Year-end tax planning is critical if you and your clients want to minimize your annual "contributions" to our government. Without attempting to create a comprehensive list or extensive details, I have highlighted below some issues that you may want to address as you prepare for year-end. You should carefully review detailed requirements or consult a tax advisor with respect to any relevant items.
1. Take Advantage of Timing
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; these situations require careful scrutiny.
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 where the applicable tax rates are relatively low, and paying expenses in years where the applicable tax rates are relatively high. Of course, this requires a variety of considerations, including filing status (single, married (joint or separate), divorced, deceased), income level, application of alternative minimum tax, etc. If a taxpayers marginal rates 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 able to bunch income and/or expenses in certain years to take advantage of this effect.
2. 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 an accelerated "write-off" for up to $18,500 of depreciable assets placed in service during 1998. The annual Section 179 deduction is increasing each year, with a yearly maximum of $19,000 allowable next year, $20,000 allowable in the yer 2000, $24,000 allowable in the years 2001 and 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.
3. Personal Residence
A taxpayers 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 into 1998, 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 nondeductible items, such as utilities and depreciation. Starting next year, home office deductions should be available to even more small business owners because of an expanded definition of "principal place of business" for purposes of the deduction. Taxpayers who have not qualified before should reconsider, in advance, whether or not home office deductions may be available for 1999.
Year-end is a good time to gather and organize all receipts and other 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 most married taxpayers filing joint returns) of gain realized on the sale or exchange of a principal residence if certain 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. These effects depend on both the number of days the home is rented and the number of days of personal use. These rules should be reviewed on an annual basis, and it makes sense to start planning these issues for next year.
4. 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 from capital losses. Generally, individuals are only allowed a current deduction for capital losses to the extent of capital gains for the year, plus $3,000. 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.
The recent changes in the rates applicable to capital gains (generally 10% for taxpayers in the 15% tax bracket and 20% for taxpayers in higher tax brackets; special rates for certain assets and situations) should be considered in planning. Also, recent legislation reduced the holding period for most capital assets to 12 months.
5. Retirement Planning
This is a good time to review retirement plan options and make key decisions finalizing 1998 planning and putting in place 1999 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 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" is available. Contributions to a Roth IRA are not deductible. However, if certain requiremens 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, unlike a traditional IRA, are usually available for taxpayers who participate in an employers 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. There is an incentive to complete these rollovers before January 1, 1999. For rollovers completed in 1998, the taxable amount of the rollover can be included in income over a four-year period starting in 1998. For rollovers made in later years, the total taxable amount will be included in income in the year of the rollover. Obviously, a variety of factors will go into determining whether to convert a traditional IRA into a Roth IRA, including investment planning, expected tax rates and expected withdrawal dates.
6. 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 $10,000 of gifts made by a donor to each individual donee. For taxpayers with substantial assets and potentially taxable estates, an organized program of annual gift giving within this exclusion can result in a significant reduction in overall estate and gift taxes over time.
7. Substantiation
Finally, substantiation of all issues relating to tax returns is a key to the planning process. Even though we may be now working with a "kinder and gentler" IRS, which is supposed to be more focused on "customer service," most deductions simply will not be supportable without proper substantiation when the IRS reviews 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 unreimbursed business expenses of employees.
I hope these thoughts are helpful as year-end approaches and planning begins for next year. Of course, you will need to watch for a change in the tax laws, which has become an annual event in recent years.