Earlier this week, lawmakers in Washington passed the American Taxpayer Relief Act of 2012. Not only were we relieved to see a last-minute deal preventing us from going over the fiscal cliff, but many of us also breathed a sigh of relief that tax rates were going to increase on only the wealthiest 2% of Americans.
The crisis was diverted, right? We “non-wealthy Americans” can easily presume it won’t affect us as small-business owners and we can move on with our plans for 2013? Wrong. Almost every American’s tax bill is going to go up in 2013 to some degree. This was a massive piece of legislation with hundreds of provisions and changes that will affect our tax returns and businesses. Combine this with the provisions rolling out this year with Obamacare, and business owners should take 2013 tax planning more seriously than ever.
Here is a breakdown of the main provisions and what business may want to consider doing in 2013 as part of a comprehensive tax plan:
The payroll-tax holiday is over. This means payroll taxes are going up by 2 percent and all of us with earned income will feel its impact immediately. Now if your memory has faded, it’s technically not a tax increase, but the end of a tax holiday in effect since 2010. It was a nice vacation, but it’s time we quit borrowing from a broken Social Security system to stimulate the economy.
-- Planning point No. 1: This makes the S-Corporation and payroll planning for the small-business owner even more important. If you are operating as a sole-proprietor, make sure you evaluate the benefits of an S-Corp with your tax professional. Choosing the proper amount of salary can save you thousands in self-employment taxes. The strategy being that when you organize as an S Corp, you pay yourself a salary and pay payroll taxes on it -- and you can also take a dividend, which is distributed free of payroll taxes. The catch is that you have to make sure the salary is "reasonable" as the IRS is well-aware that S Corp owners like to set small salaries to pay lower payroll taxes and then take a hefty tax-free dividend.
-- Planning point No. 2: For small-business owners with employees, new payroll-withholding schedules have been issued by the Internal Revenue Service. Employers should begin using the revised withholding tables by Feb. 15 according to IRS guidance and correct the amount of Social Security tax being withheld as soon as possible.
-- Planning point No. 3: Don’t forget that the additional Medicare tax under ObamaCare of .09% also kicks in this year on individuals with wages or self-employment income of $200,000 and $250,000 on the combined income of married couples. The new legislation makes payroll planning and the use of an S-corporation for the small-business owner even more advantageous.
Tax rates will increase for some. Tax rates will permanently increase for individuals making more than $400,000 a year and families with annual income more than $450,000. This new rate returns to the Clinton-era top rate of 39.6 percent. It's worth noting that business owners with pass-through entities (such as an LLC or S Corp) may be affected here, as the profits of the company flow through to those individuals' personal-income tax returns. But bear in mind that the U.S. Treasury Department estimated in 2011 that raising tax rates on incomes over $500,000 would only impact 750,000 small businesses, or a small sliver of small businesses.
-- Planning point: Keep in mind that our tax tables are graduated, so the new rate is applied on only the next dollars earned above $400,000 or $450,000. However, don’t forget we also have another aspect of Obamacare to contend with. In 2013 the 3.8% tax on the net-investment income kicks in as well, which applies to individuals earning more than $200,000 a year, those filing married over $250,000. As such, it's never been more important than now to make sure you structure your type of income and level of income and take into account these different tax thresholds and rates under the new tax law. Based on your situation, there may be certain types of income to maximize, while minimizing other types. For example, increase Roth and retirement plan distributions, S-corporation dividends and rental real-estate income as a real-estate professional, because these and other types of income aren’t considered "net-investment" income.
The capital-gains tax rate increases on some. There still is the 0% and 15% capital-gains tax rates for most of us, but those making more than $400,000 or $450,000 a year will now also face a 20% capital-gains tax rate.
-- Planning point: When selling your business, consider an installment sale or charitable remainder trust to create a steady level of income below the higher tax-rate schedules. An installment sale is when you sell your business on "terms" and receive the payments over time. This often allows you to demand a higher purchase price, and keeps you out of higher tax brackets and Obamacare taxes in the year of sale. A charitable remainder trust is a structure that has been used for years, in which business owners create a trust benefiting a charity, donate their business to the charity (getting a tax deduction in the process), then sell the business essentially tax-free and can receive fixed payments based on the value of the trust for the rest of their life, whereupon their passing, the trust balance goes to a charity. Both of these strategies can have a significant tax benefit when you take into account the time value of money.
The estate-tax exemption is now permanent. Estates valued below $5 million will now be exempt from estate tax, but estates valued at more than $5 million will also face a higher rate of 40%. This is good news for many people wanting to pass on their business to the next generation and do family tax planning.
-- Planning point: If you plan on passing on your business or real estate to your family after you're gone and don’t want to pay the tax, consider an A-B Trust to maximize your estate-tax exemption and effectively double it to $10 million if you are married. An A-B Trust is a type of estate plan that ensures a married couple each gets to utilize their $5 million exemption. If an A-B Trust isn’t used, when a married couple passes they only get one exemption and they’re treated as if they died single for estate-tax purposes. No matter your situation, make sure you consult with an estate-planning attorney to structure the proper succession plan for your business and real estate holdings.
Medical expenses as an itemized deduction are further limited. Under the new legislation, only medical expenses above 10% of your adjusted gross income will be deductible as an itemized deduction. Moreover, Flexible Spending Account contributions are now limited to $2,500 per year. Both of these are terrible changes for the w-2 employee, and it gives small-business owners a cutting-edge planning opportunity.
-- Planning point: Small-business owners have the unique ability to deduct 100% of their health insurance premiums, and they can use either a Health Reimbursement Plan (HRA 105 Plan) or the Health Savings Account (HSA) strategy in order to deduct the majority, if not all of their health-care costs.
There is also a package of temporary business tax breaks to consider. The key word in this discussion is "temporary," but at least small-business owners can use a host of tax strategies through the end of 2013. Some of these extensions include:
- The $500,000 limit on the Section 179 depreciation deduction on equipment
- The 50% bonus depreciation deduction on certain acquisitions
- Work Opportunity tax credits for veterans and others
- The research-and-development tax credit
- The 100% tax-free capital gains on sale of small-business stock
- The 15-year depreciation schedule for certain leasehold improvements
- Film and production tax breaks
- Race-track depreciation benefits
Even with the above provisions implemented under the new legislation, some made permanent, many government officials and political pundits already are deeming this a failed piece of legislation. For example, a number of provisions are only temporary, saving the same arguments and debates for another day. Likewise, it doesn’t address the debt-ceiling, it sequesters, meaning "postpones," the discussion on spending cuts, and doesn’t effectively tackle the farm bill, newly dubbed the "Milk Cliff."
Is real and permanent change in our future? Several senators and members of Congress are now urging their colleagues to consider "real tax reform" as the debate continues in 2013. I thought Congress had the past two years to implement real tax reform.
Whatever the future may hold, it’s more important than ever that small-business owners consider tax planning as a key strategy and issue that could impact their profits and success going forward.