E. R. McDaniel III, CPA

  • Member American Institute of Certified Public Accountants
  • Member Texas Society of Certified Public Accountants
  • Licensed by the states of Texas and Alabama
Offering a full range of accounting, tax, and consulting services to small businesses and individuals

12841 Jones Road
Suite 101
Houston, TX 77070
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Year-End Tax Planning

At year end there is always an opportunity for you to benefit from some last minute tax planning. And the beginning of a new year gives you a good chance to do some advance planning. Here are just a few ideas to get you started.

Your 2010 return may be affected by tax law changes that first took effect in 2006, IRS pronouncements, and Court decisions during 2006. A refund of long-distance telephone excise taxes, for example, will affect the 2010 tax liability of every taxpayer that made long distance phone calls over a 41-month period beginning in 2003. Parts of the Tax Increase Prevention and Reconciliation Act of 2005 (passed May 17, 2006), the Pension Protection Act of 2006, and the Tax Relief and Health Care Act of 2006 may reduce the 2010 tax liabilities of businesses and individuals or affect their tax planning for 2011.

One significant development allows any taxpayer over age 70˝ to transfer up to $100,000 from her or his IRA to a qualified charity in 2010 and 2011 without including the distribution in taxable income. Of course, there is no deduction for the contribution either, but it does count as part of any required minimum distribution and the taxpayer may designate the entire amount as from accumulated income . . . thereby reducing the taxable income element in future distributions. If you would like to make a significant gift to your church or university, this might be a good way to do it.
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What’s New for 2010: Tax Planning Considerations

Tax Increase Prevention and Reconciliation Act of 2005
The Tax Increase Prevention and Reconciliation Act of 2005 (passed May 17, 2006) made changes that might affect your tax planning for 2010 and 2011. Changes affecting the greatest number of taxpayers include:

  • The age of a child whose investment income is taxed at the parents’ income tax rate is increased from under 14 to under 18;
  • Individual AMT exemptions for 2010 are increased to $62,550 for married persons filing joint returns and $42,500 for single persons, and most non-refundable credits apply to reduce any liability;
  • The foreign earned income exclusion is increased to $82,400 and housing allowance and deduction amounts are modified...
  • 15% and 5% tax rates on dividends and long-term capital gains are extended through 2010
  • The 2005 rules for treatment of small business stock are extended through 2010;
  • An election for composers allows treatment of the sale of their musical compositions as the sale of a capital asset, and allows purchasers of music to amortize the cost over 5 years;
  • The W-2 wage limitation on Section 199 deductions is clarified as including only those wages paid in the qualifying activity.
Last but certainly not least, it’s going to be a lot more expensive and risky to submit an offer in compromise. Effective June 17, 2006, a lump sum offer must be accompanied by at least 20% of the offered amount in order to be considered. An installment offer must be accompanied by a payment equal to the proposed monthly installment amount, and the taxpayer must continue to make payments in the same amount while the IRS considers the offer.

Pension Protection Act of 2006
The Pension Protection Act of 2006 (passed August 17, 2006) made these changes to the rules governing what is deductible and how it must be documented. Among other things:
  • No deduction is allowed for a contribution of clothing or household goods unless the item is in “good used condition” (generally interpreted to mean in good repair and not broken or frayed or showing excessive wear) after August 17, 2006,
  • No deduction will be allowed for any contribution of cash after January 1, 2006, unless it is supported by a “bank record” or a written receipt from the recipient organization,
  • Contributions of fractional interests in tangible personal property must lead to a complete contribution within 10 years or upon the donor’s death, whichever is earlier,
  • Contribution deductions for gifts of appreciated tangible personal property must be recaptured if the property is disposed of by the donee organization within 3 years,
  • Contributions to donor advised funds are subject to new restrictions, and
  • Other, less frequently encountered types of contributions are subject to new limitations.
-- the section 45 renewable electricity production credit
-- for one year only, the deduction for energy-efficient commercial buildings; the business credit for energy-efficient new homes; the credit for residential energy-efficient property purchases; and a business credit for the installation of qualified fuel cells and stationary microturbine power plants and the purchase of solar energy property.

A special relief provision modifies the AMT refundable credit for individuals who exercise incentive stock options, thereby becoming subject to AMT on the excess of FMV over option price.

The IRS-imposed penalty for frivolous submissions increases from $500 to $5,000.

IRA Deduction Increased for 2007
The IRA deduction increased to $5,000 (plus $1,000 if you are 50 or older at the end of 2006). Even if you were covered by a retirement plan, you may be able to take an IRA deduction if your modified adjusted gross income (AGI) is less than $60,000 ($80,000 if married filing jointly). IRA deductions for the 2006 tax year may be taken as long as the IRA is funded by the due date of the 2006 tax return, that is, April 16, 2007.

Elective Salary Deferrals Increased for 2007
The amount you can defer under all elective salary deferral plans increases in 2007 to $15,500 ($10,500 if you have only SIMPLE plans). The “catch-up” contribution limit if you are 50 or older has increased to $5,000 ($2,500 for SIMPLE plans). That means that in 2007, you can defer up to $20,500 into a 401(k) plan if you are over 50.

Vehicle Donations
The rules for vehicle donations changed in 2005. As a result, if a charity sells your donated vehicle, your deduction is limited to the proceeds received by the charity. If the charity does not sell your vehicle but uses it in furthering the organization’s charitable purpose, you can deduct the vehicle’s “fair market value” if certain conditions are met. The conditions relate to the charity providing information to you that must be filed with your 1040.

Mileage Rates Increased
The 2006 standard mileage rate for business use of a vehicle was 44.5 cents, the medical rate was 18 cents and the charitable rate, except for hurricane relief was 14 cents. The 2010 rates are 48.5 cents for business use of a passenger car or light duty truck, 20 cents for medical mileage, and 14 cents for charitable mileage.

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General Planning Ideas

If you expect to have more income in the current year, we can help you adjust your tax withholding or estimated tax payments to avoid an estimated tax penalty.

If you expect your income to be significantly different next year, you might accelerate or delay either income or deductions.

Here is a helpful tax planning checklist. We can also help calculate your projected tax liability based on different assumptions.

Planning to Increase Income in the Current Year

  1. If you are over 59˝ and covered by an employer’s retirement plan or an IRA, you could take additional distributions in the current year even if you are continuing to work.
  2. If planning asset sales in the near future, sell the most appreciated assets before year-end.
  3. If you have sold assets on the installment basis, consider accelerating your gain by using the note as collateral for a loan.
  4. If you are self-employed, you could try to collect as many accounts receivable as possible before year-end. You might also get customers to prepay for goods or services to be provided early next year.
  5. If it makes good business sense, you could exercise incentive stock options before the end of the year.
Planning to Delay Income Until Later
  1. 1. If possible, arrange for your employer to pay any current year bonus early next year.
  2. Make the maximum 401(k) contributions.
  3. If you are self-employed, delay year-end billings so payments do not come until the following year.
  4. If you are working with creditors to settle obligations, try to postpone finalizing any debt cancellation that will result in cancellation-of-debt income until next year.
Planning to Increase Deductions in the Current Year
  1. If you wish to donate a vehicle to charity, give it to a charity that will use it rather than sell it. That will allow you to take a fair market value deduction, not limited to proceeds from a quick sale of the vehicle.
  2. Prepay your January mortgage payment. Check also if the prior January payment was made early and properly reported by the lender.
  3. Prepay deductible expenses. You can even use credit cards to make purchases or contributions so that no cash outlay is required until next year.
  4. Pay the state and local taxes that are anticipated to be due in the current year. But watch out for the Alternative Minimum Tax. You may want us to help you determine in advance whether this strategy will be useful. We can make test calculations for you.
  5. Pay any contested deductible taxes in the current year. You can still contest them, but they will be deductible if paid.
  6. If you are self-employed, establish a Keogh retirement plan before the end of the year. Contributions made in the following year before the return is filed will be deductible in the current year, so long as the plan is in place before December 31.
  7. If you are eligible, consider an IRA contribution. The contribution will be deductible if paid at any time up to the tax return deadline.
  8. Because medical and dental expenses are deductible only to the extent they exceed 7.5 percent of your adjusted gross income, you should “bunch” those expenses whenever possible into one year to get a deduction.
  9. Consider selling investment assets with losses. Up to $3,000 of net capital loss can offset other taxable income.
Planning to Delay Deductions Until Later
  1. Do not formally abandon attempts to collect slow pay receivables. That way, a bad debt deduction will be delayed until a future year when all events necessary to prove worthlessness have occurred.
  2. Don’t pay deductible business expenses until next year.
  3. Don’t pay deductible taxes, interest, and contributions until next year.
  4. Don’t sell investments that will generate capital losses.
As always, let us know if we can be of any assistance.

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Assessed a Penalty? Request Abatement!

Getting relief from an IRS penalty MAY be possible.

The tax law provides for so many penalties that the IRS had to write an entire chapter of the Internal Revenue Manual –- a “Penalty Handbook” -- to tell its employees how to administer them. What most people don’t know is that virtually all the dozens of penalties that might be assessed against an individual or a business can be abated if the taxpayer has “reasonable cause” for the action or inaction that gave rise to the penalty.

Reasonable cause for late filing of a tax return can include disability or death (of the taxpayer or a close family member); records unavailable due to fire, flood, tornado, or even a divorce dispute; bad advice from an IRS employee; no prior experience with the particular filing requirement; and reliance on the services of a tax professional that missed the deadline. Several years ago, a taxpayer in California was found to be disabled by alcoholism -- he was too drunk to sign and mail his return -- and therefore not subject to penalty for late filing!

Reasonable cause for late payment of a tax liability also includes death or disability; fire, flood, or tornado; and may even be granted when the taxpayer is suffering temporary financial hardship. According to Treasury Regulations, some collection efforts must be suspended if collection action would cause financial hardship. A manufacturing company in New Jersey was relieved of penalties for late payment of its payroll tax liabilities because the money needed to pay them was due from the United States Defense Department and was withheld during an FBI investigation of government purchasing agents.

There is even a special appeal process for taxpayers seeking abatement of penalties. It’s called a Collection Due Process Hearing, and its purpose is to assure that your explanation of special circumstances receives fair consideration by the IRS.

It’s important to respond to IRS penalty notices quickly, and to know exactly what the Internal Revenue Manual tells IRS employees to look for in abatement requests. We have studied the tax law that imposes penalties and offers abatement in special circumstances. We have experience helping individuals and businesses obtain relief from penalties when those special circumstances apply. We also have access to the IRS “Penalty Handbook,” so we know the IRS standards for granting abatement of penalties. If you have been assessed a penalty and believe you have reasonable cause for the act being penalized, we can help you present your abatement request or your request for a hearing. Just call for an appointment, but remember -- prompt action is a must. Delay can cause an otherwise strong relief claim to be denied.

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Missed a Deadline? Request Relief!

Relief from late filing is commonly available, but must be requested in different ways for different missed deadlines.

The April 15th deadline for filing individual income tax returns is common knowledge, but that’s only one of dozens of time-sensitive acts for which you or your business might be responsible. Some are strictly compliance issues -- like filing of returns. Others are deadlines for making important elections that can affect your tax liability for years to come. Still others are related to favorable tax treatment of current transactions.

Businesses must typically file income tax returns, payroll tax returns, W-2s, 1099s, excise tax returns, and returns for employee benefit plans. All have different deadlines, so it is not surprising that mistakes are made. Usually, these mistakes can be easily fixed by filing the required return with an explanation of the circumstances that caused the late filing -- a statement of reasonable cause.

Reasonable cause, as explained in the Chapter 20 of the Internal Revenue Manual (otherwise known as the “Penalty Handbook”) includes disability, death, natural disaster, first time liability for filing, or reasonable reliance on a tax professional.

Other non-return elections can be a lot more troublesome when they are not filed on time. For example, an election by a corporation to be an “S corporation” for federal tax purposes must be made before, or within 75 days after, the beginning of a tax year to be effective for that year. There is a special form, Form 2553, for making the election. An election to adjust the basis of partnership assets following a transfer of a partnership interest must be made with a “timely filed return.” There is no special form for that election, but the required content is set forth in a Treasury Regulation.

A late S corporation election can be corrected automatically and without a “user fee,” pursuant to a special provision in the law and an IRS Revenue Procedure. A late election to adjust the basis of partnership property may be excused if filed within 12 months, but after that must be made in the form of a request for private letter ruling, requires a detailed explanation of the events that caused the late filing, and may involve a substantial user fee, depending on the size of the partnership.

The tax law permits IRA rollovers to be made tax free if they are completed within 60 days. If you miss that deadline, you may be able to secure relief by filing a request, explaining the reason you missed the deadline, and paying a user fee. Any such request must be made very soon after discovery of the missed 60-day deadline.

In summary, relief from late filing is commonly available, but must be requested in different ways for different missed deadlines. All such requests must be made in a timely manner. Delay can cause your request to be denied.

We have studied the law, IRS rules, and court decisions granting relief from various failures to file documents, take action, or make tax elections. We know what forms to file and when to file them. We know what the IRS and the Courts will and will not accept as reasonable cause. If you have a problem arising from a missed deadline, please contact us at once. Available relief procedures generally include their own timely filing rules, so the sooner we get started, the better.

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Will the AMT Hit You?

The Alternative Minimum Tax, AMT for short, was enacted to ensure that wealthy individuals could not entirely escape taxation by using every legal tax break available. Today, the AMT is becoming a tax trap for the middle class.

The AMT is also referred to, not whimsically, as the added misery tax. It is a highly complex levy originally structured to ensure the payment of at least something by even the wealthiest individuals who are able to avail themselves of the most sophisticated tax breaks. However, the AMT now affects more and more far-from-wealthy folks who claim common, perfectly legal deductions that they have come to take for granted.

The new chair of the House Ways and Means Committee, Representative Charles Rangel of New York, has been a vocal critic of the AMT and has vowed to work for its repeal. That is likely to take some time, however, if it can be done at all.

To make it more likely that the IRS collects some taxes from everyone, the AMT counts more items as reportable income and allows fewer write-offs than under the normal rules used to calculate your tax bill. AMT disallowances include exemptions for dependents, the standard deduction, a flat amount based on filing status, and such itemized deductions as state and local taxes and miscellaneous expenses -- a category that includes fees for tax return preparation and planning. The IRS collects the higher tax, whether it is figured the regular way or under the AMT.

The AMT and recent tax legislation need to be considered in tandem. Thanks to Tax Acts in 2003 and 2004, the top rates for dividends and long-term capital gains are now reduced to 15 percent for individuals in the top four income tax brackets and 5 percent for those in the bottom two brackets through 2010. These reduced rates for dividends and long-term gains also apply for calculating the AMT on these two kinds of income.

The Tax Increase Prevention and Reconciliation Act of 2005 extends the AMT exemption amounts -- $62,550 for joint returns and $42,500 for single returns, but only through 2006. This tactic somewhat softens the AMT's punch, but just temporarily.

AMT exemptions for later years revert to what they were in 2001, unless Congress and the president agree to extend and perhaps increase them. However, if all our lawmakers do is continue their band-aid approach to what has become the third rail of tax legislation, the AMT is going to capture a steadily growing number of individuals. The hit list includes investors with sizable dividends and long-term gains taxed at a top rate of 15 percent, particularly those in high income or property-tax states like California, Massachusetts, New Jersey, New York and Washington, D.C.

There is, however, a rose among these thorns. True, the reduction of tax rates for ordinary income, dividends, and long-term gains means the AMT applies to far more individuals, lessening the benefit from these reductions. Nonetheless, the amount you pay for taxes will be still be less than it would have been without enactment of the tax cuts.

Although recent tax legislation has lowered your tax bill, you still should integrate taxes into your financial planning throughout the year. You may be pleasantly surprised to discover the scores of tax-saving opportunities that many individuals overlook year after year.

It remains important to act before December 31 of each year while there is still time to take advantage of tax angles that can generate dramatic savings -- if you understand the full benefit of what the law allows.

As always, please do not hesitate to contact us.

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Sweeping Recent Tax Acts Extend Benefits to Individual Taxpayers

For individuals, recent tax legislation extends lower tax rates, tax relief for dividends, capital gains, and much more.

In historical terms, income tax rates -- for ordinary income, capital gains, and most dividend income -- continue to be low. Rate reductions on ordinary income have benefitted many taxpayers. Low capital gain and dividend rates require reexamination of many tax planning concepts. The fact that cuts are “temporary” makes financial planning more tax sensitive than ever. The next four years promise to be “a roller coaster of change,” especially now that the Democrats control Congress.

The maximum tax rate on net long-term capital gain (other than from collectibles or “unrecaptured Section 1250 gain”) continues to be 15 percent, while any portion of such gain otherwise taxed at an ordinary rate of 15 percent or less qualifies for a special rate of 5 percent. The 15-percent and 5-percent rate continue unchanged through 2010.

Those lower rates apply for both regular tax and AMT purposes. On January 1, 2010, the pre-2003 rates of 20 and 10 percent come back. Long-term capital gain from collectibles remains subject to a 28-percent maximum rate, and unrecaptured “Sec. 1250 gain” (the straight-line portion of real property depreciation) is subject to a 25-percent maximum rate. Deduction of capital losses against individual ordinary income continues to be limited to $3,000 per year, and losses carried forward will not be adjusted to reflect the higher tax rate in effect when they were incurred.

There is an apparent planning opportunity for taxpayers with appreciated assets and children who will be over age 17 and exempt from the “kiddie” tax after 2007. If the child will also be in the lowest, or 10-percent, regular tax bracket, gain from sale of appreciated assets may not be taxed at all!

Special rates for property held for five years or more were effectively repealed as of May 6, 2003, and no special rate is available again until 2010 when the old 20 and 10 percent regular capital gains rates are scheduled to return.

As with long-term capital gains, dividend income received by an individual shareholder from a domestic or qualified foreign corporation continues be taxed at a maximum rate of 15 percent. Individuals otherwise in the 10 percent bracket will pay tax on all or part of their dividends at a 5 percent rate. The 15 percent rate is effective for dividends received in tax years beginning after 2002 and ending after December 31, 2010. The five-percent rate is scheduled to fall to zero after 2007. There are no special rates for dividend income after 2010. The preferential rates apply for both regular and alternative minimum tax.

Under the old law, which is scheduled to return in 2011, a taxpayer in the highest tax bracket who receives $100,000 in dividend income would pay $38,600 in tax. Under the temporary reductions, the same dividend income taxed at 15 percent results in a $15,000 tax liability, a reduction of $23,600 or 61 percent. Reductions for lower income taxpayers are less dramatic. A taxpayer in the 10 percent bracket, who receives $1000 of dividend income would have paid $100 in tax. The rate reduction to 5 percent will save 50 percent, but that's only $50.

Dividend tax relief may have a positive influence on stock values for publicly traded companies. The low rate on dividends also makes stocks more competitive with tax-free bonds. We will be pleased to assist you in evaluating your investment goals and reevaluating your portfolio allocations in light of the changed after-tax return now provided by stock dividends.

Closely held corporations frequently make S elections to avoid double taxation of corporate earnings. The impact of double taxation is lower now but can still be significant. Corporate income tax rates have not been reduced. Therefore, closely held corporations should probably continue to take advantage of the S election to pass through income at lower rates. We can also assist you in calculating the best form of entity for your business to assure the lowest overall tax burden.

As if the complexity created by a “sunset date” for dividend tax relief wasn't enough, exactly what qualifies as a dividend for purposes of the lower rates is the subject of detailed regulations and will certainly be the source of new controversies.

There are some highly technical exceptions and special rules summarized below. (See Notice 2003-69 and Notice 2003-71 for more detail.) Feel free to call and ask questions if you are concerned about these rules. Or just skip this part of the newsletter and continue on to the section discussing "Individual Marginal Rates."

These sources of dividend income are specifically excluded from “qualified dividend income”:

  • Distributions from farm cooperatives and other “not-for-profit” entities;
  • “Dividends” paid by Mutual Savings Banks;
  • Dividends on employer securities paid to a qualified retirement plan;
  • Dividends subject to limitation by IRC Sec. 246(c) because they are paid on stock acquired and disposed of within 45 days of a dividend payment date.
Dividends can be treated as “investment income” to the extent you so elect in order to gain maximum benefit from investment interest carryforwards. Dividends retained by regulated investment companies will be taxed at the maximum rate for individuals. The qualified dividend rules do apply to dividends distributed by a regulated investment company if a gross-income test is met. Distributions from a REIT are generally not considered dividends. Both the tax on excess accumulated earnings of a C, or regular, corporation and the tax on Personal Holding Company income are reduced to 15 percent by the Act -- a significant relief provision for mature C corporations.

A “qualified foreign corporation” is an entity incorporated within a U.S. possession or that is eligible for the benefits of a comprehensive U.S. tax treaty. Dividends paid by a foreign corporation that is not “qualified” may still be eligible for the lower rates if stock of that corporation is traded on an established U.S. equities market.

The 2006 tax acts extended some rate reductions. 2007 rates on ordinary income of individuals begin at 10 percent and progress through 15, 25, 28, 33, and 35 percent.

If you are making quarterly estimates, you should carefully review your anticipated withholding to assure that you are not overpaying your obligation.

In addition to extending rate cuts, 2006 tax legislation extended the 10-percent bracket for single filers at $7,825. For married couples filing jointly, that threshold is $15,650. The 10-percent bracket amount for heads of households is $11,200, and continues to be subject to inflation adjustments after 2007.

We combine our expertise with state-of-the art computers and software to analyze your income and project future tax liabilities...and we are as close as your phone.

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Check Your Tax Refund All Tax Season Long

There is a very helpful feature on this online office that will help you during tax season.
If you would like to know when you will get your refund, just use the “Check Tax Refund” feature. Simply click "Check Tax Refund" on the homepage and follow the instructions. In many cases, you will need to have your Social Security Number and the amount of your refund handy. If you have any questions, simply email or call.

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Win "Hobby Loss" Challenges

You can beat an IRS hobby loss challenge with the right documentation and preparation.

According to the tax law, there is a rebuttable presumption that an activity consistently producing losses, year after year, is not a business engaged in with intent to make a profit. Rather, it is treated as a non-business, or a hobby. Non-business or hobby losses are not deductible, so documenting your business purpose and profit motive is important. If your evidence of profit motive is strong, the hobby presumption is rebutted and losses are allowed. It should come as no surprise that taxpayers and the IRS have battled over this issue for decades.

Nine tests are usually applied to determine whether an activity is engaged in for profit. Only when these tests are met can a taxpayer deduct losses in excess of income from the activity, even if the activity is conducted in a partnership or S corporation. An analysis of over a dozen recent Tax Court decisions helps us understand the dos and don'ts of defending claimed deductions in connection with unprofitable activities.

DO: Prepare and update a business plan, including a break-even analysis, determining the amount of income needed for the activity to be profitable.

Keep detailed and accurate books and records, and keep separate checking accounts for each activity.

Advertise and promote the activity in a business-like manner.

Make major decisions relating to the activity in a business-like manner, based on the business records and expert advice.

Make changes for the purpose of reducing costs and/or increasing revenue, if the activity is not profitable.

Be prepared to demonstrate your responses to changed conditions, if losses continue.

DON’T: Incur continuing losses without changing operations and/or consulting experts on how to improve business performance.

DO: Learn as much as you can about the business before starting the activity and continue to seek expert assistance when prudent to do so.

Personally engage in research and study to increase your expertise with respect to the activity.

Pay attention to your study and/or expert advice.

DON'T: Limit consultation with experts to questions about how to deduct losses.

DO: Devote significant personal time and effort to the activity, especially those tasks that do not have substantial recreational characteristics.

Hire qualified people to do the work, if devoting only a limited amount of time to an activity.

DON'T: Make major decisions about the activity based on personal enjoyment rather than profit potential.

DO: Consider appreciation of assets used or created in the activity, as well as profit from current operations in your business plan.

DON'T: Count on appreciation of assets to provide the only “income” necessary to support your profit motive argument.

DO: Be prepared to demonstrate a history of operating other activities (in addition to your primary profession or business activity) in a profitable manner, and;

Be prepared to demonstrate how expertise acquired in different activities was applied to make this activity profitable.

DON'T: Make decisions relating to the activity based on personal whim or non-business benefit.

DO: Plan for the customary start-up period for similar activities.

Identify and keep a record of circumstances beyond your control that result in losses for longer than usual.

DON'T: Continue to fund losses out of proportion to expected gains from the activity.

DO: Report all profits from the activity, no matter how small or unusual.

Consider accelerating income in order to show a profit, when losses in one year are projected to be small. That will help avoid the rebuttable presumption that you are not engaged in the activity with intention to make a profit.

DON'T: Overlook natural business or economic cycles that might make it unrealistic to expect regular profits from an activity in any circumstance.

DO: Invest required resources in the activity to demonstrate commitment to its success, especially if you have substantial income from other sources.

Be prepared to demonstrate how the activity fits into your future financial plan, such as a plan to retire and rely on income from the activity.

DON'T: Ignore a lack of profit from the activity.

Fund continued losses, when the prudent business decision would be to terminate the activity.

DO: Be prepared to demonstrate that personal pleasure or recreation derived from the activity is insignificant or incidental when compared to business motives.

DON'T: Claim losses from an activity in which the profit potential is less significant than the potential for personal pleasure or recreation.

DO: Call us if you have any questions about this often-murky area.

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Avoid "Wash Sale" Limit on Losses in Good Times and in Bad

There have been many difficult years for investors. Many individual stocks have suffered horrific declines in value. What is the best way to minimize the hurt from a tax perspective?

It would be helpful to deduct investment losses, but what if an investor -- not ready to throw in the towel -- would like the benefit of market losses while continuing to own a security? Such persons are called "optimists." They think a stock is a good investment, just temporarily undervalued, but the “Wash Sale Rule” stands in the way of their deduction.

Without the Wash Sale Rule, you could sell stock that had lost value, recognize the loss, and immediately repurchase the same stock at lower cost -- recognizing a loss for tax purposes while ending up in the same financial position as before the "sale." The Wash Sale Rule prohibits recognition of loss on a sale of stock or securities if the investor acquires substantially identical stock or securities during a period that begins 30 days before and ends 30 days after the sale of loss property (a 61-day period).

It doesn't matter how long you may have held the stock or security that is sold. The critical question is whether substantially identical stock or securities is acquired during the 61-day period. To avoid abuse, the law also applies when the investor enters into a contract or an option to acquire substantially identical stock or securities -- even if the contract or option settles in, or could be settled in, cash or property other than stock or securities.

When the Wash Sale Rule applies, basis of “new” stock or securities is determined by adding any disallowed loss to their cost. The effect of that adjustment is to postpone a loss deduction until disposition of the new stock or securities. On a brighter note, the holding period of new stock or securities does include the holding period of stock or securities sold.

One strategy for recognizing losses; avoiding the Wash Sale Rule, but still ending up in essentially the same financial position; is to replace loss stock or securities with stock or securities that have underlying characteristics similar to those that were sold but are not substantially identical. The investment is not precisely the same, but can be close -- so that the investor is in essentially the same financial position, and loss recognition is not prohibited. The skill of course is in identifying stock or securities that are similar but not substantially identical, while making good investment decisions.

Whether stocks and other securities are substantially identical is determined based on all facts and circumstances. Stocks and securities of one corporation do not normally qualify as substantially identical to stocks and securities of another corporation. Different types of stock or securities of the same corporation will not normally be considered substantially identical, although similar characteristics may make them substantially identical.

For example, bonds or preferred stock of a corporation normally would not be substantially identical to common stock of the same corporation. However, if preferred stock is convertible into common stock and carries the same voting rights, it could be considered substantially identical. Bonds issued by different housing authorities, all guaranteed by the United States, have been treated as not substantially identical, and purchasing bonds of one authority within the 61-day period that includes a sale of bonds of another authority does not bar recognition of loss on the sale.

The question of whether a prospective alternative investment could be considered substantially identical to one that may be sold should not be the sole or controlling criteria for determining when to shift out of a losing financial position. However, if you have made a decision to sell a security and would like assistance with evaluating specific replacements or avoiding the Wash Sale trap in general, just call.

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Our Top Ten Tax Tips

Every year, Congress makes changes in the tax laws, so it's wise to consider how your tax planning will be affected. Here are our Top Ten individual tax planning tips for this year.

1. Accelerate income. Deferred compensation is attractive when future top rates will be significantly lower than current rates, but that is no longer the case. Regular income tax rates now start at 10 percent, and the top rate in 2006 will be 35 percent. These are historically low rates, but who knows what the future will bring? Take the money now!

2. Seek investments that pay ordinary dividends or distribute long-term capital gains. The maximum tax rate on both is only 15 percent in 2007.

3. Shift income to children and grandchildren. In 2007, the lowest income tax bracket is 10 percent, 25 percent lower than the highest bracket. Be sure that each child and or grandchild has enough income to take full advantage of the $850 exemption and low rates without becoming subject to the tax on investment income of a child under age 18.

4. Investigate the availability of High Deductible Health Plan (HDHP) coverage combined with a Health Savings Account (HSA). Contributions to an HSA are tax deductible and withdrawals to pay medical expenses are not taxed. The Bush administration is determined to encourage the broadest use possible of this new tax-favored medical care benefit, and many insurance companies and banks offer these plans at competitive rates.

In 2007, IRA contributions of up to $4,000 are permitted for anyone with sufficient earned income, and the limit increases to $5,000 for a person that has attained age 50 before year-end. The limits should continue to increase in years after 2007.

5. Make your maximum allowable IRA contribution as early as possible each year. Tax-deferred accumulation of income begins the day you fund the IRA, and early funding will provide greater account value at retirement. You can make your 2007 IRA contribution as early as January 2, 2007. Consider using your IRA account for the fixed-income portion of your investment plan. This way you will be deferring taxes on what would otherwise be taxed at ordinary income rates. By contrast, if you fund your IRA account with stocks or equity-based mutual funds, you could be converting long-term capital gains taxed at low rates into ordinary income taxed at higher rates when you start taking IRA distributions.

Participants in 401(k), 403(b), and 457 plans can take advantage of expanded limits on contributions. The general limit on contributions to such plans in 2007 is $15,500 with an extra $5,000 allowed for individuals over age 50 by year-end. And it gets better -- employees are permitted to defer up to 100 percent of their compensation up to the deferral limit, if the plan permits it.

6. Defer the maximum allowed by your employer's 401(k) plan. That should also assure you of receiving the maximum benefit from any employer-matching contribution, and will help you receive the maximum tax advantage possible.

7. A non-working spouse might consider working to boost the family retirement assets -- re-entering the work force primarily to make a maximum 401(k) deferral, which for 2007 is the lesser of $15,500 or total compensation.

Coordinated rules for Section 529 plans, Coverdell Accounts, Hope credits, and Lifetime Learning credits allow all these sources of funding higher education expenses to be of greater utility to many families. Planning which education costs to pay from what funding source, and when to pay them, is necessary to gain maximum benefit from all available tax-advantaged education assistance programs. Other newsletters explain these education benefits in detail.

8. Take advantage of the Tuition and Fees deduction. In addition to all other assistance provisions, and requiring careful coordination with them for maximum benefit, a deduction of up to $4,000 is allowed for college tuition costs and fees. If your adjusted gross income does not exceed $65,000 for singles, or $130,000 for married taxpayers filing jointly, you qualify for the $4,000 limit. If your adjusted gross income does not exceed $80,000 for singles, or $160,000 for married taxpayers filing jointly, you qualify for a $2,000 limit. No deduction can be claimed for expenses of a student for whom a Hope or Lifetime Learning credit is also claimed.

9. Fully fund Coverdell Education Savings Accounts. Contributions of up to $2,000 per child are allowed each year, and the benefit is not phased out until contributors have adjusted gross income in a joint return between $190,000 and $220,000. Tax-free withdrawals are also allowed for qualified elementary and secondary education expenses. If you begin funding early enough and fully fund all available programs, you can use the Coverdell account for pre-college costs and coordinate a Section 529 plan with the Hope credit and Lifetime Learning credit for higher education expenses.
10. Fund a Section 529, Qualified Tuition Program (QTP). Tax-free distributions can pay for many higher education expenses. In addition, QTP distributions can be coordinated with Hope and Lifetime Learning credits as long as each is used to cover different expenses.

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Structure Business Expense Reimbursements to Avoid AMT

Every year, the AMT continues to be a bigger problem for more and more middle income taxpayers. Here is one way to structure business expense reimbursement plans to avoid the AMT trap.

While an employee can deduct unreimbursed employment-related business expenses as an itemized deduction to the extent that those expenses exceed 2 percent of adjusted gross income, for alternative minimum tax (AMT) purposes no deduction is allowed. This trap can cause an employee with a modest regular tax liability to be subject to the AMT.

EXAMPLE: Hayden works for a corporation as a commissioned sales rep. His agreement with the corporation requires him to pay his travel and entertainment expenses. Many of his customers are in cities more than 100 miles from his home and he incurs substantial meal and lodging expenses while away from home. Hayden's commissions are reported as wages on Form W-2. Last year, he reported adjusted gross income of approximately $175,000 and claimed almost $60,000 of employment-related expenses as an itemized deduction in excess of the 2% floor. Hayden has taxable income of approximately $110,000 and a regular tax liability on a joint return of about $21,000. However, after Hayden adds back state taxes and unreimbursed employee business expenses, his AMT liability is almost $30,000, or $9,000 more than his regular tax liability.
Structure Hayden's compensation arrangement differently, and he can escape the AMT entirely.

Hayden's compensation will be taxed based on how it is classified by the corporation. The "right" thing to do in this case would be for the corporation to reimburse Hayden for his travel, charge that amount against his earned commissions, and pay him the difference. Expenses reimbursed by an employer pursuant to an "accountable plan" do not affect an employee's taxable income or alternative minimum tax liability.

The corporation must have an "accountable plan," in writing and adopted by its management, and will probably want some sort of consideration for the 50% limitation on deductions for amounts reimbursed for meals and entertainment. Hayden will have to keep and submit records -- accounting for all amounts to be reimbursed -- and return any unspent excess payments. If both employer and employee can tolerate the paperwork and work out who bears the cost of the meal and entertainment limitation, this can be a clear winner for both employer and employee.

We know how to implement accountable plans and can help you with documentation that will satisfy all IRS requirements. To discuss this or any other tax-planning question, just call or e-mail.

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Dangers in Shareholder Loans Continue

Loans between shareholders and closely held corporations are subject to special tax scrutiny and if not properly documented, can produce adverse tax results.

Loans from corporations to shareholders are the subject of an IRS Audit Technique Guide that stresses the possibility of treating them as distributions and therefore taxable as dividends. The IRS also continues to vigorously litigate the status of losses from shareholder loans to closely held corporations that turn out to be uncollectible. Either way, loans from or loans to, these arrangements must meet certain minimum standards. Here's a list of the most important ones.

  • Loans must be evidenced by a written unconditional promise to pay.
  • Loans must be due on demand or on a stated due date.
  • A rate of interest must be stated or determinable by reference to a published rate.
  • The borrower must be creditworthy.
  • Payments of principal and interest must be commercially reasonable (payments, not made for years, while interest accrues, do not meet the standard).
  • A source of repayment other than future income should be clearly identified and a collateral interest established.
Protecting the classification of a loan can mean the difference between ordinary loss and capital loss treatment when a shareholder loan to a corporation cannot be repaid. Going the other way, payments to a shareholder that are not well documented as loans can be reclassified by the IRS as distributions -- taxable dividends or distributions in excess of basis taxable as capital gains. Either way, these are bad outcomes for the individual shareholder.

Now is the time to clean up loan documentation and start making regular payments of principal and interest. In some cases, it may be advisable to borrow from a bank and pay off shareholder loans for a period of two or three months. That would be good evidence that the amount was a bona fide loan and that the shareholder is creditworthy.

We can assist you with proper loan documentation and can help you protect your transactions from IRS attack. Call for an appointment to discuss the specifics of your shareholder loans.

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What's the "Right Amount" of Compensation for an S Corporation Shareholder/Employee?

The S corporation has been used by small business owners to avoid payroll taxes, and the IRS knows it. Here is a case that describes how a CPA got into trouble with his own S corporation -- and how you can avoid the mistakes that he made.

An unpublished 2001 opinion of the U.S. Tax Court provides an important insight into the issue of "reasonable compensation" when considering a defensible minimum amount for an S corporation shareholder/employee. Many tax advisors agree that you can use this opinion as reliable guidance (even though it is not binding precedent) when planning such compensation. Here's a brief summary of the relevant facts and the Court's decision. Wiley Barron, a CPA, formed an S corporation to practice public accounting in Arkansas. The S corporation made substantial distributions of profits to him, but treated only $2,000 -- in one quarter during a three-year period -- as compensation subject to employment taxes. The S corporation was examined for payroll tax compliance by an IRS "officer/examiner" specially trained to deal with worker classification and payroll tax issues. She assessed payroll tax deficiencies to account for reasonable compensation and Wiley appealed to the U.S. Tax Court, where he represented himself under the Court's small case procedures.

In its opinion (T.C.Summ. 2001-10), the Tax Court said that Wiley "was the individual who was solely responsible for making management decisions and for controlling every facet of (his) business.” He was the only CPA employed by the corporation, he worked at it nearly full time, but he didn't pay himself a salary. Since the general rule is that a corporate officer is an employee [See Internal Revenue Code Section 3121(d)], it's fairly obvious that Mr. Barron was using his S corporation to avoid employment tax on his compensation: in this case, all or part of the S corporation's earnings which were distributed to him.

Mr. Barron is certainly not the first small business owner to use an S corporation to avoid payroll taxes on his income, and the IRS has aggressively pursued many of them. Until now, the position of the IRS had been -- and the Courts had generally agreed -- that the entire amount of S corporation distributions should be reclassified as compensation.

But the outcome of this particular case is unique and offers guidance for establishing reasonable compensation at less than total distributions from the S corporation. The Tax Court agreed with the revenue officer/examiner's proposed adjustments, which were based on information from Robert Half Associates regarding what "reasonable compensation" for a CPA of Mr. Barron's training and experience would be in the area of Arkansas where he practiced. That "reasonable compensation" was in the range of $45,000 to $49,000 for the years in dispute. Even though the S corporation had distributed from $56,000 to $83,000 in those years, only the amount of "reasonable compensation" based on the reliable comparable data was recharacterized as compensation and subjected to Social Security and Medicare taxes.

You do not have to live with uncertainty on this issue. We can help you determine reasonable compensation levels for S corporation shareholder/employees. We have full access to reliable comparable data and a complete library of federal tax reference material. Please call us to schedule an appointment.
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Good Reasons to File a Gift Tax Return

Filing a gift tax return can work in your favor.

If you make annual gifts to reduce your taxable estate, you may not be required to file a gift tax return. But in some cases you should do it anyway. Filing a return may save your family a great deal of bother -- and money -- in the future. This is especially true in the case of illiquid, hard-to-value assets, such as stock in a privately held business.

You are allowed to give up to $12,000 worth of gifts tax-free to as many recipients as you want each year. And if you stay within that limit, no gift tax return is required.

Married couples can give up to $24,000 to each recipient. Even if one spouse provides most of the gift, the other spouse may join in the gift and “split” it by filing a gift tax return.

When you hand out cash or shares of publicly traded companies, there's no valuation problem. Just be sure to keep records of the transaction in a safe place. But consider what can happen if you give an interest in your family business or an interest in real property. Those are hard-to-value assets.

If for example, you give your son $20,000 worth of stock in your company, valuing it at less than $12,000, no gift tax return is necessary. But what happens if, after your death many years later, your estate tax return is audited and the IRS questions the value of that transfer?

Unless your executor can justify the valuation, which can be difficult to do a decade later, your estate may face an enormous bill for back taxes, interest and penalties. Fortunately, there's a "safe harbor" you can use for protection. File a gift tax return and attach an explanation justifying your valuation. The clock starts running once you file the gift tax return, and assuming all valuations are adequately disclosed, the IRS has three years to question the valuation in that return.

You're home free once three years pass. The IRS can't look back at your gift tax return 25 years from now and demand more information from your executor. A similar situation arises when you make gifts to grandchildren or to a trust that names your grandchildren as beneficiaries. There's a painful generation skipping tax on these transfers when they exceed a $2 million lifetime exemption.

By filing a gift tax return, you can allocate a portion of your lifetime exemption from the generation skipping tax to the reported gift.

That doesn't cost anything and it may help your family avoid the dreaded tax, currently 45 percent of the “skip” amount.

Please consult with our office if you have any questions about these matters.
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The Essential Estate Tax Facts

Politicians keep talking about repealing the estate tax forever. In the meantime, it still exists. Here is a summary of essential estate tax facts.

A federal tax is imposed on the value of estates that exceed a statutory exclusion. That threshold of untaxed value is $2 million for individuals dying in 2007 through 2008; and $3.5 million in 2009. Under current law, the estate tax will expire on December 31, 2009, only to be reinstated on January 1, 2011.

Heirs may choose to determine the value of an estate on the date of death or exactly six months later. Surviving spouses never have to pay federal estate tax on amounts they inherit, no matter how large.

The tax rate starts at 18% and increases to 45% in 2007 (46% in 2006) for taxable estates worth more than $2 million. However, any amount that might be taxed in the low brackets is covered by the $2 million exclusion. As a practical matter then, the estate tax begins (and ends) at 45% on amounts over $2 million.

Real property used by family-run farms and businesses that is passed on to younger generations may be entitled to a special exclusion of value to reduce the estate tax burden on it. To qualify, the heirs must have been actively involved in running the business. If an estate tax is due, the heirs who run these enterprises can have up to 14 years to pay.

To keep an estate within the exclusion limit, an individual can give as much as $12,000 a year, tax-free, to an unlimited number of people, from close relatives to strangers. A couple can give $24,000 jointly. Under a 1997 law that ties the tax-free gift limit to inflation, the limit may continue to increase in $1,000 increments when inflation justifies an increase. In addition to annual exclusions, each taxpayer may exclude gifts of up to $1 million from gift tax. A properly completed gift will also be excluded from the estate tax.

If you have any questions about the infamous disappearing and reappearing Estate Tax, please call.

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Sharing Your Stock Market Losses With Uncle Sam

If you've lost money in the stock market, you should be aware of the tax breaks that capital losses can generate and how to avoid the tricky wash sale trap.

Uncle Sam is always happy to tax you when you make money. But what happens to your tax situation when you experience losses? Not every investment will be a winner, so learning how to take advantage of the tax treatment of capital losses may be as important to you as the recent run-up in the major stock indexes.

Generally speaking, capital gains and capital losses are reported on federal Form 1040, Schedule D, for the year in which the actual sale of capital assets such as stocks, bonds, and mutual funds occurs. A temporary decrease (or increase) in the value of an asset is not reported on your tax return; the asset must actually be disposed of. In the eyes of the federal government, the old Wall Street adage applies: "You don't make a profit or take a loss until you sell."

Net capital gains and losses are aggregated, and up to $3,000 of a net capital loss may be deducted against ordinary income items such as wages, interest, and dividends. Capital losses in excess of $3,000 are carried forward and deducted in future years, subject to the same limitation.

Gains and losses from the sale or disposition of capital assets are classified as long-term or short-term, depending on how long you held the asset. For example, a long-term capital asset is currently defined as an asset you have held for more than one year. Long-term capital gains generally receive favorable tax treatment. While the top tax bracket for ordinary income items such as wages is 35%, the maximum tax rate for long-term capital gains is capped at 15%. Short-term capital gains are taxed at ordinary income tax rates.

In addition to netting rules that apply when there are both capital losses and gains, you need to understand the "wash sale" loss limits, especially if you engage in frequent or "day" trading. The wash sale rule is intended to prevent you from selling assets to claim a tax loss and quickly reacquiring them. The rule stipulates that your loss will be disallowed if you purchase substantially identical stock or securities, including put and call options, within 30 days of the original sale.

The IRS of course is on the watch for wash sale violations. The wash-sale period runs for a total of 61 days -- 30 days before and 30 days after the date of the claimed loss. Year-end sales made in December also do not escape this treatment. Even if the tax year ends during the 61-day wash sale period, the loss will be disallowed if the wash sale period is violated.

Here's a coordinated investment and tax strategy you may want to consider.

While the wash sale rule prohibits you from reacquiring substantially identical securities during the specified time period, it does not prohibit you from reacquiring comparable securities. For example, you could sell shares of an industrial stock like Caterpillar, claim the loss for tax purposes subject to the rules discussed above, and immediately acquire shares of a comparable security such as Deere. This is known as tax loss swapping. The theory behind it is that if Caterpillar (the security sold at a loss) subsequently rises, so will Deere (the comparable replacement security), giving you both an economic gain and the benefit of the tax loss.

In theory, tax loss swapping is an excellent strategy, but it can prove risky in the real world. For example, the replacement security could go down even if the disposed-of security recovers. On the other hand, the replacement security could increase a small amount, while the disposed-of security enjoys bigger gains. The acceptable risk and return ratio and performance spread for tax loss swapping depends on your tax bracket, liquidity, net worth, and risk tolerance.

Fundamental economics of investment decisions should not be ignored in pursuit of tax benefits. The laws and risks applicable to wash sales and tax loss swapping are complex, and mistakes can be expensive.

We are highly experienced with both issues. Please feel free to call if you have questions about using your capital losses.

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