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What is this "Fiscal Cliff," and why are we in this handbasket?

20121001iabizThe financial press says we are heading to the edge of a fiscal cliff at year-end. Is there any way to keep from going over it, and if not, is there any way to soften the landing?

The "Fiscal Cliff" is the potential expiration of a series of federal tax breaks that will occur absent new legislation on January 1, 2013, combined with the Obamacare tax increases that take effect then. There are dozens of tax rules affected; the biggest include:

- An increase in the top rate on ordinary income -- the rate on most income passing through on shareholder and partner K-1s -- from 35% to 39.6%.  For "passive" investors, the top rate will be 43.4%.

- An increase in the top rate on most capital gains from 15% to 23.8%. 

- An increase in the top rate on dividends from 15% to 43.4% -- nearly tripling the second tax on C corporation earnings.

- A reduction in the lifetime estate and gift tax exemption from $5 million to $1 million, combined with an increase in the top estate tax rate from 35% to 55%. 

There will also be a new .9% tax on single W-2 income over $200,000 or joint W-2 income over $250,000, as well as a 3.8% tax on "passive" or "investment" income (this tax is included in the top rates listed above). 

What to do?  Everybody's situation is different. It's unwise to take action ahead of the fiscal cliff without talking to your tax advisor. Here are some of the ideas that advisors will be discussing with their clients in the coming months:

  • Pre-emptive dividends. Some taxpayers may consider paying dividends out of their corporations by December 31 to take advantage of the current 15% federal rate. Some of these taxpayers will be S corporations purging old C corporation earnings.
  • Close out some capital gains. If you are going to be selling an asset soon anyway, selling this year may save some some money.
  • Make large family gifts.  For taxpayers with enough assets to make where the diffence between a $5 million, this is an obvious thing to look at. Not everybody can or should make gifts that big, but if you are ever going to do so, this is a good time to do it.
  • Accelerate income and defer expenses. This reverses the usual strategy of deferring income and accelerating expenses, but if rates go up, it makes sense. It's silly to defer income just to see it taxed at a higher rate, and deductible expenses are worth more as deductions when rates are higher.

Of course, all of this is contingent on politics. In general terms, an Obama victory makes a trip over the fiscal falls much more likely, while a Romney victory increases the chances of an extension of the current tax rates. Of course, the composition of Congress also matters. The politicians may extend some provisions while letting others expire.  Whatever happens, it makes sense to stay flexible pending the election outcome, but to start to prepare for a big tax increase. 

-Joe Kristan

Related:

A step away from the fiscal cliff?

Journal of Accountacy Tax and fiscal cliff resources

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