2016 Year End Tax Planning Guide

By December 27, 2016 July 5th, 2019 Tax

Will Tax Rates Drop in 2017?

The maximum federal tax bracket for 2016 is 39.6%. This bracket is reached when taxable income exceeds $415,050 ($466,950 if married filing joint). In addition, capital gains are taxed at

20%, instead of 15%, once this threshold is reached.  The 3.8% Medicare tax on net investment income (NII tax) applies if your modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 if married filing joint). Keeping MAGI below $200,000 ($250,000) can eliminate this surtax.  The phase out of exemptions and loss of itemized deductions equal to 3% MAGI begins when MAGI reaches $259,400 ($311,300 if married filing joint).  This effectively adds another 1.2% tax.  Therefore, total federal income taxes could be as high as 44.6%.

California tax brackets go all the way up to 13.3% if your taxable income exceeds $1,074,996. At taxable income of $400,000, the marginal California tax rate is 11.3% (9.3% if married filing joint).  There is no reduced California tax rate for capital gains. Fortunately, state taxes are deductible for federal purposes, unless you are subject to alternative minimum tax (see below).

Focusing on federal taxes, it is generally better to defer 2016 taxable income until 2017, unless the deferral puts you into a higher tax bracket in 2017. Conversely, if you know your taxable income will be higher in 2017, you may want to consider accelerating the income into 2016 if it puts you in a lower tax bracket. Income can be delayed through setting up deferred compensation arrangements, postponing year-end bonuses, maximizing deductible retirement contributions, and delaying year-end customer collections (if cash basis).

President-elect, Donald Trump, as well as the House GOP, have proposed sweeping changes in the federal income tax, including lower tax brackets and a limitation on itemized deductions. However, it will be many months before Congress passes legislation, assuming it can reach an agreement.  While it is too early to predict the outcome for 2017, you should be prepared for change and consider the impact it may have on your 2016 tax planning.  Generally, both Trump and the House GOP proposals will reduce the maximum tax rate to 33%.  Capital gains tax rates may or may not be reduced, depending on the proposal.  Trump would retain the current itemized deductions, but cap them at $100,000 ($200,000 for married couple), while the House GOP would eliminate all itemized deductions other than home mortgage interest and charity.   Both proposals would repeal the alternative minimum tax.  This tells us it may be wise to defer income to 2017 and accelerate deductions into 2016, especially deductions that may not be available in 2017.

3.8% Medicare Tax on Investment Income

Net investment income (NII) includes interest, dividends, capital gains from investments, income from  passive  activities,  such  as  real  estate  or  rentals  and  other  passive  business  activities, annuities, and royalties. It does not include gain on a sale of an active interest in a business or retirement plan distributions. Investment expenses that reduce investment income include investment interest expense, allocable state taxes, and certain miscellaneous itemized deductions related to the investments.

As mentioned above, the NII tax only applies if your MAGI is greater than $200,000 ($250,000 if married filing joint).  Assuming you are married and your MAGI is $300,000, the maximum net investment income subject to the NII tax is $50,000. Thus, if your net investment income is say $80,000, only $50,000 will be subject to the 3.8% NII tax.

Planning techniques to avoid the NII tax include: invest in tax exempt bonds or annuities on life insurance products; materially participate in businesses or become a real estate professional, maximize use of retirement plans; avoid or postpone capital gains via tax free exchanges, installment sales or charitable remainder trusts; or change timing of income or expenses in order to keep MAGI below the $200,000/$250,000 threshold.

Since passive activity income from a trade or business is considered investment income, it is advisable to materially participate if at all possible so as to avoid the passive activity treatment. However, once treated as active, you may find yourself subject to self-employment tax unless you operate as an S corporation.  LLCs in particular have this risk. Fortunately, it is possible for an LLC to elect to be treated as an S corporation.

Catch Up Federal and State Tax Payments At The End Of The Year

If you expect to owe state and local income taxes when you file your return next year, consider asking your employer to increase withholding of state and local taxes (or pay estimated tax payments of state and local taxes) before year-end to pull the deduction of those taxes into 2016 if you won’t be subject to alternative minimum tax (AMT) in 2016.

If you are facing a penalty for underpayment of estimated tax and having your employer increase your withholding is unavailable or won’t sufficiently address the problem, take an eligible rollover distribution from a qualified retirement plan before the end of 2016.   Income tax will be withheld from the distribution and will be applied toward the taxes owed for 2016.  You can then timely roll over the gross amount of the distribution, i.e., the net amount you received plus the amount of withheld tax, to a traditional IRA.

You may want to pay contested state taxes before the end of the year, so as to be able to deduct them this year while continuing to contest them next year.

Alternative Minimum Tax (AMT)

The stealth tax, AMT, is alive and well for 2016. This alternative tax could kick-in when you have large state tax deductions (including property taxes) and/or large capital gains. It also could occur if you have large miscellaneous itemized deductions or when you exercise incentive stock options. If you expect to be subject to AMT in 2016, but not 2017, you may want to accelerate income into 2016, because the AMT tax rate is only 28%, or defer state taxes to 2017. In some cases, state taxes related to a business, asset sale, real estate operations or S corporation can be deducted for AMT purposes. Thus, it is important to have your tax professional analyze your current year’s income data to determine the AMT impact. Another area where you should obtain professional advice is on the exercise or possible exercise of Incentive Stock Options (ISOs), which may trigger substantial AMT consequences. In order to accurately predict AMT, it is generally necessary to project both your 2016 and 2017 income taxes using tax software. Your tax professional can assist you with this calculation.

Harvest Capital Losses

If you have large capital gains in 2016, it may be advisable to accelerate capital losses by selling securities with unrealized losses before year-end. If you want to continue to invest in these sold securities, make sure you wait 30 days before repurchasing the securities in order to avoid the wash sale rule. Harvesting capital losses is more important if you are in the 20% tax bracket for capital gains. This rate applies once your MAGI exceeds $415,050 ($466,950 if married filing joint). The old 15% tax bracket for capital gains continues to apply if your MAGI is less than this threshold.  If you expect net short-term capital gains for 2016 (holding period less than 12 months), you may want to accelerate short term capital losses in order to avoid ordinary tax rates on such gains.

The opportunity to have capital gains taxed at zero percent still applies if you are in the 10% or 15% tax bracket for ordinary income (taxable income of less than $75,300 if you are married filing joint).   Clearly,  if  you  are eligible for the 0% tax  on  capital  gains,  you  should  not accelerate capital losses.

Contribute To Your Retirement Plan

Individuals with a traditional IRA or an employer sponsored retirement plan, such as a 401(k) plan, should consider making a contribution to the plan before year-end. Not all taxpayers will qualify for deductible IRA contributions.

For 2016, the IRA contribution limit is $5,500 ($6,500 for individuals older than 50 years of age who qualify for the catch-up provisions). The maximum amount an employee can contribute to a401(k) in 2016 is $18,000 ($24,000 for individuals older than 50 years of age who qualify for the catch-up provision).  In certain circumstances, it may be advisable to convert an IRA into a Roth IRA.

In the case of a traditional 401(k) plan, consider making a $35,000 “after-tax” contribution in addition to the $18,000 pre-tax contribution.  The employee may be able to later roll any after- tax amounts into a Roth IRA, with the remainder to traditional IRA.

Required Minimum Distributions

Take required minimum distributions (RMDs) if you reached age 70 ½ before 2016.   RMDs from your IRA cannot be combined with RMDs from your employer plan.  Each must be calculated and distributed separately.

Non-Cash Charity

Donating appreciated securities to charity creates a tax deduction for the value of the securities donated, yet no taxes are due on the built-in gain. Other property can be donated to charity but an appraisal performed by a “qualified appraiser” will be needed if the fair market value is greater than $5,000. Gifting appreciated assets also avoids the NII tax on the gain that would otherwise be incurred on the sale of such assets.

Clothing and household items donated to charity must be in “good condition” in order to be deductible. Thus, taxpayers must be ready to prove both the value and the condition of the property contributed. In addition, taxpayers can no longer deduct charitable contributions made in cash (currency). Further, contributions made by check must be supported by bank record or receipt from the charity (contribution of more than $250 must always be supported by acknowledgement from the charity).

Foreign Investments

Make sure you disclose all foreign bank accounts and foreign investments to the IRS in order to avoid severe penalties.  See your tax professional for applicable forms and due dates.

Estate Planning

Transferring wealth to heirs reduces future gift and estate taxes. At a minimum, be sure to take advantage of the annual $14,000 gift tax exclusion per recipient. Gift splitting with your spouse increases the limit to $28,000 per recipient. The combined lifetime gift/estate tax exemption is now $5.45 million per spouse. Consider transferring securities and real estate to trusts for the benefit of your heirs. Using trusts can reduce your estate tax by 30% to 50% or more.  Certain trusts work especially well in a low interest rate environment. Consider grantor retained annuity trusts (GRATs), charitable lead annuity trusts (CLATs), and intra-family loans and installment sales that may or may not use trusts. The applicable interest rate on intra-family loans (e.g. down payment for a child’s home or for the sale of assets to a child financed with a loan) is incredibly low. A short term loan of less than three years can have an interest rate as low as 0.74% under current IRS tables. Mid-term loans (three to eight years) can be only 1.47%. Long-term loans (over eight years) can be only 2.26%. These rates change monthly.

Set Up Loved Ones to Pay No Tax on Investment Income

For 2016, the federal income tax rate on long-term capital gains and qualified dividends is still

0% for taxpayers otherwise in the 10 or 15% rate brackets. While your tax bracket may be too high to take advantage of the 0% rate, you probably have loved ones who are in the bottom two brackets (for singles, taxable income up to $37,650).

Consider giving these individuals appreciated stock or mutual fund shares. They can sell the shares and pay no tax on the resulting long-term gains. Giving away dividend-paying stocks is another tax planning opportunity. Qualifying dividends, otherwise taxed at capital gains rates, that are received by a taxpayer who is in the 10 or 15% tax bracket will qualify for the 0% federal income tax rate.

Warning: Gifts of more than $14,000 per person per year require the filing of a gift tax return. Also, if your gift recipient is under age 24, the “Kiddie Tax” rules could potentially cause some of his or her capital gains and dividends to be taxed at the parent’s higher rates. That would defeat the purpose of this plan. Contact your tax professional if you have questions about the Kiddie Tax.

Fund Education Through 529 Plans

Consider funding 529 plans by December 31 to apply 2016 annual gift tax exclusion treatment to the contributions. 529 plans can be used to fund a child’s or grandchild’s college education. Income earned on the invested funds is exempt from income taxes. You can “front-load” 529 plans by making five years’ worth of annual exclusion gifts to a 529 plan. In 2016, you could transfer $70,000 ($140,000 for a married couple) to a 529 plan without generating gift tax or using up any of your gift tax exemption. (Nevertheless, a gift tax return is required in this case).

Concentrated Stock Positions

With increased capital gains rates and the new NII tax, the tax cost of diversifying out of a position has increased. Investors with concentrated positions may also have concerns regarding liquidity, cash flow, volatility and more. Your tax professional can help you consider strategies to minimize your tax impact of diversification or to hedge against the downside of continued concentration.  Consider  whether  systematic  sales,  equity  collars,  exchange  funds,  prepaid variable forwards or charitable remainder trusts make sense in your situation, and whether it would be helpful to implement any of these before year end.

Suspended Passive Activity Losses

Consider disposing of a passive activity in 2016. Doing so will allow you to deduct suspended passive activity losses.

Basis Limitation on Partnership or S-Corporation

If you own an interest in a partnership or S-corporation, consider whether you need to increase your basis in the entity (contribute cash or become responsible for more debt) so you can deduct a current year loss.


Deferring Taxable Income

Cash basis businesses can control taxable income by accelerating expenses or deferring revenue based on when disbursements are made or revenue received.  Use of credit cards to pay expenses creates deductions when charged on credit card, even for cash basis taxpayer.  Prepaid expenses are generally deductible when paid, as long as the economic benefit related to such expense doesn’t extend beyond 12 months.

Bonus Depreciation

The 50% first year bonus depreciation allowance is available for qualified property put in service in 2016.

Section 179

Section 179 is the term used to describe the ability of a small business to deduct, as depreciation expense, a significant portion (if not all) of the cost of a qualified asset purchased. Currently, the maximum amount a small business owner can expense is $500,000 for 2016. Unlike bonus depreciation, there are certain limitations placed on the deduction. Additionally, the deduction cannot create a taxable loss.

Passenger Automobiles

For passenger vehicles used in a trade or business, the amount of depreciation allowed in the first year is $11,060 for 2016 (includes bonus depreciation element). This maximum must be reduced by the amount of personal use of the passenger vehicle. A passenger vehicle is defined as a vehicle that has a loaded gross vehicle weight of 6,000 pounds or less. Large vehicles (trucks and SUVs whose weight is more than 6,000 pounds but less than 14,000 pounds with total bed length under six feet) can utilize a Section 179 deduction of up to $25,000 in the first year in addition to annual depreciation. These provisions do not apply to used vehicles. Alternatively, taxpayers can claim business mileage at 54 cents per mile.

Retirement Plan Contributions

Retirement plan contributions should be maximized every year. If you do not have a retirement plan in place, consider establishing one before year-end. For a defined contribution plan, 2016 deductions can be as high as $53,000 per employee. Defined benefit plans have even higher limits. The plan cannot discriminate in favor of the highly compensated executives. If you are self-employed, consider a Solo 401(k) plan that has a $53,000 contribution limit ($59,000 if age

50 or older).

Home Office Deduction

Consider whether you qualify for the home office deduction (allocation of depreciation, utilities and maintenance expenses as business expense) based on exclusive and regular use of part of your home as an office for your business.

Captive Insurance Company

Determine whether a captive insurance company could be used to assume certain business risks and achieve substantial tax benefits. Annual tax deductions of up to $1.2 million are available for

insurance premiums paid to a captive insurance company, yet no income taxes are paid on the insurance premiums received by the captive (your insurance company). While it is probably too late to set-up a captive for 2016, it is not too early to plan one for 2017.  Recently, the IRS has attacked some captive insurance companies as having no economic substance; however, a properly structured captive remains a sound tax planning strategy.

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Follow the link to view the complete 2016-year-end-tax-planning-guide.

Check with your tax professional regarding the implementation of these tax planning strategies, as well as for additional tax planning strategies that may apply to you.