Year End Planning for December 31, 2007 and Beyond

RETIREMENT STRATEGIES

Traditional IRAs
Individuals who are not “active participants” in an employer retirement plan may make deductible IRA contributions up to the amount of their earned income. The deadline is April 15, 2008. If the contribution is made after December 31, 2007 but before April 15, 2008, but sure to specify that the contribution is for the year 2007. There is no extension of time and there is no adjusted gross income phaseout range. The deduction limit is $4,000 and an extra “catch-up” contribution limit of $1,000 for taxpayers age 50 or older by the end of the tax year.

Individuals who are “active participants” in an employer retirement plan may make deductible IRA contributions, but the deduction is phased out according to AGI ranges for 2007 as follows:

Single taxpayers $52,000 to $62,000
Heads of household Same
Married filing jointly $83,000 to $103,000

Above the AGI limits of $62,000  and $103,000 there is no deduction and the IRA becomes a nondeductible IRA.

Working individuals will not be considered “active participants” if their spouse is an “active participant” in a plan and they may take a deduction, but instead will be subject to a higher AGI phaseout range of $156,000 to $166,000 for 2007. Above AGI of $166,000 and the IRA becomes a nondeductible IRA.

Nonworking individuals whose spouse is an “active participant” in an employer plan may make a deductible IRA contribution, subject to the same AGI phaseout ranges as for working individuals.

Individuals who will not be able to receive a deduction for their IRA contribution or choose not to take a deduction  may make non-deductible contributions. In 2010 and thereafter (unless Congress changes the law) taxpayers may convert their nondeductible IRAs to ROTH IRAs.

Both deductible and nondeductible IRAs may be converted to ROTH IRAs but the AGI must be less than $100,000 in the year of conversion.

Distributions from both deductible and nondeductible IRAs must begin no later than April 1st of the year following the year a taxpayer reaches age 70 ½.

Strategy: All taxpayers should consider nondeductible IRAs with the possibility of ROTH IRA conversions, if they are unable to make ROTH IRA contributions.

Roth IRAs
Roth IRAs are nondeductible IRAs whose earnings grow tax-free and whose distributions are tax-free if the tax rules for those distributions are abided by. The contribution limit is the same as for traditional IRAs. Unlike traditional IRAs for which contributions may not be made after the taxpayer reaches the age of 70 ½, ROTH IRA contributions may be made, ROTH IRA contributions may be made as long as the taxpayer is alive and has earned income. However, the contribution limit is subject to AGI phaseout ranges as follows:

Single taxpayers, head of household $99,000 to $114,000
Married filing jointly $156,000 to $166,000
Married filing separately $0 - $10,000

Individuals who cannot make a ROTH IRA contribution because of the above phaseouts should make a nondeductible IRA contribution and convert to a ROTH IRA in 2010. In 2010 the $100,000 AGI limitation on conversion does not apply.

Distributions from ROTH IRAs are taxfree according to certain rules:
 
1) taxfree distributions first come from the after-tax contributions
2) distributions on account of death or disability are completely taxfree
3) distributions are taxfree if made five years after the first contribution and the taxpayer is over the age of 59 ½

Distributions from ROTH IRAs are not mandatory and therefore represent an opportunity to stretch the IRA over multigenerations with the benefits of compounding earnings.

Strategy: Consider planning now for a conversion to a ROTH IRA in 2010 when the AGI $100,000 limit is gone. Consider a conversion to a ROTH IRA for terminally ill taxpayers before death for that short tax year, when the AGI could be under $100,000. Consider using ROTH IRAs for children in order to save for college.

401(k) Contributions
The 401(k) elective deferral limit for 2007 is $15,500 with an additional “catchup” limit of $5,000 for participants who will be age 50 by December 31, 2007, provided the plan allows “catchup” contributions. As of now, the 2008 limits will not change. These are before-tax contributions which also generate employer matching contributions in most plans.

Strategy: Even though the investment choices in many employer 401(k) plans are not the best, deferral contributions always should be made at least to the extent necessary to maximize employer matching contributions. Also, since deferral contributions lower AGI limitations, there may be other tax savings from maximizing 401(k) deferrals.

Direct Rollovers to a ROTH IRA
The Pension Protection Act of 2006 signed August 17, 2006 permits distributions from tax-qualified retirement plans, tax-sheltered annuities, and governmental 457 plans to be rolled directly into ROTH IRAs if the taxpayers AGI is under $100,000. The distribution will be taxable but no 10% penalty will apply.

Qualified Charitable Distributions from an IRA
Under current law, a distribution from an IRA made payable to a recognized 501 c 3 charity, delivered to or mailed directly to the charity, may be excluded from income. They are not deductible as contributions Up to $100,000 from a plan of an owner who is at least 70 ½ years of age will qualify for the exclusion. Massachusetts will allow the exclusion also, effectively allowing a charitable deduction. Under current law, distributions after December 31, 2007 will not qualify, but this provision may retained if the Extender Bill is passed by the Senate (it has passed the House). Such distributions also count towards the minimum distribution requirement. The IRA owner must obtain the required receipt documentation. The distribution cannot be made payable to the IRA owner.

Strategy: Every taxpayer having an IRA and normally making sizable contributions at year end should consider using this IRA distribution method instead of using the normal procedure of check writing from the home checking account.

Retirement Plan Distribution Bunching
A taxpayer must take distributions no later than April 1st of the year in which he or she turns 70 ½. If a taxpayer turns 70 ½ at anytime before December 31, 2007, he or she must take the minimum required distribution for 2007 by April 1st of 2008 and another distribution for 2008 before December 31, 2008.

Strategy: Take the 2007 distribution in 2007 if that results in a lower overall tax as between the two years.

Failure to take the distributions on time results in a 50%  penalty on the amount that should have been withdrawn. ROTH IRAs are exempt from required distributions unless they are an inherited ROTH IRA. Then the distributions rules apply.

There is a “still working” exception for those who do not own more than 5% of the employer stock. The required beginning date for distributions is April 1st of the year following final retirement.

MANAGING INCOME

Minimizing the Alternative Minimum Tax (AMT)
When the AMT system was first introduced, it was intended to apply to high-income taxpayers. However, Congress conveniently forgot to inflation index the exemptions. Consequently, more and more taxpayers will be caught by this extra tax that was never intended to catch the middle class taxpayer, now in the 25%, 28%, and 33% brackets. Congress plans to finish voting on Extender Bill this year, we hope, and included in that bill is an increase of the alternative minimum tax exemption amounts. But it is not real relief. Real relief is contained in Charlie Rangel’s “mother of all tax bills” designed for passage in 2009 and the price is little too high for high-income taxpayers, defined by Representative Rangel as those with adjusted gross incomes of more than $200,000 and $500,000. Taxpayers with more than $200,000 but less than $500,000 of AGI would pay a 4% surcharge based not on the tax or taxable income, but on AGI. The rate for AGI in excess of $500,000 would be 4.6% ($250,000 for single taxpayers)

Who is at risk for AMT in 2007 and 2008 ? Those who deduct significant amounts of state income, excise, and real estate taxes; those who have large miscellaneous itemized deductions; those who exercise large amounts of incentive stock options; those who have large capital gains; those who depreciate items faster than AMT depreciation allowances; and those who deduct interest on home equity loans in excess of $100,000 (which could catch more than a few taxpayers).

The first step is to project the regular tax and AMT tax before December 31, 2007. Before strategies of accelerating income or shifting deductions, taxpayers must know whether they are “in AMT” and by how much. In many cases, accelerating income can cure the problem, but it shouldn’t be done without “crunching the numbers.”

Deferring or Accelerating Income
Generally it is desirable to pay taxes later rather than sooner, assuming the AMT does not apply. Cash basis taxpayers can delay year-end billings for services until near or after December 31. Or, billings can be accelerated into 2007 if it helps reduce or eliminate AMT. Accrual basis taxpayers can delay shipment of goods until after December 31. Short-term Treasury bills maturing in the next year can be purchased. Cash basis taxpayers can delay or accelerate business expenses. Cash basis taxpayers can accelerate business expenses and charitable contributions by using credit cards, delaying actual payment until the next tax year. State income and real estate taxes can be paid either before or after December 31, depending on the AMT number crunching. Medical expenses can be accelerated or deferred, according to whether the 7.5% AGI threshold will be exceeded in a particular year.

Recognition of Income on Forgiveness of Debt
If a property is foreclosed by the mortgage holder, and a subsequent sale results in the discharge part or all of the former owner’s mortgage, to the extent the mortgage holder suffered a loss, the mortgage-former home owner has income, to the extent of the debt forgiveness.

To the rescue, the Mortgage Forgiveness Debt Relief Act of 2007 was passed by the House of Representatives  Ways and Means Committee in September 2007 and awaits passage by the full House and Senate. It would provide a permanent exclusion for any discharge of indebtedness on or after January 1, 2007 which is secured by a principal residence and which is incurred in the acquisition, construction, or substantial improvement of the principal residence. Instead, the amount discharged would reduce the basis of the individual’s principal residence.

Note that home equity indebtedness can be a trap for the unwary. Any discharge of home equity indebtedness not used for acquisition, construction or substantial improvement would be taxable. So, for example, a loan against the home to pay for credit cards, student loans, tuition, a car, or any other personal use would be taxable when discharged.

However, as we know, under the “paygo” system, reductions in taxes must be paid for by increases in taxes. So, the bill amends the $250,000/$500,000 gain exclusion on a principal residence so that it is reduced proportionately for any non-principal residence use, such as a period of rental.

Strategy: Think twice about converting a vacation or rental home to a principal residence and selling after two years expecting to exclude most of the gain (except for depreciation taken).

Social Security Tax Reform
Projected deficits in the Social Security system has caused some uncertainty as to whether social security taxes will be raised, whether the wage ceiling will be raised (it is unlimited for Medicare taxes), or whether benefits will be reduced, or a combination of these three alternatives. Representative Rangel from the 15th District of Central and South Harlem has included in his “mother of all tax bills” a provision which would make all Subchapter S and LLC net income that relates to service business to be subject to the Social Security tax. We should not take comfort in the fact that only 39 of the 301 bills he has filed have made it out of committee. Congress is now aware of this loophole. The Social Security wage maximum for 2007 is $97,500 and for 2008 it is $102,000.

MANAGING DEDUCTIONS

Business Expenses
For the year 2007 the Section 179 depreciation deduction limit is $125,000 with a dollar-for-dollar phase-out for purchases in excess of $500,000. If equipment is purchased in December, and Section 179 is not taken, a half-year depreciation deduction can be taken.

If the business has a Medical Expense Reimbursement Plan, uninsured medical expenses can be reimbursed by the employer before December 31.

Office supplies, postage, repairs and maintenance, software and similar purchases can be accelearated or delayed, according as the AMT analysis indicates.
If the company has a Flexible Spending Account, before year-end taxpayers must specify how much of their 2008 salary they wish to be converted to tax-free contributions to the plan so that in 2008 out-of-pocket medical, dental, and childcare withdrawals can be made taxfree.

It is possible to employ a child or grandchild before the end of the year, shifting earned income to the child, enabling the child to have a ROTH IRA. Compensation is not subject to the Kiddie Tax. If the child is in college, keep in mind that if financial aid is involved, the child loses aid equal to 50% of the excess of compensation income above $3,000.

Stricter Rules for Deducting and Documenting Charitable Contributions
For 2007, no deduction can be claimed for a charitable contribution unless there is on hand by the filing date of the return, and retained for the statute of limitations period (4 to 7 years), 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 each cash donation of $250 or more, a bank record is not enough. The taxpayer must have a receipt from the charity showing the name of the donee organization, the date,  and the amount of the contribution.

Beginning with contributions made after August 17, 2007, no deduction will be allowed for contributions of clothing and household goods unless the donated property is in good used condition or better.

Strategy: Taxpayers should handcarry clothing and household goods to a distribution point that is staffed by someone who can sign the receipt and a statement, either on the receipt or separate from it, that the goods are “good used condition or better” so that the deduction cannot be disallowed. For individual donations of $500 or more, an appraisal must be obtained. Taxpayers may relay on values set forth on the website at www.salvationarmyusa.org. Click on “donate”, “receipts”, and “valuation guide”.

As in 2006, the deduction for donations of motor vehicles is limited to the amount of the sales proceeds realized by the charity. If the car cannot run or needs major repairs, the value may be zero. Likewise, donated computers, cell phones, musical instruments, and other items must be in “good used condition or better”.

INVESTMENTS

Timing Long-Term Capital Gains
Before addressing this topic, it is necessary to remind my readers that a significant amount of tax law and legislation is based on the desire of government….the President and Congress…to achieve some social objective. In other words, politics very much plays a role in future tax policy. If the Democrats take over the Presidency and a majority of seats in Congress in 2009, there is a very strong possibility that in order to fund expensive programs to fix perceived problems and accomplish social goals, taxes will have to be raised. Every Democratic candidate for office has indicated that the qualified dividend and capital gain rate of 15% will be raised to at least 20%. If that was to be the rate, for taxpayers with AGIs over $200,000, effectively the rate will be 24% and if that taxpayer is in the AMT system, the effective rate would be 32% (the 28% AMT rate plus the 4% surcharge rate). However, if no preferential rate for capital gains is kept in the law, the gains would be treated as ordinary income and the top rate as of now is 35%. Add the 4.3% surcharge on top of that, and that brings the rate to 39.3%.  If stocks and real estate are not sold before 2009, there may be no gains left that would be taxable. The stock market and the real estate market do not react positively to tax increases on capital.

Add to the mix the possibility of a slowing economy…or worst, a recession in 2008…. and that adds up to realizing long-term capital gains in 2007 or early 2008.

If a taxpayer is in the 15% or lower tax bracket, the long-term capital gain tax rate in 2007 is 5%. In 2008 it will be zero, unless Congress changes it. As a reminder, long-term capital gains result only if the asset has been held for at least one year and one day.

Remember that giving a child securities, cash, or anything is a gift, and if the value of the gift exceeds $12,000 per child per year ($24,000 if the spouse joins in the gift), then a gift tax return should be filed and some of the lifetime exemption of $1,000,000 will be used up.

Capital Losses
Capital losses may be carried over indefinitely and retain their character as to whether they are short-term or long-term. The exception is for loss carryovers on a decedent’s final return.  Net capital losses of up to $3,000 may be used to offset ordinary income, such as wages, dividends, business profits and rental income, for example. Timing of losses depends on a number of factors. If the intent is reaquire the stock, the purchase must be made after 30 days from the sale. Otherwise, the loss is not allowable and must be added to the basis of any repurchase of the same stock. If less than the total number of shares in a position is to be sold, specific identification of a higher-basis lot can be accomplished by notifying the broker. Fidelity lets it be done entirely online, but an election must be made to use specific identification for all shares in an account.

Worthless securities generally have to be sold to realize the loss because if the company is still in existence and the shares are still traded, even if on the pink sheets, they are not worthless. If they are not traded, then facts and circumstances determine the earliest year in which to claim the loss.

As a reminder during these difficult real estate markets, losses on sales of principal residences are not allowable. Losses on sales of collectibles (jewelry, art, rugs, precious metals, stamps, coins, etc.) may not be allowable if they were held for enjoyment or as a hobby.

Capital Gains
Gains on sales of capital assets such as securities are long-term if held 12 months and one day.
Gain on sale of a principal residence is excludible up to $500,000 on a joint return and $250,000 on a single or head of household return. To be eligible, a home must be owned and used as a principal residence two out of the last five years. The exclusion is prorated if the home was owned and/or used less than two years if there was a change in place of employment, a change in health, or unforeseen circumstances. IRS Publication 523 explains unforeseen circumstances as does case law.

Gain on sale of a principal residence, even if below the exclusion amount, will be taxed to the extent of depreciation taken since May 6, 1997 on any rental or home office use of the residence.

Strategy:  If entitled, it generally pays to take the home office deduction. It does qualify auto mileage to be taken as a business expense starting from the front door if a business is being run out of the home or the home is being used as an administrative office.

Gain on sale of rental or business real estate is taxed at 25% to the extent of depreciation taken while it was owned by the taxpayer. On old properties held for a long period of time, this can result in a substantially higher tax.

Strategy: A tax-free exchange can eliminate recognition of gain to the extent of depreciation.

Sales of collectibles held for profit are taxed at a 28% rate. It is a good idea to keep records of investor intent.

If a principal residence is exchanged for another principal residence in a tax-free exchange, the exclusion applies first before computing the tax-free deferred gain.

EDUCATION TAX BENEFITS

Hope Tax Credit
The HOPE tax credit is $1,650 for 2007; 100% of the first $1,100 and 50% of the next $1,100. If not enough tuition and fees have been paid to equal or exceed $2,200, prepay tuition before December 31. The credit is available for only the first two years of the student’s post-secondary education in which the student is enrolled at least half-time. It is possible to have three tax years within the two first college years.

The Lifetime Learning Credit
The Lifetime Learning Credit is 20% on the first $10,000 of tuition and fees or a maximum of $2,000 and applies to all lifetime years of post-secondary education including education to acquire or improve job skills, no matter if the education is one course or one seminar.Both credits are phased out at modified AGI levels of between $94,000 and $114,000 for joint filers and between $47,000 and $57,000 for single taxpayers.

Strategy: Parents can give up their exemption for the child so that the child can claim the credits if the AGI levels are exceeded. Income can be shifted to the child, if financial aid is not a consideration, to allow a tax liability so that the tax credit can be utilized.

Coverdell Education Savings Accounts
Coverdell Education Savings Accounts allow up to annual  cash only $2,000 contributions, up to age 18 by the due date of the tax return. Earnings are tax-free if distributions are used for tuition, fees, books, supplies, equipment, academic tutoring, room and board if enrolled at least half-time, and special needs beneficiary expenses for eligible elementary and secondary school expenses. For postsecondary schools, the student must be enrolled at least half-time and only tuition, fees, books, supplies and equipment are covered. The contribution maximum is phased-out for AGI between $95,000 and $110,000 for single filers and $190,000 and $220,000 for joint filers. Accounts can be rolled taxfree to certain related beneficiaries under the age of 30.

Strategies: Fund Coverdells first because the owner has control over the investments. If the AGI limit is exceeded, a gift can be made to the child and the child can make the contribution.

Prepaid Tuition Plans
Prepaid Tuition Plans are qualified tax-free tuition plans in which persons may purchase tuition credits in today’s dollars for tomorrow’s tuition, essentially eliminating the higher tuition inflation factor. These contracts many times allow credits to be used with out-of-state schools. Purchasers must watch for lack of guarantees, which would threaten solvency of the program and losses for purchasers.

Qualified Tuition Savings Plans
Qualified Tuition Savings Plans more popularly known as Section 529 plans allow contributions of amounts up to the cost of the education, which can be $250,000 and up. Annual contributions are limited to $12,000. A lump-sum equal to five years or $60,000 can be made in one year. Earnings are tax-free if distributions are used for college expenses. Only US citizens or residents aliens can be owners of a 529 plan account, but the account owner does not have to be a living person. The owner can also be a beneficiary, i.e. a children can have their own 529 accounts. However, the child’s assets are assessed at 20% in financial aid formulas whereas parent’s assets are assessed at only 5.6% and grandparent’s assets are not assessed. Expenses covered are similar to those covered by Coverdells. There is no AGI limit. The major risk is that the returns may not keep pace with college tuition inflation, which historically runs 2 to 3 times the CPI rate. However, 529 plans are better than no savings plan at all.

Strategy: High income taxpayers use Section 529 plans because of the lack of AGI limit. From a financial aid standpoint, grandparents should be the account owners. The drawback to 529 plans is that there is some loss of control over the timing and selection of investments.

Tuition Deduction
The above-the-line tuition deduction for qualified education expenses may be extended for 2007 by the Extender Bill. The maximum deduction is $4,000 for single taxpayers with AGI of $65,000 or less, joint filers with AGI of $130,000 or less, or $2,000 for joint filer taxpayers with AGI of $80,000 or less. These AGI limitations are not phase-outs; if the limitation is exceeded by $1, no deduction is allowed.

Strategy: In deciding between the HOPE or Lifetime Learning credits or the above-the-line deduction, don’t overlook the effect on financial aid as AGI is reduced by the above-the-line deduction. It can be the better overall choice.

Student Loan Interest
Student loan interest is an above-the-line deduction allowable up to $2,500 for interest paid on a qualified education loan. The deduction is phased out at modified AGI levels between $110,000 and $140,000 for joint filers and between $55,000 and $70,000 for single filers.

Strategy: Federal Stafford loans and Sallie Mae Signature loans are taken out in the name of the student and the student will be able to deduct the interest above-the-line because chances are the student’s income in the early years will not exceed the AGI limitations. Parents can use home equity loans or refinancings of mortgages to avoid the AGI limitations.

IRA Accounts
IRA accounts allow for penalty-free withdrawals if used for school expenses. Traditional IRA withdrawals are taxable. ROTH IRA withdrawals are not taxable to the extent of original contributions. They are treated as withdrawn first. Both Traditional IRA and ROTH IRA withdrawals are assessed as untaxed income in the financial aid formulas.

Strategy: Wait until after December 31 of the college senior year to make withdrawals and use them to pay college loans.

The Kiddie Tax
The Tax Increase Prevention and Reconciliation Act made major changes to the so-called “Kiddie Tax” rules and the contrary to its name, the Act did not prevent tax increases in this area. First, the Act increased the age at which the Kiddie Tax applies from 13 to 17 for the year 2007. The first $850 of unearned income of the child is not taxed. The next $850 is taxed at a rate of 10%. After $1,700, the unearned income is taxed at the parent’s top marginal tax rate. It just takes the fun out of shifting investment assets and unearned income to an under age 18 child in 2007 or prior to help pay for college.

Starting in 2008, the rules change again. The Kiddie Tax will apply to children age 18 and younger who have unearned income in excess of $1,800, and to full-time students ages 19 to 23 who have unearned income in excess of $1,800 and whose earned income is less than one-half of the total support for that student. Now that really takes the fun out of investment asset and unearned income shifting to pay for college.

Strategies: 1) Do not shift assets that will produce unearned income in excess of the $1,800 threshold. 2) If assets have already been shifted to the child, convert or exchange for low or no dividend paying assets, and tax-efficient mutual funds. 3)  Pay compensation only when one-half of total support is exceeded. Compensation could be bunched into tax years when the comp payments are over one-half of support. 4) Seniors who graduate and take jobs should try to exceed the one-half of support threshold so that there will be no Kiddie Tax problem in the last year of college. 5)  Students could switch to night school until age 24, although that may not be practical. 6)  Life insurance products that have investment accounts will allow tax-free cash value loans. Withdrawals do count as untaxed income in reducing financial aid, though. 7) Invest in 529 plans and Coverdell accounts. 8)  Wait until after graduation to realize gains for sales of investment assets. 9)  Invest in Series EE US Savings Bonds for the tax-deferred interest feature.

Employer-Provided Educational Assistance
Internal Revenue Code Section 127 provides that an employer may provide educational assistance by reimbursing undergraduate, graduate, or professional course costs, including tuition, fees, books, supplies, and equipment, as a tax-free fringe benefit to employees under a nondiscriminatory written plan of up to $5,250 per year. Any excess over $5,250 would be taxable to the employee, but still deductible by the employer. A business owner may provide this benefit to his children. To qualify, the child must be at least 21 years of age, be a legitimate employee of the business, own no more than 5% of the business, and not be a tax dependent of the parent/owner. Benefits paid reduce expenses eligible for the HOPE and Lifetime Learning Credits and are considered a resource to the student, reducing financial aid.

Strategy: This plan works well if the business owner is a grandparent, as the dependency exemption is not an issue. It also works if the child/student is reimbursed during the senior year of college and after graduation, as financial aid will not be an issue. Also, reimbursing the child/student after terminating employment has been OK’d by IRS.

AUTOMOBILES

Automobile Lease-deduction Reduction
The Internal Revenue Code (280F(c)) requires a lessee of an automobile to pick up in gross income on the tax return each year for which the lease is in effect an amount from a special table which is supposed to substantially represent the equivalent of the limitation on depreciation deduction of an outright owned vehicle. For example, on a $50,000 vehicle, the amounts to be picked up in gross income are $241 in year 1, $528 in year 2, $786 in year 3, $942 in year 4, and $1,087 in year 5. This allows a full deduction for the lease rental and operating expenses, if used 100% for business. The lease rental is much greater than the depreciation, unless of course the automobile has a gross vehicle weight of between 6,000 and 14,000 pounds. The maximum depreciation allowances for automobiles under 6,000 pounds are $3,060 in year1, $4,800 in year 2, $2,850 in year 3, and $1,775 thereafter. The greater the value of the car, the greater the advantage to leasing.

Strategy: If the vehicle being looked at for purchase or lease is under 6,000 pounds gross vehicle weight, checkout the leasing deal and see if it works economically, including the tax situation.

Vehicles Exempt from Auto Depreciation Limits
Depreciation limits apply only to vehicles that fall under the definition of a passenger automobile which is a four-wheeled vehicle designed for street use with an unloaded gross vehicle weight of 6,000 pounds or less. Trucks or vans fall outside the passenger automobile definition if their loaded gross vehicle weight is over 6,000 pounds. SUVs and minivans also escape the definition of passenger automobile if they are built on a truck chassis and have an enclosed body.

Special vehicles such as ambulances, hearses, taxicabs, and specially modified trucks and vans to make more likely than not that they can be used for more than a de minimis amount for personal use are also excluded from the passenger automobile definition.

Several of the sport utility vehicles are heavy enough to weigh over 6,000 pounds. To find out if your vehicle weighs over 6,000 pounds, go to www.intellichoice.com or www.carsdirect.com/research/new_cars  to look up the weight.

In addition to greater depreciation, generally 20% per year for exempt vehicles,  the Section 179 deduction of up to $25,000 is available for vehicles exempt from auto depreciation limits, and it is a per vehicle allowance, not per taxpayer. So if 10 SUVs are purchased, the Section 179 depreciation deduction could be as much as $125,000, subject to the overall Section 179 depreciation limit.  

Deducting Two Cars
If a taxpayer has two cars already or has occasional use of the spouse’s car, extra deductions can result without any additional out-of-pocket cost. The caveat is that cost to use for depreciation is the lower of original cost of the personal car or market value on the date first used for business.

TRAVEL AND ENTERTAINMENT

Business Meals
Only 50% of business meals are tax-deductible, but it is important to preserve that deduction. The magic little-known secret to doing that is to keep a diary. I like the DAY MINDER Brand, but any diary that has a day and a date and space to write will do. Here are the five questions you need to answer to substantiate and audit-proof your entertainment:

1) Who was entertained and what is the business relationship? Identify the persons entertained, occupation if not obvious, and any other information to establish the
business relationship.
2) When did the entertainment take place? Normally just filling in the information under the date in the daytimer will take care of this requirement.
3) Where did the entertainment take place? Normally just the name of the restaurant will take care of this item.
4) Why..what was the business purpose? Here the taxpayer must be very specific. It will not be enough to say “potential client”. “Discussed using our services” or “Discussed his financial plan” or “Discussed potential divorce settlement and tax effect” is specific.
5) How much did the meal cost? For a meal and tip costing less than $75, the IRS only requires the taxpayer to write down the cost, but the IRS is very impressed if you save the receipt for every meal.

Strategy: First, every meal that you attend with customers, clients, prospects, anyone.. always talk business for some part of the time, even if it is your wife. In fact, every lunch or dinner with your wife should be deductible, as long as you follow the rule…always talk business for some part of the time.  The discussion does not have to be long, but it does have to be in a setting that is “conducive” to business discussions. A nightclub with a continuous floorshow would not be conducive.
 
Second, carry your diary with you. The IRS requires that recordkeeping be done at the time or very soon after the time that entertainment takes place. Having a diary with you helps to avoid forgetting to do the recordkeeping.

Business Gifts
Normally deductions for  business gifts to an individual are limited to $25 per individual per year, which is a ridiculously low amount if you are sending this individual a $200 Christmas basket. But here’s how you get the deduction. Send the basket to the whole company or department where the individual works. If the individual is the only person in the company, well, that’s a problem.

Gifts of season tickets to …… fill in the blank…New England Patriots, Boston Red Sox, Celtics, etc. will be 50% deductible if it is treated as entertainment expense, but the taxpayer has to attend the event so that the event is closely connected with a business discussion.

How to Deduct 100% of Meals
The annual picnic, the annual Christmas party, celebration of 5, 10,15, 20 years in business party, birthday party for an employee, all are annual once-a-year events. The food and beverage would be 100% deductible as a de minimus fringe benefit. It would actually be accounted for in a separate ledger account (in Quickbooks, Peachtree, etc.) by that name. On caveat: you must invite all employees.

The sales presentation or seminar will allow food and beverage costs to be 100% deductible, even if the sales presentation or seminar is held in the principal residence of the taxpayer.

If you provide lunch for the employees for a short period (no more than 45 minutes), if the employees are available for emergencies, and there are insufficient eating facilities nearby,  the food and beverage is 100% deductible.  

How to Deduct Cruises
The world is awash in cruise offerings. Some of them are sponsored by organizations offering seminars. If more than 50% of the total days are spent on business, then the cruise is really deductible, regardless of what the organization or sponsor says. There are some additional requirements:

1) The ship must be a US registered vessel.
2) The ports of call must in the US or US possessions.
3) Two supporting statements must be attached to the tax return; one from the ship’s officer verifying the number of seminar hours and the other is the taxpayer’s own signed statement giving days of transportation, number of hours of the trip, and the program of business activity (so the IRS can figure out if the 50% rule has been met).

Making the Most of Overnight Business Trips
The tax rules allow deductions for the cost you would have incurred for the business trip had your spouse not been with you. In other words, there is no proration rule. So take your spouse on business trips. If the trip includes the weekend (trip starts on Wedneday and ends Monday), the weekend counts as business days. If Monday or Friday happens to be a holiday, it counts as a business day also. Travel days are also considered business days.
Example: Jose and Almeida Sanchez, whose home is Miami, travel to Hawaii to attend a real estate conference held Thursday and Friday, July 1 and 2. (The Sanchez’s own a number of rental properties.) They have fun and frolic on Saturday, Sunday, and Monday (a holiday) and return Tuesday. The whole trip is deductible except for the 50% meals disallowance and any additional cost of the hotel due to double occupancy. This is a Hawaii fun-filled extended weekend subsidized by the IRS. The fact that the conference is held in Hawaii, rather than Miami, has no effect on the deduction; it is perfectly legal.

MISCELLANEOUS ITEMS

Underpayment of Taxes
If you are underpaid in either federal or state taxes, there are two ways to cure the situation. The first one is to have more taxes withheld from wages, retirement plan distributions, dividends, or any other form of payment from which taxes can be withheld. Withholding taxes are considered to have been withheld ratably over the entire year. Thus, the underpayment penalties are a nonissue, if the balance can be covered.

If the balance cannot be covered by withholding, then estimated tax vouchers must be filed by January 15th to avoid underestimated tax penalties for the fourth quarter only. Any underpayment for earlier quarters cannot be corrected at this point.

Energy Incentives
Nonbusiness Energy Expenditures for certain items will expire at the end of 2007. The credit is computed as follows:

1.) 10% of expenditures for qualified energy efficient improvements installed during the tax year (i.e. qualifying exterior windows and doors, skylights, insulation, and certain metal roofs.)
2.) 100% of residential energy property expenditures paid or incurred by the taxpayer during the tax year (i.e. central air conditioning, air source and geothermal heat pumps, furnaces, water heaters, main air circulating fans, etc.)

The limitations are as follows: up to $500 for all tax years, except that the credit for exterior windows and skylights is limited to $200, the credit for a circulating fan is limited to $50, the credit for a furnace is limited to $150 and the credit for heat pumps, water heaters,  and central air conditioners is limited to $300. The credit for qualified energy efficient improvements is only allowed for the material cost, not for the labor to install.

Taxpayers are required to maintain certain records, including a manufacturer’s certification that the qualified energy efficient improvements actually qualify for the credit. An exterior window or skylight that bears the Energy Star label is a substitute for a certification document for that item.

Residential Energy Efficient Expenditures for solar system property, photovoltaic property and fuel cell property are eligible for larger credits up through 2008. The credit is limited to 30% of the first $6,667 spent for qualified photovoltaic property and $6,667 for qualified solar water heating property expenditures, and $1,667 for qualified fuel cell property. Installation labor does count here.

The Sales Tax Deduction
Last year, Congress extended the provision allowing taxpayers who itemize deductions the option of choosing between a deduction for sales tax or a deduction for income taxes. The option is scheduled to expire in 2008 but a one-year extension is included in the Extender Bill. In most instances, for Massachusetts residents, only a major car, boat or plane purchase would swing the deduction to the sales. Deciding when to make the purchase would depend on both the amount of the purchase and whether the Extender Bill passes.
Gift Tax Annual Exemption
The annual gift tax exclusion per donee per year is $12,000 for 2007 and probably for 2008; therefore, no gift tax return needs to be filed. If a married couple give $24,000 to a donee, perhaps one of their children, the exclusion is $24,000 and not gift tax return needs to be filed.
If a business interest is given away, the value is discounted usually, so more shares can be given away. However, a gift tax return should be filed so that the statute of limitations closes and the value cannot be questioned after three years. The annual gift tax exclusion does not accumulate if unused; it is a use-it or loss-it situation.

Gifting Appreciated Assets to Your Child or Grandchild
Parents and/or grandparents may be tempted to shift appreciated assets to children in 2007 or 2008 in order to take advantage of these preferential rates. In the past that would have been a great strategy and it still may be for the year 2007 in limited situations. Congress passed a law this year that changed the ages Kiddie Tax at which the tax applies from age 13 to age 17 for 2007 and from 13 to 18 in 2008 or 23 if the child is a full-time student. So if the intended donee child is age 18 in 2007, go ahead and make a gift of appreciated securities or other assets, and have the child sell either in 2007 or 2008, provided that  it does not affect financial aid.
Remember that giving a child securities, cash, or anything is a gift, and if the value of the gift exceeds $12,000 per child per year ($24,000 if the spouse joins in the gift), then a gift tax return should be filed and some of the lifetime exemption of $1,000,000 will be used up.

Tax Preparer Penalties
The IRS has increased the penalty for understatement of tax that is due to an undisclosed position for which there was a reasonable belief that the position was more likely than not of being sustained on its merits, or for a frivolous position to the greater of $1,000 or 50% of preparation fee, provided the preparer knew or reasonably should have known of the position. If the preparer was willful or reckless in preparing the return, the penalty is the greater of $5,000 or 50% of the preparation fee. Needless to say, tax return preparers are going to be more careful, cautious, and transparent, meaning at a minimum, there will be more Form 8275 disclosures on tax returns.

Let’s Set the Facts Straight

The Top 1% of all Taxpayers:

          Reported 21.2% of all income in 2005 (it was 19% in 2004)
          Had average AGI of $364,654
          Paid 39.4% of all taxes paid to the US Government
          The average tax rate was 23.5% in 2005 (27.5% in 2004)

The Bottom 50% of all Taxpayers:

          Reported 12.8% of all income in 2005 (down from 13.4% in 2004)
          Had median AGI of $30,881
          Paid 2% of all taxes paid to the US Government
          The average tax rate was 3% in 2005 (4.5% in 2004)

These facts may help us as we think about future taxation and wealth transfer policy issues.