Tax Article - Plan Now For Tax Savings Later!

When it comes to taxes, 2006 is already off to a fast start—we have already seen one Tax Act and it looks likely that there will be more before the year’s end. All this is right on the heels of 2005, where we saw four major Tax Acts. What does all this mean to you? Despite the tax rules being in a seemingly endless state of flux, the current tax environment is about as good as its going to get. If you wait until the tax laws settle down before doing any serious planning, you may miss out on some great opportunities to reduce your overall tax burden. What’s important is to set long-term financial goals now and then update them as the tax law evolves.

Use the following ideas as a starting point to identify specific actions you can take while there is still time to take action. Some planning ideas need to be implemented before year-end to be effective for this year. With that in mind, here are some ideas to consider.

Take a Look at Your Investments

Most long-term capital gains for 2006 are taxed at a maximum federal rate of only 15%. Even better, long-term gains that fall within the 10% and 15% brackets are taxed at only 5%. Qualified dividends from most domestic corporations and many foreign firms are taxed at these same low rates. For 2006, a married joint filer can have taxable income as high as $61,300 (after reductions for personal exemptions and deductible items) and still be eligible for the ultra-low 5% rate on long-term gains and dividends. These favorable rules have several implications for you.

Holding on Longer Can Lower Your Taxes.If you hold appreciated securities in taxable accounts, owning them for at least one year and a day is necessary to qualify for the preferential long-term capital gains tax rates. In contrast, short-term gains are taxed at your regular rate, which can be as high as 35%. Be sure to consider this when evaluating your investment portfolio. Whenever possible, try to meet the more-than-one-year ownership rule for appreciated securities held in your taxable accounts. (Of course, while the tax consequences are important, they should not be the only consideration for making a buy or sell decision.)

Sell the Right Shares. Generally, when you sell stock or mutual fund shares, the shares you purchased first are considered sold first, which is good news if you are trying to qualify for the long-term capital gain rate. But, there may be situations where you’re better off selling shares that have been held a year or less rather than those held longer. Selling recently purchased shares at little or no gain (because you purchased them at a higher price) may be better than selling shares held for more than one year if that sale would produce a significant gain. Whenever you want to sell shares other than those you purchased first, you must properly notify your broker as to the specific shares you want sold.

Sell Losers with Tax Savings in Mind.It’s also important to consider the best time to trigger capital losses by selling losers held in your taxable investment accounts. Capital losses are used to offset any capital gains for the year. Specifically, short-term losses first offset short-term gains; then long-term gains. Long-term losses first offset long-term gains; then short-term gains. If total losses exceed total gains, the excess can be used to offset up to $3,000 ($1,500 if married filing separately) of ordinary income.

To the extent you have long-term gains for this year, triggering capital losses before year-end may produce a tax benefit of only 15% (or possibly only 5%). 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 long-term gains. That could be next year. On the other hand, triggering capital losses this year to offset short-term capital gains is almost always a good idea. Call us if you have questions.

Warning: Beware of the wash-sale rule when considering sales to trigger tax losses. You cannot deduct the loss if you purchase substantially identical securities within the period beginning 30 days before and ending 30 days after the date of the loss sale.

Consider Giving Appreciated Securities to Your Children. A great way to reduce the tax hit on an appreciated security is to give it your child (or grandchild). The child (or grandchild) can hold the security until the year she turns 18 and then sell without being subject to the “kiddie tax.” Assuming the current tax rate structure is left in place, the resulting capital gain will probably be taxed at only 5% if the stock is sold this year or next. If sold in 2008 through 2010, the tax rate will likely be 0%. Remember, your child’s lower tax rates won’t apply if the stock is sold before the year she turns 18 (until this year the applicable age was 14) Also, 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 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.

Don’t Pass up Tax-free Income

Enjoy Tax-free Rents. The law currently allows you to rent a residence for up to 14 days annually without having to report the income (or being able to deduct the rental-related expenses). Renting your vacation home or even your regular residence to a coworker or friend for a couple of weeks could be a nice deal for both of you.

Excluding rental income under this rule has no effect on your ability to claim an itemized deduction for property taxes and mortgage interest paid in connection with the house. However, going over the 14-day limit causes all the rental income to be taxable, not just the portion attributable to Day 15 and later.

Take Advantage of Retirement Plan Options. The earnings on most retirement accounts are tax-deferred. (With Roth IRAs, they’re normally tax-free.) Thus, the sooner you fund such an account, the quicker the tax advantage begins. If you can come up with the cash now, there’s no need to wait until year-end or the April 15 tax filing deadline to make your 2006 contributions.

However, if your employer offers a 401(k) or SIMPLE-IRA plan at work, you’ll probably want to contribute enough to that plan to receive a full employer match before making an IRA contribution. If you can’t take advantage of an employer’s retirement plan because you’re self-employed, make this the year you resolve to set up a retirement plan if your business doesn’t already have one.

Make Sure You Qualify to Exclude Principal Residence Gain. Gains up to $500,000 on the sale of a principal residence are completely tax-free for married couples who file joint returns. A still-generous $250,000 is the limit for singles and married individuals filing a separate return. To qualify for this break, you normally must have owned and used the house as your principal residence for a total of at least two years in the five-year period prior to the sale. You’ll definitely want to take these rules into consideration if you’re planning on selling your home.

Invest in Tax-free Securities. The most obvious source of tax-free income is tax-exempt securities, either owned outright or through a mutual fund. Whether these provide a better return than the after-tax return on taxable investments depends on your tax bracket and the market interest rates for tax-exempt investments. These factors change frequently, so it’s a good idea to periodically compare taxable and tax-exempt investments. In some cases, it may be as simple as transferring assets from a taxable to a tax-exempt fund.

Making Good Use of the Available Deductions

Make the Standard Deduction Work for You. The tax rules allow you a deduction equal to the greater of your itemized deductions or a flat amount known as the standard deduction. Thus, itemized deductions only lower your taxable income to the extent they exceed the standard deduction. For 2006, the standard deduction is $10,300 for married taxpayers filing joint returns. If you are single, the amount is $5,150 (unless you qualify as head of household, in which case it’s $7,550). If you’re at least 65, you receive an additional standard deduction of $1,000 if you’re married (plus another $1,000 if your spouse is also 65 or older) or an additional $1,250 if you’re single. In 2007, these amounts will all likely be slightly higher after adjustment for inflation.

If your total itemized deductions are normally close to whichever standard deduction applies to you, you may be able to leverage the benefit of your deductions by bunching them in every other year. This allows you to time your itemized deductions so that they are high in one year and low in the next. You claim actual expenses in the year they are bunched and take the standard deduction in the intervening years. (Deductions you may be able to shift between years include your January 1 mortgage payment, state and local income taxes, property taxes, and charitable contributions.)

Monitor Personal Use of Vacation Homes. Renting a vacation home can help offset the cost of owning and operating the property. However, the tax rules generally limit your rental deductions if you personally use the property during the year for more than the greater of 14 days or 10% of the rental days. Personal use days include any day when the property is leased at less than a fair market rental and normally include all the days the property is used by family members or other owners. By monitoring personal use for the rest of the year, you may be able to avoid the limitation on rental expenses and report a tax loss for the year.

Increase Participation in Otherwise Passive Activities. The so-called passive activity rules prevent many taxpayers from currently deducting losses from business activities in which they do not “materially participate.” These losses are typically from partnerships in which they are not personally involved or do not participate to the extent required by the tax rules. Taxpayers can normally satisfy any one of several tests (e.g., spending more than 500 hours per year in day-to-day operations, performing substantially all the work in the activity, or completing more than 100 hours per year and more than anyone else) to meet the material participation standard. If you’re expecting a current-year loss from an activity (or have a loss carrying over from an earlier year) with proper planning between now and year-end, you may be able to increase your involvement in the activity and thus avoid having the loss disallowed under the passive activity rules.

Ideas for Your Business

Maximize the Domestic Producer Deduction. For 2006, businesses (incorporated or not) can deduct (for both regular and alternative minimum tax) up to 3% of their qualified domestic production activities income. “Qualified domestic production activities income” is essentially the net income from certain business activities conducted in the U.S. (or its possessions). In addition to traditional manufacturing, the deduction is available for income from selling personal property that the business manufactures, grows, produces or extracts; construction; producing software, film, or videotape; farming; and processing agricultural products and food.

If your business is engaged in one of these qualified activities, the deduction can be significant. But, there is one catch—the deduction can’t exceed 50% of the wages paid to employees (W-2 wages) for the year. This could be a problem for businesses that pay little or no wages. Many sole proprietorships do not pay the owner a salary. Likewise, S corporations often pay owners relatively small salaries to minimize their payroll taxes. This means that, after applying the W-2 wages limit, their deduction for U.S. production activities could be significantly reduced.

Business owners who are eligible for the domestic producer deduction should look at their compensation policies and consider increasing owner salaries to ensure their deduction is not scaled back. Also, because the deduction is based on net income from qualifying activities, it would be a good idea to take a look at your accounting system to be sure it will allow you to determine the income from qualifying activities as well as expenses directly related to or allocable to that activity. If not, some tweaking of the accounting system may be in order.

Consider Reimbursing Employees’ Out-of-Pocket Business Expenses. Employees normally receive little or no tax benefit from paying business expenses because they’re deductible only to the extent they exceed (a) 2% of the employee’s adjusted gross income and, (b) when combined with the employee’s other itemized deductions, the employee’s standard deduction. Thus, for example, an employee whose compensation is $2,000 higher than it would otherwise be because he’s expected to incur about $2,000 in unreimbursed business expenses isn’t being fairly compensated for the out-of-pocket expense. After paying income and payroll taxes on the $2,000, he has less than this amount to spend on the business expenses. A better approach would be for the company to reimburse at least part of the employee’s business expenses (and renegotiate the employee’s compensation accordingly). Because properly documented expense reimbursements aren’t considered compensation, both the company and the employee save payroll taxes on this arrangement. Plus, the employee comes out better on income taxes as well.

Consider Selling Rather Than Trading-in Vehicles Used in Business. Although a vehicle’s value typically drops fairly rapidly, the tax rules limit the amount of annual depreciation that can be claimed on most cars and light trucks. Thus, when it’s time to replace the vehicle, it’s not unusual for its tax basis to be higher than its value. If you trade the vehicle in on a new one, the undepreciated basis of the old vehicle simply tacks onto the basis of the new one (even though this extra basis generally doesn’t generate any additional current depreciation because of the annual depreciation limits). However, if you sell the old vehicle rather than trading it in, any excess of basis over the vehicle’s value can be claimed as a deductible loss to the extent of your business use of the vehicle.

Employ Your Teenagers. If you are self-employed, employing your children (or grandchildren) can lower your family’s overall tax bill. By paying your child wages, you effectively shift income from a higher bracket taxpayer (you) to a lower bracket one (your child). Because the income is considered earned income to your child (as opposed to unearned income like dividends and interest), it can be offset by his or her standard deduction ($5,150 for 2006). To the extent the income is taxed, a low 10% rate will generally apply to all or part of it. Thus, the family’s income tax savings can be significant since some of the income normally taxed at your rate might escape taxes entirely or be taxed at your child’s low rate.

There can also be payroll tax savings when employing your child. Wages paid to a child under the age of 18 from a parent’s sole proprietorship are exempt from social security and unemployment taxes. Thus, depending on your total self-employment earnings, your tax savings can also include up to an additional 15.3% of the amount of wages you pay to your child since you avoid paying self-employment tax on that amount and no payroll taxes are due on the wages.

Employing your teenager has the side benefit of enabling him or her to make an IRA contribution. With earned income (received from your business or elsewhere), your child is eligible to make a 2006 contribution to a traditional or Roth IRA, up to the lesser of $4,000 or earned income. Generally, the Roth IRA is the better choice because although no deduction is allowed for the contribution, the earnings will never be taxed if your child does not withdraw them until at least age 59½. That’s a long time for the funds to grow. And if you choose, you can gift your child the funds to make the allowable contribution.

Before leaving this subject, it’s important to point out two things. First, you must make sure that any wages you pay your child are reasonable based on the work performed and the child’s age. Second, if your child is in college or is going to college soon, shifting income to him or her can have a detrimental impact on your family’s eligibility for need-based financial aid.

Set Up a Retirement Plan. If your business doesn’t offer a retirement plan, now might be the time to take the plunge. Current retirement plan rules allow for significant deductible contributions. Even if your business is only part-time or something you do on the side, contributing to a SEP-IRA or SIMPLE-IRA can enable you to reduce your current tax load while increasing your retirement savings. With a SEP-IRA, you generally can contribute up to 20% of your self-employment earnings, with a maximum contribution of $44,000. A SIMPLE-IRA, on the other hand, allows you to set aside up to $10,000 plus an employer match that could potentially be the same amount. In addition, if you’re age 50 or older by year-end, you can contribute an additional $2,500 to a SIMPLE-IRA.

Watch out for the Alternative Minimum Tax

While recent tax law changes have done a lot to reduce your regular federal income tax bill, they didn’t do nearly as much to reduce the odds that you’ll owe the alternative minimum tax (AMT). Therefore, it’s critical to evaluate all tax planning strategies in light of the AMT rules before actually making any moves. Because the AMT rules are so complicated, you may want our assistance here. We stand ready to help!

Dealing with Estate Tax Uncertainty

As you probably know, Congress has considered over the last few years a number of bills repealing the estate tax. So far the votes have not been there for it and it’s looking less and less likely that they will be. However, absent outright appeal, there continues to be a good chance the estate tax exclusion amount (currently $2 million per person) will be raised, perhaps substantially. In any case, there’s a good chance that that far fewer of us will eventually be subject to the federal estate tax. Until things are settled, we recommend that you avoid transfers subject to gift tax (since there is a possibility that you will be able to transfer that property free of estate tax in the future). That said, there are many estate planning moves made for nontax reasons. For example, you may want to make gifts to children or grandchildren just because you love them. As long as you don’t trigger any gift tax, there’s no reason not to do so. Gifts up to $12,000 per donee can be made in 2006 and sheltered from gift tax with your annual exclusion.

If you are interested in larger gifts, you can still do so without incurring gift tax, but only to the extent you haven’t already used your $1 million lifetime exclusion for gifts. Likewise, you may want to transfer assets to trusts (either during your lifetime or at your death) for a variety of reasons, such as professional management, asset protection, or the ability to keep the trust corpus intact. The potential repeal (or scale-back) of the estate tax should not affect those plans. However, as mentioned earlier, at this time we recommend that you avoid any transfers that trigger a gift tax.

This letter is intended to give you just a few ideas to get you thinking about planning for 2006. We would like to discuss your situation in detail to see how these and other planning ideas can be used to reduce your tax bill. Please don’t hesitate to call us if you would like more details or would like to schedule a tax planning strategy session.

Find out how our expertise in tax and accounting adds value to your business. Email us or call us at 1 (888) 875-9770.

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