The remainder of 2012 will bring a politically charged Presidential election, a lame duck Congress and tremendous income tax planning opportunities.  Unless Congress takes some legislative action, ordinary income and capital gains rates will increase significantly on January 1, 2013.  Prudent individual taxpayers should accelerate income transactions into 2012 to avoid paying higher taxes.

Individual taxpayers have grown accustomed to historic low tax rates over the past decade.  The highest ordinary income rate is currently 35 percent.  Long-term capital gains rates and qualified dividend rates are 15 percent.  These rates will expire after December 31, 2012.  The highest ordinary income rate will increase to 39.6 percent.  Long-term capital gains rates will increase to 20 percent and dividends will be taxed at an individual’s marginal tax rate instead of the current 15 percent.

Also effective next year, certain taxpayers will face a new tax on investment income – dividends, interest , rents and capital gains.  To help pay for Medicare reform, Congress enacted a 3.8 percent tax on investment income for individuals with adjusted gross income of $200,000 and married couples with AGI of more than $250,000.  Conceivably, a high income-earner receiving dividend income would be taxed on that income at 43.4 percent rates.

These rate increases provide taxpayers with an impetus to accelerate transactions.  A few examples can illustrate the potential savings:

Example 1

A taxpayer owns investment real property that would yield long-term capital gain of $1,000,000 upon sale.  If the taxpayer sells this real property in 2012, then the federal tax would be $150,000 (15% x $1,000,000).  If the taxpayer sells this real property in 2013, then the federal tax would be $238,000 (20% rate plus 3.8% tax x $1,000,000).  The taxpayer would save $88,000 by selling before 2013.

Example 2

A sole shareholder of a C corporation wants to distribute dividends to herself.  Her current income places her in the highest tax bracket.  Should she distribute $1,000,000 in one lump-sum payment in 2012 or distribute $200,000 per year over five years (2013 – 2017)?

The tax on the lump-sum dividend in 2012 would be $150,000 (15% x $1,000,000).  Conversely, the aggregate tax on a dividend distribution plan over five years would be $377,200 (39.6% rate plus 3.8% rate x $1,000,000).  The shareholder would save $227,200 by taking the lump-sum dividend in 2012.