All I want for Christmas is a new bulldozer
Beginning in 2010, businesses have been afforded beneficial tax breaks via fixed asset additions and depreciation. These breaks are primarily Bonus depreciation and Section 179 expensing. Absent further action by Congress, Bonus is scheduled to go away and the 179 limits will be greatly reduced after 2013. Taxpayers can make an election to expense 100% of the cost of a new asset in the year of purchase under code section 179 of the Internal Revenue Code. This method, commonly known as "179", has both cost and income limits. In 2013, taxpayers can expense up to $500,000 under Section 179. If the taxpayer's acquisitions exceed $2 million, their allowable expense is reduced and the taxpayer's 179 deduction cannot exceed taxable income for the year. However, in 2014 the allowable expense drops to $25,000, with an acquisition limitation of $200,000.
Similarly, in 2013 taxpayer's can expense expense 50% of an acquisition up front, and then take normal depreciation on the other 50% for the year. For example, taking bonus on a $1,000 asset would result in a $500 expense up front, plus regular depreciation for the year on the remaining $500. It does not matter if the asset is new or used, there are no income or acquisition limits, and bonus can still be taken even if the taxpayer has no taxable income or the depreciation causes the taxpayer to have a net operating loss. But, in 2014, bonus depreciation will "retire".
Now that we've discussed the rules, take a look at this bad boy.
This is a fine bulldozer made by Caterpillar, one of the largest heavy machinery manufacturers in the world. Let's say that a taxpayer is in the market for this bulldozer and finds one at their local heavy machinery dealer with a list price of $250,000 (not actual list price, hypothetical only). We can now look at how making that purchase in December 2013 vs. January 2014 will affect the taxpayer's situation.
If the bulldozer is purchased in December 2013, the taxpayer can either expense 100% of the cost assuming they had < $2 million in total additions and taxable income of at least $250,000, or the taxpayer can expense $125,000 of the bulldozer under bonus depreciation regardless of their other acquisitions and taxable income.
If the bulldozer is purchased in January 2014, the taxpayer will not be permitted to expense any of the addition under 179 because their acquisitions will exceed the limit. The taxpayer will not be able to take any bonus depreciation either.
In this case, assuming a 39% tax rate, delaying the purchase to 2014 will cost the taxpayer savings in tax dollars of $97,500 if 179 could be taken, or $48,750 if bonus could be taken.
Although it is likely that Congress might pass some kind of extension to these depreciation rules, at this time there is no indication that the rules will be changed. Taxpayers that have been considering making fixed asset additions, from bulldozers to printers to office furniture, should take advantage of the tax benefits in 2013 while they last.
Harvest time
December is a good time of year for taxpayers to take a look at the performance of their investments over the past year. During that time taxpayers might consider selling some assets, either to free up cash for future investments or living expenses, or to harvest capital gains in their account.
The basic harvest
Before a taxpayer can properly plan their capital gains harvesting, it is important to understand capital assets and how gains/losses are determined. A capital asset includes just about everything a taxpayer owns for personal use (not business) such as a home, stocks, bonds, cars, etc. When capital assets are sold, the difference between the proceeds received and the original cost basis of the asset is the resulting gain or loss. If the proceeds are more than the cost, the result is a gain, and vice versa a loss. Once the gain/loss is calculated, the next step is to determine if the gain/loss is long-term or short-term. If the asset had been owned by the taxpayer for 1 year or more when it is sold, then the gain/loss is long-term. Otherwise, the gain/loss is short-term.
Basic capital gains harvesting attempts to offset capital gains against capital losses. For example, let's say a taxpayer has $10,000 worth of investments in their account. $5,000 of the investments have an unrealized gain of $1,000, and the other $5,000 have an unrealized loss of $1,000. The taxpayer can sell all of the investments, generate $10,000 in cash, but have zero capital gains, because the $1,000 gain offsets the $1,000 loss.
Tax rates
Unfortunately, if the taxpayer's investment account has significant gains, 2013 might not be the best year to start liquidating large portions of their portfolios. As has been the case for several years, long-term capital gains are only taxed at 15%, but beginning in 2013, taxpayers with income in excess of $400,000 (single) or $450,000 (married) could be subject to a 20% capital gains tax rate. Of course this applies only to long-term capital gains; short-term capital gains are always taxed at the ordinary tax rate.
Reap what you sow
Taxpayers often ask themselves "if I sell assets at a gain and other assets at a loss, don't I lose money?" The answer is yes and no. Yes, the taxpayer loses money on the assets sold at a loss, because they spent more on the initial purchase than they received from the sale. At the same time, the answer is no because the taxpayer still receives cash from the sale. This cash can be used to make additional purchases and investments, without any tax consequences because the capital gains and losses offset each other.
Another aspect to consider is the capital loss carryover. Individual taxpayers are allowed a maximum of $3,000 in net capital losses be reported on their tax return. The good news is that the capital losses not used in that year can be carried forward to future years. Therefore, if a taxpayer has long-term capital gains of $1,000 and long-term capital losses of $5,000 (net capital loss of $4,000), the maximum net capital loss they can report on their tax return is $3,000, but the other $1,000 can be carried over to future years. This means that in the next year, $1,000 in capital gains could be taken without taking any corresponding losses, because the $1,000 could be used from the previous year.
December is a good time to review investment holdings and consider harvesting capital gains in order to generate cash with minimal tax consequences. At the same time, taxpayers should also consider if they have any capital loss carryovers on their Schedule D from the previous year.
Happy harvesting!
The not-so-Alternative Minimum Tax, Part 2
A few days ago, this blog addressed the Alternative Minimum Tax (AMT) as it applies to individuals. A little known fact is that businesses, like individuals, can be subject to the AMT. Although the purpose is the same - assure that taxpayers with certain types of income and deduction structures pay at least a minimum amount of tax - the way in arriving at the AMT is slightly different. This article addresses AMT as it applies to tax-paying corporations (C Corps). It does not apply to passthrough entities such as S Corps or Partnerships, because AMT is calculated at the individual level.
Not all businesses are alike
Unlike individuals, some corporations are exempt from the AMT. A corporation that qualifies as a "small corporation" is exempt from the AMT. To be classified as a small corporation, the entity must:
- Be in its first year of existence, i.e. the current tax year is the year the entity began operations, or
- The company was treated as a small corporation for all prior tax years beginning after 1997, and
- The company's gross receipts did not exceed an average of $7.5 million for the preceding 3 tax years ($5 million if the entity has been in existence for 3 years or less)
After determining that the corporation is subject to the AMT, the taxpayer will complete Form 4626 with the Form 1120. Form 4626 is organized similar to Form 6251 for individuals. It begins with the corporation's taxable income, and then adds back / takes away various adjustments and preferences, such as:
- Differences in depreciation
- Differences in gains and losses
- Depletion
- Intangible drilling costs
- Adjusted Current Earnings adjustments (ACE)
After the corporation accounts for these adjustments and preferences, they arrive at their alternative minimum taxable income (AMTI). Corporations are afforded an exemption if their income falls in a certain range, typically $40,000. The AMTI is then multiplied by 20% to arrive at the AMT.
Just like individuals, if the AMT exceeds the corporation's regular tax, then they must pay the higher amount.
Because corporation's do not receive the same preferential treatment of gains being taxed at a lower rate like individuals, the biggest factor in a corporation's AMT calculation is depreciation. A corporation needs to be mindful when capitalizing depreciable property that a large difference between the tax and AMT depreciation methods could subject the corporation to a higher tax rate. Some assets, when capitalized using the 200% double-declining method of depreciation can only be depreciated using the 150% MACRS method for AMT purposes. This will cause the AMT depreciation expense to be lower than the tax depreciation, resulting in an addition to taxable income in arriving at AMTI.
The not-so-Alternative Minimum Tax, Part 1
The Alternative Minimum Tax (AMT) for individuals, enacted by Congress in 1969, is becoming less of an alternative for some taxpayers. The AMT was originally targeted at approximately 150 taxpayers that had high adjusted gross income (AGI), but paid zero tax due to the types of income and structuring of deductions. In effect, under the current structure the AMT almost guarantees that once taxpayers reach a certain level of income, their effective tax rate will be at least 26% or higher.
The AMT is calculated by both businesses and individuals, but under different circumstances. This post will discuss the AMT as it applies to individuals.
Individuals subject to AMT
Individuals calculate their share of the AMT on Form 6251. That taxpayer begins with their AGI after itemized deductions, and then adds back the following:
- Medical expenses
- State and local income, real estate, and property taxes
- Miscellaneous deductions
The taxpayer must also add back or reduce by the difference between their income tax and AMT amounts for the following:
- Investment interest expense
- Depletion
- Basis in exercised incentive stock options
- Depreciation expense
Taxpayers may also have to report AMT adjustments passed through on K-1's from their other activities (partnerships, trusts, or S-corporations).
Once all of these adjustments have been considered, the taxpayer arrives at their alternative minimum taxable income (AMTI). Taxpayers are allowed an exemption amount, which has been indexed for inflation thanks to acts by Congress at the end of 2012. This exemption amount is $51,900 S / $80,800 MFJ for 2013. The exemption amount is subtracted from AMTI, and the resulting amount is multiplied by either 26% or 28% depending on whether the amount is above or below $179,500 MFJ / $89,750 S. If income is above that amount, it is multiplied by 28%, and 26% if not.
Once the AMT is calculated, it is compared to the regular tax calculated on the taxpayer's Form 1040. This is where the AMT earns the name "alternative": once the taxpayer compares their AMT to their regular tax, the higher amount becomes their income tax.
Why?
Why does the AMT work? Because it attacks two types of tax situations and makes them less beneficial.
First, the AMT true's up the tax rate for taxpayers that have high incomes from sources that are not taxed at regular tax rates, such as long-term capital gains, qualified dividends, and tax-exempt interest. If a taxpayer has $10 million in AGI, but it consists completely of long-term capital gains and qualified dividends, their tax rate is only 15% (20% in 2013) as opposed to 35% (39.6% in 2013). The AMT would require this taxpayer to pay a higher rate due to their high income.
Second, the AMT penalizes taxpayers with certain higher-than-normal deductions. As mentioned above, one deduction added back for AMT purposes is state and local taxes from Schedule A. For a taxpayer living in an income tax state (a state that has their own income tax, such as Arkansas or Louisiana, but not Texas), a deduction is allowed on their Federal return for state tax payments made during the calendar year. The difference between paying the state 4th quarter estimated tax payment on Dec 31 instead of Jan 15 of the following year is that the payment will be allowed as a deduction Schedule A in the year of payment. However, making that payment before year-end will not matter if the taxpayer will be subject to AMT, because those amounts will be added back.
Can it be avoided?
Unfortunately, the AMT is a "do not pass go, do not collect $200" situation. One simple way to forego the calculation is for the taxpayer's income after itemized deductions to stay below the AMT exemption amounts. Also, if the majority of the taxpayer's income is taxed at regular rates, the AMT will not be a problem because the regular tax will most likely exceed the AMT. If a taxpayer, because of their types of income, will be subject to the AMT, they should try to avoid certain deductions (if possible) in order to minimize their AMTI. Simple planning maneuvers such as paying state taxes on Jan 15 of the following year and staggering the exercise of incentive stock options can minimize the amount of AMT adjustments in a given year. Taxpayers with depreciable property can elect depreciation methods that do not create large tax to AMT differences.
In all, taxpayers that are subject to the AMT can contact their tax preparer and run a projection before year-end to see what impact the AMT could have on their situation, and what measures can be taken now in order to minimize the AMT's impact.
Stay tuned for The not-so-Alternative Minimum Tax, Part 2, which will address the AMT as it pertains to businesses.