Year-End Tax Planning for 2008
Scott E. Vincent
Vincent, Fontg & Hansen, L.L.C.
Kansas City
Tax planning for 2008 and 2009 is critical with the current volatility in the market, continuing economic challenges, tax changes already enacted this year, and additional tax changes likely over the next few months. Careful consideration of these changing financial and tax circumstances before year end may result in significant savings for both you and your clients. This article highlights some of the tax changes already in place for 2008 as well as basic issues that should be considered every year. 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.
New Items for 2008
Certain provisions of the Small Business and Work Opportunity Tax Act of 2007 (enacted May 25, 2007) became effective or have continuing effect in 2008, including the following:
• The Work Opportunity Tax Credit was extended to August 31, 2011, and veterans with service-connected disabilities are added to the list of qualified employees.
• The gain from sales or exchanges of S corporation stocks or securities is eliminated from the definition of passive income for tax years beginning after May 25, 2007.
• Electing small business trusts can deduct interest on indebtedness relating to acquisition of stock in the S corporation.
• The “kiddie tax,” requiring that children’s tax returns be prepared with reference to their parents’ return and marginal rates, is extended to children up to the age of 18 at the end of the taxable year (or age 23 for full-time students) who meet an earned income test, with the new provisions applicable to tax years beginning after May 25, 2007.
The Economic Stimulus Act of 2008 (enacted February 13, 2008) provided refundable rebate credits for individuals and stimulus provisions designed to encourage businesses to make capital expenditures in 2008, including the following:
• Certain individuals are eligible for a 2008 refundable recovery rebate credit, including retirees receiving only Social Security income and disabled veterans and their survivors.
• Qualifying first time home buyers are eligible for a 2008 credit for a primary residence purchase after April 8, 2008 and before July 1, 2009.
• The § 179 expense deduction for otherwise depreciable property is increased to $250,000, with the initial phase-out level also increased to $800,000 and no mid-year or mid-quarter conventions so that purchases near year end remain eligible for the full allowance.
• Bonus first-year depreciation of 50% is available for qualifying new assets purchased in 2008.
• Regular MACRS depreciation remains allowable following the § 179 expense deduction and the 50% bonus depreciation.
• Property taxes can be deducted without itemizing by additions to the standard deduction.
• Mortgage forgiveness of up to $2 million related to qualified debt on a principal residence can be excluded from income, effective retroactively to 2007 and prospectively until 2014.
The Financial Rescue Package recently enacted also included multiple tax items for consideration in planning, including the following:
• The alternative minimum tax (AMT) has been “patched” for 2008, with increased AMT credits and applicability of several nonrefundable credits to both AMT and regular tax without limitation.
• The option to deduct state and local sales taxes rather than state and local income taxes is reinstated and extends through 2009.
• The “above-the-line” deduction for higher education expenses is also reinstated and extended through 2009.
• The standard deduction for property taxes is extended through 2009.
• The deduction for teachers’ classroom supplies is extended through 2009.
• Certain charitable contributions of IRAs are eligible for tax free withdrawal (but no charitable deduction) retroactively to January 1, 2008 and through 2009.
• Research and development credits are increased and extended from January 1, 2008 through 2009.
• Leasehold and restaurant improvements are now eligible for a 15-year depreciable life, rather than 39 years in most cases, and the eligibility extends through 2009.
• Enhanced deductions for contributions of food, books and computers to schools are extended.
• Tax return preparers are now subject to a less stringent standard to avoid penalties, with the former standard, “more-likely-than-not” that the return position would be upheld, now changed to “substantial authority” for the return position; preparers remain under scrutiny due to an increased penalty and broader definition of preparer (can include lawyer’s advising on return positions).
• Multiple “revenue raisers” were also enacted, including broker reporting of basis to clients, foreign deferred compensation provisions, oil and gas industry provisions, a FUTA surtax extension and limitations on deductions for wages paid to executives of companies funded as part of the rescue packages.
As always, be careful to watch for new legislation as return filing season approaches, as well as any new forms or filing requirements. We are almost sure to see additional economic stimulus and related tax legislation before 2008 tax returns are filed.
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 where 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. Many 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.
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, § 179 allows accelerated write-offs for depreciable assets placed in service in a trade or business during the tax year, although there are limitations based on the amounts of qualified property placed in service during the tax year. The recent 2008 tax legislation again modified the applicable limits (see above discussion).
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.
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 the exclusion for 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 two year ownership and use requirements are met. There are also exceptions to these two-year requirements for taxpayers that have to move under particular circumstances.
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. There are also new rules in place that may limit the ability of taxpayers to convert vacation homes to principal residences for two years in order to qualify for the personal residence exclusion.
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 limited current deduction for capital losses in excess of capital gains for the year. Unused capital losses do generally carry forward to shelter capital gains in subsequent years for individuals.
Corporate capital losses 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. 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 following the loss year.
The rates applicable to capital gains of individuals, estates and trusts 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. Generally, capital gain and dividend rates for individuals are historically very low, which should be considered in long-term planning with respect to capital assets.
Retirement Planning
Year end 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.
Taxpayers should also review Roth IRAs for planning. 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.
Rollovers from traditional IRAs into Roth IRAs are also possible in many circumstances. Although these rollovers may be 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 for gifts made by a donor to each individual donee, which is currently $12,000. 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. Most deductions simply will not be supportable without proper substantiation if the IRS audits a tax return 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.
Hopefully, 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 over the next few months with the continuing efforts to spur economic recovery and the change in administration.