Tax Risks for 2013

Key deductions and credits scheduled for changes

2012 marks the last year for many tax provisions that were "patched" in 2010. There are also a number of expiring tax provisions in 2012 that have been in place for many years. Outlined here are some of the key changes in deductions and credits that will impact most taxpayers. These changes are in addition to tax rate changes in many parts of the tax code.

1. Medical Expense Threshold is Going Up.

When the Health Care Reform Act was signed into law it included a tax provision that raises the threshold for medical expenses prior to being able to deduct them from your income. The threshold in 2012 is 7.5% of your Adjusted Gross Income (AGI). In 2013 the threshold prior to deducting medical expenses moves to 10%. Thankfully there is an exclusion built into the law that allows taxpayers 65 or older to continue to use the lower 7.5% of AGI amount.

Action to take now

	Plan for elective, qualifying medical procedures to be conducted prior to year-end. But do not plan purely cosmetic procedures as they do not typically qualify for medical expense deductions.
	As you approach the 7.5% threshold in 2012 load elective medical costs into the year. Perhaps you need an eye exam and new glasses. Why not pay an orthodontist up front for a child's braces?
	If you are due for a physical, consider doing it now. If something comes up, you will have plenty of time to make tax-smart decisions on possible follow-up medical expenses.
	Consider shifting income into 2013 to allow your 2012 income threshold to be lower for the purpose of calculating your medical deduction threshold.

2. Child Tax Credit (CTC) Cut in Half.

The Child Tax Credit is $1,000 in 2012 with some of the credit being refundable. Refundable credits can give you money back even if you owe no Federal Income Tax. In 2013, the credit is to be cut by 50% to $500 and the refundable nature is set to expire.

Action to take now

Review your current tax return and understand the financial impact of the Child Tax Credit reduction. Consider changing your withholdings to account for the drop and avoid owing additional tax at year-end.

3. Earned Income Tax Credit (EITC) available to fewer taxpayers.

The number of taxpayers who qualified for this popular tax credit in the last few years was increased with expanded income qualifications and the addition of another dependent category. These expanded income qualifications and added dependent categories are scheduled to roll back at the end of this year.

Action to take now

If you received the EITC in 2011 or expect to receive it in 2012 you should forecast the impact it will have on you in 2013.

4. The Adoption Credit is Going Down.

Those who have gone through or are going through the adoption process know only too well how long it takes and how expensive the process is. According to the 2011 Adoptive Family Survey, adoptions can range in cost from $7,000 to over $50,000! And, unless Congress acts to change the current tax law, the $12,650 adoption credit available in 2012 will no longer be available beginning in 2013.

Action to take now

	To qualify for the credit your adoption must be finalized prior to year end. Proof of finalized adoption may include a final adoption decree, placement agreement from an authorized agency, court documents and the state's determination for special needs children.
	Document all your adoption expenses. Per the IRS, reasonable expenses are: "... reasonable and necessary expenses directly related to the legal adoption of the child. These expenses may include adoption fees, court costs, attorney fees and travel expenses..."
	Keep things moving. If you are currently adopting make sure your process is constantly moving forward. Press your agency to schedule timely home visits. Review the list of needed information and get on it right away. Even delivering forms to your agency versus mailing them saves time.
	Talk to your representatives. Make sure your adoption agency, legal representatives and others are aware of the possible tax penalty you may face for not finalizing your adoption in 2012. Losing a $12,000+ credit can be a tremendous financial hardship for most families.

5. Phase-outs are Back In.

Itemized deductions and tax exemptions are common benefits within the tax code that reduce your taxable income. Prior to 2010, there were provisions to phase out these tax reduction benefits for those whose income surpassed certain income thresholds. After 2012, unless Congress acts, your itemized deductions and tax exemptions may once again be phased-out.

Action to take now

Review your most recent tax return and see if you may be impacted by the itemized deduction and tax exemption phase-out. The phase-outs were triggered in 2009 when: Filing Status:   Personal Exemption Itemized Deductions Single AGI exceeds: $166,800 $166,800 Head of Household 208,500 166,800 Married Joint/Widow 250,200 166,800 Married Filing Separate 125,100 83,400

Unlike past years, many of these changes will occur automatically unless Congress acts. Because of this, tax planning in 2012 and 2013 is more important now than any time in the past ten years. While no one knows what will occur, one thing is certain. There will be dramatic tax law changes. Will you be ready for them?

 Flow-through Entities

In the cross-hairs of tax rate increases

As politicians argue over increased taxes and reduced spending, there is a group of taxpayers that are getting caught in the middle of the argument: Small Businesses legally formed as "flow through" entities.

Background

If you own a business you have a number of options on how to organize the business legally and for tax purposes. Many small, single owner, businesses are not incorporated, and are deemed "sole proprietors", in the eyes of the IRS. Other business entities, like C-Corporations, are taxed as a separate entity with distributions to owners taxed a second time as dividends. While still others are deemed "flow-through" entities like S-Corporations and Limited Liability Companies (LLC).

Flow-through Entities Overview

With flow-through entities (S-Corporations and LLC's) the business files a tax return, but does not pay tax as part of the tax filing. Instead, the corporate tax return reports the income to the IRS, but then allocates the taxable income to their respective owners via a K-1 tax form. Each individual owner then reports their share of the net income on their individual tax return and pays the tax on this and any other personal income.

Generally, business owners prefer flow-through entities because:

	The business income is taxed once instead of twice as in the case of C-Corporation entities.
	The business format provides the owners a level of legal protection from possible business liabilities that is not available by doing business as a sole proprietor.

What you should know

	Any increase in individual tax rates will have an impact on the amount of tax paid on small business net income for all flow-through entities.
	Small "flow-through" businesses must pay income tax on all their business profits. However the business entity is NOT required to distribute cash from the company to pay the tax. So "flow-through" owners could see a larger tax bill without money to pay it.
	There may not be enough cash in the company to pay the increased tax. This is especially true for seasonal businesses with high sales volumes in the summer. Most cash for these businesses is typically used to build inventory at the same time taxes are due.
	Minority Shareholders in "flow-through" entities are doubly cursed. They not only may not receive distributions to pay taxes due, but they are often precluded from selling their shares, and they do not have enough ownership to require distribution of funds through shareholder voting.
	Marriage "Super" Penalty. The increased tax rates on flow-through entities becomes even higher if you are married filing jointly. This is due to the pre-built tax rate penalty for married couples in the current tax code.
	This is not a small problem. According to the IRS the S-Corporation formation is still the most popular business entity type with 4.5 million S- Corporations filing tax returns in 2007. And LLC's are quickly becoming the new entity of choice with growth from 250,000 entities to over 1 million entities today.

Action to take now

If you are an owner in a flow-through entity like an S-Corporation or an LLC, you should understand the potential tax liability you may be facing over the next few years. If you are a minority owner, it may make sense to discuss a requirement for all owners to receive sufficient cash distribution to pay your tax liability. If nothing else, you and your business should start building enough cash reserve to ensure you will be able to pay the tax on your business income.

 Preparing for Zero Interest Deposits

With lending rates at all time lows and Federal lending incentives at all time highs, you might expect there to be a large demand for increased deposits from the banks to fulfill lending demand.

Unfortunately this is not the case. Many banks are flush with depositors' cash and have no qualified borrowers to place the funds. This is because in addition to placing fewer loans, bank's customers have continued to park liquid funds outside of the stock market. In addition, Federal banking authorities limit the amount of deposits that can be lent out at any one time. These reserve requirements can be from 10 to 15% of total deposits. So banks have excess cash that they need to place to receive some sort of return.

What is happening now

The rates banks and credit unions are receiving for their excess cash is often less than they're paying their large depositors. So banks are now starting to consider paying low or NO interest on large deposits. Some banks are even telling their larger depositors that balances over a threshold level (like $100,000) will receive no interest.

Action to take

If you think this may happen to you:

	Consider short-term CDs. CDs have contractual interest rates that must be paid. So even though the interest rate is low, it must be paid for the duration of the term. Just be aware that there are early withdrawal penalties attached to these bank products if you need the funds prior to the expiration of the CD.
	Look at your bank's balance sheet. If they have a lot more deposits in relation to loans, they will need to address their short-term deposit interest rate problem.
	Spread out your risk by moving funds to a number of banks. This is especially true if your deposits in any one institution exceed the FDIC $250,000 insurance limit.
	If you do not need the funds, look at other investment alternatives. While bond funds may be at risk when rates start to rise once again, if you hold a bond to term, you will at least know what your interest income will be. But caution is required, because the price of bonds will generally drop when rates rise in the future.

While earning no interest on your savings can be a hardship, remember banks that resort to this tactic are running the risk of alienating a key source of funds the bank may wish to have when the rate environment becomes more favorable for the banks to lend money.