Ready or Not: Planning for Significant Tax Changes in 2013

The time is now for all businesses, law firms included, to plan for major tax changes that are scheduled to take effect on Jan. 1, 2013. Without congressional action, a variety of tax credits, exemptions and reduced tax rates will expire at the end of this year, and at this point election year politics make it difficult, if not impossible, to determine what Congress will do as the year winds down. Accordingly, all prudent business owners, including law firms and their partners, should be planning now for the potential tax changes that lie ahead.

Income Tax Rates

Perhaps the most well-publicized tax change scheduled to become effective Jan. 1, 2013 is the increase in income tax rates, with the highest marginal rate rising back to 39.6% from its current 35%. To make clear what this change represents, for a cash-basis law firm, this means that a client payment received in 2012 will generate approximately 13% more after-tax dollars for the firm's partners than the same payment received in 2013. While firms sometimes defer the receipt of end-of-year income until early in a new calendar year in order to defer also the associated tax liability, that may not be good planning this year if Congress fails to take action to keep income tax rates at their lower current levels. In fact, the scheduled increase in 2013 rates should serve as a powerful incentive for partners to bring dollars in the door before the end of this year.

At the same time, firms should be looking closer at deductible expenses that they expect to incur in the last few months of 2012, and perhaps consider deferring them until 2013, when they will offset higher taxed income. Most cash-basis firms, for example, make their annual profit-sharing or discretionary 401(k) contributions after the end of the year, but before the deadline for filing their firm tax returns for the year, so that they can claim a deduction in the earlier year. This year, assuming their plan permits them to do so, they may want to postpone their deduction until the beginning of 2013 by using it to offset income taxable at the higher 39.6% rate for 2013 rather than the 35% rate applicable for 2012.

Payroll Taxes

Income tax rates are not the only change providing incentives to accelerate income into 2012. Effective Jan. 1, 2013, the Medicare tax rate on wages will increase by 0.9%, from 1.45% to 2.35% on earnings over $200,000 for individual taxpayers and over $250,000 for a married couple filing jointly. For employees, this is an increase of 62% over the rate in effect for 2012. Medicare taxes on partners will rise by a similar amount, from 2.9% to 3.8%.

Thus, if the firm's Chief Financial Officer is eligible for a significant bonus with respect to 2012, making the bonus payment in 2012 rather than 2013 could mean significant savings for him or her. For a cash-basis firm, however, this may create a tension between the best interests of the partners (who may prefer to pay the bonus in 2013 to take advantage of the greater value of the deduction then), versus the best interest for the employee, who will pay a lower payroll tax if the payment is made in 2012.

Another change affecting all employees in 2013 is the scheduled expiration of the so-called “payroll tax holiday” on Dec. 31, 2012. The sunset of this holiday, which applies to the employee paid portion of Social Security (“FICA”) tax, will cause employees to pay two percentage points more in Social Security taxes (6.2% versus 4.2%) on the same wages in 2013 compared with 2012. For employees at the Social Security maximum taxable wage base (currently $110,100 per year), that means paying just over $2,200 more in Social Security taxes on the same earnings in 2013. Year-end bonus payments made before Jan. 1, 2013, therefore, may provide an extra holiday gift to the firm's employees.

Other Benefits

Still another change that may affect employees of the firm is the imposition, effective Jan. 1, 2013, of a $2,500 per year limit on health flexible spending account contributions under a cafeteria plan. For 2012, there is no dollar limit on the amount that an employer may allow an employee to contribute each plan year to such an account by means of a salary reduction agreement.

Many firms also sponsor employer-provided educational assistance for their employees. Any firm that does so will want to review its program to determine whether it covers graduate school, because the current exclusion for such assistance at the graduate level will not be available for years beginning on or after Jan. 1, 2013.

Expensing Depreciable Business Assets

Is the firm considering a purchase of computers, furnishings or other assets? If so, it should consider now whether it would be more advantageous from a tax perspective to complete the purchase before the end of the year and plan accordingly.

The incentive to purchase assets and place them in service this year is the special deduction available under ' 179 of the Internal Revenue Code that will allow the firm to expense currently the purchase price for certain depreciable business assets rather than depreciate that purchase price over a number of years. Up to $125,000 of such purchases can be expensed this year, compared with just $25,000 in 2013 and later years. In fact, because the $125,000 limitation is indexed for inflation, the total figure for 2012, as adjusted, is $139,000. To avoid losing the full benefit of this faster write-off, the firm also must be careful not to exceed $500,000 in total purchases. If it does, the $125,000 limit will be reduced, dollar for dollar, by the excess of purchases over $500,000.

Bonus Depreciation

If the special expensing rules of ' 179 do not cover all of the firm's asset purchases in 2012, there is another opportunity also favoring a 2012 purchase. It is in the form of special bonus depreciation for items purchased and placed in service this year. Assume, for example, that the firm decides to purchase new equipment or other personal property (such as new computers), but is undecided whether to do so during 2012 or to defer the purchase until sometime in 2013. By completing the purchase and placing the property in service this year, the firm can claim a 50% first-year bonus depreciation allowance with respect to the property. No similar bonus depreciation will be available after Dec. 31, 2012.

Although this special bonus depreciation for 2012 suggests in most cases that the purchase be made this year, the firm should balance this faster write-off against the greater value the deduction may have if the property is depreciated under the usual depreciation schedule (perhaps over three or five years), but at the then higher income tax rates that will go into effect in 2013 and later years. In other words, will the deduction be more valuable to the firm today or in future years when the partners will be subject to higher income taxes? Even if it is more valuable later, the “bird in the hand” element of the faster write-off may make the decision an easier one.

Michael E. Mooney, a member of this newsletter's Board of Editors, is the managing partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations in a broad range of tax issues, reorganizations, business combinations and divestitures. He can be reached at [email protected].