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The following Client Bulletins are posted on this page:
Client Bulletin 9-7-05:
Code Section 179 Expense Election
(annual election to claim immediate deductions, instead of deductions in later years, for business property)
Generally, the cost of property placed in service in a trade or business can't be deducted in the year it's placed in service if the property will be useful beyond the year. The cost is "capitalized" and depreciation deductions are allowed for the property, but are spread out over a period of years (a "cost recovery period"). Capitalization delays the tax benefits of business expenditures. For example, you may spend $50,000 on a new computer system today, but must spread your depreciation deductions over a five-year period. That's why the election to take immediate deductions is important.
The expense election is made available, on a tax year by tax year basis, under Section 179 of the Internal Revenue Code (the "Code"), and is often referred to as the "Section 179 election" or the "Code Section 179 election."
Subject to a dollar limit, the election allows you to deduct, in the tax year for which the election is made, the cost of qualifying property (described below) placed in service during the tax year. The deductions allowed are in lieu of depreciation deductions. For tax years beginning in 2005, the dollar limit is $105,000 (up from $102,000 in 2004). Based on the rate of inflation, the limit may be raised higher in future years. However, for tax years beginning after 2007 (i.e., 2008 and later) the dollar limit is scheduled to drop to $25,000. (As discussed below, the dollar limit is reduced, i.e., made more stringent, if more than $420,000 of qualifying property is placed in service during the tax year, or if taxable income from your trade or business is low for the tax year. On the other hand, higher limits apply to certain property used in a qualified business in designated geographic areas, such as the DC Zone and the New York Liberty Zone.)
Qualifying property. To qualify for the election, the property must be "tangible personal" property. This means that real estate (land, buildings, and their structural components) does not qualify, nor do intangibles such as patent rights. However, for tax years beginning after Dec. 31, 2002 and before Jan. 1, 2008, off-the-shelf computer software qualifies. Also, to qualify, property must be "purchased." Thus, if you acquired the property in a tax-free exchange or from an individual or entity to which you bear a close relationship specified in the Code, the property does not qualify.
Dollar limit. The dollar limit doesn't mean the election can't be made for property costing more than that amount. For example, if you buy a machine for $110,000 and place it in service in a business in a tax year beginning in 2005, you can elect to deduct $105,000 of its cost for that year. The remainder ($5,000) is capitalized and depreciated. Also, you can make the election for two or more separate assets as long as the total cost covered by the election doesn't exceed the dollar limit for that year.
You should be aware, regarding the dollar limit, that if the total cost of qualifying property that you place in service during a tax year beginning in 2005 is over $420,000 (the "phaseout" amount), the dollar limit is reduced by that extra amount. For example, if you place in service $430,000 of qualifying property in a tax year beginning in 2005, you can make the election for no more than $95,000 of property ($105,000 minus the $10,000 excess over $420,000). For tax years beginning in 2004, the phaseout began at $410,000. Based on the rate of inflation, the phaseout amount may be raised higher after 2005. For tax years beginning after 2007, the phaseout amount is scheduled to drop to $200,000. You might consider postponing, to later tax years, or accelerating, into earlier tax years, placing property into service, to take best advantage of the dollar limits (as further limited by the phaseout rule). For example, if you have ordered two items of qualifying property costing $105,000 each, you might want to consider placing only one of them in service in 2005. Doing so will permit you to elect to expense $105,000 in 2005 and $105,000 in 2006 (when the inflation-adjusted amount will be at least $105,000). If both are placed in service in 2005, your expense election for the two items is limited to $105,000.
Taxable income limit. If your taxable income from all of your trades or businesses is less than the dollar limit for that year, the amount for which you can make the election is limited to that taxable income. However, any amount you can't currently deduct because of the taxable income limitation is carried forward and may be deducted in later years (to the extent that the applicable dollar limit, the phaseout rule and the taxable income limit permit).
Recapture. If you dispose of the property, or stop using it in a trade or business, before the end of the cost recovery period that would have applied to the property had you not made the election for the property, all or part of the amount of the deduction you claimed under the election must be taken back into income ("recaptured"). Exactly how much will depend on the type of property and how long you used the property in a trade or business.
The above information covers the essential elements of the Code Section 179 election. Clearly, many considerations go into each decision to acquire business assets, and most involve non-tax factors. However, the election should play a role; accelerated tax benefits may enable you to obtain the property you need earlier and at reduced after-tax costs.
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Client Bulletin 10-1-05:
529 Plans - Qualified Tuition Programs
October 1, 2005
If you have a child (or a grandchild) who is going to attend college in the future, you have probably heard about qualified tuition programs, also known as 529 plans (for the Internal Revenue Code section that provides for them), which allow prepayment of higher education costs on a tax-favored basis.
There are two types of programs: prepaid plans, which allow you to buy tuition credits or certificates at present tuition rates, even though the beneficiary (child) won't be starting college for some time; and savings plans, which depend on the investment performance of the fund(s) in which you place your contributions. You don't get a federal deduction for the amount you contribute to a 529 plan, but the earnings on the account are not taxed while the funds are in the program. You can change the beneficiary or roll over the funds in the program to another plan for the same or a different beneficiary without tax consequences.
Distributions from the program are tax-free if they don't exceed the student's qualified higher education expenses. If the program was established by a private education institution (rather than a state), the distributions are tax-free beginning in 2004.
Qualified higher education expenses include tuition, fees, books, supplies, and required equipment. Reasonable room and board is also a qualified expense if the student is enrolled at least half-time.
Distributions in excess of qualified expenses are taxed to the beneficiary to the extent that they represent earnings on the account. A 10% penalty tax will also be imposed.
Accredited colleges, junior colleges, and area vocational schools are qualified to participate in the tuition program. Accredited post-secondary schools offering credit towards a bachelor's degree, an associate's degree, a graduate or professional degree, or another recognized post-secondary credential, are also eligible to participate, as are certain proprietary institutions and post-secondary vocational schools.
The contributions you make to the qualified tuition program are treated as gifts to the student, but the contributions qualify for the annual gift tax exclusion, which is $11,000 for 2005. If your contributions in a year exceed the exclusion amount, you can elect to take the contributions into account ratably over a five-year period starting with the year of the contributions. Thus, assuming you make no other gifts to that beneficiary, you could contribute up to $55,000 for each beneficiary in 2005 without gift tax. (In that case, any additional contributions during the next four years would be subject to gift tax, except to the extent that the exclusion amount increases.) You and your spouse together could contribute $110,000 per beneficiary, subject to any contribution limits imposed by the plan.
A distribution from a qualified program isn't subject to gift tax, but a change in beneficiary or rollover to the account of a new beneficiary is.
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Client Bulletin 2-3-06:
2006 Mileage Rates
2006 mileage rates announced. For 2006 the optional standard mileage rate drops to 44.5¢ per business mile, down from 48.5¢ for the last four months of 2005. The 2006 rate for computing deductible medical or moving expenses drops to 18¢ a mile, down from 22¢ for the last four months of 2005. A person who uses a vehicle in providing donated services to a charity for relief related to Hurricane Katrina during 2006 computes the charitable mileage deduction by using a standard mileage rate of 32¢ (rather than the usual charitable standard mileage rate of 14¢). Additionally, volunteers may be reimbursed by a charity for the cost of driving their cars for the charity's benefit in connection with providing donated services for Hurricane Katrina relief during 2006. These volunteers may exclude a reimbursement of up to 44.5¢ per mile.
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Client Bulletin 2-7-06:
Gulf Opportunity Zone Act of 2005-Hurricane Wilma
The recently enacted Gulf Opportunity Zone Act of 2005 contains a package of tax relief provisions for victims of Hurricane Wilma. These include relaxed restrictions on early withdrawals from retirement plans, increased deductions for corporate charitable contributions, eased casualty loss rules, an employee retention credit, relaxed restrictions on mortgage revenue bonds, boosted deductions for timber reforestation, and increased low-income housing credits. These tax breaks apply in the Wilma GO Zone, which is comprised of those areas of Florida that have been designated by the President as counties warranting individual or individual and public assistance because of Hurricane Wilma. Here are more details on these key relief provisions:
Early withdrawals from retirement plans. The new law allows Wilma affected families to dip into IRAs and pensions without penalty. Specifically, the Act waives the 10% penalty for early distributions from pensions and IRAs if the taxpayer suffered an economic loss because of Hurricane Wilma and the taxpayer's main dwelling on Oct. 23, 2005 was located in the Wilma disaster area. The distribution must be made on or after Oct. 23, 2005 and before Jan. 1, 2007. The income tax can be paid ratably over three years. Amounts repaid to the pension or IRA within the three-year period receive rollover treatment and thus are not subject to income tax. The waiver of the 10% penalty, 3-year income averaging and recontribution provisions for retirement plan withdrawals are limited to $100,000 per individual. Distributions for home purchases which were not finalized because of Hurricane Wilma can also be recontributed to a qualified retirement plan or IRA.
Eased qualified plan loan limits. The limits on the amount of loans that may be withdrawn from qualified employer plans without paying a current tax are increased for Hurricane Wilma victims by doubling the thresholds to the lesser of $100,000 or 100% of the individual's account balance. Additionally, payments due from hurricane victims on qualified plan loans on or after Oct. 23, 2005, and before Jan. 1, 2007, can be deferred, and twelve months can be added to the maximum repayment period of affected loans.
Eased casualty loss rules. The Act allows Wilma affected individuals to fully deduct all of their personal property losses from their itemized federal taxes. Generally, non-business casualty losses are deductible by taxpayers who itemize only to the extent they exceed 10% of adjusted gross income and a $100 floor. The Act eliminates the 10% and $100 floors for casualty losses resulting from Hurricane Wilma in the disaster area, including those claimed on amended returns. The relief applies only for casualty losses arising in the Hurricane Wilma disaster area after Oct. 23, 2005.
Look-back election provided for the earned income credit and the refundable child credit. For the working poor, the Act makes sure that their child and earned income tax credits are not impacted by the disaster. It does so by allowing individuals affected by Hurricane Wilma to calculate their EIC and refundable child credit for 2005 using their earned income from 2004.
Corporate charitable contributions relief. The Act permits unlimited cash donations to be deducted by corporations. The usual cap of 10% of taxable income is disregarded for cash contributions related to Hurricane Wilma for contributions before Jan. 1, 2006.
Employee retention credit. The Act provides an up to $2,400 credit per worker for businesses in the Wilma GO Zone to keep employees on the payroll through the end of 2005. Specifically, the Act provides a 40% tax credit for wages paid up to $6,000 if paid after Oct. 23, 2005, and before Jan. 1, 2006, by employers located in the Wilma GO Zone who continue to pay their employees while their business is inoperable.
Timber industry relief. The Act addresses the hurricane's impact on the timber industry by doubling to $20,000 the deduction for reforestation expenses in the Wilma GO Zone and by permitting timber land owners to carry back certain losses for 5 years instead of the usual 2-year period. However, neither provision applies to publicly traded corporations, real estate investment trusts, or taxpayers that hold more than 500 acres of timber.
Additional low-income housing credits. The Act allows Florida to receive an additional allocation of $3.5 million in low-income housing tax credits to address the housing shortage brought on by the displaced families from Hurricane Wilma. This tax credit offers developers and landlords incentives to provide low cost housing to eligible families, in the communities where they live. Additionally, the Wilma Go Zone will be treated as a difficult development area, allowing investors to calculate credits for a project on an amount equal to 130% of new construction or rehabilitation expenditures.
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Client Bulletin 5-18-06:
Tax Increase Prevention and Reconciliation Act
Congress recently passed the Tax Increase Prevention and Reconciliation Act, a new law that carries important tax changes for individuals. Some apply this year while others kick in several years down the road, and while most changes (such as those affecting the AMT and capital gains) are tax-savers, others (such as the new “kiddie tax” rules) could have a negative affect on you and your family. Here's an overview of what you need to know right now about this new law.
AMT relief. In general terms, to find out if you owe alternative minimum tax (AMT), you start with regular taxable income, modify it with various adjustments and preferences (such as addbacks for property and income tax deductions and dependency exemptions), and then subtract an exemption amount (which phases out at higher levels of income). The result is subject to an AMT tax rate of 26% or 28%. You pay the AMT only if it exceeds your regular tax bill. Although it was originally enacted to make sure that wealthy Americans did not escape paying taxes, the AMT has wound up ensnaring many middle-income taxpayers. The reason? Many of the tax figures (such as the tax brackets, standard deductions, and personal exemptions) used to arrive at your regular tax bill are adjusted for inflation, but the tax figures used to arrive at the AMT are not. For 2006 only, the new law provides some relief. It increases the maximum AMT exemption amount over its 2005 level by $4,550 for married taxpayers filing joint returns, and by $2,250 for unmarried individuals. However, after 2006, the maximum AMT exemption amount will drop precipitously to where it was in the year 2000 unless Congress provides another fix.
Another provision in the new law provides AMT relief for those individuals claiming certain “nonrefundable” personal tax credits (such as the credit for dependent care and the Scholarship and Lifetime Learning credits). For 2006, these credits may offset an individual's regular tax and AMT. After 2006, unless Congress acts, these credits will be allowed only to the extent that an individual has regular income tax liability in excess of the tentative minimum tax, which has the effect of disallowing these credits against AMT.
Investor tax breaks extended. An individual's long-term capital gain generally isn't taxed at a rate higher than 15%. It may be taxed at just 5% (0% for tax years beginning after 2007) if the gain would have been taxed at 10% or 15% if it were ordinary income instead of long-term capital gain. Most dividends from domestic corporations (and certain qualifying foreign corporations) also qualify for the same favorable tax treatment as long-term capital gain. These favorable tax rates were set to expire at the end of 2008, but the new law extends the favorable rates through 2010.
Income limit on Roth IRA conversions eliminated, beginning in 2010. A person who makes deductible contributions to a regular individual retirement account (IRA) gets a tax break now for the dollars he puts in and his earnings grow tax free. However, he pays ordinary income tax on every dollar he takes out, and withdrawals are subject to significant restrictions, such as the required minimum distribution rules. A person who makes contributions to a Roth IRA can't get a tax deduction for contributions, but his money grows tax free and there's no tax, and few restrictions, on qualifying withdrawals.
Under current law, only individuals with $100,000 or less in modified adjusted gross income can convert a regular IRA into a Roth IRA. A taxpayer making the conversion generally must pay tax on money he takes out of his regular IRA, but once it's in his Roth IRA, he won't pay tax on the withdrawal of that money or the money it earns (assuming a few relatively simple requirements are met). Generally speaking, Roth conversions appeal to taxpayers who either think their tax rate will go up in retirement, or believe that the value of their account will rise significantly, and thus are willing to make an upfront tax payment when they convert in order to reap large tax savings in later years.
Under the new law, beginning in 2010, taxpayers will be able to convert a regular IRA into a Roth IRA regardless of how high their modified adjusted gross income is. What's more, the new law permits taxpayers who convert in 2010 to spread the income and resulting tax payments on the converted funds over two years—2011 and 2012.
Kiddie tax age limit raised from under 14 to under 18. At one time, wealthy parents could significantly lower their family's tax bill by transferring investment assets to minor children. This tax technique, called income shifting, worked by taking income out of the parents' higher tax bracket and placing it in the lower tax brackets of their children. To curtail the use of this tax technique, Congress enacted the “kiddie tax” rules, which provided that children under 14 who had more than a small amount of unearned (investment) income had to pay tax at their parents' marginal tax rate (the rate of tax on the last dollar earned). The threshold amount at which the kiddie tax kicks in is two times the amount allowed as a standard deduction for a dependent who has only investment income. For 2006, that amount is $850, so the kiddie tax begins to apply when the child has more than $1,700 in unearned income.
Under the new law, the age limit below which a child's income from investments is taxed at the parents' rates is raised from 14 to 18. The new law specifies, however, that the kiddie tax does not apply to a child who is married and files a joint return for the tax year. It also adds an exception to the kiddie tax for distributions from certain qualified disability trusts. The new provisions apply to tax years beginning after Dec. 31, 2005.
Capital gain treatment for self-created musical works. Before the new law came along, literary, musical, or artistic compositions, letters or memoranda, or similar property held by a taxpayer whose personal efforts created the property weren't treated as capital assets. As a result, when a taxpayer sold copyrights he owned in songs he created, gain from the sale was treated as high-taxed ordinary income rather than low-taxed capital gain.
Under the new law, at the election of a taxpayer, the sale or exchange of musical compositions or copyrights in musical works created by the taxpayer's personal efforts is treated as the sale or exchange of a capital asset. This applies to sales in exchanges after the date the Tax Increase Prevention and Reconciliation Act is signed into law by the President, and before 2011.
Changes to the foreign earned income exclusion and housing allowance for U.S. citizens working abroad. The new law makes three changes to the foreign earned income exclusion and housing allowance. First, the income exclusion is indexed for inflation starting in 2006 (rather than 2008 under current law). Second, the base housing amount used in calculating the foreign housing cost exclusion in a taxable year is modified (the new base amount is 16% of the amount of the foreign earned income exclusion limitation). Reasonable foreign housing expenses in excess of the base housing amount remain excluded from gross income, but the amount of the housing exclusion in excess of the base housing amount is limited to 30% of the taxpayer's foreign earned income exclusion. Third, income excluded as either foreign earned income or as a housing allowance is included for purposes of determining the marginal tax rates applicable to non-excluded income.
The above only describes highlights of the new law. If you would like more details on any aspect of this legislation, please contact us.
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Client Bulletin 8-30-06:
Pension Protection Act of 2006
August 30, 2006
The recently passed Pension Protection Act of 2006 is a massive tax bill that overhauls the funding and disclosure rules for defined benefit plans, addresses conversions of pension plans to cash balance plans, carries liberalized payout and rollover rules, and makes a host of other changes relating to pension plans and their beneficiaries. Here's an overview of the key tax changes in this important new legislation:
Reform of the single-employer defined benefit rules
For single-employer defined benefit plans, the Act:
· requires employers to make contributions to their single-employer defined benefit pension plans over the next seven years in order to make those plans 100% funded. Formerly, a 90% funding level was acceptable;
· specifies that the discount rate used to calculate the present value of current pension liabilities be based on a segmented yield curve of corporate bonds;
· triggers accelerated contributions for at-risk plans;
· reduces the smoothing of interest rates to two years (instead of five for assets and four for liabilities under current law);
· permits employers to make additional maximum deductible contributions;
· prohibits further benefit accruals for lump-sum distributions or shutdown benefits from plans funded at less than 60%;
· restricts the use of deferred executive compensation arrangements for employers with severely underfunded plans;
· permanently establishes an employer-paid termination premium of $1,250 per participant if a plan sponsor terminates its employee pension plan upon entering bankruptcy; and
· establishes special rules for airlines.
Reform of the multiemployer pension system
The Act's changes relating to multiemployer plans include:
· identifying underfunded multiemployer pension plans and establishing quantifiable benchmarks for measuring a plan's funding improvement;
· providing new notice requirements for underfunded plans;
· changing the amortization schedule for any plan benefit amendments from 30 years to 15 years;
· increasing the maximum deductible limit to 140% of current liability;
· requiring plans trustees to improve the health of the plan by one-third within 10 years if a plan is less than 80% funded or will hit a funding deficiency within seven years; and
· prohibiting benefit increases if the increase causes the plan to fall below 65% funded status.
New disclosure rules for qualified plans
One of the overarching themes of the Act is that there should be more pension transparency so that workers, regulators and investors can better keep tabs on the financial health of traditional pension plans. To meet this need, the Act:
· requires both single and multiemployer plans to include more detailed and specific information on their Form 5500 filings;
· enhances Form 4010 disclosure requirements and makes all Form 4010 information filed with PBGC available to the public, save for sensitive corporate proprietary information;
· establishes an 80%, at-risk threshold that determines whether plans pose a threat to PBGC and therefore must file Form 4010 information;
· requires both single and multiemployer pension plans to notify workers and retirees of the funded status of their plan within 120 days after the close of the plan year;
· prohibits companies from forcing employees to invest any of their own retirement savings contributions in the stock of the employer;
· makes it clear that companies have a fiduciary responsibility for workers' savings during “blackout” periods, when workers are temporarily barred from making changes to their 401(k) investments; and
· requires companies to give workers quarterly benefit statements that include information about accounts, including the value of their assets, their rights to diversify, and the importance of maintaining a diversified portfolio.
New investment advice rules
The Act:
· permits qualified “fiduciary advisers” to offer investment advice to help employees manage their 401(k) and other retirement options;
· puts in place fiduciary and disclosure safeguards to ensure that advice provided to employees is solely in their best interest;
· requires fiduciary advisers for employer-sponsored plans to base their recommendations on a computer model that is certified and audited by an independent party; and
· requires fiduciary advisers for non-employer sponsored plans to charge a flat rate fee for one year (with no computer model).
Liberalized plan payout and rollover rules
Provisions in the Act that liberalize plan payout and rollover rules include the following:
· after 2007, taxpayers will be permitted to make direct rollovers from qualified plans to Roth IRAs;
· for purposes of the 401(k) hardship distribution rules, “hardship” includes hardship of a beneficiary under the plan (even if the beneficiary is not a spouse or dependent). This provision is effective on August 17, 2006;
· members of the National Guard and Reserves called to active duty through 2007 can make penalty-free withdrawals from retirement plans. Withdrawn amounts may be repaid to the IRA or pension plan within two years of the distribution;
· the 10% early withdrawal penalty for distributions to public safety employees over age 50 (including police, fire, and emergency medical services) who may retire early is waived;
· effective for post-2006 distributions, nonspouse designated beneficiaries are allowed to make rollovers of inherited amounts in qualified plans, governmental Section 457 plans, or tax-sheltered annuities to their own IRAs (treated as inherited IRAs); and
· effective for distributions in plan years beginning after 2006, defined benefit plans can make in-service distributions to age-62-or-older participants.
Retirement savings provisions made permanent
The Act makes permanent a number of retirement plan and IRA liberalizations that were added to the tax laws in 2001 but were set to sunset after 2010. By making the 2001 changes permanent, the new law preserves the advantages of higher employee contribution limits for employer plans, higher IRA contribution limits, more flexible plan rules, portability, a catch-up for those over 50, and an increase in employer contribution limits. The new law also makes permanent the saver's credit, which would not have been available after 2006 absent the extension.
Charitable reforms
The Act also contains a package of provisions to help prevent abuse in the charitable sector and provide additional tax incentives for Americans to give more resources to the charitable community. The incentives include:
· Tax-free distributions from IRAs for charitable purposes. Taxpayers can exclude from gross income certain distributions of up to $100,000 from a traditional or Roth IRA if made to a tax-exempt organization to which deductible contributions can be made. The provision is effective for two years through 2007.
· Charitable deduction for contributions of food inventory. An enhanced deduction for donations of food inventory which was formerly available only to C corporations is extended to all trades and businesses, effective for two years through 2007.
· Basis adjustment to stock of S corporation contributing property. If an S corporation contributes property to a charity, an S corporation shareholder only has to reduce his basis in stock of the S corporation by his pro rata share of the adjusted basis of the contributed property, rather than by the amount of the charitable contribution that flows through to him. The provision is effective for two years through 2007.
· Charitable deduction for contributions of book inventory. The current-law provision that adds public schools to the list of eligible donees for the enhanced deduction for contributions of qualified book inventory by C corporations is extended for two years through 2007.
· Qualified conservation contributions. The new law raises the charitable deduction limit—from 30% of adjusted gross income (AGI) to 50%—for qualified conservation contributions, as long as it does not prevent the use of the donated land for farming or ranching purposes. The charitable deduction limit is raised to 100% of AGI for eligible farmers and ranchers. Unused contributions can be carried forward for up to 15 years. The provision is effective for two years through 2007.
On the charitable reform side, the new rules:
· require reports to the Treasury Department on certain life insurance contracts;
· double the fines and penalties applicable to certain activities by charities, social welfare organizations, private foundations and exempt organization managers;
· clarify the terms of facade easements in historic districts, and also clarify that the charitable deduction is reduced if a rehabilitation tax credit has been claimed with respect to the donated property;
· limit the basis for donated taxidermy property and provide that the value of the deduction is equal to the lesser of basis or fair market value;
· require the recapture of any tax benefit derived from the contribution of property with respect to which a fair market value deduction was claimed if the property is not used for an exempt purpose of the donee organization, effective for contributions made after September 1, 2006;
· generally prohibit deductions for contributions of clothing and household items unless they are in good used condition or better;
· require that in the case of a charitable contribution of money, regardless of the amount, the donor must maintain a cancelled check, bank record or receipt from the donee organization showing the name of the donee organization, the date of the contribution, and the amount of the contribution. This is effective for contributions made in tax years beginning after August 17, 2006;
· lower the threshold for imposing accuracy-related penalties on a taxpayer who claims a deduction for donated property for which a qualified appraisal is required;
· impose certain requirements on tax-exempt organizations that offer credit counseling services;
· apply an excess benefits transaction tax on any grant, loan, compensation or other similar payments from a donor-advised fund to a person that with respect to such fund is a donor, donor adviser, or a related person, and from a supporting organization to a substantial contributor or a related person; and
· require that unrelated business income tax returns of 501(c)(3) organizations be made publicly available.
Charitable giving:
The recently enacted Pension Protection Act of 2006 contains a package of provisions to help prevent abuse in the charitable sector and provide additional tax incentives for Americans to give more resources to the charitable community. Here is a brief overview of those provisions.
Charitable Giving Incentives
The Act contains a charitable giving incentives package designed to encourage charitable donations. The incentives include:
· Tax-free distributions from IRAs for charitable purposes. The Act permits taxpayers who have reached age 70-1/2, to exclude from gross income certain distributions of up to $100,000 from a traditional individual retirement account (IRA) or Roth IRA which would otherwise be included in income. The charitable distribution must be made to a tax-exempt organization to which deductible contributions can be made. The change is effective for two years through 2007.
· Charitable deduction for contributions of food inventory. Under the Act, an enhanced deduction for donations of food inventory which was formerly available only to C corporations is extended to all trades and businesses, effective for two years through 2007.
· Basis adjustment to stock of S corporation contributing property. The Act provides that if an S corporation contributes property to a charity, an S corporation shareholder only has to reduce his basis in stock of the S corporation by his pro rata share of the adjusted basis of the contributed property, rather than by the amount of the charitable contribution that flows through to him. For example, if an S corporation with one individual shareholder makes a charitable contribution of stock with a basis of $200 and a fair market value of $500, the shareholder will be treated as having made a $500 charitable contribution and will reduce the basis of the S corporation stock by $200. The provision is effective for two years through 2007.
· Charitable deduction for contributions of book inventory. The provision extends the current-law provision that adds public schools to the list of eligible donees for the enhanced deduction for contributions of qualified book inventory by C corporations. The provision is effective for two years through 2007.
· The tax treatment of certain payments to controlling exempt organizations. Under prior law, rent, royalty, annuity, and interest income paid to a tax-exempt organization by a controlled taxable subsidiary was generally treated as unrelated business income, which was taxable to the tax-exempt parent organization. The new law modifies that rule such that only the portion of such payments which is not regarded as fair market value will be treated as unrelated business taxable income. Exempt organizations are required to report certain amounts received from controlled organizations. The provision is effective for two years through 2007.
· Qualified conservation contributions. The new law raises the limit on deducting contributions of capital gain property by individuals—from 30% of adjusted gross income to 50%—for qualified conservation contributions. The charitable deduction limit is raised to 100% for qualified conservation contributions by individual and corporate farmers and ranchers, as long as the contribution includes a restriction that the land remain available for farming or ranching. Unused contributions can be carried forward for up to 15 years. The provision is effective for two years through 2007.
Employees or Independent Contractors? A Brief Discussion . . .
October 5, 2006
It's critical for an enterprise periodically to review the status of its workers and see if they are properly classified. An enterprise must withhold federal income tax, social security taxes, and federal unemployment taxes on wages it pays workers who are employees. It also may have to provide them with the same fringe benefits and retirement plan coverage available to its other employees. There may be state tax obligations as well. By contrast, these responsibilities don't apply for workers who are independent contractors. The business simply cuts them a check for their services and sends them a Form 1099-MISC.
Under the “common law” rules developed by the courts, a worker generally is an employee for federal tax purposes if the employer has the right to control and direct the worker regarding the job he is to do and how he is to do it. The employer doesn't have to actually direct or control how the services are performed; it's enough if the employer has the right to do so. IRS usually applies the following factors to see if the employer has the right to direct and control the worker:
- A worker who must comply with instructions about when, where, and how he or she is to work is ordinarily an employee. This control factor is present if the business has the right to make the worker follow instructions. However, instructions regarding government standards are given little weight, as is the absence of instructions for professionals such as attorneys, who must follow the rules of their profession.
- Training a worker by teaming an experienced employee with the worker, by corresponding with the worker, by requiring him or her to attend meetings, or by using other methods, indicates the business wants the services performed in a particular method or manner. Ongoing training is a particularly strong sign of an employer-employee relationship, but orientation or information programs about company policies aren't.
- Integration of the worker's services into the business operations generally shows the worker is subject to direction and control.
- If the services must be rendered personally, the business probably is interested in the methods used to accomplish the work as well as in the results.
- A business that hires, supervises, and pays assistants for a worker is exhibiting employer-like control over the worker on the job. Conversely, an independent contractor relationship is indicated if a worker is contractually obligated to hire, supervise, and pay assistants.
- A continuing relationship between the worker and the business indicates an employer-employee relationship exists. A continuing relationship may exist where the worker is called in at frequently recurring, although irregular, intervals.
- The fact that a business requires work to be performed on its premises suggests control over the worker (if the work could be done elsewhere). Work done off the premises, such as at the worker's office, indicates some freedom from control. The importance of this factor depends on the type of services involved and whether an employer generally would require employees to do similar work on its premises.
- A business exhibits control over a worker if it requires him or her to perform services in a specific order or sequence.
- A business's requirement that the worker submit regular or written reports indicates a degree of control over the worker.
- Payment by the hour, week, or month generally points to an employer-employee relationship, if this method of payment isn't just a convenient way of paying a lump-sum agreed upon as the cost of a job. Payment by the job or on a straight commission basis generally indicates a worker is an independent contractor.
- A business exhibits characteristics of an employer if it supplies a worker with significant tools, materials, and other equipment, or ordinarily pays the worker's business and/or traveling expenses.
- A worker exhibits independent contractor status if he or she invests in facilities that aren't typically maintained by employees (e.g., renting his or her own office). By contrast, an employee usually relies on the employer to provide the facilities needed to do the job.
- A worker who can realize a profit or suffer a loss as a result of his or her services generally is an independent contractor, but a worker who can't is an employee. The risk that a worker won't be paid isn't factored in.
- A worker who performs more than minimal services for a number of unrelated businesses at the same time generally is an independent contractor. However, a person who works for more than one business may be an employee of each business, especially where the businesses are part of the same service arrangement.
- The fact that a worker makes his or her services available to the general public on a regular and consistent basis indicates an independent contractor relationship.
- The right to fire a worker is a factor indicating that he or she is an employee. An independent contractor on the other hand, can't be fired as long as he or she produces the work that was contracted-for.
There is no litmus test for exactly how many of these factors must be satisfied, nor are these factors uniformly applied. Please call our offices if you would like to arrange for an appointment to see whether your workers are classified properly.
Client Bulletin 12-12-06:
Income Tax Update - Winter 2006
December 12, 2006
The end of the year is a good time for you to engage in tax planning. By this time, you have a fairly accurate idea of your tax and financial picture for this year. With that knowledge in hand, you are now in a position to take various actions that may save taxes for this year or next year.Our goal with this mailing is to interrupt your daily routine for a few minutes and encourage you to consider your tax situation. Many sound, basic planning techniques are consistent year-to-year, and you will see some of the same topics covered as in previous years. This edition of Income Tax Update will provide you with information on Energy Tax Incentives, Hurricane Emergency Tax Relief, and the provisions of the new Tax Increase Prevention and Reconciliation Act of 2005 (enacted May 17, 2006) and the Pension Protection Act of 2006. Due to space limitations, we can not provide complete coverage of the new laws. Please also bear in mind that the following are general planning ideas; we suggest you contact us to determine which ideas will fit best into your specific tax situation.
Tax Planning for Individuals and Families
Change in marital status. If you are contemplating marriage or divorce, consider how a change in marital status could affect your taxes.
Maximize your flexible spending account at work. Increase the amount you set aside for next year in your employer's health flexible spending account if you set aside too little for this year. Don't forget you can set aside amounts to get tax-free reimbursements for over-the-counter drugs, such as aspirin and antacids. Also, new rules allow your plan to permit a grace period after year-end for using remaining amounts.
Use a credit card for deductible expenses. For individuals and businesses, consider using a credit card to prepay expenses that can generate deductions for 2006.
Estimate your taxes. If your taxable income has dropped in 2006, you may be able to reduce your final Federal or State estimated tax installments. If your taxable income has increased, you may want to consider increasing your withholding between now and the end of the year, or increasing your installments, in order to avoid or reduce any underpayment penalties.
Consider dividend-paying stocks. Qualifying dividends continue to be taxed at a 15% maximum federal tax rate. Notwithstanding issues of investment risk, this preferred tax rate is a huge incentive to own dividend-paying stocks rather than bonds or certificates of deposit. We suggest that you consider owning these stocks outside of your retirement plans so that you will benefit from the lower rate.
Reduce turnover in your portfolio. There is a heavy incentive to recognize long-term capital gains rather than short-term capital gains. Long-term capital gains are taxed at the lower 15% rate; if your ordinary income tax bracket is 10% or 15%, your capital gains rate is only 5%. Short-term capital gains, however, are taxed at ordinary tax rates, which depending on your tax bracket, could be as high as 35%.
Review your partnership investments. Determine if you should dispose a passive activity in the current year in order to free up any suspended passive activity losses.
Match capital gains and losses. If you have already recognized some gains this year, consider selling investments that will offset those gains with capital losses. Examine your holdings closely to see if you have any worthless securities. You may take the loss from worthless securities, which include nonbusiness loans, as an offset to your capital gains in the year in which the security became worthless.
Identify which shares are to be sold. It is very important to maintain good cost records for your investments, so you can choose to identify which shares of stock or bonds you sell instead of following the first-in, first-out (“FIFO”) method. If you bought the same security at different times and prices, this could allow you to sell shares with the highest cost per share to reduce a gain or increase your loss. You will need to maintain good records and carefully note (send a letter to your broker as well) which securities are being sold, and tender the correct certificates.
Avoid wash sales. As you consider year-end sales of securities to balance gains and losses, bear in mind that the wash sale rule prevents you from taking a loss if you buy an identical or significantly similar security within 30 days before or after you sell it. To get around this rule, consider buying securities of a different company in the same industry, or swapping bonds. With a bond swap, you sell a bond, take a capital loss and then immediately buy another bond of similar quality from a different issuer.
Alternative Minimum Tax (“AMT”). While significant AMT reform has not yet happened and a growing number of individuals continue to be exposed to the AMT, TIPRA attempts to resolve the inflation problem by increasing the 2006 exemption for married filing joint returns to $62,550 and single returns to $42,500. However, this only applies to 2006. Generally speaking, the most common elements that trigger AMT tend to be high levels of 1) state and local income tax deductions, 2) miscellaneous itemized business expenses, 3) medical expenses, 4) home equity interest, and 5) exercising and holding stock received from incentive stock options. However, a combination of other factors can also trigger AMT, and each return must be studied on a case-by-case basis. For instance, large amounts of long term capital gain combined with other factors can result in the AMT. If you were not in the AMT in 2005 but experienced unusual income or deductions in 2006, we suggest you contact us.
Maximize home-related deductions. If you use a mortgage to finance the purchase or improvement of your home, you can most likely deduct the related points or prepaid interest, as well as the annual amount of interest paid on the mortgage. With the recent run-up in real estate prices, however, understand that interest is deductible on home mortgage indebtedness of up to $1,000,000; interest on mortgages in excess of $1,000,000 is typically nondeductible. Be careful if you refinance your mortgage—only the amount of points paid that are allocable to proceeds of the refinancing used to improve your home may be deductible in the current year. Points paid for refinancing your existing home mortgage debt, or for obtaining home equity debt, have to be amortized over the life of the loan. In general, bear in mind that home equity interest is only deductible on the first $100,000 of home equity debt.
Exclude the gain on your home sale. As often as every two years you can exclude up to $250,000 ($500,000 if married filing jointly) of the gain you realize on the sale of your principal residence as long as you meet certain tests. You do not need to buy a replacement residence to take advantage of this tax break, which is a huge help to older taxpayers who want to sell their house and downsize.
Consider donating appreciated assets to charity. You can take a charitable deduction on appreciated assets, like stocks and bonds, when those assets are contributed to organized charities. The deduction is equal to the current fair market value, and you will avoid paying capital gains tax on the appreciation. For instance, rather than giving your church a $5,000 cash contribution, if you make a gift of $5,000 of stock for which you only paid $1,000 many years ago, you will save the equivalent of 15% of the gain, or $600. Please note, however, the charitable deduction for appreciated assets is limited to 30% of AGI. Should your giving exceed the deductible limits, you may carry the unused contributions forward for 5 years.
Special rules for charitable contributions in 2006 and 2007. Individual taxpayers may claim a $500 deduction against taxable income for each "Hurricane Katrina displaced individual" that the taxpayer houses for free in the taxpayer's principal residence for a period of at least 60 days that ends in the taxable year. The deduction is available in 2006. The aggregate total (including any amount claimed in 2005) cannot exceed $2,000. Additionally, those individuals who have attained age 70-1/2 may exclude up to $100,000 a year (for 2006 and 2007) for otherwise taxable distributions from an IRA (or a Roth IRA) that are paid directly to a qualifying charitable organization by the IRA trustee.
Shift income to children. The Tax Increase Prevention and Reconciliation Act of 2005 retroactively extended the “kiddie tax” to children under the age of 18 as of December 31, 2006 if their 2006 unearned income exceeds $1,700. The kiddie tax refers to taxing the unearned income of minor children at their parent’s marginal tax rate, which is typically higher. However, for children ages 18 and older, all of their income (earned and unearned) will be taxed at their own (generally lower) marginal rates. While prior law imposed the kiddie tax on children up to age 14, working effectively with the new rule can still help to reduce a family’s tax burden. Usually, children are “gifted” assets in order to generate unearned income. In 2006 and 2007, a taxpayer may gift, without federal gift tax consequences, up to $12,000 to any one individual. By combining exclusions, you and your spouse together can gift up to $24,000 of assets to each of your children or grandchildren.
Claim deductions and credits for education expenses. For the first two years of post-secondary education, you may be able to claim a Hope credit of up to $1,500 per student for 2006. Similarly, you may be eligible for a Lifetime Learning credit of up to $2,000 per taxpayer for an unlimited number of years of post-secondary, graduate and certain other education expenses. Both credits phase out in the income range of $45,000-$55,000 for singles and $90,000-110,000 for joint filers.
Consider a 529 plan. These plans are particularly valuable if your family will only qualify for minimal financial aid for education. 529s are state-sponsored plans that enable parents and grandparents to either secure current tuition rates with a prepaid tuition program or create tax-free savings accounts to fund college expenses. The contribution may qualify for the $12,000 annual gift tax exclusion ($24,000 for gifts by married couples). In fact, only for 529 contributions, you can elect to use annual exclusions for five years all at once. For example, you may contribute during the year up to $60,000 to a 529 plan, or $120,000 with a joint gift. Distributions used to pay for qualified expenses will be income tax-free.
Deduct student loan interest. You may be able to deduct up to $2,500 of interest paid on student loans from gross income. The AGI phaseouts for this deduction begin at $50,000 for single filers and $105,000 for joint filers.
Open a Roth IRA for your teen. Roth IRAs are perfect for teenagers in low tax brackets with many years to let their account grow tax-free. The dollar limit for minors is the same as for adults under age 50: the lesser of $4,000 or 100% of earned income from a legitimate job reported on their tax returns.
Tax credits for energy-saving improvements. The Energy Tax Incentives Act of 2005 introduced two new tax credits for energy efficient improvements to existing homes and for the purchase of residential energy efficient property effective January 1, 2006, through December 31, 2007. A taxpayer may claim a lifetime credit of up to $500 for making qualifying energy saving improvements to an existing home. Taxpayers will also be eligible for a credit for 30% of the amount paid for qualified photovoltaic property that uses solar energy to generate electricity (limited to a maximum credit of $2,000), 30% of the amount paid for qualified solar water heating property (limited to a maximum credit of $2,000), and 30% of the amount paid for qualified fuel cell property for generating electricity (limited to a $500 credit for each half kilowatt of capacity).
Tax credit for purchasing a hybrid vehicle. On January 1, 2006, The Energy Tax Incentives Act of 2005 converted the deduction for buying or leasing a new manufacturer’s hybrid vehicle to a tax credit along with credits for a qualified fuel cell motor vehicle, an advanced lean-burn technology motor vehicle, or qualified alternative fuel motor vehicle. The amount of the credit ranges from $400 to $2,400 based on the fuel savings percentage and may be increased based on lifetime fuel savings.
Tax Planning for Businesses
Energy efficient commercial building deduction. The Energy Policy Act of 2005 provides a deduction for qualifying energy efficient commercial building property placed in service after December 31, 2005 and before January 1, 2008. The building may be a new or existing structure and the full deduction is equal to the cost of qualified property up to an aggregate lifetime limitation of $1.80 per square foot of the commercial building where the property is installed. Qualified energy efficient commercial building property must be installed on a building in the United States, constructed within the scope of Standard 90.1-2001 of the American Society of Heating, Refrigeration, and Air Conditioning Engineers and the Illuminating Engineering Society of North America, and installed as part of either the interior lighting system, the heating, cooling, ventilation and hot water systems or building envelope. It also must be certified as being installed as part of a plan designed to reduce the total annual energy and power costs for the above items by 50% or more in comparison to a comparable reference building. A partial deduction of $0.60 per square foot is allowed for certain expenditures that do not meet the 50% energy savings requirement.
Business solar investment credit. The business solar investment tax credit has been made more attractive by increasing the credit from 10% to 30% for solar energy property, hybrid solar lighting systems, and qualified fuel cell property, effective for periods after December 31, 2005 and before January 1, 2008.
Deduction for qualified production activities income. For tax years beginning in 2005, taxpayers can claim a deduction, subject to limits, for a specified percentage of the taxpayer's “qualified production activities income” for the year. Generally, qualified production activities eligible for the deduction include the net income from U.S. manufacturing, production, or extraction activities, U.S. film production, U.S. construction activities, and U.S. engineering and architectural services. For 2006, the production deduction is equal to 3% of the lesser of (1) the business's total taxable income (adjusted gross income, in the case of a sole proprietor) or (2) the business's “qualified production activities income” for the year. The deduction is further limited to 50 percent of the qualified W-2 wages paid by the business during the calendar year that ends in the tax year. The deductible percentage will remain at 3% for 2006, increases to 6% for 2007 through 2009, and increase to 9% for tax years beginning after 2009.
Reduce retained earnings in a C corporation. Many successful C corporations have large amounts of retained earnings. There has been a disincentive in the past to pay these earnings out in the form of dividends, as the dividends were taxed at the ordinary tax rates. However, the tax rate on dividends has dropped to 15%, making it much less painful to pay dividends. Should the 15% tax rate on dividends be repealed, this opportunity will disappear.
Defer income. When you have high-income years, consider deferring some income to later years. For example, if your business uses the cash method of accounting, you could delay billing notices as you approach year-end and pay as many expenses as possible in the current year. If you use the accrual method, you could delay shipping products or delivering services until the next year. Remember, however, that reductions to your net income for tax purposes may also be noticed by your bankers or other investors.
Deduct equipment purchases. Rather than receiving a partial deduction in the current year through depreciation,the election to expense the purchase of assets under Internal Revenue Code Section 179 allows a current deduction for assets that are acquired during the course of the year and used in a trade or business. The Section 179 deduction has been increased to $108,000 for 2006, but begins to phase out if more than $430,000 of assets is purchased during the year.
Take advantage of depreciation rules. Careful planning during the year can help you maximize the deduction in the year of purchase. The IRS generally treats all newly acquired tangible assets other than real estate as being placed in service at the year’s midpoint. This possibly gives you six months of depreciation in the first year, even if you buy the equipment in December. One caveat: if you made more than 40% of the year’s asset purchases in the fourth quarter, you may be required to use the generally less favorable midquarter convention.
Benefit from tax breaks for the self-employed. If you are self-employed, you can deduct 100% of your health insurance costs for yourself, your spouse, and your dependents. This deduction is limited to the income you have earned from your trade or business. If you are self-employed, consider how you can maximize savings through a retirement plan for your business. There are a myriad of plans from which to choose, many of which must be established by December 31st.
Examine your basis. If you own an interest in a partnership, LLP, LLC, or an S corporation, consider if you should increase your basis in order to be able to deduct a loss in the current year.
Tax Planning for Retirement and Estates
Contribute to a traditional IRA, Keogh, SEP, or Roth IRA. Contributions to all three plans accumulate tax deferred, and you may be able to deduct the contributions from gross income. The 2006 deduction for traditional IRA contributions is $4,000 or 100% of earned income, with an extra $1,000 eligible for deduction for taxpayers over age 50. The annual contribution limit for Keogh and SEP plans for 2006 is the lesser of $44,000 or 100% of compensation. The Roth IRA in many cases is the best way to plan for retirement, even though you cannot deduct current contributions. Annual contributions of the lesser of $4,000 or your earnings for the year are allowed, plus any applicable catch-up contributions if you are over age 50, with qualified distributions coming out tax-free.
Direct deposit of tax refunds to an IRA. Beginning in 2007, you can authorize the IRS to directly deposit your refund into your retirement account (i.e., IRAs, qualified retirement plans, §403(b) annuities, or §457 plans). The new split refund option will even allow you to direct a portion of your joint refund into your respective retirement accounts. This helps the cash flow problem for many taxpayers who wanted to contribute to IRAs, but needed to use their refunds to do so.
Maximize contributions to Employer-sponsored plans. You may be able to make pre-tax contributions to your 401(k), 403(b) or 457, or salary-reduction SEP plan up to the legal limit, which is $15,000 for 2006 with a $5,000 allowable catch-up contribution if you are age 50 and older. In addition, your employer may match some of your contributions. If your employer matches, you need to contribute the amount required to take full advantage of the match. Plan assets are allowed to grow tax deferred. Similarly, under a Savings Incentive Match Plan for Employees (SIMPLE), you may be able to defer up to $10,000 of your salary, or $12,500 if you’re 50 or older. The employer will provide a matching contribution, typically up to 3% of your salary.
Plan for retirement account withdrawals. Generally, withdrawals from retirement accounts made before age 59 ½ are subject to a 10% penalty; after age 70 ½, the minimum must be withdrawn or you face a 50% penalty. Deciding if you should take distributions before age 70 ½, or more than the minimum after that age, depends on how much you will receive from other income sources, your life expectancy, and other factors.
Consider the effects of estate and gift taxes. For those dying in 2006 through 2008, there is no estate tax on the first $2 million of net assets in the estate. Lifetime gifts to heirs can also be made without incurring gift taxes, up to the exemption limit of $1 million. Remember that gifts you make during your lifetime are subject to federal gift tax. Fortunately, you can exclude gifts of up to $12,000 per recipient each year, or $24,000 per recipient if your spouse elects gift splitting. To use the annual exclusion, the law requires you to give recipients a present interest in the property.
Determine which property to gift. To minimize estate taxes, consider gifting property with the greatest future appreciation potential. While the estate tax is in effect, it may make sense in some cases to wait to transfer highly appreciated assets until your death because the basis will be stepped up to the market value at your date of death and the capital gains tax can be avoided. For property that has declined in value, you may want to sell the property during your lifetime to take advantage of the tax loss.
Use the unlimited marital deduction. Your estate generally can deduct the value of all assets that pass from you to your spouse during your lifetime or at your death, provided your spouse is a U.S. citizen. However, if the combined estates of you and your spouse are greater than the exemption amount ($2 million in 2006), simply using the full marital deduction to avoid taxes on the first spouse’s death could result in needless estate tax liability on the surviving spouse’s death. A credit shelter trust can help minimize the estate tax for the family by making use of both spouses’ exemptions.
Other retirement provisions. In addition to making the saver’s credit a permanent part of the tax code and indexing the AGI eligibility threshold for inflation beginning in 2007, the Pension Protection Act of 2006 contains numerous provisions for retirement plans which apply to specific circumstances. If you’re contemplating pension rollovers, withdrawals, conversions or retirement distributions, further discussions of the tax effects prior to any action would be a wise idea.
We hope this provides you with useful information as we near the end of the year. As with most things, those who plan rather than simply react tend to be more heavily rewarded. If you have concerns about year-end planning, please feel free to call our office to set up an appointment.
Client Bulletin 12-4-07:
Income Tax Update - Winter 2007
December 4, 2007
Our goal with this mailing is to interrupt your holiday routine for a few minutes and encourage you to consider if your tax strategy is on track. We anticipated additional tax legislation this year, but with each passing day it is less likely that Congress will pass any significant tax act before the end of the year. Due to space limitations, this newsletter will present a checklist and in-depth discussion on just a few tax issues. For more detailed articles on various tax issues, including a look at the alternative minimum tax, please see our website at www.bsd-cpa.com. As always, remember that any tax advice should be tailored to your particular situation, and we encourage you to contact us with any specific concerns.
Here are some snapshots of tax strategies to consider in the remaining weeks of this year:
v Capital gains - Long-term capital gains are taxed at a maximum rate of 15% (possibly 5% in 2007 in some cases). In some situations, you may want to take advantage of this low rate; in other cases, you may want to offset your capital gains with as many capital losses as possible.
v Preferred tax rates on dividend income - Qualified dividend income received in 2007 or 2008 is taxed at the same favorable tax rates that apply to net capital gains. Consider converting investment income taxable at regular rates into qualified dividend income to achieve tax savings.
v Deducting sales taxes as an itemized deduction instead of state income taxes - 2007 is the final year individual taxpayers can elect to claim an itemized deduction for state and local sales and use taxes instead of state income taxes.
v IRA and Roth-IRA year-end moves - Consider if it is worthwhile to 1) recharacterize an IRA-to-Roth IRA convention, 2) deduct losses in a retirement account, 3) withdraw required minimum distributions before year-end to avoid a penalty, or 4) accelerate the first required minimum distribution.
v Expensing deduction - For tax years beginning in 2007, the maximum amount of eligible assets that can be expensed under Code Section 179 is $125,000, and the expensing deduction does not begin to phase out until expensing-eligible property placed in service during the year exceeds $500,000. This means that many small- and medium-sized businesses will be able to currently deduct most, if not all, of their outlays for machinery and equipment, rather than claiming the expense over several years through depreciation.
v Changes in tax status - Changes in an individual's tax status due to divorce, marriage, or loss of head of household status must be considered. Marital status as of the last day of the year will determine how taxes will be filed.
v Alternative minimum tax (AMT) - It is predicted that the number of individual taxpayers subjected to the AMT will increase dramatically in 2007. While there has been some talk of relief, Congress has thus far failed to take action to curb the AMT’s reach for 2007. One of the frustrating aspects of AMT is its reach: It was originally intended as a tax on the super-wealthy, but each year it affects a growing number of upper middle income taxpayers. Another frustration is that, while there are some factors that are more prone to generate AMT, it is not always possible for taxpayers to identify when they will be exposed to AMT, as the tax is often triggered by a combination of factors. Because of its elusive nature, it is important that any tax planning include an analysis of AMT.
v Estimated tax or tax withholdings - If you need to make additional Federal or state income tax payments for 2007, determine if it is more advantageous to pay those taxes through adjusting the amount of income tax that is withheld from your wages or by making an estimated tax installment. Be aware that accelerating any state income tax payments could affect your exposure to AMT.
v Charitable contributions - Gifts must be made prior to the end of the year in order to be deducted in 2007 – gifts made using a credit card will be deductible in 2007, even if paid in 2008. Note that in 2007 (but not in 2008 unless Congress acts to extend the provision), individual taxpayers who are at least 70-1/2 years old may contribute to charities directly from their IRAs without having the contribution included in their gross income. By doing this, some taxpayers may be able to reduce their tax liability even more than they would have if they had received the distribution from their IRA and then contributed the amount distributed to charity.
v Energy tax incentives – While these tend to be rather small, tax credits are available for qualifying energy-efficient home improvements made in 2007. These credits will not be available for improvements made, or property placed in service, after 2007 unless Congress acts to extend the availability of the credits. A credit also is available for residential energy efficient property placed in service before 2009.
Checklist of things to do before the end of 2007
The following is a list of potential tax-saving steps that can be taken before the end of this year:
1. Analyze net capital gains and losses before the end of the year.
2. Convert investment income taxable at regular rates (e.g., interest income) into qualifying dividend income.
3. Consider the possibility of deferring a bonus until 2008, if possible.
4. Increase basis in partnership or S corporation to make possible a 2007 loss deduction.
5. Use credit card to prepay expenses for deductible items.
6. Make energy saving improvements to your home that qualify for tax credits in 2007 or purchase a credit-eligible hybrid car or alternative fuel motor vehicle.
7. Pay contested taxes to deduct them this year while continuing to contest them next year.
8. Put equipment in service before year-end to get six months' worth of depreciation deductions, unless the mid-quarter convention would be triggered.
9. Make expenditures qualifying for $125,000 business property expensing option (section 179).
10. Settle insurance or damage claim if this will maximize casualty loss deduction.
11. Apply “bunching” strategy to miscellaneous itemized deductions, medical expenses and other itemized deductions to increase deductible amounts.
12. Increase withholding or make an installment to eliminate or reduce any estimated tax penalty.
13. Set up self-employed retirement plan prior to year end.
14. Make gifts to family to take advantage of the $12,000 gift tax exclusion per recipient.
15. Consider the tax effect of a change in marital status during the year.
16. Consider deferring a debt cancellation event until 2008.
17. Decide whether to elect to deduct investment interest against capital gains.
18. Avoid personal holding company tax by making dividend payments.
19. If possible, take steps to avoid or minimize income tax on Social Security benefits.
20. Step up level of participation in a business activity to meet material participation standard under passive loss rules.
21. Dispose of passive activity to free up any suspended losses.
22. Ask employer to increase withholding of state and local taxes to pull the deduction of those taxes into 2007 or to avoid underpayment penalties.
Straight talk on interest expense
In the frenzy of the housing boom, mortgages were easy to obtain, which encouraged individuals to maximize the amount of house they bought and the amount of debt they were willing to assume. Often, individuals were encouraged to combine primary mortgages with home equity loans in order to maximize the amount of house they could afford or to purchase a second home. Unfortunately, many homebuyers will be surprised to learn that some of the interest may not be deductible.
The Tax Code allows that qualified residence interest is deductible. This includes interest on debt secured by the taxpayer's principal residence and one other qualified residence, which can include a trailer or houseboat. If the taxpayer has a principal residence and two or more other residences, he can choose each year which of the other homes qualifies as his second residence. Qualified residence interest includes acquisition debt and home equity debt with respect to a taxpayer's qualified residence. In order to deduct the mortgage interest, the maximum amount of acquisition debt, for a principal residence and a second residence combined, is $1,000,000. Home equity debt can not exceed $100,000 in order for the interest to be deductible.
“Acquisition debt” is debt that is incurred in acquiring, constructing, or substantially improving the principal or second qualified residence of the taxpayer and which is secured by the residence. If the debt to acquire, construct, or substantially improve a principal and second residence exceeds $1,000,000, then only the interest on a total principal amount of $1,000,000 is deductible as interest on acquisition debt.
“Home equity debt” is debt (other than acquisition debt) secured by the taxpayer's principal or second residence. Interest on home equity debt is deductible even if the proceeds are used for personal purposes.
Bear in mind that personal interest is not deductible. Personal interest includes interest paid on credit cards and car loans. Since qualified residence interest is deductible while personal interest is not, typically individuals will want to allocate their resources to pay down personal loans before pre-paying any principal on their mortgage loans. One strategy that can benefit taxpayers, but needs to be employed prudently, is to use home equity debt to pay for personal nondeductible expenditures. For example, subject to the home equity indebtedness limits discussed above, a taxpayer may be able to use home equity loan proceeds to pay for the purchase of a car used for personal purposes, thereby making the interest tax deductible.
Investment interest, generally defined as interest used to buy or carry investment property, is deductible by individuals only to the extent of net investment income. Investment income includes income such as dividends, interest, and certain gain on the sale of investment property but, for purposes of the investment interest deduction, generally does not include net capital gain from disposing of investment property (including capital gain distributions from mutual funds) or qualified dividend income. Net capital gain is the excess of net long-term capital gain for the year over the net short-term capital loss for the year. Qualified dividend income is income from dividends that qualify to be taxed at the net capital gain tax rates. However, the taxpayer can choose to include part or all of net capital gain and qualified dividend income in investment income but, in doing so, the net capital gain and qualified dividend income will not qualify for the favorable maximum tax rates. Regardless, in some cases it may be worthwhile to make this election. Investment interest not allowed as a deduction for a tax year may be carried over to the next year, where it is subject to the same limitations again.
Tax planning for capital gains and losses
Individuals who lost money in the stock market in 2007 may have other investment assets that have appreciated in value. These taxpayers should consider the extent to which they should sell appreciated assets (if their value has peaked) and thereby offset gains with pre-existing losses.
Long-term capital losses are used to offset long-term capital gains before they are used to offset short-term capital gains. Similarly, short-term capital losses must be used to offset short-term capital gains before they are used to offset long-term capital gains. Noncorporate taxpayers may use up to $3,000 of total capital losses in excess of total capital gains as a deduction against ordinary income in computing adjusted gross income.
For 2007 and 2008, a noncorporate taxpayer is subject to tax at a rate as high as 35% on short-term capital gains and ordinary income. On the other hand, most long-term capital gains are taxed at a maximum rate of 15%. However, for 2007, the maximum rate is only 5% to the extent the gain would otherwise be taxed at a rate below 25% if it were ordinary income.
In an ideal setting, a taxpayer should try to avoid having long-term capital losses offset long-term capital gains since those losses will be more valuable if they are used to offset short-term capital gains or ordinary income. To do this requires making sure that the long-term capital losses are not taken in the same year as the long-term capital gains are taken. However, this is not just a tax issue. As is the case with most planning involving capital gains and losses, investment factors need to be considered. A taxpayer will not want to defer recognizing gain until the following year if there is too much risk that the value of the property will decline before it can be sold. Similarly, a taxpayer will not want to risk increasing the loss on property that is expected to continue to decline in value by deferring the sale of that property until the following year.
So what do you do in a case where you have a loss in a stock, but you believe that the stock is a good investment for the long term? There is no way to precisely preserve a stock investment position while at the same time gaining the benefit of the tax loss, because the so-called “wash sale” rule prevents taking a tax loss where substantially identical securities are bought and sold within a 61-day period (30 days before or 30 days after the date of sale). As a result, a taxpayer can not sell the stock to establish the tax loss and simply buy it back the next day. However, there are a few techniques that can be used to substantially preserve an investment position while realizing a tax loss:
1) “Double up” - Buy more of the same stocks or bonds, then sell the original holding at least 31 days later. The risk here is of further downward price movement.
2) Sell the original holding and then buy the same securities at least 31 days later.
3) Sell the original holding and buy similar securities in different companies in the same line of business. This approach trades on the prospects of the industry as a whole, rather than the particular stock held.
4) In the case of mutual fund shares, sell the original holding and buy shares in another mutual fund that uses a similar investment strategy.
Note that the wash sale rules apply only when securities are sold at a loss. As a result, a taxpayer may recognize a paper gain on stock in 2007 for year-end planning purposes and then buy it back at any time without having to worry about the wash sale rules.
In certain cases, it may be worthwhile to defer a gain into the following year. As a reminder, an individual’s net capital gain is taxed at a maximum rate of 15%. However, if the individual’s income is low enough that the net capital gain would be taxed at a rate below 25% if it were ordinary income, it is taxed at a 5% rate this year, rather than at 15%. The news is even better for the future: Given the same scenario, the gain will be subject to a zero percent rate for 2008 through 2010. A taxpayer whose top dollars will not be taxed at more than 15% this year or next, and who is considering the sale of appreciated capital assets before the end of the year, should instead defer the sale until next year. By doing this, the taxpayer could end up paying zero tax on his gain instead of paying 5% if he sold this year. This should be done only if (1) deferring the sale is not likely to result in a reduced sales price, and (2) the taxpayer is not likely to be subject to the “kiddie” tax next year.
The advantage of dividend income
Qualified dividend income is taxed at the same favorable tax rates that apply to adjusted net capital gains. In general, the maximum tax rate on qualified dividend income is 15%. However, the maximum tax rate on qualified dividend income is 5% for 2007 and zero percent for 2008-2010 if the gain would be taxed at a rate below 25% if it were ordinary income. In light of this, it makes sense for a taxpayer to consider shifting out of investment holdings that generate income taxed at ordinary rates (for example, bonds or certificates of deposit) and into stocks that pay qualified dividends.
In order to receive this favorable treatment, the dividends must be “qualified”. Dividend income is “qualified” if it is received from domestic corporations or certain foreign corporations. Additionally, for the dividend income to be qualified, the stock must have been held by the taxpayer for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (for certain preferred stock, more than 90 days during the 181-day period beginning 90 days before the ex-dividend date). Because of these holding requirements, the tax reduction strategy of shifting out of interest-paying investments and into dividend-paying stocks must be undertaken with enough time left in the year. Regardless, any actions taken will provide a benefit in the following year.
Once again, before any change is made in tax strategy, it is important to consider non-tax factors as well. As we have seen the last several months, the stock market can fluctuate wildly on any given day. If someone is dependent on their income and needs to preserve their principal, buying stocks that pay qualified dividends may not be the best strategy. If a taxpayer had cashed out of bonds only to buy high-yielding dividend stocks in the banking sector, for instance, the taxpayer would have seen the value of the portfolio sink dramatically in the latter half of 2007, as banking stocks were reeled by vacillations in the interest rates and sub-prime loan concerns. Furthermore, as a result of their declining profitability, it is possible that some of those banks may have to reduce the level of dividends that are being paid. If that is the case, a taxpayer who switched out of bonds and into these unlucky stocks may find that the dividends and the overall value of the stock have declined.
We hope this provides you with useful information as we near the end of the year. As with most things, those who plan rather than simply react tend to be more heavily rewarded. If you have concerns about year-end planning, please feel free to call our office to set up an appointment.
Client Bulletin 1-16-08:
Retention of Records
January 16, 2008
Many clients inquire as to how long they should hold on to their personal income tax records. These records may have to be produced if IRS (or a state or local taxing authority) was to audit your return or seek to assess or collect a tax. In addition, lenders, co-op boards, or other private parties may require that you produce copies of your tax returns as a condition to lending money, approving a purchase, or otherwise doing business with you.
Keep returns indefinitely and the supporting records usually for six years. In general, except in cases of fraud or substantial understatements of income, IRS can only assess tax for a year within three years after the return for that year was filed (or, if later, three years after the return was due). For example, if you file your 2006 individual income tax return by its original due date of April 16, 2007, IRS will have until April 16, 2010 to assess a tax deficiency against you. If you file your return late, IRS generally will have three years from the date you filed the return to assess a deficiency. The problem with the three-year rule is that the assessment period is extended to six years if more than 25% of gross income is omitted from a return. In addition, the assessment period doesn't begin to run until a return is filed. Therefore, if IRS claims that you never filed a return for a particular year, it can assess tax for that year at any time (even beyond three or six years), unless you can prove that you did file. Proving that you filed would, of course, be impossible after you have discarded your returns.
While it's impossible to be completely sure that IRS won't at some point seek to assess tax, retaining tax returns indefinitely and important records for six years after the return is filed should, as a practical matter, be adequate. If you file your returns electronically, be sure to get copies from the company that prepared and/or filed your return; it is required to provide you with a paper copy of the return. Records relating to property may have to be kept longer. Keep in mind that the tax consequences of a transaction that occurs in one year may depend on things that happened in earlier years—and that the period for which you should retain records must be measured from the year in which the tax consequences actually occur. This may be significant, for example, where you sell property that you bought years earlier.
For example, suppose you bought your home in 1985 for $100,000 and made an additional $20,000 of capital improvements in 1992. To determine the tax consequences of the sale, it's necessary to know your basis (i.e., original cost plus later capital improvements). For example, if you sell your home in 2007, and your return for that year is audited, you may have to produce records relating to the purchase in 1985 and the capital improvement in 1992 to be able to show what your basis is. Therefore, those records should be kept for at least six years after your 2007 return is filed instead of just six years after the transactions they relate to occurred. Even though as much as $250,000 of home-sale gain can escape tax—up to $500,000 for joint return filers—you should still retain all records relating to home purchases and improvements. There's no telling how much the home will be worth when it's sold, and there's no guarantee that the home-sale exclusion will still be available when the future sale takes place.
When new property takes the basis of old property, records relating to the old property should be kept until six years after the sale of the new property is reported. For example, suppose you bought a car for business use in 1998 and you traded it in on a new car for business use in 2001. If you sell that car in 2007, your basis in the car will determine whether you have a tax gain or a tax loss on the sale, and your basis in the car is determined, at least in part, by your basis in the car you traded in for it in 2001. Accordingly, records relating to your old car should be kept until 2014 (i.e., for six years after your 2007 return is filed in 2008).
Similar considerations apply to other property which is likely to be bought and sold—for example, stock in a business corporation or in a mutual fund, bonds (or other debt securities), etc. In particular, remember that if you reinvest dividends to buy additional shares of stock, each reinvestment is a separate purchase of stock, and the records of each reinvestment should be kept for at least six years after the return is filed for the year in which the stock is sold.
Because the calculation of the casualty and theft loss deduction is determined in part by your basis in the damaged or stolen property, you'll need to have records to support that basis, until six years after you file the return claiming the loss deduction. In case of separation or divorce. If separation or divorce becomes a possibility, be sure you have access to any tax records affecting you that are kept by your spouse. Or better still, make copies of the tax records, since in such situations, relations may become strained and access to the records difficult. Your records should include a copy of the divorce decree or agreement of separate maintenance, which may be needed to substantiate alimony payments and distinguish them from child support or a property settlement. Copies of all joint returns filed and supporting records are important, since the liability for tax on a joint return is joint and several and a deficiency may be asserted against either spouse. Your records should also include agreements or decrees over custody of children and any agreements as to who is entitled to claim an exemption for them. Retain records of the cost of all jointly-owned property. Also, get records as to the cost or other basis of all property your spouse or former spouse transferred to you during your marriage or as a result of the divorce, because your basis in that property is the same as your spouse's or former spouse's basis in it was.
Loss or destruction of records. To safeguard your records against loss from theft, fire or other disaster, you should consider keeping your most important records in a safe deposit box or other safe place outside your home. In addition, consider keeping copies of the most important records in a single, easily accessible location so that you can grab them if you have to leave your home in an emergency.
If, in spite of your precautions, records are lost or destroyed, it may be possible to reconstruct some of them. For example, a paid tax return preparer is required by law to retain, for a period of three years, copies of tax returns or a list of taxpayers for whom returns were prepared. Most preparers comply with this rule by retaining copies (sometimes for a longer period than the legally required three years) and can furnish a copy if yours is not available. In the case of our clients, copies are retained for 7 years. Similarly, other professionals who assisted you in a transaction may retain records relating to the transaction. For example, a stockbroker through whom you bought securities may be able to help you to determine the basis of the securities, and an attorney who represented you in the purchase of your home may retain records relating to the closing. Nonetheless, because you can never be sure whether those persons will actually have the records you need, the safest course of action is to keep them yourself, in as safe a place as possible.
Client Bulletin 11-15-09:
Year-end purchase of business equipment can save taxes
November 15, 2009
Although bonus first-year depreciation has been extended a number of times, another lease on life for this tax break may not be in the cards. Unless Congress acts, additional depreciation deductions under Code Sec 168(k) in the placed-in-service year equal to 50% of the adjusted basis of qualified property won't be available after this year. Thus, enterprises planning to purchase new depreciable property this year or the next should try to accelerate their buying plans, if doing so makes sound business sense. Here's how the rules work.
The adjusted basis of qualified property is reduced by the additional 50% depreciation deduction before computing the amount otherwise allowable as a depreciation deduction for the tax year and any later tax year. If Code Sec 179 expensing is claimed on qualified property, the amount expensed “comes off the top” before the additional 50% first-year depreciation allowance is computed. Then the taxpayer computes regular first-year depreciation (and depreciation for future years) with reference to the adjusted basis remaining after expensing and after the additional 50% first-year allowance. There is no AMT depreciation adjustment for property written off under the bonus depreciation rules, which provides for the additional 50% first-year depreciation allowance.
The bonus depreciation deduction is determined without any proration based on the length of the tax year. As a result, accelerated first-year deductions are available even if qualifying assets are in service for only a few days in 2009.
How to qualify for bonus depreciation. In general, an asset purchased in 2009 qualifies for the bonus depreciation allowance if
... It falls into one of the following categories: property to which the modified accelerated cost recovery system (MACRS) rules apply with a recovery period of 20 years or less; computer software other than computer software covered by the amortization of goodwill and other intangibles ; qualified leasehold improvement property; or certain water utility property.
... It is placed in service before Jan. 1, 2010 (certain property with a recovery period of ten years or longer and certain transportation property may be placed in service before Jan. 1, 2011).
... Its original use commences with the taxpayer. Original use is the first use to which the property is put, whether or not that use corresponds to the taxpayer's use of the property.
The 50% additional first year depreciation allowance applies to qualified property unless the taxpayer “elects out.” The election out may be made for any class of property for any tax year, and if made applies to all property in that class placed in service during that tax year.
Last year for extra-generous luxury auto depreciation limits? If bonus first-year depreciation deductions come to an end at the close of 2009, so will the extra-generous first-year dollar limit on autos, light trucks and vans subject to the Code Sec 280F “luxury auto” rules. Under these rules, the first-year depreciation deduction for new vehicles that qualify for bonus depreciation is $8,000 more than the first-year depreciation limit that would otherwise apply.
For new vehicles bought and placed in service in 2009, and that qualify for bonus first-year depreciation, the boosted first-year dollar limit is $10,960 for autos (not trucks or vans), and $11,060 for light trucks or vans (passenger autos built on a truck chassis, including minivans and sport-utility vehicles (SUVs) built on a truck chassis). The regular first-year luxury auto limits (e.g., for used vehicles) are $2,960 for autos and $3,060 for light trucks or vans. However, these boosted dollar amounts apply only for vehicles bought and placed in service before 2010. As a result, taxpayers thinking of buying a new auto, light truck or van for trade or business use should buy the vehicle and place it in service this year if they want to maximize first-year deductions.
Client Bulletin 11-15-09:
Home mortgage debt forgiveness relief
November 15, 2009
For indebtedness discharged on or after Jan. 1, 2007 and before Jan. 1, 2013, taxpayers generally may exclude up to $2 million of mortgage debt forgiveness on their principal residence. Specifically, under Code Sec 108(a)(1)(E), gross income doesn't include any discharge of qualified principal residence indebtedness. Qualified principal residence indebtedness is acquisition indebtedness with respect to the taxpayers 's principal residence, but with a $2 million limit ($1 million for married individuals filing separately). Acquisition indebtedness of a principal residence is indebtedness incurred in the acquisition, construction, or substantial improvement of an individual's principal residence that is secured by the residence. It includes refinancing of debt to the extent the amount of the refinancing doesn't exceed the amount of the refinanced indebtedness.
The basis of the taxpayer's principal residence is reduced by the excluded amount, but not below zero.
If any loan is discharged, in whole or in part, and only part of the loan is qualified principal residence indebtedness, the mortgage forgiveness exclusion applies only to so much of the amount discharged as exceeds the amount of the loan (as determined immediately before the discharge) which is not qualified principal residence indebtedness.
The exclusion doesn't apply to a loan discharged on account of services performed for the lender or any other factor not directly related to a decline in the value of the residence or to the taxpayer's financial condition. The exclusion also doesn't apply to a taxpayer in a Title 11 bankruptcy. An insolvent taxpayer (other than one in a Title 11 bankruptcy) can elect to have the mortgage forgiveness exclusion not apply and can instead rely on the exclusion for insolvent taxpayers., which allows insolvent taxpayers to exclude cancellation of indebtedness income to the extent of the insolvency.
Client Bulletin 11-15-09:
Individuals who have reached age 70 1/2 should consider making charitable contribution from IRA
November 15, 2009
An individual taxpayer's deduction for contributions (other than contributions of appreciated capital gain property) may not exceed 50% of the taxpayer's contribution base (i.e., adjusted gross income, computed without regard to any net operating loss carryback) if made to certain charitable organizations (e.g., public charities, private foundations other than private non-operating foundations, and certain governmental units) or 30% of the contribution base if made to nonoperating private foundations and certain other qualifying organizations. Contributions of appreciated capital gain property to certain charitable organizations generally are deductible up to 30% of the taxpayer's contribution base unless a special election is made to limit the taxpayer's contribution to the basis in the property (in which case the 50% ceiling applies). Contributions of appreciated capital gain property to certain private foundations are deductible up to 20% of the contribution base.
For pre-2010 distributions, an exclusion from gross income (not to exceed $100,000) is available for otherwise taxable IRA distributions that are qualified charitable distributions as defined below. Such distributions from an IRA aren't subject to the percentage limitations on making contributions since they will neither be included in gross income or be claimed as a deduction on the taxpayer's return. Since such a distribution is not includible in gross income, it will not increase adjusted gross income for purposes of the phaseout of itemized deductions, personal exemptions, or any other deduction, exclusion, or tax credit that is limited or lost completely when adjusted gross income reaches certain specified levels.
To constitute a qualified charitable distribution, the distribution must be made directly by the IRA trustee(after the IRA owner attains age 70 ½) to a charitable organization . Also, to be excludible from gross income the distribution must otherwise be entirely deductible as a charitable contribution deduction without regard to the charitable deduction percentage limits discussed above. Thus, if the deductible amount is reduced because of a benefit received in exchange, or if a deduction is not allowable because the donor did not obtain sufficient substantiation, the exclusion is not available for any part of the IRA distribution.
Illustration (1): Jason, who is age 71, is the owner of a traditional IRA with a balance of $300,000, consisting solely of deductible contributions and earnings. He wants to make a contribution of $100,000 to his college before the end of 2009 to mark the 50th anniversary of his graduation. Jason, who is a widower and files his tax return as a single taxpayer, expects to have adjusted gross income of $110,000 in 2009, itemized deductions of $25,700 (before taking the $100,000 contribution to his college into account) and a personal exemption of $3,650 in computing his taxable income. The itemized deductions of $25,700 include $20,000 of other contributions to public charities.
If Jason takes a distribution of $100,000 from his IRA, his adjusted gross income for 2009 will be increased to $210,000. If he then contributes the $100,000 to his college, it will only increase his total charitable deduction by $85,000 (the charitable deduction is limited to 50% of his adjusted gross income less the $20,000 of other charitable contributions he has made). While his gross itemized deductions will be $110,700 ($25,700 plus $85,000), the amount he may deduct will be reduced by $432 due to certain phase outs to $110,268. In addition, his personal exemption will be phased down by $438 . Accordingly his taxable income will be $96,520 (AGI of $210,000 less itemized deductions of $110,268, and less personal exemption of $3,212), and his income tax for 2009 will be $20,746.
If instead, Jason has the Trustee of his IRA transfer the $100,000 directly to his college, his adjusted gross income will not increase and he will not be entitled to a charitable contribution deduction for the amount transferred from the IRA. His adjusted gross income will remain at $110,000, and there will be no reduction in his itemized deductions of $25,700, and his personal exemption of $3,650. His taxable income will be $80,650 ($110,000 less itemized deductions of $25,700, and less personal exemption of $3,650), and his income tax for 2009 will be $16,350, or $4,396 less than it would have been if he had taken a distribution of $100,000 from his IRA and then contributed it to his college.
Illustration (2): The facts are the same as in illustration (1) except that $60,000 of the $300,000 in Jason's traditional IRA (20% of the total value of the IRA) consists of nondeductible contributions. If $100,000 is distributed to Jason and then contributed to his college, only $80,000 will be included in his gross income (80% of the total distribution). On the other hand if the $100,000 is transferred directly by the IRA's Trustee to Jason's college, the entire $100,000 will be treated as coming from earnings and deductible contributions, no part will be included in Jason's gross income, and $60,000 (30%) of the $200,000 amount remaining in the IRA will continue to consist of nondeductible contributions. Thus, if Jason takes a further distribution of $10,000 from the IRA in 2009, only $7,000 (70% of $10,000) will be includible in his gross income.
Illustration (3): Jack, a widower, age 73, expects to have adjusted gross income of $100,000 in 2009 before taking any distributions from his traditional IRA into account. Jack has $80,000 in his IRA including $50,000 of nondeductible contributions. Jack plans to make $13,350 in charitable contributions in 2009 not counting $50,000 he plans to make as a gift to his church. To make the gift to his church, he plans to take $50,000 from his IRA. If he makes the gift directly from the IRA to the church, his taxable income for 2009 will be $83,000 (adjusted gross income of $100,000, less itemized deductions of $13,350, less personal exemption of $3,650).
On the other hand, if he takes a distribution of $50,000 from the IRA, $40,000 of the distribution will be included in his gross income and will increase his adjusted gross income to $140,000. However, if he distributes the entire $50,000 to his church his charitable contributions will increase to $63,350 ($13,350 + $50,000). His taxable income will be $73,000 (adjusted gross income of $140,000, less itemized deductions of $63,350, less personal exemption of $3,650). Thus, his taxable income will be $10,000 less than it would be if he made the contribution through a direct transfer to his church from his IRA.
Even though a direct distribution from an IRA to a charity is not included in the taxpayer's gross income, it is taken into account in determining the owner's required minimum distribution (RMD) for the year. Thus, if the amount distributed directly from the IRA to an eligible charity at least equals the amount of the owner's RMD for the tax year, he will not be required to take any other distribution from the IRA for that tax year. Note that RMDs have been suspended for the 2009 tax year.
Client Bulletin 12-7-09:
Liberalized IRA-to-Roth Conversions
December 7, 2009
For tax years beginning after 2009, the $100,000 modified adjusted gross income (AGI) limit on conversions of traditional IRAs to Roth IRAs is eliminated. Additionally, married taxpayers filing a separate return will be able to convert amounts in a traditional IRA into a Roth IRA.
A unique income inclusion rule will apply for IRA-to-Roth-IRA conversions occurring in 2010. Unless a taxpayer elects otherwise, none of the gross income from the conversion is included in income in 2010; half of the income resulting from the conversion will be includible in gross income in 2011 and the other half in 2012.
A major wild card in making this choice is the tax-rate picture after 2010. Absent Congressional action, after 2010 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 those making $250,000 or more, but it is difficult to predict who will get hit by higher rates. What's more, there are proposals on the table to help finance healthcare reform with a surtax on higher-income taxpayers.
It is always difficult to accept paying taxes today in return for lower taxes in the future, but we suggest that most taxpayers seriously consider the advantages of this opportunity next year, at least to some extent. However, in some cases, conversion to a Roth would not be the best recommendation. Each taxpayer is unique and this is why it is important to let us review your specific situation before any decision is made.
Taxpayers who intend to take advantage of the new Roth IRA conversion option next year should consider the following year-end strategies:
A) Non-high-income taxpayers who are able to make deductible IRA contributions this year should do so. They'll reduce their 2009 tax bill and, if they make the conversion to Roth IRA next year, they won't have to pay back the tax savings until 2011 and 2012.
B) High income taxpayers who haven't made deductible IRA contributions in the past (or made a tax-free rollover from a qualified plan to an IRA) should consider making nondeductible IRA contributions this year. The conversion generally is taxable only to the extent of earnings on the nondeductible contributions. However, if the taxpayer previously made deductible IRA contributions, or rolled over qualified plan funds to an IRA, complex rules determine the taxable amount. That's because all IRAs are treated as one for distribution purposes and then IRS rules govern what part of the converted amount is treated as a tax-free return of nondeductible contributions and what part is treated as taxable.
C) Some high-income taxpayers plan to make large conversions in 2010 but to opt out of the deferral of tax until 2011 and 2012 because they fear they will be in a higher tax bracket in those years than in 2010. These taxpayers should avoid the standard year-end-planning wisdom of accelerating deductions and deferring income but should rather do the reverse in an effort to avoid being pushed into the highest brackets by a large IRA-to-Roth-IRA conversion. These taxpayers should consider ways to defer deductions to 2010, and accelerate income from next year into 2009.
Client Bulletin 11-15-09:
Individuals who have reached age 70 1/2 should consider making charitable contribution from IRA
November 15, 2009
An individual taxpayer's deduction for contributions (other than contributions of appreciated capital gain property) may not exceed 50% of the taxpayer's contribution base (i.e., adjusted gross income, computed without regard to any net operating loss carryback) if made to certain charitable organizations (e.g., public charities, private foundations other than private non-operating foundations, and certain governmental units) or 30% of the contribution base if made to nonoperating private foundations and certain other qualifying organizations. Contributions of appreciated capital gain property to certain charitable organizations generally are deductible up to 30% of the taxpayer's contribution base unless a special election is made to limit the taxpayer's contribution to the basis in the property (in which case the 50% ceiling applies). Contributions of appreciated capital gain property to certain private foundations are deductible up to 20% of the contribution base.
For pre-2010 distributions, an exclusion from gross income (not to exceed $100,000) is available for otherwise taxable IRA distributions that are qualified charitable distributions as defined below. Such distributions from an IRA aren't subject to the percentage limitations on making contributions since they will neither be included in gross income or be claimed as a deduction on the taxpayer's return. Since such a distribution is not includible in gross income, it will not increase adjusted gross income for purposes of the phaseout of itemized deductions, personal exemptions, or any other deduction, exclusion, or tax credit that is limited or lost completely when adjusted gross income reaches certain specified levels.
To constitute a qualified charitable distribution, the distribution must be made directly by the IRA trustee(after the IRA owner attains age 70 ½) to a charitable organization . Also, to be excludible from gross income the distribution must otherwise be entirely deductible as a charitable contribution deduction without regard to the charitable deduction percentage limits discussed above. Thus, if the deductible amount is reduced because of a benefit received in exchange, or if a deduction is not allowable because the donor did not obtain sufficient substantiation, the exclusion is not available for any part of the IRA distribution.
Illustration (1): Jason, who is age 71, is the owner of a traditional IRA with a balance of $300,000, consisting solely of deductible contributions and earnings. He wants to make a contribution of $100,000 to his college before the end of 2009 to mark the 50th anniversary of his graduation. Jason, who is a widower and files his tax return as a single taxpayer, expects to have adjusted gross income of $110,000 in 2009, itemized deductions of $25,700 (before taking the $100,000 contribution to his college into account) and a personal exemption of $3,650 in computing his taxable income. The itemized deductions of $25,700 include $20,000 of other contributions to public charities.
If Jason takes a distribution of $100,000 from his IRA, his adjusted gross income for 2009 will be increased to $210,000. If he then contributes the $100,000 to his college, it will only increase his total charitable deduction by $85,000 (the charitable deduction is limited to 50% of his adjusted gross income less the $20,000 of other charitable contributions he has made). While his gross itemized deductions will be $110,700 ($25,700 plus $85,000), the amount he may deduct will be reduced by $432 due to certain phase outs to $110,268. In addition, his personal exemption will be phased down by $438 . Accordingly his taxable income will be $96,520 (AGI of $210,000 less itemized deductions of $110,268, and less personal exemption of $3,212), and his income tax for 2009 will be $20,746.
If instead, Jason has the Trustee of his IRA transfer the $100,000 directly to his college, his adjusted gross income will not increase and he will not be entitled to a charitable contribution deduction for the amount transferred from the IRA. His adjusted gross income will remain at $110,000, and there will be no reduction in his itemized deductions of $25,700, and his personal exemption of $3,650. His taxable income will be $80,650 ($110,000 less itemized deductions of $25,700, and less personal exemption of $3,650), and his income tax for 2009 will be $16,350, or $4,396 less than it would have been if he had taken a distribution of $100,000 from his IRA and then contributed it to his college.
Illustration (2): The facts are the same as in illustration (1) except that $60,000 of the $300,000 in Jason's traditional IRA (20% of the total value of the IRA) consists of nondeductible contributions. If $100,000 is distributed to Jason and then contributed to his college, only $80,000 will be included in his gross income (80% of the total distribution). On the other hand if the $100,000 is transferred directly by the IRA's Trustee to Jason's college, the entire $100,000 will be treated as coming from earnings and deductible contributions, no part will be included in Jason's gross income, and $60,000 (30%) of the $200,000 amount remaining in the IRA will continue to consist of nondeductible contributions. Thus, if Jason takes a further distribution of $10,000 from the IRA in 2009, only $7,000 (70% of $10,000) will be includible in his gross income.
Illustration (3): Jack, a widower, age 73, expects to have adjusted gross income of $100,000 in 2009 before taking any distributions from his traditional IRA into account. Jack has $80,000 in his IRA including $50,000 of nondeductible contributions. Jack plans to make $13,350 in charitable contributions in 2009 not counting $50,000 he plans to make as a gift to his church. To make the gift to his church, he plans to take $50,000 from his IRA. If he makes the gift directly from the IRA to the church, his taxable income for 2009 will be $83,000 (adjusted gross income of $100,000, less itemized deductions of $13,350, less personal exemption of $3,650).
On the other hand, if he takes a distribution of $50,000 from the IRA, $40,000 of the distribution will be included in his gross income and will increase his adjusted gross income to $140,000. However, if he distributes the entire $50,000 to his church his charitable contributions will increase to $63,350 ($13,350 + $50,000). His taxable income will be $73,000 (adjusted gross income of $140,000, less itemized deductions of $63,350, less personal exemption of $3,650). Thus, his taxable income will be $10,000 less than it would be if he made the contribution through a direct transfer to his church from his IRA.
Even though a direct distribution from an IRA to a charity is not included in the taxpayer's gross income, it is taken into account in determining the owner's required minimum distribution (RMD) for the year. Thus, if the amount distributed directly from the IRA to an eligible charity at least equals the amount of the owner's RMD for the tax year, he will not be required to take any other distribution from the IRA for that tax year. Note that RMDs have been suspended for the 2009 tax year.
Client Bulletin 7-15-10:
Mid-Year Tax Update
July 15, 2010
Although this year is half over, we’ve already seen legislation with major tax changes, and more are almost certainly on the way. Despite confusion created by the never-ending changes, the 2010 federal income tax environment is still quite favorable. However, we may not be able to say that for 2011 and beyond. Therefore, tax planning actions taken between now and year-end may be more important than ever. This letter presents some planning ideas to consider this summer while you have time to think. Some of the ideas may apply to you, some to family members, and others to your business.
Traditional Strategy of Deferring Income Is Dicey This Year
Be careful when considering the time-honored strategy of deferring taxable income from this year into next year. The strategy still makes sense if you’re confident you’ll be in the same or lower tax bracket next year, but the tax picture for 2011 is blurry.
The top two rates are widely expected to increase from the current 33% and 35% to 36% and 39.6%, respectively. Therefore, individuals in the top two brackets might want to consider reversing the traditional strategy and accelerating income into 2010 to take advantage of this year’s presumably lower rates.
Until very recently, the conventional wisdom said the existing 10%, 15%, 25%, and 28% rate brackets would be left in place for next year. The little-known fact is that Congress must take action for that to occur. If Congress sits on its hands (which now looks more likely than just a few months ago), the four lowest rates will automatically be replaced by three higher rates: 15%, 28%, and 31%. Therefore, individuals in the existing 10%, 15%, 25%, and 28% rate brackets should also be skeptical about following the traditional strategy of deferring income into next year.
We wish we could give you more definitive advice about the advisability of deferring income (or not), but the uncertainty about future tax rates is what it is. Please check back with us later this year when we may have much better intelligence about what’s going to happen with 2011 tax rates.
Higher-income Individuals May Benefit from Accelerating Itemized Deductions into This Year
For 2010, the dreaded phase-out rule that previously reduced write-offs for the most popular itemized deduction items (including home mortgage interest, state and local taxes, and charitable donations) is gone. However, the phase-out rule is scheduled to come back with a vengeance in 2011 unless Congress takes action to prevent it, which now looks increasingly unlikely. If the phase-out rule comes back as expected, it will wipe out $3 of affected itemized deductions for every $100 of Adjusted Gross Income (AGI) above the applicable threshold. Individuals with very high AGI can see up to 80% of their affected deductions wiped out. For 2011, the AGI threshold will probably be around $170,000, or around $85,000 for married individuals who file separate returns.
Bottom Line: Depending on your AGI, you may get more tax-saving benefit from accelerating your January 2011 mortgage interest payment, your state and local tax payments that are due early next year, and some charitable donations. However, things get a bit tricky if you’ll be subject to the Alternative Minimum Tax (AMT) this year.
Time Investment Gains and Losses and Consider Being Bold
As you evaluate investments held in your taxable brokerage firm accounts, consider the impact of selling appreciated securities this year instead of next year. The maximum federal income tax rate on long-term capital gains from 2010 sales is 15%. However, that low 15% rate only applies to gains from securities that have been held for at least a year and a day. In 2011, the maximum rate on long-term capital gains is scheduled to increase to 20%. That will happen automatically unless Congress takes action, which looks increasingly unlikely right now.
To the extent you have capital losses from earlier this year or a capital loss carryover from pre-2010 years (most likely from the 2008 stock market meltdown), selling appreciated securities this year will be a tax-free deal because the losses will shelter your gains. Using capital losses to shelter short-term capital gains is especially helpful because short-term gains will be taxed at your regular rate (which could be as high as 35%) if they are left unsheltered.
What if you have some loser securities (currently worth less than you paid for them) that you would like to dump? Biting the bullet and selling them this year would trigger capital losses that you can use to shelter capital gains, including high-taxed short-term gains, from other sales this year.
If selling a bunch of losers would cause your capital losses for this year to exceed your capital gains, no problem. You will have a net capital loss for 2010. You can then use that net capital loss to shelter up to $3,000 of this year’s high-taxed ordinary income from salaries, bonuses, self-employment, and so forth ($1,500 if you’re married and file separately). Any excess net capital loss gets carried forward to next year.
Important Point: Selling enough loser securities to create a big net capital loss that exceeds what you can use this year might turn out to be a pretty good idea. You can carry forward the excess net capital loss to 2011 and beyond and use it to shelter both short-term gains and long-term gains recognized in those years. This can give you extra investing flexibility in future years because you won’t necessarily have to hold appreciated securities for over a year to get better tax results. Remember: It’s widely expected that the maximum federal income tax rate on long-term capital gains will be increased to 20% after 2010 (up from the current 15%). Also, the top two federal rates on ordinary income, including short-term capital gains, are widely expected to be increased starting in 2011 to 36% and 39.6% (up from the current 33% and 35%).
For the Charitably Inclined: Sell Loser Shares and Give Away Cash; Give Away Winner Shares
Say you want to make some gifts to favorite relatives and/or charities (who may really be hurting financially). You can make gifts in conjunction with an overall revamping of your holdings of stocks and equity mutual fund shares held in taxable brokerage firm accounts. Here’s how to get the best tax results from your generosity.
Gifts to Relatives. Don’t give away loser shares (currently worth less than what you paid for them). Instead sell the shares, and take advantage of the resulting capital loss. Then, give the cash sales proceeds to the relative. Do give away winner shares to relatives. Most likely, they will pay lower tax rates than you would pay if you sold the same shares. In fact, relatives who are in the 10% or 15% federal income tax brackets will generally pay a 0% federal tax rate on long-term gains from shares that were held for over a year before being sold this year. Hopefully, the same will be true if they sell appreciated shares next year. (For purposes of meeting the more-than-one-year rule for gifted shares, you get to count your ownership period plus the recipient relative’s ownership period, however brief.) Even if the shares are held for one year or less before being sold this year, your relative will probably pay a lower tax rate than you would (typically only 10% or 15%). However, beware of one thing before employing this give-away-winner-shares strategy. Gains recognized by a younger relative who is under age 24 may be taxed at his or her parent’s higher rates under the so-called Kiddie Tax rules.
Gifts to Charities. The strategies for gifts to relatives work equally well for gifts to IRS-approved charities. So, sell loser shares and claim the resulting tax-saving capital loss on your return. Then, give the cash sales proceeds to the charity and claim the resulting charitable donation write-off (assuming you itemize deductions). As you can see, this idea results in a double tax benefit (tax-saving capital loss plus tax-saving charitable donation deduction). With winner shares, give them away to charity instead of giving cash. Here’s why. For publicly traded shares that you’ve owned over a year, your charitable deduction equals the full current market value at the time of the gift. Plus when you give winner shares away, you walk away from the related capital gains tax. So this idea is another double tax-saver (you avoid capital gains tax on the winner shares, and you get a tax-saving charitable donation write-off to boot). Because the charitable organization is tax-exempt, it can sell your donated shares without owing anything to the IRS.
Convert Traditional IRA into Roth IRA
Here’s the best scenario for this idea: Your traditional IRA is (or was) loaded with equities and took a major beating during the 2008 stock market downturn. So your account is still worth considerably less than it once was. Correspondingly, the tax hit from converting your traditional IRA into a Roth IRA right now would also be a lot less than before. Why? Because a Roth conversion is treated as a taxable liquidation of your traditional IRA followed by a nondeductible contribution to the new Roth IRA. While even the reduced current tax hit from converting is unwelcome, it may be a small price to pay for future tax savings. After the conversion, all the income and gains that accumulate in your Roth IRA, and all withdrawals, will be totally free of any federal taxes—assuming you meet the tax-free withdrawal rules. In contrast, future withdrawals from a traditional IRA could be hit with tax rates that are higher than today’s rates (maybe much higher depending on how things go).
Of course, conversion is not a no-brainer. You have to be satisfied that paying the upfront conversion tax bill makes sense in your circumstances. In particular, converting a big account all at once could push you into higher 2010 tax brackets, which would not be good. You must also make assumptions about future tax rates, how long you will leave the account untouched, the rate of return earned on your Roth IRA investments, and so forth.
Important Point: Before this year, there were two big restrictions on the Roth IRA conversion privilege. First, your Modified Adjusted Gross Income (MAGI) could not exceed $100,000. Second, you were completely ineligible if you used married filing separate status. For 2010, both restrictions are eliminated. If the Roth IRA conversion idea intrigues you, please contact us for a full analysis of all the relevant variables.
Take Advantage of Temporary Business Tax Breaks
Several favorable business tax provisions have a limited shelf life that may dictate taking quick action.
Big Section 179 Deduction. Your business may be able to take advantage of the temporarily increased Section 179 deduction. Under the Section 179 deduction privilege, an eligible business can often claim first-year depreciation write-offs for the entire cost of new and used equipment and software additions. For tax years beginning in 2010, the maximum Section 179 deduction is a whopping $250,000 (same as last year). For tax years beginning in 2011, the maximum deduction is scheduled to fall off the cliff to only $25,000. (Congress will probably increase the number, but don’t bet the house on it.). Also note that various limitations apply to the Section 179 deduction privilege.
Longer Carryback Period for Net Operating Losses (NOLs). Legislation passed last year allows businesses to carry back Net Operating Losses (NOLs) generated in tax years beginning in 2009 for up to five years (versus the two-year carryback rule that usually applies). If your business uses a fiscal tax year (say one that began last October), you may still have time to take actions that will create or increase an NOL for the current tax year. That NOL can then be carried back for up to five years to recover taxes paid in those years.
Social Security Tax Exemption for Wages Paid to New Hires. Wages paid to a qualified new employee between March 19, 2010 and December 31 2010 are exempt from the employer’s portion of the Social Security tax (the employer portion equals 6.2% of wages up to $106,800). The exemption doesn’t apply to the employee’s portion of the Social Security tax (also 6.2% of wages of up to $106,800). Qualified new employees are full-time or part-time workers who—(1) start work after February 3, 2010 and by no later than December 31, 2010, and (2) were not employed more than 40 hours during the 60-day period ending on the start date. The new worker cannot displace a current employee unless that person quit voluntarily or was discharged for cause. Wages paid to workers who are related to an owner of the employer may be ineligible. Please contact us if you think you might qualify for this tax break.
Tax Credit for Retaining New Hires. Above and beyond the Social Security tax exemption, employers can also claim a new tax credit of up to $1,000 for wages paid to each qualified new employee(defined the same way as for the Social Security tax exemption). However, there are some additional requirements to collect this break. You must keep the worker on the payroll for at least 52 consecutive weeks, and wages during the second 26 weeks must equal at least 80% of wages paid during the first 26 weeks. The credit equals the lesser of—(1) 6.2% of qualifying wages paid during the 52-consecutive-week period or (2) $1,000. To claim the maximum $1,000 credit, the worker must be paid at least $16,130 during the 52-week period.
Every business and individual may have unique circumstances that impact their taxes. As a result, the above advice must be viewed as general in nature. Please contact us if you have any questions on how the above might affect your particular situation.
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