The acceleration of income for tax purposes has not traditionally been a top-shelf strategy because of the simple fact that the delay of taxable income means the postponement of tax into a subsequent year, which is usually a good thing based upon time-value-of-money principles. The same reasoning applies to postponing deductions.
With the current uncertainties over the tax laws in 2013, however, some taxpayers are trading in the time-value-of-money principle in favor of a bird-in-hand. Rising income tax and capital gains rates, as well as new "Medicare taxes" for 2013, are persuading more advisors to take a closer look at techniques to accelerate income into 2012.
The tax law itself sometimes puts restrictions on the recognition of income. At other times, certain facts and circumstances must be present to have a transaction considered complete and income recognized in the current year. Broadly speaking, however, taxpayers who anticipate a higher income tax rate after 2012 should explore shifting income into 2012 and pushing deductions into 2013 and beyond.
MEASURING TYPES OF INCOME
A taxpayer can have net losses and still have taxable income. This apparent contradiction arises from the fact that not all income is treated equally. Certain types of losses can only be netted against certain income, so delay tactics in moving a deduction into the subsequent year may not increase income at all if the deduction is allowed only against certain income. The most common losses in these categories are capital losses and passive activity losses. A third type, investment income expenses, also becomes relevant in 2013 in figuring the new 3.8 percent Medicare surtax on net investment income.
• Capital gains and losses. Capital gain net income is the excess of all gains from the sale or exchange of capital assets over all losses from the sale or exchange of capital assets arising during the tax year. Net capital losses are only deductible to the extent of $3,000 against ordinary income. The remainder must be carried forward.
Capital assets yield short-term gains or losses if the holding period is one year or less, and long-term gains or losses if the holding period exceeds one year, so that care must be taken in timing a sale. The excess of net long-term gains over net short-term losses is net capital gain. While short-term capital gains are taxed at ordinary rates, net capital gains of noncorporate taxpayers, as adjusted for certain types of long-term gains (adjusted net capital gain), are eligible for lower maximum tax rates than ordinary income.
Depending upon the appreciation locked into a current portfolio, strategies should be considered to either accelerate long-term capital gains, which has the certainty of being taxed at the Bush-era 15 percent maximum, or increase carryover losses into potentially higher-rate years after 2012. In C corporations, declaring special dividends to be distributed before 2013 may prove even more fruitful, if top rates on dividends rise from 15 percent to 43.4 percent (39.6 percent plus the 3.8 percent Medicare surtax).
• Passive income and losses. Individuals, trusts, estates, personal service corporations and closely held C corporations may only deduct passive activity losses from passive activity income. The reciprocal, however, may not always be the case: Net passive activity income is lumped into a taxpayer's gross income and is taxed at regular income tax rates to the extent that it is not reduced by deductions in arriving at adjusted gross income or taxable income. Nevertheless, ordinary losses or capital losses are not deductible from passive activity income. While holding a capital asset for investment may be passive in the sense of requiring no active participation on the investor's part, it is not considered passive income for the passive activity rules and, therefore, net capital losses may not reduce passive activity income (except to the extent of the $3,000 used to offset any other form of ordinary income, $1,500 for marrieds filing separately).
A passive activity is a trade or business activity in which the taxpayer does not materially participate. Rental activity is a passive activity without regard to the taxpayer's material participation, except for real estate professionals, and certain taxpayers primarily providing services and short-term rentals. Remaining passive activity deductions are deductible against nonpassive income only when the taxpayer disposes of the passive activity.
• 3.8 percent net investment income surtax. For tax years beginning after Dec. 31, 2012, a 3.8 percent Medicare contribution tax is imposed on the lesser of an individual's net investment income for the tax year or the excess of modified adjusted gross income for the tax year over $200,000 ($250,000 for joint filers and surviving spouses and $125,000 for married taxpayers filing separately).
"Net investment income" as defined under Code Section 1411(c) means the excess (if any) of the sum of gross income from interest, dividends, annuities, royalties and rents; income derived from passive activities; and net capital gain derived from the disposition of property, over the deductions allowed and properly allocable to such gross income or net gain.
Tax-exempt income is not a component of net investment income. Gain from the sale of a residence is also excluded from net investment income, but only to the extent exempt under the Code Sec. 121 exclusion up to the $250,000/$500,000 maximum, as applicable. Those fortunate homeowners with excess gains may want to accelerate any plans for moving into 2012 if the numbers add up and a closing can be done in time.
Non-investment income such as wages, Social Security payments or IRA and other qualified plan distributions also may have a bearing on payment of the surtax, since they can increase MAGI, which determines when the surtax kicks in. It should also be noted that certain forms of tax-favored income under other provisions are cut no breaks under the 3.8 percent surtax; for example, long-term capital gains are taxed at the same 3.8 percent rate as short-term capital gains.
• Roth Conversion and the 3.8 percent surtax. Net investment income for purposes of the 3.8 percent surtax does not include distributions from qualified plans or IRAs, but taxable distributions count towards the income threshold amount. A Roth conversion now in 2012 will not only ensure being taxed at the Bush-era income tax rates, but will also lower taxable income during the upcoming years in which the 3.8 percent tax is in play. (Contributing the maximum allowed to a qualified retirement plan once 2013 arrives also may prove to be a good retirement strategy two ways, first in reducing MAGI in the year of contribution and then in being exempt from the surtax when eventually distributed.)
RESETTING BASIS
Wash sales are sales of stock or securities in which losses are realized, but not recognized, because the seller acquires substantially identical stock or securities 30 days before or after sale. Nonrecognition, however, applies only to losses; gains are recognized in full. As a result, both a higher capital gains rate and the 3.8 percent surtax rate may be avoided by selling before year-end 2012 and then immediately re-investing. To buy back the same or substantially similar securities both in kind and amount, of course, there is the upfront cost of finding the cash elsewhere to pay the immediate tax, or lowering the amount re-invested.
While there is no wash sale rule for gains, a true sale must nevertheless take place to successfully accelerate income. Outside of the context of marketable securities, this rule prevents "basis resetting" without further substance behind it. For example, selling real estate to a straw man who then sells it back to the taxpayer does not accomplish a resetting of basis since there must be an underlying true sale to support it. A leaseback, however, would work ... unless other than a true lease is otherwise apparent. While arguments of sham transaction and economic substance are more likely raised when a loss is involved, courts have nevertheless often looked to determine whether or not the parties intended that the purchaser retain title in the property. The benefits and burdens of ownership must be transferred for a sale to occur.
Further, while a sale must be final or closed to determine gain or loss, determining what is final or closed for tax purposes is not always intuitive. Despite the general rule that a sale occurs when title to property is transferred to a buyer, a sale for tax purposes can occur before or without the transfer of title. For example, once the parties have reached a binding agreement, the transfer of possession of property to a buyer usually closes a sale for tax purposes.
In selling to reset basis, looking ahead to 2014 also requires building in the flexibility of being able to sell at long-term capital gain rates at the end of 2013 to take advantage of any Bush-era extended rates on capital gains that may not last into 2014. Long-term capital gain rates are only available to assets held for more than one year. The holding period starts the day after a capital asset is acquired and ends on the date of its disposition. The holding period of securities generally begins on the trade date if they are publicly traded or upon receipt of title if not publicly traded.
ADVANCE PAYMENTS
Accelerating income, especially within the business setting, has been made easier by published policy from the Internal Revenue Service (for example, Revenue Ruling 66-347) that generally taxes prepaid income in the year of receipt, whether the income is derived under contracts to furnish services or is prepaid rent, royalties, bonuses, etc. This blanket rule applies regardless of whether the period of the recipient's performance under the contract is definite or indefinite.
Generally, the IRS's interest has been at the other end of the income recognition argument, in opposing taxpayers who seek deferrals. In those cases, the IRS usually maintains that, for both cash and accrual method taxpayers, payments received in advance are income in the year received, provided no restriction has been placed upon their use. The IRS has ruled that this holds true even though the advances may be returnable upon the happening of some specified condition.
Of course, one practical challenge to receiving advance payments is persuading the other party to make the payment in advance. If there is little negotiating room, a discount may be required, the extent of which may vitiate the extent to which taxes are saved.
MANDATORY NONRECOGNITION
A taxpayer cannot recognize gain or loss that is otherwise realized when an income tax provision of the Internal Revenue Code specifically excludes the gain or loss from being recognized. This list of nonrecognition transactions includes:
• Contributing property to a corporation in exchange for its stock under Code Section 351;
• Contributing property to a partnership in exchange for an interest in the partnership under Code Section 721;
• Exchanging, distributing or receiving stock or debt securities of a corporation pursuant to a plan of re-organization under Code Section 368;
• Exchanging property used in a trade or business or held for investment for property of like kind under Code Section 1031;
• Replacing involuntarily converted property under Code Section 1033;
• Selling a principal residence within the gain exclusion limit under Sec. 121; and,
• Transferring property to a spouse or incident to a divorce under Code Section 1041.
Techniques are available to "bust" certain mandatory recognition provisions, for example as a contribution to capital or like-kind exchanges. Taxpayers can look for techniques no further than within the many cases in which taxpayers have tried unsuccessfully to obtained nonrecognition treatment. However, awareness of these restrictions is first necessary, and those attempting to accelerate income should heed the cautionary tales of both those taxpayers and the IRS when on the losing side.
MISCELLANEOUS ITEMS
In reviewing opportunities to accelerate income into 2012, taxpayers should also keep in mind the following rules.
• Installment sales. Installment-method reporting applies to gain on a sale if at least one payment is to be received after the tax year of the closing. An installment sale that qualifies for use of the installment method is reported using that method, unless the taxpayer elects to have the provisions not apply to a particular transaction. A taxpayer elects out of installment sale treatment by not reporting a transaction as an installment sale. This election may be revoked only with the consent of the IRS. However, installment reporting may be effectively revoked by selling the installment obligation to a third party or negotiating with the purchaser to accelerate payments, thus accelerating income in either instance.
• Certificates of deposit. A cash-basis taxpayer recognizes interest income on a CD based on the terms of the certificate. The rules in this regard will generally favor recognizing CD income in 2012: If the terms require that interest be paid currently (that is, at least annually), or be credited currently and made available to the depositor without penalty, the taxpayer reports interest income as it is received or credited. If interest is not paid currently and the term of the instrument is more than one year, the original issue discount rules require the depositor to report the amount of interest income earned, even if it is not paid, in a manner similar to that used by accrual-basis taxpayers. Thus, even if interest is not paid, the taxpayer must report interest income throughout the term of the instrument, based on the effective interest rate of the instrument.
• Discharge of indebtedness income. If a debtor acquires his own debt, the cancellation of indebtedness income is recognized at the time of purchase. However, in situations in which a debt is claimed to be canceled or forgiven, an "identifiable event" to indicate that a debt will not be paid may in fact not be so easy to identify. An overt act by the taxpayer is evidence of the time the debt is discharged; however, such an act is not necessary.
• Liquidations. Corporate liquidations are on the uptick as some owners attempt to get taxed on distributions at the Bush-era rates before the end of the year. The general timing rule that applies requires each shareholder of a liquidating corporation to recognize and report gain or loss in accordance with his method of accounting.
• Deferred compensation. The employee's control of an enterprise requires that a bonus or other form of contingent compensation be included in their income in the year it is authorized unless special facts indicate that payment is not fully possible or authorized in that year. Starting in 2013, high-income individuals will pay another 0.9 percent on earned income over $200,000 ($250,000 for joint filers) in addition to the 1.45 percent portion of the high-income (Medicare) tax now paid.
CONCLUSION
The fate of the Bush-era tax rates for higher-income individuals likely will not be put to a vote until a lame-duck session of Congress convenes after the November elections. That Congress might punt the decision into January 2013, instead. More tenuous still, if efforts to repeal the 3.8 percent Medicare tax gain momentum, a decision on whether to keep the surtax may not take place until later in 2013, if at all. Given the present uncertainties, accelerating a little more income than is otherwise required into 2012 through a variety of strategies might prove a conservative approach worth considering for many taxpayers.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
