Income tax rates are going up, but it is not clear when the increase will happen or how high rates will go. The current low rates, which reflect tax cuts implemented during the Bush administration, are set to expire at the end of 2010 if nothing is done legislatively to change them.
President Barack Obama has outlined significant tax increases, similar to the Bush cuts, in his budget proposal that could come about sooner than 2011.
“We know there is no current political will or ability to lower rates,” says Mark D. Klimek, chair of the tax practice group and member at McDonald Hopkins LLC. “We’re spending unprecedented amounts of money on military operations, health care and stimulus actions, so nobody is going to even propose to decrease tax rates. What we do know is that tax rates will go up in 2011, even with no political intervention.”
Smart Business spoke with Klimek about the different upcoming tax increases and how to prepare for these.
What are the specific tax increases?
The top marginal rate for wages and business income that is passed through to certain business owners is scheduled to increase from 35 to 39.6 percent. The capital gains rate will increase from 15 to 20 percent. But, the biggest change is for dividends, which will increase from 15 to 39.6 percent, the same tax rate as ordinary income.
What types of businesses will be most impacted by these increases?
These increases will mainly affect businesses set up as pass-through entities, since the income of these entities is allocated to their owners. Normally these are smaller, closely held businesses that are partnerships, LLCs and/or S corporations. Since most of the proposed increases are geared toward individuals, these types of businesses would be hit harder, which is ironic since these entities are generally much more tax efficient. There has not been much talk about raising corporate tax rates, but it is hard to imagine that it will not be on the table at some point.
How can you prepare for these increases and mitigate the impact?
Preparation in this environment requires some counterintuitive tax planning. Most tax advisers will try to defer taxes to future years. Taxpayers ultimately do have to pay tax on deferred profits or gains, but paying the tax later is almost always better than paying it currently. But, in this environment, you should consider whether it makes more sense to accelerate income. Should you consider paying income tax in 2010 if you know you will otherwise need to recognize income in 2011 at a much higher rate?
You can accelerate income by steering away from transactions that defer income. One example is the installment sale. You do not have to recognize gains on the sale of stock or assets that are sold in exchange for a note until payments are received on that note. If that note provides for payments over five years, you will not recognize that last bit of income until five years down the road. In an environment of rising tax rates, a taxpayer may want to pay all taxes upfront by electing out of the installment sale treatment. You must have enough cash to pay all of the tax in the current year, but it may be best to pay the tax in the current year at a lower rate and not pay it in future years when rates are higher.