10 Year-End Tax Planning Topics
November 26, 2011
1. Deferring income to 2012 means postponing taxes
Consider opportunities you might have to defer income to 2012. You might be
able to delay a year-end bonus, for example. If you’re able to push what would
have been 2011 income into 2012, you may be able to put off paying income tax on
the deferred dollars until next year.
2. Paying deductible expenses sooner may help you in 2011
Does it make sense for you to accelerate deductions into 2011? If you itemize
deductions, it might help your 2011 bottom line to pay deductible expenses like
medical costs, qualifying interest, and state and local taxes before the end of
the year, instead of waiting until 2012.
3. Income tax rates to remain the same in 2012
The same six federal income tax rates that apply in 2011 will apply in 2012.
So, depending upon your income, you’ll fall into either the 10%, 15%, 25%, 28%,
33%, or 35% rate bracket. And, as in 2011, long-term capital gains and
qualifying dividends will continue to be taxed at a maximum rate of 15% in 2012;
and if you’re in the 10% or 15% tax rate brackets, a special 0% tax rate will
generally continue to apply.
If you’re subject to the alternative minimum tax (AMT), special rules apply.
For example, the AMT rules can effectively disallow a number of itemized
deductions, making it a potentially significant consideration when it comes to
year-end planning. You’re more likely to be subject to AMT if you claim a large
number of personal exemptions, deductible medical expenses, state and local
taxes, and miscellaneous itemized deductions. If you’ve been subject to the AMT
in the past, or think that you might be for 2011, you’ll want to make sure that
you understand how the AMT rules might affect you.
5. IRA and retirement plan contributions
Employer-sponsored retirement plans like 401(k) plans and traditional IRAs
(if you qualify to make deductible contributions) present an opportunity to
contribute funds on a pre-tax basis, reducing your 2011 taxable income.
Contributions that you make to a Roth IRA (assuming you meet the income
requirements) aren’t deductible, so there’s no tax benefit for 2011–they’re
still worth considering, though, because qualified distributions are free from
federal income tax. The window to make 2011 contributions to your employer plan
closes at the end of the year, but you can generally make 2011 contributions to
your IRA up to April 17, 2012.
6. Special distribution requirements at age 70½
Once you reach age 70½, you’re generally required to start taking required
minimum distributions (RMDs) from any traditional IRAs or employer-sponsored
retirement plans you own. It’s important to make withdrawals by the date
required–the end of the year for most individuals. The penalty is steep for
failing to do so: 50% of the amount that should have been distributed. Barring
additional legislation, 2011 will be the last year to take advantage of a
popular provision allowing individuals age 70½ or older to make qualified
charitable distributions of up to $100,000 from an IRA directly to a qualified
charity (these charitable distributions are excluded from your income, and count
toward satisfying any RMDs that you would otherwise have to take from your IRA
for 2011).
7. Depreciation and expense limits to drop for business owners and the self-employed
If you’re a small business owner or a self-employed individual, you’re
allowed a first-year depreciation deduction of 100% of the cost of qualifying
property acquired and placed in service during 2011; this “bonus” first-year
additional depreciation deduction will drop to 50% for property acquired and
placed in service during 2012. For 2011, the maximum amount that can be expensed
under IRC Section 179 is $500,000, but in 2012 the limit will drop to
$139,000.
8. Last chance to deduct energy-efficient home improvements
This is the last year you’ll be able to claim a credit for energy-efficient
improvements you make to your home (up to 10% of the cost of qualifying
property). Improvements can include a qualifying roof, windows, skylights,
exterior doors, and insulation materials. Specific credit amounts may also be
available for the purchase of energy-efficient furnaces and hot water boilers.
However, there’s a lifetime credit cap of $500 ($200 for windows). So, if you’ve
claimed the credit in the past–in one or more years since 2005–you’re only
entitled to the difference between the current cap and the amount you’ve claimed
in the past.
Barring additional legislation, this is the last year that you’ll be able to
elect to deduct state and local general sales tax in lieu of state and local
income tax, if you itemize deductions. This also will be the last year for both
the above-the-line deduction for qualified higher education expenses, and the
above-the-line deduction for up to $250 of out-of-pocket classroom expenses paid
by education professionals.
Making effective year-end moves requires a solid understanding of the rules
that are in effect for both 2011 and 2012. It also requires a comprehensive
grasp of your overall financial situation. A financial professional can help you
evaluate potential opportunities, and can keep you apprised of any last-minute
legislative changes.
Home Office Use
November 9, 2011
I’ve been frequently asked about the home office tax deduction. There are some important rules to remember. The critical factor is if the home office passes the “regular-use” test.
How is regular use defined by the IRS?
The IRS defines regular use as using an area of your home exclusively for business on a continuing basis. The occasional use of an area in your home does not meet the regular use test. There have been some court cases where 10 hours per week of home office use was determined to be the minimal requirement.
How to document your home office use?
First of all you might keep a log or appointment book that references your time in the office. Documents that would prove this would be emails you send from your home office as well as a signed guest log for client meetings. Phone bills showing long distance calls from the home office would be another valuable document.
photo credit: Jeremy Levine Design
Family Business Succession
October 11, 2011
Succession Planning and Estate Planning for Family Businesses
Succession planning is as important in a family business as in a public corporation. According to the Family Business Institute, 97% of family businesses do not survive past the third generation. Succession planning and estate planning can help determine what to do if a family member who is next in line is performing poorly.
There are numerous high profile examples of failed family businesses. Perhaps the most glaring is the Busch family, founders of Anheuser-Busch. Adolphous Busch joined the struggling company in 1864, and through four generations it thrived, generating nearly $17 billion in revenue in 2008. But personal problems and failure to adapt to the market led to the company’s hostile takeover by Belgian-Brazilian conglomerate InBev.
With successful family businesses, the generation that created the wealth tends to be highly productive. The creator is frequently a larger-than-life type A personality who enjoys enormous control over the company and undertakes extreme effort for wealth creation, which can be detrimental to family relationships. The founder often does not share control or ideas about the company with his family while he is alive.
The next generation doesn’t learn about saving or wise spending, becoming accustomed to a lavish lifestyle. Subsequent generations lack the incentive to become strong, resourceful leaders and to strike out on their own to make more money. They develop a completely different ethic about spending than the previous generation. Since the founder put himself over his family, adversarial relationships develop between spouses and children, often leading to conflicts and alcohol and drug abuse.
The failure of wealth to survive to the third or fourth generation is usually not because of estate taxes or the inability to transfer the wealth, but because the knowledge of how to create wealth and then to keep it is not passed on. When the children are not integrally involved in the company before the founder’s death, they lack wisdom and experience. They also may feel they have something to prove once they take over, which can lead to reckless decision-making.
Children in the second and subsequent generations also may not be as intelligent or shrewd as the founder and find themselves taken advantage of. This is especially the case for children with a famous name. The name attracts hangers-on who do not have the children’s best interests at heart. Detailed estate planning using trusts can help mitigate this problem by not allowing the children unfettered access to inherited money.
Estate planning is also important because of the danger of drug and alcohol abuse. The World Health Organization states that the more money someone has, the more likely they are to abuse drugs and alcohol. Substance abuse is one of the most common reasons wealthy families see their fortunes squandered. Trusts can be used to help encourage entry into a recovery program or keep substance abusers away from the family fortune.
A successful family business created through dedication and hard work by one generation can be preserved through careful succession planning and estate planning by qualified professionals.
photo credit: Tumbleweed:-)
Job Search Deductions
October 6, 2011
Job Seeker or Self-Employed?
Job seekers would be well-served to get tax advice for the numerous and tricky potential deductions for job search expenses. The most commonly-used provision, the “miscellaneous deduction,” can strictly limit write-offs, while the Alternative Minimum Tax may deny them entirely. However, for people who can earn income on the side while seeking full time employment, setting up a sole proprietorship can convert these limited write-offs into full deductions.
The miscellaneous deduction is the usual first option for deducting business cards, subscriptions, travel, entertainment, and other costs, but permitted expenses are deductible only to the extent they exceed 2% of the taxpayer’s adjusted gross income, and job hunting expenses are only deductible if the taxpayer is looking for work in the same occupation as that held previously. These limits can therefore eliminate potential deductions if the job hunter has a working spouse, a large severance, or other income.
The better option for job seekers who are able to earn some side income while they search may be to set up a sole proprietorship business with income and expenses reported on Schedule C of the tax return. Sole proprietorships can fully deduct “ordinary and necessary” business expenses, including deductions for travel, resume-preparation, health insurance premiums, travel, and business cards, as long as these costs are matched up against income on Schedule C. In addition, there is no requirement that the taxpayer seek work in the same former occupation.
To get the full deductions, the sole proprietorship must earn income. The IRS will closely scrutinize a business that does not show profit in at least three years out of five, but even a small profit opens the door to many deductions. Sole proprietorships must also pay the employer’s and employee’s share of payroll taxes on net income (currently 13.3%), and must file quarterly. There may also be a state tax liability.
Comparing the potential deductions under the miscellaneous deduction or under Schedule C, the benefits of setting up a sole proprietorship are clear. Under the miscellaneous deduction, unreimbursed medical expenses (including insurance premiums) are deductible only for those who itemize and only to the extent that they exceed 7.5% of the taxpayer’s adjusted gross income. With a low income, it is easier to exceed these limits. Meanwhile, for taxpayers who set up a Schedule C business, health insurance premiums may be fully deductible.
Home offices also usually get a better break if they are reported on Schedule C because of the limits on miscellaneous expenses. To be deductible, a home office must be used exclusively and regularly as the principal place of business. Professional fees, cell phone, business cards, and resume-preparation services for the business or the job hunt are often deductible as well, and equipment like a computer can be depreciated over time.
Thorough record keeping is the key for job seekers who anticipate taking deductions of any type. Receipts should be kept and a notebook or diary should be devoted to job-seeking expenses. Professional tax advice can be a significant money-saver in the long run.
photo credit: Manchester Library
A Child’s Inheritance
September 28, 2011
Inheritance Planning for Children
Parents often worry that their children will spend their inheritance recklessly. There are a number of steps that can be taken to ease their concerns. Select financial training, carefully chosen trustees, and creatively written trusts can be used to develop a plan that gives children room to mature financially while still respecting their independence.
Parents need to make an honest determination of their children’s financial knowledge. Often, simply allowing children to sit in on meetings with financial advisors can help teach them how to be an owner of wealth. Another method is to create a family investment firm that can give children some experience. They sit on the company’s board, interview investment advisors, and hold quarterly strategy calls where the parents listen, but don’t talk. The company can even pay for financial education programs for the children. Such methods often yield surprising results.
Picking the right trustees can also be important. One approach is to have a corporate trustee who controls cash disbursement and a co-trustee who knows the child, like a longtime family friend. The co-trustee can periodically report to the corporate trustee on the beneficiary’s financial development. Alternatively, the heir could serve as the co-trustee in a sort of apprenticeship role.
Creatively written trusts are the most common way parents try to protect their assets from reckless spending. A delicate balance must be achieved between honoring the parents’ goals for their children, respecting the children’s independence, and not putting too much of a burden on the trustee.
Some parents depend on extremely specific trust language describing how their children can access inherited money, but most experts advise against this. Such language constrains both the children and the trustee and can be very hurtful to a child. Clauses that hold money back if an heir is not behaving should include generic language instead of singling out an individual by name. The goal is to find a middle ground where the parents make clear that the trust should not be the sole means of support for a child in good health.
Parents with children who are demonstrably reckless spenders or other problem heirs have several ways to use trust language to protect their assets. For example, having a trustee from outside the family can be essential for children with substance abuse problems. Trust language can give a trustee the ability to pay bills like rent or medical costs, if necessary. In addition, a trust can be structured so that a spendthrift child cannot get title to the family home, allowing the trust to buy real estate on behalf of the heir. A trust can also be set up so a child’s creditors cannot access the inheritance.
Parents must realize that a trust can continue for more than one hundred years, so clauses should not be too narrow or specific. Trustees should be permitted to adapt to changed circumstances. A great approach is to include a letter with the trust documents which can expand on the legal language to explain the parents’ decisions.
photo credit: quinn.anya
Social Security Truths
September 21, 2011
The Truth about Social Security
With all the attention Social Security has been getting in the current election cycle and the national debate regarding the nation’s debt, it is perhaps the most popular and the most misunderstood government program.
Social Security is designed to serve two purposes: first, it acts as a form of insurance by providing an income floor to keep people out of poverty in retirement; second, it is a forced saving scheme that replaces income from previous work. Although there may be more efficient ways of achieving these goals, Social Security actually does an admirable job at both. The problems and disagreements come about because of misunderstandings about the program’s financing.
On this point, both sides of the aisle share the blame. The left seems to believe that nothing is wrong with the program and when revenues and the trust fund can no longer cover benefit payments, some simple accounting trick can be performed to save the program. With an aging population, Social Security’s financing must be stabilized, and the sooner that is done, the cheaper it will be. Delaying action for down the road will just make it more expensive for future generations.
The right has argued through Texas Gov. Rick Perry that Social Security is a Ponzi scheme based on lies and has suggested that a privatized system would be better. Social Security is financed as pay-as-you-go, so today’s workers pay for current retirees, giving it the flavor of a pyramid. The nature of such a system is that the later you are born, the lower your return on contributions. However, Social Security fully indexes benefits with inflation and provides vitally important insurance.
Social Security is also not based on lies. It is an exceptionally transparent system where benefits are based on income and the average rate of wage growth. The real risk in Social Security is in the confusion about the program’s future financing, which has made saving and investing for retirement so much more difficult. There is evidence that people now hold less risky, lower-yielding asset portfolios as a result of the uncertainties.
Discontinuing Social Security and moving to a fully funded or privatized program would be even more expensive than fixing the current system. Any hypothetical rate of return advantage would be eliminated because new taxes would be required to pay for benefits already accrued. In addition, arguments for privatization underestimate the riskiness of stock investments, so that privatization and diversification actually have a much smaller effect on returns than reformers typically claim.
Although the design of Social Security may not be ideal, it is not a terrible program. However, until its financing problems are addressed, it has the potential to become an albatross. Despite the hand wringing in Washington, the good news is that Social Security’s financing problems can be fixed relatively easily. Ideally, some combination of tax increases and progressive benefit cuts will provide the financial stability that Social Security requires to continue providing insurance and income for future generations of retired Americans.
photo credit: Phil Guest
Minnesota Gift/Estate Tax
September 16, 2011
Minnesota is one of 18 states that collect its own estate tax. With an exemption amount of $1 million, the state uses a complex sliding scale to determine the amount of tax owed. For estates worth less than $1 million, there is no tax; for estates worth between $1 million and $5 million, the state collects approximately 10%; and for estates worth greater than $10 million, the tax is about 16%.
Complications arise when one considers Minnesota’s estate tax in tandem with the federal rules. In 2010, Congress revamped the federal tax laws to provide a $5 million exemption for the estate tax, the gift tax, and the generation-skipping transfer tax. Therefore, a Minnesota resident with a $5 million estate would not even have to file with the IRS, but would owe approximately $391,000 in tax to Minnesota.
Anecdotal evidence indicates that some high-net-worth individuals in Minnesota are changing their state of residence at least in part because of these tax peculiarities. For a Minnesota resident who already has a winter home in another state, establishing a new state of residence can be as simple as spending six months there instead of five.
Under Minnesota law, one must spend over half the year, at least 183 days, outside of Minnesota to change the state of residence. In combination with the 183-day rule, the state may consider a 26 part facts and circumstances test that the Minnesota Department of Revenue lays out in an A-to-Z format, taking into account where a driver’s license was issued, club memberships, active church affiliations, and location of bank accounts. In the current economic downturn, the state has become much more aggressive in challenging state of residency for tax purposes.
Of course, Minnesota’s estate tax is just one piece of the puzzle. Minnesota also has state income and capital gains taxes, but even in states with no income tax, other factors must be considered before changing residences, including property taxes, sales taxes, gas taxes, and quality-of-life factors.
There are other tax planning opportunities besides simply moving away, however. Although Minnesota has an estate tax, it does not have a corresponding gift tax. Therefore, that same $5 million estate can be gifted, even on one’s death bed, without incurring any federal or state tax liability. Gifting clearly makes more sense for Minnesota residents than leaving a high-value estate to heirs when they die, but one must be sure to keep enough to live comfortably.
The economic downturn and corresponding decline in the commercial real estate market have also depressed the value of businesses and their holdings, making it a great time to gift shares in a business, especially if it is poised for growth. Business owners planning to sell a business instead of passing it on have even established residency in other states to avoid Minnesota’s capital gains taxes.
Opportunities for tax planning are everywhere and are constantly shifting. Congress’ 2010 revamp of the tax code will expire in 2012, and any new provisions may require revised planning.
photo credit: Unhindered by Talent
Tax Whistleblower Program
September 10, 2011
The Internal Revenue Service encourages taxpayers to turn in tax scofflaws by offering a program in which whistleblowers can receive up to 30% of the tax recovered. The downside is that the IRS takes relatively few cases and the average case takes six to seven years to resolve. In addition, although the Service tries to protect whistleblowers’ identity, there is no legal protection from retaliation by an employer.
Despite the drawbacks (including the fact that proceeds received by the whistleblower are taxable), last year the IRS accepted nearly 7,600 new claims in its small-awards program (less than $2 million in tax), the most in five years. Over 1,300 large-award claims have been accepted since 2006.
The IRS has great discretion over which cases they accept and in the amount ultimately awarded to a whistleblower. To be successful, claims must be timely and well-developed with “specific and credible” information obtained legally.
How to Turn In a Tax Cheat to the IRS
The Internal Revenue Service has two whistleblower programs offering rewards to people who expose tax fraud. The small-awards program involves cases with less than $2 million in tax and the award is up to 15% of the tax collected, although it is often far less. In the large-awards program, taxes, penalties and interest must total at least $2 million and the award can go as high as 30% of the money collected.
The U.S. has rewarded whistleblowers for turning in citizens or companies for defrauding government programs since the passage of the False Claims Act in 1863. The IRS has had its own whistleblower statutes since the introduction of the income tax in 1913, but Congress created the beefed-up large-awards program in 2006 and the IRS has since accepted 1,328 submissions involving nearly 10,000 alleged tax cheats. In fiscal 2010, the IRS accepted nearly 7,600 new claims in the small-awards program, the highest total in five years. It collected $464.7 million in extra tax but paid out just 4%, $18.7 million, which is lower than most years.
The IRS has tremendous discretion over what cases they accept and how much they pay out, although the large-award program allows whistleblowers to appeal the award to the U.S. Tax Court. The Service accepts relatively few cases and each case takes an average of six to seven years to resolve. In addition, unlike other U.S. whistleblower statutes, the IRS programs contain no protection against retaliation from an employer, although they do try to protect the whistleblowers’ identities.
The large-award program is based on taxes, penalties and interest, while the smaller cases are based on just taxes and penalties. In the small-award program, the award is entirely at the discretion of the IRS, meaning that they don’t have to pay anything at all. Large-program awards are 15% – 30% of the proceeds collected, but this amount can be reduced if the whistleblower was involved in the tax fraud.
Besides the difficulty in predicting an outcome, the length of time the cases take to resolve, and the lack of protection from retaliation, there are other drawbacks. Most whistleblowers use expert attorneys who often charge 20% – 40% of the gross amount collected, and whistleblower awards are fully taxable.
IRS Form 211 is used for both the large- and small-awards programs. To be accepted, the IRS wants a timely, well-developed claim with “specific and credible” information that was legally obtained in the normal course of business. Although the law does not prohibit convicted felons from collecting awards unless they were architects of the cheating, a whistleblower involved in tax fraud can be prosecuted separately.
Despite the obstacles, cases have been resolved in whistleblowers’ favor. In April 2011, the attorney for an unnamed retired accountant announced the first award in the large-case program: $4.5 million to a former employee of a large financial services firm. According to the attorney, the payment represented 22% of the tax collected. Although the proceeds were taxed, fortunately the attorney’s fees are deductible.
Your Financial Records – Household and IRS Rules
September 4, 2011
Creating a Financial Records Filing System
Having a well-organized filing system for your financial records makes tax preparation easier and less time-consuming, provides a better handle on your overall financial situation to help identify planning opportunities, and eases the burden on your loved ones in case of death or sudden incapacitation.
The first step is to determine how to organize your files. Records can be kept with manila folders and a metal filing cabinet, or electronically with various software packages. Whatever the method, documents should be divided into three main areas: 1.) “current” files, which are added to throughout the year; 2.) “dead” files, which need to be kept but do not need to be accessed often; and 3.) a safe deposit box for documents that are costly or difficult to replace, like wills.
There are seven general subject areas of financial records that should be kept in separate files: taxes, banking, investments, retirement plans, insurance policies, health care paperwork, and documents pertaining to your home.
For the tax files, there should be one file for this year’s return, which would include income statements and back up for any deductions. The prior year tax return should also be kept in this file, while previous returns can go in the “dead” storage area for a minimum of three years, although it is advisable to keep them for six to ten years.
Bank statements should have separate files for statements from savings and checking accounts. When you receive your 1099, you can check it against these statements and then discard them if the 1099 is correct.
Investment account monthly statements will go in another file. Save everything on the purchase, sale, and anything that happens in between for all investments.
There should be one file for each retirement account, including IRA, 401(k), and any employer-sponsored plans. Keep enrollment papers, statements, lists of beneficiary designations, and contact information.
Insurance documents should be kept in a separate file for each policy with policy numbers, issuing companies’ names, and agents’ names. Include information on the people covered and the beneficiaries.
The health care receipts and paperwork file should include complete contact information for personal physicians, medical history, and prescriptions. You should also keep a copy of your identification, who to call in an emergency, the name and phone number of your primary doctor, and your insurance card. This is also a good place for premium statements, health insurance explanations of benefits, doctor bills, hospital bills, prescription copies, immunization records, and records from any health screenings.
Home-related paperwork will include a file on the home’s purchase, including sales agreements, closing documents, and copies of mortgages and appraisals. Separate files should also be kept for an inventory of belongings and another for any home improvements.\
Difficult to replace documents should be kept in a safe deposit box, including birth and marriage certificates, any documents pertaining to adoption, citizenship, and divorce, proof of ownership of major possessions like the deed for your house and titles for cars, and a signed, original copy of your will.
By making a weekly habit of going through your paperwork and filing the documents appropriately, you will keep your financial house in order and save time and frustration in the future.
IRS Tax Record Retention Periods
General Rule:
You must keep records in sufficient detail to establish the amount of income, deductions, and credits shown in any tax or information return [Reg. § 31.6001-1(a)]. You must keep them available for IRS inspection for as long as the contents may become material in the administration of any tax law [Reg. § 31.6001-1(e)].
Decision Process for General Rule:
First ask, “Was the expenditure for purchase of a property?” If no, then keep documents for three open tax years. If yes, then keep documents for as long as asset is owned and for three open tax years after taxable disposition.
Three Year Rule:
Generally, all income taxes must be assessed within three years from the date the return was filed, or due, whichever is later [IRC §6501(a)].
Extension By Agreement: The statute of limitations can be extended by a written agreement between you and IRS [IRC §6501(c)(4)].
Six-Year-Rule: If you omit an amount in excess of 25 percent of gross income shown in the return, a six-year limitation period applies [IRC §6501(e)(1)(A)].
No Limitation Rule: If you fail to file a return, or file a fraudulent return, there is no statute of limitations [IRC §6501(e)(1) & (3)].
photo credit: Librarian Avenger
Teenagers and Roth IRAs
August 11, 2011
Dear CPA
Recently I had a discussion with my husband about putting some funds in an IRA for our 18 year old. We have little extra money this year and thought it might be good to get her going with a retirement savings account. Should we do a Roth or traditonal IRA?
Marie, Eden Prairie
Hello Marie,
Yes, I think you’re on to something. Not only would starting a retirement account for your daughter be a good idea, funding a Roth IRA would be an even better idea.
If you daughter is receiving compensation in the form of wages, she could begin a retirement account and (you can) fund it up to $5,000 depending on her compensation. She must have taxable wages in the year.
A Roth contribution is non-deductible for taxes, but once the funds are in a Roth, the earnings would be tax free once withdrawn. Starting a Roth for a younger person offers tremendous benefits over the years.
Keep in mind that you have until the April filing deadline to fund the Roth.
Call me to help get you started!
888-RAPACKI
Joe
photo credit: alancleaver_2000
