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Blog facts correction: Capital Gains Harvesting

The tax harvesting blog had an error that we’d like to correct.  The concept is still important to consider.  However we were comparing short term capital gain tax rates to long term capital gain tax rates.  

Long term capital gains tax rate is currently maxed at 15%.  It will go back to 20% in 2013 and is subject to the 3.8% investment surtax for higher income individuals (for a total of 23.8%).  

Short term capital gains are taxed at your ordinary income rate which is current maxed at 35%.  It will jump up to 39.6% if Congress doesn’t act.  When you ad the 3.8% investment surtax for higher income individuals, the total is 43.4%. 

Historically capital gains harvesting has been a strategy to use up large capital losses.  This year, it’s a strategy to pay federal capital gains tax at a lower rate (15%) rather than pay tax at the projected rate of 23.8%. If you sell the asset, thus harvesting the capital gain, you can turn around and purchase the asset again.  Now you have a higher basis so that when you sell it in the future, you are paying less tax. 

Here is the simplified example: 

Stock X purchased 1/1/2005  $      5,000 Stock X purchased 1/1/2008  $          5,000
Value on 11/30/12  $    75,000    
Projected value on 12/31/14  $  105,000 Projected value on 12/31/14  $     105,000
       
If sold on 11/30/12 and then repurchased:    
2012 capital gain  $    70,000    
Tax on capital gain  $    10,500    
New Stock X basis  $    75,000    
       
Then sold again on 12/31/14   Sold  on 12/31/14  
2014 capital gain  $    30,000 2014 capital gain  $     100,000
Projected tax on gain  $      7,140 Projected tax on gain  $       23,800
       
Total tax paid on investment  $    17,640 Total tax paid on investment  $       23,800
Total gain after taxes  $    82,360 Total gain after taxes  $       71,200

 Tax saved from harvesting capital gains is $11,160. 

This strategy is easily executed with publicly traded stock.  It’s a bit trickier with other assets.  However, if you have been trying to sell a capital asset with a large gain, it might be worth sitting down with your accountant to find out if the tax savings justify lowering the price to affect a sale in 2012. 

We used an extremely simplified example to help illustrate the concept.  However, investments are usually much more complicated.  As always, see your tax advisor for help in applying tax planning strategies to your tax plan. 

We apologize for the error.

All $250,000 taxpayers may be the Wrong Target…Too important for such a broad brush.

All $250,000 taxpayers will often be the wrong target if the goal is to rebuild the economy with private sector jobs.

I have served small and medium sized private companies for over 35 years. The proposed tax increase on those so called “wealthiest Americans” is one of those broad brush solutions that will turn out to be counter-productive.

We know that employment is driven primarily by small to medium size privately held companies.  This makes sense.  These are usually owned by someone who lives in the U.S., works in the U.S. and does business primarily in the U.S.  Simply put, most small businesses exist to create a job for their owners and employees.  Contrast this “business purpose” with the purpose of a public company.  Public companies strive to build shareholder value.  Ever increasing pressure to create earnings tends to push labor intensive processes overseas and eliminate jobs through automation.

A study of most business classes will indicate that profit margin (net profit) generally runs between 5% and 10% if the business is profitable.  This category called “small to medium” size will have revenues somewhere between $2 million and $200 million.

Most of these businesses report their income and pay their taxes on the owner’s tax return.  Most of these business owners will tend to take salaries in the low 6 figures….say between $100,000 and $300,000.  Now let’s say that a typical “expanding” business grosses $5 million and nets 5%.  That net is $250,000.  When you add that to the say, $200,000 in salary, you are right in the cross hairs of the president’s proposed tax increase.  What may not be understood is that the $250,000 in profit is not in the owner’s hands.  It is in the business.  These earnings pay for things like new equipment, additional employees, debt principal and owner draws for taxes which are not deductible. 

In the accounting business, we call the $250,000 in my example “pass through” income.  The taxable income is passed to the shareholder’s or partner’s tax return, but the cash generally, is not.  When you tax it, the money has to come out of the company’s working capital leaving fewer dollars for expansion, hiring new employees, etc.

Also, when this “pass through” income is added to the owner’s salary, it is taxed at the owner’s highest rate which will be higher than the corporate rate if the President’s proposal is accepted by Congress.  It should not be taxed at a higher rate than the large corporations pay.  To do so will further cripple our economy.

An Individual who makes $200,000 per year in salary or a couple that makes $250,000 without adding any jobs to the economy probably ought to pay more tax.  But a business that employs people should not be subject to the same level of tax.  Fairness is not at issue here.  Our struggling economy is the issue!  There should probably be some sort of exemption or maximum rate of tax (like the current treatment of capital gains) for business pass through income that will help stimulate job growth in the economy.

Tax Planning Strategy: Capital Gains Harvesting

This post is currently being updated for corrections, watch for the re-post.

Unusual Year for Tax Planning

Today is the day.  It’s VOTING day and likely one to go down in history as a game changer.  We have two very different options and two very different paths for our future.  I find it interesting how much social media has contributed to this election.  Almost everyone is talking about it and I feel it has increased the conversation that was lacking in prior years.  My generation (20-35 year olds) needs to step up, and I feel social media has helped start it.  When you see people talking about politics, it encourages you to pay attention and maybe even do some research.  I personally have done more research this year than all my prior voting years combined, and I for one think it’s a good thing.

 

Why am I talking about the elections? Because depending on who wins tonight (both president and congress) decides how we start guessing what the future holds… as far as taxes, that is.  Everyone agrees, our combined tax rates are at the lowest levels in recent history (some of you may remember the days when the top federal tax rate was 91%!).  It’s very likely that tax rates will increase, especially for the “wealthy”.  Usually tax planning involves finding ways to reduce the tax liability by deferring income and accelerating deductions.  It may not be the right choice this year.  Believe it or not, it may be a year to INCREASE the tax liability!  You read it right!  Pay more taxes.  Why?  Because you may be in a higher tax bracket next year and in future years.  This isn’t the right strategy for everyone.  Tax planning is complicated and should always involve your tax advisor.  We will start discussing possible strategies in the weeks to come that may be helpful to you when developing a tax plan with your tax advisor.

Don’t forget to vote!

Whistleblower gets a Payday

According to the National Whistleblowers Center, the Internal Revenue Service (IRS) has awarded former UBS banker Bradley Birkenfeld a whistleblower reward of $104 million which is believed to be the largest reward ever given to an individual whistleblower in the US.

The IRS is authorized to pay rewards from 15% to 30% of the collected proceeds if information provided by a whistleblower substantially contributes to the detection and recovery of taxes, penalties and interest. While the IRS was aware of the compliance issues and the illegal offshore banking scheme, it was Mr. Birkenfeld’s disclosures that “formed the basis for unprecedented actions against UBS” and resulted in a fine paid to the US by UBS bank for $780,000,000 (that’s a lot of zeros!). The IRS also launched the amnesty program for taxpayers to voluntarily disclose their offshore accounts which resulted in 35,000 taxpayers participating and paying over $5 billion in back taxes, fines and penalties.

Supreme Court Decision on Health Care Act

The Supreme Court upheld the individual mandate of the Affordable Health Care Act by a 5-4 vote.  (Read the decision here).  What is interesting is their conclusion and basis for such a vote.  Most of the arguments made were centered on the Commerce Clause yet the Supreme Court voted against the argument saying Congress has no authority over individuals who choose not to engage in commerce.  Commerce requires the activity of trade.  If you aren’t buying anything (in this case health insurance), then you are not engaging in commerce and therefore Congress has no power.  The ruling was based on Congress’ power to tax.  Now the Obama administration went through great efforts to stress the “fact” that the penalty for not buying insurance was NOT a tax, it was a penalty.  This is obviously for political reasons and the Court says you have to call it what it actually is, and that’s a tax.  What concerns me is what else can Congress tax me for not doing or buying?

At the end of the day, the Court probably wanted to stay out of the political game, as they are supposed to stay out of it.  Whether you are for the Act or against it, the Court is making a silent statement.  If you want to change the law, do it at the polls.  VOTE.

B is for Bad Debt (Business)

In some instances bad debts may be written off.  Here we’ll look at what factors must be present in order to take a deduction.

For Accrual Method Taxpayers:

When using the accrual accounting method, management estimates an allowance for bad debts based on several factors such as prior experience, industry comparisons, the debtor’s ability to pay and/or appraisals of current economic conditions.  This is known as the allowance method.  Keep in mind; this is an estimate of an event that has not yet occurred.  When it comes to tax, the IRS does not allow you to make this estimate.  As you can imagine, it would be abused as a “tax planning” strategy.  Therefore, for tax purposes, we can only deduct actual bad debts.  The following factors must exist in order to deduct a bad debt:

  1. It must be a creditor-debtor relationship
  2. There must be a legal obligation to pay a fixed sum of money
  3. There must be an actual loss of money (loss of time spent rendering services is not a loss of money unless the uncollected fee has already been included in taxable revenues on the accrual method)
  4. Proof that the debt is and will remain uncollectible
  5. A business purpose for the debt

When using the specific charge-off method to deduct bad debt (unlike the allowance method previously discussed), management has to prove that the debt is uncollectible to expense it.

Recovery of previously written off bad debts in subsequent years is recognized as other income in the year received.  As always, see your tax preparer when determining what your business can deduct for bad debt expense.

For Cash Method Taxpayers:

Cash basis businesses cannot deduct bad debt since the related revenue was never recognized.  There would only be bad debt for actual cash lost, i.e. because it was paid in cash to a vendor, etc.

This is Your Blog Too!!

I can’t believe this blog will celebrate its two year anniversary in April.  I think we should have a party!  Oh wait, we already do… it’s our “end of tax season” party.  We’ve had our ups and downs but I’m proud of us for sticking with it.  Our staff stays very busy and sometimes posting a blog is challenging.  Things got pretty quiet during my four months of maternity leave last year, but I’m back!  I know you are excited! 

We created this blog to help you; our readers, our clients, our friends.  We know you are bombarded with information.  Tax and accounting can sometimes be intimidating topics.  Our goal is to keep you informed so you can be better business owners, employees and asset managers.  You can help us by giving us your feedback and requests.  If you have a question related to a particular blog already posted, leave a comment.  You can always email us questions on requested topics.  There are no dumb questions.  I’d bet money that if you have a question, many others have the same one.

One of my personal goals this year is to ramp up the blog again.  I want it to be resource for our readers. 

So bring on the questions!

Year-End Tax Planning, Part 2

I previously compiled a list of year-end tax planning strategies for individuals.

Here is a list of year-end strategies for businesses and business owners:

1.   Businesses should consider making expenditures that qualify for the business property expensing option.

Code sec. 179 expense: For tax years beginning in 2010 and 2011, the expensing limit is $500,000 and the investment ceiling limit is $2,000,000, and a limited amount of expensing may be claimed for qualified real property. However, unless Congress changes the rules, for tax year beginning 2012, the dollar limit will drop to $125,000 and $500,000 (both indexed for inflation) respectively, and expensing won’t available for qualified real property. Keep in mind, Sec. 179 deductions are limited by net income, thus, they cannot be used to create a tax loss.

Bonus depreciation: Property that does not qualify for an immediate tax write off under the Sec. 179 may qualify for bonus depreciation. Unlike the Sec. 179 deduction, there are no restrictions on the amount of qualifying property and there is no taxable income limit. The deduction is 100% of the cost for qualified property purchased and placed in service during 2011. This first year write off won’t be available next year (2012) unless Congress acts to extend it.

2.   Businesses that hire qualifying workers (such as certain veterans) before the end of 2011 can claim a credit up to 40% of the first $6,000 in wages paid to each such employee.

3.   Make qualified research expenses before the end of 2011 to claim a research credit, which won’t be available for post 2011 expenditures unless Congress extends the credit.

4.   If you are self-employed and haven’t done so yet, set up a self-employed retirement plan.

5.   If you own an interest in a partnership or S corporation, and the business incurs a loss in 2011, you may need to plan ahead to be sure you can take advantage of that loss. These rules can be complicated,  and you should consult with your tax adviser.

6. Depending on your particular situation, you may also want to consider deferring a debt-cancellation event until 2012, and disposing of a passive activity to allow you to deduct suspended losses.

Again, we recommend that you always, see a professional when considering tax planning strategies for your situation. There are very important details underlying each of these strategies which must be thoroughly understood before you employ them!

The Dry Cleaner

One morning I stopped by my dry cleaners to drop off some clothes. There was a sign on the door thanking the loyal customers of so many years, and due to an equipment breakdown, same day service was no longer available.  Also, the prices were increased by about 40%. The reason I have been using this cleaner for the past 20 years is that he offered same day service.  The convenience of only having to remember “CLEANERS” one day a week made this dry cleaner very appealing to me.  He was also the cheapest cleaner in town.

One day I asked the owner what happened.  He told me that his equipment was very old and he had never been able to save enough money to replace it.  Now, with credit markets as tight as they are, he cannot get financing to purchase new equipment. 

There are valuable lessons here for business owners: 

It is critical that you know your competitive advantages and disadvantages, in the customers’ eyes.  This business owner thought that he had to have the lowest price to compete.  So he priced his service about 16% to 30% below the competition. He was the only cleaner that offered same day service without an extra “same day” charge.  Now, he no longer has either the price advantage or the service advantage; he is just like his competitors. 

I wonder how much business he would have lost if he raised his prices to a point midway between the competition’s regular price and their “same day” price?  Certainly, he would have lost the “bottom feeders”, but by observation, most of his business was “going out” or office work clothes and uniforms…..clothes people need every day for work.  I’ll bet he wouldn’t have lost much business at all.  You are talking about 50 to 75 cents per garment. 

Here are some lessons in this unfortunate story:

  1. Know your costs…..including the wasting cost of the assets used in your business.  Nothing lasts forever.  Manufacturers have data they are more than willing to share.  Also consider the obsolescence risk.  Due to the high cost of labor, most manufacturers are automating equipment to greater degrees to limit labor inputs.  Many business owners think of depreciation as something you do for taxes.  In reality, it is “a rational method of allocating the cost of an asset to the periods it is used in the business.”
  2. Know your customers.  Ask them why they like to do business with you.  They will tell you.  If my cleaner friend had asked me I would have told him that it was worth a premium to be able to pick up my cleaning the same day I dropped it off.  If most customers were like me, he could have earned more over the life of his business and been in a position to replace the equipment.  When he is ready to retire, he would have had a saleable business.  I’m not sure he has that anymore.  He’s just another dry cleaner now.
  3. Find differentiators other than price.  Someone else can always do what you do cheaper.  Find a unique value proposition you can offer your customers and set your price based on that value proposition.  Regularly review your cost of providing the goods or services you sell and make sure you protect your margins. Frequently we help our clients in this regard by illustrating “cost, volume profit analysis” at various price points with various volume assumptions.  It is much easier for a small business to achieve and retain profitability at low volume and high margins than attempting to ramp up volume and hold down prices.
  4. Always keep an eye on technology as applied to your business.  Don’t be afraid to adopt new technology if your due diligence indicates that it will improve your value proposition. 

Michael Gerber, author of the “E Myth” and several other best selling business books, has built an empire based on a simple concept:  An owner must work “on” his business, not “in” his business.  

We must all work smarter, not harder.  Working hard at the wrong thing frequently leads to exhaustion, burnout and failure.

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