Tax Planning Under the New Law
By: Richard M. Colombik, JD, CPA
Tax planning keeps twisting and turning in the wind. This is due to the our government blowing in the winds of change and trying to regulate how you spend your funds. Cynical? Yes! Truthful? Yes!!
Home mortgage interest continues to be deductible with a large limit of one million dollars of debt per home. Is a home not personal? Of course, but it is not classified as personal interest debt, which is non-deductible, and has a specific tax code exemption. Automobile depreciation is limited for ?luxury autos?. Yet for autos costing 2 – 5 times as much almost the entire amount may be deductible if you lease the vehicle. Is the government encouraging us to lease vehicles as opposed to buying them. You make that determination.
What about business meals, only 50% deductible. If you want a full write-off you best fly coach or economy class. There are many examples of the government legislating lifestyle.
But the question is;
What is new and how does it affect your planning?
I. Individual Planning
POSTPONING TAXABLE INCOME
The following strategies are generally used to defer taxable income from a current period to a subsequent period.
Interest Income. You can defer interest recognition by purchasing Treasury Bonds, Series EE Bonds, etc. with maturity dates after 1998. The interest income reflected in these discounted obligations is not taxable until the obligation matures unless you sell the instrument prior to maturity.
Self-Employed Business Income. If you are self employed and use the cash method of accounting, consider delaying year-end billings to defer income until a subsequent period, for example 1999.
Installment Sales. If you plan to sell certain appreciated property in 1998, you may be able to defer gain until later years by receiving a promissory note instead of cash. If you qualify, the gain will be taxed to you prorata as you collect the notes? principal payments.
Certain Short Sales Of Stock No Longer Defer Gain. Historically, you were not required to recognize the gain on stock sold short (e.g. sold ?short against the box?) until you closed out the transaction by delivering your stock, which could be days, weeks, or months after the short sale. Generally, effective for short sales of appreciated stock after June 8, 1997, selling ?short against the box? will be treated as a ?deemed? taxable stock sale (for computing gain, but not loss) on the short sales? date.
Deferred Compensation. There are established ways to defer recognition of 1998 compensation until 1999. These ?deferred compensation? rules are extremely complex. We would be pleased to work with you and your employer to address these complex rules.
Postponing Qualified Plan Distributions. Deferring distributions from a qualified retirement plan can sometimes save taxes. Tax Tip. As a result of recent tax legislation, you may be able to postpone payments from your qualified retirement plan (other than an IRA) beyond age 70-1/2, if you continue to work and you don?t own more than 5% of your employer.
Asset Protection. The rules for taxation of offshore asset protection trusts and transfers to foreign entities have changed. Call us for updates.
TAKING ADVANTAGE OF RECENT CHANGES TO CAPITAL GAINS AND HOME SALE RULES
Congress Reduces Holding Period For Capital Gains Break. Effective for capital gains after December 31, 1997. The maximum tax rate of 20% on long term capital gains is effective for capital assets held loner than one year.
Depreciable Real Estate Gets Same Break.. Effective for gains after December 31, 1997, the new law reduces the holding period to more than one year to obtain the 25% rate on recaptured depreciation as ordinary income.
Collectibles. Capital gains from the sale of collectibles held more than one year (e.g., artwork, antiques, rugs, stamps, coins) are taxed at a maximum rate of 28% (not 20%).
Taking Advantage Of The New Gain Exclusion On Home Sales. Congress replaced the 2-year rollover rules and the $125,000 exclusion for taxpayers over age 55, with a new rule. Under the new rule, if you sell your ?principal residence? after May 6, 1997, you can exclude up to $250,000 (up to $500,000 on a qualifying joint return) of the gain from taxable income. Subject to limited exceptions, you must haveowned and occupied your home as your principal residence for at least two of the five years preceding the sale.
Don?t Throw Away The Old ?$125,000 Exclusion.? If you sold a house before May 7, 1997 when you were age 55 or older, and failed to elect to exclude up to $125,000 of the gain, you should consider amending your return to exclude the gain. This may allow you to get your taxes back, and it will not impact your new $250,000 or $500,000 exclusion.
TAKE ADVANTAGE OF ITEMIZED DEDUCTIONS
?Bunching? Itemized Deductions. If your itemized deductions equal your standard deductions in most years, you are receiving no benefit from your itemized deductions. You may significantly reduce your taxes over the long term by bunching your itemized expenses in alternative tax years.
Deduction For Self-Employed Health Insurance Costs. If you are self-employed, a partner, or own more than 2% of an S corporation, your tax deduction for health insurance premiums will increase to 45% of your health insurance premiums as an ?above the line? deduction, the remaining 55% is an itemized medical deduction (1998). For 1999 through 2001, the ?above the line? deduction increases to 60% and will increase again in 2002 (70%), 2003 and thereafter (100%).
Maximizing Employee Business Expenses. If you are incurring unreimbursed employee business expenses, you must reduce those expenses by 2% of your adjusted gross income. ?Bunching? these expenses into 1998 or 1999 so the 2% threshold is exceeded may reduce your taxes..
Take Advantage Of Employer?s ?Accountable Plan.? As an employee, you can avoid the 2% rule altogether if you document your business expenses and get reimbursed by your employer under an accountable plan. We will be glad to help you establish a proper reimbursement arrangement with your employer.
Using Appreciated Property For Charitable Contributions. By contributing long-term capital gain property a deduction is generally allowed for the property?s full value but no tax is due on the appreciation. Tax Tip. This rule, generally, does not apply to contributions to private foundations.
Time Your Payment Of State And Local Taxes. Consider paying all property taxes, state income taxes (fourth quarter estimate and balance due for 1998), etc. for 1998 prior to January 1, 1999 if your tax rate for 1998 will be higher than or the same as your 1999 rate. This will allow a deduction for 1998 (a year early) and possibly against income taxed at a higher rate.
Office-In-Home Expenses. The rules for taking the home office deduction will be relaxed. This relief will be particularly helpful if you are self employed and your only permanent office is in your house.
PLANNING WITH YOUR QUALIFIED RETIREMENT PLANS
Increased IRA Deductions For Certain Taxpayers. If you are married, even if your spouse has no earnings, you can deduct up to $4,000 for contributions to your and your spouses IRAS .
Good News For Married Taxpayers! Don?t forget, 1998 is the first year you can contribute to an IRA if you are not covered by an employer?s plan — even if your spouse is covered. However, even if you qualify for this new rule, your IRA deduction is phased out if your adjusted gross income is between $150,000 and $160,000.
Consider Contributing To Your Company?s 401(k) Plan. If you are covered by your company?s 401(k) plan, you should consider putting as much of your compensation (pretax) into the plan as allowable. The maximum amount for 1998 is $10,000. This is particularly appealing if your employer offers to match your contributions.
Consider A SIMPLE Retirement Plan. Businesses (including self-employed persons) may, if qualified, set up a new simplified retirement plan (called a SIMPLE plan). SIMPLE plans can be set up after December 31, 1996, and are designed to be less costly and easier to administer than other qualified plans.
OTHER ITEMS TO CONSIDER
Adoption Credit. A credit for adoption expenses of up to $5,000 per child ($6,000 for special needs children) is available to taxpayers who incur qualifying adoption expenses during 1998. Also, an employee can exclude from income up to $5,000 ($6,000 for special needs children) per child of qualifying employer-paid adoption expenses.
Social Security Numbers For Dependents. For 1998, all dependents must have a social security number, even if they are born as late as December 31, 1998..
Penalty For Under Withholding Or Under Estimating. If you have not paid sufficient estimates to avoid an underpayment penalty for 1998 and you have wages subject to withholding, you can have additional amounts withheld on or before December 31, 1998. Withholding is deemed paid equally on each quarterly installment date, even if the withholding occurs in December.
Domestic Workers. If you use a domestic worker (e.g., house cleaners, yard workers, baby sitters), you may have certain employment tax obligations.
Estate Taxes. Congress enacted several estate and gift tax changes in 1997 and 1998 which could impact your existing estate plan. Caveat!! In light of these changes, if you haven?t had your estate reviewed in the past few years, it would probably be wise to do so as soon as possible.
What Are Your Chances Of Being Audited? There are no ironclad rules for determining what will cause an IRS audit. However, most agree that audit chances increase if your return includes: (1) the home office deduction; (2) Schedule C (Profit or Loss From Business), especially if it shows a loss; (3) significant travel or entertainment expenses; (4) high casualty-loss deductions or (5) passive losses. If you plan to report any of these items on your 1998 return, make sure that you have proper documentation supporting these as well as all deductions.
II. CORPORATE PLANNING
Year-End Planning With Corporate Tax Rates. Your regular (non-S) corporation may be able to shift income between 1998 and 1999 and save taxes by taking advantage of the progressive corporate tax rates. The first $50,000.00 of corporate income is only taxes at a 15% rate.
Be Sure To Properly Document Loans To Shareholders. If you borrow from your closely-held corporation, make sure that, there is a written agreement to repay your loan, the loan is authorized within the corporate minutes and interest is charged. Without adequate documentation, the IRS may treat your loans as a constructive dividend.
AMT Relief For Small Corporations. Qualified small corporations are exempt from the alternative minimum tax (AMT) effective for taxable years beginning after December 31, 1997. Your corporation qualifies for this exemption if (1) it had average gross receipts of $5 million or less for 1994, 1995, and 1996, and (2) it had average gross receipts of $7.5 million or less for 1995, 1996, and 1997. If a corporation?s first year of existence is after 1997, the corporation is exempt from AMT for that first year regardless of the amount of its gross receipts.
Corporations Get Increased Deduction For Contributing Computers To Schools. For contributions made in tax years beginning after 1997, and before January 1, 2001, regular corporations get a larger deduction for contributions of computer equipment and technology to primary and secondary schools (grades K-12). Instead of deducting only the tax basis of the contributed computer equipment, your corporation may deduct the basis plus one-half of the appreciation (not to exceed twice the basis).
PLANNING FOR S CORPORATIONS
Number Of Shareholders Increases. S Corporations can have up to 75 shareholders.
Trust Can Own S Corporation Stock. An entirely new type of trust can now own stock of your S corporation (an electing small business trust). All beneficiaries of this trust generally must be either individuals or estates, and no interest in the trust can be acquired by purchase (i.e., generally must be acquired by gift or inheritance).
Your S Corporations Can Now Own Corporate Subsidiaries. An S corporation can now own 100% of a qualifying subsidiary corporation and elect to report all of the subsidiary?s operations on the parent S corporation?s income tax return. The 100% subsidiary will not file a separate return and, for tax purposes, will effectively be treated as a branch or division of the parent S corporation.
IRS Can Now Waive Faulty S Elections. If an S election was not executed properly, or was filed late, the law previously provided no authority for the IRS to waive the faulty election. Congress now authorizes the IRS to waive improperly executed or late S elections.
Starting In 1998, Certain Tax Exempt Organizations Can Own S Corporation Stock. Traditionally, you could not transfer your S corporation stock to a tax exempt organization without terminating the corporation?s S election. This year, exempt charities, and most qualified retirement plans (e.g., profit sharing plans, employee stock ownership plans) are able to own S corporation stock without terminating the S election.
Employee Stock Ownership Plans (ESOPs). Last year, Congress changed the rules for employee stock ownership plans (ESOPs) that own S corporation stock effective for years beginning in 1998. Under the new rules, if your S corporation sponsors an ESOP, the S corporation income that passes through to the ESOP as a shareholder will be tax exempt.
GENERAL BUSINESS PLANNING
Medical Savings Accounts. Beginning last year, small employers (generally businesses with 50 or fewer employees) could begin providing tax-free medical savings accounts (MSAs) to employees. Also, self-employed taxpayers are now allowed an above-the-line deduction for contributions to an MSA for themselves even if they have more than 50 employees
Legislation Increases 179 Deduction. Recent tax legislation increased the d179 deduction to $18,500 in 1998, $19,000 in 1999, and increases it each year thereafter until it reaches $25,000 in 2003.
New Tax Break For Employer-Provided Meals. If an employer furnishes meals to employees on its business premises (for the convenience of the employer), the full value of the meals is generally excludable from the employee?s income.
Congress Extends Expiring Tax Breaks. Just before it broke for its October, 1998 recess, Congress extended several business tax breaks that had expired earlier in 1998. These tax breaks are as follows: (1) the research and experimentation tax credit is extended from July 1, 1998 to June 30, 1999; (2) the special tax break for charitable contributions of qualified appreciated stock to private foundations is extended permanently from July 1, 1998; and (3) the work opportunity tax credit is extended from July 1, 1998 through June 30, 1999.
Recent Changes To NOL Carrybacks And Carryforwards. For losses incurred in tax years beginning after August 5, 1997, the net operating loss (NOL) carryback period is reduced from 3 years to 2 years. The carryforward period is increased from 15 years to 20 years.
Accounting For Inventory Shrinkage Clarified. In several recent court cases, the IRS has argued that businesses could not deduct year-end inventory shrinkage (lost and stolen merchandise, etc.) unless a physical inventory is actually taken at year end. Several courts disagreed with the IRS.
New Reporting Requirements For Payments To Attorneys. Effective for payments made after 1997, a business must file a Form 1099 for all gross payments to attorneys even if the payments are made to a professional corporation.
Richard M. Colombik, JD, CPA, is a principal in the law firm of Richard M. Colombik & Associates, P.C., and formerly served as former chairman of the ISBA Federal Taxation Council and its? liaison to the IRS. Mr. Colombik is a noted author and frequent lecturer on Asset Protection Plans, IRS Defense, Estate Planning and Business Entity Structuring. Among his many accomplishments, he is a former officer of the American Association of Attorney-CPAs, the Northwest Suburban Bar Association, and currently the vice-chair of the American Bar Association general practice taxation sub- committee. He is also a member of the Offshore Institute and elected as an Illinois Leading Attorney in Tax Law, as well as Estate Planning, Trusts and Business Law. Their national and international tax practice is headquartered in Schaumburg, Illinois with offices throughout Chicago and the suburbs. Mr. Colombik can be reached at 630-250-5700 or at www.colombik.com.