500 in taxes if held long-term, but the tax bill jumps to as much as $3,500 for not waiting 12 months to sell.

The American Taxpayer Relief Act of 2012 added a new tax bracket in 2013 and a new rate for long term capital gains. Single taxpayers with taxable income greater than $400,000 are subject to the 39.6% ordinary income tax rate and a long-term capital gains rate of 20%. Joint filers reach the same tax rates when their taxable income exceeds $450,000. The tax rate on a short-term gain is nearly double that of a long-term gain for a taxpayer in this tax bracket.

The bottom line – if you want to minimize your tax bill in 2013, it often pays to be patient.

Tax Planning for 2013 Begins Now

Just because tax season is over doesn’t mean your tax planning is done.  Whether you owed the IRS money or got money back, tax planning is something you can do all year.  Consider these tax tips:

Did you get money back?

If so, you may have had too much income tax withheld from each paycheck.  Some taxpayers don’t mind getting a tax refund because they treat it as a forced savings account. They look forward to getting their refund each year to pay off credit card debt, take a vacation, or just to get caught up on late bills. Others resent the idea of letting the IRS have free access to their money that they could be getting throughout the year.

If you like the idea of getting an annual tax refund, then perhaps you can leave well enough alone, but if the idea of foregoing a tax refund for a larger paycheck is music to your ears, then consider adjusting your tax withholding. It sounds simple, and it is.  If you prefer more money in your paycheck, increase the number of allowances you claim on your W-4 and have less income tax withheld from each paycheck.

The IRS offers this nifty calculator to help you determine the right number of allowances based on your situation.  If you run the calculator midyear, be sure to run it again at the beginning of next year.  Otherwise, you could end up increasing your allowances too much, which could result in owing the IRS on your 2014 return.

Did you owe?

If so, you may have had too little income tax withheld from each paycheck.  This sometimes happens when there is another source of income, such as rental income, that is not subject to withholding. This can be remedied by decreasing the number of allowances on the W-4, requesting additional tax withholding on the W-4, and by making quarterly estimated tax payments to the IRS.

Here are some other ways to reduce your taxes:

Contribute to a Roth retirement account.

If you can live off of your current paycheck and don’t mind paying taxes today for the benefit of tax-free money in the future, consider funding a Roth IRA or 401(k).  Roth accounts are funded with after-tax money, and if you have a Roth account for at least five years and wait until age 59 ½ or older before you withdraw money, the distributions are tax free.

Contribute to a traditional retirement account.

In contrast to the Roth, contributions to a traditional retirement account may be tax deductible, thus reducing your taxable income and subsequently the amount of tax you owe.  There are no income limits to the traditional 401(k), but the IRS does impose income limits on deductible contributions to a traditional IRA.

Maximize tax deductions, exemptions, and credits.

Deductible expenses and exemptions lower the amount of taxable income and thus reduce a taxpayer’s liability.  Some deductions are taken above the line (as adjustments to income) and some are taken below the line (as reported on the Schedule A).

Credits, unlike deductions and exemptions, do not reduce the amount of taxable income, but they offset your tax liability dollar-for-dollar.  Commonly used credits include the Saver’s credit, the Earned Income credit, energy credits, credits for parents, and credits for education.

Reallocate investments.

Certain investments held in taxable accounts may be working against you, since interest, earnings and dividends are generally taxable.  Consider placing ordinary income investments like corporate bonds, high dividend paying stocks, and REITs in tax-advantaged accounts like IRAs.

Capital assets, such as growth stocks, mutual funds, and real estate, may generate little if any taxable income while held, and are subject to preferential long-term capital gains tax rates when held for longer than a year.  Taxable accounts are also appropriate for municipal bonds, which pay interest that is generally tax free at the federal level, and possibly the state level if you live in the issuing municipality (although municipal bond interest is considered a preference item for purposes of calculating AMT).

Contribute to a 529 college savings program.

Similar to Roth accounts, 529 plans are also funded with after-tax money.  As long as the funds are used for qualified education expenses, distributions are generally tax free.  As an added benefit, some states give residents a state income tax deduction for their contributions to the state’s plan.

A final word about tax planning

Whether you prepared your taxes using tax preparation software or with the help of a tax preparer, you should look over your return (at least the 1040) and make a note of anything on the return that you don’t understand.  Make it a goal to learn more about these specific items.  Chances are, the more familiar you become with what goes on your tax return, the better you can plan to minimize your taxes.

Plan for the new surtaxes from the federal government.

As you calculate your estimated federal tax for 2013, be sure to take into account two new surtaxes: the net investment income tax and the additional Medicare tax. Here’s how to tell if they’ll affect you and what you can do to blunt some of the impact.

Net investment income tax: This 3.8% tax applies when you have investment income such as dividends, interest, and capital gains, and your modified adjusted gross income (MAGI) exceeds $250,000 (for married filing jointly). When you’re single, the MAGI threshold is $200,000.

Mitigating the impact: Some types of income are not considered when computing your investment income for purposes of this tax. One example is tax-exempt interest. Depending on your overall investment goals, purchasing municipal bonds may be an option to consider.

Retirement plan distributions, including withdrawals from your IRA, are not counted as investment income when figuring the tax, either. However, taking money from your accounts does increase your MAGI.

Income from passive activities such as rental real estate is generally subject to the new tax. Depreciation deductions and a one-time opportunity to revise the way you group income from your rentals can offer some relief.

Additional Medicare tax: This 0.9% surtax applies to wages, tips, and self-employment income when your earned income exceeds $250,000 if you’re married filing a joint return ($200,000 when you’re single).

What to watch out for: Your employer is required to begin withholding the additional tax once you’ve earned $200,000, regardless of your filing status. Other earnings, including wages earned by a spouse or from a second job, are not considered. Depending on your total income, you may need to revise your W-4 or make quarterly estimated tax payments.
Give us a call for an analysis of your exposure to these new taxes. We’re here to help with personalized planning advice

Tips to Start Planning Next Year’s Tax Return

For most taxpayers, the tax deadline has passed. But planning for next year can start now. The IRS reminds taxpayers that being organized and planning ahead can save time and money in 2014. Here are six things you can do now to make next April 15 easier.

1. Adjust your withholding. Each year, millions of American workers have far more taxes withheld from their pay than is required. Now is a good time to review your withholding to make the taxes withheld from your pay closer to the taxes you’ll owe for this year. This is especially true if you normally get a large refund and you would like more money in your paycheck. If you owed tax when you filed, you may need to increase the federal income tax withheld from your wages. Use the IRS Withholding Calculator at IRS.gov to complete a new Form W-4, Employee’s Withholding Allowance Certificate.

2. Store your return in a safe place. Put your 2012 tax return and supporting documents somewhere safe. If you need to refer to your return in the future, you’ll know where to find it. For example, you may need a copy of your return when applying for a home loan or financial aid. You can also use it as a helpful guide for next year’s return.

3. Organize your records. Establish one location where everyone in your household can put tax-related records during the year. This will avoid a scramble for misplaced mileage logs or charity receipts come tax time.

4. Shop for a tax professional. If you use a tax professional to help you with tax planning, start your search now. You’ll have more time when you’re not up against a deadline or anxious to receive your tax refund. Choose a tax professional wisely. You’re ultimately responsible for the accuracy of your own return regardless of who prepares it. Find tips for choosing a preparer at IRS.gov.

5. Consider itemizing deductions. If you usually claim a standard deduction, you may be able to reduce your taxes if you itemize deductions instead. If your itemized deductions typically fall just below your standard deduction, you can ‘bundle’ your deductions. For example, an early or extra mortgage payment or property tax payment, or a planned donation to charity could equal some tax savings. See the Schedule A, Itemized Deductions, instructions for the list of items you can deduct. Planning an approach now that works best for you can pay off at tax time next year.

6. Keep up with changes. Find out about tax law changes, helpful tips and IRS announcements all year by subscribing to IRS Tax Tips through IRS.gov or IRS2Go, the mobile app from the IRS. The IRS issues tips regularly during the summer and tax filing season.

You can find forms and publications at IRS.gov or order them by calling 800-TAX-FORM (800-829-3676).

IRS Warns about Boston and Texas Charity Scams

The Internal Revenue Service is warning potential donors to beware of charity scams operating in the wake of the explosions last week at the Boston Marathon and a Texas fertilizer plant.

The fraudulent schemes involve solicitations by phone, social media, email or in-person, the IRS noted. “Scam artists use a variety of tactics. Some operate bogus charities that contact people by telephone to solicit money or financial information. Others use emails to steer people to bogus websites to solicit funds, allegedly for the benefit of tragedy victims. The fraudulent websites often mimic the sites of legitimate charities or use names similar to legitimate charities. They may claim affiliation with legitimate charities to persuade members of the public to send money or provide personal financial information. Scammers then use that information to steal the identities or money of their victims.”

The IRS is offering the following tips to help taxpayers who wish to donate to victims of the recent tragedies at the Boston Marathon and a Texas fertilizer plant:


• Donate to qualified charities. Use the Exempt Organizations Select Check tool at IRS.gov to find qualified charities. Only donations to qualified charitable organizations are tax-deductible. You can also find legitimate charities on the Federal Emergency Management Agency Web site at fema.gov.

• Be wary of charities with similar names. Some phony charities use names that are similar to familiar or nationally known organizations. They may use names or websites that sound or look like those of legitimate organizations.

• Don’t give out personal financial information. Do not give your Social Security number, credit card and bank account numbers and passwords to anyone who solicits a contribution from you. Scam artists use this information to steal your identity and money.

• Don’t give or send cash. For security and tax record purposes, contribute by check or credit card or another way that provides documentation of the donation.

• Report suspected fraud. Taxpayers suspecting tax or charity-related fraud should visit IRS.gov and perform a search using the keywords “Report Phishing.”

More information about tax scams and schemes is available at IRS.gov using the keywords “scams and schemes.”

Start planning now to lower your taxes for the year

There are times when the only way to lower your tax liability is to have more taxes withheld from your paycheck or retirement. As children leave the home, your tax liability begins to increase. After a child turns 17, and it doesn’t matter what time of the year this happens, you no longer qualify for the Child Tax Credit of $1,000.

This affects the amount of taxes you will owe. Once the children leave the home or turn 19 and are not full-time students or they work, if they make more than the exemption amount ($3,900 for 2013), they cannot be claimed on the parent’s tax return. This can greatly affect the amount of taxes you will owe.

These are events that need to be planned for during the year. I have seen many incidences of this happening this tax season. Taxpayers are unprepared for their tax bill because they did not make adjustments to the withholdings from their paychecks. Even if your children still live with you and you support them, if they are 19 and not full-time students, the income factor comes into play. The child may not even need to file a tax return, but that does not mean you can claim the child on your return if the child earned more than the exemption amount.

Another area that causes your tax liability to increase is if your deductions fall below the standard deduction rate. Deductions taken on Schedule A such as medical bills (more than 10 percent of your Adjusted Gross Income for 2013), state taxes withheld or paid during the year, property taxes, mortgage interest and charitable donations must add up to more than the standard deductions. For 2013, they are $12,200 for married filing jointly, $8,950 for head of household; $6,100 for individual taxpayers; and $6,100 for married taxpayers filing separate.

If you add up the amounts for medical and your income is $50,000, these medical bills must be more than $5,000 to even begin to get a deduction for them. If they are under this amount, you do not need to track your expenses. However, let’s say for example you make $50,000 and your medical bills were $5,500. You medical deduction is $500. It is not $5,500. The first $5,000 does not count; only amounts over this will be deductible.

Let’s take another example. You are a single taxpayer and give $2,000 to your local church. Your other deductions such as medical, state taxes withheld, property taxes and mortgage interest all must add up to more than $6,100 to get the deduction for your donation to your church. If you are a renter, had little taken out of your paycheck or retirement for state withholdings, the standard deduction of $6,100 will more likely be the better option.

Another way to reduce your tax liability is to lower your taxable income by contributing to your employer’s 401k or other retirement plan. This lowers the amount of taxable income and keeps your money with you instead of having more withheld from your paycheck for taxes. Talk with a financial adviser to take advantage of this option to lower your taxable income.

Planning throughout the year for life-changing events can help lower your tax liability.