By Kenneth H. Bridges, CPA, PFS November 2023
Late November through year end is the time for year-end tax planning. While every client’s situation is unique, here are some of the more common strategies we employ.
Acceleration or deferral of income and deductions – Businesses which use the cash basis of accounting for income tax purposes often have a great deal of control over the timing of income and deductions. Similarly, individuals can often time the recognition of significant gains or a significant deduction (e.g. charitable contributions). Shifting income from a high-rate bracket year to a low-rate bracket year can obviously result in a permanent tax savings. And now, with short-term interest rates fairly high, deferral of the payment of tax for a year can provide a meaningful benefit.
Harvesting of capital losses – Capital losses can, for the most part, only be deducted against capital gains. And while capital losses can be carried forward, for individuals they cannot be carried back to previous years. Accordingly, it is generally a good strategy to go ahead and recognize any potential capital losses you have.
Optimizing the “qualified business income” deduction – The Tax Cuts and Jobs Act included a 20% deduction for business income from most flow-through entities (other than “specified services businesses” like accounting and law firms). For individuals with taxable income over the threshold amounts ($182,100 for singles and $364,200 for married couples, with phase-outs up to $232,100 and $464,200, respectively), the deduction is generally limited to the lesser of 20% of the K-1 profit or 50% of your share of the W-2 wages paid by the business. For companies with a significant amount of payroll, this W-2 wages limitation is generally not a problem. However, for companies with few if any employees other than the owners, the deduction may be maximized by paying the optimal level of owners’ compensation.
Passthrough entity tax election – Since 2018, there has been a $10,000 per year limit on individuals' deduction for state and local taxes (SALT) on Schedule A as itemized deductions. Since that time, most states with an individual state income tax (including Georgia) have enacted legislation permitting S-corps and partnerships to elect an entity level tax in lieu of the income being taxed at the level of the individual owners, thus providing a potential workaround to the $10,000 limit. For S-corps and partnerships, consideration should be given each year to whether the election is advantageous and, if so, whether the entity needs to make state estimated tax payments.
Use of tax credits to minimize state income tax – There are various tax credits which can be utilized to minimize state income tax. Some must be generated by a business entity (e.g. the Georgia jobs credit, research credit and retraining credit), some can essentially be purchased (e.g. the Georgia low-income housing credit and film credit), and others are based on taking some action which the government is encouraging (e.g. the Georgia credits for donations to provide private school scholarships, and assistance to charter schools, foster child support organizations, law enforcement foundations, and rural hospitals).
Timing of charitable donations – It is generally advantageous to time significant charitable donations to coincide with a year in which you have significant income and are in a higher rate bracket. Because of the percentage of income limitations on charitable deductions and the inability to carry the deduction back to earlier years, making a substantial donation in the year after a big gain can potentially result in the permanent loss of a tax benefit versus having made the donation in the same year as the substantial gain. On the other hand, if you have charitable carryforwards that are in danger of expiring, deferring additional donations to the next tax year may be prudent. For those who want a charitable donations tax deduction in the current year, but want to control the donated assets for a while longer or have a number of years over which to distribute the funds to the ultimate charities, a private foundation or a donor advised fund may work well. A charitable remainder trust can work well where you have an appreciated asset you wish to sell and desire to retain an income stream from the proceeds but are willing to commit the remainder to charity at your death. Those age 70 ½ or older can make charitable gifts directly from their IRA, and have such count towards their IRA required minimum distributions; with a limit of $100,000 per year for each eligible spouse.
Estimated tax payments – In order to avoid a penalty, you are generally required to pay in through withholding or quarterly tax payments the lesser of 90% of your current year tax liability or 110% of your prior year tax liability. With respect to estimated tax payments, you get credit the day you actually make the payment. Withholding, however, is generally deemed to have occurred ratably throughout the year. Accordingly, if you realize late in the year that you have a shortfall for earlier quarters, you can sometimes avoid the penalty by increasing your withholding late in the year (e.g. having all of a year-end bonus withheld for taxes).
S-corp and LLC basis and at-risk limitations – In general, you can deduct your share of losses from S-corps and LLCs, and distributions from such entities are generally tax-free. However, the ability to deduct losses or receive tax-free distributions is limited by the “basis” and “at-risk” rules. Basically, the amount of loss you can deduct or distributions you can receive tax-free is limited to your unreturned investment in the entity (including past undistributed profits and, in the case of partnerships and LLCs, your share of the entity’s liabilities which are either bank debt on a real estate project or debts for which you are personally liable). With respect to flow-through entities in which you own a stake, you should review your basis and at-risk amounts prior to year end to determine whether any tax advantage can be gained by increasing such amounts and whether such is prudent from an economic standpoint.
Exercise of ISOs in year not in AMT – “Incentive stock options” (ISOs) hold out the promise of being able to potentially convert what would otherwise be ordinary income into long-term capital gain. However, because the bargain element is an “alternative minimum tax” (AMT) adjustment on the date of exercise, the AMT often eliminates much of the hoped-for benefit. A tax year in which you will not be in the AMT represents an opportunity to exercise some ISOs at no tax cost, meaning a potential permanent tax savings if you hold the stock for the requisite period.
Sale of ISO shares that have fallen in value - If you exercise ISOs and sell in the same tax year, then the AMT issue goes away. Accordingly, we typically advise our clients who want to exercise and hold ISOs to do so early in the year, giving us almost a full year to watch the stock price and to sell the stock before year end if necessary in order to cure the AMT problem. If you exercised ISOs earlier this year, you still hold the shares, and the value of the shares has fallen dramatically, then now may be the time to sell.
Bonus first-year depreciation and Section 179 expense – For most depreciable assets (other than buildings and with some limitation on “luxury automobiles”), 100% of the cost up to $1,160,000 can be deducted immediately (so long as the cost of eligible assets placed in service during the year does not exceed $2,890,000) under IRC 179. Alternatively, 80% of the cost can be expensed immediately in 2023 under the “bonus depreciation” rules (with the percentage set to decline each year going forward).
Selection of accounting methods – New businesses can, within certain limitations, select the tax accounting methods (e.g. cash or accrual) which are most beneficial for them; and existing businesses have some latitude to later change their accounting methods. Your situation should be reviewed each year in order to determine which accounting methods are most advantageous for you.
Conversion of IRA to Roth status - With a traditional deductible IRA, you get a tax deduction on the front end when you make the contribution, but then are subject to ordinary income tax rates on withdrawals. With a nondeductible traditional IRA, you get no tax deduction on the front end, but then a portion of your withdrawals is tax-free recovery of basis. With a “Roth IRA”, you get no front-end tax deduction but the appreciation in value permanently escapes tax. Traditional IRAs can be converted to Roth IRAs. The conversion is a taxable event (unless you have tax basis from nondeductible contributions equal to value), so careful planning is necessary to determine if a conversion makes sense for you.
IRA Required Minimum Distributions (RMDs) – Once you attain age 72 (or 73 if you reach age 72 after 2022), and for each year thereafter, you are required to take distributions from your IRAs (and other qualified retirement plans) at least equal to a minimum amount computed using IRS-provided tables. Failure to take at least this minimum amount can subject you to a significant penalty on the shortfall (previously 50%, now 25%, and possibly only 10% if corrected within 2 years). For the year you first reach the RMD age, you have a grace period up through the first three months of the next tax year in which to take your RMD. However, utilizing the grace period will mean doubling up your RMD amount in that next calendar year, which could force some of the income into a higher rate bracket. The years between age 59 ½ (the earliest date at which you can take IRA distributions without incurring an early distribution penalty) and 73 may represent a good time to begin taking some IRA distributions (even though not required) if you are otherwise in a very low-rate bracket for those years or have excess deductions which may otherwise be wasted. Charitable distributions made directly from an IRA can count towards your RMD (up to $100,000 per year for each eligible spouse).
Children and education – While generally subject to limitation based on income level, the tax code provides deductions and credits associated with having children, paying for daycare, and education. Section 529 plans (which are not subject to limitation based on income) permit investment gains to permanently escape tax, so long as the funds are used for qualified education expenses. While there is no Federal income tax deduction for the contribution, many states do provide a deduction (e.g. for a married couple in Georgia, up to $8,000 per child, so long as the contribution is to Georgia’s 529 plan).
Energy efficiency tax credits – In an effort to continue to encourage electric vehicles, Federal tax law provides (subject now to income limitations and limitation on price of vehicle) a tax credit of up to $7,500. Similarly, but not subject to income limitations, you can receive a Federal tax credit of up to 30% of the cost of installing a residential geothermal system.
Relocation to a tax-friendly state – Most states subject their residents to tax on their worldwide income (while permitting them a credit or partial credit for tax properly paid to other states), whereas non-residents pay tax only on income sourced to the state (e.g. from business conducted in the state or real estate located in the state). State income tax rates on individuals can range from 0% to 13%. Accordingly, substantial savings can often be generated from establishing domicile in a state with no state income tax (while minimizing contact to the extent possible with those states which have an individual income tax). While it is probably too late now to avoid 2023 state income tax, now is an optimal time to position yourself for 2024.
Utilization of annual gifting exclusion – With respect to the estate and gift tax, there is an annual exclusion which permits you to give up to $17,000 per year per donee ($18,000 in 2024), without incurring any tax or eating into your lifetime exemption. For married couples, this amount is effectively doubled to $34,000. For those with a significant number of potential heirs, this represents an opportunity to remove a significant amount of value from the taxable estate, especially when gifting assets that may be subject to discounted valuation. The annual exclusion is on a use-it-or-lose-it basis with no carryover, so if you haven’t maximized your annual exclusion gifts yet for 2023, consider doing so before year end.
Utilization of life-time estate and gift tax exemption – For 2023, each person has a lifetime exemption from estate and gift tax equal to an exclusion of $12,920,000 (i.e. almost $26,000,000 for a married couple). For 2026 and beyond, this amount is scheduled to drop to about $6,000,000 (the exact amount is tied to inflation). Accordingly, those who intend to leave their heirs in excess of $6,000,000, may want to go ahead and move a significant amount of assets to trust now in order to take advantage of the high current exemption. Also, by removing assets from your taxable estate now, you are also removing the future appreciation on those assets from your taxable estate.
Setting expectations and avoiding surprises – One of the key advantages to engaging in year-end planning is that it enables you to appropriately plan your required cash outlay for taxes and avoid any unpleasant surprises at April 15 or any regrets as to actions that could have been taken by year end but were not.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP, an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.