Sunday, November 11, 2012

Tax Planning Considerations After the Election

With the elections now behind us, we have a little more clarity regarding what lies ahead from an economic policy perspective.  Some initiatives, such as Proposition 30 (Temporary Taxes to Fund Education) are certain to raise taxes for California residents immediately.  In fact, the terms of Proposition 30 go into effect retroactively to January 1, 2012.  Prop 30’s provisions include creating a series of high income tax bracket rate increases (see the table below) beginning at $250,000 taxable income for single taxpayers and $500,000 for joint taxpayers.  Also the sales tax rate for California will increase from 7.25% to 7.5%.  Estimated revenues expected to be generated from Prop 30 range from approximately $7 billion to $9 billion with most of the funds allocated to K-12 grade levels with the balance going to community colleges.

Other issues affecting how much we pay in taxes, often referred to as the “Fiscal Cliff”, are not quite as clear in terms of the final outcome at this point.  The “Fiscal Cliff” reference includes tax increases that will go into effect January 1, 2013 such as the reversal of last year’s payroll tax cuts, expiration of income tax rate cuts put into effect  by President Bush and his team in the early 2000’s, the start of taxes related to President Obama’s healthcare law, cuts in defense and non-defense spending (approximately equally), etc.

President Obama has been clear that he wants to let the Bush tax cuts expire on December 31, 2012 for those earning over $250,000 annually.  Although it is possible President Obama and the Democrat controlled Senate may compromise and extend those tax breaks for a year or so, there’s still a strong chance those cuts will be allowed to expire and higher Federal income tax rates will accompany higher State income tax rates for many California business owners.


Generally the rule of thumb is to defer income and accelerate deductions as permissible using a variety of strategies.  With the prospect of income tax rates rising January 1, 2013, it may be wise to abandon the general rule and bring income, at least in a measured way, into 2012.  With federal tax rates set to increase as much as approximately 5 points (from 35% Federal to 39.6%), it seems quite appealing to take income now rather than paying almost 5 points higher in federal taxes next year.  In this environment, it is difficult to get much return on investment so why not consider taking the several point benefit in 2012?  Of course President Obama and Congress may extend the Bush-era tax cuts for all, including the high income earners, but in my view playing roulette with those prospects isn’t worth earning only a deferral (remember, it’s only timing we’re talking about).  If you gamble and win, you pay taxes next year (a nice benefit and supplement to cash flow to be sure) instead of this year at the same rates as 2012.  If you gamble on this issue and lose, you pay taxes next year anyway, just at higher federal rates.

Another issue that has to come back into the conversation is whether S Corporation status is as attractive as it’s been these past many years for small business owners.  See my article on S Corporations wherein I discuss this issue in January 2009 in my final paragraph of that posting.  The average corporate federal tax rate is 34% (there are lower tax rates for corporations with taxable income less than $75,000 which get phased out at higher income levels).  The California State Corporate tax rate is 8.84% and the personal tax rates (see schedule below) will fall somewhere between 10.3% and 13.3% for many business owners who are structured as S Corporations.  Given the higher personal income tax rates versus corporate tax rates, it makes sense to consult with your advisors as to whether S Corporation status still makes sense.  In many cases the answer will still be yes as avoiding the double taxation of corporations, especially in a liquidation event, will still win the day for S Corporations.

California Personal Income Tax Rate Structure Under Prop 30

Single Filer's Taxable Income
Joint Filer's Taxable Income
HOH Taxable Income
Current Tax Rate
Additional Tax Rate
Total Tax Rate
500,000 - 600,000
Over 500,000
Over 1,000,000
Over 680,000