Observations from Tax Season

"Tax season" ended last week for 2011 income tax returns.  This season seemed particularly painful given the expanded reported requirements for sales of investments and the delay in receiving Forms 1099 from financial institutions.  Some of the tax returns also held surprises for some taxpayers.  Here are a few observations that may be of benefit to you.

1. A windfall of additional income does not belong 100% to you.  The government is your partner in every dollar you earn.  You cannot spend the extra income without first providing for income taxes or you may find that the money left over not sufficient to pay your partner!  If you are in the top Federal and Utah brackets, for 2012 the government will be at least a 40.0% to 42.9% partner.  In 2013, the government demands an even larger share, 48.4%.
2. Your choice of investments can greatly complicate your income tax return.  Although income taxes should not be the primary factor in choosing suitable investments, you should be aware of the tax reporting implications of those choices, which can add to the costs of preparation and delay the timing of when the tax return can be completed.
   
   For example, with the sharp decline in interest rates over the past several years, purchasing Treasury notes and CD's on the market rather than at original issue will result in the payment of premiums and accrued interest.  The financial institution's Form 1099 will report to the IRS the amount interest income earned according to the stated coupon rate, which greatly overstates the actual economic interest earned.  Tax elections and complicated calculations for premium amortizations and accrued interest adjustments are necessary to avoid overpaying tax.
   
   Another example relates to investments that are bought and sold by investment advisors as if the investment were shares of stock, but the investment is actually a tax partnership.  As an owner of a partnership you will receive a Schedule K-1 rather than a Form 1099 for the investment income or loss.  Tax partnerships are complicated!  Many times the K-1s are not even provided until September, requiring a six-month extension of your tax return.  Some of the partnerships invest in foreign entities that require expanded disclosures in your tax return.  Others hold property in a variety of other states that may require you to file tax returns in those states.  All of these consequences bring delays and added costs.  Therefore, an investment structured as a tax partnership should be a conscious choice because of its unique investment opportunities not otherwise available.
3. Tax planning beyond 2012 is difficult because of tax law uncertainty.  We know what most of the rules are for 2012.  We know what the tax laws are scheduled to be in 2013.  But we don't know what the outcome of the national elections will be this fall, and we certainly don't know what our elected politicians will do about the dramatic fiscal, debt, and tax problems this country is facing.  In the face of uncertainty, it is wise to be conservative and to use the tax benefits currently available.  Three of the most important benefits that are scheduled to disappear after 2012 are:  (1) the 15% Federal long-term capital gain tax rate, (2) the 35% top ordinary tax rate, and (3) the $5.12 million gift tax exemption amount.  You should plan to use these benefits where they fit into your overall financial and estate plan.  Consultations with your tax advisor this summer and again after the elections may prove particularly valuable this year.