Year-End Tax Planning for 2007
Scott E. Vincent
Vincent, Fontg & Hansen, L.L.C.
Kansas City
Careful consideration of financial and tax circumstances before year end can often result in significant savings for both you and your clients. 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, as well as new items for 2007 that should be considered. 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 2007
The Small Business and Work Opportunity Tax Act of 2007 (enacted May 25, 2007) provided several new items to consider in planning for this year, including the following (effective for tax years beginning after December 31, 2006, unless otherwise indicated):
• 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 annual depreciation expense amount under § 179 is increased to $125,000 for 2007, with the phase-out level increased to $500,000. Both limits are extended through 2010 and indexed for inflation.
• Alternative minimum tax limits are eliminated for the Work Opportunity Tax Credit and the cash tips credit.
• “Qualified joint ventures” owned solely by a husband and wife who both materially participate in the trade or business can make an election to avoid partnership reporting requirements and simply be reflected on Schedule C.
• 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.
• Sales of qualified subchapter S subsidiaries (“Qsubs”) that terminate the Qsub election are treated as sales of an undivided interest in the Qsub assets followed by a deemed transfer to the Qsub so that § 351 tax free treatment applies.
• Electing small business trusts will be able to 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.
• A new 20% penalty for filing erroneous refund claims, effective on claims for refunds or credits filed after May 25, 2007, will apply to the disallowed portion of the claim for refund or credit for which there is no reasonable basis to support the claimed tax treatment.
• Preparer penalties are significantly expanded for returns prepared after May 25, 2007, and now include preparers of estate and gift tax, employment tax and excise tax returns, as well as returns of tax exempt organizations. The standard to avoid the preparer penalty is also increased from the prior “realistic possibility” standard for undisclosed positions to a standard requiring a reasonable belief that the tax treatment of the position was “more likely than not” the proper treatment. Similarly, the standard for disclosed positions is increased from “not frivolous” to “reasonable basis” for the tax treatment.
As always, be careful to watch for new legislation as return filing season approaches, as well as any new forms or filing requirements.
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, a “Section 179” deduction 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 2007 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.
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 from year to year, particularly with the changes in Congress and the presidential election on the horizon.