Tax uncertainty

guest commentary by David Potts

You’ve got one month left to arrange your affairs, at least to arrange your affairs to save yourself money by lowering your 2010 income taxes.

Most people are aware that income tax rates are scheduled to increase in 2011. Usually it is a standard and recurring year-end tax planning maneuver to defer your income and to accelerate your deductions to lower your current year income taxes. But should you defer your income into a year where income tax rates will be higher? But then again, will the rates really be higher? Based on the election results earlier this month and based on statements by President Obama and some members of Congress, you might expect to see the “Bush” tax cuts extended.

As 2010 ends, our government has imposed great uncertainty related to whether the current low tax rates will be extended past 2010. It is certain unless Congress intervenes, income tax rates will increase, with the long-term capital gains rate increasing a bit more than ordinary income tax rates.

Since 1921, long-term capital gains have been taxed at lower rates than other types of income. The tax rates applied to long-term capital gains have gone up, down, and sideways during the last 89 years, and the definition of what is long-term has been changed several times, but long-term capital gains have generally been treated differently than “ordinary” income.

Currently, at least until Dec. 31, 2010, “net” long-term capital gains for non-corporate taxpayers are taxed at a maximum rate of 15% and for non-corporate taxpayers in the 10% and 15% tax brackets for their ordinary income, the long-term capital gains rate is 0%, nada. And although not technically a capital gain, qualified dividends have been taxed at the lower long-term capital gains rates since 2003. After Dec. 31, 2010, (again, unless Congress intervenes) the income tax rates on long-term capital gains will increase and qualified dividends will no longer be treated as long-term capital gains but taxed as ordinary income.

Long-term capital gains previously taxed at the 15% rate will be taxed at 20% and long-term capital gains previously taxed at 0% will be taxed at 10% (18% and 8%, respectively, for assets held for longer than five years.) For qualified dividends, the tax increase is over 100% for those taxpayers in the highest tax bracket. For these taxpayers, qualified dividends taxed at a maximum capital gains rate of 15% in 2010 will be taxed at the new maximum ordinary income tax rate of 39.6% in 2011.

If you aren’t familiar with how capital gains are taxed, here is a quick overview. A capital gain is created when you sell a capital asset where the sales price exceeds the asset’s basis. In most cases, the asset’s basis is its cost. The Internal Revenue Code defines a capital asset not by what it is, but by what it is not. It’s not always simple to determine what is and isn’t a capital asset. However, for our discussion and for simplicity’s sake (relatively speaking), keep in mind the great majority of capital gains are created when you sell stocks and bonds or real estate for more than you paid.

A long-term capital gain is differentiated from a short-term capital gain and is defined as an asset that is held by the taxpayer by more than one year (at least a year plus one day). In order to determine if you have a “net” long-term capital gain with a preferentially low tax rate, you have to do some grouping, some netting.

I’ve been talking as if there were only capital gains, but over the last couple of years many taxpayers have become real familiar with capital losses. To determine if you have a net long-term capital gain, you first net short-term capital losses against short-term capital gains. If there is a net short-term capital loss, this loss must reduce any net long-term capital gain. If there is a short-term capital gain, it is taxed at ordinary income tax rates. Long-term capital losses must be netted long-term capital gains.

If after all this netting you end up with a net long-term capital gain, the lower capital gain tax rate is applied to the “net” long-term capital gain. On the downside, if you end up with a net capital loss, this loss is limited to $3,000 each year. But any capital loss not used because of this limitation can be carried forward indefinitely to future years.

Being a CPA, I have to interrupt the flow of our discussion to issue a short disclaimer. This discussion is limited and general in nature and won’t cover a lot of information that can affect your income tax liability. For example, art and antiques are treated differently and have a top tax rate of 28% and depreciated property can have a tax rate of 25%. Also, taxation of capital gains for corporations is entirely different than for individuals. If you are a do-it-yourselfer and want to learn all the rules, let me refer you to IRS Publication 544 Sales and Other Disposition of Assets.

Back to the task at hand. How do you cope with this year’s increased uncertainty?

In my opinion, the tax consequences of a transaction should never be the primary driving force as to whether or not to sell an asset. First you should ask what is the investment potential of the asset. Only after you have analyzed the future investment potential of an asset and determined the asset should be sold do you consider the timing or the structure of the sale to maximize the asset’s after tax return. Just keep in mind that a 3% to 10% tax increase on a long-term capital gain isn’t chicken feed. You should analyze the tax consequences of any potential asset sale to choose when and how the asset should be sold.

Keep in mind that income taxes are always uncertain. This year they are just more uncertain than usual. When President Obama talks about making the current tax rates permanent for taxpayers with income under $200,000, ask yourself what his definition of permanent is. Two more years? Six? Ever since I have been alive, presidents and politicians have tinkered with the income tax laws. It is one way they have to pay their political debts. One thing is certain; our tax laws are not and will not ever be permanent. So if you apply effort and thought to your 2010 tax situation you can still save yourself money in spite of this uncertainty.

So if you have capital gains or losses or potential capital gains or losses this year, take time to schedule a meeting to discuss your particular tax situation with your tax advisor. If you wait until after Dec. 31, its history; any potential to save income taxes requires action before then.  A good CPA will help you decide if it is appropriate to sell certain assets now or wait until next year.

Also, review your investments with your investment advisor. It might be wise to convert any unrealized gains or losses in your portfolio to realized status.

Finally, one situation I feel has the greatest potential for the tax consequences to affect a business decision is related to qualified dividends, where the maximum tax rate could increase from 15% in 2010 to 39.6% in 2011. If you are a stockholder in a C corporation with substantial retained earnings and you can influence the timing of when dividends are to be distributed, you should analyze the benefit of distributing qualified dividends before Dec. 31, 2010, especially if the end of your corporation is within sight.

About Potts
David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow more of his thoughts at ThePottsReport.com. Although every effort is made to provide you accurate and timely tax information, it is general in nature and not specific to your facts and circumstances. Consult a qualified tax professional to discuss your particular case.

Also, feel free to e-mail topic suggestions or questions to [email protected]