Tax Strategies for Business Owners

The 2013 tax year will be a Brave New World for many closely-held business owners. A number of tax rates are increasing, depreciation incentives are ending, and then there's the Affordable Care Act (ACA). Business owners face many new tax challenges in 2013. Business owners will want to identify how these many changes will affect both their business and personal taxes.

New tax rate increases in 2013

The legislation early this year that added a new top bracket for higher-income individuals was well-publicized, but 2013 has a whole array of tax rate increases applying at varying income levels:

  • New ACA taxes beginning in 2013. The first is a new federal surtax of 3.8% on net investment income. This tax is imposed on items such as interest, dividends, annuity income, rents and royalties, passive business income, and most capital gains, other than those from an active participation business. The second tax is a 0.9% add-on to the Medicare tax applying to wages and self-employment income. Both of these taxes are imposed on single incomes above $200,000 and joint income above $250,000. For business owners who use pass-through entities and pay all tax at the 1040 level, any salaries, and also any rental income from the business, both face a 3.8% added tax: 3.8% net investment income tax on the rent and a 3.8% combined Medicare tax (2.9% old plus 0.9% new) on wages or self-employment income. 
  • Phase-out of itemized deductions and personal exemptions. Beginning in 2013, two back-door rate increases apply. As 1040 income moves above $250,000 single or $300,000 joint, both itemized deductions and personal exemptions are gradually phased out. These phase-outs are designed to raise rates by 1% for the itemized adjustment and another 1% per person on the personal exemption phase-out. Thus, a family of four moving through the phase-out range would have an additional 5% federal income tax rate increase. 
  • New top end brackets. The top rates on both ordinary income and capital gain were increased for 2013. A seventh ordinary income bracket of 39.6% was added for joint filers whose income exceeds $450,000 and single filers over $400,000. This income was previously taxed at 35%. And for those with capital gain and dividend income at these levels, the former 15% rate becomes 20% (23.8%, taking into account the net investment income tax). 
  • The continuing AMT. The Alternative Minimum Tax (AMT) continues as in the past, requiring a taxpayer to pay the greater of the regular tax computation or the AMT. Unfortunately, several of these new taxes, such as the 3.8% net investment income tax, are independent add-ons. Further, the AMT rate itself can impart a higher-than-expected 35% rate at incomes as low as $200,000, due to the phase-out of its exemption.

The difficult part of these many rate changes is that identifying the tax cost of incremental income is no longer an easy matter. A capital gain, for example, could easily range anywhere from a 15% to a 25% rate, depending on how it fits into other income within the 1040. For many upper-income filers, the tax cost increase from 2012 to 2013 will be eye-popping. A year-end tax projection may make sense, as it can identify not only the magnitude of the increase, but whether actions such as prepaying state income tax or accelerating quarterly estimates would be helpful.

End of the first-year depreciation incentives

Since the beginning of the recession in 2008, Congress has been providing two first-year depreciation incentives to incent business owners to expend for capital equipment and other depreciable improvements. The first-year Section 179 deduction was increased, and a 50% first-year bonus deduction has been allowed for most new, but not used, business property (other than real estate). But these incentives both expire going into 2014.

Our expectation is that Congress will not extend either of these provisions: 50% bonus depreciation will end on December 31, 2013 for all businesses, regardless of tax year, and the Section 179 deduction, currently $500,000, will likely return to its former range, which, with inflation indexing, should be about $145,000. That decrease will occur effective with the tax year beginning in 2014. Business owners with capital improvement needs will want to consider acquiring and placing in service those improvements before these incentives disappear.

Repair regulations

In September of this year, the IRS issued final regulations on its important repair vs. capitalization project. These final regulations have been years in the making and contain important guidance on when an expenditure is a capital asset vs. a currently deductible, supply, or repair item.

Most businesses will want to adopt the de minimis accounting policy, in writing, that will allow smaller capital expenditures to be currently deducted. This policy can allow a current deduction of items up to $5,000 if the taxpayer has a formal financial statement (10-K, certified audit, or government-required financial), and is up to $500 per item for those without this type of financial statement. This policy must be in place by the beginning of the tax year that commences in 2014 and, accordingly, must be in place as early as January 1, 2014, for calendar year taxpayers.

Author: V. E. "Butch" Shoup, Tax Principal at CliftonLarsonAllen, LLP

(originally published in the December 2013 eNewsletter)