YEAR-END INCOME TAX PLANNING
FOR INDIVIDUALS
INTRODUCTION
Each year, we work with our clients to maximize tax savings through year-end planning. Traditionally, we have recommended that you make sure your income is taxed at the lowest possible rate, and that you postpone your taxes by deferring taxable income and accelerating deductions. These time-honored strategies are still generally beneficial for 2004. In addition, recent tax legislation makes tax planning for 2004 even more critical. For example, the AAmerican Jobs Creation Act of 2004" (signed by President Bush on October 22, 2004) offers several new tax planning opportunities involving: business use of SUVs; charitable contributions of vehicles; deferring income under nonqualified deferred compensation plans, and deducting sales tax. We are sending you this letter to bring you up-to-date on the many new tax planning opportunities under the 2004 tax legislation, and to remind you of several "tried and true" year-end tax planning strategies.
Please keep in mind that moving income from one tax year to another may reduce your personal exemptions and itemized deductions, or may subject you to the alternative minimum tax (AMT). Consequently, you should not adopt any tax planning strategy contained in this letter without first computing the impact of the strategy on your overall tax liability, including your alternative minimum tax liability for 2004 and 2005. Therefore, we suggest that you call our firm before implementing any tax planning technique discussed in this letter. You cannot properly evaluate a particular planning strategy without calculating your overall tax with and without that strategy. Please be careful!
Please Note! This letter contains ideas for Federal Income tax planning only. State income tax issues are not addressed.
HIGHLIGHTS OF THE "AMERICAN JOBS CREATION ACT OF 2004" IMPACTING INDIVIDUALS
SELECTED PROVISIONS OF THE "WORKING FAMILIES TAX RELIEF ACT OF 2004"
SELECTED PROVISIONS OF "THE MILITARY FAMILY TAX RELIEF ACT OF 2003"
THE MEDICARE PRESCRIPTION DRUG MODERNIZATION ACT OF 2003
PLANNING WITH CAPITAL GAINS AND LOSSES
TAKING ADVANTAGE OF DEDUCTIONS
TAX-WISE PLANNING FOR EDUCATION COSTS
PLANNING WITH RETIREMENT PLANS
HIGHLIGHTS OF THE "AMERICAN JOBS CREATION ACT OF 2004" IMPACTING INDIVIDUALS [table of contents]
On October 22, 2004, President Bush signed the AAmerican Jobs Creation Act of 2004" ("Jobs Act"). This legislation is far too large and complex to cover in depth in this letter. Instead, the following summary highlights selected provisions we feel will have the greatest impact on 2004 planning for individuals.
New Deduction for State and Local Sales Tax. Prior to 1987, you could deduct both your state and local income taxes and sales taxes as an itemized deduction. After 1986, however, Congress removed the deductibility of state and local sales taxes. Generally for 2004 and 2005, the Jobs Act allows you to "elect" to deduct "either" state and local income taxes or state and local sales taxes, as itemized deductions. If you elect to deduct sales taxes, your deduction is either 1) your actual sales taxes substantiated by receipts, or 2) an amount provided in IRS tables (based on your filing status, income, etc.), plus any sales tax you pay on the purchase of a motor vehicle, boat, or other items prescribed by the IRS. Tax Tip. This new election will be particularly beneficial to the residents of states with little or no state income taxes or states where the state income tax rate is generally lower than the sales tax rate. However, this option may also help individuals in any state where the state income tax liability has been significantly reduced because of state credits, etc. Also, taking the sales tax deduction rather than the state income tax deduction may avoid including a state income tax refund in federal taxable income in a subsequent year.
Excluding Gain on Sale of Principal Residence. For the past several years, Congress has been concerned that taxpayers were inappropriately combining the '1031 like-kind exchange rules with the '121 home-sale exclusion rules. For example, assume you own a highly-appreciated commercial building worth $500,000. You swap that building in a tax-free, like-kind exchange for a $500,000 beach resort home that you rent to an outsider for a reasonable period of time. Later, you move into the beach home and establish it as your principal residence for 2 years. Under prior law, you could then sell the beach home and exclude up to $250,000 of gain ($500,000 on a joint return) under the home-sale exclusion rules. To curb this perceived abuse, the Jobs Act provides a new rule. Effective for home sales after October 22, 2004, if you sell your residence and it was acquired in a tax-free, like-kind exchange within the five year period ending on the date of the sale, any gain on the sale is taxable. Tax Tip. The new rule doesn't change the requirement that you must "use" the residence as your principal residence for 2 years out of the 5-year period ending on the date of the sale, it merely adds a new 5-year waiting period where the residence was acquired in a like-kind exchange.
Donations of Motor Vehicles, Boats, and Aircraft. Generally, if you contribute non-cash property to a charity, you are entitled to a charitable contribution equal to the fair market value of the contributed property. Items valued at more than $5,000 (except marketable securities) generally require a "qualified appraisal." In recent years, the IRS has been concerned that some taxpayers were contributing automobiles, boats, etc. and deducting an inflated value as a charitable contribution. To curb these perceived abuses, the Jobs Act adds stringent reporting and documentation requirements, for the donor and the charity, that must be satisfied in order to claim a charitable deduction in excess of $500 for a "qualified vehicle". A "qualified vehicle" generally includes motor vehicles designed for highway use, boats, or airplanes. The new rules are effective for contributions made after December 31, 2004. Generally, under the new rules, you will be required to receive a detailed, written receipt from the charity. If the charity sells the vehicle without any material improvement or significant use of the vehicle by the charity, your charitable deduction cannot exceed the gross sales price of the vehicle which must be listed on the receipt. The charity will be required to send a copy of the receipt to the IRS, and you will be required to attach a copy of the receipt to your tax return. Furthermore, significant penalties are imposed if the charity fails to provide a timely, accurate and complete receipt. Tax Tip. You will not be subject to these new stringent reporting requirements if you contribute your qualified vehicle by December 31, 2004. However, if the vehicle has a value of more than $5,000, an appraisal is required.
'179 Deduction for SUVs Reduced. The maximum annual depreciation deduction for business, passenger automobiles is capped at certain dollar amounts. However, trucks, vans and SUVs are exempt from these Apassenger auto" depreciation limitations if the "gross vehicle weight" exceeds 6,000 lbs. (e.g., a full-size pick-up; a full-size van; or a sport utility vehicle, including: Expedition, Range Rover, Tahoe, Durango, Suburban, BMW X-5, etc.). Consequently, under current law, if more than 50% of the use of one of these vehicles was for business purposes, you could have taken the '179 deduction (up to $102,000 in 2004) with respect to the business portion cost of the vehicle. For example, if this vehicle had 100% business use, you could have immediately deducted up to $102,000 of its cost in 2004 (if it otherwise qualified under '179). Under the Jobs Act, SUVs, vans and certain other vehicles that have a gross vehicle weight of 14,000 lbs. or less are limited to a '179 deduction of up to $25,000 (reduced from $102,000). This new rule is effective for vehicles placed in service after October 22, 2004. Example. Assume that on December 1, 2004, your business purchases an SUV (weighing 6,005 lbs.) for $70,000, which you use 100% for business. Assume further that this SUV qualifies for the maximum '179 deduction, the 50% additional first-year depreciation, and the normal accelerated depreciation deductions (using the mid-quarter convention). The total deductions in 2004 on this SUV would be $48,625, computed as follows: (i) a '179 deduction of $25,000, plus (ii) additional 50% first-year depreciation of $22,500 on the remaining basis ([$70,000 - $25,000] x 50%), plus (iii) $1,125 of MACRS depreciation ([$45,000 - $22,500] x 5% [using mid-quarter convention and 200% declining balance]). The remaining $21,375 of cost would be recovered in 2005 and later under the general depreciation rules. Planning Alert! If the SUV is instead placed in service on January 2, 2005 (when the 50% depreciation is no longer available), the total depreciation deductions for 2005 would be only $34,000 (using the mid-year convention). Therefore, if you want maximum up-front depreciation deductions, you must place the SUV in service before 2005. Tax Tip. As you evaluate the impact of this new rule, please keep the following points in mind:
New Restrictions on Non-Qualified Deferred Compensation Plans. Non-qualified deferred compensation plans are frequently used as part of a compensation package providing financial incentives to executive and middle management employees. Congress believes that many companies are too aggressive with their non-qualified deferred compensation plans and are deferring compensation income without sufficient restrictions on the funds. Consequently, generally effective for compensation amounts deferred after 2004, the Jobs Act for the first time establishes comprehensive statutory criteria that must be satisfied to defer compensation income under non-qualified plans. Generally, amounts deferred under these plans before January 1, 2005, will not be subject to these new rules. However, if the plan is "materially modified" after October 3, 2004, amounts deferred prior to 2005 could be subject to taxation, an interest charge, and a 20% penalty. Caution! Materially modifying a deferred compensation plan after October 3, 2004 could result in serious tax consequences unless the plan already complies with the Jobs Act requirements! Planning Alert! If your company sponsors, or you are a beneficiary of, a non-qualified deferred compensation plan, it is imperative that this plan be reviewed by us and an attorney responsible for the plan. At least a preliminary review should take place before December 31, 2004 and before any additional deferrals are elected for 2005. Please call our office if you want us to assist you in this review.
Attorney Fees. After years of controversy, Congress has resolved the issue of how to deduct attorney fees relating to taxable damage awards. Unless you are recovering for a "physical" personal injury, most lawsuit recoveries are fully taxable. However, courts in some circuits (5th, 6th, 9th, and 11th Circuits) believe that an individual is taxed only on the damage award net of any attorney's fees paid with regard to the lawsuit. In other circuits (2nd, 4th, 7th, 10th, and Federal Circuits), courts have held that an individual is taxed on 100% of the damage award, and is entitled to a "miscellaneous itemized deduction" for the resulting attorney's fees. Unfortunately, a miscellaneous itemized deduction cannot be deducted for "regular" tax purposes, except to the extent all miscellaneous itemized deductions exceed 2% of adjusted gross income. Furthermore, these deductions are not allowed at all for alternative minimum tax (AMT) purposes. Consequently, individuals receiving payments in circuits that treat attorney's fees as miscellaneous itemized deductions pay significantly more taxes than plaintiffs recovering in circuits that only tax the award net of attorney's fees. Effective for fees and costs paid after October 22, 2004, with regard to any judgment or settlement taking place after October 22, 2004, the Jobs Act allows an "above-the-line" deduction for claims of unlawful discrimination, certain claims against the Federal Government, and certain claims under the Medicare Secondary Payer Statute. Good News! Because this deduction is now "above-the-line," the attorney's fees and court costs will no longer be subject to any percentage reduction applied to itemized deductions, and can be claimed fully for AMT purposes. Tax Tip. The United States Supreme Court is poised to settle this issue for judgments, settlements, and related fees before October 23, 2004. If you have settled a lawsuit in the past and treated the attorney's fee as a "miscellaneous itemized deduction," you should consider filing a protective claim for refund before the statue of limitation runs for that tax year. This could enable you to recover your taxes if the Supreme Court rules that taxable damage awards are included in income net of attorney fees. We will gladly help you prepare a protective claim for refund.
SELECTED PROVISIONS OF THE "WORKING FAMILIES TAX RELIEF ACT OF 2004" [table of contents]
On October 4, 2004, President Bush signed the Working Families Tax Relief Act of 2004 ("Family Tax Act") into law. This $146 billion tax bill extended more than ten income tax benefits that expired at the end of 2003 and eight tax benefits that were scheduled to expire during or after 2004. In addition to the extension of these expiring tax benefits, the Act contains several changes to the tax law as discussed below.
Exempt Combat Pay Is Earned Income for Earned Income Credit Calculation. Low-income workers can qualify for a refundable earned income credit ("EIC"). The amount of the credit varies with the amount of their "earned income." Prior to the Family Tax Act, "earned income" for purposes of the EIC did not include tax exempt combat pay for military personnel. For tax years ending after October 4, 2004 and before January 1, 2006, military personnel may elect to treat combat pay as earned income for EIC purposes. Planning Alert! If a taxpayer has "earned income" from sources other than combat pay, electing to treat the combat pay as earned income could actually cause the taxpayer to lose all or a portion of his or her earned income credit. In that case, the election should not be made.
Increased Child Tax Credit. The $1,000 child tax credit was scheduled to drop from $1,000 to $700 in 2005. The Family Tax Act maintains the credit at $1,000 through 2010. Also, you may be entitled to a refund of your child tax credit even if your credit exceeds your federal income tax liability. Last year, you could have received a refundable credit to the extent of 10% of your "earned income" in excess of $10,500. For years beginning after 2003, the Act increases the refundable credit to 15% of your earned income in excess of $10,750. Moreover, starting in 2004, the Act includes tax exempt "combat pay" in the definition of "earned income" for purposes of the refundable child tax credit. Tax Tip. Last year, if you had one qualifying child, you had to earn at least $20,500 to be entitled to a full "refundable" child tax credit of $1,000. For 2004, you need earned income of only $17,417 to qualify for the full $1,000 refundable credit.
Educators Classroom Expense Deduction. The Family Tax Act extends the above-the-line deduction for up to $250 for books, supplies, computer equipment, etc. used in the classroom by elementary and secondary school teachers through 2005. This deduction had been scheduled to sunset after 2003.
Uniform Definition of Child for Tax Purposes. Before the Family Tax Act, taxpayers with children could possibly qualify for five different tax benefits: the dependency exemption; the child tax credit; the earned income credit; the child dependent care credit; and head-of-household filing status. Each of these provisions had separate tests for determining whether the child qualifies the taxpayer for the tax benefit. Starting in 2005, the Act establishes a uniform definition of "qualifying child" that can be used for each of the above-listed tax benefits. Planning Alert. The Act also contains new rules for divorced or separated parents. For example, legal custody will not determine who is the custodial parent after 2004. Instead, the custodial parent will be the parent with whom the child lived for the greater portion of the year. As under current law, the custodial parent may allow the non-custodial parent to claim the child as a dependent.
SELECTED PROVISIONS OF "THE MILITARY FAMILY TAX RELIEF ACT OF 2003" [table of contents]
On November 11, 2003, President Bush signed the Military Family Tax Relief Act of 2003 ("Military Tax Act"). This Act provides relief not only to members of the Armed Forces serving in Iraq and Afghanistan, but also members serving in the National Guard, the Military Reserve, and other military personnel. The following is a summary of selected items included in the Act.
Increased Death Benefits. The Military Tax Act doubles the military death benefit from $6,000 to $12,000, effective for deaths after September 10, 2001.
Home-Sale Relief. If you are in the military and you are transferred due to a military assignment more than 50 miles away from your home, under the new Act, you may suspend the 2 out of 5 year testing period for excluding the gain on the sale of your home (i.e., the $250,000 or $500,000 gain exclusion rule) for up to 10 years. This new rule is effective for sales or exchanges after May 6, 1997. This generally means that if you meet the 2-year rule (or qualified for a pro ration of the 2-year rule) at the time you were placed on a qualified military assignment, you will continue to qualify for that exclusion while you are on that assignment for up to 10 years. This new rule is available to members of the Army, Navy, Air Force, Marine Corps, Coast Guard, Commissioned Corps of the National Oceanic and Atmospheric Administration, Commissioned Corps of the Public Health Service, and the Foreign Service. Tax Tip. This tax relief is retroactive, so, if you have previously sold your house while in the military and you were on a qualified long-term assignment and paid tax on the gain on the sale of the house, please contact our office. We will help you determine whether you are entitled to a tax refund.
Tax Relief for Homeowners' Assistance. The Department of Defense operates a special program to assist military homeowners when military bases close and home values decline. If you received a payment under this program after November 11, 2003, that payment is now tax free.
National Guard and Reserve Travel. If you are a member of the National Guard or Military Reserves, you may now take an "above-the-line" deduction for travel costs more than 100 miles from your home that requires you to stay overnight. Before this change, these travel expenses were required to be itemized and subject to the 2% reduction rule. Tax Tip. This new rule applies to any amount paid or incurred for tax years starting after December 31, 2002. If you qualify for these deductible travel expenses and failed to take them as an "above-the-line" expense on your 2003 return, please call us. We will assist you in amending your 2003 return.
Tax-Free Child Care Benefits. Effective for tax years beginning after December 31, 2002, all child care benefits provided to military employees are excluded from income (civilians can only exclude up to $5,000 annually for employer-provided childcare). Tax Tip. This complete exclusion is available to all members of the Uniform Services, including the Army, Navy, Air Force, Marine Corps, Coast Guard, the Commissioned Corps of the National Oceanic and Atmospheric Administration, and the Commissioned Corps of the Public Health Service.
Service Academy Appointments. For tax years beginning after 2002, you may make distributions from '529 plans and Education Savings Accounts penalty free (but not income tax free), up to the amount of tuition, fees, etc. for attending military academies (Westpoint, Naval Academy, Air Force Academy, Coast Guard Academy, and Merchant Marine Academy).
THE MEDICARE PRESCRIPTION DRUG MODERNIZATION ACT OF 2003 [table of contents]
In December, 2003, President Bush signed into law the "Medicare Prescription Drug Modernization Act of 2003." This Act ushered in the new health savings account (HSA) effective beginning in 2004. Contributions to the HSA are fully deductible whether or not you itemize deductions, and distributions for qualifying medical expenses are tax free. In other words, an HSA permits medical expenses (including non prescription drugs) to be deducted directly from your adjusted gross income whether or not you itemize and avoids the rule that only medical expenses in excess of 72 % of adjusted gross income are deductible. To qualify for an HSA, you must be covered by a qualifying "high deductible health plan" (HDHP). If you have "self only" coverage, your HDHP must have a minimum annual deductible of $1,000, and your maximum out-of-pocket exposure cannot exceed $5,000. If you have "family" coverage, your minimum annual deductible is $2,000, and your maximum out-of-pocket exposure cannot exceed $10,000. Tax Tip! Generally, you cannot receive a tax-free medical expense reimbursement from an HSA for any medical expense incurred before you established the HSA. However, the IRS has waived this rule for 2004 only. Consequently, let's assume that for every day in 2004 you are covered by a qualified medical plan with a $5,000 deductible. The 2004 medical expenses for you and your family are more than $5,000. For 2004, you could 1) establish an HSA by April 15, 2005, 2) contribute $5,000 into it by April 15, 2005, 3) take a $5,000 above-the-line deduction on your 2004 return, and 4) reimburse yourself for $5,000 of your 2004 medical expenses out of the HSA tax free. In effect, this would convert your $5,000 of medical expenses from an itemized deduction (allowed only to the extent of the excess of the medical expenses over 7.5% of your adjusted gross income) to an above-the-line deduction for the full $5,000 amount.
If you need any further information on HSAs, please contact our office and we will be glad to assist you.
PLANNING WITH CAPITAL GAINS AND LOSSES [table of contents]
Watch Out For Incentive Stock Options And AMT. If you exercised an incentive stock option (ISO) in 2004, the exercise could trigger the alternative minimum tax (AMT) on your 2004 return. Your AMT income includes the excess of the fair market value of the stock acquired upon the exercise of the option over the exercise price. This excess is not included in calculating your regular income tax for 2004 but is included in calculating the AMT. The exercise of the option could create a large tax bill even if the value of the stock you acquired plummets after the date of exercise. Tax Tip. If you exercised an ISO in 2004 and the stock you acquired has declined in value since the date of exercise, it may be possible to eliminate or reduce your AMT tax liability if you sell the stock on or before December 31, 2004. Please check with us if you have exercised incentive stock options during 2004 and the price of the stock has fallen since the date of exercise. A sale of the stock after December 31, 2004 will not affect your AMT liability for 2004. So, we must act timely for a sale to reduce 2004 taxes!
Year-End Considerations For Capital Assets. Timing your year-end sales of stocks, bonds, or other securities may save you taxes. After fully evaluating the economic factors, the following are several year-end tax planning ideas for sales of capital assets. Caution! Always consider the economics of a sale or exchange first!
Stock "Traders" May Save Taxes By Electing "Mark-to-Market." If you are a "trader" in stocks, the "mark-to-market" election could possibly save you taxes. If you invest in stocks, the IRS will generally consider you either an "investor" or a "trader" (unless you sell securities to the general public). Generally, the IRS will treat you as a "trader" if you have frequent purchases and sales of stock, you hold the stock for short-term gain (rather than long-term appreciation and dividends), and you have a high volume of stock transactions for the entire year. If you qualify as a trader, you can elect (for tax purposes) to mark your stock down or up to market at year end. This election will convert what would generally be short-term capital gains and losses, into "ordinary" gains and losses. Tax Tip. This election could save taxes if you anticipate incurring significant capital losses. Each tax year you can only deduct $3,000 of the amount by which your capital losses exceed your capital gains. However, if you make a timely "mark-to-market" election, you can fully deduct those losses as "ordinary losses." Also, making this election will not subject your mark-to-market stock gains to Social Security or Medicare taxes. Planning Alert! Unless you made the election for a prior year, the mark-to-market election, unfortunately, must be made by the due date (without regard to extensions) of your prior year's tax return. Even though it is too late to make the election for 2004, you may wish to make the election by April 15, 2005 for 2005 and future years. Tax Tip. For new taxpayers (e.g., a partnership created to trade securities), the election is due within two months and 15 days after the creation of the entity. For example, a partnership created on October 1, 2004 should have until December 15, 2004 to make the election. Please call us if you think this election might save you taxes-we will be glad to fill you in on the details.
POSTPONING TAXABLE INCOME [table of contents]
Generally, it's a good idea to defer as much income into 2005 as possible if you believe that your marginal tax rate for 2005 will be equal to or less than your 2004 marginal tax rate. Deferring income into 2005 could also increase various credits and deductions for 2004 that are being phased out as your adjusted gross income increases. If you believe that deferring taxable income into 2005 will save you taxes, consider the following strategies:
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 2005. Caution! If you have already received the check in 2004, deferring the deposit does not defer the income. Also, you may not want to defer billing if you believe this will increase your risk of not getting paid.
Installment Sales. If you plan to sell certain appreciated property in 2004, you might be able to defer the gain until later years by taking back a promissory note instead of cash. If you qualify, the gain will be taxed to you as you collect the principal payments on the note. Planning Alert! Although the sale of real estate and closely-held stock generally qualify for this deferral treatment, some sales do not. For example, even if you are a cash method taxpayer, you cannot use this gain deferral technique if you sell publicly-traded stock or securities. Also, you may not want to take back a promissory note in lieu of cash if you believe that your chances of getting paid are at risk. Caution! As the law is currently written, the general, maximum long-term capital gains rate will increase from 15% to 20% after 2008. This increase in the long-term capital gains rate should be considered before agreeing to accept an installment note with payments due beyond the 2008 tax year.
Real Estate Swaps. If you want to sell investment or business real estate but plan to use the proceeds to purchase other investment or business real estate, consider a like-kind exchange. You could have the purchaser of your property buy the property you want and trade it to you. This way there should be no gain on the exchange. Tax Tip. In certain cases, the IRS rules will permit tax-free treatment even if you acquire the real estate you want before you transfer your existing realty. This is commonly referred to as a "reverse like-kind exchange." Planning Alert! Although like-kind exchanges may appear simple, they are not. It is easy to convert what appears to be a tax-free exchange into a fully taxable transaction. Tax-free exchanges present wonderful tax planning opportunities but please do not attempt one without calling us first.
Deferred Compensation. There are established ways to defer the taxation of 2004 compensation until 2005. These "deferred compensation" rules are extremely complex. Planning Alert! The American Jobs Act of 2004 imposes new restrictions on non-qualified deferred compensation plans, effective for compensation amounts deferred after 2004. Please call us before participating in a deferred compensation arrangement with your employer. We will help explain the new rules.
Required Distributions From Retirement Plans After 70½ Or Death. If you want to postpone the distributions (and therefore the taxation) of amounts in your traditional IRA or in a qualified retirement plan as long as possible, it is critical that you name the appropriate beneficiaries. You should generally name an individual or a "qualified trust" as the beneficiary. Caution! If your estate is the beneficiary of your IRA or qualified plan account, your heirs will generally miss out on substantial tax deferral opportunities after your death. In addition to naming an individual or individuals as your beneficiary, you should also name a "contingent beneficiary" in case your primary beneficiary dies before you. If you do not name a qualified beneficiary or if your estate is your beneficiary and you die before reaching age 70½, your entire retirement account generally must be distributed and taxed within five years of the year of your death. This will cause your beneficiaries to lose valuable tax deferral benefits. Planning Alert! The rules for maximizing the tax deferral possibilities for IRAs and qualified plan accounts are complicated. However, we will gladly review your beneficiary designations and offer planning suggestions. Tax Tip. If you are the current owner of a Roth IRA, you'll have no minimum required distributions after you reach age 70½. However, distributions must be made to your heirs after your death.
Also, if you are the beneficiary of the IRA or qualified plan account of someone that has died, there are certain planning techniques you should consider as soon as possible.Tax Tip. If the decedent named multiple beneficiaries or included an estate or charity as a beneficiary, we should review the situation as soon as possible to see if there is anything we can do to avoid certain tax traps. The rules for rearranging IRA beneficiaries for maximum tax deferral are complicated and are subject to rigid deadlines. Acting before certain deadlines pass is critical. The best tax results can generally be achieved by making any necessary changes no later than the end of the tax year in which the owner of the IRA or retirement plan dies. If you need assistance, please call our office as soon as possible so we can advise you.
IRS Grants Relief for Late IRA Rollovers. If you receive a distribution from your IRA or qualified retirement plan, and you want to avoid taxation, you typically must roll the distribution over into a new IRA or qualified retirement plan within 60 days. Tax Tip. You generally are allowed only one tax-free rollover of an IRA each year. If an IRA account is rolled over more than once each year, the amount involved in the second rollover is taxed and could be subject to a 10% penalty. However, there are no limits on the number of times you may have direct "trustee-to-trustee" transfers of your account between IRA trustees. If you wish to change your IRA trustee (e.g., move your IRA from one financial institution to another), please call us and we will assist you with a trustee-to-trustee transfer.
If you have taken money from your IRA or a qualified plan and intended to roll over the funds within 60 days, but failed to do so, please give us a call. The IRS has issued special procedures for applying for an extension of the 60-day rollover period if you satisfy certain criteria and has granted several taxpayers extensions during 2004. We will help you apply for an extension of time to complete the rollover. Caution! The IRS generally allows extensions only where the taxpayer intended to rollover the funds at the time of withdrawal and illness, death, bad advice, or misunderstandings of the law caused the taxpayer to fail to complete the rollover within the 60-day period. Obtaining an extension of the 60-day rollover is a time-consuming process. The best policy is always to complete the rollover within the 60-day period. Or, better yet, don't rollover at all. If you wish to change plan trustees, then simply transfer the funds using a trustee-to-trustee transfer. In a trustee-to-trustee transfer, the check for the amount transferred should be written to the new trustee, not to you.
TAKING ADVANTAGE OF DEDUCTIONS [table of contents]
Accelerating Deductions Into 2004. If you are a cash method taxpayer, you can generally accelerate a 2005 deduction into 2004 by "paying" it in 2004. Accelerating an "above-the-line" deduction into 2004 may allow you to reduce your "adjusted gross income" below the thresholds needed to qualify for many tax benefits. Remember, however, that itemized deductions do not reduce your "adjusted gross income" and, therefore, will not affect your 2004 deductions and credits that are reduced as your income increases. Itemized deductions include charitable contributions, state and local taxes, medical expenses, unreimbursed employee travel expenses, and home mortgage interest. Tax Tip. "Payment" typically occurs in 2004 if a check is delivered to the post office, or if an item is charged on a credit card in 2004.
"Bunching" Itemized Deductions. If your itemized deductions fail to exceed your standard deduction in most years, you are not receiving maximum benefit for your itemized deductions. You could possibly reduce your taxes over the long term by bunching the payment of your itemized deductions in alternate tax years. This may produce tax savings by allowing you to itemize deductions in the years when your expenses are bunched, and using the standard deduction in other years. Tax Tip. The easiest deductions to shift between tax years are charitable contributions, state and local taxes, and your January home mortgage interest payment. For 2004, the standard deduction is $9,700 on a joint return and $4,850 for single individuals. If you are blind or over age 64, you get an additional standard deduction of $950 if you're married ($1,200 if single).
"Bunching" Medical Expenses. Many taxpayers ignore the medical expense deduction because medical expenses are deductible only if they exceed 7.5% of your adjusted gross income (10% for AMT purposes). However, if you have medical expenses that are discretionary, you may be able to "bunch" them into 2004 or 2005 and exceed the 7.5% floor. For example, braces are discretionary, and such medical procedures as radial keratotomy and laser eye surgery may be discretionary and qualify for the medical expense deduction. Tax Tip. You can include in your medical expense the following: medical insurance premiums, transportation essential for medical care, lodging (but not meals) while away from home primarily for medical care, and changes to your house to accommodate a physical handicap. Tuition payments to a special school for a child with severe mental or physical disabilities (which would include medically diagnosed attention deficit hyperactive disorder) may also qualify as a medical expense. However, the IRS requires that a doctor recommend that a child attend the school, and the school generally must determine the portion of the tuition payment that relates directly to the medical needs of the child. Also, the costs of programs and prescription drugs to help people stop smoking qualify as a medical expense.
Deduction For Self-Employed Health Insurance Costs. If you are self-employed, a partner, or own more than 2% of an S corporation, you are generally entitled to an above-the-line tax deduction for your health insurance premiums.
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 2004 or 2005 so the 2% threshold is exceeded may reduce your taxes. You can bunch 2005 expenses into 2004 by prepaying the 2005 amounts in 2004. Planning Alert! The IRS says that prepayments of expenses applicable to periods beyond 12 months will not be deductible in 2004. Tax Tip. If you are a "statutory employee" (e.g., full-time life insurance salesperson, certain commissioned drivers, certain home workers) you are not subject to the 2% limitation for employee business expenses. The "statutory employee" box on your Form W-2 should be checked if you are classified as a statutory employee.
Charitable Contributions.
Maximizing Home Mortgage Interest Deduction. If you are looking to maximize your 2004 deductions, you can increase your home mortgage interest deduction by paying your January, 2005 payment on or before December 31, 2004. Typically, the January mortgage payment represents interest that was accrued in December and, therefore, is deductible if paid in December.
Tax Relief for Hurricane Losses. This year's hurricane season has had a devastating impact on many southeastern and east coast states, including, Alabama, Florida, Mississippi, Louisiana, Georgia, Virginia, North Carolina and South Carolina. Many counties in those states have been declared "Presidential Disaster Areas" which qualify those counties for various tax relief provisions recently announced by the IRS. For an updated list of Presidential Disaster Areas by state, please consult the FEMA website at www.fema.gov. For the most recent IRS tax relief announcements, please consult the IRS website at www.irs.gov. Tax relief for these counties which have been declared as part of a Presidential Disaster Area include extensions of time to file tax returns and pay taxes, and special periods within which the IRS may waive penalties for failure to timely deposit payroll taxes and excise taxes. Tax Tip. If you or your business is in a county located in a Presidential Disaster Area, you will receive this relief whether or not you or your business suffered damage because of the storms. If you have a loss from a casualty in one of these disaster areas (after considering any insurance claims), you have an option to deduct the loss on either your 2004 income tax return or on your 2003 return. You should generally take the deduction in the tax year that produces the greater tax reduction. Planning Alert! If the loss produces about the same tax benefit on the 2003 or the 2004 return, then you may wish to amend the 2003 return and take the loss in order to "speed up" the refund. Caution! Generally, if you wish to take the casualty loss deduction on the 2003 return, the return must be amended no later than April 15, 2005. We will gladly help you determine the amount of your deductible casualty loss and help you decide whether to take the loss in 2003 or 2004.
Tax-Wise Payment Of State And Local Taxes. Consider paying state and local income taxes (fourth quarter estimate and balance due for 2004) and property taxes for 2004 prior to January 1, 2005 if your tax rate for 2004 is higher than or the same as your projected 2005 tax rate. This will allow a deduction for 2004 (a year early) and possibly against income taxed at a higher rate. Planning Alert! You should not employ this tactic without carefully calculating the alternative minimum tax impact. Also, "overpayment" of your 2004 state and local income taxes is generally not advisable since a refund in 2005 from a 2004 overpayment may be taxed at a higher rate than the 2004 deduction rate. Please consult us before you overpay state or local income taxes! Tax Tip. Remember, the 2004 Jobs Act allows you to elect to deduct state and local sales taxes in lieu of state and local income taxes.
Club Dues. Club dues are generally not deductible at all, unless the dues are business related and are paid to professional organizations (e.g., ABA, AICPA, AMA), civic or public service organizations (e.g., Kiwanis, Lions, Rotary, Civitan), business leagues, trade associations, chambers of commerce, boards of trade, or real estate boards. Tax Tip. Although you may not generally deduct dues paid to country clubs, golf and athletic clubs, and airline clubs, there is a special rule for employers who reimburse these club dues. If you document to your employer the percentage of the time you use these clubs for bona fide business purposes, your employer can reimburse you for this business portion of the club dues and elect to exclude that reimbursement from your Form W-2. However, if your employer makes this election, the employer may not deduct the reimbursement.
Companion Travel Expenses. Generally, you are not allowed a deduction for taking your spouse or other companion on a business trip unless there is a "bona fide business purpose" for taking the person, and the person is also a "bona fide" employee of the person paying or reimbursing the expenses. Tax Tip. If your spouse is not an employee, but there is a bona fide business reason for taking your spouse on a business trip, your employer may reimburse you for your spouse's expenses without including the reimbursement on your Form W-2. However, you must document the amount and the business nature of your spouse's expenses. Furthermore, if your employer chooses this option, the employer will not be allowed a deduction for the reimbursement of the expenses.
TAX-WISE PLANNING FOR EDUCATION COSTS [table of contents]
Over the past several years, Congress has enacted many tax benefits for individuals that pay qualified education costs for themselves or their family members. The following are selected "education" tax breaks for your consideration as you develop your 2004 tax planning strategies.
Coverdell Education Savings Accounts. You can contribute up to $2,000 annually to a Coverdell education savings account (formerly "education IRA"). This limit applies to the aggregate contributions that may be made by all contributors to one or more Coverdell education savings accounts (CESAs) established on behalf of any particular beneficiary. Tax Tip. You may make a contribution to CESA for 2004 by April 15th of 2005. Your $2,000 contribution amount is phased out on a joint return as adjusted gross income goes from $190,000 to $220,000 ($95,000 to $110,000 if you are single). Planning Alert! The IRS says a child may make an education savings account contribution for himself or herself. Thus, if the adjusted gross income of both the parents and the grandparents exceed the limits, the child's parent or guardian may wish to establish a CESA with the child's funds (e.g., funds in a Uniform Gift to Minors Act account).
Although your contribution to a CESA is not deductible for tax purposes, you may make tax-free distributions from a CESA for the payment of qualified education expenses for elementary or secondary school education as well as for higher education expenses. This includes expenses for public, private, or religious schools (kindergarten through grade 12). "Qualified education expenses" include tuition, fees, academic tutoring, special need services, books, supplies, computer equipment (including related software and services), room and board, uniforms, transportation, and extended day programs (required or provided by the school in connection with the student's enrollment or attendance at that school). Therefore, if the funds accumulated in the CESA are distributed for qualified education expenses, the earnings on the funds are tax free.
Section 529 Plans. Earnings of a qualified state tuition plan (section 529 plan) may be distributed tax-free for qualified "higher" education expenses. So, unlike CESAs, K-12 education expenses should not be paid with section 529 plan funds. However, there is no $2,000 per year limitation on the amount that may be contributed to a section 529 plan and there are no income limits above which the contribution may not be made. Instead, once the amount in a section 529 plan equals the amount necessary to fund 5-years of undergraduate education at the highest cost institution in the state, no more contributions are allowed to that particular beneficiary's plan. Many state tuition plans have limitations on total contributions of $250,000 or more. So, if you wish to accumulate funds for qualified college education expenses (tuition, fees, and room and board), you should consider a section 529 plan. Tax Tip. Many individuals are using CESAs to save for private school education expenses and setting up section 529 plans to fund college expenses. You may establish both a CESA and a section 529 plan for the same individual.
Caution! Contributions to CESAs and to section 529 plans are gifts to the beneficiary of the account for gift tax purposes. However, the $11,000 annual exclusion for gifts is available to offset these contributions for gift tax purposes. Also, there is a special rule which allows you to consider the amount of gifts to a CESA or a qualified tuition plan for a year as made over five years. Therefore, it is generally not wise, from a gift tax standpoint, to transfer the maximum amount allowed to a qualified tuition plan in one year. However, by electing the 5-year rule, you could contribute $55,000 ($110,000 if both husband and wife make contributions or elect split-gift treatment) to a section 529 plan in one year and there should be no federal gift tax on the contribution as long as no other gifts are made to the beneficiary of the account for the current year and the next four years.
All 50 states now have state tuition plans. Also, most states allow non-residents to invest in their plan. If you wish to review the state tuition plans offered by your state as well as other states, please go to www.savingforcollege.com. This web site summarizes the plans for every state. Tax Tip. Please call us before contributing to a state tuition program. We can help you decide which plan best suits your needs. Also, some states allow a state income tax deduction for contributions to qualified state tuition plans but only if you contribute to that state's plan. We can advise you if you get additional state income tax benefits by contributing to your state's plan.
Education Expense Deduction. If you pay for qualified higher education tuition and fees for yourself, your spouse, or your dependents, you may qualify for an education expense deduction. This maximum $4,000 deduction is available whether or not you itemize. For 2004, you are allowed this maximum $4,000 deduction only if your adjusted gross income ("AGI") does not exceed $130,000 on a joint return ($65,000 if single). If your AGI is between $130,000 and $160,000 ($65,000 and $80,000 if you're single) your maximum deduction drops to $2,000. Planning Alert! If you expect to take this deduction and your income is close to the $130,000 or $160,000 limits ($65,000 or $80,000 if you're single), we should discuss your situation and see if we can take steps to keep your income below those thresholds for 2004. If you exceed the $160,000 or $80,000 limitation by even $1, the entire deduction is lost.
IRS Releases Final Regulations for Student Loan Interest. You may deduct (whether or not you itemized deductions) up to $2,500 of interest on qualified student loans. Your deduction phases out as your adjusted gross income increases from $100,000 to $130,000 on a joint return (from $50,000 to $65,000 on a single return). In recently released regulations, the IRS says that loan origination fees or late fees on qualified student loans will generally be deductible as interest. The regulations also say that any payment you make on the loan will first be applied to interest that has accrued and remains unpaid before it will be applied to outstanding principal. Furthermore, if someone else pays your interest, the payment will be treated as a gift to you, and you will then be treated as paying the interest yourself. Tax Tip. If you paid any student loan interest in 2004, be sure to provide us with Form 1098-E. This will help us determine your interest deduction for 2004.
"HOPE" Education Tax Credit. If you pay post high school education expenses for yourself, your spouse, or a dependent, you may be entitled to a tax credit of up to $1,500 per student. The HOPE scholarship credit is available only for two years of post-secondary education with respect to any one student. Under the two-year rule, the credit is allowed for a tax year if the student has not yet completed, before the beginning of the tax year, the first two years of postsecondary education at an eligible educational institution. For a full-time student who enters college in the autumn, that means that the credit is available for two of the first three calendar years the student attends college. The credit phases out ratably as your modified adjusted gross income increases from $85,000 to $105,000 on a joint return ($42,000 to $52,000 on a single return). The HOPE credit equals 100% of the first $1,000 (and 50% of the second $1,000) of tuition and fees required by the educational institution. No credit is allowed for meals, lodging, transportation, or other personal living expenses. Tax Tip. To get the full $1,500 credit for 2004, you must pay tuition of at least $2,000 for the student by December 31, 2004. If tuition, for example, is $1,200 each semester, you must pay two semesters of tuition in 2004 to get the full credit of $1,500. If your child began college in August or September of 2004, you should pay the $1,200 tuition for the spring semester of 2005 no later than December 31, 2004 (payments after that date will not qualify for credit during 2004). Tax Tip! Unless more than one member of your family qualifies for either the HOPE credit or the Lifetime Learning credit for 2004, the Lifetime Learning credit will produce a larger tax benefit than the HOPE credit if tuition and fees paid for 2004 exceed $7,500.
The Lifetime Learning Credit. You may qualify for a Lifetime Learning credit of up to $2,000. This credit equals 20% of the first $10,000 of qualified higher education tuition and fees. The phase-out rules for the Lifetime Learning credit are the same as those for the HOPE credit discussed above. Unlike the HOPE credit, the Lifetime Learning credit is for an unlimited number of years and can be used for graduate or professional degrees (as well as undergraduate education). Also, the Lifetime Learning credit limitation of $2,000 is per tax return not per student. Caution! The Lifetime Learning credit is not available for any of the education expenses of a student for 2004 if you take the HOPE credit for education expenses for that same student on your 2004 return. Tax Tip. In some situations, it may be better to claim the Lifetime Learning credit for qualified expenses that would otherwise qualify for the HOPE credit. For example, if a freshman's tuition is $10,000 in 2004, the Lifetime Learning credit would give you a $2,000 credit compared to the HOPE credit of 1,500. Keep in mind, however, that your total Lifetime Learning credit on your 2004 return cannot exceed $2,000. By contrast, you may take a HOPE credit of up to $1,500 for tuition and fees for each family member who qualifies. Planning Alert! If your income is more than $105,000 ($52,000 on a single return), you do not qualify for the Hope credit or the Lifetime Learning credit. However, the IRS says the student (e.g., your child) may claim the credits on his or her return, provided you elect not to claim that child as a dependent on your tax return (even if the child otherwise qualifies as your dependent). Of course, since the HOPE and Lifetime Learning credits are non-refundable credits, your child must have an income tax liability to utilize the credits on his or her return.
TAX PLANNING FOR YOUR HOME [table of contents]
IRS Releases Final Home Sale Exclusion Regulations. If you have owned your home and used it as your "principal residence" for at least two out of the last five years, you can exclude up to $250,000 of the gain ($500,000 on a joint return) when you sell it. The IRS recently issued new regulations that, in several situations, expand this rule. For example, contrary to an earlier IRS position, the new regulations generally allow you to exclude gain that would otherwise be allocable to your "qualified home office" (except gain is triggered to the extent of depreciation taken on the home office after May 6, 1997). The new rules also allow you to exclude gain when you sell land adjacent to your residence so long as the land is sold within two years of the sale of your home and the land has been owned and used as part of your residence for the required period. In addition, the regulations provide rules that will automatically allow you to claim a portion of the exclusion when you have not owned and used the residence for the required two-year period, but you sell the home because of a change in place of employment, for health reasons, or because of certain unforseen circumstances. For example, the new regulations say that you are entitled to relief if you move: for health reasons pursuant to a physician's recommendation; because of an employment change satisfying a 50-mile test; or because of a divorce, legal separation, or natural disaster. Tax Tip. These rules are retroactive (generally for three years) and provide relief in many situations. If you think that you have previously filed a return reporting a house gain that may be excluded under these new regulations, we can help you determine whether you should amend that return and recoup the taxes paid.
The Home Office Deduction. Recent tax law changes have made it easier for you to qualify for home office deductions (e.g., depreciation, insurance, utilities, repairs and maintenance). If you're self-employed, you only have to establish that you use your home office "regularly and exclusively" to perform management or administrative duties for your business and there is no other fixed location where you perform substantial management or administrative duties relating to that trade or business. If you are an employee, in addition to meeting the above requirements, you must also establish that your home office is "for the convenience of your employer" (this generally means you're not provided an office at work). Tax Tip. The IRS says that if you have a qualifying home office, you can deduct any travel from your home office to another work location as a business expense. So, by having a qualified home office, you will generally have more deductible business travel. Furthermore, if you're an employee who qualifies for home office deductions, you should ask your employer to reimburse your home office expenses. This reimbursement should be excluded from your income if reimbursed under an "accountable reimbursement arrangement." If you are an employee and your home office expenses are not reimbursed, the home office expense deduction will be reduced by 2% of your adjusted gross income.
Renting Your House To A Relative Can Be Tricky. If you are renting a house to a relative as their principal residence and they pay you fair rental value, you will be able to deduct depreciation and your other rental expenses (e.g., utilities, insurance, repairs and maintenance). However, if they pay you less than fair rental value, you may only deduct interest and taxes. Tax Tip. Always get independent, written confirmation of the market rental value of any house you rent to a family member, and charge at least that amount if you want to deduct depreciation, insurance, repairs and maintenance.
PLANNING WITH RETIREMENT PLANS [table of contents]
Consider Contributing The Maximum Toward Your Retirement. As your income rises and your marginal tax rate increases, deductible retirement plan contributions generally become more valuable to you. Also, making your deductible contribution to the plan as early as possible generally increases your retirement benefits. As you evaluate how much you should contribute, consider the following:
The Roth IRA - A Valuable Retirement Savings Option. The Roth IRA continues to be a popular retirement savings option. If you have "earned income" at least equal to the contribution, you may make a nondeductible contribution of up to $3,000 ($3,500 if you are at least age 50) to a Roth IRA. You may generally make a contribution for 2004 anytime on or before April 15, 2005. If you are married, you can contribute up to $3,000 for yourself, and an additional $3,000 for your spouse, provided your combined earnings are at least $6,000. However, the $3,000 contribution limits are phased out as your adjusted gross income increases from $150,000 to $160,000 on a joint return($95,000 to $110,000 if single). Also, the $3,000 amount you may contribute to a Roth IRA is reduced by any contributions you make to a regular IRA for the same tax year.
You can not deduct your contributions to a Roth IRA. However, qualified distributions from the Roth are tax free. If you maintain your Roth IRA for at least five years, amounts may be withdrawn completely "tax free" if you meet any of the following conditions: (1) you have attained age 592, (2) the distribution results from your death or disability, or (3) the distribution is for qualifying first-time home buyer expenses. Also, distributions from a Roth IRA are deemed to come from your nondeductible contributions first. Thus, you may generally withdraw any or all of the amounts you have contributed tax free without meeting the above requirements.
Setting Up A Roth IRA For A Minor. You can set up a Roth IRA for your minor child, provided the child has "earned income" at least equal to the Roth IRA contribution (the maximum contribution is $3,000). Your child's earned income can include money from baby sitting or mowing lawns. Furthermore, if your child's outside earnings do not exceed $400, the child will not be subject to Social Security taxes. If you are a sole proprietor, you don't have to pay FICA or medicare taxes on wages paid to your child who is under age 18. Furthermore, assuming you are paying reasonable compensation, your child's wages may be taxed at a rate as low as 10% and deducted by you at your rate (as high as 35%).
OTHER ITEMS TO CONSIDER [table of contents]
$250 "Above-the-Line" Deduction For Teachers. For 2002 through 2005, if you are an "eligible educator" you will be able to deduct as an "above-the-line" deduction (deductible even if you don't itemize) up to $250 of your qualified classroom expenses. Your qualified expenses include books, supplies (other than non-athletic supplies for courses in health or physical education), computer equipment (including software and services), other equipment, and supplementary materials. Planning Alert! To be an "eligible educator" you must be a kindergarten through grade 12 teacher, instructor, counselor, principal, or aide working at least 900 hours during the school year.
Adoption Tax Credit. If you are considering adopting a child, the adoption tax credit may substantially reduce your tax bill. This year, you may be entitled to an adoption tax credit for qualifying adoption expenses of up to $10,390 per child. Also in 2004, the adoption credit is phased-out as your modified adjusted gross income increases from $155,860 to $195,860. Tax Tip.If you finalize the adoption of a "special needs child" in 2004, you may receive the full adoption tax credit of $10,390 even if this is more than your adoption expenses. This credit for the excess of $10,390 over your actual expenses is allowed only in the year the adoption is finalized.
Foreign Adoptions. If you are adopting a child who is not a citizen or resident of the U.S. when the adoption commences, you are allowed the credit only if, and when, the adoption becomes final. The IRS has recently released guidance on when a foreign adoption becomes final. Call our firm if you need more information. Planning Alert! Your adopted child must have a taxpayer identification number (TIN) for you to take the credit. A child's Social Security number is normally the TIN. If, after reasonable efforts, you are unable to obtain a Social Security number for the child, you can apply for an "adoption taxpayer identification number" by filing a Form W-7A with the IRS.
Clean-Fuel Vehicles Deduction. If you purchase a new "qualified clean-fuel auto" (certain automobiles adapted to run on clean-burning fuels), you may take a $2,000 above-the-line deduction, whether or not you used the vehicle in your business. The IRS has certified the following vehicles as qualifying for this $2,000 deduction: the Toyota Prius (for model years 2001, 2002, 2003, 2004 and 2005), the Honda Insight (for model years 2000, 2001, 2002, 2003, and 2004), and the Honda Civic-Hybrid (for model years 2003 and 2004). Tax Tip. Please let us know if you have purchased any of these vehicles during 2004 or a prior year, so we can make sure you get this deduction.
Moving Expenses. If you had a job-related move in 2004, you may be entitled to deduct unreimbursed moving expenses. Deductible moving expenses only include: (1) moving household goods and personal effects from your former residence to your new residence, and (2) travel costs (including lodging during the travel) from your former residence to your new residence. Tax Tip. If your employer reimburses your moving expenses, provide your employer with proper documentation of the moving expenses. Otherwise, the IRS says employer reimbursements should be included in your Form W-2.
Social Security Numbers For Dependents. All dependents must have a social security number, even if they are born as late as December 31, 2004. If you don't include a valid social security number for a child (or other dependent), the IRS can disallow tax benefits relating to that dependent, including the dependency exemption, child tax credit, dependent care credit, adoption expense credit, HOPE scholarship credit, Lifetime Learning credit, earned income credit, as well as the exclusion from gross income of employer‑provided adoption assistance payments. If you do not have a social security number for your dependents, please apply to the Social Security Administration for the number using Form SS-5, which can be obtained from any office of the Social Security Administration.
Penalty For Under-Withholding Or Under-Estimating. One way to avoid a penalty for failing to pay or withhold sufficient income taxes for a tax year is to pay 100% of your prior year's tax liability in quarterly estimated payments or through income tax withholding. Planning Alert! If your 2003 AGI was over $150,000, you must pay in 110% of your 2003 tax liability to qualify for this safe harbor in 2004. Tax Tip. If you have not paid sufficient estimates to avoid an underpayment penalty for 2004 and you have wages subject to withholding, you may have additional amounts withheld from these wages on or before December 31, 2004. Any withholding for 2004 is deemed paid equally on each quarterly installment date for estimated tax purposes, even if the withholding occurs in December.
Tax Court Finds Taxable Portion of Non-Taxable Physical Personal Injury. Generally, damage awards for a "physical" personal injury are fully tax free (except to the extent allocated to "punitive damages"). So, for example, damage payments to a taxpayer for medical malpractice or a negligent car accident are typically tax free. However, in a recent case, the Tax Court held that a professional photographer who was intentionally kicked by an NBA basketball player during a game, and received a $200,000 settlement for his "physical" personal injury, must pay tax on a portion of the settlement agreement. In the settlement, the photographer expressly agreed not to disclose the terms of the settlement. The Tax Court held that the portion of the damages that could be reasonably allocated to the non-disclosure provision were taxable, even though the original claim constituted a physical personal injury. Tax Tip. If you anticipate receiving any settlement or lawsuit damage awards for a physical personal injury, make sure you obtain competent tax advice before agreeing to the structure of the settlement. Any damage allocation to punitive damages or non-disclosure agreements will be fully taxable. Feel free to contact our office if you need more information on damage award allocations.
IRS Warns Against Frivolous Arguments. The courts and the IRS are "cracking down" on taxpayers taking frivolous positions or making unsupportable arguments in attempts to avoid paying taxes. These arguments include: the 16th amendment which authorizes the income tax is invalid because it contradicts the original Constitution and was not properly ratified; an individual can escape taxes by placing all his or her assets in an offshore bank account; a taxpayer can escape taxes by placing all of his or her assets in a trust; the Internal Revenue Code does not require taxpayers to file tax returns; payroll taxes are voluntary; taxpayers can avoid taxes by disclaiming their tax liability; and social security taxes are refundable. The IRS and the courts have consistently disagreed with all these arguments and have charged the taxpayers substantial penalties in addition to the unpaid taxes and interest. Please call our office before becoming involved in any of these types of arrangements or any other "tax saving" transaction that seems too good to be true.
FINAL COMMENTS [table of contents]
Please call us if you are interested in a tax topic that we did not discuss. Tax law constantly changes due to new legislation, cases, regulations, and IRS rulings. Our firm closely monitors these changes and will be glad to discuss any current tax developments and planning ideas with you. Please contact us before implementing any planning ideas discussed in this letter, or if you need more information.