As taxpayers begin to asses 2014 tax liability, certain investment-related tax planning strategies may provide opportunities to defer income or deductions to later years. Depending on the taxpayer’s circumstances, they may wish to defer (or advance) the reporting of taxable events if they anticipate facing different tax rates in the future.
As part of this assessment, there are four areas that investors may want to consider which may allow them to take steps before the end of the year to minimize their liability.
Timing of capital gain or loss
Owners of capital property may be able to control when gain or loss is recognized for tax purposes. In general, gain is not recognized until property is sold. There are certain ways to control the timing of such recognition and, thus, manage taxation.
The problems of determining the correct year to report income or take deductions flow from the requirement that income must be reported on the basis of annual periods. Although a few exceptions exist, as a general rule investors must report income and claim deductions according to annual accounting periods.
Investors can defer recognition of gain on investments such as stock or bonds by using a buy and hold strategy because generally taxpayers do not recognize gains until they sell their investments. When investors sell stocks or bonds, they can minimize gains by selling stocks or bonds with the highest bases relative to sales prices. In the same year, investors also may be able to sell stocks or bonds at a loss to offset gains recognized on other sales.
Investors can accelerate recognition of loss on investments such as stocks or bonds by selling the stocks or bonds. However, in certain circumstances the tax law disallows the current recognition of a loss such as when the sale is between certain related persons, or where the investor holds or acquires certain other positions in the property being sold at a loss.
The ability to time the reporting of gain or loss is critical to enhancing the success of the investor. Deferring income until a later year, particularly a year in which the investor is in a lower tax bracket, or accelerating a deduction into a year in which the taxpayer has a great deal of income can significantly enhance the after-tax return from an investment.
Most investors are cash basis taxpayers who report income as it is received and take deductions as expenses are paid. As such, they will generally recognize a gain or loss from the disposition of an asset at the time the transaction is closed. The mere signing of an agreement to sell does not trigger the recognition of gain or loss. A transaction is not closed until the seller transfers title to the property in exchange for cash or other proceeds.
Cash-basis taxpayers report income in the year that they receive it and, generally, deduct expenses in the year that they pay it. The cash-basis method is therefore essentially an “in and out of pocket” method of reporting. Items do not have to be received or paid in cash; receipts and payments in property are income and deduction items to the extent of the fair market value of the property received or paid.
Cash-basis investors will generally include interest, royalty, dividend, and other investment income, as well as gains from the sale of investments, in gross income in the year in which they receive cash or other property. They will also deduct interest and other expenses they incur in connection with their investments, as well as losses from the sale of investments, from gross income in the year in which they pay cash or other property. Thus, they may deduct interest expense, investment advisory fees, and other deductible expenses in the year paid, but deduct losses on the sale of securities on the trade date (even if delivery and receipt of the proceeds occurs in the following year). Some exceptions to the general rules governing cash basis investors follow.
Under the doctrine of constructive receipt, an investor must include an item in gross income even though he does not actually take possession, if the item is:
- credited to the investor’s account;
- set apart from other funds; or
- otherwise made available without any substantial conditions or restrictions.
Therefore, income is taxable if the investor can take it when he or she wants it.
The purpose of the doctrine is to prevent investors from determining at will the year in which they will report income. Without the doctrine of constructive receipt, investors could postpone the taxability of income until the year in which they chose to reduce the item to their actual possession. For example, taxpayers must report interest credited to their bank savings accounts regardless of whether they withdraw the interest or leave it on deposit.
Constructive receipt will not apply if the taxpayer’s control of the income is restricted in some meaningful manner. For instance, an investor will not be considered to have constructively received money or other property if:
- it is only conditionally credited;
- it is an indefinite amount;
- the payor has no funds;
- the money is available only through the surrender of a valuable right; or
- receipt is subject to any other substantial limitation or restriction.
The doctrine of constructive receipt is particularly important to individuals whose employers have enhanced their financial security through nonqualified deferred compensation arrangements. As a taxpayer approaches the end of the year, slight changes in the conditions that trigger a constructive receipt may allow them to defer the receipt of income to a later year.
An investor can defer the recognition of gain until the actual receipt of cash or other property in exchange for the asset sold. The key ingredient in an installment sale is that the seller will receive at least one payment in a year after the year of sale.
The installment sale provisions are particularly important to an investor who has sold an asset for a substantial profit and has received a cash down payment and note from the purchaser for the balance due. Usually, these notes are not readily transferable. Without the installment sale rules, the investor would incur a large tax in one year even if he does not have sufficient cash from the transaction to pay the tax.
Installment sales are also indicated when an investor wants to sell property to another party who does not have enough liquid assets to pay for the property in a lump sum at closing. Installment sales are an important estate as well as financial planning tool and are used to shift wealth within the family unit as well as to protect appreciating assets from creditors.
The basic rules for installment sale reporting include the following:
1. A seller of property can defer as much or as little as desired and can set payments to fit his financial needs. Even if the seller receives payments in the year of sale, he may still use the installment method for the unpaid balance.
2. The seller does not have to receive any payments in the year of sale. An investor may contract to have payments made to him at the time when it is most advantageous (or the least disadvantageous).
3. Installment sale treatment is automatic unless the investor affirmatively elects not to have installment treatment apply. No special election is required.
4. The contract may provide that the installment note receivable is independently secured (such as with a letter of credit obtained from a bank) without triggering the recognition of income when the note is secured.
The tax law imposes several limitations on the use of the installment sale method of accounting for gain on the sale of property. One such limitation is that taxpayers may not use the installment sale method for the sale of stock or securities that are traded on an established securities market.
Readjustment of installment terms to move receipt of sale proceeds forward or back around the end of the year can potentially make an important difference in the seller’s tax liability.
In certain situations, cash-basis investors can control the year in which they will take deductions. They can, for instance, prepay certain taxes and take the deduction in the year of payment even though the expenses relate to future years. This ability to time deductions is limited. For example, taxpayers cannot deduct the payment of multiple years’ prepaid rent and insurance premiums in the year of payment. They generally must spread the deductions over the period covered by the prepayment if the deduction of the prepayment would materially distort income.
Special rules apply to the deductibility of interest expense for all taxpayers, whether they use the cash-basis or the accrual-method of accounting. A cash-basis investor must deduct prepaid interest over the period of the loan to the extent the interest represents the cost of using the borrowed funds during each taxable year in the period. Generally, investors must deduct points paid on an investment loan ratably over the term of the loan. An investor on the accrual method of accounting accrues interest ratably over the loan period. This means the accrual-method investor must deduct the interest ratably even if he prepays the interest.
As investors approach the end of the year, they may want to consider pre-paying upcoming deductible obligations to offset gains.
An employer often transfers property to an employee in connection with the performance of services. A business may give or sell stock or other property to a key employee but withhold, by separate agreement, significant rights. For example, an employer may transfer stock to an employee but restrict the employee’s right to vote the stock or sell it. The idea is that the employer will withhold (restrict) property rights until the employee has performed certain specified services. If the employee fails to achieve the goal or meet the specified requirements, the employee may forfeit his right to the stock or other property.
Suppose an employer pays a bonus to an executive in the form of company stock. Assume the ownership of this stock is subject to certain restrictions, including a provision that if the employee leaves the company within a five-year period he will forfeit the stock and will receive no compensation. Such property, appropriately, is called restricted stock or restricted property.
If an employer gave an employee property with no restrictions, the entire value of the property would constitute current compensation income. For instance, an employee who receives a bonus of one-hundred shares of his employer’s stock currently selling for $200 a share realizes $20,000 of income. But, if certain requirements are met, an employer can compensate an employee in a manner that delays the tax until the employee is given full rights in the property.
The general rules governing restricted property (the IRC Section 83 rules) provide that employees will report transfers of restricted property as income in the first tax year in which the employees’ rights are not subject to any substantial risk of forfeiture, and transferable free of this risk.
“Substantial risk of forfeiture” means that rights in transferred property are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person or upon the occurrence of a condition related to the purpose of the transfer. In addition, there must be a realistic and substantial possibility of forfeiture if the specified condition is not satisfied. The following examples illustrate common situations that probably would not be considered substantial restrictions:
- a consulting contract with a retiring executive that called for only occasional services at the executive’s discretion;
- a requirement that an employee must return the property if he commits a felony; or
- a noncompetition provision (because this is largely within the employee’s control).
In other words, employees will not be subject to tax on restricted property as long as their rights to that property are forfeitable (subject to a substantial risk of forfeiture) and not transferable by them free of such risk. (This means that if employees should sell or give the property away, the recipients of the property must also be under a substantial risk that they (the new owners) would forfeit the property if the employees failed to satisfy the conditions necessary to obtain full ownership.
What happens when the restrictions expire? At the lapse of the restrictions, the employee generally must include in income the value of the property at that time. Sometimes an employer will remove restrictions in stages so that an employee may “earn out” of the restrictions.
But the employee has a choice — he can elect to have the value of the restricted property taxed to him immediately in the year he receives it (even though it remains nontransferable or subject to a substantial risk of forfeiture). If an employee makes this election within thirty days of receipt of the property, the general restricted property rules do not apply. Any appreciation in the value of the property is treated as capital gain rather than as compensation. The employee pays no tax at the time the risk of forfeiture expires (and will pay no tax until the property is sold or otherwise disposed of in a taxable exchange). But if the property is later forfeited, no deduction is allowed for the loss.
An employee who makes this election must be willing to pay ordinary income tax on the fair market value of the property in the year he receives the stock or other property. He is gambling that the value of the property will increase considerably before the restrictions lapse (in which case he may be eligible to pay tax on any realized gain as capital gain). He is also gambling that he will not forfeit the stock before he is able to sell or dispose of it without restriction.
Another exception to the strict rule of includability of the fair market value of the property (upon the lapse of restrictions) concerns restrictions that affect value. This exception pertains to value-affecting restrictions, which, by their terms, will never lapse. For instance, if an employee may sell restricted property only at book value and that restriction, by its terms, will never lapse, that amount will be treated as the property’s fair market value.
An employer’s compensation deduction will be allowed at the time the employee recognizes income from restricted property. The amount of the deduction will be the same as the amount of income recognized by the employee.
Tax planning for the AMT
The existence of the alternative minimum tax places a premium on planning techniques. With the availability of the AMT credit, it is less critical to undertake some of the more drastic planning concepts when the taxpayer will be able to use the AMT credit within a year or two after the AMT tax would be due.
As part of a taxpayer’s end-of-year planning activities, there are several steps that can be taken to avoid or minimize the effect of the AMT. First, investors should determine the maximum amount of deductions or losses that an investor can claim before becoming subject to the AMT. Once an investor reaches the point where the AMT applies, any additional deductions will yield at most a 26 percent (or 28 percent as determined by AMTI) tax benefit. Investors can reduce or eliminate tax preference items by:
- electing to capitalize excess intangible drilling costs, mining exploration expenses, and research and experimentation expenses, and amortize them over the permissible AMT periods;
- electing the AMT or straight-line methods of computing depreciation; or
- considering an early disposition (in the year of exercise) of stock acquired through the exercise of an Incentive Stock Option.
When it has been determined that the investor will be subject to the AMT the investor should consider deferring current year deductions (which will be of minimal value because of the AMT) and save them for a future year when they will be more valuable, by:
- postponing charitable contributions;
- postponing elective medical treatments; or
- delaying making estimated state tax payments.
The investor should also consider accelerating ordinary income, because it will be taxed at no greater than the AMT rate. This can be accomplished, for example, by exercising options under an Incentive Stock Option Plan (ISO) and selling the stock within the same year. (This has the double advantage of qualifying the ordinary income from the accelerated sale of the ISO for the maximum AMT tax rate and eliminating the ISO as a tax preference item.)
Although not included in the list of tax preferences or tax adjustments, capital gains and qualifying dividends can play a significant, yet not well understood, role in the alternative minimum tax. While capital gains and qualifying dividends are taxed for AMT purposes at the same favorable rate they are taxed for regular tax purposes, they may still contribute indirectly to the creation of AMT in some circumstances.
First, capital gains increase the taxable income from which the alternative minimum taxable income is computed. For certain ranges of income, it may phase out a part of the AMT exemption applicable to the taxpayer. Depending on the amount of other ordinary income and the proportion of adjustments and preferences relative to regular taxable income, recognition of capital gains may cause the AMT. Second, large capital gains generally create a large state income-tax liability, which itself is a tax adjustment in computing AMT in the year paid.
Investment tax issues
One of the most important considerations for investors is the tax liability that arises from investment income. With regard to investment income, there are three areas that investors should review prior to the end of the year for possible tax mitigation steps: OID elections, market discount elections, and application of loss deferral rules.
Original issue and discounts
Original Issue Discount (OID) arises when corporate or governmental borrowers originally issue bonds or notes (or other similar debt instruments) at a price that is less than the stated redemption price at maturity (i.e., par or face value). The extreme example is zero coupon bonds that borrowers issue at deep discounts from the redemption value at maturity. The difference between the issue price (the original buyer’s initial basis in the bond) and the redemption price is the original issue discount. But a de minimis exception in Code section 1273(a) provides that the discount can be ignored if it is less than 1/4 of 1% (0.0025) of the stated redemption price multiplied by the number of complete years to maturity. For example, a corporation could issue a twenty-year bond with a $10,000 par or redemption value at a price as low as $9,500 and buyers could ignore the discount. ($10,000 x 0.0025 = $25; $25 x 20 years = $500.)