Don't Forget Year-End Tax Planning

By Scott E. Vincent

Careful consideration of financial and tax circumstances before year end can often result in significant savings for both your practice and your clients. You probably receive a variety of literature, much of it incredibly technical, on ways you can save taxes. The main purpose of this article is to remind you to think about tax issues generally as year end approaches. I have highlighted below some basic issues that you may want to address as you prepare for year-end, without trying to develop a comprehensive list or extensive technical details. Of course, you should consult a tax advisor with respect to any complex transactions and with respect to 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; 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, app-lication of alternative minimum tax, etc. If a taxpayer's 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.

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 $19,000 of depreciable assets placed in service during 1999. This deduction is limited if qualified property in excess of $200,000 is placed in service during the tax year. The annual Section 179 deduction is increasing each year, with a yearly maximum of $20,000 allowable in the year 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, 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 nondeductible items, such as utilities and depreciation. Starting this 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 home office deductions for 1999.

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 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. Both the number of days the home is rented and the number of days of personal use should 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 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. 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 indefinitely to shelter capital gains in subsequent years for individuals. Corporations generally can 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 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 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.

I also want to note that many taxpayers made Roth IRA conversions or contributions in 1998 who were not actually eligible to use Roth IRAs (usually because they reported more than $100,000 in modified adjusted gross income for 1998). The IRS is allowing "recharacterization elections" that effectively reverse the improper Roth IRA conversion or contribution made by these taxpayers. The "grace period" for these corrections was recently extended to December 31, 1999.

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.

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, 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, we will all have to continue watching for the changes in the tax laws that Congress usually provides each year.