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CAPITAL GAINS IN 2008 - 2010 The original tax legislation a number of years ago was very clear and concise. Beginning in 2008 and extending through 2010 if you are a taxpayer in the 10% or 15% income tax bracket there is NO TAX on long term capital gains. Sound too good to be true? Perhaps. That was then - this is now. As the old saying goes, ‘the devil is in the details’. Vermont Payroll Tax Alert SUBCONTRACTORS
– UNEMPLOYMENT TAX COVERAGE December 2007 Over the past couple years both the Vermont Department of Labor and insurance companies issuing workers’ compensation policies have been actively auditing small businesses that utilize subcontractors. The scope and results of these audits have surprised most business owners. Even worse, the additional tax and insurance premiums assessed after the audits have, in many instances, created severe financial burdens for the business. It is important to remember that the rules and regulations regarding subcontractors vary between the Internal Revenue Service and the Vermont Department of Labor. While Vermont may classify your subcontractor as a statutory employee for their purposes, the IRS may not take the same direction. A Vermont audit and tax assessment will not automatically guarantee an audit from the IRS. If you truly have subcontractors then their payments are NOT subject to federal Social Security, Medicare, or income tax withholding. In addition the payments are not subject to Vermont income tax withholding. You should report the amount you pay subcontractors on Form 1099-MISC as non-employee compensation and NOT on Form W-2. As we end 2007 and prepare for 2008, let’s take an opportunity to review what issues are being audited, what the rules are, and how to ‘audit-proof’ your business. VERMONT UNEMPLOYMENT INSURANCE: Although it is called ‘insurance’ this is really a tax imposed on businesses and collected by the Vermont Department of Labor. Under Vermont’s unique “A-B-C Test” many subcontractors ARE subject to this tax even though the tax was originally enacted to protect employees without a job. If a subcontractor is providing ‘substantially similar’ services to your customers – meaning the subcontractor does the same thing that your business does – then you must pay Vermont ‘unemployment tax’ on their earnings if they are a sole proprietor. Fortunately the tax per individual subcontractor is not substantial. The maximum compensation subject to the tax is $8,000 per year and the tax rate is generally one (1) percent, which produces a maximum tax of $80 per subcontractor. The tax is reported and paid quarterly. What to do? Register with the Vermont Department of Labor, pay the tax, and avoid costly multiple year assessments of tax, penalties and interest if you are audited down the road. The tax is relatively minor, even with several subcontractors, but the peace of mind you’ll enjoy will far outweigh the costs to your business. VERMONT WORKERS’ COMPENSATION INSURANCE: This is truly an insurance policy purchased from a private insurance carrier. Its purpose is to provide employees with medical and disability benefits if they were injured in the course of their employment. Employers bear the responsibility for anyone they employ. Vermont law defines “employer” broadly and includes work performed by independent contractors or subcontractors. Under the same ‘substantially similar’ service test used in determining unemployment insurance coverage, the Vermont Department of Labor requires subcontractors to be covered by YOUR workers’ compensation insurance policy. If you are audited by your insurance carrier the final assessment imposed could be a financial ‘knockout punch’ for your business. Since questions in this area involve not only tax but also insurance issues, you should definitely consult with your insurance broker to navigate this potential minefield. I am fortunate to deal with Laberge Insurance and Bill Laberge has been particularly helpful in this regard. What is financially at stake should you be audited? All payments to subcontractors could be subject to your workers’ compensation insurance rates. In the case of a carpenter or builder whose rate is $17 per $100 of wages, payments to subcontractors of $50,000 would require a payment of $8,500. Could your business sustain a financial hit of this magnitude? Fortunately there is a solution to avoid having subcontractors be subject to your workers’ compensation insurance. Require the subcontractors to purchase their own workers’ compensation policy and provide you with a certificate of insurance. Be aware however that a basic policy, which can be purchased for a little over $700, may NOT suffice in the event of an audit. According to my insurance broker, Bill Laberge, those policies generally exclude the policy owner from coverage and an aggressive insurance auditor may disallow that insurance certificate citing the fact that the subcontractor really doesn’t have workers’ compensation insurance coverage. Check with your insurance broker for answers in your particular situation. THE BOTTOM LINE: Proper planning now can save your business thousands of dollars of unnecessary penalties, interest, and insurance costs not to mention the time and aggravation of a nasty audit. If you are following the requirements for unemployment insurance and workers’ compensation insurance then congratulations, you are taking the necessary steps to insure your business success. If you need to comply with these regulations then now is the time to take action to correct the problems. I realize you may have questions relating to your specific situation. If you do please call me at (802) 545-5600 to set up an appointment or time to talk on the telephone. I can address your concerns and assist you in developing a plan that can provide you with some peace of mind.
Tax
Surprises in Iraq Spending Bill
On May 25, the President signed the Iraq war-funding bill.
Look closely. Congress couldn't resist tacking on a few tax
provisions.
Kiddie Tax To Age 24.
One year ago, the "kiddie tax" was extended from age 14
to 18. In 2008, it will affect students up to age 24!
The "Kiddie Tax" Idea. To catch
parents who move income into a child's lower bracket, there's a
special rule. A youngster with investment income over $1,700
is taxed at the higher of the tax rate of the child of the parent.
Income from a job is not affected.
In the year the youngster reaches age 18, the rule does not apply.
Few families can afford to sock away enough money to generate this
much investment income for a youngster. But, for those who can
afford it, this rule is a big problem.
Target 2008. Here's the latest plan to
collect extra tax from middle and high-income families. Next
year brings the lowest capital gains rates in history. We
currently have five tax "brackets". Find your
taxable income, and use these rates:
Taxable Inc. Up To
Tax Rate
Singles
$ 7,825
10%
$31,850
15%
over $31,850
25% & up
Couples $15,650
10%
$63,700
15%
over $63,700
25% & up
Long-term capital gains get lower rates. The lower rates also apply to dividends of domestic corporations. This type of income acts as if it "floats" at the top of the taxable income pile. Any capital gain income falling in 25% or higher brackets is taxed at 15%. Long-term capital gain falling in the normal 10% or 15% brackets is taxed at 5%. Sound good? Wait until next year! For 2008, 2009 and 2010 the rate on that 10% or 15% layer drops from 5% to ZERO! Not one penny of tax! Trap! More "Kiddies" Next Year. Families who can afford to save for college banked on using that 0% tax rate for help. Transfer stocks to the youngster. Let the youngster sell to pay college costs - with no loss to income tax. Congress has shot down this plan. For 2008 and on, dependents between age 19 and 23 who are full-time students will be considered "kiddies". Their long-term gains will be taxed at the higher tax rates of the parents. The only way to avoid the rule is to show the youngster has enough W-2 income to cover more than half his/her support costs. Not likely. Expensing Business Equipment. A business normally must depreciate equipment. Small businesses can choose to write off limited amounts of equipment. This applies for up to $112,000 of equipment, but only if the business spent less than $450,000 on new equipment. Congress just raised the $112,000 to $125,000 and raised the total spending cap to $500,000. The rules will be with us (and adjusted for inflation) through 2010. After 2010 we are scheduled to return to the $25,000 limit from 2001 when these changes began. Break for Mom and Pop Businesses. When both spouses run a family business, IRS had insisted they file a partnership return, except in community property states. Now Congress says they may simply file a joint return and split the profits equally.
Other Business Items. The Work Opportunity Tax Credit offers incentives to hire certain groups of workers. The credit was set to expire after 2007, but is extended to those hired before September 1, 2011. Several new categories of workers were added. Several measures for businesses affected by Hurricane Katrina were extended.
Other Measures. IRS is given more powers to deal with late return filings and erroneous refunds. They also got stiff new penalties for tax practitioners. The new sanctions cover all returns, not just income tax for all individuals and businesses. Tougher standards, and larger fines will help IRS crack down on unscrupulous practitioners. I'll be doing more research on "gray" areas. More Laws To Come? We're likely to see more changes. However, some important items will likely be left for next year. Reform of the Alternative Minimum Tax is still a hot issue, but complicated, and very expensive. The Estate Tax is still unsettled after 2009. We are not likely to see these resolved in 2007.
Mutual Funds For Beginners
The stock market is rocketing to new highs. More and more
people are turning away from banks and savings accounts.
They're jumping onto the mutual fund bandwagon. It's a very
different game.
More Growth - More Risk. Generally
speaking, money invested in the business community will grow
faster than money deposited in a bank. Generally.
Eventually. Banks provide the money used by business for
growth. They collect interest. They return some of the
interest to account holders who supplied the money. Business
must generate more profits than the interest they pay. It's
practically a Law of Nature.
In the bank, your money is secure, but the growth is slow.
In the stock markets your "account" balance rises and
falls. If you invest in the wrong companies you could
lose everything. But, eventually the markets must show more
growth (or else America is doomed!).
Mutual Funds vs. Stocks. Most people don't
buy individual stocks. You need to "diversify" to
protect against the occasional failure of a business. In a
mutual fund, hundreds of investors pool their money to buy a
diversity of stocks. Fund managers make the actual
decisions. The pool of investors share in the profits, the
risks, and the cost of management.
Capital Gains Taxes. Good news at tax time.
Interest you earn from a bank is taxed as "ordinary"
income. Stocks can yield two types of income,
dividends (a share of the company profits), and capital gain (or
loss) when the stock is sold. Current tax law gives both
dividends and long-term gains lower rates than other income.
If your taxable income is in 10% or 15% brackets, your long-term
gain is taxed at only 5%. If your tax rate is 25% or higher,
most of your mutual fund income is taxed at 15%. Quite a
savings.
Record Keeping A Must! You can ignore a
bank account if you wish. Your money is always there - along
with some interest income. The bank sends a Form 1099-INT
each January showing the income you must report. Easy.
Mutual funds take more work. Sure, the dividend income is
reported on Form 1099-DIV. Gains, however, may come in two
different forms:
1. Capital Gain Distribution.
This means the fund manager sold some of the fund's stock
at a profit. The profit is not paid to the investors.
It's used to buy some other stock. That's how a fund grows.
Problem - you are taxed on this gain, even though you don't
receive any money. Tax law says it's a long-term capital
gain, even if you invested just a few weeks ago. Of course,
you get the low tax rates mentioned above.
2. Gain/Loss Upon Sale. When
you sell some or all of your shares you must report the sale.
Your cost for the original shares (including any commission) is
compared with what you receive upon sale (less any commissions
paid) to measure the gain or loss. If you have held the
shares for more than one year those extra-low tax rates mentioned
above will apply.
Full Details Needed. A
full history of your investment is needed to measure your gain.
Suppose you invested $1,000 a few years ago, and now sell
for $1,400. You might think your "profit" or
"gain" is $400. But, what about capital gain
distributions. Likely you have nearly $400 of such
distributions over time - that's why the fund is now worth an
extra $400. You already paid tax on the $400.
You have no gain or loss.
Broker Often Helps. Today
most brokers and mutual fund companies keep these records for you.
They send a "Statement of Realized Gain/Loss" when you
sell. IRS would like them to report your gain/loss directly
to them. This is all well and good - until you change
brokers. How can the new broker know your investment
history? If you invest using an on-line account, the
information can be found in the "My Account" section,
but many folks don't know how to use the feature. Keep
records!
Reinvesting Dividends. This
is the most popular form of investing. To maximize growth,
the fund offers to use your dividends to buy more stock. Now
the records are a serious chore. You made a buy when you
started, but you buy more stock every time there's a dividend -
often it's every single month! After a few years
there are dozens of purchases to track. Thank goodness the
brokers offer to provide a statement of your gain/loss. Don't lose
it!!!
Hybrid Cars - Some Credits
To Disappear
More and more hybrids qualify for up to $3,400 in tax credits.
Problem - Toyota's credits will end in September.
Gasoline prices continue to rise. Hybrid car sales increase just
as rapidly. These vehicles feature both a gasoline engine
and an electric motor - plus a higher price tag.
Tax credits help cut the cost, but the credits' days are numbered.
Credits Limited. If your tax bill is low,
the credits can only reduce it to zero. The extra credit is
lost. Also, your credit can be lost if you run into the
Alternative Minimum Tax. Call me before you buy - I may be
able to tell whether the credit is available.
Toyota Credits To Decline. IRS has approved
more than 35 models for the credits so far. Ask your car
dealer, or check at the IRS website. In theory, the credit
can be as large as $3,400. In fact, Toyota Prius has the
highest credit so far at $3,150. However, Prius's credit is
already less, and soon will be gone. Credits decline after
more than 60,000 qualified vehicles are sold by a given
manufacturer. Toyota (who also makes Lexus) sold the
60,000th hybrid in June of 2006. For all models of Toyota
and Lexus hybrids, here's the scheduled "phase out":
Until October 2006
Full credit
Oct. '06 until Apr '07
50% credit
Apr '07 until Oct '07 25%
credit
Starting October 1, 2007
No credit
For April 1 through September 30 of 2007, the Toyota credits are:
$787.50 - Toyota Prius
$650 - Highlander Hybrid
$550 - Lexus RX 400h
$387.50 - Lexus GS45oh
The numbers were twice this size for purchases earlier in 2007.
Ford, GM, Honda, Mazda, and Saturn all have vehicles qualifying
for varying amounts of credit. None have reached the
60,000-vehicle level to date.
I Get Questions
Here are a few questions that pop up over and over again.
Q Roth IRA. I had to take some money from
my Roth IRA. I'm only 51 years old. Will there be a
tax, or penalty, or both?
A Perhaps Neither. A Roth IRA has a
peculiar "layering" of the dollars within it, much like
a cookie jar. The first dollars you take out are deemed to
be the ones you contributed. You got no tax break when you
contributed, so there is no tax or penalty on these dollars.
The second layer of money is any that you "converted"
from traditional IRA to Roth IRA. You already paid the tax,
and won't be taxed again, but a 10% penalty applies unless the
conversion was more than 5 years ago. The bottom layer is
the growth money. Take any of these dollars and both income
tax and penalty (since you are not yet 59 1/2) will apply.
Q Closed Business. I shut down my business
last year, but paid the last of the expenses this year. May
I deduct these?
A Very Likely! Assuming you were a
"sole proprietor" filing Schedule C, we'll simply file
another Schedule C and deduct the expenses. If your business was a
partnership or corporation things are more involved, but we'll
still get value from your expenses.
Q Large Medical Gift. I've heard the most I
can give to someone this year is $12,000. I just paid
$26,000 of my mother's medical expense. Do I have a problem?
A Nope! You fall under an exception.
A gift is limited to $12,000 in any year. There is an
unlimited exception for medical expense or school tuition.
The single catch is that the payments must be made to the provider
or school rather than to your mother. You may have a small
bonus - your mother might qualify as your dependent, but I'll need
more information from you.
Q Charity From Inheritance. My mother
passed away this year. I donated her furniture to a local charity.
Do I get a deduction?
A Depends. We need to know who made
the contribution. I realize you did this, but who did the
furniture belong to? Was it your Mother's estate or
trust making the donation? If so, the deduction is
not yours. If the furniture was now yours (that is, you inherited
it), you may definitely claim a deduction for its fair market
value.
Q Forgot a Stock Sale. I just realized that
I forgot to report a small stock sale on my last return. The
sale caused a tiny $20 loss. Is it worth worrying about this?
A We Probably Need to Amend Your Return. The
$20 loss is not important. There's another problem.
IRS receives Form 1099-B listing "gross proceeds" for
any stock sale. Since no sale appears on your return, IRS
will say the full amount may be income. If this was a
"penny stock" you bought for $50 and sold for $30, we
might be OK to ignore it. IRS is not likely to bother you
over a possible $30 of income. But, suppose you bought the
stock for $10,000 and sold for $9,980. The IRS computer will
spot you, and IRS will presume you have an additional $9,980 of
income. We can clear this up, of course. However, you
have just given IRS a chance to say "let's take a close look
at this return before we send a letter". Bad move!
You never want to invite them to inspect your tax return.
If your case is like this, I suggest we file an amended return as
soon as possible.
IRS Crackdown Coming
The "Tax Gap" - IRS Top Target. Last
year IRS concluded a massive study of 2001 income tax returns.
They wanted to measure the "Tax Gap", the difference
between the income tax we actually paid and what we should
have paid. Why did this take 5 years? Late in
2001 IRS began the National Research Program (NRP) to study our
2001 income tax returns. They randomly selected 46,000
returns for audit. The audits were thorough and
time-consuming. The NRP took 3 years to complete.
$345 Billion Shortfall. The
number is indeed large. Consider that in 2001 we paid income taxes
of just under a trillion dollars. We should have paid
another $345 billion. IRS says we should have paid over
one-third more than we did. Why? Clearly, some tax is
underreported. IRS says the largest understatements come
from self-reported items - no big surprise.
How To Fix It? IRS wants to see more
information reporting. They'd like brokers to report
gains/loss from stock sales. Even more information on W-2s.
Reporting on government contracts. And --- more and more.
They also want stiffer audits and more information on where the
errors are most likely to be found.
Tougher Audits. Early this year IRS set up
new standard for audits. We can expect more correspondence
reviews on items that do not match IRS records. Face-to-face
meetings last longer, and auditors demand more and better records.
They ask more questions than ever - probing questions aimed at
understanding spending patterns and life-style. The only
good news here is the total number of face-to-face audits will
decline a bit as more time is spent on each case.
Random Audits Return. It's been more than
10 years since IRS was forced to stop a different random audit
program. They used results to fine-tune their top-secret
computer program to identify items most likely to yield extra tax
revenue. IRS did about 2,500 of these special audits each
year. They checked every single line on the tax forms.
Folks were asked to prove why most lines are left blank!
Taxpayers complained the program was too harsh and time-consuming,
so Congress shut it down.
They're back. Same goal - learn how
well we comply with the system. The new audits are shorter, and
focus on one or two areas of the return. To gather enough
information IRS needs more audits - 13,000 each year for 3 years.
Chances you will see one - 1 in 9,000. We won't
know details until reports come in from folks who have faced the
new audits. The program is set to begin in October. It
probably will be 6-10 months before we hear any real details on
what happens at the meetings. Stay tuned.
Tips For You
Donated Property - No IRS Help. On August
16, 2006 we got a new rule on deductions for donated household
items. No deduction is allowed unless items are in
"good used condition or better". We've been
waiting for IRS help in making this determination. IRS
Publication 561, Determining the Value of Donated Property, was
re-written in April 2007. No real help. They tell us
the value of such items is far less than the price paid when new.
They say the items may have little or no market value because of
their worn condition, or they may be out of style, or no longer
useful. They do not explain "good used
condition or better". IRS says the "value
list" offered by Goodwill, Salvation Army, and other is not
an accurate valuation method. Looks like we're on our
own here. I still recommend (a) don't try to claim
deductions for junk, (2) make a fairly detailed list, with
descriptions, and (3) take some snapshots.
College Savings Programs. The new "kiddie
tax" rules at the beginning of this newsletter may scare
parents out of trying to save for a college education for a
youngster. We still have two "tax-favored"
programs that avoid the issue.
Coverdell Education Savings Accounts are
much like an IRA for education. An account is set up for a
specific child's benefit. The most one may contribute for a given
child is $2,000 per year. Also, anyone may contribute, not
just parents.
Section 529 Plans. Each
state has one of these. Many colleges also have one.
Contribution limits are much higher - over $100,000 total in most
cases.
Both plans allow income to
build up without tax. When money is withdrawn, even the
growth is tax-free if the funds are spent on the proper education
costs. There are many other differences. For a clear
and readable explanation, look at the website www.collegesavings.org.
The big news - neither program generates kiddie tax problems.
In-Home Day Care Providers. If you run a
day care center at home IRS uses an allowance for meals and
snacks. No need to keep receipts. The 2007 figures for
each meal or snack served are:
Breakfast - $1.11
Lunch or dinner - $2.06
Snacks - $0.61
You must record names of the children, hours or care, and meals
and snacks provided. The allowance often exceeds actual
costs, but you are still allowed to use it. Rates are higher
for those living in Alaska and Hawaii. Complete details are
at www.fins.usda.gov
under "Child and Adult Care Food Program".
Volunteer Work. If you do work for your
church, library, or other charitable group you are entitled to
charitable deductions for your direct contributions, but not for
your time. Direct expenses could include office or hobby
supplies, telephone or fax expense, photocopying, or the cost to
provide refreshments at meetings.
Mileage and Travel for such
work are deductible, as long as there is no significant element of
leisure or vacation involved. For out-of-town events,
include all fares, lodging and meals. Local transport
usually is just mileage. The allowance is only 14 cents per
mile for charity, but the value can add up quickly. Be sure
to make note of all the driving you do for the group, including
shopping and preparation for the events.
TAX CALENDAR
Sept. 17
3rd Quarter estimated tax payments due.
Oct. 15
Extensions to file 2006 Form 1040 expire.
Oct. 31
3rd Quarter payroll returns due.
Dec. 31 Last
chance for deductions in 2007.
Jan. 15
4th Quarter estimated tax payments due.
Make Standard Deduction Worth More by Bunching Deductible Expenditures This year, the standard deduction for married joint filers is $10,700. The magic number for single filers is $5,350, while the figure for heads of households is $7,850. If your 2007 itemized deductions are likely to be just under or over this amount, it may pay to adopt the strategy of bunching together expenditures for itemized deductions every other year, while claiming the standard deduction in the intervening years. Examples of items that often work well for this strategy include the interest on your January home mortgage payment, charitable contributions, property taxes, and state income tax payments. For example, say you’re a joint filer whose only itemized deductions are $4,000 of annual property taxes and $7,000 of annual home mortgage interest. If you prepay your 2008 property taxes by December 31, you could claim $15,000 of itemized deductions on your 2007 return ($4,000 of property taxes for this year, plus another $4,000 for the 2008 bill, plus $7,000 of mortgage interest). In 2008, you would only have the $7,000 of mortgage interest, but you can claim the standard deduction which will probably be around $11,000 after an inflation adjustment. This strategy allows you to cut your taxable income by a meaningful amount over the two-year period. You can then repeat the drill all over again in 2009 and 2010. Consider Deferring Income It may also pay to defer taxable income from this year to next year, especially if you expect to be in a lower tax bracket in 2008. For example, you can postpone taxable income by putting off client billings until late in the year so you don’t receive payment until 2008 (assuming you are a cash method taxpayer) and by prepaying deductible business expenses near year-end. Deferring income may also be helpful if you’re affected by unfavorable phase-out rules that reduce or eliminate various tax breaks (such as your itemized deductions, the child tax credit, the education tax credits, and so forth). By deferring income every other year, you may be able to substantially increase your eligibility for these tax breaks every other year. Time Investment Gains and Losses As you evaluate investments held in your taxable accounts, consider the impact of selling appreciated securities. Regular federal income tax rates for 2007 can go as high as 35%, whereas taxes on long-term capital gains (LTCGs) from 2007 sales are generally taxed at no more than a 15% federal rate. The preferential LTCG rates are only available for securities held for over one year and they expire after 2010. Therefore, it makes more sense than ever to hold appreciated securities for at least a year and a day before selling. That said, now may be a great time to cash in some long-term winners to benefit from the historically low tax rate. However, if you expect to be in the 10% or 15% bracket for regular income taxes next year, you might benefit from postponing LTCGs until then. Why? Because LTCGs will be taxed at 0% to the extent they fall within the income limits for the lowest two regular income tax brackets. Obviously, 0% is the best tax rate you’ll ever see! For 2008, you should be in this sweet spot (where LTCGs will be taxed at 0%) if your taxable income (your income reduced by all your deductions and exemptions) doesn’t go over about $64,000 for joint filers, $43,000 for heads of household, and $32,000 singles. Selling some loser securities (currently worth less than you paid for them) before year-end can be a good idea too. The resulting capital losses will offset capital gains from other sales this year (including short-term gains from securities owned for one year or less). If capital losses exceed capital gains, the excess losses can be used to shelter up to $3,000 of your high-taxed ordinary income from salaries, bonuses, self-employment, and so forth ($1,500 if you’re married and file separately). Depending on your exact situation, you could actually collect greater tax savings by triggering capital losses during a year in which you have minimal or no LTCGs, so that the losses will offset higher taxed ordinary income. That could be next year rather than this year. Call us if you want help in identifying your tax-smart options. Kiddie Tax Alert: Will Your Child Be 18 or Older at Year-end? When the dreaded Kiddie Tax hits part of your child’s unearned income (typically from investments), it gets taxed at your higher marginal rate rather than at your child’s lower marginal rate. For 2007, the Kiddie Tax won’t affect a child who is age 18 or older as of year-end. Next year, however, the Kiddie Tax can hit part of the unearned income of a child who will be age 18 and a student who will be age 19–23 as of 12/31/08 if the child earned income (such as, wages) for the tax year doesn’t exceed one-half of his or her support. As you can see, your child could be exempt from the Kiddie Tax this year (because he or she will be 18 or older at year-end), but not next year (because he or she will be a student age 19–23 without sufficient earned income). In this scenario, consider having your child trigger some taxable gains and income this year. They will be taxed at your child’s lower rate. Next year, that might not be true due to the new Kiddie Tax age rules. Keep in mind that, for this year, the Kiddie Tax only hits unearned income in excess of $1,700. The threshold for next year will probably be higher due to an inflation adjustment. Also, the student’s earned income is not subject to this tax. Consider Giving Appreciated Securities to Younger Family Members A great way to reduce the tax hit on an appreciated security is to give it your child or grandchild. The child can hold the security until a year when the Kiddie Tax doesn’t apply and then sell. (Take care to avoid the new Kiddie Tax rules that will kick in next year.) The resulting capital gain may well be taxed at 0% if the sale takes place in 2008–2010 (assuming the current rate structure is left in place). For example, in 2008, the 0% LTCG rate will apply if the child isn’t subject to the Kiddie Tax and his or her taxable income doesn’t go over about $64,000 for joint filers, $43,000 for heads of household, and $32,000 singles. Remember that giving the security to your child is considered a gift. However, you can use your annual $12,000 gift tax exclusion to shelter the transaction from any gift tax. For larger gifts, you can use up part of your $1 million lifetime gift tax exemption to avoid any gift tax hit. However, dipping into your $1 million exemption could result in a higher estate tax bill after you die. Take Advantage of Favorable New Provisions Several taxpayer-friendly changes kicked in this year. They include the following.
Take Advantage of Expiring Tax Breaks before They Become History As the tax law currently reads, a host of valuable breaks are scheduled to expire at the end of this year. While the odds are good that some, or even most, of them will be extended by future legislation, don’t bet the farm on it. The prudent course is to take action before year-end to cash in on breaks that are meaningful to you or your business. Here’s a brief rundown on expiring provisions (this is not a complete list).
Watch for These Unfavorable Changes Several anti-taxpayer changes also kicked in this year or in the middle of last year when you might not have noticed. They include the following:
Don’t Forget about Your Estate The current federal estate tax exemption is $2 million. It’s scheduled to increase to $3.5 million in 2009 and then be completely repealed in 2010—but just for that one year. It now seems quite clear that if the promised repeal ever happens at all, it will just be for 2010. The more likely scenario is that we will continue to have a federal estate tax for 2010 and beyond, but possibly with a somewhat larger exemption than the current $2 million figure. Therefore, planning to avoid or minimize the federal estate tax should still be part of your overall financial game plan. Whittling your estate down by making annual gifts continues to be a tax-smart strategy. If you have some favorite relatives or unrelated persons, you can give each of them up to $12,000 this year. Your spouse can do the same. These gifts will reduce your estate tax exposure without any adverse gift tax effects. Making multiple gifts over multiple years can dramatically reduce your exposure. So, the sooner you start an annual gifting program, the better. Contact us for more information on the best ways to avoid estate taxes. Small Business and Work Opportunity Tax Act of 2007 In late May, Congress passed yet another major new tax law. This one is called the Small Business and Work Opportunity Tax Act of 2007 (the Act). The president signed it into law on May 25. The stated purpose of the new legislation was to provide small business owners with tax relief to help offset scheduled increases in the federal minimum wage. However, the Act also includes "revenue raisers" (better known as tax increases). This Tax Tidbit briefly summarizes the most important tax changes. Unfavorable New Kiddie Tax Rules If the Kiddie Tax applies to your child, part of his or her unearned income (typically from investments) will be taxed at your higher marginal federal rate rather than at your child’s lower rate. For 2008 and beyond, the Kiddie Tax can potentially come into play until the year during which a child turns 24. It finally cuts out for that year and for all subsequent years. More specifically, for 2008 and later years, the Kiddie Tax applies only when all of the following four requirements are met. The first three requirements are the same as before the new law. The fourth requirement (the one having to do with the child’s age) was changed. 1. Living Parent Requirement. One or both of the child’s parents are alive at year-end and in a higher marginal federal income tax bracket than the child. (Since you are reading this letter, this first requirement is probably met.) 2. Filing Requirement. Your child doesn’t file a joint return for the year. 3. Unearned Income Requirement. Your child’s unearned income for the year exceeds the annual threshold. For both 2006 and 2007, the threshold is $1,700. For 2008, it may be higher due to an inflation adjustment. If your child’s unearned income doesn’t exceed the threshold, the Kiddie Tax doesn’t apply. If your child’s unearned income exceeds the threshold, only the amount in excess of the threshold is hit with the Kiddie Tax. That means the excess income gets taxed at your higher marginal rate. 4. Age Requirement. Your child is—
Liberalized Section 179 Instant Deduction Rules Under the Section 179 rules, many small businesses can immediately write off the entire cost of equipment and software additions in the year of acquisition. The Act extends the current very favorable Section 179 deduction rules for one more year—through tax years beginning in 2010. In addition, the Act makes the rules even more generous starting with tax years beginning in 2007 (this year) by increasing the maximum Section 179 deduction to $125,000 (up from $112,000). For 2008–2010, the $125,000 amount will be indexed for inflation. Note: Unless Congress takes further action, the maximum Section 179 deduction will revert back to only $25,000 after 2010. Liberalized Rules for S Corporations The Act makes the following favorable changes (among others) to the S corporation tax rules.
Other Revenue Raisers (Tax Increases) In addition to the unfavorable Kiddie Tax changes, the Act includes (among others) the following additional revenue raisers (otherwise known as tax increases).
MIXING BUSINESS & PLEASURE WITH TRAVEL Although business is business and pleasure is pleasure, the world rarely adheres to absolutes. Thus, this time of year you may want to mix some vacation days with your business travel. With a little planning, you can get Uncle Sam to subsidize your downtime. Here are the strategies for doing just that. Combine Business and Vacation Plans for Domestic Travel If you go on a business trip within the U.S. and add on some vacation days, you know you can deduct some of your expenses. The only question is how much. First, let’s cover just the pure transportation expenses. By this, we mean the costs of getting to and from the scene of your business activity, which includes travel to and from your departure airport, the airfare itself, baggage tips, cabs to and from the destination airport, and so forth. Costs for rail travel or to drive your personal car also fits into this category. The bottom line is your domestic transportation costs are 100% deductible as long as the primary reason for the trip is business rather than pleasure. On the other hand, if vacation is the primary reason for your travel, none of your transportation expenses are deductible. The IRS doesn’t specify how to determine if the primary reason for domestic travel is business. Obviously, the number of days spent on business versus pleasure is the key factor. We can look to the rules covering foreign travel for guidance on this issue. They say your travel days count as business days, as do weekends and holidays if they fall between days devoted to business and it would be impractical to return home. "Standby days," when your physical presence is required, also count as business days, even if you’re not called upon to work on those days. Any other day principally devoted to business activities during normal business hours is also counted as a business day, and so are days when you intended to work but couldn’t due to reasons beyond your control (local transportation difficulties, power failure, etc.). For domestic trips, you should be able to claim business was the primary reason for a sojourn whenever the business days exceed the personal days. Be sure to accumulate proof about this and keep the proof with your tax records. For example, if your trip is made to attend client meetings, log everything on your daily planner and copy the pages for your tax file. If you attend a convention or training seminar, keep the program and take some notes to show you attended the sessions. Once at the destination, your out-of-pocket expenses (lodging, hotel tips, 50% of meals, seminar and convention fees, cab fare, etc.) for business days are fully deductible. Expenses for personal days are nondeductible (except in the "Saturday Night Stayover" situation covered later in this letter). Example: You are a sole proprietor. You arrange a business meeting with an important client in San Francisco on Wednesday morning. You fly out Sunday evening and spend all day Monday sight-seeing. Tuesday you spend most of the day preparing for the meeting, attend the powwow the next morning, take the client to lunch, and return home Wednesday night. So, Sunday, Tuesday, and Wednesday count as business days. The business meeting obviously necessitated the trip, and you clearly didn’t spend an unreasonable amount of time on personal activities. Therefore, you can deduct your airline tickets, plus your lodging for Sunday and Tuesday nights, 50% of your meals for Sunday, Tuesday, and Wednesday, your other out-of-pocket expenses for those days, and 50% of the cost of lunching with your client. Maximizing the Tax Benefits of a Saturday Night Stayover A great way to maximize deductions for the personal portions of a trip is with a Saturday night stayover that reduces the overall cost of the trip. If you can show staying the extra day or two costs less (or no more) than coming back home immediately after the business meeting is over, the IRS allows you to deduct your additional meal and lodging expenses (subject to the 50% rule for meals) for the extra day(s). Naturally, you still must have a dominant business purpose for making the trip in the first place. Be sure to document that your airfare savings equaled or exceeded the out-of-pocket costs of staying the extra day(s). Keep the proof with your tax records. Example: You have a business meeting in New York on Monday morning. You and your spouse fly into town Saturday morning and spend the weekend seeing the sights in the Big Apple. Your round trip airfare is only $400 versus $1,200 if you came in Sunday night and left Monday. In this situation, Saturday is a personal day since you would normally fly in Sunday. No problem. As long as your meal and lodging expenses for Saturday are no more than $800, you can write-off your whole trip (subject to the 50% rule for meals). Of course, you generally can’t deduct the additional costs for your spouse (his or her airfare and meals and any extra charges for having two people instead of one in the hotel room), and you can’t deduct purely personal expenses like show tickets and baseball games. Still, this is a great deal tax-wise. Deducting Foreign Travel Costs When you travel outside the U.S. primarily for business reasons, the general rule is that you must allocate all your travel expenses, including transportation, between business and personal. However, there are two big exceptions, and you often can plan ahead to take advantage of them. You can deduct 100% of your transportation expenses if you meet either of the following rules:
Even if you don’t qualify for either of the above two exceptions, you (or, more likely, your employer) can still deduct 100% of your transportation costs if you’re traveling under a reimbursement or travel allowance arrangement and you’re not a managing executive of the company or related to your employer. And finally, in sort of a catchall provision, 100% of your transportation costs to foreign destinations are deductible if you can prove a personal vacation was not a consideration in choosing to make the trip. If 100% of your transportation expenses aren’t deductible under any of the above rules, the business percentage of your transportation costs are still deductible—assuming the trip is primarily for business. To calculate the business percentage, divide the days spent principally on business activities by the total number of days outside the country, counting departure and return days. The travel days count as business days, just as the other types of days are considered business days for purposes of the one-week rule and 25% rule. You can also deduct the out-of-pocket expenses allocable to your business days (subject to the 50% rule for meals). Example: On Thursday, you fly to Milan, Italy for customer meetings on Friday and Monday. You vacation the following Tuesday through Friday and return home Saturday. The two travel days, the two meeting days, and the weekend days in between count as business days. However, the four vacation days amount to 40% of your time, so you fail the 25% test. Therefore, you must allocate your airfare between business and personal. You can deduct 60% of your airfare, plus your out-of-pocket expenses for the six business days. Example: Same as above, except this time you have only two vacation days (20% of your total days). Remember, the weekend days between your business meetings also count as business days. Now you can deduct 100% of your airfare because you pass the 25% test. You can also deduct your out-of-pocket expenses for the eight business days. Example: Same as above, except this time you return home on Thursday, three days after concluding your business meetings. Now, your trip is considered to last only a week (the departure day doesn’t count). So, you can deduct 100% of your airfare under the one-week rule. You also deduct your out-of-pocket expenses for all the business days. Travel to Attend Foreign Conventions If the reason for a trip outside North America is to attend a business convention directly related to your trade or business, you may qualify for deductions. However, you must follow all of the above foreign travel rules plus show it was just as reasonable for the meeting to be held on foreign soil as in North America and that the time spent in business meetings or activities was substantial when compared to that spent sight-seeing and other personal activities. Otherwise, you can only deduct the registration fees and other costs directly related to business while on your trip. Also, regardless of the location, you cannot deduct travel costs to attend investment or financial planning conventions and seminars. Fortunately, the stricter rules for foreign conventions are inapplicable in many cases because the definition of "North America" for this purpose is very liberal. It includes Canada, Mexico, Puerto Rico, the U.S. Virgin Islands, American Samoa, the Northern Mariana Islands, Guam, the Marshall Islands, Micronesia, Palau, Netherlands Antilles, Bahamas, Aruba, Antigua, Barbuda, Barbados, Bermuda, Costa Rica, Dominica, Dominican Republic, Grenada, Guyana, Honduras, Jamaica, Saint Lucia, Trinidad and Tobago, Midway Islands, Palmyra Atoll, Baker Island, Howland Island, Jarvis Island, Johnston Island, Kingman Reef, and Wake Island. Conventions on Cruise Ships Deductions related to conventions directly related to your trade or business that are held aboard cruise ships are limited to $2,000 per individual per calendar year. In addition, the ship must be a U.S. registered vessel, and all of its ports-of-call must be in the U.S. or its possessions. Finally, the following information must be attached to your return in the year the deduction is claimed: 1. A signed statement showing the total days of the trip (excluding travel to and from the ship), the number of hours each day spent attending scheduled business activities, and the program of the convention’s scheduled business activities. 2. A statement signed by an officer of the sponsoring organization that includes a schedule of each day’s business activities and the number of hours you attended those activities. With the current year winding down, it’s time once again to consider year-end tax planning as a way to keep more of your hard-earned money. Year-end planning changes each year due to changing tax rules, as well as changes in your own personal financial and tax situations. For 2006, there are new planning strategies resulting from the two Tax Acts Congress has passed so far this year, as well as the phase-in and expiration of some provisions of prior year Tax Acts. Here are a few tax-saving ideas to get you started. As always, you can call on us to help you sort through the options and implement strategies that make sense for you. Know Your Alternative Minimum Tax Exposure The first step in year-end planning is to see whether you might be subject to AMT this year (or next year for that matter). Taxpayers must compute their taxes under both the regular tax and AMT rules and then pay the greater of the two. The current rules encompass many unsuspecting taxpayers. However, some AMT tax relief was granted this year in the form of higher AMT exemptions for 2006. AMT greatly complicates tax planning because many great planning strategies that work in a regular tax situation have adverse consequences for AMT. Certain items can increase your risk of AMT, including exercising incentive stock options, recognizing substantial long-term capital gains, and deducting a significant amount of state and local taxes or miscellaneous itemized deductions (like unreimbursed employee business expenses). But no one is safe from AMT anymore, and planning when AMT applies is tricky because each situation is unique. Therefore, if you have any of the items mentioned or suspect AMT might be an issue, please contact us so we can help you review and plan for your particular situation. Now that we’ve addressed the AMT matter, let’s move on to a variety of tax planning strategies that normally apply to the vast majority of taxpayers—that is, those in a regular tax situation. Business Planning Expense the Cost of up to $108,000 of Business Property. The Section 179 deduction allows business owners to deduct up to $108,000 of the cost of qualifying depreciable property placed in service in 2006. Property eligible for the immediate tax write-off can be new or used and includes "off-the-shelf" computer software. (Even property purchased on the last day of the year qualifies.) However, the allowable deduction cannot exceed your business’s net income and is reduced dollar-for-dollar to the extent the amount of qualifying property placed in service during the year exceeds $430,000. If you have plans to buy a business computer, office furniture, equipment, vehicle, or other tangible business property, you might consider doing so before year-end to maximize your 2006 deductions. Paying Dividends in Lieu of Owner Salaries. If you expect to personally be in the 28% or higher tax bracket for 2006 and you own a corporation that you expect to be in the 15% income tax bracket (taxable income of $50,000 or less), you could net more cash after taxes by paying yourself some dividends in lieu of additional salary. This is because dividend income is subject to a maximum 15% tax rate, while your salary is subject to your 28% or higher tax rate, plus you and your corporation must pay payroll taxes on your salary. Any dividends paid to you must be paid to other owners as well. Thus, if there are multiple shareholders, paying dividends could alter the bottom-line cash flow reaped by the various shareholders, which may make this strategy unworkable in some situations. However, in the context of family-owned C corporations, this may be a good thing—a family recipient who is in the 10% or 15% tax brackets (which many children are) will pay taxes of only 5% on this dividend income. New Twists for Charitable Donations Another common year-end planning strategy is to increase charitable donations. However, this year offers some new twists. Tax-free IRA Distributions for Charity. Taxpayers who are age 70½ or older may temporarily (in 2006 and 2007) be able to claim tax-free treatment for otherwise taxable distributions from traditional IRAs, when the IRA money is paid out directly to a tax-exempt charity. This new "qualified charitable distribution" is subject to a $100,000 annual cap. Since the qualified charitable distribution is federal-income-tax-free, you don’t get any federal income tax deduction for the contribution. However, the income exclusion is definitely better than a deduction for seniors who might not otherwise itemize deductions. It may also pay off even if you do itemize by reducing taxable Social Security and increasing itemized deductions restricted by the adjusted gross income (AGI) limitations. Changes for Gifts of Clothing and Household Items. The Pension Protection Act of 2006 raised the bar for the quality of used clothing and household items qualifying for a charitable deduction. After 8/17/06, generally you can no longer deduct donations of used clothing and household goods unless they are in "good used" or better condition. So, no more write-offs for that "junk" piling up in your closet, attic, garage, or basement. Unfortunately, the new law doesn’t define "good used" or better condition. Fortunately, donations of used clothing and household items that are in good or better condition continue to be tax deductible and still present a great tax saving opportunity for taxpayers who itemize their deductions. Eligible household items include furniture and furnishings, electronics, appliances, linens, and similar items. However, be sure to keep a list and a photo (to help establish the item’s condition) of the donated items. You can still deduct individual items that appraise for more than $500 even if they are not in "good condition." However, this will require you to get a qualified written appraisal, which must be attached to your tax return. Reap Tax Savings with Energy Efficient Purchases Residence Credits for Energy Efficient Improvements. For 2006 or 2007, there are two new tax credits available for energy efficient improvements made to your home: 1. Nonbusiness Energy Property Credit. This credit is generally limited to a lifetime amount of $500, although other limits may also apply. Basically, the credit will equal (a) 10% of what you pay for qualified energy efficiency improvements (such as, certain energy efficient insulation, windows, doors and roofs), plus (b) 100% of what you pay for qualified residential energy property (such as, certain energy efficient heat pumps, hot water heaters or boilers, and advanced main air circulating fans) on your principal residence (no vacation homes). 2. Residential Energy Efficient Property Credit. This credit equals 30% of expenditures for the following types of equipment: (a) qualified solar water heating equipment (limited to a maximum credit of $2,000), (b) qualified electricity generating solar photo voltaic property (maximum credit of $2,000), and (c) qualified fuel cell property (maximum credit of $500 for each .5 kilowatt of capacity). The credit only applies to equipment you place in service in your personal U.S. residence, and it cannot be claimed for equipment used to heat a swimming pool or hot tub. The credit for fuel cell property is only available for your principal residence; however, the two solar credits apply to any residence (including vacation homes). You can rely on the manufacturers certification that the property qualifies for the credit. If you’re planning on making any of these improvements to your home in the near future, you’ll want to do so before the end of the year if there’s any possibility you’ll be subject to AMT this year or the next. Why? These credits can be used to offset AMT in 2006, but absent Congressional extension, they won’t be in 2007. Hybrid Vehicle Credit or Alternative Fuel Motor Vehicle (AFMV) Credit. If you are considering a hybrid vehicle or AFMV purchase in the near future, please give us a call. The IRS is constantly updating the list of vehicles that qualify for tax credits. The hybrid credits vary in amount by vehicle with the maximum credit being $3,400. The AFMV credits can be up to $4,000 per vehicle. The full hybrid credit is available only up until the end of the quarter in which the manufacturer records the sale of the 60,000th vehicle. For the second and third calendar quarters following the sale of the 60,000th vehicle, the credit is reduced to 50% of the full credit. For the fourth and fifth calendar quarters, taxpayers may claim only 25% of the full credit. No credit is allowed after the fifth quarter—so the early bird gets the worm. Education Planning 529 Plan Benefits Now Permanent. The Pension Act of 2006 made permanent the current ultra-favorable federal income tax treatment of Section 529 plans used to finance college education costs. Of particular importance, qualified Section 529 plan distributions (i.e., those used for qualified higher education expenses) will continue to be federal-income-tax-free, even after 2010 when they were previously scheduled to be taxable again. This eliminates the concern that funds distributed after 2010, when many 529 plan beneficiaries would be in college and withdrawing the plan assets for educational expenses, could be taxed. If you haven’t previously taken advantage of these plans, it may be time to reconsider them. Investment Planning Lower Tax Rates on Capital Gains. Long-term capital gains and qualifying dividend income are subject to a tax rate of only 15% for taxpayers in a regular tax bracket of 25% or higher and 5% for taxpayers in the lower regular tax brackets. Given tax rates as high as 35% for other types of income, this is quite a break. To be eligible for the lower 15% (or 5%) capital gain rate, a capital asset must be held for more than a year. So, when disposing of your appreciated stocks, bonds, investment real estate, and other capital assets, pay close attention to the holding period. If it’s less than one year, consider deferring the sale so that you can meet the greater-than-one-year period. While it’s generally not wise to let tax implications drive your investment decisions, you shouldn’t ignore them either. When selling stock or mutual fund shares, the general rule is that the shares you acquired first are the ones you sell first. However, if you choose, you can specifically identify the shares you’re selling when you sell less than your entire holding of a stock or mutual fund. By notifying your broker of the shares you want sold at the time of the sale, your gain or loss from the sale is based on the identified shares. This sales strategy gives you better control over the amount of your gain or loss and whether it’s long-term or short-term. Harvesting Capital Losses. It’s always a good idea to periodically review your investment portfolio to see if there are any losers you should sell. This is especially true as year-end approaches, since it’s the last chance to offset capital gains recognized during the year or to take advantage of the $3,000 ($1,500 for married separate filers) limit on deductible net capital losses. But, don’t forget the wash-sale rule. This rule defers your loss if you purchase a substantially identical security within the period beginning 30 days before and ending 30 days after the date of sale. Retirement Planning IRA Contributions. Don’t forget to make your traditional or Roth IRA contributions before the due date (4/16/07) of your tax return. For 2006, IRA contributions generally can be made up to the lesser of (1) $4,000 ($5,000 if age 50 or older by the end of 2006) or (2) 100% of compensation. Compensation includes wages, salaries, other amounts derived from or received for personal services actually rendered including self-employment income, and alimony. For married couples, IRA contributions up to $4,000 ($5,000 if age 50 or older by the end of 2006) can be made for each spouse if the combined compensation of both spouses is at least equal to the contributed amount and they file a joint return. The contribu |
