Copyright © 2000 Robert L. Sommers, all rights reserved.
December, 2000 Hot Topics
The new president, whomever he may be, will face an almost evenly-divided Congress making it difficult to enact major tax changes. Even if the Republican estate tax elimination proposal is passed, it will not take effect for 10 years. Income tax reductions are problematic since the presidential candidates' proposals were based on unrealistic budget-surplus projections that did not reflect the economy's recent slowdown.
If you believe that tax reduction will occur in 2001, then defer income until next year and maximize deductions this year. Remember, there are three general goals for income tax planning: (1) recognize income and pay taxes when you are in a low tax bracket; (2) use deductions to offset income when your tax bracket is high; and (3) when possible, delay the recognition of income, thus delaying the payment of tax.
As discussed in last year's article on year-end tax planning, the simple rule -- defer income to next year and accelerate deductions in 2000 -- no longer automatically applies. Such a strategy could backfire, causing taxpayers to lose benefits in 2001. The problem with the current tax law is that tax breaks are phased out (reduced ratably over a range of income) when a taxpayer's adjusted gross income ("AGI") reaches certain levels. Therefore, it is critical to determine which tax breaks you are eligible for and then take the appropriate steps to keep your AGI within the limits. The accompanying chart illustrates the impact of AGI on various tax incentives.
| Tax Break | Description |
AGI Limitations |
| Dependency Credits | $500 per child in 2000, for children under age 17 | Single: $75,000 Joint: $100,000 |
| Hope Scholarship | $1,500 credit for first two year of post-secondary education | Single: $40,000 -$50,000 Joint: $80,000 to 100,000 |
| Lifetime Learning Credit | 20% of first $5,000 ($10,000 in 2003). $1,000 in total ($2,000 in total in 2003) | Single: $40,000 -$50,000 Joint: $80,000 - $100,000 |
| Education IRA | $500 per student until age 18 | Single: $95,000 - $110,000 Joint: $150,000 - $160,000 |
| IRA Contributions | Eligibility increases in stages | Single: Increase from $25,000 to $40,000 in 2005. Joint: Increase from $40,000 to $80,000 in 2007. |
| Educational Loan Deductions | Interest deduction of $2,000 in 2000; $2,500 in 2001 | Single: $40,000 to $55,000 Joint: $60,000 to $75,000 |
| Roth IRA | Non-deductible $2,000/ yr. Distributions are tax-free | Single: $95,000 to $110,000 Joint: $150,000 to $160,000 |
| IRA Rollover to Roth | Rollover of IRA account to Roth IRA (transaction could be taxable) | Single: $100,000 Joint: $100,000 (ineligible if married filing separately) |
| IRA for Non- Participant Spouse | Up to $2,000 per year | Joint: $150,000 |
When calculating your 2000 tax bite, start with your total income. From total income, there are certain "above-the-line" deductions (IRA, SEP and Keogh contributions, moving expenses, self-employed health insurance and alimony payments) which may be taken to arrive at AGI. These deductions are permitted whether or not you itemize deductions. Your AGI becomes your focal point for potential tax benefits.
Roth Rollover: The most important investment decision most taxpayers will make this year is whether to take advantage of the Roth IRA by rolling over some or all of their investments held in traditional IRAs.
If your adjusted gross income ("AGI") is less than $100,000, seriously consider converting all or a part of your IRA to a Roth IRA by year's end. The tax is due in the year of the rollover.
Those who converted prior to the market's decline, may switch back to an IRA and then reconvert to a Roth (at the lower value) by the year's end.
For example: If you transferred your original IRA to a Roth when the IRA was worth $20,000 but now is worth only $12,000, you may switch back to the old IRA, then attempt to time the market to fund your Roth at $12,000 or a lower valuation.
Sales of securities and real estate held for more than one year qualify for the maximum long-term capital gains deduction. These assets are taxed at a maximum 20% federal rate (California does not have a special rate for capital gains). If these assets are received by inheritance, they are treated as long-term capital gains, whether or not you hold them for 12 months. Note: The long-term capital gains rate for collectibles (generally trading cards, automobiles, antiques, artwork, jewelry, stamps and coins) is 28%.
If you purchased investment assets eligible for long-term capital gains in 2000 and held them for at least 5 years, you'll pay a maximum federal long-term capital gains rate of 18%, down from the current 20%. Assets held between 1 and 5 years will continue at the 20% LTCG rate.
Capital gains and losses during each year are netted: If you have a net capital gain, you pay tax on the gain; if you have a net capital loss, you may carry forward the loss to future years. The loss is applied first against capital gains, and then up to $3,000 can offset ordinary income, per year.
Because of these rules, those with a large capital gain in one year and a loss the next could face disaster – the loss does not offset the previous gain.
Note: Many "day-traders," those who use the internet to execute stock trades on a daily basis for their own personal gain, are in for a rude tax surprise. Not only are their STCG taxed at ordinary income rates (as high as 45% for federal and California combined), but short-term capital losses (STCL) incurred in the subsequent year do not offset gains for the prior year.
Suppose you own a stock that has lost value, but you want to keep it. Can you sell it, recognize the loss, then repurchase it? Yes, if you wait at least 31 days before repurchasing it. This is called a "wash transaction" and the rules state that you cannot acquire "substantially identical securities" within a 61 day period which begins 30 days before the sale and ends 30 days after it.
The lesson for all investors: If you have a net recognized capital gain during 2000, get your tax money off the table; do not let it ride in the stock market.
If you expect to owe AMT, because of the exercise of incentive stock options or otherwise, consider accelerating income into 2000 -- by exercising non-qualified stock options, receiving bonuses, collecting on accounts receivable, collecting on installment notes, increasing retirement plan or IRA distributions, or exercising your ISO and disposing of the stock -- by year’s end. Wait until January, 2001, to pay state income taxes, interest payments on home-equity loans or other expenses which are not deductible in calculating the AMT for 2000.
Note: If you have large long-term capital gains, the AMT might eliminate the deduction for state taxes paid in 2000. Run the numbers, you might be better off paying state income taxes on those gains in 2001. The same holds true for real estate taxes and other deductions that do not count for AMT purposes, principally home-equity loan interest and itemized miscellaneous deductions.
If you have Incentive Stock Options, exercising them is not a taxable event under the regular tax system; however, the spread between the option price and the stock price is an item of tax preference under the Alternative Minimum Tax (AMT). For example, if you exercise 10,000 options at $5.00 each (total option price $50,000) and the stock is worth $50 a share (total value $500,000), the spread will be $450,000 for AMT purposes. If the stock price drops to $10/share, your stock will be worth less than the amount of AMT payable on that stock. In this case, you should consider selling your stock prior to year's end to avoid the AMT.
Note: Watch out for stock options that produce income to you when exercised, buy when the underlying stock is "locked-out" of the market (cannot be sold usually for six months). If you exercise stock options in December, you’ll be taxed on the income in 2000, but because of the lock-out, you cannot sell your stock in time to pay your tax liability on April 15, 2001.
There is an annual AMT exemption ($33,750 for single and $45,000 for married filers - although actual exemption amount is usually less). This should be used by those holding ISOs. Calculate the maximum amount you can exercise without triggering tax consequences under the AMT by using a tax software program or contacting a tax preparer.
For those who itemize their deductions consider the following standard techniques:
Charitable Deductions: Empty your house of old clothes, furniture, computer and sports equipment and other "garage sale" items, estimate their fair market value (make an inventory and take pictures as part of your records), then donate them to Goodwill or your favorite charity to claim a charitable deduction. Items over $250, require a receipt. Also, if you have a used car, consider donating it to charity for a full blue book deduction. Note: IRS is investigating abuses involving charitable donations of automobiles so be prepared to substantiate the value of your automobile at the time of donation.
Contribute appreciated property to public charities and receive a deduction for the full fair market value on the date of the donation. Congress restored the provision allowing a full charitable deduction for gifts of publicly traded stock (held more than 12 months) to a private foundation for the full fair market value of the stock. Remember, donations of appreciated property, such as stock, include the appreciation as part of the charitable donation, but you do not have to pay capital gains tax on the transaction.
Example: If you donate stock having a $1,000 basis worth $10,000, you receive a charitable deduction for $10,000. When the charity sells the stock, it pays no tax on appreciation. In contrast, if you sold the stock and gave the proceeds to the charity, you’d pay tax on the $9,000 gain. Assuming a combined federal and state tax rate of 27.5%, your cash donation would be $10,000, less $2,475 (27.5% of $9,000) = $7,525.
Taxes and Mortgage Interest: Pay your fourth quarter state income tax estimate and prepay your January mortgage payment this year. Pay your second property tax installment due in 2001, by the end of 2000. The same holds true for deductible alimony payments and deductible student loan interest.
The mortgage and property tax prepayment techniques work when you make direct payments to the property tax authorities, rather than include them ratably with your mortgage payment. Also, it is prudent to pay your January mortgage several weeks in advance so that your mortgage company will properly record the payment as made in 1999 when it issues you a Form 1096, a tally of your principal and interest payments.
Note: Although an inaccurate Form 1096 does not prevent you from deducting the January payment, it could require that you prove to IRS that you actually made the January payment in December, if you should be audited. Remember, if you prepaid your January, 2000 mortgage payment in December, 1999, then you must prepay your January, 2001 payment in December, 2000 to obtain a full 12 months' deduction.
Taxes and Mortgage Interest: Pay your fourth-quarter state income tax estimate and prepay your January mortgage payment this year. Pay your second property tax installment due in 2001, by the end of 2000. The same holds true for deductible alimony payments and deductible student loan interest.
Medical Expenses: Schedule medical and dental work prior to the end of this year and pay all medical expenses before December 31; these expenses are deductible to the extent they exceed 7.5% of your AGI.
Itemized Miscellaneous Deductions: Itemized miscellaneous deductions must exceed 2% of AGI. Employee expenses not part of an employer’s accountable plan are considered itemized miscellaneous deductions. These include uniforms, travel expenses, automobile expenses, job-related moving expenses, meals and entertainment expenses (these have strict requirements), certain education expenses for maintaining skills, union and professional dues and expenditures for equipment (up to $20,000) placed in service in 2000, supplies and publications. Note: Special rules might apply to computers, automobiles and other mixed-use equipment.
Paying Deductible Expenses: Payments by check and credit card made in 2000 count as 2000 deductions, even though the credit card charges are actually paid in 2001.
Maximize your annual gift tax exclusion by gifting up to $10,000 (couples may gift $20,000), per beneficiary, by year's end. Gifts can be in the form of money, stocks or property and this annual benefit expires on December 31 of each year. For those facing large estate taxes, it is prudent to maximize your gift-giving privilege each year. Note: Gift-giving reduces your estate for estate tax purposes, but does not reduce your income tax burden. There is no income-tax deduction for gifts.
Note: The unified gift and estate tax credit, currently $675,000 per taxpayer in 2000, will not increase in 2001.
Use the "minority discount" technique to gift a much larger percentage of property than the equivalent amount of cash. For example, a couple owning real estate worth $200,000 gifts a 10% interest to their daughter. If the gift is subject to a 30% minority discount, the interest is not valued at $20,000 ($200,000 x 10% -- pro-rata amount of the total value), but is worth only $14,000. Thus, they could gift a 14.25% interest valued at $28,500, which when discounted by 30%, is worth $19,950; below the $20,000 annual gift tax limit.
By forming a family limited partnership (FLP) and gifting limited partnership interests at a discount, taxpayers hope to substantially reduce their estates. But be cautious about using a FLP to create minority discounts when the partnership only holds appreciated securities or other passive investments. This no longer works (if it ever did) and IRS is aggressively challenging these arrangements as lacking economic substance.
If you are using family limited partnership techniques for real estate, make sure you structure the transaction so as not to create a "reappraisal" under California's Proposition 13. You need to transfer the undivided interest in real estate directly to the children, and then transfer all the undivided real estate interests to the FLP in exchange for exactly the same ownership. You can then give a portion of your ownership interest in the FLP to your children in subsequent years without causing an immediate Proposition 13 reassessment. A reassessment will occur when the "original owners" collectively transfer (in one or more transfers) more than 50% of their interests or when another FLP member obtains more than a 50% interest. Note: The parent/child exemption does not apply to avoid a change on ownership under these circumstances, however, the interspousal exclusion should apply.
For example: Suppose a parent gifts a 10% undivided interest in real property to each of two children and retains the remaining 80%. The two children and the parent form a limited liability company or family limited partnership and transfer their real estate interests into the newly-formed entity, in exchange for exactly the same ownership interests held in the real estate (i.e. child one has a 10% interest, child two has a 10% interest and parent has an 80% interest in the new entity). There will be no change in ownership under California’s proposition 13 until one of the children receives more than 50% ownership, or until the parent’s interest drops below 30% through a series of future transfers (the parent, as an original co-owner transferred more than 50% of the ownership interests).
Couples who "tie-the-knot" before January 1, 2001, are considered married throughout 2000. The impact of getting married on one's taxes cannot be underestimated. Usually, but not always, marriage will have a negative impact if both parties are earning significant amounts of income. For instance, the initial exemption under the Alternative Minimum Tax is $45,000 for joint filers, but only $33,750 for single taxpayers.
Conversely, the 10% surcharge on high incomes (increasing the top marginal tax bracket from 36% to 39.6%) applies to taxable income greater than $288,350 for single and joint filers alike. Therefore, two individuals with a combined taxable income of more than $288,350 should consider postponing marriage until 2001.
Roth Limitation: An individual with an Adjusted Gross Income ("AGI") of $100,000 or less may engage in a Roth rollover, and the same AGI limitation applies to the combined income of a married couple. Postpone marriage until next year if are considering a Roth rollover and your combined AGI will exceed $100,000
Sale of a Principal Residence: Individuals who have owned and lived in their home for two of the past five years prior to sale ("residence") may exclude up to $250,000 in profits ($500,000 for joint filers). Assume a single woman, who has lived in her residence with her fiancée for at least two years, sells her residence during the year for a $500,000 profit. If the couple marries before year's end and files a joint return, the full $500,000 will be excludable, even if the residence was sold prior to their marriage.
Taxpayers with multiple sources of income or significant investment gains should make estimated tax payments. In general, you need to make estimated tax payments totaling an amount at least equal to your actual tax liability for 1999.
Your are not required to pay estimated tax if your 1999 tax withholding and credits: (1) equal at least 90% of your 1999 tax liability; (2) equal 100% of your 1999 tax liability (108.6% if your 1999 AGI was greater than $150,000); or (3) reduce your total tax to less than $1,000.
Remember, your estimated tax must include any self-employment taxes owed on income from a sole proprietorship. Also, income from a partnership, limited liability company or S corporation is often subject to self-employment taxes.
Provided you qualify as a "trader" as opposed to an "investor," you may elect "mark-to-market" accounting by the due date of your tax return (with no extensions). Unfortunately, this remedy is no longer available for 2000 because the time to elect expired on April 17, 2000. You may elect it for 2001 by April 16, 2001.
A trader is defined as someone whose full-time business activity is buying and selling securities for his own account as a continuous and frequent occupation. Traders must actively and continuously purchase and sell securities, devoting the same time and energy as to a full-time job, while concentrating on short-term swings in stock prices.
Even if you qualify for trader status, you may not offset capital gains with future capital losses unless you elect mark-to-market accounting for your trades. Then, your trades will be taxed as follows: (1) you recognize gains and losses at year’s end; and (2) gains or losses are determined and reported as though your stocks and securities were sold at fair market value on the last trading day of the tax year. In short, gains and losses are netted, whether or not the stock or security is actually sold, and the difference is reported as ordinary income or loss.
If you have a capital gain in 2000 and have not paid estimated taxes on this amount, immediately take steps to protect your tax dollars. Either sell the stock in 2001 or segregate the portion of stock that you will use for taxes and place a stop loss order to protect against a decline in the stock price. Alternatively, buy a "put option" that will allow you to sell the stock at a set price. Do not just leave your tax dollars in the stock market - you could be flirting with disaster if your stock portfolio drops in value.
Need a last-minute tax break? Open an IRA, or contribute to an existing IRA, before April 16th and deduct the payment (within the limits pertaining to IRA deductions) in tax year 2000. The IRA deduction phases out for individuals with AGI between $30,000-$40,000 and joint filers between $51,000-$61,000. In general, joint filers may make a $2,000 contribution to an IRA for a non-working spouse, provided their combined earned income is at least $4,000.
Don't overlook a Roth. Although you do not receive a tax deduction, contributions to a Roth grow tax-free and the distributions available at age 59 1/2 are completely tax-free. The Roth benefit phases out for individuals with AGI between $95,000 - $110,000 and joint filers between $150,000 - $160,000. Single and joint filers with AGI of $100,000 or less may roll-over some or all of their IRA to a Roth; however, the rollover is subject to tax.
Consider using the Roth to speculate on high-flying tech stocks. If you hit it big, sell the stock, diversify your portfolio, then manage your investment until retirement age, at which time you'll draw down your booty tax-free!
The home-office definition has been expanded to include the conduct of administrative or management activities of a business when there is no other fixed location from which to perform these tasks. Remember, the office must be exclusively used on a regular basis for business. Also, if you use a portion of your home as an office and claim depreciation, the depreciation will be recaptured at a 25% tax rate, even though your home otherwise qualifies for the residence exclusion.
Annual Minimum Franchise Tax: California charges corporations, limited partnerships and limited liability companies an annual minimum franchise tax of $800 a year.
If you have an inactive company, liquidate it prior to the end of the year. You need to file for dissolution with the Secretary of State prior to the end of the year. Check out the new corporate dissolution form which allows a corporate dissolution if the officers merely state that they have paid (or provided for) all known debts and liabilities, as far as assets permit.
Likewise, wait until 2001 to form a new entity and save the annual minimum tax otherwise payable in 2000. Beginning in 2000, LLCs may have just one member.
Whether to reduce your income in 2000 or 2001 depends on the income restrictions for those tax breaks you desire and your AGI estimate in 2000. You lower your income in 2001 by deferring AGI adjustments to 2001 or by accelerating income into 2000. You lower your income in 1999 by doing the opposite. Remember: Itemized deductions reduce your taxable income but not your AGI.
The Roth rollover is the most important investment decision facing taxpayers in many years. The Roth holds the promise of a tremendous tax break in the future, although you will likely pay an up-front tax, payable at the time of conversion. Juggling the incentive stock options within the AMT exclusions is another important tax decision that should be made annually. Also, maximizing your gift-giving on an annual basis will reduce your estate for estate tax purposes.
Remember, deductible expenses and charitable contributions paid by credit card in 2000 are considered 2000 expenses, even though you pay the credit card in 2001. To qualify for a deduction by check, the check must be delivered to the recipient by midnight, December 31, 2000, even if it is deposited later. You are not permitted to delay the receipt of income by deliberately not cashing a paycheck or designating a payment made to you a "deposit" and then converting it to a payment in 2001.
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| All contents copyright © 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers. |
