Alert: What Should You Do In Light Of Uncertain Tax Rates?

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July 27, 2012

The “Gordian knot” today is what should a businessman or an investor do in light of the expiration of the Bush income tax cuts and the imposition of new taxes effective in 2013.

Income taxes and the tax rates have at least three important consequences to taxpayers.  First, it affects entity selection: whether the taxpaying entity is an individual; a flow-through organization such as a partnership or Subchapter S corporation; or is a C corporation. Second, the determination of whether to sell today or defer until a later point is impacted by the tax rate. Lastly, the taxation choice of income mix to the recipient, whether in the form of wages, dividends, and capital gains, is of increased tax significance.

The 2001 Bush tax cuts will sunset and expire as of December 31, 2012. [1] How the expiration of these tax cuts will affect tax rates is set forth below:

TAX RATES: TODAY AND TOMORROW

INCOME TAXES:

 Current (2012)

 Income Level

 Scheduled Tax Rate
Next Year (2013)

    10%

 $0 - $16,750

    15%

 15

 16,751 - 68,000

 15

 25

 68,001 - 137,300

 28

 28

 137,301 - 209,250

 31

 33

 209,251 - 373,650

 36

 35

 373,651 and above

    39.6

CAPITAL GAINS TAXES:

Current (2012) 

 Income Level

Scheduled Tax Rate
Next Year (2013)

    15%

 couples up to $250,000

    20%

 15

 couples over $250,000

 20

TAXES ON DIVIDENDS:

Current (2012) 

 Income Level

Scheduled Tax Rate
Next Year (2013)

    15%

 couples up to $250,000

 up to 36%

 15

 couples over $250,000

 up to 39.6

ESTATE TAX:

 

 Current (2012)

Scheduled Tax Rate
Next Year (2013) 

 Rate

 35%

 55%

 Exemption

 $5,120,000

 $1 million

CORPORATE TAX:

 

 Current (2012)

 Scheduled Tax Rate
Next Year (2013)

 Top Rate

 35%

 35%

In addition to the “inlaw” tax increases scheduled for 2013, new taxes were passed in the Health Care Bill in 2012, effective 2013.

Individuals will pay an extra 0.9% Medicare tax on earned income in 2013. That is, an individual’s tax rate will increase from 1.45% to 2.35% for single taxpayers with earned income of $200,000 and for married filing jointly with earned income of $250,000. This increase only affects the employee’s portion and not the employer’s. It will appear as a separate line on Form 1040.

Starting in 2013, individuals will also be required to pay a new Medicare surtax on unearned income of 3.8% on modified adjusted gross income for couples earning more than $250,000 and $200,000 for singles. The new 3.8% unearned income surtax will be imposed on interest, dividends, annuities, rents, royalties, passive income, capital gains, and financial instrument trading. It will not include tax-exempt interest, self-employed income, active business income, IRA, or retirement distributions. 

Therefore, in 2013, a capital gain could be taxed at 23.8% (20% capital gain tax plus 3.8% Medicare surtax). 

Moreover, in 2013, dividends could be taxed at 43.4% (39.6% ordinary income tax plus 3.8% Medicare surtax).

It is also important to remember that dividends, which are payouts from business earnings, are already taxed at the corporate rate of 35%. The individual dividend tax is a second levy on that same income that is already taxed to the corporation, and a rate of 43.4% to the shareholder would increase the total tax to $0.60 on each dollar paid in dividends. These are not unsubstantial tax adjustments.

Further, the individual medical expense deduction threshold will increase from 7.5% to 10% of adjusted gross income through the recent health care tax changes.

If taxes are a concern, an individual who can sell their business in 2012 may want to consider doing so. An illustration will make the point.

The long-term capital gains rate has ranged from 15% to 28% since 1981; and, as indicated above, the current rate is 15%. Below is a table that represents the percentage increase in the sale price of an asset needed to achieve the same net after-tax proceeds using various capital gains tax rates.

CAPITAL GAIN CHART

Rate 

 Capital Gain

 Tax

 Net

 % more in price

   15%

 100

 15

 85

 -

 20

 106

 21

 85

 6

   23.8

 112

 27

 85

 12

 28

 118

 33

 85

 18

 The new tax environment contains many provisions that will affect you and your business, such as choice of entity, the determination to sell now or defer, and how to arrange your income mix to get the best tax position without sacrificing security and safety (wages, dividends, or capital gains).

While the expiring Bush tax cuts are under Congressional review and some of the health care tax provisions do not take effect until 2013, businesses and individuals need to assess their tax situation and plan ahead how to best survive in an increasing tax environment.

We would be happy to discuss what the new tax rates mean for you and your business today and in the future. If you have any questions on the new tax rate regime, please contact a member of the Tax Section or Business Law Section.


[1] For simplicity, the effect of the expiring clawback on itemized deductions and personal exemptions is not shown on the 2013 rates. In 2013, the provision that shaves deductions claimed by upper-income taxpayers as well as the phase out of personal exemptions will come back, in effect adding another 1.2% to the 2013 rates.