Grant Thornton\'s Year End Tax Guide for 2011

1. Year-end tax guide for 2011

3. Year-end tax guide for 2011
Table of contents
Introduction: Planning makes perfect .................................................................................................................... 1
1. Tax law changes: What’s new this year? ......................................................................................................... 2
Chart 1: Individual income tax rate scenarios under current law ........................................................................................3
Chart 2: AMT exemption for 2010 and 2011 ...................................................................................................................3
Chart 3: Estate, gift and GST tax rates and exemptions 2009–13 ....................................................................................4
Business perspective: New tax opportunities for business ................................................................................................5
2. Getting started: Individual tax rates and rules.................................................................................................. 6
Chart 4: 2011 individual ordinary income tax rates ..........................................................................................................6
Chart 5: 2011 tax benefit thresholds ...............................................................................................................................7
Action opportunity: Maximize above-the-line deductions ....................................................................................................8
Tax law change alert: Strict new rules for medical spending in 2011.................................................................................8
Tax law change alert: Payroll tax holiday for 2011 ...........................................................................................................8
Chart 6: Employment tax rates and thresholds.................................................................................................................9
Action opportunity: Make up an estimated tax shortfall with increased withholding .............................................................9
Action opportunity: Bunch itemized deductions to get over AGI floors..............................................................................10
3. Alternative minimum tax ............................................................................................................................... 11
Tax law change alert: AMT relief extended through 2011 ...............................................................................................11
Chart 7: 2011 individual AMT rate schedule and exemptions ..........................................................................................11
Action opportunity: Accelerate income to “zero out” the AMT..........................................................................................12
4. Investment income ....................................................................................................................................... 13
Chart 8: Investment income tax rates for 2010 and beyond ...........................................................................................13
Action opportunity: Avoid the wash sale rule with a bond swap........................................................................................14
Tax law change alert: New broker reporting rules affect basis on stock sales ..................................................................14
Action opportunity: Use zero capital gains rate to benefit children ...................................................................................15
Tax law change alert: No tax on gain from QSB stock purchased in 2011 .......................................................................15
Action opportunity: Defer investment interest for a bigger deduction ...............................................................................16
Tax law change alert: Deduct interest on a mortgage of up to $1.1 million ......................................................................17
Tax law change alert: Primary residence gain exclusion limited .......................................................................................17

4. 5. Executive compensation ............................................................................................................................... 18
Action opportunity: Consider an 83(b) election on your restricted stock...........................................................................19
Business perspective: Managing the pay plans in your business......................................................................................20
Tax law change alert: New executive compensation rules ...............................................................................................20
Chart 9: Strategies for dealing with underwater stock options ........................................................................................21
6. Business ownership....................................................................................................................................... 23
Chart 10: 2011 corporate income tax brackets .............................................................................................................23
Chart 11: Comparison of tax differences based on business structure ............................................................................24
Action opportunity: Organize or convert into a QSB ........................................................................................................24
Action opportunity: Set salary wisely if you’re a corporate employee-shareholder .............................................................24
Tax law change alert: No built-in gain tax for certain S corporations ................................................................................25
7. Charitable giving........................................................................................................................................... 27
Chart 12: AGI limitations on charitable contribution deductions .......................................................................................27
Action opportunity: Give directly from an IRA if 70½ or older ..........................................................................................28
Action opportunity: Give appreciated property to enhance savings ..................................................................................28
8. Education savings: The ABCs of tax-saving education .................................................................................... 30
Chart 13: 2010 education tax break income phaseouts .................................................................................................30
Tax law change alert: Tuition and fees deduction extended through 2011 .......................................................................30
Action opportunity: Make payments directly to educational institutions ............................................................................31
Tax law change alert: Above-the-line loan interest deduction extended through 2012 .......................................................31
Action opportunity: Plan around gift taxes with your 529 plan .........................................................................................31
Tax law change alert: Coverdell ESA benefits extended ..................................................................................................32
Tax law change alert: Kiddie tax increases bite ..............................................................................................................32
9. Retirement savings ....................................................................................................................................... 33
Chart 14: Comparison of tax-preferred retirement savings vehicles.................................................................................33
Action opportunity: Wait to make your retirement account withdrawals ............................................................................34
Tax law change alert: Roth rollover limitation disappears ................................................................................................35
Action opportunity: Roll over into a Roth IRA ..................................................................................................................35
Action opportunity: Get kids started with a Roth IRA ......................................................................................................35
Business perspective: Maintaining your company’s retirement plans ...............................................................................37
Tax law change alert: Employees can roll over into Roth 401(k)s ....................................................................................37
10. Estate planning ............................................................................................................................................. 39
Chart 15: Estate, gift and GST tax rates and exemptions ...............................................................................................39
Tax law change alert: Transfer tax changes ...................................................................................................................39
Action opportunity: Exhaust your lifetime gift tax exemption ............................................................................................40
Action opportunity: Use second-to-die life insurance for extra liquidity ..............................................................................42
Action opportunity: Zero out your GRAT to save more ....................................................................................................43
Grant Thornton offices ........................................................................................................................................ 44

5. Introduction
Planning makes perfect
Success isn’t easy and it certainly isn’t free. As your income The guide includes information on the following:
increases, so does your tax burden. For successful individuals,
tax rules become complicated quickly. Whether you’re managing • Tax law changes: We’ve dedicated a section to cover the
your individual tax rates, the rates on your investments, the taxes most important tax changes for you and your business.
on your privately held or pass-through business, or the income Plus, look for our highlighted Tax law change alerts
of executives and shareholders at your company, managing a tax throughout each section of the guide.
burden has never been more difficult.
That’s where tax planning comes in. With so much at stake, • Action opportunities: We’ve highlighted our top 20
don’t bury your head in the sand and wait for a big surprise on Action opportunities. These are strategies you can put
April 15. There are now more ways than ever to reduce your into play right now.
tax liability, but all of them take planning. Both the tax code and
your economic situation are continually evolving. You need to • Business solutions: We know you don’t look at your
think farther ahead, employ clearer strategies and use every tax tax situation as an individual taxpayer alone, but also as a
break you can. Don’t act first and think about taxes later. A little shareholder, owner, employee or executive. We’ve added
foresight can go a long way. sections throughout the guide that focus on tax opportunities
To help answer as many of your questions as possible, this from the Business perspective.
Grant Thornton guide discusses recent tax law changes and
provides an overview of strategies to deal with your situation. As always, our guide will help show you how to tax-efficiently
invest for education and retirement and transfer your wealth to
loved ones in the most tax-efficient manner possible. However,
this guide simply can’t cover all possible strategies, and there
may be legislative tax changes after this guide goes to print.
Our Washington National Tax Office tracks tax legislation as it
moves through Congress. Be sure to contact us to find out what
strategies will work best for you and what is happening on the
legislative front.
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6. Chapter 1
Tax law changes:
What’s new this year?
Congress walked back from the edge of a tax precipice in 2010 2001 and 2003 individual income tax cuts
and agreed to extend the 2001 and 2003 tax cuts for two years. The biggest development by far was the extension of the 2001
The scheduled expiration of these tax cuts at the end of 2010 had and 2003 tax cuts. These tax cuts include rate cuts across the
threatened to increase taxes on virtually every taxpayer in 2011. individual income tax brackets, plus scores of other tax benefits:
The compromise legislation passed last December extended the • The top rate of 15 percent on dividends and capital gains
individual income tax cuts in their entirety through the end of (on most sales and exchanges)
2012. This massive December tax bill also extended alternative • The zero rate for capital gains and dividends in the bottom
minimum tax (AMT) relief and a number of popular temporary brackets
tax provisions known as “extenders.” • The top rate on ordinary income of 35 percent
Yet lawmakers weren’t content with a simple extension • The repeal of the phaseouts of the personal exemption
of expiring tax laws — they also made some key changes. The and itemized deductions
December tax cut package made dramatic changes to transfer • Marriage penalty relief
tax rules and offered taxpayers new tax incentives, such as 100 • $1,000 child tax credit and its refundability
percent bonus depreciation and an employee payroll tax holiday. • The increased dependent care credit
Earlier legislation, the Small Business Jobs Act of 2010, also • $10,000 adoption credit and $10,000 income exclusion
included many tax incentives that could benefit businesses for employer assistance
this year. • $2,000 contribution limit for Coverdell education savings
So far, Congress has been quieter in 2011. Lawmakers accounts
did repeal an onerous expansion of Form 1099 reporting • The above-the-line deduction for student loan interest
rules early in the year, but as this guide went to print, had not • The exclusion for employer-provided education assistance
yet enacted any major tax bills. Of course, 2011 is not over.
Congress could still consider revenue increases or tax reform as When originally enacted in 2001 and 2003, these tax cuts
part of a deficit reduction effort, and the president was pushing were given sunsets for a variety of policy, political and budget
for a job creation tax package as this guide went to print. Check reasons. The sunset dates are now extended through 2012.
with Grant Thornton’s Washington National Tax Office for the Without legislation, the tax cuts will now expire in 2013 — at
latest information. the same time new Medicare taxes enacted in the health care
reform legislation are scheduled to take effect. These Medicare
taxes will impose an additional 0.9 percent tax on earned income
above $200,000 for singles and $250,000 for joint filers, and a 3.8
percent tax on investment income above those thresholds. We’re
likely to see another legislative battle over the tax cuts in 2012.
See Chart 1 for what is scheduled to happen to tax rates under
current law.
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7. Chart 1: Individual income tax rate scenarios under current law
Ordinary income tax brackets (2011 levels) Rates
Single Joint 2011–12 2013 +
$0 – $8,500 $0 – $17,000 10% 15%
$8,501 – $34,500 $17,001 – $69,000 15% 15%
$34,501 – $83,600 $69,001 – $139,350 25% 28%
$83,601 – $174,400 $139,351 – $212,300 28% 31%
$174,401 – $379,150 $212,301 – $379,150 33% 36%
Over $379,150 Over $379,150 35% 39.6%
Capital gains top rate 15% 23.8%*†
Dividend top rate 15% 43.4%*
Interest income top rate 35% 43.4%*
* Includes new 3.8% Medicare tax on investment income
†
Top capital gains rate in 2013 is scheduled to be 20% for assets held 1 year and 18% for assets held 5 years, plus a 3.8% Medicare tax
Extenders and AMT Chart 2: AMT exemption for 2010 and 2011
The popular tax provisions known as “extenders” include
2009 2010 2011
over 30 tax provisions that have traditionally been renewed by exemption exemption exemption
Congress on a temporary basis. The provisions expired again at
the beginning of 2010, but most were retroactively reinstated for Single or head of household $46,700 $47,450 $48,450
Married filing jointly $69,950 $72,450 $74,450
all of 2010 and through 2011. They are now scheduled to expire
Married filing separately $34,975 $36,225 $37,225
at the end of 2011.
Key individual tax extenders include the following: Estate and gift taxes
• Election to deduct state and local sales taxes No area of the tax code has shifted more dramatically over the
• Above-the-line tuition deduction last few years than transfer taxes. Under the 2001 and 2003 tax
• $250 above-the-line teacher expenses deduction cuts, the estate tax and generation-skipping transfer (GST) tax
• Standard deduction for property taxes for non-itemizers were temporarily repealed for 2010. This relief was scheduled to
• Tax-free charitable distributions from individual retirement be short-lived. Like the individual income tax cuts, all transfer
plans tax relief was scheduled to expire beginning in 2011, with the
• Withholding exception for interest-related dividends rules reverting to those in place in 2000.
of regulated investment companies (RICs) Instead, the compromise tax bill enacted in late 2010 puts
• Estate tax look-through for RIC stock held by nonresidents in place a new transfer tax regime for 2010, 2011 and 2012.
In general, the legislation:
Lawmakers also completed an AMT “patch” for 2010 and 2011. • reunifies the gift and estate tax;
The AMT relief increases the exemptions modestly over 2009 • increases the gift, estate and GST tax exemption amounts
levels (see Chart 2). to $5 million;
• provides for a top gift, estate and GST tax rate of
35 percent; and
• allows portability between spouses of their estate tax
exemption amounts.
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8. Although the estate tax and GST tax were nominally reinstated Chart 3: Estate, gift and GST tax rates and exemptions 2009–13
for 2010 under the legislation, the GST tax rate in 2010 is zero
Estate tax Gift tax GST tax
and estates of 2010 decedents can elect out of the estate tax if Exemption Top rate Exemption Top rate Exemption Top rate
desired. In 2013, transfer taxes are once again scheduled to revert 2009 $3.5 M 45% $1 M 45% $3.5 M 45%
to the rules in place in 2000 — though legislative intervention is 2010 $5 M* 35%* $1 M 35% $5 M 0%
2011–12 $5 M 35% $5 M 35% $5 M 35%
likely. See Chart 3 for the shifting transfer tax rules. (portable)
The drastic swings in transfer tax rules and rates present 2013 $1 M 55% $1 M 55% $1 M 55%
challenges and opportunities for estate planning. You will likely
* May elect to apply law under the Economic Growth and Tax Relief Reconciliation Act of 2001
need to review your estate plan to make sure it still makes sense (EGTRRA) (i.e., no estate tax in 2010, carryover basis)
Note: Some of the exemption levels are to be indexed for inflation.
given the changes in tax law (and your own circumstances). See
Chapter 10 for a full discussion of estate planning issues.
Payroll tax holiday
The December tax cut compromise reduced the employee
share of Social Security taxes under the Federal Insurance
Contributions Act (FICA) from 6.2 percent to 4.2 percent in
2011. Social Security tax is imposed on wages up to an annually
adjusted cap that reached $106,800 in 2011, meaning taxpayers
at or above the wage cap received a $2,136 tax cut from this
provision.
The reduction in FICA taxes also applies to the self-
employment tax, reducing the combined rate from 15.3 percent
to 13.3 percent for self-employment income earned in 2011.
Consistent with the concept that this reduction comes from the
employee’s share of employment taxes, this will not reduce the
amount of self-employment taxes allowed as an above-the-line
income tax deduction, which will continue to be calculated as
one-half of 15.3 percent of self-employment income.
4

9. Business perspective
New tax opportunities for business
It was another stormy economic year for many businesses, required reporting on payments made for property, payments
but on the tax front, it was mostly sunshine. Lawmakers again made to corporations and payments in connection with earning
looked to the tax code to try and add fuel to the slow-burning rental income. However, the legislation did not repeal new,
economic recovery. The legislative efforts included not just higher penalties for information-reporting failures.
extensions of current benefits, but many new tax provisions.
Organizing as a QSB
Business extenders Qualified small business (QSB) stock has become an even more
Congress last year gave businesses a two-year extension, attractive investment. Legislation enacted in September 2010
through 2011, of the popular business tax provisions known offers a generous new tax planning opportunity to enterprises
as “extenders.” These provisions are now scheduled to expire that meet qualified small business (QSB) requirements. QSB
at the end of the year. These “extender” provisions include the stock purchased after Sept. 27, 2010, and through the end of
following: 2011, will never be subject to tax on the gains if the stock is held
• Research credit at least five years and all other requirements are met.
• 15-year cost recovery for qualified leasehold improvements, QSB stock must be original issue stock in a C corporation
qualified restaurant buildings and improvements, and with no more than $50 million in assets (and meet several other
qualified retail improvements tests). Investments in QSB stock also come with several other
• New markets tax credit tax benefits and restrictions. See Chapter 4 for a discussion from
• Subpart F exception for active financing income an individual investor’s perspective and Chapter 6 for a QSB tax
• Look-through treatment for payments between related planning opportunity from the business perspective.
controlled foreign corporations under foreign personal
holding company income rules Fully expensing business investments
Legislation enacted in 2010 doubles a bonus depreciation tax
Form 1099 reporting benefit for property placed in service after Sept. 8, 2010, and
Lawmakers gave businesses a break this year by repealing a before the end of 2011 — meaning taxpayers can expense the
drastic expansion of information reporting that would have cost of eligible equipment placed in service before the end of
forced businesses to issue millions of additional Form 1099 the year. To qualify for bonus depreciation, property must
information reports beginning in 2012. generally have a useful life of 20 years or less under the modified
Trades and businesses are generally required to report accelerated cost recovery system (MACRS). The amount of
(typically on a Form 1099) payments over $600 per year to business investment that can be expensed under Section 179 was
a vendor for services, and the regulations generally exempt also increased to $500,000 for tax years beginning in 2010 and
payments made to a corporation. These rules will now remain 2011 (with the phaseout increasing to $2 million). See Chapter 6
intact, as lawmakers repealed an expansion that would have also for a full discussion of these tax benefits.
5

10. Chapter 2
Getting started:
Individual tax rates and rules
Whether you’re an executive, partner or owner, your business Chart 4: 2011 individual ordinary income tax rates
income eventually gets taxed at the individual level. That’s where
SINGLE FILER
tax planning needs to start. Taxable income Rate
Different types of individual income are taxed in different $0 – $8,500 10%
ways, and you want to start by looking at ordinary income. $8,501 – $34,500 15%
$34,501 – $83,600 25%
Ordinary income includes things like salary and bonuses, self- $83,601 – $174,400 28%
employment and business income, interest, retirement plan $174,401 – $379,150 33%
distributions and more. Over $379,150 35%
Ordinary income is taxed at different rates depending on
MARRIED FILING JOINTLY
how much you earn, with rates increasing as income goes up. Taxable income Rate
These tax brackets, along with many other tax preferences, are $0 – $17,000 10%
$17,001 – $69,000 15%
adjusted for inflation annually. Persistent low inflation provided
$69,001 – $139,350 25%
another year of relatively shallow adjustments in 2011. Check $139,351 – $212,300 28%
Chart 4 for a full breakdown of the tax brackets for ordinary $212,301 – $379,150 33%
income in 2011 and Chart 5 for the 2011 adjustments to a Over $379,150 35%
number of other tax items. MARRIED FILING SEPARATELY
The top tax rate that applies to you is usually considered Taxable income Rate
your marginal tax rate. It’s the rate you will pay on an additional $0 – $8,500 10%
$8,501 – $34,500 15%
dollar of income. But unfortunately, the tax brackets for
$34,501 – $69,675 25%
ordinary income don’t tell the whole story. Your effective $69,676 – $106,150 28%
marginal rate may be very different from the stated rate in your $106,151 – $189,575 33%
Over $189,575 35%
tax bracket. Hidden taxes that kick in at higher income levels
when you reach the top tax brackets can drive your marginal HEAD OF HOUSEHOLD
tax rate higher. These hidden taxes largely include phaseouts of Taxable income Rate
many tax benefits at high income levels. $0 – $12,150 10%
$12,151 – $46,250 15%
Fortunately, two of the most costly phaseouts are currently $46,251 – $119,400 25%
repealed. The personal exemption phaseout (PEP) and “Pease” $119,401 – $193,350 28%
phaseout of itemized deductions will not affect your 2011 return, $193,351 – $379,150 33%
Over $379,150 35%
and you will be able to enjoy these tax preferences in full this
year. However, they are scheduled to return in 2013.
You want to avoid early withdrawals from tax-advantaged This can raise your effective federal tax rate to as high as 45
retirement plans, such as 401(k) accounts and IRAs. percent on the income. Generally, distributions must be made
Distributions from these plans are treated as ordinary income, after reaching the age of 70½ to avoid penalties.
and you’ll pay an extra 10 percent penalty on any premature
withdrawals (generally, withdrawals prior to reaching age 59½).
6

11. Chart 5: 2011 tax benefit thresholds
Personal exemption $3,700 per person
Standard deduction $11,600 (MFJ)
$8,500 (HH)
$5,800 (S)
$5,800 (MFS)
Maximum retirement plan contributions 401(k), 457 and 403(b): $16,500 ($22,000 if 50 or older)
Simple: $11,500 ($14,000 if 50 or older)
IRA: $5,000 ($6,000 if 50 or older)
Defined contribution plans: $49,000
Defined benefit plans: $195,000
IRA benefit phaseout Traditional: Contribution deductibility phaseout begins at $90,000 (MFJ), $56,000 all others
(if you’re covered by a retirement plan at work)
Roth: Ability to contribute begins to phase out at $107,000 AGI (S), $169,000 (MFJ), $0 (MFS)
Standard mileage rates January–June July–December
Business: 51 cents 55.5 cents
Charity: 14 cents 14.0 cents
Medical/moving: 19 cents 23.5 cents
Kiddie tax Not taxed: First $950
Child’s rate: $950 to $1,900
Parent’s rate: $1,901+
(Applies to children under 19 and college students under the age of 24 who do not provide over half
of their own support)
Foreign income exclusion $92,900
Section 179 limit $500,000 (reduced by amount of Section 179 property exceeding $2 million)
Annual gift tax exclusion $13,000
Mandatory retirement account withdrawals Age 70½
Transportation fringe benefit exclusion $230
MFJ = married filing jointly; HH = head of household; S = single; MFS = married filing singly
7

12. Action opportunity: Maximize above-the-line deductions
Nearly all of the tax benefits that phase out at high income levels are tied to adjusted gross income (AGI). The list includes personal
exemptions and itemized deductions (except in 2010–12), education incentives, charitable giving deductions, the alternative minimum tax
(AMT) exemption, the ability to contribute to some retirement accounts and the ability to claim real estate loss deductions.
These AGI-based phaseouts are one of the reasons above-the-line deductions are so valuable. They are not subject to the AGI floors that
hamper many itemized deductions. They even reduce AGI, which provides a number of tax benefits. Most other deductions and credits only
reduce taxable income or tax, itself, without affecting AGI.
Above-the-line deductions that reduce AGI could increase your chances of enjoying other tax preferences. Common above-the-line deductions
include traditional Individual Retirement Account (IRA) and Health Savings Account (HSA) contributions, moving expenses, self-employed
health insurance costs and alimony payments. Remember that beginning this year, HSA’s can no longer be used to pay for over-the-counter
drugs unless you have a prescription, and penalties for improper expenditures have increased from 10 percent to 20 percent.
Save on taxes by contributing as much as possible to retirement vehicles that provide above-the-line deductions, such as IRAs and SEP IRAs.
Don’t skimp on HSA contributions either. When possible, give the maximum amount allowed. Even if you withdraw the full amount that was
contributed to pay medical expenses, at least you have effectively moved those medical expenses “above the line.” And don’t forget that if
you’re self-employed, the cost of the high deductible health plan tied to your HSA is also an above-the-line deduction.
Tax law change alert: Strict new rules for medical spending in 2011
The health care reform bill enacted in 2010 made many changes to health care-related tax rules that will be phased in over the next several
years. Beginning in 2011, you can no longer use an HSA, flexible spending arrangement (FSA) or health reimbursement account (HRA) to pay
for over-the counter dugs unless you have a prescription. Employers are also now operating under stricter rules to prevent improper HSA
expenditures, and your penalty for misuse has increased from 10 percent to 20 percent.
Tax law change alert: Payroll tax holiday for 2011
The Social Security tax rate is typically 6.2 percent for both employees and employers, while the Medicare rate is 1.45 percent. However,
lawmakers provided a partial payroll tax holiday in 2011 that reduces the employee Social Security tax rate from 6.2 percent to 4.2 percent.
The employer rate is unaffected.
This Social Security rate cut also applies to the self-employment tax, lowering the combined rate from 15.3 percent to 13.3 percent for
self-employment income earned in 2011. Consistent with the concept that this reduction comes from the employee’s share of employment
taxes, this will not reduce the amount of self-employment taxes allowed as an above-the-line income tax deduction, which will continue to be
calculated as one-half of 15.3 percent of self-employment income.
Payroll taxes take a bite
Payroll taxes are scheduled to become even more costly in
Employment taxes, often called “payroll taxes,” are
2013. The health care reform bill enacted in 2010 is scheduled to
imposed against earned income under the Federal Insurance
increase the employee share of Medicare tax in 2013 from 1.45
Contributions Act (FICA). Earned income generally comprises
percent to 2.35 percent on any earned income above $200,000
wages, salaries, tips and self-employment income. There are
(single) or $250,000 (joint). What’s worse, a Medicare tax on
two components to employment taxes: Social Security and
unearned income will be imposed for the first time. Income such
Medicare. Generally, FICA requires matching contributions
as interest, dividends and capital gains above the $200,000 and
from the employer and the employee for both Social Security
$250,000 thresholds will be subject to an additional 3.8 percent
and Medicare taxes. Social Security taxes are imposed up to a
Medicare tax beginning in 2013. This new employment tax on
wage cap that is adjusted for inflation each year and is $106,800
unearned income will not apply to distributions from IRAs and
in 2011. Medicare taxes are uncapped and apply to all income.
other qualified plans, which may provide an additional incentive
If you are employed and your earned income consists of
to maximize contributions to those plans. See Chart 6 for the
salaries and bonus, your employer will withhold your share of
employment tax rates under current law.
employment taxes and pay them directly to the government. If
you are self-employed, you must pay both the employee and the
employer portions of employment tax, though you can take an
above-the-line deduction for the employer’s portion of the tax.
8

13. Paying your tax Remember to be cautious. Legislative action is likely to
Although you don’t file your return until after the end of make a big difference in this area, as will your personal situation.
the year, it’s important to remember that you must pay Tax rates were scheduled to go up in 2011, but in the end no
tax throughout the year with estimated tax payments or one saw a rate increase. Income acceleration can be a powerful
withholding. You will be penalized if you haven’t paid enough. strategy, but it should be employed only if you are comfortable
If your adjusted gross income (AGI) will be over $150,000 with your own political analysis and are prepared to accept the
in 2011, you generally can avoid penalties by paying at least 90 consequences if you are wrong. Because today’s low tax rates are
percent of your 2011 tax liability or 110 percent of your 2010 available through 2012, you should wait until next year before
liability through withholding and estimated taxes (taxpayers thinking of accelerating taxes. Even if some of the tax cuts expire
under $150,000 need only pay 100 percent of 2010 liability). If in 2013, the time value of money will still make deferral the best
your income is irregular due to bonuses, investments or seasonal strategy in most cases. Whether it eventually makes more sense
income, consider the annualized income installment method. for you to defer or accelerate your taxes, there are many items
This method allows you to estimate the tax due based on income, with which you may be able to control timing:
gains, losses and deductions through each estimated tax period.
Income
Leveraging deductions and managing tax burden • Consulting income
Why pay tax now when you can pay tomorrow? Deferring tax • Other self-employment income
is a traditional cornerstone of good tax planning. Generally this • Real estate sales
means you want to accelerate deductions into the current year • Other property sales
and defer income into next year. So it’s important to review your • Retirement plan distributions
income and deductible expenses well before Dec. 31. You need
to take action before the new year to affect your 2011 return. Expenses
But the current legislative scenario presents a unique • State and local income taxes
challenge. Many tax benefits in place right now are scheduled • Real estate taxes
to disappear in 2013. You may be asking yourself if this is the • Mortgage interest
year to reverse your tax strategy and accelerate income and defer • Margin interest
deductions. • Charitable contributions
Chart 6: Employment tax rates and thresholds
Income subject to tax Individual rate Employer rate
Social Security Earned income up to $106,800 (adjusted annually) 4.2% in 2011 6.2%
6.2% in 2012+
Medicare All earned income 1.45% 1.45%
Medicare surtax Earned income over $200K (single) and $250K (joint) 0.9% in 2013+ 0%
Medicare investment income tax Dividends, capital gains and interest over $200K (single) 3.8% in 2013+ 0%
and $250K (joint)
Self-employed taxpayers pay both the individual and employer rates on self-employment income.
Action opportunity: Make up an estimated tax shortfall with increased withholding
If you’re in danger of being penalized for not paying enough tax throughout the year, try to make up the shortfall through increased
withholding on your salary or bonuses.
Paying the shortfall through an increase in your last quarterly estimated tax payment can still leave you exposed to penalties for
underpayments in previous quarters.
But withholding is considered to have been paid ratably throughout the year. So a big bump in withholding on high year-end wages can
save you in penalties when a similar increase in an estimated tax payment might not.
9

14. Action opportunity: Bunch itemized deductions to get over AGI floors
Bunching deductible expenses into a single year can help you get over AGI floors for itemized deductions. Miscellaneous expenses that
you may be able to accelerate and pay now include:
• deductible investment expenses, such as investment advisory fees, custodial fees, safe deposit box rentals and investment publications;
• professional fees, such as tax planning and preparation, accounting and certain legal fees; and
• unreimbursed employee business expenses, such as travel, meals, entertainment, vehicle costs and publications — all exclusive
of personal use.
Bunching medical expenses is often easier than bunching miscellaneous itemized deductions. Consider scheduling your non-urgent medical
procedures and other controllable expenses in one year to take advantage of the deductions. Deductible medical expenses include:
• health insurance premiums,
• prescription drugs, and
• medical and dental costs and services.
In extreme cases — and assuming you are not subject to the AMT — it may even be possible to claim a standard deduction in one
year, while bunching two years of itemized deductions in another.
Keep in mind that medical expenses aren’t deductible if they are reimbursable through insurance or paid through a pretax Health Savings
Account or Flexible Spending Account. The AMT can also complicate this strategy. For AMT purposes, only medical expenses in excess
of 10 percent of your AGI are deductible.
It’s important to remember that prepaid expenses can be Maximizing deductions can make a big difference
deducted only in the year they apply. So you can prepay 2011 Timing can often have the biggest impact on your itemized
state income taxes to receive a 2011 deduction even if the taxes deductions. How and when you take these deductions is
aren’t due until 2012. But you can’t prepay state taxes on your important because many itemized deductions have AGI floors.
2012 income and deduct the payment on your 2011 return. And For instance, miscellaneous expenses are deductible only to the
don’t forget the alternative minimum tax (AMT). If you are extent they exceed 2 percent of your AGI, and medical expenses
going to be subject to the AMT in both 2011 and 2012, it won’t are only deductible to the extent they exceed 7.5 percent of your
matter when you pay your state income tax, because it will not AGI. Bunching these deductions into a single year may allow
reduce your AMT liability in either year. you to exceed these floors and save more. Also keep in mind that
the AGI floor for medical expenses is scheduled to increase to 10
percent for taxpayers under 65 beginning in 2013.
10

15. Chapter 3
Alternative minimum tax
The alternative minimum tax (AMT) is perhaps the most • Investment advisory fees
unpleasant surprise lurking in the tax code. It was originally • Employee business expenses
conceived to ensure all taxpayers paid at least some tax, but has • Incentive stock options
long since outgrown its initial purpose. The AMT is essentially a • Interest on a home equity loan not used to build
separate tax system with its own set of rules. How do you know or improve your residence
if you will be subject to the AMT? Each year you must calculate • Tax-exempt interest on certain private activity bonds
your tax liability under the regular income tax system and the • Accelerated depreciation adjustments and related gain
AMT, and then pay the higher amount. or loss differences on disposition
The AMT is made up of two tax brackets with a top rate
of 28 percent. Many deductions and credits are not allowed Proper planning can help you mitigate, or even eliminate,
under the AMT, so taxpayers with substantial deductions that the impact of the AMT. The first step is to work with Grant
are reduced or not allowed under the AMT are the ones stuck Thornton to determine whether you could be subject to the
paying. Common AMT triggers include the following: AMT this year or in the future. In years that you’ll be subject
• State and local income and sales taxes, especially in to the AMT, you want to defer deductions that are erased by
high tax states the AMT and possibly accelerate income to take advantage
• Real estate or personal property taxes of the lower AMT rate.
Tax law change alert: AMT relief extended through 2011
The AMT includes a large exemption, but this exemption phases out at high-income levels. And unlike the regular tax system, the AMT was
never indexed for inflation. Instead, Congress must legislate any adjustments. Congress has been doing this on an approximately year-by-
year basis for many years, and lawmakers in 2010 raised the exemption levels through 2011.
But it’s important to remember that Congress only increases the exemption amount with each year’s “patch,” while the phaseout of the
exemption and the AMT tax brackets remain unchanged. See Chart 7 for a full breakdown. Without further AMT relief, the exemption will
plummet in 2012 and subject millions more taxpayers to the AMT.
Chart 7: 2011 individual AMT rate schedule and exemptions
AMT brackets AMT exemption
26% tax rate 28% tax rate 2011 exemption Phaseout
Single or head of household $0 – $175,000 Over $175,000 $48,450 $112,500 – $299,300
Married filing jointly $0 – $175,000 Over $175,000 $74,450 $150,000 – $429,800
Married filing separately $0 – $87,500 Over $87,500 $37,225 $75,000 – $214,900
11

16. Action opportunity: Accelerate income to “zero out” the AMT
You have to pay the AMT when it results in more tax than your regular income tax calculation, typically because the AMT has taken away key
deductions. The silver lining is that the top AMT tax rate is only 28 percent. So you can “zero out” the AMT by accelerating income into the
AMT year until the tax you calculate for regular tax and AMT are the same.
Although you will have paid tax sooner, you will have paid at an effective tax rate of only 26 percent or 28 percent on the accelerated
income, which is less than the top rate of 35 percent that is paid in a year you’re not subject to the AMT. If the income you accelerate
would otherwise be taxed in a future year with a potential top rate of 39.6 percent, the savings could be even greater. But be careful. If the
additional income falls in the AMT exemption phaseout range, the effective rate may be a higher 31.5 percent. The additional income may
also affect other tax benefits, so you need to consider the overall tax impact.
Capital gains and qualified dividends deserve special The credit can be taken against regular tax in future years, as
consideration for the AMT. They are taxed at the same 15 it is meant to account for timing differences that reverse in the
percent rate either under the AMT or regular tax structure, future. AMT credits at least four years old can be taken in 50
but the additional income they generate can reduce your AMT percent increments over a period of two years, even in years
exemption and result in a higher AMT bill. So consider your when the AMT continues to apply. Under legislation passed in
AMT implications before selling any stock that could generate the last several years, there is no AGI phaseout for this benefit.
a large gain. If you haven’t kept careful records of your credits because you
If you have to pay the AMT, you may be able to take assumed that you would continue to be subject to the AMT and
advantage of an AMT credit that has become more generous unable to use them, consider reviewing your prior-year returns
recently. You can qualify for the AMT credit by paying AMT to determine if you can benefit from this new provision.
on timing items such as depreciation adjustments, passive activity
adjustments and incentive stock options. Most individuals
paying the AMT do not have AMT credits and will not benefit
from this new break. However, you may have earned credits if
you’ve had business income from a partnership, S corporation
or Schedule C business.
12

17. Chapter 4
Investment income
Managing your investment tax burden can feel like driving with Chart 8: Investment income tax rates for 2010 and beyond
your eyes closed. The tax treatment of investment income should
2011–12 2013+
affect how you organize your portfolio, but it’s difficult when Ordinary income 35% 39.6%
the economy is so unpredictable. Qualifying dividends 15% 43.4%*
The financial crisis and the slow recovery have taken the Capital gain on property held more than a year 15% 21.8%*
Capital gain on property held more than 5 years 15% 23.8%*
stock market on several wild turns since 2008. You likely
experienced upheaval in your own business enterprises. * These figures include a 3.8% tax on investment income above $200K (single)
and $250K (joint)
Although the temptation may be to focus on economic decisions
now and worry about taxes later, this is when tax planning
becomes even more important. You can’t grope in the dark Medicare surtax on investment income such as dividends,
and hope it all works out in the future, especially with so capital gains and interest. This surtax, enacted in the 2010 health
much legislative uncertainty. Taxes on investment income are care bill, will add an additional 3.8 percent tax on investment
scheduled to rise in 2013 without congressional intervention. income above $200,000 (single) or $250,000 (joint) beginning
A little upfront consideration may save a lot in the long run. in 2013 (see Chart 8).
First, investment income comes in a variety of forms, and it’s 2011 is probably not the year to begin accelerating your
not all created equal. Income such as dividends and interest arises investment income. First, the current low tax rates could
from holding investments, while capital gains income results very well be extended as they were at the end of 2010. More
from the sale of investments. And while investment income is importantly, you still have next year to think about accelerating
often treated more favorably than ordinary income, the rules your gain, and you’ll have more information then on the
are complex. Long-term capital gains and qualifying dividends legislative outlook. Deferral is a cornerstone of good tax
can be taxed as low as 15 percent, while nonqualified dividends, planning and may still be the best strategy even if your
interest and short-term capital gains are taxed at ordinary income tax rates do go up in 2013.
tax rates as high as 35 percent. Special rates also apply to specific Regardless, your investment planning should go well
types of capital gains and other investments, such as mutual beyond any one-time decision about a prospective tax
funds and passive activities. increase. The various rules and rates on investment income
But more importantly, the top tax rates on investment offer many opportunities for you to manage your tax burden.
income are scheduled to change dramatically over the next Understanding the tax costs of various types of investment
several years. If the 2001 and 2003 tax cuts expire as scheduled income can also help you make tax-smart decisions. It starts
at the end of 2012, the top long-term capital gains rate would with understanding all the investment income tax rules. But
increase from 15 percent to 20 percent for property held more remember that tax planning is just one part of investing. You
than a year and 18 percent for property held more than 5 years. should also consider your risk tolerance, desired asset allocation
Dividends would be taxed as ordinary income at a top rate of and whether an investment makes sense for your financial and
39.6 percent. Yet, it gets worse! Those rates don’t include a new personal situation.
13

18. Managing capital gains and losses There are ways to mitigate the wash sale rule. You may be able
To benefit from long-term capital gains treatment, you must to buy securities of a different company in the same industry or
hold a capital asset for more than one year before it is sold. shares in a mutual fund that holds securities much like the ones
Selling an asset you’ve held for a year or less results in less you sold. Alternatively, consider a bond swap.
favorable short-term capital gains treatment. (In 2013, assets held It may prove unwise to try and offset your capital gains
more than five years will be subject to a separate capital gains at all. Up to $3,000 in net capital loss can be claimed against
rate unless legislation changes the rules.) Several specific types of ordinary income (with a top rate of 35 percent in 2011, scheduled
assets such as collectibles have special, higher capital gains rates, to increase to 39.6 percent in 2013), and the rest can be carried
and taxpayers in the bottom two tax brackets enjoy a zero rate forward to offset future short-term capital gains or ordinary
on their capital gains and dividends in 2011 and 2012. income.
Your total capital gain or loss for tax purposes generally is Regardless of whether you want to mitigate a net capital gain,
calculated by netting all the capital gains and losses throughout the tax consequences of a sale can come as a surprise, unless you
the year. You can offset both short- and long-term gains with remember the following rules:
either short- or long-term losses. Taxpayers facing a large capital • For tax purposes, the trade date and not the settlement date
gains tax bill often find it beneficial to look for unrealized losses of publicly traded securities determines the year in which
in their portfolio so they can sell the assets to offset their gains. you recognize the gain or loss.
But keep the wash sale rule in mind. You can’t use the loss if you • If you bought the same security at different times and prices,
buy the same — or a substantially identical — security within 30 consider specifically identifying which shares are to be sold
days before or after you sell the security that creates the loss. by the broker before the sale. Selling the shares with the
highest basis will reduce your gain or increase your losses.
Action opportunity: Avoid the wash sale rule with a bond swap
Bond swaps are a way to maintain your investment position while recognizing a loss. With a bond swap, you sell a bond, take a capital loss
and then immediately buy another bond of similar quality from a different issuer. You’ll avoid the wash sale rule because the bonds are not
considered substantially identical.
Tax law change alert: New broker reporting rules affect basis on stock sales
Beginning in 2011, brokers for the first time are required to report your basis to the IRS when you sell stock. Brokers must generally report
the sales of securities on a first-in, first-out basis within an account unless the customer specifically identifies which securities are to be sold.
The sale of any shares with unknown acquisition dates are reported first. Taxpayers have the option of electing an average basis method.
Your broker may also use a default basis method, so make sure you check the rules and affirmatively elect the method you want to use.
Deferral strategies An installment sale allows you to defer capital gains on most
Deferring taxes is normally a large part of good planning. Even assets other than publicly traded securities by spreading gain
with the possibility of capital gains rates going up in 2013, the over several years as you receive the proceeds. If you’re engaging
time value of money will still make deferral the best option for in an installment sale, consider creating a future exit strategy.
many taxpayers. If you believe your rates will go up, you can You may want to build in the ability to pledge the installment
also consider adjusting the strategies you’re using to defer gain, obligation. Deferred income on most installment sales made after
such as an installment sale or like-kind exchange. 1987 can be accelerated by pledging the installment note for a
Like-kind exchanges under Section 1031 allow you to loan. The proceeds of the loan are treated as a payment on the
exchange real estate without incurring capital gains tax. Under a installment note itself. If legislation is enacted that increases the
like-kind exchange, you defer paying tax on the gain until you capital gains rate in the future (or makes clear that the scheduled
sell your replacement property. increase will occur), this technique can essentially accelerate the
proceeds of the installment sale.
14

19. Action opportunity: Use zero capital gains rate to benefit children
Taxpayers in the bottom two tax brackets pay no taxes on long-term capital gains and qualifying dividends in 2011 and 2012. If income
from these items would be in the 10 percent or 15 percent bracket based on a taxpayer’s income, then the tax rate is zero.
If you have adult children in these tax brackets, consider giving them dividend-producing stock or long-term appreciated stock. They can sell
the stock for gains or hold the stock for dividends without owing any taxes.
Keep in mind there could be gift tax and estate planning consequences. Income generated by gifts to children up to the age of 23 can also
be subject to the “kiddie tax,” which taxes some of their unearned income at the marginal rate of their parents (see Chapter 8 for more
information).
Mutual fund pitfalls Small business stock comes with tax rewards
Investing in mutual funds is an easy way to diversify your Buying stock in a qualified small business (QSB) comes
portfolio, but comes with tax pitfalls. Typically, earnings on with several tax benefits, assuming you comply with specific
mutual funds are reinvested. Unless you (or your broker or requirements and limitations. QSB stock must be original issue
investment adviser) keep track of these additions to your basis, stock in a C corporation with no more than $50 million in assets
and you designate which shares you are selling, you may report (and meet several other tests).
more gain than required when you sell the fund. There are other tax benefits for small business stock that meet
It is often a good idea to avoid buying shares in an equity separate eligibility requirements. If you sell small business stock
mutual fund right before it declares a large capital gains under Section 1244 (generally stock in a domestic corporation
distribution, typically at year-end. If you own the shares on with no more than $1 million in capital) for a loss, you can treat
the record date of the distribution, you’ll be taxed on the full up to $50,000 ($100,000, if married filing jointly) as an ordinary
distribution amount even though it may include significant gains loss, regardless of your holding period. This means you can use
realized by the fund before you owned the shares. Worse yet, it to offset ordinary income such as salary and interest taxed at a
you’ll end up paying taxes on those gains in the current year — 35 percent rate (or 39.6 percent rate in future years if tax rates go
even if you reinvest the distribution in the fund and regardless up as scheduled).
of whether your position in the fund has appreciated.
Tax law change alert: No tax on gain from QSB stock purchased in 2011
Thanks to legislation meant to jumpstart the economy, you won’t have to pay a dime of tax on gain from QSB stock purchased in 2011,
ever, as long as you follow all the rules. You can normally exclude only half of the gain on QSB stock held for five years. The new legislation
doubles this exclusion to 100 percent for QSB stock bought after Sept. 27, 2010, and before the end of 2011. So invest in a QSB stock
before the year is up, and enjoy any future growth in value totally tax-free.
You can also roll over QSB stock without realizing gain. If you buy QSB stock with the proceeds of a sale of QSB stock within 60 days,
you can defer the tax on your gain until you dispose of the new stock. The new stock’s holding period for long-term capital gains treatment
includes the holding period of the stock you sold.
Rethinking dividend tax treatment • foreign investments,
The tax treatment of income-producing assets can affect • regulated investment companies, and
investment strategy. Qualifying dividends generally are taxed • stocks — to the extent the dividends are offset by margin
at the reduced rate of 15 percent in 2011, while interest income debt.
is taxed at ordinary income rates of up to 35 percent.
As long as dividends remain at a lower rate than ordinary Some bond interest is exempt from income tax. Interest on
income, dividend-paying stocks may be more attractive from a U.S. government bonds is taxable on your federal return, but
tax perspective than investments such as CDs and bonds. But generally it is exempt on your state and local returns. Interest on
there are exceptions. Some dividends are already subject to state and local government bonds is excludible on your federal
ordinary income rates. These include certain dividends from: return. If the state or local bonds were issued in your home state,
• money market mutual funds, interest also may be excludible on your state return. Although
• mutual savings banks, state and municipal bonds usually pay a lower interest rate, their
• real estate investment trusts (REITs), rate of return may be higher than the after-tax rate of return for a
taxable investment.
15

20. Review portfolio for tax balance Rental activity has its own set of passive loss rules. Losses from
You should consider which investments to hold inside and real estate activities are passive by definition unless you’re a real
outside your retirement accounts. If you hold taxable bonds to estate professional. If you’re a real estate professional, you can
generate income and diversify your overall portfolio, consider deduct real estate losses in full, but you must perform more than
holding them in a retirement account where there won’t be a half of your personal services annually in real property trades
current tax cost. and businesses and spend more than 750 hours in these services
Bonds with original issue discount (OID) build up “interest” during the year.
as they rise toward maturity. You’re generally considered to If you participate actively in a rental real estate activity but
earn a portion of that interest annually — even though the bonds you aren’t a real estate professional, you may be able to deduct
don’t pay you this interest annually — and you must pay tax on up to $25,000 of real estate losses each year. This deduction is
it. They also may be best suited for retirement accounts. subject to a phaseout beginning when adjusted gross income
Try to own dividend-paying stocks that qualify for a lower (AGI) reaches $100,000 ($50,000 for married taxpayers filing
qualified dividend tax rate outside of retirement plans so you’ll separately).
benefit from the lower rate.
It’s also important to reallocate your retirement plan assets Leveraging investment expenses
periodically. Assuming different investments yield different You are allowed to deduct expenses used to generate investment
returns, it may not take long for your portfolio to have a very income unless they are related to tax-exempt income. Investment
different allocation than you intended originally. And the expenses can include investment advisory fees, research costs,
allocation you set up for your 401(k) plan 10 years ago may not security costs (such as a safe deposit box) and most significantly,
be appropriate now that you’re closer to retirement. investment interest. Apart from investment interest, these
expenses are considered miscellaneous itemized deductions
Planning for passive losses and are deductible only to the extent they exceed 2 percent
There are special rules for income and losses from a passive of your AGI.
activity. Investments in a trade or business in which you don’t Investment interest is interest on debt used to buy assets
materially participate are passive activities. You can prove your held for investment, such as margin debt used to buy securities.
material participation by participating in the trade or business Payments a short seller makes to the stock lender in lieu of
for more than 500 hours during the year or by demonstrating dividends may be deductible as an investment interest expense.
that your involvement represents substantially all of the Your investment interest deduction is limited to your net
participation in the activity. investment income, which generally includes taxable interest,
The designation of a passive activity is important, because dividends and short-term capital gains. Any disallowed interest
generally passive activity losses are deductible only against is carried forward for a deduction in a later year, which may
income from other passive activities. You can carry forward provide a beneficial opportunity.
disallowed losses to the following year, subject to the same If you don’t want to carry forward investment interest
limitations. There are options for turning passive losses into expense, you can elect to treat net long-term capital gain or
tax-saving opportunities. qualified dividends as investment income in order to deduct
For instance, you can increase your activity to more than 500 more of your investment interest, but it will be taxed at
hours so the losses will not be passive. Alternatively, you can ordinary-income rates. Remember that interest on debt used to
limit your activities in another business to less than 500 hours or buy securities that pay tax-exempt income, such as municipal
invest in another income-producing business that will be passive bonds, isn’t deductible. Also keep in mind that passive interest
to you. This will allow the other businesses to give you passive expense — interest on debt incurred to fund passive activity
income to offset your passive losses. Finally, consider disposing expenditures — becomes part of your overall passive activity
of the activity to deduct all the losses. The disposition rules can income or loss, subject to limitations.
be complex, so consult with a Grant Thornton tax adviser.
Action opportunity: Defer investment interest for a bigger deduction
Unused investment interest expense can be carried forward indefinitely and may be usable in later years. Many taxpayers elect to treat
qualified dividends and long-term capital gains as investment income in order to deduct unused investment expenses. It could make sense
instead for you to carry forward your unused investment interest until after 2013 when tax rates are scheduled to go up and the 15-percent
rate on long-term capital gains and dividends is scheduled to disappear. The deduction could save you more at that time if taxes increase
as scheduled.
16

21. Your home as an investment Maintain thorough records to support an accurate tax basis,
There are many home-related tax breaks. Whether you own one and remember, you can only deduct losses if they are attributable
home or several, it’s important to maximize your deductions exclusively to business or rental use (subject to various
and plan for any gains or rental income. Generally, property tax limitations).
is deductible as an itemized deduction, but isn’t deductible for The rules for rental income are complicated, but you can
AMT purposes. rent out all or a portion of your primary residence and second
Consumer interest isn’t deductible, so consider using home home for up to 14 days without having to report the income. No
equity debt (up to the $100,000 limit) to pay off credit cards or rental expenses will be deductible. If you rent out your property
auto loans. But remember, home equity debt is not deductible for 15 days or more, you have to report the income, but you
for the AMT unless it’s used for home improvements. can also deduct all or a portion of your rental expenses — such
When you sell your home, you generally can exclude up as utilities, repairs, insurance and depreciation. Any deductible
to $250,000 ($500,000 for joint filers) of gain if you’ve used it expenses in excess of rental income can be carried forward.
as your principal residence for two of the preceding five years, If the home is classified as a rental for tax purposes, you can
subject to new limitations based on how long the home may not deduct interest that’s attributable to its business use but not any
have been used as your primary residence. interest attributable to personal use.
Tax law change alert: Deduct interest on a mortgage of up to $1.1 million
You can deduct mortgage interest and points on your principal residence and a second home. For many years, courts and the IRS had
interpreted the tax code to limit your deduction to the interest from up to:
• $1 million in total mortgage debt used to purchase, build or improve a home, PLUS
• $100,000 for home equity debt that is NOT used to acquire the home.
This allowed taxpayers to deduct interest on up to $1.1 million in mortgage debt, but only if $100,000 was not used to purchase or build
the home. The IRS in 2010 issued a revenue ruling (Rev. Rul. 2010-25) taking a more taxpayer-favorable position. The IRS has now ruled that
debt used to buy, construct or improve a home can be treated as both acquisition and equity indebtedness — allowing taxpayers to deduct
interest on up to $1.1 million in mortgage interest even if all of it was used to purchase or build the home.
Tax law change alert: Primary residence gain exclusion limited
New rules limit how much gain you can exclude under the general exclusion rules applying to the sale of a principal residence. You will now
have to include gain on a pro-rata basis for any years after 2009 that your home was not used as your principal residence. So if you use a
home as a rental from 2010 through 2014, and then use it as a primary residence from 2015 through 2019, you will only be able to exclude
half of any gain.
17

22. Chapter 5
Executive compensation
Whether you’re an executive at a private or public company There is potential alternative minimum tax (AMT) liability when
— or an employee-owner of an enterprise — you’ve likely the options are exercised. The difference between the fair market
come face to face with some complex executive compensation value of the stock at the time of exercise and the exercise price
decisions. You’ve got to think beyond salary, fringe benefits and is included as income for AMT purposes. The liability on this
bonuses. You need to make sure you’ve got a grip on the tax bargain element is a problem because exercising the option alone
consequences of more complex pay plans, such as stock options, doesn’t generate any cash to pay the tax. If the stock price falls
deferred compensation plans and restricted stock. before the shares are ultimately sold, you can be left with a large
AMT bill in the year of exercise even though the stock actually
Benefiting from incentive stock options produced no income. Congress has provided some relief from
Stock options remain one of the most popular types of incentive past ISO-related AMT liabilities, and a new more generous
compensation, and incentive stock options (ISOs) deserve special AMT credit is also available (see Chapter 3 for more information
attention in your tax planning. If your options qualify as ISOs, on the AMT credit). Talk to a Grant Thornton tax adviser if you
you can take advantage of favorable tax treatment. have questions about AMT-ISO liability.
ISOs give you the option of buying company stock in the As noted above, if the stock from an ISO exercise is sold
future. The price (known as the “exercise price”) must be set before certain holding period requirements are met (referred
when the options are granted and must be at least the fair market to as a “disqualifying disposition”), the gain is taxed at ordinary
value of the stock at that time. It is customary for the exercise income tax rates. The employer is entitled to a compensation
price to be set at exactly the fair market value. Therefore, the deduction for ISOs only if the employee makes a disqualifying
stock must rise before the ISOs have any value. If it does, you disposition.
have the option to buy the shares for less than they’re worth. If you’ve received ISOs, you should decide carefully when
to exercise them and whether to sell immediately or hold
ISOs have several tax benefits: the shares received from an exercise. Acting earlier can be
• There is no tax when the options are granted. advantageous in some situations:
• There is no tax when the options are exercised. • Exercise earlier to start the holding period for long-term
• Long-term capital gains treatment is available if the stock is capital gains treatment sooner.
held for more than one year after exercise. (If the stock isn’t • Exercise when the bargain element is small or the market
held for at least two years after the option’s grant date, and price is low to reduce or eliminate AMT liability.
at least one year after the exercise date, then the increase in • Exercise annually and buy only the number of shares
value over the exercise price as of the exercise date is taxed as that will achieve a breakeven point between the AMT
ordinary compensation income rather than as a capital gain.) and regular tax.
18

23. But be careful, because exercising early accelerates the need for Considerations for restricted stock
funds to buy the stock. It also exposes you to a loss if the value Restricted stock provides different tax considerations. Restricted
of the shares drops below your exercise cost and may create a stock is stock that is granted subject to vesting. The vesting is
tax cost if the exercise generates an AMT liability. If you exercise often time-based, but can also be performance-based so that the
an ISO and later feel that the stock price will fall, you can vesting is linked to company and/or individual performance.
consider selling the stock in the same year as the exercise (i.e., Normally, income recognition is deferred until the restricted
resulting in a disqualifying disposition, as described above) in stock vests. You then pay taxes on the fair market value of the
order to pay the higher ordinary income rate. In this situation, stock at the ordinary income rate. However, there is an election
the AMT does not apply to the exercise. Tax planning for ISOs under Section 83(b) to recognize ordinary income when you
is truly a numbers game. With the help of Grant Thornton, you receive the stock. This election must be made within 30 days
can evaluate the risks and crunch the numbers using various after receiving the stock and can be very beneficial in certain
assumptions. situations.
Action opportunity: Consider an 83(b) election on your restricted stock
With an 83(b) election, you immediately recognize the value of the restricted stock as ordinary income when the stock is granted.
In exchange, you don’t recognize any income when the stock actually vests. You only recognize gain when the stock is sold, and it
is taxed as a capital gain.
So why make an 83(b) election and recognize income now, when you could wait to recognize income when the stock vests? Because the
value of the stock may be much higher when it vests. The election may make sense if the income at the grant date is negligible or if the
stock is likely to appreciate significantly before income would otherwise be recognized. In these cases, the election allows you to convert
future appreciation from ordinary income to long-term capital gains income.
The biggest drawback may be that any taxes you pay because of the election can’t be refunded if eventually you forfeit the stock
or the stock’s value decreases. But if the stock’s value decreases, you’ll be able to report a capital loss when you sell the stock.
Understanding nonqualified deferred compensation Additionally, there are the following rules:
Nonqualified deferred compensation (NQDC) plans pay • Benefits must either be paid on a specified date according to a
executives in the future for services being performed now. fixed payment schedule or after the occurrence of a specified
But they don’t have the restrictions of qualified retirement event — defined as death, disability, separation from service,
plans such as 401(k) plans. Specifically, NQDC plans can favor change in ownership or control of the employer, or an
certain highly compensated employees and can offer executives unforeseeable emergency.
an excellent way to defer income and tax. • The decision about when to pay the benefits must be made at
However, there are drawbacks. Employers cannot deduct the same time the election is made to defer the compensation.
any NQDC until the executive recognizes it as income, and • Once that decision is made, the timing of benefit payments
NQDC plan funding is not protected from an employer’s can be delayed, but generally cannot be accelerated.
creditors. Also, employers must be in full compliance now with • Elections to delay the timing or change the form of a
IRS rules under Section 409A that govern NQDC plans. The payment must be made at least 12 months in advance of the
rules are strict, and the penalties for noncompliance are severe. If original payment commencement date.
a plan fails to comply with the rules, plan participants are taxed • New payment dates must be at least five years after the date
on plan benefits immediately with interest charges and the payment would have been made originally.
an additional 20 percent tax.
The new rules under Section 409A make several important It is also important to note that employment taxes generally are
changes. Executives generally must make an initial deferral due when the benefits become vested. This is true even though
election before the year they perform the services for the the compensation isn’t actually paid or recognized for income
compensation that will be deferred. So an executive who wanted tax purposes until later years. Some employers withhold an
to defer some 2011 compensation to 2012 or beyond generally executive’s portion of the tax from the executive’s salary or
must have made the election by the end of 2010. ask the executive to write a check for the liability. Others pay
the executive’s portion, but this must be reported as additional
taxable income.
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