To Our
Clients and Friends,
With 2005
winding down, it’s time once again to consider year-end tax planning as a way to
keep more of your hard-earned money. Year-end planning changes each year due to
changing tax rules, as well as changes in your own personal financial and tax
situations. For 2005, there are new planning strategies resulting from the three
Tax Acts Congress has passed so far this year, as well as the phase-in of some
provisions of prior year Tax Acts. Here are a few tax-saving ideas to get you
started.
As always,
you can call on us to help you sort through the options and implement strategies
that make sense for you.
Assess Your Alternative Minimum Tax Exposure
The first
step in year-end planning is to see whether you might be subject to AMT this
year (or next year for that matter). Taxpayers must compute their taxes under
both the regular tax and AMT rules and then pay the greater of the two. Although
AMT was originally designed to apply only to taxpayers who took too much
advantage of certain tax breaks, the current rules encompass many unsuspecting
taxpayers. Being in the world of AMT puts a whole new spin on tax planning
because many great planning strategies that make sense in a regular tax
situation completely backfire in an AMT scenario.
Certain
items can increase your risk of AMT, including exercising incentive stock
options, recognizing substantial long-term capital gains, and deducting a
significant amount of state and local taxes or miscellaneous itemized deductions
(like unreimbursed employee business expenses). But no one is safe from AMT
anymore, and planning when AMT applies is tricky because each situation is
unique. Therefore, if you have any of the items mentioned or suspect AMT might
be an issue, please contact us so we can help you review and plan for your
particular situation. Now that we’ve addressed the AMT matter, let’s move on to
a variety of tax planning strategies that normally apply to the vast majority of
taxpayers—that is, those in a regular tax situation.
Deferring Income and Accelerating Deductions
The most
common year-end tax planning strategies are those that defer income from the
current year to later years and those that move deductions from later years into
the current year. The underlying reason is that it’s better to pay taxes later
rather than sooner due to the time value of money.
So, how do
you shift income and deductions between tax years? The most common techniques
are using income or deductions that you can easily control. For example, if
you’re due a year-end bonus and you can get your employer to agree, receive the
bonus in January 2006 rather than 2005. On the investment side, income from
short-term (i.e., maturity of one year or less) obligations like Treasury Bills
and short-term CDs is not recognized until maturity. Income from those
straddling year-end is deferred to the following year. For sales of property,
consider an installment sale that shifts part of the gain to later years when
the installment payments are received.
On the
deduction side, move charitable donations you normally would make in early 2006
to the end of 2005. Do the same with real estate taxes or state income taxes. If
you own a cash-basis business, delay billings so payments are not received until
2006 or accelerate payment of certain expenses, such as office supplies and
repairs and maintenance, to 2005. Of course, before deferring income, you must
assess the risk of doing so.
Deferring Energy Efficient Purchases
Residence Credits. The
Energy Tax Incentives Act of 2005 provides two new credits for energy efficient
improvements made to personal residences, but only if the improvement is made after 2005. So, if you are planning on making any such improvements in
the near future, you will want to put them off until 2006. Otherwise, the credit
won’t be available. Improvements eligible for credits in 2006 are as follows:
· Qualified home improvements on your
principal residence (no vacation homes), including metal roofs coated with
heat-reduction pigments; exterior windows, including those in skylights;
exterior doors; insulation materials or systems designed to reduce heat loss or
gain, energy efficient electric heat pumps, electric heat pump hot water
heaters, geothermal heat pumps, and central air conditioners; qualified natural
gas, propane, and oil furnaces and qualified hot water boilers; and advanced
main air circulating fans. The available credit for such expenditures is
generally limited to a lifetime amount of $500, although other limits may also
apply. And to reiterate, it only applies to items put to use after
12/31/05.
· Qualified solar water heating equipment, electricity
generating solar photovoltaic property, and fuel cell property put to use after 2005 in your personal residence. However, equipment used to heat
swimming pools or hot tubs does not qualify. The credit will generally equal 30%
of the item’s cost, limited to $2,000 per type of item or, in the case of fuel
cell property, $500 for each .5 kilowatt of capacity.
Hybrid
Vehicles. The
Energy Tax Incentives Act of 2005 replaced the $2,000 deduction available for
hybrid vehicle purchases made before 2006 with a credit of up to $3,400 for
hybrid vehicles purchased after 2005. At first blush, delaying hybrid vehicle
purchases to 2006 to take the credit seems to be the best deal. However, that is
not necessarily so. You might actually be better off making the purchase before
the end of this year and cashing in on the existing $2,000 deduction. To figure
out where you stand on this issue, you must assess (1) the expected amount of
the 2006 credit compared to the $2,000 deduction available for 2005 and your
expected marginal tax rate for 2005, (2) the impact of the credit phase-out
rules, (3) your projected 2006 AMT situation, and (4) whether the emissions
standards will make your desired vehicle ineligible for the credit in 2006. If
you are considering a hybrid vehicle purchase in the near future, please give us
a call. We can put all the pieces together to ensure that you make the optimal
tax-saving decision.
Increase Charitable Giving
Ordinarily, the amount of
cash donations to IRS-approved public charities that an individual can deduct in
any year is limited to 50% adjusted gross income (AGI). Any charitable
contribution deduction is also potentially subject to phase-out if your AGI
exceeds $145,950 in 2005. Given the horrendous tragedies that occurred in 2005,
Congress has bent these rules for most cash contributions made between
8/28/05 and
12/31/05. Such contributions are
deductible—without any reduction under the phaseout rule—up to 100% of your AGI
when combined with donations made earlier in the year.
This makes
2005 a particularly good year to make charitable contributions if you are so
inclined. And, if you charge the contribution to a credit card, it is deductible
in the year charged, not when payment is made on the card. Thus, charging
donations to your credit card before year-end enables you to increase your 2005
charitable donations deduction even if you’re temporarily short on cash or
simply want to defer payment until next year. Note, however, that any interest
paid with respect to the charge is not deductible.
Deducting State
and Local Sales Tax
If you
itemize deductions, you can deduct either state and local sales taxes or state
and local income taxes. While this option clearly benefits individuals who live
in states that don’t impose a significant income tax, even taxpayers subject to
state income tax may find that the sales tax deduction exceeds their state
income tax deduction. This is especially true if you make significant purchases
this year.
If it turns
out that the sales tax deduction is more beneficial than deducting state income
taxes, you can choose between claiming the actual sales taxes you paid during
the year or an amount from IRS-published tables. The table amount is based on
your income level and the size of your family. Saving your receipts to document
the sales tax you actually paid (especially if you made or are planning to make
significant purchases) may yield a larger deduction than using the IRS tables.
But, even if you use the IRS tables, the sales tax on certain big-ticket items
can be added to the sales tax amount from the tables. Namely, the sales tax on
motor vehicles, whether purchased or leased, aircraft, boats, homes (including
mobile and prefabricated), and home building materials (if the tax rate was the
same as the general sales tax rate) can be added to the table amount. A motor
vehicle includes a car, motorcycle, motor home, recreational vehicle, SUV,
truck, van, and off-road vehicle. So, even if you plan to simplify your life and
use the IRS tables to figure your 2005 sales tax deduction, be aware of these
items and be sure to keep documentation of sales tax paid on them so the tax can
be added to the table amount.
Adjusting Federal Income Tax Withholding
If it looks like you are
going to owe income taxes for 2005, consider bumping up the Federal income taxes
(FIT) withheld from your paychecks now through the end of 2005 so that your
total tax payments (estimated payments plus withholdings) equal at least 90% of
your estimated 2005 liability or, if smaller, 100% of last year’s liability
(110% if your 2004 AGI exceeded $150,000). On
April 15,
2006, you will
still have to pay the taxes due less the amount paid in, but you won’t owe any
interest or penalties.
Alternatively, you could take an IRA or qualified plan distribution and
request that enough FIT be withheld to cover the payment shortfall. However, the
total amount of the distribution (i.e., before FIT withholding) must be rolled
into an IRA (or qualified plan) within 60 days. Otherwise, the distribution will
be fully taxable, and, if you are under age 59½, subject to the 10% early
distribution penalty. Therefore, this should be considered only if you have the
funds available to fully complete the rollover.
Year-end Planning for Your Business
Expense the Cost of up to $105,000
of Business Property. The section 179 deduction allows business owners
to deduct up to $105,000 of the cost of qualifying depreciable property placed
in service in 2005. Property eligible for the immediate tax write-off can be new
or used and includes “off-the-shelf” computer software. (Even property purchased
on the last day of the year qualifies.) However, the allowable deduction cannot
exceed your business’s net income and is reduced dollar-for-dollar to the extent
the amount of qualifying property placed in service during the year exceeds
$420,000. If you have plans to buy a business computer, office furniture,
equipment, vehicle, or other tangible business property, you might consider
doing so before year-end to maximize your 2005 deductions.
Maximize the New
Deduction for
U.S. Production
Activities. For
2005, businesses (incorporated or not) can deduct (for both regular and
alternative minimum tax) up to 3% of their qualified domestic production
activities income. “Qualified domestic production activities income” is the net
income from certain business activities, if substantially all the activity takes
place in the
U.S. (or its possessions). “Production” is
somewhat of a misnomer. In addition to traditional manufacturing, the deduction
is available for income from selling personal property that the business
manufactures, grows, produces or extracts; construction; producing software,
film, or videotape; farming; and processing agricultural products and food.
If your business is engaged
in one of these qualified activities, the new deduction can be significant. But,
there is one catch—the deduction can’t exceed 50% of the wages paid to employees
(W-2 wages) for the year. This could be a problem for businesses that pay little
or no wages. Many sole proprietorships do not pay the owner a salary. Likewise,
S corporations often pay owners relatively small salaries to minimize their
payroll taxes. This means that, after applying the W-2 wages limit, their
deduction for
U.S. production activities could be
significantly reduced.
Business owners who are
eligible for the
U.S. production activities deduction should
look at their compensation policies and consider increasing owner salaries to
ensure their deduction is not scaled back. Also, because the deduction is based
on net income from qualifying activities, it would be a good idea to take a look
at your accounting system to be sure it will allow you to determine the income
from qualifying activities, as well as expenses directly related to or allocable
to that activity. If not, some tweaking of the accounting system may be in
order.
Work
Opportunity Tax Credit. Employers can claim the work opportunity
tax credit (WOTC) if they hire individuals from designated target groups. The
credit generally equals 40% of the first $6,000 of wages paid to the employee in
the first year. However, the rate is 25% of wages for employment of 400 hours or
less. Therefore, the maximum credit is $2,400.
“Hurricane
Katrina employees” are now considered members of a targeted group for purposes
of the WOTC. This includes employees who: (1) on 8/28/05 had a principal place
of abode in the core disaster area and (2) are hired during the two-year period
beginning on 8/28/05 for a position the principal place of employment of which
is located in the core disaster area. It also includes employees who: (1) on
8/28/05 had a principal place of abode in the core disaster area and were
displaced from that abode because of Hurricane Katrina and (2) are hired by any
employer (regardless of location) during the period beginning on 8/28/05 and
ending on 12/31/05. So, if your business is in the hiring mode, Hurricane
Katrina transplants can make a good choice.
Paying Dividends in
Lieu of Owner Salaries. If for 2005 you expect to personally be
in the 28% or higher tax bracket and you own a corporation that you expect to be
in the 15% income tax bracket (taxable income of $50,000 or less), you could net
more cash after taxes by paying yourself some dividends in lieu of additional salary. This is because dividend
income is subject to a maximum 15% tax rate, while your salary is subject to
your 28% or higher tax rate, plus you and your corporation must pay payroll
taxes on your salary.
Any
dividends paid to you must be paid to other owners as well. Thus, if there are
multiple shareholders, paying dividends could alter the bottom-line cash flow
reaped by the various shareholders, which may make this strategy unworkable in
some situations. However, in the context of family-owned C corporations, this
may be a good thing—a family recipient who is in the 10% or 15% tax brackets
(which many children are) will pay only 5% on this dividend income.
Strategies That Never Go out of Style
Lower Tax Rates on Capital
Gains. Long-term capital gains and qualifying dividend income are
subject to a tax rate of only 15% for taxpayers in a regular tax bracket of 25%
or higher and 5% for taxpayers in the lower regular tax brackets. Given tax
rates as high as 35% for other types of income, this is quite a break. To be
eligible for the lower 15% (or 5%) capital gain rate, a capital asset must be
held for more than a year. So, when disposing of your appreciated stocks, bonds,
investment real estate, and other capital assets, pay close attention to the
holding period. If it’s less than one year, consider deferring the sale so that
you can meet the greater-than-one-year period. While it’s generally not wise to
let tax implications drive your investment decisions, you shouldn’t ignore them
either.
When
selling stock or mutual fund shares, the general rule is that the shares you
acquired first are the ones you sell first. However, if you choose, you can
specifically identify the shares you’re selling when you sell less than your
entire holding of a stock or mutual fund. By notifying your broker of the shares
you want sold at the time of the sale, your
gain or loss from the sale is based on the identified shares. This sales
strategy gives you better control over the amount of your gain or loss and
whether it’s long-term or short-term.
Harvesting Capital
Losses. It’s always
a good idea to periodically review your investment portfolio to see if there are
any losers you should sell. This is especially true as year-end approaches,
since it’s the last chance to offset capital gains recognized during the year or
to take advantage of the $3,000 ($1,500 for married separate filers) limit on
deductible net capital losses. But, don’t forget the wash-sale rule. This rule
defers your loss if you purchase a substantially identical security within the
period beginning 30 days before and ending 30 days after the date of sale.
Manage Your
AGI. Many tax
breaks are only available to taxpayers with adjusted gross income (AGI) below
certain levels. Some common AGI-based tax breaks include the child tax credit
(phase-out begins at $110,000 for married couples and $75,000 for
heads-of-households), the $25,000 rental real estate passive loss allowance
(phase-out range of $100,000–$150,000 for most taxpayers), and the exclusion of
social security benefits ($32,000 threshold for married filers; $25,000 for
other filers). In addition, taxpayers with 2005 AGI in excess of $145,950 begin
losing part of their itemized deductions, to the extent of 3% of the excess.
Accordingly, strategies that lower your income or increase certain deductions
might not only reduce your taxable income, but also help increase some of your
other tax deductions and credits.
Retirement Plan
Distributions. If
you’re age 70½ or older, you’re normally subject to the minimum distribution
rules with regard to your retirement plans. Under these rules, you must receive
at least a certain amount each year from your retirement accounts. You can
always take out more than the required amount, but anything less is subject to a
50% penalty on the shortfall amount. Thus, if you haven’t taken your required
distribution for 2005, do so before year-end to avoid a hefty penalty. If you
turned age 70½ in 2005, you can delay your 2005 required distribution until
April 1, 2006 if you choose. But, waiting until 2006
will result in two distributions in 2006—the amount required for 2005 plus the
amount required for 2006. While deferring income is normally a sound tax
strategy, here it results in bunching income into 2006, which may push you into
a higher tax bracket or have a detrimental impact on other tax deductions you
normally claim.
Conclusion
Taking the
time now to review your 2005 tax situation gives you a chance to take advantage
of many year-end tax saving opportunities. This letter highlights selected
strategies, but there are many others that might also apply to your particular
situation. We are here to help. If you would like to discuss the strategies
mentioned here or other ideas for reducing your 2005 tax liability, please don’t
hesitate to call us. We would be pleased to set up a meeting within the next few
weeks while there’s still time to implement tax strategies before
year-end.
