TaxView - Winter 2003

On-Point Tax Planning Tips and Strategies

“Of those to whom much is given, much is required.”

When soon-to-be-President John F. Kennedy spoke those words to the Massachusetts State Legislature some 40 years ago, he wasn’t talking about tax planning for high-net-worth individuals and business owners. But he could have been.

It’s a simple fact of fiduciary life that as the value of a taxpayer’s assets and income increase, so do the complexity—and stakes—of tax planning. With that in mind, TaxView has put together the following list of tips and reminders that readers may find helpful in tax-planning discussions with their accountants or financial advisors in their year-end planning.

Treatment of Income and Deductions
With tax rates holding steady from 2004 to 2005, the question of whether to accelerate certain deductible items into the current tax year and/or defer certain income items into the coming year becomes a time-value issue for taxpayers whose marginal tax rates will remain unchanged. Deferring income from 2004 to a future year frees up capital equal to the amount of the postponed tax liability, which is then available for investment, savings or other purposes. The tradeoff is loss of immediate availability of the after-tax income flowing from the deferred item. The same principles apply in weighing decisions about allowable prepayment of certain expenses to accelerate deductions into the current year.

Among income items that may be accelerated or deferred are:

Short-term investment income from vehicles that allow control over the timing of interest payments, such as T-bills and CDs.
Bonuses, incentive awards and other types of employee compensation that offer recipients an election to accelerate or defer payment.
Payment of income items such as fees and commissions which can be controlled via timing of invoice issuance.

Deductible items that may be accelerated or deferred include:

Contributions to qualified charities.
Interest payments on some types of loans.
Certain miscellaneous deductions (only deductible if they exceed 2% of the taxpayer’s adjusted gross income).
Real estate and personal property taxes.
State and municipal income taxes.

The AMT Trap
Although Congress provided some measure of relief with its eleventh-hour passage of the 2004 Working Families Act, the alternative minimum tax (AMT) remains a potential minefield for many, and taxpayers should discuss this issue with their advisors. The risk of AMT should cause a taxpayer to re-examine the general rule of deferring income and accelerating deductions. The legislation preserves partial relief from AMT by extending the increased 2003 exemption amount through 2005. For some taxpayers, the change could affect tax-planning decisions for both 2004 and 2005.

Interest Deductions on Residential and Nonresidential Loans
Interest paid on loans associated with a qualified residence is deductible for income tax purposes. Qualified residences include a taxpayer’s principal residence and one other residence, such as a vacation home. There are three types of qualified residence interest:

Acquisition indebtedness, which is debt incurred in acquiring, constructing or substantially improving a qualified residence and is secured by a lien against it. Acquisition indebtedness related to both qualified residences may not exceed $1 million in the aggregate.
Home equity indebtedness, which is secured by a qualified residence and is deductible to the extent that it does not exceed the residence’s fair market value reduced by the amount of any outstanding acquisition indebtedness secured by the same residence. Deductible home equity indebtedness tops out at an aggregate of $100,000.
Points paid on a mortgage incurred for the purchase or capital improvement of a primary residence are immediately deductible, but not so with a mortgage on a second residence or the refinancing of a principal residence. In those cases, points are capitalized at the outset and amortized over the term of the loan on a pro rata basis through deduction of a percentage of the points each year.

While interest expense associated with nonresidential loans is sometimes deductible, that deductibility is generally case-specific and determined largely by the nature and purpose of the loan. For example:

Interest expense accruing from an investment loan is deductible for federal income tax purposes, but the deduction is limited to the taxpayer’s net investment income from all sources. Interest disallowed by that limitation may be carried forward and deducted in future years. No deduction is allowed for interest on loans used to purchase tax-exempt securities.
Interest on trade or business loans is fully deductible.
Personal interest expense—including interest on credit cards, tax deficiencies, car loans, etc.—is not deductible. Converting such loans to a deductible form of debt, such as a home equity loan or line of credit, is a tax-planning strategy that should be discussed with your tax advisor.

Contributions to Retirement Plans
The following tips apply:

The deduction for contributions to an individual retirement account (IRA) is generally not available to high-net-worth individuals due to income limitations, but there are exceptions. The maximum IRA contribution amount is deductible, regardless of income, for single taxpayers who are not active participants in an employer-sponsored retirement plan; for married taxpayers when neither spouse is a participant in such a plan; and in other limited circumstances.
Eligible participants in 401(k) plans may make tax-deductible contributions up to $13,000 in 2004, $14,000 in 2005; those over age 49 may also make an additional $3,000 “catch up” contribution this year ($4,000 next year) that is deductible.
Self-employed taxpayers may be eligible to make tax-deductible contributions totaling as much as $41,000 to a Keogh plan in 2004, $42,000 in 2005. Taxpayers who are employees in their principal occupation may be considered self-employed for purposes of establishing and funding a Keogh plan if they derive income from other activities, such as serving as a director on the board of another company.

Other Points of Interest

It’s “use it or lose it” time for the 50% bonus depreciation put in place as an economic stimulus following 9/11 and set to expire on December 31 of this year. While moves to extend or make permanent some favorable provisions facing “sunset” in 2005 and beyond are likely next year, this is not among them. The Bush Administration’s position is that it was always intended as a short-term measure and that it has done its job.
Don’t forget about the Gift Tax annual exclusion which allows taxpayers to give gifts of up to $11,000 ($22,000 for married couples) to any number of individuals in 2004 without incurring any gift tax liability. Under certain circumstances, gifts greater than $11,000 may be made tax-free. This can be an effective strategy for transferring assets to heirs in a tax-favorable manner.
If you are thinking of donating a motor vehicle, boat or airplane valued in excess of $500 to charity, doing so before the end of the year might maximize your deduction. Taxpayers can deduct the full fair market value of the contributed asset on 2004 returns, as long as the charity supplies the filer with the required documentation. Starting in 2005, the deduction will be limited to the amount the charity realizes from the sale of the vehicle, which is generally a deeply discounted wholesale price. Documentation and substantiation requirements for this deduction also become much more stringent and detailed after 2004.

Legislative Update: Two New Bills May Affect Taxpayers

While doing your tax planning for the coming year, you need to be aware of two new pieces of legislation passed during the 2004 Congressional session. Both bills—the American Jobs Creation Act of 2004 and the Working Families Tax Relief Act of 2004—contain provisions that may affect both individual and business filers.

The American Jobs Creation Act of 2004
Despite the bill’s title, the driving force behind the American Jobs Creation Act of 2004 was repeal of existing federal income tax breaks for extraterritorial income (ETI). Those provisions ran afoul of World Trade Organization agreements and triggered sanctions on U.S. exports by the European Union.

Along with those changes, however, the bill includes $137 billion in tax cuts phased in over 10 years and focused primarily on four areas:

$77 billion in tax relief for U.S.-based manufacturers.
$43 billion in tax reduction through reforms in the taxation of multinational businesses.
About 50 different provisions targeting specific items of business tax and producing $10 billion in tax relief.
A handful of targeted individual tax cuts and excise tax reforms providing $7 billion in tax relief.

The new law phases out the ETI exclusion beginning in 2005, but affected taxpayers may still claim 100% of ETI tax benefits for 2004. The exclusions drop to 80% for 2005, 60% for 2006 and zero for 2007 and beyond. The bill includes a new deduction for domestic production activities that will be phased in over six years, intended to offset tax benefits lost due to repeal of ETI. The bill defines “domestic” producers only loosely, so the deduction’s applicability is expected to be widespread. The deduction is 3% for tax years beginning in 2005 and 2006, 6% for 2007 through 2009, and it tops out at 9% in 2010 and subsequent years.

Other provisions in the bill affecting business taxpayers include:

A two-year extension of the business property deduction provision and other favorable rules under Section 179. The provision allows for expensing up to $100,000 of assets a year, phasing out if more than $400,000 of qualified property is placed in service in one year. Both amounts are indexed for inflation and stand at $102,000 and $410,000 currently. Unless the provision is extended again or made permanent, the allowable amount of qualified property reverts to $25,000 in 2008.
Reduction of the maximum Section 179 deduction for “heavy” SUVs to $25,000.
Option to deduct up to $5,000 of start-up and $5,000 of organizational expenses in the first year of business.
Increase in the number of maximum shareholders in S corporations to 100 from 75, and the option for all family members (up to six generations) to elect to be treated as one shareholder.
Tougher rules for “nonqualified” deferred compensation plans and an imposition of potentially large tax penalties for noncompliance.
Simplification of the foreign tax credit rules.
An allowance for repatriation of cash from a controlled foreign corporation to a U.S. corporate shareholder. The U.S. corporate shareholder may deduct 85% of the cash dividends received during the tax year. This is a temporary provision, and there is no intent to make this tax break permanent or to extend or enact it again in the future.
A 10-year carry-forward and one-year carry-back of the foreign tax credit.
Repeal of the 90% limitation on using foreign tax credits against the alternative minimum tax.
Increase in the threshold for a corporate taxpayer’s substantial understatement. A corporate taxpayer has a substantial understatement of tax if the amount of the understatement exceeds the lesser of:

Companies will no longer be allowed to deduct the expenses for use of a facility, such as an airplane, in connection with a non-business activity of officers, directors and owners (10% or greater) to the extent that the expenses exceed the amount treated as compensation or includible income for that individual.

Provisions affecting individual taxpayers include:

Option of taking an itemized deduction for state and local sales taxes rather than state and local income taxes, effective only for 2004 and 2005 (unless renewed by Congress thereafter). Timing big-ticket purchases and even alternating between taking the sales tax and the state income tax deduction each year may make sense. The provision is retroactive to January 1, 2004.
Changes in the tax treatment of compensation resulting from exercise of incentive stock options and employee stock options.
Changes in the treatment of certain charitable contributions, including stricter reporting requirements for donations of motor vehicles, boats and aircraft. (See "Other Points of Interest")
New civil penalty for failure to report interest in foreign financial accounts. The penalty, which may be up to $10,000, may be waived if there is a reasonable cause for the failure to report and if any income from the transaction was properly reported. The penalty for willful violations is also increased to the greater of $100,000 or 50% of the amount of the transaction or the balance in the account at the time of the violation.
Employment taxes do not apply to the transfer of a share of stock pursuant to an exercise of incentive stock options or options received under an employer stock purchase plan or on account of a disposition of stock acquired through such an exercise.
Deposits may be made to suspend interest on potential underpayments. A taxpayer may make a cash deposit with the IRS for future application against an underpayment of various taxes, such as income, gift, estate or generation-skipping tax, which has not been assessed at the time of the deposit. To the extent that a deposit is used by the IRS to pay a tax liability, the tax is treated as paid when the deposit is made and no interest underpayment is imposed. Furthermore, if the dispute is resolved in favor of the taxpayer or the taxpayer withdraws the deposited money before resolution of the dispute, interest is payable on the deposit at the federal short-term rate.

The Working Families Tax Relief Act of 2004
This legislation is expected to deliver a $146 billion tax cut for both individuals and businesses, with President Bush promising at the signing ceremony that 94 million Americans will have a lower tax bill next year as a result. Most of the tax savings will accrue from extension of two sets of expiring provisions: four accelerated tax cuts from the 2001 and 2003 tax acts that were set to expire at the end of 2004, and a package of regularly expiring business tax provisions, most of which expired on December 31, 2003.

Among the tax cuts for individuals included in the bill are:

Full elimination of the marriage penalty in the standard deduction through 2010.
Full elimination of the marriage penalty in the 15% tax bracket through 2010.
Higher alternative minimum tax (AMT) exemptions continued through 2005.
Provision allowing nonrefundable personal tax credits to the full extent of regular and AMT liability is extended to tax years beginning in 2004 and 2005.

Provisions in the bill of interest to business filers include:

Extension of the research and development tax credit for amounts paid or incurred after June 30, 2004 and before 2006.
Welfare-to-work and work-opportunity tax credits are extended for wages paid or incurred for qualified individuals starting work after 2003 and before 2006.
Enhanced deduction for charitable contributions of qualified computers is extended for donations made in tax years beginning after 2003 and before 2006.
Renewable-source energy credit is extended for facilities placed in service after 2003 and before 2006.
Deductibility of contributions to Archer Medical Savings Accounts (MSAs) is extended through 2004 and 2005. Archer MSAs are similar to IRAs in that participants can claim a tax deduction for contributions to the account, and interest and earnings are not taxed. The MSA is coupled with a high-deductible health insurance policy, and the amount of the participant’s contribution to the savings plan that is tax deductible is equal to a percentage of the insurance policy’s deductible amount. Money withdrawn from an MSA is not taxed if used for qualifying medical expenses.

The above is just a sampling of what’s included in these two important pieces of tax legislation. The Working Families Tax Relief Act alone contains 175 tax code changes, and the 600-page American Jobs Creation Act includes hundreds of changes with multiple effective dates. How those changes might affect the tax planning strategies of both individual and business taxpayers is something they should discuss with their tax advisors.