Reducing The Tax Bite By Postponing It

Before the chronically underperforming Chicago Cubs broke a 108-year championship drought with their 2016 World Series victory, their beleaguered fans found solace in the rallying cry, “Wait until next year.” Made expendable by Chicago’s World Series win, “Wait until next year” might soon be picked up by a different team — tax advisors.

With Republicans now controlling both the White House and Congress, significant reforms to the U.S. tax code — including lower tax rates — are likely to be enacted by the end of 2017. If that happens, “waiting until next year” to recognize income could yield significant tax savings because of the lower income tax rates likely to be in place in 2018. Pushing the sale of appreciated assets into 2018 might yield similar benefits depending on the size and timing of the capital gains tax cuts.

Whether deferring income — a useful planning strategy in any tax environment — is particularly beneficial this year will depend on the effective date of the tax law. If lower income tax rates are enacted this year and made retroactive to the start of 2017, there would be little impetus to shift income into 2018 because the tax rates for the two years would be the same. If the effective date is January 1, 2018, however, deferring income into 2018 would allow taxpayers to maximize the benefit of the tax cuts by applying the lower rates to income that otherwise would have been taxed at the higher 2017 rates.

For the purposes of this discussion, we will assume that the proposed tax reforms will take effect in 2018. Given the complexity of the subject matter and the number of constituencies that must be appeased, it is unlikely that comprehensive tax legislation would pass in the first half of 2017, reducing the odds of a January 1, 2017 implementation date.

As it stands now, President Trump’s tax plan would collapse the seven tax brackets currently in place into three. The top rate on ordinary income would drop from 39.6% to 33%, and the alternative minimum tax (AMT), which often hits high-income taxpayers with numerous deductions, would be eliminated. Income still would be offset by itemized deductions, but those deductions would be capped at $100,000 for single taxpayers and $200,000 for married couples filing jointly.

Pay Now or Pay Later?

If the new tax provisions take effect in 2018, the majority of taxpayers would benefit by pushing ordinary income from 2017 to 2018. To execute this strategy, they might defer 2017 year-end bonuses to the following tax year; ask customers to remit payments for purchases made in 2017 to 2018; and delay the exercise of stock options until lower tax rates are in effect.

Delaying the sale of an appreciated asset until 2018 might make sense, as well, depending on the size of any cut to the capital gains rate and when it takes effect. Congressional Republicans’ current plan to repeal and replace Obamacare would eliminate the 3.8% surtax on capital gains income received by high-income taxpayers effective January 1, 2018. If the proposal becomes law, the top capital gains tax rate would drop from 23.8% to 20% (the current statutory rate and the rate proposed by President Trump) and possibly as low as 16.5% —the rate proposed by Congressional Republicans in their tax reform package. Whether the 2018 rate is 20% or 16.5%, it would behoove the majority of upper income taxpayers to postpone the sale of appreciated assets until next year.

Of course when deciding whether to delay the recognition of a capital gain, taxpayers also must factor in a potential change in the value of the asset.

Making Deductions Count

One downside of lower tax rates is that tax deductions become less beneficial. Assuming President Trump’s tax cuts are in place for the 2018 tax year, eligible deductions for taxpayers in the highest bracket would be worth less in 2018 than they would be in 2017 simply because the top rate would be 6.6% lower in 2018. Clearly it would benefit the majority of taxpayers to accelerate as many deductions as they can into 2017.

Of course, some of the most valuable deductions — for mortgage interest and property taxes — typically cannot be front-loaded into a year with a higher tax rate because mortgage and property tax payments are deductible only in the year they are both paid and economically accrued, i.e., due. There is more flexibility around state income taxes, which can be deducted in the year they are paid even if they are not due that year. As such, taxpayers could maximize their state income tax deduction by paying their last estimated tax payment for 2017 (due in January 2018) in 2017. Finally, because donations to charity are discretionary, taxpayers could pull gifts they might have made in 2018 and beyond into 2017.

Front-loading charitable deductions would become even more beneficial for donors who could not deduct the full value of their gifts because of caps on deductions. Depending on the size of their gifts and the value of their other deductions, some high-income taxpayers might be unable to deduct the full value of their gifts. These individuals should consider bundling gifts they would have made over several years into a large donation in 2017. Using a donor-advised fund, a family foundation or other structure, they could distribute the gifts over several years, while writing off their full value in 2017.

Consider Your Options

Deferring income in advance of tax cuts can yield significant tax savings; delaying the exercise of stock options can do the same depending on the type of option and the prospects for the underlying stock.

With standard stock options, the tax event occurs when the options are exercised, and the tax liability is on the difference between the options’ strike price and the stock’s fair market value. If the options’ strike price were $15 per share, for example, and the stock were trading at $20 per share, the individual would pay tax on $5 at the rate in place at the time of exercise. Under this scenario, waiting until 2018 to exercise the options would significantly reduce the tax liability on the transaction. Of course, the taxpayer also must consider the price appreciation — and the additional tax on the appreciation — that might accrue by delaying the exercise date.

The tax treatment of incentive stock options is a bit different. Exercising these options does not create a tax event, but it could trigger the AMT. Given Republicans’ proposal to eliminate the AMT, taxpayers would be wise to delay exercising their incentive options until 2018 if they otherwise would be subject to the AMT in 2017. Of course, the taxpayer must weigh the potential tax benefits from this strategy against the possibility that the value of the underlying stock could decline before the options are exercised.

The Case For An 83(b) Election

For individuals receiving restricted stock in 2017, determining the optimal time to pay tax on the value of the shares can be challenging because of the multiple variables to consider. Usually, tax on restricted stock is not triggered until the stock vests, typically within three years of the grant date. For those with stock vesting in 2018 and later, it would seem to make sense to let the usual rules apply — pay tax on the fair value of the stock when it vests at the lower rates likely to be in place then. There is a complication, though — the potential price appreciation of the stock.

With most restricted stock vesting over several years, the price of the shares has plenty of room to run between the grant date and the vesting date. If the shares appreciate, the tax bite would increase accordingly because the tax liability would be based on the fair market value of the stock when it vests.

If significant price appreciation is anticipated, the recipient of the stock grant can make an 83(b) election, which allows the individual to pay the tax on the value of the restricted stock when it is granted rather than when it vests. If the stock were to appreciate significantly between the grant date and the vesting date, an 83(b) election could yield sizeable tax savings. If the stock saw little appreciation, however, an 83(b) election would have accelerated a costly tax event by several years. The decision would be even more expensive if the tax rate at the time of the election were higher than the rate on the vesting date.

Hurry Up and Wait

The lack of detail around President Trump’s tax proposals, coupled with the unknown implementation date makes developing an effective tax strategy analogous to hitting a moving target from a moving platform. All we know now is that the tax environment is likely to be more favorable in 2018 and beyond than it is now. That is enough to do some preliminary tax planning, but developing a more nuanced tax strategy will require more detail. Given that the new tax policies might not be known to us until late 2017, taxpayers must be prepared to move quickly if they want to extract maximum value from “waiting until next year.”