End-of-year tax planning for investors

By Stephan R. Leimberg, Robert J. Doyle Jr., Thomas R. Robinson, Robert R. Johnson

December 05, 2014 at 08:20 AM

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As taxpayers begin to asses 2014 tax liability, certain investment-related tax planning strategies may provide opportunities to defer income or deductions to later years. Depending on the taxpayer's circumstances, they may wish to defer (or advance) the reporting of taxable events if they anticipate facing different tax rates in the future.

As part of this assessment, there are four areas that investors may want to consider which may allow them to take steps before the end of the year to minimize their liability.

Timing of capital gain or loss

Owners of capital property may be able to control when gain or loss is recognized for tax purposes. In general, gain is not recognized until property is sold. There are certain ways to control the timing of such recognition and, thus, manage taxation.

The problems of determining the correct year to report income or take deductions flow from the requirement that income must be reported on the basis of annual periods. Although a few exceptions exist, as a general rule investors must report income and claim deductions according to annual accounting periods.

Investors can defer recognition of gain on investments such as stock or bonds by using a buy and hold strategy because generally taxpayers do not recognize gains until they sell their investments. When investors sell stocks or bonds, they can minimize gains by selling stocks or bonds with the highest bases relative to sales prices. In the same year, investors also may be able to sell stocks or bonds at a loss to offset gains recognized on other sales.

Investors can accelerate recognition of loss on investments such as stocks or bonds by selling the stocks or bonds. However, in certain circumstances the tax law disallows the current recognition of a loss such as when the sale is between certain related persons, or where the investor holds or acquires certain other positions in the property being sold at a loss.

The ability to time the reporting of gain or loss is critical to enhancing the success of the investor. Deferring income until a later year, particularly a year in which the investor is in a lower tax bracket, or accelerating a deduction into a year in which the taxpayer has a great deal of income can significantly enhance the after-tax return from an investment.

Most investors are cash basis taxpayers who report income as it is received and take deductions as expenses are paid. As such, they will generally recognize a gain or loss from the disposition of an asset at the time the transaction is closed. The mere signing of an agreement to sell does not trigger the recognition of gain or loss. A transaction is not closed until the seller transfers title to the property in exchange for cash or other proceeds.

Cash-basis taxpayers report income in the year that they receive it and, generally, deduct expenses in the year that they pay it. The cash-basis method is therefore essentially an "in and out of pocket" method of reporting. Items do not have to be received or paid in cash; receipts and payments in property are income and deduction items to the extent of the fair market value of the property received or paid.

Cash-basis investors will generally include interest, royalty, dividend, and other investment income, as well as gains from the sale of investments, in gross income in the year in which they receive cash or other property. They will also deduct interest and other expenses they incur in connection with their investments, as well as losses from the sale of investments, from gross income in the year in which they pay cash or other property. Thus, they may deduct interest expense, investment advisory fees, and other deductible expenses in the year paid, but deduct losses on the sale of securities on the trade date (even if delivery and receipt of the proceeds occurs in the following year). Some exceptions to the general rules governing cash basis investors follow.

Constructive receipt

Under the doctrine of constructive receipt, an investor must include an item in gross income even though he does not actually take possession, if the item is:

credited to the investor's account;
set apart from other funds; or
otherwise made available without any substantial conditions or restrictions.

Therefore, income is taxable if the investor can take it when he or she wants it.

The purpose of the doctrine is to prevent investors from determining at will the year in which they will report income. Without the doctrine of constructive receipt, investors could postpone the taxability of income until the year in which they chose to reduce the item to their actual possession. For example, taxpayers must report interest credited to their bank savings accounts regardless of whether they withdraw the interest or leave it on deposit.

Constructive receipt will not apply if the taxpayer's control of the income is restricted in some meaningful manner. For instance, an investor will not be considered to have constructively received money or other property if:

it is only conditionally credited;
it is an indefinite amount;
the payor has no funds;
the money is available only through the surrender of a valuable right; or
receipt is subject to any other substantial limitation or restriction.

The doctrine of constructive receipt is particularly important to individuals whose employers have enhanced their financial security through nonqualified deferred compensation arrangements. As a taxpayer approaches the end of the year, slight changes in the conditions that trigger a constructive receipt may allow them to defer the receipt of income to a later year.

Installment sales

An investor can defer the recognition of gain until the actual receipt of cash or other property in exchange for the asset sold. The key ingredient in an installment sale is that the seller will receive at least one payment in a year after the year of sale.

The installment sale provisions are particularly important to an investor who has sold an asset for a substantial profit and has received a cash down payment and note from the purchaser for the balance due. Usually, these notes are not readily transferable. Without the installment sale rules, the investor would incur a large tax in one year even if he does not have sufficient cash from the transaction to pay the tax.

Installment sales are also indicated when an investor wants to sell property to another party who does not have enough liquid assets to pay for the property in a lump sum at closing. Installment sales are an important estate as well as financial planning tool and are used to shift wealth within the family unit as well as to protect appreciating assets from creditors.

The basic rules for installment sale reporting include the following:

1. A seller of property can defer as much or as little as desired and can set payments to fit his financial needs. Even if the seller receives payments in the year of sale, he may still use the installment method for the unpaid balance.

2. The seller does not have to receive any payments in the year of sale. An investor may contract to have payments made to him at the time when it is most advantageous (or the least disadvantageous).

3. Installment sale treatment is automatic unless the investor affirmatively elects not to have installment treatment apply. No special election is required.

4. The contract may provide that the installment note receivable is independently secured (such as with a letter of credit obtained from a bank) without triggering the recognition of income when the note is secured.

The tax law imposes several limitations on the use of the installment sale method of accounting for gain on the sale of property. One such limitation is that taxpayers may not use the installment sale method for the sale of stock or securities that are traded on an established securities market.

Readjustment of installment terms to move receipt of sale proceeds forward or back around the end of the year can potentially make an important difference in the seller's tax liability.

Prepaid deductions

In certain situations, cash-basis investors can control the year in which they will take deductions. They can, for instance, prepay certain taxes and take the deduction in the year of payment even though the expenses relate to future years. This ability to time deductions is limited. For example, taxpayers cannot deduct the payment of multiple years' prepaid rent and insurance premiums in the year of payment. They generally must spread the deductions over the period covered by the prepayment if the deduction of the prepayment would materially distort income.

Special rules apply to the deductibility of interest expense for all taxpayers, whether they use the cash-basis or the accrual-method of accounting. A cash-basis investor must deduct prepaid interest over the period of the loan to the extent the interest represents the cost of using the borrowed funds during each taxable year in the period. Generally, investors must deduct points paid on an investment loan ratably over the term of the loan. An investor on the accrual method of accounting accrues interest ratably over the loan period. This means the accrual-method investor must deduct the interest ratably even if he prepays the interest.

As investors approach the end of the year, they may want to consider pre-paying upcoming deductible obligations to offset gains.

Restricted property

An employer often transfers property to an employee in connection with the performance of services. A business may give or sell stock or other property to a key employee but withhold, by separate agreement, significant rights. For example, an employer may transfer stock to an employee but restrict the employee's right to vote the stock or sell it. The idea is that the employer will withhold (restrict) property rights until the employee has performed certain specified services. If the employee fails to achieve the goal or meet the specified requirements, the employee may forfeit his right to the stock or other property.

Suppose an employer pays a bonus to an executive in the form of company stock. Assume the ownership of this stock is subject to certain restrictions, including a provision that if the employee leaves the company within a five-year period he will forfeit the stock and will receive no compensation. Such property, appropriately, is called restricted stock or restricted property.

If an employer gave an employee property with no restrictions, the entire value of the property would constitute current compensation income. For instance, an employee who receives a bonus of one-hundred shares of his employer's stock currently selling for $200 a share realizes $20,000 of income. But, if certain requirements are met, an employer can compensate an employee in a manner that delays the tax until the employee is given full rights in the property.

The general rules governing restricted property (the IRC Section 83 rules) provide that employees will report transfers of restricted property as income in the first tax year in which the employees' rights are not subject to any substantial risk of forfeiture, and transferable free of this risk.

"Substantial risk of forfeiture" means that rights in transferred property are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person or upon the occurrence of a condition related to the purpose of the transfer. In addition, there must be a realistic and substantial possibility of forfeiture if the specified condition is not satisfied. The following examples illustrate common situations that probably would not be considered substantial restrictions:

a consulting contract with a retiring executive that called for only occasional services at the executive's discretion;
a requirement that an employee must return the property if he commits a felony; or
a noncompetition provision (because this is largely within the employee's control).

In other words, employees will not be subject to tax on restricted property as long as their rights to that property are forfeitable (subject to a substantial risk of forfeiture) and not transferable by them free of such risk. (This means that if employees should sell or give the property away, the recipients of the property must also be under a substantial risk that they (the new owners) would forfeit the property if the employees failed to satisfy the conditions necessary to obtain full ownership.

What happens when the restrictions expire? At the lapse of the restrictions, the employee generally must include in income the value of the property at that time. Sometimes an employer will remove restrictions in stages so that an employee may "earn out" of the restrictions.

But the employee has a choice — he can elect to have the value of the restricted property taxed to him immediately in the year he receives it (even though it remains nontransferable or subject to a substantial risk of forfeiture). If an employee makes this election within thirty days of receipt of the property, the general restricted property rules do not apply. Any appreciation in the value of the property is treated as capital gain rather than as compensation. The employee pays no tax at the time the risk of forfeiture expires (and will pay no tax until the property is sold or otherwise disposed of in a taxable exchange). But if the property is later forfeited, no deduction is allowed for the loss.

An employee who makes this election must be willing to pay ordinary income tax on the fair market value of the property in the year he receives the stock or other property. He is gambling that the value of the property will increase considerably before the restrictions lapse (in which case he may be eligible to pay tax on any realized gain as capital gain). He is also gambling that he will not forfeit the stock before he is able to sell or dispose of it without restriction.

Another exception to the strict rule of includability of the fair market value of the property (upon the lapse of restrictions) concerns restrictions that affect value. This exception pertains to value-affecting restrictions, which, by their terms, will never lapse. For instance, if an employee may sell restricted property only at book value and that restriction, by its terms, will never lapse, that amount will be treated as the property's fair market value.

An employer's compensation deduction will be allowed at the time the employee recognizes income from restricted property. The amount of the deduction will be the same as the amount of income recognized by the employee.

Tax planning for the AMT

The existence of the alternative minimum tax places a premium on planning techniques. With the availability of the AMT credit, it is less critical to undertake some of the more drastic planning concepts when the taxpayer will be able to use the AMT credit within a year or two after the AMT tax would be due.

As part of a taxpayer's end-of-year planning activities, there are several steps that can be taken to avoid or minimize the effect of the AMT. First, investors should determine the maximum amount of deductions or losses that an investor can claim before becoming subject to the AMT. Once an investor reaches the point where the AMT applies, any additional deductions will yield at most a 26 percent (or 28 percent as determined by AMTI) tax benefit. Investors can reduce or eliminate tax preference items by:

electing to capitalize excess intangible drilling costs, mining exploration expenses, and research and experimentation expenses, and amortize them over the permissible AMT periods;
electing the AMT or straight-line methods of computing depreciation; or
considering an early disposition (in the year of exercise) of stock acquired through the exercise of an Incentive Stock Option.

When it has been determined that the investor will be subject to the AMT the investor should consider deferring current year deductions (which will be of minimal value because of the AMT) and save them for a future year when they will be more valuable, by:

postponing charitable contributions;
postponing elective medical treatments; or
delaying making estimated state tax payments.

The investor should also consider accelerating ordinary income, because it will be taxed at no greater than the AMT rate. This can be accomplished, for example, by exercising options under an Incentive Stock Option Plan (ISO) and selling the stock within the same year. (This has the double advantage of qualifying the ordinary income from the accelerated sale of the ISO for the maximum AMT tax rate and eliminating the ISO as a tax preference item.)

Although not included in the list of tax preferences or tax adjustments, capital gains and qualifying dividends can play a significant, yet not well understood, role in the alternative minimum tax. While capital gains and qualifying dividends are taxed for AMT purposes at the same favorable rate they are taxed for regular tax purposes, they may still contribute indirectly to the creation of AMT in some circumstances.

First, capital gains increase the taxable income from which the alternative minimum taxable income is computed. For certain ranges of income, it may phase out a part of the AMT exemption applicable to the taxpayer. Depending on the amount of other ordinary income and the proportion of adjustments and preferences relative to regular taxable income, recognition of capital gains may cause the AMT. Second, large capital gains generally create a large state income-tax liability, which itself is a tax adjustment in computing AMT in the year paid.

Investment tax issues

One of the most important considerations for investors is the tax liability that arises from investment income. With regard to investment income, there are three areas that investors should review prior to the end of the year for possible tax mitigation steps: OID elections, market discount elections, and application of loss deferral rules.

Original issue and discounts

Original Issue Discount (OID) arises when corporate or governmental borrowers originally issue bonds or notes (or other similar debt instruments) at a price that is less than the stated redemption price at maturity (i.e., par or face value). The extreme example is zero coupon bonds that borrowers issue at deep discounts from the redemption value at maturity. The difference between the issue price (the original buyer's initial basis in the bond) and the redemption price is the original issue discount. But a de minimis exception in Code section 1273(a) provides that the discount can be ignored if it is less than 1/4 of 1% (0.0025) of the stated redemption price multiplied by the number of complete years to maturity. For example, a corporation could issue a twenty-year bond with a $10,000 par or redemption value at a price as low as $9,500 and buyers could ignore the discount. ($10,000 x 0.0025 = $25; $25 x 20 years = $500.)

Purchasers or lenders must include the amount of OID in income as it accrues over the life of the debt instrument. Similar rules apply to tax-exempt municipal bonds with original issue discount with respect to the accrual of OID and adjustment of basis. But the OID accruing each period is tax exempt, just like the cash interest payments.

The purpose of the OID rules is to prevent purchasers of OID bonds from deferring tax on the interest they are implicitly earning each year until the bonds mature, or until the owners sell, exchange, or otherwise dispose of the bonds. For deep discount bonds, this means that bondholders may have tax liability that exceeds the actual cash interest income from the bonds.

For bonds issued after April 4, 1994, bondholders must accrue the OID at a constant rate (explained next). Bondholders may use accrual periods of different lengths provided that no accrual period is longer than one year. Generally, if the bond pays some periodic interest, the accrual period is equal to the period between interest payments. Treasury Regulations section 1.1272-1(b)(1) provides that interest payments may occur either on the first day or final day of an accrual period.

In many, if not most, cases, an accrual period may span two taxable years of the bondholder. Bondholders apportion to each taxable year the amount of OID in the accrual period spanning the two tax years by ratably allocating the period's accrued discount to each day in the period. For instance, if the accrual period is the three months from November 1, to January 31, and the OID accruing in that three-month period is $184, the bondholder would allocate $2 to each day in this ninety day period ($184 / 92). Thus, a calendar year taxpayer would include $122 (sixty-one days in November and December x $2) of this period's OID in income for the current tax year and $62 (thirty-one days in January x $2) in the subsequent tax year. These OID allocation rules apply to both accrual basis and cash basis taxpayers.

Bondholders add the amount of OID taken into income each period to their basis in the bond. The constant rate method requires bondholders to accrue interest on the bond at its yield to maturity. The yield to maturity is the rate that equates the issue price to the present value of all scheduled cash interest payments on the bond, if any, plus the present value of the redemption.

End of year planning should include a review of any OID elections made in previous years as well as OID elections made (or yet to be made) for new acquisitions to an investor's bond portfolio.

Market discounts

Market discounts (or premiums) in bond prices arise as a result of fluctuations in market rates of interest or changes in the borrower's credit rating after the bond is originally issued. If bondholders sell, exchange, or otherwise dispose of an OID bond before maturity, they determine their gain or loss in reference to their adjusted basis. Generally, the gain or loss is treated as long-term or short-term capital gain or loss, depending upon the bond owner's holding period.

How does the new bondholder treat the purchase? Under Code section 1278 if a bond was originally issued at par, the market discount is the amount by which the stated redemption price exceeds the taxpayer's basis in the bond immediately after its acquisition. If the bond was originally issued at a discount and later purchased on the market for less than the original issue price increased by the amount of original issue discount accruing since issue up to the date of purchase, the difference is market discount. Therefore, a person who purchases a bond that was originally issued at a discount measures the market discount or premium not by reference to the redemption value, but by reference to the basis adjusted for OID. Similar to original issue discounts, if the total market discount is less than 1/4 of 1 percent (0.0025) of the stated redemption price at maturity (or, if the bond was issued at a discount of the issue price increased by original issue discount accruing since issue to the date of purchase) multiplied by the number of complete years until maturity, it is treated as if there is no market discount.

In general, investors do not include market discount in income until they sell or dispose of the bond. But if they purchase a bond that was originally issued at a discount, they must continue to accrue the OID at a constant rate over the remaining term until the bond matures or until they sell or dispose of the bond, just as if they were the original bondholders. They must include the OID in income as it accrues and increase their bases accordingly.

Although an investor who buys a bond at a market discount generally does not have to accrue the market discount over the remaining term of the bond, upon the sale, exchange, redemption, or other disposition of the bond for a price in excess of the bondholder's adjusted basis, the investor must treat as ordinary interest income any gain up to the amount of the market discount. Any gain in excess of the market discount is treated as long-term or short-term capital gain, depending upon the investor's holding period. If the amount received is less than the investor's adjusted basis, the loss is treated as long-term or short-term capital loss, depending upon the investor's holding period.

Investors may elect, pursuant to Code section 1278(b), to include market discount as it accrues on bonds and notes other than:

tax-exempt obligations purchased before May 1, 1993;
short-term obligations;
U.S. Savings Bonds; or
certain obligations arising from installment sales of property.

In general, deferring the tax on market discounts until disposition of the bond is preferable. But investors may wish to make the election if they have insufficient investment income to absorb all of their investment interest expense on borrowing to finance their investments. Once an investor makes this election, it applies to allobligations having market discount (other than those listed in the preceding paragraph) acquiredby the taxpayer in the tax year of the election, and any future years unless the investor petitions the IRS to revoke the election.

If an investor elects to accrue the market discount, the default method is to accrue the discount on a ratable basis. Investors determine the daily accrual under the ratable accrual method by dividing the total market discount on the bond by the number of days after the date of acquisition up to and including the date of maturity. Alternatively, an investor may elect to use the constant yield method, similar to the original issue discount rules, with respect to particular bonds and notes. Once elected, the constant yield election is irrevocable with respect to that particular bond. But investors may use the ratable method with respect to any other market discount bonds, unless they choose separately for each bond to apply the constant yield method.

End-of-the-year planning is a good time to review a bond portfolio's performance examine the possibility of making market discount elections.

Straddles and loss deferral rules

A straddle is any set of offsetting positions on personal property. For example, a straddle may consist of a purchased option to buy and a purchased option to sell on the same number of shares of the security, with the same exercise price and period.

Although stock is generally excluded from the definition of personal property when applying the straddle rules, it is included in either of the following two situations:

1. The stock is part of a straddle in which at least one of the offsetting positions is:

a) an option to buy or sell the stock or substantially identical stock or securities;

b) a securities futures contract on the stock or substantially identical stock or securities; or

c) a position on substantially similar or related property (other than stock).

2. The stock is in a corporation formed or availed of to take positions in personal property that offset positions taken by any shareholder.

Generally, investors can deduct a loss on the disposition of one or more positions only to the extent that the loss is more than any unrecognized gain they have on offsetting positions. Unused losses are treated as sustained in the next tax year.

Unrecognized Gain is:

1. the amount of gain investors would have had on an open position if they had sold it on the last business day of the tax year at its fair market value; and

2. the amount of gain realized on a position if, as of the end of the tax year, gain as been realized, but not recognized.

Example: On July 1, Dave entered into a straddle. On December 16, he closed one position of the straddle at a loss of $15,000. On December 31, the end of his tax year, Dave has an unrecognized gain of $12,750 in the offsetting open position. On his return for the year, his deductible loss on the position he closed is limited to $2,250 ($15,000 – $12,750). He must carry forward to the following year the unused loss of $12,750.

Exceptions – The loss deferral rules do not apply to:

1. a straddle that is an identified straddle at the end of the tax year;

2. certain straddles consisting of qualified covered call options and the stock to be purchased under the options;

3. hedging transactions; and

4. straddles consisting entirely of IRC Section 1256 contracts (but see "Identified Straddle," next).

Identified Straddle – Losses from positions in an identified straddle are deferred until investors dispose of all the positions in the straddle. Any straddle (other than a straddle described in (2) or (3) of the preceding list) is an identified straddle if all of the following conditions exist:

1. Investors clearly identified the straddle on their records before the close of the day on which they acquired it.

2. All of the original positions that investors identify were acquired on the same day.

3. All of the positions included in item (2) were disposed of on the same day during the tax year, or none of the positions were disposed of by the end of the tax year.

4. The straddle is not part of a larger straddle.

Qualified Covered Call Options and Optioned Stock – A straddle is not subject to the loss deferral rules for straddles if both of the following are true:

1. All of the offsetting positions consist of one or more qualified covered call options and the stock to be purchased from the investor under the options.

2. The straddle is not part of a larger straddle. (But see the "special year-end rule" described below for an exception.)

Qualified covered call options are any options investors grant to purchase stock they hold (or stock they acquire in connection with granting the option), but only if all of the following are true:

1. The option is traded on a national securities exchange or other market approved by the Secretary of the Treasury.

2. The option is granted more than thirty days before its expiration date.

3. The option is not a deep-in-the-money option.

4. The investor is not an options dealer who granted the option in connection with his activity of dealing in options.

5. Gain or loss on the option is capital gain or loss.

Investors should also be aware of a special year-end rule for straddles that applies if all of the following are true:

1. The qualified covered call options are closed or the stock is disposed of at a loss during any tax year.

2. Gain on disposition of the stock or gain on the options is includable in gross income in a later tax year.

3. The stock or options were held less than thirty days after the closing of the options or the disposition of the stock.

End-of-year planning should include a review of any straddle positions taken during the year for potential applicability of the loss deferral rules, especially if the straddles may qualify for the special year-end rule.

For more information about the investment planning, see The Tools & Techniques of Investment Planning, 3^rd Edition, from National Underwriter for a comprehensive source of information on the entire range of investment-related tax planning strategies.

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