Scott E. Vincent
Shughart, Thomson & Kilroy
Kansas City

Careful consideration of financial and tax circumstances before year- end can often result in significant savings for both you and your clients. You probably receive a variety of technical literature on tax planning. The main purpose of this article is to remind you to think about tax issues generally as year- end approaches. Highlighted below are some basic issues that you may want to address as you prepare for year-end. Of course, you should consult a tax advisor with respect to any complex transactions and with respect to the best approaches for your particular tax circumstances.

Timing Advantages

Shifting income and deductions between tax years is a common approach for deferring and sometimes reducing taxes. Postponing taxes until a later year is generally a sound approach; this allows the taxpayer, rather than the government, to have the use and benefit of the funds in question. Therefore, when all other variables are equal, it usually makes sense to defer income until next year and accelerate deductions into this year. Accelerating deductions is fairly simple — payments are just made before the end of the year. Deferring income can be more complicated because taxpayers may be in constructive receipt of amounts available before the end of the year.

Taxpayers with fluctuating taxable income or changing circumstances from year to year may not want to simply defer income and accelerate deductions. With varying income or deductions, or changing status, the focus should be on recognizing income in years when the applicable tax rates are relatively low, and paying expenses in years when the applicable tax rates are relatively high. Of course, this brings into play a variety of considerations, including marginal income level, filing status (single, married-joint, married-separate, head of household, divorced, deceased), income level, etc. With the reductions in tax rates in recent years, many more taxpayers also need to consider alternative minimum tax when developing timing strategies. If a taxpayer's marginal rates (regular and AMT) are fluctuating from year to year, this approach can result in an overall reduction in total taxes paid, rather than just a deferral. Some taxpayers are also able to bunch income and/or expenses in certain years to take advantage of this effect.

2001 Tax Act

The Economic Growth and Tax Reconciliation Act of 2001 enacted in June of last year made several changes affecting 2002. For example, a limited deduction for college tuition payments is available to families that meet income limitations. The new law also exempts

§ 529 college savings plans earnings from federal tax effective this year. The credit for adoption expenses is expanded, and the income limits for phasing out the credit will also significantly increase. Similarly, student loan interest deductions will be available to many more taxpayers starting in 2002.

Accelerate Depreciation

One key timing issue is depreciation. Business taxpayers should carefully review all purchases of depreciable property during the year and, if it is consistent with overall timing strategy, plan to accelerate depreciation as much as possible into the current tax year. This will include carefully determining what level of depreciation is allowable for this year under the "placed in service" timing rules with respect to each asset purchased.

In addition, a "Section 179" deduction allows accelerated write-offs for depreciable assets placed in service during the tax year, although there are limitations on the amounts of qualified property placed in service during the tax year. The annual § 179 deduction is increasing each year, with a yearly maximum of $24,000 allowable in the year 2002, and $25,000 allowable for the year 2003 and thereafter. Significant equipment purchases should be planned in light of these limits, and staggered purchases may maximize this benefit or avoid the limitation.

Personal Residence

A taxpayer's personal residence is a source of important planning considerations. Home mortgage interest is the primary itemized deduction for many individual taxpayers. For taxpayers attempting to accelerate deductions, an extra mortgage interest payment can be made before the end of the year. In addition, mortgage points paid in connection with the purchase of a home, including points paid on behalf of the purchaser by a seller, may be deductible by the purchaser.

Taxpayers with home offices need to consider the availability of home office deductions for otherwise non-deductible items, such as utilities and depreciation. Home office deductions are available to many small business owners partly because of an expanded definition of "principal place of business" for purposes of the deduction. Taxpayers who have not qualified before should reconsider deductions relating to a home office.

Year-end is a good time to gather and organize all receipts and verification of home improvements and other expenditures that add to home basis. Of course, basis is important in determining gain upon the sale of a residence. Taxpayers should also remember that, for homes sold after May 6, 1997, they can exclude up to $250,000 ($500,000 for certain married taxpayers filing joint returns) of gain realized on the sale or exchange of a principal residence if the two-year ownership and use requirements are met.

Finally, taxpayers should consider the tax effects of rental income and possible deductions relating to vacation or second homes. Both the number of days the home is rented and the number of days of personal use must be calculated to determine whether deductions are available. These rules should be reviewed on an annual basis, and it makes sense to start planning use of the properties in question for next year.

Capital Gains and Capital Losses

Capital gain and loss planning should be considered each year in order to maximize the tax benefits of capital losses. The capital loss limitations rules often largely prevent taxpayers from receiving a current tax benefit. Generally, individuals are only allowed a current deduction for capital losses to the extent of capital gains for the year, plus $3,000. Corporate capital losses can only offset corporate capital gains. It may make sense to recognize capital gains or losses, as appropriate, in a given year to take advantage of this offsetting. Unused capital losses do generally carry forward to shelter capital gains in subsequent years for individuals. Corporations can usually carry capital losses back three years to offset capital gains (as long as net operating losses are not increased for carryback years); any excess capital loss can then be carried forward for five years.

The recent changes in rates applicable to capital gains of individuals, estates and trusts (generally 10% for taxpayers in the 15% tax bracket and 20% for taxpayers in higher tax brackets) should also be considered. Because there are now a variety of potentially applicable capital gains rates and holding periods for certain assets and circumstances, each transaction should be carefully analyzed.

Retirement Planning

This is a good time to review retirement plan options and make key decisions to finalize current year planning and implement next year's planning. The first thing to consider is often an employer-sponsored plan, such as a 401(k) plan. Self-employed taxpayers should consider similar retirement plans, sometimes called Keogh plans.

In addition to traditional retirement plans, individual retirement accounts should be considered. There are limitations on use of certain IRAs for participants in employer-sponsored plans and their spouses, but these should be reviewed each year. In addition, there are income phase-outs for traditional IRAs that must be considered.

Starting in 1998 a new "Roth IRA" became available. Contributions to a Roth IRA are not deductible. However, if certain requirements are met, withdrawals from Roth IRAs avoid federal income tax. The availability of Roth IRA contributions is phased out over certain income levels, but most taxpayers should at least consider this planning alternative. Please note that contributions to a Roth IRA are usually available for taxpayers who participate in an employer's qualified retirement plan.

Taxpayers should also consider rollovers from traditional IRAs into Roth IRAs. Although these rollovers are treated as taxable distributions from the traditional IRAs, the funds rolled over to the Roth IRA, including future earnings and growth within the Roth IRA, should be available for tax-free withdrawal at a later date. Obviously, a variety of factors will be relevant in determining whether to convert a traditional IRA into a Roth IRA, including current tax effects, investment planning, expected tax rates and expected withdrawal dates.

Annual Gift Tax Exclusion

Estate and gift planning should be considered each year. One item that is often overlooked is the annual gift tax exclusion of $11,000 for gifts made by a donor to each individual donee. For taxpayers with substantial assets and potentially taxable estates, an organized program of annual gifting within this exclusion can result in a significant reduction in overall estate and gift taxes over time.

Substantiation

Finally, substantiation of all issues relating to tax returns is a key to the planning process. Even though we may be working with a "kinder and gentler" IRS that is supposed to be more focused on "customer service," most deductions simply will not be supportable without proper substantiation if the IRS audits tax returns several years later. Substantiation should certainly include careful records of income as well as documentation of expenses. For individuals, this should include documentation relating to wages, transactions, investments, mortgage interest payments, taxes paid, medical expenses paid, charitable contributions and business expenses.

I hope these thoughts are helpful as year-end approaches and planning begins for next year. Of course, we will all have to continue watching for changes in the tax laws from year to year.