Year-End Gain Harvesting May Create Impressive Tax Savings, But Be Careful!

(October 2013)

Bracket management has always been an important part of income tax planning. As we noted in our May newsletter, however, the 3.8% Medicare Surtax and higher tax rates make it even more important in 2013. We listed the following strategies that taxpayers can use to avoid the surtax and stay out of the higher tax brackets: (1) Income smoothing CRTs; (2) income shifting CRTs; (3) using NIMCRUTS as a substitute for or supplement to a retirement plan; (4) CLATs; (5) Life Insurance; (6) deferred annuities; (7) installment sales; (8) managing IRA distributions; (9) loss harvesting; (10) gain harvesting; (11) Roth IRA conversions; (12) converting passive business activities to active activities by changing grouping elections; (13) private split dollar insurance; (14) reverse mortgages; (15) low NII investments; (16) real estate investments; (17) oil and gas investments; (18) choice of filing status; and (19) increasing above-the-line deductions.

Year-End Planning
While some of these strategies, like Roth IRA conversions, income-shifting CRTs, retirement plan NIMCRUTs and deferred annuities require a long period of time to produce their benefits, others can be used as year-end planning strategies. Included in this latter category are gain harvesting, loss harvesting, increasing above-the-line deductions and income smoothing CRTs. In this newsletter we will take a detailed look at gain harvesting.

Gain Harvesting
For married taxpayers filing jointly, the long-term capital gains rates are as follows:

Income < $72,500……………………………………….0%
Income $72,501 - $450,000……………………………15%
Income > $450,000……………………………………..20%

Unless the capital gain is from the sale of active business assets, it is treated as net investment income (NII) and may also be subject to the 3.8% Medicare surtax, depending on the taxpayer’s modified adjusted gross income (MAGI). Thus, the total tax on long-term gains could vary from 0% to 23.8%.

The significant difference in rates might make it advantageous for clients to harvest gains in the current year if they expect a higher rate to apply in later years. This might be true for both high income clients and for clients with more modest amounts of income.

Example 1.  Mark and Helen are married taxpayers filing jointly. In 2013 their salaries total $350,000 and they have no other income. In 2014 they expect their income to increase to $450,000. Mark and Helen own XYZ stock with a basis of $50,000 and a FMV of $150,000 that they planned to sell in 2014. If they sell the stock in 2013, the $100,000 gain will be taxed at a 15% capital gain rate. The 3.8 percent Medicare Surtax also applies to the gain, making the total tax on the gain 18.8% and the tax payable $18,800. By contrast, if Mark and Helen wait until 2014 to sell the stock, the $100,000 gain would increase their taxable income to $550,000, making it taxable at 23.8%. By selling in 2013 instead of 2014, they save $5,000 ($100,000 * (.238 - .188)). (Note that all examples assume a long-term holding period.)

Example 2. Art and Carol are married taxpayers filing jointly with total salary income of $52,500 in 2013. They own ABC stock with a basis of $5,000 and a FMV of $25,000 and expect their total income to increase to $72,500 in 2014. If they sell the stock in 2013, they will pay no capital gains tax (and no surtax). If they wait until 2014 to sell they will pay $3,000 in capital gains tax.

Reduced Tax Rate vs. Loss of Tax Deferral
Deciding whether to harvest gains at the end of 2013 is not as simple as it might appear, however, because it introduces a trade-off between paying tax at a lower rate and losing tax deferral. To analyze whether gain harvesting makes sense in a particular case, we can think of the tax paid in 2013 as an investment to buy tax savings in a later year and calculate a rate of return on the investment. We will assume that the investment is in publicly traded stock, that the sells the stock in 2013, repurchases similar stock and sells the replacement stock whenever the original stock would have been sold if the gain harvesting strategy had not been employed. The following simple example illustrates how the analysis would be done.

Example 3. Toward the end of 2013, Ann owns XYZ growth stock with a basis of $10,000 and a FMV of $110,000 that she otherwise would have kept until 2014. Assume that the stock grows in value by 6% per year. If Ann sells the stock in 2013, her total tax rate will be 18.8%, but if the stock is sold in 2014, the rate will be 23.8%. The following charts compare the economic consequences of (1) foregoing gain harvesting in 2013 and selling the stock in 2014 and (2) harvesting the loss in 2013, reinvesting the after-tax proceeds in similar stock and reselling it in 2014. Assume that in both cases Ann will have a long-term holding period for the stock.

  2013 2014
Stock Value $110,000 $116,600
Less basis   10,000
Gain   106,600
Tax @ 23.8%   25,371
After-tax value   $91,229

  2013 2014
Stock Value $110,000 $96,672
Less basis 10,000 91,200
Gain 100,000 5,472
Tax payable 18,800 1,302
After-tax value $91,200 $95,370

Ann ends up with $4,141 more in the gain harvesting alternative ($95,370 - $91,229). This makes the rate of return on the tax paid 22.02% ($4,141/$18,800). Because this is presumably far above Ann’s opportunity cost of capital, she should harvest her gains in 2013.

Sensitivity Analysis
The 2013 gain harvesting decision is very fact sensitive. Under the facts assumed above, 2013 gain harvesting turned out to be very favorable, but in other cases it could be disastrous. The key variables are (1) the time period between the gain harvesting sale and the sale of the repurchased assets and the difference in tax rates between the two sales. 

Time Horizon
The shorter the time period between the loss harvesting sale and the second sale, the more favorable gain harvesting will be. The following chart assumes the same facts as in Example 3 and shows the effect on rate of return (ROI) for longer time horizons.

Year of Resale                            ROI

        2014                                    22.05%

        2015                                     8.25%

        2016                                     3.86%

        2017                                     1.61%

        2018                                     0.16%

        2019                                    -0.90%

Tax Rate Differential
The greater the difference between the 2013 tax rate and the tax rate when the stock is resold, the greater the ROI. If the taxpayer is in the 0% capital gain bracket in 2013 and the 15% bracket in 2014, as in Example 2 above, the ROI would be infinite because no tax would be paid on the gain in 2013. In effect, taxpayers would get a free basis step up. The chart below shows the ROIs for the unusual case in which a taxpayer went from a 15% capital gains bracket in 2013 to a 23.8% tax rate in later years to illustrate the effect of the wider rate differential.

Year of Resale                              ROI

        2014                                     54.09%

        2015                                     22.17%%

        2016                                     12.95%

        2017                                      8.52%

        2018                                      5.85%

        2019                                      4.03%

Other Variables
ROIs are also sensitive to the assumed rate of return for the stock. The higher the expected return, the lower the ROI for the gain harvesting strategy will be. The taxpayer’s opportunity cost of capital is also important because it represents the hurdle rate the ROI on gain harvesting must exceed to make it worthwhile for the taxpayer.

Caveat—Economic Substance Doctrine
The courts have long held that tax motivated transactions will not be respected unless they have economic effect apart from the tax benefits. In 2010, this doctrine was codified in IRC § 7701(o), which provides that a transaction has economic substance only if (1) it changes the taxpayer’s economic position in a meaningful way and (2) the taxpayer has a substantial non-tax reason for entering into the transaction. This Code section imposes a 20 percent penalty on any underpayment of tax from a transaction that does not pass the two-pronged test. The penalty increases to 40% if the transaction is not adequately disclosed on the return.

There are two ways to build economic substance into the gain harvesting strategy. One would be to add time between the gain harvesting sale and the later repurchase. The longer the time period between the sale and the repurchase, the greater the change in value a taxpayer could expect in the interim. If the taxpayer likes the long-term prospects for a stock, but believes its value is likely to drop in the short term, he might consider this strategy even without the potential gain harvesting benefit.  A safer alternative might be to reinvest in different, but similar assets.  The new assets could still fit the taxpayer’s investment strategy and there would be no need to stay out of the market for a substantial period of time.

2013 year-end gain harvesting could be very favorable or very unfavorable, depending on the facts of the case. Analyzing clients’ fact situations to determine whether they could benefit from loss harvesting might be a key part of year-end tax planning for many clients. This column provides a basic model for performing this analysis.

PLR Opens Door to Post-Death Exchanges of Non-Qualified Annuities Tax-Free!

(September 2013)

IRC § 1035 generally allows taxpayers to make a tax-free exchange of one annuity for another better suited to the taxpayer’s needs. Until recently, however, this benefit was not available to taxpayers who inherited non-qualified annuities. Such taxpayers were stuck with the annuity selected by the decedent no matter how unfavorable it may have been for them.

Recently issued PLR 201330016 now gives a green light to tax-free exchanges of such annuities, however, provided that certain requirements are satisfied.  This creates an important new opportunity for tax and financial advisors to help clients.

Background—Requirements for a Tax-Free Exchange
The following three requirements must be met to have a tax-free exchange of an inherited, non-qualified annuity:

(1) both the original contract and the new contract must qualify as annuities under the requirements of IRC § 72(s);

(2) the exchange must meet the technical requirements of IRC § 1035; and

(3) it must be possible to extract the full value of the old contract  so it can be transferred. 

IRC § 72(s)
For purposes of IRC § 1035 exchanges, the key IRC § 72(s) issue is the distribution schedule for the new annuity. IRC § 72(s)(1)(B)) provides that if the holder of a contract dies before the annuity starting date, the entire interest in the contract must be distributed within five years after the death of such holder. Under an exception in IRC § 72(s)(2), however, the interest can be paid over the life of the designated beneficiary.

IRC § 1035
IRC § 1035 introduces two more potential obstacles to a tax-free exchange. First, Reg. § 1.1035-1 provides that tax-free treatment is available only if the owner under the new contract is the same as the owner under the original contract. Second, Revenue Ruling 2007-24 holds that there must be a direct transfer of funds between the issuer of the original annuity and the issuer of the new annuity.

Extracting the Value of the Old Contract
Note that an exchange of an inherited annuity can be made only if the full value of the original contract can be removed and transferred directly to the new issuer. If an inherited annuity contract has been annuitized, there is no cash value to exchange. A tax-free exchange may also be impossible if the inherited annuity limits payouts. For example, some contracts requirethat the beneficiary take money out over a minimum of 5 years and not as a liquid lump sum. A restricted beneficiary designation form that allows beneficiaries to access only set annual amounts would also appear to prevent a postmortem IRC §1035 exchange by the beneficiary.

PLR 201330016
The taxpayer in PLR 201330016 was able to meet all three requirements. Thus, the ruling can be used as a roadmap for taxpayers who wish to make a tax-free exchange of an inherited, non-qualified annuity.

Facts of the Ruling
The taxpayer’s mother owned fixed and variable annuities naming the taxpayer as beneficiary. The annuities all provided that if the mother died before reaching her required beginning date, the death benefit would be paid to the taxpayer. When the mother did die before reaching her annuity starting date, the taxpayer elected to receive the death benefits provided by the annuities over her life expectancy, as permitted under IRC § 72(s)(2)(B).

The taxpayer later determined that she might be able to increase the amount of her payouts if she could replace them with payouts from another company. To take advantage of this opportunity, she acquired new annuities, remitting the amounts payable under the original annuities directly to the new issuer, which credited these amounts to the new contract. In acquiring the new contract, the taxpayer elected to receive payments over her life expectancy and agreed (1) not to transfer ownership of the new contract and (2) not to make any additional contributions to the new contract.

The IRS ruled that the exchanges were tax-free under IRC § 1035. The original contract was an annuity because it provided for distribution of the mother’s entire interest over her life expectancy as required by IRC § 72(s). The new contract was also an annuity contract. The combination of (1) the election by the taxpayer to receive distributions over her life expectancy, (2) the agreement not to transfer the annuity and (3) the agreement not to make any additional contributions to the new contract obligated the new issuer to pay the taxpayer the entire interest her mother had in the original contracts over the taxpayer’s life expectancy as required under IRC § 72(s). In addition, the value of the original contract was transferred directly to the new issuer, the owner of the new contract was the same as the owner of the original contract, no additions could be made to the new contract and there were no restrictions on extracting the value of the original contract. Thus, all requirements were met.

Planning Implications
PLR 201330016 opens up important new planning opportunities for taxpayers who inherit non-qualified annuities. They may now be able to make a tax-free exchange of the annuity to: (1) take advantage of higher payouts, (2) switch from a fixed annuity to a variable annuity, (3) switch to investments better suited to their investment objectives, (4) switch to a stronger annuity issuer, (5) lower annuity expenses or (6) simply update the annuity. For example, a fixed annuity invested to produce income might have been a good choice for an elderly annuity owner, but is not suitable for a young beneficiary of the annuity who wants a variable annuity that can be invested for growth.

Several cautions are in order.

Effect of a PLR. APLR can be relied upon only by the taxpayer to whom it was issued and applies only to the specific facts presented. On the other hand, PLRs reflect the current IRS position on an issue and the position is unlikely to change unless the PLR is abused. Thus, other taxpayers with similar facts can draw considerable comfort from the ruling.

Will Insurance Companies Allow the Exchanges?  Historically, annuity companies have not permitted beneficiaries to make IRC § 1035 exchanges of non-qualified inherited annuities. PLR 201330016 is a favorable development for the insurance industry, however, and it seems likely that many companies will decide to allow exchanges in the future. To make sure that the technical requirements of PLR 201330016 are satisfied, they should develop standard forms similar to those used in the ruling. These forms should include contractual provisions stating that: (1) annuity ownership could not be transferred, (2) new contributions could not be made to the annuity and (3) distributions had to be made as least as rapidly as required under IRC § 72(s) for the original annuity contract.

Due Diligence. Investors and their advisors should carefully analyze the exchange decision. This may include an in-depth comparison of the payouts, potential investments, expenses, and issuer strength for the original annuity with those for potential replacement annuities. Given that withdrawals willbe required in the first year from the new contract to comply with IRC § 72(s), it is also important to verify that those withdrawals will not run afoul of any new surrender charges of the new contract or result in the immediate forfeiture of any gains.

PLR 201330016 creates an important new planning opportunity for taxpayers who inherited a non-qualified deferred annuity. Tax and financial advisors should send out client letters on the PLR to identify clients who could benefit from the ruling. 

Tax and Economic Implications of the DOMA Decision

(August 2013)

Section 3 of the Defense of Marriage Act (DOMA) provided that in determining the meaning of any Act of Congress, the word “marriage” meant only the legal union between one man and one woman as husband and wife, and the word “spouse” refers only to a person of the opposite sex who is a husband or a wife. On June 26, 2013, the U.S. Supreme Court invalidated this section of the Act in United States v. Windsor. The decision has far reaching planning implications for married same-sex couples whose marriage is recognized under applicable state law, affecting the income tax, gift tax, estate tax and social security and employee benefits. This article summarizes some of the key ramifications of the decision.

Income Tax
Perhaps the most important change in the income tax area will be the ability of same sex couples to file joint income tax returns. This will generally reduce the total tax payable by the spouses.

Example1. Al and Bill are a same-sex couple whose marriage is recognized in their home state. Al has income of $200,000 and Bill has income of $0. If Al and Bill filed individually, their total tax would be $50,130 ($50,130 for Al and $0 for Bill). If they filed a joint return, however, their tax would be $43,466.

If a same-sex couple’s income is relatively high and the amounts earned by the two spouses are comparable, however, the ability to file a joint return won’t always help them.  

Example 2. Assume the same facts as in Example 1 except that Al and Bill each has $100,000 of taxable income. If they filed separate returns, they would each pay $21,293, making the total tax payable $42,586 (2 x $21,293). Thus, they would pay $880 more by filing a joint return ($43,466 - $42,586).

Other income tax advantages and disadvantages of married status are listed below.


  1. The ability of the surviving spouse to use surviving spouse status after the death of the first spouse.
  2. The ability to deduct medical and dental expenses paid for spouse.
  3. Non-recognition of gain on a sale to the spouse.
  4. The ability to roll over an IRA into a spousal IRA on the death of the first spouse.
  5. Protected rights in a spouse’s retirement benefits under ERISA.


  1. A taxpayer loses the ability to step up basis by selling property to the spouse.
  2. Spouses are jointly and severally liable on joint returns, subject to possible relief under the innocent spouse rules.
  3. The inability of a taxpayer to recognize loss on a sale of property to a spouse under IRC § 267(c).
  4. Wider application of the constructive ownership rules under IRC §§ 318 and 267.

Gift Tax
Married same-sex couples whose marriages are recognized under the law of their home state can now make unlimited tax-free gifts to each other. Although the marital deduction will no longer be necessary to avoid taxable transfers in most cases given the $5.25 million exemption amount currently in effect, it could be extremely valuable for very large estates. Married same-sex couples can also elect to split gifts, increasing the annual exclusion amount from $14,000 to $28,000.

Married status does eliminate some powerful gift tax strategies that are available only to unmarried individuals, however. For example, the special valuation rules of Chapter 14 do not apply to unrelated individuals. This means that same-sex, unmarried couples can use common law GRITs or GRATs that are not subject to the limitations in IRC § 2702. If the couples are treated as married, though, they become related persons subject to the Chapter 14 rules. 

Estate Tax
Following Windsor, married same-sex couples will be able to take advantage of the estate tax marital deduction in the same way as opposite sex couples. This effectively increases the exclusion amount from $5.25 million to $10.5 million and will leave very few estates subject to the estate tax. Moreover, even for very large estates, estate tax will be deferred until the death of the surviving spouse. Married same-sex couples will also be able to take advantage of the portability rules.

Social Security
The Social Security system affords two important benefits to married couples that are not available to single individuals.

(1)  The spouse of a retired worker can elect to receive the greater of his or her own Social Security benefit or 50 percent of the retired spouse’s benefit. For families in which one spouse is a homemaker or works only part-time outside the home and who would otherwise have minimal social security payments, this is an important advantage.

(2)   Following the death of a spouse, the surviving spouse can choose between receiving his or her own Social Security payment or the payment the surviving spouse would have been entitled to.

Presumably, these benefits will now be available to same-sex married couples as well as to opposite-sex married couples.

Employee Benefits
Prior to Windsor, employees who added a same-sex spouse to their health plan had imputed income equal to the fair market value of the coverage provided to the spouse, unless the spouse qualified as a dependent. Following the Supreme Court decision, taxpayers will be able to obtain coverage for a same-sex spouse on a pre-tax basis

Open Questions
Windsor leaves a number of issues unclear. Some of the unanswered questions are as follows.

  1. Can married same-sex couples file amended returns or refund claims for open years?
  2. How will the decision apply to states that allow only civil unions?
  3. How will Windsor apply to married same-sex couples who were married in a state recognizing such unions who later move to a state that does not recognize them? 

Planning Implications
Windsor opens up important new tax planning opportunities for many taxpayers. Their advisors will need to determine how they can maximize these opportunities. 

"Green Book" Proposals and Income Tax Planning

(June 2013)

On April 13, the Treasury Department issued its annual Revenue Raising Proposals, commonly referred to as the “Green Book”. In this column we will summarize the key income tax proposals and suggest some planning ideas. These proposals include:

(1)  Implementing the Buffett Rule by imposing a new “Fair Share Tax;”

(2)  Reducing the value of certain income tax deductions and exclusions;

(3)  Limiting the total amount a taxpayer can accrue in tax favored retirement plans;

(4)  Shortening the deferral period for inherited IRAs; and

(5)  Taxing carried interests as ordinary income.


Implementing the Buffett Rule by Imposing a New “Fair Share Tax”

This proposal would create a new tax called the Fair Share Tax (FST) that would be phased in as income increased from $1 million to $2 million. The tentative FST would be equal to 30% of AGI less a credit for charitable contributions. The final FST would be the excess, if any, of the tentative FST over the regular income tax, after certain credits, the AMT, the 3.8% Medicare surtax and the employee portion of payroll taxes were taken into account. The Green Book provides the following example of how the tax would be calculated.

Example 1. T has AGI of $1,250,000, tentative FST of $375,000 (.3 x $1,250,000) and a regular tax of $250,000 (.2 x $1,250,000). The FST payable would be:

  • (($1,250,000 - $1,000,000)/($2,000,000 - $1,000,000)*($375,000 - $250,000)
  • = ($250,000/($1,000,000) * $125,000
  • = ¼ * $125,000
  • = $31,250

Now let’s look at a more detailed example. Assume the same facts as in the Green Book example except that T makes a $100,000 charitable contribution and all the full $1,250,000 of income is long-term capital gain, taxed at 23.8%.

Example 2. The tentative FST would now be $347,000 ($375,000 - $28,000 charitable deduction credit) and the regular tax would be $297,500 (.238 x $1,250,000). The FST payable would be:

  • (($1,250,000 - $1,000,000)/($2,000,000 - $1,000,000)*($347,000 - $297,500)
  • = $250,000/($1,000,000 * $49,500)
  • = ¼ * $49,500
  • = $12,375

The proposal would be effective for tax years beginning after December 31, 2013.

Planning Implications
Note that the tax applies to capital gain as well as to ordinary income. Thus, if it appears that the proposal will become law, affected taxpayers may wish to sell stock or other appreciated capital assets with a long-term holding period before 2014. This may reduce the tax rate on the gain from 30% to 23.8%. In deciding whether to recognize gains in 2013, the opportunity cost of paying the capital gains tax early should be taken into account.

Reducing the Value of Certain Deductions and Exclusions

Under current law, deductions are worth more to high income tax payers than to lower income taxpayers. To address this perceived issue, the second key tax proposal would cap the value of certain above-the-line deductions and all itemized deductions at 28% of the amount deducted. This would presumably mean, for example, that if a taxpayer in the 39.6% ordinary income tax bracket had an itemized deduction of $10,000; the deduction would reduce tax liability by $2,800 instead of $3,960.

The above-the-line deductions this would apply to include (1) contributions to defined contribution retirement plans, (2) contributions to IRAs, (3) moving expenses, (4) interest on education loans, (5) health insurance costs for self-employed individuals, (6) certain trade or business deductions of employees,(7) employer-sponsored health insurance paid for by employers or with before-tax employee dollars, (8) certain higher education expenses, (9) tax-exempt state and local bond interest and  (10) the costs of domestic production activities. The cap would also apply to itemized deductions like mortgage interest, property taxes, medical and dental expenses, state and local taxes and charitable contributions. The proposal would be effective for tax years beginning after December 31, 2013.

Planning Implications
If it appears that this provision will be enacted, taxpayers with income in the higher brackets might consider accelerating applicable deductions and exclusions into 2013. For example, they might wish to increase 2013 charitable contributions, pay extra on their mortgages or undergo medical or dental procedures in 2013 rather than in 2014. Again, the tax benefits would have to be weighed against the opportunity cost of making the payments early.

Limiting the Total Amount in Tax Favored Retirement Plans

This proposal would cap a taxpayer’s total balance in all tax-favored retirement accounts at the amount necessary to make the maximum payout permitted under a defined contribution plan. For 2013, this maximum payout is $205,000 for a joint and survivor annuity beginning at age 62. Given current interest rates, this translates to an account balance of approximately $3.4 million. Tax-favored retirement accounts for this purpose include (1) traditional IRAs, (2) Roth IRAs, (3) stock bonus plans, (4) profit sharing plans, (5) pension plans, (6) section 403(b) plans of non-profit organizations and (7) funded section 457(b) plans of state and local government employers.

The limitation would be determined at the end of each calendar year and would apply to contributions or accruals for the following year. If a taxpayer reached the maximum accumulation, no further contributions or accruals would be allowed, but the taxpayer’s account balance would continue to grow with investment earnings and gains.

If a taxpayer received a contribution or an accrual that would result in an accumulation in excess of the maximum permitted amount, the excess would be treated in a manner similar to the treatment of an excess deferral under current law. The excess amount would be included in current income, but the taxpayer would be given a grace period to remove it from a plan. If the taxpayer did not withdraw the excess contribution or accrual, the excess amounts and earnings attributable to them  would be subject to tax when distributed without any adjustment for basis. This would be true even if the distribution was made from a Roth IRA or from a designated Roth account inside a plan. Thus, the proposal would not force taxpayers to remove (1) excess amounts in the plan when the law went into effect, (2) excess amounts resulting from investment growth after the law went into effect or (3) excess amounts resulting from decreases in the maximum accrual amount due to rising interest rates.

The proposal would apply to contributions and accruals for taxable years beginning on or after January 1, 2014.

Planning Implications
The maximum accumulation amount would be highly sensitive to changes in interest rates. The lower the interest rate was, the larger the amount that would be necessary to pay a given annuity amount. As noted above, given the current low interest rates it would take approximately $3.4 million to pay a joint and survivor annuity of $205,000 beginning at age 62. If interest rates increased to 6%, the maximum accumulation would drop to about $2.4 million. This suggests that if the proposal went into effect, taxpayers should try to maximize the amounts they could accrue in tax-favored retirement vehicles before interest rates increase.

The effect of this proposal may be less important than it might appear on the surface. For taxpayers with accruals in excess of the permitted amount, growth in the assets may be far more important than additional contributions.  Suppose, for example that T has $5 million in a 401(k) plan, a 403(b) plan, a 457 plan or a federal government Thrift Savings Plan. The maximum annual contribution for an employee under age 50 for these plans is $17,500 in 2013. Thus, the maximum contribution would represent an increase in the value of the account of only 0.35%.

Taxpayers who are no longer able to invest in tax-favored retirement vehicles will look for other favorable investments. As a result, deferred annuities and permanent life insurance may become more popular.

Shortening the Deferral Period for Inherited IRAs with Non-Spouse Beneficiaries

Under current law, if an IRA owner dies after reaching age 70 ½, and a non-spouse individual is the designated beneficiary, required minimum distributions are made over the beneficiary’s life expectancy. A popular planning strategy for inherited IRAs is to have the youngest possible designated beneficiary to maximize the tax deferral opportunities. 

The proposal would limit the tax benefits of deferral by generally requiring non-spouse beneficiaries to take distributions over no more than five years. The reason for the change is that IRAs were intended to provide retirement security for individuals and their spouses, not to provide a tax break for non-spouse beneficiaries.

Planning Implications
Although a planner’s first reaction might be that the requirement could be avoided by converting traditional IRAs to Roth IRAs, this is not the case. Roth IRAs do not have required minimum distributions during the IRA owner’s life, but a non-spouse beneficiary of an inherited Roth IRA is subject to the same payout restrictions as the beneficiary of a traditional IRA.

The proposal would also change IRA beneficiary planning because there would be no need to qualify a beneficiary with a long life expectancy as the designated beneficiary. This would make it more popular to name trusts as beneficiaries, particularly accumulation trusts which could provide much needed asset protection without the loss of potential lifetime stretchout of minimum distributions which may occur under current law. It might also make it more popular to include charities as IRA beneficiaries.

Tax Carried (Profits) Interests as Ordinary Income

A carried interest is a share of profits that general partners of private equity and hedge funds receive as compensation.  Under current law such amounts are treated as capital gains even though they are received in connection with the performance of services rather than as a return on invested capital. The proposal would generally tax carried interests as ordinary income. This would increase the effective tax rate on carried interests in most cases from 23.8% to 43.4%.

Planning Implications
When a bill with similar provisions was introduced by Senator Levin (D. Michigan), it included an exception for a “qualified capital interest.” Such an interest included (1) the portion of a partner’s interest attributable to a contribution of money or other property to the partnership, (2) the inclusion of compensation income under IRC § 83 when the partnership interest was granted and (3) allocation of net partnership income for years after the proposal went into effect.

Commentators have suggested that if the proposal becomes law and includes a similar exception, ordinary income treatment could be avoided in the future by converting a partnership profits interest into a qualified capital interest. Ordinary income would be recognized on the conversion equal to the FMV of the interest, but future income would be capital gain and would not be subject to the payroll tax. A detailed quantitative analysis would be necessary to determine whether such a conversion would be advisable.


It is not clear at this time which, if any, of the Treasury Revenue Proposals discussed above might become law. Because the window of opportunity for limiting their impact might be short, however, planners should start thinking about planning implications now…and keep current with the status of these Proposals! 

Tax Planning for 2013 Under the New Laws

(May 2013)

As you probably know all too well, tax rates increase substantially in 2013 and later years for high income taxpayers. Not only did the top income tax rate increase from 35% to 39.6%, but a 3.8% Medicare surtax is now imposed on net investment income (NII). The 39.6% rate now applies to taxable income over $450,000 for married taxpayers and $400,000 for single taxpayers. In addition, net investment income is subject to a new 3.8% Medicare surtax to the extent modified adjusted gross income exceeds $250,000 for married taxpayers and $200,000 for single taxpayers. Together, the 39.6% rate and the 3.8% Medicare surtax could increase your clients’ effective tax rate to as much as 43.4%.

The increased tax rates make managing income from year to year more important than ever. Fortunately, there are a number of strategies you can use to help your clients stay out of the top marginal bracket and/or eliminate or reduce their surtax exposure. These include (1) charitable remainder trusts (CRTs) to smooth income, (2) CRTs to shift income, (3) CRTs to save for retirement. (4) charitable lead trusts, (5) life insurance, (6) deferred annuities, (7) installment sales, (8) managing IRA distributions. (9) gain harvesting,  (10) loss harvesting, (11) Roth IRA conversions, (12) converting passive activities to active activities by changing grouping elections, (13) private split dollar insurance, (14) reverse mortgages, (15) low NII investments, (16) real estate investments, (17) oil and gas investments, (18) choice of filing status and   increasing above-the-line deductions.

Beginning with next month's newsletter, I will be discussing one or more of these strategies in more detail each month. To set the stage, however, I will briefly lay out how the surtax works in this issue.

Overview of the 3.8% Medicare Surtax

For individuals, the surtax applies to the lesser of (1) net investment income (NII) or (2) the excess of a taxpayer's modified adjusted gross income (MAGI) over an applicable threshold amount (ATA).[1]


NII is the sum of three kinds of income reduced by deductions properly allocable to them:

  1. Gross income from interest, rents, dividends, annuities and royalties unless such income is derived in the ordinary course of an active trade or business other than a securities or commodities business;
  2. Gross income from a trade or business that is either (a) a passive activity for the taxpayer under IRC § 469 or (b) a financial instruments or commodities business; and
  3. Net gain (to the extent taken into account in calculating taxable income) attributable to the disposition of property other than property held in an active business that is not a securities or commodities business.[2]

The following items of income are specifically excluded from NII:

  • Distributions from Roth IRAs
  • Distributions from traditional IRAs
  • Distributions from 401(k) plans
  • Social security
  • Life insurance proceeds
  • Municipal bond interest
  • Schedule C income from businesses
  • Income from a business in which the taxpayer pays self-employment tax
  • Veterans’ benefits
  • Deferred compensation

MAGI is adjusted gross income (AGI) increased by net foreign-source income exempt from regular tax under IRC section 911(a)(1). For most taxpayers, MAGI is simply the amount reported on line 37 (bottom of Page 1) of Form 1040.

ATA Amounts
The applicable threshold amounts are as follows:

  • Married taxpayers filing jointly.............................$250,000
  • Married taxpayers filing separately........................$125,000
  • All other individual taxpayers...............................$200,000

A simple example will illustrate how the surtax is calculated.

Example. Ron is a single taxpayer with the following items of income:

  • $150,000 salary
  • $50,000 Roth distribution
  • $60,000 traditional IRA distribution
  • $10,000 of dividends
  • $5,000 of interest income
  • $100,000 gain on the sale of publicly-traded stock

Ron is subject to the surtax on the lesser of NII or the excess of MAGI over the ATA of $200,000 for a single taxpayer.

The following items of income are included in MAGI:

  • Salary............................................................................$150,000
  • Traditional IRA distribution...................................................60,000
  • Dividends.........................................................................10,000
  • Interest.............................................................................5,000
  • Gain on the sale of stock...................................................$100,000
  • Total MAGI.....................................................................$325,000
    (MAGI in excess of $200,000 ATA = $125,000)

These items are included in NII:

  • Dividends.........................................................................10,000
  • Interest.............................................................................5,000
  • Gain on sale of stock.........................................................$100,000
  • Total NII.........................................................................$115,000

Thus, the lesser of NII and MAGI – ATA is $115,000 and the surtax payable is $4,370 (.038 x $115,000). Note that the Roth distribution is neither MAGI nor NII. Note also that although the traditional IRA is not NII, it increases the surtax payable by increasing MAGI. Without the traditional IRA distribution, MAGI – ATA would be only $265,000 - $200,000 = $65,000, and the amount subject to the surtax would be only $65,000 instead of $115,000.

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