Tax Armageddon: Planning for Long-Term Capital Gains & Qualified Dividends

Unless extended, the tax cuts of 2001 and 2003 expire after 2012.  The Federal top long-term capital gain (LTCG) rate will increase from 15% to 20% (ignoring the special, super-long-term 18% rate for assets acquired after 2000 and held for more than five years).  For qualified dividends (QD), the top tax rate will increase from 15% to 39.6%.  In addition, for single and joint taxpayers having modified adjusted gross income in excess of $200,000 and $250,000 respectively, a new and additional 3.8% Medicare tax will apply to net investment income after 2012 as part of the Affordable Care Act currently under review by the U.S. Supreme Court.  Furthermore, a return of the phase-out of itemized deductions for taxpayers having AGI above certain limits will effectively add another 1.2 percentage points to the tax rate.  Consider the following planning ideas to help reduce post-2012 income tax on your LTCGs and QDs:

1. Harvest capital losses.  Capital losses are deductible to the extent of capital gains.  Excess capital losses may offset up to $3,000 of ordinary income, with the balance carried forward to future tax years with no expiration until death.  Capital loss carryforwards are a shelter against future capital gain taxes.  Given the volatility of the financial markets, you may be able to recognize capital losses throughout the remainder of 2012.  Harvesting need not wait until the end of the year.  When reinvesting sale proceeds, be aware of the "wash sale" rule.  That rule disallows losses if the purchased security is substantially identical to the security that was sold for a loss, and it is purchased during the 30-day period before the date of sale or the 30-day period after the date of sale.  Therefore, to maintain your asset allocation,  reinvest your proceeds in similar but different securities.  The IRS even looks through to IRA holdings to apply the wash sale rule to your taxable account transactions.
2. Diversify your concentrated asset position before 2013.  Some individuals hold concentrated equity positions that they haven't sold because of capital gain taxes.  It is risky to hold a large percentage of your net worth in a single stock.  Many advisors believe that capital gain tax rates are at the lowest point they will be in the future.  Diversifying before 2013 could reduce your capital gain taxes significantly.
3. Sell your business or major asset before 2013.  If you are selling your business or a major asset for cash, close the transaction before 2013.  If a portion of the sale price will be paid in the future and the sale qualifies for the tax installment method, consider electing out of the installment method in order to recognize all of the tax gain in 2012 rather than having it spread out into future years when the tax rate is higher.
4. Accelerate deferred gain from prior year sales.  If you sold your business or major asset in a prior year on a deferred-payment promissory note for which you are using the tax installment method, consider taking steps to cause the gain to be accelerated into 2012.
5. Pay dividends from closely-held C corporations.  If you own a taxable C corporation with excess cash, the corporation could be at risk to the personal holding company penalty tax or the accumulated earnings penalty tax.  Paying a dividend to the shareholders before 2013 could lower the exposure to these penalty taxes, and bail out the excess earnings at favorable tax rates.  In addition, if the C corporation has strong cash flow, low debt, and currently pays dividends, it may make sense to borrow in order to prepay future dividends.
6. Elect to pay dividends from certain S corporations.  If you have an S corporation that generates lots of investment income, and it has earnings and profits from a previous C corporation status, the corporation is at risk to a penalty tax and loss of the S election.  In this situation, consider making the special election to distribute the C corporation dividends before distributing S corporation earnings.  Purging the S corporation of prior C corporation earnings and profits before 2013 will eliminate the risk of the excess net passive income penalty tax and loss of the S election at a lower QD tax rate.

The situation of each taxpayer is unique, and multi-year tax projections should be made before implementing the above ideas.  In some situations, even a sale of stock followed by a repurchase in order to pay tax now at a lower rate in order to avoid a future tax at a higher rate could make sense.

Consider also the following potential pitfalls to your planning:

1. Triggering the alternative minimum tax (AMT).  Recognizing additional income in 2012 to beat the tax rate increases could cause the AMT to apply, reducing the expected tax benefits.
2. Making a bad investment decision.  Selling an asset before its full value has been realized in order to save some income taxes may be a bad financial decision.
3. Taking action too early or too late.  If Congress and the President enact a further extension of the Bush tax cuts during the last days of 2012, will you have made a bad decision by implementing a strategy earlier in the year under the assumption that tax rates would increase?  On the other hand, if you wait to see if the Bush tax cuts will be extended and they aren't before December 31st, will you have made a bad decision by waiting too long to pull the trigger?
4. C corporations don't have a favorable LTCG rate.  Be careful of selling capital assets owned by a C corporation in order to save taxes because C corporations do not have a favorable LTCG rate and their tax rates are not scheduled to increase after 2013.  Furthermore, net capital losses of C corporations can only be carried forward five years.

Be sure to consider all the potential ramifications of implementing tax planning.  That is a very challenging assignment given all of the political and economic uncertainties in the world.  All you can do is the best that you can and to have a rational basis for what you plan to do in response to Tax Armageddon!