PLANNING TO SAVE (TAXES)

Part 1 of a 2-part series [an error occurred while processing this directive] Introduction [an error occurred while processing this directive] The Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA), signed into law on May 28th of this year, radically changed the tax planning landscape. Act before December 31st and you may be able to substantially reduce your tax burden. As noted below, tax planning involving children over age 14 is once again in vogue.

Lower Tax Brackets [an error occurred while processing this directive] Most taxpayers will enjoy a decrease in taxes due to lower tax brackets, a new 15% long-term capital gains rate, an increase in the standard deduction for joint filers and an increase in the child tax credit from $600 to $1,000 for eligible taxpayers. Note: The non-refundable portion of the tax credit can offset both regular tax and the alternative minimum tax, a change from previous law.

With the 5% and 10% tax brackets expanded to include more taxable income, gift giving to children over age 14 or others who are taxed in these low brackets has become a popular tax-planning tool. Note: Children under age 14 are taxed at their parent's tax rates, which eliminates the benefits of the lower tax brackets with respect to gifts made to these beneficiaries.

401(k) Plans and IRA Elections [an error occurred while processing this directive] Currently, employees can deposit up to $12,000 in tax deferred 401(k) retirement plans, but this year those 50 years and older can add another $2,000, provided their employers elected this additional provision. Check with your Human Resources representative to determine your eligibility and be sure to inform them that you want them to withhold the additional monies. Don't forget to check your contribution schedule for next year too when the limits go up to $13,000 and $16,000 for older employees.

Also, taxpayers have until April 15th to increase their limits in IRAs for this year and extension deadlines will apply to Keogh accounts if elections are made by this December 31st.

Saving For School [an error occurred while processing this directive] Children can earn annual income of up to $4,750 with no tax liability this year. Parents with businesses that employ their dependent children do not have to pay Social Security or Medicare taxes and they get to deduct any wages paid.

These savings can be deposited to Coverdell Education Savings Accounts or qualified tuition programs, otherwise known as Section 529 plans, and reap even greater savings.

Roth IRA [an error occurred while processing this directive] A Roth IRA may be opened and funded for a child with earned income. The funding for the Roth IRA does not have to come from the child's earnings. For example, if a child earns $5,000, he or she may fund up to $3,000 in a Roth IRA. The contribution can be made by a parent or relative as a gift to the child. A Roth IRA is considered a "tax-free money machine" because it accumulates income tax free and the distributions are made tax-free after age 59 ½.

Gifting to the Family [an error occurred while processing this directive] This year you can gift $11,000 (in money or property) to any individual free of gift taxes. For a child over age 14, one may give appreciated stock which the child can then sell and pay taxes at the child's lower tax bracket.

Example: A parent gifts stock (held at least 12 months, thereby qualifying for long-term capital gains) worth $11,000 to a child. Parent's basis in the stock is $1,000. If a parent sold the stock, the federal tax, calculated on a $10,000 profit would be $1,500 under the new long-term capital gains rate of 15%. If a child (who receives a "carryover" basis - the donor's basis in the stock) sells the stock, the tax rate is 5% or $500 - a tax savings of $1,000.

Note: the 5% rate applies while the taxpayer is in the 10% or 15% bracket. In our example, if the child has no other income, the 5% long-term capital gains rate applies to as much as $29,150 of gains, per year.

New Dividend Tax Rate [an error occurred while processing this directive] Corporate dividends are now taxed at 15%. While this provision was enacted to encourage corporations to distribute profits to shareholders rather than retain them, corporate tax planning, especially for small, closely-held companies, has become much more complex. Prior to this change, the tax law was consistent - dividend treatment meant a second tax on earnings. Corporations pay tax on their income, then individuals pay tax when they receive dividends.

Now that dividend treatment is no longer a scourge (in many cases, the 15% tax will approximate payroll taxes for compensation), corporations with retained earnings now may disgorge those earnings with minimal tax consequences. Going forward, the corporate tax rate for the first $50,000 in pre-tax income is 15% and the dividend rate is 15% for a combined tax rate of 30%. The highest individual tax rate is 35% so, in many instances, there is a lower overall tax if corporate earnings are paid out as dividends rather than as compensation to corporate shareholders. Remember, there is an additional payroll tax liability when corporate earnings are distributed to a shareholder/employee as compensation.

Classroom Supplies [an error occurred while processing this directive] For tax years 2002 and 2003, teachers may deduct a maximum of $250 per year for out of pocket expenses for books, supplies, computer equipment, software and supplementary materials (pencils, paper) used in the classroom. The deduction is available whether the teacher uses the standard or itemized deduction. Make purchases by the end of the year since this benefit is scheduled to expire.

Depreciation [an error occurred while processing this directive] Under Section 179 of the tax code, businesses can immediately write off up to $100,000 of equipment placed in service by December 31st.

In addition, there is also a new 50% bonus depreciation. Buy $150,000 worth of new equipment, immediately expense $100,000, and then take an additional 50% off the remaining $50,000 leaving only $25,000 to be depreciated.

Taking the depreciation over the next 5 years gives you $5,000 more depreciation in the first year for a grand total of $130,000 in just one year. For a business in the 35% tax bracket, that amounts to an immediate tax savings of $45,500.

Note: Vehicles weighing more than 6,000 pounds, gross vehicle weight (maximum design loaded weight of a vehicle; i.e. Hummers and other heavy SUVs) qualify as equipment and may be expensed in the year of purchase.

Year 2003 also extends the 50% bonus depreciation to cars purchased after May 5th. The first-year write-off rises to a maximum of $10,710.

Gifting to Charity [an error occurred while processing this directive] Give away low basis stock and deduct the current market value without owing any capital gains tax. If you still want to own the stock, purchase it again and receive a higher basis.

Capital Losses [an error occurred while processing this directive] If you have capital losses that exceed your capital gains, up to $3,000 of losses can be taken against ordinary income. Since capital losses and capital gains are netted at the end of the year, be careful if you decide to recognize long-term capital gains at the new rate of 15%, you could be losing an opportunity to use a capital loss to offset income taxable at a rate of up to 35%.

For example, if you have recognized a capital loss from the sale of stock this year in the amount of $3,000 and are holding stock eligible for a long-term capital gain, if you sell the gain stock, you will save $450 in tax ($3,000 capital gain x 15% = $450). If you retain the gain stock and apply the capital loss against ordinary income, the potential tax savings is $1,050 ($3,000 x 35% = $1,050), a net tax savings of $600.

Watch Out for the AMT [an error occurred while processing this directive] With the new lower tax brackets, more people will fall victim to the alternative minimum tax (AMT) . If you are among this group, do not prepay state and local taxes for 2004. Accelerate as much income as possible into 2003 to take advantage of the lower AMT rates of 26% and 28%. The AMT exemption thresholds have increased to $40,250 for single filers and $58,000 for joint filers, however, make the AMT calculation in December to determine whether you should accelerate income or defer deductions by year's end.

AMT and ISOs - Planning Note: Those with Incentive Stock Options (ISOs) may want to exercise just enough options to fall below these new exemption amounts. With ISOs, the spread between the exercise price and the fair market value of the stock on the date of exercise is a tax preference under the AMT ( example, if the exercise price is $1.00 and the stock is worth $101 on the date of exercise, $100 is a preference under the AMT).

Because the AMT calculation is complex, use a software tax program or consult with a tax professional to determine the maximum amount of options that may be exercised without triggering the AMT.

The spread between ordinary income tax on non-qualified stock options of 35% compared to the AMT of 28% is just 7 percentage points. With non-qualified stock options, there is withholding of taxes at 28% so the employee is at a maximum risk as to 7% if the stock collapses. In contrast, the employee who exercises an ISO is at risk as to 28% if the stock value evaporates since there is no required withholding when an ISO is exercised.

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© 1995-2004 Robert L. Sommers, attorney-at-law, all rights reserved. This article and 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.