Tax cuts enacted by the Bush administration nearly a decade ago are set to expire at the end of the year, creating uncertainty – as well as opportunity – for investors looking at year-end tax planning strategies. If those tax cuts expire without Congressional action, virtually all taxpayers will see an increase in federal income taxes next year. In addition, the federal estate tax, which was temporarily repealed this year, would revert to its highest level in almost 10 years. While there has been substantial debate over what should happen to taxes, there has been little activity thus far. Given what we know now, though, there are some planning opportunities to consider before year-end.

Recognize Capital Gains in 2010
The top tax rate for long-term capital gains in 2010 is 15%, and there is no tax on gains for couples with income below $68,000 (single taxpayers below $34,000). Those rates are scheduled to increase to 20% and 10%, respectively, for long-term gains realized after 2010. President Obama proposed maintaining the current rates for most taxpayers, while raising the rate to 20% for couples with income over $250,000 (singles over $200,000). However, no legislation has been introduced yet.

This means that, at best, some taxpayers will see capital gain rates that are the same in 2011 as in 2010. However, higher-income taxpayers, and possibly all taxpayers, are likely facing larger taxes on their capital gains next year. Therefore, if you are considering recognizing a gain in either 2010 or 2011, it appears 2010 is the better option. Before you do that, though, you should understand the investment implications.

While taxes are an important aspect of managing a portfolio, the investment impact of portfolio changes should be the primary concern. The chart on the adjacent page shows how much an investment would need to grow to offset the higher tax you would owe in 2011. For example, an investment worth $10,000 that has a $1,000 cost basis would need to grow 5.6% in 2011 to offset the additional tax owed by selling it in 2011.

As the cost basis of the position increases, or the time horizon for selling is extended (assuming the tax stays at 20% in the future), the annual growth needed to offset the additional tax decreases. In other words, the larger the gain you currently have or the shorter the time horizon for selling the stock, the better off you will be selling in 2010 under the current tax structure.

Unique 2010 Estate Tax Strategy
While the federal estate tax has been temporarily repealed for 2010, an expiration of the Bush tax cuts will restore the federal estate tax in 2011 with a top tax rate of 55% and an exemption of only $1 million. For higher-net-worth clients who are likely to owe federal estate taxes at death, even if future legislation increases the estate tax exemption to proposed levels of $3.5 million to $5 million, making taxable gifts in 2010 may be a unique planning opportunity.

The downside of this strategy is that it requires paying federal gift taxes during the client’s lifetime – something clients and estate planners alike are typically loathe to consider. However, the upside is that the net tax rate for taxable gifts made in 2010 could significantly reduce overall transfer taxes. Paying a gift tax in 2010 may provide two distinct economic benefits:

• First, the tax rate on taxable gifts made in 2010 is only 35%. Under current law, the top tax rate for estates and taxable gifts above $3 million will be 55% in 2011. (Gifts are “taxable” only if the value of the gifted property exceeds the donor’s $1 million lifetime exemption.)
   
• Second, the gift tax is computed on a tax-exclusive basis (as a percentage of the value of property transferred), while the estate tax is computed on a tax-inclusive basis (as a percentage of all property in a decedent’s estate, including the amount used to pay estate taxes). For example, to give away one dollar by taxable gift in 2010, the donor would pay an out-of-pocket total of $1.35 (the gift of $1, plus gift tax of 35 cents). This factor further reduces the effective gift tax rate to approximately 26% (35/135 = 25.93%), compared to the top estate tax rate of 55% in 2011.

This chart represents the annual appreciation in the value of a $10,000 investment needed to offset the additional capital gain tax if the top tax rate increases to 20%. The lower the cost basis of the position, or the shorter the time period, the more appreciation that is needed to offset the increased tax cost. For example, an investment worth $10,000 that has a $1,000 cost basis would need to grow 5.6% in 2011 to offset the additional tax owed by selling it in 2011.