Tuesday, November 22, 2011

e-YWM Alert #21- How to Shift Income

One of the most commonly used methods of tax planning revolves around the shifting of revenue recognition between years. A taxpayer who on the basis of income projections, marital status, etc., for 2011 and 2012 will be better off taxwise by deferring income from this year to next should consider acting along the lines explained in the following paragraphs.

Under current law, tax rates in 2012 will remain the same as they are this year. Therefore deferring income from 2011 to 2012 will not cause it to be taxed at a lower rate, but will only delay its recognition, unless the taxpayer expects to be in a lower tax bracket in 2012. (Note that while tax rates will be the same in 2012, the point at which each of the higher tax brackets begins generally will be slightly higher for 2012 than for 2011 as a result of inflation adjustments.)

High income taxpayers should be wary of deferring income past 2012, because of the danger of being subject to a higher bracket. Without Congressional intervention, after 2012 the tax brackets above the 15% bracket will revert to their pre-2001 levels. That means the top four brackets will be 39.6%, 36%, 31%, and 28%, instead of the current top four brackets of 35%, 33%, 28%, and 25%. The Administration has proposed to increase taxes only for wealthier taxpayers, but it is difficult at this point in time to predict who will get hit by higher rates.  

Income-shifting by cash basis taxpayers.


A cash basis taxpayer can postpone income to the next year as long as it isn't actually or constructively received this year. Income is constructively received if there is no substantial restriction on the time or manner of payment.

Income the taxpayer earns by rendering services isn't taxed until the client, patient etc., pays. If the taxpayer holds off billing until next year-or until so late in the year that no payment can be received in 2011-he won't have taxable income this year.

In some cases, income can be deferred by arranging to have payment of a bonus earned in 2011 delayed until 2012.

Income-shifting by accrual-basis taxpayers.


The mere fact that the receipt of cash is delayed doesn't defer taxable income for an accrual-basis taxpayer. As soon as an accrual-basis taxpayer's right to the income is fixed, and its amount can be determined with reasonable accuracy, it's taxable. Because of this, generally the only way an accrual-basis taxpayer can postpone income (other than by using the installment sale method) is to defer the actual right to payment for the services or merchandise delivered.

One way to do that would be to postpone completion of a job until 2012 so as to have the right to income arise only in 2012, even though most of the actual work is done in 2011. (Note, however, that some special rules apply to certain long-term contracts for the manufacture, building or construction of property, which often require the recognition of income on a percentage-of-completion basis.)

Another way would be to hold up deliveries where that would defer accrual. This would be the case where the seller's right to payment is contingent on delivery of the property to the buyer. In fact, delaying delivery until 2012 can defer accrual even where an advance payment for the merchandise is received in 2011. Advance payments against the sale of merchandise generally don't give rise to income until the payments are otherwise properly accruable under the taxpayer's own method of accounting.

Other ways to defer income are by postponing the closing of a sale, or by delaying the settlement of a pending dispute over an item of income.  

Special accounting rule defers employee recognition of taxable fringe benefits.


The value of taxable fringe benefits (e.g., the personal use of a company car) must generally be included in the employee's income for the tax year in which the benefit is received. However, employers may treat fringe benefits provided in the last two months of the calendar year as having been provided to the employee in the following year. Thus, if the employer makes the election, the employee can defer paying taxes on two months' worth of benefits received in 2011 until 2012. If an employer uses this rule, it must notify each affected employee between the time of the employee's last pay check and at or near the time that the Form W-2 is provided.

Employers can allow employees to shift FSA funds to 2012.


A flexible spending arrangement (FSA) is a form of a cafeteria plan that allows employers to offer their employees a choice between cash salary and nontaxable benefits without being subject to the principles of constructive receipt. FSAs are commonly used, for example, to reimburse employees for medical expenses not covered by insurance. However, FSAs may be used to provide other qualified benefits, such as dependent care or adoption assistance.
At one time, FSAs were required to operate on a strict use-it-or-lose it basis. Employees were required to forfeit any amount contributed to the plan for a 12-month coverage period that exceeded reimbursable expenses actually incurred during the coverage period. However, employers now have the option of having their FSA documents provide for a 2 1/2 month grace period immediately following the end of the plan year. Qualified expenses incurred during the grace period may be paid or reimbursed from funds remaining in an employee's FSA at the end of the prior plan year.
IRS says an employer can adopt a grace period for the current plan year (and for subsequent years) by amending the cafeteria plan document before the end of the plan year. Thus, a calendar year plan that wants to extend the deadline for using 2011 FSA contributions until Mar. 15, 2012, must have a plan amendment in place by Dec. 31, 2011.

Adoption of the grace period will obviously be beneficial for employees who participate in FSAs. However, there are some drawbacks for employers. FSA administration will be more complicated since an employer will have to monitor carryover amounts during the grace period and keep them segregated from current year contributions. In addition, many employers count on forfeitures to offset part or all of their administration costs. If the grace period reduces forfeitures, an employer will have to pay for these costs from other funds.  

Some taxpayers may want to accelerate income.


While most taxpayers look to defer income recognition at year-end, others may be in situations where the opposite strategy is advantageous. This could be the case, for example, for taxpayers who expect to be in a higher tax bracket in 2012 than in 2011 or to have fewer deductions, or whose filing status will change to their detriment. These taxpayers should do the opposite of those who are acting to defer receipt of income, e.g., move up the closing date for asset sales, bill clients as early as possible, etc.
Accelerating installment sale gain. If a taxpayer has unrealized profit on obligations arising out of installment sales made in prior years and finds it desirable taxwise to accelerate income into 2011, he should consider selling part or all of the obligations, or negotiating with the buyer for accelerated payments.

Recognizing savings bond interest. A taxpayer who wants to accelerate income into 2011 can do so by redeeming U.S. Saving Bonds. Or, for unmatured Series EE or I bonds, he can elect to report interest each year as it accrues. That way, he has all of the income accrued through the end of 2011 (including interest that accrued in earlier years) taxed in 2011. But note that this election can't be reversed without IRS consent. In the future, the taxpayer must pay tax annually on the income as it accrues, and not in the year the bonds mature or are redeemed.

All information presented above is generic, if you would like to know how this may be applied to your specific situation please give us a call at 303-792-3020 or reply directly to this email.  Additional resources are always available at our website, www.ywmcpa.com.

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