By Carole C. Foos, CPA and David B. Mandell, JD, MBA.
As we are well within the fourth quarter of the year, most lawyers now have a good idea of what their taxable income will be for 2014. You may be wondering, “is there anything I can do now to save taxes on April 15?”
Following are a few ideas that could save you tens of thousands of dollars on your 2014 income tax bill, depending on your facts and circumstances, as well as some capital gains and planning concepts. This is especially important in 2014 because federal income and capital gains taxes are again higher compared to 2012 because of the Fiscal Cliff deal signed in January 2013 and Medicare taxes are higher because of the Affordable Care Act.
1Maximize the Tax Benefits of Your Qualified Retirement Plan (QRP)
Most attorneys have some type of QRP in place. These include 401(k)s, profit-sharing plans, money purchase plans, defined benefit plans, or even SEP or SIMPLE IRAs, for these purposes.
However, most of these plans are not maximized for deductions for the law practice owners. The Pension Protection Act of 2006 improved the QRP options for practice owners. In other words, many owners may be using an “outdated” plan and forgoing further contributions and deductions permitted under the most recent rule changes. By maximizing your QRP under the new rules, you could increase your deductions significantly for 2014 and reduce your taxes on April 15, 2015.
2Implement a Fringe Benefit Plan
Unfortunately, the vast majority of attorneys begin and end their retirement planning with QRPs. Most have not analyzed, let alone implemented, any other type of benefit plan. Have you explored fringe benefit plans, non-qualified plans or “hybrid plans” in the last two years? The unfortunate truth for many attorneys is that they are unaware of plans that enjoy favorable short-term and long-term tax treatment. If you have not yet analyzed all options, we highly encourage you to do so. A number of these plans can help you reduce your taxable income in 2014 significantly…and they can be put into place in a few weeks, so it’s not too late for 2014.
3Consider a Captive Insurance Company (CIC)
CICs are used by Fortune 1000 companies for many strategic reasons. For a law practice, a CIC can be equally beneficial, especially for the practice owners. Here, you actually create your own properly licensed insurance company to insure all types of risks of the practice – often those that have little coverage today. These can be:
- Economic risks (that revenues drop)
- Business risks (that electronic records are destroyed)
- Litigation risks (coverage for defense of harassment claims or wrongful termination)
- Even coverage for real estate.
If it is created and maintained properly, the CIC can enjoy tremendous income tax benefits that can translate into hundreds of thousands of dollars of tax savings annually.
4Pre-Pay 2014 Expenses in 2014
It is a good idea to prepay for some of the following year’s expenses in the present year. As long as the economic benefit from the prepayment lasts 12 months or less, this can be done. Because 2015 highest marginal tax rates will likely be the same those in 2014, this makes sense because of the benefit of the early deduction.
5Planning for the 3.8% Medicare Surtax
Beginning in 2013, the tax law imposed 3.8 percent surtax on certain passive investment income of individuals, trusts and estates. For individuals, the amount subject to the tax is the lesser of:
- Net investment income (NII) or
- The excess of a taxpayer's modified adjusted gross income (MAGI) over an applicable threshold amount.
Net investment income includes dividends, rents, interest, passive activity income, capital gains, annuities and royalties. Specifically excluded from the definition of net investment income are self-employment income, income from an active trade or business, gain on the sale of an active interest in a partnership or S corporation, IRA or qualified plan distributions and income from charitable remainder trusts. MAGI is generally the amount you report on the last line of page 1, Form 1040.
The applicable threshold amounts are shown below.
- Married taxpayers filing jointly: $250,000
- Married taxpayers filing separately: $125,000
- All other individual taxpayers: $200,000
A simple example will illustrate how the tax is calculated: Al and Barb, married taxpayers filing separately, have $300,000 of salary income and $100,000 of NII. The amount subject to the surtax is the lesser of (1) NII ($100,000) or (2) the excess of their MAGI ($400,000) over the threshold amount ($400,000 -$250,000 = $150,000). Because NII is the smaller amount, it is the base on which the tax is calculated. Thus, the amount subject to the tax is $100,000 and the surtax payable is $3,800 (.038 x $100,000).
Fortunately, there are a number of effective strategies that can be used to reduce MAGI and or NII and reduce the base on which the surtax is paid. These include:
- Roth IRA conversions
- Tax exempt bonds
- Tax-deferred annuities
- Life insurance
- Oil and gas investments
- Timing estate and trust distributions
- Charitable remainder trusts
- Installment sales
- Maximizing above-the-line deductions.
6Use Charitable Giving for Capital Gains Tax Planning
There are many ways you can make tax beneficial charitable gifts while benefiting your family as well. Charitable Remainder Trusts (CRTs), Charitable Lead Trusts (CLTs), Private Foundations all can be used, within the IRS rules, to benefit charitable causes, reduce taxes and retain some benefits for families. If you have considered any of these tools in the past, implementing them in a year of high income might be a good idea.
Consider acting on these ideas for potential tax savings for 2014 income and beyond. The key is to take the time to evaluate which of these concepts may work for you. In 2014, all attorneys need to be as financially efficient as possible.