November, 2007
To Our Clients and Friends,
As 2007 winds down, it is again time to contemplate year-end planning strategies that can help minimize your tax bill. This will be more challenging than usual because of uncertainty related to several pieces of proposed legislation. One of those bills, the “Temporary Tax Relief Act of 2007” (2007 TTRA) will provide AMT relief and extend a number of important tax breaks otherwise set to expire at the end of 2007. The 2007 TRRA has been passed by the House of Representatives, but must still be approved by the Senate before being sent to the President. Since Congress has started their Thanksgiving break, we won’t know the exact details of applicable 2007 and 2008 tax law until at least December. Even the IRS has refused to update its forms to incorporate some of the Act’s provisions despite Congressional assurances that those provisions will be included in the final version of the bill.
Also introduced in both the House and the Senate is a “technical corrections” bill that would modify and clarify several existing tax laws. Once again, there are changes that could impact 2007 tax filings, but we won’t know the final details (or if the law passes) for a little while.
With that background, let’s begin to look at some tax planning ideas, while keeping an eye on the potential impact of AMT.
YEAR END PLANNING CONSIDERATIONS
Individual Planning
Assess Your Alternative Minimum Tax (AMT) Exposure: The dreaded AMT continues to impact more taxpayers every year as income levels rise with inflation. While Congress continues to discuss a permanent repeal of the AMT, such action would require significant additional tax reform to offset the resulting lost revenue. Meanwhile, current law would subject millions more to AMT in 2007 than 2006 due to expiration of last year’s “AMT Patch.” The 2007 TTRA would alleviate AMT concerns for millions by raising the 2007 AMT Exemption at least to 2006 levels. Watch out, however, because Congress’ tardiness means that the final legislation won’t be in place before the IRS publishes what is sure to be just the first version of its 2007 forms. Tax preparation software will also have to be updated to incorporate the new law. Make sure that your 2007 returns are prepared using the proper statutory amounts.
Kiddie Tax Alert - Kiddie Tax to Hit Harder in 2008: As we discussed in our August letter, when the 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 will affect a child who is age 17 or under as of year-end. Next year is even worse, however, as 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 12/31/2008, if the child’s earned income (such as wages) for the year does not exceed 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 investment 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 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, earned income, such as salaries and wages, is not subject to this tax.
Stricter Charitable Contribution Rules: For 2007, you cannot deduct any cash contribution unless you retain either a bank record that supports the donation (such as a cancelled check or credit card receipt) or a written statement from the charity that meets tax-law requirements. For cash donations of $250 or more, consistent with prior law, a bank record is not enough. You must obtain a charity-provided statement that meets tax-law standards. Also, you cannot deduct donations of used clothing and household items unless they are in good used condition or better. This includes furniture and furnishings, electronics, appliances, linens and the like. Be sure to keep a list of donated items along with a photo to help establish the item’s condition. For non-cash donations of greater than $5,000, you must obtain an appraisal to substantiate your deduction (except when giving publicly traded securities).
Charitable Donations from IRAs: If you’ve reached age 70 ½, you may arrange to transfer up to $100,000 of otherwise taxable IRA money (including your required minimum distribution) to specified tax-exempt charities. Such a transfer is federal-income-tax free to you, but you don’t get to claim it as an itemized deduction on your Form 1040. However, the tax-free treatment equates to a 100% write-off, and you don’t have to itemize your deductions to get it. Additionally, as a write-off, it may reduce your Social Security benefits subject to tax. Be careful, to qualify for this special tax break, the funds must be transferred directly from your IRA to the charity. This favorable provision will also expire at the end of the year unless the 2007 TRRA is passed in its current form (which would extend the benefit to 2008).
State Sales Tax Deduction: The optional deduction for state and local sales and use taxes (in lieu of deducting state income taxes) is another item currently set to expire at the end of this year. The 2007 TTRA extends this provision through 2008. However, if you live in a state with low or no state income tax (such as Florida) and plan on making big ticket purchases (such as a new car or boat) in the near future, you may want to go ahead and make them before year-end to cash in on the sales tax break for 2007.
Consider Filing Protective Ohio Refund Claims: The US Supreme Court has agreed to hear a case that would eliminate the State of Ohio’s ability to tax the interest income of non-Ohio municipal bonds. If you have significant non-Ohio municipal interest income ($1,000 of interest income equates to about $70 of Ohio tax) you may want to consider filing protective refund claims to lock in the refund potential until the case is resolved. For 2007 and later originally filed returns, we believe that non-Ohio municipal interest must be included in Ohio taxable income pending the Supreme Court decision.
Tax Credits for Going Green:
ü 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, window, 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). If you’re going to go green, now may be the time – unless extended by Congress, this credit won’t apply to purchases made after 2007.
ü Hybrid Vehicle Credit: The IRS is constantly updating the list of vehicles that qualify for the Hybrid Vehicle Credit, so if you are considering a hybrid vehicle purchase in the near future, please give us a call. The maximum credit for hybrids is $3,400. However, this credit is not available to offset the alternative minimum tax. It is also phased out after the manufacturer records the sale of the 60,000th hybrid vehicle. Under this rule, Lexus and Toyota purchases made after 9/30/07 are not entitled to any credit. If you are considering another manufacturer’s hybrid, you may want to act fast before it reaches this limit (assuming AMT is not an issue).
Business Planning
Expense $125,000 of Property Additions Today! The §179 deduction allows business owners to deduct up to $125,000 of the cost of qualifying depreciable property placed in service in 2007. 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’ net income and is reduced dollar-for-dollar to the extent the amount of qualifying property placed in service during the year exceeds $500,000. 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 2007 deductions.
Faster Depreciation for Leasehold and Restaurant Improvements: Favorable 15-year depreciation (versus 39 year) is allowed for qualified leasehold and restaurant improvements that are placed in service by 12/31/07. The 2007 TTRA would extend this through 2008, however, if your business is working on these types of improvements, you may want to try to get them done and placed in service by the end of the year.
Paying Dividends in Lieu of Owner Salaries: If for 2007 you expect to personally be in the 28% or higher tax bracket and you own a C corporation that you expect will 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. This planning must be done carefully and with consideration to IRS guidelines on “reasonable compensation” and dividends that may be required for other shareholders.
The Deduction for U.S. Production Activities is Worth More: There have been several changes to some of the detailed mechanics of computing the “Section 199” deduction, but the principle benefit to businesses that manufacture in the U.S. remains. However, the deduction amount for 2007 is now 6% of “qualified domestic production activities income”, which is double the percentage allowed in 2006. Remember, however, the deduction can’t exceed 50% of the W-2 wages paid to employees involved in the qualified activities for the year. Please call us if you would like assistance navigating the complicated rules surrounding qualifying activities and allocation of costs.
Employ Your Child (or Grandchild): Employing your children (or grandchildren) shifts income from you to them, which typically subjects the income to the child’s lower tax bracket and may actually avoid tax entirely (due to the child’s standard deduction). There are also payroll tax savings, since wages paid by sole proprietors to their children age 17 and younger are exempt from both social security and unemployment taxes. Employing your children has the added benefit of providing them with earned income, which enables them to contribute to an IRA.
When employing your child or grandchild, keep in mind that the wages paid must be reasonable given the child’s age and work skills. Also, if the child is in college or entering soon, excessive earned income may have a detrimental impact on the student’s eligibility for financial aid.
Consider Voluntary Disclosure Agreements to Minimize State Tax Exposure: State governments continue to be aggressive in attempting to impose taxes on out-of-state businesses. If you conduct business in states in which you are not filing tax returns, you may be at risk for a tax assessment. We can assist you in being proactive to determine your potential income, franchise, sales or use tax exposure. We can also help you obtain voluntary disclosure agreements with the states to help mitigate that exposure.
Beware of Changing State Tax Laws: Businesses that conduct business in multiple states need to be aware of the significant tax law changes at the state level. Two states currently undergoing significant changes are Michigan and Texas. If you conduct business in Michigan or Texas, please contact us to see how these changes might impact you.
Continued Application of the Ohio Commercial Activities Tax (CAT): Ohio tax reform continues its phase-in with the increase in CAT tax rate along with the reduction to individual income tax rates and phase-out of the personal property tax. The Ohio Department of Taxation continues to fine tune its position with respect to the numerous rules used to calculate CAT taxable sales. We would be glad to discuss any changes that relate to your business, or, you can monitor the changes yourself on the State’s website at www.state.oh.us/tax.
Estate & Trust Planning
Annual Gifts: Remember, you can gift up to $12,000 per person, per year without incurring any Gift Tax or reducing your lifetime exemption. Before the end of the year, make sure those 2007 gifts have been made to help reduce your taxable estate.
Fiduciary Tax Rates: A trust that is not required to distribute its income generally pays tax to the extent the trust has income that has not been distributed. Since the trust tax rate brackets escalate more quickly than the individual income tax brackets, it may be more tax efficient to tax trust-related income at the beneficiary level by making distributions out of the trust. Of course, any distributions must make sense from a fiduciary perspective.
Increase in Lifetime Exemption: In 2007 (and in 2008) the one time amount excludable from a person’s estate for estate and GST tax purposes is $2 million. Unfortunately, individuals can still only use $1 million of this for gifts during their lifetime. However, the increase is important since it may impact the flow of funds to your heirs depending on the wording in your will. Be sure to review that document to make certain your affairs are carried out according to your intentions.
Strategies For Every Year-End Plan
Deferring Income and Accelerating Deductions: Since it’s generally better to pay taxes later rather than sooner, look for ways to delay the recognition of income such as delaying a year-end bonus until 2008 (if your employer will agree) or using an installment sale if selling property.
On the deduction side, move charitable donations you normally would make in early 2008 to the end of 2007. Do the same with real estate taxes or state income taxes. If you own a cash-basis business, delay billings so payments are not received until 2008 or accelerate payment of certain expenses, such as office supplies and repairs and maintenance, to 2007. Of course, before deferring income, you must assess the risk of doing so. Also, keep the AMT in mind when employing this strategy.
Adjusting Federal Income Tax Withholding: If it looks like you are going to owe income taxes for 2007, consider bumping up the Federal income taxes (FIT) withheld from your paychecks now through the end of 2007 so that your total tax payments (estimated payments plus withholdings) equal at least 90% of your estimated 2007 liability or, if smaller, 100% of last year’s liability (110% if your 2006 AGI exceeded $150,000). On April 15, 2008, you will still have to pay the taxes due less the amount paid in, but you won’t owe any interest or penalties.
Alternatively, if you’re planning to take an IRA or qualified plan distribution, request that enough FIT be withheld to cover the payment shortfall. Remember, however, that the distribution will be fully taxable, and, if you are under age 59½, subject to the 10% early distribution penalty.
Manage Your AGI: Many tax breaks are only available to taxpayers with adjusted gross income (AGI) below certain levels. In addition to some education incentives (such as the previously mentioned education credits), other common AGI-based tax breaks include the child tax credit (phase-out begins at $110,000 for married couples and $75,000 for heads-of-households), the $25,000 rental real estate passive loss allowance (phase-out range of $100,000 - $150,000 for most taxpayers), and the exclusion of social security benefits ($32,000 threshold for married filers; $25,000 for other filers). In addition, taxpayers with 2007 AGI in excess of $156,400 begin losing part of their itemized deductions, to the extent of 2% of the excess. Accordingly, strategies that lower your income or increase certain deductions might not only reduce your taxable income, but also help increase some of your other tax deductions and credits.
Planning for Your Investments: The beneficial maximum tax rates for long-term capital gains and qualifying dividend income will continue through at least 2010. The tax rates on these forms of income are still only 15% for taxpayers in a regular tax bracket of 25% or higher and 5% for taxpayers in the lower regular tax brackets. These favorable tax rates might make dividend-paying stocks of most domestic corporations more attractive than they were in the past when dividends were taxed at ordinary income rates. Pay special attention, however, to the holding periods required to benefit from these rates. Capital assets must be held for more than a year to receive the 15% or 5% gain rate. Dividend-paying stocks must be held 60 days during the 121 day period beginning 60 days before the stock’s ex-dividend date (90 days during a 181 day period for some preferred stocks).
Look at triggering capital losses. It’s always a good idea to 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.
Remember, 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. While it’s generally not wise to let tax implications drive your investment decisions, you shouldn’t ignore them either.
IRA Contributions: Don’t forget to make your traditional or Roth IRA contributions before the due date (4/15/08) of your tax return. For 2007, IRA contributions generally can be made up to the lesser of (a) $4,000 ($5,000 if age 50 or older by 12/31/06) or (b) 100% of compensation. For married couples, contributions of $4,000/$5,000 may 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. For the contributions to be fully deductible, the taxpayer (and spouse) may not be active participants in an employer-maintained retirement plan or must have modified AGI below a certain level ($83,000 married filing joint / $52,000 single).
Retirement Plan Distributions: If you’re age 70½ or older, you’re normally subject to the minimum distribution rules with regard to your retirement plans. Under theses rules, you must receive at least a certain amount each year from your retirement accounts. You can always take out more than the required amount, but anything less is subject to a 50% penalty on the shortfall amount. Thus, if you haven’t taken your required distribution for 2007, do so before year end to avoid a hefty penalty. If you turned age 70½ in 2007, you can delay your 2007 required distribution until April 1, 2008 if you choose. But, waiting until 2008 will result in two distributions in 2008–the amount required for 2007 plus the amount required for 2008. While deferring income is normally a sound tax strategy, here it results in bunching income into 2008, which may push you into a higher tax bracket or have a detrimental impact on other tax deductions you normally claim.
Conclusion
Tax planning is somewhat more difficult this year as it is still unclear what the final versions of year-end legislation will look like. It is therefore, very important for each taxpayer to review his own tax situation and employ proper tax planning strategies.
Taking the time now to review your 2007 tax situation gives you a chance to take advantage of many year-end tax savings opportunities. This letter highlights selected strategies, but there are many others that might also apply to your particular situation. We are here to help. If you would like to discuss the strategies mentioned here or other ideas for reducing your 2007 liability, please don’t hesitate to call us. We would be pleased to set up a meeting within the next few weeks while there’s still time to implement tax strategies before year-end.
Best regards,
LIBMAN, GOLDSTINE, KOPPERMAN & WOLF
IRS Circular 230 Disclosure: To ensure compliance imposed by the IRS, we inform you that any tax advice contained in the body of this letter (including attachments) is not intended or written to be used and cannot be used, by the recipient for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or applicable state or local tax law provisions or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
The information in this letter is not intended for use without personalized professional assistance. If you need to discuss any issues in this letter, please contact your tax advisor.
