It's the holiday season - time for revelry, family clashes
and, oh yes: year-end tax planning. During this holiday season,
do yourself a financial favor by reviewing your tax situation
with a professional. Who knows? There might be enough savings to
partially off-set your holiday spending. At least skim through
the following list of tax-planning opportunities and traps,
before uncorking the Champagne in 1997.
In 1996, Congress passed legislation, principally aimed at California and other tax aggressive states, to prevent them from taxing the pension and retirement benefits earned by former residents. You can now work and earn retirement benefits in one state, then retire in a low tax state, without paying taxes on your retirement benefits. Therefore, do not file a tax return or pay any taxes with respect to your retirement benefits, except to the state in which you now reside.
Remember that loan you made to your deadbeat Uncle Harry years
ago? You are permitted to take a bad debt deduction on your tax
returns for that loan, provided the debt becomes worthless. To
establish worthless, you must take affirmative steps to collect
the debt during the year it becomes worthless. In Uncle Harry's
case, write him a letter (return receipt requested), demanding
full payment. It is not necessary to sue the person, if such an
action would be fruitless.
The bad debt deduction is usually a capital loss. However, if
you own stock in a small corporation that becomes worthless (the
company goes out of business or is insolvent), you may be
entitled to an ordinary loss under the Section 1244 stock rules.
Keep this in mind if you make a stock investment in a family
corporation. Check with the corporation to determine whether your
worthless stock is Section 1244 stock.
If you have capital gains, consider selling those stocks which
will generate a capital loss, prior to the end of 1996. Capital
gains are netted against capital losses. Capital losses that
exceed capital gains may offset ordinary income up to $3,000 per
year and can be carried forward indefinitely until used in full.
Suppose you own a stock that has lost value, but 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.
Suppose two years ago you purchased 1,000 shares at $90/share
which is now worth $50/share. You might: (a) sell the shares and
recognize a $40/share capital loss, then repurchase the stock 31
days later; (b) buy 1,000 shares of the stock at $50/share, then
sell the original lot 31 days later; or (c) sell the stock and
immediately buy stock in a similar company, hold the new stock
for 31 days then sell it, and then repurchase shares in the
original company. Each strategy has its own set of risks, but all
circumvent the wash sale rules and permit you to deduct the loss
on the original stock.
There is a tax break that almost every family can successfully
utilize: A child's unearned income (interest, dividends, rents or
royalties) to $650 is not taxed, and income from $650 to $1,300
is taxed at a 15% tax bracket. Therefore, a gift transfer to a
child of $10,000 which earns 6.5% annually will not be taxed. A
transfer of $20,000 earning 6.5% annually ($1,300 in income) will
produce just a $97.65 tax (15% of $650) to the child. If the same
income were taxed to a parent in the 31% tax bracket, the tax
would be $403.
Parents who own their own businesses are permitted to hire a
child and the income (which is considered earned income) is taxed
to the child. Also, any other earned income by a child, such as a
paper route, will be taxed to the child.
If a child is under age 14, then unearned income over $1,300
is taxed at the parent's tax bracket; children over age 14 are
taxed at their bracket which is usually 15%. Carefully drafted
college trusts and other types of financial arrangements for
children over age 14 can take advantage of the child's lower tax
bracket as well as protect those funds from the parent's
potential creditors.
A variation on the college trust arrangement is now possible
under recently enacted tax legislation which allows states to
create tuition guaranty programs. A trust is formed with the
child as the beneficiary. The trust's earnings are tax-free until
withdrawn for tuition and the income generated by the trust is
taxed to the child (at the lower tax brackets).
Teachers who spend their own money on classroom supplies may
deduct a portion of those expenses, if they itemize their
deductions, rather than using the standard deduction. Itemized
miscellaneous deductions, which includes unreimbursed business
expenses, union or professional dues, tax preparation, income or
investment related expenses and education, are deductible,
provided they exceed 2% of a taxpayer's adjusted gross income
("AGI"). If a teacher's AGI is $40,000, then expenses
over $800 are deductible. For example, if a teacher earning
$40,000 a year pays $500 in union dues, $500 for continuing
education and $1,000 in classroom supplies, the itemized
miscellaneous deduction will be $1,200 ($2,000 less the $800
floor). In this case, it is beneficial to bunch expenses in one
year, if possible (purchase supplies needed for the remaining
school year in 1996). These rules apply to others who incur
business related expenses in their occupations.
If your income will be relatively lower for 1996 (loss of a
job, one parent working) or if you expect an increase in income
for 1997, there are several ways to accelerate income into 1996.
If you are involved in a divorce, you may want to accelerate
income into 1996 while you are permitted to file a joint return.
If you are subject to the AMT, you may want to accelerate
income into 1996 since the additional income may not have an
effect on your tax bracket under the AMT.
If you have net operating losses which are going to expire, or
otherwise have excess deductions, then accelerating income into
1996 could be a shrewd move.
Sell stocks at a capital gain; or sell appreciated stocks held
less than one year for a short-term capital gain which will be
taxed at ordinary income tax rates.
Settle a lawsuit this year or arrange for the collection of
money this year. Offer a discount if feasible. In reality, your
creditors might want to take the deduction this year anyway so
this could be a win-win situation.
You can accelerate the income from an installment note by
having the payor pay it off this year, by selling the note to a
third party, or by borrowing a sum of money and using the note as
collateral for the loan. An extra interest payment made in late
December will shift 13 months of interest income into 1996 and 11
months of interest income into 1997.
If you are eligible to withdraw funds from a retirement
account, check with your plan provider as to whether you can
withdraw additional income under the plan this year. Make sure
not to exceed the maximum yearly limit.
If you have an incentive stock option plan, check to determine
whether you can exercise your stock option and sell the stock
this year.
Restricted stock is stock provided in connection with your
employment that is subject to a substantial risk of forfeiture.
This stock is not considered yours for tax purposes until the
restrictions lapse. You can, however, make a special election
(Section 83(b) election) to treat the stock as yours currently
and pay the tax on the stock's value at the time of election.
This will accelerate the stock's value as income to you in 1996.
The downside is if the stock does not become vested, you will
have paid for something with no value. On the upside, if the
stock increases greatly in value, you'll be entitled to capital
gains treatment on the appreciation.
Example: If you have 100 shares of restricted stock with a fair market value of $2/share and you make a Section 83 (b) election, you'll be taxed on $200 of income. If the stock then appreciates to $100/sh and you sell it, you'll have capital gains on $98/sh of gain. If you did not make a Section 83(b) election, then the entire $100/sh would be taxed as ordinary income to you.
If you own your business, attempt to collect your outstanding
accounts receivable in 1996. If you are an employee, request that
any bonuses be paid to you on or before December 31st.
To the extent possible, have dividends from a C corporation
paid to you prior to the end of the year. Purchasing a mutual
fund which will pay a year-end dividend will also accelerate
income.
If you own S corporation stock or a partnership interest, the
corporation or partnership will have to generate income by either
collecting receivables or postponing deductions this year, since
you'll be taxed on your allocable share of income and gains from
these entities. If you are an active shareholder or partner, take
a larger salary this year or (if your entity files tax returns on
a calendar year basis) postpone deductions for the entity, such
as interest payments, rental payments or payments to suppliers
until next year.
Trust distributions should be made timely (usually within 65
days from the end of the taxable year). Discuss with your trustee
the possibility of receiving a distribution to you that will
count as income in 1996.
If you itemized your deductions, delay mortgage payments,
state tax payment and other deductible expenses until 1997.
Paying expenses on January 1, 1997 which are part of your
itemized deductions, such as medical expenses (to the extent they
exceed 7.5% of AGI), property taxes, mortgage interest deductions
on a first or second home, charitable contributions and itemized
miscellaneous deductions (to the extent they exceed 2% of AGI),
will increase your taxable income by decreasing your deductions.
Note: The delay will not cause your creditor any
financial problems since there is no practical difference between
a check dated December 31st and one dated January 1st,
since New Year's day is an official holiday anyway.
If you expect to be in a lower tax bracket next year, there
are several ways to defer income to 1997 and to accelerate
deductions into 1996.
Sell appreciated stock or other types of investment property
in 1997. Delay taking more than the minimum from retirement
accounts in 1996. Request that year-end bonuses be paid in
January, 1997. Settle lawsuits in 1997 and ask creditors who owe
you money to delay paying the December installment until January
1st .
Payments by check and by credit card made in 1996 count as
deductions in 1996, even though the credit card is paid off in
1997. If you have several large amounts outstanding, obtain a
home-equity line of credit (or use the one you already have in
place) to pay the expenses in 1996. Prepay your January mortgage
or rental expenses in December. Pay any other outstanding
liabilities in 1996. Pay your employees their bonuses in 1996.
Purchase computer equipment that you will use in business in
1996. The maximum amount of equipment that is eligible for a full
deduction is $17,500 per year. Buy that color printer you've been
eyeing, or that laptop computer. If you borrow the money for
these purchases, you'll receive a current deduction even though
the pay back will occur in 1997 and thereafter.
Make a gift of appreciated property to charity. You'll obtain
a current deduction for the fair market value of the property
without incurring out-of-pocket expenses. There are strict
substantiation rules for gifts of property over $250 in value.
Make an earnest attempt to collect outstanding debts this year
and then declare them as bad debts. You must be able to show the
debt became worthless in 1996. Remember, cash basis companies
(this includes most small service businesses) cannot deduct an
uncollected receivable as a bad debt, rather, it must involve
money owed to you or an investment made by you that has become
worthless.
Determine the maximize you can contribute to your retirement
or 401 K plans and make the contribution. Note: The recent change
allowing a $2,000 IRA deduction for a non-working spouse is
effective in 1997, so this break will not help you in 1996.
Beginning in 1997, death benefits paid to the chronically ill
or terminally ill may be received prior to death on a tax-free
basis. Delay receiving these benefits to 1997. If you have
received death benefits in 1996, argue that these benefits were
tax-free to you under the Treasury's temporary regulation
permitting such treatment.
Beginning in 1997, a non-working spouse will be entitled to
fund an IRA with up to $2,000 (up from the present $250). Do not
fund a non-working spouse's IRA with more than $250 in 1996.
Delay purchasing a mutual fund late in the year since the fund
might immediately issue a taxable dividend to you. Purchase the
fund after the "ex-dividend" date, the date in which a
dividend has been declared. Also, if you invest in a mutual fund
that has a high turnover ratio of investments, you could be taxed
on capital gains from those transactions, even though you have
not sold any of your mutual fund shares. Also, the wash sale
rules described above will apply if your distributions are
automatically reinvested into fund shares and then you sell your
shares at a loss within 30 days.
A new $5,000 tax credit for qualified adoption expenses such
as legal fees and court costs ($6,000 for the adoption of a
special needs child) goes into effect in 1997.
Note: expenses for a surrogate parent are not considered qualified adoption expenses.
The credit will be phased out ratably for AGIs between $75,000
and $115,000.
The 15% excise tax on excess distributions (currently, the tax
applies on distributions over $150,000 a year) under IRC Sec.
4980A has been waived for tax years 1997, 1998 and 1999. This
applies only to lifetime distributions. The excise tax will apply
to excess accumulations at death. Wait until next year to take an
excess distribution from a retirement plan.
Both President Clinton and Senator Dole proposed a radical tax
break for the sale of a principal residence. The present system
of a tax-free rollover under IRC Sec. 1034) and the
once-in-a-lifetime exemption of $125,000 for persons over age 55
would be replaced by a $500,000 exclusion of profits available to
anyone who sells a home. The $500,000 exclusion under Clinton's
plan would apply once every two years. Whether Congress will pass
this legislation is unclear, but anyone contemplating the sale of
a home should wait until 1997 to see whether this legislation is
passed.
Under the deferred exchange rules, people mistakenly believe
they have 180 from the date of sale on the first leg of the
transaction to complete the acquisition of the replacement
property on the second leg of the transaction. The deadline is
actually 180 days or the due date of the tax return (with
extensions). Those selling property late in the year may run
afoul of this rule if they fail to acquire the replacement
property by April 15, 1997 and fail to obtain an extension on
their tax return.
You may gift up to $10,000 per year in cash or property per
beneficiary without incurring a gift tax. Husband and wives may
gift up to $20,000 per year per beneficiary. A gift of cash or
property may be given to a properly drafted trust so that the
beneficiaries will not have ownership of the asset when they
reach the age of majority.
Consider giving an undivided interest in an asset, such as
real property, rather than cash. The benefits are two-fold:
first, you will not deplete your cash reserve by making a gift of
property rather than cash and second, the gift of property might
qualify for a "minority" discount, if the beneficiary
ends up with less than a majority interest in the asset.
The minority discount rules work as follows: Suppose you are
married and own real estate worth $200,000. If you and your
spouse gift $20,000 of the property, the beneficiary receives a
10% interest in the property. However, assuming the undivided
interest is subject to a 30% minority discount, then the $20,000
interest would be worth $14,000, which is less than the $20,000
annual gift tax limit.
Thus, with a 30% minority discount, you and your spouse may in
effect gift $28,500 of the property per year, and remain under
the $20,000 gift tax limit ($28,500 discounted by 30% is $19,550,
which is less than the $20,000 gift tax limit). Note: 30% is a
typical discount percentage used, but there is no uniform
standard discount and you'll need an appraisal to justify the
discount percentage applied to your particular asset.
Using this technique, one can gift a much larger percentage of
property than the equivalent amount of cash. Also, one can
greatly leverage the annual gift tax exemption to reduce the
donor's estate for estate tax purposes while shifting the future
appreciation of that asset to the child.
For example, compare the difference between a gift of cash of $20,000, which earns 5% interest, and a gift of $28,500 of property valued at $200,000 (which is within the $20,000 annual gift tax limit, assuming the 30% minority discount applies). At the end of 10 years (using a simple interest calculation) the beneficiary's stake in the property would be worth $42,750, but the bank account would be worth $30,000. The interest earned would be subject to ordinary income taxes (currently a maximum federal tax rate of 39.6%), but the property's appreciation is not subject to tax until the asset is sold, and then is subject to capital gains taxes (currently a maximum federal tax rate of 28%). In addition, the property may be part of a tax-free Section 1031 exchange which would defer taxation until the property is later sold for cash.
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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**