Year-End Tax Guide for Private Wealth Planning

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2016 Year-End Tax Guide for Private Wealth PlanningGrant Thornton LLP’s Year-End Tax Guide for Private Wealth Planning is designed to give comprehensive information about the complex tax issues you worry about. We include a portion of the guide here. The full guide, available by downloading the PDF, includes additional discussions about investment income, charitable deductions, retirement savings, education incentives and estate planning. It also contains planning tips, helpful tables and clarifications of tax law changes.    

This year we’ve put together three guides for your ease of use. In addition to the guide for private wealth planning, take a look at our Year-End Tax Guide for Privately Held Businesses and our Year-End Tax Guide for Compensation and Benefits. Each guide is focused on its topic while being expansive in its coverage.

Contents Introduction: Thinking forward
Tax law changes: What’s new this year?
The beginning: Individual income taxes
AMT: Punishment for success
Investment income: Juggling the tax impact
Charitable deductions: Saving by giving
Retirement savings: Growing your nest
Education incentives: The ABC's of tax savings
Estate planning: Transfer tips
Introduction: Thinking forward Success isn’t easy and it certainly isn’t free. As your income increases, so does your tax burden. You need to think ahead if you want to protect your investments and pass your wealth to the next generation. Tax planning for successful individuals means acting well before your return is due. Many estate planning strategies take years to implement and involve both income and estate tax considerations. Your income tax planning itself should not be an annual exercise. The alternative minimum tax and yearly limits on many tax benefits make multiyear income tax planning a must for high-income taxpayers.

Don’t panic. This isn’t as overwhelming as it sounds. This Year-End Tax Guide for Private Wealth Planning organizes
your planning considerations into easy-to-understand sections on topics like income taxes, alternative minimum tax, investment taxes, and estate and gift taxes. To make tax planning easy, we’ve also included:

  • Comprehensive tables that lay out important tax rules, limits and rates
  • Explanations of new tax law changes
  • Planning strategies you can use right now with examples that describe how they can save you taxes

This guide will show you how to tax-efficiently invest for education and retirement, leverage your charitable giving, and share your wealth with loved ones. But remember, this guide can’t cover all possible strategies, and tax law changes are always possible. Many of the most significant tax changes of the last decade were made in “lame duck” sessions of Congress, and many outgoing presidential administrations have been known to issue controversial regulations just before leaving office. You should check with a tax professional for the most up-to-date tax rules and regulations before making any tax decisions.

Tax law changes: What’s new this year? Lawmakers gave us a pleasant surprise at the end of 2015. After years of spinning their wheels and repeatedly extending some of the tax code’s most popular provisions temporarily, they passed a sweeping compromise that made many of the most important provisions permanent. Not much tax legislation has passed since, and not much is likely for the rest of the election year, but the IRS has released some important pieces of guidance.

Extenders More than 50 popular temporary provisions expired at the end of 2014. Congress typically extended them retroactively every year or two on a short-term basis until the Protecting Americans from Tax Hikes (PATH) Act of 2015 was enacted. It makes permanent some of the most popular tax benefits for high-net-worth individuals, including the following:

  • Election to deduct state and local sales taxes
  • Tax-free charitable distributions from individual retirement accounts (IRAs) for taxpayers 70½ and older
  • American opportunity tax credit
  • Full exclusion from capital gain for sales of qualified small business stock
  • Estate tax look-through for regulated investment company stock held by nonresidents

In addition, the PATH Act extended through the end of 2016 the above-the-line deduction for qualified tuition, the exclusion from income for debt forgiveness of a personal residence and the deduction for mortgage insurance premiums.

New estate tax reporting Executors filing estate tax returns are now generally required to furnish the value of all assets to the IRS and beneficiaries on the new Form 8791. The IRS has long suspected that taxpayers were deflating the value of assets when calculating their estate taxes, only to have the beneficiaries inflate the value after inheriting the property to increase the income tax basis. Taxpayers will now have to use the value assigned by the estate as the basis for their assets or face a penalty. Form 8791 is generally due within 30 days from when Form 706 is filed, and any estate required to file an estate tax return must generally provide a valuation for all property in the estate and report this information to all heirs who may receive it. The proposed and temporary regulations also require reporting for some subsequent transfers of inherited property.

Curbing FLP valuation discounts The IRS has proposed regulations that would gut your ability to take valuation discounts for lack of marketability and control when transferring interests in a family limited partnership (FLP) or other family-controlled entity (FCE). FLPs have long been a staple of transfer tax planning because they can provide an excellent vehicle for passing assets to heirs at a steep discount. When you pass an interest in an FLP to a family member, the value of the partnership interest used to calculate the transfer tax implications may be discounted significantly because the underlying assets are subject to restrictions on marketability and control.

The IRS has long successfully challenged FLPs that are set up solely for tax planning purposes and FLPs in which the donor retains the actual or implied right to enjoy the FLP assets (or the donor retains the right to control the FLP). The new proposed regulations would go much further, and if finalized in their current form, could virtually erase any valuation discounts for most FLPs and FCEs. If you are considering transferring interests in an FLP, consider acting before the guidance is finalized.

IRS allows full mortgage interest deduction on co-owned property The IRS did offer some good news this year, announcing it will no longer challenge taxpayers who deduct interest on up to $1.1 million in mortgage debt even if another taxpayer also holds debt on the same property. Taxpayers can generally deduct interest paid on up to $1 million in debt used to buy a principal residence and one other home and another $100,000 in general home equity debt on the properties.

The IRS had long argued that the $1.1 million limit applied to both taxpayers and property so that unmarried co-owners of the same properties could take combined interest deductions on only $1.1 million total mortgage debt between the two of them, instead of up to $1.1 million each. After losing a recent court case, the IRS relented on the issue. The decision represents a second positive development in the past several years for taxpayers on the mortgage interest deduction. The IRS ruled in 2010 that taxpayers could use the additional interest deduction on up to $100,000 in home equity debt even if the debt was “acquisition” debt used to acquire, construct or substantially improve the home.

The beginning: Individual income taxes Many successful taxpayers use aggressive strategies for transfer taxes and charitable and investment vehicles but overlook some of the simplest and easiest ways to reduce their tax bills. Your tax planning should start with understanding the basic rules for income tax rates and deductions. Some of the simplest strategies about when and how you use deductions and when you recognize income can profoundly affect when and how much you pay.

First, your rates. Different types of income are taxed differently. The biggest chunk of your income is likely ordinary income. It includes items like salary and bonuses, self-employment and business income, and retirement plan distributions. Most types of investment income — like rents, royalties and interest — are also taxed as ordinary income. Two kinds of investment income are subject to special lower rates: qualified dividends and long-term capital gains from assets held more than one year.

Tax benefit thresholdsThe top rate on ordinary income is 39.6%, while the top rate on long-term capital gains and qualifying dividends is 20%. These figures don’t include employment tax and net investment income (NII) tax. We’ve included tables with the full tax brackets for investment and ordinary income, plus the 2016 figures for many important tax rules and benefits. Note that low gas prices actually pushed down the standard mileage deduction from 57.5 cents in 2015 to 54 cents per mile in 2016.

Looking beyond the tax brackets Your income is subject to different rates as you climb the tax brackets. The top tax rate that applies to you is often called your marginal tax rate. It’s the rate you would pay on an additional dollar of income. It’s also the percentage you can save when you find an additional deduction or a way to defer or avoid the recognition of income.

Unfortunately, the tax brackets for ordinary income don’t tell the whole story. Your effective marginal rate may differ significantly from the nominal rate in your top tax bracket. Hidden taxes like the alternative minimum tax (AMT) (see the next section on AMT) and penalties on early retirement plan withdrawals can drive your tax rates higher. Many tax credits and deductions also phase out as your adjusted gross income (AGI) increases — meaning an extra dollar of income actually increases your tax more than the nominal tax rate. Two of the most costly phaseouts apply to your personal exemptions and itemized deductions.

Personal exemption phaseout Under the personal exemption phaseout (PEP), you will lose 2% of your total personal exemptions ($4,050 for yourself, a spouse and any dependents) for every $2,500 that your AGI (or portion thereof) exceeds $259,400 (single), $285,350 (head of household) or $311,300 (joint). That means that by the time your AGI reaches $381,901 (single), $407,851 (head of household) or $433,801 (joint), you will lose 100% of your personal exemptions.

‘Pease’ phaseout The “Pease” phaseout for itemized deductions operates a little differently. Some deductions — such as medical expenses, investment interest, casualty losses and certain contributions to disaster relief — aren’t included in the phaseout. But many of the most popular and valuable itemized deductions — such as mortgage interest, charitable contributions and employee business expenses — are affected. In 2016, the affected deductions are reduced by 3% of the total amount of AGI exceeding $259,400 (single), $285,350 (head of household) or $311,300 (joint) up to a maximum reduction of 80%. For instance, the itemized deductions of a single taxpayer with $359,400 in AGI would be reduced by 3% of $100,000 ($3,000), assuming $3,000 is less than 80% of the taxpayer’s total itemized deductions.

Earned income taxes Employment taxes apply to earned income, which generally includes items like wages, bonuses, salaries, tips and self-employment income. If you are employed and your earned income consists of salaries and bonus, your employer will withhold your share of Social Security and Medicare earned income taxes and pay them directly to the government. Your employer will also begin withholding at the higher 2.35% Medicare rate once earned income reaches $200,000 regardless of your filing status and whether you have other earned income outside of your employment. You will then have to calculate your total Medicare tax on earned income on your annual return and will be responsible for paying any difference from the amount withheld.

If you are self-employed, you must pay both the employee and the employer portions of employment tax, though you can take an above-the-line deduction for the employer portion of the tax.

Above and below the line Deductions are often referred to as being either above or below the line. This phrasing comes from where they are listed on your annual income tax return, but it also has important tax implications. An above-the-line deduction is taken on the first page of your tax return, and more importantly, it reduces AGI. Above-the-line deductions help with AGI-based phaseouts and are taken whether or not you itemize deductions. Important above-the-line deductions include alimony, contributions to health savings accounts and individual retirement accounts, and the deductions for student loan interest and college expenses.

Itemized deductions are taken on the second page of the individual income tax return (Form 1040) and reduce taxable income, not AGI. You typically take these deductions only when they exceed the standard deduction. Most deductions are itemized deductions and include the deductions for state and local taxes, mortgage interest, charitable donations, medical expenses and unreimbursed job expenses. They are often less valuable because they do not lower AGI and because many have limits, phaseouts or AGI floors.

Planning tip: Bunch itemized deductions
Timing significantly affects your itemized deductions because many of those deductions have AGI floors. For instance, miscellaneous expenses are deductible only to the extent they exceed 2% of your AGI, and medical expenses are deductible only to the extent they exceed 10% of your AGI (7.5% for taxpayers 65 and older). Bunching these deductions into a single year may allow you to exceed these floors and save. You may be able to accelerate and pay the following miscellaneous expenses:
• Deductible investment expenses such as investment advisory fees, custodial fees, safe deposit box rentals and investment publications
• Professional fees such as tax planning and preparation, accounting and certain legal fees
• Unreimbursed employee business expenses such as travel, meals, entertainment, vehicle costs and publications — all exclusive of personal use

Bunching medical expenses is often easier than bunching miscellaneous itemized deductions. Consider scheduling your nonurgent medical procedures and other controllable expenses in one year to take advantage of the deductions. Deductible medical expenses include:
• Health insurance premiums
• Prescription drugs
• Medical and dental costs and services, including elective surgical procedures that are not purely cosmetic
When you can’t reduce, defer Sometimes you can’t control whether you pay tax, but you can control when. Deferring tax can be almost as good as escaping it. With the time value of money, postponing a tax bill can help you generate a return that almost pays for the tax itself. The idea is to delay recognizing income while accelerating deductions. There are many items for which you may be able to control timing.
  • Consulting income
  • Self-employment income
  • Real estate sales
  • Gain on stock sales
  • Other property sales
  • Retirement plan distributions

  • State and local income taxes
  • Losses on sales of stock and other investment property
  • Real estate taxes
  • Mortgage interest
  • Margin interest
  • Charitable contributions

But be careful. Certain circumstances may affect your strategy. You may want to delay an itemized deduction to bunch it with future expenses, or your tax planning may be affected by the AMT. You will likely benefit from multiyear tax planning.

You should also remember that prepaid expenses can be deducted only in the year they apply. So you can prepay 2016 state income taxes and take a deduction now even though they aren’t due until 2017. But you can’t prepay state taxes on 2017 income and deduct them on your 2016 return.

AMT: Punishment for success
The AMT is one of the most frustrating surprises hiding in the tax code. Just when you think you’ve figured out your taxes, you stumble onto the AMT and are forced to run everything through a completely different set of calculations. The AMT is essentially a separate tax system with its own rules. Each year you must calculate your tax liability under the regular income tax system and the separate AMT system and pay the higher amount.

The AMT has a lower top rate than the regular income tax system, with just two tax brackets of 26% and 28%. So how can your AMT be greater than your normal income tax? It’s because many deductions and credits aren’t allowed against the AMT. Taxpayers with substantial deductions or benefits that are reduced or not allowed under the AMT are the ones stuck paying it.

That’s why it’s so important to know whether you’ll be subject to the AMT before your tax return is due. You need to know if you’ll benefit from certain tax incentives before making business and investment decisions that hinge on the tax treatment. Common AMT triggers include the following:

• State and local income and sales taxes, especially in high-tax states
• Real estate or personal property taxes
• Investment advisory fees
• Employee business expenses
• Incentive stock options
• Interest on a home equity loan not used to build or improve your residence
• Tax-exempt interest on certain private activity bonds
• Accelerated depreciation adjustments and related gain or loss differences on disposition

AMTThe AMT does come with a significant exemption, and the good news is that the AMT brackets, exemptions and exemption phaseouts are now permanently indexed for inflation. Even better: There are ways to mitigate or even benefit from the AMT by leveraging its low top rate. You just need to plan. Multiyear tax planning can help you accelerate income into years when you are subject to the lower AMT rates and postpone deductions into years when you can use them against the higher regular tax rates. But remember that this strategy runs counter to the usual tax planning goal of deferring income and accelerating deductions, so read our two AMT tax planning tips carefully and make sure you work with a tax professional to understand all the implications.

Planning tip: Zero out the AMT You have to pay the AMT when it results in more tax than your regular income tax calculation, typically because the AMT has removed key deductions. The silver lining is that the top AMT tax rate is only 28%. So you can “zero out” the AMT by accelerating income into the AMT year until the tax you calculate for regular tax and AMT are the same. Although you will have paid tax sooner, you will have paid at an effective tax rate of only 26% or 28% on the accelerated income, which is less than the top rate of 39.6% that is paid in a year in which you’re not subject to the AMT. But be careful. If the additional income falls into the AMT exemption phaseout range, the effective rate may be a higher 31.5% (because the additional income will be reducing the amount of exemption you can use). The additional income may also affect other tax benefits, so you need to consider the overall tax impact.Capital gains and dividends Long-term capital gains and qualified dividends deserve special consideration for the AMT. They are taxed at the same 15% and 20% rates under either the AMT or regular tax structure, but the additional income they generate can reduce your AMT exemption and result in an effective rate of 20.5% instead of the normal 15% (or 25.5% for capital gains in the 20% bracket). So consider the AMT as part of your tax analysis before selling any asset that could generate a large gain.

Investment income: Juggling the tax impact Investing is a long-term game, so tax planning for your investment income should be as well. Small tax differences can have a big impact over the life cycle of investment decisions that will play out for years or even decades.

So it’s important to make sure you aren’t organizing your portfolio solely on economic decisions while ignoring the tax consequences. First, you need to understand how different investment income is taxed. Investment income such as rents, royalties, interest and short-term capital gains is taxed as ordinary income. The top ordinary income tax rate is 39.6%. The top rate on long-term capital gains and qualifying dividends is 20%. But these rates don’t tell the whole story. The new 3.8% Medicare tax on NII can push the top investment tax rates even higher.

Combined top rates on investment income

Managing capital gains and losses To benefit from long-term capital gains treatment, you generally must hold a capital asset for more than one year before selling it. Selling an asset you’ve held for a year or less results in less-favorable short-term capital gains treatment. Some assets, like collectibles, have special, higher capital gains rates, and taxpayers in the bottom two tax brackets enjoy a zero rate on their capital gains and qualified dividends.

Your total capital gain or loss for tax purposes generally is calculated by netting all the capital gains and losses throughout the year. You usually cannot use a capital loss against other kinds of income, so consider the tax consequences before selling an asset that will generate a large loss. When selling securities, keep in mind two rules that can affect your gain or loss:

  • If you bought the same security at different times and prices, you should identify in writing which shares are to be sold by the broker before the sale. Selling the shares with the highest basis will reduce your gain or increase your loss.
  • For tax purposes, the trade date, and not the settlement date, of publicly traded securities determines the year in which you recognize the gain or loss.

You can offset both short- and long-term gains with either short- or long-term losses. Taxpayers facing a large capital gains tax bill often benefit from looking for unrealized losses in their portfolio so that they can sell the assets to offset the gains. But keep the “wash sale” rule in mind. You can’t use the loss if you buy the same – or a substantially identical – security within 30 days before or after you sell the security that creates the loss.

Leveraging deferral Deferral is one of the most powerful planning techniques for investment income, because it allows all of the investment income to continue to appreciate. You can control the timing on investment decisions, which often allows you to control the timing of recognizing income. Capital gains and losses, in particular, present excellent opportunities for deferral because you have nearly complete control over when you sell them.

Planning tip: Work around the ‘wash sale’ rule
There are ways to mitigate the wash sale rule. You may be able to buy securities of a different company in the same industry or shares in a mutual fund that holds securities much like the ones you sold. Alternatively, consider a bond swap, which is a way to maintain your investment position while recognizing a loss. With a bond swap, you sell a bond, take a capital loss and immediately buy another similar-quality bond from a different issuer. You’ll avoid the wash sale rule because bonds from different issuers aren’t considered substantially identical.
Net investment income tax Most investment income is now subject to the 3.8% NII tax once AGI exceeds certain thresholds. NII comprises the following:

  • Rents
  • Royalties
  • Interest
  • Dividends
  • Capital gains
  • Annuities
  • Any income from a trade or business that is a passive activity

There is an exception if the income is derived in the ordinary course of a trade or business in which you are not passive. But all income from a trade or business in which you are passive is NII, regardless of the type. For example, the ordinary income earned through your company’s business operations will generally be included in NII unless you work enough in the business to meet IRS participation tests. Plus, income from trading in financial instruments or commodities is always NII, regardless of whether you participate in the business.

Planning tip: Manage capital gains with installment sales and like-kind exchanges
Consider more-sophisticated opportunities for deferring gain:
• Installment sale: If you don’t need the money immediately, structuring a transaction as an installment sale allows you to defer capital gains on most assets other than publicly traded securities by spreading the gain over several years as you receive the proceeds.
• Like-kind exchange: Like-kind exchanges under Section 1031 allow you to exchange similar property without incurring capital gains tax. Most types of business and investment property qualify, and the planning technique can be very powerful in real estate deals. Under a like-kind exchange, you defer paying tax on the gain until you sell your replacement property.
Income that is generally excluded under other provisions of the Internal Revenue Code, such as tax-exempt interest or certain gains from the sale of a principal residence, is generally excluded from NII. NII also doesn’t include qualified retirement plan distributions such as withdrawals from your IRA or 401(k). However, distributions from these accounts can indirectly increase NII tax by pushing AGI higher and forcing more of your other NII above the AGI threshold.

Use your deductions The IRS allows you to reduce your NII by many common deductions that can be attributed to the income that gives rise to NII. Among the most common deductions you can allocate to NII are the following:

  • Deductions attributed to rent and royalty income
  • Penalties for early withdrawal of retirement accounts
  •  Investment interest
  • Investment expenses such as investment management fees and investor publications
  • Tax preparation fees
  • State, local and foreign income taxes
  • Certain fiduciary fees

Some deductions, such as investment interest, can be allocated fully to NII. Other deductions, such as state taxes and tax preparation fees, can be only partially attributed to NII and are therefore only partially allowed against NII. The IRS allows you to allocate these deductions by any reasonable means. The simplest way is to use the ratio between overall AGI and investment income, but other methods may provide better results.

You don’t have to reduce your deductions on the income tax side by any allocation of these deductions to NII. The tax bases are separate, and the deductions are allowed against both taxes at the same time. However, you can deduct expenses against NII only to the extent the expenses are deductible for regular income tax purposes.

Download the full PDF of the Year-End Tax Guide for Private Wealth Planning to read more about other aspects of investment income, including participating in your business activities and exploring your options.

Other chapters cover:
  • Charitable deductions: Saving by giving
  • Retirement savings: Growing your nest
  • Education incentives: The ABC’s of tax savings
  • Estate planning: Transfer tips

Contact David Walser
Managing Director, Private Wealth Services
T+1 602 474 3410

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.

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