The tax obligations if your business closes its doors

Sadly, many businesses have been forced to shut down recently due to the pandemic and the economy. If this is your situation, we can assist you, including taking care of the various tax responsibilities that must be met.

Of course, a business must file a final income tax return and some other related forms for the year it closes its doors. The type of return to be filed depends on the type of business you have. Here’s a rundown of the basic requirements.

Sole proprietorships. You’ll need to file the usual Schedule C, “Profit or Loss from Business,” with your individual return for the year you close the business. You may also need to report self-employment tax.

Partnerships. A partnership must file Form 1065, “U.S. Return of Partnership Income,” for the year it closes. You also must report capital gains and losses on Schedule D. Indicate that this is the final return and do the same on Schedule K-1, “Partner’s Share of Income, Deductions, Credits, etc.”

All corporations. Form 966, “Corporate Dissolution or Liquidation,” must be filed if you adopt a resolution or plan to dissolve a corporation or liquidate any of its stock.

C corporations. File Form 1120, “U.S. Corporation Income Tax Return,” for the year you close. Report capital gains and losses on Schedule D. Indicate this is the final return.

S corporations. File Form 1120-S, “U.S. Income Tax Return for an S Corporation,” for the year of closing. Report capital gains and losses on Schedule D. The “final return” box must be checked on Schedule K-1.

All businesses. Other forms may need to be filed to report sales of business property and asset acquisitions if you sell your business.

Employees and contract workers

If you have employees, you must pay them final wages and compensation owed, make final federal tax deposits and report employment taxes. Failure to withhold or deposit employee income, Social Security and Medicare taxes can result in full personal liability for what’s known as the Trust Fund Recovery Penalty.

If you’ve paid any contractors at least $600 during the calendar year in which you close your business, you must report those payments on Form 1099-NEC, “Nonemployee Compensation.”

Other tax issues

If your business has a retirement plan for employees, you’ll want to terminate the plan and distribute benefits to participants. There are detailed notice, funding, timing and filing requirements that must be met by a terminating plan. There are also complex requirements related to flexible spending accounts, Health Savings Accounts, and other programs for your employees.

We can assist you with many other complicated tax issues related to closing your business, including debt cancellation, use of net operating losses, freeing up any remaining passive activity losses, depreciation recapture, and possible bankruptcy issues.

We can advise you on the length of time you need to keep business records. You also must cancel your Employer Identification Number (EIN) and close your IRS business account.

If your business is unable to pay all the taxes it owes, we can explain the available payment options to you. Contact us to discuss these issues and get answers to any questions.

© 2022


Five tax implications of divorce

Are you in the early stages of divorce? In addition to the tough personal issues that you’re dealing with, several tax concerns need to be addressed to ensure that taxes are kept to a minimum and that important tax-related decisions are properly made. Here are five issues to consider if you’re in the process of getting a divorce.

  1. Alimony or support payments. For alimony under divorce or separation agreements that are executed after 2018, there’s no deduction for alimony and separation support payments for the spouse making them. And the alimony payments aren’t included in the gross income of the spouse receiving them. (The rules are different for divorce or separation agreements executed before 2019.)
  2. Child support. No matter when the divorce or separation instrument is executed, child support payments aren’t deductible by the paying spouse (or taxable to the recipient).
  3. Personal residence. In general, if a married couple sells their home in connection with a divorce or legal separation, they should be able to avoid tax on up to $500,000 of gain (as long as they’ve owned and used the residence as their principal residence for two of the previous five years). If one spouse continues to live in the home and the other moves out (but they both remain owners of the home), they may still be able to avoid gain on the future sale of the home (up to $250,000 each), but special language may have to be included in the divorce decree or separation agreement to protect this tax exclusion for the spouse who moves out.
    If the couple doesn’t meet the two-year ownership and use tests, any gain from the sale may qualify for a reduced exclusion due to unforeseen circumstances.
  4. Pension benefits. A spouse’s pension benefits are often part of a divorce property settlement. In these cases, the commonly preferred method to handle the benefits is to get a “qualified domestic relations order” (QDRO). This gives one spouse the right to share in the pension benefits of the other and taxes the spouse who receives the benefits. Without a QDRO the spouse who earned the benefits will still be taxed on them even though they’re paid out to the other spouse.
  5. Business interests. If certain types of business interests are transferred in connection with divorce, care should be taken to make sure “tax attributes” aren’t forfeited. For example, interests in S corporations may result in “suspended” losses (losses that are carried into future years instead of being deducted in the year they’re incurred). When these interests change hands in a divorce, the suspended losses may be forfeited. If a partnership interest is transferred, a variety of more complex issues may arise involving partners’ shares of partnership debt, capital accounts, built-in gains on contributed property, and other complex issues.

A variety of other issues

These are just some of the issues you may have to deal with if you’re getting a divorce. In addition, you must decide how to file your tax return (single, married filing jointly, married filing separately or head of household). You may need to adjust your income tax withholding and you should notify the IRS of any new address or name change. There are also estate planning considerations. We can help you work through all of the financial issues involved in divorce.

© 2022


The kiddie tax: Does it affect your family?

Many people wonder how they can save taxes by transferring assets into their children’s names. This tax strategy is called income shifting. It seeks to take income out of your higher tax bracket and place it in the lower tax brackets of your children.

While some tax savings are available through this approach, the “kiddie tax” rules impose substantial limitations if:

  1. The child hasn’t reached age 18 before the close of the tax year, or
  2. The child’s earned income doesn’t exceed half of his or her support and the child is age 18 or is a full-time student age 19 to 23.

The kiddie tax rules apply to your children who are under the cutoff age(s) described above, and who have more than a certain amount of unearned (investment) income for the tax year — $2,300 for 2022. While some tax savings on up to this amount can still be achieved by shifting income to children under the cutoff age, the savings aren’t substantial.

If the kiddie tax rules apply to your children and they have over the prescribed amount of unearned income for the tax year ($2,300 for 2022), they’ll be taxed on that excess amount at your (the parents’) tax rates if your rates are higher than the children’s tax rates. This kiddie tax is calculated by computing the “allocable parental tax” and special allocation rules apply if the parents have more than one child subject to the kiddie tax.

Note: Different rules applied for the 2018 and 2019 tax years, when the kiddie tax was computed based on the estates’ and trusts’ ordinary and capital gain rates, instead of the parents’ tax rates.

Be aware that, to transfer income to a child, you must transfer ownership of the asset producing the income. You can’t merely transfer the income itself. Property can be transferred to minor children using custodial accounts under state law.

Possible saving vehicles

The portion of investment income of a child that’s taxed under the kiddie tax rules may be reduced or eliminated if the child invests in vehicles that produce little or no current taxable income. These include:

  • Securities and mutual funds oriented toward capital growth;
  • Vacant land expected to appreciate in value;
  • Stock in a closely held family business, expected to become more valuable as the business expands, but pays little or no cash dividends;
  • Tax-exempt municipal bonds and bond funds;
  • U.S. Series EE bonds, for which recognition of income can be deferred until the bonds mature, the bonds are cashed in or an election to recognize income annually is made.

Investments that produce no taxable income — and which therefore aren’t subject to the kiddie tax — also include tax-advantaged savings vehicles such as:

  • Traditional and Roth IRAs, which can be established or contributed to if the child has earned income;
  • Qualified tuition programs (also known as “529 plans”); and
  • Coverdell education savings accounts.

A child’s earned income (as opposed to investment income) is taxed at the child’s regular tax rates, regardless of the amount. Therefore, to save taxes within the family, consider employing the child at your own business and paying reasonable compensation.

If the kiddie tax applies, it’s computed and reported on Form 8615, which is attached to the child’s tax return.

Two reporting options

Parents can elect to include the child’s income on their own return if certain requirements are satisfied. This is done on Form 8814 and avoids the need for a separate return for the child. Contact us if you have questions about the kiddie tax.

© 2022


When inheriting money, be aware of “income in respect of a decedent” issues

Once a relatively obscure concept, “income in respect of a decedent” (IRD) may create a surprising tax bill for those who inherit certain types of property, such as IRAs or other retirement plans. Fortunately, there may be ways to minimize or even eliminate the IRD tax bite.

Basic rules

For the most part, property you inherit isn’t included in your income for tax purposes. Items that are IRD, however, do have to be included in your income, although you may also be entitled to an IRD deduction on account of them.

What’s IRD? It is income that the decedent (the person from whom you inherit the property) would have taken into income on his or her final income tax return except that death interceded. One common IRD item is the decedent’s last paycheck, received after death. It would have normally been included in the decedent’s income on the final income tax return. However, since the decedent’s tax year closed as of the date of death, it wasn’t included. As an item of IRD, it’s taxed as income to whomever does receive it (the estate or another individual). Not just the final paycheck, but any compensation-related benefits paid after death, such as accrued vacation pay or voluntary employer benefit payments, will be IRD to the recipient.

Other common IRD items include pension benefits and amounts in a decedent’s individual retirement accounts (IRAs) at death as well as a decedent’s share of partnership income up to the date of death. If you receive these IRD items, they’re included in your income.

The IRD deduction

Although IRD must be included in the income of the recipient, a deduction may come along with it. The deduction is allowed (as an itemized deduction) to lessen the “double tax” impact that’s caused by having the IRD items subject to the decedent’s estate tax as well as the recipient’s income tax.

To calculate the IRD deduction, the decedent’s executor may have to be contacted for information. The deduction is determined as follows:

  • First, you must take the “net value” of all IRD items included in the decedent’s estate. The net value is the total value of the IRD items in the estate, reduced by any deductions in respect of the decedent. These are items which are the converse of IRD: items the decedent would have deducted on the final income tax return, but for death’s intervening.
  • Next you determine how much of the federal estate tax was due to this net IRD by calculating what the estate tax bill would have been without it. Your deduction is then the percentage of the tax that your portion of the IRD items represents.

In the following example, the top estate tax rate of 40% is used. Example: At Tom’s death, $50,000 of IRD items were included in his gross estate, $10,000 of which were paid to Alex. There were also $3,000 of deductions in respect of a decedent, for a net value of $47,000. Had the estate been $47,000 less, the estate tax bill would have been $18,800 less. Alex will include in income the $10,000 of IRD received. If Alex itemizes deductions, Alex may also deduct $3,760, which is 20% (10,000/50,000) of $18,800.

We can help

If you inherit property that could be considered IRD, consult with us for assistance in managing the tax consequences.

© 2022


Getting a divorce? Be aware of tax implications if you own a business

If you’re a business owner and you’re getting a divorce, tax issues can complicate matters. Your business ownership interest is one of your biggest personal assets and in many cases, your marital property will include all or part of it.

Tax-free property transfers

You can generally divide most assets, including cash and business ownership interests, between you and your soon-to-be ex-spouse without any federal income or gift tax consequences. When an asset falls under this tax-free transfer rule, the spouse who receives the asset takes over its existing tax basis (for tax gain or loss purposes) and its existing holding period (for short-term or long-term holding period purposes).

Let’s say that under the terms of your divorce agreement, you give your house to your spouse in exchange for keeping 100% of the stock in your business. That asset swap would be tax-free. And the existing basis and holding periods for the home and the stock would carry over to the person who receives them.

Tax-free transfers can occur before a divorce or at the time it becomes final. Tax-free treatment also applies to post-divorce transfers as long as they’re made “incident to divorce.” This means transfers that occur within:

  1. A year after the date the marriage ends, or
  2. Six years after the date the marriage ends if the transfers are made pursuant to your divorce agreement.

More tax issues

Later on, there will be tax implications for assets received tax-free in a divorce settlement. The ex-spouse who winds up owning an appreciated asset — when the fair market value exceeds the tax basis — generally must recognize taxable gain when it’s sold (unless an exception applies).

What if your ex-spouse receives 49% of your highly appreciated small business stock? Thanks to the tax-free transfer rule, there’s no tax impact when the shares are transferred. Your ex will continue to apply the same tax rules as if you had continued to own the shares, including carryover basis and carryover holding period. When your ex-spouse ultimately sells the shares, he or she will owe any capital gains taxes. You will owe nothing.

Note that the person who winds up owning appreciated assets must pay the built-in tax liability that comes with them. From a net-of-tax perspective, appreciated assets are worth less than an equal amount of cash or other assets that haven’t appreciated. That’s why you should always take taxes into account when negotiating your divorce agreement.

In addition, the beneficial tax-free transfer rule is now extended to ordinary-income assets, not just to capital-gains assets. For example, if you transfer business receivables or inventory to your ex-spouse in a divorce, these types of ordinary-income assets can also be transferred tax-free. When the asset is later sold, converted to cash or exercised (in the case of nonqualified stock options), the person who owns the asset at that time must recognize the income and pay the tax liability.

Plan ahead to avoid surprises

Like many major life events, divorce can have major tax implications. For example, you may receive an unexpected tax bill if you don’t carefully handle the splitting up of qualified retirement plan accounts (such as a 401(k) plan) and IRAs. And if you own a business, the stakes are higher. We can help you minimize the adverse tax consequences of settling your divorce.


Can you deduct charitable gifts on your tax return?

Many taxpayers make charitable gifts — because they’re generous
and they want to save money on their federal tax bills. But with the tax law
changes that went into effect a couple years ago and the many rules that apply
to charitable deductions, you may no longer get a tax break for your generosity.

Are you going to itemize?

The Tax Cuts and Jobs Act (TCJA), signed into law in 2017,
didn’t put new limits on or suspend the charitable deduction, like it did with
many other itemized deductions. Nevertheless, it reduces or eliminates the tax
benefits of charitable giving for many taxpayers.

Itemizing saves tax only if itemized deductions exceed the
standard deduction. Through 2025, the TCJA significantly increases the standard
deduction. For 2020, it is $24,800 for married couples filing jointly (up from
$24,400 for 2019), $18,650 for heads of households (up from $18,350 for 2019),
and $12,400 for singles and married couples filing separately (up from $12,200
for 2019).

Back in 2017, these amounts were $12,700, $9,350, $6,350
respectively. The much higher standard deduction combined with limits or
suspensions on some common itemized deductions means you may no longer have
enough itemized deductions to exceed the standard deduction. And if that’s the
case, your charitable donations won’t save you tax.

To find out if you get a tax break for your generosity, add up
potential itemized deductions for the year. If the total is less than your
standard deduction, your charitable donations won’t provide a tax benefit.

You might, however, be able to preserve your charitable
deduction by “bunching” donations into alternating years. This can allow you to
exceed the standard deduction and claim a charitable deduction (and other
itemized deductions) every other year.

What is the donation deadline?

To be deductible on your 2019 return, a charitable gift must
have been made by December 31, 2019. According to the IRS, a donation generally
is “made” at the time of its “unconditional delivery.” The delivery date
depends in part on what you donate and how you donate it. For example, for a
check, the delivery date is the date you mailed it. For a credit card donation,
it’s the date you make the charge.

Are there other requirements?

If you do meet the rules for itemizing, there are still other
requirements. To be deductible, a donation must be made to a “qualified
charity” — one that’s eligible to receive tax-deductible contributions.

And there are substantiation rules to prove you made a
charitable gift. For a contribution of cash, check, or other monetary gift,
regardless of amount, you must maintain a bank record or a written
communication from the organization you donated to that shows its name, plus
the date and amount of the contribution. If you make a charitable contribution
by text message, a bill from your cell provider containing the required
information is an acceptable substantiation. Any other type of written record,
such as a log of contributions, isn’t sufficient.

Do you have questions?

We can answer any questions you may have about the deductibility
of charitable gifts or changes to the standard deduction and itemized
deductions.

© 2020


Cents-per-mile rate for business miles decreases slightly for 2020

This year, the optional standard mileage rate used to calculate
the deductible costs of operating an automobile for business decreased by
one-half cent, to 57.5 cents per mile. As a result, you might claim a lower
deduction for vehicle-related expense for 2020 than you can for 2019.

Calculating your deduction

Businesses can generally deduct the actual expenses attributable
to business use of vehicles. This includes gas, oil, tires, insurance, repairs,
licenses and vehicle registration fees. In addition, you can claim a
depreciation allowance for the vehicle. However, in many cases depreciation
write-offs on vehicles are subject to certain limits that don’t apply to other
types of business assets.

The cents-per-mile rate comes into play if you don’t want to
keep track of actual
vehicle-related expenses. With this approach, you don’t have to account for all
your actual expenses, although you still must record certain information, such
as the mileage for each business trip, the date and the destination.

Using the mileage rate is also popular with businesses that
reimburse employees for business use of their personal vehicles. Such
reimbursements can help attract and retain employees who drive their personal
vehicles extensively for business purposes. Why? Under the Tax Cuts and Jobs
Act, employees can no longer deduct unreimbursed employee business expenses,
such as business mileage, on their own income tax returns.

If you do use the cents-per-mile rate, be aware that you must
comply with various rules. If you don’t, the reimbursements could be considered
taxable wages to the employees.

The rate for 2020

Beginning on January 1, 2020, the standard mileage rate for the
business use of a car (van, pickup or panel truck) is 57.5 cents per mile. It
was 58 cents for 2019 and 54.5 cents for 2018.

The business cents-per-mile rate is adjusted annually. It’s
based on an annual study commissioned by the IRS about the fixed and variable
costs of operating a vehicle, such as gas, maintenance, repair and depreciation.
Occasionally, if there’s a substantial change in average gas prices, the IRS
will change the mileage rate midyear.

Factors to consider

There are some situations when you can’t use the cents-per-mile
rate. In some cases, it partly depends on how you’ve claimed deductions for the
same vehicle in the past. In other cases, it depends on if the vehicle is new
to your business this year or whether you want to take advantage of certain
first-year depreciation tax breaks on it.

As you can see, there are many factors to consider in deciding
whether to use the mileage rate to deduct vehicle expenses. We can help if you
have questions about tracking and claiming such expenses in 2020 — or claiming
them on your 2019 income tax return.

© 2019


4 new law changes that may affect your retirement plan

If you save for retirement with an IRA or other plan, you’ll be
interested to know that Congress recently passed a law that makes significant
modifications to these accounts. The SECURE Act, which was signed into law on
December 20, 2019, made these four changes.

Change #1: The maximum age for making
traditional IRA contributions is repealed.
Before 2020,
traditional IRA contributions weren’t allowed once you reached age 70½.
Starting in 2020, an individual of any age can make contributions to a
traditional IRA, as long he or she has compensation, which generally means
earned income from wages or self-employment.

Change #2: The required minimum distribution
(RMD) age was raised from 70½ to 72.
Before 2020, retirement
plan participants and IRA owners were generally required to begin taking RMDs
from their plans by April 1 of the year following the year they reached age
70½. The age 70½ requirement was first applied in the early 1960s and, until
recently, hadn’t been adjusted to account for increased life expectancies.

For distributions required to be made after December 31, 2019,
for individuals who attain age 70½ after that date, the age at which
individuals must begin taking distributions from their retirement plans or IRAs
is increased from 70½ to 72.

Change #3: “Stretch IRAs” were partially
eliminated.
If a plan participant or IRA owner died before 2020, their
beneficiaries (spouses and non-spouses) were generally allowed to stretch out
the tax-deferral advantages of the plan or IRA by taking distributions over the
beneficiary’s life or life expectancy. This is sometimes called a “stretch
IRA.”

However, for deaths of plan participants or IRA owners beginning
in 2020 (later for some participants in collectively bargained plans and
governmental plans), distributions to most non-spouse beneficiaries are
generally required to be distributed within 10 years following a plan
participant’s or IRA owner’s death. That means the “stretch” strategy is no
longer allowed for those beneficiaries.

There are some exceptions to the 10-year rule. For example, it’s
still allowed for: the surviving spouse of a plan participant or IRA owner; a
child of a plan participant or IRA owner who hasn’t reached the age of
majority; a chronically ill individual; and any other individual who isn’t more
than 10 years younger than a plan participant or IRA owner. Those beneficiaries
who qualify under this exception may generally still take their distributions
over their life expectancies.

Change #4: Penalty-free withdrawals are now
allowed for birth or adoption expenses.
A distribution from a
retirement plan must generally be included in income. And, unless an exception
applies, a distribution before the age of 59½ is subject to a 10% early
withdrawal penalty on the amount includible in income.

Starting in 2020, plan distributions (up to $5,000) that are
used to pay for expenses related to the birth or adoption of a child are
penalty-free. The $5,000 amount applies on an individual basis. Therefore, each
spouse in a married couple may receive a penalty-free distribution up to $5,000
for a qualified birth or adoption.

Questions?

These are only some of the changes included in the new law. If
you have questions about your situation, don’t hesitate to contact us.

© 2020


TCJA Tax Strategies 2: Capital Gains – accessing the 0% and 15% capital gain rates and tax planning for capital transactions.

Often clients inquire with our office with questions like “What is my capital gains rate?” or “How much will I be taxed on a sale of <insert asset here> in 2019?”

While it is important to understand the amount of tax to be paid on any given transaction, it is even more important to understand the new opportunities afforded to those with capital transactions under the Tax Cuts and Jobs Act. The TCJA significantly expanded the 0% and 15% capital gain rate brackets. By pushing the 20% capital gain rate into higher territory – taxpayers with higher income can access the more favorable rates on their capital sale transactions. By expanding the 15% capital gain rate bracket more gain can also be fit into those brackets allowing for more gains to be taxed at lower rates. Based on historical tax rates and brackets, it’s a pretty great deal.

Capital Gains in General

When considering capital gains, you must first separate your short and long-term gains. Long-term, for these purposes, means gains or losses from investments you held for more than a year. Gains and losses from investments held for one year or less are short-term. Once you isolate your long and short term gains, you must separate your long-term gains and losses into three rate groups:

  • the 28% group, consisting of:
    1. capital gains and losses from collectibles (including works of art, rugs, antiques, metals, gems, stamps, coins, and alcoholic beverages) held for more than one year;
    2. long-term capital loss carryovers; and
    3. section 1202 gain (gain from the sale of certain small business stock held for more than five years that's eligible for a 50% exclusion from gross income).
  • the 25% group, consisting of “unrecaptured section 1250 gain”—that is, gain on the sale of depreciable real property that's attributable to the depreciation of that property (there are no losses in this group); and
  • the 20%/15%/0% group, consisting of long-term capital gains and losses that aren't in the 28% or 25% group—that is, most gains and losses from assets held for more than one year.

While the 28% and 25% rate groups are relevant for many taxpayers, the majority of capital transactions still fall into category #3. As such, this article will focus on planning opportunities for most standard capital transactions.

Once you arrive at a net gain or loss from the three long-term categories above, you must net and apply short term and long term losses to the above:

  • Short-term capital losses (including short-term capital loss carryovers) are applied first to reduce short-term capital gains, if any, otherwise taxable at ordinary rates. If you have a net short-term capital loss, it reduces any net long-term gain from the 28% group, then gain from the 25% group, and finally reduces net gain from the 20%/15%/0% group.
  • Long-term capital gains and losses are handled as follows. A net loss from the 28% group (including long-term capital loss carryovers) is used first to reduce gain from the 25% group, then to reduce net gain from the 20%/15%/0% group. A net loss from the 20%/15%/0% group is used first to reduce gain from the 28% group, then to reduce gain from the 25% group.

If, after the above netting, you have any long-term capital gain, the gain that's attributable to a particular rate group is taxed at that group's marginal tax rate—28% for the 28% group, 25% for the 25% group, and the following rates for the 20%/15%/0% group:

0%

For 2019, the 0% capital gains tax rate applies to adjusted net capital gain of up to:

  • $78,750 for joint filers and surviving spouses;
  • $52,750 for heads of household;
  • $39,375 for single filers; and,
  • $39,375 for married taxpayers filing separately.

15%

For 2019, the 15% tax rate applies to adjusted net capital gain over the amount subject to the 0% rate, and up to:

  • $488,850 for joint filers and surviving spouses;
  • $244,425 for married taxpayers filing separately;
  • $461,700 for heads of household; and,
  • $434,550 for single filers.; i.e., for 2018, the 15% tax rate applies to adjusted net capital gain over the amount subject to the 0% rate, and up to: $479,000 for joint filers and surviving spouses; $239,500 for married taxpayers filing separately; $452,400 for heads of household; and, $425,800 for single filers);

20%

Gain that otherwise would be taxed in excess of the amount taxed under the 0% and 15%

A 3.8% tax on net investment income applies to taxpayers with modified adjusted gross income (MAGI) that exceeds $250,000 for joint returns and surviving spouses, $200,000 for single taxpayers and heads of household, or $125,000 for married taxpayers filing separately. After the 3.8% tax is factored in, the top rate on capital gain is 23.8%.

If, after the above netting, you're left with short-term losses or long-term losses (or both), you can use the losses to offset ordinary income, subject to a limit. The maximum annual deduction against ordinary income for the year is $3,000 ($1,500 for married taxpayers filing separately). Any loss not absorbed by the deduction in the current year is carried forward to later years, until all of it is either offset against capital gains or deducted against ordinary income in those years, subject to the $3,000 limit. If you have both net short-term losses and net long-term losses, the net short-term losses are used to offset ordinary income before the net long-term losses are used.

Planning for the 0% and 15% capital gain rate

The first thing to remember is that the 0% and 15% rate brackets apply to LONG-TERM gains only (see above for definition of long-term gains). So make sure when you’re analyzing a transaction that you know the holding period of the asset in question. The holding period starts (usually) when you acquire the asset – the simplest way to think about it is a stock purchase; the holding period begins when you buy the stock. Long-term gains (and reduced rates) are for assets with a holding period of one year or more.

The second important thing to understand is the interaction of your ordinary income and capital income – meaning, how do we actually “access” the preferential rates?

Let’s do an example. Say you know that you’re a Married Filing Joint filer. Say that you also know that you have ordinary income from wages of about $250,000 between you and your spouse. Say you take the standard deduction and have no other adjustments or deductions. Lastly, say you’re planning to sell some company stock that you were awarded a few years ago that has appreciated significantly. How do you know when to sell it and how to you access those beneficial lower tax rates??

For purposes of this example, we’ll say that you have about 10,000 shares of company stock in Startup Co (your employer). You were awarded this stock about 3 years ago when the stock price was $1. The company has done well and the stock is currently trading at $31 per share.

Your basis (investment) in the stock is $10,000 (10,000 shares times the $1 FMV at time of award).

In a potential sale, you have proceeds of $310,000 - if you sell all of the stock.

The potential gain is $310,000 (proceeds) minus $10,000 (basis) = $300,000 of long-term capital gain.

Here’s a rough summary of how you would do the calculation (for simplicity we used the 2018 brackets):

Taxable Income (before gains): Wages $250,000 less standard deduction of $24,000 equals $226,000

Dividends: $0

Capital Gains: $300,000

Taxable income exceeds the 0% rate bracket for joint filers ($77,200 for 2018) before considering capital gains so none of the gains are taxed at 0%.

Since the 15% capital gain rate bracket is available until $479,000 then $253,000 of capital gain income can be taxed at 15%. How does that work? Simply subtract your other taxable income (per above) of $226,000 from the full rate bracket of $479,000. The difference is how much “room” is left in the 15% capital gain rate bracket.

So $253,000 of gains can be taxed at 15%.

The remaining gain of $47,000 ($300K total gain less $253K gain taxed at 15%) is taxed at 20%.

How can we do better?

One of the simplest planning methods is to split the gain into two years. How does this work?

If you sell half the stock in Year 1 – you will have only $150K of gain. This gain will not make it all the way to the 20% rate bracket and the entire gain will be taxed at 15%.

If you sell the other half of the stock in Year 2 – you will get to have another run at the 15% rate bracket. With only $150K of gains (assuming all other income is about the same), you’ll stay within the 15% rate bracket in year two.

The difference?

With planning: You pay $45,000 in capital gains taxes (not considering the NIIT) on your sale.

Without planning: You pay $47,350 in capital gains taxes (not considering the NIIT) on your sale.

Savings: $2,350

This example is minor and involves a modest amount of gain. However, the bigger the gain, the bigger the stakes. Splitting gain over multiple years is a tried and true method. Other planning options include netting and harvesting losses and structuring sales to coincide with other income and loss events. More advanced strategies like the 1031 exchange or qualified opportunity zone funds can also be considered. If you’re selling your primary residence, don’t forget about the primary residence gain exclusion.

Dividends taxed at long-term capital gains rates

Dividends that you receive from domestic corporations and “qualified foreign corporations” are taxed at the same rates that apply to the 20%/15%/0% group mentioned above. However, these dividends aren't actually part of that group, and aren't subject to the grouping and netting rules discussed above. The 3.8% tax on net investment income applies to dividends. With dividends, proper planning can also help keeping those taxed at the 0% or 15% rate. Some planning actions may be to consider the timing of capital transactions and dividend transactions.

Some other planning suggestions. Since losses can only be used against gains (or up to $3,000 additionally), in many cases, matching up gains and losses can save you taxes. For example, suppose you've already realized $20,000 in capital gains this year and are holding investments on which you've lost $20,000. If you sell the loss items before the end of the year, they will “absorb” the gains completely. If you wait to sell the loss items next year, you'll be fully taxed on this year's gains and will only be able to deduct $3,000 of your losses (if you have no other gains next year against which to net the losses).

Another technique is to seek to “isolate” short-term gains against long-term losses. For example, say you have $10,000 in short-term gains in Year 1 and $10,000 in long-term losses as well. You're in the highest tax bracket in all relevant years (assume that's a 37% bracket for Year 1). Your other investments have been held more than one year and have gone up $10,000 in value, but you haven't sold them. If you sell them in Year 1, they will be netted against the long-term losses and leave you short-term gains to be taxed at 37%. Alternatively, if you can hold off and sell them in Year 2 (assuming no other Year 2 transactions), the losses will “absorb” the short-term gains in Year 1. In Year 2, the long-term gains will then be taxed at only 20% (unless the gains belong in the 25% or 28% group).

Alternative minimum tax. The favorable rates that apply to long-term capital gain (and qualified dividend income) for regular tax purposes also apply for alternative minimum tax (AMT) purposes. In spite of this, any long-term capital gains you recognize in a year might trigger an AMT liability. This can happen if the capital gains increase your total income enough so that your AMT exemption phases out. The extra income from capital gains may also affect your entitlement to various exemptions, deductions, and credits, and the amounts of those AMT preferences and adjustments, that depend on the amount of your income.

Want to learn more about planning for capital transactions and accessing the preferential rates? Please contact us by submitting the form on our site or give us a call at 617 651 0531.